School Speciality (SCOO) – When your moat is a bureaucracy

Here is my April 2018 Value YYX presentation for School Specialty.

School Speciality sells the supplies, instructional materials, and furniture needed by over 13,000 school districts to equip schools with what they need. Arguably its a lousy business with highly cyclical summer sales, half of sales are commodity products, and its subject to the whims of public school budgets, yet those same characteristics keep competitors out of the space as well.

But at the right price, I don’t think its lousy. In fact, I’ll argue it even has a moat in the inefficiency of school districts purchasing rules. You don’t really think a school administrator can just click on Amazon, order 239 school desks that match the order placed three years ago and then route the same order through five  levels of administrative signatures, do you? This too keeps competitors out. For me, the secret of School Speciality is that they sell school districts what they need, when they need it, the way they want to order it and you need all three abilities to close the sale.  School district sales are not about efficiency, they are about selling what schools want to buy the way their purchasing departments are mandated by law to buy it.  This may change in 20 years, but it’s not changing next week or next year.

School Speciality’s edge lies in its established history and relationships to work with school districts the way a school district works.  School administrators with small needs can use purchasing cards to order direct from Office Depot or Amazon, but when you need 916 art supply kits to arrive in early August before school starts, you’re using School Speciality.

Do I like that half their sales are commodity items? No, but the commodity products are the sales bait that gets School Speciality in the door while the higher margin furniture and instructional materials are the sources of profit. Management understands this and is seeking more opportunities to drive growth over its existing network like its accretive acquisition last year of Triumph Learning’s instructional materials.

Did, I mention its cheap? How about an EV/EBITDA of 5?  Its priced like Office Depot and Barnes and Noble which ignores its better products lines that deserve higher multiples more inline with content creators.  Mark the company up to a 6 ratio and the market cap (and your stock price) will go up by 50%. (The company is leveraged so assuming debt and EBITDA remain constant, the benefits of a re-rating would all fall to the equity holders).

And what would attract this new investor interest, raise demand and get the stock priced closer to fair value? How about moving the stock from the pink sheets to NASDAQ. The company crossed the 300 registered share holders mark last month and began the process to up-list in early May after I wrote the April presentation. I expect increased visibility, liquidity and especially the ability of funds which do not buy OTC stocks to now increase the number of buyers for School Speciality once it is listed on a major exchange.

Good luck!



Playing with rattlesnakes in West Texas and trying not to get bit.

Viper Energy Partners (NASD:VNOM) is a three-year-old Master Limited Partnership (MLP) that owns oil and gas royalties in the Permian Basin of West Texas.  Backed by a strong shale oil exploration and production partner, Diamondback Energy (NASD:FANG), Viper possesses good visibility to increase its cash distributions 25-30% over the next two years while paying out a 7% distribution along the way as it continues to  purchase more royalty stakes from its general partner and third parties in West Texas.  While I am generally bearish on holding MLPs as long-term investments, I find Viper’s risk/reward attractive for the next year or two as its growth story plays out.

First, I need to apologize for writing about another MLP, as I do not like MLPs. Its just that every year or two, I do seem to find one that is relatively low risk with a meaningful reward such as last year’s PennTex Midstream Partners. So onward I go, but first I feel compelled to rehash some of the structural problems with MLPs.

Once upon a time, MLPs used to only own long-life, irreplaceable assets like interstate pipelines operated under long-term take or pay contracts with significant tax shielding depreciation that easily exceeded the pipeline’s maintenance requirements. This was all done under a partnership structure to avoid corporate income tax.  Even better, unlike a fixed bond, classic MLPs held the potential for increased distributions over time as pipeline contracts are adjusted for inflation. Additionally, the nature of a pipeline system also provides opportunities for increased throughput and extensions. Yes, those were the good old days, back when MLPs owned real assets, and you could safely buy and hold.

Of course, MLPs were never really that great.  Unlike the owners of common stock, limited partners in a MLP, own “units” not “shares” and have no shareholder rights at all. You must never forget that the “L” in MLP stands for limited.  MLPs are not accountable to unitholders, but are managed by the general partner who holds all the cards and often collects excessive incentive fees at the limited partners expense.  As a limited partner, you truly have no say in any matters of significance – honest, its says as much about 20 times in the 10-K. Don’t wait for an activist investor to show up and rescue you in an MLP, that’s not going to happen.  There simply is no such thing as an activist limited partner.  You just own “units” which are entitled to a proportional share of the available cash should the general partner care to distribute it, but you do not own a proportional share of the company.

Furthermore, owning an MLP with assets in 20-30 states means you pick up the responsibility to potentially file state income taxes in 20-30 states each spring.  Did I say spring? I meant to say summer because you will likely get your K-1 forms late, so you will need to extend your filing date.

And what exactly does your partnership own? Does it possess an irreplaceable asset like the Colonial Pipeline running from Houston to New Jersey with dual 40” pipes buried in no longer obtainable right of way or do you have an asset that like an oil well that simultaneously reduces its reserves by one barrel for every barrel of oil it produces?

Its these later MLPs which own wasting assets that are most problematic.  I wouldn’t say Ponzi scheme, at least in front of a lawyer, but I would say that when an MLP has to continually replace wasting assets with new assets, trouble eventually ensues somewhere down the line. Usually, the process is manageable at the beginning when the MLP is new, but it is as its asset base grows ever larger, the trick is harder to pull off.  I am reminded of the circus act with the spinning plates, and even the best talent can’t keep all the plates spinning forever (See: Kinder Morgan dividend cut).

Lastly, you are buying an income producing asset whose price is intrinsically tied to interest rates, and the last time I checked, interest rates are inching up. Yes, its a real slow increase, but it’s upwards all the same, and investing, like sailing, is a lot more fun with the wind at your back.

But of course, it is precisely the hated qualities that create the opportunity. It’s the MLP’s tax restrictions which limit their ownership to individuals and away from large institutions. It’s their low liquidity which effectively prohibits large firms from buying the undervalued units while also exaggerating the downside effect of the occasional large sales that do occur. Or the tax filling challenges themselves probably lead many folks to say never again after they receive their first K-1, and the oddball nature of the sector further which can’t help but reduce investor awareness interest as well.

