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Expectations Regarding Natural Gas Prices Should Be Handled With Care – Part 2: EQT Corporation

Summary Even though the expectations regarding the natural gas prices have become even more bearish recently, I continue viewing the current situation in the markets as an overreaction. Despite the positive expectations for deep Utica play and positive analyst ratings, EQT is a risky stock with a substantial downside potential in the worst-case scenario. The company is overvalued. It is struggling to generate cash while at the same time having an accumulating debt pile. The far-away outcome of deep Utica play should not overshadow the importance of the company’s present performance and financial strength. While remaining bullish on natural gas for the nearest future, I continue analyzing securities with exposure to this commodity. Even though the expectations regarding the natural gas prices have become even more bearish recently, my view on the current situation in the natural gas market has not changed – I still perceive the recent developments to be an overreaction to the real fundamentals, and I remain long natural gas despite the higher risk. The company to be analyzed in this article is EQT Corporation (NYSE: EQT ). Being a Credit Suisse’s recent pick for natural gas exposure, the company is pretty popular among investors. With a market capitalization of $9 billion, this natural gas producer might prove to be a good natural gas bet for a variety of reasons. Nevertheless, the outlook is not exactly clear for EQT, as it is for every natural gas producer at current commodity price levels. At a total natural gas and NGL (Natural gas liquids) sales volume of 155,194 Mmcf, natural gas accounted for more than 99% of total company’s sales, placing it in a good position to benefit from the possibility of this commodity rising in price. Marcellus Play EQT Corporation strongly depends on its Marcellus wells, which accounted for 83% of total natural gas sales in the latest quarter, and this number has been nearly constant over the last three quarters. Known for many years, the Marcellus Shale only started causing excitement in 2002, when the estimations of its natural gas reserves started increasing, confirming its status of one of the largest natural gas shale formations in the U.S, which is spread over Ohio, West Virginia, Pennsylvania and New York. Marcellus is the main asset of EQT Corporation, with the company owning approximately 630,000 gross acres in the Marcellus play. Marcellus has been a major contributor to the company’s proved reserve growth, making it clear that the company is not running out of its reserves anytime soon. (click to enlarge) Source: Company’s Website , (2015). The number of wells spud in the Marcellus play is increasing strongly. The company is ramping up production, as the number of completed, not-in-use wells only rose modestly compared with the number of wells online during the last quarter. (click to enlarge) Source: Company’s Quarterly Reports , (2015). Despite the positive expectations for the future potential of Marcellus play, the 22% after-tax IRR for the realized price of $2.50 sets the scene for skepticism, as the future price dynamics of the commodity are not clear. Deep Utica Play It is well-known how the bold, full-of-hope statements make it sometimes nearly irresistible for people to turn too optimistic on a company’s potential. The willingness to have a quick profit (arguably, the most vulnerable state of a man) resulted in a possible overestimation of the future prospects of Deep Utica Play, which is currently the main focus of the company and the media following it. Seeking lower production costs, the company turned its focus to the Utica shale, which is located just below the Marcellus. I will not go in too much detail here, but I would like to outline the complexity of production in the Utica Play. At the depth of approximately 13,000 feet, with only 1 well online and 2 in progress, there is a possibility of the company’s estimated costs of $12.5-14 million turning out to be underestimated. Source: Geology.com , (2015). Nevertheless, the estimated 21% after-tax IRR at a realized price of $2, combined with production and efficiency at the low-end levels is certainly better than that for the Marcellus play, taking into account the difference in the realized prices. Source: Company’s Website , (2015). It is clear that the company’s decision might prove to be very profitable in the long run, with the company’s CEO, David L. Porges, stating the following: “If the deep Utica works, it is likely to be larger than the Marcellus over time […] we’re going to be able to supply a big portion of North America’s natural gas needs from a relatively small geography.” At the same time, it is not clear whether the best-case-scenario will unfold, as it is strongly expected at the moment. “There have been fewer than 10 wells drilled and completed in the deep Utica around our acreage, so it is still too early to say that the play