With natural gas (NG) prices soaring, it seems prudent to explore the possibility of Antero Midstream Corporation (NYSE:AM) once again paying a $1.20 dividend. In February, Paul Rady, Chairman and CEO (Resources) said, "Antero Resources (AR) announced the formation of a drilling partnership through 2024 that is expected to result in incremental throughput and fresh water volume growth on Antero Midstream dedicated acreage. As a result... Antero Midstream is forecasting a 2021 capital budget of $240 to $260 million, reflecting approximately $65 million of incremental capital that has been accelerated into 2021 above the previous maintenance capital program." Midstream cut the dividend from $0.30 per quarter to $0.22 in order to fund drilling. With natural gas prices through the roof, we wondered if Resources might return that $65 million or at least part of it. If so, how would Midstream use it? We also wonder if the statement, "Antero Midstream dedicated acreage" precludes changes? Is this production profit dedicated for Midstream? Details about the source for Midstream's benefits seem sketchy. Regardless, Midstream's benefit improves either way with natural gas above the roof. Our approach looks at Resources taking on the full responsibility for the drilling capital.
A few quarters ago, Midstream announced a dividend cut from $0.30 a quarter to $0.22 a quarter. Management promised savings from the change for Resources to expand its drilling of new wells, thus improving production. Since Midstream provides Resources' transportation, this also significantly improves Midstream's cash flow. At the announcement, Resources noted that it expected that Midstream would experience a cash flow increase of $200 million over the four years, 2021-2024. In our view, looking at two major financial markers provides investors with some needed insight, Resources' debt and debt objective plus natural gas hedging. It follows that the barriers resulting from at least these two hurdles must be cleared before Resources might consider changes. Or can it?
We begin with debt. At the end of the June quarter, Resources carried $2.4 billion in long-term debt. Management stated that it expected to reach the corporate goal of $2.0 billion by early 2022. How fast it may achieve this objective depends on in significant fashion, the price of natural gas. The following chart graphs a recent history. At the July conference, gas traded at approximately $4.0. Since the conference, it has climbed into the $5.5-$6.5 range.
Management also added that "leverage is expected to fall below 1.5 times by year-end 2021 and below one-times in 2022." It's clear Resources plans mandate a conservative approach for its operations. When compared to key competitors as shown in the next slide, Resources isn't just conservative, it's ridiculously conservative.
At the call, it noted a reduction of over $1 billion in its YOY debt, not a small feat. Some the down payment was through asset sales. When asked by an analyst, Michael Kennedy, Senior Vice President & Chief Financial Officer offered, "Yeah, good question. We are paying down debt much more rapidly than anticipated even from this first quarter and so it should be in early 2022. I think previously, we thought it'd be kind of mid-'22, so that's been accelerated." Remembering that at this conference, NG traded at $4.0, a cheap price compared to $5.5-$6.5 range today. The pay-off date again moved forward.
Continuing from the company's prepared remarks, management predicted significantly higher cash flow moving forward. "We forecast over $750 million of free cash flow in 2021 and even higher free cash flow expected in 2022. Further, looking out through 2025, we are now targeting over $3.5 billion in free cash flow signifying substantial annual free cash flow growth through that time period, despite the heavily backward-dated commodity strip."
Resources debt and balance sheet repairs are happening fast, much faster than anticipated.
When companies turn to hedging, the practice of entering into contracts that guarantee minimum sells price, it can forgo profits if the price turns bullish. Management again addressed this issue at the July conference, "Given our continued bullish view on the outlook for NGL pricing, we remain essentially unhedged on our LPG beginning on October 1 and through 2022 and beyond, as we look to take advantage of the pricing dislocation, we see this winter and into next year." With respect to LPG, "Overall, the global demand pool for LPG continues to materialize and Antero continues to benefit on multiple fronts." LPG exports from the United States is booming with European NG pricing near $20, yes $20, at times.
The next slide shows the effects NG pricing has upon Resources' financial future.
With regard to NG, management stated, "Looking ahead, we are currently the least hedged in our company history on the natural gas side entering 2022 and have very little NGLs hedged and no propane after October 1 of this year, 2021."
From the above slide, the company added that for each ten cents increase in NG pricing, it increases revenue by approximately $100 million. Since July, the prices have jumped by approximately $2 or 20 times $100 million equaling $2.0 billion per year. Obviously, we don't know for how long the price might remain high, but winter and its cooler weather always increases demand.
With Resources limited hedging, investors may expect even higher cash flow for the next several months. But, more importantly, the limited number of hedges also offers the company an opportunity to hedge at significantly higher prices thus holding on to high profits long-term. For Resources' investors, this opportunity requires a watchful eye.
To summarize, Antero Resources is on track to meet and exceed financial goals freeing up large chunks of cash much more than the $65 million Midstream is paying for new drilling. Although the company has stock purchase plans, it seems unlikely that it might use such a large percentage of it for that action.
With Resources rolling in cash, Midstream might become a beneficiary, since the major hurdles have been jumped. First, it must be noted that Resources owns 30%. So for each dollar returned, it costs only 70 cents. Returning the dividend means $50 million in real cash from Resources, peanuts compared to the vast increase. Next, investors must understand Midstream's own goals. The following slide summaries its five-year plan.
Of particular interest appears in the last line, a goal for reducing leverage. With leverage near 3.3 and a target near 2.8, the company needs to pay down debt. According to the slide, cash is expected to increase by $50 million a year ($200 million for the total period), which by definition lowers leverage. The company carries $3.0 billion in debt divided by 3.3 equals $900 million a year in EBITDA. Add $50 million/year in cash to the $900 million, multiply by 2.8 to find an approximate debt target. That calculation equals $2.65 billion. The additional drilling cash, if spent on lower debt, still leaves the company short by a modest, but real, $150 million.
The truth of the matter is that we don't know what direction management will chose, but it seems clear that the major hurdles were cleared opening a door of opportunity. The decision lies with them.
Our thinking is that at some point Resources will return some cash or Midstream might use some of the windfall, allowing it an opportunity. From our perspective, an advantageously managed dividend paying business, such as Midstream, peaks in price at 8-9% yields. A table illustrates possible peak stock prices based on this belief.
|Stock Price||Yield||Basis (% yield)||Possible Stock Price|
|1st Possible Guess||$1.00||8.5||$12|
|2nd Possible Guess||$1.10||8.5||$13|
Approximately 80% of our Midstream holdings are hedged with January 2022 calls, strike price of $12.5. With the close of these calls, assuming the price is at or below $12.5, we plan to move the strike price upward to $15 or even leave some completely unhedged. We just sense, that at some point, a dividend increase is coming. By accepting more risk, an investor might consider selling $10 or $12.5 puts longer in term.
Always remember risk exists for any investment. With elevated debt, risk is always higher. With a political climate seeking to completely eliminate Antero's basic industry at a future date, valuation can be stunted. Cirrus Logic (CRUS), with its high reliance on Apple (AAPL), is a prime example. But, we believe that even with risks, Antero is positioned smartly for the future. It will continue to pay at least the $0.22. We welcome other thoughts especially concerning Midstream's source for increased operating cash going forward.
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Disclosure: I/we have a beneficial long position in the shares of AM either through stock ownership, options, or other derivatives. 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.