Wyatt’s “Unconventional IPO” — CEO Invests $25 Million to Start New Energy Company?

Ian Wyatt pitches "Freedom Drillers" after the Iran news.... Can you really buy into a South Texas oil producer before it goes public? Is it worthwhile?

This tease caught my eye, mostly because I was genuinely curious — Ian Wyatt is promoting a “webinar” he’s going to host on May 10 that will talk up a way to play the “new bull market” in oil, and part of it, at least, is going to be about a “unconventional IPO.”

So I wanted to know what he’s talking about. And, of course, I want to share my thoughts with all my dear friends here at Stock Gumshoe. Let’s dig in, shall we?

There’s not a lot of info, but here’s a taste of the email:

“… crude oil is surging 51% in the last year.

“Now’s the time to invest.

“That’s why one top venture capital firm just invested $300 million.

“They’ve already made a killing with early investments in Airbnb and Uber. But instead of sinking more cash into private tech companies…

“They’re backing a retired Fortune 500 CEO.”

And then we get a few more tidbits on the signup form for this webinar — a webinar that, I assume, will be similar to his past webinars in that he talks up the opportunity but reserves the actual information about the investment for his paid subscribers.

Which is fine — I have no problem with folks selling information or research, but I’d rather not sit through an hour-long sales pitch… and if it’s something I can learn on my own, I know I’ll have a better chance of thinking rationally if I take my time and research several sources first. If I pay for the idea or listen to talk about crazy return potential, odds are pretty good that I’ll be overwhelmed with profit lust and will have trouble thinking clearly.

Or that’s the idea, anyway, and the core reason why I started doing what I do here at Stock Gumshoe, revealing these “secret” stocks and trying to add some perspective here and there — the more you can think for yourself and poke a few holes in the hype, the better the chance you have of thinking rationally. Most of us will still do dumb stuff most of the time, I guess, but it’s nice to at least improve the odds a little.

Ready? OK, here are the other clues from the signup page:

“Former Fortune 500 CEO emerges from retirement to launch a new oil stock IPO!

“… one company acquired 360,000 acres in the Texas oil belt

“Why this new company could earn $250 million in cash profits – starting THIS YEAR

“How to claim your shares NOW – before this unconventional IPO”

And that’s pretty much it, at least until we get to the actual webinar at lunchtime on Thursday. So what’s the stock they’re hinting at?

I suspect this is a recent SPAC deal, and our Mighty, Mighty Thinkolator concurs: This is almost certainly the soon-to-be Magnoia Oil & Gas.

Which doesn’t exist yet, but is expected to soon — and it will have a new ticker, but for right now the “unusual IPO” means that you can buy into the SPAC if you wish, and will own shares of Magnolia once the transaction happens to create it.

What does that all mean? A SPAC is a Special Purpose Acquisition Vehicle, also often called a “blank check” company. These are pools of money that are raised in the public markets via an IPO, usually connected to an established investor or an industry bigwig who has some “brand value,” and they take those IPO proceeds and try to buy a company or merge into a company. For the target company, this has the advantage of bringing that big bolus of cash and sometimes a stronger management team or higher visibility, and usually the big advantage is that the target company can go public without itself having to go through the sometimes onerous IPO process… since the SPAC already trades publicly, it just changes its name and ticker and voila! The new combined company is publicly traded.

In this case, the SPAC was sponsored by TPG, the huge venture capital/private equity company, and headed by Stephen Chazen, who retired as CEO of Occidental Petroleum (OXY) in 2016. They called it TPG Pace Energy Holdings (TPGE), and it went public almost exactly a year ago.

The plan was to search for a target business in the energy business… from their website, “The strategy of TPG Pace Energy Holdings is to identify and acquire businesses that are better suited to generate strong returns in a public market environment while benefitting from the operational expertise of TPG and Mr. Chazen.”

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And that’s what they’ve done in agreeing, on March 20, to buy the South Texas oil and gas assets of the giant Houston private equity firm EnerVest. EnerVest was reportedly in serious trouble a year ago, with oil prices down sharply, so this way they sell off a share of some of their best assets to a strong and experienced operator, maintain 51% ownership, and also get a lot of cash that should make their investors much happier (and perhaps generate some fees from a portfolio that was probably pretty disastrous for a few years following the 2014 oil crash).

When it goes public, according to the Magnolia investor presentation, EnerVest will own 51% of the new company, the sponsor (TPG) will own 7%, and public investors, both the SPAC shareholders and the folks who added more capital in a private fundraising round in conjunction with the merger, including the new CEO, will own 43%.

