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This week we welcomed back the management team of Diversified Gas & Oil to present at a Yellowstone Advisory webinar. The company is listed on the premium segment of the London Stock Exchange and with a market cap of £900m is part of the FTSE250 index. For investors looking for a high and rising dividend the stock currently yields 11% and is growing this at 4%.
The company reported HY numbers on 5th August and management took the opportunity to update on their performance, recent acquisitions and the opportunities for further growth. A recording of the webinar can be found here.
Rusty Hutson Jr., Co-founder and CEO, started the presentation with the highlights from the first half: Free Cash generation reached $117million, adjusted EBITDA margin came in at 50% (after the hedging program) and average daily production reached 106Mboepd. Acquisition spend was $342m on three transactions taking the company into the Central Region in partnership with finance provider Oaktree. Rusty explained that the Central region will be key to future growth and they hope to replicate their success in the Appalachian region. Rusty also stressed progress on recent ESG initiatives and it is clear this is increasingly becoming more central to the business model.
That ESG is good for business was the first part of the operational highlights too. Progress has been made building out the environmental team, improving emissions detection and data collection and safely retiring over 80% of the annual target for well retirement at the HY point. Costs of well retirement has been reduced by a further 25%. The process of recruiting an additional female director has commenced.
The recently acquired assets in the central region provide the starting point to a large opportunity set and further consolidation of assets is planned. There are 169k vertical wells and 49k horizontal wells producing 24 Bcfepd to go after in this region. The acquired wells have been integrated into the Diversified operating model, at the heart of which is Smarter Asset Management to optimise performance. These assets provide a lot of opportunities for production enhancement, cost improvement and they are already tackling some of the low hanging fruit available. As well as better management of the assets there are opportunities to improve pricing through sales of gas at Gulf Coast locations.
Turning to total production, average daily net production grew 2% to 106 MBoepd and the June exit rate reached 116 MBoepd, a record for the company. The acquisitions increase pro forma production to 141 MBoepd. The company retains its ability to manage well life with minimal declines in production. Although decline rates have increased slightly, they are still well ahead of pretty much all the major players in the industry.
Diversified continues to invest in vertical integration opportunities and has recently installed a new pipeline which has enabled them to reroute gas to a higher gas price market achieving a 25% price improvement and a 20-month payback on cash invested. They want to be less reliant on third party gas pipeline operators and will continue to purchase mid-stream assets where it makes sense.
CFO Eric Williams then went through the financial numbers, which need a little explanation to the hedging policy the company deploys and the accounting requirements for how the profit/loss on these hedging contracts is treated. There is a noncash adjustment to profits of $371m for these hedging contracts, which may appear a little confusing. The key for any company though is the strength of cash generation and this remains strong at $117m of free cash flow, down 5% on last year. There was a positive impact from higher realised prices offset by higher operating expenses due to the additional costs of moving into a new region. Management indicated that as they consolidate and infill their position in the central region there is scope for operating expenses per BOE to fall again and cash margin to rise.
Eric then spent a little more time to explain the hedging policy which has been part of the Diversified strategy from the outset and has helped reduce revenue volatility. It does mean that from time-to-time net achieved prices can be above or below current spot pricing and accounting adjustments are required in the P&L to reflect the value of these hedge contracts at the end of each period. In the current period there was a negative $371m that went through the income statement and the total unsettled liability of $537m. It is important to remember that this is over a 10-year period and there is also an improvement to the value of reserves based on these higher actual prices of $1bn. Almost 90% of current year production is hedged, reducing to 75% in 2022 and 30% in 2023. Any unhedged volumes will achieve the higher prices available in the current market and overtime the hedged amounts for the outer years will increase.
On the cost front, overall costs per barrel have decline 45% since 2017 but there was a small increase in the first half of 2021. This can be accounted for by the move into the central region which is a higher cost region but the region also achieves higher realised prices from the gulf market. The 50% cash margin in the first half is running at a pro-forma rate of 54% and as scale is built out in the new region over time this could rise up to 60% over time.
Diversified has taken great pride in structuring its debt with the majority amortising over 10 years and without further acquisitions the company would be debt free by 2030. Leverage is currently at 1.9x ND/EBITDA, comfortably below the target of 2.5x which provides ample capacity for further acquisitions without the need for equity issuance. The average cost of debt remains at 5%.
The significant free cash flow is used to pay a steadily increasing dividend, reduce debt and invest in the business. Based on the long-term decline ratio of 7% and an acquisition multiple of 3x EBITDA the company needs to spend $33m on new assets to relace the lost EBITDA. Of the $117m of free cash flow, $62m was used for dividends and $55m was available for reinvestment or reducing the borrowings, comfortably in excess of the $33m needed to maintain the EBITDA profile.
Rounding up the presentation, Rusty talked about the four priorities for the rest of the year, At the top of the list is the continued integration of the acquired assets, taking costs out, improving efficiency and increasing production. The ESG focus continues and the company has planned an ESG specific capital markets day in October. In the meantime, the company will continue to progress a number of ESG initiatives. Further acquisitions in the Central area and Appalachia are planned as the company develops scale, makes additional cost efficiencies and improves return on capital. Finally, the focus on shareholder returns which have been a focus of the company from the start continue with a commitment to shareholder distributions.
This was another excellent update from Diversified. In the short term the operating progress and consistent delivery may not always be reflected in the share price but consistent delivery of strong cash flows is generally rewarded in the longer term.
A recording of the webinar can be found here.
If you would like to receive information about future Yellowstone Advisory webinars, please email info@yellowstoneadvisory.com.