EQT (NYSE:EQT) recently announced that management unwound some hedges to raise the company exposure to the currently strong pricing. The CEO noted that obviously hedging against lower prices was not correct. Investors need more managements that own up to the current situation as bluntly as this CEO did. Managements that own up to corrections did to fix problems whereas managements that sweep problems "under the rug" tend to let problems pile up.
The other issue here is the failure of GAAP to present an accurate picture of company accomplishments. Marking hedges to the market price every month and causing the company to report large gains or losses causes the income statement to materially misstate actual net income. The reason is that hedging valuation changes are an opportunity cost. Management had the option to decide to risk the company future by selling at market price when the time came or go for certainty by locking in the future sales price received for production.
The fact is that EQT is probably profitable at the low price of the hedges. But Mr. Market would never know it from the income statement. EQT lost the opportunity to sell the natural gas at a now fairly certain higher price because much of the industry did not see the currently high prices for natural gas coming in the future at the time the hedges were created. So, in exchange for risking any one of unfavorable future industry pricing, the company accepted the hedge prices.
Source: EQT Third Quarter 2021, Earnings Press Release.
The adjusted net income has a difference that is largely due to the "mark to market" calculation of unsettled hedging contracts. Now that profitability is close enough to breakeven that some of the smaller adjustments could change the figure to a small loss if the investor decided that those adjustments should not be in the calculation.
What is clear from the calculation is that the company is doing much better than was the case in the previous year. Net cash provided by operating activities has been affected by some significant acquisitions made. Therefore, it may be a couple of quarters before the cash flow reflects ongoing business conditions.
The hedging business often looks bad during an industry recovery. On the other hand, management is a hero if they fully hedged for something like fiscal year 2020. But the reality is that management never saw the challenges of 2020 ahead of time. So, it is probably reasonable to assume that management never saw the benefits of a strong fiscal year 2021 pricing on the horizon either. Yet Mr. Market will punish losses when all management tried to do is lessen the selling price volatility to justify the capital budget.
Source: EQT Corporation Third Quarter 2021, Earnings Press Release
What needs to be watched instead is cash flow generated by operating activities before the changes in other assets and liabilities. That non-GAAP measure gives an idea of the profitability of the business. Of course, it's also helpful to review the amount of capital needed to maintain production as well as many other items. But at least the investor as some idea from the adjusted operating cash flow as to whether or not the company is making financial progress.
The various other assets and liabilities used working capital because this company made some significant acquisitions. Acquisitions themselves are considered one-time events whereas the adjusted cash flow is likely to repeat in the future as long as industry conditions stay about where they are.
Probably the one item that appears to be logically absurd is the calculation of free cash flow. Management had really almost no cash flow from operating activities. Yet the free cash flow calculation shows plenty of cash available for any purpose management would want to have. That is supposedly the definition of the "free" part of free cash flow.
This is a major problem with free cash flow (it does not reflect the actual cash available for anything management chooses). Furthermore, there are many competitors in the industry that need to reduce debt. Yet debt reduction is nowhere mentioned in the free cash flow calculation. At least the changes in other assets and liabilities are shown in the calculation so the shareholders know where the cash went.
Clearly the free cash flow calculation that Mr. Market is in love with needs a workover. It is time for this calculation to show or demonstrate cash which is available after necessary expenses like debt reduction (and changes in other assets and liabilities). Clearly GAAP and more than a few non-GAAP measures have put the reporting in a position to tell investors everything except whether the company is making money (and free cash) from operating activities. Someone needs to stop this "runaway train".
The cash flow statement is not going to be affected by the non-cash re-evaluation of the hedging contracts that are part of the quarterly income reporting. What will affect the cash flow statement is the relatively low (realized) prices reflected in the hedges. But that is very different from calling an opportunity cost a loss. GAAP should require a note about the hedging situation rather than require the market value change to be reported as income or loss. Income should bear some relation to the cash flow statement. Currently GAAP has really disassociated the income statement from company financial progress by including the hedge reporting.
The other consideration is that the acquisitions will likely increase the cash flow as operations are properly integrated and optimized. That could take at least a year. But there should be material cash flow improvements along the way.
Source: EQT Corporation Second Third 2021, Earnings Press Release
Sooner or later the organization behind GAAP is going to have to tackle the non-GAAP reporting of adjusted income if the organization continues to insist that hedges be revalued each quarter with the result of that change on the income statement.
Investors can argue that some items like lease expiration do not belong in adjusted income. But a lot of adjustments can still be made in favor of the chart above. It conforms far more closely to the progress shown on the cash flow statement. Clearly, despite the hedges, the company is participating in the industry recovery. It sure could participate more without the hedges. But given the information that management had at the time; the hedges established were reasonable. After all, management is only human and regularly deals with imperfect information.
Source: EQT Second Quarter 2021, Earnings Conference Call Slides.
What is important is that the company has made two very decent acquisitions while lowering key ratios (like the debt ratio) in the process. In the eyes of the debt market, the financial strength of the company has increased.
Management is relying upon operating leverage to bring about sustainable operating gains that would lead to a higher share price. There was and probably will be some selling shareholders as a result of the acquisitions. But that generally is a situation that will not last long term.
This management has everything it wants in terms of desirable lease locations and lower debt. Now it is up to management to produce long term results that will result in higher share prices. The current focus on hedges probably takes away from the longer-term benefits of the acquisitions, operational optimization, and bargain acquisition purchases.
The commodity business gives lots of managements opportunities to make decisions that quickly look like mistakes. The key is to make more right decisions than wrong decisions so that an adequate profitability track record is established. This management appears to be up to the job. So, the current market concern could represent a decent opportunity for investors to do their homework and establish an initial position.
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