Investing in EP Energy (NYSE: EPE) IPO

Amid fine performances from several high flying energy IPOs lately, expectations were equally high for the latest public offering in the energy space – EP Energy (NYSE: EPE), which debuted this past Friday.

But the day before it began trading, the offering price was slashed by some 25 percent from a mid-range price of $25 to $20. Then, as the first day of trading proceeded, the share price just kept falling, settling at $18.08 for a loss of 9.6 percent of the $20 debut.

What happened? With crude oil prices closing up 0.4 percent on Friday and up 1.8 percent on the week after the seventh weekly decline in U.S. crude oil inventories, you would think EPE’s IPO would ride the oil band wagon to impressive gains.

A look into the company’s Q3 2013 report and the intended use of the IPO money raised might shed some light on the stock’s poor outing. Let’s start with the expectations.

High Hopes

EP Energy describes itself as “a leading North American oil and natural gas producer” with “a proven strategy, a significant reserve base, multi‐year drilling opportunities, and a strategic presence in fast‐emerging unconventional resource areas. EP Energy is active in all phases of the E&P value chain—exploring for, acquiring, developing and producing oil and natural gas.”

It certainly has some rich properties, which include the rich Texas deposits of Eagle Ford and Wolfcamp Shale in West Texas, the Altamont field in Utah, and the Haynesville Shale in Louisiana. It expects to have almost 25 years worth of drilling inventory based upon locations it has identified within these properties. In September, EPE had proven reserves of 513 MMBoe, and average daily production of 88,149 Boe/d.

What’s more, the company has an experienced team of executives to lead it. President, CEO and Chairman Brent J. Smolik has been with EPE and its predecessor company since 2006. He had also served as President of ConocoPhillips Canada and President of Burlington Resources Canada before the two companies merged. The majority of EPE’s senior management team has worked over a decade at prominent oil and gas companies with ample experience in acquiring and developing resource-rich leasehold properties.

It’s enough to make any oil company investor salivate. According to Seeking Alpha, EPE’s S-1 balance sheet for the first nine months of 2013 showed revenues of $1.24 billion, net income of $397 million, assets of $7.99 billion, liabilities of $5.14 billion, and equity of $2.85 billion.

“This firm is very profitable and making money hand over fist, and doing so in a highly efficient manner,” investment site Seeking Alpha said. “Its net income was equivalent to nearly a third of its revenue for the nine months ended September 2013.”

The Numbers May Not Be That Great

But a closer look at the company’s Q3 2013 report shows that it really isn’t making profit “hand over fist.” Although its net income of $427 million for the first nine months of 2013 was a cool 37 percent of its $1.135 billion in total operating revenues, its continuing operations actually incurred a net loss of $69 million.

While operating income for the first three quarters of 2013 came in at $221 million, or 19.5 percent of revenues, the company incurred even more in interest expenses of $269 million, or 23.7 percent of revenues.

So if the company actually incurred operating losses of some $69 million during the first three quarters of 2013, how did it manage to report a net income of $427 million? Quite simply, it sold a number of its assets in July and August, earning $458 million as “income from discontinued operations” in Q3 alone, plus another $38 million of gains from divestitures during Q1 and Q2 of 2013.

The report explains under the heading “Discontinued Operations”:

“In June 2013, EP Energy LLC, our wholly-owned subsidiary entered into three separate agreements to sell its CBM properties located in the Raton, Black Warrior and Arkoma basins; its Arklatex conventional natural gas assets located in east Texas and north Louisiana and our legacy south Texas conventional natural gas assets. In July and August 2013, these sales were completed for total consideration of approximately $1.3 billion and recorded a gain on the sale of approximately $455 million.”

“On July 16, 2013, we entered into a Quota Purchase Agreement to sell our Brazil operations which is expected to close by the end of the first quarter of 2014.”

“We have classified the assets and liabilities associated with each of these dispositions as discontinued operations in our condensed consolidated balance sheets in these condensed consolidated financial statements to the extent they have not already been sold.”

Under “Other Income”, therefore, the company reported $455 million as a “gain on sale of assets”.

Unless the company is planning on continually selling vast tracts of properties, future reports will not show such high net income numbers. Remember that due to the high interest payments on its debt, net income from the company’s continued operations was a $69 million loss during the first 3 quarters of last year. Investors might be expecting losses in 2014 as well.

Proceeds Well Directed

But there is hope for the young company, which is officially less than 2 years old in its current incarnation. Management seems intent on cutting its interest expenses by paying down its $4.117 billion of debt obligations, which represent some 52 percent of its $7.95 billion worth of assets.

Of that debt, a full $2 billion carries an interest rate of 9.375 percent, with another billion or so ranging from 6.8 to 7.8 percent interest, while $644 million carries variable rates.

Paying down these debts was the whole purpose behind the pubic offering, as the company noted in its press release the day before the IPO:

“Net proceeds to EP Energy from the sale of the shares of its common stock… are approximately $664 million (or $765 million if the underwriters’ option to purchase additional shares is exercised in full). EP Energy intends to use the net proceeds from this offering:

(i) to redeem all of the outstanding 8.125 percent/8.875 percent Senior PIK Toggle Notes due 2017 … and pay the redemption premium and the accrued and unpaid interest on those notes,

(ii) to repay outstanding borrowings under the reserve-based revolving credit facility,

(iii) to pay a fee under the management fee agreement with certain affiliates of EP Energy’s sponsors and

(iv) for general corporate purposes.”

But even if the maximum $765 million raised were applied to the debt in full, the company’s debt obligations would be reduced by a mere 18.6 percent, leaving $3.35 billion of debt, worth some 42 percent of company assets.

Investors might be looking at this as a reason to wait for lower stock prices before jumping in.

Bright Future Ahead

Even so, we mustn’t ignore EP Energy’s attractive properties brimming with oil and gas reserves. As Seeking Alpha acknowledges:

“The fact that the company has abundant drilling inventory and significant proven reserves leads us to believe that EPE will maintain its operations well into the future. Also, this oil and gas company focuses on shale drilling in the Texas, Utah and Louisiana states that are very promising and proven.

“Its excellent management team lead by Mr.Smovik, featuring numerous officers with extensive experience with major oil and gas firms like ConocoPhillips and BP (and EPE itself), is one of the best in the shale oil drilling business.”

That management team seems quite keen on making the company profitable, raising money through a mix of property sales and a stock offering to pay down its most expensive debt.

Given a little more time, and given the recent surge in demand in anything shale related, investors can expect solid growth from EPE. Yet over the immediate term, lower stock prices should be expected, which could present great entry points for long term holders.

Joseph Cafariello