Description

We recommend a stub trade by investing long in Teekay Corporation (TK US) and shorting the daughter companies, Teekay Offshore (TOO US), Teekay LNG (TGP US) and Teekay Tankers (TNK US). Although TK’s share price has rebounded since the distribution cuts in December, it is still trading at a significant discount to intrinsic value at a recovered GP distribution level. We believe the market is attributing a $20mm-$30mm value to the GP at current TK share price of $7.70, while true value should be closer to $350mm to $900mm depending on multiple applied and recovery level of distributions at daughters. Based on our assumptions this trade provides the opportunity of 6-7x upside to downside return in one to two years.

Summary of SOTP

Below is a summary of our SOTP scenarios pro forma the upcoming equity financing at TK ($100mm common equity offering at $8.32/share with 12 million shares being issued). This offer is contingent on a preferred equity offering being completed at TOO, and is expected to close by end of June.

Bull Scenario: $500mm GP value at TK Parent; stub upside of $5.66/share

• Scenario: Equity markets recover, company reinstates dividends at the highest IDR level for TGP ($0.70/share) and at lower end of Level 3 for TOO ($0.44/share); GP value returns to ~$500 million

Base Case Scenario: $350mm GP value at TK Parent; stub upside of $3.89/share

• Scenario: Daughters complete capex commitments and debt repayments from internally generated cash and refinancing of term loans; however, equity markets do not recover in the next two years and TOO/TGP are forced to continue retaining some of internally generated cash flows to meet future debt repayments

• Distributions recover partially, quarterly $0.67/share for TGP and $0.425/share for TOO

Current Implied Scenario: $20mm GP value at TK Parent; stub priced at $0.29/share

• Scenario: Daughters continue to finance debt repayments and capex from cash flow generation and distributions remain at current depressed level for more than two years

Bear Scenario: $20mm GP value at TK Parent; stub downside of $0.59/share

• Scenario: Daughters continue to finance debt repayments and capex from cash flow generation and distributions remain at current depressed level for more than two years

• Value of vessels at TK Corp are worth $250mm instead of $300mm

Company Summary

TK and its various counterparts have been written up several times in the past on VIC. The focus of this writeup is on the SOTP and risk profile at TK parent and we encourage you to read the recent write-ups on TOO and TNK for further background on the daughter companies.

Teekay provides international crude oil and gas marine transportations services, and also offers offshore oil production, storage and offloading services, primarily under long-term, fixed-rate contracts. The group of companies consists of four publically listed companies:

• Teekay Corporation (TK US) - the parent company, which has common/LP ownership in all three daughters, along with GP value in two of them

• Teekay LNG Partners (TGP US) - MLP focused on gas projects, one of the largest LNG carrier owners and operators

• Teekay Offshore Partners (TOO US) - MLP focused on offshore projects; leader in harsh weather FPSOs and shuttle tankers

• Teekay Tankers (TNK US) – C-Corp focused on conventional tankers

Situation Overview

Teekay Corporation (TK US) had a business update call on December 17 to announce distribution cuts at its daughters and parent level in order to internally finance equity capex in upcoming projects and also pay for upcoming debt maturities. The share price fell 58% from $17.49 on December 16 to $7.27 on December 17. Although the share price had somewhat recovered to above $11 due to the recovery in oil prices, it has fallen back to $7.70 and is currently still trading 56% below the price before the update call and ~85% off the 52 week high of $50.88.

We believe the market reaction was overdone and the share decline was driven by MLP retail investors focused on dividend yields. Recall, the distribution cut came at year end and totally caught investors blind-sided, plus MLPs at that time were quickly becoming the most hated of asset classes. The underlying business has not changed dramatically and an opportunity has presented itself to own the GP optionality on TK at a significant discount by shorting the proportionate ownerships in the daughters. Even with the recently announced dilutive financings at both TOO and TK, we believe TK Corp is greatly undervalued and that the investment profile has been significantly de-risked since December.

