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Welcome to Episode 52 of Special Situation Investing.
Back in Q1 of 2021, the 13F filing of Oaktree Capital, the firm led by renown investor Howard Marks, revealed a new stake in Chesapeake Energy (CHK). The purchase caught our attention because it was, first, an energy company, and second, because it was so large it became the top holding in Oaktree’s fund. Clearly Howard Marks had conviction about this investment. Over the last two years that conviction paid off as Chesapeake Energy has more than doubled.
Having watched that episode playout from the sidelines, it’s easy to regret not jumping in on the play after seeing a great investor display such conviction…and then watching the stock’s price double. But since we didn’t understand the company at the time, we chose to remain inside our circle of competence and take a pass. Although copying the moves of great investors, or “cloning” as Monish Pabrai puts it, is a legitimate strategy and one we often employ, blindly cloning is never wise.
That brings us to today. In Oaktree’s most recent Form 13F, it revealed a $285 million stake in Sitio Royalties (STR). While the investment didn’t steal the top spot in Marks’ fund, it did jump to spot number six; once again revealing high conviction.
Since royalty companies are one of our favorite business models and since we don’t want to risk the potential for a repeat of the episode with Chesapeake Energy, we decided to investigate Sitio Royalties and make it the topic of today’s episode.
So let’s dive in.
The Business
Sitio Royalties Corp is an oil and gas royalty and minerals company. The company’s stated goal is to grow shareholder value through large-scale consolidation of high-quality oil and gas mineral and royalty interests across premium basins.
Sitio’s history, although quite short, does support the argument that the company has had a healthy measure of success.
The company, founded in 2016, was originally called Osprey Energy Acquisition Corp. As a blank check company, the business plan was to grow via acquisition, merger, and other similar transactions as it consolidated the highly fragmented gas and oil minerals sector. From 2016 through 2022, the company acquired net royalty acres (NRAs) in private transactions and along the way changed its name to Desert Peak Minerals. In June of 2022, Desert Peak Minerals went public through a reverse merger with Falcon Minerals and simultaneously renamed itself Sitio Royalties Corp. Since then, Sitio’s had a busy second half of the year. Just after its reverse merger, the company announced a $550 million purchase of additional net royalty acres. A couple months later it initiated its first divided. And finally, in September, the company announced the acquisition of one of its peer royalty companies, Brigham Minerals, Inc.
The merger with Brigham Minerals is the latest milestone in the company’s quick-paced, large-scale acquisition strategy.
Merger Details
On September 6th, Sitio announced it had enter into an agreement to merge with Brigham Minerals. The merger is structured as an all-stock transaction where Sitio acquires 100% of Brigham and its slatted to close in Q1 of 2023.
The merger has been approved by the boards of directors of both Sitio and Brigham. In the case of Sitio, funds managed by Kimmeridge, Blackstone and Oaktree, which own 43.5%, 24.8% and 15.4% of the outstanding shares of Sitio, respectively, have voiced their approval of the transaction as well. So the likelihood of the merger being executed is high.
As Sitio will be the acquirer, the deal does seem to slightly favor Sitio’s shareholders over those of Brigham. Brigham shareholders will receive 1.133 common shares of the combined company for each common share of Brigham owned on the closing date and Sitio’s shareholders will receive one share in the combined company for each common share of Sitio owned on the closing date. At the conclusion of the at-the-market transaction, previous Sitio shareholders are projected to own 54% of the combined company compared to the 46% owned by the previous Brigham shareholders. In addition, of the nine total directors for the new company, five will be nominated by Sitio and four nominated by Brigham.
The new company will also be run by the executive team of Sitio. During that company’s latest quarterly call, the CEO, Chris Conoscenti, stated that they are in the process of evaluating Brigham’s team and inviting certain members to join the combined company. At that time, 14 individuals were identified as planning to transition from Brigham to the new Sitio. That would bring the total head count for the new company to 49 employees.
Merger Goals
Since its founding, Sitio has pursued its plan of growth through acquisition and consolidation with the belief that greater size would allow greater efficiency and greater, what they call, “investability.” In the latest quarterly call Conoscenti reiterated that the goal of the Brigham merger is just a continuation of this theme. Early in his prepared remarks he touted that the deal would add “additional high quality assets” to Sitio’s portfolio, “reduce their leverage statistics,” and also “increase the company’s public float.” Later during the call, in response to a question, he said: “its not size for size sake. It’s really size for efficiency sake.”
So if that’s the case, let’s take a look at what the company is projected to look like post merger.
