New Holdings - Vulcan and Texas Pacific Land Trust

Gareth Campbell - Fund Manager

17 June 2020

The coronavirus has had a severe impact on parts of the physical economy, many of these businesses will struggle to recover but others we believe are facing near term headwinds while the long term value of the business remains largely intact.

We’ve added a couple of businesses that we think fit into that latter category. Using the fall in recent prices as an opportunity to own high quality businesses, with high barriers to entry and unchanged long term growth opportunities.

New holding – Texas Pacific Land Trust

Texas Pacific Land Trust own 900,000 acres of land in Texas. The majority of the business is driven by royalty income from oil and gas extracted from their land. The rest of the business is from fees received to build infrastructure on the land and the sourcing and disposal of water.

Why did we invest?

The royalty business model Texas Pacific Land Trust operate has exceptionally high margins, is profitable at a $20 oil price and has very low capital requirements. These characteristics make it unique in the energy sector, limit the risk from a prolonged period of low oil prices while retaining optionality to a recovery in oil prices.

Its 900,000 acres are primarily located in the Delaware basin, one of the lowest cost areas of production in US shale with resources that are expected to last for a long time. This means that even in a low growth environment it will increasingly take share from other regions of production.

The water business was started in 2017. Revenue is from selling clean water used in the drilling process as well as the storage of waste water from producing wells. This is an interesting way to monetise its acreage as it has a sustainable advantage over competitors who have to negotiate access from private landowners.

High barriers to entry

Texas Pacific Land Trust’s ownership of 900,000 acres in West Texas makes it one of the largest landowners in the US; to replicate today would be extremely costly and challenging. Its portfolio was uniquely acquired as it dates back to the 19th century and the bankruptcy of a railway which owned large tracts of land.

Ownership of this land in the most important oilfield in the US means virtually all operators will at some point need to interact with it to access or drill on their land. This makes it an invaluable partner throughout the whole lifecycle of oil production and means it can operate on an equal level to their counterparties despite being a fraction of the size.

Oil price uncertainty

As economic activity stopped due to the coronavirus the demand for oil fell and so has the price. We typically avoid investing in businesses where their value is driven by something we can’t control but with the price significantly below marginal cost (the costs of producing an additional barrel of oil), we think the risk reward at this time looks compelling.

Governance changes

In March 2020 the trustees agreed to convert the Trust into a corporation registered in the US. As a trust shareholders had minimal rights and trustees were lifetime appointments. The new structure will significantly improve shareholder rights and makes the business more investable.

New holding – Vulcan Materials

Vulcan materials is the largest aggregates business in the US. Aggregates are gravel, sand and crushed rock which are used heavily in infrastructure as well as residential and commercial construction.

Why did we invest?

US infrastructure is old and in need of replacement with the American society of civil engineers grading it a D+. There is wide acceptance of the need to increase spending on infrastructure with 89% of proposals for tax increases to fund infrastructure passing at the most recent election. This unmet need should help support higher levels of growth in the future.

The coronavirus has plunged the US economy into a recession. We increasingly think some form of fiscal stimulus will be needed to support economic growth. With both presidential candidates supporting infrastructure building we are hopeful this can happen despite the political differences.

The price of aggregates has consistently increased above inflation. For example even when demand fell 30% during the financial crisis the price of aggregates was essentially flat. This makes it unique within the majority of building materials which typically have volatile pricing and volumes.

The majority of Vulcan materials revenue is from US states with faster GDP growth than the average. We think this should help the business grow faster than the industry as a whole.

High barriers to entry

Aggregates have a low value per ton making them expensive to move by truck, so the transportation costs limit competition to local markets. If Vulcan Materials has a dominant position in a local market it can better manage competition to help improve pricing and margins.

It is incredibly hard for new quarries to open, regulation and permitting can take years and few local populations want a quarry. This limits new supply to the market and helps protect pricing and market share.

Budget concerns

The negative impact of coronavirus on income and fuel taxes means government budgets are increasingly pressured, limiting investment in infrastructure. We appreciate this risk and expect we may see some volatility as these issues are discussed. Longer term the need for more infrastructure spending is unchanged and we expect these budget issues will be resolved, limiting the impact on the intrinsic value of the business.

Asset value

With 80 years of production still in the ground we believe that at current aggregate prices Vulcan materials has a significant asset value not recorded on its balance sheet. Given the history of price increases above inflation we think that in the longer term the value of these assets will increase in real terms. This underlying hidden value helps put a floor in valuation and improves the risk reward of owning the business.