Whiting Trust I: Overpriced Till It Falls Below $1.75

| About: Whiting USA (WHX)


WHX is overpriced. Friday's closing price was $2.73, yet WHX will terminate in less than a year, and its remaining distributions will total just $1.75.

To get a 9% return, buyers should pay no more than $1.60.

The idea that short rebate fees justify a higher price is a fallacy.

The average WHX shareholder can expect less than 1.5 cents in short rebate fees over the next year.

Whiting USA Trust I (NYSE:WHX) is overpriced. On Friday, buyers were paying $2.73 for WHX, perhaps seduced by the eye-popping 65% "dividend yield" that showed up on Yahoo Finance. But WHX is not a dividend stock. It's not going to pay dividends indefinitely like, say, a utility. WHX is a terminating royalty trust that will only pay distributions until shortly after it terminates in March 2015, less than a year from today. After its final distribution, WHX's value will be $0.

The year-off termination of WHX is disclosed clearly on WHX's FAQ page. What it means is that a "yield" of 65% isn't going to cut it. If you hold from here until termination, you need WHX to pay out 100% of the current price over the next year--just to break even. And that isn't going to happen.

How much is WHX going to pay out over its final year? About $1.75. If you pay more than $1.75 for WHX and hold until termination, you're likely to lose money. And if you want to make money owning WHX, you should pay less than $1.75. For example, to make the 9% return that WHX was originally designed to provide, you should pay no more than $1.60 today.

The recent price of $2.73 represents an excellent opportunity to sell. By selling now, you will immediately get about $1 per share more than you would if you held until termination.

Calculating final distributions

How do we know that the final distributions will be about $1.75? The calculation isn't hard. WHX sells oil and gas and distributes the profits to shareholders. To estimate future distributions, we start with the oil and gas that WHX will sell in the next year, then multiply that by the expected profits per unit of oil and gas.

We know with certainty how much oil and gas WHX will sell in the next year. When WHX formed in October 2007, it stated that shareholders would receive 90% of the net profits from a mix of oil and gas equal that would total, over the life of the trust, 9.11 million barrels of oil equivalent (9.11 MBOE). In other words, shareholders would receive 100% of the net profits on 8.20 MMBOE (8.20=90%x9.11). As of March 31, 2014, 7.37 of the original 8.20 MMBOE had been sold--so just 0.83 MMBOE remain (0.83=8.20-7.37). WHX projects that it will sell the last 0.83 MMBOE over the next 4 quarters, finishing by March 31, 2015, and making its last distribution soon after.

What distributions will shareholders get from the last 0.83 MMBOE? We can get a good idea by looking at recent history. Over the past 4 quarters, WHX sold 1.02 MMBOE of shareholders' interest and paid $2.15 in distributions. That's $2.11 per MMBOE. At that rate, selling the last 0.83 MMBOE will result in distributions totaling $1.75 (=2.13x0.83).

Other analysts have arrived at similar estimates. In February-March 2014, using a variety of methods, Profit Propositions, Russian Hill, Fair Value and Weighing Machine estimated that future distributions would total between $2.10 and $2.29. Those analysts were including the May 2014 distribution, which turned out to be $0.47, but today new buyers can't get the May distribution since it went ex-dividend on Friday. So past estimates should be adjusted downward by $0.47. After that adjustment, the estimates of Profit Propositions, Russian Hill, and Weighing Machine range from $1.63 to $1.82, which are close to my estimate of $1.75.

Even WHX's management has acknowledged that the shares are overvalued. The company's 2013 annual report stated: "To the extent that the Trust units are trading at a price substantially in excess of the aggregate distributions that may be reasonably expected to be made prior to the termination of the Trust, the market price decline in Trust units is likely to include one or more abrupt substantial decreases." After that disclosure was publicized in a March 2014 press release, WHX's price dropped from $5.39 to $2.53 in just two days.

The price crept up again as buyers tried to capture the May distribution of $0.47, but that's over now since WHX went ex-dividend on Friday. You can't collect the May dividend if you buy today; you will still collect the May dividend if you sell today.

Another drop in price is inevitable.

The short rebate

"But wait!" I hear you cry. "What about the short rebate fee?" Recently short sellers have been paying an annualized rate of 65% to borrow shares of WHX and sell them short. Don't WHX shareholders pocket some of those fees, and couldn't the fees justify paying a price for WHX that substantially exceeds future distributions?

