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(Note: This article originally appeared in the August 20, 2022 newsletter and has been updated as needed.)

Diamondback Energy (NASDAQ: FANG) has long had a rock-solid balance sheet. This company has a long history of mitigating typical business risk (financial leverage) by using stocks to make acquisitions. This has reduced the risk of default that occurs when debt has to be repaid during cyclical periods of low commodity prices. At the same time, the business has rock-bottom operating costs that limit the risk of shutdowns during periods of low commodity prices.

The above-average profitability that results from both strategies is a good way to minimize the risk of a business crisis during a cyclical downturn. So many investors believe that huge financial leverage is necessary for above-average returns. Yet, this business has been running strong operating results for years without needing a lot of debt.

The result is a company that can meet market demands for shareholder payouts while choosing to increase production. Right now, it looks like a choice has been made to repay debt, pay shareholders and maintain production. But conservative debt levels allow for a change in strategy at any time, even though some high margins already demonstrate generous cash flow for the amount of production.

Diamondback Energy Second Quarter 2022 Operational and Financial Highlights

Diamondback Energy Second Quarter 2022 Operational and Financial Highlights (Diamondback Energy Second Quarter 2022 Earnings Conference Call Slides)

The capital required to maintain production is essentially a very small portion of reported cash flow. This allows proportionally more cash to be allocated to other priorities.

So many times investors wonder where the overall profitability of leases is demonstrated. Usually, this profitability is demonstrated by the average profitability and cash flow reported throughout the industry cycle. Write-offs and write-downs have traditionally not been as significant here as with some competitors.

This average profitability should also be factored into the multiple attributed to the company’s shares throughout the economic cycle. It is one of the few independent companies to have an investment grade rating for issued debt. It takes a certain size of trades to get that rating. But it also implies above-average profitability throughout the business cycle.

Diamondback Power Reserve Costs and Growth History

Diamondback Energy Reserve Costs and Growth History (Diamondback Energy Q2 2022, Earnings Conference Call Slides)

Reserve growth mirrors production growth and emphasizes a counter-cyclical growth strategy. For example, reserves have increased dramatically in fiscal years 2017 and 2021. This growth comes primarily from acquisitions that were planned and executed long before the industry recovery was evident to the market.

While management may talk about honoring market demand for dividends and share buybacks at the expense of growth, the company is well positioned to continue acting as a consolidator. Although growth is unlikely to continue at the breakneck pace of the story pictured above. Acquisitions made at the bottom of the market are likely to be sufficiently accretive for the company to see mid-double-digit earnings-per-share growth going forward.

Sometimes acquisition activity can significantly increase research and development costs for a fiscal year. But the ongoing operating activity shown above demonstrates costs that are much more typical of a natural gas producer than a company with a substantial percentage of oil production. The result is directly attributable to the huge operating percentage that the company regularly reports.

Another reason not to increase production during a cyclical recovery is the rising costs that accompany a recovery. This company has excellent ongoing cost advantages, not only in geology, but also investing in acquisitions during market declines (or before recovery becomes apparent to the market).

The Permian is notorious for its take-out capacity constraints which often result in deep discounts to posted oil prices. This company avoids this by contracting for capacity and then waiting for that capacity before ramping up production.

second quarter

The second quarter report highlighted the company’s profitability at lower prices. This is going to be important when the next inevitable cyclical decline occurs.

Diamondback Energy Second Quarter 2022 Results Summary

Diamondback Energy Second Quarter 2022 Earnings Summary (Diamondback Energy Second Quarter 2022 Earnings Press Release)

Operating expenses combined with research and development costs shown above imply a break-even point when oil prices received are in the order of $20. This range compares favorably to some of the most profitable large projects in the industry.

Many leases have multiple intervals that are not yet part of the reserve report. The current acreage could occupy this business for a very long time as there are more intervals to derisk.

It should also be noted that the Permian is quite close to many export facilities. This is important because the country largely exports the unconventional light oil produced while importing heavier oils to make money from the gap between the two products. This is one of the few things the country is doing to help its balance of payments deficit.

The future

A company as well run as this is an attractive candidate for acquisition (at the right price, of course). Many of the unconventional producers that exist today will eventually consolidate. It’s been a long-term trend for a very long time.

Investors should remember that any company making an acquisition wants the best deal for its shareholders with the least amount of hassle. This often eliminates highly leveraged companies, as the debt was often incurred during times when acquisition costs were higher. Therefore, the more debt a company has, often the less it can be offered to shareholders.

The profitability set by management allows for a generous dividend while shareholders wait for the future to unfold. In fact, the dividend and share buyback program should generate double-digit returns as long as oil prices remain strong.

The recent sale offers investors an opportunity to consider a well-run business. This company tends to have a well above average financial performance and historical growth rate.

Whenever the next cyclical industry downturn occurs, this direction will likely be a consolidator looking for accretive acquisitions. This strategy should provide above-average growth rates during cyclical downturns combined with generous dividends during periods of high commodity prices. Even given the cyclical nature of the industry, the long-term performance of current common stock prices should prove attractive.

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