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Inflation Protection Model Portfolio

Portfolio Update: May 14, 2024

Publication date: May 14, 2024

Current portfolio holdings

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Executive summary

• No changes to the portfolio with this update. The Inflation Protection Portfolio is performing well half-way through the month as the stock market recovers from a difficult April.

• We are writing to provide an update on Permian Resources (PR), which reported earnings last week.

• PR is a relatively smaller and presumably less familiar portfolio position but is appealing on multiple levels as an oil and gas play: asset quality, management strength, valuation, dividend policy and takeout potential.  

• Our comparatively low 5% portfolio allocation is driven by risk management (since PR is a smaller, more concentrated business) as opposed to lower conviction.

Portfolio discussion

The Inflation Protection Model Portfolio is performing well two weeks into the month, generating a total month-to-date return of 5.5% on a weighted average basis. This compares with a 4.2% return for the S&P 500.

Notable movers thus far include WESCO International (WCC), which has advanced 18%, and Floor & Decor (FND), up 12%. Both positions performed quite poorly in April and have recovered sharply as markets have generally bounced.

As we previously discussed, April ended on a sour note, as bad inflation data led to a fairly sharp spike in long-term bond yields. This led to some material weakness in more cyclical stocks. However, long-term bond yields have trended down in May, reversing much of that late April sell-off. The 10-year Treasury yield ended April at 4.68% and is 4.45% as of May 14.

Oil prices have also trended down somewhat in May. As a result, our energy holdings are not participating in the broader recovery in stocks.

There are no portfolio weighting adjustments with this update.

The primary purpose of this update is to provide commentary on Permian Resources (PR), which reported earnings last week and has been a strong performer year-to-date. While we maintain PR as a smaller portfolio allocation, the reason is primarily the nature of the investment.

As a smaller company with a regionally concentrated asset base, there is inherently more idiosyncratic risk. Additionally, the portfolio holds Diamondback Energy (FANG), which operates in the same region.

The 5% portfolio weight does not reflect a lack of conviction around the investment. Below, we walk through five aspects of PR that we believe make it a compelling energy sector investment opportunity.

Asset quality

Permian Resources is the second largest pure-play exploration and production operator in the Permian Basin. Headquartered in Midland, Texas, PR acquires, optimizes and develops high return oil and natural gas properties.

Discovered in 1920, the Permian Basin is the most important oil-producing region in the United States. The territory takes its name from the Permian geologic timeframe (approximately 250 million to 300 million years ago). The vast prehistoric sea once located there left enormous deposits of organic material that evolved into one of the thickest hydrocarbon structures in the world.

The Permian Basin covers approximately 75,000 square miles and extends across west Texas and southeast New Mexico. Originally a marine basin called the Tobosa basin, the Permian Basin was formed when the supercontinents Laurasia and Gondwana collided to form Pangea.

Over 30 billion barrels of crude oil have been recovered from the Permian, with more than 20 billion estimated to be remaining. Technological innovations in hydraulic fracturing (or “fracking”) have led to a resurgence of activity in the Permian.

The  Permian Basin

The assets of PR are primarily located in a sub-basin known as the Delaware Basin. The Delaware Basin is one of three main sections of the Permian Basin which formed in the final phase of the creation of the Permian Basin with massive sediment deposits. The other two major sections are the Midland and Central Basins.

Located on the western side of the Permian Basin, the Delaware Basin encompasses 13,000 square miles in sparsely populated areas. It is the deepest sub-basin and has the thickest rock deposits.

With proved reserves of over 900 million barrels of oil equivalent (approximately 70% oil), PR reports over 15 years of inventory life. PR drills in highly economic districts, which translates into low break-evens and high margins.

This asset base provides the foundation for many years of cash flow growth, but PR has also proved adept at replenishing it through acquisition. As a relatively smaller player, PR is able to move the needle with bolt-on acquisitions within the territory.

With a far superior cost structure versus small independent players, PR is able to offer the owners of these properties a return profile they would be unable to achieve on their own, while at the same time offering PR shareholders cash flow accretion.

