Description

Hoegh LNG Holdings (HLNG NO) – BUY

Note: Unless disclosed otherwise, all figures are in USD which is how HLNG contracts with customers and is HLNG’s financial reporting currency. The company’s shares however are traded on the Oslo Exchange and are quoted in NOK. Market Cap in boxes above is quoted in NOK for consistency with share price but all valuation is converted at spot USDNOK as financials are reported in USD. EV/EBIT for 2015 reflects EV/EBITDA per the below.

Thesis:

We believe that shares in Hoegh LNG (HLNG) are oversold among the general carnage as of late crushing stocks with any link to energy due to crashing Oil prices. HLNG provides an opportunity to invest in a collection of attractive assets with long term cash flow visibility and large AND attractive (high Return on Investment) growth potential through increased FSRU/FLNG assets over time. At 82NOK, we believe that the shares should gradually rerate upward to at least 110NOK and likely higher as catalysts play out over time. This provides roughly 35%+ upside which we think will likely be surpassed with downside protection through secure long term contracts on existing assets.

Business Overview

HLNG is one of a handful of players with the technical experience and know how to operate FSRUs and soon FLNG assets which as the players add assets is a virtuous cycle reinforcing their entrenched positon in securing FSRU/FLNG contracts that come up for bid (Key players are HLNG, Golar LNG and Excelerate; other notable players with less presence include BW Gas, MOL (JV partner with HLNG) and Exmar). In short, barriers to entry exist allowing HLNG to capitalize on high attractive asset level investment opportunities in FSRU and soon FLNG. In numerous meetings with HLNG, management has reiterated to us that they do not view themselves as shipping company. Rather, they view themselves as a provider of the complex parts of the LNG infrastructure chain, notably FSRU’s and soon potentially FLNG’s.

In August 2014, the company executed on a long planned US listed MLP for its some of its FSRU assets demonstrating clear focus on enhancing shareholder value by placing its assets in the corporate structure which best allows for value to be realized, namely an MLP due to long and stable contracted cash flow. Since IPO, the shares have traded down, most notably in recent weeks with the decline in Oil prices, only to start increasing steadily as of late.

It is well recorded that there is a Natural Gas arb worldwide with cheap US gas relative to worldwide gas leading to attractive US export opportunities. There are 3 basic parts to the LNG infrastructure chain: 1) the Gas needs to be liquefied either onshore or offshore (FLNG is offshore option), 2) the gas needs to be transported to the end use location (LNG carriers), 3) the liquid ‘gas’ needs to be re-gasified again either on shore or offshore. FSRU’s are Floating Storage and Regasification Units which allow for offshore regasification of the gas.

The intermediate part of the chain – LNG carriers – is the least technical relatively speaking within the supply chain (though certainly more complex/higher barriers to entry than other parts of the world of Maritime Transportation such as dry bulk or crude transport). FSRU’s are more complex in terms of ‘know how’ experience (customers more inclined to sign contracts with those that have the experience thereby reinforcing the positon of the incumbent players). FSRU’s are particularly attractive as a Regasification means as compared to on shore as they can float to different locations with demand and can also be utilized in areas where it is not feasible (political instability for example) to spend hundreds of millions of dollars on land based infrastructure.

While the recent and dramatic decline in oil prices worldwide has reduced the arb as outside the US (gas prices are linked to oil prices) this leads no headline noise pressuring HLNG but with no concerning fundamental impact. In fact, we would be more concerned for the LNG part of the chain as cheaper gas worldwide means US gas is less attractive to the global community relative to its economic attractiveness say 3 months ago. This could potentially put pressure on LNG aggregate ton miles (no intent to discuss LNG supply/demand economics in this write up). With FSRU’s, however, as HLNG notes in its 2014 Capital Markets Investor Presentation, 12/9/14 Page 39, lower LNG prices worldwide can actually boost demand for FSRU’s as it makes even more import projects now economic.

