| 2010 | 2011 | ||||||
| Price: | 8.89 | EPS | $1.06 | -$0.75 | |||
| Shares Out. (in M): | 19 | P/E | 8.3x | n/a | |||
| Market Cap (in $M): | 169 | P/FCF | 7.8x | 28.9x | |||
| Net Debt (in $M): | 359 | EBIT | 36 | 10 | |||
| TEV (in $M): | 529 | TEV/EBIT | 14.5x | 54.2x | |||
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Trading at less than tangible book value and right around our estimate of liquidation value, we believe KSP offers a compelling risk reward profile with significant upside potential and downside risk that is limited by the liquidation value of the company's fleet.
Due to better formatting and the inclusion of charts, I strongly recommend looking at thisreport through the following Google docs link:
Investment Thesis
Structured as a Master Limited Partnership (MLP), K-Sea Transportation Partners L.P. (NYSE: KSP) is the largest provider of marine transportation for refined petroleum products in the U.S. In the past twenty four months, as the wheels came of the US economy, demand for transportation fuels such as gasoline, diesel, jet fuel and #6 oil (bunker fuel), all dropped off sharply. Against this backdrop, KSP with its fortunes very much tied to US refinery capacity utilization, has also seen the bottom fall out on revenues, as its large customers have either been slow to renew existing long-term service contracts or are demanding deeper price concessions on barge day rates. Due to a marked decline in earnings and poor near term visibility on day rates and barge utilization levels, in fiscal Q2 2010 (ended December 31st 2009), the Company temporarily eliminated its dividend. As expected, yield seeking investors immediately punished the stock to where it is now trading close to liquidation value. At 0.5x Price/Book, 0.6x Price/ttm Sales, a 5.9x EV/ttm EBITDA multiple (all close to 5-year lows) and at 3.6x ttm DCF (Distributable Cash Flow), units of this limited partnership look very attractive.
I estimate the liquidation value of KSP's assets at $8.34 per unit. At their current going rate of $8.81, the units are trading close to this liquidation value estimate - from here the downside seems limited, and while the exact timing remains uncertain, there appears to be considerable upside, assuming the US economy eventually finds a path to recovery. Since energy usage in inextricably linked to GDP growth, an investment in KSP is a leveraged bet that, in due course, the US economy will expand, domestic refinery utilization will in turn mean revert, and with it, the need for the Company's water transportation services will rise.
Company Background
The Company operates a fleet of 69 tank barges and 66 tugboats that serve a wide range of customers, including most major US refiners and several independent oil trading companies. With approximately 4.1 million barrels of capacity, KSP operates the largest coastwise tank barge fleet in the United States.
Top 6 customers consist of integrated oil majors or large independent refiners:
During FY2009, the Company derived approximately 80% of its revenue from longer-term contracts that are generally for periods of one year or more; as of September 30th, 2009, approximately 83% of the Company's barrel-carrying capacity was double-hulled. The remaining 17% of capacity consists of older, single-hulled tank vessels that are required to come out of service prior to January 1st, 2015 in compliance with the Oil Pollution Act of 1990, or OPA 90, which mandates the phase-out of all single-hull tank vessels transporting petroleum and petroleum products in U.S. waters. All but two of the Company's tank vessels, operate under the U.S. flag, and all but three are qualified to transport cargo between U.S. ports under the Jones Act[1] federal statutes.
K-SEA Operations
The company segregates its business into two reporting divisions - coastwise trade and local trade.
Coastwise Fleet The term coastwise fleet generally refers to tank vessels that transport petroleum products along the Atlantic, Gulf and Pacific coasts; between the U.S. mainland and Puerto Rico, Alaska, Hawaii and other U.S. Pacific Islands; and, between the Atlantic or Gulf and Pacific coasts by way of the Panama Canal.
Local Fleet The term local fleet generally refers to tank vessels that transport petroleum on the navigable internal waterways of the Atlantic, Gulf and Pacific Coasts, and the Mississippi River System; and, on the navigable waters among the U.S. Great Lakes and connecting waterways. The inland waterways fleet consists of tugboats and tank barges which typically have a shallower depth (draft requirement). These tank barges are generally less costly than most tank barges operating in the coastwise fleet.
