The energy sector had an impressive run last year compared to other sectors as commodity prices increased. And even as commodity prices started to slow down around the second half, energy exploration and production (E&P) companies remained dominant. A good example of this is Earthstone Energy (ESTE), a multi-bagger E&P stock whose net income increased 10 folds last year, yet rating agencies are still concerned about its potential. In today’s FA Alpha, we will look into how credit rating agencies misfire their risk rating for ESTE using Credit Cash Flow Prime.
FA Alpha Daily:
Powered by Valens Research
While most of the sectors record massive losses all around the world, the energy sector had an impressive performance.
It is a highly volatile and cyclical industry, and the profitability in this sector depends on crude oil or natural gas prices.
When commodity prices decline below breakeven costs, they tend to record huge losses. However, the situation is vice versa when prices rise.
This is what happened last year. As crude oil and natural gas prices started to increase significantly, the sector performed well.
But especially one part of the sector, energy exploration and production (E&P) companies, stood out the most as they recorded massive profits.
Even though commodity prices started to decline by the second half of the year, they are still well above breakeven costs for E&P companies, which means that drilling is still highly profitable.
This is why now is the right time to be in E&P land, and everyone in E&P land has the potential to return excess cash flows, which are likely to be around for a while.
This is also the case for Earthstone Energy (ESTE), the company made 10 times its net income in the first three quarters of 2022 than what it made in 2021.
Yet, rating agencies still seem highly concerned about the company’s credit risk. They are rating it like it is a high-yield name with a 25% chance of bankruptcy, which is unbelievable for a solid company like Earthstone.
We can figure out if there is a real risk for this company by leveraging the Credit Cash Flow Prime (“CCFP”) to understand the company’s obligations matched against its cash and cash flows.
In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
The CCFP chart shows that Earthstone Energy’s cash flows are much above its obligations going forward.
CCFP chart indicates that the company does not have any debt maturities in the next four years and only in 2027 presents a debt barrier, which could be easily covered with its cash flows.
It’s highly unlikely that these limited debt maturities could bear a huge credit risk for the company as credit rating agencies suggest.
Also, taking into account its tailwinds that are coming from a possible oil and gas boom in the next few years, coupled with its strong cash flows relative to its obligations, the company does not deserve to be treated like it is going bankrupt.
That is why, at Valens, we think that a rating of IG3+ would be much more reasonable for Earthstone Energy, which implies around just a 1% chance of default.
It is our goal to bring forward the real creditworthiness of companies, built on the back of better Uniform Accounting.
To see Credit Cash Flow Prime ratings for thousands of companies, click here to learn more about the various subscription options now available for the full Valens Database.
SUMMARY and Earthstone Energy (ESTE:USA) Tearsheet
As the Uniform Accounting tearsheet for Earthstone Energy (ESTE:USA) highlights, the Uniform P/E trades at 4.5x, which is below the global corporate average of 18.4x and its historical P/E of 8.3x.
Low P/Es require low EPS growth to sustain them. In the case of Earthstone Energy, the company has recently shown a 84% Uniform EPS shrinkage.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Earthstone Energy’s Wall Street analyst-driven forecast is for a 695% and 10% EPS growth in 2022 and 2023, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Earthstone Energy’s $13 stock price. These are often referred to as market embedded expectations.
Furthermore, the company’s earning power in 2021 was below the long-run corporate average. Moreover, cash flows and cash on hand are 3x its total obligations—including debt maturities and capex maintenance. The company also has an intrinsic credit risk that is 80bps above the risk-free rate.
Overall, this signals a low credit risk.
Lastly, Earthstone Energy’s Uniform earnings growth is above its peer averages and is trading below its average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
This analysis of Earthstone Energy (ESTE) credit outlook is the same type of analysis that powers our macro research detailed in the member-exclusive FA Alpha Pulse.