Description

KRP is a diversified mineral and royalty MLP (no IDRs) that went public in February 2017 at $18.00/unit.  At its current price of ~$22.00/unit, KRP is cheap on a relative and absolute basis. Mineral and royalty interests are entitled to a portion of a well’s revenues but are not obligated to fund drilling and completion costs, lease operating expenses or plugging and abandonment costs at the end of a well’s productive life. Snarfy and jso1123 posted great write ups on VNOM and BSM, respectively, which are worth reading for additional background on the minerals space and KRP’s comps. Snarfy also posted an abbreviated write up of KRP on the VNOM message board. We approached KRP from a different angle than Snarfy and arrived at the same place. KRP is undervalued at its current market price.

KRP recently announced a large acquisition (“Haymaker”) that increases their TEV by more than 100%. The purchase price appears very reasonable, and the Sellers (KKR, Kayne Anderson, Haymaker mgmt) took 45% of the consideration in KRP units. The Sellers will own ~37% of the pro forma company. Legacy KRP directors and management will own ~15% of the pro forma entity (~$90mm).  

Reason for Discount

We believe a large part of what is driving KRP’s discount is terrible disclosure of where exactly their acreage is. Mgmt discloses net royalty acres by loosely defined basins/areas and provide some rough guidance in the Permian by county. This is not even close to sufficient data to come up with a reasonably precise valuation. However, even if we drastically risk their total acreage figures, the valuation still appears quite attractive. We believe this lack of information creates the opportunity, but it is also definitely a source of risk. We have calculated a risked, probabilistic valuation range. We believe that we have been extremely conservative in our risking, but there remains the possibility that we have not been conservative enough.

Based on PDP PV10 at strip and our probabilistic acreage valuation, we estimate ~40% to 76% upside to KRP’s current unit price.

KRP Strategy

KRP’s strategy is to buy mineral and royalty interests from the GP (dropdowns) as well as from third parties. In addition, KRP expects organic production growth at >1.5x the overall L48 production growth rate. KRP has 2 years remaining on its ROFO on the Sponsor’s retained mineral and royalty assets in the Permian, Bakken, and Marcellus. We attribute no value to the ROFO on the dropdown inventory. Management built KRP’s asset base by acquisition over past twenty years, but they are not merely asset aggregators. Importantly, they have shown the willingness to sell assets when the price is right. In May 2018, KRP sold 41 net royalty acres in the Delaware Basin for $9mm (>$200k/NRA) and indicated on Q118 CC a willingness to “consider additional sales when we have the opportunity to deliver compelling value to our unitholders” as well as on the Haymaker acquisition CC “we’ll consider sales if we believe they are highly accretive on a per unit basis”. Also on the Haymaker call, KRP’s CFO stated “If we get third-party interest in picking out some assets and we can sell them for massively accretive valuations, we're absolutely going to consider doing that. We're committed to optimizing our portfolio of assets, and frankly, obsessed about driving per unit accretion. So that's, that's consistent with our strategy. We have more assets now that we can consider.” This is music to my ears and is indicative of a rational capital allocation philosophy and process.  That said, I do not expect large scale asset sales in the future. In fact, maintaining and building scale is important for KRP. One of the benefits of the Haymaker transaction is that KRP’s G&A expense per boe (20:1 gas) decreases ~40% vs SQ.

Asset Overview

KRP interests are well diversified across the lower 48. Existing production is very low decline (avg 10%/yr over next 5 years) and very well diversified, although at only 22% oil (6:1), it is gassier than would be ideal from an oil bull’s perspective. The Permian is the largest constituent of their current production and accounts for ~28% (20:1). On the Q118 cc mgmt highlighted production growth in the Permian, DJ Basin, and Eagle Ford. There are currently 73 rigs drilling on KRP’s acreage (25 on their legacy position and an incremental 51 on the Haymaker acreage). Pro Forma 2017 year/year production growth is 5% (1.6x L48 growth rate).

The map below is what they give you to figure out what they own along with a table that has the NRA’s by basin. This is not very helpful but provides enough to start pushing numbers around and see what sort of bet we are making at the current unit price.

Permian Detail (excludes Haymaker Permian position)

Acreage Valuation and Implied Unit Price Upside

We estimate 40% to 76% upside to KRP’s current unit price based on PDP PV10 at strip and our probabilistic acreage valuation. The tables below lay out KRP’s NRAs by major basin. The risking is based on the company provided maps. We have the most data for the Permian as mgmt provides the actual number of acres that are prospective for the Wolfcamp/Bone Springs as well as a heat map showing NRA’s by county. The Midcon is the biggest question mark. We have risked it the most because the area is enormous, but there could be upside (or downside). We give no value to KRP’s Permian acreage outside of the Wolfcamp/BoneSpring (i.e. CBP) despite the fact that there are rigs currently drilling on it. We also give no value to any acreage outside of the named basins listed on the table. It is worth highlighting that this risking is overly simplistic. There is almost certainly less “core” acreage than what we have laid out. But there is also certainly meaningful acreage that is worth something between 0 and our core acreage valuations. Despite its shortcomings, we believe this framework is the best way to analyze the value embedded in the current KRP unit price and the potential upside.