The New Sitio Royalties
After the merger’s announcement, many analysts wrote articles claiming the future combined company would be the largest publicly traded mineral and royalty company in the United States. While that claim depends on what metric is used to measure size, it is unquestionable that the new Sitio will be a top-tier company in the royalty and mineral space. Here’s a list of data points on the new company:
Depending on stock prices when the merger closes, the combined company’s market cap will likely be in the ballpark of a $5 billion. This puts it behind Texas Pacific Land (currently at $20 billion) and barely behind Viper Energy (at $5.4 billion).
The combined company’s asset portfolio will total approximately 260,000 (259,510) net royalty acres (NRAs). That places its third behind both Viper Energy and Kimball Royalty Partners.
Of its total net royalty acreage, 182,500 NRAs will be focused in the Permian Basin. This will give the company access to approximately 32% of the total Permian Basin acreage and exposure to more than 34% of all the wells drilled in that basin in 2021. But even while the majority of its NRAs will be located in the low-cost Permian Basin, the company will also have the benefit of basin diversification as the remainder of its NRAs will be spread across the Eagle Ford, Williston, DJ, Anadarko, PRB and Uinta Basins.
The merger will increase Sitio’s public float by a factor of 5.8 times, from approximately $320 million to approximately $1.9 billion (based on Sitio’s share closing price as of September 2, 2022). This is what the CEO means by becoming more “investable” as this could drastically increase the number and size of potential shareholders.
The all-stock merger will reduce Sitio’s pro forma 2022 2Q leverage ratio from 1.4x to approximately 1.0x on a net debt to adjusted EBITDA basis. Sitio’s CEO commented during the company’s latest quarterly call that the priority use for excess cashflow for the time being is to pay down its debt even further. He also set the expectation that in their efforts to pay down debt, any possible acquisitions for the near term would likely be funded via all-stock transactions.
Combining the two companies will also create $15 million in annual operational cost synergies and will reduce Sitio’s G&A per Boe cost by 19% to approximately $1.72 (on a 2Q 2022 pro forma basis). By this metric, compared to its peers, the post merger Sitio will rank third. Only Viper Energy and TPL will have lower G&A costs per Boe.
The new company will have a balanced capital allocation framework that prioritizes return of capital to shareholders and is in line with Sitio’s current framework. This means the company will have a minimum 65% payout ratio. The remaining cashflow will be utilized for balance sheet management and to fund cash acquisitions.
Sitio’s latest investor presentation provided a handful of helpful chart, shown below, that help visualize some of these data points and how the company will compare to its peers, post merger.
The Company’s Valuation
In terms of valuation on a dollar per NRA basis, both Sitio and Brigham trade middle-of-the-pack in relation to their peers, but well below other Permian-Basin-focused peers, namely TPL and Viper Energy.
The table above compares both Brigham and Sitio as separate companies and as a combined company to their peers. It shows that new Sitio will likely be valued at approximately $18,111/NRA, while TPL and Viper Energy are priced 5.9 and 11.4 times higher.
Concluding Thoughts
In conclusion, Sitio Royalties appears set up to continue to meet its goal of growing shareholder value by being a major consolidator in the oil and gas mineral and royalty sector. At the closure its newest announced merger with Brigham Minerals, Sitio will be one of the biggest minerals and royalties companies with the majority of its NRAs positioned in the top U.S. oil basin. This situation doesn’t appear to offer any arbitrage due to the merger, but does create a very solid company supported by the investments of renown investors. Neither hosts of this podcast own Sitio at the time of this episode, and we tend to think there are better plays in the oil and gas royalty space namely TPL, and possibly PHX. (If your surprised by our preference for TPL, given its sky-high dollar per NRA valuation, listen to Episode 16 and Episode 30 for details on our thesis.)
Alright, as we wrap this up, a few more general concluding thoughts.
If one, after doing their own in depth research on this situation, were inclined to invest in Sitio, it could be done at any point prior to the merger by buying either Sitio of Brigham. Remember to take into account that post merger, current Sitio and current Brigham shareholders, respectively, will have 54% and 46% stakes in the new company.
Also, take into account that a few institutions have large stakes in Sitio and will subsequently have large stakes in the combined company. Before investing in a company where this is the case its worth considering the likely exit strategies of those institutional shareholders. Are they likely long-term holders or not?
Okay, that concludes Episode 52 of Special Situation Investing. We hope you found this research valuable and helpful in your own investment journey.
Remember, you can access transcripts for each of these episodes, as well as additional material not on any podcast, by subscribing to our Substack at specialsituationinvesting.substack.com.
SUBSTACK-ONLY BONUS
A couple books that the two of have read and that we highly recommend for improving your investing skills, are Warren Buffett’s Ground Rules by Jeremy Miller and Blood in the Streets by James Dale Davidson.
For investors such as all of us, it’s so true that education has no graduation.
Sitio Royalties, Brigham Minerals merger (STR)