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…

Outside the Strike Zone (CDK)

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.

Share Price
25 27.5 30 32.5 35
Market Cap 4003 4403 4803 5203 5604
Net Debt 725 725 725 725 725
EV 4728 5128 5528 5928 6329
Year Ebitda EV/Ebitda
2012 314 15.1 16.3 17.6 18.9 20.2
2013 379 12.5 13.5 14.6 15.6 16.7
2014 413 11.4 12.4 13.4 14.4 15.3
200 4.2% 3.9% 3.6% 3.4% 3.2%
Share Count 160.1

All models are wrong, but some are useful (AWLCF)

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.

Key Assumptions:

  1. We know that Awilco is committed to distributing all cash above its reserve for major expenditures.
  2. We know its rig rates.
  3. We know how much it has paid in dividends.
Quarter Quarterly Dividend Per Share (USD) Dividends Paid (millions) Contracted Daily Rig Rate (thousands) Quarterly Revenue (millions) “All costs”       (Revenue – dividend)
13Q1 1.00 30 338 59 29
13Q2 1.00 30 338 59 29
13Q3 1.10 33 338 59 26
13Q4 1.10 33 348 61 28
14Q1 1.15 35 350 61 26
14Q2 1.15 35 364 64 29
14Q3 1.15 35 405 71 36
14Q4 1.20 36 386 67 31
15Q1 1.20 36 386 67 31
15Q2 1.20 36 386 67 31
15Q3 1.20 36 386 67 31
15Q4 0.85 26 322 56 31
16Q1 0.65 20 285 50 30
16Q2 0.40 12 202 35 23
16Q3 0.60 18 275 48 30

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)
48% 0.16 5 200 35 30
42% 0.30 9 225 39 30
35% 0.45 14 250 44 30
29% 0.59 18 275 48 30
22% 0.74 22 300 52 30
16% 0.89 27 325 57 30
9% 1.03 31 350 61 30

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%
48% 0.64 5.33 4.57 4.00
42% 1.20 10.00 8.57 7.50
35% 1.80 15.00 12.86 11.25
29% 2.36 19.67 16.86 14.75
22% 2.96 24.67 21.14 18.50
16% 3.56 29.67 25.43 22.25
9% 4.12 34.33 29.43 25.75

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 hidden value at Third Federal Savings and Loan (TFSL)

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

TFSL Corporation   Actual Ratio
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.

  30-Jun 30-Sep 30-Sep 30-Sep 30-Sep 30-Sep
  2014 2013 2012 2011 2010 2009
 Selected Financial Ratios and Other Data:            
 Performance Ratios:            
 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%
 Efficiency ratio(3)   59.81% 59.67% 60.31% 56.59% 54.59%
 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%
 Capital Ratios:            
 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. 

One more blogger writing about Awilco Drilling (AWLCF)

Awilco Drilling

Awilco drilling is seemingly every small cap value investor’s favorite North Sea driller; you’ll find it written up wherever value guys hang out.  Its high dividend is its primary attraction and the dividends sustainability, its primary question mark.

Usually high yields usually scream trouble to me, and I can identify several scenarios where Awilco’s dividend could be challenged, but I believe Awilco also holds a sustainable niche. I purchased it last year before the first dividend was paid and while it’s not the “load up the truck” buy of last year, it’s still attractive.

This post is my one year update. I wrote it to help me freshen up my valuation.  Your constructive criticisms will help me refine my analysis, so have at it, but please note I am using a yield based analysis to ballpark the value of the company. In the links to other sources at the bottom of this article, you can find a more traditional cash flow model if that’s your preference.

History of Awilco

Awilco Drilling PLC is a UK based drilling contractor. It owns and operates the two refurbished and enhanced mid-water semi-submersible drilling units, WilPhoenix and WilHunter, each rated to operate in 1200 and 1500 feet of water respectively.  In 2009, Transocean wanted to merge with GlobalSantaFe, but the combination would have created a total monopoly in the North Sea. To obtain UK approval, Transocean was required to sell off two ships to another operator. Transocean needed a buyer quickly, the Awilhelmsen group fit the bill, and thus began the current incarnation of Awilco Drilling.

For those like me, who hadn’t heard of the Awilhelmsen group before, it is a private Norwegian company with interests in shipping, oil field services, real estate and financial investments.  They owns 48.7% of Awilco Drilling and are the controlling investor. Awilco’s market cap is approximately 645 million with 125 million in 5 year debt. The stock was listed publically in 2011 on the Oslo Axess exchange as AWDR:NO and  is also available on the pink sheets as AWLCF. Not surprisingly, liquidity is significantly better on the Axess market than the pink sheets.

