Unloved, underfollowed and misunderstood, Cheniere Energy (NYSEMKT:LNG) is a company, with over $15bn in debt, negative earnings and negative cash flow, with a long history of losing money. It is part of the energy sector, and its main business is based on natural gas. The energy sector is in a severe downturn, and natural gas prices have fallen over 60% over the last year. The company's business is complex and requires massive capital expenditures. No wonder then that Cheniere has been lumped together with all other companies with energy exposure, and investors have seen the value of the company's common stock evaporate from around $78/share a year ago to today's $34.03 - an astonishing 54% loss. The above ingredients have over the past year meant that most investors have not been willing to touch this name with a ten-foot pole.
But... things are about to change.
Elevator pitch explanation of Cheniere's business
In essence, Cheniere buys natural gas and converts (or plans to convert upon completion of construction) this into liquefied natural gas (LNG) at its two facilities/terminals: the Sabine Pass Liquefaction (SPL) terminal in Louisiana and the Corpus Christi Liquefaction (CCL) terminal in Corpus Christi, Texas. The liquefied natural gas is then pumped into the tankers (chartered vessels) at their respective terminals to be exported to Europe, Asia and Latin America, where liquefied natural gas/natural gas prices are higher than in the US.
On the surface, there are a lot of "red flags," and many screeners (and lazy or sub-par analysts) are likely to overlook this opportunity due to these factors mentioned above. However, let's take a look at these items one by one to see if we can make sense of them.
First, Cheniere's debt is simply a result of a massive investment undertaken over a number of years to build advanced liquefaction facilities in order to export liquefied natural gas (to Europe, Asia and Latin America) to markets where prices are significantly higher than in the US, where - due to the shale boom - oil and natural gas have recently become an abundant and cheap resource. That is, you invest and forgo consumption/dividends/payouts today in order to reap the benefits tomorrow, and that's exactly what Cheniere has been doing for the last several years. A company in this situation - investing heavily in order to ramp up its production/facilities - typically has little in terms of revenue to show for until the various projects come online and become operational, and that is exactly the situation Cheniere finds itself in. However, investors relying on many standard metrics or valuation screens, will naturally discard this company without as much as looking at it (for example, Cheniere would screen poorly based on a common P/E, P/B, C/F, EV/EBITDA "value" screen setup).
However, the company recently completed the first of several stages of its multi-year project, completing Train 1 at SPL; and just a few weeks ago (February 24th) dispatched its very first LNG vessel to Brazil (Petrobras (NYSE:PBR)). Demonstrating the ability to successfully manage one of the stages of the project by completing Train 1 of a total of seven LNG trains (under construction), without incidents, cost-overruns and ahead of schedule - and successfully operating the new facilities in order to execute on its sales and purchase agreements (SPAs) - should give investors and analysts alike some comfort as to the viability of the company's strategy. I believe this, along with further progress and completion of additional trains for the Sabine Pass and Corpus Christi facilities, will serve as a catalyst for the company.
As for the company's exposure to the energy sector and plummeting oil and gas prices, I can only say that this is the conclusion of the lazy investor's superficial analysis. In reality, and as many on this board probably know, Cheniere's business has virtually no market risk exposure to oil or natural gas prices as the cash flow from its long-term (20-year duration) SPAs are predominantly fixed fee based - thus securing support for interest payments and debt servicing. This last point is especially important, so let me explain how this works in a little more detail.
Cheniere buys natural gas (feedstock) from a number of producers and from a number of pipelines (in order to reduce risk of any one going out of business, not performing etc.) and has transmission agreements in place to guarantee the delivery to its interconnects. The company is currently negotiating gas supply contracts for its CCL facility and has already secured 1-7 year term gas supply contracts for the SPL terminal for an aggregate of some 2Tcf, which according to the company, constitute 50% of the required load for trains one through four. Cheniere's term gas supply contracts lock in prices the company has to pay at Henry Hub (HH) - $0.10.
Thus, the company is able to buy natural gas at around the Henry Hub price in the worst case, and Henry Hub minus a discount for at least 50% of its supply needs.
