Epsilon Energy: Production Increase Should Imply Higher Price Marks (NASDAQ:EPSN)

Epsilon Energy Ltd. (NASDAQ:EPSN) reported an impressive increase in production in Oklahoma, and benefited from natural gas price increases. As a result, EPSN recently noted a significant amount of cash in hand, which management could use for inorganic growth. Considering expectations about future production in Oklahoma, I believe that FCF expectations could imply a fair price higher than the current market price. Even considering risks from new regulatory frameworks or a limited number of customers, EPSN appears cheap.

Epsilon’s Business Model And Massive Quarterly EBITDA Generation

Focusing on the acquisition, development, and management of energy from oil and gas, Epsilon Energy is an offshore company born in Canada and currently based in the United States, where it maintains its properties.

Epsilon maintains commercial relations with Auburn Gas Gathering System, to which all of its production in Pennsylvania is supplied, through a 15-year long-term contract expiring in 2026. In addition, it owns extraction plants in Oklahoma, through which it subsequently markets both liquid gas and natural gas and oil.

95% of production during fiscal years 2020 and 2021 came from its plant in Pennsylvania, while the remaining percentage of production came from Oklahoma. For the marketing of its products, Epsilon contracts with a third party company, ARM Energy Management, which manages these activities. Another fundamental fact in relation to the company’s operations is that it still does not have a transport fleet of its own, thus depending on the transport of the Pennsylvania region, which is in turn one of the key factors in the elements of competitiveness in this market.

Considering the recent increase in quarterly EBITDA, I believe that Epsilon is a great read. I am going to review the company’s financials carefully in the article. The quarterly EBITDA increased from $6.7 million in the quarter ended September 30, 2021 to $16.54 million in the same period in 2022.

From 2016 To 2021, Financial Figures Included 14% Average Sales Growth And An Average EBITDA Margin Of 57%

Since I am going to offer my own financial models about the future, in my view, it is fair that readers learn about previous financial figures reported by Epsilon.

2021 net sales were $42.4 million together with a net sales growth of 73.77%. In addition, 2021 EBITDA stood at around $22.4 million accompanied by an EBITDA margin of 52.83%. 2021 operating profit was $15.6 million, and operating margin stood at 36.90%. 2021 pre-tax profit was $16.1 million together with a net income of $11.6 million. Finally, 2021 free cash flow was $14.9 million with FCF / sales of 35.14%. My numbers are not far from the average figures reported by Epsilon.

Balance Sheet

As of September 30, 2022, cash stood at $40.254 million, with accounts receivable of $10.06 million and other current assets worth $0.7 million. Besides, total current assets were $51 million, close to 10x the current amount of liabilities. Yes, I believe that liquidity does not seem to be an issue for this name.

Non-current assets include proven properties of $147 million with unproved properties of $18 million. In sum, the total oil and gas properties were worth $58 million. The gathering system was valued at $42 million with an accumulated depletion of $34 million. Finally, total property and equipment stood at $68 million, with non-current assets of $68 million and total assets worth $119 million.

The list of liabilities include accounts payable worth $2.20 million, with gathering fees payable of $1 million and royalties payable worth $2.8 million. Besides, with an income tax payable of $3 million, other accrued liabilities were worth $1 million with total current liabilities of $10 million.

Non-current liabilities included asset retirement obligations worth $2 million, deferred income taxes of $10 million, total non-current liabilities worth $13 million, and total liabilities of $23 million. The asset/liability ratio is close to 5x, so I believe that Epsilon’s balance sheet stands in good shape.

Natural Gas Price Increase, Inorganic Growth, And More Activity In Oklahoma Could Bring Significant FCF Generation

Epsilon recently experienced a significant increase in the natural gas price, which obviously helped the company deliver significant sales growth. We are talking about a triple digit price increase in the Marcellus Shale:

During the three months ended September 30, 2022, Epsilon’s realized natural gas price was $7.34 per Mcf compared to $3.43 per Mcf over the same period in 2021, a 114% increase. Source: 10-Q

At present, Epsilon concentrates its commercial efforts on the management of its capital flow with two specific objectives, position these capitals in medium-risk investments that generate immediate profits, and continue with its acquisition strategy in the medium term through the identification and purchase of shares of other companies with intra-coastal activities. Under this scenario, I assumed that new cash obtained thanks to the increase in the price of gas may be used for new acquisitions. In the coming years, inorganic growth could accelerate the company’s revenue growth.

In parallel, Epsilon believes that its activity in Oklahoma will likely grow in the coming years due to the increasing demand for natural gas and oil in the region as well as the demand from Mexico, where it exports its products through subsidiary companies. In line with these expectations, let’s note that in the last quarter, management noted increased production from new wells in Oklahoma.

