Texas Pacific Land: Unique Model With Good Prospects, But May Be Overvalued (TPL)

Texas Pacific Land Corporation (NYSE:TPL) is a unique entity primarily engaged in land and resource management. TPL’s origins date back to the mid-19th century, when it was initially formed to manage the land grants received by the Texas and Pacific Railway Company. Over time, as railroad land grants diminished, TPL became a modern land management company focusing on managing its vast land holdings and maximizing their value.

Headquartered in Dallas, Texas, the company owns approximately 868,000 acres of surface area and 2.4 million acres of mineral interests in various counties in West Texas. These assets include significant oil and gas resources and agricultural and water rights.

TPL’s business model generates revenue through various means, including leasing its land for oil and gas production, agricultural activities, surface leases, easements, and water sales. The company also actively monitors its mineral interests and seeks to capitalize on opportunities in the energy sector.

Where does TPL’s revenue come from?

To sufficiently understand the specifics of a business when solving an investment problem, I usually study the breakdown of revenue by segment at a minimum. For this, I will need the latest 10-K report for 2023.

Oil and gas royalties – 57% of consolidated revenue for 2023

A significant portion of TPL’s revenue comes from its ownership of mineral rights, particularly oil and gas interests. The company leases its mineral rights to energy companies for exploration and production activities. In return, TPL receives royalties based on the production of oil, gas, and other minerals from its land. Companies such as Occidental Petroleum (OXY), Chevron (CVX), and ConocoPhillips (COP) are TPL’s largest customers.

Due to the dominance of this segment in the company’s revenue, Texas Pacific Land belongs to the Energy sector and the Oil, Gas & Consumable Fuels industry. The company receives revenue from oil and gas production, without being its producer, and from its transportation, without being its carrier, but only by selling easements. Despite license revenues from oil and gas being subject to fluctuations in the market prices of energy resources and depending on the decisions of well owners, TPL has no direct peers in this segment because it sells, leases and generally manages land owned by the Company.

Water sales and water royalties – 31% of consolidated revenue

TPL is the sole owner of Texas Pacific Water Resources LLC, which provides a full range of water supply services in the region. Revenue is generated through royalties from oil and gas companies for the use of associated water for technological needs and from its sale to service companies in the region. In this segment, TPL is not the only player in the market, but as a landowner, it is freed from the need to spend money on water delivery through other lands, while competitors are forced to spend additional costs on this.

Easements and other surface-related income – 11% of revenue

The report (page 3) says that several renewable energy companies have agreements with TPL for future land use, and the company’s management expects this segment to grow in the long term. Additionally, the company leases its land for various surface uses, including commercial and residential development, agricultural purposes, such as farming and ranching, and recreational activities.

As a major landowner, Texas Pacific Land also occasionally accepts third-party land sales offers, and this segment accounts for no more than 1% of the company’s revenue for 2023.

Business Scale

Even though the company has only about 100 employees, it is a company with a market cap of over $18 billion as of September 12, which corresponds to the Large cap segment. The annual revenue for 2023 was $631.6 million, and analysts predict that the company is unlikely to reach a one-billion level until 2027.

The company owns 868,000 acres, or approximately 3,500 square kilometers, which is 0.52% of the land area of ​​the second-largest state in the United States after Alaska.

Pros of TPL as an investment idea

Let me make it clear right away that I mainly study any company in the context of the quantitative analysis method. Understanding the essence of operating activities and agreeing with the business model, I then analyze only the numbers: statements – for assessing the quality of the business, separately – the price and its valuation relative to itself in retrospect.

1. High Earnings Quality

In this part of the research, I refer to the report on Form 10-Q, and the numbers and calculations below correspond to the period of the last 12 months (TTM). Texas Pacific Corporation does not disclose the cost of goods sold and, as a result, does not provide a calculation of gross profit, which does not allow us to estimate the gross margin. However, the operating profitability is consistently above 75% (79% at the end of 2Q2024), and the net is 67%. These are grandiose levels, at least the best among all mega and large caps in the US in the Energy sector.

According to Seeking Alpha, the gross margin is 93.6%, which only adds optimism to me as a fan of high-profit businesses. I also highly value such an indicator as earning quality, calculated based on the ratio of cash flow from operating activities and net earnings. Texas Pacific is able to confirm every dollar of profit accrued in the report received in the company’s accounts, since the value of this indicator exceeds 100%.

2. Solid Financial Position

With assets such as water and land and building its business on receiving royalties, the company does not need capital expenditures and operates completely debt-free. Therefore, the liquidity (current ratio=17) and debt burden (debt-to-equity=0) metrics look more than strong with growing equity, which reached $1.2 billion, and cash on hand of $894 million as of June 30, 2024.

3. The Most Profitable Energy Company

As in the case of operating margin and net margin, the company has the highest return on assets and capital metrics in the sector, which are impressive and are due to the uniqueness of the business model. Since equity is almost equal to the company’s assets, ROA and ROE are almost identical – 37% and 41%, if we take the last 12 months as the basis for calculation. But ROIC is seriously different and exceeds 100%! Return on invested capital is good for assessing management efficiency because it does not take into account those assets that are not involved in operating activities.

