Investment Thesis
Southwestern Energy Company (NYSE:SWN) stock has gained more than 40% over the last year, beating the S&P 500 by a margin of more than 13%.
However, despite this impressive performance, I have a cautious outlook on this stock given its volatile and weak financial performance characterized by a trailing net loss of 32.93% being significantly below the sector median net income of 11.44%. Further, my reservation for this stock is solidified by the market volatility, especially given the ongoing geopolitical tensions. Above, the pending merger with Chesapeake Energy Corporation, although it harbors a lot of growth potential, adds a layer of uncertainty. Consequently, given the weak financial performance and the uncertainty revolving around the volatile market and pending merger, I believe this stock is a hold for now.
Company Overview
SWN is an independent energy company that deals with the exploration and production of natural gas, natural gas liquid, and oil in the US. Its operations are concentrated in the country’s most prolific shale gas basins in Pennsylvania, Ohio, and West Virginia. It also has a significant presence in the Appalachian basin. The company operates through two major segments whose revenue contribution is as shown below.
This company continues to be a dynamic player in the energy sector, and it is positioning itself competitively through strategic initiatives such as the pending merger, which will be covered in detail in this analysis.
Financials: A Reason To Be Cautious
One of my major reasons for being cautious with investing here is the company’s financial performance. Despite having the second-highest market cap among its peers of $8.33 billion and the highest enterprise value of $12.44 billion, the company has registered an underwhelming financial performance.
First off, SWN has the second-worst financial growth rate among its peers, registering a YoY revenue decline of 58.94%, just 3.94% above the worst-performing peer and a whopping 73.34% below the best performer.
In addition, despite the company having the highest total revenue of $5.82 billion TTM, $2 billion above the second-highest revenue generator among its peers, it had the worst profit profile.
Despite this high revenue, the company reported the worst profit with a net loss of $1.92 billion, being the only company making losses on a TTM basis.
The awful financial performance appears to be persistent as shown by the weak MRQ, Q1 2024 report, dated May 2nd, 2024. The company reported revenue of $1.42 billion, marking a decline of 33% YoY and missing estimates by $120 million. Net loss was $1.54 billion, way below a net income of $1.94 billion in Q1 2023. However, the adjusted net income was $131 million, which fell short of the estimated figure of $158.9 million, further indicating the poor financial performance of this company. Diluted EPS was a loss of $1.39 indicating the impact of impairments. The adjusted EPS was $0.12 $0.02 below the expected EPS of $0.14. This below-expectation performance is an indication of the financial pressure being faced by SWN.
Among the main reasons for the underwhelming performance are substantial impairment charges that the company has to account for. For instance, in Q1 2024, the company had about $2.09 billion in impairment charges which affected its profitability. The second reason which, I believe, is a major concern is the volatile commodity price climate which saw the NYMEX Henry Hub price decrease by 35% this in my view affected the company’s revenue generation given that production levels were relatively low.
In other words, the declining revenues were a result of low output levels and low prices. In my view, this poor financial performance could improve in case the pending merger closes successfully because it will improve gas production volumes significantly, as will be discussed later in this article.
In summary, SWN has very weak financial performance both on a comparative basis and when viewed in isolation. This translates to weak fundamentals, which could usher in a bearish stock trajectory. Further, the poor financial performance, especially the net losses, are deterrents for new investors, which, I believe, could spark bearish sentiments in the market, and therefore the stock prices could take a hit if its financial performance doesn’t improve. Given that the US energy sector is projected to be volatile in the coming years, I believe investors need to observe patience before investing here.
Market Volatility
The US energy sector is projected to exhibit prolonged volatility due to several reasons, some of which I will discuss in this analysis. To begin with are production and storage challenges. Variations in production levels and storage capacities can lead to price volatility because this leads to a significant disruption in supply chains, therefore distorting the forces of demand and supply which dictate the price stability. Given this background, let’s look at some of the dynamics in the US energy sector. First off, the US natural gas storage capacity is projected to be volatile through 2024 and 2025 which implies that we expect an equivalent measure in price movement.
In addition, it is projected that the US production will increase through 2025 pushing prices lower further, translating to volatility and potentially low revenues for oil producers and marketers.
Below is the projected price movement amidst the projected increased production volumes.
The other factor is commodity price fluctuation. Mostly, the energy sector, especially gas and oil, is susceptible to wide fluctuations in commodity prices. According to the World Bank, commodity prices are going to experience a downturn in 2024 and 2025, which translates to a bleak outlook for energy stocks SWN inclusive.
The projected falling prices imply low revenues for energy companies, which paints a pessimistic outlook for their financial performance.
Given this inherent uncertainty in the energy market, I believe it is one of the most volatile sectors currently, and considering SWN’s poor financial performance, potential investors should exercise patience before investing here to see how the company adapts to the volatility.
Pending Merger: Promising But Uncertainties Precedes
In January 2024, SWN announced it had agreed to merge with Chesapeake. The deal is an all-stock transaction valued at $7.4 billion or $6.69/share based on Chesapeake’s closing price on January 10th, 2024. Upon the closure of the deal, the new entity would have a combined value of $24 billion, approximately 2x SWN’s current enterprise value of $12.33 billion.
Under the terms of the merger, SWN shareholders will receive 0.0867 shares of Chesapeake common stock outstanding at closing. This would imply that SWN shareholders would have a 40% ownership of the new entity. I believe this is justifiable considering that SWN has total assets of $10.40 billion compared to CHK’s total assets of $14.02 billion, meaning SWN accounts for about 42.59% of the combined assets.
In valuation terms, the deal appears to be a strategic move to consolidate resources and leverage synergies between the two companies. In my view, the valuation seems to reflect the future potential of the combined entity. This can be justified by the synergies and potential benefits of the deal that I will discuss below.
