When a company has a high yield it can sometimes be a red flag – or a brilliant opportunity. So what to make of Diversified Energy (LSE: DEC)? After recent share price turbulence, the Diversified Energy dividend yield is now just under 19%.
That sounds like it might be too good to be true. But is it?
Strong dividend history
The company pays out dividends quarterly.
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Last year it raised its annual dividend, as it has done for the past six years in a row.
Past performance is not necessarily a guide to what might come next, however. With the annual Diversified Energy dividend approaching close to a fifth of its current share price, I think understanding the Diversified business model is crucial to considering the sustainability of the unusually lucrative payout.
Novel business model
The company operates tens of thousands of gas wells. It typically buys them near the end of their operational lives from oil and gas firms that no longer want to keep them.
That has allowed the business to build up a sizeable asset base relatively quickly.
One might ask: if an oil major with economies of scale regards such wells as surplus to requirements, why would Diversified be able to turn a profit from them? After all, volumes can be small and the cost of capping a well once it ends its productive life could eat into profitability.
On the other hand, Diversified might be able to give more focus to a ragtag collection of relatively modest gas wells than would be the case if they were owned by a massive producer like Exxon.
Dividend economics
How does Diversified fund a dividend? After all, it reported its third annual loss in a row last year. At £621m, that loss was not far off the company’s entire current market capitalisation of £722m.
The company is also cash flow negative. Last year it did record operating cash flows of $388m. But investing cash flows were -$386m while financing cash flows were -$7m. All things considered, more cash went out the door than came in.
Of that, $143m went on dividends, which can always be cut.
But the financing cash flows that concern me as a potential investor are those related to borrowings. The business repaid $2.1bn of borrowings, but still saw cash inflows of $2.6bn from borrowings. At the end of last year, net debt stood at $1.4bn, an increase of 42% over the prior 12 months.
A juicy dividend may attract investor attention. But even with fairly high energy prices, Diversified had a negative free cash flow last year, borrowed heavily, and is carrying a sizeable net debt.
Energy market pricing
I continue to have doubts about the long-term viability of such a business model and what it means for the Diversified Energy dividend.
If energy prices crash at some stage, revenues will be hit badly. But with its large debt pile, the company needs funds to service and ultimately pay down its borrowings.
The novel strategy has rewarded shareholders with large dividends to date and they could continue, especially if energy prices rise.
I see the energy market as cyclical, though, which could spell bad news for the Diversified Energy dividend. I have no plans to invest.