What we have done in our valuation is show three cases. The first case shows one example of acreage risking that gets you to the current share price. In this scenario, you need to apply our “core” NRA valuation to only ~5% of KRP’s NRAs. We also show a Base Case and a High Case with slightly less draconian risking. Both of these case imply meaningful upside. There is no firm catalyst for achieving that upside. Additional disclosure of more precise acreage maps as well as further asset sales highlighting the value of the assets would be very helpful. That may or may not happen in the near future (unitholders should definitely push for additional disclosure). But in the meantime, KRP unitholders own a security that throws off a growing 9%+ distribution yield and that has a good probability of latent meaningful upside to NAV.

Note that we do not know the breakout of Haymaker’s Permian position between WC/BS and Other, so we have assumed the same proportion as KRP’s legacy position (accounts for ~$25mm-$35mm in our NAV).

Acreage Valuation

We derive our core acreage valuations in the tables below. A few words on methodology. We modeled a MTDR Delaware TC to determine what we can pay in the Delaware Basin and achieve a reasonable pre-tax IRR (>15%) with our well inventory and type curve assumptions and a <=10 year drillout schedule ($55 WTI and $2.75 HHUB). Based on that output we determined that you need to target a pre-tax ROI of ~4.0x to hit the IRR threshold. We then modeled representative TC’s and well inventories per drilling unit by basin to get revenue per drilling unit by basin and divided by the number of acres per drilling unit to get revenue per net royalty acre by basin and divided by 4 to get the implied value per net royalty acre by basin that will allow a mineral purchaser to achieve a pre-tax 4.0x ROI. Note that a net royalty acre = royalty rate x net acres. So ownership of a “net royalty acre” equates to ownership of 100% of the revenue associated with that “net royalty acre”.

Relative Value and Private Market Data Points

As a relative value check, VNOM’s current PDP adjusted implied value is ~$270,000/NRA with no risking at all. VNOM’s disclosure is excellent and their acreage is pretty much all core so it doesn’t deserve any risking; also VNOM’s partnership with FANG definitely deserves a premium as it has completion timing influence / alignment with the operator on a meaningful portion of its asset base. That said, $270k/NRA is a 54% premium to our Permian NRA valuation (which we apply to only 25-30% of KRP’s Permian Wolfcamp/Bone Spring acreage).

BSM’s disclosure rivals KRP for opacity, but I cannot get to the same type of implied upside for BSM under similar assumptions as I do for KRP. I think BSM is very good value today, but KRP is even better, in my opinion.

There are additional private market data points supporting our acreage valuations. As mentioned previously, KRP just sold 41 NRA’s in the Delaware Basin for $9mm (>$200k/NRA) to help fund the Haymaker acquisition. That is clearly not representative of all of their Permian acreage, but there is that kind of value in at least some of it. VNOM also regularly announces Permian mineral acquisitions at >$100k - $175k/NRA. And VNOM’s recent core Eagle Ford acquisition was >$130k/NRA (this was core of the core with Austin Chalk inventory as well; our Eagle Ford core valuation only assumes $45k/NRA). Anecdotally, we have heard of mineral transactions in the core Haynesville regularly occurring at north of $40k/NRA.

Conversion to C-Corp

KRP is in the process of converting from partnership to C-Corp (required votes are secured between the Haymaker Sellers and KRP Sponsors/mgmt). This will dramatically increase expand the KRP investor universe and is widely seen as a positive catalyst. It may or may not also necessitate a switch to standard public company governance (i.e. investor elected board of directors). If so, that would be a further positive as I believe that even the best run MLP’s have some degree of LP unit discount rooted in the lack of corporate governance (this point being highlighted by the current BWP saga). After the conversion, management expects to pay no cash taxes for the next five years.

Current Distribution Yield

KRP has a variable distribution policy and targets 1x coverage. Its Q118 annualized dividend yield is ~7.6%. The Haymaker transaction was ~20% accretive on a DCF/unit basis, so pro forma Q118 yield at 1x coverage is ~9%. Yield can be very misleading, so I tend to focus on NAV. But at 9%, it becomes a meaningful portion of the total annual return proposition. And investors often focus on it as its easy to run comps. VNOM’s Q118 yield is ~7% but has higher growth than KRP. BSM Q118 yield is ~6.7% but has higher coverage than KRP.

KRP Balance Sheet and Trading Stats

At ~2x debt/EBITDA, KRP is not unlevered, but still well within their means. Management targets a long term leverage ratio <1.5x. KRP’s organic production growth has been trending >1.5x Lower 48 production growth rate. This organic production growth will lead to some natural de-levering over time. Mgmt expects to complete the first dropdown transaction later this year, which will be another potential method of de-levering if the Sponsors take units as consideration. We would prefer that they under-distribute and retain cash flow over the next several quarters rather than issue more units, but we would not be surprised either way.

Catalyst

Additional acreage location disclosure

Additional high value acreage asset sales

Conversion to C-Corp