Business Update Summary

On the business update call on December 17, management cut distributions across the board at both the MLP daughters and parent level, which also impacted the GP distributions as IDR levels dropped from last levels to bottom level:

• TGP – LP distribution cut 80% from 70 cents/quarter to 14 cents

• GP distribution was cut from $8.8mm/quarter to $227k

• TOO – LP distribution 80% cut from 56 cents/quarter to 11 cents

• GP was cut from $8.4mm/quarter to $240k

• Total GP distribution from $17mm to $470k/quarter

• TK – Dividend cut 90% from 55 cents/quarter to 5.5 cents at parent level

Management’s view of the business was unchanged and they continued to have a positive outlook on the fourth quarter and fiscal 2016, with all businesses performing well and projected growing cash flows. They expect TGP distributable cash flows to increase by 10% per year and TOO cash flows by 25% per year over the next three years. However, the reason of the cuts given by management was a significant increase in the cost of issuing equity. Both daughters have projects coming on line in the next couple years, and although most of the debt financing is secured, equity financing is still required. To issue equity in this market environment would be extremely dilutive to both LP unitholders and TK Parent, and as such, management decided to finance the projects using internally generated cash. Over the next two years, TOO will save $450 million and TGP will save $430 million, with following uses of capital:

• TOO: $220 million will be used towards equity capex and $190 million towards Norwegian bond repayment in 2016

• TGP: $250 million will be used towards equity capex and $125 million towards Norwegian bond repayment in 2017

Nonetheless, at the end of 2015, TOO was still showing a funding gap of $250mm for 2016 and $90mm for 2017. However in the latest Q1 2016 earnings release, the company announced several financing initiatives that closed this gap, including extension of debt maturities, issuance of $100 million of common equity and $100mm of preferred units (more detail provided in the Risks and Cash Profile section). Although these measures are still dilutive and will slightly hinder the recoverability of the GP distribution, we believe there is still significant upside value in the GP at TK and the downside risk has been significantly reduced.

Opportunity

The sum of the parts at Teekay Parent level consists of LP/common ownership in the three daughters, 4 vessels owned by parent, the GP value and net debt of $594 million ($694mm as of Q1 2016 and additional $100mm cash to be raised from common equity offering by end of June). TK also owns a small investment in Sevan Marine (SEVAN NO) and Tanker Investments (TIL NO).

The opportunity presenting itself is a “stub” equity value of the parent level assets and GP value by hedging out the proportionate amount of shares in the daughters. Historically this equity stub value has traded between $500 million - $1 billion, and in 2015 it traded above these levels as the GP distributions were in the highest level of IDRs. However, since the distribution cuts, the equity stub has been trading at negative values, anywhere between -$89 million to -$175 million or -$1.23 to -$2.41/TK share. It is currently trading at -$0.94/share pre-common equity offering and $0.29/share post offering.

Below is a detailed summary of the SOTP at TK and per share values using the pro forma share count of 84.7mm (72.7mm as of Q1 and 12mm from equity offering).

TK Parent consists of:

• $628 million of LP units/common shares in daughters, or $7.41/TK share:

• Other assets (excluding GP value) of $598 million or $7.06/TK share:

• $300mm value of 3 FPSO vessels and a VLCC tanker (management estimate of FMV, confirmed with research analysts)

• $59mm investment in Sevan Marine (SEVAN NO) – 21.1mm shares at $2.78 (NOK$23.20)

• $15mm investment in Tanker Investments (TIL NO) – 2.5mm shares at $5.96 (NOK$49.80)

• $200mm intercompany loan to TOO

• $25mm investments in JVs and other (management estimate)

• Net debt of $594 million or $7.02/TK share: $839 million of debt as of Q1 and $244 million of cash ($144mm at Q1 and $100mm equity raise)

• Implied GP value of ~$20 million at current TK share price

GP Value

As shown above, the current share price of TK is implying a $20mm GP value at a ~11x multiple to the current annualized reduced GP distribution of $1.87mm (or 9% dividend yield). This implies no recovery in the IDRs, while TOO and TGP were both at the highest level before the distribution cuts in December. As mentioned earlier, the underlying business has not changed dramatically and is still growing. However, one major change has been the dilution at TOO level from the $100mm equity financing and $100mm preferred, which will have an impact on recoverability of distributions (discussed further below).