Combined, these problems reduce market efficiency and create mispricing for you and me. Sure, all things equal, I’d rather buy something without these issues, but many of my best purchases come not from buying what others don’t want to buy, but from buying what others would like to buy, but can’t for technical reasons.

So, let’s talk about why some of these technical issues that don’t apply to Venom Energy Partners.  First, all of its assets are located in the state of Texas which doesn’t have a state income tax, so no special tax filing is required. True, the partnership may establish operations across the state line in New Mexico someday, but I can deal with one or two states’ filing requirements, its MLPs like Enterprise Partners with filing requirements in 35+ states that gives me nightmares.

Second, the general partner of Viper Energy does not charge an incentive distribution rights (IDR) management fee. To say this is unusual is an understatement, but it is came about because Venom Energy was primarily brought into existance to finance Diamondback Energy’s drilling program. By buying a royalty, Viper is effectively is buying part of Diamondback’s future production to fund Diamondback’s drilling program. This is similar to Taco Bell selling its physical stores to a real estate investment trust, leasing those stores back and using the freed up capital to build new ones. Oil wells, tacos, whatever; capital will find its highest use.

Currently Diamondback owns over 70% of the shares of Venom. Since Diamondback is still using Venom to raise funds, it is in Diamondback’s best interest to keep Viper’s expenses reasonable. Someday down the road, Diamondback’s interest in Viper will be much lower and the temptation to raise fees and turn Viper into a piggy bank will become irresistible, but we are a few years off from that for now.

Third, is that Diamondback’s CEO and CFO own just about as much Venom stock as they do Diamondback stock.  Nothing gives me greater comfort than knowing that the CEO and CFO combined own over 20 million (one million shares @$20/share) reasons not to sacrifice Venom Energy Partners for the benefit of Diamondback.

Lastly, when I buy the occasional MLP, I strongly prefer ones that are trading down from their initial public offering (IPO) date for a couple reasons. For starters, I don’t want to pay the seven percent underwriter fees for the IPO and when the hype is the loudest. The best time is while they are still small enough to have a good runaway of accretive transactions.  Many new MLP’s really do have reasonable growth plans at their start, its  five to ten years later when the IDR fees become so large that trouble begins. Its then that the MLP can no longer make new acquisitions below the cost of its capital, growth stalls, investors demand higher yields further increasing the cost of capital, a vicious cycle begins the dividend gets cut and limited partners become bag holders.

Ok, that’s enough ragging on MLPs, it’s time to actually talk about what Viper actually does. Viper owns royalty interests in currently and future producing oil and gas wells in the Permian Basin of West Texas.  Before an Exploration and Production (E&P) company like Diamondback Energy can drill a well, they must obtain lease rights to drills from the mineral right’s owners.  In return, Diamondback pays a royalty to on all oil and gas production produced and sold.  The royalty owner has no expenses other than taxes, no drilling costs or operating expenses. The royalty owner simply collects a check from the operator every month the well produces whether the operator makes money or not.  Being a royalty owner is a definitely a good thing, but some people like don’t like to wait, so they sell their future royalties to third parties in exchange for a lump sum.

In fact, the only bad thing about being a royalty owner is that for every barrel of oil produced on your leasehold, the number of barrels left to be produced is, by definition, reduced by one. This is a little detail often overlooked by retail investors. You’ve really got to think of your distribution as part income, part return of capital because the asset you own isn’t going to produce forever.

Over the life of an oil well, its highest production is achieved on its first day. It declines rapidly at first and then more slowly, until many years later, the well produces less oil than it costs to operate it. At that point, the well is plugged and the royalty checks stop.  Depending on the oil field, cumulative production in the first year or two could easily exceed all the production extracted over the next twenty. From the net present value perspective, getting your production back early is almost always economically advantageous. However, early paybacks also mean that if you don’t have a steady stream of new wells coming online, your royalty income will decline as your production naturally declines.  Fortunately, for Viper, they have 250+ well sites left to be drilled compared to 786 wells currently in operation, which will push off the day of reckoning for a few years.  In addition, their properties are in the Delaware and Midland Basins of West Texas where stacked plays are common.  This means that there may be several oil and gas reservoirs located vertically under a single surface location (think free option), though some of the lessor reservoirs may not be viable for drilling at current prices.

To keep feeding the MLP so future distributions can grow, new royalties need to be purchased to replace the depleting production from older wells.  Currently, Viper is successfully doing this. Diamondback has enough dropdown candidates lined up for Viper to acquire that the next few years to keep production rising and distributions increasing. But will they able to continue growing from a larger asset base, ten years from now?

I don’t know and fortunately, it is not critical to my investment thesis.  Simply put, I only want to own Viper in its early growth stage, when the partnership’s goals are more manageable.  I leave the riskier long-term ownership to yield hog investors who don’t appreciate the challenges of growing a depleting asset. (See red queen problem).


I own an asset with the plan to sell it before others who own it realize that it can’t grow forever.   Yes, I know this means I am speculating more than I am investing, but I am doing so with my eyes wide open.

Oil Prices

Obviously, a drop in the price of oil would immediately translate into lower cash distributions just like an increase would raise them.  But a royalty owner, unlike a producer, doesn’t get impacted as severly.  A drop-in oil prices from $50 to $49/bbl, will reduce a royalty owner’s income by 2%, but for an E&P company with $40/bbl in operating expenses, the same one dollar drop in oil prices will result in a 20% reduction in net profit.

I expect oil prices to drift in their current range until a little more global inventory is worked off, a geopolitical event occurs, or we have a recession. If I only knew which scenario would happen first, I could make a much more accurate prediction! If you really do know what the price of oil will be next year, I suggest skipping the rest of this post, and suggest you just buy oil futures on the NY Mercantile instead.

Cutesy Tickers

My track record of owning companies with cute ticker names like VNOM and FANG is mixed. Sometimes it means the company is owned by a maverick with an independent streak, but other times it signals a promoter.  I put FANG and Diamondback into the independent streak, but I still prefer boring names and dull tickers for reducing the odds of a getting snake-bit.

