CONSOL Energy Could Double After Spinoff
By Matt Franz
November 14, 2017 - The market views CONSOL Energy as a coal company, but over half of its value is in its natural gas operations.
"Outsider" management is pursuing a spinoff to separate the coal and gas assets. They are prepared to buy back stock.
Conservative estimates of intrinsic value suggest the stock could double after the spinoff.
The market views CONSOL Energy (CNX) first and foremost as a coal company. But more than 50% of the company's value is now in its Marcellus and Utica natural gas E&P operations. To help the market realize this management is splitting up the company with a tax free spinoff. The result will be a pure-play Marcellus and Utica shale E&P gas company and a low-cost Appalachian coal miner.
Below I explain how the spinoff came about, analyze management's incentives, and analyze the company's intrinsic value using the sum-of-the-parts technique. The names and tickers of the ParentCo and SpinCo will change after the spinoff, so for simplicity I refer to the companies as "GasCo" and "CoalCo". At the end I explain which business will be called what post-spin.
Background
Management and investors have felt the company was undervalued for years. Mason Hawkins of Southeastern Asset Management first bought a position in the company in Q1 of 2012 (Source: 13F-HR, 05/14/2012). David Einhorn of Greenlight Capital bought shares in 2014 Q3 (Source: 13F-HR, 11/14/2014). Energy prices collapsed during 2015 which hurt the company. Hawkins has not criticized the company's management. But he wanted them to move ahead with their restructuring plans faster so he filed a 13-D in July 2015.
Hawkins wrote in his 2015 Q4 commentary:
CONSOL Energy, the Appalachian coal and natural gas company, was down 76% in 2015 after falling 19% in the fourth quarter as the company missed operating cash flow (OCF) estimates amidst declining coal and gas prices. Management is adjusting to lower commodity prices and adopted significant cost controls under zero-based budgeting while still growing natural gas production. We led a 13-D during the third quarter to discuss with third parties as well as management and the board a potential monetization or separation of the valuable Marcellus and Utica gas assets. This has been a constructive process since filing, and we appraise these assets at worth demonstrably more than CONSOL’s total equity capitalization. CONSOL’s exploration and production (E&P) business is unique, with low cost reserves given the company’s fee ownership of many acres. CONSOL announced in the fourth quarter that its thermal coal business, which enjoys a low cost position, had contracted for 93% of production for 2016 at a confirmed price of $50-55 per ton, providing near-term downside coal business risk mitigation. Multiple directors recently purchased shares.
Since then the board has been reshuffled. Most notably William Thorndike of Housatonic Partners was brought in as Chairman of the Board. Thorndike is well known for writing the book Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint For Success.
Today Einhorn owns 22.6 million shares, which is about 5% of his total portfolio and his 5th biggest position. Hawkins owns 47.7 million shares, which is also about 5% of his capital and also his 5th largest position. Together they own approximately 30% of CONSOL Energy.
It's a reasonable to assume that with Thorndike at the helm and Einhorn and Hawkins on-board, capital allocation will be excellent. In fact the ParentCo (GasCo) has repurchased $81 million worth of shares in October and announced a new repurchase authorization for $450 million following the spinoff (Source: Press Release).
As Joel Greenblatt teaches in You Can Be A Stock Market Genius, many spinoffs see selling pressuring during their first few days. Management looks well prepared to capitalize on this if it materializes.
Management Incentives
Greenblatt also teaches that the most important thing in spinoff investing is to figure out what's in it for management. Since Thorndike came on board, the compensation scheme has been simplified. The company believes in "pay for performance" and as such 90% of the CEO's pay, and 80% of other executives is "at risk". The at-risk component is a mix of short-term and long-term compensation and is paid primarily in company stock to promote an ownership mentality.
Short-term compensation is tied to free cash flow generation, with modifiers (+/- 30%) for safety, environmental, and stock price performance metrics (Source: 2017 Proxy Page 38).
Long-term compensation is tied to stock price performance: 50% relative to the S&P 500 and 50% in absolute terms. 55% is paid in PSUs and 45% in options. These vest over a five year periods based on the stock's performance (Source: 2017 Proxy, Page 39).
Spinoff Details
The ParentCo (GasCo) will distribute 100% of its interest in CoalCo tax free. Investors in the ParentCo will receive 1 share of CoalCo for every 8 shares of ParentCo they own. The record date is 11/15/2017 and the distribution date is 11/28/2017. "When issued" trading is expect to begin on 11/14/2017 and "regular way" trading on 11/29/2017 (Source: Press Release, 10/31,2017).
CoalCo
The CoalCo's assets will consist of:
- A 90% interest in the Pennsylvania Mining Complex (OTC:PAMC), comprised of:
- A 75% undivided interest in the PAMC.
- A 60% limited partner interest and a 1.7% general partner interest (reflecting 100% of the general partner units) and 100% of the incentive distribution rights in CNX Coal Resources LP (CNXC), which owns the remaining 25% stake in PAMC.
- A marine terminal at Baltimore Port.
- 1.6 billion tons of coal reserves in the Northern Appalachian, Central Appalachian and Illinois basins.
This is summarized in the graphic below.
Source: Form 10-12b/a Page xii
CoalCo will assume $800 million of debt and distribute $425 million to GasCo before separation (Source: Form 10-12b/a Page 48). Pro Forma net debt (debt and capital leases less cash) will be $733 million (Source: Form 10-12b/a Page 46). CoalCo will have 28 million shares outstanding based on approximately 230 million of GasCo shares (Source: Form 10-12b/a Page 45).