HLNG is also exploring FLNG opportunities which are floating terminals to turn the gas into liquid: Floating Liquefaction Terminals. In the summer of 2014, Golar grabbed headlines with a several hundred million dollar equity raise targeted at securing capital for an FLNG project albeit without any announced customer. HLNG is quietly but surely making progress in this area as well. As this is new and more complex than even FSRUs, HLNG will require higher unlevered returns (14% or higher) than FSRU’s but is seriously exploring implementing an FLNG strategy which can be utilized to enhance dropdowns into HMLP (see below). We do not attribute any value to the FLNG option as it is too undefined as of yet to try and quantify but we see the ordering of an FLNG unit and subsequent contracting with a customer for the offtake of the gas to be a material source of upside to our numbers.

Key compelling Investment Attributes of HLNG

1. In the ‘Right’ part of the ‘Right’ Sector

   1. LNG Story: FSRU and FLNG focused = higher barrier to entry, longer term contracts; legacy LNG carriers (unlike Golar/GasLog where LNG is core/whole part of story) remain within the company simply to ensure that HLNG retains technical knowhow of the operating the LNG carriers as FSRU’s are really simply glorified LNG carriers (when not operating as FSRU’s they can fully function in the LNG trade; HLNG provided us with this explanation for the retention of its LNG carriers in response to our question as to why the company does not simplify its story both from an accounting standpoint and also sector standpoint and sell their LNG carriers).

   2. Ability to debt finance 100% of earlier units (2006 vintage –Arctic Lady/Princess) reflects demand for these assets

   3. High returns on FSRUs – low double digit unlevered and high double digit (~30%) levered cash on cash (EBITDA/Purchase price / EBITDA-Interest/Equity)

2. Attractive financial profile: long term fixed cash flow (i.e. EBITDA not Revenue) contracts with solid counterparties

   1. Bermuda Incorporated Company: No Corporate taxes which increases free cash flow; negligible taxes associated with some local jurisdictions such as UK

3. Aligned interests with Management (44% of shares controlled by Leif Hoegh & Co., Hoegh family holding company which has investments in wide range of sectors)

   1. Management recently acquired shares in the open market (albeit negligible amount)

12/18/14 release: “Leif Höegh & Co. Ltd., which is represented on the board of directors of the Company by Morten W. Høegh (Chairman) and Leif O. Høegh (Deputy Chairman), purchased 7,579 common shares in the Company in a series of transactions 17 December 2014 at an average price of NOK 73.6546 per share”

4. Prudent Management which takes step to create shareholder value (management is the ‘anti-Golar’; they are weary of being overly naked, meaning having too many assets on order without contracts lined up. While Golar may benefit from the risk it bears, we like management’s prudent approach to speculative asset ordering which is not to have more than 1 or possibly 2 assets on order at a given point in time without a commensurate contract). This dramatically minimizes ‘blow up risk’ and leaves us with a collection of long term contracted assets which in line with market demand management adds to.

5. Multiple catalysts over time to propel value

   1. Dropdown of additional assets into the MLP

   2. IDRs increasing

   3. FLNG Potential

So what do you get when you buy into HLNG?

We view shares of HLNG as providing access to 4 sources of value (3 of them tangible, 1 intangible):

1. Owned Assets at the Parent –which have not yet been dropped down to the MLP

2. LP Shares in the MLP; can mark to market at current prices though we believe these shares themselves are undervalued

3. GP Value which we believe (and this should hold true for most GPs) have two sources of independent and not mutually exclusive value:

   1. Ability to capitalize on MLP multiple ‘arbitrage’ – i.e. there is a bidder for your assets at multiples higher than what the market ascribes to those same assets and importantly materially higher than the levels at which you can continue to buy new assets. HLNG as noted is well positioned to add compelling ROI assets at low multiples and has a buyer lined up to pay more than what HLNG has to pay for those very same assets. This is a source of value even if the GP had zero IDR claims – i.e. no claim to cash flow once the assets are dropped down. It is important to separate out these two benefits of being in the GP seat.

   2. GP claim to IDRs which increase with dropdowns – GP entities and associate fees are akin to asset light investment ‘managers’, though with HLNG the cash flows are contracted often between 10-20 years and the GP simply skims from the cash flows generated.

