Description

Texas Pacific Land Trust (NYSE: TPL)

Current Price: $146.31

Fair Value: $106.41

Return: -27.3%

Borrow Cost: 2-3%

Thesis

Texas Pacific Land Trust (TPL) is a passively managed oil and gas trust. It owns the surface rights to 878,897 acres and nonparticipating perpetual oil and gas royalty interests in 459,191 acres in Texas. TPL primarily generates revenue through its royalties, easement and sundry income, and land sales. Before the recent drop in oil prices, Texas experienced a massive boom in oil production, causing TPL’s revenue to grow dramatically (69% from 2012 to 2014). From the start of 2013 to the peak towards the end of 2014, the stock appreciated 337%, far outpacing EPS growth of 88%. Over the same period, rig count in the Permian basin increased 20% with specific focus on higher producing horizontal wells. Since its peak, the stock price has only dropped 37% even though Permian rig count is down 59% from 568 to 231. To put this in context, the lowest Permian rig count since Baker Hughes has started tracking them at the start of 2011 was 358. The time periods are comparable because what the company owns is exactly the same. Because it is a passively managed trust, the only change in its asset mix is the small amount of land it has sold in the interim.

TPL’s stock price has remained relatively high because the stock, which has no analyst coverage and a lack of liquidity, has a retail-heavy investor base that is focusing on the most recent blowout quarter fueled by all-time high oil production and a large land sale. These investors don’t appreciate how the drilling of new wells coming to a standstill and the heavy decline curves seen in unconventional wells will result in a steep decline in oil production. In addition, investors incorrectly believe that TPL’s fastest growing source of revenue, easement and sundry income, is recurring when it is one-time in nature.

Now is an ideal time to short TPL because it had an abnormally large land sale in Q1’15 which inflated earnings. EPS was $2.67 vs $0.99 in the previous quarter. Adding up the impacts of future declines in production, normalized easement and sundry income, and the normalization of land sales, should reduce earnings power to $3.55 in a year vs TTM EPS of $5.94. By applying TPL’s historical average P/E multiple of ~30x (even though I believe it deserves something much less), the stock should drop to $106.41 in a year.

Income

TPL generates income from 3 material categories: 1) Oil and gas royalties, 2) Easement and sundry income, and 3) Land sales. All three are tied to commodity prices and have finite lives.

Oil and gas royalties (~53% in 2014; historically 49%)

Royalty income growth has been driven by a combination of an increase in production on the acreage that TPL has royalties on and the increase in the price of oil. With oil prices significantly lower, not only will the value of their production be impaired, but the addition of new wells will slow down drastically with Permian rig count down 59%. In addition, there will be a natural decline due to the aggressive decline curves seen in the Permian. Depending on the well type, 3-year decline rates can range from 60% to 91%. To make matters worse, the higher producing wells are the ones with the more aggressive decline rates. Because new wells (production is up 33% from Q4’14 to Q1’15) and wells with larger decline rates provide more barrels, the typical decline rate experienced by TPL should be higher than the average year (25% decline) implied by the 3-year decline rate range above.

Easement and sundry income (~39% in 2014; historically 21%)

An example of easement income is a midstream oil and gas company paying TPL a fee to build a pipeline through its acreage. Easement income makes up a majority of this category and has been the driver of its recent spectacular growth. While many market participants believe this is a continuing source of revenue, easement income is only a one-time payment. This fact coupled with the large drop in oil and gas activity should result in a decline in easement and sundry income that is larger than the decline in oil and gas royalties.        

Land sales (7% in 2014; historically 23% but lumpy)

TPL owns the surface rights to almost 1MM acres in Texas. Over 99% of their acreage is leased out for grazing at immaterial rates. While some of their land does have value, it is important to note that they are a passive seller. They do not market their land. Instead, the trustees wait until someone approaches them with an offer, and then decide whether or not to accept that offer. As a result, it is safe to assume that reported land sales are for the more desirable tracts. Consequently, TPL’s leftover acreage will decrease in quality as time goes on. In addition, lower oil and gas activity should result in much lower land sales as demand for this land is largely tied to the industry.

TTM land sales have been $24.0MM largely in part to a large sale in Q1’15 for $20.3MM. In 2014, land sales were only $3.7MM. The last time oil prices dropped this much, land sales slowed to $0.8MM and $0.5MM in 2008 and 2009, respectively. In light of the above, I believe ~ $3.0MM (with a high standard deviation) is a conservative estimate for annual land sales going forward.

Costs

Over the past decade, operating costs have consistently stayed between $3MM-4MM. TPL has an extremely lean structure with only 8 employees and 3 trustees. It is not required to hold annual meetings and is run extremely passively.

EPS and Valuation

If you assume that oil and gas royalties and easement and sundry income fall by the implied average decline rate and land sales slow to $3.0MM, earnings power should be $3.55 in a year. Like I said above, production from existing wells and easement and sundry income should drop more than the implied average decline of 25%. However, this should be slightly mitigated by the addition of new wells, albeit at a very slow rate. Overall, this assumption should be conservative.

If you apply TPL’s historical P/E multiple of 30x (which I believe is high given that TPL has a diminishing asset base, is unable to reinvest capital, is tied to volatile commodity prices, and has non-recurring revenue streams), the fair value is $106.41 per share.

Catalysts

·         TPL’s TTM EPS is $5.94 but earnings power should fall to $3.55 in a year

o   The 3 largest contributors to the drop in order are:

§  Land sales: -$1.73

§  Oil and gas royalties -$0.70

§  Easement and sundry income -$0.14

Risks

·         Commodity price risk

·         Borrow availability

·         Lumpy land sales

Catalyst

Catalysts

·         TPL’s TTM EPS is $5.94 but earnings power should fall to $3.55 in a year

o   The 3 largest contributors to the drop in order are:

§  Land sales: -$1.73

§  Oil and gas royalties -$0.70

§  Easement and sundry income -$0.14