Revenue Mix
The Company generates revenue by charging customers for the transportation and distribution of their products utilizing its tank vessels and tugboats. These services are generally provided under the following four basic types of contractual relationships:
In addition, a variation of a voyage charter is known as a "consecutive voyage charter." Under this arrangement, consecutive voyages are performed for a specified period of time.
One of the principal distinctions among these types of contracts is whether the vessel operator or the customer pays for voyage expenses, which include fuel, port charges, pilot fees, tank cleaning costs and canal tolls. Some voyage expenses are fixed, and the remainder can be estimated. If the Company, as the vessel operator, pays the voyage expenses, it typically passes these expenses on to its customers by charging higher rates under the contract or by re-billing such expenses to them. As a result, although voyage revenue from different types of contracts may vary, the net revenue that remains after subtracting voyage expenses, which the Company calls "net voyage revenue", is comparable across the different types of contracts and is what the Company uses to track performance between periods.
cash payout policy & Incentive Distribution Rights
KSP is organized as a limited partnership. The General Partners (GP's) own 1.05% of the outstanding units and have ultimate responsibility for managing the business while investors, as limited partners (LP's), own 98.95% of the outstanding units. Per the most recent annual filing, the GP's also own ~20% of the outstanding LP units, and in this regard, their interests appear to be well aligned with investors.
Within 45 days after the end of each quarter, the partnership is required to distribute all available cash from operating surplus to unit-holders. Incentive distribution rights (IDR's) represent GP rights to receive an increasing percentage of quarterly distributions of available cash from operating surplus after the minimum quarterly distribution (MQD) has been achieved. The MQD is set at $0.55 per LP unit.
Industry Competition & Outlook
In addition to pricing, the basis for competition in the TTB (tug and tank barge) industry centers around four major determinants. A TTB operator's market reputation is a function of its performance against each of these criteria.
KSP has a very long track record in the industry, and has had long standing relationships with several of its large customers. Per a recent sell side report, 6 Companies make up 80% of the industry capacity and KSP is reported to have the leading market share at 22%. Separately, in a recent IR presentation, Hornbeck Offshore (NYSE: HOS) estimates that KSP accounts for 26% of the East Coast Short-Haul market which it defines as the entire Atlantic seaboard, the NE US to Florida and the Gulf of Mexico. See pie-chart below.
In the same IR presentation, HOS references a US Coast Guard Report to Congress which shows the cumulative barrels of capacity that will have to be retired to comply with the OPA 90 mandated phase-out of single-hulled tank barges. The chart is as follows:
In its most recent 10Q filing, HOS announced that it was permanently retiring 10 single-hulled barges due to weak demand. As of Q2 FY2010, KSP indicated that it too was permanently retiring 4 single-hulled barges well ahead of the OPA mandated 2015 deadline. From these announced actions, it appears that suppliers are proactively taking out excess capacity to arrest the price decline in barge rates.
While pipelines are the most cost effective means of transportation of crude oil and petroleum products to America's heartland, in certain geographies, there are no viable substitutes to marine transportation. This is particularly true for a) trading related bulk movements between the New York Harbor and the US Gulf Coast, b) Heating oil deliveries into the Northeast where pipeline infrastructure is limited, and c) delivery of refinery intermediates (blend stocks) between the US Gulf Coast and US West Coast. In certain markets, customers simply have no other options for moving product out of their facilities for distribution to their customers. Refiners typically carry 3 to 5 days of cycle stock, and at most, have capacity to hold 7 days of production. This means that product has to keep moving in order to sustain high utilization rates which are critical to a refiner's profitability, given the high fixed cost nature of the business. Thus, barge companies provide a critical service for their refining customers. This explains why KSP, like many pipeline companies, is able to organize itself as a MLP. With a captive customer base and predictable cash flows, one normally would expect its income stream to be almost annuity like. In the longer term, as more single-hulled capacity is retired, I expect the industry should return to this dynamic.
The chart below shows that the domestic tank vessel fleet capacity troughed in 2005 and since then, both the product carrier (typically 300,000+ barrels of carrying capacity) and the tank barge (typically 150,000 barrels or less of carrying capacity) fleet size has been growing steadily. From the chart it also appears that tank barges have slowly been taking share away from the bigger carriers and that this trend is expected to continue.
