TPL - Texas Pacific Land Is Downgraded To Sell From Hold

2024-01-18 08:31:37 ET

Summary

• The judge has decided that Horizon Kinetics has to vote in favor of increasing the number of authorized shares, conditioned upon the company declaring a 3 for 1 stock split.
• TPL has a low dividend yield and a very high P/E.
• Since they do not hedge, the company is exposed to oil and natural gas price volatility.
• They have a very strong balance sheet with no debt and $654 million cash.

Potential profits of Texas Pacific Land Corp. (TPL) are not being maximized because of continued fighting between management and a large investor group. Over the last few years, I had "hold" recommendations for TPL with the expectation that fighting would be resolved. Since I now expect it to continue, I am downgrading TPL to a "sell".

Owning Surface Land Is Not a Reason to Own TPL Stock

I first want to point out that investors should not buy/hold TPL stock based on the company's vast surface land holdings. It is what is below the surface that makes TPL valuable. Using their 868,446 surface acres they own and total equity capitalization $11.75 billion, the implied market value per acre is about $13,530. That figure, however, needs to be adjusted for their cash and total liabilities, which then implies a market value of $12,250 per acre. The surface acres are almost completely raw barren land. Land sales at this point most likely would be sold just to some local rancher - not a condo developer.

It is unrealistic to expect development of this surface land into residential and/or commercial use. Because of the location it would cost a fortune to construct needed infrastructure such as roads, a sewerage system, and other utilities. Current new infrastructure being built on their land are mostly pipelines and transmission lines. While a few surface acres might be worth $5,000+/acre, most surface acres are worth only $1,000 to $1,500, in my opinion. What is under the surface, of course, is worth a lot more per acre.

Litigation Over Increasing Number of Authorized Shares

Most TPL investors already know that Judge Laster handed down his post-trial opinion (text of 70-page opinion ) on December 1, 2023 regarding Texas Pacific Land Corp. v. Horizon Kinetics LLC, (C.A. No. 2022-1066-JTL) (Del. Ch.) that conditionally results in HK voting in favor of proposal #4 "to increase the authorized shares of common stock from 7,756,156 shares to 46,536,936 shares".

One of the reasons why company wants to increase the number of authorized shares is so they can have a 3 for 1 split. The judge's opinion actually is conditioned upon this stock split:

the Company repeatedly stressed during this litigation that the bulk of the shares will be used for a 3-for-1 stock split. But the Company never committed to the split. Having relied on the split for purposes of this case, the Company cannot now walk away from it. Consequently, the final order will condition the increase in the authorized shares on the Company completing the split. If the Company does not complete the split, then the additional authorized shares will be void.

As I covered in my prior article, most of the focus of the case is regarding NYSE Rule 452 . Basically, if the vote to increase the authorized number of shares is "routine", HK would have to vote in favor of #4 under the terms of the Stockholders Agreement (text of the agreement ). If there was a related transaction such as a proposal to use the increased number of shares to buy another company, then it would be considered "non-routine", and HK could vote against it. Without going into the details of the judge's opinion, he concluded that there was no other direct or indirect proposed transaction regarding the increased number of shares, so #4 proposal is "routine". Other points were asserted by HK, but the routine issue seemed to be the one that they would be most likely to win.

The opinion also includes instructions stating:

Within thirty days, the parties will submit a joint letter that either attaches an agreed-upon form of final order or identifies any issues that remain to be addressed and proposes a procedure for resolving them.

I have not been able to find any final order filing or any amended charter filing. I am not asserting there has not been any, I just have not been able to find the documentation. After the charter is amended, the board of directors would still have to vote to have the stock split.

In my opinion, this 3 for 1 split is useless because it would not significantly increase the trading liquidating that a split of 20 for 1 and higher would achieve. So TPL would trade at $510 instead of $1530, but it would still have very low average daily volume. It is absolutely critical to note a TPL stock split does not result in dilution. What the company does with the remaining 23,268,468 post-split authorized shares, in theory, could result in some type of dilution.

Acquisition of Companies and Assets

If I was an investment banker advising TPL I would encourage them to buy a company with fairly high-quality assets/operations that has a large amount of short-term borrowings with high variable interest rates. TPL could use much of their own cash to pay down those borrowings and also use TPL's high cash flow to pay down any remaining short-term borrowings over a short period of time. I would not advise buying a highly leveraged company that has mostly notes/bond debt - just buy a company with mostly high variable rate bank debt that can be paid down. TPL could most likely buy a highly leveraged company using TPL stock much cheaper than non-leveraged companies.

