Diversified Energy Co Q4 FY2023 Earnings Call

Ladies and gentlemen, good morning. And welcome to Diversified Energy 2023 Final Results Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Douglas Kris, SVP IR and Corporate Communications. Please go ahead, sir.

Good morning, and welcome to the Diversified Energy 2023 Results and Acquisition Conference Call. Joining me today are Rusty Hutson, our Founder and Chief Executive Officer, and Brad Gray, our President and Chief Financial Officer. During this call, we will make certain references to non-GAAP financial measures. Reconciliations to those financial measures are in both of our earnings release as well as our annual report, which was published this morning and available on our website, as well with our filings with the SEC. Now, my pleasure to hand the call over to Rusty Hutson. Rusty, please go ahead.

Thank you, Doug. I appreciate it. Real quickly, just to kind of set the stage for the presentation today, I'm going to kick it off, talk a little bit about the 2023 numbers and the success that we had in 2023. I will turn it over to Brad Gray, our Chief Financial Officer, to discuss financial metrics associated with the year. Then I will come back on and update on the acquisition that we announced this morning, along with our 2024 strategic outlook for the remainder of the year. So, with that, I'll go to page 3 of the presentation and start there. I just want to say that we’re pretty proud of our year in 2023, the strategic successes that we had. It was a great year for diversifying in a very challenged commodity price environment. We'll talk about this, but our hedging program and our hedging portfolio were very successful in insulating us from much of the commodity price risk that we faced in 2023. Overall, it was a very good year. You can see here on page three some of the highlights that I'd bring to note. Our production was strong through 2023, averaging 821 million cubic feet per day of natural gas production. We continue to see resilient decline rates as we held it under 10% again, which is key to our long-term success with the mature producing assets that we operate. This gives us the ability to hedge and be successful with our cash flow profile. We had $543 million of EBITDA for the year, a record for us. Our net debt stands at 2.3, again, within the margin of the two to two and a half that we discuss with our investors. Cash margin was strong at 52%, a stable factor since 2017. A very key factor that investors should be pleased with is that over the last several years, since our IPO, we have returned $800 million of cash back to our investors, over $700 million of that in dividends and the remainder in share purchases. In December, we publicly listed on the New York Stock Exchange, something we had been striving for for about a year and a half prior to that. This is a very significant milestone for us as we move forward to access public markets and institutional investors in the U.S. Our free cash flow stood at $219 million. Again, from an ESG perspective, we continue to see positive results around our emissions and our identification and reduction programs. The OGMP awarded us with the gold standard for the second consecutive year, and we retired over 400 wells last year through our asset retirement programs and Next Level Asset Retirement Company. So all in all, a great year. We'll discuss some specifics around some of that as we move through the presentation. Moving to page four, delivering our de-risk model results in de-risking four key areas: commodity price risk, which we manage through our hedging program; operational risk, managed through our asset management strategies; financing risk, through our RBL and ABS structures; and environmental risk, through our stringent ESG programs aimed at emissions detection and reduction, which we believe is best in class in our sector. All of this leads to a low-risk model that generates consistent cash flow, which we've maintained since 2017 with at least 50% cash margins consistently. Continuing to page five, again, we maintained leading decline rates in 2023 under 10%. This statistic applies to the entire portfolio and comparatively puts us ahead of our peers, showcasing superior capital intensity at only $0.25 per mcf. This illustrates how little cash flow we need to reinvest to maintain our current decline rates, allowing us superior capital intensity that enhances our free cash flow and generates regular returns for our shareholders over time. Flipping to page six, regarding our hedging strategy, 2023 posed a challenging commodity price environment, and this has carried over into 2024. Yet our hedging program offers us considerable advantages, evidenced by our hedge price for natural gas at 3.09. We have about 85% of our production hedged for the remainder of this year and into 2024. Moving on to page seven, we announced in December we successfully executed an innovative asset sale where we bundled an asset and sold it to institutional investors for a significantly higher multiple than third-party sales would allow. We sold this asset for a 5.7 times multiple, which provided us with an uplift of $90 million and helped de-leverage the business structure. This innovative asset sale enhances liquidity, reduces debt, and is a structure we plan to continue using moving forward. Now, let me turn it over to Brad to present additional financial metrics, and then I will return to discuss the acquisition and outlook for 2024.

