XHB - Tejon Ranch: Difficult Macroeconomic Backdrop Keeps Me On The Sidelines

2023-10-28 03:44:19 ET

Summary

• Tejon Ranch, a real estate development company, has struggled to deliver long-term shareholder value.
• The company's major proposed housing projects are likely still years away from development.
• Rising interest rates and a softening commercial real estate market further reduce the incentive to build at Tejon Ranch in the near future.
• I see shares as a hold and note insider buying as a positive. However, there is little in the way of catalysts that would support a near-term rally.

Tejon Ranch (TRC) is a real estate development company with a massive land position 25 miles south of Bakersfield, California. The company has a long history on public markets having listed on the American Stock Exchange in 1973 and moving to the NYSE in 1999.

The company had initial success, at least from a valuation standpoint. Shares jumped in the 1970s amid the inflationary environment which made asset plays such as Tejon Ranch compelling. Shares further soared in the 1980s as fund managers started to pile into TRC stock in hopes of imminent development of the firm's massive land parcel. Since the 1980s, however, TRC stock has largely laid fallow, with shares delivering no return whatsoever over the past 35 years or so:

While the company has failed to deliver long-term shareholder value over the past few decades, there have been periods of heavy speculation in the shares. In the mid-2000s, for example, Tejon Ranch shares ran up to new highs on the back of the tremendous strength in the housing market at that time. However, nearly Bakersfield would go on to be one of the worst hit places in terms of foreclosures and housing valuation declines in the ensuing 2008 financial crisis, and Tejon Ranch shares lost steam as investors gave up on the hopes of near-term development.

Fast forward to today, and Tejon Ranch's major proposed housing projects are still years (or longer) away from development. There has been incremental progress in building retail and industrial facilities at the ranch, but nothing that would meaningfully move the needle for the stock's valuation.

Back in April, I wrote It's A Bad Time To Own Tejon Ranch , noting its historic challenges in generating shareholder value and the difficult macroeconomic environment it current faces. Shares have underperformed the S&P 500 by about 15% since that point. While I remain skeptical, I am moving from a "sell" to "hold" rating due to the lower valuation and recent insider purchases of TRC stock.

Interest Rates: Bad To Worse

The huge question facing Tejon Ranch over the next few years is simply what demand there would be for its property given soaring interest rates. Since April, the situation has gotten worse with benchmark mortgage rates moving even higher:

Previously, one could argue that the housing market performed well in the mid-2000s with 30-year mortgages in the low 6s. But that offers cold comfort with the 30-year mortgage rate now approaching 8 percent. This is simply unprecedented territory for a large chunk of the prospective homebuying population.

Bulls will say that interest rates haven't crushed other homebuilders or land development companies. And that's true to a reasonable degree, though the S&P Homebuilders ETF ( XHB ) peaked this summer back around the old 2021 highs and has now started to roll over:

Still, there are other land development companies like The St. Joe Co. ( JOE ) that are having reasonable success at the moment. Why isn't Tejon Ranch comparable? For starters, St. Joe in particular is developing home sites near beachfront land within close shot of an existing Florida city. And Florida has been attracting a ton of new folks over the past few years as people have prioritized low taxes and quality of living as of late.

Tejon Ranch does not benefit from these sorts of factors. Its land parcel is 25 miles from Bakersfield and a long drive into Los Angeles. This makes it far from the most obvious choice as far as being the next urban development opportunity in Greater Los Angeles.

And California as a whole does not have the same favorable economic development backdrop as states with booming economies such as Florida or Texas. California currently faces a high taxation and regulatory burden and increasing social issues that are concerning to its residents. In fact, many of the new arrivals in states like Texas have been Californians that decided to leave it behind.

I'd further suggest that the idea of building massive tracts of suburban housing is now an idea passed its prime. Thirty years ago, when Tejon Ranch stock was a hotter commodity, it was natural to buy a house out in a far-flung suburban community and drive 45 minutes into the office every day. That mode of living has come under increasing pressure; nowadays, urban apartments are the hot development category.

Assuming that there isn't demand for a major housing development an hour north of Los Angeles at the moment, aren't there still other great monetization opportunities? I'd argue the appeal of most forms of commercial real estate has dropped markedly over the past couple of years. Retail was already under heavy fire from e-commerce, and now rising interest rates have caused further declines in valuation for many commercial real estate properties.

