CNX Resources Corp Q4 FY2022 Earnings Call

Good day, and welcome to the CNX Resources Fourth Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. And please note that this event is being recorded. I would now like to turn the conference over to Tyler Lewis, Vice President of Investor Relations. Please go ahead.

Thank you, and good morning, everybody. Welcome to CNX's fourth quarter conference call. We have in the room today Nick DeIuliis, our President and CEO; Alan Shepard, our Chief Financial Officer; and Navneet Behl, our Chief Operating Officer. Today, we will be discussing our fourth quarter results. This morning, we posted an updated slide presentation to our website. Also detailed fourth quarter earnings release data, such as quarterly E&P data, financial statements, and non-GAAP reconciliations are posted to our website in a document titled 4Q 2022 Earnings Results and Supplemental Information of CNX Resources. As a reminder, any forward-looking statements we make or comments about future expectations are subject to business risks, which we have laid out for you in our press release today as well as in our previous Securities and Exchange Commission filings. We will begin our call today with prepared remarks by Nick, followed by Alan and then we will open the call up for Q&A where Nav will participate as well. With that, let me turn the call over to you, Nick.

Good morning, everybody. 2022 marked the best year ever for CNX as a public company with respect to free cash flow generation. The fourth quarter marked 12 consecutive quarters of significant free cash flow generation, which helped produce an annual record of $707 million. We utilized the free cash flow to reinvest into the asset base, reduce debt, and to acquire our discounted shares. Cumulatively, you add all this up, we've retired nearly 25% of the outstanding shares of the company since the inception of the share repurchase program in 2020. To put this in perspective in terms of the total impact, the cumulative result of acquiring nearly a quarter of our company in a short period of time has been matched or vested by only four other companies in the S&P 500 and only by 22 companies in the S&P 1500. When you consider the steep discounts in price that we enjoyed when acquiring our shares relative to the low-risk, long-term free cash flow yield and the intrinsic per share value, CNX may very well be unique in the S&P 1500 universe of public companies. We're doing two things simultaneously: material share count reduction and at the same time, at a substantial discounted price. While we typically reference share repurchases since the midstream acquisition, we've been consistently repurchasing shares since 2017. And we’re potentially just getting started because if we continue to see substantially undervalued shares, we're going to continue to opportunistically acquire ourselves to grow per share value for owners. Stepping back for a moment to assess the results of the past few years, it’s clear that at the halfway point of our initial seven-year plan that we provided in 2020, we’ve exceeded our initial expectations. The long-termism that wraps around our sustainable business model and that’s embedded in our decision-making is beginning to add up to incredible achievements on our key objective of long-term, low-risk free cash flow per share and, more importantly, allocating that free cash flow thoughtfully to produce, in the end, a drastically reduced share count and reduced debt level. This underpins our ability to grow long-term free cash flow per share in various macro environments over the next decade and beyond. Despite the important success of 2022 and the continuing march of our long-term strategy, we find ourselves amid very chaotic times. There are broader macro challenges that the industry has to contend with moving forward, particularly increased inflationary pressures in the second half of 2022, coupled with the rapid deterioration of pricing through this winter, creating near-term challenges throughout the industry. In CNX, we're not immune to either challenge, although I will say we are better positioned than most due to our midstream ownership, our focused activity set and due to our programmatic hedging strategy. Although these two issues will impact near-term free cash flow generation, we're still able to execute the core tenets of our sustainable business model, as we have consistently done year after year across all phases of the macro and commodity cycles. The next seven years are going to set up to be vastly improved compared to the original seven-year outlook laid out back in 2020. Our consistent generation of substantial free cash flow per share stems from the foundations of our competitive moat, much of that captured in our Appalachia First Vision. I encourage you to review it if you haven’t seen it already or to revisit it if you want to take another look. The competitive advantages that CNX brings are tied effectively to the strength of the Appalachian region itself. To summarize the three largest contributors to the CNX competitive moat: First Advantage, we have a unique stacked pay position in Appalachia with the Marcellus and Utica, presenting an unparalleled opportunity to lead in the development of what we believe will be one of the world’s top two most prolific natural gas basins. The second major strategic advantage we have is our integrated upstream midstream structure, allowing us to make long-term investments to generate high rates of return, effectively creating the lowest all-in