Southwestern Energy Co. (SWN) $1.3 billion Mandatory Convertible Issue

The mandatory convertible issue, paired with a common stock offering, should raise over $1.7 billion. Funds will be used to help pay down a $4.5 billion, 1 year unsecured bridge loan.  SWN took out the bridge loan facility and an additional $500 million two-year unsecured term loan in December to complete the acquisition of natural gas leases.  As for the mandatory, it looks reasonably priced (read: cheap enough) at the midpoints of 6% dividend and 20% premium.

Southwestern Energy is a US natural gas and oil exploration and production (E&P) company primarily operating in the Fayetteville (Arkansas) and Marcellus (Northeast Pennsylvania) shale reservoirs. The company also has E&P activities in Colorado, Louisiana, Texas and the Arkoma basin in Arkansas & Oklahoma. In addition, SWN operates a natural gas gathering pipeline business.

Almost all revenue is derived from the sale and marketing of natural gas, with oil related sales comprising less than one percent of revenue. In late December, Southwestern completed the acquisition of oil & gas assets on 443,000 acres in West Virginia and Southwest Pennsylvania for $5.3 billion. The purchases are estimated to have 2.5 billion cubic feet of gas on a contiguous land track, offering economies of scale.  Southwestern now holds about 4.8 million net acres of undeveloped land, 2.5 million of which are in New Brunswick, Canada.

With cascading oil prices and natural gas slumping due to forecasts for a warmer winter, investors might question the timing of SWN’s recent large asset purchase. However, a look at history shows that Southwestern is battle-tested. During the last warm weather winter of 2011/2012, natural gas prices were capped in the $2 range and eventually reached a $1 handle in the spring. The dropping prices resulted in a 2012 $1 billion+ non-cash asset write down, but Southwestern rolled on, generating $1.6 billion in adjusted EBITDA in 2012.

Despite a rising risk profile by doubling company debt as a result of the recent acquisition, Southwestern, using its vertically integrated operations and economies of scale, looks set to repeat 2012 results. 26% of estimated natural gas production in 2015 is hedged at $4.40 and lower oil prices may actually aid Southwestern.  Natural gas is a byproduct of oil production and the recent explosion in domestic oil production has unleashed large volumes of “free” natural gas on the market. As oil prices fall, that natural gas supply should contract. Over time, natural gas exports should also boost demand. Southwestern looks set to take advantage of those trends.

With the recent asset acquisitions, Southwestern increased its active drilling territory by over 25%, excluding its exploratory holdings in Canada. The stock currently trades at just over 10 times 2014 consensus per share earnings estimates. That’s despite trading at a significantly higher multiple when natural gas, not oil, was experiencing a crash in 2011/2012. At that time, SWM was trading with a P/E in the high teens for 12 month trailing earnings.  With increased acreage and the demand/supply relationship more in-balance for natural gas than oil, we think the luster will return to SWM common shares once oil reaches a bottom over the next three to six months.  While it may be a bumpy ride, patient investors should be rewarded.