Oiltanking Partners (OILT) is a midstream company engaged in providing storage, terminalling and transportation services of crude oil, refined petroleum products and liquefied petroleum gases. Listed on the NYSE since 2011, the company operates as a master limited partnership. Over the course of its post and pre IPO history, the company has been able to rapidly boost its revenue and earnings through its asset base expansion. Providing deep water docking services and storage facilities, the company operates under long-term contracts with its customers. This results in the company having zero exposure to commodity prices. These long-term contracts and a high retention rate of customers, almost 95 percent, provide a unique low risk and high growth opportunity for the investors.
The company primarily operates under two types of contracts; storage and throughput. Under the terms of the storage contract, the company agrees to dedicate a certain portion of its storage capacity to its customers at a negotiated fixed periodic payment. These payments are due to the company regardless of the utilization of the capacity allocated.
The throughput contract, on the other hand outlines that the company provides transportation services of materials to non-storage and existing storage customers. The company receives payment for the goods transferred through its system. In addition, the company charges for the utilization, of the storage capacity and throughput services, that exceed the predefined limits set in its storage contracts.
These long-term fixed rate or per usage rate contracts provide the company with a limited risk profile. Its earnings are also tipped towards growing at a significantly higher rate than the industry, making OILT a good investment opportunity.
The U.S. oil and gas industry has been booming in the last few years despite the lack of economic activity in the domestic market. Lower consumption in the U.S. has enabled the producers to take advantage of high international prices for crude oil and other related petroleum products. As can be seen from the graph above, the international oil price has sustained its position at a high level over the last five years and this has enabled the U.S. producers to grow exports of oil and petroleum products by more than 15 percent in the same period as compared to the growth in exports of 3.3 percent per annum from 1981 to 2007.
The future outlook of international oil prices, as given by US EIA, is highly positive; with the worst case scenario defined as the prices sustained at current levels over the long term. The forecast of the production of oil, natural gas and petroleum products in the U.S. is also attractive and with continued slow growth in consumption in the domestic market, it is expected that the exports will grow in the future.
High growth in the oil and gas sector through exports causes an increase in the demand for midstream companies, especially those providing deep water Terminalling services. Thus with a positive outlook, it is expected that companies such as OILT will achieve exponential growth in the coming years.
Based upon P/E and EV/EBITDA multiples, OILT is trading at a discounted price. The company is expected to grow at a CAGR of more than 28 percent for the next 5 years. This expected CAGR is quite higher as compared to the consensus growth expectation for the overall industry. The company provides an upside potential along with a dividend yield of 2.9 percent. This return potential has brought the stock to my attention. I have used several approaches to value the company.
The PEG ratio of the company is 0.76 as compared to the industry's PEG ratio of 0.99. This fact displays that the company is trading at a relative discount. Based upon the comparative multiples, the company's target price comes out to be equal to $62.81. Whereas, the dividend discount model results in an intrinsic value of $59.85. Based on these valuation metrics, the company is offering a return potential of 17 percent, 22.5 percent and 16.8 percent, respectively.
Exponential growth in its revenues and earnings are the key drivers to the company's investment opportunity. Another plausible facet that will enable the company to sustain high growth is to broaden its customer base and also to retain its existing customers. Currently 61 percent of the company's total revenues are derived from only five large customers. Although this ratio has fallen from 66 percent over the last five years, the high exposure puts the company at risk if any of its large customers decides not to renew its contract with the company. With large investments in developing its assets base and infrastructure, it is vital for the company to keep hold and nurture relationship with its existing clientele alongside expanding its customer base in order to generate hefty returns on the invested capital.
Significantly low debt levels and being part of a large international group, does help solidify the company's financial position, and despite consistent negative cash flows, primarily due to high investments, the company does not face any critical financial constraints in the future. Based on the invested thesis, the company's past performance is scrutinized below in order to build an expectation of its future performance.