operating costs in the basin. The third strategic advantage is our opportunity set within our new technologies business segment, such as methane capture and abatements regarding transportation fuel market development and overall technology deployment. These continue to differentiate us and create growth outlets for CNX as the world focuses on lower emissions and lower risk energy solutions. All three pillars of these strategic advantages support a sustainable business model that generates significant free cash flow to simultaneously reinvest into the business, reduce debt, and acquire our discounted shares year after year. This is basically a long-term recipe for success anchored by our Appalachia First Vision. In 2023, each of these themes is playing out in various ways regarding our capital allocation. Some allocation decisions, like our core D&C program, may be familiar. Other capital allocations, including those in the new technologies segment, were discussed in 2022 but are now becoming tangible in 2023. Allow me to touch on each of these broad buckets of capital investment for 2023. The first bucket is the continuation of a 1.5 rig plus 1 frac crew D&C program to develop our core Southwest Pennsylvania assets. This will comprise the bulk of our 2023 capital spend, subject to the inflationary pressures experienced earlier. However, today’s higher capital costs are offset by the increased pricing outlook we continue to hedge. Our project-level returns remain robust in this environment, thanks to our consistent derisking approach. While some are suggesting inflation is waning, we assume current inflationary pressures will persist throughout our 2023 activity set. If inflation does drop in 2023, we can adjust capital guidance accordingly. However, we are committed to using the highest quality crews and products to ensure long-term focused decisions that will derisk our plans. The second component of our capital investment plan for 2023 is our fully integrated midstream and water infrastructure. Similar to last year, we are investing capital dollars in 2023 to enjoy the returns and benefits over the next 30 years. While these projects underpin our long-term plan, the magnitude of these investments will vary year-to-year due to inflationary pressures and planned timing shifts as we constantly evaluate how to best derisk and delineate and profitably develop our stacked pay fields. Many of these highly accretive life-of-field investments not only solidify us as the region’s low-cost operator but also raise our ESG performance. For example, this year marks the construction of a centralized above-ground water storage tank facility in our Southwest Pennsylvania field. This facility will provide a low-cost, low-risk water supply while starting to phase out in-ground impoundments without adding trucks to the road, which is an excellent outcome from our perspective. Lastly, in terms of capital programs for 2023, we have targeted several discretionary capital allocation opportunities whose risk-adjusted returns compete for investment and reinforce our Appalachia First Vision. For instance, in 2023, we will be participating as a major non-op partner in the Pittsburgh International Airport project. This project is crucial for CNX and our Appalachia First Vision, as it continues with the terminal modernization program and is pivotal for the wider region, given the airport’s role as an economic development engine. This project, alongside several other emission reduction business opportunities in our new technologies unit, lays the cornerstone to support that Appalachia First Vision. Next, I want to pivot to our 2023 production outlook. Production, as you know, is a result for us, not an objective within our strategy and business model. While our focused activity set results in lower operational risk and long-term certainty of execution, any short-term delays or disruptions will create noise in production on a quarterly or yearly basis. For example, as we discussed in the Q3 call last year, we faced delays associated with an abandoned Utica wellbore. While we initially planned to offset those delays and maintain flat production levels year-over-year, weather-related and other operational delays in last year's fourth quarter flexed production levels. Therefore, we now expect production in 2023 to be modestly lower compared to 2022 and the lowest in the first quarter, gradually building throughout the year as TILs accelerate. Most importantly, we anticipate returning to our 2022 production level run rate around midyear 2023. After midyear, we expect to see elevated annual levels in 2024 and beyond. This is a short-term issue. The plan for 2023 is straightforward: continue the march of our sustainable business model. Before handing it over to Alan for further discussion, I’d like to introduce our new Chief Operating Officer, Nav Behl. Nav has extensive experience and a proven track record of building effective teams, developing shale plays, and offshore work globally. His diverse experience and impressive technical expertise are already proving invaluable as we pioneer the benefits of the deep Utica in the Appalachian Basin while focusing on our operational plan’s safe and compliant execution. This is a highly competitive business, and we aim to win on behalf of our owners. Therefore, whenever we have an opportunity to improve the team, we will act swiftly. We are fortunate to have Nav join us, and you can expect to see and hear more from him in the future. With that, I’m going to hand it over to Alan.