will be economic,” the CEO said during the earnings call in October. Even though it is not the time to turn entirely pessimistic on the company, the downside potential for the case of the company missing the Deep Utica Play expectations should be taken into the account. Good performance of Marcellus Play, combined with rising hopes for Utica have significantly contributed to the analyst ratings, with the shares of the company currently holding 10 ” Strong Buy” and 3 “Hold” ratings . With institutional ownership accounting for 85% , should the expectations be missed, the downside risk for the stock could be substantial. Even though the number of positions initiated is currently outperforming that of the closed ones, it is important to remember the downward trend the shares of the company have been following since the middle of 2014, when the price was nearly double what it is today. (click to enlarge) Hedging Activities It is important to mention the company’s hedging activities against the further natural gas price declines. In its latest quarterly report, the company emphasized the importance of its derivative transactions, role of which I expect to continue rising over the next quarters. Source: Company’s Quarterly Reports , (2015). Even though the total cash provided by derivatives does not seem to have risen too much over the last three quarters, cash-settled derivatives accounted for 14%, 37% and 24% of the total realized natural gas price during the last three quarters, with hedging-designated ones providing more than $65 million last quarter, which is impressive taking into account that quarter’s profit of $40.79 million. So far, it is hard to deny the management’s ability to hedge the risks of environment the company is currently operating in. Even though natural gas prices have a significant potential to rise in the near future, natural gas companies’ hedging operations should be paid more attention to, as long-term plans (such as the Deep Utica Play) might become irrelevant if they either do not play out or the company runs out of its cash resources. With only 1 Utica well online at the moment, the target cost of $12.5-14 million per well accounts for only 1% of the company’s total cash position at the end of the latest quarter. Nevertheless, Deep Utica might turn out to be a severe cash burning process in case the company struggles to earn money at the current price levels or its strategy turns out to be somewhat too optimistic. The company’s current hedging position for the rest of 2015 (outlined in yellow) is sufficient enough to cover almost half the amount of the company’s natural gas sales for the latest quarter. Nevertheless, it is hard to form solid expectations regarding the hedging effectiveness in the next quarter as we cannot predict the revenue growth and the adjustments to the hedging position throughout the quarter. Despite the fact that the accumulation of the company’s hedging position for 2016 is fast-paced, average fixed prices for 2015 and 2016 are declining significantly. (click to enlarge) Company’s hedging position at the end of each quarter, 2015. Source: Company’s Quarterly Reports , (2015). Fundamentals The falling natural gas prices have had a substantial impact on the financial positions of all producers, and EQT Corporation is no exception. Despite the company’s efforts to save the revenue growth, net profits have significantly decreased during 2015, with some hope emerging for the upcoming quarters. With natural gas outlook being unclear and much time required for Utica Play to start firing on all cylinders, even more attention should be paid to the company’s current hedging activities. COGS increased strongly in the latest quarter, making the gross profit margin fall to 77.5%, way below the 2-year average of 82.4%. Revenue, Gross and Operating of EQT Corporation, quarterly, Sep 2013-2015. Source: GuruFocus , (2015). Net income margins have become quite volatile lately, falling sharply in the latest quarters and keeping return on assets and equity ratios at close range. Net Margins, ROA and ROE ratios of EQT, Sep 2013-2015. Source: GuruFocus , (2015). Following the fluctuations of the company’s revenues, interest coverage ratio has shown concerning performance during the last five quarters, falling below 1 in June 2015. Even though interest expense has been nearly unchanged at approximately $37 million over the same time period, fluctuating EBIT might become a problem in the future. There is a fast-paced accumulation of deferred tax liabilities, which have been growing by 1.82% on average during the last five quarters, conquering almost 22% of the liability part of the balance sheet by September 2015. (click to enlarge) Interest Coverage Ratio (right axis), EBIT and Interest Expenses (in $ mln, left axis) of EQT, Sep 2014-2015. Source: Morningstar , (2015). Even though the debt/equity ratio of EQT Corporation has been decreasing lately and is fairly low at 0.64, it is important to remember that the large “E” in the D/E ratio is mostly there because of a large