Diamondback Energy Is A Buy

About: Diamondback Energy, Inc. (FANG)
by: Sarfaraz A. Khan

Improvement in oil prices to $60 a barrel combined with the start up of crude oil pipelines in the Permian Basin will lift Diamondback Energy’s realized oil prices.

Better prices, production growth, and lower costs should have a positive effect on the company’s earnings and free cash flows.

Diamondback Energy will use its liquidity and free cash flows to cut down debt and reward investors with buybacks and dividends.

Diamondback Energy (FANG) has transformed into one of the biggest Permian Basin oil producers. In the near future, the company could turn into a free cash flow machine that regularly churns out excess cash which is used for shareholder-friendly initiatives. I believe Diamondback Energy’s future is looking promising and investors should consider buying this stock which is priced just 9-times future earnings.

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Diamondback Energy was one of several mid-cap energy companies which focused on producing oil from the Permian Basin. But it closed three major acquisitions in the fourth quarter of 2019, including the takeover of its rival Energen, which increased Diamondback Energy’s footprint in the Permian Basin’s Delaware and Midland regions to 364,000 net acres with more than 7,600 horizontal drilling locations while its proved reserves almost trebled to 992 million boe. This made Diamondback Energy one of the leading Permian Basin pure-play companies. Its position as one of the biggest players in the region got reaffirmed after the company released its first-quarter results which was the first full quarter following Energen’s acquisition.

Diamondback Energy produced 262,000 boe per day in the first quarter, which was 68% oil, depicting a strong gain of 156% from the corresponding period last year. On the other hand, like all oil producers, Diamondback Energy experienced weak prices in the first quarter as realized oil price dipped from $61.64 a barrel in Q1-2018 to $46.12 in Q1-2019. Its adjusted operating income (EBITDA), however, surged from $362 million to $675 million as the negative impact of lower realized prices was offset by higher production. Its adjusted net profit came in at $229 million, or $1.39 per share, beating analysts’ consensus estimate by $0.04 per share.

What I also like about Diamondback Energy’s performance was that it managed to generate decent levels of cash flows as well, even though it operated in a tough oil price environment. The company generated $639 million of cash flow from operations (ex. changes in working cap.) which fully covered capital expenditure of $627 million (including D,C&E & midstream CapEx). As a result, the company ended the period with $12 million ($639Mn - $627Mn) of free cash flows - or cash flows in excess of capital expenditure.

Moving forward, I believe the company’s profits will increase while its free cash flows will expand. That’s because Diamondback Energy will benefit from the improvement in oil prices. The spot price of the US benchmark WTI crude has been hovering above $60 a barrel since late-March, higher than the first quarter average of $54.83 a barrel. The increase in oil prices can be attributed in large part to supply reduction from the OPEC and its partners, including Russia, decrease in Iranian oil exports, the possibility of further reduction in supplies from Venezuela, and weak output from non-OPEC producers (ex. North America) due to years of underinvestment in the exploration and production sector. The fact that oil has remained above $60 despite growing production from the US and the escalating trade war jitters between the US and China shows how tight global supplies are. This improvement in prices will lift Diamondback Energy’s earnings and cash flows.

I also believe Diamondback Energy will likely report better oil price realizations in the near future. That’s because the company has contracted volumes on the EPIC and Gray Oak pipelines which will give it access to the lucrative Gulf Coast market and its premium prices which are benchmarked against Brent crude. Both EPIC and Gray Oak will start up in the second half of 2019 and will allow Diamondback Energy to fetch higher prices as the company’s oil starts flowing through these pipelines.

On top of this, Diamondback Energy also aims to grow production which should continue lift the company’s earnings and operating cash flows. For the full year, the company is targeting a 26% increase in total production led by a 30% increase in oil volumes on an adjusted basis.

At the same time, Diamondback Energy will experience better than expected cost savings associated with merger-related synergies. By combining Energen and Diamondback Energy’s operations, the company expected to reduce drilling and completion costs in the Midland and Delaware regions of the Permian Basin during 2019-20. However, the actual cost savings are coming in higher and sooner than expected. For instance, the company was targeting $223/ft of drilling and completion well cost savings in the Midland Basin by 2020 but it is now on track to deliver $240/ft of savings in 2019. This could translate into $155 million to $175 million of annual savings in the Midland Basin. Additionally, Diamondback Energy also expects to save $30 million to $40 million through G&A cost savings.

The merger-related synergies didn’t move the first quarter results in a big way since the company has only recently closed the Energen acquisition and is just starting to realize the benefits. But the expected cost savings should have a positive impact on the company’s profits in the coming quarters.

As indicated earlier, Diamondback Energy delivered modest levels of free cash flows while operating in a weak oil price environment. But the company will likely report much higher levels of free cash flows in the next quarters as the improvement in oil prices, better crude oil realization, production growth, and lower costs have a positive impact on the company’s operating cash flows. This will likely strengthen the company’s liquidity by bolstering its cash position.

Diamondback had $126 million of cash reserves at the end of the last quarter but I believe this will likely grow in the future. The company is also targeting asset sales as well as dropdowns to its subsidiary Viper Energy Partners (VNOM). It recently announced $322 million of asset sales and I am expecting additional divestitures in the future. Therefore, I think the free cash flows, asset sales, and dropdowns will likely significantly strengthen Diamondback Energy’s cash muscle.

I believe Diamondback Energy will use that cash, particularly the proceeds from asset sales and dropdowns, for debt reduction purposes. Diamondback Energy has a decent balance sheet, with a total debt of $4.67 billion which translates into a healthy debt-to-equity ratio of 33.9%. That’s lower than the average D/E ratio of around 63% of large-cap independent oil producers, as per my calculation. But the company has drawn $1.91 billion from its $2.5 billion revolving credit facility which matures in 2022 and the management will likely focus on using cash to repay the revolver balance in the short-term. Successful debt reduction will improve Diamondback Energy’s financial health and can have a positive impact on the company’s valuation.

I also expect the company to use the free cash flows for buying back shares and on dividends. Remember, Diamondback Energy’s board has authorized share repurchases of up to $2 billion through the end of next year. This shows that the company is confident about its ability to generate strong levels of free cash flows and will likely buy back significant shares this year. At the same time, the company will continue paying the cash dividend of $0.75 per share.

I believe in the short term, Diamondback Energy will mainly use buybacks as the primary method of returning capital to shareholders. But in the long run, as the company continues to generate free cash flows and brings the revolver balance down to manageable levels likely by 2020, it can increase dividends. The company currently offers a below average dividend yield of 0.70% but this will likely increase as Diamondback Energy regularly produces free cash flows and returns that to shareholders as dividends and buybacks.

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Diamondback Energy stock has risen by 18% this year. The company has managed to outperform its exploration and production peers (XOP) who have posted gains of 12% in the same period. But I believe the company’s shares have room to move much higher given the stock is trading just 9-times next year’s earnings estimates, as per data from Thomson Reuters. This makes Diamondback Energy one of the cheapest oil stocks around among mid to large-cap independents. The company’s shares will likely continue to rally on the back of free cash flow growth and debt reduction. I believe investors should consider buying Diamondback Energy stock while it is still cheap.

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.

Additional disclosure: The article is for information purposes only. It is not intended to be investment advice. The performance of Diamondback Energy stock is heavily influenced by movements in oil prices and other factors. Weakness in oil prices may drag Diamondback Energy shares. Carefully consider your investment objectives, level of experience, and risk appetite before buying the company's shares. Always perform your own research before making any investment decisions.