EPSN - Epsilon Energy: Sustained Investment Should Pay Off Over Time

2023-12-13 01:38:42 ET

Summary

• Epsilon Energy's stock has been on a downward trend, with lower highs and lower lows, potentially revisiting its March 2023 lows.
• The company's cheap valuation and strong cash position were attractive, but declining earnings resulting in the doubling of the stock's trailing GAAP earnings multiple over the past few quarters raise concerns.
• EPSN's cash balance has declined, and management has entered into a new credit facility and implemented hedges to protect against downside risk.

Intro

We wrote about Epsilon Energy Ltd. ( EPSN ) back in late June of this year when we stated our intent on the possibility of buying into the stock's strong up move at the time. Epsilon Energy at the time was printing repeated higher highs and this pattern continued until early August (with shares surpassing $6 a share by some distance). Since then, however, all we have seen is lower highs & lower lows in Epsilon which means shares could easily revisit their 2023 March lows if the present bearish trend continues. As we see below, Epsilon's near-term technicals are worrying in that

1. Shares are trading well below their 200-day moving averages where the gap between this crucial support zone continues to increase.
2. The ADX (Trend-Following) indicator has ticked up in recent sessions demonstrating that Epsilon's bearish trend is gaining traction to the downside.
3. This means the stock's October lows of approximately $5.14 per share look vulnerable as a prolonged breach of this support level most likely would hurl shares back down to their March'2023 lows as alluded to earlier.

Investment Case

We were very much attracted to Epsilon 5+ months ago due to its cheap valuation, strong cash position, and attractive business model. Epsilon's modus operandi is to acquire assets in the energy sector (upstream & midstream natural gas & oil operations) and lease them out to operators who essentially run operations. The advantage of this model is the ability to invest profits quickly from existing assets (like a landlord) into other assets. This can happen when scale can be accelerated when both the price of the respected commodity (high price) as well as the productivity of the operator on-site (speed) result in strong profits for Epsilon.

Leverage though in the upstream space as we know is a double-edged sword in that the more assets Epsilon has on its books, the more risk is being taken if trading conditions do not align. This is why a willingness to invest in more midstream assets (which are far less volatile due to their consistent cash flow) seems prudent despite their lack of 'upside leverage'. Bulls will state that with the 70+ yet undeveloped gas locations in the Marcellus along with the recent decision to roll out 7 more wells there is a statement of intent concerning the company taking a long-term view. This may be true but is Epsilon strong enough to keep investing through the present cycle if gas prices remain depressed?

Elevated Spending Through The Cycle

Therefore given how the price of oil as well as natural gas has struggled in recent months, shares of Epsilon are down roughly 3% (when we include dividend payments) since our last commentary. The most glaring trend however is how earnings have declined over the past few quarters with operating profit coming in a mere $1.7k in Q2 & $0.7k in Q3 compared with $11+ million in Q4 last year. A key component of the stock's investment case back in June was the attractiveness of its trailing GAAP earnings multiple. However, given the poor showing we have seen in the company's net-profit trend over the past few quarters, Epsilon's trailing GAAP earnings multiple has more than doubled to a present 8.57.

Furthermore, Epsilon's cash & short-term investments balance has declined by almost $18 million over the past two quarters as management has remained firm concerning its investment initiatives, stock buybacks as well and continuous quarterly dividend payments. Moreover, given management's goal to keep investing through the present cycle (which will impact volumes), Epsilon in Q2 entered into a new credit facility to ensure liquidity remained strong going forward. With capital spending on existing sites expected to ramp up pretty aggressively over the next 12 months, management also has decided to hedge a portion of its gas portfolio to reduce downside risk. These hedges are also expected to transfer over to the liquid side due to additional wells from Ector County recently coming on stream.

Don't be fooled that these hedges are just for pricing purposes. They are also being carried out due to how the company's balance sheet has weakened in recent quarters. Epsilon (due to being a micro-cap stock) knows it has to overly protect its downside due to its under-average trading volume. It can do this to some degree with hedging which most likely will have to increase if gas prices remain depressed going forward.

Conclusion

To sum up, given how Epsilon's financials have been trending, things may get worse here over the near term (lower share price) before we finally register a concrete bottom in the stock. Long-holders need to take a long-term view and collect the dividend while waiting. We look forward to continued coverage.

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