Lack of detailed information on the royalty terms and locations

The information in the Viper 10-K and investor presentations are summarized data.  Limited partners will never know in detail what Viper owns and what the terms are for most of its leases.  For instance, you’ll get a pretty map of where leases are located but it won’t tell you if that dot on the map represents a 1% royalty interest or 12.5%.  Until the next 10-K, we lack updated reserve information for the most recent acquisitions.

At a certain point, you basically just have to trust the management which is easier to do when like Viper, management owns a meaningful stake.  So far, I haven’t come across anything suspect in my research that would lead to doubt them, but I do think their investor materials are best read with a critical eye.   For example, management compares Viper’s cash margins and operating expenses to 20 E&P companies in the Permian. Of course, Viper’s numbers kick butt –  a royalty owner it doesn’t have any operating expenses besides taxes and management salaries, it would be a scandal if its margins weren’t higher.

Or take a look at management’s presentation on distributions (below) and see the distributions going up in a nice smooth line.  Of course, the distribution bars are always going up, they are plotting cumulative distributions!


Here is my look at the same quarterly distributions. In my chart, they still trend up, but the inherent volatility of owning mineral royalties is much more apparent.QuarterlyD

In fairness, the company presented the actual quarterly numbers more reasonably in the “Significant Future Growth Trajectory” slide.

This slide highlights the short-term opportunity for me, but also the long-term risk. Viper has royalty positions on enough undrilled property and likely dropdown acquisitions to realize these projections in the near term, but what happens 5-10 years from now? Where will the production come from to replace the production lost as the wells deplete over time? As production increases, so does the amount of oil that needs to be replaced from depletion.  The challenge just gets harder as the asset base gets bigger. Eventually, the gap can’t be filled, growth slows or reverses, distributions get cut and the limited partners find themselves holding a declining asset.


Blackstone Minerals (BSM) operates in the same oil and gas minerals royalty space and yields roughly the same but is diversified across many more geographies.  While diversification is usually a good thing, I prefer the much narrow scope of Viper in the Permian Basin where break-even costs are lower for E&P companies.  One of the risks of holding an oil lease royalty is that your E&P operator will chose to drill wells elsewhere rather than on your property.  Since, drilling for oil in the Permian is more profitable than anywhere else in the U.S. right now, I prefer keeping all my eggs in the prettiest basket.

When to buy:

Well a couple weeks ago would have been good, like back when I started writing the post, but don’t worry, you will probably have another opportunity to buy lower in the future as well. MLPs raise capital to fund acquisitions by selling new shares.   (My hate of dilution is one more reason not to buy a MLP).  To sell these large blocks of new stock, Viper will have to offer a 10-15% discount to the current stock price to attract large institutional buyers.  Some of these buyers will then turn around and flip the shares for a quick buck. By all means, if you suspect a secondary offering is being planned, wait to buy until the price drops on the news.

When to sell:

A great reason to sell an investment held by yield seekers is when the future gets murky. Should Diamondback slow down its land acquisitions and drilling, Viper’s most visible growth path would slow down as well. Another reason to sell is when the asset base gets significantly larger and growth becomes mathematically challenging. Currently, Viper has a market cap of 2.5 billion. I will likely sell around a 3.5-4.5 billion market cap because I want to be out of the company before it becomes difficult to find enough future acquisitions at attractive prices to feed the growth beast. Until then, I like the risk/reward.



I want to crawl under a rock

I just had my first podcast interview ever and I say “Turn the drill bit to the left” Left??? Really, I said left?  Was I on drugs?  There is nothing that will turn your brain into mush faster than being worried about saying “um” and “ah”. Oh well, at least I didn’t say “um right”.

The interview came about because after I met Eric Schleien at the Berkshire AGM this year.  I mentioned that I enjoyed his podcasts ( and then after twenty minutes spent chatting about microcap stocks, he’s inviting me on his show.

Last week, I talked with Eric Schleien again for the podcast. We discussed two of my favorites, Contura Energy (CNTE) and Hostess Brands (TWNK), but frankly his Travis Wiedower and Geoff Gannon interviews make for much better listening.

As I mention in the podcast, “Turn the drill bit to the right” was one of the late CEO of Contango Oil and Gas, Kenneth Peak’s, favorite things to say.  Because as Ken saw it, virtually all the exploration and production industry’s value creation occurs through the drilling of successful exploration wells, and if you’re going to drill that successful exploration well, then you need to turn the drill bit to the right to actually make the hole and prove your idea right or wrong.

Ken was also one of a kind, he not only named his largest field discovery after his parents, he also once named a set of three exploration wells after The Big Lebowski’s protagonist: the prospects Dude, His Dudeness and El Duderino.  He was anything but ordinary.

I will close this post with my favorite example of his non-traditional thinking from this August 2012 investment disclaimer slide.

August 2012 Investment Presentation

Contango Oil and Gas August 2012 Investment Presentation





Make money with mutual funds, buy a mutual fund manager (HNNA)

Not sure which mutual fund to buy? You might want to consider the mutual fund manager instead.


Hennessy Advisors (HNNA), the red line in the above chart, is a publicly traded stock mutual fund manager.  The other lines represent its two largest mutual funds as well as the SP500. Any questions?

In rising markets, its almost axiomatic that an investment in a mutual fund management company will be more profitable than an investment in any of its mutual funds. (The inverse is mostly true as well).   For an investment advisor, revenue is proportional to the quantity of assets under management while expenses are not, so the mutual fund management business becomes immensely profitable in rising markets with pretax margins approaching 45% in the case of Hennessy.

Mutual Fund manager Hennessy Advisors (HNNA)  is a tiny, overlooked player in the investment advisor business with 16 open ended mutual funds holding combined assets under management (AUM) of 6.6 billion. The company started its first mutual fund in 1996 focused on quantitative factors. Later, the company added a broader range of more traditional equity funds through acquisitions for other fund companies.  Today, over 70% of its assets are less than five years old with the largest jump resulting from the purchase of FBR’s mutual funds in 2012. More recently, on September 23, 2016, the company obtained 440 million in new assets from the Westport fund management company growing AUM by an additional 7%. Due to the advantages of scale in the mutual fund industry, earnings from the acquisition should increase by a slightly higher amount, say 8-10%.

