Diamondback Energy's (FANG 0.20%) share price rise of 29.1% in the first six months of 2024 easily outpaced the 14.5% gain of the S&P 500. That's great news for investors. But investing is much more about future potential than past performance. Can this outperformance continue? What conditions are needed to ensure Diamondback keeps outperforming?
Acquisition fever
The last couple of years have been a period of merger and acquisition deals for the energy sector. Examples of this include ExxonMobil's $59.5 billion acquisition of Pioneer Natural Resources and Chevron's $53 billion bid to acquire Hess.
The reasoning behind the deals is understandable. With the price of oil remaining relatively steady at a somewhat high price, oil companies are generating bumper cash flows. At the same time, the market continues to price oil stocks at a discount compared to other sectors largely over concerns about the companies' long-term future as the world continues to move away from fossil fuel usage.
That combination of circumstances is giving oil industry executives an incentive to acquire or invest in new assets. Many are using the cash flow and their ability to raise debt to acquire companies and buy energy assets that are attractively priced. This logic works if the price of oil stays relatively high and the acquirer can get assets that will generate significant amounts of cash to pay off the debt.
For an idea of how attractively priced oil stocks are, consider Diamondback Energy itself. This company just generated $791 million in free cash flow (FCF) in the first quarter of 2024, and the market expects it to generate $3.26 billion FCF for all of 2024. With a current market cap of $36.1 billion, the estimated FCF represents 9% of its market cap.
Diamondback Energy makes its move
In February, Diamondback's management initiated its own significant merger and acquisition activity by agreeing to purchase Endeavor Energy for $26 billion, including $8 billion in cash and 117.3 million shares in Diamondback. As such, the new company will be 60.5% owned by existing Diamondback stockholders, with the remaining 39.5% in the hands of Endeavor stockholders.
Clearly, the market likes the deal, and the stock has significantly outperformed the S&P 500 since its announcement. There are a few reasons why.
First, the deal brings together two leading players in the highly attractive Permian Basin that straddles West Texas and southern New Mexico. Thanks to the advent of horizontal drilling, fracking, and other techniques, oil and gas production in the Permian basin has boomed over the last decade or so.
Permian Region Total Oil Production data by YCharts
As such, investors warmed to the idea of combining Diamondback's 494,000 acres in the Permian with Endeavor's 344,000 acres to create a combined acreage of 838,000 acres. Moreover, management took a conservative approach in outlining how many profitable locations the combined company would have. For example, it used an assumption of a $40-a-barrel breakeven price (meaning the location would be profitable at any price above $40). Under this assumption, Diamondback has 3,800 locations and Endeavor 2,300.
Combining the acreage and locations in the Permian basin should result in substantive synergy generation opportunities, and management is aiming for $550 million in annual synergies, resulting in a net present value of $3 billion if discounted at 10% over the next decade. That would be an excellent result for a deal worth $26 billion. In addition, management sees an opportunity to significantly improve FCF generation in the combined company through synergy generation by lowering costs.
Image source: Getty Images.
Can Diamondback outperform again?
Going back to the question posed at the top of this story, the short answer on outperformance is "yes," provided the price of oil stays relatively high. The valuation remains compelling, as does the current dividend yield of 4.6%, and the strategic acquisition of Endeavor must make sense if you believe the price of oil will stay relatively high. As such, the stock remains an excellent option for oil bulls and income-seeking investors.
