Description
Introduction
Texas Pacific Land Trust (TPL) is a passively managed liquidating trust that generates income by selling parcels of its 988,000-acre portfolio of West Texas real estate (scrub ranch land), collecting oil/gas royalties on its mineral rights scattered throughout Texas’ Permian Basin, leasing its land for grazing, and providing seller financing. In 2004, the company experienced an extraordinary confluence of events that sent the stock soaring to above $180 versus its previous all-time high of $68 (November 1980). I estimate intrinsic value is less than half the current quote.
Background
To fully appreciate the TPL story, it is helpful to have a general understanding of how the company came to exist. Established in 1888, TPL is an outcome of the bankruptcy of Texas & Pacific Railway (TPR). TPR was formed in 1871 under federal charter and was granted over 5mm state-owned acres in Texas for the purpose of building a portion of the southern transcontinental railroad that was planned to originate in Marshall on the eastern boundary of Texas and terminate in San Diego. For a more detailed on TPR’s colorful history check out the following link:
http://mopac.org/history_tp.asp
Land grants were bequeathed to railroads to establish a feasible right-of-way, as well as provide a marketable asset to help fund construction costs. The intent was to invigorate investment and development. The size of grants was determined by a “swath” of real estate, which was typically comprised of ten miles of land straddling both sides of the right-of-way. This swath was then divided into a checkerboard-style grid of square-mile sized parcels (640 acres). The railroads received even-numbered plots, while the government retained the odd-numbered. Mineral rights were also included, although oil wasn’t developed in Texas until the early 1900s. Quite often though, the quality of the land was poor with limited access and generally uninhabitable.
Ten years after its formation, TPR went into receivership. TPL was then formed to hold 3.5 millions acres of TPR land, and its ownership was distributed on a pro rata basis to TPR bond holders in 1888. The trust was charged with liquidating the vast real estate holdings and distributing the proceeds to the unit holders.
Of course, the Texas oil boom emerged at the turn of the century, and oil and gas revenues became a major windfall to TPL. In 1954, TPL spun off its E&P assets into a separate company, TP Oil (TPO), which held 1.7 million acres in the Permian Basin. However, TPL retained small perpetual oil and gas royalty interests on 470,000 acres, which it still holds today. Texaco purchased TP Oil in 1962, and then Chevron purchased Texaco in 2000.
Management/Corporate Governance
Headquartered in Dallas, TPL is comprised of only eight employees and three trustees. Of the eight employees, two are officers – the general agent and assistant general agent – who are responsible for the day-to-day management of the company. The GA’s and assistant GA’s total annual compensation in 2004 was $190k and $110k, respectively. The trust has neither a restricted stock nor a stock option plan for any employee or trustee. Combined, insiders only own 0.7% of the shares outstanding, as the chairman of the trustees is the only insider with a position of note (14,000 shares). The chairman’s interest appears to have been inherited from his father, a longtime TPL chairman and former chairman of the old TP Oil. There is no board of directors, but only the three trustees, who are compensated annually to the tune of $2,000-$4,000. A trustee holds office until death, resignation or cause and is selected by the other two trustees.
Operational Overview
TPL has three streams of revenue, each of which we discuss in more detail below: Land Sales, Oil & Gas Royalties, and Leasing & Interest. Historically, O&G royalty revenue has been the largest and most consistent income source with fairly stable production flow, but still subject to unpredictable commodity price swings. Income from land sales has proven to be more sporadic, both in terms of absolute acreage sold and pricing. Land sales are entirely passive, meaning TPL does not market its real estate in any way. They simply wait for someone to make an offer on one of their parcels. The remainder of TPL’s revenue comes from grazing leases and interest income received from seller-financing of certain land sales.