amount of fixed assets, leaving the current ones a lot of room for improvement. The company’s cash position has been increasing strongly over the last two years. Accounting for only 12.1% of total assets, it is not sufficient to cover the long-term debt of the company, however, and the accumulating current portion of long-term debt should be paid more attention to. Company’s free cash flow has been negative since 2007. (click to enlarge) Source: Gurufocus , (2015). Although the growing debt, worsening profitability and a low Altman’s Z-value of 1.36 are concerning factors, the debt maturity schedule demonstrates why it is too early to get too pessimistic about the company’s financial position. It should be understood, however, that the company might significantly decrease its cash position in the coming future if no net profit surprises follow. Source: Company’s Website , (2015). The argument in favor of a decrease in the company’s cash position sounds even more valid when the historical net changes in cash are taken into account. Net change in cash has been negative during 3 out of the 7 latest quarters. Among the remaining 4, positive net change in cash in 3 quarters can be attributed to large stock or debt issuance (it is easier to follow with the help of the table below). Debt is slowly becoming a problem for the company, while continuous stock issuance can drive the share price even lower. (click to enlarge) Net change in cash; net debt and stock issuance of EQT Corporation, March 2014 – September 2015. Source: Gurufocus , (2015). There is a certain amount of divergence between the stock’s valuation and current performance of the company. Even though it can be said that at a price/book of 1.69 (which is close to its 10-year low) the stock seems to be fairly valued, I am returning to my argument of over-optimistic expectations due to the trailing P/E ratio exceeding 42. Conclusion Despite the positive expectations for the future of Deep Utica play, the company is heading towards additional risk. The financial strength of the company is slowly decreasing, making it strongly dependent on the outcome it will face regarding the Utica play. Even though the strategy might prove to be a major success, there is a high probability of earnings disappointments and further balance sheet deterioration in the future. Accompanied by high valuation and negative free cash flow, growing debt and cash generation issues might leave the stock with a large downside risk should the natural gas prices continue their downward trend in the nearest future. High ratings among the analysts covering the stock make it vulnerable to potential downgrades, as the popularity of the stock might turn against it. Nevertheless, there are various possible reasons for the stock to outperform as well. Positive developments in the Utica play, possibility of a dividend increase (which, despite being a questionable decision, might be introduced by the company as a save-the-day solution against the falling stock price) and the overall bullish attitude towards the company might make it a market’s darling should the natural gas prices rise as I expect them to be, although the downside risk makes it a much riskier bet when compared with Gulfport Energy Corporation (NASDAQ: GPOR ), which I analyzed in my previous article. The far-away outcome of deep Utica play should not overshadow the importance of the company’s present performance and financial strength.

Is SLV Heading Towards A New Low?

A busy week ahead for SLV. The upcoming ECB rate decision could result in a weaker Euro. And as the Euro/USD falls, SLV is likely to follow. The next NFP report could also bring down the price of SLV. This week is expected to be turbulent not only for silver and the iShares Silver Trust ETF (NYSEARCA: SLV ) but also for other commodities and major currencies, considering the upcoming non-farm payroll report, Yellen’s testimony and the ECB rate decision. The first two events could influence people’s perspectives regarding the upcoming FOMC meeting, while the last event could have a strong impact on the Euro. And given the expected changes of both central banks’ monetary policies, the price of SLV is likely to resume its descent. The highly expected European Central Bank policy meeting will be on Thursday. Currently, some analysts think the ECB may announce a two tier deposit rate for commercial banks parking their cash at the ECB – a similar system to the one they have in Switzerland. Others think ECB President Draghi will just consider lowering again the deposit rate and increasing the already running quantitative easing program. In either way, this could mean a weaker Euro, which may put additional downward pressure on SLV. The following day, the non-farm payroll report will be published. Last time, the NFP’s headline figure was high at 271,000 jobs – well above market estimates. And wage growth rate rose to 2.5%, which was the highest rate since 2009. With such progress, the FOMC is likely to move forward with raising its cash rate, assuming the next NFP report