A Big Fat Guaranteed Dividend

Investors can make big money from unknown and misunderstood companies. Recently, I found a spinoff whose fat dividend is "guaranteed" for the next four years. The large dividend and the fact that the company is a spinoff have me excited that this stock could produce huge returns over the years ahead.

The stock is SandRidge Mississippian Trust I (NYSE: SDT  ) , a royalty trust that was spun off from SandRidge Energy (NYSE: SD  ) . Royalty trusts entitle unit holders (shares in publicly traded partnerships are called units) to profits from specific mineral properties. Like master limited partnerships, or MLPs, they are taxed differently from normal corporations and have some tax advantages for long-term shareholders. A key difference, however, is that royalty trusts represent a share of proceeds of a depleting asset. There's only so much oil in a given area that can be profitably drilled. With that said, royalty trusts have a history of being great dividend performers. For instance, long-ago BP spinoff BP Prudhoe Bay Royalty Trust (NYSE: BPT  ) is the top dividend stock so far this millennium.

I'm hoping SandRidge Mississippian Trust can be as successful. The trust was spun off by SandRidge just last month with SandRidge retaining a 38.4% stake. The stock is so new that Yahoo! Finance doesn't even have a yield for the trust on its site. Don't be fooled; enterprising investors who dig deeper will find that is just not the case.

Royalty
The trust owns royalty interests in oil and natural gas properties leased by SandRidge in the Mississippian formation in Oklahoma. These royalty interests entitle the trust to receive 90% of the proceeds from 37 horizontal wells that are already producing oil and gas. The interests also entitle the trust to receive 50% of the proceeds from 123 horizontal wells that are still to be drilled. SandRidge is obligated to drill the 123 wells by December 31, 2015.

The trust then will use these proceeds to pay out the following distributions to shareholders.

Year

Distribution

2011 $1.85
2012 $2.25
2013 $2.42
2014 $2.70
2015 $2.41

Source: Company prospectus.

At a recent price of $25, that's a yield of 7.4%. The distributions above, however, are the "guaranteed" payments -- the actual distributions will likely be much higher. I'll explain the guarantee in a moment.

The opportunity
The trust actually expects to pay out much higher distributions based on reasonable estimates of future production and hedges on 70% of the trust's expected oil production, locking in today's high prices and holding out for the possibility of higher natural gas prices in the future.

The following table lays out the trust's expectations:

Year

Target Distribution

2011 $2.31
2012 $2.82
2013 $3.03
2014 $3.36
2015 $3.01

Source: Company prospectus.

A $2.31 per-unit distribution equals a yield of 9.2%. That figure clearly surpasses other oil royalty trusts:

Trust

TTM Yield

Distributions Per Share

Permian Basin Royalty Trust (NYSE: PBT  ) 5.7% $1.24
BP Prudhoe Bay Royalty Trust  8.2% $9.57
San Juan Basin Royalty Trust (NYSE: SJT  ) 4.0% $0.99
MV Oil Trust (NYSE: MVO  ) 7.9% $3.28
Hugoton Royalty Trust  (NYSE: HGT  ) 5.1% $1.23
ECA Marcellus Trust I 7.0% $2.00
Average 6.3%  

Source: Yahoo! Finance.

Based on other oil royalty trusts, the average yield is a little more that 6%. If SandRidge Mississippian were to trade with a comparable yield, the trust's units would trade for $36, or 45% higher than where they've traded recently.

The guarantee
As stated earlier, SandRidge owns 38% of the trust. Its portion is divided into 3.75 million regular shares (13% of the total units) and 7 million subordinated shares. Until SandRidge drills the 123 wells as it is obligated to, if the trust cannot pay the minimum distributions above to all trust holders, the money is taken from the subordinated shares to pay out the minimum distribution. SandRidge's shares thus "guarantee" trust holders will get the above minimum distributions. Twelve months after SandRidge fulfills its drilling obligations, the company's subordinated units turn into regular units, and then all royalties are split as would be normal.

Foolish bottom line
With a 9% distribution, SDT's units are definitely worth a look, especially if you believe in higher oil prices in the future and appreciate a margin of safety with the subordinated units.

Given the tax considerations of publicly traded partnerships, the units may not be for everyone. For those looking for dividends for their retirement accounts I invite you to take a look at 13 other dividend stocks in a free report from The Motley Fool called "13 High-Yielding Stocks to Buy Today." Hundreds of thousands have requested access to this special free report, and now you can access it today at no cost. To get instant access to the names of these 13 high yielders, simply click here -- it's free.

