Between 2018 and 2020, energy was the worst-performing sector on the stock market. The pandemic-induced downturn further strained the industry and resulted in several bankruptcies and record impairments. But one oil and gas company has no debt, $300 million in cash, and is generating record revenue, profit, and free cash flow (FCF).
This hidden gem is Texas Pacific Land Trust (NYSE: TPL). TPL is one of the few oil and gas companies that has outperformed the market over the past three years. The simple reason: It owns a lot of land with oil and gas reserves — namely in the Delaware/Permian Basin of West Texas and eastern New Mexico. As one of the largest private landowners in Texas, TPL can sit back, relax, and rake in profits. Here’s what makes TPL a top oil stock to buy now.
Image source: Getty Images.
Formed 150 years ago to build a railroad from Texas to California, TPL acquired 3.5 million acres of Texas land for building nearly 1,000 miles of track. The railroad was never completed, and the company went bankrupt in 1888. From there, the land was put into a trust for bondholders. During the 20th century, TPL gradually sold some of its land. It currently owns about 900,000 acres, or about 25% of its original holdings.
Although oil was discovered in West Texas about 100 years ago, the big boom for TPL didn’t happen until around 2010 when horizontal drilling and hydraulic fracturing paved the way for profitability. Since the oil crash of 2014 and 2015, small and large oil companies have continued investing in West Texas because it offers some of the lowest breakeven levels of onshore North American plays. A great deal of oil on TPL’s land can be produced for a breakeven cost of less than $40 per barrel, which is competitive at today’s prices. The result has been a surge in oil and gas production. Oil and gas wells operating on TPL’s land increased production by 130% from 2018 to the end of 2019. And with this surge came record performance for TPL.
How it makes money
In 2017, TPL formed a business that sells water. A lot of water is used in oil and gas processes, namely fracking. But this business comprises just 7% of its revenue. Its main bread and butter is land and resource management, which can be broken down into five categories:
- Land sales: TPL can sell its land when prices are high.
- Royalties: TPL collects a portion of the revenue generated from oil and gas production on its land without incurring operational expenses.
- Easements: TPL generates revenue (mainly from pipelines) but also from utilities and other businesses that pass through its land.
- Commercial leases: TPL leases its land to agricultural, wind power, oil and gas, and construction businesses. This is similar to how a shopping center leases land to retail outlets.
- Material sales: TPL gets revenue from selling caliche (sedimentary rocks) that can be used to make things like cement.
Profitability put into perspective
The beauty of TPL’s business is that it doesn’t need to spend money to make money. The self-proclaimed “exchange-traded fund of the Permian Basin” benefits from growing oil and gas production without outlaying tons of capital. Its gross margin routinely exceeds 90% and its operating margin is over 75%. A 75% operating margin means that TPL pockets $0.75 for every $1 earned, and that includes indirect expenses like sales, general, administrative, and depreciation. To put this level of profitability into perspective, consider that TPL has a higher gross margin and operating margin than the 10 largest publicly traded real estate investment trusts (REITs), the top five of which are shown below.
Dividend growth and resilience during downturns
Oversupply coupled with plummeting demand for oil and gas due to the COVID-19 pandemic impacted TPL’s top and bottom line in 2020. Although challenging, the company’s profitability and consistent revenue streams helped it earn $136 million in FCF for the first nine months of 2020, which is more than all of 2018. Although FCF was lower than a record 2019 ($306 million), TPL returned a staggering $200 million in dividends to shareholders in 2020 — a $16-per-share dividend in March and a $10-per-share dividend in December. At a share price of $720, TPL’s dividend yield for 2020 was 3.6%, making the company a high-yielding yet reliable dividend stock. The company has increased its annual dividend payments for 17 consecutive years.
With no debt and over $315 million in cash on its balance sheet, TPL is essentially taking the majority of its FCF and returning it to shareholders. And although lower oil and gas prices tend to mean less drilling, production, and construction (and ultimately less profit for TPL), the company’s lack of expenses and debt obligations means it can generate positive FCF even during oil and gas downturns. As proof, TPL earned about $39 million in FCF in 2014 and $49 million in 2015 while the rest of the oil and gas industry was in disarray.
TPL’s characteristics make it a dream business to own. But at what price?
TPL’s stock is trading near an all-time high. But its valuation is reasonable when you consider how much cash it’s generating. For example, the company has a price-to-FCF of 22, meaning the price of its stock is about 22 times its annual FCF.
This puts TPL at an attractive valuation compared to the aforementioned top 10 largest REITs, especially if you consider its lack of debt and expenses. However, TPL’s valuation looks a lot worse if FCF is lower. If we take the amount of FCF it earned in 2018 — $119 million — TPL has a price-to-FCF of closer to 50, which is expensive.
The beauty of simplicity
Texas Pacific Land Trust isn’t trading at bargain-bin prices like other dividend stocks. But its business is simple, easy to understand, and ridiculously profitable. You would be hard-pressed to find an oil stock that has generated better returns than TPL over the past three years.
The company could easily snap its 17-year streak of raising annual dividends if oil and gas prices languish in 2021. And its FCF could be lower as well. But West Texas remains one of the preferred regions for oil and gas investment, and that means TPL is sure to generate reliable FCF used to pay dividends for decades to come.
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