Even before energy prices began spiking, Diamondback Energy Inc. (FANG, Financial) began growing its free cash flow aggressively. That growth began in the fourth quarter of 2019, when the average closing price of West Texas Intermediate was $56.99 and the high of the year was $66.24.
For corporations, strong free cash flow provides a passport for growth and for rewarding shareholders. In its November 2022 investor presentation, the company forecasted, with conditions, FCF of at least $4.45 billion for 2022. Approximately three-quarters of that amount will be returned to shareholders through base dividends, variable dividends and stock repurchases.
About Diamondback
Based in Midland, Texas, the company has a market cap of $24.86 billion and trailing 12-month revenue of $9.63 billion. It describes itself this way in its 10-K for 2021:
“We are an independent oil and natural gas company focused on the acquisition, development, exploration and exploitation of unconventional, onshore oil and natural gas reserves in the Permian Basin in West Texas. This basin, which is one of the major producing basins in the United States, is characterized by an extensive production history, a favorable operating environment, mature infrastructure, long reserve life, multiple producing horizons, enhanced recovery potential and a large number of operators. We report operations in two operating segments: (i) the upstream segment and (ii) the midstream operations segment, which includes midstream services.”
It also owns majority interests in two publicly traded subsidiaries, Viper Energy Partners LP (VNOM, Financial) and Rattler Midstream LP (RTLR, Financial). Diamondback owned about 54% of Viper, which has mineral interests in the Permian Basin and Eagle Ford Shale. It holds about 74% of limited partner interests in Rattler, which owns and develops midstream infrastructure assets in the Midland and Delaware Basins of the Permian Basin.
In addition, Diamondback announced in October that it was buying the leasehold interests and assets of FireBird Energy. The deal will cost 5.86 million shares and $700 million. CEO Travis Stice said in a news release that the deal adds “significant, high-quality inventory right in our backyard.”
Financial strength
With this acquisition, big dividend payments and share repurchases, it appears Diamondback has a solid financial base.
That’s confirmed by several important measures. First, it has an interest coverage ratio of 50.97, meaning it generates enough operating income to pay its interest expenses nearly 51 times over. That’s very solid.
Second, it has a higher-than-average Piotroski F-Score, indicating it manages nine key financial issues well. With an 8 out of 9 ranking, only two of 10 industry players have higher scores: Marathon Oil Corp. (MRO, Financial) and Ovintiv Inc. (OVV, Financial).
Third, its return on invested capital is higher than its weighted average cost of capital, 23.4% for ROIC and 16.15% for WACC. This makes it a value creator for shareholders.
Profitability
Its financial situation is enhanced by industry-leading gross, operating and net margins. Looking at the latter two over the past decade, we see the net margin has been volatile:
Returns on equity and assets also have been industry-leading: ROE is 34.51%, while ROA is 18.86%. And despite the deep plunges in energy prices over the past decade, the company has been profitable in six of the past 10 years.
Growth
Over the past three years, Diamondback has delivered double-digit increases in revenue (22.7% per year), Ebitda (12.5%) and earnings per share without non-recurring items (15.1%).
As noted above, free cash flow picked up in 2019, after languishing during the previous five years. This chart shows the extent of the turnaround:
Thanks, in part, to that free cash flow, Diamondback joined the Nasdaq 100 on Dec. 12, 2022. That means, according to the company, it is one of “the top 100 largest domestic and international non-financial companies on The Nasdaq based on market capitalization.”
Dividends and share repurchases
On Nov. 7, Diamondback announced both a base and variable dividend.
The base was a quarterly cash payment of 75 cents ($3 per year), and based on the closing share price on Nov. 4, that worked out to a 1.9% annualized yield.
The variable was a cash dividend of $1.51 per share, which implied a yield of 5.6%, again based on the closing price on Nov. 4. Currently, the combined dividend yields 6.54%.
While the 6.54% yield is very attractive, keep in mind that the majority of it comes from the variable dividend and that, in turn, depends on free cash flow. A significant drop in oil prices could reduce or eliminate that "bonus."
Turning to share buybacks, the company has issued far more shares than it has repurchased over the past 10 years. However, it has cut the count slightly over the past three quarters:
Valuation
The GuruFocus system gives Diamondback a 9 out of 10 rating for value. That’s based on the market price and GF Value price. The market price at the close of trading on Dec. 29 was $136.33, while the GF Value chart values the company at $173.21.
Dividing $136.33 by $173.21 equals 0.79. Because that result is less than 1, the stock is undervalued.
The GF Value valuation is based on four historical multiples plus an adjustment factor (that accounts for past returns and growth) and future estimates of business performance.
The price-earnings multiple is relatively low at 5.57, while the oil and gas industry median is 8.27.
As for the share price, it is below the highs it hit last summer, but above the trendline:
Gurus
There’s lots of confidence among the gurus for Diamondback’s prospects: 12 of them had positions at the end of September. The largest three holdings were:
- Yacktman Asset Management (Trades, Portfolio) with 1,262,012 shares, representing 0.71% of Diamondback’s shares outstanding and 1.66% of the fund’s holdings. This was a new holding for the fund.
- Bill Nygren (Trades, Portfolio) of the Oakmark Fund had 873,000 shares, after a reduction of 38.52%.
- And the Yacktman Fund (Trades, Portfolio), as distinct from Yacktman Asset Management (Trades, Portfolio), held 685,000 shares, again a new holding in the third quarter.
Institutional investors have piled into the stock and at last report held 95.25% of shares outstanding. Insiders own 0.45%, led by President and Chief Financial Officer Kaes Van’t Hof with 158,969 shares.
Conclusion
After struggling in the mid-2010s, Diamondback Energy regained its direction and momentum just before the decade of the 2020s began. Since then, it has posted attractive growth on key financial measures. It has stepped up its borrowing, but nevertheless has a solid financial base. It is also profitable, pays a significant dividend and is modestly undervalued according to one valuation source.
