Southwest Energy (NYSE: SWN) has seen its share price fall, along with its peers, in recent days.
Here I describe why investors are overreacting to the Freeport LNG fire and its implications for nature gas market.
That being said, by my estimate, Southwestern’s natural gas production for 2023 is about 62% hedged at just over $3. This low price of its natural gas production leaves little room for shareholders to take full advantage of high natural gas prices.
In short, it will still take time before Southwestern can roll out its capital allocation program.
Therefore, overall, I consider Southwestern a lukewarm buy, based on its 6x free cash flow multiple.
Southwestern Energy Short-Term Outlook
Southwest is one of the largest producers of natural gas and natural gas liquids in the United States. Southwest is focused on the production and transportation of natural gas and natural gas liquids. As such, it benefits from high natural gas prices.
That being said, as widely reported, the main natural gas export facility in the United States, the Freeport LNG, caught fire. This has resulted in a sharp drop in natural gas prices over the past week.
However, let’s put this sale in context. In the first case, the Freeport facility expects a partial resumption of operations in approximately 90 days. With a full recovery by the end of 2022, i.e. 6 months.
So there will be some ability to get exports out by the end of the third quarter, and an acceleration from then on.
In the second case, it is important to realize that the Freeport LNG facility accounts for only 20% of US LNG exports.
Therefore, I believe this major overreaction in the futures market will soon correct itself as market participants begin to notice that the momentum that brought us here has not changed significantly.
Yet the markets have been so fragile lately, with investors in and out of commodity companies, as they try to position themselves as best they can in this highly uncertain market. Altogether, this culminated in a spark that led natural gas companies to sell off in droves, and are now down more than 20% in a matter of days.
However, I believe that amidst this fear and uncertainty, there is a compelling opportunity for investors to consider Southwestern Energy.
Capital repayment policy?
The only reason I’m only rating Southwestern with a lukewarm buy is that it doesn’t have a clear immediate capital repayment policy. And the reason why this is so is twofold. Leverage and hedges.
Southwestern has approximately $5 billion in net debt. And for Southwestern to reach its targeted leverage range, it will take a bit longer.
As you can see above, investors are looking to close in on year-end before Southwestern’s balance sheet hits its sub-1.5x net leverage range.
The second consideration to keep in mind is that Southwestern offers a significantly leveraged book.
Southwestern’s first quarter 2022 natural gas production was 376 billion cubic feet, while its second quarter forecast also points to a very similar range.
Accordingly, if we estimate that for 2023 Southwestern’s total production reaches 1.52 trillion cubic feet, as you can see above in the red box, that puts its total production at around 62% hedged at a price slightly greater than $3.
If investors have a bullish outlook on natural gas prices, getting involved in a company that has nearly two-thirds of its production hedged at significantly lower natural gas prices doesn’t make much sense.
Along these lines, on its earnings call, Southwestern said:
As we achieve our target leverage ratio and have a clear view of our target total leverage range, we expect to be able to launch a sustainable capital return program.
Investors will therefore have to wait some time to gain greater visibility into 2023 before Southwestern can announce its sustainable capital return program.
Valuation of SWN shares – At the price of 6x free cash flow
For the first quarter of 2022, Southwestern’s free cash flow was $317 million. This figure includes its unsettled hedges of $3.2 billion that have been added back.
If we roughly estimate a similar run rate for the remainder of 2022, that would put Southwestern on target to report somewhere near $1.3 billion in free cash flow for 2022.
That leaves Southwestern at a very rough price of 6x this year’s free cash flow.
This multiple is largely in line with its peers. While many of its peers looking to 2023 are significantly less covered.
The reason I have a lukewarm buy rating on this stock is because the value investor in me will never shy away from a company that is priced in mid-figures to free cash flow.
On the other hand, since its natural gas portfolio is so heavily hedged, by my estimate at around 62%, this leaves very little room to take full advantage of high natural gas prices.
The way I would describe it is something like being at “the natural gas party‘ and everyone’s on champagne and you’re on orange juice. It’s cool and all, but it’s far from the full experience.