SRC Energy Inc. (SRCI) is an oil and natural gas company in Colorado, which has been doing well in recent years. Still, the stock price has been declining in recent quarters, and so the valuation. During 2018, it used to trade at +10x earnings, but now it is at 4.95x.
A new law regulating the oil and gas industry in Colorado, and some infrastructure constraints, have been driving the stock downwards.
The fundamentals’ reality is another story. Sales and earnings have been growing nicely. LT Debt is moderate. The management is doing a great job at keeping costs and expenses under control. And production capacity is expanding as well.
The management has good relations with the government of the county, where its assets are concentrated.
As the market realizes that the company is not being affected by the new regulations and the infrastructure restrictions end by 2020, the stock should go back to its normal valuation.
In fact, the company will report earnings for Q2 2019 on July 31. If the market is pleased with the results, there could be a huge increase in the stock price, starting a long-term bullish trend.
The company match my criteria for a defensive stock
As you may know, we are at the gates of a recession. Some say that we will get there before the end of 2019 or during 2020, while others say that this bull market is in a halfway stage.
The US economy is going through one of its longest expansion periods in history, and the longer it gets, the greater the probability of a recession.
Two things are certain, we don’t know when a recession will happen, but we do know that the market is quite expensive right now (CAPE ratio of 30x). With this in mind, as we can’t time a recession, we can buy stocks that might thrive during such times, or at least, won’t be hit as hard as the rest of the market.
It is known that certain industries outperform the overall market during recessions or market crashes. Discount retailers, healthcare providers, and grocery stores were some businesses that thrive during the 2008 crisis.
Regardless of the sector or industry, there are stocks that are cheap enough to consider them as defensive and of high probability of outperforming the market.
In my opinion, stocks with low P/E, above average ROE, moderate LT debt, and low P/B offer a nice margin of safety against a market crash.
SRC Energy, Inc. fits those criteria.
Existing research papers confirm my thesis
Back in September 2018, SA author Hervé Blandin mentioned that the company was a low cost operation because of its concentrated assets in the DJ Basin, it was expanding nicely, and that the market was punishing the stock due to legal uncertainties and infrastructure issues.
The author recommended investors to wait for the legal environment to clear itself before entering a position.
Later in May, SA author Long Player argued that the legal landscape was favorable to SRCI, pointing out that the company’s management had good relations with the Weld County, and the values and processes of the company’s operation were in line with the new law.
The thing is, SRCI has most of its operations in rural Weld County, while most problems arise with business made near the more populated counties.
The author also mentioned that some midstream capacity constraints are hurting the stock price, but those are to be resolved in late-2019, with effects to be seen during 2020 in the top and bottom lines of the financials.
I agree with both of them. The market is not seeing the bright side on this stock. Other analysts are rating the stock as a buy, outperform, or overweight, with an average price target of $8.51 (67% upside from the current price of $5.10).
But, I think that analysts are still missing something (including me). With the legal issue with non-to-little effect on the company fundamentals and the capacity constraints disappearing during 2020, why is the price still falling and the valuation still so poor?
Technical analysis might give us some answers
The chart above shows that the stock is in a bearish trend, which has tested support three times since December. The price is in a triangle pattern, that is bound by the purple line as resistance, and the blue as support.
The fact that the blue line is almost flat, and the purple one is clearly sloping down, suggests the downtrend is likely to continue. The trend could be harmed if the current rally takes the price to cross the purple line by a significant amount.
The current rally could make the price touch the resistance line at the beginning of August, near the date when the company will report its earnings for Q2 2019.
By that time, the market will be watching whether the company continues unaffected by the current legal environment, as the management alleges.
That will be a crucial point. If results satisfy investors, the rally might continue, and the long-term trend would turn bullish. This would please value investors, which have been claiming that the stock is quite undervalued.
If the results confirm the bearish thesis, the price will break the triangle pattern and we could see more downward action.
I think that this opportunity unveils an asymmetric risk-reward trade-off. On the bullish side, the company needs only to keep results as the management has been guiding to make a huge boost in price.
Otherwise, as bad results are already expected by the market, suggested by a discounted price, there is a need for significant changes in the fundamentals driven by legal burdens to justify a huge decrease in price. Small changes wouldn’t translate into significant price decrease.
Fortunately, the following factors suggest that the results will be affected by the legal environment by a low degree or will not be affected at all:
- The management has good relations with the government of the county where the company concentrates most of its operation
- The company’s policies regarding environmental pollution are favorable to the eyes of the government
- The company’s operations are mostly located quite far from populations, which is one of the most important concerns of the new law
This context creates a risk-reward trade-off with a bullish case with +70% upward potential as well as a bearish case with a much less downward potential. An attractive position to be in.
Most ratios suggest that the stock is trading at a discount to its intrinsic value. The following list summarizes them:
- P/E = 4.95x
- Forward P/E = 4.42x
- P/B = 0.74
- EPS Growth (past 5yr) = 23.70%
- PEG (next 5yr) = 1.07
- ROE = 15.80%
- LT Debt/Equity = 0.45
The company is growing at a nice rate (23.70%), while the ROE is 15.80%. Stocks with these fundamentals use to trade at higher multiples.
A PEG of 1.07 is amazing and a strong sign of undervaluation. This ratio is of more importance than the widely used P/E, as it takes into account the growth factor.
The stock is also trading at a discount to its book value (P/B = 0.74), which reduces downside risks and offer a good margin of safety.
Wait for July 31 to enter a position
I started researching SRCI because it looked like a cheap and defensive play in this expensive market, and this near-recession economy. It is undervalued, and the market seems to be overreacting about some issues that are not affecting the company so hardly. Most analysts believe that there is upside in the stock.
The chart is indicating that the start of August is a proper entry point. Investors will be closely watching the Q2 results to be reported on July 31, as it could determine the long-term direction of the price.
Even though the stock is undervalued, I wouldn’t recommend to buy at this time. I would watch the stock closely during July for any PR related with negative effects from the new law.
You can start a position before July 31, with the risk-return profile I explained earlier. Or you can wait for the results to be reported, and buy the stock if you like what you see. This setup is less risky, but the return will be smaller, as the price should have reacted to the news when you enter the position.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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