SM Energy

Moat: 1/5

Understandability: 2/5

Balance Sheet Health: 3/5

SM Energy is an independent oil and natural gas company engaged in the exploration, development, production, and acquisition of oil and natural gas properties, primarily in Texas.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

SM Energy operates within the oil and gas industry, focusing on onshore exploration and production in the United States, specifically in the Permian Basin and Eagle Ford regions of Texas.

  • Revenue Distribution: SM Energy’s revenue is derived primarily from the sale of crude oil and natural gas, with a smaller contribution from natural gas liquids (NGLs). The proportions vary due to commodity price changes and production mix. Generally, crude oil is the biggest revenue source, with natural gas taking second place. Revenue is largely driven by oil prices due to crude being the most significant revenue stream.
  • Industry Trends: The oil and gas industry is highly cyclical and volatile, influenced by global supply and demand dynamics, geopolitical events, and economic conditions. There has been a push for more ESG practices, and there has been significant consolidation in the oil and gas sector.
  • Margins: Profit margins for companies in the oil and gas sector can vary depending on market prices for crude oil and natural gas. Companies with cost-effective operations can increase the profits even further, and are better able to absorb shocks when commodity prices decline. In the past few years, profitability has been very high for oil and gas companies due to the global market disruptions and the increased demand for oil. In times of lower prices, profit margins are directly correlated with low oil prices, as the company is a price taker.
  • Competitive Landscape: The oil and gas industry is very competitive, with many players from global behemoths to smaller private entities. The key aspects of competition include operating costs, efficiency, technological capabilities, financial capacity, regulatory compliance, and access to and development of prime resources.
  • What Makes SM Different: They focus on the Permian and Eagle Ford regions, and have significant assets in those locations. They also seem to be more focused on oil rather than gas. They are not involved in refining and distribution (like many big companies in the oil and gas sector are), they rather focus on exploration and extraction. It is a mid-sized producer, and they have had some issues with their capital allocation strategies. They also have very ambitious goals for the next few years.
  • Latest news and controversies: The company faced significant challenges in the last five years, mostly in 2020 with COVID, then in 2023 with the uncertainty of oil and gas prices. They have tried to mitigate the risks by making sure their finances are very strong, and have lowered their debt to almost zero. As they are more focused on crude oil than gas, their profits are likely more exposed to the fluctuations in oil prices.

Financials Analysis

SM Energy’s financial health is a mixed bag. Their balance sheet has improved drastically due to their financial strategy, and the company has reduced debt in favor of increasing cash holdings. However, their financials are largely tied to the volatility of crude oil and natural gas prices and lack predictability and consistent margins. They have a relatively small market share and do not influence or control the prices they are selling their products at. The future profitability is hard to predict and depends on the overall health of the industry rather than their own operations. Here’s a deeper look:

  • Revenue: SM Energy’s revenues are primarily tied to the price and volume of oil and gas they sell. In 2023 the revenues were $4.4B, down from $4.9B in the previous year. The company’s revenues are very volatile and are expected to fluctuate.
  • Profitability: Net income in 2023 was $1.3B, down from $1.9B in the prior year. Due to fluctuating prices, profitability can swing heavily from positive to negative.
  • Cash Flow: The company’s free cash flow of $763 million in 2023 is much lower than $1.7B in the previous year. However, this may be impacted by the large asset sales they had in 2022. The free cash flow is volatile and depends on the production volumes, prices, and operating expenses. It is expected that a lower free cash flow is likely as commodity prices are not as high as in 2022, and companies increase spending to increase production.
  • Return on Invested Capital (ROIC): The company has averaged a ROIC of 11.2% since 2013. In the more recent years, ROIC has swung wildly depending on the market fluctuations. ROIC peaked at 29.4% in 2022 and fell to 12.6% in 2023. A positive ROIC shows that the company is creating value and using capital efficiently, but since they do not control oil prices, the fluctuation can be too high, and may not be an accurate indicator of their business.
  • Capital Structure: SM Energy’s management has focused a lot on increasing financial flexibility by reducing its total debt. This includes the early retirement of senior notes and reducing total debt by more than 60% in 2023. As a result of that, their debt is very low and very manageable, but it also means that the interest expenses will be a non-factor in the valuations.
  • Current Debt: As of December 31, 2023, SM Energy had long-term debt of $1.5B (excluding liabilities from acquisitions and lease liabilities). With the current cash balance of $930 million, the net debt is very low.
  • Cash Position: The company has around $930 million in cash, which makes them resilient to downturns.