doesn’t disappoint. After all, the FOMC promised in the last meeting that if economic data show promising results, the committee will move forward with a rate hike in December. The market is still not fully convinced the FOMC will hit liftoff in a few weeks from now – the implied probabilities for a December hike are at 78%. Perhaps if the next NFP report shows a growth rate in jobs of over 200,000 – the market currently estimates a growth of 201,000 – and a wage growth of at least 2.4%, the market will be more inclined to believe higher interest rates are up ahead. And then the market could start focusing on the pace of subsequent rate hikes. So far this month, long-term treasury yields also rose: 10-year yields increased by 0.06 percentage points while 1-year yields added 0.16 pp. For SLV, a higher cash rate also means higher long-term interest rates, which are likely to bring down silver prices. But it’s worth noticing that it’s still not a done deal about the December rate hike. If the NFP report shows a very modest gain in jobs and lower growth rate in wages, this could reduce the odds of a December hike by the Fed. And that also means a short term bounce for SLV. Chair Yellen will testify this week in front the Joint Economic Committee of the U.S. Senate and before Economic Club of Washington regarding the economic outlook of the U.S. This will be her last public address before the December meeting. Perhaps she will refer to progress of labor market and inflation. After all, according to the personal and income outlay update , consumption grows at a slower pace than income. And the core PCE inflation is only at 1.3% (back in October) – well below the Fed’s 2% target . It seems that the rise in wages didn’t result in more spending, which, in turn, didn’t raise core inflation. Without higher inflation, the Fed will still reconsider up to the last minute whether raising rates in December is a prudent move. The silver market has seen better days. If the NFP report shows another modest gain in jobs and the ECB moves forward in reducing its rates or augmenting its QE program, the U.S. dollar is likely to appreciate. And given the current expectations of what’s up ahead, the price of SLV is more likely to keep declining in the short term. For more please see: Choosing Between Gold and Silver

A Rate Hike Will Threaten This Bond Fund’s Reach For Yield

Summary HYT has moved towards higher duration issues to maintain distributions, making it more heavily exposed to a rate hike than other high yield funds. HYT’s dividend history and its current failure to earn income to cover distributions indicate a rate cut in 2016. Nonetheless, there is an opportunity to purchase HYT when the market discounts its underperformance too heavily — although that time has not come quite yet. BlackRock Corporate High Yield Fund (NYSE: HYT ) is a thinly traded and often overlooked closed-end fund that seeks consistent high income to shareholders through active capital allocation in the high yield taxable bond and debt derivative universe, with a smattering of equity on the side. To its credit, the fund has a solid track record of paying special dividends that have driven its total yield above 8% for most of its history since inception. This must be counterbalanced by a consistent decline in dividends and a fall in NAV that make it suspect for the income-seeking investor. Currently, the fund deserves attention because a recent dividend cut for HYT and turmoil in the high-yield market as a whole have generated interest in just about any high-yielding CEF. But there is cause for caution. The Dividend History Unfortunately, regular dividends have been consistently falling for this fund for a long time: (click to enlarge) In 2015, shareholders faced a 7.3% dividend cut after similar cuts came to the fund in 2012, 2013, and 2014. Dividends have fallen 41% since the fund’s inception, and the fund’s market price has fallen by a third. The Capital Losses Some CEF investors like to catch funds that trade at a discount to NAV using the logic of value investors: get dollars when they’re on sale for 80 cents. In addition to the falling dividends HYT pays out, there is another reason why this strategy will not work with HYT. The fund’s overall capital losses are not abating. According to the fund’s most recent annual and semi-annual reports , the fund has lost 7.4% of its value from June to September. Over a one-year period to September, the fund lost 3.14% of its NAV. Since then, the fund has lost another 0.6% of its NAV. Greater Exposure to Rising Rates We can largely attribute these losses to a cratering in the high yield market, which has also caused a distressing decline in the NAV of high yield funds such as Pimco High Yield Fund (NYSE: PHK ) and caused me to sell my holdings in that fund (I discuss this decision here ). In the case of PHK, management seems to be preparing for this fall in junk debt values by shifting the portfolio towards shorter duration holdings at higher yields. In theory, this will free up capital for new issues