This is a popular idea, but it doesn't stand up to scrutiny, as I've written before. Let's walk through the numbers for WHX.

The naïve version of the short-rebate argument goes something like this. WHX is selling for $2.73 and shareholders can only look forward to $1.75 in distributions. But short sellers are paying 65% annualized to borrow WHX, and 65% of $2.73 is another $1.77. So including the short rebate fee, a shareholder can look forward to something like $3.52 in income over the next year ($3.52=$1.75+$1.77). Seen through that lens, the current share price of $2.73 looks justified. It may even be a bargain!

But it doesn't work that way. In fact, the average shareholder can expect to receive less than 1.5 cents in short rebate fees over the coming year.

To see that, you have to recognize that the short-rebate argument is full of holes. The first hole in the argument is the biggest: buying a share of WHX does not guarantee that anyone will borrow it and sell it short. To the contrary, only 6.6% of WHX shares are currently sold short. If you're holding a share of WHX, the chances are 93.4% that no one is paying a cent to borrow it.

The second hole in the argument is that, even if someone is paying to borrow your share, they're not paying you. They're paying your broker, and many brokers don't share the short rebate fee with customers. If you have a premium account with a generous broker (Interactive Brokers is an example), then you'll get half the short rebate fee if someone borrows your shares-but only if your broker can't find a non-premium customer to borrow from first. Naturally, your broker would rather borrow shares from a customer who they don't have to pay. So as a premium customer, your chances of having your shares lent out are probably less than average-i.e., less than 6.6% in the case of WHX. If you're an institutional customer, maybe you can get a better deal, but only 3% of WHX shares are held by institutions.

The third hole in the short-rebate argument is that the price of WHX isn't going to stay at $2.73 until termination. We know very well it's going to $0; the company's own website says so. We don't know how the price will get from $2.73 to $0, but the annual report suggests that the ride is "likely to include one or more abrupt substantial decreases." Even so, let's be naïve and assume that the ride will be a smooth, linear descent from $2.73 to $0, so that the average price over the next year will be about $1.36 (half of last Friday's price). This is a very generous assumption, since it amounts to saying that the stock is going to remain overvalued until it terminates.

A final hole in the argument is that the short rebate isn't going to stay at 65% for the next year. It may go higher for brief periods, but when WHX falls to fair value there won't be much demand to sell shares short, and the short rebate fee that brokers can charge will fall accordingly. In addition, short sellers will close their positions, so not as many shares will be held short.

With all that in mind, let's come up with a generous estimate of the short-rebate income that the average shareholder can expect over the next year. Let's heroically assume that the short rebate stays at 65%, that the percentage of shares held short stays at 6.6%, and that the average share price over the next year is $1.36. Let's further assume that fully 50% of shares are held in premium accounts whose customers can expect their broker to share 50% of the short rebate fee.

Under those heroic assumptions, we get the result that we stated earlier: the average shareholder can expect about 1.5 cents in short rebate fees over the next year. This number is obtained by simple multiplication of the numbers in the last paragraph ($.015=$1.36x65%x6.6%x50%x50%).

As small a number as 1.5 cents is, it is actually an unrealistically optimistic estimate that depends on everything going right for WHX shareholders. And things can go very wrong, as the history of Great Northern Iron (NYSE:GNI) illustrates. GNI is another royalty trust, which at one time was even more overvalued than WHX. Back in early January, 11.5% of GNI shares were sold short even though the short rebate was 48%. Then in a matter of days, GNI fell by two-thirds to land at its fair value. Today the shares remain at fair value, the short rebate has come down to 24%, and only 1% of shares are held short. If something similar happens to WHX, the average shareholder can look forward to collecting less than a tenth of a penny in short rebate fees over the trust's last year.

In sum, the short rebate doesn't materially change what buyers should be willing to pay for WHX. There's really nothing to justify any informed investor paying $2.73 per share.

A comedy of errors

The price of WHX has been held up by a series of misunderstandings. Some buyers don't realize that the trust is going to terminate in a year. Some realize the trust is going to terminate, but don't appreciate how small the remaining distributions will be. And some realize the remaining distributions will be small, but think the price is justified by income from short rebate fees--not realizing that for the average shareholder those fees will bring in less than 1.5 cents.

Buyers are participating in a comedy of errors--a comedy that can only end happily if they sell while the price is still high.

Disclosure: I am short WHX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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