($000s) 2000 2001 2002 2003 2004 YTD
Revenues 7,799 13,429 9,122 9,953 29,141 6,644
Percent of Total
Oil and gas 54% 31% 41% 54% 22% 56%
Land sales 19% 50% 33% 16% 70% 19%
Interest 11% 7% 11% 10% 4% 13%
Other 16% 12% 15% 19% 4% 11%
EPS $1.47 $2.79 $2.09 $2.34 $7.89 $1.71
The entire trust operates on a skeleton crew, thus there is very little overhead. Major expenses include salaries, pension expenses, legal fees, and oil/gas taxes. As a result, margins are high and typically range from 75-80% pretax and 50%-55% net (tax rate of 30%). The majority of its earnings are paid out to shareholders in the form of buybacks (which are very minimally accretive at these price levels) and to a lesser extent annual dividends, which are payable during Q1 ($0.55, 0.3% yield). The company will occasionally pay out special dividends, as was the case following a large land sale in 2004 when it distributed an additional $1.75/share. Over the last 5 years TPL has distributed about 90% of its cash flow ($10mm in dividends and $18mm in share buyback).
Land Sales
As of June 30, the company owned 988,000 acres, including 12,118 acres that were acquired through foreclosure and government sales to enhance the value of certain parcels. No book value is assigned to the legacy land, while its purchased property has a book value of $1.8m, or $152/acre. Again, it is important to emphasize that the company is a passive seller of its acreage. The land is located in West Texas, stretching from east of El Paso toward Midland, with the largest chunk in Culberson County. The vast majority of its land holdings are best described as very low value scrub ranch land adequate for grazing. In fact, 99.5% of its land is currently leased for grazing purposes at an average rate of $0.48/acre. With few exceptions, these are not inhabitable parcels and access is often a challenge. Remember, because of the way the government divided the original land grants, TPL’s holdings are mostly divided into 640-acre parcels in a checkerboard pattern (where TPL owns the “black squares” and the government and others own the “red squares”). In many cases, the local ranchers treat TPL’s leased land as if it is part of their own.
Land sales are lumpy from year to year, and it is not unheard of for a quarter or two to pass without a land sale. Since 1993, but excluding 2004 (more discussion later), the company has sold an average of 15,000 acres per year, with a wide variance ranging from 3,545 acres sold in 1996 to a high of 31,962 acres in 1998. The average price per acre over the same time period has ranged from $75/acre to $892/acre. Again excluding 2004, in only 2 of those 11 years did TPL report annual land sales in excess of $6mm; the average annual total was $3.4mm. On a cumulative basis since 1993, the company sold 167,409 acres for $37.5m, or $224/acre.
2000 2001 2002 2003 2004* YTD
Acres Sold 19,592 13,579 9,295 7,841 12,023 9,975
Sales ($000) 1,443 6,709 3,051 1,629 20,277 1,295
$/Acre 74 494 328 208 1,687 130
*2004 results include the sale of 1,400 acres outside of El Paso for $19.2MM. Excluding this unique sale the company sold 10,594 acres for $1.0MM ($98/acre).
In 3Q04 TPL sold a 1,400-acre plot for $19.2m, or $13,460/acre. That startling deal along with growing excitement over real estate in general and land trusts in particular catapulted TPL’s stock from $65 to $100. Did the U.S. land boom finally reach the rural ranch lands of West Texas? Not really. In that one rare instance, the 1,400-acre parcel was a “developable” stretch of property on the extreme eastern outskirts of El Paso. According to the company and its 10-K, developable land in the trust’s remaining holdings is practically non-existent, with certainly nothing material in the near-term pipeline. We have confirmed this through discussions with locals who are very familiar with TPL’s remaining holdings. Absent the one large sale in 2004, the company parted with 10,594 acres for $1.0m, or $98/acre. 2005 year-to-date results are typically unimpressive. Through June 30, the company has sold 9,975 acres for $1.3m, or $130/acre. Expect more of the same in H2 and beyond.
As an aside, some TPL investors may have become enamored by various media accounts which tell of recent “Texas land grabs,” where buyers clamor to purchase their very own Texas ranch, in some instances on Ebay auctions sight unseen, in hopes of cashing in big in the future. According to TPL, these bizarre transactions have been initiated by unscrupulous entrepreneurs buying a plot of several thousand acres, dividing it up into small “ranchettes” and enticing buyers with misleading promotions. In reality, no one will ever live on this property. No roads. No utilities. No water. Nothing. It is akin to selling swamp land. In doing so, these transactions divide the land into small parcels with numerous owners, in an area where large contiguous land chunks have more value; thus perversely reducing its value over the longer-term.