Dan Dzombak's musings and articles he finds interesting can be found on his Twitter account: @DanDzombak.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (31) | Recommend This Article (183)

Comments from our Foolish Readers

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  • Report this Comment On May 05, 2011, at 10:21 AM, Zade wrote:

    I read that US Royalty Trusts (unlike Canadian ones) are NOT allowed to obtain new properties and therefore don't grow. If this is true, shouldn't this article make people aware of this. By that I mean that this trust could not acquire other companies' properties. Is this true and shouldn't it be mentioned if it is?

  • Report this Comment On May 05, 2011, at 5:03 PM, sidsb wrote:

    what are the risks?

  • Report this Comment On May 05, 2011, at 5:23 PM, mbwo wrote:

    When talking about large dividend stocks, one should consider Annaly Capital Management, Inc. (NYSE:NLY).

  • Report this Comment On May 05, 2011, at 5:39 PM, ordo3 wrote:

    A very important consideration is when the trust's assets will be exhausted. Can you provide guidance on how the investor can estimate this?

  • Report this Comment On May 05, 2011, at 6:48 PM, Tygered wrote:

    This is probably a dumb question, but when can we expect the distributions? I can't find anywhere that it says X amount will be paid to owners of record as of mm/dd/yy date. I checked Fidelity, Google and Yahoo. I understand that this SDT is very new, so probably none of those details are worked out yet. I must say I'm a bit excited, but high profits always turn me on, so it might just be my greed kicking in.

  • Report this Comment On May 05, 2011, at 7:17 PM, LakeJuJu wrote:

    I'm new at this, eventhough I've been a member for 7 years. Where do I find the answers to these questions?

  • Report this Comment On May 05, 2011, at 7:57 PM, Betterknown wrote:

    This article is extremely misleading. It uses the term guarantee (curiously placed in quotes -- "guaranteed" -- every time used) to seemingly signal that the minimum returns, and perhaps even the principal invested, are protected against loss: "SandRidge's shares thus 'guarantee' trust holders will get the above minimum distributions. "

    This is not true. Read the prospectus. The "guarantee" is not a guarantee at all. It does not guarantee ANY return, let alone the minimum. It is only a subordination agreement -- a limited one at that. It says that to "support" the "minimum" dividends, the parent, SandRidge Energy, will not take a full distribution unless the "minimum" amount is available to common holders. It does not guarantee payment. If royalty income is negative or insufficient cover costs for the period, there will be a reduced (i.e., less than the minimum) or no dividend. This is even in the prospectus: "The subordination of certain trust units held by SandRidge does not assure that you will in fact receive any specified return on your investment in the trust." Some "guarantee," eh author?

    There is no make-up either. Plus, like with a stock, you could lose all of your initial investment on top of never seeing a dividend if the operation (the trust itself or the parent) goes belly up.

    The risk of no return is out there. While the trust holds royalty interests, rather than operating interests, there are still costs. For example, there is a $166 million mortgage note that needs to be serviced. There are other debts, too. There are also post-production costs and taxes. These can cut into profits and returns. But the biggest risk is the price of oil. Read the prospectus. They are basing their projections largely on the price of oil and natural gas over the past 3 months and a 33-month futures projection. But as we all know, these prices are very volatile. Just look at the past few years. In summer of 2008, when prices were around $100-120 barrel for sweet crude, many people/companies invested on the assumption that it would stay in that neighborhood or higher (remember "peak oil" / $150 per barrel projections?), only to see the price fall to an average of $53 the next year. Figure what that would do to your return. (Note: the trust is party to various hedging transactions to guard against it, but as the prospectus says: "The hedging contracts entered into by SandRidge pursuant to the derivatives agreement will cover only a portion of the oil and natural gas production attributable to the trust, and such contracts limit the trust’s ability to benefit from commodity price increases for hedged volumes above the corresponding hedge price. In addition, the trust will be required to pay SandRidge any amounts that SandRidge is required to pay its counterparties under the hedge contracts.")

    None of this is to say that this investment will not perform well. It's just that we don't know. And there is no guarantee. But reading the article, you would think that this was some kind of "guaranteed" investment.

  • Report this Comment On May 05, 2011, at 7:59 PM, Quaker08 wrote:

    Anand,

    What are the tax implications for this investment? Is it like an MLP, which mails a K-1 every year? Will there be any state taxes in OK? Additionally, how do you think royalty trusts will perform when interest rates rise? Historically they have performed quite well in a falling interest rate environment.

    Thanks

  • Report this Comment On May 05, 2011, at 8:14 PM, morganics wrote:

    The prospectus notes that owners of the trust units will be required to file state income tax returns (and pay tax in) Oklahoma. This is a downside for those who don't live in that state.