The one point I'd concede to the bulls is that Tejon Ranch is very well situated for industrial uses, and I could see a lot more logistics buildings going up there over the years given its proximity to Los Angeles. While it isn't close enough to be an obvious housing development site at the moment, it certainly holds a lot of appeal in helping facilitate last-mile deliveries for e-commerce firms.

What About The Longer-Term Outlook?

At this point, bulls might be agreeing that the near-term outlook is challenging given soaring interest rates and the slowing economy. But what about the long-term view, isn't that more promising?

In fact, given how many permitting and environmental hurdles remain for Tejon Ranch's primary proposed housing projects, there's an argument that the near-term housing market doesn't matter much. If Tejon Ranch starts selling a large number of houses, that's quite likely to be a 2030s story anyway.

And that's all well and true to a point. The value of land goes up over time, and there are not many large attractive parcels left in California. Tejon Ranch has a rare asset, and one which should appreciate simply from California's inherent population and economic growth along with inflation.

At the same time, the share price is no higher today than it was in 1985 . On its face, this sounds like a highly attractive argument. After considering dilution, however, this is less of a plus. Tejon Ranch's share count has roughly doubled since the mid-1980s, meaning that the market cap has also doubled even as the share price has been flat. Over time, as some of Tejon Ranch's land has been developed or put into conservation agreements, one would hope to realize tangible shareholder value. So far, that's been tough to find.

One promising note was that Tejon Ranch became profitable recently and has enjoyed rising revenue from the commercial operations that are at the ranch including its outlet shopping partnership along with mineral rights and farming operations.

Between 2018 and 2022, Tejon Ranch grew its annual revenues from $46 million to $79 million and last year, it put up meaningfully positive GAAP EPS. If this continued, it would allow Tejon Ranch to be self-funding and perhaps even buy back stock rather than burning cash and having to dilute shareholders (or sell land) to keep operations going.

However, I'd note that much of the recent bump in revenues was due to a rise in revenues from farming and mineral rights, rather than its development properties. This farming and minerals income is fickle and can easily decrease again. In fact, in Q2 of this year, revenues slumped 21% year-over-year and it appears the company will be only marginally profitable going forward.

If Tejon Ranch could consistently deliver significant profits and cash flows, that would greatly alter the investment case here, as it'd be an asset with a positive carry rather than simply hoping for rising land values or housing permits to finally catalyze the stock. But I wouldn't make too much of Tejon Ranch's 2022 profits, as that was a highly favorable time for commodities, and it appears that the Ranch's farming and mineral rights will return to more modest revenue levels going forward.

We should learn more with Tejon Ranch's upcoming Q3 results. The company reported Q3 earnings last year on November 7th, and I'd expect them to be released around the same date this year, that is to say in the next two weeks or so. As per Seeking Alpha's earnings screen, there is only one analyst covering the company. And historically, shares have not usually reacted with too much volatility to earnings. That said, investors should be watching for the release to see if Tejon Ranch can recapture some of its recent momentum, or if the slide in commodity prices continues to reduce the Ranch's top-line revenues.

Tejon Ranch Stock Verdict

I want to be clear that I'm not inherently against these sorts of land bank stocks. I highlighted Maui Land & Pineapple ( MLP ) this past winter as an attractive opportunity near its 5-year lows ; MLP stock has popped 60% since then. With the right land package and a not too unfavorable economic outlook for the specific project, good things can happen with these sorts of properties.

However, I simply don't see it being the time for Tejon Ranch. Higher interest rates and California's economic issues make the idea of building far-flung suburban housing quite unattractive for the foreseeable future. That's especially true as nearby Bakersfield was a focal point of the foreclosure wave during the 2008 financial crisis. Given that history, I expect banks and other capital providers to be highly skeptical of advancing Tejon Ranch toward its full potential over the next few years. As such, I see little reason to rush to buy shares today, even though the stock price has declined since my previous report.

That said, I will grant that I see shares as a hold rather than a sell at this point. Additionally, there has been insider buying over the past month. With shares not too far from the COVID-19 lows, I would expect the stock to not drop too much farther from here in the near-term unless we get a broader bear market in stocks. However, with nothing in the way of catalysts and a difficult macroeconomic environment ahead of it, Tejon Ranch shares could be trading here about $15 each for quite a while.

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