Description

Falcon Minerals (NASDAQ:FLMN) represents an asymmetric opportunity to buy a mineral royalty interest owner with minimal leverage primarily in one of the leading oil basins in the world (the Eagle Ford) at a valuation that provides potential double-digit FCF yields in the current environment with room for significant valuation expansion potential driven by three main potential catalysts:

1. Potential closing of a ~30-50% market valuation discount relevant to comps

2. Near-term production growth from wells recently turned in line and a strong pipeline for the remainder of 2021

3. Renewed “ground-game” acquisition activity that should help the company grow its asset base over the next 12-24 months

Background

Falcon Minerals manages and acquires mineral royalty interests, primarily in the Eagle Ford in south Texas. Currently, FLMN owns ~2,132 producing wells and ~2,700 net royalty acres (NRA) primarily operated by premier operators including ConocoPhillips, BP and EOG Resources. 

Valuation

Falcon Mineral’s (FLMN) share price declined precipitously (-58%) in 2020 as a combination of macro events destabilized oil markets worldwide. The stock began and ended 2020 at $7.06 and $3.15, respectively. The share price has recovered well since its trough in the fourth quarter, currently trading at ~$4.76, but continues to lag its peer group and historical valuations given its forward production profile. It is currently trading at ~5.7x NTM TEV/Forward EBITDA whereas its median peer group is ~9.2x, implying a 30-50% discount and providing a potential catalyst for multiple expansion if the company delivers on its production guidance. 

In the first quarter, the company only averaged ~4,116 Boe/d of net production but saw significant activity by their operators. 1.23 net wells were turned in line (“TIL”) during the first quarter vs. 1.91 for all of 2020. Additionally, FLMN has ~2.04 net wells permitted and in active development. The company has communicated this level of activity should increase production by ~15-25% and could clear the 5,000 Boe/d threshold as early as the second quarter. At current prices, this would imply >$0.60 of FCF/share annualized, or a ~13% FCF yield. This FCF yield coupled with its historical payout ratio of ~90% would imply an 11.5% dividend yield. Current competitors are trading at a ~7% dividend yield, implying a potential fair value price >$7. It should be noted FLMN’s net realized price for oil during the first quarter was $56.69/bbl, and FCF yields should also be directly supported from current prices >$60. The chart below illustrates potential FCF yields according to production and WTI. As shown, FCF yields should be resilient across a range of production and price assumptions.  

*FCF yields are based on a share price of $4.76 and determined by internal models with a number of assumptions we believe to be reasonable.

“Falcon 2.0”

Management has become increasingly vocal about driving value to shareholders and recently announced its intent to restart its “ground-game” acquisition activity which could meaningfully increase production activity over the next 12-24 months. While current guidance is minimal, one of FLMN’s largest headwinds is its smaller size. We believe asset base growth through an effective ground game should be accretive. 

Risks

1) Falcon continues to miss production guidance

• Mitigant: Much of the recent well activity took place late in the first quarter, which should make immediate impacts in the second quarter

• Mitigant: As seen in the sensitivity analysis above, FCF yields should withstand a broad range of production rates and oil prices without going negative due to the minimal operating and financial leverage of the company

 2) Commodity Risk 

• Mitigant: Falcon Minerals is largely unlevered with Net Debt to LTM EBITDA of 1.44x (which is drastically inflated by poor LTM performance). It could be reasonably assumed this will drop back below 1.0x on a go-forward basis. 

• Mitigant: The royalty payment structure implies FLMN could be cash-flow positive all the way down to ~$10/bbl WTI

• Mitigant: FLMN has hedged ~1,096 Bbl/d for Q2 2021 at $57.85. Hedged volumes continue through 2021 at slightly lower levels

3) US drilling rates collapse again

• Mitigant: Lower drilling rates would hurt FLMN’s production growth going forward but would be supportive of oil price increases

• Mitigant: U.S. oil consumption should favor increased production as demand recovers from economic shutdowns

• Mitigant: FLMN experienced this environment throughout 2020 and demonstrated pronounced resilience, making distributions in all quarters

Conclusion

Despite a recent rally, we believe Falcon Minerals’ share price still poorly reflects the resiliency and growth opportunity baked into the business model. At ~$4.76/share, the company can reasonably be expected to achieve and sustain $0.55 to $0.65 cents of annual FCF in the current environment. Noteworthy competitors such as Blackstone Minerals and Brigham Minerals are trading at ~7% dividend yields, implying potential upside to >$7/share should those targets be reached. We believe management’s commitment to drive value to shareholders further supports an upside for the equity and presents a potential positive near-term catalyst. Assuming FLMN can generate $0.60 of FCF for the next two years and is valued at a 10% FCF yield implies a potential total return of ~50%.

Disclosures

1. I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.

2. Certain economic and market information may be published from other sources, may not be updated in a timely manner and are believed to be reliable. We do not assume responsibility for accuracy or completeness of information.

3. All information is as of 5/20/2021 unless stated otherwise. Information is subject to change. There is no expectation this post will be updated.

4. Not a recommendation for any security and should not be construed as investment advice, or as an offer to buy or sell securities.

5. This information is for informational purposes only.

6. Forward looking statements may not come to pass as described herein.

Catalyst

1. Potential closing of a ~30-50% market valuation discount relevant to comps

2. Near-term production growth from wells recently turned in line and a strong pipeline for the remainder of 2021

3. Renewed “ground-game” acquisition activity that should help the company grow its asset base over the next 12-24 months