Description

Sugar magnolia, blossoms blooming, heads all empty and I don’t care

Saw my baby down by the river, knew she’d have to come up soon for air—The Grateful Dead

Don’t try to buy at the bottom and sell at the top.  This can’t be done; except by liars—Bernard Baruch

My wife has always liked dividends and so at some point the dividends will come into play—Steve Chazen, Magnolia CEO

Summary:

Magnolia (MGY) just hit an all-time low and is down 33% since January 1.  Meanwhile it just reported a solid year notwithstanding very challenging industry conditions:  Free cash flow was $223MM ($0.88/share); cash built on an already conservative balance sheet despite a 7MM share buyback; and reserves expanded both through the drill bit and bolt-on acquisitions in its core Karnes County area.  Unless one believes that oil and gas prices will plummet from here and remain very low for a very long time, MGY is just too cheap.

I had never heard of the company until Sancho presented the idea on VIC in June, 2018. Anyone still interested in a terribly out of favor idea should go back and read his analysis, which is well-argued.  Last November Sancho exited the recommendation at approximately the same price as his entry point. I thought his call was wrong, but, at least in the short term, he has been absolutely correct.  

My goal has always been to find well-capitalized stocks that could produce a total return of 30-40% over two years without market tailwinds. Ideally, they should also have the promise of compounding for a very long time. MGY, in my view, qualifies at these levels in an environment where there do not appear to be many such candidates. 

February 20 Investor Presentation:

https://www.magnoliaoilgas.com/sites/magnolia/files/mgy-4q19-earnings-presentation-final.pdf

Corporate Strategy and Recent Guidance:

As Sancho detailed, Magnolia is the outgrowth of a SPAC created by TPG and Steve Chazen, formerly the CEO of Occidental Petroleum (before the Anadarko acquisition). Chazen has described hunting for purchase candidates in the Permian, which he knew well given OXY’s activities there), but ultimately settling on the Eagle Ford given its lower acreage costs and proven production capability (see p. 13 of the Presentation for a comparison of breakevens by area).  

Froom inception, management has been laser focused on spending only 60% of EBITDAX, reserving the balance for modest acquisitions in adjacencies, share repurchases, and, at some point, dividends. Chazen has repeatedly cited the virtues of a typical industrial company’s financial model versus the norms in oil and gas. Debt is modest at $400MM (6% notes due in 2026) and the company grew its cash in 2019 to $183MM.  In an environment of low oil and gas prices in which many producers, both public and private, are too levered, this is a significant competitive advantage.  

The heart of the company today is Karnes County (65% of current production and quite oily.)  Since MGY’s formation in 2018, it has expanded its Karnes acreage by roughly 50% to 22,100 net acres. Chazen has stated that approximately twice as much might be for sale in Karnes; the issue is that prospective sellers haven’t come to grips with the current realities of the market. Margins are very attractive, even at current oil prices. Karnes wells pay back rapidly (6 months or so), but have a steep decline curve.  

One reason for the very weak stock price over the last couple of days is that production guidance for 2020 was lower than at least some sell-side analysts anticipated, based on the projected move of a drilling rig from Karnes to Giddings County, in the Northeast Eagle Ford.  MGY has 430,000 net acres in Giddings: hence potentially decades of production opportunity. On the Q4 call this week, the company disclosed a plan to shift a drilling rig from Karnes to Giddings, transitioning there from purely appraisal (where the results have been good) to an early stage development program.  But the price for this is lower production growth this year.  

As Chazen observed on the recent call, “We can make any production growth we want just by doing all Karnes wells.  The problem is that the wells have a sharp decline.” And also:

Shifting our operating rig to Giddings over a short period of time, we expect Giddings production to overtake Karnes on a BOE basis and a little longer period overtake Karnes on a barrel-of-oil basis. With increased production at Giddings, we can start building a base of lower decline production in a more efficient manner, ultimately reducing the amount of cash flow needed to keep production flat. The price for this is lower volume growth this year as the Giddings wells come on slower than Karnes wells, but also have a much shallower production profile.

I believe this is the right long-term move for the company--more definitive results at Giddings could be transformational for MGY--but perceived disappointing guidance in a stock that was already terribly out of favor given industry concerns is a recipe for short-term pain.

Steve Chazen:  Ownership and Compensation:

I don’t know Steve Chazen, but I know a lot about him and admire his stewardship of Occidental Petroleum.  As a generalist, I take comfort in his large personal ownership and significant investment in Magnolia. The 2019 proxy showed that he owned 8.5MM shares; he made two further open market purchases of 25,000 shares each over the balance of the year.  He was granted 4MM shares and 2.5MM warrants (subsequently converted to stock) as part of the SPAC. By my reckoning, however, he has also invested about $17MM personally. His salary is a flat $250,000. No bonus; no options; no stock grants. Success or failure at Magnolia won’t change his life, but he has a significant financial interest, to say nothing of his self-esteem, in making this work.

Risks:

--Oil demand, especially given China and coronavirus.

--Natural gas prices.  Hard to believe they could go much lower, but I have been very wrong on this in the past.  For what it’s worth, I like the longer-term analysis of gas pricing in the recent Cabot Oil and Gas VIC report.

ESG. Antagonism to fossil fuel investments.

--Steve Chazen’s health.  He will be 74 this year and I already said he is an important part of my thesis.  A mitigating factor is that CFO Chris Stavros worked with Chazen for many years at OXY and I believe shares the same business philosophy.

--Disappointing progress at the Giddings Field.

Catalyst

Continued buybacks.  Progress at the Giddings Field over the course of the year.  Greater recognition of the differentiated corporate strategy. WTI climbs over $60 (has done so every year except 2016).