Below is a comparison of what the GP values could be at different levels of the IDR and also shows where the GP distributions were in Q3 2015 before the cuts and where they are now. Our base case assumes that distributions will return to 5% below where they were before the cuts for TGP and at 24% below for TOO. At this level, quarterly distribution will recovery to $8mm and annual to $32mm, still 54% below what they were in Q3 2015. At a 10-12x multiple, GP value would be $317-380mm or $350mm at the mid-point. For our bull case we assumed a $500mm GP value, which implies a recovery to Q3 levels for TGP and lower range of Level 3 for TOO.

Below we illustrate what the GP value would be at recovery of distributions at different levels of the IDRs. Note that for TOO we use the pro forma diluted share count of ~160mm (see following section for explanation on dilution impact from equity raises).

TOO Dilution Impact on GP

We want to address the recent equity financings announced by TOO and the impact to the value of GP stream to TK. On January 17, TOO announced the refined equity financing plan to fund the cash gap for 2016 and 2016: consisting of:

• $100mm of common units issued $4.55/unit, 22mm shares

• $100mm of Series D Pref Units – convertible into common shares after 5 years at prevailing market prices; included 4.5mm of warrants with strike price of $4.55/unit and 2.25mm warrants with strike price of $6.05/unit

TOO’s latest presentation in Jun 2016 shows management’s assumption for share count by end of 2017 on slide 37 and a range of increased distributions on slide 9 of $1.41-1.76:

http://teekay.com/wp-content/uploads/2016/04/TOO-Equity-Investor-Presentation.pdf

• TOO currently has 107mm shares and total quarterly distribution is $12mm including $240k GP distribution to TK and $11.8mm LP distribution to all LPs (including TK)

• Pre-distribution cuts, TOO was distributing $68.3mm/quarter from a $0.56/share distribution: $8.4mm GP and $59.9mm LP

• We used management’s estimate of pro forma shares of ~160mm shares to get to a base case recovery in distribution to $1.70/year

• At this level, quarterly distribution would be $0.425/share or halfway through Level 2 of the IDRs (versus Level 4 pre-cut)

• Total quarterly distributions would be at $70mm, including $1.95mm GP distribution and $68mm LP distribution, a level reasonably close to pre-cut outflows and also implied coverage ratio of 1.15x based on management’s assumptions on slide 9 of the presentation

Summary Trade Strategy

Trade strategy consists of shorting 0.451 TOO shares, 0.298 TGP shares and 0.477 TNK shares for every 1 TK share purchased (ratios assume completion of $100mm equity offering at $8.32/share). The GP was generating $17 million/quarter or $69 million/year before the distribution cuts. At a 10x P/E ratio or 10% dividend yield, the GP would be worth close to $700 million if distributions are fully recovered.

Current borrow costs are 4% for TOO, 3% for TGP and 0.3% for TNK and the dividend yields on the daughters are 11% for TNK,  5% for TGP and 8% for TOO, while the parent yields 3%.

Below are illustrative 1-year returns, based on different recoveries in GP value by buying 500 thousand shares of TK and shorting the respective amounts in the daughters, for implied equity stub of $0.29:

In $ thousands

Illustrative recovery of GP value to $350 million:

In $ thousands

Risks and Cash Profile

TOO Cash Needs: TOO has several FPSO contracts that expire in 2016-2018 that could hinder the daughter’s ability to repay debt and reinstate a higher distribution. Management is confident that the renewal rates are sticky and they will be able to re-contract the vessels at favourable rates. In addition, they have several contracts coming online in the next couple of years that will offset some of the cash flow drop-off from these contracts.