      1. Similar to the first source of value, IDR values exist whether or not there is a multiple arb here. Even if dropdowns occurred at the same multiple the market ascribes to the assets when they are in the HLNG structure/where HLNG can acquire assets, the ability to monetize an asset at the price you paid (i.e. ‘cash out’) yet continue to generate cash flow from the sold asset is highly valuable.

4. Meaningful and High ROI Growth potential— what is it worth to be positioned in a market with technical (and to a degree financial) barriers to entry where the Company can continue to grow accretively through high ROI investments in FSRUs and potentially down the line FLNG assets? While we are not ascribing value per se to this ‘growth potential,’ the growth is very much there and serves as a major series of potential catalysts to drive the shares of the company higher.

Summary Asset Overview & Debt per Asset:

Post MLP, HLNG consists of 7 assets (3 LNG carriers, 4 FSRUs with 2 of the FSRUs on order with expected delivery in early 2015 and 2017 respectively). The Libra (old LNG) will be scrapped near term but has 1-2 years of expected active duty remaining. Scrap assumptions per management are roughly $12mm an asset. Two of the assets—Arctic Lady and Arctic Princess, the earliest and oldest FSRU’s in the HLNG FSRU program—are not fully owned. These assets were levered more onerously (or favorably depending on the perspective) than current assets whose target leverage is 60-70% (LTV). Importantly, these received worse contract terms (EBITDA/Purchase Price) relative to current assets as the assets were 100% debt financed (HLNG did not have to put up any equity). Beyond the lack of required equity, these were attractive as they provided the foray for HLNG to enter the FSRU market, thereby broadening its horizons beyond the more commoditized (relative term) LNG Transport market.

At the MLP (Hoegh LNG Partners LP, “HMLP”), there are 3 assets, though the 2 GDF assets are 50% owned which leads to an effective ownership at HMLP of 2 FSRUs. Over time, HLNG plans to drop down additional FSRUs into the MLP.

As can be seen through the expiration date, the assets in general have an extremely attractive contract profile providing long term cash flow visibility. The MLP fleet has average remaining contract duration of 17 years (HLNG 2014 Capital Markets Investor Presentation, 12/9/14 Page 32) while the assets at HLNG that are ripe for dropdown have contracts often greater than 10 years (i.e. Independence). The Gallant which will be used on a 5 year contract by the Egyptian Natural Gas Holding Company, a state controlled utility. The contract could have been for 10+ years like other contracts except the utility had a technical ceiling on contract duration. We expect the Gallant to be in place for more than 5 years as the FSRU provides a value add service to Egypt and there is little reason to think the need suddenly goes away: Management is very comfortable with this point: to the extent an FSRU is required at a location where the company has a contract, Management believes it is highly unlikely and very impracticable for a new FSRU to replace the incumbent HLNG FSRU and therefore the FSRU in Egypt and other locations can potentially be in place for many years post contract. All this being said, a critical benefit of the “F” in FSRU is that the assets float and can be moved across the world where demand is best should the needs in an existing location shift over time. In November 2014, the #6 was awarded a 20 year contract with Sociedad Portuaria El Cayao S.A. E.S.P. (SPEC). SPEC has the ability to reduce the term to 5,10 or 15 years but must make the election prior to operations which are expected to commence in mid-2016. FSRU #7 is a November 2014 ordered FSRU with 2017 delivery date and we assume will attain contract terms in line with the last few FSRUs ($40mm+ EBITDA, 10-20 year contract).

A note on Opex/Capex

With the exception of the Independence ($3-4mm maintenance capex/drydock cost every few years), both Opex and Capex (drydock) is built into the contracts providing a tremendous degree of financial visibility. Essentially it is EBITDA and not Revenue which is contracted as in most contracts Opex is passed through and when it is not there are usually cost escalators in place aimed at keeping EBITDA constant (e.g. Gallant and #6; Independence operating in Lithuania has pass through except for Crew which is ~60% of Opex BUT which is tied to a Lithuanian wage index so one would expect that more or less for all assets currently in place, current contracted EBITDA should be EBITDA on a going forward basis for many years to come).

