My presentation on Contura Energy. Yes, I know its coal, but did I tell you it was cheap?
My presentation on Contura Energy. Yes, I know its coal, but did I tell you it was cheap?
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|
GP (IDR holder)
above $0.3163 up to $0.3438
above $0.3438 up to $0.4125
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
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.
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.
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.
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.
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.
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.
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:
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):
|Distribution per unit||$2.89||$2.69||$2.37|
|General partner distributions||18,625||16,355||12,515|
|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!
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…
Since buying from forced sellers is one of my favorite investment strategies, I always like to look at spin-offs. At the end of today, September 30, ADP, the enormous payroll processor, is spinning off its highly profitable and growing car dealer services company, CDK Global. Each holder of ADP on September will be receiving 3 shares of of CDK for each share of ADP.
Since ADP is in the S&P 500 and CDK will not be (its joining the smaller S&P Midcap index), every S&P500 index fund that owns ADP will need to sell their CDK shares quickly to stay aligned with the proper index composition. Because the amount of money invested in midcap funds is dwarfed by the S&P 500 funds, there will be many more forced sellers of CDK from the SP500 funds than forced buyers from the midcap funds. The result is a potential opportunity for a mispriced stock.
How good is the opportunity? Well, its good enough that I decided to read the CDK roadshow materials and run some simple calculations. Unfortunately, its not a value play, at least at current when issued pricing of around $30.50 share.
Growth investors who believe that CDK’s smaller digital car sales marketing division (373M revenue) will continue to increase at 20% year for years to come and overtake its slower growing but larger back office car dealer services (1500M) division should look at CDK more closely. But I’m a value guy, so I think I’ll take a pass.
Here is my 10 minute analysis. Call me if the stock drops to $20.
Given the recent events surrounding Awilco, the management sale of a small stake below then current market prices, the Scottish independence scare changing North Sea capex plans, and the decline in energy prices, I wanted to revisit the impact on daily rig rates on Awilco’s dividend.
Currently, Awilco owns two rigs under contract in the North Sea at an average day rates of $386,500 through 2015. At these rates, it is able to cover all maintenance and capex and still pay an impressive $4.60/year dividend, for a 25% yield at its current $18.25 stock price.
If nothing changed, we could simply multiply the current $1.15 quarterly dividend by the 18 year remaining life of Awilco’s two rigs, discount the dividends at 10%, skip the dividend once every three years to reflect downtime for maintenance, plug the numbers into Excel and get a future dividend stream worth $35. At today’s price of $18.25, that looks like a pretty attractive proposition. Of course, drilling is a cyclical business and assuming the rig rates stay constant is about the only thing I can guarantee won’t happen.
So what happens when rig rates change? Given that most rig operating costs are fixed, changes in rig rates show a leveraged impact on profitability. To help me with this, I constructed a simple model to estimate the impact of a change in daily rates on the dividend.
|Quarter||Quarterly Dividend Per Share (USD)||Dividends Paid (millions)||Contracted Daily Rig Rate (thousands)||Quarterly Revenue (millions)||“All costs” (Revenue – dividend)|
Color code: The values in purple are my estimates, the values in orange include a month when a rig is in dry dock (Dec 2015- Jan 2016 and March 2016 – April 2016), and the values in black are either actual or calculated values.
The contracted Awilco Daily Rig Rate = the sum of both rigs contracted rate divided by two. Zero is used for rigs in dry dock undergoing maintenance.
Quarterly Revenue = Average Rig Rate * 90 days * 2 Rigs * 97% up-time
“All costs” is the catchall bucket for what it costs Awilco to pay all expenses and capex.
Lastly, there is a gap of about 45 days between when the quarter ends and the company pays the dividend.
Impact of a cut in Rig Rates on the dividend
|Rig Rate Cut||New Quarterly Dividend||Dividends Payable (millions)||Post 2016Q3 Rig Rates (thousands)||Quarterly Revenue (millions)||“All costs” (Revenue – dividend)|
How do these rates translate into dividend yields and stock prices?
|Stock price that supports the following yields|
|Rig Rate Cut||New annual dividend rate||12%||14%||16%|
I use high rates to reflect that some of the dividend is really a return of capital since the rigs will be scraped in 18 years.
