Description

TOO is the world’s largest shuttle tank fleet operator. It is a vital part of its customers supply chains. TOO owns a 51% interest in a fleet of 34 shuttle tankers, four floating storage and offloading units (FSO’s), nine double-hull conventional oil tankers, and two lightering vessels. In addition, TOO has direct ownership of two additional shuttle tankers and one FSO unit, plus the rights to participate in certain floating production and storage offloading (FPSO) opportunities through its general partner.

TOO’s most compelling feature is that it has substantial long-term fixed-rate contracts with strong counterparties. Coupled with its favorable debt profile, and high (and growing) dividend, this makes a strong combination for protecting the downside.

Prior to the current widening of credit spreads, TOO was able to raise money at significantly higher levels--$21/share during its IPO in 12/06, and at $20/share in 6/08. Recently, TOO and its related companies had to restate their earnings results due to not meeting the requirements for hedge accounting. This had no effect on cash flows, but shifted unrealized mark-to-market changes from the balance sheet to the income statement. It recently announced those changes, and chose the occasion to emphasize the strength of their debt-profile, leading to a significant rally in TOO and its related companies.

TOO has no CAPEX commitments. One of the attractions of MLP’s in addition to their dividend and favorable taxation are their ability to grow. The growth of an MLP is intertwined with the ability to raise equity capital and levered financing to expand the asset base. The valuation assumptions in such a growth model tended to build in the favorable dynamics of arbitraging private versus public equity values. That allowed TOO to get as high as $37/share last year. The similarities of this model to private-equity/LBO transactions has led to stressed valuations in any company that had benefited from these dynamics. However, at current valuations, it’s worth a closer examination.

Unlike other maritime stocks, TOO did not commit to a vessel newbuild expansion program. Instead, TOO’s growth will typically come via dropdown acquisitions from its parent general partner. Given the arms-length deal requirements, TOO will need to have these drop down acquisitions prove accretive in order to proceed. As long as TOO doesn’t commit to drop down acquisitions prior to gaining financing, the business model has conservative elements lacking in other growth MLP’s. And TOO has “inherited” the transferable financing from its GP in other drop-down transactions, so there remains many growth possibilities for Teekay Offshore.

Intertwined with the valuation dynamics of a growing MLP with a growing dividend is the general expectation that MLP’s are dependent on cheap equity and financing to be compelling investments. While I’d argue that at a dividend yield of less than 8%, that is definitely the case, at the current dividend yield of over 16%, any growth is frosting on the cake. The more germane argument in the current environment, and much more on investors’ minds, has more to do with return of capital rather than return on capital. With that in mind, let’s examine the capital structure.

TOO has a market cap of $231 million. Against this, it has $1618 million in debt less $113m in cash. The fair market value of vessels, as of 6/30/08 was $2.908 billion, according to management estimates. Granted, the fair market value has declined since then, but only a very manageable portion of the company’s debt is against fair market value (more below).

The company has only $50 million in balloon payments due between now and the end of 2013. Here is the company breakdown as of 6/30/08:

1H ’08: Total Liquidity +$259 million
2H ’08: Balloon payment -$18.4 million
1H ’09: --
2H ’09: Balloon payment -$17.5 million
1H ’10: --
2H ’10: --
1H ’11: Balloon payment -$14.3 million
2H ’11: --
1H ’12: --
2H ’12: --
1H ’13: --
2H ’13: --

Hopefully, the credit markets will have recovered by then!

In the meantime, the debt is covenant-lite. The company states that the partnership has no covenant concerns. TOO has only one facility representing $87m that is tied to hull values. The current coverage is approximately 185%, and the required minimum is 105%. If vessels dropped by 50%, TOO would lose debt capacity of $10m.

More interestingly is the average contract life for TOO—which goes directly to the return of capital concerns.

TOO has 22 shuttle tankers on life of field contracts (15 year average field life), plus 17 vessels on 5 year time/bareboat charter contracts. The FSO units average 4 year contracts, and the conventional tankers average 6 year contracts (plus options to extend). Their customers include ExxonMobil, StatoilHydro, Teekay Corp., ConocoPhillips, BP, Hess, Hydro, Shell, Marathon, Chevron, Petrobras, Total, and Apache. There is some concentration risk, as StatoilHydro, TK, and Petrobras account for 40%, 20%, and 13%, respectively, of 2007 voyage revenues.

Another protection for stockholders is that TOO’s contracts contain cost escalators. In addition, the distributable cash flow is based on realistic capex to keep the size of the fleet perpetually the same size. In other words, these depreciating assets are dinged not only for maintenance capex but replacement capex as well. TOO’s distributable cash flow for Q3 was greater than the previous quarter and exceeds the total cash distributions paid to the LP unitholders and GP interests for the quarter.

(According to the company’s press releases: “Distributable cash flow is a non-GAAP financial measure used by certain investors to measure the financial performance of the Partnership and other master limited partnerships. Distributable cash flow represents net income adjusted for depreciation and amortization expense, non-controlling interest, non-cash items, estimated maintenance capital expenditures, gains and losses on vessel sales, income taxes and foreign exchange related items.”)

Growth prospects:

TOO has the potential to increase their interest in the operating company (OPCO) that it currently co-owns with TK (the general partner owns 49%), as well as acquiring four Aframax shuttle-tankers estimated to be in service in 2010-2011, plus the ability to participate in the acquisition of further FPSO interests.

While some may question the economics of deep water production, and the rate of FPSO demand,  over the next decade, it seems very clear that the shallow water fields will have necessarily been replaced by deep-water drilling. An FPSO unit is very significant in terms of TOO’s size (FPSO’s cost at least $250 million, and are often twice that cost). FPSO’s are generally operated under long-term, fixed-rate contracts, and TOO can choose whether or not to participate in the deals that TK has already committed to in the FPSO space.

The long-term investment success of TK relies to a large extent on the growth and strength of TOO. TK has tremendous interest in growing the distributions of TOO, and ensuring the long-term viability of both companies. The virtuous circle makes TOO an extraordinarily compelling play in the event that the investment environment begins to normalize.

The current valuation seems to assume that there will be little to no sustained dividend growth at TOO beyond what its current assets can deliver. However, it is easy enough to make the case that there is considerable upside from growth. The main argument against growth is the requirement to raise equity in order to finance growth. However, if long-term contracts and financing are in place, equity financing arguably doesn’t need to be dilutive to TOO’s current market cap. And with no compelling need to finance current commitments, TOO should be in the drivers seat on these growth decisions.

Indeed, it is quite possible that in the interests of growth, the parent general partner would be willing to drop down assets at compelling values. The goals of TK and TOO are compatible, in that TK wants to be the asset-lite general partner of several MLP’s and related companies, and TOO is the growth vehicle that drives TK’s incentive distribution rights. 

TOO is an interesting combination of productive assets with long-term contracts financed by an arguably favorable debt profile. In addition, it has tremendously favorable growth possibilities via its contractually guaranteed options for accretive drop-down acquisitions. While the current credit and commodity market reversals have diminished the attraction to an MLP pipeline-over-the-seas story, TOO deserves a closer examination for its favorable dynamics.

Catalyst