Description

Thesis

After the upcoming IPO of Teekay Shipping’s (“TK”) fixed-rate shuttle tanker business into an MLP (ticker “TOO”), there will be two public market subsidiaries for two of the company’s three business segments.  At the recent price of $44 per share and considering the expected value of the pending IPO, the market is assigning no value to the company’s spot market assets, the lone segment that will not be public.  This IPO will serve as a catalyst for the market to reassess the value each of the pieces of the company.  When this occurs, I believe the market will see there is approximately $16 of incremental “hidden” intrinsic value per share.  This will potentially generate a 35%+ appreciation (excluding a 2.3% dividend) from the value the market is currently assigning to the company and its holdings.

Summary

This is admittedly a complicated story which I will do my best to simplify.  TK will become, after this IPO, a holding company of the stock of two publicly traded MLPs (acting as their GP) and the operator of predominantly spot market oil tankers.  This savvy management team has recognized that the market will not provide full value to its different business lines as a tanker conglomerate given the disparate economics of each business line and thus they have created MLPs for the two different parts of the business that have high cash yields and stable earnings.  In addition, the superior returns of a General Partner to an MLP help maximize the returns to the parent company (TK).

Teekay Shipping is a leading crude oil and petroleum product shipper and service provider, shipping approximately 10% of the world’s seaborne oil.  TK consists of several business units with different economic characteristics making the entire business difficult to value—a “sum of the parts” story.  Management took its LNG tanker business unit (ticker TGP) public in 2005 in the form of an MLP helping create a tangible valuation for one portion of the business.  With its recent filing to sell at least 10% of its shuttle tanker business in the form of MLP units filed this week, TK is one step further in illuminating the intrinsic value of the entire business to the market. 

The remaining piece of the business is the “spot” market tanker business.  Without long term contracts, highly cyclical earnings and competitive industry characteristics, it has the least predictable and favorable economics of all its business lines.  As it turns out, the current outlook for the spot market for 2007 is cautious at best and thus the market is currently attributing little value to this segment within TK.  With a tangible value about to be assigned to the shuttle tanker business and a tangible market value already assigned to the LNG transportation business, it will become abundantly clear that the value of the spot tankers should be greater than zero.  In addition, management performed two value-creating moves by reorganizing the company in connection with this IPO.  Firstly, they assigned 9 additional spot tanker ships to the shuttle tanker business, thereby arbitraging the same asset from a low multiple business to what will be a high multiple business.  Secondly, management contributed $1.3B of debt to TOO from the parent, TK, effectively leaving significantly less net debt at the parent company making it more compelling to re-value the spot market assets higher. 

Below I have summarized the sum of the parts.  There is a more detailed version of the sum of the parts analysis found in the Valuation / Sum of the Parts section below.  Essentially, using the current market capitalization plus pro forma net debt shows there is no value attributed to the Spot market business (estimated at $1,050 of value), or $118MM of excess value from the other parts of the business.  This equates to $16 per share of excess value the market has not yet acknowledged.

Business Description

The company can best be described as a shuttle tanker fixed-rate business (about to be taken public as an MLP, ticker TOO), a liquefied natural gas transport business already public as an MLP (ticker TGP) and the spot tanker business which includes a chartered-in fleet business as well. 

To make matters even more complicated, the parent company is in the midst of acquiring Petrojarl, a leading operator of Floating Production Storage and Offloading (FPSO) units in the North Sea.  It owns and operates four FPSO units in addition to operating two shuttle tankers and one storage tanker. In February of this year, Teekay entered into a joint venture with Petrojarl to pursue FPSO projects and then ultimately made an offer for the entire company.  Ultimately, it is expected that this business will be contributed to the shuttle tanker MLP but the timing of this acquisition conflicted with the IPO timing so management scrapped the plans to merge the operations in the near term.  You will see below I value this investment at cost, though it is very clear that the company has under-market contracts currently and when they re-price in a few years, substantial value will have been created by this purchase.

A.)  Fixed Rate Tanker Business

The fixed rate tanker business primarily consists of “shuttle tankers” which move oil from offshore production platforms to onshore storage and refinery facilities where it is either economically or operationally not viable to put in a pipeline.  Revenue in this segment is earned on long term fixed-rate contracts.  There are approximately 49 vessels in this fleet and they primarily operate in the North Sea as well as 4 shuttle tankers which serve as holding vessels for crude oil.  Currently there are 2 shuttle tankers on order due in 2008.  Operations in the North Sea are more specialized and require more servicing due to the harsh weather environment.  The size of the world fleet for this segment has been fairly stable over the past several years making this currently a very steady business.