They’re also raising some debt in a senior note offering, but not very much, so the numbers actually look fairly appealing — they will be much less debt-burdened than many oil companies, and they are expected, at least they themselves so believe, to generate a lot of free cash flow and to be valued, on an EV/EBITDA basis, among the cheapest South Texas oil companies.

The stock actually looks pretty interesting at this valuation — I did go through the investor presentation, though I didn’t dig much deeper than that, and the financial metrics look really impressive, and if Steve Chazen is able to have anything like the kind of success he had at Occidental there’s a chance that he could build the company into something far more substantial, presumably by adding to their Eagle Ford and Austin Chalk properties. Of course, Steve Chazen does not have a magic wand to control the oil price, and Occidental under his leadership did fall plenty fast in 2014 and 2015 when oil fell, dropping 30% or so.

If oil stays at $58/barrel and the other forecast assumptions are accurate, (which I have no outside expertise in assessing), then Magnolia thinks they’ll be earning $200 million in EBITDA after Capex (almost $550 million before Capex, but you can’t capex or you stop producing oil). That’s $184 million in free cash flow, and that means they could potentially have paid off their net debt (the current $300 million debt offering) by the end of 2019. That’s a little lower than the cash flow yield for 2018, mostly because capex will be higher, but it’s still a pretty solid cash return… and I would guess that they would bump up the capex and try to grow production more, with additional drilling, given the relatively high oil price and their lack of leverage.

So that seems pretty interesting, particularly since I don’t really have any oil exposure right now. That’s not enough to make me commit a meaningful amount of cash to this after spending just an hour or two browsing through the presentation, but it’s enough to get me intrigued. If you want a little more background, there was a quick Bloomberg story here that sums it up and has some quotes from Chazen about his (conservative) strategy.

The story is a little bit reminiscent, at least for me, of the last big oil CEO who came back to start a new company — Mark Papa from EOG Resources, who formed Centennial Resource Development using a SPAC called Silver Run Acquisition about two years ago. That one was a little more richly valued on the basic EV/EBITDA numbers, but oil prices were also quite a bit lower then — and the stock has certainly done well, going from about $10 to $19 in a couple years.

And those of you who’ve been reading my work for a long time probably know what my next thought was — “if this was a SPAC, there are warrants… right?”

And yes, there are warrants — almost every SPAC comes with warrants attached, and after a few months those warrants typically begin trading separate from the equity (the initial ticker at the IPO was TPGE.U for the combined units, they have now split into TPGE and TPGE.WS — each unit included one third of a warrant). That warrant piece is where a lot of the juice comes from for the sponsors of the SPAC, and the extra sweetener to get public investors to invest in something that doesn’t really exist yet… warrants provide substantial leverage if the eventual business combination ends up being a great investment.

The odds of that are fairly long, it must be said — most SPACs disappoint, partly because the SPAC backers are under pressure to make a deal, any deal, within their two-year window before they have to return the cash to shareholders. But sometimes they work out… and outside of SPACs, it’s very rare to get long-term warrants on businesses that aren’t in hyper-risk areas like biotech or junior mining. That’s why they appeal to me, because long-term warrants are typically not given a lot of value by mainstream investors — when you’re focused on the next six months, you forget how valuable it can be to get five YEARS of upside exposure in a strong company with a small cash outlay.

So yes, TPG has warrants, with the ticker TPGE.WS (sometimes the ticker symbols of warrants differ, could be TPGE-WT or TPGEWS on some platforms). Those will become warrants on the shares of Magnolia and will, like TPGE, get a new ticker symbol when the deal is done, probably in a month or so. And those warrants give you the right to purchase shares of the stock (TPGE) for $11.50 for five years.

Normally that would be a no-brainer for me — I’d speculate a little with the leverage of the five-year warrant for an oil producer that looks pretty solid and doesn’t have massive capital costs, particularly because of the recent strength in oil prices (the estimates in the presentation look like they are for oil prices that were meaningfully lower, at $58, when the deal was being built over the winter).

It looks like there’s a little catch, though — the public warrants, unlike the private warrants given to the sponsors as part of the SPAC IPO, have a redemption price… so they can force you to redeem the warrants when TPGE shares (or whatever the new ticker is) hit $18.

