Sitio Royalties (STR) Notes from CS - Aug 1

[dan_s]

Notes below are from Credit Suisse Equity Research Team

Sitio Royalties (STR): Catching up on the story… In January, Falcon Minerals (FLMN) announced a $1.9 billion all-stock merger with Desert Peak Minerals (Private). In addition, following the completion of the merger on 6/7 the combined company rebranded as Sitio Royalties (NYSE: STR). We view the merger as transformative, adding scale and significant diversification into the Permian Basin.

The combined company is now led by the former Desert Peak management team, which was successful in nearly doubling the size of its acreage footprint in 2021 via the acquisition of Rock Ridge and Source Minerals (pre-merger). Since the merger closed STR has remained on offence, announcing the accretive acquisition of Foundation and Momentum Minerals assets on 6/27 (less than 3 weeks after the merger closed) for $547 million; these all-cash acquisitions boost STR's Permian footprint by 30% and are expected to increase its 2H22 quarterly dividends by 15%.

On a pro forma, basis STR now offers exposure to 1 in 4 wells drilled in the Permian. Strong execution on consolidation strategy key to differentiating STR vs mineral peers. STR management has clearly articulated a strategy focused on returning a majority of cash to shareholders via a quarterly variable dividend equal to 65% of cash available. The residual 35% retained cash is expected to help partly fund accretive large-scale acquisitions aimed at increasing the company's scale, enhancing near-term production visibility (i.e. increasing its DUC and permit backlogs), complementing existing asset quality, and putting downward pressure on its fixed cost structure.

Over time, we expect STR to use a mix of retained cash and equity to fund deals with a focus on Permian exposure / the low end of the cost curve. Moreover, given its first deal as a public company was all-cash, we expect retained cash to go toward bringing leverage back below 1.5x and that near-term any/all large deals would need to be mostly equity-funded. Using current strip we forecast STR's leverage to improve to 1.6x/0.9x at YE22/YE23 vs mineral peers at ~0.4x/0.4x (not comparable to E&Ps given minerals have no required/maintenance capex).

Additional details

Sponsor sell down a near-term headwind. The two large-scale deals Desert Peak
completed in 2021 were entities sponsored by Blackstone and Oaktree, and following the
merger these sponsors own 26.9% and 15.4% of the combined company. In addition,
Desert Peak's founding sponsor Kimmeridge owns 43.3% of shares outstanding.
Importantly, we expect Kimmeridge to be a patient shareholder. Over time, we expect
future large-scale acquisitions and sponsor sell down to help alleviate the overhang, while
we believe STR remains open to potentially buying back shares via block trades (similar to
what MGY has done with EnerVest). That said, we believe share repurchases are likely off
the table near-term following its recent all-cash acquisition of Foundation & Momentum
Minerals.

2Q Earnings: Messy quarter with stale consensus. For 2Q22 STR will officially report
results reflecting a full quarter of legacy Desert Peak along with 24 days of Falcon Minerals
(June 7th through the 30th). However, we expect STR to pay out a 2Q dividend equal to
65% of cash generated by the combined company for the full quarter. On a fully combined
basis, we forecast STR generated 2Q CFPS of $0.91 and expect it to pay out a
$0.59/share dividend.