Using this model, the $19.12 price (120NOK) at which the Wilhelmsen’s sold a 10% stake would imply they expect a 25% or so drop in rig rates in 2016 if they are seeking a 14% yield. Or it may just imply how hard it is to sell a large stake in an illiquid company that they had to take a discount even if they expect rates to stay the same.
For more information on rates, the Awilco site has a recent “Pareto Oil & Offshore Conference September 2014” slide with North Sea rate history.
In closing, I know this model is very simplistic, and I know it is “wrong”, but I found it a useful way to think about rates and I hope you have as well.
Disclosure: I still own AWILCO, but I am no longer interested in being overweight this stock until the bottom of the next cycle when its inherent leverage will be more likely to work in my favor.
The Third First Savings and Loan corporation is trading at a significant discount to its intrinsic value exists because generally accepted accounting practices overstate the number of economically relevant shares to be used in determining common financial ratios. As a result, the thrift appears more expensive at first glance than it does upon closer inspection. Management recognizes the opportunity this is creating and is aggressively buying back stock at highly accretive prices. These purchases along with the upcoming dividend reinstatement should help TFSL trade closer to fair value.
If you look up Third Federal Savings and Loan Corporation (TFSL) on any online data service, the market cap will be reported as $4 billion, price to book at 2.2, and a share count of 304 million. Yet, of the 304 million TFSL shares on file with the SEC, only 73 million shares at the corporation are economically relevant at this time. The remaining 227 million are in reserve until the demutualization process completes. Since these share have yet to be sold and do not receive dividends, I believe they should be treated as dormant treasury shares until their full value is realized and the capital received in their exchange is placed on the books. Adjusting the share count drops the market cap of TFSL to 1 billion. It also places its price to book ratio at a tantalizing 57%. To explain the justification for this accounting change, a little background on Third Federal and the two-step demutualization process is necessary.
The Third Federal Savings and Loan Corporation (TFSL) is a mid-tier mutual holding company which owns the Third Federal Savings and Loan Association. The association operates branches in Ohio and Florida with over 11 billion in assets. It was founded in 1938 by Ben and Gerome Stefanski. Until its 2007 IPO, the ownership of the mutual was 100% owned by the members, that is the depositors, of the thrift.
In the early 20th century, mutual companies were common form of organization for businesses, especially savings thrifts and insurance companies. Investors who are fans of the movie, “It’s a Wonderful Life” will recognize the Bedford Falls Building and Loan as a mutual association. In the film, the townsfolk’s deposits weren’t just their savings, they were also shares in their mutually owned Building and Loan. Of course, that’s why old man Potter wanted to buy their deposits for fifty cents on the dollar, he wanted to gain control of that miserly little old institution.
Because the depositors of a mutual thrift are also the owners, tracking who owns what can be a little confusing when holding companies are involved. Following is a list of the three different organizations named Third Federal Savings and Loan and their distinguishing features:
Third Federal Savings and Loan Mutual Holding Company (MHC)
(74% owners of the Third Federal Savings and Loan Corporation)
(100% owned by the members of the Third Federal Savings and Loan Association)
Third Federal Savings and Loan Corporation (NASD: TFSL), the mid-tier holding company which owns 100% of the TFSL Association.
(26% owned by public shareholders, 74% owned by the MHC)
(100% owner of the Third Federal Savings and Loan Association)
Third Federal Savings and Loan Association, a regulated thrift institution
The members (depositors) elect the board of directors to the MHC which maintain majority controls of the corporation for the benefit of the association.
Mutual thrifts depend on their retained earnings and new deposits for growth capital. This leads to steady but slow growth which probably suites most members of the association just fine, but not necessarily their more ambitious managers who usually want to grow as fast as their peers at stock owned corporations.
To accommodate a mutual’ s need or desire for more capital, the Federal Reserve permits them to convert to stock holding corporations following well established procedures and regulations. Depending on how much capital they seek, they can chose to either partially or fully convert from mutual ownership to a stock corporation. In a partial sale, up to 49%, the mutual association gets to raise capital while retaining control of the thrift, while in a full conversion, more capital is raised but the resulting corporation is now solely in the hands of the stock holders.