  • Report this Comment On May 05, 2011, at 8:23 PM, guiseppewv wrote:

    Thanks for the article! Is the "drill by" date for the remaining 123 wells actually 12/31/2014? Thanks!

  • Report this Comment On May 05, 2011, at 10:05 PM, PeakOilBill wrote:

    This should be viewed as a speculative investment, for now. No one knows what the wells might find, if anything. But it might prove lucrative. The tax paperwork will require a lot of work and time.

    Consider AT&T, yield 5.5%, institutions own 58% for a reason. I guess. I don't own any, but I probably should, since I pay them $70 a month.

  • Report this Comment On May 06, 2011, at 1:29 PM, KMack23 wrote:

    Dan,

    I'd be interested to hear your take on the bear case. what if the future wells turn up nothing? Is the worst-case scenario the 7.4% yield you noted above?

  • Report this Comment On May 06, 2011, at 3:02 PM, sept2749 wrote:

    Guaranteed?? I think not! Why the quotes "guarantee"? Very misleading as it may strike a newbie as a "safe" and "guaranteed" investment which it's certainly not. It's a speculative stock and should be noted as such.

  • Report this Comment On May 06, 2011, at 3:39 PM, whyaduck1128 wrote:

    Quaker08,

    The taxable amounts for royalty trusts are computed differently than those for limited partnership (LP) interests. Instead of receiving a K-1, a royalty trust unitholder receives a booklet from the trust each year, which he/she can then slog through or give to his/her long-suffering tax preparer.

    Here's an example, from SJT--

    http://www.sjbrt.com/files/2010_tax_info_book.pdf

    For the tax professional, these aren't that difficult, but they do take a little time (and therefore the client's money). For the individual who does his/her own taxes, lotsa luck.

  • Report this Comment On May 06, 2011, at 11:26 PM, aberger1 wrote:

    Can anyone explain what is going to happen to the share price when the wells are all empty?

    Does it convert to cash in my brokerage account?

  • Report this Comment On May 08, 2011, at 2:01 PM, jonthegreat88 wrote:

    This article is horrible. You clearly have zero understanding of oil and gas. The prospectus itself lays out, at $75 oil and $4.30 gas, that the PV10 of the assets is $430 million. Now given its a royalty and hence not levered to the upside for prices (ie no op costs, so a 40% increase in the forward price curve will lead to 40% more value within a fairly small margin of error), it would stand to reason that the current PV10 is more like $430 * 1.40 = ~$600 million, given the locked in prices are about 40% above those used by the reserve engineers, Netherland Sewell and the assets are more oil weighted than gas.

    The market cap is $700 milion odd. So if you buy at todays prices, you are absolutely, categorically, overpaying. This analysis doesnt even take into account G&A which will further sap value from that $600 million number. On top of that if the undeveloped wells come in less than expected (and P U D's usually do!), you move further down in value.

    You should not be giving financial advice. This is categorically a terrible idea.

  • Report this Comment On May 08, 2011, at 2:22 PM, shivy1 wrote:

    Terrible recommendation. Also these trusts do not pay dividends, they pay distributions which are different. The wells deplete over time. Assuming they even hit target estimates. The distributions will slow down. Im surprised this is advertised on the front page like that.

  • Report this Comment On May 09, 2011, at 1:23 PM, TMFBomb wrote:

    @Quaker08,

    Just to clarify, Dan Dzombak wrote this article, not me.

    Thanks for reading, just the same!

    -Anand Chokkavelu

  • Report this Comment On May 09, 2011, at 7:31 PM, TMFDanDzombak wrote:

    @Zade That is true. U.S. Royalty trusts are not allowed to make acquisitions financed by new debt or equity. Since they pass through most of their income to investors none is left over for acquisitions. This means U.S. royalty trusts are depleting assets as stated in the article.

    Once the decision is made to end the trust as the assets have depleted, the assets are sold and the cash received from the sale is distributed to the unit holders at that time. An upcoming example is Great Northern Iron Ore (Amex: GNI), which will be terminated on April 6 2015.

    @mbwo Thanks for the comment.

    @LakeJuJu All questions asked are now answered below.

    @sidsb The main risks are that the 123 wells to be drilled turn up far less oil & gas than expected or that oil prices crater and stay there for years. Both are unlikely.