Thank you, Rusty. It’s great to be back in London and to return to a financial leadership role at our company. I thoroughly enjoyed my six-plus years as Chief Operating Officer and am proud of the results our operational teams achieved. I also appreciate the opportunity to re-engage as Chief Financial Officer, which helps strengthen our financial operations and results. My comments today will reflect on our solid financial results across several areas of our operations and I'll start on page nine. As Rusty mentioned, 2023 was an outstanding year for multiple reasons. We generated a record $543 million of adjusted EBITDA, delivering our sixth consecutive year with gross margins of over 50%. This $543 million of EBITDA equated to $410 million in cash provided by operations, although it involved significant working capital usage in the first six months. We ended 2023 with an average daily production of 821,000 cubic feet equivalent, which was another record for us. Our product mix continues to lean heavily toward natural gas at 86%, with natural gas liquids making up 11% and crude oil at 3%. Our disciplined hedging produced a healthy net realized price of $3.48 for Mcfe while operating costs improved from $2.02 to $1.69 per Mcfe. Even amidst a challenging commodity price environment, our assets continue to provide our shareholders with notable future value, indicated by a net asset value per share of slightly over $28. Our operational teams also achieved great results focusing on sustainability, retiring 384 wells in our Appalachian operations. Our gold standard OGMP measurement detection practices and LDAR efforts maintain a remarkable 98% leak-free rate of our wells. We continue converting our pneumatic devices on over 50 well pads. Moving on to page 10, our annual report is being published today, sharing significant information on our strategy, priorities, and key metrics we track for success. Our KPIs presented here were determined by our board of directors, and we monitor and discuss our progress and results throughout the year. Most of these KPIs have been discussed by Rusty or me, but we want to highlight our methane emissions intensity ratio, which ended 2023 at 0.8. Achieving this ratio seven years ahead of our 2030 goal is a considerable accomplishment for our teams. Next, I’ll move to page 12 where our disciplined hedge practices continue to underpin our capacity to produce healthy cash margins and flows. Our natural gas hedge price is 25% higher than the 2024 NYMEX strip. For 2024, we are 85% hedged in natural gas and 50 to 60% on NGLs and oils. Our revenue in 2023 was impacted by significantly lower commodity prices, but we concluded higher than our figures from 2022, showcasing the strength of our low decline assets and thoughtful hedging program. From a cost perspective, our price length expenses declined while our field teams utilized smarter asset management to achieve cost savings and efficient operations, generating a cash margin of 52%. Moving to page 13, technology is becoming a critical competitive advantage for our company. Our CIO David Myers was named one of the top CIOs in energy in 2023 due to leadership in expanding our IT capabilities. We have developed a fully cloud-based technology platform and commitment to single software applications, aligning with our One DEC culture to streamline operations and enhance decision-making. On page 14, we discuss our Smarter Asset Management Program, recording great results. Whether these efforts optimize production, vertically integrate operations, or reduce unnecessary spending, our goal is to increase our cash margins. Our Central Region teams had significant success throughout 2023, and we’ve highlighted some results on page 14. Moving on to page 15, as mentioned earlier, we achieved our 2030 methane emissions intensity ratio goal this year—seven years ahead of schedule. Our leadership team set various climate-focused targets in late 2021 and our ongoing efforts have yielded considerable progress in this area. By the final quarter of 2023, we plugged 384 wells in Appalachian and overall, our Next Level Energy team plugged over 150 wells for third parties, generating revenues that offset our plugging costs. Closing on page 16, we made intentional investments in 2022 to expand our internal retirement asset capacity, consolidating four different plugging companies to establish Next Level Energy as a full-service retirement company. We’re pleased with our retirement team's results in 2023.