TPL currently leases 99.5% of its property at $0.49 per acre. It also receives interest income on loans made to certain land purchasers. Lease income and interest combined are currently running around $2.5MM annually.
Oil & Gas Royalties
As discussed earlier, TPL has perpetual royalty rights on a combined 470,000 mineral fee acres spread throughout the Permian Basin of Texas, all of which is owned by Chevron. We estimate total annual production on TPL’s fee acreage has range 4 to 5 million BOE (barrels of oil equivalent) over the past 10 years. TPL’s net BOE volume averages about 170k, which equates to a blended royalty rate around 3.5%. A total proven reserve estimate for the current production on this property is not known. The royalty acreage breaks down as:
Acres Wells Royalty Rights
Lot 1 386,988 856 1/16 (6.25%)
Lot 2 85,414 2,031 1/128 (0.78%)
Total 472,402 2,887 Blended rate: 3.5% (our est.)
CVX farms out the majority of this production. For example, CVX accounted for only 14% of TPL’s O&G revenue in 2004, while the remainder is drilled by smaller privately-held entrepreneurs. TPL literally receives royalty checks from dozens of operators. During 2004, 94 wells were drilled on TPL’s fee acres, 100 were plugged, and over the past 10 years the total number of producing wells has ranged between 2,800 and 3,000. TPL’s volume share has been reasonably steady over the last decade with its net interest fluctuating between 155,000 and 185,000 BOE (approximately 2/3’s oil and 1/3 gas). With oil and gas prices now at record highs, TPL’s run-rate royalty revenue is probably running close to $9mm annually.
2000 2001 2002 2003 2004 YTD
Royalty Rev 4,231 4,177 3,710 5,412 6,535 3,743
Oil (bbls) 100,807 99,000 103,221 120,883 113,794
Gas (mcf) 413,817 391,306 478,708 410,514 528,614
BOE 150,186 161,616 159,364 185,442 172,778
TPL’s at times has had a somewhat contentious relationship with CVX. In fact, TPL has filed various grievances against CVX, which primarily cite CVX’s failure to adequately develop and exploit the reserves. TPL also claims physical property damage to its land on which CVX operates. The numerous claims, which we believe each range from a few hundred thousand dollars to a few million, have yet to reach arbitration and total well less than $50MM. Any resolution of these is a ways off.
Vaquero Option Agreement
A partnership known as Vaquero GP has offered an unknown sum to purchase certain CVX acreage in the Permian Basin, including the land on which TPL has royalty interests. Vaquero was formed within the last 3-4 years with the financial backing of a couple high profile oil men, T. Boone Pickens and J. Cleo Thompson. Vaquero hopes to exploit underutilized energy assets, primarily in Texas, although as we understand it, the company has yet to actually purchase an asset. As part of its offer to CVX, on December 7, 2004, Vaquero inked an option agreement with TPL which gives Vaquero the right to purchase TPL’s damage claims against CVX for a total of $8MM. Per this option agreement with TPL, if Vaquero succeeds in acquiring the land from CVX, then it will grant TPL an additional 5% royalty on is current fee acreage (470K acres), plus a 5% royalty on any production from other acreage acquired. This would obviously be an incredibly sweet deal for TPL. Its existing royalty interest would increase by 2.4X (3.5% to 8.5%), plus additional royalties of 5% on any production on other property acquired in a Vaquero-CVX deal.
The announcement of this option agreement, which happened to coincide with a rapidly rising oil price and continued excitement over land trusts, drove TPL’s stock from $100 to $180.
Vaquero’s motive for gaining control over TPL’s claims against CVX? With this potential liability in its pocket, Vaquero believed it had an extra chip at the negotiation table. Vaquero made its offer (price unknown) to CVX early this year, thinking that having an option on TPL’s damage claims would give it an advantage over other potential bidding rivals. In reality, Vaquero’s tactic and timing weren’t very effective at all. Based on our discussions with multiple parties familiar with the situation (including a CVX North American M&A executive), CVX is not going to part with these properties any time soon, and in particular is not very interested in Vaquero’s offer. CVX also indicated that it didn’t view TPL’s damage claims as material to a decision to sell any acreage. In fact, a long time has passed and CVX hasn’t even responded to Vaquero. If at some point down the road CVX decides to sell, it has apparently received multiple indications of interests that it deems more compelling than Vaquero’s. Keep in perspective that this is a relatively small asset for an enormous company that is now preoccupied with the integration of Unocal and the aftermath of Katrina and Rita.
