Permian Drilling Slowdown And Margin Compression Will Shape Future Returns Amid Concentrated Exposure

Catalysts

About Viper Energy

Viper Energy is a mineral and royalty company focused on oil and gas interests in the Permian Basin, generating high margin cash flows with no direct drilling capital.

What are the underlying business or industry changes driving this perspective?

• Although Diamondback's deep inventory and Viper's 5% to 7% average interest in its wells support several years of oil volume growth, any sustained pullback in Permian drilling activity would slow production per share expansion and temper revenue growth.
• While exposure to nearly half of all third party Permian activity and more than 25,000 horizontal wells provides valuable scale and data, a prolonged period of flat basin wide oil growth could reduce the pace of new well additions and moderate long term earnings growth.
• Despite strong free cash flow generation and a path to returning nearly 100% of cash available for distribution, reliance on elevated distributions and buybacks to drive total shareholder return may cap balance sheet reinvestment and limit future net margin expansion.
• Although AI driven automation and big data capabilities from the Sitio combination can lower back office costs and improve decision making, these efficiencies are likely to deliver incremental rather than step change operating leverage, which may result in only modest uplift to net margins over time.
• While concentrating around core Permian assets and divesting non core properties simplifies the portfolio, it also heightens geographic and commodity exposure. An extended low oil price environment could weigh on cash flow stability and pressure earnings.

Assumptions

This narrative explores a more pessimistic perspective on Viper Energy compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Viper Energy's revenue will grow by 21.4% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 21.6% today to 8.7% in 3 years time.
• The bearish analysts expect earnings to reach $177.1 million (and earnings per share of $1.51) by about December 2028, down from $244.2 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $391.3 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 54.4x on those 2028 earnings, up from 27.8x today. This future PE is greater than the current PE for the US Oil and Gas industry at 13.3x.
• The bearish analysts expect the number of shares outstanding to grow by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 6.96%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• If Viper continues to grow oil production per share at double digit rates for several years, supported by Diamondback's advantaged drilling inventory and broad third party exposure across the Permian, the market could re rate the stock higher on structurally rising revenue and earnings.
• The planned shift to returning nearly 100% of cash available for distribution through a rising base plus variable dividend and sizable buybacks, backed by very high free cash flow margins and a rapidly de risked balance sheet, could be associated with a materially higher total shareholder return profile than a flat share price would imply by lifting net income per share.
• Successful integration of Sitio, including realized cost of capital savings, automation and AI driven back office efficiencies, and big data advantages for capital allocation and deal sourcing, could expand operating leverage over time and support higher net margins and stronger earnings growth.
• Concentration around core Permian minerals with exposure to almost half of all third party activity, combined with an extremely low breakeven and zero CapEx model, may position Viper to outperform in a range of oil price scenarios, which could lead to more resilient and growing cash flows and a higher valuation multiple on revenue and earnings.
• If the company continues to use asset sale proceeds and robust free cash flow to drive net debt down toward its long term target while opportunistically repurchasing undervalued shares, the resulting balance sheet strength and shrinking share count could accelerate earnings per share and support a rising share price rather than a flat one.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Viper Energy is $38.14, which represents up to two standard deviations below the consensus price target of $50.67. This valuation is based on what can be assumed as the expectations of Viper Energy's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $64.0, and the most bearish reporting a price target of just $38.0.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be $2.0 billion, earnings will come to $177.1 million, and it would be trading on a PE ratio of 54.4x, assuming you use a discount rate of 7.0%.
  
• Given the current share price of $40.34, the analyst price target of $38.14 is 5.8% lower. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.