$894 million cash on hand is almost 68% of the company’s assets, and if we remove them from the investment capital, and use net operating profit after tax as the numerator, which according to my calculations was $104 million dollars against $114 million accrued net profit in the report for the second quarter, then we get a serious boost for this ratio. TPL with its 104% confidently ranks first in the sector among mega and large-cap companies in the USA. In second place is EOG Resources (EOG) with a value of 21%!

4. Dividends and Buybacks

All of the above-mentioned qualitative indicators allow TPL management to implement one of the main stated goals for shareholders – income payments through dividends and share buybacks. Even taking into account special dividends, which, for example, were paid on July 15, 2024, in the amount of $10 per share, TPL’s dividend yield is low – 1.68% according to my calculations.

This yield level is more than 2 times lower than the risk-free rate (US 5-Year Treasury) of 3.426% on September 12. And this is significantly lower than what is paid in the industry. For some reason, the TPL yield is underestimated in the chart below:

But the dividends are very stable: the company has not paid them only once since 1981 – in 2013. The average yield for 3 and 5 years does not differ much from the current one – this allows me to count on them as a reliable source of passive income.

But what is more important for shareholders is the share buyback. According to the annual reports, $19.6 million was spent on buyback in 2021, $87.7 million in 2022, $42.5 million in 2023, and $16.7 million for the first 6 months of the current year. Only in 2020, for obvious reasons, there was no share buyback, but this is a stable tool for maintaining the growth of quotes and returning profits to shareholders.

Cons and Risks of Investing in TPL

Although I use quantitative analysis, and it presents an objective picture of numbers, their perception is still subjective. Each investor has their threshold values ​​for a particular area of ​​analysis or a specific parameter from the financial statements. As with the strengths of the business, the weaknesses in the text below are my interpretation of the risks that are worth keeping in mind when holding TPL shares.

1. Growth Estimates

From the Covid bottom (from April 2020 till September 2024), the company’s capitalization has grown 5.5 times. Including thanks to the stock split carried out on March 27, 2024.

Even for such an attractive and effective business model, this may seem like a lot. What did the shares and investors’ appetites grow on, except for dividends, buyback and high business efficiency indicators? The 5-year CAGR of revenue growth was 16%, and for the net profit, it was 14%. However, it is noticeable to the naked eye that the rate of net profit generation is decreasing.

And Wall Street analysts are not encouraging in their forecasts. The consensus for revenue growth is +10%, and profit +12%, which is worse than the pace that the company has demonstrated in the medium term. And for the price, the average consensus is 4% lower than the current level.

2. Current Valuation

TPL is currently trading at around 40 times its net annual earnings. This is significantly higher than the industry average P/E and is also more expensive than the market has typically valued the company over the past 5 years, with the median value for the company itself being 31.3. If I take the maximum, median, and minimum P/E for 5 years and multiply it by the current 12-month earnings per share ($19.39), I get this interesting chart. This is called a historical multiples valuation.

By and large, I have been singing the praises of the company’s business and its excellent business indicators for quite a long time, so it is partly clear why its shares are quoted so highly. But the fact that the price is above the red and yellow lines, which in my analysis system correspond to the best scenario case and fair value for entering into the investment, does not allow me to call TPL undervalued. On the contrary, the shares are overvalued relative to themselves in history, according to my calculations, by 23%. This does not mean that they will fly down. But it does mean that even entering such a cool business at current prices is an increased risk.

3. Oil prices

I have already cited the figure that 57% of revenue is generated from oil and gas royalties. Therefore, even without being an oil producer, or a company for its processing or transportation, TPL depends on prices on the raw materials market. Unfortunately, I do not have a detailed understanding of how the royalty price is formed, what can change it, and what clauses each license agreement contains, but logic suggests that the lower the price on the world market is, the less a hypothetical Chevron will pay Texas Pacific Land.

Crude Oil is testing its 52-week low, trading below $70 per barrel as of 12 September. If we look at the latest investor presentation, the average selling price of oil from wells on TPL land over the past two years was $78.4.

On the other hand, if oil prices start to rise, this is an opportunity for shareholders. But the oil price is not the object of this research, so I will leave this topic without conclusions; however, it is necessary to study the potential trends in the oil market if you are going to buy TPL at current prices.

Bottom Line

I bought TPL shares in the spring of 2024 when they were last valued at the median P/E (around $575) and closed the position in mid-summer, fixing almost 40% of return excluding dividends received. Despite the uniqueness of the business model, I am not ready to hold TPL shares at such a high price, since the boundaries of this business are clearly defined: 868,000 acres of surface area and 2.4 million acres of mineral interests located in various counties in West Texas.

This business cannot be scaled infinitely, as in the case of IT or pharma technologies, as an example. And it is investment attractive as long as asset management is effective. I believe in TPL’s prospects, but as an investor with moderately conservative views, I prefer to control risks and buy outstanding assets at a fair price, as Buffett advised.

Therefore, my goal is to wait for the price closer to $600 per share to restore the long position.