Teekay: Irrational Sell-Off As Transition Continues

Photo Credit: LNG World News

Review of Teekay Investment Thesis

Teekay Corporation (TK) was our top idea for 2017, which was based on the prospect of stabilization and major growth at Teekay LNG Partners (TGP) leading to an eventual significant dividend raise and a massive revaluation of the GP/IDR controlled by TK. Weve released nearly a dozen full-length public and private reports over the past 18 months, chronicling the transition of TGP from nearly $2B in unfunded expansion capex and additional looming 2018 refinancing obligations of over $1B, to a healthy growth company with the largest LNG backlog and modern fleet in the public markets.

Our thesis has always been that TGP would survive and would be able to fund the entirety of their order book without equity dilution. We also believed the remaining 2018 maturities wouldnt provide serious concerns due to underlying asset coverage. Although we were too optimistic in our initial forecasts and didnt anticipate the depths of TGPs related LPG trade exposure, thus far the operational and financial execution at Teekay LNG Partners has been to near perfection.

Although we like TGP as an investment, I believe the far greater upside is via an investment in the General Partner (GP”), Teekay Corporation, due to their potentially lucrative incentive distribution rights (IDR). When a limited partnership, such as TGP, pays out large distributions, the GP makes significant profits due to the IDR structure.

The current trend of GP/LP firms has been towards simplification of the capital structure. This often means the LP will ‘buy out’ or repurchase the GP/IDR from the parent asset, creating a more competitive structure for future investors. I believe such a move by Teekay could lead to significant near-term upside for TK shares. As I discussed in a major report last month, such a buyout transaction could lead to near-term valuations of $421M to $561M and longer-term valuations in excess of $800M. The report contains significantly more detail, but I’ve copied one of our charts below:

Market Skepticism vs. Reality of Results

I believe that TK has never received proper credit for their GP/IDR, primarily because the market is skeptical about the health of TGP and doubts their future payout capacity. This skepticism was healthy 18 months ago, or even just a couple quarters ago, as significant growth projects remained unfunded and bearish research from major firms including Morgan Stanley (NYSE:MS), suggested 2018 maturities would present a significant obstacle to distribution ambitions.

Despite these bearish considerations, we believed that TGP would be able to fully finance their growth program and would also be able to refinance the bulk of their 2018 maturities. This was a counter-consensus view during early-2017. In June 2017, we released a report which broke down each of TGPs 2018 maturities in detail. I estimated that even under conservative estimates, TGP would need approximately $120M to handle all 2018 maturities.

In December 2017, TGP announced the final major financing for their significant Yamal growth project, laying to rest all remaining concerns about their newbuild program. This progress was covered in their Q4-17 presentation (slide 11). The remaining estimated cash requirement through early-2020 is negative $7M. TGP will receive more funding than required, very rare.

Teekay LNG Partners also disclosed the latest status (slide 12) of their 2018 refinancing initiatives, which included a full $197M refinancing on two vessels. Even in my conservative estimates, I had predicted a refinance of $143M (approx. 75%) to $189M (100%). TGPs $197M deal was extremely strong.

I’m perhaps one of the biggest Teekay bulls and this level of financing was far higher than even I was anticipating a few quarters ago. To provide context, my full report from last summer is linked here, but I have included the two relevant snippets below (highlights added):

TGPs updated refinancing schedule is shown below. As confirmed on the latest earnings call transcript, management plans to refinance essentially all of these maturities, but they have hinted at using excess cash to repurchase the $136M in unsecured NOK bonds in September. This move makes sense and would improve quarterly DCF by another $0.03.

The exact quote from the CFO, Brody Speers, is included below (emphasis added):

When we look at the refinancings this year, weve now that weve completed one of them. Weve got three more secured loans to refinance this year, and our plan is to refinance all three of those. And were targeting, on an overall basis, to refinance roughly the billions outstanding. So we dont see any, at this stage, real equity need on any of those on an overall basis. But when we look at the NOK bond, for example, we did raise the we did do the preferred equity issuance in Q4 of last year. And so that has put us in a pretty strong position from a liquidity standpoint, so that is something that we will look at doing potentially, is possibly taking out that bond. But I think well continue to examine that as we go forward here and be opportunistic, especially if theres favorable terms being offered.

Once TGP clears the remaining 2018 maturities, TGP does not face any significant secured debt maturities until 2022. This will be a major pivotal point for them. On the latest conference call, Teekay management once again reiterated that their priority is to complete these refinancing initiatives and that they will offer more detailed distribution guidance this fall. This is in line with the priorities that they have communicated over the past 12-18 months. They have always wanted to finish funding newbuilds and then address 2018 maturities prior to setting out longer-term payout guidance or commitments.

Previous Coverage & Recent Price Action

Ive extensively covered the bullish thesis on Teekay in several write-ups, some within the past couple months. These include a major enterprise review in mid-December and a full-length 19-page updated thesis, posted in early January.

Despite a strong start to 2018, TKs price completely collapsed in late-January as shown below from Google Finance.

This price collapse was accelerated by the recent market panic and slight oil price dip, but the primary reason was due to TKs decision to issue new equity at $9.75/sh and to sell 5.0% convertible bonds due 2023 ($11.70 conversion). TK conducted this measured equity issuance to pre-emptively address part of their 8.5% 2020 bonds, of which $593M is due in January 2020. They plan to tender for part of these notes, utilizing a mixture of the convertible proceeds and common equity. If $100M of the convertibles and $50M of cash is utilized, TK will save nearly $13M in annual interest expenses while also strengthening their balance sheet. Although this was a cautious move, it was a very prudent move and fully de-risks the company.

