Wells of Wealth
In this edition of the Smart Investor newsletter, we examine the stock of one of the key players in the U.S. oil and gas landscape. We are not selling any stocks today, though we are keeping an eye on the Portfolio companies’ performance during the ongoing earnings season. But first, let’s dive into the latest Portfolio news and updates.
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Portfolio Updates
❖ The U.S. Department of Treasury finalized the Biden Administration rules to further limit U.S. investments in advanced technologies in China to protect U.S. national security. The rules cover U.S. investments in three areas: semiconductors and microelectronics, quantum information technologies, and certain AI systems. The administration says those technologies are “core to the next generation of military, cybersecurity, surveillance, and intelligence operations.” According to the White House statement, these rules—effective January 2nd, 2025—complement the existing export controls and prevent American capital and know-how from facilitating the advancement of “sensitive technologies and products in countries of concern.” The new rules may affect companies like Nvidia, AMD, Qualcomm, Micron, Broadcom (AVGO), Applied Materials (AMAT), and others, preventing them from establishing research facilities, joint ventures, and partnerships with Chinese firms. Some of their existing partnerships – such as Broadcom’s work with China-based ByteDance to develop an advanced AI processor – may now come under heightened scrutiny.
❖ OpenAI, the Microsoft (MSFT)-backed startup behind ChatGPT, has reportedly abandoned plans to build its own chip foundry. Instead, the GenAI leader is working with Broadcom (AVGO) to develop a proprietary AI inference chip. OpenAI is also consulting with Taiwan Semiconductor (TSM) about production plans.
❖ General Dynamics (GD) reported a relatively tepid Q3 2024, with revenue and EPS missing analyst estimates mostly due to fewer G700 aircraft deliveries than initially guided. Still, the company recorded year-over-year revenue growth of 10.4% and EPS growth of 10.2%. Growth in the third quarter was led by solid demand for Gulfstream business jets and defense unit combat systems. The company’s backlog remains robust, suggesting continued revenue growth in the coming quarters. In addition, GD’s Defense segment received two major contracts from the Pentagon, adding to a positive outlook. However, analysts from Barclays and Bank of America Securities reduced their price targets, while Wells Fargo maintained a “Hold” rating due to a lack of clarity on G700 delivery delays.
❖ Amphenol (APH) surpassed analyst estimates for yet another quarter, posting blockbuster Q3 results. Following the Q3 earnings release, the company lifted its Q4 sales and profit guidance above Wall Street consensus, forecasting continued strong demand for its equipment and technologies. APH is benefiting from increased capital spending related to AI and cloud computing, as well as data center proliferation and increased defense outlays.
❖ KKR & Co (KKR) reported a stellar third quarter, beating Wall Street’s revenue and EPS estimates by a wide margin and showcasing a robust financial performance. The asset manager’s adjusted net income surged by 58% year-over-year, while fee-related earnings surged by 80% to set a new record. Assets under management jumped by 18% year-on-year.
❖ Check Point (CHKP) reported robust Q3 financial results, with revenue in line with analyst estimates and EPS exceeding the consensus. Revenues were up 7% year-over-year, while EPS rose by 9%. Wedbush analysts said that they view Q3 as a “transitional quarter,” remaining firmly bullish on CHKP going into year-end and 2025.
❖ ITT Corp. (ITT) reported third-quarter earnings that beat analysts’ revenue and EPS expectations, thanks to strong performances across all segments. The industrial manufacturing company saw order growth of 17% year-on-year, with the operating margin expanding to 23.5%. Looking ahead, ITT raised its full-year 2024 revenue and operating margin guidance above the previous midpoint, while also increasing the midpoint of its adjusted EPS outlook. ITT said it now expects revenue growth of 10%-12% and EPS growth of 11-12% for the year.