Hennessy is currently priced substantially below its peers based on its current earnings trend. Due to the company’s small size (174 million market cap), fund concentration and low liquidity, a discount to peers of 10 – 25% would be reasonable, but the current  50% discount seems  excessive especially in light of the recent Westport transaction.

To acquire Westport, the company paid 1.75% of the 646 million in assets at the time of the agreement or 11.3 million, even though it appears that only 440 million in assets remained in the fund by the time the transaction completed. [edit – I originally wrote that the purchase price was based on assets at close date, but actually it was based on AUM at agreement date – my mistake].  The assets were merged into the Hennessy Cornerstone Mid Cap 30 Fund which will charge 1.0% of fund assets annually (4.4 million) for fund expenses and shareholder services. With less than a three year payback, this acquisition should yield strong returns, but that’s only if most of the customers’ funds remain with Hennessy.

In the bull case, the clients who own the Westport funds will appreciate the lower fees and better record of the Mid Cap 30 Fund and want to stay.  Additionally the transaction preserves continuing fund holders tax basis, while creating a tax liability for those who chose to sell instead of stay. But, Hennessy’s record for keeping assets is stronger when they retain the existing fund using a sub-advisor than when they merge, so the move for higher fees may raise  asset flight.

Lastly, the acquisition of mutual fund companies creates an accounting asset on the acquirer’s balance sheet that gets amortized over time increasing cash earnings. In 2016, the company will record a deferred tax asset of approximately 2 million due to amortization so cash earnings are about 8% higher than reported earnings.


Market Sensitivity: Hennessy’s fee generation is directly tied to market performance and fund holder retention. While no one complains about this in the good times, in a down market not only will the value of the funds’ assets drop, but the lower prices will also scare investors into redeeming their shares dropping AUM even further. This is why leveraged companies do and should sell at discounts.

Concentration Risk: The Hennessy Focus Fund (HFCSX) is Hennessy’s largest fund with 2.4 billion or 36% of all Hennessy assets under management. Morningstar gives the fund a five star rating a special Bronze star analyst rating. The second largest fund with 1.46 billion or 22% of AUM is the Hennessy Gas Utility (GASFX) Fund with four stars from Morningstar. For those counting, 58% of the assets are in just two funds.  As these funds go, so goes the bottom line of Hennessy Advisors.

Management Compensation: The CEO, Bill Hennessy, is also the founder and largest owner with 30% of the shares outstanding.  In 2014, he made a sweetheart contract for his services and collects 10% of the net profits each year.

Mr. Hennessy is entitled to receive a quarterly incentive-based bonus in the amount of 10% of the company’s pre-tax profits for each fiscal quarter, as computed for financial reporting purposes in accordance with accounting principles generally accepted in the United States of America, except that pre-tax profit is computed without regard to (A) bonuses payable to employees (including related payroll tax expenses) for the fiscal year, (B) depreciation expense, (C) amortization expense, (D) compensation expense related to restricted stock units (or other stock-based compensation expense) and (E) asset impairment charges (such amount, for each quarter, the “Quarterly Bonus”).

Wow, nice work if you can get it!  Fortunately, his ownership stake is  18 times greater than his his 3.3 million compensation in 2015, so he is still well motivated to build shareholder wealth.  His leadership team is also highly paid with his CFO and Executive Vice President making $1.3 and $1.0 million in 2015 as well.

Neil Hennessy is only 58 and show no signs of selling the company.  Eventually, when the company does get sold years from now, the acquirer will likely already have a President, CFO, and EVP, so the 5.6 million in bonus and salary can be eliminated which will increase the value of the company six to eight times that amount over its worth as an ongoing investment with the extra salary.

A look at some numbers:


Share Count (Diluted) 5,154,094
Price 34
Earnings for TTM: $2.67 PE 12.7
Earnings as 4 times last quarter $3.04 PE 11.2
Earnings with last quarter annualized + 6% earnings increase for Westport acquisition $3.22 PE 10.6
MV (millions) 175.2
Debt (millions) 27.0
Net Cash after Westport (millions) .4
EV 201.8
2016 Second Quarter Numbers
Operating Income Q2 2016 (millions) 6.1
Interest (millions) 0.1
Taxes (millions) 2.0
Depreciation (millions) 0.3
Amoratization (Deferred Income Tax) 0.5
EBITDA for Q2 2016 (millions) 8.9
Annualized Ebitda 35.8


Comparable Companies: While Hennessy does not have any publicly traded micro cap peers, larger investment managers in the 2.5 to 8 billion market capitalization range like Janus Capital (JNS), Federated Investors (FII), Legg Mason (LM), Eaton Vance (EV), and Affiliated Managers Group (AMG) have P/E ratios for 15-18 compared to 11 for HNNA. While P/E’s are easily manipulated by debt, in this case several of the larger companies are carrying proportionally more debt than Hennessy as well.

Management: While I think they are overpaid, Hennessy management is competent and adaptive. The company has adjusted its strategy over the years to grow the business by adding funds and providing more services, they are survivors of the 2008 financial crisis, and they have successfully integrated acquisitions.  But I’m not impressed with the board, it includes family members and appears more typical of a 15 million nano-cap than a 175 million small cap. At the end of the day you have to be comfortable with Bill Hennessy as the CEO/Chairman and not expect much from the board; fortunately, he did build this company after all and  appears to know what he is doing.

So is Hennessy cheap? Yes, but there is a reason mutual fund companies sell at a discount to the market. For Hennessy to continue growing at 15-20%, several trends must continue to be favorable: general market performance needs to remain bullish, the company’s largest funds (Focus, Gas Utility) can’t have bad years, newly purchased fund assets need to be at least somewhat sticky, and new acquisitions must be available for purchase at fair prices.  I’m not betting the company goes five for five on that list, but then I also don’t believe the price I am paying requires perfect execution either.

