Description

EXECUTIVE SUMMARY:

The investment thesis is relatively straight-forward, as it is a simple buy-and-hold idea unless price converges with value quicker than expected. NFG was incorporated 109 years ago in Buffalo, NY as a natural gas distribution utility company. Over the decades, the business has grown into a vertically integrated operation, including the upstream, midstream, and obviously downstream natural gas industries. The company is in the process of a gradual transformation in which they will no longer be identified primarily as a utility company, but instead as a diversified energy company with an exploration and production growth engine. The value proposition is in its sum-of-the-parts value. These stories tend to take longer to play out than do cash flow or earnings-based value ideas unless there is a buyout or some other unidentified catalyst. However, even with a multi-year investment horizon, I believe NFG will generate attractive, market-beating returns. The company has durable competitive advantages within its growth assets, it has good growth prospects, and a purchase price that offers an attractive upside if the company's growth strategy pans out and/or natural gas prices improve.  Importantly, this investment does not need an improved gas price environment for the thesis to hold -- NFG's E&P operations earn enviable returns on capital even at sub-$4 natural gas prices.  The downside scenario is somewhat buffered by the recession-proof cash flows of the distribution business and extremely low cost E&P business, but with the price run up over the past several months I would not be surprised if the market offered it up at lower prices in a serious market correction or double dip recession. Caveat emptor.

OVERVIEW OF THE BUSINESS SEGMENTS:

The utility segment is what you would expect: an operation that has limited growth prospects but brings balance and diversity to the company's cash flows. Given the history and shareholder base, the company has put a high emphasis on non-volatile cash flows and the utility segment helps achieve this goal.

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In the Northeastern United States, the demand for both storage and transportation capacity has been strong. NFG is well positioned for future growth in their pipeline and storage segment due to their enviable proximity to gas producing regions of Canada and the Marcellus and Utica Shale formations in the United States. In addition to the planned capital projects to build out infrastructure, I believe the company has a multi-decade growth engine in which they will deliver non-discretionary services to producers and result in steady, reliable earnings for NFG. The Marcellus and Utica Shale plays are still very young and underdeveloped, and at least the Marcellus has demonstrated that it is a low-cost shale play that will continue to be developed in almost all natural gas price environments. According to their most recent annual report, they "aim to become the preeminent transporter of Marcellus supply."

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The E&P segment is where most of the potential growth and value lies within this company. They have assets in California and the Appalachian region of the United States. Over the past few years the company has dramatically diverted capital spending away from their higher risk production assets in the Gulf of Mexico and towards their low cost natural gas production assets in the Marcellus Shale. ?See slide 29 of their 5/13/11 presentation: http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9OTM2NjZ8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1. (Note: NFG sold their Gulf of Mexico assets on April 27, 2011).  The company has more than 745,000 prospective acres in the Marcellus Shale, approximately 80% of which is held in fee title (no lease expirations and no royalty payments to landowners). In other words, they have a wide and sustainable economic moat relative to most of their peers. They are able to further lower their cost structure by utilizing economic multi-well drilling pads because so much of their acreage is contiguous.  David Smith, NFG's CEO, made the following remarks during the November 2010 conference call:

"Well over two-thirds of the capital on our system is going to Appalachia, going to the Marcellus and we told you last year we'd do that, we plan on continuing, in fact increasing the amount of capital that we are putting into Appalachia and you know people said well why are you doing that with gas prices we've had? Well I think first, even with relatively depressed gas prices and you'll see this later, our returns are still very, very strong. And two, I might feel a little different if we only had 30,000 acres or 40,000 acres. We have so much running, we have running room for 20 years. So it's not like by drilling now we're giving up, you know a significant percentage of our opportunity. And given that running room it's our intention to keep moving forward, to keep on increasing our capital spending in Appalachia."

