Sitio Royalties Corp.

Good morning and thank you for joining the CTO 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 two. 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 thanks operator and good morning everyone welcome to the city of royalty's second quarter 2023 earnings call if you don't already have a copy of a recent press release and updated investor presentation please visit our website at www.cityo.com or you will find them in our investor relations section With me today to discuss second quarter 2023 financial and operating results is Chris Conocenti, our chief executive officer, Kerry Osika, 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. And with that, I will turn the call over to Chris.

Thanks, Ross. Good morning, everyone, and thank you for joining CTO's second quarter 2023 earnings call. Following a quiet first quarter of this year, we are excited to share some success we have 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 Citio 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 had 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 seven times next 12-month 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 7 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, CITIO'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 CITIO'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 CTO'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 June 30th. 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 Eagleford, 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.

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 timeframe 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, and 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, ducks in the Permian are down by 73 from 930 to 857 between March and June of 2023, and are at their lowest level since July of 2014. This quarter-over-quarter drawdown of 73 ducks is the lowest amount since the duck drawdown began in the fall of 2020 when there was an average change of 384 ducks a quarter. There were 3,519 ducks at the peak of the duck buildup in July of 2020, so the current level of 857 ducks is nearly a quarter of that high mark. These data points give us confidence that the duck 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 duck 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 CDO's financial results and second half 2023 guidance. 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 half a million dollars, 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 SOCR rates. Our board declared a dividend of 40 cents per share of Class A common stock for the second quarter, which will be paid on August 31st to record holders at the close of business on August 18th. This dividend is down by 10 cents 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 1.5 cents per share higher than it otherwise would have been due to the inclusion of a full quarter of cash flow from the stock acquisition 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 first 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 August 7th, we had an outstanding revolver balance of $605 million. We are issuing new operational and financial guidance for the second 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 to 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 to 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 rates to shift back to the normal 11 to 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.

Thank you. If you would like to ask a question, you may do so by pressing Start followed by 1 on your telephone keypad. To revoke your question, please press Start followed by 2. When preparing for your question, please ensure your phone is unmuted locally. Our first question comes from Tim Redsvan from KeyBank Capital Markets. Your line is now open, Tim. Please go ahead.

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

Yeah, good morning, Tim. Thanks for the question. So good news is we're not seeing any degradation in timing for SPUD to turn in line or permit 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 35,500 DOEs per day. And if you just look at that relative to the first half of the year and ask yourself what would you have to believe for the back half of the year, you'd have to see greater than 5% growth In the back half of the year and on the base asset, we just, you know, 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. So, 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 seven times next 12 months cash flow. So, a lot to be excited about around the acquisitions and filling in some more growth in the back half of the year.

Okay. I appreciate the context. And then I was just 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 management and the board has been thinking about. So just curious kind of what your thoughts are on that potential for CITIO in the future.

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

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

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

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

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. So it was a meaningful deal, but I wouldn't call it large. Large for us gets north of a few hundred million dollars. So we would characterize all these individually as relatively small, but impactful, as you can see from the accretion and the valuation 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 a billion dollars or larger there's I would say there's a couple dozen for the ones that are 500 million to a billion range there you're talking literally dozens and dozens so 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 past three months these were Several of these were ones where we'd been talking to the owners for upwards of four years. So these relationships take a long time to cultivate, and we have to find that right time when the seller is ready and when the valuation is right for us. So in terms of the competitive dynamic, obviously we see the most heated competition in those situations that are broadly auctioned. And that's why we have very, very limited success 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, etc. So we continue to focus there. We do look at some of these auctions, but we have been unsuccessful this year 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. So we're gonna continue to focus on the relationship-based approach.

Okay, makes sense. I guess just lastly on the tax guidance, Maybe just a little color 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?

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

that's correct chris we we will still have state income tax and margin tax but uh but other than that yeah we don't expect to be paying federal taxes um significant payments until next year again okay um 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 um

You mentioned that rigs on your acreage have held in better than kind of what we've seen on some of the headline numbers. So your rigs are holding in about flat. Just to be clear, your assumptions kind of driving the production range is assuming that rig activity on your acreage normalizes closer to what some of the clients have 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 duct drawdowns. Am I framing that right?

I'll make a couple comments there and ask Jared 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 and what basins those rigs are active. And so, you know, a well in Appalachia is going to be a different impact than a well in the heart of the Midland Basin. So, a few key things to pay attention to there. But 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.

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 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 concentration of our acres in that growth footprint is towards the fairways of the basin. So 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. So when we think about the macro backdrop, you know, we don't believe that we're going to get, you know, zero effect of the macro backdrop, but we think we'll be, you know, not directly correlated to what's happening in the rig count.

Okay. No, that makes sense. Thank you.

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

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?

Good morning, Nathan. Thanks for the question. the uh 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 uh our underwriting standards remain the same regardless of the commodity price environment got it uh thanks and uh for my follow-up

Regarding return of capital, can you discuss some of your considerations when you're assessing the right longer-term mix now that your unsecured notes have been amended?

That's a good question. We did have some success with our unsecured note holders in securing an amendment that would allow us to buy back $25 million of stock above and beyond our 65% dividend payout. Our board has not yet authorized a buyback program. We're watching closely on the stock's behavior to see what the right timing is. But the other thing we think about in that context is our leverage and liquidity. And as you can see from the last six 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. So 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.

Thanks, Chris. I appreciate it, Taylor. Thanks, Nathan.

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

Hi. Good morning.

Hey, Noel.

So with the acquisitions, is it safe to assume that they fall sort of in your sweet spot of A little additional overhead for the new assets and hopefully some leasing opportunities for the mineral.

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. And yes, we do expect subsequent leasing opportunities on these assets like we see with all of our acquisitions.

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

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. Now, 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. So 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. So, occasionally we see opportunities like that, but more frequently we see that at the larger end of the deal spectrum. Got it.

And just sort of a more general question. I feel like I've been hearing generally more optimism about gas takeaway in the Permian. that easing has a potential issue that may thwart drilling activity or turn in line activity. I was wondering if you had any perspective on that.

We do. If you look at the response that the gas market has had to infrastructure build out, it's encouraging just when you look at Waha differentials. So if you look at projects that are already underway with the Whistler expansion, Permian Highway, with Matterhorn getting FID'd, and another project, you have upwards of 3.6 BCF per day of new capacity coming on over the next year, year and a half. And so 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. But we're very, very fortunate in West Texas and Southeast New Mexico to have a much more constructive regulatory environment.

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

So 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 to $75. 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 approach we take is to consider it when we're in that band and then definitively to hedge when we're above that band. but the decision was made on these acquisitions not to hedge the cash acquisitions. Regardless of what we do on hedging, it's not going to 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.

Okay, great. That's all for me.

Thank you.

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