Coincidentally enough, that’s the same deal that CDEV warrant holders had, and that stock surged higher quickly so the redemption was called by the company — in this case, they offered a cashless redemption and essentially turned each tendered warrant into 0.376 shares of stock, since that was the average value of the warrants with the shares at a bit above $18.

So if something similar might happen with TPGE, how does that impact the price and valuation assessment of the warrants? In the case of CDEV, it worked out pretty well — if you bought a warrant for about $2 around the time the deal was announced, the stock was over $18 before a year was out and the redemption means your $2 warrant turned into almost $7 worth of CDEV stock, and it so happens that CDEV didn’t go up all that dramatically in the time since that redemption came in January, 2017, but, well, that partial share is still worth close to $7. The stock rose by 90%, the warrant returned about 250%, and from January 2017 on they’re all CDEV shareholders, so there’s no further leverage for folks who started out as warrantholders.

Right now, TPGE trades at about $10.34. Investors are pretty happy with the Magnolia deal, it was trading at about $9.70 before the deal was announced (SPACs represent $10 of cash, give or take a few cents, and can usually be redeemed for very close to $10 in cash if shareholders decide they want to opt out of whatever the “business combination” is — so they typically trade right around $10, usually a few percent below, until a deal is announced). The warrants were trading at about $1.50 or so before the deal was announced, as is also fairly typical for a SPAC that investors have a decent amount of confidence in, but bumped up immediately to almost $2 when the deal was announced and last traded at about $2.15.

Warrants give you the right to buy the shares for $11.50 for five years after the business combination is consummated, so you’re effectively betting that the shares will be over $13.65 by the spring of 2023. The $18 redemption, however, like with CDEV before them, means that the value of the warrants is capped at $6.50 — which is fine if the stock surges to $20 in the next year and you get that huge leveraged return quickly, but frustrating if you were hoping for more leverage than that.

So how does the value work? The “Capital at risk” assessment you start with is important. Say you have $5,000 to invest in TPGE, and you’re willing to put 40% of it at real “I might lose 100%” risk — a loose stop-loss order in case oil crashes again or the company screws up. Everyone uses different position sizing to plan for what might happen if things go south, more typically folks would use a stop loss of 20-25% and say they’d sell the shares if they fell below $7.50 or so, as that might indicate it’s “broken” or that you were just wrong… but let’s say you’re willing to give it more leeway and risk up to 40%.

That means you’re putting $2,000 at “real” risk, assuming that it’s a decent operating company and not a fraud, and that oil won’t drop to $20 again and the stock won’t collapse to zero overnight — despite being newly public, this is a pretty large and established company, and chances are pretty good that you’d be able to get out of it with a stop loss order if the shares fall in a somewhat normal way.

So if you’re buying warrants instead of equity, the fairer comparison is to say that you’d risk $2,000 on the warrants, since those currently have an actual liquidation value of zero as long as the stock is below $11.50. You’re willing to lose $2,000, then that’s all you put into the warrants, and you put the other $3,000 into something safer — maybe cash, maybe an index fund if you don’t feel the need to hold cash, whatever.

So if you put $2,000 into the warrants today, we’ll be generous and assume you can get them for $2 — you get 1,000 warrants.

Or you put $5,000 into the shares, we’ll be similarly generous and assume you can get them near $10 and buy 500 shares.

What happens in the future? Say, three years from now — we’ll assume that the stock is at $14. Your 500 shares are worth $7,000, and you’ve made a nice 40% return. Maybe a little more, if they start paying a dividend (Chazen’s record at building a nice dividend growth company at Occidental was part of the presentation, though they didn’t actually promise that Magnolia will eventually pay a dividend).

The warrants, alternatively, would have an exercise value of $2.50 each (buy at $11.50, sell at $14 = $2.50). They’ll probably also carry a premium over that to account for the fact that they still have two years before expiration, but unless the stock is really surging the premium is often not huge at that point — I’d guess they’d trade not a lot over $3 then. That would turn your $2,000 into perhaps $3,000, and you had another $3,000 that you invested in something else, so that’s a total of $6,000 if you just put your additional $3,000 into cash. You would have been better off in the stock, if you were honest with yourself about how much risk you were willing to take.

How about if the stock really does surge, and it doubles in three years to $20? Then the shares double, that’s easy math and you make $5,000 on your $5,000 investment for a 100% return, plus, perhaps, some dividends, and you’ve got $10,000.

