VNOM - Viper Energy Partners: More Money Ahead

2023-06-09 16:07:37 ET

Summary

• Viper Energy Partners LP is a rapidly growing royalty company.
• The rapid growth ensures higher cyclical dividends.
• A royalty company does not have the exploration risk of upstream.
• Royalty companies do not control the development of the leases that they have interests in.
• Management is repurchasing shares. That indicates that management believes that the stock is cheap.

Viper Energy Partners LP ( VNOM ) has a very good history since going public. The rapid growth of the royalty company assures a lot more money ahead for this variable distribution entity. Management continues to look for good royalty deals while repurchasing shares. Both of these ensure a bright future that augment the business strategy of purchasing royalties on acreage that is relatively sure to be developed sooner rather than later or maybe never.

A royalty company does not bear the typical exploration risk nor the expense of drilling and completing wells. A royalty company also does not control the rate of development of the royalty acreage. This is why it is so important for companies to determine if the geology is favorable enough for that acreage to be developed. So far, this management has an excellent record of finding acreage that will be developed.

The cash available for distribution will vary with the price of oil and natural gas. But the growth ensures that each cyclical peak will be higher than the last. Now, fiscal year 2022 had tremendous commodity prices early in the fiscal year. That led to a new distribution per share record even though the company switched its strategy for distribution.

The big change shown above is that the payout ratio is 75%. Originally, when the company went public, Viper Energy paid out 100% of distributable cash. That shrank to 50% for a while during the fiscal year 2020 coronavirus challenges and now appears to have stabilized into a long term strategy.

As part of this change, management apparently views the common as undervalued. Therefore, what was part of the distribution is now used to repurchase shares. This has decreased current income to shareholders. But that strategy will also accelerate annual growth through less shares outstanding.

It would appear that market demands for self-funding of growth projects has finally arrived at the front door of the royalty companies. This change in market attitude was readily apparent in midstream long before now. But it appears to be spreading to all kinds of investments.

Note that management can switch between return of capital through distributions and share repurchases. Viper Energy partners already has a fair amount of production growth. So, the share repurchases indicate that management believes that the stock is relatively cheap.

Oil prices are in a range that really many of us were hoping for just a couple of years back. Natural gas prices will likely gradually join the much stronger world market as North America continues to increase its capacity to export natural gas. The chronic oversupply of natural gas in North America will likely become a fading memory within the next few years.

Viper Energy Partners strategy of only purchasing acreage royalties in leases that will be developed is clearly paying off. Much of the industry is focused upon balance sheet repair and getting production back to where it was before the fiscal year 2020 covid challenges that saw industry activity largely ground to a halt. Clearly, the partnership production outperformed the industry in fiscal year 2020.

That relatively strong performance in fiscal year 2020 allowed production growth to resume rather quickly as shown above. Notice that the cash margin did decline along with the cyclical weakness in oil prices. However, this management does hedge production to protect that margin during times of extreme volatility (as was the case in fiscal year 2020).

The nice part about the business strategy is that when prices cyclically strengthen (as they inevitably do), those stronger prices usually are always on higher production. So, while the distribution is volatile, it does trend higher over time.

Management does have a base dividend in an attempt to provide a continuing distribution during cyclical downturns. But the maintenance of the base dividend is heavily dependent upon commodity price levels. As fiscal year 2020 demonstrated, prices can always go lower than the assumptions for maintaining the dividend would have predicted.

Therefore, even though the setup of a base dividend and a variable dividend at least attempt to have a minimum maintenance distribution. Industry conditions can dictate otherwise. What investors can depend upon is that the base dividend will survive a wide variety of industry conditions because it is a small part of current cash flow. But this investment idea still should be considered a variable distribution entity "just in case."

Notice that the 25% of retained cash flow available for distribution will be used for a combination of acquisitions and debt reduction. Reducing the debt will allow for larger purchases in the future should such an opportunity become available. This is a further indication that the days of selling stock to finance sizable royalty purchases are probably over for the foreseeable future.

Management did mention a small acquisition that closed in the first quarter. The new policy enables acquisitions within cash flow. Those acquisitions will likewise accelerate growth.

As shown above, the debt ratio is extremely conservative for the industry. This has been a typical characteristic of the Diamondback Energy ( FANG ) organization for some time. The key idea is that the ratio needs to remain conservative at considerably lower commodity price levels so that management can go shopping for bargains when bargains abound. That is usually at lower (than current) commodity price levels.

Key Takeaways

Management has embarked upon a growth strategy that is likely to continue for an indefinite amount of time into the future. The production growth ensures ever higher distributions even if those distributions depend upon the cyclical price of oil and natural gas.

The management strategy of finding leases that are likely to be developed appears to have resulted in Viper Energy partners outperforming the industry in terms of production levels during the fiscal year 2020 coronavirus challenges. That is likely to continue into the future.

The fact that management is opportunistically repurchasing stock means that management considers the stock relatively cheap. That is an insider's perception of the current situation that should be well worth noting.

For income investors, Viper Energy Partners LP is not an investment for those that need the money on a predictable basis. The industry is notoriously low visibility and extremely variable. But for those income investors who can withstand varying levels of dividends, Viper Energy Partners could be a decent investment consideration.

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