B.) Fixed Rate LNG Segment

The fixed-rate LNG segment, which trades as TGP, is also subject to long-term, fixed rate contracts (20-25 years) and is a high growth sector.  This business was purchased in 2003 for $298MM, contributed other assets already owned by the company and then took public one year later netting proceeds of $120MM while still holding 67% of outstanding shares as well as 100% of a GP interest (with its hedge fund-like compensation structure).  Currently there are 4 vessels in this business unit and 17 on order.  LNG projects are highly capital intensive and require a great deal of logistics planning and coordination which is why the contracts are long term.  Competition generally comes from the energy companies themselves although the independent operators are gaining share.

C.) Spot Fleet

There are 17 conventional tankers excluding chartered-in vessels.  Contracts here can be highly volatile and cyclical and dependent on oil prices and weather.  This business is highly competitive as well.  However, the fleet is approximately 7 years old, below the industry average of nearly 9 years.  The company primarily serves the Indo-Pacific and Atlantic Basins.  The company focuses on Aframax size vessels which are on the smaller side of the spectrum of types of carriers.  Strategically, management likes this type of vessel as opposed to larger carriers due to less rate volatility and greater variance of markets that Aframaxes can serve.

Management

Management is viewed favorably as both capable operators and capital allocators.  They are not afraid to buy back significant amounts of stock when they see value in their own company.  Given the very short term orientation of investors and analysts in this industry, this creates a lot of volatility and thus a lot of opportunity to repurchase shares at a discount.  In fact, since late 2004, management has repurchased 27% of outstanding shares.  In addition, management has increased the dividend four years in a row, 93% increase since 2002 (now yielding over 2%).

Operationally, management looks to serve niche markets in addition to being a spot provider.  They have created a diverse operation organically, via acquisition as well as joint ventures.  Present management has transformed the business over the past 8 years when the CEO, Bjorn Moller took charge, changing their focus from just a pure crude carrier to a mid-stream services company.  Current EVP and Chief Strategy Officer and former CFO, Peter Evensen, joined the company in 2003 from JP Morgan has also helped shape this transformation.

They have ably reinvested cash flow and generated strong returns for shareholders over that time frame.  For instance, in addition to the acquisition that brought them into the LNG transportation business described earlier, they grew their fixed rate shuttle tanker business from hardly existent in 2000 to 40 shuttle tankers and 4 floating and storage tankers (FSO’s) via 2 acquisitions as well as a joint venture with Petro Geo-Services to be a leader in this fast growing niche.  They sold most of their single hull tankers at the peak in 2004 way in advance of the 2010 double hull deadline and reinvested in the shuttle tanker business.  They have reduced debt where advantageous when selling off assets and have increased the dividend as mentioned above.

Valuation / Sum of the Parts

Below is a table working from the company’s current capital structure and market capitalization to what it will look like pro forma for the IPO of TOO and the completion of the acquisition of Petrojarl, which should be completed within the next quarter.

In summary, after the giving effect to all the transactions, there is about $1B of incremental value the market is not attributing to the company ($16/share).  This is roughly equivalent to the entire Spot business.  Admittedly, the entire business is difficult to value, but with two public components, analysts will have an easier chance of seeing this discrepancy.  

Management, frustrated by this fact, has historically performed their own sum of the parts analysis which they have included in their presentations.  The last one they did, which occurred in Q1’06 put their estimate of value at over $58.  They have not updated it since then due to the pending IPO.

Additionally, management estimates that TK will receive almost $200MM in dividends as unit holders of TGP and TOO units ($2.77/share).  Thus I would expect to see the dividend increase at some point as well.  I also have attributed zero value to the soon-to-be two GP interests of TPG and TOO.  With their hedge fund-like economics, they will accrete significant value in the coming years assuming the cash flow grows at each MLP as is expected.

Notes:

1.        Assigns 10x Ebitda (low end of MLP universe) for EV of TOO on $278MM of ’07 EBITDA as guided by management

2.        Values Petrojarl at expected final cost of $1.1B

3.        Spot business is valued at industry spot multiple of ’07 Ebitda and average estimate of ’07 Ebitda for spot fleet at $30K day rates for Aframaxes.  It assigns no value to the company’s in-charter business which is over $100MM of Ebitda per year.  This $1.1B value triangulates to the $1.0B plus net asset re-sale value analysts have previously assigned to the fleet.

Conclusion

I believe TK represents a good risk reward at this price.  The majority of the value is in fixed rate assets, thus not subject to the vagaries of the spot market.  This provides significant downside protection from here.  Additionally, the Spot valuation correlates to net asset re-sale market values of the fleet providing a margin of safety.  At the same time, the 35% upside does not include any growth in intrinsic value from the MLP’s (which are growing) or TK’s growing dividend stream.

Risks

1. Oil services is highly cyclical and subject to geo-political events
2. Outlook for spot rates is mixed given new supply of ships coming in during ’07 is expected to outrun supply
3. The MLP IPO could be unsuccessful causing a lower valuation

Catalyst