Earthstone Energy Doing Well – Can It Continue? (NYSE:ESTE)

Leonid Ikan

Measured by the last couple of years, Earthstone Energy (NYSE:ESTE) has been performing very well, but when considering its share price movement from the beginning of 2022, it has, outside of a brief three-week period, traded in a fairly tight range.

With the significant amount of free cash flow, the company throws off, it would appear the market would reward ESTE, but I think concerns about demand, its heavy debt load, and rising interest rates may be holding the stock back.

In this article we’ll look at its recent earnings report, its business strategy, and the challenges the company faces over the next year or so.

Latest earnings

Revenue in the third quarter soared to $531.5 million, up 381.9 percent year-over-year, beating estimates by $71.06 million.

Net income in the quarter was $2.99 ​​million, or $2.09 per adjusted diluted share. Adjusted net income was $1.30, missing estimates at $0.12. Adjusted EBITDAX was $346 million, up 15 percent sequentially. Both of those numbers were records for the company, attributed to strong commodity prices, and “a full quarter of Bighorn assets and a partial quarter of Titus assets.”

ESTE continues to throw off a lot of free cash flow, with the company generating about $175 million in free cash flow in the reporting period, up seven percent from the prior quarter. For the first three quarters the company generated $374 million in free cash flow, another record for the firm.

A major priority of ESTE is to use free cash flow to pay down its debt. Excluding the acquisition of Titus, the company paid down $290 million in debt on its credit facility, bringing total debt to a little under $1.2 billion. At the end of the third quarter the company had about $636 million drawn on its credit facility. Management said its debt to adjusted EBITDA should remain below 1x going forward.

On the production side, ESTE produced 94,329 barrels of oil equivalent per day, of which 41 percent was oil, 32 percent natural gas, and 27 percent natural gas liquids.

Based upon results from its drilling program, the company raised its production guidance in the fourth quarter by approximately 2 percent, with expectations production will be in a range of 98,000 to 102,000 barrels of oil equivalent per day.

CapEx in the third quarter was $147 million, but the company is guiding for CapEx in Q4 to be from $170 million to $185 million. The additional spend will be to “extend the completed lateral length of wells drilled in the fourth quarter by about 30 percent compared to our prior plan and our guidance, which is really resulting in significantly improved capital efficiency with the longer laterals.” Concerning hedging, the company is hedged at about 54 percent for oil and 62 percent for gas in the fourth quarter. For 2023, it is hedged at approximately 35 percent oil and about 31 percent for gas. It also has hedging structures in place to protect the downside as well.

On a WAHA basis, the company is hedged at close to 75 percent of overall gas for 2023, and 100 percent of its WAHA pricing exports gases. Last, on its borrowing base ESTE increased it from $1.7 billion to $1.85 billion after the Titus acquisition.

Share price performance

Over the last two years, ESTE’s share price has soared from about $2.50 in early November 2020, to a high of $22.25 on June 6, 2022. Since early January 2022 the share price has consolidated, moving in a range of $11.00 to $16.00 per share , with the exception of a short-term burst to its 52-week high of $22.25, before pulling back again.

That suggests that its shares may be fully priced based upon current visibility and guidance.

It appears the major concern is the growing debt load of the company after closing seven acquisitions over the last seven quarters. In that regard management is saying and doing the right things, asserting the balance sheet remains the top priority for the company, adding they’re not only interested in growing scale, but making decisions that allow for profitable growth, not growth for its own sake .

More than likely ongoing concerns about the costs associated with higher interest rates are weighing on some investors’ minds, and that could be a reason it hasn’t been able to sustainably break out in 2022.

With the company’s strategy of primarily growing via acquisitions, cost of debt is going to rise for the company.

CEO Robert Anderson did allude to the strength of its asset base commenting its “large, low declining asset base also assisted in our outperformance.” That of course is a positive for the company, but it also reminds investors that the asset base is still declining.

It also reminds shareholders that the company will have to continue to acquire assets to maintain its inventory.

This isn’t a near-term issue, but over time it could start to have an impact on the performance of ESTE.

One last thing I do want to comment on, which may be having an impact on the share price is, there is some uncertainty concerning demand going forward. If demand does start to fall, all the inventory and production capacity won’t matter if sales start to decline. That, combined with debt is probably the two things keeping its share price from sustainably breaking out.

Cash flow and its strategy

Cash flow has been extraordinary for ESTE, and it’s likely to improve going forward. That will allow the company to not only pay down its debt load, but also to make strategic acquisitions that add to it inventory.

With solid cash flow it provides flexibility and options that will benefit shareholders. For example, the company can buy back shares.

One thing I believe investors will have to come to terms with is ESTE will continue to make acquisitions that make financial sense to the company as it builds and replenishes its inventory. So, while it has the capacity to pay down its debt, it will also, without a doubt, add more debt, depending on the size of the acquisitions it’s targeting.

The bottom line is, at this time ESTE is throwing off more than enough cash flow to continue to implement its business model. That isn’t going to change anytime soon, so investors should feel confident in holding for the long term.

conclusion

As noted above, ESTE is solid in generating free cash flow, and as long as the price of energy finds support, it will continue to do so.

At this time, it seems the company is lacking the catalyst that will help it sustainably move above the $16.50 mark. Since there is clarity within its existing assets, it appears it may take a significant acquisition for the company to do so.

In regard to concerns, they are real, and need to be taken into account. For example, demand could decline if the recession starts to go deeper for longer. There is the high interest rate environment that makes money more expensive, and the need for the company to steadily increase inventory by acquiring more assets.

This can largely be overcome with its current free cash flow, but if demand declines and costs rise, free cash flow won’t be near the levels it is now.

For these reasons I think ESTE is going to continue to trade choppy in the current range it has been moving in. One positive catalyst that would change my thesis would be if the price of oil in particular soared again from some geopolitical event. Under that scenario the share price of ESTE would likely jump significantly.

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