SRC Energy: Midterm Election Results Clear Political Risks

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About: SRC Energy Inc. (SRCI)
by: Hervé Blandin

Summary

The midterm election results and the vote against the proposition 112 eliminate the political risks for the company.

The Q3 results highlight a good performance despite issues with the gas infrastructure.

As a result, the stock price is gaining about 20% pre-market. But the market still values the company at a discount to my estimation of fair value.

SRC Energy (SRCI) reported Q3 earnings last week. But the most awaited development related to the results of the midterm elections and the vote about the drilling restrictions in Colorado.

Now that the most important risk for the company is greatly reduced, the company and the investors can focus on the operational results.

With the positive voting results for the company, the stock price is gaining approximately 20% during the pre-market. But the market still values the company below my estimation of fair value.

Oil pump jack Image source: skeeze via Pixabay

The relief from the midterm elections

In my previous article, I had highlighted the risks related to the midterm elections in Colorado for the company. And management was looking forward to the end of the political uncertainties. One week before the results of the elections, the Q3 2018 8-K stated:

"When the dust settles from the midstream and political issues that have surrounded our Company this year, I hope that everyone will focus on the fact that we are on track to deliver 45% growth on a year over year basis which is being funded largely through internally generated cash flow."

The results of the voting involved two favorable outcomes for SRC Energy. Jared Polis, who opposes the initiative 97 (drilling restrictions), won the Colorado governor elections. And the voters rejected the proposition 112 that aimed at restricting the oil drilling.

In the Q3 2018 10-Q, management expressed prudence before the results of the elections:

"Finally, even if Proposition 112 is not approved, we expect that some political leaders will propose new regulations to restrict oil and natural gas development activities by other means in an attempt to address concerns underlying the proposition. We cannot predict the outcome of any such proposals, but they could have material and adverse effects on our business."

But considering the results of the elections and despite the judgment of management, the political risk is greatly reduced. The company and the investors can now focus on the operations.

So, let's analyze the latest results.

Q3 earnings

During Q3 2018, the production increased by 22% YoY and average realized price increased by 27%.

SRC Energy Q3 2018 volumes and prices

Source: Q3 2018 8-K

As a result, revenue increased by 55% YoY. But not everything is perfect. Despite the 38% increase in natural gas production YoY, revenue from natural gas dropped by 3%.

SRC Energy Q3 2018 revenues

Source: Q3 2018 10-Q

The midstream restrictions pressured the gas Colorado Interstate Gas index differential. As shown below, the gas differential almost doubled compared to last year, reaching $1.11/mcfe.

SRC Energy Q3 2018 realized prices

Source: Q3 2018 10-Q

Management provided the details about the following gas prices dynamics in the Q3 2018 10-Q:

"Second and third quarter 2018 results were impacted by this lack of spare gas processing capacity, which resulted in persistently high line pressures and the inability to maintain consistent production flows. Further exacerbating the midstream constraints were above average temperatures in Colorado in June and continuing into July as well as unplanned shutdowns of natural gas processing facilities. As a result, many of the Company's wells could not be produced consistently, and the Company was unable to turn recently completed wells to sales as desired."

While the weather and the unplanned shutdowns are short-term events, the gas infrastructure issues need long-term solutions.

During this quarter, a new 200 MMcf/day processing plant became operational. And another 300 MMcf/day will be operational during Q2 2019. There are also other projects with a capacity of up to 1 Bcf/day after 2019.

In the meantime, despite the low gas prices, realized price amounted to $35.15/boe during Q3 2018. And, as shown in the table below, the company realized a total netback of $15.06/boe before hedges.

SRC Energy Q3 2018 costs and netbacks

Source: author, based on company reports

Thus, the company needs to realize prices of $10.1/boe + $9.99/boe = $20.09/boe to break even while replacing the depleted production, assuming Q3 costs and prices.

The company generated a Q3 2018 Adjusted EBITDA of $121.5 million.

SRC Energy Q3 2018 adjusted EBITDA

Source: Q3 2018 8-K

Over the first 9 months, the debt increased by $112.8 million to finance the capital program and the acquisitions in excess of the $343.6 million cash flow.

SRC Energy Q3 2018 cash flow extract

Source: Q3 2018 8-K

The net debt amounts to $634,8 million and the net debt to annualized adjusted EBITDA ratio is low at 1.3.

The capital structure of the company is comfortable. The senior notes expire in 2025 and the company drew only $115 million from the $650 million credit facility. Also, management guided on free cash flow generation in 2019.

Outlook and valuation

The Q3 2018 10-Q provides the following guidance:

"We currently estimate that full-year 2018 production will average approximately 50,000 BOED with the oil mix being approximately 45% of production."

The guidance of the FY 2018 production at 50,000 boe/d represents the mid-point of the previous estimations. But the company decreased the oil mix expectations to 45%. During the previous quarter, management guided on the lower part of the range 47%-50%.

The company will announce the complete 2019 guidance at the beginning of next year. But during the Q3 2018 earnings call, management communicated:

"From a capital expenditures standpoint, you can probably mirror our 2019 CapEx to what we experienced this year as we plan to continue with our two rig and about 1.5 completion crew with our development program. With that type of program, we expect to generate free cash flow in 2019."

Considering the guidance, I assume the company will keep on realizing a total netback of $15/boe. Thus, taking into account the mid-point of the production guidance and assuming the production stays flat, the company will generate a profit of $273 million.

The table below summarizes my estimation of the fair value.

Source: author, based on company reports (estimations highlighted in yellow)

I apply an arbitrary multiple of 12x to the profits the company would generate if the production stayed flat. It is equivalent of applying a PE ratio of 12x to a company with no growth. The corresponding valuation amounts to $3.285 billion ($13.49/share).

The table below shows the flowing barrel valuation based on the stock price at $9.12.

Source: author, based on company reports

Even with the stock price movement pre-market, the flowing barrel valuation is low at $57,122/boe/d, considering the netback margin and the low debt.

Conclusion

The results of the midterm elections and the rejected proposal 112 greatly reduce the political risks for the company. As a result, the stock price is rising by more than 20% before the opening of the market.

During Q3, the company realized high netbacks despite temporary issues with the gas infrastructure. Also, the debt is low and management guided on growth and free cash flow generation in 2019.

Even with the stock price increase during the pre-market, the market values the company with a discount of about 30% to my estimation of the fair value.

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Disclosure: I am/we are long PEYUF, BTE, BNEFF, CPG.

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.