Sitio Royalties - Q2 2023

Transcript

Operator (participant)

Good morning, and thank you for joining the Sitio Royalties second quarter 2023 earnings call. My name is Carla, and I will be the operator of today's call. If you wish to ask a question for the Q&A portion of the call, please press star followed by one on your telephone keypad. When asking your question, please ensure your telephone is unmuted locally. To revoke your question, you can press star followed by 2. I would now like to pass the conference over to our host, Ross Wong, Vice President of Finance and Investor Relations. Ross, please go ahead when you're ready.

Ross Wong (VP of Finance and Investor Relations)

Thanks, operator, and good morning, everyone. Welcome to the Sitio Royalties second quarter 2023 earnings call. If you don't already have a copy of our recent press release and updated investor presentation, please visit our website at www.sitio.com, where you will find them in our investor relations section. With me today to discuss second quarter 2023 financial and operating results is Chris Conoscenti, our Chief Executive Officer, Carrie Osicka, our Chief Financial Officer, Jarrett Marcoux, our EVP of Engineering and Acquisitions, and other members of our executive leadership team. Before we start, I would like to remind you that our discussion today may contain forward-looking statements and non-GAAP measures. Please refer to our earnings release, investor presentation, and publicly filed documents for additional information regarding such forward-looking statements and non-GAAP measures. With that, I will turn the call over to Chris.

Chris Conoscenti (CEO)

Thanks, Ross. Good morning, everyone, and thank you for joining Sitio's second quarter 2023 earnings call. Following a quiet first quarter of this year, we are excited to share some success we have had with recent acquisitions. In the past two months, we have closed on five accretive acquisitions in the Permian Basin for aggregate consideration of approximately $248 million. We funded one of these transactions with approximately 2.5 million shares of Sitio stock in June. In July and August, we signed and closed the remaining four acquisitions with $181 million in cash, representing 27% equity and 73% cash in total.

These transactions were with sellers that we know well and have had relationships with for a number of years, and the stock transaction in June was with a seller that has taken our equity in exchange for assets before. This relationship-based approach to generating and executing on minerals acquisitions is a true differentiator and has been a staple of our growth strategy for many years. We acquired these assets for less than 7x next 12 months cash flow, and in aggregate, expect them to be approximately 6% accretive to our second half 2023 Discretionary Cash Flow per share at current strip pricing and a payout ratio of 65%.

The acquired assets are highly complementary to our existing portfolio, as you can see on page seven of our earnings presentation, and in total, added 13,705 NRAs, or 7% to our Permian Basin position, with 82% of the NRAs in the Delaware Basin and 18% in the Midland Basin. The acquired assets also had 2.6 net spuds and 1.1 net permits for a total of 3.7 net line of sight wells as of June 30th. In aggregate, the acquired assets produced an estimated 1,918 BOEs per day during the second quarter and have a similar mix of existing production and remaining locations as our legacy Permian Basin assets. Although we were successful recently in closing these five deals, we still see the M&A environment as extremely competitive.

During the second quarter of 2023, Sitio's assets averaged a record high of 34,681 BOEs per day, which included 17 days of production from the stock acquisition that closed in June. Production from Sitio's mineral and royalty assets has grown each quarter since we became public last June. Including a full quarter of production from all of the recently acquired assets, Sitio's second quarter production would have been 36,462 BOEs per day, or 1,781 BOEs per day higher than reported. We estimate that pro forma for these newly acquired assets, there were 8.1 net wells turned in line during the quarter and an all-time company high of 50.8 net line of sight wells as of 30 June.

From a geographic perspective, our pro forma net line of sight well increase came from 61% in the Delaware Basin, 16% in the Midland Basin, and 23% in the Eagle Ford, with the rest of our basins relatively flat on a combined basis. I would now like to turn the call over to Jarrett Marcoux to make some comments on the macro backdrop and activity on our assets.

Jarrett Marcoux (EVP of Engineering and Acquisitions)

Thanks, Chris. As Chris just mentioned, we have 50.8 net line of sight wells, 47.1 of which are from our asset, excluding the acquisitions just discussed. This compares to 42.8 net line of sight wells at the end of Q1 on a like for like basis. This quarter-over-quarter organic increase of 10% in net line of sight wells is encouraging for near term production visibility, despite a material slowdown in rig counts over the last quarter across the U.S. and in the Permian Basin of 12% and 8% respectively. The rigs on our acreage during the same time frame have been flat. However, we believe that rig count on our acreage will eventually moderate if rigs continue to be dropped overall.