Valuing the Pieces:

Recapping the 4 sources of value noted above:

1. Owned Assets at the Parent

2. GP Value:

   1. Ability to capitalize on MLP multiple ‘arbitrage’

   2. GP claim to IDRs which increase with dropdowns

3. LP Shares in the MLP

4. Meaningful and High ROI Growth potential

What are the Owned Assets at Parent Worth?

A Brief note on Accounting

HLNG’s numbers are undoubtable confusing. The company has JVs (non-fully owned assets) at both HLNG as well as at HMLP. Further it only owns 58% of HMLP. It consolidates HMLP for accounting purposes but treats the non-owned assets at HLNG under the equity method of accounting. This leads many on the street to simply value the JV assets at the JV book value. This also makes making sense of the financials difficult: we observed in one sellside presentation a complete omission of a Tranche of debt while not tremendously meaningful to valuation, still highlights the careful eye required to make sense of the numbers (same sellside analyst agreed his analysis had the error). The company previously utilized a method known as the Proportionate Method for accounting which allocates to the company’s financials its pro rata share in all financial line items, be it revenue, profit, debt or cash. We believe this former method is the most simple and further optimal way to approach the company as it eliminates accounting obfuscation and simply allows one to focus on the ‘what do I as an owner get when I buy this company; plain and simple.’ Our analysis below shies away from the HLNG financials which especially as many assets have yet to ramp up and the MLP was just launched are fairly meaningless on a historical basis and due to JV equity method accounting and MLP consolidation accounting are not that useful even on a go forward basis. Instead, our work attempts to create a look through analysis showing proportionate owned EBITDA, Debt, Cash etc. for TEV and other calculations.

Current Valuation

On that note: Depending on how one values HLNG (methodologically), the assets at HLNG are trading either at ~9.8x or ~9.2x on its fully ordered and delivered assets.

Before showing Current valuation, we present the 1) valuation of the HLNG’s HMLP equity stake and 2) current debt outstanding per Asset (on a Pro Forma basis for Gallant, #6 and #7) as both tables feed into current valuation:

Method 1: Values HLNG using Pro Rata share in HLNG asset level debt as well as HLNG corporate debt and only includes HLNG EBITDA. The HMLP stake is marked at market and no value is provided to GP interest.

Method 2: We prefer this alternative method which instead of taking the HMLP stake at market, starts off with all debt and EBITDA of HLNG across the Parent and the MLP, all on a proportionate basis to HLNG basis. The current TEV of HMLP is then stripped from the company. Given HMLP is trading at a higher multiple (11.1x by our count; see further below) than HLNG the implied multiple ticks down for the remaining assets at HLNG.

We believe that the market is currently undervaluing the assets at parent. This is both in Absolute terms as well as Relative MLP terms:

1. Absolute: we think assets with 10+ years remaining on their contracts, 35 year useful lives (and the majority of value coming from ~1 year old assets) and EBITDA not Revenue based terms which provides cash flow (not just top line) stability are extremely attractive assets to own. This does not take into account Value component #4 above which is simply the value of the ‘opportunities’ which HLNG has to increase its asset base over time at highly attractive investment ROI terms.

2. Relative MLP:

Ability to capitalize on MLP multiple ‘arbitrage’

1. 1) HLNG assets within the HLNG structure trade below the range it can drop those same assets into the MLP. This is especially the case as the MLP is new to market and therefore the IDR splits in favor of the GP have yet to kick in. HLNG believes it can drop down the next few assets in at least the 9-10 range (we think possibly higher). This compares with an August 2014 IPO multiple of 11.6x by our calculations (and 11.1x currently). HLNG assets current trade at ~9.2x by one way of looking at the math (presented above).

Here is current valuation at HMLP:

2. 2) Further, HLNG can continue to acquire assets at multiples on expected contracted cash flows similarly below the multiples at which it can drop those very same assets into the MLP: ~$300mm/$~40mm EBITDA = 7.5x. For context on the most recent dropdown in the FSRU universe, on 12/15/14, Golar LNG Partners (parallel to HMLP) agreed to acquire the Golar Eskimo, an FSRU similar to HLNG’s ‘to be dropped FSRUs,’ from Golar LNG Ltd. (parallel to HLNG) for a purchase price of $390mm, reflecting roughly 8.75x multiple on EBITDA.

