A double-digit dividend yield is a red flag. Diversified Energy Company’s move to cut its dividend and rethink its capital allocation strategy should not be a surprise. Its dividend yield had topped out north of 30 per cent.
The American oil and gas producer has reduced its final quarterly dividend to 29 cents a share, a two-thirds reduction from the third quarter, once a share consolidation is taken into account. A $42 million tender offer has also been cancelled. Cash will be redirected towards acquisitions and paying down debt.
The reset should be welcomed by investors. Suspicion that the dividend had become unsustainable had sent the shares down by more than 50 per cent over the past 12 months. Last year the group generated free cashflow of $219 million, returned $180 million to shareholders via dividends and share buybacks and reduced debt by $150 million. An equity raise of $163 million in February last year might have helped. But cash has been stretched.
Diversified’s debt structure is anomalous within the oil and gas sector. The company repays debt steadily over a period of ten years or so, rather than being subject to lumpy debt maturities. The downside is that a constant drip feed of cash is needed. The structure is designed to match the long-term cashflows generated by gas wells it operates.
Diversified buys up mature gas wells, with an average age of between 10 and 15 years. Diversified is the most prolific and has built up a portfolio of more than 65,000 wells. The rate of production decline is about 10 per cent a year, lower than the annual rate from newly drilled wells, but still a shortfall that still needs to be replenished. That means it needs to keep cash free for acquisitions.
A $410 million deal to buy out Oaktree Capital from several gas assets in Louisiana, Texas and Oklahoma will increase production by 15 per cent. It will also give Diversified more exposure to the Gulf of Mexico and major liquefied natural gas export terminals, which should attract premium pricing compared with gas sold domestically, according to Rusty Hutson Jr, the company’s founder and chief executive.
The company can sustain operational expenditure on its existing wells as well as the newly rebased dividend for three years without making any more acquisitions, said Hutson Jr. It should also manage to reduce leverage to the lower end of a target range of a ratio of between 2 and 2.5, he reckons, from 2.3 at the end of last year.
Merger activity in the US between oil and gas major producers means that more assets will be up for grabs, Hutson thinks, as the energy giants are forced to divest to get deals approved by competition regulators. Diversified wants to be in the running.
That is one reason for revising the capital allocation strategy. A recent listing in New York might have also focused management’s thinking. A yield north of 30 per cent is not a great advert. Investors Stateside are more concerned with growth than income. It will also bring with it access to a wider pool of capital.
An extensive hedging programme means that there is some protection against fluctuating gas prices. About 85 per cent of production for this year is hedged with an average floor of $3.09 per thousand cubic feet (mcf), but that compares with an average floor of $3.83 mcf last year.
There is also the regulatory risk that hangs over the company relating to its environmental liabilities. In December, four members of the House of Representatives alleged in a letter to Hutson Jr that the company may be “vastly underestimating well clean-up costs”. The company said at the time that “full modelling and accounting for the company’s asset retirement obligations are audited by independent, global accounting firms and reserve engineers and transparently disclosed”.
A more realistic approach to capital allocation could start to be recognised by the market.
Advice: Hold
Why: Rethinking its capital allocation could aid the recovery in the shares
Derwent London
A lot has happened in the 18 months since Tempus last looked at Derwent London, the developer and owner of nearly £5 billion of central London office blocks. Back then, this column put a “hold” rating on the shares given the potential for interest rates to put a dent in commercial property values.
That proved to be the case: interest rates rose and commercial property values fell sharply. Derwent’s shares have drifted about 15 per cent since. Investors, understandably, are wary that further falls in value could be around the corner. That is reflected in the shares which, at £20.58, trade at a 34 per cent discount to the last reported net asset value of £31.29.
But there is reason to believe that this discount could narrow over the coming months. Paul Williams, Derwent’s chief executive, has been reluctant to call the bottom of the market, but he admits that “we’re getting there”.
That view is not uncommon across the industry, given that inflation is retreating and central banks will, in all likelihood, start cutting interest rates later this year. If prices look like they have stabilised, listed landlords should, in theory, see that reflected in their shares.
For the bits of the business more within its control, Derwent is faring better. The company’s exposure to newer, greener buildings in the West End of London is allowing it to benefit from the “flight to quality” as corporate renters demand better, if smaller, bases. Supply of that best-in-class space is, for various reasons, tight, which is pushing up rents.
While the feeling is that the commercial property market is past the point of peak pessimism, there remains uncertainty as to when, and how quickly, central banks will start cutting rates.
Consequently, the timing of the market’s recovery is also uncertain and, even when it does arrive, it is unlikely to be smooth. Those averse to risk will want to see concrete evidence that the rebound is here before buying Derwent shares. But those with a bit more appetite risk might see the weakness in Derwent’s share price this year to get in ahead of the market’s upturn.
ADVICE: Hold
WHY: Commercial property market looks set for recovery, but too soon to call the bottom
