Sitio Royalties Corp

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

Sitio Royalties Corp. is a company focused on acquiring and managing mineral and royalty interests, predominantly in the US oil and gas industry.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview & Moat Assessment:

Sitio Royalties is not a traditional oil and gas producer; rather, it operates as a pure-play mineral and royalty interest company. This means they own the mineral rights underlying oil and natural gas properties, and collect royalties from the energy producers that extract those resources. Their primary revenue is derived from these royalties, which are based on a percentage of production revenues generated by the operating companies and calculated over the life of the wells.

The company’s business is primarily dependent on (1) commodity prices (2) oil and gas production volumes on their properties, and (3) the amount of the well costs and royalty burden they have. Let’s delve into why their economic moat is a 2 out of 5:

Moat Strengths:

  • Asset-Light Business Model: Sitio Royalties benefits from an asset-light business model. Unlike operating companies, they don’t bear the risk of exploration, development, and operations. There are minimal capital expenditure requirements since their role is largely passive, relying on the activities of other operators. As long as these companies extract from the ground, Sitio will receive the royalties
  • Geographically Diversified Acreage: Sitio’s portfolio covers large, proven onshore basins in the US, providing some degree of diversification in their cash flows. The basins include Permian, DJ, and Anadarko which provide long-lasting diversified production.
  • Contractual Revenue: Their revenue is contractual and structured to provide cash flows over long durations, with little operational risks.

Moat Weaknesses:

  • Price Takers: Sitio’s revenues are almost entirely driven by prices for the commodities and therefore they are price takers. They have no pricing power.
  • Lack of Control over Production: The Company has no control over production volumes, as they are entirely reliant on the activity of the energy companies operating on their land. They also have little control over how quick they extract from their lands.
  • Reliance on Economic Activity: The oil and gas industry is cyclical and depends heavily on macroeconomic forces that are difficult to predict (such as the overall demand of oil, gas prices, etc.)
  • Limited Differentiation: Mineral rights in a given region are generally similar, thus, limiting differentiation. However, the larger portfolio, compared to a smaller portfolio, provides some level of differentiation.

Moat Rating: 2 / 5. While the asset-light model and diversified portfolio are significant advantages, their dependence on commodity prices and lack of control over operating volumes significantly limit moat protection. The lack of barriers to other investors from making offers for mineral rights means they have little control over the pricing of their assets.

Business Resilience & Risks to the Moat:

Legitimate Risks to the Moat:

  • Commodity Price Volatility: A major risk is that their business is dependent on volatile oil and gas prices, which are impacted by supply/demand changes, geopolitical events, and global economic conditions.
  • Production Declines: Reduced production volumes from existing wells or failure of oil/gas exploration and development efforts by operators on their land will directly translate to reduced royalty income. This can be caused by poor drilling results, lower prices, reduced exploration by the oil companies on their land.
  • Regulatory and Political Risks: Regulatory changes, environmental policies, and political developments that affect oil and gas production or that disincentivize them represent significant risks.
  • Operator Bankruptcy and Defaults: If the operators on their lands go bankrupt or default on contractual obligations, that would reduce their revenue streams, or their business might take over operations, which will increase their risks. This is a risk, but it rarely happens.
  • Lack of Diversification in Investments and Limited Control: Diversification is crucial, even if they have a diversified geography of their lands; however, most of their eggs are in one basket (oil and gas). And they have limited control over production levels, as they are controlled by the operating companies.

Business Resilience:

  • Low cost structure: By having a royalty focused model with no operating expenses, it has a good cushion for volatility.
  • Geographic Diversification: Having a large diversified land portfolio in the USA limits its exposure to a single area of production decline.
  • Long Duration Revenues: Their revenue contracts tend to be for a very long duration, providing stable revenues for the long term.

Business Details:

  • Revenue Distribution: Sitio’s revenue is overwhelmingly driven by royalty interests on oil and natural gas production.
  • Industry Trends: The oil and gas industry is currently experiencing significant volatility due to geopolitical uncertainties and demand swings. While high prices boost profits, the industry is still very cyclical and dependent on economic factors.
  • Competitive Landscape: Sitio competes within the fragmented market of other royalty and mineral interest owners, as well as operating oil and gas companies. The companies that operate the lands themselves have direct control over operations and cashflows while Sitio must rely on the companies. They also compete with private equity and hedge funds that have the capital to compete with deals.
  • Company Differentiation: Sitio’s business model focuses solely on acquiring and managing mineral and royalty interests, distinguishing it from operating companies. Their ability to identify strategic acquisitions and structure deals in a way that maximizes long-term value, with a specialized management team, is where the differentiation comes from.

Financial Overview

Income Statement:

  • Sitio’s revenues are linked to production volumes and commodity prices. For 2023, revenues were $809.1 million, compared to $666.2 million in 2022. 2023 has seen relatively high prices compared to 2022.
  • The company is very efficient, so they have low operating expenses and general & administrative expenses. Operating expenses were $197.4 million in 2023, increasing from $124.8 million in 2022 due to acquisitions made.
  • The Company has consistently grown its revenues and profitability; however, the growth depends on the current price. It’s also important to realize these are not “real profits”, as they do not reflect the long term costs that would come into play to maintain operations (like exploration, and R&D) - something oil companies would have.
  • Adjusted EBITDA has risen to $771 million, from $577 million in 2022.
  • Net income was $456.5 million, up from $361.5 million.

Balance Sheet Health: 4/5

  • Strengths:
  • Sitio has a reasonable amount of cash and cash equivalents ($429.4 million), and manageable levels of debt on a relative basis to its equity, which totaled $11.3 billion.
  • They have been generating positive free cash flows.
  • Risks:
  • Their debt levels can fluctuate depending on their acquisitions. They had $3.8 billion in debt at the end of 2023. Although, it has been decreasing and they are managing debt effectively. * Their assets are intangible, making it hard to ascertain a true value.

Understandability Rating: 3 / 5 While the business model itself is simple to understand (collecting royalties on oil and gas production), the impact of industry cycles, commodity pricing fluctuations, and accounting intricacies make it somewhat complex. Furthermore, having a decent understanding of what ROIC is required to value the company effectively is essential. The complexity in determining value puts the understandability rating at a 3.

Recent Concerns/Controversies & Management Commentary

  • Merger with Brigham: The merger with Brigham in December 2022 was a big step for the Company. Integration of this merger has had an influence on its earnings as well. However, management has been very positive on synergies created.
  • Commodity Price Fluctuations: Management acknowledged the volatility in the market environment, and they believe that their diversification and hedging policies offer stability. They are not expecting the prices to rise as high, they are expected to decline, and they should be prepared for volatility as price moves downwards.
  • Production Volatility: While production has been robust for the past few years, management focuses on maintaining a stable and reliable asset base, emphasizing long term production over chasing short-term growth, which may not be prudent or value additive.
  • Financial Health: Overall, the management teams focus on using adjusted EBITDA or the free cash flow metric to value its growth and acquisitions and it believes it has the financial strength to deal with its debt.

In Conclusion Sitio Royalties is a company that has several things going for them but at the same time are quite vulnerable in case oil and gas prices drop. The focus should be on how management plans to perform while prices are low, if there is an opportunity or if the company can create value if it had a low oil and gas price. It seems like the company knows it can’t control much, so they want to make the most from their land when companies are willing to extract from it. This is a company that will do well in times of growth, but its resilience is somewhat tested when things aren’t going its way.