It is CRUCIAL to note that with this dropdown the Golar GP has now reached the high splits (50% IDR to GP) which should arguably command lower dropdown multiples. HLNG on the other hand is just getting started and has yet to dropdown an asset post IPO.

Below outlines the illustrative value uplift stemming from Dropdown potential:

HLNG has a simple slide in their 2014 Capital Markets Investor Presentation, 12/9/14 Page 17 which elucidates this point quite simply:

On a more granular basis, here is what the math looks like on the current asset base:

Putting it all together…….Base Case Valuation – Sum of the Parts

Step 1: HLNG Assets Only

In short, a multiple higher than the implied current multiple of HLNG is justified both due to the nature of its owned assets/contracts, but more importantly due to the fact that it has a buyer lined up to acquire its assets via dropdowns at multiples higher than where it currently trades. For our illustrative math, we assume 10.0x for dropdowns though note the first few dropdowns can possibly be done at higher multiples (capital markets dependent) given HMLP trading levels (north of 11x EV/EBITDA) and due to the fact that IDRs have not kicked in for the GP (i.e. we have not even started splits yet in contrast to Golar noted above).

Step 2: Adding in the Value of the LP Stake in HMLP (including illustrative value for the GP IDR)

Based on the above we would conclude HLNG is slightly cheap (10-20%) with an attractive margin of safety as we believe contracted EBITDA on the owned assets should provide valuation downside (we would argue it is hard to justify 10 year contracted EBITDA trading at only 7.5x etc.). We show the build up to the IDR value in the appendix and believe that this is certainly a source of potential upside as splits begin and then increase in the GP’s favor and the market subsequently ascribes higher value to the GP IDRs (easier to value actual cash flows than theoretical cash flows).

What is the right way to value the MLP?

Step 2 above seems somewhat silly though this is the approach most commonly utilized for HMLP on the street. We are working to figure out what the assets are worth and taking HMLP at market is to us the lazy man’s approach to valuation: I will value the HLNG assets granularly as a means to determine HLNG consolidated valuation and to evaluate whether the market appropriately values HLNG but I will take HMLP (almost identical assets to those very same assets within HLNG) at market (I think the market is spot on in its valuation of HMLP). Hmm…

We prefer instead to value HMLP itself – on a dividend yield basis in line with MLP valuation. Note as discussed we believe these assets are above average assets in quality (barriers to entry, LNG industry fundamentals) and financial stability (long term contracted EBITDA):

Here is what the ‘all in’ valuation of HLNG looks like if we actively value HMLP in lieu of relying on the market value based on HMLP trading levels (owned assets at parent, IDR value plus HMLP stake at ‘fair value’):

Summary:

We believe investing in the shares of HLNG provides a compelling opportunity to own existing assets with long term contracts, growth potential through added FSRUs and FLNGs, uptick value through the GP stake in the MLP, increased value through the MLP itself rerating. We believe shares should rerate 20-40% (100-110NOK) higher over the next 12 months and would not be surprised to see further announced drop downs into the MLP push levels above our target range.

Key Risks (Mitigants):

1. Management strays from its prudent approach to ordering and starts to have ore than 1 or 2 assets orders on spec (no contract) (Mitigant: Management owns large stake in company so incentives are aligned; management has also noted on numerous meetings with us their commitment to a prudent approach to speculative capex)

2. FX (listed in NOK but all financials/cash flow are in USD)

3. MLP valuations may compress if interest rates rise (Mitigant: Not an MLP play per se, in place assets are fair to undervalued)

4. Energy names have been weak (Mitigant: Oil decline can ironically be a boon for the company)

Catalysts

1. Dropdown of additional assets into the MLP

2. IDRs increasing

3. FLNG Potential

4. Management figures out a way to simplify the story from a number standpoint (confused due to JV Equity Method and MLP Consolidation account)

Appendix A: Illustrative IDR Math for GP Valuation:

Catalyst

    Dropdown of additional assets into the MLP

    IDRs increasing

    FLNG Potential

    Management figures out a way to simplify the story from a number standpoint (confused due to JV Equity Method and MLP Consolidation account)