CNX Midstream: The Party Is Over

Summary

• CNX Resources got a "top dollar" fair deal to eliminate IDRs.
• The payments to CNX Resources destroyed the dividend coverage despite the distributable cash flow calculation.
• The current situation demonstrates the weakness of the distributable cash flow calculation.
• Long-term (and short-term) debt due to a related party needs to be included in the financial leverage calculations for the midstream.
• The IDR elimination agreement significantly weakened the balance sheet.
• This idea was discussed in more depth with members of my private investing community, Oil & Gas Value Research. Get started today »

CNX Midstream (NYSE:CNXM) is a "captive" division of CNX Resources (CNX). The attraction to investors was the low leverage and the well-covered dividend. Unfortunately, for the shareholders of CNX Midstream, CNX Resources management made a grab for both in the process of raising badly needed cash. They obviously succeeded at the expense of CNX Midstream shareholders.

Source: CNX Midstream Fourth Quarter 2019, Conference Call Slide Presentation

CNX Resources management badly dented the distribution coverage by negotiating a cash payment as well as 3 million shares of Class B units that would not receive any distribution until January of 2022. Any time an investor sees the distribution of a Class B type situation, that investor can be sure that the parent company (in this case CNX Resources) got the better deal and the conflicts committee was sleeping through the review of the fairness of the deal.

This deal also raised the debt roughly 20%. Interestingly, management did not include these payments in the debt ratio calculation. However, for shareholders of CNX Midstream, that $135 million represents money owed to someone, and it is properly part of short-term and long-term debt. It should, therefore, be included in the debt ratio.

Balance Sheet Effect

This is also the kind of agreement that makes lenders "put their foot down" and refuse to finance.

Source: CNX Midstream First Quarter, 2020 Earnings Press Release

In order to satisfy both the capital budget and the distribution, management needed to borrow significantly as shown above. For most lenders, this is okay as long as proportionate growth does not send the ratios skyward. Profitable growth that prevents the ratios from growing larger is an expected discipline by lenders.

This management tread upon some very sacred lending ground with the agreement shown above. Borrowing would have meant some key ratio deterioration. Lenders are not going to put up with financial deterioration, so the parent company can skirt some financial stress. Therefore, the midstream investors would be "footing the bill". But look what happened even then:

Source: CNX Midstream First Quarter, 2020 Earnings Press Release

The midstream balance sheet was immediately thrown "out of wack" by the agreement. Negative working capital ballooned to an unacceptable amount for a company of this size. That $50 million payment was beyond anything that would have been dictated by the partnership financials. Including the first $50 million payment as a current liability put the partnership in a bind.

Clearly, the cash flow was not supporting anything approaching the capital budget of the previous year plus the partnership distributions, and now a payment to CNX Resources for the IDR eliminations. The balance sheet very quickly became anything but conservative.

In addition, the coronavirus challenges have added uncertainty to the cash flow. Management took care of that problem by simply excluding the debt incurred for the IDR elimination from the long-term debt-to-EBITDA calculation. But you had better believe the lenders saw that one coming.

Source: CNX Midstream First Quarter 2020, Earnings Slide Presentation

Let's be a little conservative here and add the whole $135 million (owed to CNX Resources) to the debt and use $200 million at the low end of the guidance to re-calculate the debt ratio. Then, long-term debt climbs from $741 million to $876 million. In the meantime, EBTIDA guidance is reduced. The new long-term debt-to-EBITDA is headings towards 4.5.

For many partnerships that leverage is acceptable. Then again cash flow from operating activities dropped to $40 million in the first quarter despite considerably higher EBITDA. That extra difference may not come back because guidance was lowered and the industry is still in a major period of uncertainty caused by the demand destruction of the coronavirus challenges. Most lenders would allow management to handle the extra risk created by those sizable payments.

There will always be a certain amount of difference due to the interest and taxes included in EBITDA but subtracted to calculate cash flow calculation from operating activities. Given the industry uncertainty at the current time, there is a very good possibility that cash flow and EBITDA could be guided lower as the year progresses. What was once a fairly conservative situation has become a whole lot more financially strained.

In fact, the payment obligations due to the IDR elimination agreement appear to forestall anything approaching a return to the previous distribution levels for about two years. Depending upon the industry recovery, this partnership may need at least a year after that to recover from the cash drain caused by those payments. This is clearly something that CNX Resources should have dealt with before any CNX Midstream units were in public hands.

Source: CNX Resources First Quarter 2020, Earnings Press Release

The overriding problem is the excessive consolidated debt caused by the debt at the E&P (or upstream) level of the company. The low natural gas pricing means that the upstream part of the company needs sources of cash to properly handle the debt load. Clearly, the available avenue was to press the midstream for cash. Now, the midstream must not only make priority payments to the parent company. But the parent company also holds 3 million shares that do not yet earn a distribution but will have to be paid with other unit holders in the future.

There are many kinds of fairness in this world. But a financially leveraged parent company will get a cash-rich deal from the midstream subsidiary whenever possible. Clearly, this fair deal was cash-rich and very expensive for midstream investors.