Thanks, Nick, and good morning to everyone. As Nick mentioned, this quarter represents the 12th consecutive quarter of free cash flow generation through the execution of our sustainable business model grounded in clinical capital allocation to optimize long-term free cash flow per share growth. In the fourth quarter, we generated approximately $276 million of free cash flow, totaling $707 million for the year. This brings our three-year cumulative total free cash flow close to $1.6 billion, approximately 55% of our current market cap. Let’s first turn to the capital allocation side of the business as highlighted on Slide 5. As you can see, we continued our market-leading shareholder return initiatives by purchasing 12.6 million shares in the quarter and another 1.3 million shares after the close of the quarter through January 17. In other words, we bought back nearly 7% of our total shares outstanding during that time. Since we started this program in Q3 2020, we have repurchased approximately 24% of the outstanding shares of the company. We continue to see this as a remarkable low-risk capital allocation opportunity. Although we have not provided an explicit capital allocation framework, extrapolating these levels of buybacks moving forward indicates that we will continue to drastically reduce our denominator and significantly grow our long-term free cash flow per share. On the balance sheet side, this quarter, we reduced adjusted net debt by $57 million, bringing our annual total reduction to $107 million or $360 million since we began the program in Q3 2020. More importantly, our robust liquidity position and long-dated debt maturity profile enable us to take advantage of any deepening valuation disconnects in either the equity or debt markets. Let’s now shift to our updated 2023 outlook on Slide 6. From a macro perspective, we expect recent pricing volatility to continue in 2023 due to fluctuations in U.S. domestic markets driven by shifting weather expectations, uncertain domestic production levels, and increasing LNG demand worldwide. The unfolding of gas prices in 2023 will depend on this challenging interplay. Despite the uncertainty, CNX's focus will remain on safely and efficiently developing our assets and generating free cash flow for clinical allocation towards reducing our debt and share count. The combination of these core elements is easy to predict: high rates of return on our capital investments and sustainable long-term per share value growth. Our initial expectations for 2023 production volumes are between 555 and 575 Bcfe, marking a slight decline based on the midpoint of guidance versus the 2022 production total of 580 Bcfe. As previously discussed, 2022 brought various operational delays, particularly from the abandoned Utica wellbore, resulting in reduced production. Recent weather and operational delays in Q4 2022 are expected to make Q1 volumes the lowest quarter of the year, with quarter-over-quarter increases anticipated moving forward. Despite operational delays faced in 2022, we believe we've made the necessary adjustments that will enable a return to our 2022 production run rate of approximately 1.6 Bcf per day around mid-2023. Based on our 2023 production range and using January 5 strip pricing, we expect annual EBITDAX to range between $1.1 billion and $1.25 billion. Given that our 2023 gas production volumes are roughly 80% hedged, this EBITDAX range includes estimated open volumes of around 100 Bcfe. As we saw throughout 2022 and in recent weeks, extreme volatility in natural gas markets will significantly impact near-term results, but forward prices along the strip remain materially higher than in previous years. Consequently, rates of return on capital investments remain high and even improved under this environment. Our future business plan not only remains intact but has also strengthened. Regarding the 2023 capital outlook, we anticipate a capital range for the year between $575 million and $675 million, reflecting the continued operational plan utilizing approximately 1.5 drilling rigs and one continuous all-electric frac crew. This budget assumes a full year of increased inflationary costs experienced during 2022 and reflects our intent to use the highest-quality crews and products, making the best long-term decisions to derisk our plans. In terms of budget components, around 75% is allocated to D&C capital, including pad construction and production equipment; approximately 20% to non-D&C capital towards the core business, including midstream and water pad hookups and other centralized infrastructure; and the remaining 5% is discretionary capital investments for opportunities that outcompete other potential capital expenditures. For instance, we will be spending discretionary capital on a major non-op pad to provide multiple benefits for economic terms while supporting our Appalachia First Vision. Additionally, we are directing targeted capital towards our new tech business group to advance mine methane abatement projects and other emission-reduction technologies. We believe these discretionary investments will yield significant returns and represent prudent actions today. Using the midpoint of guidance ranges, we set our initial free cash flow outlook at approximately $375 million. Based on that estimate and our current share count, free cash flow per share is projected at around $2.20. Notably, this estimate does not rely on potential year-end share count projections but rather reflects our latest share count. Overall, our goal remains to grow the long-term free cash flow per share of the company, and our 2023 business plan marks another step in achieving this objective. Now let's shift to Slide 7. This new slide highlights our hedging strategy, which programmatically locks in higher future gas prices. The dark blue portion of the graph represents the percentage of hedges as of Q1 2022, while the light blue section displays hedges added over the last three quarters. The tan dashed line illustrates open volumes assuming the midpoint of our 2023 production guidance of 565 Bcfe and estimates for 2024–2027, reduced by 7.5% for liquids. As Nick mentioned, the current higher capital costs are offset by the enhanced pricing outlook we continue to hedge into. Our project-level returns remain robust in this environment, thanks to our consistent derisking approach. Thus, our execution strategy remains intact despite the recent volatility in commodity markets, affirming our confidence in our sustainable business model. We believe our focus in 2023 will continue to revolve around safe and compliant execution to develop our extensive asset base, and our clinical capital allocation drives long-term free cash flow per share growth. In essence, we will operate with an owner mindset.

Thank you, Alan. Operator, if you can open the line up for questions at this time, please.

And our first question today will come from Zach Parham with JPMorgan. Please go ahead.

Nick, I know you mentioned that project level returns are robust at current prices and that you've got a significant amount of volumes hedged. But given the pullback in natural gas prices, would you consider delaying some completions or slowing activity at all? And if not, is there a price level where you might consider slowing down?