Oil tanking partners have been able to grow revenues at a CAGR of approximately 14.4 percent over the course of the last five years aided by the recent boom in the U.S. oil and gas sector, a consequence of increased drilling activity, greater exploration of oil and the shale boom. Sustained increase in international prices of crude oil due, in large part, to supply constraints has also helped the oil and gas sector to boom.
Source: OILT SEC Filings
With consistently high retention of customers and high utilization of assets, the growth in revenues can be attributable to the growth in the average storage capacity of the company that increased at a CAGR of 5.5 percent with the largest growth witnessed in 2009 and 2010 corresponding to the fastest revenue growing periods of the company.
The year 2011 saw a decline in the oil prices from the end of the first quarter to the start of the fourth quarter of the year. During this period, West Texas Intermediate crude price fell from close $110 per barrel to less than $88 per barrel. This drop in price forced the oil producers to cut production which in turn caused the demand for the company's services to plunge. This plummeted demand also forced the company to delay its capital expenditure in relation to expansion of operation and thus the company did not add to its average storage capacity in 2011. It was only at the end of 2011 that the company increased its capital expenditure when the demand for its services recovered after the increase in crude oil prices.
In the current year, the company has continued its heavy investments as it strives to increase its storage capacity as well as throughput capacity in order to generate high revenue growth in the future. So long as the company is able to utilize its increased installed capacity, the company will be able to grow revenues in the future. However, this growth will be highly dependent on future crude oil price movement as lower prices will make exploration from non-conventional plays no longer feasible and will result in the decline in the supply of crude oil and other petrochemical products.
Source: OILT SEC Filings
Due to large variations in the company's interest expense and other non-recurring items, such as tax benefits and other incomes, the company's operating income and margin are more meaningful to analyze. Over the year, the company has been able to improve its operating margin from 34 percent in 2008 to 47.8 percent in 2012. Over the same period, the company's operating income has increased by a CAGR of 24.5 percent. The increase in the company's operating income has also continued in the recent two quarters and as per the recent reports, in 2013 for the six months ended on June 30, the company's operating margin has increased to 57 percent, already surpassing the operating income achieved in FY2011.
The growth in the operating margin of the company has been through controlled costs as a percentage of sales. The operating costs have decreased to 26.6 percent of revenues in 2012 from 37.2 percent in 2008 owing to high revenue growth and also through cost cutting via re-negotiation of power and fuel rates and lower rental costs due to purchase of previously leased lands. Similar to operating costs, depreciation expense has also decreased as a percentage of revenues due to high sales growth and distribution of certain assets to Oil tanking Holding America in relation to the company's IPO in 2011.
Selling, general and administrative expenses are the only costs that increased as a percentage of revenues post IPO. These costs increased to 15.3 percent of total sales in 2011 as compared to 12.3 percent of sales in 2008, primarily due to high professional fees in operating as a public company; and also due to hiring of more personnel in anticipation of greater sales growth. This ratio then declined to 13.9 percent of sales in 2012 as the company realized high growth in 2012. These costs have fallen further as a percentage of sales in the first six months of the current fiscal year to stand at 10.55 percent.
Despite these improvements, the company has raised its debt levels again in 2012 after reducing it in 2011 by using the proceeds used from the IPO to pay off debt. In 2011, the company's debt-to-capital ratio fell to 0.07, the lowest in the last five years and then increased to 0.52 in 2012. Regardless of the increase in debt to capital in 2012, the company still is at a significantly lower debt as compared to operation prior to the IPO. From 2008 to 2010, the company operated at an average debt-to-capital ratio of 1.84. The paying off of the previously accumulated debt and raising the new debt at lower rates has enabled the company to reduce its interest expense significantly over the years. The interest coverage of the company increased from 2.82x in 2008 to 39.12x in 2012. Thus the company has been able to significantly reduce its risk by curtailing the debt levels as well as increasing its interest coverage.