In a one-step conversion, shares in the new corporation are offered first to the current members of the association. The offering is usually at an attractive price recommended by an “independent appraiser”. Frequently, the appraised price doesn’t fully reflect the intangible factors of value such as the mutual’s branch network, relationships, depositor base, and especially its increased value as an acquisition target. Not surprisingly, the share subscriptions are almost always oversubscribed. Since the amount of capital raised in a one-step conversion could be more than its existing retained equity, a single step conversion can easily raise more capital than the thrift can effectively manage.
As a result, most mutuals chose to convert in a two-step demutualization process. In step one, the thrift is transferred to a mid-tier holding company that issues the shares on behalf of the association. Up to 49% of the shares are sold to the members and sometimes the general public to raise capital, while the remaining, majority of the shares are assigned to a new mutual holding company (MHC). Because the public shares are a minority position, they are often referred in financial analysis as the “minority shares” of the new corporation.
The board of the MHC is elected by the members of the association from a slate of nominees provided by the management. The MHC board then controls the mid-tier holding company which owns the thrift. The result is that capital can be raised by the mutual without its members or managers losing control. Should later, the thrift want to raise more capital, or go fully public, it can then sell the rest of the MHC shares to its members and become 100% shareholder owned. Most thrifts chose to convert in two steps rather than one to better manage the amount of capital they raise at any one time.
Some thrifts, including TFSL chose to only complete the first step of a two-step conversion and remain indefinitely at step one. This allows them to obtain more capital, but remain with the mutual holding company structure preferred by the members and management. This is in contrast to most thrifts where the management seeks the glory and gain of selling to a larger public institution at a premium and encourages the mutual membership to complete a second-step a few years after the first step.
In the case of TFSL’s step one IPO, 30% of the corporation was sold to the public raising $886 million including a $106 million dollar loan to the ESOP which bought 5 million in public shares with the proceeds, 1.5% was granted gratis to the Third Federal Foundation, and the remainder was issued to a newly created Third Federal Savings and Loan mutual holding company (MHC).
The board of TFSL’s MHC is elected by the members (depositors) of the Third Federal Savings and Loan association by voting to approve a slate of nominees provided by the bank’s management. The MHC structure allows the association to maintain majority control of the corporation while raising capital from the benefit of the savings association. While independent nominees can be selected, this never happens, as the depositors are far less interested in these details of the mutual than is the management.
Should TFSL ever fully demutualize, the MHC would dissolve by selling its shares of the corporation to the members of the association in a second step conversion. The capital raised by selling the MHC shares would then drop down to the association creating an extremely, if not excessively, well capitalized thrift. Since the capital raised by the share subscription stays within the corporation, the members who take advantage of a second step conversion are effectively paying for their shares with their own capital and getting a portion of the retained earnings for free. Hence, most subscriptions are oversubscribed. Upon completion of the second step, the new corporation would be completely shareholder owned, over-capitalized, and led by a management that would quickly become more profit focused than before. The result is a highly attractive takeover candidate.
In our case, TFSL is showing no interest in completing a second step conversion. Mark Stefanski, 59, CEO and Chairman of the board, started at the thrift in 1981 and took on his current roles in 1988 at age 34 when his dad, the original CEO retired after 50 years of service. While he grown the bank five-fold in his 25 years, his current returns on equity and assets are unimpressive given the thrifts overcapitalization, though the numbers are trending favorably out of the recession. Besides being very well compensated, Mark Stefanski is leading a bank with a unique culture and it is hard to envision he would want to leave or change it.
While Mr. Stefanski is unlikely to be confused for John Stumpf at Wells Fargo for profitable growth, shareholders can be thankful that he does solidly understand the value of properly priced buybacks. Since 2007, TFSL has bought back 29 million shares of the publically traded shares. The public float is now 24%, or 70 million shares, down from 105 at the time of the step one IPO.
There is a caveat to ignoring the MHC shares in financial calculations. When (if) a mutual fully converts, and the shares at the MHC are sold, it is almost a certainty that they will be sold to the members at an attractive discount to their true value, as evidenced by the 10-20% jump on the IPO most conversions experience. This discount is dilutive to the public shareholders, but they too gain from the IPO jump, so some of the dilution is gained bank. However, a few percent of the shares are often given gratis to a local community foundation or as well as a usually larger stake that is given to establish a management incentive pool. Those shares will be 100% dilutive to the public, but the second step conversion also makes the new corporation an extremely well capitalized and desirable takeover target which is accretive to the public shareholders. The net effect of these actions will likely be a small, but manageable dilution for the public holders when the second step occurs, but it does not break the investment thesis. In any case, at TFSL, a second step is probably years away.
