Sitio Royalties Corp.NYSE:STR) is an oil royalty company that has taken several steps to reduce the cost of its debt and increase cash flow available to shareholders. The company refinanced its high-interest senior notes due in 2026 while selling its Anadarko and Marcellus assets to repay its debt. Through these actions, the company could directly save more than $20 million per year in reduced interest costs.
Operationally, the company is expected to achieve revenue growth through increased activity in the DJ pool. Permitting activity was strong in the fourth quarter and this momentum has continued into the first quarter so far. The combination of cost reductions and increased revenue should offset the effect of lower energy prices and support a minimum return of 8.5% at current prices.
I previously covered STR in June 2023 with a MAINTAIN rating. After a 20% share price decline, the company fell well below my previously stated buy threshold of $24.25/share. With an improved track record, I upgraded STR to BUY.
The balance sheet continues to strengthen
On November 3, STR agreed to sell its assets in the Appalachian and Anadarko basins for $117.5 million. The combined revenue contribution from these assets was $3.8 million in the third quarter, compared to total revenue of $152.8 million as a whole for STR. Using the third quarter band, this sales price equates to 7.73x annualized revenue. Energy prices in the third quarter are what I consider to be above the long-term average. This would imply that the sales multiple would probably be slightly better than this figure, or even 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. (AAPL) stock and well above that of Exxon Mobil Corporation (XOM) or Diamondback Energy, Inc. (FANG) .
During the third quarter conference call, STR said it plans to allocate these funds to debt reduction with the goal of achieving its leverage target of <1.0x debt to EBITDA. CEO Chris Conoscenti provided the following context on the transaction.
In total, for the third quarter of 2023, Appalachia and Anadarko only contributed 0.4 net wells out of 9.5. This compares to the total figure for the Appalachia and Anadarko wells of 0.1 of 8.1 in the second quarter of 2023. The divestiture takes effect September 1 and is expected to be finalized near the end of the year. Pro forma for this divestiture, our total debt as of November 3 would be approximately $864 million, and our liquidity under our reserve-based loan would be approximately $588 million, assuming a borrowing base stable at $850 million.
Total debt before this transaction was $979 million. The average interest rate for the Sitio revolving credit facility was 8.42% at the end of the third quarter. Applying this repayment to the credit facility will result in interest expense reductions of approximately $9.7 million per year.
Given that this transaction represents less than 2.5% of the company's total revenue and its drilling activity is marginal, I consider this transaction an overall win.
Refinancing of the 2026 Senior Bonds
In addition to the savings from the Appalachia/Anadarko transaction, the company also refinanced its 2026 senior notes, which were among its highest interest rate debt. The company estimated that this transaction would generate savings of more than $11 million per year.
This refinancing, coupled with previously announced debt reductions, will more than replace lost revenue from the Appalachia/Anadarko sale while also freeing up additional FCF.
Activity in the DJ pool 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 land area. In the third quarter, STR saw a considerable increase in activity from this pool, as detailed by the company's CEO.
We estimate that during the third quarter, 9.5 net wells came online across our assets, representing 72% and 19% of overall activity in the Permian and DJ basins, respectively. This is a change from second quarter activity where 87% of our wells online were in the Permian Basin and there was minimal activity on our DJ Basin assets.
Based on activity authorizations, I anticipate activity levels will continue to increase outside of DJ for STR. Since the start of the fourth quarter, 244 wells have been approved. This is a big increase from 56 in the third quarter and 153 in the second quarter of 2023. I took a sample of 15 of the largest permitted multi-well sites and laid them out using Google Earth. In the image below, I've combined this map with the STR asset map to show that recent activity coincides with areas of STR asset exploitation.
Activities authorized in the DJ pool can be easily found on the COGCC website.
Continued production growth on the STR property coincides with the growth trajectory outlined by management during the third quarter conference call.
The line-of-sight inventory of 50.9 net wells or 50.2 pro forma for the divestiture we announced represents a healthy volume of line-of-sight wells. When we look at our wells needed to maintain stable production across our asset base, we see the number of net wells per quarter in the high single digit range. And so, at 50.2, it's above that high number per quarter. On average, if these wells come online in the next 12 to 16 months. This therefore implies a certain growth compared to the current situation.
As a royalty company, STR's dividends are strongly linked to energy prices. As a result, the company uses a variable dividend model that allocates 65% of FCF to fund the dividend.
About 85% of STR's revenue comes from crude oil sales. Based on the current WTI strip, the fourth and first quarter payouts are expected to be slightly lower than the $0.49/share paid in the third quarter. WTI averaged $78.41/barrel in Q4. This will correspond to a fourth quarter dividend of between $0.46/share and $0.47/share.
Energy prices have continued to decline through the first five weeks of 2024 and, barring major improvement, are expected to trend toward $0.44/share assuming a going rate of $74/barrel. Despite this decline, the current share price supports an 8.5% return to $74/barrel through 2024.
Under its dividend program, the remaining 35% of free cash flow goes toward maintaining the balance sheet. This will provide the company with enough capital to continue reducing interest costs and growing the dividend in the long term.
The correlation between STR stock price and WTI is very strong, as shown in the price chart below. Inevitably, this will make the STR stock price volatile. Operationally, part of this risk is managed by the company through hedging.
In the fourth quarter, the company hedged 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.
Its natural gas hedges are also significantly higher than the current band, but also only cover about 18% of the current production rate. These hedges will help mitigate the decline in energy prices the market has seen so far in 2024, but the protection is limited due to the lack of volume.
Buying during low points in the energy cycle will help investors protect against capital losses. The price chart above shows that the STR stock price is disconnected from the current WTI price. The STR stock price is near a two-year low and so I view the company's performance as an asymmetric bet at current prices.
Sitio Royalties divested its assets in the Appalachian and Anadarko basins to improve its balance sheet with minimal impact on daily operations. This move, coupled with refinancing activities, is expected to save the company more than $20 million per year in interest costs and improve FCF.
Operationally, the Company is positioned to continue to experience increased activity across its DJ Basin assets, as demonstrated by high levels of permitting activity. The locations of these permitted wells correspond well to existing STR assets.
The projected dividend at an average WTI price of $74/barrel will allow investors to earn a yield of 8.5% at the current stock price.
The STR stock price is directly correlated to WTI prices and therefore a high degree of volatility should be expected. The company addresses this risk in part through low volume, high value hedges. After a 20% share price decline, I believe STR is oversold and currently offers an attractive entry opportunity. I consider STR a BUY.