Conclusion: I recently bought Hennessy Advisors stock because I don’t believe the positive earnings trend is priced into the stock. But due to the inherent leverage in a market leveraged investment, the concentration of the majority of assets in just two funds, and the secular headwinds facing all actively managed equity funds I cannot justify over-weighting the position, but I expect it to continue performing better than the overall market until the next recession (whenever that is).

PennTex Partners – A safe midstream MLP

The Short Story:

PennTex (PTXP) is a small midstream MLP backed by deep pocketed NGP Partners with two gas plants and a gathering system in Northern Louisiana serving the prolific Terryville field in the Cotton Valley formation.  For years, vertical wells in this region have yielded mostly mediocre results, but with horizontal drilling, mile long laterals, and hydraulic fracturing are changing the game. PennTex’s sister company, the well hedged Memorial Resource Development (MRD) is using these techniques to develop Marcellus class wells in the Terryville without the infrastructure constraints of Appalachia. After last year’s IPO, PTXP is already down over 50%,  but yielding a relatively secure 11% covered by a minimum volume commitment (MVC) contract and a subordinated share structure. PennTex is basically an “earn while you wait” situation.  While 11% is not bad, only a modest increase in oil prices to $45-$50/barrel and $2.50 gas is required for PennTex to obtain the volume increases necessary to feed even higher distributions. Given PennTex’s secure distribution and future prospects, the yield on the distribution should reset to a more appropriate 7-8% yield once the winners and losers in the MLP space are sorted out and generate a corresponding share price increase as well.

Why does the opportunity exist now?

All midstream MLP’s are getting hammered in the MLP selloff, and most of them for good reason. If your midstream operation is servicing a high cost basin, or bankruptcy bound partners like Chesapeake, then your MLP’s value should be impaired. I will argue however that PennTex is the exception due to its strong distribution coverage. It is a case of the baby getting thrown out with the bathwater.

The stock price distortion is magnified for PennTex, because it is new and unknown, and because it is small.  PennTex is just a 400 million market cap company with an even smaller public float of 125 million. At this size, a little forced selling by a distressed seller (see over leveraged closed- end MLP funds) can go a long way to depressing the stock price.

What is the long-term opportunity?

Memorial Resource Development (MRD) is PennTex’s primary customer and the counterparty to the MVC. Fortunately, MRD is fully hedged for its production through the end of 2017.  Its primary asset is the Terryville field, a stacked play in the Cotton Valley formation in Northern Louisiana.

NGP partners directly and through affiliates owns 45% of MRD as well as PennTex’s general partner (GP), the Incentive Distribution Rights (IDRs) and 67% of PennTex limited partners (PTXP).   NGP could run MRD at break-even and still make good money processing MRD’s wet gas through PennTex.  This is critically important because when you own units in the MLP’s limited partner, you are at the mercy of the general partner to treat you well.

As a new MLP, the IDRs are currently set at zero, but the IDRs increase quickly to 50% with an 50% increase in the current distribution. In addition, at $1.60/year, the subordinated shares are converted to full shares.

Total Quarterly Distribution

Target Amount

Unit holders

GP (IDR holder)

Below $0.3163



above $0.3163 up to $0.3438



above $0.3438 up to $0.4125



above $0.4125 50%


 Following the original IPO prospectus and MRD’s 2015 drilling schedule, the IDRs were on target to be at 50% by 2017.  With MRD announcing in January 2016 that it was reducing its drilling rig count from 8 in 2015 to 1 by Q2 2016, volumes may not be increasing as fast and the date to reach a $1.60/unit distribution will be correspondingly delayed. I say “may” and not “will” because MRD will still have 30 drilled, but uncompleted wells, available for completion by Q2 2016.  But eventually, if drilling does not resume at higher rates, volumes will definitely decrease.

If $50 oil and $2.50 gas is reached by 2018,  MRD will likely increase its rig count back to 2015 levels, and a $1.60 distribution or more would be a certainty shortly thereafter. Applying a  7% yield on the $1.60 implies a $22.58 share price and an annual return from capital gains and distributions would be approximately 27% per year.   More aggressive oil price projections would get you a much higher return.

The Terryville does not require $80 oil. Some of the best detail on MRD’s economics are in the April 2015 MRD Analyst Field Trip Presentation. The company offers claims a 200% IRR on Upper Red zone wells at, $60 oil and $3 gas, and a 122% IRR on the same wells with $50 bbl oil, and $2.50 MCF gas.  I don’t think you have to be an oil bull to expect close to $50 oil by 2018.  MRD shareholders may want $100 oil, but $50 is good enough at PNTX.

Given that these are all company supplied numbers, they probably do leave out corporate overhead among other expenses, but in any scenario, full scale drilling will return to the Terryville much sooner than say the Bakken or Eagle Ford with higher break-even points.  And with the Terryville only two hundred miles from the Henry Hub sales point, Terryville gas sales without a negative pricing differential.

How well is the current $0.27 distribution covered in case we see no growth for a few years.

PennTex needs 11 million in distributable cash flows per quarter to cover a $0.27 distribution and until it completed its second plant in October 2015, it was not covering its distribution. But after the plant came online, the minimum volume commitment increased the following quarter to its present 340 MMCF/D.

The estimate in the IPO prospectus (see page 62 below) for the quarter ending July 2016, includes a full quarter at the 340 MMCF/D MVC rate shows $13.7 million in revenue from the MVC, 3.5 million in revenue for volume in excess of the MVC, and 5.5 million in pipeline usage fees for a total of 22.6 million.  Against this, deduct 10 million in expenses, add back 3.7 million for EBITDA adjustments, subtract 1.9 for interest and maintenance capital and you get 16.6 million or coverage of 16.6/11 = 1.5x

Estimated Cash Available for Distribution

Including “excess volume over MVC” if MRD is cutting back its drilling  is dubious  even if production in January 2016 is still 416 MMCFeD.  But excluding that 3.5 million only reduces distributable cash to 13.1 million and coverage still remains strong at 13.1/11.1 or 1.2x.