CoalCo's most valuable asset is the PAMC, which is a a large, longwall mining complex. Longwall mining is a highly automated underground mining technique. The Washington Post explains that it "shaves coal off the face of the coal seam with each pass — a little like slicing brisket." As a result, CoalCo's cost of production is very low. According to David Einhorn, only 12% of coal in Appalachia has a lower cost of production (Source: Presentation, Slide 22). This is an critical competitive advantage to have when you produce a commodity.
CoalCo's coal is also higher quality than most mines produce. On the 2015 Q3 earnings call, management said:
Since our coal is 13,000 BTUs per pound it travels very well. People often forget to take into account BTU adjustments when comparing the different basins. Not all tons are created equal, and CONSOL has a premium product which is illustrated by our contracting success.
To value CoalCo I use multiple approaches. First, I use CNXC's market price to figure out the implied value of the PAMC. Then, I consider the valuation of comparable companies with respect to EV/EBITDA and EV/Reserves. Finally, I consider David Einhorn's November 2015 valuation as a double check.
CNXC owns 25% of the PAMC. Its enterprise value is $548 million with the stock at 13.40. This implies that CoalCo's 90% interest is worth $1,973.
Source: Author, Data From 10-Ks
CNX's Q3 presentation (slide 12) guides for $340 million of EBITDA in 2017 for CoalCo.
Below is a summary of valuations taking the average EV/EBITDA and EV/Reserves from above.
Source: Author, Greenlight Capital 11/2015 Presentation Slide 26
These estimates are particularly wide. The value of reserves can differ based on where they are located, which makes EBITDA a little more reliable in this case. Even more reliable is CNXC's current market price. The market is likely to value CoalCo's interest in PAMC the same as it values CNXC's. Using these two valuations narrows the intrinsic value estimate to $5.40-6.60 per share, pre-spin.The post-spin equivalent is $43.20-52.80.
This intrinsic value estimate gives no credit to the Marine Terminal, which is worth something, but I'm not sure what. It's strategically valuable to CoalCo because it gives them the option to sell coal abroad if domestic demand dries up.
GasCo
A summary of GasCo's assets are below:
Source: 10-K, Page 9
The most valuable assets are the reserves in the Marcellus and Utica shale formations. At current prices it does not make sense for the company to invest beyond the bare minimum in its coal bed methane operations. This is what management is doing and production continues in runoff. Einhorn believes this business is worth $900 million (Source: Greenlight Capital Presentation Slide 28).
The GasCo's primary competitive advantage is that it owns much of its acreage outright, not by lease. This means it does not have to pay royalties like competitors do. It also means that it is not under the gun to drill. It can wait for the market to trade at a price which justifies the drilling (Source: Greenlight Capital Presentation Slide 45).
I value the GasCo's Marcellus and Utica operations via comparable EV/PV-10 and EV/Reserves.
Source: Author, Data from 10-Ks
Below is a summary of valuations taking the average EV/PV-10 and EV/Reserves from above.
Source: Author and Greenlight Capital's 11/2015 Presentation Slide 50
In addition, GasCo owns 21.7 million shares of CONE Midstream Partners LP (CONE). This is worth $1.58 per share at CONE's market price.
Nobel Energy (NBL) recently sold it's interest in CONE Midstream for $765 million, cash (Source). This suggests CONSOL's stake is worth $3.33 per share to a private buyer. To be conservative I will continue to use the CONE's market price as the intrinsic value.
This does not take into account any value of GasCo's runoff CBM business, which, at $900 million, would be worth an additional $3.91 per share, according to David Einhorn.
Sum Of The Parts Valuation
In summary, the CoalCo is worth $5.40-6.60 per share on a pre-spin basis. The GasCo is worth $22-31. That's $27.40-37.60 total, and the stock trades at $15.75.
Using a the Nobel Energy sale to value CONE Midstream and Einhorn's estimate of the CBM business adds an additional $5.66 of value per share.
Catalyst
There are two clear catalysts to the company realizing this value. The first is the spinoff, which will force the market to recognize the GasCo and the CoalCo's assets separately.
If the market doesn't revalue the company higher, the ParentCo (GasCo) is prepared to buy back up to $450 million of stock, which is the second catalyst.
In Greenlight's Q3 letter Einhorn wrote:
We expect the separation between the coal and natural gas businesses to be completed this year and we are surprised that the shares have not re-rated much in anticipation of that event. We believe this position is particularly promising in the near-term as the market focuses on the new math. Notably, CNX announced its first share repurchase program in many years.
In the Q3 earnings call CNX management said:
We'll continue to opportunistically buy back the shares as the market conditions warrant it, and our execution of the share repurchase program, it should indicate our level of conviction when it comes to EBITDA ramp and leverage profile from this point forward.
Risks
The primary risk when investing in a commodity company is commodity prices. Lower gas and coal prices will hurt the company just as higher prices will help. The threat of low prices over the long term is partially mitigated by the company's low cost structure: prices cannot remain below the lowest cost of production forever. But they can go lower in the short term.
Name Changes
Source: Press Release, 10/31/2017
The names changes are a little confusing because the SpinCo (CoalCo) will retain the CONSOL Energy name, but with a new symbol. The GasCo will have a new name and the old symbol.
Summary
A simple sum-of-the-parts valuation points to a value significantly higher than the market price. Capable owners and experienced capital allocators are well incentivized to make sure the market values the company properly. The record date for the spinoff is November 15th, and "when issued" trading should begin on the 14th.
Nacco Industries (NC) is a coal company which recently completed a spinoff. It's shares are up over 30% since, suggesting that the market has an appetite for coal spinoffs.
Normally I would not invest in a mining or E&P company. But I have confidence in the capital allocation skills of Einhorn, Hawkins, and Thorndike. This, combined with a 50% discount to intrinsic value, means investors are unlikely to lose money in CNX. An imminent catalyst means investors stand a good chance of achieving high near-term returns.