PrairieSky Royalty Ltd. Reports Q2 2022 Earnings ($PREKF)

[Previously: PrairieSky Royalty Ltd. Reports Q1 2022 Earnings ($PREKF).]

Prairie Sky Royalty (PREKF, PSK.TO) is a pure-play royalty company, earning royalty revenue from oil and natural gas produced from their 18.5 million acres of royalty properties spanning Western Canada from Northeast British Columbia to Western Manitoba. They have the largest independently owned portfolio of fee simple mineral title and oil and gas royalty interests in Canada. 

The land that they own originally came from Canadian Pacific Railways, which was given a checkerboard pattern of land (25 million acres of land, including mineral rights) along its right-of-way from Winnipeg to British Columbia in exchange for building the road. Later, the railway created and spun-off Canadian Pacific Oil and Gas Limited, which became PanCanadian Petroleum Limited through a merger with Central Del Rio Oils Limited, and then Encana when PanCanadian merged with Alberta Energy Company. In 2014, Encana spun-off PrairieSky Royalty, which grew even further in 2015 when it acquired a substantial portion of Canadian Natural Resources's royalty assets. PrairieSky's total acreage has grown to 18.5 million acres from 5.2 million at IPO.

The IPO price of Prairie Sky was $28, and it now trades at $14 (figures in USD), having paid $6.085 of dividends to shareholders along the way. Management uses some of the royalty cash flows to repurchase stock, and they include an acreage per share metric in their investor presentations (pdf), showing that it has grown from 0.04 acre/share at IPO to almost 0.08 acre/share today, almost doubling the acreage per share in eight years. That means that an investor is currently paying less than $200 per mineral acre. 

The proved and probable reserves (2P) of hydrocarbon per share have held steady since the IPO:

The 2015 reserves (2P) were 0.3 MBOE per share and the figure for the end of 2021 was the same. The share count has increased since the IPO, despite repurchases, but the acreage has increased faster and the 2P reserves have increased just as fast. And the 2P reserves understate the amount of ultimately recoverable hydrocarbon since so much of the 18.5 million acres are undeveloped. (It is equal to 29,000 square miles which is about the size of Maine.)

The market capitalization of Prairie Sky (at $14 per share for the U.S. ADR) is $3.3 billion and the enterprise value with $277 million of net debt is $3.6 billion. The company just announced results (MD&A, financials) for the second quarter of 2022 (these figures are in CAD):

• Record average royalty production of 25,992 BOE per day, a 9% increase over Q1 2022 and 32% over Q2 2021 with oil royalty production reaching a record 12,220 barrels per day.
• Total revenues increased to $198.1 million, 42% over Q1 2022 and 184% over Q2 2021, comprised of royalty production revenues of $190.2 million and other revenues of $7.9 million.
• Generated record quarterly funds from operations of $159.6 million ($0.67 per common share basic and diluted), 52% above Q1 2022 and 182% above Q2 2021 driven by royalty production growth and strong commodity pricing.
• Declared a second quarter dividend of $28.7 million ($0.12 per common share), representing a payout ratio of 18%, with excess cash flow allocated to $15.6 million of royalty acquisitions and the balance to retiring bank debt.
• Net debt totaled $453.9 million, down 20% or $115.0 million from March 31, 2022 as excess funds from operations were used to retire indebtedness incurred in connection with acquisitions completed during the second half of 2021.
• PrairieSky completed $15.6 million of royalty acquisitions in the quarter adding approximately 360 BOE per day (86% natural gas) of incremental gross overriding royalties in Central Alberta and Northeast British Columbia, as well as adding undeveloped land in the Clearwater oil play.
  

Production of oil and gas per share declined from 120 BOE per million shares at IPO to 80 BOE per million at the low in Q2 2020, but keep in mind that this time period coincided precisely with a bear market in oil that saw a decline from $105/bbl in 2014 to almost nothing at that pandemic low. Now that there is a bull market in oil again, drilling activity on PrairieSky lands is increasing and production is recovering: 

The funds from operations of $160 million CAD is $125 million in USD. That is $500 million annualized, a 14% yield on the enterprise value. (The average WTI price during the quarter was $109/bbl, Edmonton Light Sweet Crude was $138/bbl, and AECO gas was $6.3 per mcf.)

The FFO/EV yield of 14% is very impressive considering how much of Prairie Sky's acreage is still undeveloped, and considering the quality of their capital allocation and corporate governance. Since the current earnings and FFO/EV yield are attractive enough to justify the current price, you are getting quite a lot of future production "for free". Stacking barrels.

Something that is obviously nice about a pure royalty business is that it virtually always makes money. Their worst quarter for funds from operations since January 2020 was the second quarter of 2020. They still had $21 million (CAD) of FFO that quarter. PrairieSky has 60 full time employees at their head office in Calgary. Their enterprise value is thus $60 million per employee, and their FFO is $8 million per employee.

On the Q2 conference call, there was discussion of capital allocation:

In terms of capital allocation, I know we increased the dividend in February by 33% and the debt repayments happening at a faster pace, just due to the strong pricing and the growing production volumes underlying that. We -- our priority is paying down the debt we view on the NCIB. We effectively, for the first time in our history, made an acquisition using leverage. And we use 2/3 leverage for that acquisition, $500 million in pretty low cost debt. And so I think our priority is paying that down and we view that as effectively prefunding the buyback. So that was effectively NCIB and now we're paying it down by returning the leverage. So I think when you look into the next time we review the dividend early next year, there's going to be continued strong cash flows. The debt targets will be retiring that at a faster pace and there'll be the opportunity for a significant increase at that point on the dividend.

Management projects that at $100/bbl WTI oil, $3.50/mcf AECO natural gas, and flat production (~24k DOE/d) that the company will generate $3.6 billion in funds from operations the next decade - equal to the current enterprise value.