Teekay LNG Partners Offers Investors An Opportunity

Teekay LNG Partners L.P. (NYSE: TGP) is a Master Limited Partnership (MLP) which operates LNG tankers. The stock recently closed around $14.00 and pays a dividend of 56 cents per year for a yield of 4.0%. This would not ordinarily put it on the radar screen for investors seeking out high yield equities. But conservatively calculated, TGP is now trading at roughly 4 times current “distributable cash flow” (DCF) which we estimated at $3.26 for 2016, and this qualifies it as a “dirt cheap MLP.” Our estimate for DCF is conservative – estimated as twice the DCF for the 6-month period January-June 2016. In fact, DCF should increase in the 2nd half of the year because the latest conference call reveals one new ship was delivered in the 2nd quarter and another new ship was delivered on August 1st and both of these ships are under contract. The latest conference call reveals that the second ship will add $30 million a year to DCF on an annual basis. This should add up to $12.5 million in the calendar year 2016. We also have not included the revenue from the ship which was delivered in the second quarter and is also under contract.

So our projected DCF is very conservative and lower than the projected DCF by Wells Fargo in their August 2016 presentation, which stands at $3.47.

Ship-to-ship transfer expertise for oil, LNG & LPG products

Low-Yield/High DCF – The MLP model is a bit similar to that of Business Development Companies (or BDCs). These companies generate solid cash flow and pay most of it out in the form of dividends or distributions. For example, coverage (calculated as DCF/Distributions) for many MLPs is close to 100%. When the companies need additional capital, they issue new shares in follow-on offerings. This model was badly disrupted for MLPs in the past two years as MLP share prices got crushed due to the general energy sector crash as well as specific problems for some MLPs. It became impossible to issue new shares without ruinous dilution of existing shareholders. For many MLPs, the solution was to cut capital expenditures (CapEx) drastically and continue paying most DCF out in the form of distributions. TGP had commitments to expand that was unfunded and could not withdraw from these without repercussions. It elected to cut back on distributions and use the available cash flow to fund these commitments. Thus, for TGP, coverage is roughly 600%, meaning that more than 5 out of every 6 dollars of DCF (which is running at $3.36 per year) are being reinvested rather than paid out as distributions (running at 56 cents per year or 1/6th of $3.36).

There is a “bad news/good news” aspect to 600% coverage. The bad news is that unitholders don’t receive large distributions; the good news is that the company is currently generating a 24% cash flow return based on its market cap and reinvesting the vast majority of the cash flow. In effect, TGP is internally financing its growth and its DCF should continue to grow in future years as the projects that are financed come online. Based on the company’s most recent conference call “cash from vessel operations” (CFVO) will increase from $470 million in 2016 to $720 million in 2020 due to the income from new vessels being financed with the funds from current cash flow. If DCF increases proportionately (by 53%), it would go from $3.26 in 2016 to $5.00 by 2020. But DCF should increase by a GREATER proportion because certain management expenses (filing SEC forms, accounting, corporate overhead, etc.) should not go up proportionately with CFVO and leverage (and therefore proportional interest expense) is actually decreasing because the growth is being financed with cash flow rather than debt.

Thus, based on conservative projections of DCF derived from the company’s own CFVO projections, TGP’s DCF per unit should grow to at least $5.00 in 2020. In this regard, investors should be aware that projections of DCF, income, cash flow, and other metrics are always subject to considerable uncertainty and may not materialize as anticipated. On the other hand, TGP charters out its vessels on long-term, fixed-fee contracts with creditworthy counterparties so that there is a degree of reliability in projections.

Dividend Anticipation Strategy – Dividend anticipation strategy involves buying a stock with the anticipation that there will be a dividend increase and the share price will go up in response to the increase. TGP definitely fits this mould. Its current DCF of $3.36 will support a much higher dividend as soon as the need for capital due to expansion projects is complete. While TGP temporarily cut its distribution in late 2015 in order to self-finance 100% of its remaining growth projects, it is also the case that, based on the Q2-16 presentation, there remains only $133 million in additional equity CapEx required through 2020 to be financed internally. During the first half of 2016 alone, TGP had a cash surplus of $107 million. So it would take three quarters for the company to complete its full internal financing. According to Teekay Corporation CFO Vincent Lok on the Q2-16 conference call:

One of the key events in TGP is to finance our existing newbuilding program in TGP and we are making significant progress on those efforts. So (we are) very much focused on restoring the distributions.”

TGP should be able to increase distributions in mid-2017. Over time, distributions could go over $3.00 (which is less than the conservatively projected 2016 DCF of $3.36). This would result in a yield of 22% based on the current share price and should be able to support a unit price of $30 or more. At $30, the stock would yield 10%, which is in line with most LNG shipping LP companies including GasLog Partners (NYSE: GLOP) yield 9%, Dynagas LNG Partners (NYSE: DLNG) yields 10.9%, and Golar LNG Partners (NASDAQ: GMLP) yield 12%, all of which distribute close to 100% of their DCF to shareholders. It should also be noted that between 2012 and 2014, TGP issued over 20 million shares at prices between $30 and $45. This does not necessarily mean that TGP’s share price will soon (or even ever) return to those levels, but it does illustrate the fact that considerable money was invested and put to work in the company at a higher dollar price per share.

