Earthstone Energy shares: increased risk perceived by the market (NYSE: ESTE)

(Note: This article originally appeared in the July 1, 2022 newsletter and has been updated as needed.)

Earth Stone Energy (NYSE:ESTE) had announced the acquisition of Titus. This comes after several significant acquisitions that have expanded the business to several times the size before the start of the shopping spree. The stock price is starting to reflect concerns about so many acquisitions as well as managing more shares outstanding. Investors should keep in mind that sellers who receive shares often sell those shares. This will drive the stock price down until the big seller comes out.

The market is also concerned that management is making so many big acquisitions in such a short time. This management can prove these worries unfounded because management has built and sold businesses before. Nevertheless, it is clear that the market is pricing in more risk in the stock price.

The current measures of debt presented above are clearly conservative. The concern is that the debt is growing at a very rapid rate and the business is growing rapidly. Therefore, the reported current debt ratio will not reflect the figures above until a full year of operation with all acquisitions has been reported.

This market sees ghosts everywhere. Nothing is worse for the market than a high debt ratio. Even though there is production on the last leases purchased (and therefore established cash flow), management still has to report essentially mixed numbers until the business is running for a year.

The market worries when there is a major acquisition on risks like the logistics of combining major acquisitions into an optimal combination. Here there are now several great acquisitions. So these concerns are starting to multiply.

Clearly, the market reaction to the latest acquisition announcement has been less than stellar. This is partly due to the recent decline in the price of oil and other market concerns about the industry.

Another concern is that the series of transactions creates large shareholders from the shares issued through these transactions. One of them, Warburg Pincus, has just announced that it holds a significant amount of shares. A large shareholder can drive the stock price down significantly until selling pressure subsides. This company issued a lot of shares to acquire a good number of properties. An additional risk is that some of these big sellers will liquidate their holdings to delay an appreciation in the stock when the combined results point to a recovery in the stock price.

But the accelerating pace of debt growth is also worrying the market. The first thing to do will probably be to pay off this debt as quickly as possible. Certainly, management can use some of the cash flow initially to combine acquisitions and optimize operations. But if cash flow is as generous as management suggests, debt repayment should begin fairly quickly.

This is a notoriously inconspicuous industry that often holds nasty surprises. Even though the current rally appears to be sustainable for a while, long-term readers know we’ve been down this road before before we were quickly disappointed. Therefore, it may be time to slow down the buying frenzy to allow the market to see the benefits of the “new” Earthstone Energy.

What is probably of concern is not the leverage ratio in the current price environment, but the leverage ratio when commodity prices are much lower. After going through serious situations in 2008 and 2020 (and less serious situations like 2015), this market has an increasingly worried view of debt.

On top of that, the market has been disappointed with “single decision” stocks which are no longer as “safe” as the market thought. This usually leads to a swing to safety where Mr. Market goes too far as usual. This means that management experience may not be valued as it would be in other market climates (or situations).

Management clearly addresses these concerns by explaining the valuation method it uses. It helps that many of these acquisitions arrive with infrastructure and transportation commitments in place. Most likely, the company also retains the necessary staff, as this reduces the risk of new employees who are unfamiliar with rental operations.

The real key for the market will be how the company performs in the next recession. All of the acquisitions made it a materially new company with no public operating history. Therefore, investors should expect stock price actions similar to other new issues (rather than an established company) until there is sufficient evidence of superior performance. .

One of the keys to better market performance will be maintaining the low costs shown above combined with at least the expected well performance data. If management is able to keep up with the technological changes sweeping the industry to maintain the cost leadership shown above, superior pricing action is likely to result.

Management has clearly acquired excellent acreage. Concerns would relate to the logistics involved in rapid growth. Inexperienced management can easily lose control of cost or quality (which would quickly cost customers in a commodity business). This is also part of the debt servicing concerns.

The future

The stock price is likely to underperform the rest of the industry until it is clear that management can report satisfactory (or better) results from the combined company. This latest acquisition is expected to add economies of scale in one of the most profitable regions of the Permian.

Often, synergies are difficult to determine for individual investors. But what will grab the market’s attention are high margins, low costs and, of course, above-average profitability.

Management has reduced the risk of all acquisitions by purchasing established production. Management further reduced risk by keeping the rig count constant while allowing an additional rig once they understood all new acquisitions.

The debt ratio remains low in the current environment. But the market will likely want evidence of a low leverage ratio at significantly lower commodity prices. Production based on purchases gives management a huge head start on this requirement.

Here’s at least some of the management’s past experience and what they’ve done for investors. This leadership has been together for a long time and continues to do what it does best.

Despite the concerns of the market, the best asset on the shareholders’ side is this management and its experience (as well as the success shown above). Obviously, this stock is not for everyone. But good management can generally surprise positively. It seems like very good management.