In the warrants, though, you would have been stopped by the redemption clause along the way and been forced to convert to equity or sell at $18 — your $2,000 investment in the warrants would have turned into $6,500. That’s pretty awesome, a 200%+ return in a few years… you don’t get those very often. Add back the $3,000 you had sitting aside in something less risky, since, remember, you were only willing to risk 40% of your investment, and you end up with…. $9,500. Or if you did the cashless exercise, assuming a similar number to what CDEV offered, you end up with roughly a third of a share for each warrant, and you could just let those ride instead of selling them (you’d have to be active and paying attention, though — warrants can become worthless if you ignore a redemption notice, or forget the expiration date and don’t do anything, particularly if your broker happens to not notice for some reason and doesn’t hound you about it, as discount brokers often will not).

Converting the warrants at $18 would let you enjoy that two dollar move from $18 to $20, assuming it happens and you have about 2/3 as many shares as you would have had if you had just committed $5,000 to the stock in the first place… but you do get enough pop from that to make up for the extra $500, and your account value probably still sits right around $10,000… actually, $10,200 as I mock it up on the back of envelope.

And, of course, if the stock is at $11 or below in three years, your warrants will likely have dropped by 60%, at least… and if they are below $11.50 in five years and you’re still holding, they go to zero. That’s a very real risk of a 100% loss if this recent happiness in the oil market turns to sadness again for several years, or if the company itself has bad news.

At the other end of the spectrum of possibilities, unfortunately, because of that redemption clause, warrant holders don’t get to daydream about what would happen if this turns out to be a hugely successful oil company, or oil jumps to $150 and the shares surge to $30 in a few years — you’re capped at $6.50 per warrant. That’s fine in the probability world, and probably works OK in most of the models that the Wall Street folks will use, which is why warrants are often relatively underpriced in my mind… but that’s because unlike the computer models, I think there’s real value in the long tail of possible but unlikely outcomes for warrant speculations, the chance that TPGE might get to $30 or $40 within five years and turn that $2 warrant into $25. But there’s no shot at that here, which means I’d want to pay a little less for the warrant.

So what does that mean?

It really just means that warrants are leverage — if you invest as much in warrants as you would in equity, you’re taking a much larger risk to get a much larger return. If you put the full $5,000 you have available into the warrants and the stock gets to that redemption price of $18 right around expiration in five years, the maximum possible return is just over 200%, your speculation would turn into $16,250 while an investment of $5,000 in the stock itself would turn into $9,000.

If the stock goes to $40 somehow on an oil surge, and you convert into shares at the $18 redemption and let them ride, a $2,000 investment turns into $14,440 — still a levered return of 600%+, and if that other $3,000 you held aside returns 10% a year it’ll be $4,400 in five years, so add that on and you’ve got $18,840.

$5,000 invested in the equity, on the other hand, turns into $20,000 if you go to $40, for a simple 300% gain. But since you invested more, because the risk of a 100% loss was not as meaningful, you still end up with more. Obviously, whatever you end up doing with that “less risky” money that doesn’t go into the warrant has a lot to do with those comparative returns.

That’s what makes warrant investing exciting and sexy, but it’s important to realize that you probably really can limit your losses in the underlying stock, at least 99% of the time, and you have a much lower possibility of limiting your losses in the warrants if the stock does poorly.

That’s just a little screed on warrant speculating — If I decide to buy into this Magnolia story, my initial impulse would have been to take on a small speculative position in the warrants if it weren’t for that redemption clause, but as I mull it over and try to be somewhat conservative, I’d also think more seriously about the actual equity, or some blended exposure (if that sounds appealing, the original units still trade, too, at TPGE/U or TPGE.U, each of those consists of one share of TPGE with a third of a warrant attached).

I haven’t invested in this one either way, but if you think oil prices are going to stay relatively high, the numbers in their investor presentation do look pretty compelling — that is, of course, the job of an investor presentation, to be compelling, but the combination of good cash flow at $58 oil and a low debt level means that the company could pretty quickly lever up to grow, and that tends to be good for equity returns.

So I don’t know the company well, but I’m intrigued — if oil stays strong it could do very well, and they do have a solid base expectation that’s below the current oil price, and an experienced CEO who has rewarded shareholders in past oil bull markets.

That’s just my quick take, though — it’s your money, so what do you think? Have other ideas? Leery of these retired oil CEOs who are coming back to try to build another company? Think the forecasts are too conservative or too aggressive? If you’ve some wisdom to add, we’d love to hear it — just use the friendly little comment box below. Thanks for reading!

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