Many TPL investors are worrying about an acquisition using TPL stock that results in dilution for current shareholders, and they also worry about some mega deal that completely changes the characteristics of the current company. A number of modest-sized acquisitions over time might be beneficial for current TPL shareholders as long as there is limited or no dilution. These purchases may also bring in some top-quality management that could replace current TPL management.

(In the judge's opinion he mentioned that there were prior asset purchases being considered over the last two years, including buying some assets from Occidental Petroleum ( OXY ).)

Is TPL Stock a Buy at Current Price?

When trying to determine if TPL is currently a buy at $1,531 per share there are a number of metrics to look at. First, is dividend yield. TPL currently pays a $3.25 quarterly dividend, which implies a dividend yield of 0.85%, but many investors are expecting a special dividend of at least $10 per share, which would imply a yield of 1.5%. A special dividend of $20, which they paid in 2022, still results in only a 2.2% yield. So, the dividend, in my opinion, is not really an incentive to buy TPL.

Related to dividend payments is stock repurchases. I am absolutely against stock repurchases by companies. In the case of TPL they should use that cash to pay a higher cash dividend. Under their $250 million repurchase program, they repurchased 80,162 shares for a total cost of $133.852 million or an average cost per share of $1,670. Since the stock is trading at $1,531, they have a "paper" loss on these repurchases.

Another metric used to determine if a stock is a buy is price/earnings ratio. Using the trailing 12 months earnings of $50.98 per share, the current P/E 30x. That is very high, especially since earnings this year are going to be lower than 2022. To have a high P/E a company needs high consistent growth. TPL is also mostly in the fossil fuel business that is a target of many of the politicians. Their P/E is too high and, therefore is not an incentive to buy the stock, in my opinion.

A metric some investors use to value a stock is based on free cash flow. In 2022 TPL had free cash flow of $451.6 million. The equity capitalization is currently 26x 2022 free cash flow. Free cash flow in 2023 will most likely be lower than in 2022 based on the first nine months, which would mean this multiple will be even higher based on 2023 annual results. That is a very high multiple for a commodity-based company. TPL does not hedge energy prices, which they now are allowed to do after they converted from a trust to a corporation, so TPL is completely at the mercy of the energy market price volatility. TPL is not some REIT that has long-term leases that enable reasonable future cash low estimates. Their cash flow varies significantly from year to year. Based on the very high free cash flow multiple there is no incentive to buy TPL.

With no debt and $654 million cash, their very strong balance sheet would be an incentive to buy the stock. An investor, however, needs to look at other factors besides just their strong balance sheet.

A major negative is that TPL does not control their energy operations. They only get royalties based on what the actual operators decide. For example, TPL does not decide where or when to drill. This, in my opinion, means that a "haircut" value would be appropriate when valuing TPL.

Finally we get to the primary reason for the downgrade from "hold" to "sell". The fight between management and Horizon Kinetics does not seem to be ending anytime soon. Often a long-term fight between management and a major stockholder group is not good for shareholders on the bottom who too often end up with bus tire marks on their backs. If some new very sharp CEO or management team is finally appointed to run TPL I might consider buying the stock again. Until management is changed, I will remain in the bleachers watching what happens.

WTI Oil Price Outlook

Because TPL does not hedge energy prices the company is exposed to potentially large price changes, especially the WTI price because a majority of their revenue is from oil royalties. The problem is that oil prices have become so dependent upon geo-political events that it is difficult, if not impossible, to forecast oil prices with any degree of certainty. If TPL did hedge some of their exposure, then at least a portion of their future revenue/earnings could be estimated. I ran some econometric models using different geo-political assumptions and I got a very wide WTI price range. I find it sort of odd that the U.S. Energy Information Administration's latest oil price forecasts show relatively flat prices over the next two years.

Conclusion

I booked nice profits on TPL trades a few years ago. I have been waiting for the fighting between management and the investor group to stop. Actually, I was hoping for new dynamic management to come in because I have strong negative opinions of management and those associated with Horizon Kinetics.

TPL stock is not cheap. The dividend yield is low, the P/E is very high, and the stock price compared to free cash flow is also very high. While the balance sheet is very strong, that is not enough to justify buying/holding TPL. They also have no control over drilling and are exposed to energy price changes because they do not hedge. Therefore, I rate TPL a "sell".

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