    @ordo3 From the prospectus on pages 14 and 15. The trust will dissolve and begin to liquidate on the Termination Date, which is December 31, 2030, and will soon thereafter wind up its affairs and terminate. At the Termination Date, 50% of the PDP Royalty Interest and 50% of the P U D Royalty Interest will revert automatically to SandRidge. The remaining 50% of each of the PDP Royalty Interest and the P U D Royalty Interest will be retained by the trust at the Termination Date and thereafter sold, and the net proceeds of the sale, as well as any remaining trust cash reserves, will be distributed to the unitholders pro rata. SandRidge will have a right of first refusal to purchase the royalty interests retained by the trust at the Termination Date.

    @Tygered From the prospectus. Timing of Actual Cash Distributions. Quarterly cash distributions will be made on or about the 60th day following the end of each calendar quarter to unit holders of record on or about the 45th day following each calendar quarter. Due to the timing of SandRidge’s receipt of cash for production, it has been assumed that cash distributions for each quarter will include production from the first two months of the quarter just ended as well as the last month of the immediately preceding quarter. The first distribution, which will cover the first and second quarters of 2011, is expected to be made on or about August 30, 2011 to record unit holders as of August 15, 2011, and will include sales for oil and natural gas for the months January through May 2011. Thereafter, quarterly distributions will generally relate to production of oil and natural gas for a three month period, including one month of the prior quarter.

    @Betterknown I wrote “guarantee” in quotes to signify that it is not a true guarantee, and explain in the article in simple terms that it is a subordination agreement.

    If royalty income is negative or insufficient to cover costs for the period, there will be a reduced (i.e., less than the minimum) or no dividend.

    Correct, the likelihood of this is small

    The risk of no return is out there. While the trust holds royalty interests, rather than operating interests, there are still costs.

    Correct

    For example, there is a $166 million mortgage note that needs to be serviced. There are other debts.

    You misread the prospectus here. You are referring to the Drilling Support Lien (page 43). This means SandRidge grants the trust a claim on its interests in the state worth at most $166 million that the trust can claim if SandRidge does not honor its agreement to drill. This claim lessens proportionately as SandRidge fulfills its drilling obligations.

    There are also post-production costs and taxes. These can cut into profits and returns.

    The trust estimates that total trust expenses will be roughly 600 thousand a quarter.

    But the biggest risk is the price of oil.

    Correct, if oil prices cratered to $50 a barrel and stayed there for years the distributions would be lower than the trust targets going forward.

    @Quaker08 @morganics From the prospectus (page 106) it seems unitholders will have to file state income tax returns in Oklahoma. See whyaduck1’s answer above.

    @guiseppewv From the prospectus. Pursuant to a development agreement between SandRidge and the trust, SandRidge is obligated to drill, or cause to be drilled, 123 P U D Wells in the AMI by December 31, 2014. In the event of delays, SandRidge will have until December 31, 2015 to fulfill its drilling obligation. I used the latter date to simplify the story.

    @PeakOilBill Thanks

    @KMack23 Worst-case scenario with any investment is always a total loss. The chance though of the future wells turning up nothing is minimal.

    @sept2749 I explicitly laid out what I meant by “guarantee” in the article.

    @jonthegreat88 Thank you for your comments. The locked in prices are only for the first 5 years and only for a percentage of the production. If oil & NG prices continue to rise above the locked in prices as they have the PV-10 of the assets will continue to rise.

    @shivy1 Your comments are all address in the article.

    @TMFBomb Thanks for the clarification

    @random Learn something new every day, who knew P U D (without spaces) is a profanity

  • Report this Comment On May 11, 2011, at 12:00 AM, kf9211 wrote:

    I'm kind of new to trading royalty trusts so please correct me if I'm wrong, but it seems like in order to get to $25 a share you need to give its future target distribution about a 6% discount rate.

    I did some quick math and I got the following NPV's based on the following discount rates:

    6.136% = $25.927

    8.24% = $22.7

    10.38% = $20.097

    It seems to me that assigning the stock a 6% discount rate is ridiculously low, and it should be at least 8%, if not 10%+. Once again though, I am very new to these types of stocks, so I could be completely wrong in some of my assumptions about how to value it.

  • Report this Comment On May 11, 2011, at 1:23 PM, ikkyu2 wrote:

    Gah. Royalties and REIT end-of-year payouts are not dividends. I am really tired of articles and comments that suggest investors should behave as if they were dividends, with no understanding of what they actually represent.

  • Report this Comment On May 11, 2011, at 3:23 PM, KurtEng wrote:

    The income tax thing is actually a deal breaker for me. I wouldn't invest more than $1,000 to start on this trust. That means i would get about $75 per year from the trust, while incurring at least $20 in additional tax FILING fees alone using my preferred method, Turbotax. That eats around 30% of my profits off the bat. The extra work and tax worries simply aren't worth it to me, since I don't live in Oklahoma.