Well production rates are in line with our expectations, our PDP decline rate over the next 12 months is 32.4% pro forma for the recent acquisitions. This is comparable to our decline rate of 32.7% prior to the acquisitions. According to EIA estimates, DUCs in the Permian are down by 73 from 930 to 857 between March and June of 2023, are at their lowest level since July of 2014. This quarter-over-quarter drawdown of 73 DUCs is the lowest amount since the DUC drawdown began in the fall of 2020, when there was an average change of 384 DUCs a quarter.

There were 3,519 DUCs at the peak of the DUC buildup in July 2020, so the current level of 857 DUCs is nearly a quarter of that high mark. These data points give us confidence that the DUC drawdown is nearly over, and that future production from our assets will be tied more directly to rig activity compared to the past couple of years, which was somewhat misleading due to the tailwinds from the DUC drawdown. Our second half guidance, which Chris will discuss in a moment, are informed by these macro as well as asset level trends. Now I'll turn it back over to Chris to discuss Sitio's financial results and second half 2023 guidance.

Chris Conoscenti (CEO)

Thanks, Jarrett. Moving on to our financial results. We reported second quarter adjusted EBITDA of $127 million and Discretionary Cash Flow of $95 million, which were down by 9% and 21% respectively, relative to the first quarter of 2023. Much of these variances were driven by pricing, as our average hedged realized price per BOE for the second quarter was $44.45, a 9% decrease compared to 1Q23. Quarterly cash G&A was up by just over $500,000, primarily due to salary expenses and the timing of vendor payments. For the first half of 2023, our cash G&A was $12.8 million, which is tracking just below the midpoint of our full year guidance, assuming a run rate of $13 million for half a year.

Our second quarter Discretionary Cash Flow was impacted by changes in cash taxes and cash interest paid during the quarter. Cash taxes were up $7.7 million relative to the first quarter, primarily due to $5.9 million of taxes that were paid in April, but related to the first quarter. Quarter-over-quarter cash interest was up by $4.5 million, which was driven by a $2.7 million interest payment related to the first quarter borrowing that was paid in the second quarter, and also due to higher SOFR rates. Our board declared a dividend of $0.40 per share of Class A common stock for the second quarter, which will be paid on 31st August to record holders at the close of business on August 18th.

This dividend is down by $0.10 per share relative to the prior quarter, primarily due to the factors I mentioned during my discussion of our financial results. Our second quarter dividend was $0.015 per share higher than it otherwise would have been, due to the inclusion of a full quarter of cash flow from the stock acquisitions that closed in June, providing immediate accretion for our shareholders. Regarding the balance sheet, at the end of June, we made our third consecutive amortization payment at par of $11.25 million on our unsecured note, reducing the remaining principal to $416.3 million.

Our ending credit facility balance on June 30th was $486 million, which was comparable to the amount drawn at the end of the 1st quarter, even though we drew on the RBL in June to fund a portion of the cash acquisitions that closed in July and August. Since then, we have funded the remainder of our recent cash acquisitions using our revolver and cash from operations. As of 7th August, we had an outstanding revolver balance of $605 million. We are issuing new operational and financial guidance for the 2nd half of 2023 to reflect the impact of our recent acquisitions and the macro backdrop that Jarrett discussed earlier.

Compared to our previous guidance for the full year of 2023, we are increasing our production guidance for the second half to 35,000-37,000 BOEs per day and reducing our gathering and transportation guidance range. We have also been advised by our tax consultants that we should expect minimal cash tax payments for the rest of the year due to a tax benefit from 2022. Therefore, we have provided a cash tax guidance range of 2%-4% of pre-tax income for the second half of the year. We expect this benefit to last through calendar year 2023 and for cash tax rate to shift back to the normal 11%-13% range afterwards. All other guidance metrics remain in line with prior full year 2023 guidance. That concludes our prepared remarks. Operator, please open up the call for questions.

Operator (participant)

Thank you. If you would like to ask a question, you may do so by pressing star followed by 1 on your telephone keypad. To revoke your question, please press star followed by two. When preparing for your question, please ensure your phone is unmuted locally. Our first question comes from Tim Rezvan from KeyBanc Capital Markets. Your line is now open, Tim. Please go ahead.

Tim Rezvan (Managing Director, Equity Research Analyst)

Good morning to the, to the team there. I guess, Chris, my first question, we're trying to kinda make sense of the, the production impact and the earnings impact from acquisitions and the sort of the updated guide. You know, it looks like you're adding about 6% to production and, and EBITDA from these deals. We thought we might see a little more of an uptick, you know, in, in, in the guidance and, you know, you talk about the accretion. Is there sort of a timing factor with sort of the line of sight wells? Is this more a fourth quarter or 2024 benefit that you see? I was wondering if you could kinda talk through the, the dynamics on the production guide and the acquisitions.