At the end of 2015, TOO was showing a funding gap of $250mm for 2016 and $90mm for 2017. However, in the latest Q1 2016 earnings presentation management announced several financing initiatives at TOO that will close the cash gaps. A good summary is on slides 6-8 of the latest quarterly presentation:

http://teekay.com/wp-content/uploads/2014/12/TOO-Q1-16-Earnings-vFINAL-2.pdf

TOO initially announced raising $200mm of preferred equity with a warrant structure and also extending a majority of their capex to 2019 and delay the maturity of the NOK bonds and interest rate swaps. A graph of the old and new maturity profile is on slide 8 of the presentation. The company then provided an update on June 17, which included more details on the equity offering. TOO will now issue $100mm as common equity at $4.55 and $100mm in preferred equity with warrants. Details are in following updated presentation from June:

http://teekay.com/wp-content/uploads/2016/04/TOO-Equity-Investor-Presentation.pdf

Below is a quick summary of the differences between the financing profiles:

However, if the weakness in energy markets and oil prices continue for a prolonged time, TOO’s counterparties may end up shutting down the fields and not exercise their options on renewing the contracts. TOO has enough liquidity to meet debt repayments and capex commitments until end of 2018; however, the main concern is a $300 million bond issue due in July 2019. If equity and debt markets don’t recover by then, TOO will have difficulty in repaying the bond issue and there is a low probability it could be put into bankruptcy.

We have looked at a more draconian scenario where TOO declares bankruptcy and only TGP has a recovery in distribution. We believe this scenario has a very low chance, especially after the recent financing initiatives at TOO. However, for illustrative purposes, in this scenario, TK NAV would be $3.40 and stub value -$1.60/share:

• Daughter equity value would drop to $5.00/TK share from $7.41/share assuming a value of $0 for TOO

• Net Debt would increase to $11.03/share from $7.02/share from an additional $340mm of recourse debt at TOO

• We assume a partial GP value recovery to $200mm, assuming TGP recovers its distribution to level 3 IDR

TK Segments

Below is a summary of the free cash flow generation at the parent for the past 5 quarters. GPCO Cash Flow is expected to remain constant at ~$7-8mm per quarter with $0.5mm/quarter from the reduced GP distributions, $11-12mm/quarter from LP and common distributions and $5mm G&A corporate expense.

In the OPCO Cash Flow section, TK reports its vessel operating cash flow in 4 major segments:

1. Owned conventional tankers

This segment includes cash flows from the Shoshone Spirit VLCC, which is currently on a $49k per day one-year charter contract, expiring in December 2016.

2. In-chartered conventional tankers

Includes chartered in vessels from TOO. Q1 2016 had an additional $4mm fee that was paid to TOO for early termination of Kilimanjaro Spirit charter.

3. FPSOs

Intention over long term is to sell these assets to TOO, once it has more balance sheet capacity. In the meantime, TK has the following contracts:

• Petrojal Banff FPSO contracted to CNR in the Banff field in North Sea; life of field expected firm period to Dec 31, 2019

• Hummingbird Spirit FPSO contracted to Centrica Energy; firm period to March 31, 2017 and currently discussing to extend existing contract

• Petrojarl Foinaven FPSO contracted to BP; firm period to Dec 31, 2021

4. Other

This segment includes the Arctic and Polar LNG carriers chartered-in from TGP and two chartered-in FSO units from TOO. Both Arctic and Polar vessels are currently unchartered and are expected to be laid-up in Q2 2016. These two vessels will continue to create a cash flow drag of $9mm/quarter until Q1 2017 when they are expected to be redeployed.

Summary

Although TK share price has seen a recovery since the December dividend cut announcement, we believe the market is still considerably undervaluing the GP value at parent. In addition, after the recently announced financing strategies at both TK and TOO, a stub trade is considerably de-risked and TK will be able to withstand lower distributions inflows from daughters at least until 2020 when the 8.5% bonds mature. However, we believe that TOO and TGP will increase their distributions much sooner, in the next 2 years, and the GP value will return to $350-500mm from the current implied $20mm. A stub trade by going long TK and shorting the daughters would allow for a return profile of 6-8x upside/downside by participating in the upside of the GP value while protecting the downside from any deterioration in the equity value of the daughters.

Catalyst

Increased TOO or TGP distribution

Recovery in MLP equity markets

Dropdowns or asset sales of vessels at TK Parent

Sustained recovery in oil prices