Diversified Energy Company (LSE:DEC) currently offers investors a near-20% dividend yield, making it the highest payout level in the entire FTSE 350. Normally, this double-digit level would be a ginormous red flag. And the 40% slide in market capitalisation over the last 12 months certainly raises some alarm bells about an impending dividend cut.
And yet the firm has a long history of defying such expectations. In fact, analysts from the UK investment bank Peel Hunt have described the group’s free cash flow and dividends as “some of the most secure in the sector”. Does this mean investors are looking at an exceptionally rare opportunity to lock in a massive source of passive income?
Let’s take a closer look.
The power of hedging
As a quick reminder, Diversified Energy is an oil & gas enterprise with a portfolio of onshore US wells within the Appalachian basin. Over two decades, the group has accumulated control of around 17,000 miles of pipelines and an average output of 142,000 barrels per day.
With the energy sector taking a bit of a hit throughout the summer period, weakness in the oil market has understandably spooked investors. But while everyone seems to be getting their knickers in a twist, a critical factor may have been overlooked – the firm has a fairly extensive hedge book.
Like many companies exposed to fluctuating commodity prices, Diversified Energy has made moves to protect its profit margins even during a weaker price environment. As a result, when looking at the performance of the first six months of 2023, underlying earnings are on the rise. Excluding the effects of non-cash items, EBITDA grew by 26% year-on-year, reaching $283m.
In turn, the group’s free cash flow yield jumped from 22% to 34%! And with the winter period starting to settle in with rising demand for oil, the group’s record production levels place it in a strong position, in my eyes.
What’s the problem?
These financials look terrific for income investors. And while earnings have historically been lumpy, the upward trend of dividends is remarkably consistent. So the question now becomes, why have the shares fallen so steeply throughout 2023?
Like all investments, there are numerous factors at play. However, a rising level of concern seems to surround the group’s debt position. With a reputation for being quite acquisitive in adding new wells to its portfolio, management has reaffirmed this strategy to capitalise on sector instability.
But this requires a lot of funding, both in the form of debt and equity. The number of shares outstanding over the last five years has increased by 77%!
Meanwhile, its pile of loan obligations now sits at just over $1.5bn. The latter has pushed the debt-to-EBITDA ratio to 2.4. That’s certainly not a huge level, but it’s quite close to management’s target limit of 2.5 times.
This could pose particularly bad news for shareholders. Why? Because while breaching this threshold won’t cause the balance sheet to crumble, it puts management’s compensation packages at risk.
This could mean that extreme equity dilution may be set to continue in the coming months. And with that in mind, a sudden drop in valuation makes sense. Therefore, even though the near-20% dividend yield may be sustainable, it’s not one I’m tempted to grab if my stake in the company is going to shrink massively.
