Future LNG Exposure And Asset Retirement Risks Will Eventually Be Rewarded

Catalysts

About Diversified Energy

Diversified Energy acquires, operates and optimizes portfolios of long life, low decline U.S. oil and gas assets to generate cash flow.

What are the underlying business or industry changes driving this perspective?

• Although the company is growing its low decline production base with acquisitions like Maverick and the pending Canvas deal, integration missteps or lower than expected operational efficiencies could limit the benefit of larger scale for EBITDA and free cash flow margins.
• While Diversified is positioning production to participate in LNG exports and rising data center power demand, any slowdown or delay in these end markets could leave volumes more exposed to regional pricing pressure and cap revenue growth.
• Although the move to a primary New York Stock Exchange listing and SEC reporting is intended to increase liquidity and index inclusion, higher disclosure costs and greater scrutiny could pressure net margins if the expected trading volume and ETF ownership do not materialize as hoped.
• While the company’s use of asset backed securitization provides access to investment grade rated, amortizing debt, a change in investor appetite for this type of private credit or tighter terms from insurers could raise funding costs and reduce the cash spread available for earnings.
• Although the Mountain State Plugging Fund and the focus on well retirement services address part of the asset retirement obligation, if similar arrangements in other states are slower or smaller than management expects, long term decommissioning cash needs could continue to weigh on free cash flow and limit flexibility for dividends and buybacks.

Assumptions

This narrative explores a more pessimistic perspective on Diversified Energy compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Diversified Energy's revenue will grow by 11.1% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from -12.0% today to 7.4% in 3 years time.
• The bearish analysts expect earnings to reach $117.0 million (and earnings per share of $2.82) by about January 2029, up from $-137.8 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $231.0 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 16.2x on those 2029 earnings, up from -7.6x today. This future PE is greater than the current PE for the GB Oil and Gas industry at 13.3x.
• The bearish analysts expect the number of shares outstanding to grow by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.86%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The roll up model depends heavily on buying PDP assets at attractive valuations and then extracting efficiencies, so if future acquisition opportunities come at higher prices or with fewer easy cost savings, cash flow per acquired dollar could shrink and weigh on EBITDA and free cash flow.
• Access to low cost, long dated asset backed securitization funding is central to the company’s financing approach, so any sustained change in insurer or private credit appetite for this structure, including higher required coupons or tighter terms, could reduce the spread between asset cash flows and interest costs and pressure net margins and earnings.
• The business is increasing exposure to long life natural gas volumes that are positioned for LNG exports and data center demand, so if these end markets build out more slowly than management expects, realized pricing and volumes could be less favorable which would affect revenue and cash margins over time.
• The Mountain State Plugging Fund is sized to address roughly 25% to 30% of the discounted asset retirement obligation, so if similar arrangements in other states are slower to materialize or not as comprehensive, future well retirement spending could remain a sizeable cash claim and constrain free cash flow and dividend capacity.
• The plan to grow the well retirement subsidiary by plugging third party wells assumes a durable long term market for these services, so if regulatory approaches to decommissioning change or competing capacity increases faster than expected, pricing power for this line of business could be limited, which would dampen its contribution to revenue and margins.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Diversified Energy is $15.0, which represents up to two standard deviations below the consensus price target of $20.5. This valuation is based on what can be assumed as the expectations of Diversified Energy's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $26.0, and the most bearish reporting a price target of just $15.0.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be $1.6 billion, earnings will come to $117.0 million, and it would be trading on a PE ratio of 16.2x, assuming you use a discount rate of 9.9%.
  
• Given the current share price of $13.3, the analyst price target of $15.0 is 11.3% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.