It had the effect of elevating the payments from the midstream from distributions that were equal in priority with public partnership unitholders to debt payments that superseded any payments to public partnership unit holders. The 80% dividend cut should have been anticipated because the dividend simply was not covered no matter the "distributable cash flow" calculation. Basically, a new kind of distributable cash flow calculation was needed to account for the payments to CNX Resources that are really now accounted for as debt.

This whole situation highlights a huge weakness of the distributable cash flow calculation. First, there is nothing in the calculation to account for the sizable payments to CNX Resources. Secondly, there are 3 million Class B shares not receiving a dividend. But those shares should be included in the coverage ratio calculation to account for the day when they are eligible to receive the dividend and convert to regular partnership units.

The Future

Anytime the parent company finances are stressed as they are here, this type of action is a logical follow-up to stress finances elsewhere in the consolidated company. Partnership shareholders need to be aware that at any time, they can be notified that one way or another they will help out with parent company financial problems. The current solution should be considered a dry run for future potential handouts to the parent company. There always seems to be a management excuse for sending cash payments to a cash strapped parent at the expense of the partnership.

Source: CNX Midstream First Quarter 2020, Earnings Slide Presentation

On the positive side, CNX Midstream should have a low capital budget for awhile as the natural gas industry recovers from demand destruction and low prices. The latest projects should put this partnership in a higher cash flow situation after considering capital budget expenses. A growth budget is unlikely to be anything near a priority for about two years.

In the meantime, this partnership clearly needs to reduce debt levels as well as required cash payments and wait for industry activity levels to resume. That would revive cash flow from operating activities. In the meantime, these partnership units may be fully priced. In fact, they may be overpriced now that the market knows that CNX Resources found a personal piggybank. There are other units that I follow that have larger appreciation potential from current prices. At some point, the dividend will be restored. But not until all those payments are made to the parent company.

Those interested in this partnership should probably consider waiting until the financial health of CNX Resources is a lot better. Generally speaking, this deal to eliminate IDR's was not structured for a healthy parent company.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.

Comments

[bagger10]

Nearest comp to CNXM is probably AM (my core holding). Have to wonder if CNXM and AM share price ever crosses. I have already dipped a toe into CNXM at $1 difference, and plan on more buys if share diff (CNXM - AM price) goes to $.50 and $0.00.

Might be a couple of years, but when CNXM gets CNX paid off CNXM will be a solid Marcellus midstream.

[Long Player]

That is at least a year. Plus unlike AR, CNX does have cash flow issues. That is the main problem here.

[Carolina1954]

Plenty of good quality midstreams now trade at stable or rising yields of 10-15%. So why invest in CNXM at 5%?

Maybe CNXM is a "buy" at $2-$3, and maybe that is the trading range to which it is headed.

If it goes there, look for CNX to announce that, unfortunately, the "market has rejected the MLP business model", followed by a takeover at a modest "premium" to market.

[komokazi]

You do realize that they could very well put the dividend back to the previous rate next quarter (or anywhere in between).

[Long Player]

Here we go again!!

[Long Player]

@komokazi One of the things demonstrated is that they cannot put the dividend back up. The leverage as shown in the article climbed too much and the payment to CNX is far too much to have more than a nominal amount of cash available for CNXM holders. Major damage was done to the balance sheet and available cash.

[komokazi]

CNX/CNXM and AR/AM are interesting comparisons. CNX/CNXM are as conservative as AR/AM are aggressive. CNXM could have maintained the dividend but chose to be conservative and retain $30 million in free cash flow which reduces the $135 million liability to $105 million based on conservative assumptions of NGL shut-ins in Appalachia. The rest will be covered if they keep the dividend low this year. AR/AM are being aggressive growing production, buying back shares, and maintaining the dividend. Both paths will likely work out with AR/AM being riskier but with a higher return.

[Long Player]

Actually CNXM is riskier than AM as it has more leverage. Same with CNX which has really no cash flow to speak of right now and therefore far higher leverage at the E&P level. AR had better margins going into this and a better hedging program and therefore has the money to grow. CNX ran out of money. It is that easy. You have to ask why a lot of companies ran fro the dry "low cost" Marcellus to the rich "high cost" liquids Marcellus and Utica Shale to understand why the AR strategy is not that risky.

[komokazi]

Not exactly sure what data you're looking at - CNX Resources had $129 million in free cash flow in Q1 20.

[komokazi]

CNX conslidated guidance for 2021 has CNX CAPEX at $400 million and consolidated CAPEX at $440 million - CNXM 2021 CAPEX of $40 million. 2022-2026 guidance has CNXM CAPEX of $30 million. Production is relatively flat at 550 Bcfe.

[7716391]

Isn't Ichan's team a major shareholder of the CNX sponsor/parent - with a BoD seat? If so, it explains a lot.

[rochapeau]

Then there is a question at what price CNXM becomes a buy. I think it is already a buy below 7, but sell above 10. After reading your articles about CNXM I sold almost my entire holding when it started trading with a double digit handle. But with all the bad things considered, it should still make 20-25 cents a share every quarter or just under a $1 a year in EPS and even better when the debt is lower. This is considering that CNXM has nothing to do with oil and it will benefit from shutting down the oil fracking that result in wells with natural gas as a by-product. Also remember that we are facing a major currency (and debt in US dollars) debasement, but the value of the gas storage and transport facilities is not being debased. Of course, it makes sense to hold more than one pure gas midstreams, so CNXM goes well with AT for example.

