STR - Sitio Royalties: Solid Production Growth Supports FCF Despite Weaker Commodity Prices

2023-03-16 08:13:48 ET

Summary

• Sitio's production expectations for 2023 increased by 6%.
• This helps keep projected free cash flow at $2.70 per share in 2023 despite the WTI oil strip falling to around $70.
• Sitio's production and production growth mostly comes from the Permian.
• Interest costs are fairly significant due to high-interest rates on its variable rate debt.
• The estimated value is around $27 to $28 in a long-term $70 WTI oil environment.

Sitio Royalties ( STR ) reported strong production guidance for 2023 , with a 6% increase in production compared to earlier expectations . The increased production helps offset Sitio's relatively high interest costs and should allow it to generate around $2.70 per share in 2023 free cash flow at the current $70 WTI oil strip. Thus I have slightly increased my projections for Sitio's free cash flow in 2023 despite oil and gas prices dropping a bit since I looked at it in January.

At $20 per share, Sitio appears to have a solid amount of upside in the $70 WTI oil and $4 NYMEX gas long-term pricing environment that I expect. At those commodity prices, I believe Sitio can be worth around $27 to $28 per share.

Production Geography

Sitio's production (pro forma for its merger with Brigham Minerals) is primarily concentrated in the Permian Basin. Approximately 74% of its pro forma Q4 2022 production was from the Permian, including 80% of its pro forma Q4 2022 oil production. The DJ Basin accounts for another 11% of its total production and 8% of its oil production, while the Eagle Ford accounts for 7% of its total production and 8% of its oil production.

Increased Production Expectations

Sitio increased its expectations for 2023 production by approximately 6% at guidance midpoint from what it mentioned in November 2022 . The November 2022 guidance was for the 12 month period ending June 2023, but I had modeled that Sitio's production would remain flat at that level for the rest of 2023. Sitio's oil cut remains at approximately 50%.

Sitio's increased production expectations are due to its line of sight inventory (spud and permitted wells that are expected to come online within 12 months) remaining relatively high.

Sitio mentioned there is some data lag with its numbers, so the weakening in commodity prices over the last couple months may result in slowing production growth later in 2023 and into 2024. However, reduced drilling and completions activity would help support commodity prices.

2023 Results Based On Current Strip

Sitio now expects to average around 35,500 BOEPD (50% oil) during 2023. At current strip of approximately $70 WTI oil and near $3.00 NYMEX gas, Sitio is projected to generate $575 million in revenues before hedges. Sitio's 2023 hedges add another $32 million in value.

Sitio's hedging situation is relatively favorable. Although it only has a modest amount of production hedged, these hedges are at fairly high levels. Sitio has around 17% of its 2023 oil production hedged at a swap price of $93.71, and 14% of its 2023 natural gas production hedged at an average floor/swap price of $4.77.

Sitio's interest costs are relatively high, with it having $930 million in net debt at the end of 2022 along with a weighted average interest rate of around 9% to 10% between its credit facility debt and its variable rate unsecured notes due 2026.

Sitio closed on its new revolving credit facility in February 2023, which helped trigger a 75 basis point reduction of the interest rate on its unsecured notes, so that helped a bit.

Interest costs are Sitio's main expense, although it is still projected to generate $417 million in free cash flow in 2023 at current strip. This is approximately $2.70 per share in free cash flow.

Assuming Sitio keeps a 65% payout ratio, that would allow it to declare $1.75 per share in dividends related to 2023 results, while also putting $147 million towards debt reduction. Sitio is limited to a 65% payout ratio as long as its leverage is above 1.0x and its unsecured notes due 2026 remain outstanding. With $70 WTI oil, it may take Sitio until 2025 to bring its leverage down to 1.0x or lower.

The projected debt reduction during 2023 would bring Sitio's net debt down to $783 million at the end of 2023.

Valuation

Sitio's estimated value is now approximately $27 to $28 per share with long-term $70 WTI oil and $4.00 NYMEX gas, with a roughly 10% free cash flow yield. Sitio's value was boosted by its increased production expectations for 2023. However, this was offset by its post-merger net debt being higher than I expected, consequently resulting in greater interest costs. The effect of the increased production on Sitio's projected free cash flow is slightly more than its increased interest costs.

Conclusion

After dropping down to around $20 per share, Sitio appears to be a pretty good value now. Sitio's 2023 production expectations (based on line of sight inventory) were higher than expected, fueled by Permian Basin activity. There is a risk of a slowdown in production growth later in 2023, but Sitio's assets seem relatively well positioned.

I believe that Sitio can be worth around $27 to $28 in a long-term $70 WTI oil and $4 NYMEX gas scenario. Sitio is likely to maintain a 65% payout ratio for now while it pays down its debt, resulting in a projected dividend of $1.75 per share based on 2023 results. Sitio's projected cash flow will improve as it reduces its debt, since its debt has fairly high interest rates.

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