Thank you, Brad. I will now speak from slide 18. As many of you noted this morning, we announced a strategic acquisition that should come as no surprise to anyone following the company for any length of time. The Oaktree working interest was an opportunity I had anticipated, and it's a major step for us in scaling into a new region rapidly. The synergies present in this acquisition, specifically the concentrated geographic presence, will help lower operating costs efficiently. We partnered well with Oaktree and this acquisition year is timely for us. We are paying $386 million net purchase price, which reflects about a PV17 on PDP future cash flows and a 3.1 times multiple. Just to remind everyone, we discussed a recent asset sale at almost a six times multiple. Thus, generating liquidity at six times while reinvesting at three times is advantageous for us. The assets we acquire are synergistic; we currently operate many of them and have a strong handle on their effective operational procedures, as well as their metrics and stability. With around $122 million a day in natural gas production, this acquisition covers our decline rates through 2025 without necessitating reinvestment. These assets yield high margins, with EBITDA margins of 65%. They will contribute an estimated $126 million of EBITDA in 2024. The PV17 on these assets was $462 million. Overall, this asset purchase is strategic, aligning perfectly with our market positioning. Turning to page 19, you can view where these assets are located. We operate and own 51% of the same assets. Increasing exposure to Gulf Coast gas pricing is significant. Although we don’t sell directly to these export facilities, we benefit from index pricing differentials on the Gulf Coast. With the acquisition, we will operate these assets, giving us complete ownership of production and enhancing our marketing opportunities in this area. Moving to page 20, we see a 2% reduction in unit costs and $15 million in efficiencies across the portfolio without any need for additional G&A costs. This acquisition will increase our reported margins from 52% to 54% and opens several opportunities for smarter asset management due to 100% ownership of this asset. Integration risks are minimal since we simply switch the working interest in our accounting from Oaktree to Diversified. Lastly, page 21 shows that this transaction includes a no-bargain on Oaktree's 2024 hedges at $3.89, which encompasses nearly all gas production in East Texas and Louisiana, representing substantial value for us in 2024. This will elevate our average floor price by 25% and enhance our pro-forma average price in 2024. Importantly, no hedges carry over into 2025 and 2026 which provides us with upside flexibility. Moving to page 22, we discussed our increased exposure to premium Gulf Coast pricing. We believe the U.S. natural gas price market will experience fragmentation across various basins. The Gulf Coast has the potential for superior pricing due to recent and upcoming export facilities. We project that by 2026, approximately 20% to 25% of U.S. production may be exported, which could stabilize natural gas prices significantly. We're currently collaborating on operational projects to enhance our gas delivery efficiency and increase natural gas liquid exposure from these assets. Finally, on page 23, we observe significant merger activity in the U.S. over the past 12 months. This reflects institutional investor interest in fewer, larger companies with stronger balance sheets. We anticipate ongoing mergers in the natural gas sector and consequently, many divestitures will occur that will provide quality opportunities. The natural gas sector has shown a decent dislocation between the U.K. and U.S. markets; the latter has seen increased earnings. I expect to see further resets of entity value, positioning us well to capitalize on asset acquisition opportunities. We remain committed to exploring strategic partnerships aligned towards growth in scale and expansion. Now let’s discuss our 2024 outlook outlined on page 25. In 2024, we plan to renew our focus on our business model and strategic plans established over the last seven years. We aim to regain free cash flow generation by unlocking asset value with all acquired assets, enhancing production, revenue through our hedge strategies while growing through accretive initiatives. We actively seek to reduce costs and vertically integrate the business, leveraging technology to lower expenses. As mentioned earlier, sustainability and innovation remain pivotal. We call this our Focus 5 - elements that will shape our future business model and operations. Flipping to page 26, our capital allocation framework discusses how over the last seven years, we have returned close to $800 million to our shareholders. We are proud of forming a resilient business, elevating cash margins, driving cost synergies, and increasing cash flows to reward our shareholders. In light of this, we want to create a holistic capital allocation strategy. Our recent dividend recalibration, announced this morning, serves to empower us in several dimensions including debt reduction, leading to a more sustainable dividend and the possibility of strategic share repurchases. We plan to implement a share buyback program tightly controlled by brokers to execute according to our guidelines to maximize value favorable to our shareholders. Regarding our plans for 2024 on page 27, we aim to reduce debt significantly. The Oaktree acquisition will leverage approximately $120 million from the ABS structure with an additional deferred payment of $90 million. We expect to reduce overall borrowings by around $200 million this year while maintaining our fixed sustainable dividend for the next three years. Our share repurchases will be strategically planned allowing us to conduct continuous buybacks until we believe the stock undervalues its inherent worth. The Oaktree acquisition stands as a pivotal decision with substantial opportunities awaiting for returns on our investments through added cash flows in 2024. We will remain vigilant to capitalize on avenues for acquisition moving forward.