[Long Player]

This management will take you to the cleaners any time it can. You have your notice and that needs to be in any forecast you make. You will not be treated well here even if it meets the definition of fair. Best thing is to avoid poor management like this crew.

[rochapeau]

Then it is even worse than bad management, it is management effectively stealing from the shareholders. Ok, I will heed your advise and not invest in this stock. Moreover, I will sell my entire position. I think, AM is a much better bet on growing natural gas consumption in the NE US (chemical industry, electric vehicles and shortage of nuclear plants) and the Marcellus and Utica shale. Thank you for heads up.

[Long Player]

Compare what AM did to what happened here. AM did pay $300 million to AR. But they were able to loan it while increasing the distribution as a result of the buyout. The result is the public was not hurt. Compare that to here and you can easily see significant differences.

[bagger10]

With your $135 mil addition to CNXM "debt" - which is certainly correct - CNXM loses the lowest Debt/EBITDA crown to AM (of the 12 midstreams I follow)...

[Long Player]

The biggest problem by far is that it needs to be paid so fast. Evidently CNX needed it badly enough to elevate it past the distribution received by unit holders.

[Long Player]

Just for the record I follow 2 with less leverage. RTLR being one of those two.

[ofirm]

RTLR would have a gp that is also in a cash crunch. that would be
jumping from one fire to another.

[CapVandal]

The current distribution of 33 cents is a rate of 4.5%. I think the current unit price is likely to decrease further as a number of reasonably conservative midstreams are yielding over 10%.

Without overthinking it, it seems like the two entities aren't independent at all and need to be owned as if they are a single entity if owned at all. That is some combination of CNX and CNXM. If that seems too complicated, which it is, then avoid.

[Long Player]

The way the E&P is capitalize, the latest events have shown the weakness of this strategy. Granted no one predicts a super warm winter followed by an oil price war and then a coronavirus. However, you never (I hope) run your company so the debt is not where the cash flow is which is the situation currently. that just screws things up so badly as is the case here. Everyone was focusing on the management FCF projections years out on my last article. Problem is management can only get there with a convertible bond offering NOW and then by really raking over the midstream holders.

[Darren McCammon]

CNX Midstream Suffers From Management Misalignment
seekingalpha.com/...

[Long Player]

There is a couple of these. MMLP is yet another.

[davexplorr]

What are the prospects for a class action suit against CNX Resources?

[Long Player]

You realize the results of that are probably a toothbrush for everyone if its successful and a brand new house and car for the attorneys?

[Long Player]

On the more serious side, one of the points of the article is that there is a wide range of fairness. Therefore, you have to be on guard when the parent company is not in good shape and learn to walk away no matter what the stock does. Here, it did about double from its lows. But when you see abuse like this along with the market reaction, then to me that is a sell and I really don't need to be associated with management like this no matter "how good they are". Too many times, managements like this come back for a second grab at your expense. Others of course can disagree.

[imlongnow]

@LP......I think the word "abuse" you used above is appropriate. I wish the SEC had the staff , resources and desire to take some of this abuse on, but they dont.....I totally agree you have to look at the health of the parent, regardless of the cash flow, distribution, coverage of the child. Shell the parent cut their divi, yet SHLX has been supported so far to keep their distribution going.

[Paul Petterson]

Should have heeded Long Player's warning right after this happened in February. Bought cheap and held for what I expected to be a relatively minor distribution cut.

Excellent, consistent analysis on this one per usual.

[Long Player]

Unfortunately, my warning track record about extra risk is generally among the top contributors. Here, it was hard to figure out just where exactly the breaking point would be. The coronavirus unfortunately did the job nicely. After this one and MMLP, I will no longer go near anything where the parent company is in financial hot water. In both cases they milked the LP for all they could get.

[User 40402486]

@Long Player Well written article. Any thoughts on MMP?

[Long Player]

Thanks. Anytime you have something like this where the parent company is in less than stellar shape, you get a money grab. Over at MMLP it was the trucking company drop down which accountants had to record $100 million of that as a distribution to MRMC. Once you saw that, then you know what was up. Here, the e&P company needs to dump all that debt. It can be done but obviously a little cash from the midstream must have been needed.

[Long Player]

I honestly have not gotten to MMP yet. I have a handful with what my readers already asked for.

[UGAZ Ended My Marriage]

2 potential things going on here:

1. Exactly like you outlined which I think is feasible. The management team over there loves to financially engineer and pass the buck.

2. It is a contrived tank job by CNXM management to destroy value to make it easier to pull it back into CNX (same management).

[metameta]

your username should win an award

[Long Player]

I would go for number 2 except for that slide on E&P cash flow combined with debt at the E&P level. If those numbers are for real, then the e&P company does not meet conventional lending guidelines and that is big long term trouble.

[Long Player]

Thanks!