❖ PayPal Holdings (PYPL) Q3 2024 earnings topped expectations by a wide margin, though revenue missed expectations. Total payment volumes climbed by 9% year-on-year, while free cash flow surged by 31%. The company said it expects revenue in the ongoing quarter to grow by a “low single-digit” percentage, which would probably be lower than Q3’s growth of 6% YoY. Still, the digital payments giant guided for higher EPS growth in the full year 2024, changing it projected growth from “low to mid-teens” to “high-teens”. Under its new management, PayPal is shifting its focus from aggressive expansion to higher-margin businesses, while emphasizing efficiency and cost discipline.
❖ Taiwan Semiconductor Manufacturing (TSM) reported higher chip production at its first U.S. facility than at equivalent plants in Taiwan. The Phoenix, Arizona plant yielded 4% more usable chips than plants in Asia since beginning production this past April. The positive production results are a significant development for TSM’s presence in the U.S. The world’s largest foundry is in line for billions of dollars in U.S. government grants, loans, and tax credits from the Chips and Science Act to build three more facilities in Arizona. In other company news, Nvidia’s CEO Jensen Huang revealed that Taiwan Semiconductor helped the AI leader fix the design fault in its Blackwell AI chips, which affected production and shipments.
❖ Alphabet (GOOGL) released its Q3 2024 results on Tuesday after hours, smashing expectations on all metrics. Revenues rose by 15% year-on-year, led by Google Cloud revenues which surged by 35%. This was the fourth consecutive quarter of accelerating cloud revenue for the company. Total operating income soared by 34% in the third quarter, while EPS jumped by 37% YoY. Strong growth in Google’s core advertising business helped expand top and bottom lines. In addition, AI has contributed to growth in YouTube revenue, reversing the weakness seen in Q2. The company’s CEO Sundar Pichai said that the momentum across Alphabet’s businesses is “extraordinary,” supported by its AI advancements.
According to the company, its massive investments in AI are paying off. Thus, AI-driven Google search is expanding and AI monetization efforts are showing traction. Alphabet’s capex amounted to $13 billion during Q3, with the company expecting a similar level of expenditure in the current quarter as in continues to work to realize AI potential. Analysts view Alphabet’s stellar results as positive also for its cloud business competitors, Microsoft (MSFT) and Amazon (AMZN), signaling that their enormous AI investments will pay off as demand for AI-assisted computing accelerates.
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Portfolio Stocks Under Review
❖ Super Micro Computer (SMCI) remains under review, although the stock’s trend in the past month is broadly positive. The company’s shares were supported lately by several operational highlights. Thus, SMCI released a new liquid cooling solution for data centers, positioning Super Micro for further expansion in the rapidly growing direct liquid cooling (DLC) market and supporting its vast market share. The company also disclosed shipments of more than 100,000 GPUs with its liquid cooling solution system to “some of the largest AI factories ever built, as well as other cloud service providers.” The announcement underscored surging demand for Super Micro’s servers, driven by AI data center proliferation, which could translate into billions of dollars in revenue.
In addition, SMCI announced the launch of a new optimized storage system for high-performance AI training, inference, and HPC workloads. This system, called JBOF (Just a Bunch of Flash), contains up to four NVIDIA BlueField-3 units in a compact size. Supermicro’s new systems offer superior performance, greater reliability, and are better suited for evolving technological demands, particularly in AI and data-heavy environments. Moreover, Super Micro is launching a line of new liquid-cooled AI servers powered by Nvidia’s Blackwell line of processors, with full-scale production beginning this quarter. Both the JBOF system and the new AI servers are targeted at advanced computing tasks such as AI training and inference. This suggests a strategic alignment within Super Micro to strengthen its portfolio in the AI and HPC sectors. Both systems also leverage Nvidia’s technology, indicating a strong partnership with the AI leader.