The WilPhoenix and the WilHunter rigs were almost 30 years old when they were purchased from Transocean in December 2009. Upon receipt, Awilco’s first action was to take the old rigs to dry dock and invest another 97 million to upgrade the rigs, enhance their capabilities and extend their life another 20 years.  The upgrades improved the rigs highly desirability and reliability. They have been under continual contract since released from the shipyard in 2011.

In January 2013 the company announced it would begin paying out all its available cash over a $40 million reserve as dividends.  Until then, the company was aggressively paying down debt. The first dividend payment began at $1/quarter in May 2013 and was raised to $1.10/quarter this past November.

On a $21.50 stock, a $4.40 per year dividend is a yield of 20.4%. Pretty good, eh? Well yes, but there are some gotchas. For starters, the rigs only have 18 years of fatigue life left in them.  This means (a) we only get the dividends for 18 years and then nothing, and (b) part of our dividend is really the depreciation of our rigs as they covert from productive equipment today to scrap in 18 years.  We should consider this portion of the dividend as a return of capital and definitely not earnings.

To model the depreciation in value, we can divide the share price of $21.50 by 18 years of remaining life or $1.20/year. Now the value of the rig probably only declines as a straight-line if you’re an accountant. In reality, the decline in the rigs useful value would be more back end weighted, but I’m being intentionally conservative. With this assumption, the $4.40 actual dividend, less this $1.20 adjustment equals a $3.20 normalized dividend.  At our $21.50 share price, we get a normalized yield of 14.9%.

But we still have some adjustments to make. We need to account for scheduled and unplanned maintenance. For instance, one ship is due to dry dock for two months in 2016.   While the cost of the maintenance is already accounted in the cash the company keeps in reserve for maintenance; there is no reserve for the loss of revenue while the rig is in dry dock.    So if both rigs are out of action two months every five years for scheduled maintenance and we have another two months of unplanned downtime per rig every five years as well, we need to reduce the normalized yield by 4/60 or 6.6%. This takes us down to a normalized yield of 13.9%.

While 14% is not as eye catching as 20%, it’s still a pretty impressive number in a low interest world. For comparison, Awilco’s 5 year bonds yields 7%.  If a normalized 12% would seem reasonable for a small cap with good management, then a little more capital appreciation would seem possible as well.  With a 16% bump in price to $25/share, Awilco would trade for a 12% normalized yield while still paying out $4.40 per share in dividends.

Currently, day rates in the North Sea are benefiting from a tight market.

Can this last? Normally, I would advocate for a quick revision to the mean, but Awilco is a little different situation that many rig operators.

Awilco management thinks day rates will soften in 2015 and firm back up in 2016.  The following two charts from their March presentation show the status of North Sea rig utilization and contracts.




But aren’t day rates are notoriously volatile and what about all those new super rigs being built?

Yes, rates are volatile, but only where there is an active, changing market. For me, this is where the investment gets very interesting and Awilco picks up a little bit of a moat.

The North Sea is a mature oil province that was drilled up in the 1970’s and 80s. In its day its wells drilling in 1000 feet of water were considered deep, but that was 20 years ago.  Now, no one considers the North Sea to be deep water anymore. So while plenty of new rigs are being built, all of them are being built for much deeper water (5000-10,000 feet) where operators will pay much higher rates.

No one is building brand new rigs for the old mature fields and no one can afford to pay deep water rates for routine work in the North Sea. But the old mature fields aren’t dead just yet; there is still remedial work to be done and spot opportunities to apply new technology. If nothing else, the current rigs in the North Sea could stay busy plugging and abandoning the old wells for years to come.

What keeps competition from moving in and lowering day rates?

While rigs can be moved across the ocean from one basin to another that takes months during which time the rig is not earning money.  Furthermore, not just any rig can be certified for North Sea operations, so there is a regulatory hurdle to be overcome to operate in the UK during which time the rig would also be sitting around not earning any money.  Finally, but not insignificantly, the old rigs made for the North Sea were designed for the North Sea and deal with its notorious weather and rough seas better as well, but no one is building brand new, old rigs anymore.

The most likely competition would be someone doing what Awilco did.  Buy an old rig take it off the market for a year and retrofit it.  To make the economics work best, it would help to have a forced seller like Awilco had with Transocean.  It could happen, but it will not happen overnight.

The company’s current contracts are with strong counter-parties, so we’re covered through 2016, but long term this is probably the most significant risk.

Key Indicators to watch: 

Day rates for Awilco’s drill semi-submersibles – Any changes on the contracts?

Day rates for North Sea drillers – Is anybody bring new rigs into the market?

