Oil Dividend Stock is a Screaming Bargain

The company is shifting its cash-flow priority from paying dividends to repurchasing shares.

Diamondback Energy (FANG) is generating lots of cash these days. At $70 a barrel — slightly below the current price point — the oil company can produce over $2.7 billion in free cash flow (FCF) this year. It aims to return about 75% of that money to shareholders via a combination of its base dividend, variable dividend payments, and share repurchases.

While it had favored returning excess cash to shareholders by paying variable dividends last year, the company has firmly shifted its capital return strategy in favor of share repurchases this year. The increase in share repurchases is due to its strong conviction that the current stock price represents an excellent opportunity.

A bottom-of-the-barrel valuation

Shares of Diamondback Energy have fallen nearly 20% from their 52-week high and were recently around $135 a piece. That's a dirt-cheap price based on the cash flows it can produce. Diamondback Energy could generate about $15 of FCF per share if oil averages around $70 a barrel this year. That gives it a valuation of around nine times FCF or an FCF yield of about 11%. For perspective, that's more than 50% below broader market indexes, as the S&P 500 trades at about a 5% FCF yield and the Nasdaq 100 at around 4%.

Meanwhile, Diamondback Energy can produce even more FCF at higher oil prices:

$80$3.2+ billion$17.6713.1%
$90$3.7+ billion$20.4415.1%
$100$4.2+ billion$23.2017.2%

While oil prices are currently closer to $70 a barrel, they were in the $80s very recently. Meanwhile, oil prices could heat up this summer, fueled by resurgent demand and supply constraints. Because of that, Diamondback Energy could produce more FCF this year, potentially giving it an even cheaper valuation.

Capitalizing on the situation

Diamondback Energy's strategy is to return 75% of its FCF to investors each quarter. The base return is a fixed quarterly dividend payment currently set at $0.80 per share. The company has the flexibility to pay an additional variable dividend or repurchase shares to achieve its capital return target.

Last year, Diamondback Energy paid significant variable dividends to help deliver on its objective:

A chart showing Diamondback Energy's dividend payment by quarter.

It also repurchased some shares last year. Diamondback spent $309 million to purchase 2.5 million in the first half of the year and another $788 million to buy back 6.2 million shares in the second half.

This year, Diamondback has gone almost all-in on repurchasing its stock. In the first quarter alone, it spent $332 million to buy back over 2.5 million shares. That utilized most of its post-base-dividend FCF. The company had only $6 million remaining to achieve its 75% cash return target in the first quarter. It paid that out via a variable dividend of only $0.03 per share, bringing its total dividend payment for the quarter to $0.83 per share.

In a letter to investors, CEO Travis Stice commented on the company's decision to concentrate on repurchasing shares, writing: “The first quarter is exactly the reason we elected to implement a return of capital program with flexibility to allocate capital between share repurchases and a variable dividend. During the banking crisis and Silicon Valley Bank collapse, we took advantage of volatility and repurchased a significant amount of stock.”

The company continued to buy back shares in the second quarter. It has spent another $72 million to repurchase more than 500,000 shares. Given how cheap the stock remains, it will likely continue using most of its excess cash on repurchases this year.

Shifting its priorities

Diamondback Energy paid out a gusher of dividends last year as it supplemented its base dividend with even higher variable payouts. However, given its current valuation, the company has used most of its excess cash to repurchase its cheap shares. It believes shares are a compelling investment opportunity, even more so given the cash it can produce at higher oil prices.

Originally published on Fool.com