The US-Flag Domestic-Trade (Jones Act) Tank Vessel Fleet (May 2009)
In looking at the tank barge new builds scheduled for delivery in 2009 and 2010 (see table on the next page), it also appears that the tank barge sizes are increasing. In the long term, both developments should to be a tailwind for tank barge operators who are able to survive the current turmoil. Per projections made in May 2009 in the chart above, after peaking in 2011, with OPA 90 mandated single-hulled vessel retirements, the fleet size is projected to contract back to the 2005 level by 2015. In my view, in light of the more recently announced early retirements, these projections may be overstating the peak in 2011. Given current credit market conditions and the tough operating environment, I expect some new builds will be deferred or cancelled, and this could lead to a tighter vessel supply/demand balance when we start to see a rebound in demand for refined products - particularly for diesel and jet fuel, as domestic trade activity picks up.
In a recent IR presentation, KSP also projects that by 2015, the market for its equipment could get much tighter. In its estimates, KSP is more narrowly defining its target market, and in doing so, is excluding barge sizes greater than 150,000 barrels - this makes the balance look even tighter than the industry projections sited above. Per the Company's projections, the JAV (Jones Act Vessel) fleet capacity is expected to shrink by ~20% over the next few years.
Pricing & Utilization Rates are Key
Starting in the second half of CY2008, demand for the Company's barges started to come under pressure as demand for refined products cratered. In the short run, suppliers, unable to adjust their capacity, were willing to price contracts for positive cash margin. In the longer run, the industry has to recover depreciation costs, and as more single-hulled equipment is taken out of the market, day rates should start to stabilize. As demand rises, pricing power should then slowly shift back to the suppliers. KSP, with its leading market share should be well positioned for recovery when the market dynamics shift.
Historical Financial Performance
From the table above, it is clear that the Company has been aggressively growing assets since it went public in January of 2004. Total assets have more than doubled over the past 5 years - this is understandable, since management (GP) interests are strongly aligned with growing earnings and dividends. With rising earnings, the GP's share of earnings increases as the IDR increases. Up until last year this strategy appeared to have been working quite well for investors as well, as is evidenced by the chart below:
Over the past 5 years, the distribution coverage ratio averaged 1.04x and through Q1 FY2010, KSP had been paying out a steadily growing dividend stream to income sensitive investors.
Recent Quarterly Performance Trends
More recently, with lower demand for refined products, over the past five quarters, KSP's revenues have declined sequentially as many of its single-hulled barges have either been unable to find new work or have found new bookings at much lower day rates. As a result, in Q1 FY2010 the Company cut the quarterly dividend from $0.77 to $0.45 per unit, and then in the recently ended Q2 FY2010 (December 2009), the Company announced it was temporarily eliminating the dividend payment altogether.
Debt Obligations & Covenants
Due to the continuing decline in revenues and the resultant drop in EBITDA, the Company was at risk of violating a maximum debt/ttm EBITDA ratio covenant in its upcoming Q3 FY2011. On January 22nd, 2010, a week ahead of its Q2 FY2010, the Company announced an amendment agreement with its lenders that gave the Company much needed relief for the next two quarters. The loan covenants were modified as follows:
The fiscal third quarter (ending March) is seasonally the weakest quarter as most barge activity on the Great Lakes and in Alaska shuts down for winter from October through April. The fiscal fourth quarter (ending June) is usually the strongest as gasoline demand tends to be the highest in the summer months. Per the table above, the covenant modifications give the Company relief for the next two fiscal quarters, after which the Debt/EBITDA ratio will be ratcheted down from 5.0x to 4.5x (still higher than the 3.75x in place before the modifications).