Chris Conoscenti (CEO)

Yeah. Good morning, Tim. Thanks for the question. We-- good news is we're not seeing any degradation in timing for spud to turn in line or permits to spud to turn in line. That has remained relatively constant for those timelines. But we did look at our prior guidance, which had a midpoint of, of 35,500 BOEs per day. You know, if you just look at that relative to the first half of the year and, and ask yourself, what would you have to believe for the back half of the year? You'd have to see, you know, greater than 5% growth in the back half of the year. On the base asset, we just, you know, as, as you can look across the entire Permian Basin, we just aren't seeing that kind of growth.

It's more, you know, flat or low single digit kind of growth on the base asset. The good news on the acquisitions is higher spud activity and visible near-term development on those. Yes, we do see the accretion around 6% from the acquisitions. We're excited about that, and the valuation at which we got them was very compelling at less than 7x next 12 months cash flow. A lot to be excited about around the acquisitions and filling in some more growth in the back half of the year.

Tim Rezvan (Managing Director, Equity Research Analyst)

Okay, I appreciate the, the context. I was just, I was wondering, you know, Viper came out on their call announcing a change in the governance structure to allow for broad index inclusion. I know that's something that, you know, management and the board has, you know, been, been thinking about. Just curious kind of what, what your thoughts are on that potential for, for Sitio in the future.

Chris Conoscenti (CEO)

Right. Sitio is already a C corp, so we're already index eligible. You know, like, like Viper, we don't know the timing of when any index inclusion could come. The other development that happened in the last few months, you know, I'm sure you saw, was the S&P indices now allow for companies like ours that have an Up-C structure to be included in the indices. Previously, we were ineligible from index inclusion in the S&P indices because of our Up-C structure. They recognize that the Class A and Class C shares have equal voting rights and equal economic rights in the dividends as, as, as the Class A shareholder, shareholders. They, they now allow for index inclusion for companies like ours, but we don't have to change our structure or anything.

We were, we were already a C corp, so we didn't have to convert from a partnership.

Tim Rezvan (Managing Director, Equity Research Analyst)

Okay, thanks. I wasn't aware of that last piece on the S&P. I appreciate you, you clarifying it. That's all I had. Thanks.

Chris Conoscenti (CEO)

Thanks, Tim.

Operator (participant)

Thanks, Tim. Our next question comes from TJ Schultz from RBC Capital. Your line is now open. Please go ahead.

TJ Schultz (Managing Director)

Hey, good morning. First on the, the M&A, on the, on the 5 deals you transacted, over the last couple of months, was the stock deal the largest? I, I, I know you've indicated in the past, obviously, more impact from, from larger type transactions. Just how would you bracket what you characterize as, as larger deals? Is it $100 million plus? Then how many of those packages do you think are out there? Chris, I think you commented it's still fairly competitive. If you could just give some color on, on how you expect that to transpire the rest of the year. Thanks.

Chris Conoscenti (CEO)

Sure. Thanks, TJ. Good morning. The stock transaction was not the largest individually of the five, but on its own, the stock deal, as you probably saw from the filings that the seller made, it was about $65 million, with the stock price at closing there. It was, it was a meaningful deal, but I wouldn't call it large. You know, large for us gets north of a few hundred million dollars. We would characterize all these individually as relatively small, but impactful, as you can see from the accretion and evaluation at which we were able to acquire them. You asked how many were out there and what the competitive dynamic looks like.

For the, for the very large transactions, the ones that are sort of, you know, ballpark $1 billion or larger, there's, I would say, a couple dozen. For the ones that are $500 million-$1 billion range, there you're talking literally dozens and dozens. We, we see a lot of opportunity there. We're in discussions with a lot of those, owners like we have been for years, and that's, that's exactly how these transactions played out this, this past three months. These were, several of these were ones where we've been talking to the, the owners for, upwards of, four years. These, these relationships take a long time to cultivate, and we have to find that right time when, when the seller is ready and, when the valuation is right for us.

In, in terms of the competitive dynamic, obviously, we see the, the most heated competition in, in those situations that are broadly auctioned, and that's why we have very, very limited success in, in those situations. We tend to do a lot better where we have a relationship with sellers and can align ourselves better on data and talk directly with them, and figure out a solution that works best for both parties in terms of valuation, consideration, mix, et cetera. We continue to focus there. We do look at some of these auctions. We have been unsuccessful in this year in, in these broad auction processes.

