Description

TEEKAY CORP

We believe investing in TK Corp is highly opportunistic (many upcoming immediate catalysts) with little downside (valuation and the stock itself at historical lows, whereas the business arguably has never been as strong as it is today, essentially firing up at all cylinders). TK should be worth (today) approximately $12/share (close to 90% upside) while fair value should be (in our opinion) closer to $19-20 per share (a triple from here) within a 12 to 18-month timeframe.

The stock is trading at 52-week lows for reasons beyond our understanding. As said, management has executed flawlessly on the plan they’ve been presenting for a couple years now, and the business has never been as good as it is today for Teekay.

Technical factors that might influence the present (in our opinion)  mispricing include a sub billion market cap (small for the larger funds) and the fact that the company is structured as an MLP (totally out of favor, for good reasons). The latter being a big catalyst for Teekay to reach our fair value target as I’ll discuss later on.

Full disclosure- we’ve been shareholders of TK for about a year and own 4% of the outstanding shares, adding ocassionaly and our average cost is in the mid $7’s range.

Let me begin with a brief summary of what Teekay is:

Teekay Corporation (listed TK) owns the following equity stakes in its listed subsidiaries:

• 31% interest in Teekay LNG Partners (listed TGP)
• 14% interest in Teekay Offshore Partners (listed TOO)
• 29% interest in Teekay Tankers (listed TNK)

TK also has direct ownership of three floating production, storage and offloading (FPSO) units which are carried at book value (around $280 million) but which are now worth in excess of that amount given the strong oil market. In our opinion fair value is closer to $350 million today. Another catalyst here but we’ll discuss this later as well.

In our analysis we value TOO and TNK at current market prices. Although both companies are operating at trough levels and have multiples of upside (as an example TNK now trading for roughly $1/share would deliver free cash flow of $1/per share if day rates normalize back to $20-$25,000 a day versus current levels, something that we believe is very possible given the scrapping we’ve recently seen and global demand for oil), we use that optionality as a further margin of safety.

Our entire thesis on Teekay lies on TGP, Teekay LNG which is the “crown asset” within the Teekay family. 

What is Teekay LNG? (TGP)

Teekay LNG operates in the LNG and LPG shipping market through its interest of 42 LNG carriers and 29 LPG carriers. A great majority of this ships operate under long term, fixed rate charters. Some of them spanning 30 years. Thus, the cash flow visibility here is significant. A true rarity within the (mostly spot confined) shipping industry. TGP has both the most modern fleet and the largest backlog in the industry ($11B in secured forward revenues).

As an MLP, TGP in the past (circa before 2015) paid out huge quarterly distributions that approximated the cash flow it generated and would seek to fund its growth by issuing new equity. Something quite common in shipping which many of us would have difficulty understanding but common practice. However, as oil prices crashed in 2014 and credit markets were affected in 2015, TGP was left in a difficult predicament: It had just embarked so to say in its largest expansion ever (21 LNG vessels, 7 LPG vessels and a 30% interest in a regasification terminal) which now needed to be funded. Suddenly TGP had $3B of unfunded capex in a soft market with no practical financing alternatives. Late in 2015 the company made what in our opinion was a very wise decision- cut its quarterly distribution a full 80% (from $0.70 to $0.14) and fund the new ships with internally generated funds versus more dilution as an alternative. As wall street digested this news (good news for any long-term investors), TGP’s stock plummeted from $40 to $10 in. a matter of weeks. Of course, TK’s stock followed.

Fast forward to today- Three years later, TGP has funded all of its future growth capex (all $3B have been secured), refinanced the totality of its 2018 maturities ($782M of successfully refinanced) and has begun delivery of the ships ordered (with long term contracts attached) years ago. Thus, cash flow (both CFVO which is cash from vessels operations and DCF which stands for distributable cash flow) have begun to ramp up as anyone could’ve seen given the contractual nature of the business. 

Today TGP is in its best shape ever. No argument there. Whereas it’s shares trade 65% below its 2014 peak.

In order to illustrate the magnitude of the incremental cash generated by TGP let’s put this into perspective- TGP generated annual CFVO of $450 million in 2017 whereas existing growth projects are expected to add an additional annual $270 million as new ships are delivered into 1Q 2020. Thus, the actual CFVO will now be in excess of $720 million on an annual basis.

