Small-Cap Energy Stock EROC the Best Value on Wall Street

Eagle Rock is an MLP without a dividend, but not for long

   
Small-Cap Energy Stock EROC the Best Value on Wall Street

Whether you agree or disagree with David Tepper’s recent suggestion to not “be too frickin’ long right now,” his comments clearly reflect growing caution and skepticism about the stock market on the part of many investors. We’ve seen evidence of this “risk off” mentality in the dramatic underperformance of small-cap stocks versus their larger brethren.

But there are certainly value investments out there if you know where to look — as in the case of small-cap energy stock Eagle Rock Energy Partners (EROC).

Broadly, I personally view the markets more favorably while the Federal Reserve continues to drop money from helicopters and maintain an open commitment to low interest rates to prevent deflation. This being said, the economy and markets remain fragile, and it would be a mistake to make a large directional portfolio bet when we simply can’t forecast with a high degree of confidence.

I may have an opinion, but I am not willing to build an outsized trade on it. I like to manage risk from the bottom up in the money I manage and my Contemporary Value Investor service. I do that by buying stocks that give me a margin of safety because they are selling at a discount to intrinsic value. By doing this, we are more likely to earn an attractive return on our capital and take on less risk in the process.

And one stock that’s certainly worth exploring to find intrinsic value is EROC.

EROC – The Case of the Returning Dividend

Eagle Rock Energy Partners (EROC) is a master limited partnership (MLP) that recently suspended its cash distribution, or dividend. That makes investors nervous in any case, but especially when we’re talking about an MLP.

The reason investors buy MLPs is for the dividend, so the stock got hit hard, falling 17% on April 24 after the news got out. With the bad news already out, investors can buy the stock at a significant discount to intrinsic value. All of those folks willing to sell the stock at that price are ignoring the fact that the dividend is likely to be reinstituted.

EROC did this because they are in the midst of a divestiture and a recapitalization of the balance sheet, and they need to conserve cash at this particular moment as they bump up against debt covenants while the process plays out. Eagle Rock is selling its midstream energy business to Regency Energy Partners LP (RGP) for $1.325 billion in consideration, which will be a combination of debt assumption, cash and stock in RGP. The sale of this business will recapitalize and deleverage their balance sheet, putting them in a position to reinvest in their upstream operations (exploration and production), which are already substantial.

We are able to buy EROC at a significant discount to value, giving us a nice margin of safety with little additional downside risk (and little, if any, risk of “permanent loss of capital”). At the same time, we can see two very clear value-driving catalysts directly ahead.

The first is the closing of the sale of the midstream assets to Regency. I expect this to happen by the end of June, and it will help restore financial liquidity. The second is the initiation of the dividend again, which management has indicated is their intention, and once the transaction closes, EROC should have the liquidity to start paying again. It may not begin right away, but I do expect it to be within one to three quarters. A third longer-term catalyst is rising natural gas prices.

A significant portion of EROC’s production is natural gas, and rising prices would certainly drive future distributions.

EROC is a case of investors overreacting to short-term negative news and not taking a closer look at the long-term fundamentals and management’s strategy, a set-up we value investors like. The biggest risk we have to watch is if there are problems with the Regency deal. The Federal Trade Commission (FTC) has sent a “second request” for information as it reviews the application under the Hart Scotts Rodino Act. This has delayed the merger and likely contributed to some of the volatility in the stock price. If the FTC declines to let the merger close, which I view as highly unlikely, then I would be concerned and likely sell. Delays are also possible, but they are often great buying opportunities as long as the bigger story remains intact.

EROC a small-cap stock with relatively low trading volume, so should you decide to invest, I recommend you use limit orders.

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Article printed from InvestorPlace Media, http://investorplace.com/2014/05/eroc-eagle-rock-energy-stock/.

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