VNOM - Viper Energy Partners: Growing By Acquisition

2023-10-22 06:14:02 ET

Summary

• Viper Energy Partners grows regularly through accretive acquisitions and has an advantage in knowing where Diamondback Energy operates.
• Viper Energy also grows organically as well.
• Viper focuses on acreage that is likely to be developed, ensuring continued production growth and maintaining partnership growth rates.
• If management has done its homework, then the acreage production will continue to grow faster than Diamondback Energy, which controls the soon-to-be corporation.
• Distributions will likewise exhibit cyclical growth.  Management does retain some distributable cash for opportunistic stock repurchases.

Viper Energy Partners ( VNOM ) has announced another acquisition. This royalty company grows both organically and through acquisitions at a brisk pace. It has an advantage over a lot of other royalty companies in that it generally knows where the main operator, Diamondback Energy ( FANG ) is operating to develop acreage. It therefore will usually only purchase acreage that is likely to be developed in the future. This means that rapid production growth is likely to continue well into the future.

The Diamondback Energy organization came up with a strategy through Viper Energy Partners to not only acquire upstream acreage cheaply, but also the accompanying royalty interests (when possible). This is just one of several ways that the Diamondback organization makes a little more money than many of the companies that are picking up bargain acreage in the current buyers' market.

The GRP Acquisition

Viper is generally picky about acreage location and operators. Many royalty companies purchase a royalty interest in a lot of acreage and then just wait to see who develops it (and when). Here, the company generally "knows" the acreage will be developed. The assurance runs especially high on any Diamondback-operated acreage.

This company only counts an acre of royalty. So, if the royalty rate is (for example) one-eighth, then the company would divide the acreage by 8 to get the acres reported above.

The acreage that the royalty company has is naturally centered in the Permian as that is where Diamondback operates. But management has been more and more slowly heading towards other basins. The key of course is the same thing as dominates the Permian acreage. Management needs an operator with a good reputation (and reasonably large operation) and the acreage has an excellent chance of development soon. Oftentimes, the acreage obtained is at least partially developed.

This is important because management later mentions that a fair amount of this acreage is undeveloped. This management goes out of its way to make sure that any investment generates cash now rather than later. The main goal is also to make an accretive acquisition that maintains (at least) the partnership growth rates.

Growth

This royalty company likewise distinguishes itself from depleting royalty companies. If the reserves are depleting with nothing to replace the production sold, then at least part of the returns from that type of royalty company needs to be reinvested as it is an actual capital return.

Here, this company has a growth objective. Therefore, any capital return can be spent by the investor because there is more acreage to develop, and production is growing. Even if the distribution is lower, that distribution represents spendable cash and will until growth stops, and production begins to decline as reserves are finally depleted.

Activity Levels

Viper Energy can grow at a different rate from the controlling company, Diamondback Energy because of the ability to purchase superior acreage with often superior operators.

One of the key things in the slide above is that this royalty covers intervals that are not productive at the current time. As technology continues to advance, that advance will open up more intervals to produce commercially that will add to the reserve report.

Texas and really the Permian have been producing long before I was born. The whole area is likely to produce long after I am gone using technology that we had no idea existed right now but will be common at some point in the future.

The record for above average production became clear in fiscal year 2020 when the activity led to some growth despite the dismal pricing. Distributions were cyclically low that year due to the very low commodity prices. But this royalty company far outperformed the upstream industry and then the activity "bounced back" much faster than was the case for a lot of upstream companies. It validated the strategy of management.

Distribution Policy And Expectations

The distribution policy here has changed from a 100% distribution of available cash to a lower percentage. This follows midstream in that the debt and capital markets did not want a "trip to the well for money" every time a new project came up. So this partnership does maintain some cash to repay debt and make small acquisitions.

Obviously, a very large one like this one requires some help from the seller in the form of accepting stock for part of the transaction.

As long as the production keeps growing, then the variable distribution will exhibit a cyclical growth pattern. Remember that royalty companies take their share "off the top" with only limited production and processing costs. There are no drilling and well completion (capital) costs that this royalty company has to pay (for example).

But the growth strategy ensures that the variable distributions will likely show cyclical growth for a long time to come. That makes this issue suitable for income investors that can withstand the highs and lows of a variable distribution entity.

Key Ideas

The time to consider investing in a royalty company is usually when distributions are cyclically low. An accretive acquisition, like the one made here, provides some downside protection during the next cyclical downturn in the form of higher levels of production along with the promise of more growth as more acreage is developed.

Usually, the time to sell a royalty company is when the distribution rate reaches a cyclical high. Generally, at that point, the market is telling you that the next stock price move is downward.

This management will also reserve some cash to make opportunistic repurchases from time to time. There is always a base dividend that the management feels it can defend on the next downturn. There are of course no guarantees because oil prices in fiscal 2020 went negative. That put an end to a lot of "defensible base dividends". That needs to be kept in mind by any potential investor.

Upstream is a very volatile place to do business. Therefore, there is a limit to defensible base dividends.

This soon to be corporation is probably a strong buy consideration for a lot of investors. For those that do not mind the volatile nature of the upstream business cycle, this could be a buy and hold issue as the company will benefit from the production growth long term that would lead to an ever-higher cycle of distributions.

Some would much prefer to "buy low and sell high". Given the cyclical nature of the upstream industry, that strategy is easily understandable.

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