However, the company is about 12 weeks behind in filing with the SEC and over 50% below its March high. As a reminder, Super Micro underwent an extremely turbulent period, which included strong hits to investor sentiment stemming from a short-seller’s report and an SEC filing delay. We at Smart Investor see SMCI’s current difficulties as temporary, while its immense long-term potential remains intact. Still, we are mindful of the risks faced by the company, particularly the fragility of investor sentiment due to its compliance issues and lack of clear communication, and hope that the company will soon shed some light on these questions.
Barring some unforeseen negative developments, we are awaiting the company’s FQ1 2025 earnings report release, scheduled for November 4th, 2024, after which we will decide whether to retain SMCI in the portfolio. Analysts project that the company will see its EPS rise by about 115% year-over-year as the underlying demand for AI hardware remains strong and SMCI has demonstrated an ability to capitalize on this trend. If the company can meet or exceed analyst expectations, it could provide a catalyst for a strong rebound in the stock price.
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❖ Adobe (ADBE) remains under review. The company’s stock has been under pressure after the release of its FQ3 2024 report on September 12th. Despite reporting strong FQ3 results that beat analyst expectations, ADBE provided weaker-than-expected guidance for FQ4 2024 (expected to be reported on December 11th). Investors were concerned about signs of decelerating growth at Adobe, including projected FQ4 growth of only 9% year-over-year, which would be its lowest growth rate in nearly a decade. There were also worries about Adobe’s competitiveness in the rapidly evolving AI-powered software market. While Adobe remains a leader in its field with strong financials, these factors combined to create uncertainty about its near-term growth prospects, leading to declines in recent months.
However, the company’s annual Adobe Max conference on October 14th was rife with exciting news, which created some tailwinds for the stock. ADBE made several major announcements, highlighting significant advancements across Adobe’s Creative Cloud suite, including the launch of over a hundred new features. Putting a strong emphasis on AI-powered products, the company unveiled new AI-enhanced tools in Illustrator and InDesign, updates to the Substance 3D content creation tool, and a beta version of a new web-based app for in-browser creation and editing of 3D content.
In addition, Adobe introduced significant updates enabled by its highly successful AI model, Adobe Firefly, which has already gained widespread adoption. The most notable development was the launch of Firefly Video, a new AI video-generation tool, which confirmed Adobe’s capability to pose strong competition to OpenAI’s Sora, as well as generative tools offered by Meta Platforms, TikTok, Alphabet, and other current or potential rivals. Adobe’s generative video AI is differentiated by its integration into its creative tool suite, as well as by its focus on commercial safety (i.e., its models are trained on data to which ADBE has commercial rights). The integration is expected to enhance user retention and platform consolidation, increasing product stickiness and revenue growth. This approach is viewed by analysts as a path to fortify ADBE’s market position while streamlining its AI monetization process.
Most leading Wall Street brokerages were positive on the stock before the announcement, with several analysts positively opining on ADBE’s prospects after the details on the new tools were released. Thus, according to Goldman Sachs, the launch of Firefly Video underscores Adobe’s competitive edge in various creative domains, with AI technology expected to support its growth trajectory. Bank of America Securities added that Generative AI tools will be a meaningful component to Adobe’s growth. The average analyst price target for ADBE implies a potential upside of about 27% in the next 12 months.
While the recent developments around GenAI tools are positive for Adobe, we remain watchful as to whether they provide a sufficient catalyst to break the negative sentiment cycle and propel ADBE toward further gains.
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❖ Applied Materials (AMAT) remains under review. As a reminder, we placed AMAT in this bracket following its weak stock performance.
Applied Materials continues to perform well fundamentally, as seen in its solid revenue and earnings reports, and most of its recent stock underperformance can be attributed to semiconductor sector cyclicality, discussions about new U.S. regulations on chip exports to specific countries, and other external factors. The company’s shares have generally followed the market trends for the wider semiconductor sector but opened a down gap versus iShares Semiconductor ETF in mid-October.
