Look at this chart! This kind of visual makes an oil and gas CEO proud when addressing his Board of Directors or shareholders.
Source: Southwestern Energy Corporate Presentation
But despite this beautiful production growth chart–this company has COST investors BUCKETS of money over the past two years.
I’ll explain to you what happened–and how you as an investor can avoid making the mistake of losing money in the future on a company like this.
A Whole Lot Of Running To Get Absolutely Nowhere
That beautiful looking production growth chart is Southwestern Energy’s (SWN:NYSE) average annual production. The growth is there every year–and it is explosive.
Over this eight year period Southwestern’s production grew by 863%. That is an annual compound rate of growth over 38%. This is quite an operational achievement to be sure.
Now as to whether it is actually a financial achievement……that’s an entirely different story.
The next chart is even more impressive–but not in a good way.
Source of Data: Southwestern 10K’s and Corporate Presentation
This chart is Southwestern’s historical EBITDA (essentially, cash flow from operations with interest and taxes stripped out) for 2007 through 2015.
The 2016 number is Southwestern’s original 2016 EBITDA guidance. When looking at this chart, please remember that production has increased 800%…and then realize that despite that……EBITDA in 2016 is lower than it was in 2007.
An eightfold increase in production, yet no increase in cash flow. Ouch. Double Ouch.
But there is no mystery as to what has happened here. Natural gas prices in the first half of 2016 were absurdly low. The 2016 guidance figure is based on an assumption of $2.35/mcf natural gas.
We’ve had low natural gas prices for a couple of years, but in 2016 the Market is getting to see what the cash flow from shale gas producers looks like without the benefit of hedges that were layered on back when commodity prices were higher.
As full disclosure I’ve used the original Southwestern 2016 EBITDA guidance in my chart. The company has since revised that number up to $675-$700 million on slightly higher natural gas prices, but also on increased production that is coming as a result of an equity issuance (more dilution!) done mid-year.
Source: Southwestern Energy Corporate Presentation
Even with the revised guidance that is a result of the equity issuance, EBITDA is still only expected to come in at 2007 levels.
That is a whole lot of running between 2007 and 2016 without actually getting anywhere. That just says this is a cyclical business (surprise!) and you have to know how to trade these energy producers. But how do you know when to get off a fast moving bus? I’ll tell you.
The Rest Of The Story – The “I” In EBITDA
The EBITDA numbers are Capital U Ugly. Southwestern, by the way, has historically been very well respected team with some very high quality natural gas assets.
The story gets even more bleak when you factor in the cost of servicing Southwestern’s debt–which at one point was quite manageable.
In 2007 Southwestern had just $36 million of interest payments for the entire year against $675 million of EBITDA. That meant that after making those interest payments Southwestern had $639 million of cash flow, or 95%, available for capital expenditures to grow. Southwestern ended 2007 with $970 million of long term debt.
In 2016 where Southwestern will have similar EBITDA, yet now, interest expense through just six months has already been $109 million through June 30 and will exceed $200 million for the year.
With Southwestern’s new guidance EBITDA of $675 million that leaves only $475 million for capital spending. That number by itself isn’t that much lower than 2007, but here’s the key point to focus in on:
In 2016 Southwestern needs a capex budget that is multiples of 2007 to offset production declines on the corporate production base that is 8 times larger. That is why Southwestern’s production is now falling; it doesn’t have the cash flow to sustain it.
Yeah…I should mention that Southwestern now has $5.7 billion of long term debt with EBITDA that is more appropriate for the $1 billion of debt that company had in 2007. Same cash flow today as then, but nearly six times the debt.
More on how all of that debt got on the books in minute.
The hardest number to look at has to be Southwestern’s cash flow from operations figure for the six months ended June 30, 2016. After interest expense was paid this company with $5.7 billion of debt generated just $165 million of cash before capital spending.
That annualizes to $330 million or 15.6x debt to cash flow (15.6:1). Those numbers just don’t work.
If The Market Doesn’t Like An Acquisition – Don’t Hang Around
Southwestern had a “fork in the road” moment in 2014 and the company went the wrong way.
After years of running with a clean balance sheet, Southwestern gambled and took on a huge debt load to acquire some choice Marcellus assets from Chesapeake (CHK-NYSE) near–what management thought–was the bottom of the natural gas market.
That self-inflicted damage is what drove Southwestern’s share price down 90% to $5 earlier this year. The decline in natural gas prices has been damaging, having all of that debt is what made the damage life-threatening.
Southwestern’s management felt that the acquisition was going to be a homerun. Except the ball landed in the graveyard.
They believed that this was a case of the financially strong company being able to take advantage of Chesapeake the desperate seller. Southwestern’s CEO said as much in the press release that announced the deal:
“Our patience and disciplined approach to investing every dollar we spend has led to this outstanding opportunity,” added Mueller.
It hasn’t worked out that way.
With that deal Southwestern’s debt increased from $1.9 billion entering 2014 to $6.9 billion at the end of the year. Then–when natural gas prices didn’t recover and instead dropped further–Southwestern’s survival was brought into question.
Shareholders paid–and are still paying–a painful price.
There is a valuable lesson to be learned here for investors!! And it’s an easy one!
Southwestern is just another in a long line of companies that have ruined years of disciplined balance sheet management with one big acquisition–good companies, with good assets taking the wrong path at the wrong time.
Baytex Energy (BTE:NYSE) buying Aurora in 2014 is one example. Encana (ECA:NYSE) acquiring Athlon is another. For a third how about Whiting Petroleum (WLL:NYSE) purchasing Kodiak.
The list goes on….
I’ve avoided getting stuck holding these acquiring companies for the subsequent stock collapse because I have one simple rule:
If the buying company’s stock price drops 10% below the financing price of the equity issue used to pay said acquisition–I sell. If there was no new shares issued, I just use the closing price of the PREVIOUS day’s market as my benchmark.
If the deal isn’t a good one–the market will tell me quickly. And I’m not going down with any ship.
This rule has served me well in the past and I believe will serve you well in the future. On October 13 2014 SWN closed at $31.99. It took until Dec 8 of that year for the stock to drop 10% below that price…but that was THE SIGN for investors to leave the stock until it climbed above the price the stock was at the day before the deal was announced. It never did.
If I buy a financing on an energy producer, I sell the stock if it stays below issue price for more than two days, and will only buy it back once it’s above issue price again. The odd time I get whipsawed out of a good stock–but very rarely.
With SWN, a good management team made only one mistake and shareholders won’t recover for years. Their cash flow shows how highly cyclical the business is, and I’ve shown you one way to avoid the deep down-drafts off the top.
A company can spend 20 years doing a great job taking care of its balance sheet–and ruin all of that effort with one stroke of a pen.