But wait there’s more.  PNTX has 40 million shares, and 20 million of NGP’s shares are subordinated.   Public shareholders don’t need PennTex to generate 11.1 million in distributable cash to be paid $0.27/quarter, 5.55 million would cover the subordinated shares.  We really have 2.4x coverage in case things get really bad.

And if you’ve read this far, I’ll share another secret.  The MVC goes up one last time to 460 MCF/day after July 30, 2016. This will increase committed revenue from $13.7 million to $18.5 million.   Frankly at 18.5,  I will expect a small distribution increase even if there is no excess production.



Previously I wrote about Sanchez Production Partners (SPP) which has a weak, over-leveraged E&P partner, Sanchez Energy (SN). While my SPP share purchase was good for a quick couple bucks, I sold them at the end of 2015 to avoid another year of K-1 returns and more importantly because SN is likely as not to go bankrupt and I have no clue how the contracts between SN and SPP will hold up in bankruptcy court.

MRD is the counterparty to the minimum volume commitment which underpins PennTex. MRD also owns full hedges on its production through the end of 2017, so unlike many E&P peers, bankruptcy from low prices is not on the horizon. MRD’s senior debt is not due until 2022.

While I am not particularly bullish on natural gas or crude oil, but I do think natural gas prices will eventually have to increase to a price sufficient to make drilling for gas in North America’s best fields, such as the Marcellus and Terryville at least marginally profitable. For the past five years, E&P companies have continued to drill unprofitable wells after unprofitable well just to hold on to a lease agreement so that they can keep the right to drill more unprofitable wells on that land, but ultimately the financing for this nonsense will stop, and these producers will eventually go bankrupt or shift to a more profitable business model and stop drilling unprofitable wells.

The Terryville Field doesn’t turn out to be as wonderful as it appears.

While the best Terryville Field and North Louisiana Cotton Valley horizontal wells appear to be as prolific as top Marcellus class wells the future need not be as bright as the past.  Sweet spots are never as big as anyone predicts. Still the numbers in the April 2015 Analyst Day Presentation are definitely impressive.UpperRed

And while one of the appeals of the Terryville field is that it is a stacked play, currently only the thickest sands in the stack (Upper Red) are near economic at current prices.  The least appealing sands in the stack may require $80 oil to work out (see analyst day presentation).

Still what we do know about the Terryville is pretty darn good. The proved and developed reserves as reported by Netherland, Sewell, and Associates show reserves based on Dec 2015 12 month SEC prices ($46.75 oil/$2.59 gas) show proved reserves of 1378 BCFe.  At the current 426 MMCfe/d rate gives a proved reserve life of 11.1 years.   “Probable” reserves are twice as high. And “Possible” reserves are even higher, but then “Possible” is a pretty low standard, so it should be high.  I was more impressed that the reserves held constant between year-end 2014 and year-end 2015, even though the SEC pricing deck for 2015 was nearly half the 2014 prices.  Lastly, management pointed out that the decline history is favorably exceeding the auditor’s projection, so we may see future upward revisions.

In any case, this is a real field producing, real gas with NGLs and MRD continues to buy more leases in the area committed to PennTex. Whether it is a just a good field and we collect just 11% and a little bit more or a really good field and we collect 11% plus a lot more, we will learn in time.

PennTex may be unable to attract financing for growth

The current high yield on PTXP shares prevents their use in selling shares to raise new capital for expansion or acquisition.  This is certainly a challenge for PennTex and all MLPs.

First, I don’t expect the yield to stay at 11%, but more importantly NGP has the resources to obtain alternative forms of financing such as convertible preferred stock.  In the Nov 15 conference call, management mentioned that it wouldn’t be prudent to go to the capital markets at this time (sell more units), but implied they had private market options too.

MLP partnerships issue K-1’s and I hate K-1’s

True, but at least this one only has operations in Louisiana, so this doesn’t require filing in 20 states.  PennTex does have a right of first refusal to build gas processing for NGP in West Texas, but since Texas, does not have a state income tax, it would not add to the paperwork.

No governance

The biggest risk of all is that you are purchasing units in a limited partnership is that the general partner can pretty much do whatever it wants.  In our case, NGP owns the GP, the IDRs and with 68% of the PTXP LP units owns more of PTXP than public shareholders do, so in theory would like to see the LP succeed.  Additionally, NGP Partners is a significant MLP player and it would impair its ability to do future deals if it treated unit holders unfairly. For instance, OZ partners own 10% of PTXP’s units.  While the big boys at NGP may not care about a retail investor, I don’t think they want to treat a future source of capital like OZ poorly.

Lastly NGP also owns 45% of MRD and MRD needs PennTex to process MRD’s gas.  And as previously mentioned, since NGP owns a higher percentage of PTXP than MRD but effectively controls both parties, NGP can optimize its earnings by having MRD’s gas processed through PTXP’s facilities.  This become especially attractive once the IDRs kick in at 50%.


Barring $15 oil lasting for 5 years bankrupting MRD when its hedges run out at the end of 2017, downside protection is solid, and even a modest recovery in oil prices should ignite a growth story. Until then, we will collect a reasonable secure 10% and wait.

Useful Links:
Memorial Resource Development MRD – Operational, Reserves and Guidance Update Feb 2016


The author owns shares in PTXP.  Occasionally this author is wrong and he may very well be wrong in this case as well. Do your own work.

Sanchez Production Partners (SPP) – Is this a $100 bill lying on the ground?

Have you heard the old joke about the efficient market professor who walks down the street with a student who bends down to pick up a $100 bill? The professor tells her not to bother, because if the $100 bill were real, it wouldn’t be there. Well Sanchez Production Partners (SPP) kind of looks a little like that $100 bill. I’m not sure it’s real either, but I think it’s at least worth bending over to check it out.