    Thanks morganics for pointing that out.

  • Report this Comment On May 13, 2011, at 12:09 PM, mstate97 wrote:

    Are investments in MLPs and a royalty trust such as SandRidge Mississipian Trust, suitable for Roth IRA's? There is no tax on proceeds, regardless what those proceeds are derived from, with Roths.

  • Report this Comment On May 13, 2011, at 7:10 PM, ldvandew wrote:

    I am also interested in holding these Royalty trust in IRA's. It seems like there would not be a problem unless there are special rules in the IRS code.

  • Report this Comment On May 13, 2011, at 10:58 PM, justingg wrote:

    I am no tax professional, but there is the consideration of unrelated business income that comes into play with MLP's in IRA's, but I have not been able to find anything related to Royalty Trusts inside an IRA.

  • Report this Comment On May 14, 2011, at 1:41 PM, Sofoolishandwise wrote:

    Anyone in the investment world knows you do not use the word "guarantee" lighty. A subordination is not a guarantee in any sense of the word. It is simply a structural aspect to permit priority of one security over another. Putting guarantee in quotes is not an indication that it is a word with a different meaning. Moreover dividends are declared periodically based on a variety of factors - royalty interests are paid based on contractual terms without subjectivity. The money is either there or it is not with or without the share of the subordinated interest.

  • Report this Comment On May 15, 2011, at 1:41 AM, malcadam wrote:

    Can someone address the Roth tax aspect mentioned above? is there still a liability to OK tax?

  • Report this Comment On May 17, 2011, at 10:16 AM, taylorgrant wrote:

    Prospect provides all target distributions for the 20-year life of this trust. As of end of 5/16/11, the trust was traded at 26.34, with a yield of 6.32%, 386.7 bps higher than T-notes, the same spread as BB rated industrial corp bonds.

  • Report this Comment On May 17, 2011, at 4:57 PM, DFoolishInvestor wrote:

    Can someone address the Roth tax aspect mentioned above? is there still a liability to OK tax?

    Click on "Taxed Differently" where it is highlighted in the article or check out the link below. It is better to own this in a taxable account vs an IRA or non taxable account to benefit from the tax benefits...

    http://www.fool.com/investing/dividends-income/2011/04/18/ea...

  • Report this Comment On May 17, 2011, at 5:41 PM, daver4470 wrote:

    @DFoolishInvestor: Royalty trusts are different than MLPs. MLPs are specifically structured to have a certain tax "profile" that depends on the particular investing strategy the MLP is targeting. Specifically, MLPs usually back-load the tax liability on their income, giving you the use of distributed funds for several years before the tax payable on them comes due.

    Royalty trusts are actually much simpler. They are treated as grantor trusts for US tax purposes -- you, the unit holder, are treated as owning your proportional share of the underlying royalty interest directly.

    MLPs are less attractive for tax-preferenced accounts (Roths and Traditional IRAs) because the benefit of the tax deferral is lost when the MLP units are held by those types of accounts. In fact, it makes very little economic sense to hold them in a TradIRA, as 100% of the income generated will be taxable at ordinary rates when you pull the money out of the IRA. Roths, which avoid tax permanently, make more sense -- but you still should eliminate the tax benefit when considering MLPs for a Roth.

    Royalty trusts, on the other hand, make a lot of sense for tax-preferenced accounts, especially Roths. As others have noted, these are NOT dividend payments coming out of the trusts -- they are direct receipts of royalties, and therefore taxable at full ordinary rates (like interest). You don't get the benefit of the reduced qualified dividend rates. An oil stock yielding 5% is much more valuable than a royalty trust yielding 5%, because the oil stock's dividends are likely taxed at a third of the rate of the trust's distributions. Plonking the royalty trust into an IRA (where everything is taxed at that rate, so no harm no foul) or a Roth (where nothing is ever taxed) makes a ton of sense.

    @justingg -- UBI is a bigger issue for tax-exempt entities like charities than IRAs, but you're correct -- there are definitely things you can't put into your Roth. For all practical purposes, though, from an investing standpoint that no-fly zone boils down to "active businesses" and "non-publicly-traded partnerships". Royalty trusts are, for these purposes, treated in the same way as publicly traded partnerships, and are fine for Roth purposes.

  • Report this Comment On July 05, 2011, at 11:06 AM, ddammerman wrote:

    The health of the "guarantor", SD, also needs to be examined in the risk profile. Just glancing at their sheet makes me leery, (0.3 current ratio, only $8.5M cash .... I don't know the industry, but this does not sound like enough to drill 100+ new wells).

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