The shocking part is that TK currently trades at $7.60/sh despite the fact that they just convinced $100M of institutional money to pay $9.75/sh and another $125M of institutional money to purchase (heavily oversubscribed) convertibles with an $11.70 exercise price. Notably, the $11.70 does not adjust downward for the regular $0.055/qtr payout. Institutional investors dont buy shares for $9.75 or convertibles at $11.70 unless they think the medium to long-term value is significantly higher. However, despite this basic common sense logic, the market threw a temper tantrum and send shares lower for no reason besides an emotional reaction to dilution.

The emotional and visceral reaction to this conservative offering surpassed any of the panic that hit the broad market. Although the initial sell-off was likely exacerbated by the recent sell-off, as the below chart shows, the market has almost fully recovered over the past six weeks, whilst TK is still down 28%.

Brent oil prices also slid initially, perhaps adding to the late-January sell-off, but TK hasnt benefitted from any of their recent (or overall) resurgence. In fact, oil markets are sitting at the best level they have seen in 2.5 years. Judging by recent action, it appears that if oil goes down, TK gets sold off, but if oil goes back up, TK doesn’t get rewarded by the markets either.

The True/Logical Impact of Equity Issuance

I previously covered the impact of TKs share issuance to both our immediate valuation estimates and our early-2019 estimates to see if the visceral market reaction made sense. I plugged the new share issuance and expected net debt calculations into our live models. We determined that our current estimated sum-of-the-parts (SOTP) values (updated for owned share values as of February 28, 2018) dropped from approximately $11.39 to $11.09. The current valuation of TK dropped by $0.30/sh, or less than 3% of dilution and yet TK has plunged over 26% on the deal.

Institutional investors agreed to invest $225M between $9.75 and $11.70, ostensibly with expectations for significantly higher share prices in the future, and yet TK now trades at $7.60? I have seen dumb market moves, but this is mind-blowing.

Note: $392.8M GP/IDR value derived from mid-2019 valuation estimate with a 20% discount applied.

Does the Issuance Hurt Long-Term Value?

A common line of reasoning, at least from retail observations on Seeking Alpha and in other private forums, was that TKs equity issuance seemed to eliminate or heavily harm the bullish thesis. Again, we need to understand that $225M of institutional money just plowed into TK between $9.75 and $11.70, presumably with the expectation of significantly higher share prices shortly down the road. Only in the Twilight Zone of our current market chaos would this offering translate to the asinine conclusion that TK is broken and deserves to trade to $7.60/sh. TK has stated that they plan to use the vast majority of the proceeds to delever ahead of their $593M maturity of 8.5% bonds. Thats a noble pursuit and it removes a substantial degree of risk.

However, there are clearly more shares outstanding. How will this impact our future price targets? As shown below, TKs mid-2019 valuation estimate drops from $17.05 to $16.03, for a mid-term dilution of 6%. Does this deserve a 24% sell-off?

Note: $491M value for TGP GP/IDR derived from comparable MLP buyout valuation ranges (12-16x IDR flows) based on a $0.70/qtr payout level.

What About Convertible Impacts?

Taking the TK case one step further, some investors have rallied against the concept of $11.70 convertible notes. Although it might seem silly to be concerned about dilution above $11.70 when the stock price is $7.60/sh, especially considering $125M of institutional money is betting on long-term prices well in excess of $11.70/sh, weve all seen the market reaction. The following chart illustrates what the 2019 scenario would look like post-convertible exercise. As described in the prospectus, TK can force conversion when the stock price trades at 130% of the $11.70 strike ($15.21) after January 15, 2021, which I believe has a high probability of occurrence almost immediately in early-2021.

As our models show, holding the aforementioned mid-2019 scenario constant for conversion, the price drops all the way down from $16.03 to $15.57, compared to if TK never sold any equity and then had a value of $17.05.

Altogether dilution was 8.5%, but TKs pro forma net debt dropped from $525M to $265M.

In review, when applying our valuation models to the dilution case, TKs current value dropped from $11.78 to $11.42 and our mid-2019 estimated value dropped from $17.05 to $15.58. However, TK also eliminated nearly half of their net debt. I believe that TK looked at a similar valuation trade-off and made the clear conservative call to fully de-risk the company.

As weve shown, very little has changed to current and forward valuations, $225M of institutional money is betting on TK worth significantly north of $9.75 near-term and $11.70 long-term, and yet the markets have thrown a temper tantrum.

Conclusion & Valuation: $13/sh, 70% Upside

This latest report covers the latest transition progress at Teekay LNG Partners while also reflecting on the major recent equity price crash at Teekay Corporation.

I personally believe the current pricing of $7.60/sh for TK offers the best risk/reward prospects Ive ever seen for this company. Paying around $8/sh today for TK is significantly superior to paying $6/sh in late-2016 or similar levels in mid-2017. Ive recently added significantly to my equity stake in TK, nearly doubling my share holdings at $7.71.

This purchase at $7.71 was much higher than my previous average cost basis of $5.76, but I believe I got a considerably better bargain on my latest buy now that TGP has demonstrated enormous progress and TK has fully de-risked their 2020 positioning. This is also before considering the remarkable progress at Teekay Offshore (TOO) compared to a near-disaster base scenario in mid-2017. My current price target for TK is approximately $13/sh, for upside of 70%, which is slightly below the mid-point between my estimate for current SOTP value ($11.09) and my estimate for mid-2019 valuations including convertibles ($15.57).

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Disclosure: I am/we are long TK, TGP, TOO.

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.

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