As cash hits the balance sheet the company faces a conundrum- either deleverage the balance sheet (in order to have capacity for further vessel expansion should attractive projects emerge), increase distributions or both. The company will guide on its new distribution policy November 1 as they report 3Q earnings. We expect a combination of both things to occur. Another big catalyst just around the corner.

It it is important to note that our thesis on TK is based on the revaluation of TGP and the cash flow that will be paid to the parent company as it’s IDR’s kick in. Which is soon enough in our opinion.

It is our belief that as new ships are delivered (happening already), the increasing CFVO and thus increasing DCF in TGP will allow the company to return to pre-2015 level even higher in the $0.85 to $1.00 per quarter range as 2019 progresses. 

What will happen (the company will announce their distribution plan going forward November the 1^st) will be a mixed guidance. I.e. A gradual ramp up in distributions and cash kept in order to further de-lever TGP.

Current Net Debt/ CFVO lies at 8x while their goal is to lower that to 4.5x by 2020. We believe the company will be able to reach that stated goal.

The question remains- what is the market pricing today in TK and TGP?

At today’s market price TK’s common units in TGP are worth $379M, if the price of TGP would increase to $28, given a $0.70 quarterly distribution and a 10% dividend yield (yield at which a high distribution paying comparable MLP like GasLog Partners is trading at), TK’s common units in TGP would be worth $706M. 

This would represent significant upside for TK, but the real value lies in TK’s GP in TGP. As general partner TK owns incentive distribution rights on TGP’s distribution, this means that as TGP increases its distribution, TK is entitled to a larger share of the total distribution. The real hikes for the GP share increase happen when the quarterly distribution level is above $0.65, for every cent above $0.65 that TGP pays TK receives 50%. Whereas right now at the $0.14 level the share for the GP is only 2%.  

This means that at a quarterly distribution of $0.70 the GP would be entitled to 13.6% of TGP’s total payout. Therefore, if by the end of 2020 TGP returns to a $0.70 quarterly distribution, which given the numbers in the table above is possible, their total annual payout would be of $224 million, of which the general partner receives $30 million. Applying a 10x-12x multiple to this free cash flow TK’s GP share in TGP which today is being valued at zero, would be worth $300-$360M.  

As TGP de-levers even more, they could easily afford to pay $0.85 per quarter. At this level the GP is entitled to 23.4% of the total distribution, an annual payout of $64 million for TK, doing the same exercise the GP would be worth $640-$768M. The upside for TK is exponential as TGP increases distribution an increase from $0.70 to $0.85 is only 21% but the value of the GP increases 113%. 

In our base case scenario we believe that by the end of 2019 TGP’s road towards deleveraging will be clear, and that by the end of 2020 TGP will be able to raise quarterly distributions to $0.70.

At that time the IDR’s should be worth around $360M. Discounting this back one year back to 2019 by 10%, the GP should be worth around  $328M. Likewise if we assume, TGP will then trade at a 10% yield (high in our opinion) again with a 10% discount, we believe TGP’s share price would be approximately $25 at that time. 

In this scenario, TK should be worth around $13 per share. However, as 2020 approaches and TGP is able to increase its distributions to $0.85 (applying the same 10% discount back from 2020) the GP should now be worth $700M and TGP’s shares would trade closer to $32 using a 10% yield. In this scenario TK is worth close to $20 per share.

However, there is a strong possibility that TK’s corporate structure will be simplified much earlier. Reasons behind this are the inefficiency of the K-1 tax schedule, the fact that MLP’s as a whole are pretty much out of favor as yields reflect and finally the fact that the universe of possible investors is greatly expanded when a traditional C-Corp is involved versus an MLP.

Recently there have been a number of transactions (Energy Partners the latest) where MLP’s convert to a traditional C Corp and the IDR rights are outright eliminated in exchange for a larger stake in the LP (i.e. more shares in TGP).

We believe the latter makes sense and so does the company. They’ve also said publicly that in the upcoming November 1^stcall, guidance on this matter will be shared with investors. We personally think it’s more a question of how fast they migrate to a traditional structure rather than if they’ll do it.

What happens in a TGP IDR Buyout?