Financial Ratios based on adjusted share counts
|TFSL Corporation Shareholder equity||1,864,864,000|
|August 4, 2014 SEC 10-Q Share count||304,096,983|
|Shares held by MHC||227,119,132|
|Public (Minority) shares||76,254,395|
|Current Share Price||13.60|
|Share Count||Market Capitalization||Book Value||P/B ratio|
|MHC + Public Shares||4.1 Billion||6.147089||2.21|
|Public Shares only||1.0 Billion||24.45582||0.56|
|Dates||Buyback shares purchased||Average cost|
|2008 – 6/30/2014||29,444,050||est. 11-12|
|4/19/2014 – 6/30/2014||3,144,050||13.43|
Third Federal’s growth strategy
Third Federal Strategy for growing value is based on three elements: growing the mortgage portfolio with adjustable rate and 10 year fixed loans to protect exposure to interest rate risk, dividends, and buying back the minority shares. Of these, the buy-back of the public shares is the surest path to success given the accretive value of buying shares in a financial at .56 book. The company is currently purchasing around 60,000 shares/day or close to the legal maximum shares allowable of 25% of the daily volume on a 5 day moving average. On the August conference call, management said there is nothing “standing in the way” to prevent them from authorizing a new buyback program as soon as this one completes. Given, how clearly management has reiterated its commitments to buybacks, this is almost a certainty. However, there may be a 30-45 day delay between filings while awaiting approvals or “non-objection” from the Fed. Interestingly, this delay might be an optimum time for individuals to buy more shares as the company’s buying pressure will be missing.
All this buyback talk begs the question. Where did TFSL get all this capital to fund its buybacks? The answer is that TFSL is still grossly overcapitalized from its IPO in 2007.
|Third Federal Savings and Loan Association||Actual||Ratio||Required||Ratio|
|Total Capital to Risk-Weighted Assets||$1,648,098,000||23%||$710,810,000||10%|
|Core Capital to Adjusted Tangible Assets||$1,565,596,000||13%||$583,896,000||5%|
|Tier 1 Capital to Risk-Weighted Assets||$1,565,596,000||22%||$426,486,000||6%|
June 30, 2014
|Total Capital to Risk-Weighted Assets||$1,942,581,000||27%|
|Core Capital to Adjusted Tangible Assets||$1,860,079,000||16%|
|Tier 1 Capital to Risk-Weighted Assets||$1,860,079,000||26%|
From 10-Q, June 30, 2014
TFSL successfully preserved its capital during the financial crisis of 2008-9 by staying with mostly vanilla loan products, it did not seek liar loans, employ commission driven mortgage brokers, or act with reckless abandon. However, it did have a small community reinvestment program (about 1.2% of all loans) for residential mortgages called “Home Today” which applied “less stringent underwriting and credit risk standards”. Approximately half of these loans used private mortgage insurance, but the majority of those policies were underwritten by PMIC, which is now in receivership and expecting to pay out only 67% of its claims.
These loans are stinkers. Though small in number, 5 years later this tiny pool of loans is still responsible for nearly 25% of all 90+ days’ delinquent receivables. The good news is the bank fundamentally changed its community reinvestment loan program in March 2009. Borrowers without sufficiently large down payments who qualify for the “Home Today” program must now meet the same minimum credit scores and its new private mortgage insurer requirements as standard borrowers.
The other trouble spot during the financial crisis was poorly underwritten home equity loans or second mortgages. Currently, 16% of the thrifts loans are home equity loans and 18% of the company’s 90+ days delinquent receivables are attributable to these loans. In June 2010, the thrift made substantial changes to its home equity loan program and currently writes only a fraction (5-10%) of the volume in 2013 than it did in 2007-8. As the 10-K states, “When the Association began to offer new home equity lines of credit again, the product was designed with prudent property and credit performance conditions to reduce future risk.” Translated, this means the thrift writes only a small fraction or 5-10% of the home equity loan volume today than it did in 2007.
