Upgrading Sitio Royalties To A Buy Following A 20% Decline In Share Price (NYSE:STR)

baona Thesis Sitio Royalties Corp. (NYSE:STR) is an oil-heavy royalty company that has taken several actions to reduce its costs of debt and increase cash flows available to shareholders. The company has refinanced its high interest rate senior notes due in 2026 while also selling off its Anadarko and Marcellus assets to pay down debt. As a result of these actions, the company stands to directly save over $20 million annually in reduced interest expenses. Operationally, the company stands to realize revenue growth from increasing activity in the DJ basin. Permitting activity was strong in Q4 and that momentum has continued thus far in Q1. The combination of cost reductions and increased revenues should offset the effect of depressed energy prices and support a minimum yield of 8.5% at current prices. I previously covered STR in June 2023 with a HOLD rating. After a 20% decline in share price, the company has fallen well below my previously stated buy threshold of $24.25/share. With an improved balance sheet, I have upgraded STR to a BUY. The Balance Sheet Continues to Strengthen On November 3rd, STR agreed to sell its Appalachia and Anadarko basin assets for $117.5 million. The combined revenue contribution of these assets was $3.8 million in Q3 against a total revenue of $152.8 million as a whole for STR. Using the Q3 strip, this sale price works out to be 7.73x of annualized revenue. Energy prices during Q3 are what I would consider above average on a long-term horizon. This would imply that the sales multiple is likely to be slightly better than this figure, possibly higher than 8x. This is a solid return on this set of properties. The chart below shows that this PS ratio would rival that of the premium associated with Apple Inc.’s stock (AAPL) and far in excess of that of Exxon Mobil Corporation (XOM) or Diamondback Energy, Inc. (FANG). Data by YCharts During the Q3 conference call, STR stated that it plans to allocate these funds towards debt reduction in an effort to drive towards its debt goal of < 1.0x debt to EBITDA. CEO Chris Conoscenti provided the following context on the transaction. In aggregate for 3Q 2023, Appalachia and Anadarko contributed only 0.4 net wells turn in line out of 9.5. This compares to Appalachia and Anadarko wells turn in line of 0.1 out of 8.1 total in 2Q of 2023. The divestiture has an effective date of September 1st and is expected to close near the end of the year. Pro forma for this divestiture, our total debt as of November 3rd would be approximately $864 million, and our liquidity under our reserve-based loan would be approximately $588 million, assuming a flat borrowing base of $850 million. Total debt prior to this transaction stood at $979 million. The average interest rate of the Sitio Revolving Credit Facility stood at 8.42% at the end of Q3. Applying this paydown to the credit facility will result in a reduction in interest expenses by approximately $9.7 million annually. Since this transaction represents less than 2.5% of the company’s total revenue and has marginal drilling activity, I view this transaction as an overall win. Refinancing of the 2026 Senior Notes In addition to the cost savings realized by the Appalachia/Anadarko transaction, the company also refinanced its 2026 senior notes which were some of its highest interest rate debt. The company has guided that this transaction will generate savings in excess of $11 million annually. This refinancing, coupled with the previously stated debt reductions, will more than replace the lost revenue from the Appalachia/Anadarko sale while also freeing up incremental FCF. STR Investor Presentation Activity In The DJ Basin Continues The DJ basin continues to be one of the most underdeveloped basins in the STR portfolio and constitutes nearly 10% of the company’s total acreage. In Q3 STR saw a sizable increase in activity from this basin as detailed by the company’s CEO. We estimate that during the third quarter, there were 9.5 net wells turned in line on our assets with 72% and 19% of the overall activity in the Permian and DJ Basins, respectively. This was a shift from a second quarter activity where 87% of our turn in line wells were in the Permian Basin and there was minimal activity on our DJ Basin assets. Based on permitting activity, I am projecting activity levels to continue to increase out of the DJ for STR. Since the beginning of Q4, 244 wells have been approved. This is a sharp increase from 56 during Q3 and 153 in Q2 of 2023. I took a sample of 15 of the largest multi-well sites that have been permitted and laid them out using Google Earth. In the image below, I combined this map with the STR asset map to show that the recent activity coincides with the operating areas of STR’s assets. Permitting activity in the DJ basin can be easily found on the COGCC website. DJ Basin Drilling Permits (STR and COGCC Website) The continued growth of production on STR property coincides with the growth trajectory laid out by management in the Q3 conference call. The line-of-sight inventory of 50.9 net wells or 50.2 pro forma for the divestiture we announced is a healthy volume of line-of-sight wells. As we look at our wells required to keep the production flat on our asset base, it’s in the high-single digit net wells per quarter. And so, with 50.2, that’s above that high single digits per quarter. On average, if these wells are getting turned in line in the next 12 to 16 months. So it does imply some growth from where we are today. Dividend Coverage As a royalty company, STR’s dividend is highly coupled with energy prices. As a result, the company employs a variable dividend model that allocates 65% of FCF to fund the dividend. Approximately 85% of STR’s revenue is derived from crude oil sales. Based on the current WTI strip, Q4 and Q1’s payout should be expected to be somewhat lower than the $0.49/share that was paid out in Q3. WTI averaged $78.41/barrel in Q4. This will correlate to a Q4 dividend in the range of $0.46/share to $0.47/share. Energy prices have continued to dip through the first five weeks of 2024 and barring major improvement, look to be trending toward $0.44/share assuming a $74/barrel run rate. Despite this decline, the current share price supports an 8.5% yield at $74/barrel over the course of 2024. As part of its dividend program, the remaining 35% of free cash flow is designated for balance sheet maintenance. This will provide the company with sufficient capital to continue to reduce interest expenses and grow the dividend over the long term. Risks The correlation between the STR stock price and WTI is very strong as shown by the price chart below. Inevitably, this will make the stock price of STR volatile. Operationally, some of this risk is managed by the company using hedges. In Q4, the company has hedges on approximately 17% of its oil volumes at an average price of $93.71/barrel, a nice premium to the current strip. 2024 hedges drop to an average price of $82.66/barrel which will still generate a healthy profit. Data by YCharts Its natural gas hedges are also significantly above the current strip but also only cover approximately 18% of the current production rate. These hedges will help mitigate the depressed energy prices the market has seen thus far in 2024 but the protection is limited due to the lack of sheer volume. Natural Gas Hedges (STR Investor Presentation) Buying during low points in the energy cycle will help investors protect against capital losses. From the price chart above, it can be seen that STR’s share price is disconnected from the current WTI strip. STR’s share price is approaching a two-year low, and thus I view the company’s performance as an asymmetric bet at current prices. Summary Sitio Royalties has shed its Appalachia and Anadarko basin assets to improve its balance sheet with minimal impact on day-to-day operations. This move, coupled with refinancing activities stands to save the company over $20 million in interest related costs annually and improve FCF. Operationally, the company is positioned to continue to experience increased activity on its DJ basin assets as demonstrated by high levels of permitting activity. The locations of these permitted wells align well with existing STR assets. The projected dividend at an average WTI price of $74/barrel will allow investors to capture an 8.5% yield at the current share price. STR’s share price is directly correlated with WTI prices, and thus it should be expected to have a high degree of volatility. The company partially addresses this risk with low volume, high dollar value hedges. After a 20% decrease in share price, I believe STR is oversold and currently provides an attractive entry opportunity. I rate STR as a BUY.

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