at higher rates if the Federal Reserve raises rates in December or early next year. In the case of HYT, this is not management’s strategy. In September, HYT had 75% of its holdings with maturities ranging between 3-10 years, with over half having maturities between 5 and 10 years. In June, 68% of its holdings were in the 3-10-year maturity window, with 44% in the 5-10-year maturing range. This means there is now a higher risk of HYT losing more of its NAV if the Federal Reserve raises interest rates and rates for high yield debt goes up as well. Even if the Fed doesn’t raise rates, if the market worries about higher default rates due to declining profitability on the stronger dollar, or because of cheap oil, or any other of the myriad reasons that have driven a fall in the high yield market in 2015, HYT is more exposed than PHK and other actively managed high yield funds. The CLO Bet HYT is also making another small bet by moving into CLO investments. In its last annual report, HYT disclosed approximately $24.5 million in CLO investments, which is over half of its $49.5 million invested in asset-backed securities. On the plus side, CLOs remain only 2% of HYT’s total portfolio. There is potential for credit spreads to narrow if the Federal Reserve does raise interest rates and causes other interest rates, such as LIBOR, to follow suit, but this will have significantly less impact on HYT than on other high yield funds, both in the CEF and BDC universe, which have invested more aggressively in CLOs to boost returns. A good example of a much higher risk high yield fund that has seen weak NAV growth and high market value declines based on CLO exposure is Prospect Capital (NASDAQ: PSEC ). Their high CLO holdings are discussed in this prescient article by BDC Buzz. PSEC has fallen 12.7%, excluding dividends, since BDC Buzz’s article (although it was by no means his first warning on the dangers in that company). For HYT, this means its CLO holdings are relatively conservative. On the surface, this sounds good; but they are in fact so conservative that it is difficult to determine the purpose of holding such a small portion of the portfolio in these volatile assets. Additionally, many of those CLOs are in small and middle-market companies or BDCs that service the small and middle-market companies, again compounding HYT’s exposure to companies that are more likely to suffer higher default rates. For example, as of its September report, HYT held $2.1 million in asset-backed securities whose counterparty is Ares CLO Ltd. and another $877,000 to WhiteHorse subsidiaries of H.I.G. Capital, a diversified private equity investment firm. Matching Income to Distributions Since CLOs pay a higher yield than market-issued bonds, these are part of the fund’s overall strategy to make income match distributions. Unfortunately, the fund is still falling slightly short of its payout. Since March, the fund has paid $1.21 million of its distributions as a return of capital and its dividend coverage has remained below 85% for five months. Its current ROC is a small fraction of the overall value of the fund and is by no means a cause for alarm at the present time. However, it does indicate the strong likelihood of another dividend cut in 2016 as we have seen over the past few years, meaning investors should calculate their expected income from this fund not based on its current yield but on its likely future yield. Also, because of the long duration of the fund’s holdings, its ability to churn into higher yielding new issues will be limited, making it even less likely to enjoy a higher rate of income on its holdings if yields on corporate debt rise next year. Discount to NAV When deciding whether to purchase HYT or not, investors should also consider the fund’s discount or premium to NAV and how this is likely to trend in the future. Except for a brief spell in 2012, the fund has always traded at a discount, and its current discount is the steepest it has been since 2008. (click to enlarge) The fund’s current 13.47% discount is slightly above the 52-week average of 12.37%, although the last year’s tumultuous and volatile high yield bond market may make the last year’s average a less reliable indicator of timing a purchase in this fund than in the past. While investors looking for mean reversion may be tempted to buy as its discount seems curiously low, the above considerations about portfolio duration, ROC, and poor positioning for rising rates should make investors pause before jumping in. Conclusion HYT is not positioning itself for a rising interest rate environment and has seen a steep discount to NAV priced in as a result. Additionally, the fund’s consistent dividend cuts mean that it cannot be purchased as a source of reliable income. However, it can be purchased when the market undervalues its income potential. A careful analysis of the fund’s shift of its bond holdings by duration and a closer understanding of its allocations to CLOs and its exposure to smaller companies is necessary before making a purchase on this name.