The quick rise in second mortgage delinquencies, not only generated quick losses, it also raised the ire of the Office of Thrift Supervision (OTS). Upon closer examination, OTS issued a memorandum of understanding (MOU) to the MHC in February 2011 suspending any the issuance of new debt, dividends, or share buybacks until enterprise risk controls were improved. The risk control MOU was not lifted until April 2014.
The Importance of Book Value
Investors will argue what P/B should be paid for a thrift until the end of time, but just about everyone agrees that for a profitable thrift with nearly 2 billion in equity and a good chance at earning average ROE’s, 56% of book is cheap. Certainty, if TFSL were to complete its second stage conversion, it would sell for more than book value in its takeover.
In particular for mutuals completing a second step, the book value and the price of the public shares ares often the key metrics used to compare the firm with its competitors when determining at what price the MHC should sell its shares to the association’s members. Since this metric will determines how much capital is raised in the second step conversion, it is clearly in the management’s best interest to increase it.
So how much stock can TFSL buy back and what will that do for the remaining shareholders?
Currently, Total Capital to Risk Weighted Assets is 1.94 billion or 27%, if it was dropped to 1.4 billion or 20%, TFSL would still have twice the capital required and free up $500 million for share repurchases. The only real limitation is how many shares a day it can buy in a day. With 250 trading days in a year, fifty thousand shares a day would allow for 12.5 million shares to be purchased.
|Public Share Count||76,254,395|
|Current Equity||$ 1,864,864,000|
|Capital available to spend on buy-backs||$ 500,000,000|
|Equity after buy-back||$ 1,364,864,000|
|Scenario A||Scenario B||Scenario C|
|Average buy back price||$ 15||$ 16||$ 17|
|# of shares purchased||33,333,333||31,250,000||29,411,765|
|Buyback Timing @ 1Mil shares/month||33||31||29|
|Post Buy-Back Public Share Count||42,921,062||45,004,395||46,842,630|
|Reduction in public shares||44 %||41 %||39 %|
|Book Value||$ 31.80||$ 30.33||$ 29.14|
|P/B Valuations||Post buyback price at different valuations|
|50%||$ 15.90||$ 15.16||$ 14.57|
|Current||56%||$ 17.81||$ 16.98||$ 16.32|
|66%||$ 20.99||$ 20.02||$ 19.23|
|Reasonable||75%||$ 23.85||$ 22.75||$ 21.85|
|85%||$ 27.03||$ 25.78||$ 24.77|
|Takeover Price||125%||$ 39.75||$ 37.91||$ 36.42|
So what kind of return can TFSL common stock generate?
Using scenario B, book value would rise to $30.33 from the reduction of shares below book value as 31 million shares would be purchased over 2.5 years. The thrift is likely to retain approximately 3 million per month after dividends or 90 million over these 30 months which would add $2 to book value (not included in above chart). Additionally, 70 cents in dividends would be received. The return on a $13.60 investment would be 14.1% per annum if the stock continues to trade at 56% of book, but at a more reasonable 75% of book, the return would be 28% per annum.
I don’t consider an increase in the price to book value from 56% to 75% to be unreasonable for a profitable mutual demonstrating a commitment to returning capital to its public shareholders.
A note about mutual holding company dividends. MHC don’t want the dividends. Accepting dividends generates a taxable event. The most cost effective to get more money into the hands of the association’s members isn’t through dividends, but by paying higher interest rates to the depositors who are the members. Of course, the public shareholders do want the dividends, so the traditional MHC answer is to waive their right to the dividends.
Prior to the Dodd-Frank act, the board of the MHC could waive the dividends issued by a mutual thrift by a board decision. Post Dodd-Frank however, MHC’s are required to have its members vote on the waiver decision. On July 31, the members of the association, voted to approve the board’s recommendation to waive up to 28 cents of dividends for the next year by a 97% approval of those who voted. The request to begin the dividends at seven cents per quarter is now at the Fed awaiting a non-objection notice for up to 45 days. Given the strong capitalization of the thrift, the lifting of the MOU earlier in the year, the previous Fed approval of the earlier buyback, and the dividend coverage from earnings, its approval seems a formality.