The company has contracted long-term (20-year, most with an additional 10-year option to extend) SPAs in place already for 87% of its output (88% and 86% for SPL and CCL, respectively). Importantly, these are fixed-fee "take-or-pay" contracts ranging from a low of $2.25/MMBtu to $3.5/MMBtu, with an additional LNG cost component of 115% of the Henry Hub, fully offsetting the HH input cost, with an additional margin differential surplus (115% vs. Henry Hub minus discount) and fixed fee on top. Part of this surplus differential is used to power the liquefaction facilities with the natural gas it buys.
In other words, Cheniere's profit is not directly related to the price of oil and natural gas as it is neither an upstream E&P nor a downstream, consumer-facing seller. Rather it is more akin to some midstream/downstream refiners, which, due to this, have not been hit very hard by the energy downturn. Moreover, the counterparties to these SPAs are mostly large, investment-grade companies such as EDF, Total (NYSE:TOT) and Centrica (OTCPK:CPYYY) (ranging from BB+ on the low end to A+ ratings), thus significantly reducing the risk of nonperformance.
As mentioned, 87% of volumes are locked in with long-term SPAs. Cheniere Marketing (CMI), a subsidiary owned 100% by Cheniere Energy, has separate SPAs with SPL and CCL for LNG not sold through its long-term SPAs. This is thus more of an opportunistic business, and enters into short-, medium- and long-term supply contracts (currently has contracts ranging from two years to 20 years). It can be argued that Cheniere Marketing is more exposed to the price of natural gas than is Cheniere Energy, and to a certain extent this is true; however, it is equally true that this is mostly offset by the fact that the input cost is tied to Henry Hub - and in its current contracts, the floating part of the price is tied to either HH or a similar foreign benchmark (some are based on just a benchmark while others have a fixed + variable component).
There are a few different ways to invest in this opportunity due to the structure of the company (the detailed holding structure can be looked up in the 10-K or latest investor presentation), but the basic breakdown is as follows.
Cheniere Energy, as mentioned, owns 100% of Cheniere Marketing (the opportunistic play), as well as 100% in Corpus Christi Liquefaction, which holds the Texas assets of the company.
The liquefaction, regasification and pipeline assets associated with the Sabine Pass terminal is 100% owned by Cheniere Energy Partners (NYSEMKT:CQP), which has a public float of 13.1%, with Blackstone holding 29% and Cheniere Energy Partners LP Holdings (NYSEMKT:CQH) owning 55.9% (remaining 2% is owned by Cheniere Energy Partners GP, LLC, which is a pass-through company of Cheniere Energy).
Cheniere Energy Partners LP's public float is 19.9%, with the remaining 80.1% interest owned by Cheniere Energy.
As this write-up is focused on Cheniere Energy, Inc. I will not delve as deep into CQH and CQP, however, they do offer some of the same exposure as Cheniere itself and the diligent and enterprising investor can carefully monitor the price dynamic of the three companies for relative value opportunities should prices diverge sufficiently. Those interested in CQH and CQP should note that by the nature of these holdings, opportunities for expansion and growth beyond SPL can be (and probably will be vis-à-vis Cheniere) limited. That being said, it does benefit from potentially greater certainty in terms of having materially all of its business tied to the long-term SPAs mentioned.
Cheniere offers the investor exposure to the same business as CQH and CQP, but will also benefit from the growth of Cheniere Marketing and CCL, as well as further investments the company may undertake. As the economics and investment rationale of CCL is similar to SPL, and we find the economics of that business to be appealing, we naturally feel the same about CCL. Moreover, Cheniere Marketing has the potential to capitalize on Cheniere being a low-cost producer ("Breakeven LNG price for Cheniere's LNG export facilities is one of the lowest compared to other proposed LNG projects" - Cheniere investor presentation and Wood Mackenzie data), and the ability to profit even in a challenging pricing environment - with an embedded option owing to the potentially substantial upside should prices recover to a higher level. The scale and optionality thus are both factors making us favor over CQP and CQH, especially considering the price of Cheniere has suffered substantially more relative to the former two over the past year or so.
