I was going to write about ProFrac Holdings $ACDC, but it turned into me dunking on Vermillion Energy $VET, Sandridge Energy $SD, and Peabody Energy $BTU instead.

Sorry not sorry, still bagholding VET and BTU for the rerating and averaging down. Sold puts on SD for income.

Energy shareholders are ruthlessly punishing the stock price of any energy company that spends on organic growth; I know, I am bagholding Vermillion Energy VET and Peabody Energy BTU.  Some of these projects have 40%+ Internal Rates of Return!  But should investors drop organic growers like a bad habit?  

The push for share buybacks in the fossil fuel space is overwhelming, drowning out any alternative voices.  The prices are just too cheap, the voices chant, I want to own the last share.  I have heard this mantra from a lot of excellent analysts, Josh Young, Eric Nuttall, Matt Warder, and Trader Ferg with his moats and cannibals article.  All admirable gentlemen, and certainly worth a follow, but there may be another way.  

Energy extractors are shrinking businesses, and by pure math, share buybacks on a shrinking business implies that somewhere along the way, the smart investors are the ones who sell and not the ones who remain.  We are still a long way from that point, most of us are aware that we will likely be on fossil fuels for such a long period of time, that compound discounting renders the energy transition negligible.  And it does seem that share buybacks, if done aggressively, are increasing multiples compared to their competitors, but it still might not be the best path.  

There are two sources of potential return, the return of operating the business and a multiple rerating.  I think most energy investors have given up on the possibility of a multiple rerating, the environmental cult and their power over institutions will not allow inflows into energy.  However,  we small cap value junkies should know that for the last 20 years, large has beaten small.  One potential way to increase the multiple is to stop being small, become large enough for ETF inclusion; S&P 600, S&P 400, S&P 500, and bask in passive inflows ourselves.  Energy companies have such massive cashflows, instead of share buybacks, why not try to execute value accretive acquisitions?

This is what the Wilks cousins are doing over at Profrac Holding ACDC, and I think they are doing a swell job of it.  A rollup, if done well (huge honking caveat), can offer economies of scale, access to new proprietary technologies, access to human capital in a world where few new graduates are getting petroleum engineering degrees, synergies (although often over-promised and under-delivered), potentially market power, enough size to bear the cost of lobbying.  Plus, shareholders should recognize that management teams need it for their own egos to grow somehow and better through acquisitions than organically.  We spend enough time considering the psychology of investing, but maybe we should consider the psychology of management occasionally. 

Let me offer to you a possible hierarchy of capital allocation for the energy space under the current environmental regime:

1. Accretive Acquisitions

2. Share Buybacks

3. Bad Acquisitions

4. Recurring Dividends

5. Organic Growth

6. Special Dividends

7. Management Grift

Rather than abdicating and resigning yourself to share buybacks, roll that mother up.  I know that it is demoralizing to see your business trade at 2x Enterprise Value to EBITDA, but…so are your competitors!  Buy them out! I am not even saying that share buybacks are bad, just that they are second best.

Controversially I am putting bad acquisitions relatively high on this list.  But if you are predicting sustained inflation as I am, using debt to acquire, even if you overpay by a bit, could still add a lot of value over a 5+ year time horizon.  The multiple rerating of increased size could add more value than the overpayment decreases value, and congressional debauchery will evaporate the debt.  Twisted incentives I know, but not my fault.

Recurring dividends attract an income-oriented investor base, and if sustainable and never cut, can lead to a multiple rerating.  Special dividends do not.  Special dividends are almost the worst thing that management can do, it does not result in a higher stock price, and it throws off the strike prices of all our degenerate options.  Anyone bagholding Sandridge Energy SD knows the pain of waiting for the promised acquisitions and getting a special dividend in its stead.

You might wonder why I put organic growth so far down the list, when many companies in the energy space can find 40%+ Internal Rates of Return by expanding organically.  Because maybe society needs to feel the pain of expensive energy for a time in order to reevaluate their priorities.  It’s not worth it to grow production under a regime where a not-insignificant part of society calls you a murderer and protests your public speaking engagements.  In a world of rising populism, this creates an enormous political risk and the energy space should be united in attempting to mitigate this very real business risk and should prioritize changing hearts and minds.  This can done by not growing production.  I am not against internal investments that lower costs and increase efficiencies, but every management team should pause and reflect before they increase their barrel of oil equivalent production per day organically.  If you want to grow, buyout your competitors, it’s like a share buyback only better.

Obviously management grift is the worst use of shareholder capital, and those management teams who abuse shareholders should be fired as quickly as possible.  And they can be fired and they can receive their golden parachutes if we as shareholders push for this massive wave of consolidation.  Buyout the bad management teams.  Remember, once an offer is made that is so far above current shareprice that it is inevitable that there will be a sale, the Delaware supreme court recognized in Revlon v MacAndrews that there is a fiduciary obligation to stop fighting the acquisition and just try to get the best price.  Buyout the bad actors.

One last final thought, the voting power of the institutional environmentalists that seek to undermine energy companies must be mitigated.  The easiest way is if there is a large shareholder, founder, trust, etc. that cannot be outvoted, and the acquisitions are cash based and not stock based.  This is another reason why I love ACDC, the Wilks uncles can outvote whatever Larry Fink wants to impose on them.  Being a permanent minority shareholder does have its own risks, but I do believe that we as investors can find the right trains to hop aboard that are going in the right direction, and can receive the multiple rerating of passive investing while at the same time resisting the proxy power of it.   

This started out as a writeup on why I love both ACDCs, the band and the stock.  But it’s too long for the modern attention span already.  My ACDC love ballad will be coming next.