Management

PR was formed through a merger of equals between Colgate Energy, a private equity-backed firm, and Centennial Resources, which was a publicly traded Delaware Basin pure-play. Rather than go through the IPO process, Colgate merged with Centennial in 2022. The new company was renamed Permian Resources with the ticker PR.

In August 2023, PR acquired another player in the Delaware Basin, a publicly traded company called Earthstone. The Earthstone deal also brought the company a sizeable acreage position in the Midland Basin.

We became acquainted with the opportunity at PR through a former investor in one of the privately held predecessor entities, who holds an extremely high view of management. Management at PR owns approximately 7% of the shares outstanding. The co-CEOs, Will Hickey and James Walter, receive zero base salary. This translates into unusually high alignment with shareholders, similar to a private equity model.

The results since the merger of equals between Colgate and Centennial have been impressive, as PR justifiably highlighted in a recent investor presentation.  

Source: Permian Resources

Valuation

Despite the strong stock price performance since the company was formed, valuation remains subdued. The upside has been driven through organic cash flow growth and accretive M&A activity, rather than multiple expansion.

PR trades at approximately 4.5 to 5 times EBITDAX (a cash flow metric that excludes exploration costs) whereas large-cap peers trade closer to 6 times. The discount can most likely be attributed to lower liquidity. The market capitalization is approximately $13 billion, and much of the stock is held by the original private equity investors and management.

While large institutions may be interested in PR, its relatively small size and public float make it difficult to own. As noted above, being small and nimble gives PR access to small-scale transactions that will actually move the needle. Being small also translates into an advantage for individual investors, who unlike large fund managers are able to access the company’s cash flow generation at higher implied yields.

Put differently, if PR were a much larger company, it likely wouldn’t be this cheap.

On May 7, PR reported strong first quarter results that generally surpassed consensus expectations across all metrics and were well-received by the analyst community. The company raised production guidance for the year by approximately 2%. PR also announced an acquisition of private player in the basin for $270 million, which will likely contribute another 1% to 2024 production growth, although it is not included in guidance.

Dividend Policy

The fact that PR trades at a relatively low multiple is helpful for the capital return policy. PR is committed to distributing 50% of free cash flow back to shareholders in the form of a base dividend (currently $0.06 per share quarterly), a variable dividend and share repurchases. The lower relative valuation therefore translates into a higher dividend yield and more attractive pricing on share buybacks.

On a trailing basis, the dividend yield is approximately 4%. Based on the direction of the dividend thus far in 2024, the forward yield is closer to 5%.

Source: Permian Resources

Takeout Potential  

With excellent reserves and a relatively low cash flow multiple, PR is probably a tempting bite-sized acquisition target for larger players operating in the Permian, of which there are many. We suspect management and the anchor shareholders are keen to continue to build value as an independent player at this time and perceive considerable runway to do so.

When the time comes to sell, however, there will likely be significant interest, especially if PR remains at its current valuation discount to larger peers. A strategic acquirer could potentially pay a 30+% premium and deliver an accretive transaction, without even assuming any cost synergies, which would certainly be available.

A nice little package

For investors comfortable with or seeking oil and gas exposure, we view PR as a compelling opportunity to benefit from an attractive asset base with visible cash flow growth potential, a proven and incentivized management team, an attractive dividend and capital return framework, a moderate valuation and clear long-term consolidation potential.

Key metrics

Valuation detail

Performance detail

Permian Resources (PR): Company Snapshot

The 76research Inflation Protection Model Portfolio emphasizes business models that are expected to perform well on a relative basis in periods of elevated inflation. Holdings are typically drawn from industries based on supply constrained real assets, including commodity and energy businesses, or companies that otherwise demonstrate superior pricing power. The portfolio may from time to time include certain ETFs when broader asset class opportunities emerge that align with the theme. Drawing from an investable universe of expected inflation beneficiaries, specific holdings are chosen based on valuation and general business quality, growth and risk considerations. 

Disclaimer

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