Broader Setting for the Business
Natural gas and LNG are growing as a percentage of the world's energy mix both because of relative abundance and thus lower prices, but also because of secular trends, government regulation and a desire on the part of utilities and the public for "clean(er) energy". Look no further than to coal for an example of this playing out. Coal/gas switching notwithstanding, this trend is unlikely to abate, and the demand for LNG is expected to double over the next 15 years according to Wood Mackenzie, resulting in a growing excess demand/supply-demand gap starting in five years' time.
Cheniere also has a significant first-mover advantage, especially within the US, with its trains starting to come online. Significant ($ billion) investments, complex planning, development and constructing are necessary to build facilities such as SPL and CCL - it is not done overnight - and extensive permitting from DOE, EPA, FERC etc. is needed in order to build the facilities and to export LNG. Cheniere's institutional knowledge and successful execution of the first train, and on schedule, on budget, on target development of further trains are all positives in terms of future potential expansion and growth but also in terms of ability to execute and develop existing projects.
The valuation scenarios represent what we believe to be very conservative projections and estimates for fiscal-year 2021. 2016 numbers are based on 2021 numbers discounted using an 8% interest rate p.a. They are not meant to be precise - only roughly accurate under the stated assumption - but rather to illustrate that it is easy to demonstrate the company's value proposition based on its SPAs.
Conservative Base Case - Seven trains based on SPAs and management projections. No value given to Cheniere Marketing:
- EBITDA: $2.1bn
- Pre-tax cash flow per share (fully diluted): $4.2.
- Conservative P/CF of 15 yields a price of $63.
- 2016 equivalent share price: $43.
- Upside relative to today's price: 26%.
Rainy day scenario
Seven trains - No value given to Cheniere Marketing sales. Some counterparty defaults leaving the equivalent of two SPL trains idle:
- EBITDA: $1.7bn
- Pre-tax cash flow per share (fully diluted): $2.8.
- P/CF of 15 yields a price per share of $42.
- 2016 equivalent share price: $29.
- Downside relative to today's price: 16%.
Positive Base Case - Nine trains based on SPAs and management projections - no value given to Cheniere Marketing:
- EBITDA: $3.0
- Estimated pre-tax cash flow per share (fully diluted): $5.66.
- P/CF of 15 yields a price of $84.825.
- 2016 equivalent share price: $58.
- Upside relative to today's price: 70%.
The way we look at this, the odds are solidly in our favor even when using conservative estimates and multiples. Importantly, this assigns zero value to the Cheniere Marketing business, which we view as an additional free option on the spread between US and international gas prices. The reason we present it in this way is because the Cheniere Marketing option fair-value range is wide, depending on the assumptions used. We peg this option value at roughly $8/share in 2021 ($5.4/share discounted to 2016) in the most conservative scenario (Cheniere Marketing contribution capitalized at 10X multiple) and around $24/share in 2021 in a more favorable natural gas spread environment ($16.3/share when capitalized at 15X multiple and discounted to 2016).
Further significant and prolonged fall in energy prices, causing contracted counterparties to default or restructure SPAs. Tightening of the spread between HH and Asian/European/Latin America markets will cloud the opportunities for Cheniere Marketing. Rapid interest rate tightening and constrained lending environment, making refinancing and additional debt facilities unavailable or significantly more expensive.
Overall, we believe Cheniere presents an attractive investment opportunity stemming from the recent energy carnage wreaking havoc on the energy sector and dragging everything down with it (act first, think later). Moreover, the long-term stable and predictable cash flows make this an investment which offers both a margin of safety as well as protection from permanent impairment of capital.
We expect that each successful shipment of LNG will be a positive for the company in the near future as people get more comfortable with their ability to execute, and the completion of each additional train - and subsequently, the completion of the SPL and CCL facilities will serve as additional catalysts.
Disclosure: I am/we are long LNG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.