Zach, yes. There’s always going to be a price level where we adjust our activity or capital allocation regarding repurchases, debt, and other avenues. The process remains constant. We are continuously running this analysis. In conclusion, there is a substantial risk-adjusted acceptable return on our activity set regardless of foreseeable gas prices. We continue to run the figures, as it helps us contemplate how that impacts the NAV per share of the company compared to other allocation decisions like share repurchases. However, whether it’s share repurchases or the activity we’ve outlined, we’re good to go.

Just one follow-up. I know a lot has changed since you initially rolled out the seven-year plan several years ago. But in that plan, you expected operating costs to decline over time. Could you provide an update on how you expect those cash costs to trend in 2023 and going forward?

Yes. We still expect cash costs to trend lower. The '21 and '22 timeframe represented a higher mix of wet gas as we brought on additional Shirley-Penn pads, contributing to higher processing and associated costs. Additionally, higher severance taxes as pricing has increased played a role. Moving forward, as we replace legacy production with our own gathered infrastructure in SWAP CPA, you can expect to see our costs come down.

I was hoping you could speak a bit more on the operational slippage discussed in the fourth quarter. You mentioned issues with the abandoned Utica well, but were there any other major supply chain or labor issues you faced? Given the tight supply chain market, has it been difficult to source equipment rapidly?

Leo, essentially, we have a 1 frac crew program, which means any delays will push future pads to the right. The biggest contributor last year was indeed the abandoned Utica wellbore, followed by weather and a few other issues in Q4. Overall, those delays were primarily internal rather than external. We encountered supply chain issues like others in the basin, but we chose to allow production to dip in Q1 and refocus on returning to our 1.6 Bcfe run rate.

Regarding CapEx range in '23 at $575 million to $675 million, that seems to reflect a 15% to 18% increase. You mentioned assuming inflation would continue in that range; could you help us understand how to approach the lower end versus the higher end?

The range reflects the potential for softening inflation towards the year's end. You'll likely see elevated prices in the first half. There may be a reduction in supply chain costs later due to declining prices. For non-D&C investments, there will be additional variability since those bids can shift significantly based on the prevailing environment. Thus, we opted for wider ranges. We’ll clarify further as the year progresses.

On the topic of OFS inflation, it seems your day rates might be higher than for some rivals. Do you believe that the benefit of employing higher-end rigs and fracs justifies these extra costs? Also, could you comment on what you are seeing regarding OFS inflation year-to-date?

Our priority is to secure consistent crews rather than pursuing spot crews. While this might necessitate paying a bit more, we prefer stability in our supply chain to underpin our business. We’re not looking to pinch pennies on spot crews just to save a small amount. Anticipating OFS inflation for the year, the current levels reflect late 2022 rates, but expect softening as prices decline, which works as consistent with historical trends.

In terms of our strategic financial and operational strategies, we remain open to considering alternative capital allocation strategies, such as increasing growth, dividends, or other strategic moves. The first chapter of our strategy was focused on setting up for execution, culminating in reintegrating midstream, managing coal, refinancing the balance sheet, and deleveraging. These steps have positioned us for positive free cash flow generation and effective capital allocation. We’ve been transparent with the market about our intentions and remain committed to the strategy that has reflected success since 2020.

Could you discuss potential bolt-on acquisition opportunities you see in Appalachia currently? How do you view the pricing environment?

Currently, opportunities for bolt-on acquisitions are limited as there are fewer private equity operators left. We usually compare M&A opportunities to the benefits of repurchasing shares, which sets a high hurdle for any potential acquisition at this moment. So, there’s nothing significant on our radar today given our current share prices.

Regarding your hedging strategy, can you elaborate on why you prefer swaps over collars?

We evaluate various hedging strategies and consistently find that swaps provide the most effective approach. While collars offer flexibility, they don’t ensure better pricing than fixed swaps. Our focus remains on using swaps due to their reliability and our belief that the stock is currently undervalued, making our buybacks an attractive option.

Regarding free cash flow allocation towards repurchases in 2023 and after, given the current share price, should we expect this trend to continue? Are there any other factors we need to consider?

Capital allocation discussions are continuous. While we see the current share price as an opportunity for aggressive buybacks, any changes in variables would lead to adjustments in our strategy. Overall, aside from the weather-related challenges, we believe that operational issues have been resolved. The slower performance in Q4 was predominantly due to smaller delays rather than major issues.

Regarding the free cash flow calculation, there was a significant change in accounts receivable in the quarter that seems larger than usual. Could you share more insight on that?

We have been focusing on aligning the timing of physical cash receipts with our derivative payments, so the changes seen in Q4 relate to that adjustment. This approach enhances our liquidity management and lowers our risks. This was particularly vital during recent price fluctuations but continues to be essential for our overall financial health.

Thank you. Thank you, everyone, for joining this morning. Please feel free to reach out if you have any additional questions. Otherwise, we look forward to speaking with everyone again next quarter. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time.