(Note: This article originally appeared in the Marketplace Newsletter on October 19, 2022 and has been updated as needed.)
Permian resources (New York stock market :PR) is a company born recently from the merger of a private company, Colgate Energy, and a public company, Centennial Resource Development (CDEV). The company’s new CEOs will come from the private side of this merger. Thus, a public balance sheet is not really available. However, it seems that the compensation will strongly favor a management that builds the business successfully.
Management seems to want to be a consolidator in an area that has fragmented and less than optimally sized operators. This is a pretty good strategy for shareholders, as this type of consolidation often happens with properties that have limited market appeal and are therefore selling at a discount.
Against this, the management team seems to have a lot of investment and advisory experience. This can be a handicap if the management does not adapt to the “terrain” often necessary for the management and assimilation of acquisitions.
The compensation packages presented to shareholders appear attractive for several reasons. The main reason is that management is unlikely to be well paid if management does not produce for shareholders. We will have to see how the board executes this type of strategy for confirmation on this. But at least at first it looks good.
These CEOs are going to be paid only in stock. There is no cash salary or bonus. This is comparable to Kinder Morgan (KMI) whose chairman of the board worked for a long time for $1 a year. Executed correctly, it will be a powerful incentive to produce for shareholders.
The experience of the management team seems to favor a strategy of building an attractive company for potential buyers at the right price. The fact that a private company has chosen to go public in this way is another vote of knowledgeable insiders who want to “get in on the action” as opposed to a bunch of insiders selling out. So now doesn’t seem like the time to sell businesses in this industry.
Private company register
The private file revealed to shareholders and the public seems attractive.
The fact that investors recouped their total investment over a four-year period is impressive considering that one of those years was fiscal year 2020. This cash return supports the higher return claim in the next box . Similarly, the claimed IRR also has some value when the money to return to private shareholders is available. The big picture indicates good management.
Location Location Location
In many ways, this industry is taking over the real estate industry in this location, which often results in a competitive gap that provides a sustainable competitive advantage. Both companies have this geographic advantage.
The combined company has leases in substantially the same locations. The management gave the results in drilling and corresponding production. The only thing needed going forward is how it translates into ROI and cash flow. This has of course been strongly suggested in shareholder feedback in the past.
The other thing about these companies is that each was financially very strong independently. Thus, the combined company will begin its existence with very conservative balance sheet ratios. This means acquisitions are likely to be accretive by using a combination of stock and debt to keep the debt ratio very low. This keeps future opportunities to take advantage of offers on the table.
Based on the location of current leases alone, this management is likely to be very picky about the location of future acquisitions. This would keep the company’s profitability growing high in addition to low debt levels.
Returns to shareholders
The exceptionally profitable location of the leases allows for decent returns for shareholders as well as the reinvestment of some cash flow to grow the business.
Shareholder returns are based on a combination of a base dividend, a variable dividend and share buybacks which are expected to equal 50% of free cash flow. It’s about balancing market demands for return of capital with the growth needs of a business that will likely be sold in the future at the right price.
Some of these companies will emphasize the cash return shown above, whereas here the focus will likely be a bit more on stock buybacks at the expense of cash returns.
The reason for this is that it is essentially a new venture in the eyes of the market and therefore it will be likely to be discounted until it is seasoned. In my opinion, it seems that management intends to take advantage of this discount by buying back shares. Some companies like Pioneer Resources (PXD) really don’t have a discounted stock price. So it doesn’t make sense to do a lot of stock buybacks when this is the case.
Key points to remember
Permian Resources is a brand new company led primarily by the co-CEOs of the private company. The first job is to optimize the combined operations of the former Centennial Resource Development (CDEV) company and Colgate Energy.
The CEO’s compensation package appears at first glance to be very favorable for shareholders. Likewise, the return to shareholders of a fixed and variable dividend combined with share buybacks appears to have a better balance than many programs currently in place.
Many managements are touting significant returns for shareholders. But the market also values growth as well as dividends. Some of the companies that focus on dividends rather than future growth are likely to find their companies less valued than companies that manage to generate revenue, share buybacks and decent growth.
The combined plan also emphasizes the profitability of the business location. The location of the leases is likely to provide a long-term competitive gap for this business against much of the industry.
Management is giving itself an opportunity for further growth by pursuing accretive acquisitions which are very likely to keep debt low through the use of both equity and debt.
Overall, this new venture has a good track record and a decent size to offer an above-average chance of success. Yet the company is new and the new management has yet to prove itself. Shareholders and investors shouldn’t be surprised to see a valuation discount until a public balance sheet is there. At present, however, this company appears to be off to a good start and worth considering by a variety of investors who are not afraid of the risks of the new company.
Next quarterly report
This first report is likely to make a lot of “noise” because the two companies have finalized their merger very recently. This first quarterly report will probably be next to useless to many although it is worth reading to make sure no serious issues have arisen.
But even the next quarterly report might have a fair amount of one-time optimization fees. “Cleaning up” quarterly reports can take time.
An investment at this stage would be some confidence in the management and past track record of the public company. It has something going for it. Also, the location is excellent. This could therefore provide some downside protection. Still, conservative investors may want a management history of the merged company for about a year.