SPP is a small, 33 million market cap, formerly busted MLP, originally known as Constellation Energy Partners. It was picked up by the owners of Sanchez Energy (SN) last year to provide a GP/LP financing structure for funding SN via drop-downs to SPP. SPP’s assets are 60% midstream assets and 40% oil and gas production by EBITDA contribution. With the recently acquired midstream assets financed by the selling of 350 million in preferred shares to Stonebridge partners.

First the stunningly good news, on Nov 13, Sanchez initiated a forty cent quarterly distribution along with a plan for 15% distribution growth through 2019. At its current share price of $11, this is a 14.5% yield backed by 1.8x coverage for 2016. If the yield re-rates to 10%, the unis would trade for $16/share. And to top that, they also announced a 10 million dollar buyback on a stock that’s 1/3 the public float.

So is there a catch? Well if oil prices jump back up before 2017, not really, because production is fully hedged at $74/bbl and $4.17/mcf through 2016. But… SPP is only partially hedged and at lower prices for 2017-19. If oil bounces back to $65 before the hedges run out, life is good. Otherwise, challenges will loom.

First, lower oil prices will drop the coverage ratio. For example, the current $74 hedges and $24 operating expense leave a $50 spread, but $35 oil provides only a $10 spread. The current 1.8x coverage ratio is only possible because of the $74 hedges. Without higher prices, the distribution will funded only by the fee based mid-stream assets and the coverage ratio will drop to 1 at best. Furthermore, at low oil prices, SN won’t drill as many wells in the Eagle Ford which will result in less gas to process. Yes, there are minimum commitment numbers that help provide a foundation to the distribution, but the 15% distribution growth doesn’t occur unless the Catarina plant gets fully loaded, and that requires SN to drills more wells. The IR materials claim a 35% IRR on $60 oil, but no one is getting $60 anymore… Do they get 25% IRR on $50?

So is SPP a $100 bill lying on the ground? Yes, if oil goes back to $60/barrel in 2017, but it’s a mirage if oil drops to $35/barrel for an extended period. In between those prices it can still work, but maybe only turns out to be a $20 dollar bill and I think still worth bending over to pick up.  With the hedges solid for 2016, I’m long SPP, but I am keeping it on a short leash.
For more information:

There are also other moving parts in play, such as the planned sale of the legacy mid-continent producing assets, the health of Sanchez Energy, the appropriateness of holding production assets in a MLP, etc.  But if I wait to write those down, I will never finish the post.


Observation on the Rig Count

The drill rig count in the shale era just doesn’t mean what it used to during the days of traditionally drilling.   In the old days, cutting rigs immediately meant less new oil would be produced than the year before, but not anymore.

Consider the basic formula implied by the rig count:

Number of new wells drilled per year = Rig Count * average number of days to drill a well / 365

New oil production = Number of new wells * the average production of the new wells.

But in 2011, the average time for Anadarko to drill an Eagle Ford was 12 days, by the end of 2013, the average was 8 days with the record setting well only requiring 4.5 days.   In 2015, it is reasonable to assume that the drilling time will be half of 2011’s rate, so only half as many rigs are required in 2015 as 2011. Furthermore, the average oil production from new wells in the Bakken and Permian according to EIA data has doubled in the last 5 years (Bakken) and 3 years (Permian).  Everything else being equal, you’ll need half as many rigs with a doubling of production.

Combine these two observations and a 2015 rig drilling in shale is 4 times as productive as a 2011 rig.  Of course, that’s an oversimplification since no rig stays busy 100% of the time.  But at the same time, I imagine the remaining rigs are running with the best crews on the best locations, so don’t be surprised if a drop in the rig count doesn’t result in a dramatic decline in production.  Its not your father’s rig count anymore.

OneOK (OKE) and Incentive Distribution Rights

So just how much are Incentive Distribution Rights (IDR) worth?  Let’s walk through OneOK (NYSE:OKE)’s IDR agreement to get an idea.

OneOK Partners (NYSE:OKS) is a midstream Master Limited Partnership which invests in natural gas midstream processing facilities to extract natural gas liquids from “wet” gas into its more valuable components.  OneOk Partners also owns significant natural gas pipelines and gas gathering systems to bring the gas from the wellhead to the gas plants as well as ship it to interstate pipelines.

The general partner of OKS is OneOK.  OneOK owns 2% of the shares assigned to its general partner stake which controls OKS as well as 39% of the limited partner shares of OKS. The remaing 59% of OKS is owned by the general public.   While I strongly prefer OKE over OKS, I do consider it a good sign for OKS owners that OKE’s high ownership percentage of the limited partner shares does provide some measure of alignment between OKS and OKE.  However, as we shall see below, the GP receives just about as much in distributions from OKS for its 2% GP share that it does for its 39% stake in the LP shares.

How can that be? Well, under the incentive distribution provisions, as set forth in ONEOK Partners’ partnership agreement, the general partner receives:

  • 15 percent of amounts distributed in excess of $0.3025 per unit;
  • 25 percent of amounts distributed in excess of $0.3575 per unit; and
  • 50 percent of amounts distributed in excess of $0.4675 per unit.

With OKS currently paying $3.01 in distributions per unit over the last twelve months, the payout is so much higher than the highest threshold of $.4675/unit that almost all of the distribution is subject to the 50% IDR payout.  And critically, the GP gets this gain on total units, not just growth in the existing units, so every new unit that OKS issues increases the IDR payment as well.

The following table shows ONEOK Partners’ distributions declared for the periods indicated (Years ending December 31, all numbers in thousands, except unit amounts):

2013 2012 2011
Distribution per unit $2.89 $2.69 $2.37
General partner distributions 18,625 16,355 12,515
Incentive distributions 259,466 210,095 131,212
Distributions to general partner 278,091 226,450 143,727
Limited partner distributions to ONEOK 268,157 249,600 200,524
Limited partner distributions to noncontrolling interest 384,988 341,704 281,500
Total distributions declared 931,236 817,754 625,751

The IDR payment of 259 million is just 9 million less than the amount OKE receives for owning 39% of OKS. In effect, the IDR is worth about 38% of OKS!


It’s Good to be the General Partner!