The LNG Business – LNG, or liquefied natural gas, is an unusual business. Natural gas is cooled to extremely low temperatures, at which point it becomes a liquid and then transported in specially designed tankers to another location, at which point it is allowed to heat and become gaseous again. The process allows for easier transportation of gas over long distances in which pipelines are not available. The tankers and the terminals at each end are expensive so that the process makes sense if and only if the gas can be sold at much higher prices than the price at which it is bought. In certain markets, e.g. Japan, it is almost an absolute necessity because of the absence of local gas reserves. In other markets, e.g. Europe, it may be attractive to permit customers to diversify away from problematic land line sources (e.g., Russia). In the United States, it is of interest primarily as a vehicle for the export of surplus natural gas, although in certain areas (Hawaii and Puerto Rico), it may also be a good source of supply. Like anything else in energy, it is subject to cycles at both the supply and the demand end. For this reason, the business is characterized by long-term contracts which ensure the return on the large investment in tankers and terminals.

TGP has long-term contracts on most of its tankers and the counterparties are creditworthy companies and governmental entities. TGP’s contracts range in duration from 5 to 20 years and its average remaining contract duration is 13 years. Still, there is some risk that – at the point of contract expiration – TGP could find itself in a weak market and face a lower rate structure. On balance, concerns about global warming, resistance to coal, fears about nuclear power, and problems associated with reliance on petroleum should make natural gas the overwhelmingly most popular choice for new electric power plants around the world and this will create situations in which LNG will be absolutely necessary to provide plants with a stable source of fuel. In fact, LNG trade increased 9% in the first six months of 2016 as compared with the same time period in 2015 due to demand in India and China and charter rates for LNG tankers increased as well. It should be noted that the United States is starting to export LNG and that these exports should increase in the coming years. Decisions about LNG exports will be partly political as regulatory approval is necessary, but the interest of the United States in maintaining a strong natural gas production industry and in increasing export revenue should lead to the approval of more exports.

Clean Capital Structure – Unlike many MLPs, TGP has no preferred stock and, therefore, unitholders do not face the risk of dilution from convertible preferred shares. The unit count is 79.7 million and has been stable in the very recent past. TGP does not appear to contemplate issuing new shares at the current price levels and dilution will likely occur only after buyers of TGP will experience substantial price appreciation. TGP’s manager is entitled to incentive distribution rights (IDRs), but these kick in only if the annual distribution exceeds $1.85, and at the $1.85 level buyers at the current price would receive a 13.4% yield on original cost.

Risks – There are always execution risks associated with any expansion effort and TGP could run into operational problems. In that regard, yield-oriented investors should recognize that they are taking an equity stake and not buying a government bond. There are a variety of possible risks. For example, it may take longer than planned for new ships to be delivered. A major LNG accident could undermine support for LNG as a fuel source in the future. Indeed, often the worst events are events that were not identified as possible risks in advance. The biggest long-term risk is the weakness in the LNG market due to competition from pipeline gas. This is unlikely to materialize in situations where LNG is delivered to an island such as Japan which is at some distance from mainland sources of natural gas. It is, however, a risk to markets for LNG in China, India, and Europe. This long-term economic risk will probably not affect the performance of vessels already under contract but could diminish charter rates at the time contracts expire. Pipelines built from Russia or Iran into China and India could cut into LNG demand. However, these would be very expensive projects and, at any rate, China and India would both still want to have a diverse source of natural gas for geopolitical reasons.

With regard to all of the risks, there is no particular reason to assume that they are greater – or lesser – now than in the past. However, investors should be aware of these risks because they could result in financial performance different from that which is projected.

Investors should also be aware of the potential for “phantom income” in 2016 and 2017 as the income reported on the investor’s K-1 may be higher than the distribution the investor receives. This situation should be rectified during 2017 as distributions increase.

Bottom Line – At 4 times very conservatively calculated and growing DCF, TGP is a very attractive buy here and should hit $30 within the next 2 years as distributions are increased into the $3 neighbourhood. The unit price should go even higher by 2020 as DCF is increased by the deployment of more vessels. $30 per unit is more than double the current price of $14/share. The story of the stock is that they don’t really have to see growth to be a good investment. Even if DCF never grows, the company will ultimately return to a policy of paying out most of the DCF as distributions, and distributions will increase to around $3.00 a share which should support our target price of $30 unit price, resulting in a yield of 22% based on the current share price.

Still, there is a very strong case that DCF will increase enormously; over time distributions could go well over $3.00/share.

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Notes:

1. This article was jointly produced with Seeking Alpha contributor Philip Mause.
2. Photos/tables above were compiled from the Company’s website, Wells Fargo August 2016 report on TGP (presentation is only available to private clients of WF), Morningstar and YCharts, unless otherwise stated.
3. I interchangeably used in the article above the terms distributions and dividends. The main differences are: Distributions tend to be variable because they are based on DCF. Also, they are considered as “return of capital” for tax purposes; so stocks that pay distributions such as TGP are usually best held in a taxable account.

Disclosure: I am/we are long TGP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.