Idea List: Issue #10

This week I analyzed Net Lease Operating Properties and Permian Basin Royalty Trust

In this post I want to share two stock ideas that appear to be undervalued. These companies came from the “top of the funnel” of my research process, meaning they came from stock screeners, or recommendations from Twitter and Substack. What I want to do here is present some qualitative and quantitative metrics that determine if I should keep researching the stock or take a pass on it. Further, I want to do a basic valuation to verify that the company is actually undervalued. The end goal is to have some semi-vetted stock ideas that I can add to a watchlist and start doing more thorough research on.

Net Lease Operating Properties

Net Lease Operating Properties NLOP 0.00%↑ is an office REIT that is liquidating, and word on the street says they are trading below net asset value. The “net lease” that is in the companies name refers to the type of lease where the tenant pays most of operating costs and maintenance. Most of NLOPs properties are single-tenant facilities with tenants that include JP Morgan, FedEx, Siemens, CVS, Omnicom. Offices that are leased out to a single large corporation are usually considered less risky than a building leased to several smaller tenants. NLOP was spin-off from W.P. Carey Inc. (WPC), another net-lease REIT. The spin-off completed late 2023, and by December 2023 they had 55 properties, all in US except 5 in Europe. Occupancy rate is about 97%. In the company’s filings, they state their strategy is to sell all the properties, use the proceeds to pay down all the debt, and then make distributions to shareholders.

During the spin-off, NLOP started out with a $335M mortgage and $120M mezzanine loan. Most of the loan proceeds went to the parent company. Later in December, the company added and additional $168M in mortgages on 10 of its properties. In January the company paid a $0.34 special dividend, but there is no regular dividend. NLOPs total revenue for 2023 was $174.5M. From my calculation, operating expenses was $51M, so net operating income was $123.5M. This means NLOPs operating expenses are about 30% of rents. Since real estate is often valued on a multiple of net operating income, I can estimate the current value of their properties using their latest NOI figure. As for the balance sheet, December 2023 had $1.2B in buildings, total assets $1.3B, total liabilities $623.6M, equity $677M. The latest quarter showed NLOP has $904M in properties, $1.04B in assets, $380M in liabilities, $664M in equity.

A couple of weeks ago, NLOP had a press release stating they sold another property, so the current property count is 46. The press release also said that after using the proceeds to pay down debt, the mortgage is now at $74M, and is mezz at $81M. NLOP publishes a press release each time they sell a property, which includes the sale price and what the current rents were. Using this I can estimate what kind of cap rates they are getting on these properties, then use that cap rate to estimate the value of their real estate portfolio. Based on their recent transactions, NLOPs offices sold for a median cap rate of 5.7%, with a high of 11% and low of 4.16%.

NLOPs latest financials are from the end of June, and since then they have sold one property for $76M that produced $4.7M in rent. In order to value the current properties, I will take the June quarter lease revenue, annualize it, then subtract out the proportion that the recently sold property contributes. This comes out to an estimated rental income of $135.9M for the year. Applying the estimated 30% in operating expenses, we get $95.1M in NOI for the portfolio. To be more conservative, I will divide this by an 8% cap rate instead of the 5.7% of the recent sales. This gets a net asset value of $1,189M. Substituting the estimated property values in the balance sheet gets an updated asset value of $1,329.2M, with $320M liabilities, so equity value comes out to be $1,009.2M. Dividing the equity figure by 14.8M shares gets a fair value of $68, which is much higher than the current price of $30.

I feel like I missed out because NLOP was trading around $15 soon after the spin-off, which was down 75% from the spin-off price. Much the pessimism for this stock comes from the fact its a spin-off, it’s a REIT that doesn’t pay dividends, and they own office properties. It looks like as NLOP has sold some properties for fairly attractive prices, the stock price has showed some optimism. That being said, it looks like the price has a long way to go unless credit conditions deteriorate to where it takes NLOP longer to sell the properties or they have to sell at reduced prices. I am very interested in this stock so its going to the top of my research list.

Permian Basin Royalty Trust

Permian Basin Royalty Trust PBT 0.00%↑ is an oil and gas royalty trust that covers properties in Texas. I found out about this stock from the Special Situations Investing Podcast, and their thesis on the company made it sound interesting. A quick backstory is that the ownership of the underlying properties have change hands through the last 30 years. The land was originally worked by an oil company within the Burlington Northern railway, then it was eventually sold to ConocoPhilips, and finally acquired by Blackbeard LLC in 2019. Blackbeard has been investing in drilling new wells so production has increased from 1.3 million barrels of oil to almost 3 million barrels. The capital expenditures are shared between the Trust and Blackbeard, but increased capex spend means higher production figures. The capex spend for 2023 was $116M and the goal was to increase that to $310M this year. Trust revenue was $11.8M in 2021, $54.4M in 2022, $29M in 2023. Oil and gas prices were higher in 2022 than 2023, even though production was higher in 2023.

PBT’s annual report estimated proved reserves to be worth $508.5M, which varies by the price of oil and gas, as well as how much more the land gets developed. The number of barrels in reserve have nearly tripled since 2020. Currently, the market cap is about 1x the value of the reserves. Permian Basin’s income from the royalties produce a dividend yield that is almost 6%. Based on these simple figures, it seems like PBT is fairly valued. However, the increased production from the much higher capex budget does not appear to be reflected in the stock price. The proposed capex budget mentioned the amount of wells that are planned to be drilled. In a deeper dive, I would try to look at the new wells vs current wells to estimate how much that would boost production.

One thing that complicates this stocks is that I noticed the Trust filed a lawsuit against Blackbeard in May, alleging they improperly billed them $15M. Blackbeard’s response was that they were correctly sharing expenses with the Trust. So far the only impact is that the royalty distribution in May was low due to lack of cash from Blackbeard, which was paid in June. Since then, this delay has cascaded where June’s payment is received in July and so on. If the Trust is correct, the $15M is like half a years worth of royalty payments so it would be substantial if the Trust won the suit. That being said, ideally Blackbeard and the Trust can get along so unit holders can be confident there will be a steady stream of oil produced. My conclusion is that PBT may be an interesting play on oil provided the increased production materializes, while this lawsuit may keep the stock price low due to the uncertainty (which sometimes makes a good buying opportunity).