Obviously no sale to Vaquero means no additional royalty to TPL, and likely no accelerated exploration and development investment in its fee acreage. An eventual sale to any entity other than Vaquero could lead to increased production in TPL’s interests, although the impact of any increase would be limited to TPL’s current royalty structure. And this scenario appears a long ways off, if at all.
VALUATION AND CATALYST
So totaling it all up we have:
Norm RE Sales 3.5MM
Run-rate O&G Royalties 9.0MM
Grazing & Interest 2.2MM
Op Expenses (2.7MM)
Taxes (3.6MM)
Net Income 8.4MM
Shares Out 2.2MM
EPS 3.80
DPS 0.55
This means that at $160, TPL is trading at 42X norm earnings, assuming current energy prices. Since TPL typically distributes 90% of its income, I prefer to think of this valuation as an earnings yield of 2.3%. Keep in mind that normalized EPS of 3.80 compares to TPL’s highest reported EPS prior to 2004 of 2.79.
What would be a more reasonable valuation? We’ve run numerous DCF scenarios, and assuming current commodity prices, modestly increasing O&G production over the next 10 years, and a 10% discount rate, the NPV per share is $60-$70, well less than half the current quote.
What if Vaquero surprisingly succeeds in acquiring the CVX property, and therefore TPL gets the royalty bonus? We’ve again run numerous DCF scenarios, including Vaquero’s acquisition of the CVX property in 2006 followed by a doubling in production over the next five years. This extremely optimistic analysis produces a NPV per share around $140 (again assuming current commodity prices and a 10% discount rate), still below the current quote. We confidently assign almost no probability to this optimistic scenario. It’s clear to us that in valuing this stock the market has simply gotten far too carried away with the positive news flow over the past year.
You may wonder about a breakup valuation analysis. But that is simply not a realistic approach. How could TPL sell at one time 988,000 acres spread out across some of the most desolate areas of West Texas? This company started with 3.5MM acres 117 years ago, spun off 1.7MM into TP Oil, and still has 988,000 left! Breakup valuations would be nothing more than hypothetical.
As a point of comparison, as Vaquero was doing its due diligence on TPL it accumulated a block of stock starting in the 30s. They eventually made an offer for the entire company in 50-60 range, and raised it once. The trustees turned down the offer (without notice to the shareholders). Not surprisingly, as the stock skyrocketed, Vaquero happily parted with its last shares in the 120’s, amazed by that valuation.
Importantly, we see three near-term catalysts for this stock to decline. First, TPL’s trailing EPS number is about to drop off the extraordinary land sale from a year ago. So with the 3Q05 report, the EPS number falls from $7.90 to probably $3.50-4.00. This simple cosmetic adjustment will remind naive investors what the company’s typical earnings power really is. Second, land trusts have recently come under increased selling pressure as real estate euphoria fades as the Fed's tightening campaign finally sinks in (JOE, CTO, and TRC are 25-30% off their recent highs). Third, the Vaquero option agreement expires on December 7, 2005. We doubt that Vaquero will renew the option and waste another $250,000 (the original premium), and investors will then realize there is no windfall on the horizon. Even if Vaquero extends the option, the fact that nothing has happened will likely be seen as a disappointment
Risks
We see two key risks. The first is that Vaquero succeeds and therefore TPL’s royalty revenue increases sharply. The stock would likely spike (although we are confident this is not a near-term possibility), but, as stated earlier, we calculate a very generous NPV under this scenario around $140.
The second risk is that oil and gas prices double from current levels. Again, although that would likely support the stock for a time, it wouldn’t produce an NPV even equal to the current quote! Plus, we are long energy stocks where current valuations don't nearly reflect current commodity prices, and they would hugely benefit in a scenario of doubling oil and gas prices.
Catalyst