NOG - Earthstone Energy Announces Novo Acquisition; Cheaply Valued And Potential Upside

2023-06-18 09:15:21 ET

Summary

• Earthstone Energy operates in the Permian Basin and follows a roll-up strategy. It has achieved an impressive 86% compound annual growth rate in oil and gas production since 2020.
• The acquisition of Novo Oil & Gas, the seventh within 2 1/2 years, is done at a highly favorable price, positioning Earthstone as an emerging operator in the Permian Basin.
• Although Earthstone's stock pulled back over the past 12 months, the company has maintained steady growth. Consequently, the stock is currently trading at its lowest valuation in six years.

On June 15, 2023, Earthstone Energy, Inc. ( ESTE ) announced its agreement to acquire Novo Oil & Gas Holdings, LLC , a privately-held producer focused on the Delaware Basin and backed by EnCap Investments L.P. The total proceeds of $1.5 billion will be divided between Earthstone and Northern Oil and Gas, Inc. ( NOG ) in a 2/3 to 1/3 proportion.

Earthstone Energy is a growth-oriented company that pursues the so-called roll-up strategy . Earthstone acquires a series of smaller companies in the Permian Basin and integrates them into its operations to achieve an expanded acreage footprint, operational efficiencies, and economies of scale. Novo is the seventh acquisition for Earthstone in the Permian Basin within the last 2 1/2 years, as depicted in Figure 1.

What

On a net-to-Earthstone basis, Novo Oil & Gas has 11,300 net acres (99% operated, 57% working interest, and 86% held by production) in the core of the Delaware Basin in Eddy County, New Mexico, and Culberson County, Texas, as shown in Figure 1. The Novo acreage complements Earthstone's existing properties in the Delaware Basin, which is expected to enhance capital and operational efficiency.

The Novo assets recently produced approximately 38,000 boe/d (37% oil, 66% liquids) net to Earthstone from 114 producing wells. The assets include 21 gross operated drilled but uncompleted (aka, DUC) wells waiting on completion. They contain an inventory of approximately 200 high-quality gross operated drilling locations across multiple benches, which are estimated to have an average breakeven below $40/bo and generate at least a 10% rate of return. As a result, Earthstone's drilling location inventory life is expected to be extended to 13 years with a five-rig drilling program.

The Novo assets are estimated to contain 73.9 MMboe of proved developed and 37.2 MMboe of proved undeveloped reserves, totaling 111.1 MMboe of proved reserves net to Earthstone. These proved developed reserves have a PV-10 of $912 million, while the proved undeveloped reserves have a PV-10 of $260 million, resulting in a total proved PV-10 of $1,172 million net to Earthstone, as evidenced in Figure 2.

Earthstone Energy projects that these assets will generate $360-380 million of adjusted EBITDAX or $290-310 million of unlevered free cash flow on a next-twelve-month basis, assuming an effective date of May 1, 2023, and strip prices as of May 24, 2023.

To fund the acquisition, Earthstone plans to utilize cash on hand and borrowings from its senior secured revolving credit facility. Currently, Earthstone has $1.2 billion in undrawn commitments from its lenders, as its outstanding debt stood at $452 million as of the end of the first quarter of 2023. The company's credit facility, which currently amounts to $1.4 billion, will increase to $1.65 billion following the Novo acquisition. Following the transaction, the forecasted leverage at year-end 2023 is expected to be 1.1X last quarter annualized adjusted EBITDAX.

So what

Growth

The acquisition of Novo will result in a significant expansion of Earthstone's operations. On a pro forma basis, the estimated increase includes a 32% growth in proved reserves, a 24% increase in gross drilling locations, and a projected boost in production of 30,000-35,000 boe/d or 33% for the fourth quarter of 2023, as shown in Figure 3.

The transaction is also expected to result in a 20% increase in 2024 adjusted EBITDAX and, due to the capital budget being kept flat and improved capital efficiency, a more than 60% increase in 2024 free cash flow, based on strip prices as of May 24, 2023.

The presence of 21 DUC wells from Novo likely influenced Earthstone management's decision to maintain this year's capital budget unchanged at $725-775 million. As a result, the projected reinvestment rate is expected to decrease from 75% to 60%, allowing Earthstone to generate substantial free cash flow.

The growth scenario discussed above takes into consideration the sale of certain non-core properties in the Midland Basin on May 31, 2023, for $56 million. The divested assets included 530 boe/d (45% oil) production and acreage with 32 short lateral drilling locations.

Operational plan

After the transaction closes, Earthstone intends to maintain its five operated drilling rigs without increasing the capital program. One of the two rigs currently operating in the Midland Basin will be relocated to the Delaware Basin to focus on the Novo acreage. This means that Earthstone will have four rigs operating in the Delaware Basin and one in the Midland Basin, signaling a shift in operations towards the highly economic assets in the northern Delaware Basin.

Transaction valuation metrics

The purchase price of $1.0 billion implies an approximate valuation of 2.70X adjusted EBITDAX or a 30% free cash flow yield on a next-twelve-month basis. These valuation metrics suggest that Earthstone acquired Novo's high-quality, growthy assets at a favorable price.

Risks

In my opinion, the main risk associated with Earthstone Energy's roll-up strategy is the potential challenge of finding affordable and value-enhancing acquisition targets in the increasingly competitive Permian Basin . However, Earthstone has the advantage of being a portfolio company of private equity firm EnCap Investments L.P . Encap controls multiple operators in the Permian Basin that can be integrated into Earthstone to offer it a reasonably lengthy growth runway in the coming years. Furthermore, there is a possibility that Earthstone may be acquired by a major oil company before it becomes difficult to find inexpensive targets.

Now what

The talented management team at Earthstone Energy has successfully executed the company's roll-up strategy, resulting in significant growth. Upon completion of the Novo transaction, the company's production will have increased from 15,300 boe/d to 133,000 boe/d by the end of 2023, representing a compound annual growth rate of 86%. The market has recognized the company's achievements, as evidenced by the five-fold increase in share price from late 2020 to the present (Figure 4).

The acquisition of Novo Oil & Gas represents another exciting milestone in Earthstone's growth journey, as commented by CEO Robert J. Anderson,

“we are continuing to further our consolidation strategy with... the Novo Acquisition as we further build our northern Delaware Basin asset base. With significant production volumes from the Novo Acquisition, we expect Earthstone’s near-term production levels to surpass 135,000 boe/d. Further, we anticipate free cash flow to increase significantly compared to standalone Earthstone as we have added substantial producing assets but are not increasing capital expenditures. The addition of approximately 200 high-quality, low breakeven locations deepens our drilling inventory and with our flat rig count, extends our inventory life significantly to over a decade. We believe the benefits of continued consolidation are very compelling, and we strongly believe this is a value-creating transaction for Earthstone.”

The recent pullback in Earthstone's stock over the past 12 months, in response to declining oil prices, may have been an overreaction. Despite the drop in share price, Earthstone has consistently shown growth across all key operational metrics. Consequently, its EV/EBITDA multiple has reached a five-year low of 2.27X, making the stock cheaper than ever in the six years since I began covering it.

Warren Buffett famously said, " Be fearful when others are greedy, and greedy when others are fearful ". I believe that now is an opportune time to consider investing in this well-managed, growth-oriented, mid-cap oil and gas producer operating in one of the world's premier shale oil regions.

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