To beat out lease expirations, many competitors -- who purchased leases during the $10+ gas price days of 2008 -- have had to establish commercial production on uneconomic terms and in some cases without adequate transportation infrastructure. NFG, on the other hand, has been able to prudently analyze their acreage in stages before ramping up a drilling program. NFG purchased this large swath of acreage many decades ago, with no knowledge of the huge resource base underneath it. The Upper Devonian, Marcellus and Utica Shales fell in their lap. Note that the company has not yet disclosed much information related to the Utica Shale, but I believe they have very significant upside value in that play. On the 02/04/11 earnings call, Matt Cabell (SVP of Seneca Resources -- NFG's E&P subsidiary) said that they've determined that the Utica Shale is prospective over a large portion of their acreage. This could be huge in terms of asset value and private market value for the company.  I look for NFG to provide greater transparency on this play's potential sometime soon. Because of the Utica's youth, it has been a challenge to obtain enough information to draw meaningful conclusions about what it may mean to NFG, but it undoubtedly provides an upside option to the equity. Mario Gabelli, who discussed NFG at the 2011 Barron's Roundtable, had this to say about the Utica: "When you drill, the first few thousand feet of shale is the Upper Devonian. You will find gas in 98% of your wells. Below that is the Marcellus, and further down is the Utica. The Utica fields are likely to be more prolific. Some companies just lease the Marcellus, but when you own the mineral rights, you can drill all the way down." Slide 45 of the previously cited May 13th presentation has a map showing NFG's acreage in the context of the Utica.

VALUATION

As previously mentioned, the value is in the assets rather than a multiple of near-term earnings or operating cash flows. In the third quarter 2010 earnings release, the company increased the estimate of their net risked Marcellus resource potential to a range of 8 to 15 trillion cubic feet (Tcf) across their prospective acreage. There is a 52% risk factor, so there is further upside in resource potential as more reserves get proved up and more acreage becomes "un-risked." I have found enormous variability in what constitutes an appropriate valuation multiple when talking to industry experts: $1 to $3 per Mcf. The low end of this range puts a $8-15 billion price tag on NFG's Marcellus acreage, and the high end comes up with some pretty silly numbers.

Taking a look at the recent private market deals in the Marcellus Shale will also give us a reasonable idea of what NFG's acreage would be worth. Keep in mind that some acres are worth more than others depending on liquids content, royalties to landowners, geography, proximity to transportation infrastructure, etc. The following deals were done during 2010, when natural gas prices were depressed:

Atinum Partners - 17,100 acres for $70M or $4,094/acre - 9/22/10
Sumitomo - 13,000 acres for $140.4M or $10,800/acre - 8/31/10
Reliance - 10,400 acres for $65M or $6,250/acre - 8/5/10
Williams - 42,000 acres for $513M or $12,214/acre - 5/25/10
Reliance - 120,000 acres for $1.7B or $14,167/acre - 4/9/10
Consol Energy - 500,000 acres for $3.475B or $6,950/acre - 3/15/10
EQT Corp - 58,000 acres for $280M or $4,828/acre - 3/2/10
Mitsui & Co - 100,000 acres for $1.4B or $14,000/acre - 2/16/10

This averages $9,163 per acre. NFG has a low cost structure but their assets are relatively low in liquids content, so I believe that the average is a reasonably conservative proxy for what their shale acreage could fetch in a negotiated arms-length transaction. Multiplying their 745,000 prospective Marcellus acres by $9,163 gives us a value of $6.8 billion.

I estimate the values for the pipeline/storage assets, the utility, and the non-Marcellus assets to be $3 billion. Add that to the approximated $6.8 billion value for the Marcellus assets and the total comes to $9.8 billion. Deduct long-term debt of $899 million and the total equity value of the business is $8.9 billion, with further upside from improved EUR's, the Utica Shale, and a more aggressive valuation of their Marcellus properties.

$8.9 billion divided by 82.7 million diluted shares outstanding results in a per-share value of $106.

WHY DOES THIS OPPORTUNITY EXIST?

I believe the price-value discrepancy exists in part because the company has been conservative regarding their shale asset disclosures to date.  Until very recently, many peers in their industry did not recognize them as a major player.  As Matt Cabell noted in the November 2010 conference call:

"About a year and a half ago there was an article in one of the industry publications and it had a list of companies and it was companies with the most exposure to the Marcellus Shale. There were ten companies listed there; we weren't even on the list. I think now by any measure we belong at the top of that list. We have the most acres in the Marcellus per share of stock. We had either number one or number two in terms of total acres in the Marcellus in the state of Pennsylvania. We have the highest Net Revenue Interest across our acreage position at 94% and now we have some operational success that goes with that. We are the, we have the highest production per well of any of the major operators in the Marcellus."