That gap was the result of one company-specific factor weighing down the stock: exposure to the Chinese market. Applied Materials has reduced its exposure to China, with sales in China dropping from 43% of total sales in FQ2 to 32% in FQ3. This reduction was part of a strategic decision to mitigate risks associated with the geopolitical tensions and trade restrictions involving China. However, the shift had a mixed impact, as the Chinese market was a major source of revenue for the company. While AMAT’s long-term prospects are bright, it remains to be seen whether AI-related revenue can replace the lost Chinese sales in the short term.
While AMAT’s shares rebounded in the past week, it remains to be seen to which extent the company would be affected by the new rules limiting investments in advanced technologies in China. We are planning to wait for the company’s FQ4 earnings release, scheduled for November 14th, to decide whether to retain the stock in the Portfolio. However, given AMAT’s apparent vulnerability to negative market news, we will follow the stock closely, watching for any sign of trouble.
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Portfolio Earnings and Dividend Calendar
❖ The Q3 2024 earnings season is in full swing, and several Smart Portfolio holdings are scheduled to release their quarterly results in the next few days. The reporting Portfolio companies are Arch Capital Group (ACGL), Microsoft (MSFT), Parker Hannifin (PH), EMCOR Group (EME), Amazon (AMZN), Super Micro Computer (SMCI), Berkshire Hathaway B (BRK.B), Howmet Aerospace (HWM), and Texas Pacific Land (TPL).
❖ The ex-dividend date for KKR & Co (KKR) is November 4th.
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New Buy: Diamondback Energy (FANG)
Diamondback Energy, Inc., is an independent oil and natural gas company focused on the exploration, development, and production of oil and natural gas in the Permian Basin spanning Texas and New Mexico. Diamondback primarily targets unconventional shale plays and leverages horizontal drilling and hydraulic fracturing technologies to maximize output.
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Permian Riches Expected to Grow Further
The Permian Basin is vital to U.S. oil and gas production due to its vast, high-quality shale reserves, particularly in West Texas and southeastern New Mexico. The basin currently contributes approximately 40% of the total U.S. oil production, making the Permian a hub for profitable, large-scale production.
Moreover, the Permian Basin has the strongest growth prospects among U.S. oil-producing regions, thanks to its vast, untapped reserves, and favorable geology. In addition, unlike more mature basins such as the Bakken in North Dakota or the Eagle Ford in Texas, the Permian offers multiple stacked layers of shale, allowing producers to drill vertically to access different zones. This makes it a more economical and productive geology for producers.
Additionally, infrastructure in the Permian is continually expanding, supporting further output increases. As a result, industry analysts anticipate steady production growth in the Permian, even as other U.S. regions face slower expansion or plateauing production. As a result, energy producers including all the U.S. majors, along with Diamondback, are drawn to the Permian region, with many of them – including giants like ExxonMobil and Chevron – having invested significant amounts in developing their Permian resources.
For Diamondback Energy, the Permian Basin is central to its operations and growth strategy. The company focuses on cost-efficient production through advanced drilling techniques, including horizontal drilling and multi-well pad development, to maximize output from its acreage. Diamondback has also invested in infrastructure improvements, water recycling, and other operational efficiencies to reduce costs and increase sustainability. These investments position Diamondback as one of the leading independent producers in the Permian Basin.
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Strong Fundamentals Despite Rapid Expansion
Diamondback Energy was founded in 2007 in Midland, Texas, with an aim to focus specifically on oil and gas assets in the Permian Basin. The company performed an IPO in 2012, raising capital to expand its Permian operations.
After going public, FANG underwent rapid growth through strategic acquisitions, increasing its acreage and production capacity. Through 2017, the energy producer expanded primarily by acquiring both land and smaller companies with assets in the Midland Basin. This approach enabled Diamondback to increase its acreage directly through land purchases while also acquiring existing production capacity and reserves by buying out companies. These strategic acquisitions allowed Diamondback to rapidly scale up operations, boost production, and optimize efficiencies in the heart of the Permian Basin.