A 28 cent dividend equals a 2% yield at the current $13.60 share price. Given the aggressive decrease in share count, the dividend payout per share is also likely to rise quickly as the dividends from the retired shares are directed to the remaining shares. If half the stock is retired in 5 years (not an unlikely scenario given the company’s history), the dividend could double without a change in the aggregate dividend amount paid to shareholders from the company. Dividend coverage is about 30% of earnings.
The biggest risk to TFSL, is a sudden increase in interest rates. The thrift has moved over the past 4 years to lower its percentage of long-term fixed mortgages that it retains from 59% of the outstanding loans to 39% by focusing on ARMS and 10 year fixed mortgages. Still, an increase in interest rates would definitely hurt. As of June 30, 2014, in the event of an increase of 200 basis points in all interest rates, the Association would experience a 16.05% decrease in equity. Your guess about interest rates is as good as mine, but I am pleased that the management is continuing to reduce long-term exposure.
The next unknown is the final implementation of the Dodd-Frank regulations concerning mutual holding companies. For example, MHC’s are now required to obtain member approval to before waiving dividends. Will other restrictions be placed on capital transactions? Compliance costs are already up, what’s next?
The company froze its defined pension plan in 2011.
Current bank performance
I haven’t emphasized the thrift’s performance, because all the thrift needs to do to make my investment thesis work is avoid big mistakes, but a review of some key numbers are in order. First, the thrift did maintain profitability through the recession and all ratios except expense are trending favorably. While the return on assets at .61% and a return on equity of 3.75% are completely uninspiring, deleveraging the balance sheet through buybacks will increase both materially as will the continuing decline in delinquent loans. Lastly, expenses are higher and with increased regulation, and I expect them to stay elevated for the foreseeable future.
|Selected Financial Ratios and Other Data:|
|Return on average assets||0.61%||0.50%||0.10%||0.09%||0.10%||0.13%|
|Return on average equity||3.75%||3.05%||0.64%||0.53%||0.65%||0.80%|
|Interest rate spread(1)||2.24%||2.25%||2.11%||1.97%||1.77%||1.70%|
|Net interest margin(2)||2.41%||2.46%||2.39%||2.32%||2.16%||2.20%|
|Noninterest expense to average total assets||1.58%||1.52%||1.54%||1.50%||1.51%|
|Average interest-earning assets to average interest-bearing liabilities||118.49%||119.58%||119.60%||120.39%||119.70%||120.57%|
|Dividend payout ratio(4)||–||–||–||525 %||520%|
|Asset Quality Ratios:|
|Non-performing assets as a percent of total assets(5)||1.19%||1.58%||1.76%||2.34%||2.73%||2.57%|
|Non-accruing loans as a percent of total loans(5)||1.32%||1.53%||1.77%||2.37%||3.08%||2.74%|
|Allowance for loan losses as a percent of non-accruing loans(5)||59.08%||59.38%||55.03%||66.73%||46.49%||37.33%|
|Allowance for loan losses as a percent of total loans(5)||.78%||0.91%||0.97%||1.58%||1.43%||1.02%|
|Total risk-based capital (to risk weighted assets)||23.19%||24.10%||22.19%||22.29%||19.17%||18.19%|
|Tier 1 core capital (to adjusted tangible assets)||13.41%||14.18%||13.31%||13.90%||12.14%||12.48%|
|Tier 1 risk-based capital (to risk weighted assets)||22.03%||22.85%||20.94%||21.04%||18.00%||17.30%|
|TFS Financial Corporation(6)|
|Total risk-based capital (to risk weighted assets)||27.24%||27.94%||25.03%||NA||NA||NA|
|Tier 1 core capital (to adjusted tangible assets)||15.89%||16.59%||15.33%||NA||NA||NA|
|Tangible capital (to tangible assets)||16.59%||15.33%||NA||NA||NA|
|Tier 1 risk-based capital (to risk weighted assets)||26.08%||26.69%||23.78%||NA||NA||NA|
|Average equity to average total assets||16.21%||16.38%||16.00%||16.07%||16.19%||16.69%|
|Number of full service offices||38||39||39||39||39|
|Loan production offices||8||8||8||8||8|
Disclaimer: The author owns TFSL common.