TK’s thesis has always revolved around the revaluation of TGP once they raise the distributions and the subsequent hidden value in the GP given the IDR it has. The thesis remains the same, the larger part of TK’s value resides in TGP. However in a corporate simplification we could see the true economic value of TGP within the mother company reflected sooner.

The reality is that being an MLP is not as attractive anymore, Gas Log Partners, also an LNG shipping MLP, is distributing its totality of DCF, increasing its quarterly distributions consistently over the past years and even so the marker is valuating them at a 10% yield. 

As said, TK and TGP have hinted that the best way to unlock the value, is to cease being an MLP and transform TGP into a regular C-Corp. In order to this TGP would have to buy out TK’s general partnership and the corresponding IDR’s. The challenge lies in valuing an IDR that is currently deep out of the money, and since TK holds control over TGP, there is a conflicts committee that would have to approve such a transaction in a way that is fair to both TGP’s unit holders and TK shareholders.

So how much stock should TK be given in exchange for its IDR rights in TGP?

With TGP being able to pay out quarterly distributions of $0.70-$0.85 that means that TK’s GP is entitled to between 13.6 to 23.4% of the entire distribution, the midpoint would be 18.5%. However as distributions increase from those levels the upside is exponential for TK.

A fair deal would have TK receive 20 million new shares in TGP (an additional 20% of the company) in exchange for their IDR’s. That would pretty much be in-line with recently announced simplifications.

We strongly favor this simplification as once executed, TGP would no longer need to pay such high distributions and could use the extra cash to further de-lever or pursue other growth opportunities as they arise.

For argument’s sake let’s assume TGP increases its quarterly distribution to $0.30 by 2019 and allocated the remaining cash flow that will be generated ($0.30-40) towards debt repayment. If the new TGP traded at a 4.5% dividend yield TGP, that’s around $26.60 per share by 2019. By 2020 TGP could pay a quarterly distribution of $0.40 and that same yield would have it trade closer to $35 per share.

Using a SOTP model in these two scenarios TK would have a price target of $15.69 in 2019 and $20.50 in 2020 implying a 139% and 211% upside respectively

I’ll now briefly discuss TK’s other businesses. Which are at cyclical troughs and where we assign no potential upside in our valuation. 

Teekay Offshore

TOO is the other MLP in the Teekay Group. They own 62 offshore assets, including the world’s largest shuttle tanker fleet, floating production, storage and offloading (FPSO) units, floating storage and offtake (FSO) units, units for maintenance and safety (UMS), long-distance towing and offshore installation vessels and conventional tankers. The majority of Teekay Offshore fleet is employed on medium-term, stable contracts.

TOO suffered similar problems as TGP in 2015 and was forced to cut its quarterly distribution from $0.56 to $0.11 in the fourth quarter of 2015.. TOO also took on large amounts of debt in order to finance it’s large growth pipeline. To make matter worse, at the beginning of 2017 TOO suffered a large contract cancelation (by Petrobras, citing poor performance of the vessel) which only helped inflict severe strain on what was already a delicate financial position.

All the latter weighted heavily on TK as it secured $200M of TOO’s maturing debt. I believe there was a (genuine) concern in the market that if TOO went under, it’d TK along. 

Thankfully this didn’t happen as TK was able to bring Brookfield Partners into TOO. Per the transaction (summer last year) Brookfield received 60% of TOO’s common units plus 51% of the General Partnership in exchange for Brookfield injecting $610M into TOO, completely funding TOO’s growth pipeline and alleviating any liquidity concerns. As part of the transaction the guarantee that TK had on TOO’s debt was also eliminated.

Teekay Tankers: 

TNK operates in the conventional oil tanker business through its ownership of 46 double-hull tankers, including 26 Suezmax tankers, 11 Aframax tankers, and nine Long Range 2 (LR2) product tankers. TNK operates the largest mid-size tanker fleet.

As we all know, crude Tankers are extremely profitable in good markets (when daily rates are high) and can loose a ton of money when the cycle reverses and day rates don’t cover expenses.

For the past two years, TNK has been operating in one of the worst crude tanker markets in history with horrible daily rates in 2017 and even worse rates in 2018. The stock price dropping from $8.00 in the super tanker market of 2015, to as low as $0.96 in 2018, while daily rates have plummented in tandem.

With rates as low as they’ve been the company has been bleeding cash and there was well funded fear that the company couldn’t honor its 2018 debt obligations (around $100M). 