In the past half-decade, Diamondback continued its acquisitions, solidifying its position as a top Permian operator. Thus, the 2018 acquisition of Energen nearly doubled FANG’s Permian acreage, while its 2021 buyout of QEP Resources and acquisition of Guidon Resources’ leasehold interests and assets helped enhance FANG’s scale and capabilities.
In September 2024, Diamondback Energy completed its acquisition of Endeavor Energy Resources, significantly expanding FANG’s footprint in the Permian Basin through the addition of substantial high-quality acreage in the Midland Basin. The combined entity now has an extensive inventory with a production rate of approximately 816,000 barrels of oil equivalent per day, placing it third in terms of production behind the supermajors ExxonMobil and Chevron.
After a period of consolidation of energy companies operating in the Permian, FANG has become the largest pure-play company focused on Permian oil production. It managed to successfully guide through the pandemic-induced oil prices slump in 2020 thanks to its winning business model, which relies on efficient operations and cost-effective production methods, and emphasizes asset optimization and maintaining a strong balance sheet.
Today, with a market cap of almost $54 billion and annual revenues of ~$8.5 billion, FANG is one of the largest and most influential players in the U.S. energy-producing sector. Diamondback ranks #400 on the Fortune 500 list.
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The King of Growth and Efficiency
Despite several large-scale acquisitions, Diamondback Energy maintains solid financial health. Its net debt-to-equity ratio of 28% is low compared to the broader energy sector average, which tends to be over 50%. This positions FANG favorably in terms of financial stability, indicating relatively lower leverage and potentially greater resilience against industry volatility compared to other energy companies. The company’s high debt ratings – “BBB” at S&P and “BBB+” at Fitch – are a testament to its balance sheet strength.
Fitch upgraded Diamondback by one notch in September, following the completion of the Endeavor acquisition. The agency said that the merger significantly increases FANG’s production size, proved reserves, acreage, and drilling inventory in the Midland basin, and supports robust free cash flow generation. Endeavor’s assets are expected to be assimilated into Diamondback’s core production footprint in the Midland Basin with a high degree of operational integration, which is projected to generate operating and overhead cost savings. In addition, the acquisition brings FANG’s extensive high-quality acreage with drilling locations with break-evens at or below $40 per barrel.
Fitch also praised the company’s strong liquidity, low leverage, and operational efficiency. Diamondback’s strong operations and effective management are also reflected in its strong capital efficiency and profitability metrics. Thus, its ROE, ROA, and ROIC – as well as its gross and FCF margins – come in the top 20% of its industry. Meanwhile, FANG’s operating and net income margins are in the top 5%.
Notably, Diamondback Energy’s revenue and earnings growth leaves its competitors far behind, reflecting significant operational expansion driven by acquisitions and substantial production increases, as well as the cost-effectiveness of operations. In the past five years, the company’s top line has increased at a CAGR of 25%, while EPS rose at a CAGR of 27%. These rates of growth are almost unheard of in the Energy sector, where CAGRs tend to be in the single or low double-digits over comparable periods.
FANG’s revenue declined in 2023 along with that of other energy producers as crude oil prices tumbled from their latest peak of $120 a barrel in June 2022. Although oil prices continued downward and sideways for most of 2024, Diamondback returned to growth, posting higher EPS in Q1 and Q2 2024 versus the same periods of last year.
The company is expected to report a year-over-year decline in EPS in Q3 (it reports on November 4th) due to Endeavor integration costs and subdued oil prices, which are also slated to affect earnings in the ongoing quarter. However, these declines in net earnings are expected to be short-lived, and EPS growth is anticipated to resume in 2025. In the long term, Endeavor acquisition and integration are expected to further reinforce FANG’s Permian positioning, significantly increasing its top line and strengthening its bottom line through lower operating costs per barrel.
