Epsilon Energy Ltd. (NASDAQ:EPSN) popped up on our radar as part of a search for appealing value setups with positive technicals. Despite being a registered natural gas and oil firm, Epsilon Energy is not an operator but rather an investor looking to create good returns from its expanding asset base. This means that the leases are managed by experienced operators. Although it could be argued that Epsilon relinquishes a lot of control (by not operating the leases) because the company is essentially at the mercy of the speed of the operator on site, there are clear advantages in this model as well, primarily around cost reduction and the ability to scale and diversify the company in other commodities and areas (something that an investor would invariably do).

Income Streams That Are Diversified

However, in terms of diversification, Epsilon is not necessarily beginning from a poor foundation in terms of the company’s asset base. Indeed, when we examine the company’s most recent first quarter-fiscal 2023 figures, we notice that Epsilon’s midstream assets accounted for 28% of the top-line quarterly take. The ratio was 12% in fiscal 2022 as compared to the company’s upstream assets. To summarize, the more cash-generating assets Epsilon can invest in outside of the upstream nat-gas market, the less unpredictable (and more predictable) the company’s financials will become over time.

Although management did not discuss forward-looking profits on a recent liquid investment in the Permian on the Q1-2023 conference call, Epsilon has since invested in other liquid acres to further diversify its portfolio. These transactions, together with the natural gas hedge that management put in place for 2023, are the result of Epsilon’s solid balance sheet, which has no debt and reported about $50 million in cash and ST investments at the end of the first quarter of this year.

Epsilon’s projected returns appear appealing due to how much of the company’s reported sales essentially sink to bottom-line profitability. In fact, despite falling natural gas prices, Epsilon was able to generate a $4.4 million operational profit in the first quarter of this year. Now, if we take these earnings as our baseline and annualize them to a 12-month period ($17.6 million), we get an adjusted return on capital percentage of 25%, which is an amazing figure given how trading circumstances have altered in recent months. This figure is obtained by removing Epsilon’s substantial cash balance (which is not required to generate returns) from the computation.

Suffice it to say, when a company can create these kinds of returns in volatile markets, the odds are stacked in favor of the long-term investor. Why? Well, by continuing to pay out a well-covered 4.7%+ dividend (18% pay-out ratio), reducing the share count, and increasing the company’s book value over time, Epsilon is demonstrating that it cares about its shareholders, which is something that investors obviously want to see.

Positive Technicals

On a three-year weekly chart, we observe that shares recently printed a MACD bullish crossover signal, which could be significant for the following reasons. Because shares have already printed a greater weekly high this week, the ‘4-week rule’ is now in effect if we climb above $5.36 per share next week. 4 weeks of consecutive higher highs generally attract trend followers, and we consider Epsilon as a prime contender here given the company’s continued asset growth, as indicated above.

Low Valuation Reduces Risk

Given Epsilon’s micro-cap origin and hence limited trading volume, risks are obviously amplified due to how commodity price volatility can essentially alter the share price considerably. However, about $2 million in insider buying transactions have already occurred this year, owing to the company’s assets continuing to sell at a discount. At the moment, for every $1 invested in Epsilon, $0.86 cents in assets are obtained (equating to a p/b multiple of 1.16).

In our opinion, this book multiple is low because Epsilon has no debt and almost all of its equity is built up of its large cash position ($49.2 million in cash and ST investments) and assets ($67.8 million in property, plant, and equipment). Furthermore, only a small portion of Epsilon’s assets are owed to the company ($4.8 million in receivables), indicating that the company’s liquidity and solvency positions are strong.

Given the current returns on the company’s assets (as mentioned above), it stands to reason that these assets will stay cheap in the long run. Furthermore, the further shift away from upstream nat-gas dependence will reduce volatility over time and reliance on a single commodity or jurisdiction.

Conclusion

To summarize, the combination of Epsilon’s expanding diverse asset base, strong balance sheet, and good return on capital led us to anticipate that this stock can rise beyond $5.36 per share next week. The highest high that shares have printed in the last four weeks is $5.36, so ultimate confirmation will be a higher high next week. 

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