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Morningstar | Diamondback 25% Undervalued After Fairly Priced M&A Announcement Hammers Shares. See Updated Analyst Note from 15 Aug 2018

Diamondback shares plunged 12% in early trading after the announcement that it will acquire Energen in all-stock deal valued at $9 billion (reflecting a 16% premium to the last close). We think this creates an attractive buying opportunity for investors, as Diamondback was already trading at a substantial discount to our fair value estimate and the price paid appears to be fair. Incorporating the transaction and the associated assets in our model nudges our valuation to $158 (from $157).

The combined entity will be one of the largest oil and gas producers in the Permian Basin, with about 390,000 net acres of unconventional leasehold and current volumes of 215 thousand barrels of oil equivalent per day (of which Energen is contributing 179,000 net acres and 90 mboe/d respectively). This footprint is split fairly evenly between the Midland and Delaware Basins, and encompasses most of the counties in the play. The Tier 1 component by itself could support 15 years of further drilling at the current run-rate. Much of the remainder is likely to be sold to bring the value forward, generating cash that can be used to accelerate the development of the core portion (all of which is in accordance with the company's "grow and prune" strategy). As a bonus, the assets also include substantial mineral interests that are ideal for dropping into Diamondback's Viper subsidiary.

Unusually, the deal appears to enhance rather than detract from the company's narrow economic moat. In part, that's because the scale and relatively strong balance sheet of the pro forma entity warrants a slightly lower cost of capital, lowering the hurdle to excess returns on invested capital (we model 8.6%, down from 8.7%). But it also lowers overhead costs and  provides a longer runway of Tier 1 drilling opportunities (with more scope for long-lateral development). Further value is generated by bringing Energen's costs in line with Diamondback's, per guidance (as the latter is the industry cost leader).

Moreover, we emphasize that our bearish views on crude prices (outlined in "Coping with Frothy Oil Prices: Long and Short Ideas in the U.S. E&P Space") are fully incorporated. Essentially, we believe that the current U.S. activity level is well above the "goldilocks" level that keeps global markets well supplied in the next few years and can shortly reverse the current tightness caused by geopolitical supply disruptions. The resulting correction could put pressure on oil producers, including Diamondback. But the latter enjoys a strong enough cost advantage that it can still thrive at our $55/bbl midcycle forecast for West Texas Intermediate, with about 20 active rigs. That justifies our current valuation. Investors with a more bullish outlook should note that at $60/bbl, with a rig count in the high-20s per management's base case, our fair value estimate would rise to $200 (putting the stock in 5-star territory).