Epsilon Energy: Buy The Midstream And Get The Upstream Dirt Cheap

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About: Epsilon Energy Ltd. (EPSN)
by: Long Player
Summary

The company is debt free.

Cash balance is more than $16 million.

The move into Oklahoma should gain more attention for the prospects of this company.

Midstream accounts for much of the market value of the stock. This provides considerable downside protection.

Production should grow 30%.

Epsilon Energy (EPSN) just reported the first quarter operating results. The midstream compression and gathering reported revenues of $2.4 million and operating costs of $.3 million. This makes a nice gross operating margin of $2.1 million before depreciation, administrative expenses, and other odds and ends. That result lends a solid argument to the value of the business as stated by management.

Source: Epsilon Energy Corporate Presentation September 2018

About one-third of the company revenue accounts for more than three-fourths of the company market value. The nice part about that value is the no volatility part. Most oil and gas producers have a market value that varies with the pricing of the produced product. Midstream tends to have value that is far less volatile. The ownership of the midstream operations provides considerable downside protection to the stock at current valuations.

This owner of Marcellus acreage allows Chesapeake Energy (CHK) to operate its Marcellus acreage while Epsilon cashes the checks. Small companies that attract large partners are usually worth watching. It is one sign of above-average management. In the meantime, the company cashes enough checks to keep the balance sheet debt-free while managing to grow production.

Those that follow Chesapeake know that Chesapeake has gradually been reducing rigs in gas drilling areas while increasing rigs to drill for liquids. This change in emphasis has probably led Epsilon Energy to consider diversification. Recently, the company acquired acreage in the Scoop and Stack areas of Oklahoma. The company will again be passive while allowing an established operator to operate the acreage.

Current Year Budget

The company expected Chesapeake Energy to complete four wells in the first quarter. Production was expected to grow to 26 MMCFD. That production guidance appears to have been met in April.

The first well of the Stack acreage is now underway with results expected a little later. Overall, production should grow 30% this year. No debt will be needed to fund that production growth.

Cash flow is completely expected to fund the capital budget. That would mean the enterprise value of the company is trading for about 5 times expected cash flow. That is an extremely low multiple for a debt-free company that can grow production 30%.

Finances

The cash balance is $16.5 million. The company has even more liquidity from an unused credit line. Finances are not a problem for this company. The only real concern is that outside operators completely control the pace of growth and development of the company investments. Therefore, the strong financial balance sheet is a necessity in case a partner decides to make a major growth commitment.

Currently, gas production is so out of favor that this company, like many competitors, will try to strategically position itself with significant oil and liquids production. That strong balance sheet will give this company many options to pursue the strategy.

Net cash provided by operating activities was nearly $4 million. Much of the roughly 50% cash flow gain came from the change in other current assets and liabilities. Since most of the anticipated production growth will first influence the second quarter, any cash flow improvement at all in the first quarter was a decent achievement.

Stock Price

Recently, management announced an intention to repurchase about 1.4 million shares over the next year or so with a maximum authorized expenditure of $2.5 million. Clearly, management believes that the stock of this company is a bargain at current prices.

Source: Seeking Alpha Website May 18, 2019

Despite steady progress, the company stock has really not moved over several years. One of the dangers of investing in small company bargains is that those bargains may persist without a catalyst.

In this case, the company has the entry into the Scoop and Stack as a possible catalyst to a better stock price. The Marcellus has treated this company very well but that area is out of favor. Even though the operator Chesapeake clearly drilled and completed enough production for impressive growth, Mr. Market is clearly focused on the intention of Chesapeake to drill in Texas and the Powder River Basin. A company like Epsilon can end up in the doghouse for far less substantial reasons.

Summary

The fact is that debt-free companies rarely get into serious trouble. They often have more chances to "try again" to succeed than their leveraged competitors. For the patient investor, the midstream operations provide considerable downside protection to the stock price. The currently very profitable gas production business is valued at about 2 times cash flow as a result.

Part of the reason is the dour outlook for gas by Mr. Market. But the company has a midstream operation to connect that gas with some decent marketplaces. The cash flow from the gas functions as an ATM for possible diversification moves.

The move into Oklahoma appears to have been very conservatively handled. Management apparently purchased small working interests in joint ventures to gather information on the local operators before choosing an operator for its acreage. That is the kind of careful progress shareholders should want to see.

Many investors feel that larger companies are safer. That can be true because management depth and corporate resources are often greater. This company though is selling for half or less of any reasonable value. It would be hard to imagine a safer investment.

Clearly, no success is anticipated from the Oklahoma diversification move. Yet, the first well has been drilled and two more potential wells should be evaluated and possibly producing by year-end. There is far more certainty about potential reserves and production with the unconventional business than there ever was with the vertical well conventional business. As the market realizes that and growth continues, this company should attract attention and a better value.

Timing on appreciation of a company this size is very uncertain. As shown above, the stock price has lingered in the same range for several years despite cash flow and production growth. Management raised money by selling shares to fund the diversification of the company. Investors should expect that conservative financial strategy (that has been a company hallmark) will continue.

Clearly, cash flow growth and production will continue in the future. Should this company not obtain the recognition one would expect, then insiders will probably begin a process to sell the company for a premium. One such possible acquirer would be Chesapeake Energy as this operator is in both Oklahoma and Pennsylvania. For Chesapeake, this company would be a "bolt-on" mid-morning snack. They probably would not even have to call the banker for permission.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EPSN over the next 72 hours. 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.

Additional disclosure: I am long CHK.
Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.