You can see in some of the things that have transacted, we've been off by, between 15 and 100% on some of the things that have transacted this year. We're gonna continue to focus on the relationship-based approach.

TJ Schultz (Managing Director)

Okay. Makes sense. I, I guess just lastly on the tax guidance, maybe just a little color on, on what caused that change for this year. Is there a catch-up next year? And does any of the M&A transacted this year push it out any further?

Chris Conoscenti (CEO)

Sure. Yeah. Carrie can supplement what I say here, but effectively, it was a tax benefit that resulted from from Brigham. It carried over to this year, and our tax advisors have informed us that the back half of this year should should result in minimal to no federal income taxes for us because of the credit from 2022.

Carrie Osicka (CFO)

That's correct, Chris. We, we will still have state income tax and margin tax, but, but other than that, yeah, we don't expect to be paying federal taxes, significant payments until next year again.

TJ Schultz (Managing Director)

Okay. I guess just one more just to, kind of clarify again on the production guidance for the back half of the year. I think in some of the macro comments you all made, you mentioned that rigs on your acreage has held in better than kind of what we've seen on some of the high, headline numbers, so your rigs are, holding in about flat. I, just to be clear, your assumptions kind of driving the production range is assuming that rig activity on your acreage normalizes closer to, to what some of the declines you've seen. Is that fair? And then I think you're indicating that it should correlate more closely to rig activity, just given what we've seen on the DUCs drawdowns. Am I framing that right?

Chris Conoscenti (CEO)

I'll make a couple comments there and ask Jarrett to share his thoughts. Historically, what we've told you is that relying on just gross rig activity can be very deceptive and misleading, just given, one, you don't know the NRI of the wells being drilled, and two, you don't know where, in what basins, those, those, rigs are active. So, you know, a well in Appalachia is going to be a different impact than a well in the heart of the Midland Basin. A few key things to pay attention to there. I'll let Jarrett chime in on his thoughts on the trending in the rig count and impacts on our asset base in the future.

Jarrett Marcoux (EVP of Engineering and Acquisitions)

Yeah, thanks, Chris. TJ, as far as the rigs are concerned, like we mentioned in the comments, let's take Permian, for example. Rigs are down just below 8% over the last quarter, and typically when rigs pull back in these, in these type of macro environments, they pull back from the edges of the basin. If you imagine the basin as these big ovals, they kind of get smaller. Most of our acreage is concentrated in the heart of the basin, and especially our higher, our higher concentration of our acres in that gross footprint is towards the fairways of the basin. If rigs are down 8%, we expect moderation on our asset going forward, but probably not to the extent that it's happening in the basin for the reasons I just mentioned.

When we think about, you know, the macro backdrop, you know, we, we don't believe that we're going to get, you know, 0 effect of the macro backdrop, but we think we'll be, you know, not, not directly correlated to what's happening in the rig count.

TJ Schultz (Managing Director)

Okay. No, that makes sense. Thank you.

Operator (participant)

Thanks, TJ. Our next question comes from Nate Pendleton from Stifel. Nathan, your line is now open. Please go ahead.

Nate Pendleton (Analyst)

Hi, this is Nate Pendleton from Stifel. Thanks for taking my questions. For my first question, can you provide any color on how the current commodity price environment is impacting your team's outlook for acquisitions?

Chris Conoscenti (CEO)

Good morning, Nathan. Thanks for the question. The short answer is not very impactful in terms of how we look at acquisitions. We underwrite acquisitions in a base case, looking at the strip, and we don't pretend like we're any smarter than the strip. We do sensitize it down, but our underwriting standards remain the same regardless of the commodity price environment.

Nate Pendleton (Analyst)

Got it. Thanks. For my follow-up, regarding return of capital, can you discuss some of your considerations when you were assessing the right longer-term mix now that your unsecured notes have been amended?

Chris Conoscenti (CEO)

That's a good question. We did have some success with our unsecured noteholders in securing an amendment that would allow us to buy back $25 million of, of stock above and beyond our 65% dividend payout. Our board has not yet authorized that buyback program. We're watching closely on the stock's behavior to see what the right timing is. The other thing we think about in that context is our leverage and liquidity. As you can see from the last 6 months, we've made some progress chipping away at the prepayable debt balances.