Operator, can you open the lines up for Q&A, please?

Thank you. Our first question is from David Round with Stifel. Please go ahead.

Thank you. Morning, guys. Thanks for the call and the details you've provided so far. Can I just follow up on the acquisition? Are you able to mention payback? The multiple is insightful, but I’m interested in the point at which you'll be generating incremental cash from this deal.

Yes, David. This is Brad. Thanks for the question. As Rusty noted, we've shown a 3.1 multiple on a cash basis. The assets generate a sub-four payback period. For all the strategic components of the transaction, the financial ones are equally compelling.

Okay, great. I also wanted to follow up just regarding how the previous situation may have distracted you from enhancing value?

Addressing a dividend recalibration isn’t a situation we take lightly. However, as we began to evaluate our trajectory over the next 12 months, it was evident that share prices were not responding adequately to our dividend strategy. If the market isn’t pricing it correctly, we must create value to reflect our company’s worth. We intend to market confidently to U.S. investors and the recalibrated dividend enhances our position for engagement.

To elaborate, despite all discussions at the senior management level, the outcomes reveal that our team remained focused and productive throughout this time, demonstrating robust results. We take pride in that.

Thank you very much. Post-Oaktree deal, can you provide some insight into reallocating the $110 million annually between paying debt, buybacks, and M&A?

Sure, Matt. We anticipate effective allocation for that $110 million. We’ll likely implement a regimented share buyback program in place upon unlocking the lockout period under SEC rules. This could encompass anywhere between 3% to 10% of total shares annually, depending on price attractiveness.

Great, that clarifies a lot. Additionally, can you provide an overview of the current state of U.S. M&A opportunities?

Certainly. Currently, U.S. M&A has centered around public mergers, and we foresee many quality asset divestitures coming to market due to recent mergers needing compliance with FTC regulations. There’s a strong anticipation that this activity will enhance our opportunities moving forward.

Thanks for the informative call. Could you discuss the implications of trading liquidity in the States? When do you expect index trackers to engage?

Indeed, we were surprised how rapidly trading volumes in the U.S. increased, despite no equity issuance on our part. Our positions suggest we will enter the Russell 2000, which is a significant milestone. With index tracking and enhanced visibility, we can confidently expect positive outcomes.

Good morning. Regarding emissions detection and mitigation, can you detail efforts where your company excels beyond industry standards?

Our commitment towards emission reductions is unwavering, especially since we recognize it contributes positively to our business. We have continued using our superior mesh detection practices, ensuring a 98% leak-free rate for our wells. We see this initiative yielding positive results, and we have ongoing technologies aimed at enhancing emissions mitigation.

On the Oaktree deal backdrop, could you elucidate your stance on capital allocation, especially with debt reduction focus and yet pursuing a $400 million acquisition? Is there a revision viewed as market strategy?

This acquisition was not sudden; we've been negotiating for several months. Previous opportunities guided this timing, and while our dividend recalibration seeks flexibility, they don't connect directly. We prioritize enforcing a multi-faceted approach to growth and value generation.

Appreciate that insight. Could you expand on the congressional letter situation?

Regarding the congressional letter, we responded early in January. Although it required no formal response, we provided a detailed account of our operations. We anticipate maintaining constructive conversations, given our commitment to compliance and proactive emission management.

Thank you all for attending today. We appreciate your time and interest in Diversified Energy. With no further questions, we will conclude this earnings call.