Source: OILT SEC Filings
The adjusted EBITDA has been calculated by excluding non-cash charges, interest expense, taxes, other incomes and other non-recurring items from the company's net earnings. As presented in the graph above, the company's adjusted EBITDA has generally followed the trends in its operating income. Adjusted EBITDA has increased at a CAGR of 19.2 percent over the last 5 years, with the company generating an adjusted EBITDA of $80.6 million in 2012 as compared to approximately $40 million adjusted EBITDA in 2008. Apart from a small dip in 2011 due primarily to lower revenues, the company's adjusted EBITDA margin has improved over the years. The 2012 adjusted EBITDA margin rose to 59.5 percent from 50.5 percent in 2008. This improvement in adjusted EBITDA margin has been achieved primarily through high growth in revenues and also through cost controls, as explained above. Even according to the latest reports for the six months ended in June 2013, the company's adjusted EBITDA increased by 50.4 percent as compared to six months ended in June 2012 while adjusted EBITDA margin increased to 67.3 percent as compared to 60.6 percent in the corresponding period last year.
Source: OILT SEC Filings
The graph above depicts the revenues of the three reported segments by the company and metrics related to the segments. Storage is the largest reported segment of the company with on average 73.5 percent of the revenues coming from this segment over the last five years, followed by throughput fees which accounts for on average 20.5 percent and lastly Ancillary revenues account for 6 percent on average.
Over the years, the company has invested heavily in order to increase its storage capacity and pipelines and these investments have paid off through mounting revenues in all segments. Thus, it is evident that the demand for the company's services is there as the installed capacity was quickly put into operation. Another dimension that speaks for the high of the company's services is the 95 percent customer retention rate which suggests that the existing customer base of the company is highly satisfied with its operations indicating that these customers will be willing to spend on more services from OILT as it expands its operations; thus as the company progresses, it will continue to experience growth in its revenues.
To reinforce, significant discounted trailing multiple and PEG ratio and potential for high growth were primary reasons to build an analysis. The current growth in investment hence will generate high returns for the company in the coming years. Although the company will continue to be dependent on its largest customers in the short term, however, in the long term, it is probable that the company will be able to expand its customer base.
Although the company is relatively undervalued based on its PEG compared to the industry. The company's PEG ratio is 0.76 as compared to the industry PEG of 1.29. Based on PEG of the company and the industry and expected earnings of next year, I have derived a target price of $59.95 which provides an upside potential of more than 17 percent.
I have also used current multiples of the company, the industry and some of its closest competitors in order to compare and derive a target price for the company's stock. The peers' multiples and valuation methodology are shown in the table below. As can be seen, the company is relatively undervalued on the basis of its P/E and P/S multiples. Whereas, OILT is overpriced on the basis of P/B and EV/EBITDA multiples.
Hence, I have assigned weights to the valuation multiples, which is based upon the importance of the multiples and general financial industry trends. A higher weightage is given to P/E and EV/EBITDA multiples as these multiples better incorporate the company's return generating capacity. Based on the company's ttm figures and industry multiples, the company's target price is calculated to be $62.81, displaying a return potential of more than 22 percent.
In order to further justify my recommendation for the company, I have also applied the dividend discount model because the company distributes a large proportion of its earnings to its shareholders.
In order to calculate cost of equity, I have used a market risk premium of 5.7 percent (consensus premium), a risk free rate of 2.64 percent (current yield on long-term treasury securities) and a beta of 0.55 (yahoo finance). The cost of debt is the weighted average cost of long-term debt outstanding of the company. Based on these figures, the company's WACC is calculated to be 5.61 percent.
I expect the company to continue growing its revenues through high capital expenditure and also to improve its margins through cost controls. I also expect the company to increase its dividend payout over the years, moving closure to the industry average of 90 percent. Based on these assumptions, I have derived a target price of $59.85, which is quite close to the fair value derived above from fair forward PE. This target price of the company provides with an upside potential of 16.7 percent.
In order to further support my calculations, I have carried out a sensitivity analysis of the calculated value by using various terminal growth rates and WACC. Changing these two factors provides a maximum upside of 213 percent while the maximum downside is calculated to be 26 percent. Thus, it is clear that the company provides a significantly greater upside potential than the downside risk. Given the valuation and careful scrutiny of the company's operations and financials, a buy recommendation should not be a surprise to the investors.