In my view, with limited near term visibility, management's decision to eliminate the dividend seems prudent. This allows the Company to improve its balance sheet, which in the long run should allow it to once again increase dividend distributions to unit holders as market conditions improve. The street, however, did not take to management's decision kindly and the stock was punished soon after the Q2 FY2010 earnings call on January 28th, 2010. As a result, the units are now trading close to liquidation value which creates an interesting opportunity for the patient value investor willing to look past the near term headwinds
For the value investor, the balance sheet poses the biggest risk. Book value of vessels and equipment plus construction in progress amounts to $612 million. These assets have been financed with $363 million in debt (including the current portion of $18.5 million). For FY2010, I am projecting that KSP will generate ~$68.5 million in EBITDA. Taking away the $12.2 million already paid out in dividends (before the dividend was cut), the Company will have $56.3 million available to service $21 million in interest payments; ~$21 million in sustaining capex, and, ~13 million in remaining payments on its new vessel build program. If needed, the Company has $65 million cash availability under its existing $175 million credit facilities. This analysis suggests that the Company has sufficient liquidity to manage through the downturn.
In November 2009, the Company placed a newly built 185,000 barrel barge (biggest in the Company fleet) in service on a 7 year term contract. In April 2010, a new 100,000 barrel barge will commence service on a similar 7 year term. Both these long-term contracts were negotiated in late 2007, when market rates were 30-40% higher than current spot rates. In Q3 FY2010, the Company will take receipt of a newly constructed (leased) 50,000 barrel barge, and, in Q4 FY2010, two new 30,000 barrel barges (also leased) will be added to the local fleet. Incremental EBITDA from these new barges should more than offset the EBITDA loss from the early retirement of single-hulled barges.
Valuation
Given the uncertainty around the sustainability of an economic recovery in the US, I have spent some time trying to analyze the downside risk with this investment. Due to the high leverage on the balance sheet, in the event of a prolonged downturn in US demand for fuels, refining capacity could remain under-utilized and as result, the Company could remain financially stressed. Under these circumstances, liquidation value is about all that investors can hope to realize on their investment.
Liquidation Value:
I estimate the KSP's liquidation value at $8.34 per unit, calculated as follows:
To arrive at the above liquidation value, I attempted to estimate the value of KSP's hard assets, which include - 1) its single-hulled barge fleet, 2) its double-hulled barge fleet and 3) its tugboat fleet.
Single-Hulled Barge Fleet:
I assume that the entire single-hull barge fleet is retired and sold as scrap metal and that the Company realizes $200/LT (Long Ton) or a total of $8.40 million in salvage value. The $200/LT unit price for scrap metal is estimated based on information published by Marcon International (link: http://www.marcon.com/) - a used barge and tug boat supplier. Per this source, in December 2008, some retired single-hull barges were reportedly being sold to Indian scrap metal dealers for as low as $255 per LT. Although scrap metal prices have since risen from these trough levels, to be conservative, the single-hulled barges are valued at $200/LT.
Double-Hulled Barge Fleet:
A Marcon International newsletter from March 2009 suggested that new builds were being priced at ~$200-$235 per barrel of capacity. To value KSP's double-hulled fleet, I assume that in a controlled liquidation, double-hulled barges aged 5 years or less would fetch $190 per barrel of capacity. For barges ranging between 5 to 10 years in age, I assume the recovery drops to $143 per barrel, and, for barges older than 10 years, I assume recovery of $57 per barrel of capacity.
Tug Boat Fleet:
In April 2009, Marcon International estimated that used tug boats, on average, were selling at ~$600 per brake horsepower (BHP). From my conversations with KSP's CFO, I gathered that on more recent transactions, the number was as high as $1000 per BHP. To be conservative, I assume that on tug boats aged 15 years or less, the value realized is $500 per BHP and that this value drops to $300 per BHP for older tug boats.
Overall Liquidation Value Estimate:
Going-Concern Value:
The following table presents the historical trading multiples for KSP.
One way I estimate intrinsic value is based on the EBITDA multiple. On an assumption that the Company is able to achieve day rates and utilization levels I have modeled for FY2011, I estimate that KSP could generate ~$88 million in EBITDA in FY2011.
Applying a 9.0x multiple and discounting this to the present at a 15% rate, I estimate the PV of the Enterprise at $689.2 million and the fair value of equity at $16.98 per share.
As a second method to determine intrinsic value, I assume that KSP resumes its dividend distributions and pays out $1.80 in in FY2011. If these units were to trade at a 10% yield, the value per unit would be $18.00.
an average of these two valuation methods yields an intrinsic value estimate of $ 17.49 per unit.
Warning:
This report is not a recommendation to purchase or sell KSP. Do your own due diligence.
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