RISKS AND VARIANT PERCEPTION

* Environmental regulations will curtail or even prohibit drilling in the Northeastern United States. I believe this risk is small, but cannot be ignored. As we've seen in the Gulf of Mexico, one irresponsible driller can ruin it for everybody.

* Natural gas prices will go even lower because the huge shale discoveries and the associated supply growth. I believe this is nonsense. In the long-run prices will have to be sufficient to incentivize further production, just like any other industry. According to Tudor, Pickering, Holt & Co. four-fifths of U.S. natural gas production requires a price above $5 to make a 10% rate of return. I am not concerned about prices being sustained far below this level. And even at $4 gas prices NFG generates strong returns because of their low-cost position in a low-cost play.  Even though improving prices aren't a part of this investment thesis, I do believe significant price improvements are likely over the next few years due to growing industrial demand, conversion of U.S. LNG import facilities to export facilities, and most importantly because the major U.S. natural gas producers have recently shifted huge percentages of their capex towards an oilier production base.

Catalyst

It will take years for the enormous value of NFG's natural gas assets to become fully apparent to the market, but the stock does have one potential near-term catalyst. In an effort to shift a significant portion of early drilling costs to a minority-interest partner while maintaining operations across most of its acreage, the company recently announced that they've engaged Jefferies & Company to explore JV opportunities. On November 6, 2010 David Smith said "We're pleased with the level of interest expressed to date by potential partners, and we're hopeful we'll complete a significant transaction within the next three to six months. We'll only do a joint venture if it adds to shareholder value in a meaningful way."  His comments on the conference call that same month:

"You know we've engaged Jeffries who we think, you know they've done most of the big deals in the Marcellus and we're very comfortable with what Jeffries is doing. I want to make sure that people understand that very early in the process we disclosed the fact that we were considering a joint venture. I think much earlier than many of the other players. We tend to be a conservative company we're concerned about selective disclosure and so we came out pretty early, we talked about the pros and the cons and decided once we started hearing rumors about it ourselves we said, look we have got to get out there and put this out. So we did it relatively early in the process. We're just concerned about Reg FD. We expect to sell a significant percentage of our acreage, in the Marcellus. We expect a portion of the sales price will be paid up front. We expect a portion will be paid in a carry, that's how many of the deals have been structured as you know. We expect that it would result in a much more aggressive drilling schedule, although we'd work with our obviously potential partner on that. We expect that Seneca would be the operator and given Seneca's track record in the Marcellus, I think that would be a very big positive for the joint venture. We expect that we'll take a significant portion of the proceeds and put it into gathering in Pipeline and Storage to support the joint venture. And I think this is a big advantage for any joint venture that we might do. Many of the joint ventures out there are having difficulty now meeting their minimum drilling requirements in a large part because their acreage is scattered, so they're drilling here and they're drilling here and they're drilling here to hold leases. And so it's not very efficient drilling. We have the advantage of having a terrifically aggregated acreage position which allows us to be very, very efficient in our drilling. Our acreage is fee for the most part, you know we don't have to pay a royalty, we don't have to drill to hold the lease, we don't have to drill in that inefficient fashion the way some others really are frankly forced to do. So we think that our joint venture, we thought it would gain significant interest out there and we're happy, we're pleased with the interest that we've seen to dated. And so we'll be moving forward on that and we will let you know as things transpire. Really at the end of the day I guess a couple of things I can say. At the end of the day, we, number one timing is not as important to us as having the right partner, getting the right price. If we, probably more important than anything else is having a partner that we trust, having a partner that we can work together with and are compatible with, this is a long-term partnership. And number two we won't do it unless we think it will significantly add to shareholder value."

More recently, they've stated that after receiving "serious offers" they anticipate reaching a conclusion on a joint venture by the end of June 2011.  A joint venture would highlight the value of some or all of the company's Marcellus acreage and might provide the market a better benchmark upon which to measure equity value.