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Total Return In Focus
Diamondback’s stock returned about 12% over the past 12 months, as it was pressured by a ~18% crude oil price drop over that period. However, FANG outperformed all of its direct Permian competitors, which include Devon Energy, ConocoPhillips, EOG Resources, Occidental Petroleum, and ExxonMobil (which upped the ante in the basin with its acquisition of Pioneer). In fact, Diamondback’s outperformance versus its peers stretches back at least five years. Year-to-date, FANG is the second-best performer among the Permian producers after ExxonMobil.
Despite Diamondback’s outperformance, it trades at a slight discount to the Energy sector’s average and comes towards the bottom of the valuation scale for its peers. Moreover, based on projected cash flows, the company trades about 35% below its fair value. The stock’s decline of about 16% from July’s local top has depressed valuations below long-term averages, allowing for an attractive entry point.
As oil prices recover along with the global economy, they should boost FANG’s revenues. However, crude prices are hard to predict, as they are affected by many non-economic variables. Still, given that about 51% of Diamondback Energy’s total wells, including those from the Endeavor acquisition, operate at a breakeven price of $40 or below, it can maintain high profitability even in a subdued oil price environment.
In addition to the potential for stock-price appreciation, Diamondback Energy is a dividend-paying company with a six-year track record. Its dividend yield of 6.1% is substantially higher than the average for the Energy sector. The company’s dividend policy is focused on both regular and variable dividends, prioritizing shareholder returns while balancing operational investments.
On top of that, FANG performs opportunistic buybacks as part of its strategy of returning ~50% of FCF to shareholders. Diamondback has an active stock buyback authorization, in place since September 2021 when the board approved a $2 billion authorization to enhance shareholder returns. This program has since been expanded multiple times, reaching $6 billion as of September 2024. The ongoing buyback program is flexible and has no set end date, allowing the company to repurchase shares based on market conditions and cash flow availability. So far, Diamondback has repurchased approximately $2.6 billion worth of shares under this program, buying back over 20 million shares.
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Investing Takeaway
Diamondback Energy is a premier independent oil and gas producer, strategically focused on the Permian Basin, where it efficiently develops high-quality shale assets using advanced drilling techniques. The company’s disciplined operations, low-cost structure, and successful acquisition strategy have positioned it as a top-tier producer in one of the U.S.’s most productive oil regions. Following its recent acquisition of Endeavor, FANG significantly expanded its production and acreage, strengthening its ability to generate robust cash flow and deliver shareholder returns. Complementing its steady buyback program and strong dividend yield, Diamondback’s focus on efficient growth offers investors portfolio diversification into resilient, cost-effective oil producer, which can serve as an attractive balance amidst industry volatility. We view it as a valuable addition to the Smart Investor Portfolio.
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Smart Investor’s Winners Club
The 30% Winners Club includes stocks from the Smart Investor Portfolio that have risen at least 30% since their purchase dates.
Despite stock market volatility in the past several days, our exclusive club still counts 16 members: GE, AVGO, ANET, ORCL, EME, TSM, SMCI, TPL, PH, APH, HWM, GD, ITT, CHKP, AMAT, and PNR.
The next in line to join the lucrative club is now IBKR with a 27.64% gain since purchase. Will it close the gap, or will another stock outrun it to the finish line?
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Disclaimer
The information contained in this article represents the views and opinions of the writer only, and not the views or opinions of TipRanks or its affiliates and should be considered for informational purposes only. TipRanks makes no warranties about the completeness, accuracy, or reliability of such information. Nothing in this article should be taken as a recommendation or solicitation to purchase or sell securities. Nothing in the article constitutes legal, professional, investment and/or financial advice and/or takes into account the specific needs and/or requirements of an individual, nor does any information in the article constitute a comprehensive or complete statement of the matters or subject discussed therein. TipRanks and its affiliates disclaim all liability or responsibility with respect to the content of the article, and any action taken upon the information in the article is at your own and sole risk. The link to this article does not constitute an endorsement or recommendation by TipRanks or its affiliates. Past performance is not indicative of future results, prices, or performance.