EQT's Future Looks Significantly Brighter As Rice Brothers Take Control Of The Board

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About: EQT Corporation (EQT), Includes: ETRN
by: Aurelien Windenberger
Summary

The Rice brothers have officially won what may be the largest proxy battle of 2019, taking control of the board at leading natural gas producer EQT.

Large EQT owners, including D. E. Shaw, T. Rowe Price, and CalSTRS voted in favor of the 7-director slate proposed by Toby Rice's group.

Two years after selling Rice Energy to EQT, the Rice brothers will now lead the combined company with the promise to deliver significantly better well economics and higher cash flows.

I, for one, am very bullish on this development and expect to see significant gains in the stock as Toby Rice begins to execute his plan to improve operations.

Two years ago, Toby and Daniel Rice sold Rice Energy, the Marcellus Shale natural gas driller they had founded, to EQT (EQT) for over $6 billion. On Wednesday, the brothers won over 80% approval for their board director slate, taking control of the board and putting Toby Rice in charge of the company as CEO.

This is a significant positive development for EQT shareholders who saw terrible operating results in 2018 as EQT management was not able to effectively integrate two companies with very different operating cultures, leading to a greater than 40% drop in the stock between the merger announcement date and the Rice brother's announcement that they were trying to engage with the board in December 2018.

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When EQT purchased Rice in 2017 at a 37% takeover premium, EQT management justified the purchase by highlighting the large efficiencies they believed would be created by the combined company. These including SG&A cost reductions due to increased scale, as well as operational benefits such as the ability to drill longer laterals on the combined EQT and Rice acreage.

Source: Rice Team June 2019 Investor Presentation

Unfortunately, the planned benefits didn't materialize in 2018. On the contrary, operational issues that were likely certainly related to the challenge of integrating two very different company cultures resulted in significantly higher well costs for EQT in 2018 than what Rice had been able to do in 2017.

Source: Rice Team June 2019 Investor Presentation

In their highly detailed and well thought-out presentation for investors, the Rice Team highlights why they expect to be able to deliver significant well cost savings of over $300/ft versus EQT's existing plan. As Rice Energy's COO, Toby Rice was highly focused on using integrated technology to maximize the effectiveness of his operations, from land acquisition and well planning, to drilling and completion activity. The result was peer-leading performance by Rice in terms of well costs and well production before the company was sold.

Potential Impact of Management Change

Now that Toby Rice has won the confidence of EQT's shareholders, I expect him to hit the ground running to get his plan implemented. Rice expects to be able to deliver some savings in the back half of 2019, but of course, organizational change takes time, so the real benefits won't be seen until 2020 and 2021.

Back in January, EQT laid out a five-year plan in which they projected $2.7 billion in cumulative FCF generation (see page 13 of the Q4 2018 presentation). The Rice plan projects cost savings of $500 million annually on the same development profile as EQT laid out, a figure which would increase cumulative FCF by over $2 billion (assuming an 18-month ramp-up period).

Source: Rice Team June 2019 Investor Presentation

Combining the two FCF projections leads us to a total projected $4.7 billion FCF generated over the next five years. Currently, EQT's enterprise value is about $9.2 billion, and their net equity after eliminating their Equitrans (ETRN) stake is only $3.1 billion, The value accretion potential is clear, potential annual FCF averaging 20-25% annually.

EQT Enterprise Value $9.2B
Net Debt $5.1B
EQT Equity $4.1B
ETRN stake $1B
EQT net equity valuation $3.1B

Unfortunately, natural gas pricing has been very weak in 2019 due to continued over-supply versus demand. The current strip is well below where it was at the beginning of the year. Most drillers, including EQT, are relatively well hedged for 2019 and 2020, but the lower strip could have a significant impact on long-term free cash flow estimates.

This is clearly a concern for most investors today and has resulted in many natural gas E&Ps losing more than 50% of their equity value over the past few months. However, I believe that we are at or close to the bottom in natural gas pricing in large part because investors are finally forcing management teams to dial back production growth plans and dial in cash flow generation instead.

On this point, I'm happy to see that the Rice Team has suggested a bonus compensation plan which is well aligned with the metrics investors are interested in today:

Source: Rice Team June 2019 Investor Presentation

A third of their bonus will be directly attributable to delivering the cost savings they have laid out, and another third will be tied to FCF generated. The last portion is tied to their capital efficiency.

Summary

I am very excited to see that investors have voted for change at EQT. If Toby Rice is able to accomplish even half of the improvements he has laid out, I believe that investors buying the shares today can expect to at least double their money over the next 2-3 years, even if natural gas prices remain in the same ballpark. If we see the industry stop growing production, then natural gas pricing should improve and the returns for natural gas equities should be even better.

Disclosure: I am/we are long EQT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.