Description

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

1) Potential closing of ~30-60% market valuation discount to relevant comps (BSM, KRP, VNOM)

2) Production levels returning to historical averages (published new well activity in Jan/Feb alone provides indications this may be happening in real time)

3) Oil prices recovering from the recent lows driven by coronavirus concerns and the Saudi price war

Background: Falcon Minerals manages and acquires mineral rights royalty interests, primarily in the Eagle Ford in south Texas. Blackstone owns ~45% of the company (originally structured as a SPAC), and management owns 11%. Currently, FLMN has ~1,867 wells producing in the Eagle Ford, with “line of sight” on an additional ~220 wells that have been permitted to come online and produce additional revenue. Falcon claims their assets are “core-of-core”, with primarily “Tier One” operators (COP, BP/DVN, EOG) in Karnes, Dewitt, and Gonzales counties – the highest producing counties in the Eagle Ford – and significant undeveloped acreage.

Valuation: The company had already seen its share price cut in half prior to the coronavirus + Saudi price war volatility in oil in recent weeks, and is now down ~75% over the last year. Falcon Mineral’s total enterprise value is currently ~$240m with ~$40M of debt on a ~4.3% interest rate revolver, indicating a forecasted 2020 FCF Yield of ~15-20% based on the company’s range of production guidance and the current WTI strip. At ~3.7x EV/TTM EBITDA, FLMN appears to be trading at a 30-50% discount to comparable public companies, providing a potential catalyst for value creation if the company hits its production guidance and multiples expand or oil prices recover more quickly than the WTI strip currently projects. 

2020 Performance Expectations: The biggest question facing the company this year is whether it can meet its production guidance of 5,300-6,100 boe/d in 2020. The company has averaged ~6,300 boe/d of production over the past three years, but generated only ~4,850 boe/d in 2019 as high-performing wells were temporarily taken off-line by major operators and new well drilling was delayed at select sites, likely driving the negative performance of the stock. As referenced in the company's most recent earnings presentation, the 2020 production guidance is based upon ~3.5 net wells turned online in 2020, of which ~1.2 net wells have already come online in January/February alone, likely significantly increasing production near-term given the high initial decline rates of horizontal wells. As estimated below, the company has potential to generate attractive FCF yields at various levels of oil production and oil price recovery:

It’s important to emphasize the difference between royalty interest profitability and that of typical “working interests” owned by oil and gas producers. While many producers bear significant fixed operating costs and have “break-even” WTI oil prices in the $40-60/bbl range, royalty companies typically have minimal operating or financial leverage. As such, FLMN’s “break-even” WTI oil price is likely <$10/bbl from a FCF perspective.

Risks:  

• Falcon continues to miss production guidance 

• Mitigant: Management has provided multiple indicators of near-term catalysts that could drive production: 

• Temporary 2019 drilling disruptions were re-started in late 2019 and early 2020 

• New, line-of-sight wells for 2020 are ~35% higher than the company’s four-year trailing average, and >30% of 2020 guidance has already come online in the first two months of the year

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

• Commodity/ ”go-to-zero” risk

• Mitigant: Falcon Minerals is largely unlevered with Net Debt to LTM EBITDA of 0.76x and effectively zero CapEx requirements

• Mitigant: The royalty payment/economic structure implies that FLMN would be cash-flow positive all the way down to ~$10/bbl WTI, implying that a US oil production collapse would be required to cause the company to lose money 

• Gas exposure: ~30% of FLMN’s BOE/d production is gas, one of the most volatile commodity prices

• Mitigant: Gas contributes ~2% of Falcon’s revenue, making it largely irrelevant to the company's forward performance

• US drilling rates collapse

• Mitigant: Lower drilling rates would hurt FLMN’s production growth going forward, but would likely be highly supportive of a broader oil price recovery once the demand shock of the corona virus has subsided

• Mitigant: The Eagle Ford basin is estimated to be one of the lowest “break-even” oil price basins in the world, meaning that it’d likely be near “last in line” to cut drilling if oil prices remain stressed

Conclusion: Current market conditions have created an opportunistic valuation to buy into a healthy royalty and mineral interest company with “Tier One” operators in a high-quality basin for a relatively and fundamentally cheap valuation. With no valuation expansion, production at the lower end of guidance, and oil recovering with the strip in 2021-2022, FLMN should generate ~15% average annual returns from cash flow, with an additional ~30-60% return possible if the company’s multiple expands closer to market comps and/or oil prices recover to late 2019 levels.

Catalyst

Simply repeating the catalysts identified above here:

1) Closing of ~30-60% market valuation discount to relevant comps (BSM, KRP, VNOM)

2) Production levels returning to historical averages (published new well activity in Jan/Feb alone provides indications this may be happening in real time)

3) Oil prices recovering from the recent lows driven by coronavirus concerns and the Saudi price war