We've made several payments at par on our unsecured notes, and then prior to these cash acquisitions in the last two months, we were paying down our RBL balance, and we'd like to continue doing that and working towards our long-term goal of one times or less leverage, which will give us not the optimal balance sheet, but adequate liquidity to capitalize opportunistically on cash acquisitions. I would say stay tuned for more to come on buybacks under the current unsecured notes, and then once we refinance the current unsecured notes, we'll have a different framework altogether.

Nate Pendleton (Analyst)

Thanks, Chris. I appreciate the color.

Chris Conoscenti (CEO)

Thanks, Nathan.

Operator (participant)

Thanks, Nathan. Our next question comes from Noel Parks from Tuohy Brothers. Noel, your line is now open. Please go ahead.

Noel Parks (Managing Director, CleanTech and E&P)

Hi, good morning.

Chris Conoscenti (CEO)

Hey, Noel.

Noel Parks (Managing Director, CleanTech and E&P)

With the acquisitions, Is it safe to assume that they fall sort of in your sweet spot of very little additional overhead for the new assets and, you know, hopefully some leasing opportunities for the mineral?

Chris Conoscenti (CEO)

That's absolutely right. We added no overhead. There's actually a fair amount of overlap, as you can see from the overlap map in our earnings presentation, to our existing assets. Yes, we do expect subsequent leasing opportunities on these assets, like we see with all of our acquisitions.

Noel Parks (Managing Director, CleanTech and E&P)

Great. In the course of negotiating on the different deals, you talked a bit about structure being something that is meaningful. Just are there any sort of patterns you can draw as far as seller motivation, you know, at this particular juncture? You know, how much price is or, or isn't the sort of overriding factor?

Chris Conoscenti (CEO)

That's a good question. The price is always the primary motivating factor, but when you look at transaction size, when you get to a larger transaction size, I think the sellers acknowledge that the cash capacity in the minerals market has limitations, and therefore, there will be a need to accept buyer stock as consideration. One unique exception to that was the stock deal that we did in June. I would categorize that as one on the smaller end, and it happened to be with a seller that had taken our stock in exchange for assets before. Somebody that knew our equity, understood our strategy, and saw the upside in our company and wanted to take equity when they clearly could have sold for cash, but they chose our equity instead.

Occasionally we see opportunities like that, but more frequently, we see that at the larger end of the deal spectrum.

Noel Parks (Managing Director, CleanTech and E&P)

Got it. Just sort of a more general question. I feel like I've been hearing generally more optimism about gas takeaway in the Permian, and that easing as a potential issue that, you know, may thwart drilling activity or turn-in-line activity. I was wondering if you had any perspective on that?

Chris Conoscenti (CEO)

We do. If you look at the, the response that the gas market has had to infrastructure build-out, it's encouraging, just when you look at Waha differentials. If you look at projects that are already underway with the Whistler expansion, Permian Highway, with Matterhorn getting FID'd, and other projects, you have upwards of 3.6 BCF per day of new capacity coming on over the next year, year and a half. That sends a strong signal to the gas market that there's egress coming out of the Permian Basin in a volume that you just can't see in other basins, one, because there isn't demand for it, but two, just there's constraints, politically, geographically, et cetera, that will prohibit that from happening in other basins.

We're, we're very, very fortunate in, in West Texas and Southeast New Mexico to have a much more constructive regulatory environment.

Noel Parks (Managing Director, CleanTech and E&P)

Great. Just one, one other detail. I don't imagine it's, it's you moving it either way, but I was just curious, was there, any hedging on the acquired properties that, you know, helped maybe keep, keep activity going when, when things were volatile?

Chris Conoscenti (CEO)

We did not, we did not hedge any volumes from the acquired assets. We do look at hedging when we're within that mid-cycle band of, you know, $50-$75. We, we, we discussed it, ultimately did not. Commodity prices are up since then, so I'm not saying we were right or wrong, it's just the, the approach we take is to consider it when we're in that band, and, and then definitively to hedge when we're above that band. The decision was made on, on these acquisitions not to hedge, the cash acquisitions. You know, regardless of, of what we do on, on hedging, it's not gonna encourage or discourage more activity.

It's really just to protect the returns that we underwrite, and that we feel like we had underwritten the returns in a manner such as didn't require the hedging support within that mid-cycle pricing band.

Noel Parks (Managing Director, CleanTech and E&P)

Okay, great. That's all for me.

Chris Conoscenti (CEO)

Thank you.

Operator (participant)

Thank you. There are no further questions registered at this time. With that, we will conclude today's call. Thank you for joining. You may now disconnect your lines. Have a great day.