Any significant change in the price of oil? – Obviously a long-term significant price drop would impact the day rates.

Additional Risks

Rig accident –   Every 10 years there is a catastrophic offshore drilling accident resulting in a huge fire, spill, destruction of the rig, and a tragic loss of life.  However, every year 600-700 offshore rigs across the globe operate safely without incident and news coverage.  Yes, a tragedy could strike Awilco, but this needs to be weighted as a 1 in 500 type event or even a 1 in 100 probability and can be accounted for by reducing the value of your investment by 1 per cent.

Unfavorable acquisition – Currently, Awilco is a cash generating dividend paying machine. What happens if Awilco purchases another rig or makes another large acquisition?  Will this dry up the dividends? Perhaps, but let’s don’t forget that the Wilhelmsen’s made a pretty good deal when they bought the two rigs from Transocean a few years ago. Maybe should want them to make another good acquisition and make us even more money.  This risk is probably a wash. They do seem like intelligent operators.

Extended drop in oil prices – Some North Sea work is mandatory for regulatory reasons and needs to be performed regardless of the current oil price, but the majority of well work is done for purely economic reasons which would obviously suffer with a 30% drop in oil prices.  Of course, a rise in oil prices is always possible too.  Shave a little more off fair value for this risk if you want, but wait until Mr. Putin is finished annexing the Ukraine first.

Regulatory Risk – There’s been chatter of a change in UK taxes, but nothing firm.

Other good sources of information:

To learn more about AWILCO, check out these links:

Company Presentation March 2014

2013 Annual Report




Tim Eriksen’s Value Investing Congress Notes

 Disclaimer: I own AWLCF and AWDR:NO


How to make 26% annualized without really trying (too hard)

How to make 26% annualized:

  1. Find a small bank which suspended its preferred stock’s dividend during the credit crisis.
  2. Make sure the dividend was cumulative and will pay interest on the dividends in arrears while you wait for it to resume payments.
  3. Make sure the bank will have the resources to payback the dividends it missed.

Here is our candidate:

Old Second Capital Trust I, 7.80% Cumulative Trust Preferred Securities (Nasdaq: OSBCP)

Old Second Bank is a small bank holding company serving the western Chicago suburbs.  Like many banks it was unprepared for the financial crisis of 2008/9, needed TARP money, and got overextended.  At its nadir, it suspended payment of its preferred stock effective June 2010 and became subject to Federal Reserve  supervision.

The preferred is redeemable by the bank at $10 plus all outstanding dividends at anytime prior to 2033.  At $10/share, OSBCP yields 7.8% or 19.5 cents per quarter.  Since last paying its dividend in June of 2010,  the preferred will have missed 16 payments by June 30, 2014 for a total of $3.62 ($3.12 in dividends and $.50 in interest on the missed dividends).

So why buy the preferred now?  Well for starters, the bank is doing better now and is no longer under a Federal Reserve consent decree, so it can pay dividends again. Second, the bank recently issued new common stock with the stated goal of “We plan to use the proceeds of this offering to pay the accrued and unpaid interest on the Trust Preferred Securities”.  While no date has been announced for the dividend payments to resume,  my calculations use the next available payment window of June 30, 2014.

The math:

Purchase price 4/23/2014:  $12.98

Dividends to be received on June 30th, 2014: $3.62

Absolute Return on investment = $.64/$12.98 = 4.93%

Annualized return on a 67 day investment = 4.93% * (365/67) = 26.8%

Assumptions: I am assuming the preferred will trade at $10/share once the back dividend is paid and the regular dividend schedule resumes.  Most likely, it will actually trade a little below $10 once the dividend is first paid out and then start to trade a little above $10 once yield investors see a bank preferred paying 7.8% interest and bid up the price.

Taxes: You will want to do this in your IRA our else as the $3.62 dividend is fully taxable as ordinary income.

Risk:  The largest risk is that the bank delays paying off the suspended dividends for another quarter.  While we would continue to earn the 7.8% rate while waiting; our annualized return will suffer. Also, this issue is thinly traded.  Use a limit order and be patient else you could get a really bad price when buying or selling.

The prospectus:  http://www.sec.gov/Archives/edgar/data/357173/000104746903022390/a2113714z424b1.htm

Disclaimer: I own OSBCP and may sell it at anytime.


4/25/14 Update:  Since posting, I’ve received some valuable feedback from readers that leads me to be concerned that this issue may not be very liquid after it resumes its dividend. As a result, this security is unlikely to trade near par anytime soon after its dividends resumes and would therefore be unlikely to achieve a high annualized rate.

Its probably best to take a pass unless you have room for an illiquid holding.