Value Investors Club / VIPER ENERGY PARTNERS LP (VNOM)

Description

Viper Energy Partners LP (“VNOM” or “Viper Energy”) trades at a 7.5% FCF yield, growing at ~24% with

zero cap ex, and 90% EBITDA margins. If this type of earnings stream was evident in a company in any

sector outside of energy, VNOM would command a significant premium to current levels. While

categorized as an energy company, I believe the nature of this business (mineral rights) is rather

different from others in the energy sector and should be thought of as more of a real estate entity,

capturing economic rent from activity tied to its acreage. This is a business that should generate cash at

every point of the cycle, whether crude is at $100/barrel or $20/barrel and its recent conversion to a C-

Corp could set the stage for passive/index buyers over time.

So, what is VNOM? The company was set up as a mineral rights business primarily focused on the

Permian Basin. Viper Energy has over 15k net royalty acres, has distributed over $5.50/share to

shareholders since Q1’15, and has organically grown production per share by more than 130% over the

same time period. Mineral rights provide the owner with a contractual percentage of the revenue of

any oil and gas barrel produced on its acreage. Similar to a great piece of real estate, the determinant of

value is tied to the location of the land and whether the third-party user can generate attractive returns

doing business there.

Viper Energy generates ~90% EBITDA margins without any capital expenditures because the investment

is made by the exploration and production (“E&P”) companies that own the drilling rights (separate

ownership from mineral rights). There is substantially more detail on the background of the business in

a previous write-up by snarfy, who provides an excellent overview of the business. In the case of Viper

Energy, the business is tied to the most attractive oil basin in the US (Permian) which is expected to

provide most of the oil growth going forward. A detailed analysis of VNOM’s acreage underscores that

the Permian E&P companies have some of the most economic drilling opportunities in the world and are

positioned well to drill for decades given the limited hydrocarbon recovery relative to the resource in

place. One can get a sense of the Permian’s attractive value proposition by diving into the returns

exhibited by companies drilling in the basin (more on this below) or by looking into the recent public

bidding war between Chevron and Occidental Petroleum for Anadarko (APC), another major Permian

mineral rights owner.

Key Characteristics to Thesis:

• Substantial FCF Yield (~7.5%) coupled with ~24% organic growth with zero cap ex

• The company has ~90% EBITDA margins and generates FCF at trough oil prices (FCF = 10yr

Treasury Yield at $20/barrel)

• Top notch management team

• Resource is only ~20% developed and is exposed to a secular growth basin in the US (Permian

Basin)

• Passive/Index ownership provides opportunity for significant rerating following C-Corp

conversion (~65x the potential investor base following conversion)

Permian Basin:

A deep dive into the return profile of energy exploration and drilling companies indicates that the

Permian is one of the greatest oil resources in the world. It was initially developed for vertical drilling

and provided significant oil production in the 60s and 70’s at which point it went into a multi decade

decline as those resources were exhausted. Then came the US shale renaissance, which applied

horizontal drilling and fracking to access resources previously thought to be uneconomic. This

development has uncovered many different horizontal plays within the Permian Basin, similar to a layer

of cake, with each layer providing significant drilling opportunities. The Permian is further broken down

into three basins: Permian, Central, and Delaware. While the Permian Basin was initially deemed to be

only key area of economically attractive resource, it has become evident that the Delaware Basin is just

as comparable in size and scope. Overall, the Permian has proven to be an enormous resource and one

that is economic even at $45 crude (see below). This has led to enormous production growth over the

past three years (15%/35%/42%). While energy has not exactly been a great place to invest, a look at

Permian’s production growth below suggests this is a secular trend that could provide attractive

investment opportunities.

E&P Companies Struggle with FCF Generation:

While there are many companies with acreage in the Permian it is difficult to find investments that

generate FCF. For those of you who have wondered why energy stocks have performed so poorly over

the past few years as oil prices have significantly appreciated, it can be summed up in the chart below.

This shows the FCF generation from 2013-2018 for the largest independent US shale companies. While

oil has fluctuated from $40 to $100 the trend is clear; cash burn year after year. Generally speaking,

many E&P companies simply do not appear attractive due to the limited (at best) cash flow they

generate over a cycle. The industry has a history of very poor capital allocation, outspending on drilling

during the boom times, burning cash during the trough, and often requiring dilutive equity capital to

address elevated leverage.

Viper Energy Generates Cash Every Year due to its Superior Structure:

From its IPO in 2014 when oil was near $100/barrel to the trough in pricing in 2016, Viper Energy has

been able to generate cash every quarter. Then nature of this business model enables the company to

generate FCF even at trough oil prices. This is evident when looking at the company’s substantial

organic growth and cash generation through the last downturn (see below chart). In fact, VNOM’s

organic production has significantly exceeded that of the Permian Basin due to its premier acreage and

exposure to high quality companies as drillers of this acreage. The last VIC write-up went into detail on

the Spanish Trail assets (please reference old write-up, approximately ~20% of production today), but

going forward other key counties in the Permian oil play such as Loving and Reeves county should drive

growth alongside established plays. From a resource development perspective, the company believes

they are still in the early innings with <20% of its net drilling locations developed. On the first quarter

conference call, management noted that they are “still very optimistic about our growth profile for the

next decade” and that they have “decades of running room” from a development perspective.

C-Corp Conversion:

Despite the attractive business model and uniquely positioned acreage, I believe Viper Energy remains

substantially discounted on an absolute and relative basis largely because it was an MLP and categorized

as an energy company. Its partnership structure limited institutional ownership and in turn, passive and

quantitative capital flows. In 2018, the company announced its conversion to a C-Corp which I believe

paves the way for significant outperformance over time. If one observes other conversions from MLPs

to C-Corps (BX, KKR, KMI), it is evident that the improved market access to institutional investors has the

ability to dramatically improved public valuations.

In summary, I am going to quote Travis Stice, Board member and CEO Diamondback Energy (controlling

shareholder) from the Q4 Call:

“I'll just add to that commentary that in our prepared remarks, we emphasized it couple of times there's 300

million barrels of total resource there. And as Kaes pointed out decades of future development in front of Viper

Energy Partners. But what again stands unique in this investment space is that all of these resources, all of this

development, all of this organic growth occurs without one single $1 of capital being required. And I just challenge

– I'll just challenge anyone to find as unique a vehicle as this growth, this yield, where you don't have to spend any

money to get it. It's just – it stands alone.”

Disclosure: At the time of publication, the author of this article holds a position in VNOM. This

article expresses the opinions of the author. The author has no business relationship with any

company whose stock is mentioned in this article.

The author of this article has a long position in the company covered herein and stands to realize

gains in the event that the price of the stock increases. Following publication, the author may

transact in the securities of the company, and may be long, short or neutral at any time. The author

of this report has obtained all information contained herein from sources believed to be accurate

and reliable. The author of this report makes no representation, express or implied, as to the

accuracy, timeliness or completeness of any such information or with regard to the results to be

obtained from its use. All expressions of opinion are subject to change without notice, and the

author does not undertake to update or supplement this article or any of the information contained

herein. This is not an offer to sell or a solicitation of an offer to buy any security.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Continued execution via FCF generation and sustainable production growth

show sort by

			2019	2020
Price:	30.00	EPS	.95	.73
Shares Out. (in M):	135	P/E	32	41
Market Cap (in $M):	4,000	P/FCF	13	12
Net Debt (in $M):	100	EBIT	197	267
TEV (in $M):	4,100	TEV/EBIT	21.5	15.8