In my view, Cheniere Energy, Inc. (LNG) is one of the most misunderstood stories in the market right now. It seems to be trading on hope and infatuation with the idea of exporting natural gas out of the U.S., instead of facts and fundamentals. I describe the details below, but essentially LNG is currently burning $90mm of cash annually and has $500mm of debt coming due next year. The company is planning to open a liquefaction facility to improve its cash flow situation, but this will not start generating any cash for another four years even if it does lock in customer contracts and project financing. Therefore, it will likely have to issue a substantial amount of equity to either: 1) pay off the maturing debt, 2) cover the cash burn of the refinanced debt and/or 3) give to current lenders as a part of the refinancing. In addition, the economics of the proposed liquefaction facility seem to be misunderstood, so I don’t believe that the company will receive as much cash flow from this terminal as the market’s anticipating. Both of these facts lead me to believe that the equity is mispriced.
LNG is a holding company whose value comes from its 89% interest in Cheniere Energy Partners, L.P. (CQP). CQP currently owns and operates a regasification terminal that was completed in 2008 for $2b. This terminal was designed to import LNG and capture the spread between high natural gas prices in the U.S. and cheaper international LNG, but could not have been opened at a worse time. The proliferation of fracturing in new shale plays across North America led to an oversupply of natural gas. This coupled with the start of the financial crisis led to a steep decline in the price of gas. Therefore, CQP was only able to sign contracts for 50% of its capacity.
Currently, CQP collects $55mm from its regasification terminal. Due to the ownership structure, which consists of common units, subordinated units and GP units, LNG only receives $20mm from CQP’s regasification facility. LNG also collects a management fee of $10mm. After operating expenses of $50mm, the company burns $20mm per year. It also has $70mm of interest costs, leading to an annual cash burn of $90mm. Slides 17 and 18 of its August 2011 corporate presentation provide these details, which can be found in the investor relations section of its website. The only difference in the numbers that I’ve given is that its $280mm 2018 term loan started requiring that interest be paid in cash in September, which equates to $35mm annually. In addition to this term loan, the company has a $300mm term loan maturing in May 2012 and $200mm convertible bond maturing in August 2012.
Based on its current cash flow profile, LNG has no way of supporting its debt load. To improve this, management plans to transform its terminal into a bi-directional facility capable of exporting LNG. The premise being that domestic gas producers want to take advantage of the arbitrage between Henry Hub prices and worldwide LNG prices, which is based off of the price of oil. It’s been approved by the DOE to export 2 bcf/d, which will require four liquefaction trains. Its plan is to build the first two trains (1 bcf/d) before trying to finance and fill capacity for the third and fourth. On October 26th, the company announced that BG Group (OTCQX:BRGYY) had signed a contract to fill capacity for the first train (0.5 bcf/d), causing the stock to jump 70%. Since then, LNG announced that a second customer contract was close to being finalized and that it had selected Bechtel to construct the first two trains.
The stock is up another 10% since October 26th. After its recent run, the stock is currently trading at $11. The only brokerage firm that covers this stock is Citi, which has a $14 price target. Their valuation and the current price seem to reflect multiple assumptions that are either misguided or discounted at a very low rate, which I discuss below.
1) Project Cost: The company initially stated that the project would cost $400 per ton, which equates to $3.6b based on 9 mtpa. This can also be found on slide 9 of its August 2011 investor presentation. In its 10Q filed last week and in the announcement of its Bechtel contract two days ago, it stated that it would cost $4.5b - $5b before financing costs. Financing costs represent the cash reserves necessary to cover four years of interest payments before the trains start generating cash. This implies a total cost of $5.5b, or 50% higher than the estimate given by management only a few months ago.
2) Project Financers: The company has guided to 60% of the project being financed with debt and the rest with equity. The largest providers of debt financing for these types of infrastructure projects are European banks, which is the reason that it hired SocGen as its advisor. Due to the pending credit crisis in Europe, these banks may not have the ability or capacity to provide $3.3b of credit. Based on my understanding of the economics of the liquefaction facility, I believe an equity investor will need to receive 60% of CQP’s cash flow to generate a 15% return, which will significantly dilute LNG shareholders. I walk through these assumptions in the point below.
3) Economics of the Liquefaction Trains: Each train will have capacity to support 0.5 bcf/d and LNG will charge a fee of $2.25, so this implies annual revenue of $820mm ($2.25 fee x 0.5 bcf/d x 365 days x 2 trains). The company estimates that operating expenses will be $70mm per year and pipeline expenses will be $60mm per year, which implies annual unlevered cash flow of $690mm. This is a key piece of information that many market participants seem to be missing. They’re assuming that the liquefaction facility will have the same 90% margin as the regasification terminal, but the numbers above imply a 85% margin. They also guided me to $250mm in annual debt service, which includes interest and principal, leading to distributable cash flow of $440mm to CQP. This cash flow from the liquefaction trains plus $55mm received from its regasification contracts provides CQP with $495mm of total cash flow. LNG needs an equity check of $2.2b today to finance the new trains ($5.5b project cost x 40% equity contribution).
I believe that an equity investor will need to receive 60% of CQP’s cash flow to generate a 15% return. This assumes that they contribute $2.2b of capital today, start receiving $300mm of cash flow in four years (60% x $495mm), and sell their interest at an 8% yield or 12.5x cash flow for $3.75b ($300mm x 12.5x). $3.75b discounted back four years by 15% equals $2.2b. Therefore, LNG would receive the remaining 40% of CQP’s cash flow, or $200mm ($495mm x 40%), and would be generating $160mm of unlevered cash flow ($200mm + $10mm management fee - $50mm of operating expense). Applying the same 12.5x multiple and discounting back four years by 10% (for conservative purposes) implies an enterprise value of $1.4b for LNG today. Backing out the current debt balance of $785mm leads to an equity value of $615mm, or $7.40 stock price ($615mm / 83mm shares outstanding today). But this valuation leaves out a step that the market seems to be forgetting.
4) Refinancing Its Existing Debt: The company has to cross many hurdles before it can begin construction of its liquefaction facility, but regardless this will not produce cash flow for another four years. LNG has $130mm of cash today, but it’s burning $90mm annually and has $500mm of debt coming due next year. Therefore, it will need to issue shares to either pay off the debt or cover the cash burn of the refinanced debt over the next four years until the liquefaction project is complete. My guess is that the current lenders of the maturing debt, which include several hedge funds, will require a higher interest rate and some form of equity, but assuming they simply extend the maturities at current rates, the company will need $230mm of liquidity ($360mm cash burn ($90mm x 4 years) - $130mm of cash). Using the current share price of $11, it’ll need to issue 21mm shares leading to an implied valuation of $6 ($615mm equity value / 104mm shares), or 55% downside.
Even if everything goes right for this company, which is a big “if” considering management already underestimated the project cost by more than 50%, the stock is still only worth about half of today’s value. Currently, the stock price is being driven by hope, but at some point all securities reflect the fundamentals and distributable cash flows.