PrairieSky Royalty: Trading At 16x FFO, I’m On The Sidelines (TSX:PSK:CA)

Introduction

I like oil and gas, and one of the lower-risk ways to have exposure to the prices of energy commodities is by buying royalty companies. Royalty companies tend to have a reasonably high up-front cost when they acquire new royalties but that’s a sunk cost and there usually are no follow-up investments required. This means that the net operating cash flow usually also is the net free cash flow. PrairieSky Royalty (TSX:PSK:CA) (OTCPK:PREKF) has a very extensive land position in Western Canada where it holds 18.1 million acres of land where oil and gas producers are operating on. PrairieSky has been trading at a premium valuation compared to its peers Freehold Royalties and Source Rock Royalties (SRR:CA) which I discussed previously here on Seeking Alpha so I wanted to check up on the company’s Q3 performance and how the lower oil price may have an impact on its cash flows going forward.

The cash keeps on gushing in

During the third quarter of this year, PrairieSky’s average daily production volume came in at just under 25,500 barrels of oil-equivalent per day, of which 47% consisted of oil, about 11% came from NGLs and natural gas accounted for approximately 42% of the oil-equivalent output.

The relatively high contribution from natural gas worked against the company in the third quarter as the average realized natural gas price dropped by in excess of 50% compared to the third quarter of last year (shown below).

While the realized prices of all sold products were lower than a year ago, in dollar terms, the natural gas price decrease had the most meaningful impact on PrairieSky’s consolidated results. As you can see below, the total revenue of the royalty operations decreased by almost C$19M and the natural gas price decrease accounted for 60% of that revenue decrease.

The total revenue came in at C$133.1M, and as you can see below, the depletion and depreciation expenses represent the majority of the total operating expenses. G&A expenses were relatively high as well, but this still resulted in an EBIT of almost C$77M.

The net finance expense remains pretty stable resulting in a pre-tax income of C$72M and a net profit of C$55.4M which represents an EPS of C$0.23 per share. Looking at the 9M 2023 results, total EPS was C$0.67 which was approximately 35% lower than the C$1.05 in EPS generated in the first nine months of 2022. The main culprit are the lower oil and gas prices as the average realized price per barrel of oil-equivalent in the first nine months of this year was just C$52.49 compared to almost C$70/boe in the first nine months of last year.

As the majority of the operating expenses are non-cash expenses, the cash flow statement is more important than the reported net income. As you can see below, PrairieSky reported an operating cash flow of C$93.8M before taking changes in the working capital position into account. We should also deduct the C$0.2M lease payments and end up with an adjusted operating cash flow of C$93.6M.

The total cash outflow related to the investing activities was approximately C$15.1M of which the majority was spent on exploration and the evaluation of acquisitions.

The company does not include these investments in its FFO calculation. Instead, it uses the C$93.8M in operating cash flow before working capital changes and before lease payments, and this represents C$0.39 per share. The FFO/share in the entire first nine months of the year was C$1.14, and as expected this represents a substantial decrease from the C$1.63/share in the first nine months of last year.

The company provides an interesting table with its anticipated cumulative FFO for the next decade based on different production rates and oil prices. As you can see below, at an average production rate of 26,000 boe/day, and assuming a long-term WTI oil price of $70/barrel, the company will generate approximately C$3.5B in FFO during those 10 years, which works out to C$350M per year on average.

Considering there are 239M shares outstanding, the FFO/share in that scenario would come in at C$1.46/share. However, if you would apply a long-term AECO natgas price of C$2.50, you would lose approximately C$0.08-0.10 per share per year.

If you are bullish on both natural gas and oil and assume an AECO nat gas price of C$4 and a WTI oil price of US$80, the annual FFO increases to C$410M or C$1.27 per share.

Investment thesis

PrairieSky Royalty is a very well-managed royalty company but I’m not sure the projected C$1.46/share in annual FFO is sufficiently appealing to pay just over C$23 per share. I currently have no position in PrairieSky Royalty as it’s trading at almost 16 times the anticipated FFO/share which is substantially higher than for instance Freehold Royalties (9 times FFO at US$70 WTI) and Source Rock Royalties (7 times FFO). I have a long position in those two companies but I remain on the sidelines for PrairieSky.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.