Upstream oil and condensate revenue for the nine months ended September 30, 2022 increased by $1.3 million, or 107%, over the same period in 2021. This was a result of increased production from new wells in Oklahoma in addition to higher prices. Oil and condensate production for the nine months ended September 30, 2022 increased by 6.7 MBO, or 38%, over the same period in 2021. For the nine months ended September 30, 2022, the average price for oil and condensate increased by $34.17/Bbl, or 49%, over the same period in 2021. Source: 10-Q

In order to study the company’s business model, I checked each business segment. In the nine months ended September 2022, natural gas was responsible for $44 million along with natural gas liquids which reported $1.50 million. In addition, oil and condensate was responsible for $2.48 million. In sum, the company reported operating revenue worth $48 million from the company’s upstream business segment. Gas gathering was responsible for $7 million.

According to market expertise in assessment of upstream activities, the market expects to grow at close to 6% CAGR from 2022 to 2030. With this in mind, I believe that Epsilon’s upstream business segment could deliver sales growth of around 6%.

The global oil & gas upstream activities market grew from $4,113.37 billion in 2022 to $4,357.84 billion in 2023 at a compound annual growth rate (CAGR) of 5.9%. Source: Oil And Gas Upstream Activities Market Size, Trends and Global Forecast To 2032

Oil & Gas Infrastructure Market size surpassed around USD 620 billion in 2021 and is projected to grow at over 6% CAGR from 2022 to 2030. Oil & Gas Infrastructure Market Trends 2022-2030 | Global Report

My results for 2033 included net revenue from upstream of $111 million together with gas gathering of $13.9 million. In addition, the total net sales will likely be $125 million accompanied by total net sales growth of 5.7%.

2033 EBITDA would be $63 million with 2033 EBITDA margin of 57%. 2033 free cash flow would be $26 million combined with FCF/sales of 23.40%. Notice that I am expecting that the FCF/Sales will likely increase from 2023 to 2033. I believe that my figures are conservative.

Now, with a WACC of 6.51%, the NPV of future free cash flow from 2023 to 2033 would be $115.32 million. Besides, with an EV/EBITDA multiple of 5.49x, the exit value would be $348 million. The NPV of the exit value would be $174.08 million, which would imply an enterprise value of $289.40 million.

With debt of $2.7 million and cash of $40 million, the implied equity would be $326.70 million. Finally, the IRR would be 5.93%, and the fair price would be $13.9, which is significantly higher than the market price we see these days.

Risks From Large Competitors, Small Number Of Clients, And New Regulations In The Oil And Gas Industry Could Push The Stock Price Down

Epsilon is positioned as an emerging company in a highly competitive market. For the most part, due to the number of employees, the capital, and resources available, it is a smaller company than its competitors. The activity of large competitors may lead to lower FCF margins.

Epsilon’s emerging position in relation to its competitors and the lack of sufficient transport fleet for the distribution of its products are worth noting, which, in my view, may limit the potential for EBITDA margin expansion.

Epsilon also depends directly on the variability of the international oil price. We can add that almost 100% of its activity is concentrated in a single region and in a single product.

It is also worth noting that the number of clients is limited. The company’s activities are currently concentrated in regional operations without a national scope. In this sense, by the year 2022, its client portfolio was distributed in only 30 companies in terms of natural gas and 29 companies in terms of liquid gas, many of which buy both assets. Some companies such as Alta Energy Marketing, South Jersey Resources Group, or Direct Energy Business Marketing concentrate 10% of Epsilon’s total annual profits. If some of the company’s large clients decide to stop working with the company, revenue declines could be quite significant. Besides, the company’s natural gas production in Pennsylvania is destined for Auburn, so there seems to exist a lack of diversification in its operations and clients.

Finally, future restrictions, regulations, and regulatory changes in the extraction and distribution of oil and natural gas along with the obligation to comply with waste management and reduction in the pollution footprint to the environment could generate disruptions in current operations as well as a need to adapt a new strategy to survive in the new legal environment of the market.

Under the previous conditions, I included 2033 upstream net sales of $73 million accompanied by net revenue from gathering gas of $11.4 million. 2033 total net sales would be $84.1 million with a net sales growth of 1.6%. Let’s note that the company’s net sales under this case scenario are significantly lower than what I assumed in the previous case.

My figures also included 2033 EBITDA of $36 million together with an EBITDA margin of 50%. 2033 FCF would be close to -$3.65 million with FCF/sales of -5%.

I also assumed a WACC of 6.5%, which implied a NPV of future FCF of $16.56 million, with an EV/EBITDA multiple of 3.5x and an exit value of $127 million. Besides, the NPV of the exit would be $63.5 million, which would imply an EV of $80 million and equity of close to $117.5 million. Finally, with a share count of 23.497 million, the implied price would be $5 per share, and the IRR would stand at -1.35%.

Conclusion

Currently reporting a massive increase in the price of gas and production increases in Oklahoma, Epsilon successfully obtained a lot of cash in hand and FCF generation. In my view, if management uses its cash to make acquisitions, future FCF will likely continue to trend up. My discounted cash flow models indicated that the fair price is significantly higher than the current market price. Even considering risks from changing regulatory frameworks and customer concentration, the stock appears undervalued.