A look at how a recent merger provides investors with a solid entry for $COG

Company Overview

Cabot Oil and Gas Corporation (NYSE: COG) is an oil and gas company that develops, exploits, explores, and produces natural gas in the United States. It exclusively focuses on the Marcellus Shale with 175,000 acres in the dry gas window of the area located in Susquehanna County, Pennsylvania.

As of December 31, 2020, it had proved reserves of approximately 13,672 billion cubic feet of gas, and 15 thousand barrels of oil or other liquid hydrocarbons. Majority of its revenue comes from natural gas; the company is most susceptible to price swings in this commodity.

Internal Analysis

Financials

Cabot Oil recently released its first quarter 2021 results. It’s adjusted earnings per share was at $0.38 per share, which beat analyst expectations. Its natural gas price realization improved 34% from the prior year period and rose to $2.31 per Mcf. Moreover, proved reserves increased by 6% in 2020 to 13.7 Tcfe. During the quarter, 28 wells were drilled and 14 were completed.

From a revenue perspective, COG’s Q1 revenues were up 18.9% to what they were a year ago, nearing the revenue levels experienced in 2019 prior to the trough in gas prices created due to COVID.

Discretionary cash flow improved to $261.2 million, well above the $198.5 million in the prior year period. The increased cash flow led to a 10% dividend increase to $0.11 per share. This falls in line with the company’s strategy to achieve a minimum capital return target of at least 50% of annual free cash flow.

From a solvency perspective, the company’s Debt/LTM EBITDA ratio is sitting at 1.3x, and with no debt outstanding under its credit facility it has $1.6 billion of liquidity.

Overall, EPS improved this quarter as did margins, with revenues greatly increasing and expenses slightly decreasing. This can be attributed to the volatile swing in the price of oil and gas throughout 2020 and the fact that at one point the WTI was trading at a negative due to the price cuts and an already saturated market. In spite of this, COG was still able to repay all its debt and retain solvency and liquidity, indicative of great management and financial planning.

From a financial standpoint, the company is strong, and as its reserves grow and commodity prices rebound, it is poised to continue to deliver returns to shareholders.

External Analysis

The downturn in the oil and gas industry caused by COVID-19 was like any other.

The majority of the downside risk for oil and gas companies comes from commodity prices, driven by supply and demand. If natural gas prices remain low, margins can steadily decrease. Global oil demand fell by 25% in April but has strongly rebounded since then. Oil demand has been expected to recover strongly this year but remain lower than pre-COVID levels.

In addition, the COVID-19 crisis has accelerated the long-term trend of entry transition to more renewable resources. However, given that natural gas is one of the cleanest fossil fuels available at the lowest price, the projected share of gas in the future energy mix is projected to increase. The US Energy information administration estimated gas prices to average $3.14/MMBtu in 2021. YTD prices have averaged around $2.9/MMBtu and are poised to rise throughout the year.

In addition, analysts project an increased trend of consolidation in the shale market to create more balance and diversification for US oil and gas companies.

Investment Thesis

The primary rationale behind buying COG at its current price of $16.65 is because of the inability of the market to recognize the advantage it holds over its competitors coming out of the COVID-19 oil and dip in natural gas prices. From an EV/Production point of view, it is trading at a large discount to its competitors, which are trading at multiples upwards of 10x while it is still at 8.7x. This is unreasonable given that it has an EBITDA margin higher than the median 38% of its competitors, has a Debt/EBITDA sitting at 1.3x lower than all its competitors, and has the highest return on capital of 7.10% out of all its competitors.

Based on the prices the market has placed on its competitors, COG is clearly trading at a discount right now and there is great room for appreciation once the market corrects itself. It is incorrect to say that the cyclicality of the industry is what has resulted in this discount as its competitors have been equally impacted by the crisis, but from a financial point of view COG still has the best balance sheet and capacity to provide returns in excess of its cost of capital in the future.

Valuation

Using the Median EV/Production Multiple from the comparable companies analysis, COG should be currently trading at $24.77, which represents a significant 48.7% premium to its current price. If this premium is sensitized for both the current price and EV/Production multiple, it still stays above a minimum of 23%, representing a great investment opportunity.

Merger with Cimarex.

This valuation and analysis for COG was based off of Cabot as a standalone company. However it is common knowledge that recently the company announced that they’d merge with Cimarex Energy in an all-stock deal. This announcement led to a drop in share price by 6%.

Cimarex Energy focuses on oil while Cabot focuses on natural gas. This merger brings together two firms operating in different regions that are extracting different commodities and creates a more diversified firm overall. Having a mix of assets in oil, gas, and natural-gas liquids will protect the company against price swings in any single commodity, in turn providing more diversification for shareholders.

The deal is expected to provide cost savings of about $100 million from general and administrative segments. Beyond that, both companies should operate normally which is why it is likely the market negatively overreacted to this news.

Risks

1. The primary risk of investing in an oil and gas company is the cyclicality of the commodities. We witnessed a very large-scale downturn in the past 12 months and saw many companies struggle to stay afloat. The revenues of COG are highly susceptible to changes in natural gas prices so these will need to be consistently monitored alongside the futures contracts the company purchases to hedge their risk.
2. The future of oil and gas is also a long-term risk faced by the industry. COVID-19 has accelerated the shift to more renewable energy sources, and we’ve seen the S&P Global Clean Energy Index soar almost 100% this past year. A mitigation for this risk is the fact that natural gas burns the cleanest of similar fossil fuels and is projected to outlast others.

Source of the original analysis can be found here For the latest investment ideas and insights join the community here