This proposed deal although very promising with a lot to admire adds a layer of uncertainty to invest here. Let us begin by looking at the brighter side of the story. First off, upon the closure of the deal, it comes with several strategic benefits.
Among the benefits, the deal will create a premier natural gas portfolio. It is expected that this merger will create an industry-leading natural gas portfolio with high-quality, large-scale acreage in Appalachia and Haynesville. Above all, the combined company will be the largest gas producer, which, I believe, will dominate the US market due to its scale. Secondly, the combined company will see a significant increment in the production output with a net production of about 7.9 billion cubic feet equivalent per day (Bcfe/d) which is a major boost from the current levels. This increased production output bodes well for the company’s sustainable market distribution, especially given the projected volatility in production levels. I believe these high output levels will enable the company to meet its customer demands as well as earn new customers when some companies cut their production due to low prices by meeting the supply gap created in the market. Notably, the combined company is expected to achieve a cost synergy estimated at $400 million, which will improve shareholder value through improved capital efficiencies and operating margins. Speaking about shareholder value creation, it is projected that the dividend is likely to increase by 20% in the next few years due to the above synergies arising from the merger.
These are just a few aspects of the promising aspects of this deal. In summary, the merger is likely to reshape the competitive landscape of the natural gas industry, offering the potential for growth and value creation. However, while I have an optimistic image of the deal in my mind, it carries some uncertainties that, I believe, are worthy of my reservation to investing in this company.
To begin with, there is the antitrust regulatory delay. Initially, the deal was expected to close not later than June 2024, but the Federal Trade Commission requested additional documents, triggering a mandatory 30-day waiting period once the request is satisfied. Consequently, the closing date has been pushed to the second half of the year, which adds to the uncertainty of this deal closing successfully soon. This uncertainty revolving around regulatory approval and timing can create volatility in the stock, which calls for patience from potential investors.
Additionally, most of the projected synergies and financial benefits are speculative and are subject to market volatility, something which creates uncertainty of achieving the projections. Should the company’s performance fall short of its projection, this would create a lack of investor confidence, something which could deal a major hit on the stock. Above all, it may take time to realize the full synergies of this merger, something which creates questions of how long will investors wait to realize the full benefits of the transaction. In addition to this, the company is expected to trade under a new name after the deal closes, which implies that it will rebrand and therefore it is subject to challenges related to rebranding such as cultural alignment, market positioning, customer perception, and trust. All this adds to the uncertainties surrounding the success of this pending merger.
While the closure of this deal remains speculative, I am confident that the deal is likely to close based on the following reasons. First off, the current delay is primarily due to a second request for additional information from the FTC as part of its review process, and I believe this is a common step in large-scale transactions. The two firms have expressed their intention to cooperate fully with the FTC, signifying their commitment to see the merger through. Secondly, the previous commitment where Chesapeake laid off about 80 staff was related to its divestment of Eagle Ford assets, which implies that the company is restructuring to streamline operations ahead of the merger. To put it simply, both companies are committed to seeing this deal go through and given that the major barrier is the regulatory review that the companies have shown intention and commitment to comply, I believe this merger will likely go through.
While I believe this deal could sail through, it is uncertain how soon the company could realize the full projected synergies. Should it take long to integrate the two entities, thus delaying the full benefits of the deal, then it may imply limited growth potential which could reflect an overvaluation of the transaction. Consequently, this outcome may hurt the stock performance, which adds to my cautious view of the pending merger.
In a nutshell, although the merger presents opportunities, uncertainties related to its success may impact the actualization of the foreseen benefits, leading to poor stock performance. With this in mind, investors should be patient as they monitor closely the developments in the company.
Valuation
To value this stock, I will compute the net asset value per share and then compare it with its PB ratio. I believe this model is a good fit for an energy company like SWN because it accounts for the finite nature of their underlying assets and reserves that cannot be replenished.
Based on the balance sheet, SWN has total assets of $10.4 billion and total liabilities of $6 billion; this translates to a net asset value [NAV] of $4.4 billion. To get the NAV/share, we divide the $4.4 billion with the total outstanding shares of 1.1 billion, which yields a NAV/share of $4. Comparing this with the trailing PB of $1.86, it suggests that the stock is undervalued because the P/B is way lower than the NAV/share. Although this could present a good entry point for potential investors, I believe the current uncertainties in the company warrant patience, and therefore investors should wait until the merger is completed and the financial status of the company improves. In other words, I believe the current undervaluation is reflective of the impending risks and therefore the risk-reward profile is balanced, warranting a hold decision.
For context, I find the company’s balance sheet to be fairly strong. To begin with, the company has a low debt ratio of 0.39 considering its total assets of $10.4 billion and total debt of $4.14 billion. In addition, its debt-to-equity ratio is 0.95 which is below 1 and this implies that its leverage is relatively low and hence low debt risk. For this reason, I believe the undervaluation is not due to debt risk but mainly due to the uncertainties around the merger and the macro environment.
Investment Consideration
While the energy market is in a transition phase with renewable sources gaining traction and natural gas playing a pivotal role in the energy mix, SWN’s focus on natural gas exploration and production especially given its strategic move to merge with Chesapeake could position it well for future growth, but the potential is yet to be realized given the deal is yet to materialize. Therefore, a hold decision seems justified here.
Conclusion
In conclusion, considering the current financial performance, market volatility, and pending merger. I find this company worthy of a hold decision because of the uncertainty that revolves around its prospects. Potential investors should maintain a cautious approach, keeping an eye on the company’s performance and the broader market trends before making further investment decisions.
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