Diversified Energy’s (DEC) $1.8B Bet On Permian Scale

On September 2, Diversified Energy (DEC) finalized a deal to acquire Birch Permian Holdings from Elliott Investment Management affiliates for about $1.8 billion, marking the largest acquisition in the company's history. This acquisition is expected to increase production by approximately 35% and Adjusted EBITDA by around 55%. However, DEC's stock trades at a forward P/E ratio of 4.95, a multiple that typically indicates market expectations of contraction rather than expansion.

The Birch deal provides DEC with a scaled, operating position in the Permian Basin, consisting of 480 net wells with low decline rates, aligning with the company's business model focused on predictable, long-lived production. Management anticipates that the assets will contribute around $548 million of annualized Adjusted EBITDA at near 80% margins, with gross volumes expected to rise to approximately 2.5 Bcfepd, a significant increase from DEC's standalone base.

The financing structure of the deal is noteworthy, with about $1.5 billion of the purchase price financed through an asset-backed securitization with Carlyle, expanding the partnership to a potential $10 billion in future opportunities. Additionally, DEC possesses over 150 permitted enhanced oil recovery locations at Birch, with pilot programs already demonstrating promising results, which could extend well life beyond current production estimates.

However, the acquisition is being funded primarily through $1.5 billion of asset-backed debt and draws from its revolving credit facility, increasing the company's leverage on a balance sheet that was already within its targeted range just weeks prior. The acquisition's impact on earnings quality is also evident, as DEC's second-quarter results, announced on August 5, showed net income of $248 million, which included a paper gain from unsettled derivatives, while Adjusted EBITDA was $240 million, and operating cash flow was $89 million.

This disparity between reported earnings and actual cash generation is particularly relevant given DEC's plans to reduce its reliance on acquisitions for growth. Furthermore, hedge fund ownership in DEC decreased from 31 funds to 27 in the latest quarter, indicating a shift from accumulation to a retreat, alongside a short interest of 9.29% of the float, suggesting a bearish market sentiment.

Despite these factors, the forward P/E ratio of 4.95 for DEC suggests that the market is pricing in minimal growth expectations from the Birch acquisition. DEC's strategy of acquiring mature, cash-generating wells has resulted in the largest acquisition in its history, giving the company a more substantial and concentrated position in the Permian Basin.

However, the success of this expansion hinges on meeting the scheduled closing date, managing the new debt load, and validating the production projections once Birch's wells are integrated into DEC's operations. While acknowledging the potential benefits of DEC as an investment, the report suggests that there may be more attractive AI stocks with greater upside potential and lower risk.