Earthstone Energy Stock: Another Buyer’s Market Bargain (NYSE:ESTE)
Earthstone Energy (ESTE) just headed into one of the premium areas of the Permian with its latest acquisition. The company has been using a combination of stock, cash, and debt to acquire companies or parts of companies in an accretive fashion. This method of growth has kept the debt ratio at one of the lowest levels in the industry while benefiting shareholders in the process. The announcement continues a long list of announcements by industry insiders that growing by acquisition is at least, if not more profitable than organic growth at the current time. Therefore, investors can expect a continuation of both organic and acquisition growth in the future.
Notice that the company uses stock as part of the acquisition offer whenever the total package is accretive to shareholders. So many managers use financial leverage while planning to sell stock when the stock is at the right value. Unfortunately, that day never comes, and investors often pay the price.
This company has outlasted several others I follow as a result. Not only that the stock price has benefitted from the deals made.
The stock has risen along with much of the rest of the industry. Some would argue that the dilution from the deals made has slowed the stock price recovery. Frankly that argument has merit while missing some important points. This management has made largely accretive deals. So, there should be considerable operating leverage in the future. That means above average earnings growth for a few years that should more than make up for any perceived stock price lagging.
In the meantime, the leverage remained low to keep the stock relatively attractive for future deals. Another deal was made after this one. Clearly management is still shopping for accretive deals.
The company is purchasing this prime Permian acreage for about 3 times EBITDAX. Management noted that this acreage is largely on federal property. But that the sellers have a fair number of permits in hand and have more permits in process.
One of the reasons that this property is a bargain is a fear that the current administration would stop the permitting process completely. So far, those fears have not been realized. But just the existence of the fear likely motivated the selling price per acre.
What is missing from the consideration is that the existing production is long lived. There are multiple stacked zones so that wells can be completed in different intervals once drilled. Therefore, even if the worst happens, the existing locations of production should last a very long time.
There is the additional consideration that every approved permit adds value to the properties purchase. The current environment appears to allow for a lot of approved permits. That means that the company will likely receive back the money paid plus more than a reasonable profit.
This is what investors should be paying management to do. Management needs to evaluate the risk and overall make a reasonable profit. This particular acquisition appears to fit the bill rather nicely. The acquisition also provides a “foot in the door” in a particularly profitable region of the Permian where acquisitions of “bolt-on” private property leases can also be made. That would lessen the risk somewhat through geographical diversification.
Compare this one to the ConocoPhillips (COP) announced transaction:
Note the difference in the metrics. ConocoPhillips paid for some prime Permian acreage at about 4 times EBITDAX. Large transactions tend to have lower pricing because the market for these properties attracts few buyers. Yet ConocoPhillips paid a higher multiple of EBITDAX than did Earthstone.
The ESTE transaction has similar metrics to the ConocoPhillips transaction. Now ConocoPhillips management of the acreage cost takes into consideration production purchased as well as infrastructure and other items. Just a gross selling price divided by acreage is roughly $40K per acre without those other items subtracted.
In contrast, Earthstone paid less than $20K per acre using the same method of calculation. That probably means that the Earthstone acreage has considerable upside potential in the form of proportionately more drilling locations in the future. As noted above, there is some perceived political risk to that upside as well.
If one assumes that the debt ratio will remain slightly below one, then the combined Earthstone enterprise value will remain somewhere around 3 times EBITDAX. That is fairly cheap for a company that has a record of growing production profitably. Most growth companies in the industry are probably closer to a ratio of 8 to 10 before accounting for any production growth. So, this stock will likely adjust at some point to a more reasonable evaluation.
This management has a very long and successful history as shown above. The last four years have been an absolute nightmare for the industry with only a brief rally in 2018. By far, the most challenging year in a decade has to be fiscal year 2020.
Still, this company has survived when many of the speculative competitors filed bankruptcy. The reason it survived was the experience of management combined with the low debt strategy. Management will likely seek to make a decent return as it has before. That could take some time, but in the past, it has been well worth the wait.
Investors all the time ask me about next year and fair value. But when I see an experienced group like the one above, I know that this is the time to be buying, not selling. That is especially true for long term investors. Clearly this management is “buying”.
Another group of insiders took over the old Corridor Resources and renamed the company Headwater Exploration (OTCPK:CDDRF). Like this company they purchased some acreage and are now developing it. Also, like the Earthstone team, the Headwater management has built and sold a company before (Raging River (OTC:RRENF)).
Fair value does not do an investor a whole lot of good if it is the wrong time in the industry cycle to sell. There are relatively expensive properties for sale as well as bargains. A stock could certainly get ahead of itself and “need to take a break”. But usually selling at the wrong time misses out on an excellent long-term profit. Therefore, I generally follow insiders like the two companies noted before. I will worry about fair value and selling when they consider selling the company. That will usually be the time to lighten the load in energy while waiting for the next cyclical downturn to become significant enough to begin the next upcycle.
Management is now adding still another roughly 40K BOD from still another acquisition. Guidance is likely to change upon the closing of both acquisitions. Management just updated guidance for the completed Chisholm acquisition. As long as management finds accretive bargains to purchase, any guidance and update will not last long. So many want to know when a stock is overpriced. The truth is that good management is rarely priced into the stock price. As a result, a company like this one is rarely overpriced because management keeps surprising on the upside.