Moat Analysis

  • Rating: 1/5.
  • Explanation: SM Energy, unfortunately, has no real economic moat. They face significant competition in a highly volatile industry. The competitive advantages of a company are things such as brands, patents, licenses, network effects, switching costs, or cost advantages that make it difficult for competitors to compete. SM Energy has none of that. The main drivers for the company are the commodity prices, which they can’t affect. Other factors are operating efficiency and cost structure-but those can be quickly copied and implemented by others.
    • No Intangible Assets: SM Energy does not have any major brand recognition or a significant amount of intellectual property. Their products (oil and gas) are largely commoditized, and any advantages derived from those sources are very limited.
    • Very Low Switching Costs: It is extremely easy for companies to switch to another producer of oil or natural gas if the prices are more favorable. So, as an oil and gas producer, they are inherently vulnerable.
    • No Network Effect: Network effect does not apply to this company.
    • Limited Cost Advantage: SM Energy has tried to focus on lowering its operating costs by focusing on the Permian and Eagle Ford basins, where they have a lot of experience. However, those advantages can be quickly replicated by other competitors.
  • Conclusion: This company is in an industry that has low moats for all players. The best companies in this sector still struggle to maintain high profit margins, because they are price-takers in their respective market. Due to this fact and lack of other competitive advantages, I am assigning SM Energy a “no moat” rating.

Risks to the Moat

  • Price Volatility: Fluctuations in oil and natural gas prices could severely affect SM Energy’s revenue and profitability, as they don’t control the market prices.
  • Production Costs: Increases in production costs, whether from supply chain issues, labor costs or new regulations, would lower their returns and make the company less profitable.
  • Regulatory Risks: Changes in environmental regulations, or taxes could make their operations more expensive and decrease their profitability.
  • Geopolitical Risks: Geopolitical events can significantly affect energy markets, such as embargoes or disruptions to production. The price hikes and volatility in 2022 and 2023 have shown how unstable the market is.
  • Technological Disruption: Technology has not been a major factor in this sector, but disruptive changes could change the rules of the game.
  • Competition: The entry of a new very competitive company in their locations could bring down returns. There is some consolidation, but still too many companies in the market, to allow any particular company to have too much power.
  • Acquisition Risks: The company seems intent on growth through acquisitions-which often come with risks of integrations, overpaying, or overestimating the synergies from the merged business.

Business Resilience

While the oil and gas industry is known to be a boom-or-bust industry, a lot of the things that influence SM energy are outside the management’s control.

  • Their financial prudence should help them stay afloat in periods of low revenues.
  • However, a long-lasting downturn in the sector will affect their profitability.
  • Any technological change to the methods of extraction and exploration could make them uncompetitive.
  • They lack a moat in the current market, which is concerning for the long run.

Understandability Rating

  • Rating: 2/5.
  • Explanation: While SM Energy’s operations are relatively easy to grasp, such as extraction and sale of oil and gas, their financials are much more complicated, due to a variety of factors that they are subjected to. The industry is also complex, and understanding the geopolitical influences, supply, demand dynamics, and other factors requires an expert level understanding of the industry. Although the company has been trying to simplify its operations, predicting the profitability of the company is still too unpredictable.

Balance Sheet Health

  • Rating: 3/5.
  • Explanation: SM Energy has improved its financial health by drastically lowering its debts. While having extremely low debt improves financial stability, the company’s revenues and profits remain dependent on commodity prices, which can be very volatile. Due to this, a future downturn in the oil market can hurt this company significantly.