There was also fear that in case TNK defaulted, TK would need to step up and guarantee its debt.

Measures have been enacted so as to prevent this type of situation- for example the sale and leaseback of 13 tankers and the elimination of the quarterly dividend. This alone generated annual savings of $32M and the sale lease back strengthened the balance sheet.  As of June 2018 TNK, had a pro-forma liquidity of $190M.

A recovery of tanker rates could mean that TNK could be worth 3x-5x more than what it is worth today however.

TNK has traded in the $1.00-$1.10 range for most of 2018 but there’s great optionality here.  If tanker rates partially recovery to midcycle (say a $20-$25K daily rate range) TNK would then generate around $1.00 of free cash per share. 

If rates recover (which is a strong possibility given the recent increase in scrapping we’ve seen and growing oil demand) TNK could be a multi-bagger from here. 

TK’s stake in TNK is now worth $77M however as rates improve, so could its value for TK. (we estimate between $288-$385M in the midpoint) which would provide additional upside to TK.  We don’t value that optionality in our analysis however.

Finally, let’s talk about the three FPSO’s that TK owns 

FTK has complete ownership of three FPSO units, the Banff which just had its contract extended until August 2019, the Hummingbird Spirit which has an existing contract that expires in September 2020, and the Foinaven whose contract includes an annual production linked bonus. 

Since the cash flows of these vessels are directly linked to the price of oil, there has been a major shift in the value of these three assets In the past year. Up until Q3 2017 the three vessels were generating quarterly cash losses of around $3-$4M.

As oil prices began to rise late last year and Brent reached the $60-$65 range these vessels became cash flow positive, and with the price of oil at current levels the vessels have been generating quarterly cash flow from vessel operation (CFVO) of $13 million in Q1’18 and Q2’18.  

The company has mentioned it is now actively looking to sell all three vessels, and that there has been a positive change in sentiment around the offshore logistic market. 

This is only normal in the current oil market. How much are they worth? We value the combined value of these vessels between $364-$416M, applying a 7x-8x multiple to the annualized CFVO of $52M. 

What about TK’s debt? 

In January this year, TK took (what we believe was a prudent decision) to raise $125 million in convertible 5-year bonds and $100 million in new equity in order to improve their financial position.

They did that since they have a 2020 $600M bond maturity.

Looking back on the transaction we believe it was a very prudent decision as it significantly increased liquidity, it gave them more time to sell the FPSO’s in a better market but most importantly it resulted in TK not having the pressure to raise distributions in TGP earlier than needed, thus avoiding an unnecessary cash leakage.

Allow me to wrap up with a brief description of upcoming catalysts that the company faces that should help unlock value:

1. The closing of the sale of TK’s FPSO’s

Depending on weather TK sells two or the three FPSO’s we believe the company will get a $200 to $300 million cash infusion. That represents $2-3 dollars per share of immediate upside in our opinion as the funds would most likely be used to further delever the parent company. Management has publicly said they believe the ideal leverage for the company is around $200 million so if the three ships are sold, there could be $100 million left to execute what in our opinion would be a highly accretive buyback.

2. November 1 as the company reports it’s 3q18

Management has also publicly said they’ll guide then as to the future distribution strategy for TGP (a big catalyst where the market should have clear visibility of what TK’s IDR’s are worth) and they’ll also share their thoughts and more importantly timing of the corporate simplification. These two things are what we believe should actually help TK reach it’s fair value of $15+ per share.

Catalyst

1. The closing of the sale of TK’s FPSO’s

Depending on weather TK sells two or the three FPSO’s we believe the company will get a $200 to $300 million cash infusion. That represents $2-3 dollars per share of immediate upside in our opinion as the funds would most likely be used to further delever the parent company. Management has publicly said they believe the ideal leverage for the company is around $200 million so if the three ships are sold, there could be $100 million left to execute what in our opinion would be a highly accretive buyback.

2. November 1 as the company reports it’s 3q18

Management has also publicly said they’ll guide then as to the future distribution strategy for TGP (a big catalyst where the market should have clear visibility of what TK’s IDR’s are worth) and they’ll also share their thoughts and more importantly timing of the corporate simplification. These two things are what we believe should actually help TK reach it’s fair value of $15+ per share.