With the possible exception of hedge funds, it’s hard to find a more attractive business model than being the general partner (GP) of a publicly traded master limited partnership (MLP).  In return for putting up just 2% of the capital, you not only get to control all the management decisions of the partnership, you get paid to do it with lucrative incentive distribution rights (IDRs) that can grow to 50% of all funds distributed.

The partnership structure is attractive to investors because it eliminates corporate income taxes. Instead of paying taxes at a corporate level, MLPs pass through the gains and losses of the partnership to the unit holders in proportion to their share of their ownership to report on their own tax returns and avoids double taxation of dividends.

These payments arrive in the form of “distributions” which look like dividends are technically different.  These are not reported on the unit holder’s taxes as dividends but rather on the K-1 tax form along with the owner’s share of any gains or losses in the partnership.  Since depreciation is high in infrastructure based MLPs, the partnership will report a loss rather than a gain so the distributions become a return of capital rather than taxable income so no taxes are due until the investment is sold..  This combination of high yields and tax deferment makes MLPs attractive to retail investors to yield conscious investors.

So what is better than a high yield, tax–deferred investment in a limited partnership?  Well how about owning the general partner instead.  The GP gets the same pro-rata unit distribution on its 2% ownership of the MLP as the limited partners get, but much more importantly, it also gets an IDR payment, the secret sauce of MLP investing, for growing the MLP.

IDR’s are birthed in the founding prospectus of a MLP to motivate the general partner to grow the MLP by rewarding the GP annually with incentive payments over certain distribution thresholds.  As these targets are reached, the GP receives an ever increasing percentage of the growth until eventually half of the incremental gain is committed to the GP by the IDR.  If that doesn’t sound rich enough for the GP, it gets even better (or worse, if you are a limited partner).  As the partnership sell more LP units to fund the purchase of more assets, the GP gets to collect IDR payments from an ever increasing number of units. While limited partners only gain when their distribution is increased, the GP gains not only by increasing the distribution per unit, but from the increasing the number of units as well.

Since IDRs are so valuable, most publically traded MLP’s are arranged to have one partnership that owns the business assets and a second partnership or C-Corp that owns the General Partner of the first MLP. This lets Wall Street separate the usually higher yielding, but slower growing distributions of the LP, from the lower yielding, but faster growing distributions of the GP.

The problem with IDR’s is that eventually, too much of a good thing can cook the golden goose Once 50% of all future distribution growth is allocated to the GP, it can be difficult to find accretive acquisitions to grow the LP. This past fall Kinder Morgan collapsed its limited partnerships back into a new C-Corp (KMI) to deal with just this problem.  Other companies, such as Magellan Midstream have dealt with this by having the LP’s buy out the GP, but however it happens, the GP gets compensated for giving up the IDR.

By this time, it may have occurred to the reader that GP’s are leveraged investments to the LP and that leverage is the eight deadly sin.  Yes, GPs are levered to the success of the limited partner’s MLP they manage, and furthermore purchasing the GP of a bad LP is certainly not going to turn out well.  But I’m not sold that GP’s are inherently risky.  In my opinion, the way to manage this risk isn’t to necessarily pick the “non-leveraged” LP over the “leveraged” GP, but to pick a safer MLP in the first place.

The MLP business model works best for stable, long-life assets under multi-year contracts. Unlike tax paying corporations, partnerships can’t save up capital for a rainy day as they are required to distribute their excess cash as it comes in. This is not a problem for a MLP with valuable interstate pipelines shipping product owned by others under long term contracts.  Stable contracts, no commodity risk and high deprecation makes for an excellent MLP candidate. However, a MLP created from a single cyclical commodity chemical plant run on a series of short term contracts, the MLP structure is a recipe for disaster.   Because, an MLP has no reserves to draw on, all it takes is for the weak MLP to suffer, is to need to raise fresh capital in a down cycle forcing it into unfavorable asset sales or highly dilutive secondary share offerings.

With the current decline in oil prices, many energy MLP’s are being sold off, some wisely but some indiscriminately since different MLPs are more affected by commodity prices than others.  At the top rung in MLP quality in the energy space are long-haul interstate pipeline companies like Plains All America, PAA.   Since these companies have stable prospects and no commodity exposure, they should not be affected in the long-run by changes in commodity prices.

In the middle tier are the midstream players that gather gas and oil from the wellhead and process the liquids out of the gas before sending it on to the interstate pipelines.  These companies to get involved in a little hedging of the natural gas liquids in their processing facilities since they are often paid by taking a percentage of the profits for their processing, but this risk is relatively small. The larger risk for midstream players is more the general health and future prospects of the basins where they operate.  Midstream operators in a high cost basin would not see much if any growth in a low oil price environment. Should an E&P with plans to drill 1000 wells in a basin, decide to scale back their plans after drilling just 25 wells, the midstream processing plant will never be fully loaded and will not achieve its initial targets. A smart operator is aware of this risk and manages plant expansion and minimum commitments accordingly, but in boom times people write silly contracts.

At the least desirable end of the risk profile are the oil and gas producing MLP’s.  Because oil and gas production naturally declines with time, MLP’s which purchase oil and gas producing properties and fighting an uphill battle with the almighty decline curve to maintain their distributions.   Oil producing MLPs must not only generate enough cash to pay their distributions but they must fund the purchase of new producing properties at the same time to ensure future cash generation as well.  Companies like LINN energy try to remove the risk of commodity swings by hedging future oil production, and in the process they will give up the upside of higher prices in in exchange for a lower prices with less volatility. This hedging allows them to project future earnings for two to three years out, but it doesn’t protect them from long term declines in oil prices.  Like California home buyers in the 90’s, these operators think prices only go up and trouble awaits in the odd year that it doesn’t.

Eagle Rock Partners (EROC) is an example of an oil and gas producing MLP that is mostly hedged through 2016.  So it may be unfairly marked down in price if the current oil price drop is temporary what if oil prices are still low in 2016 when they need to write new hedges?   If you know the answer to that question, you could make money on Eagle Rock, but if you could answer that, I’d bet you could make more money trading oil futures on the NYMEX.

Next up, I will review some MLP GPs to put on your watch list…