Why Teekay Remains Dependent On Future Equity Issuance

May.29.14 | About: Teekay LNG (TGP)

Summary

We're building in some excellent revenue and "earnings before interest" growth for Teekay, and shares are trading at the high end of the estimated fair value range regardless.

We don't think the company offers investors an interesting valuation proposition.

Teekay's distribution strength is dependent on the healthy functioning of the capital markets. We're modeling in low-quality future share issuance to (in part) fund dividend expansion.

The only reason Teekay (NYSE:TGP) is on investors' radars is that the firm has a 6.3% annual distribution yield. The MLP, like its brethren, is dependent on the healthy functioning of the capital markets for future equity issuance to fund its dividend. This is all well and good as long as the capital markets are healthy, but we wouldn't want to be holding shares during the next economic downturn, nor would we like to hold them under any global adverse credit scenario. Investors are effectively being paid back their own money with the hefty distribution, and this simply isn't enough for us to get excited, especially considering the company's valuation. Let's take a look at our thesis on the shares in this article.

But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolio. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Teekay posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. In general, we prefer equities that register a 9 or 10 on the Valuentum Buying Index (or the equivalent of a "we'd consider buying" rating). Many of these firms are held in the Dividend Growth portfolio.

Teekay's Investment Considerations

Investment Highlights

  • Teekay LNG Partners is the third-largest independent owner of LNG carriers. The firm is a publicly-traded master limited partnership that provides LNG and crude oil marine transportation services. It boasts long-term, fixed-rate contracts that typically extend for 10-25 years, and is well-positioned to capitalize on the global demand for LNG.
  • Teekay indicates that its liabilities are matched to contracts, with the firm's repayment profile of principal matching its revenue stream. However, there exists quite a bit of operating and financial risk in its business, more than we are comfortable with.
  • Teekay's cash flow generation is about what we'd expect from an average company in our coverage universe. However, the firm's financial leverage is on the high side. If cash flows begin to falter, we'd grow more cautious on the firm's overall financial health.
  • We're building in some excellent revenue and "earnings before interest" growth for Teekay, and shares are trading at the high end of the estimated fair value range regardless. We don't think the company offers investors an interesting valuation proposition.
  • Teekay's dividend strength is dependent on the healthy functioning of the capital markets. We're modeling in low-quality future share issuance to (in part) fund dividend expansion. Investors should note that financing activities, such as debt issuance and share issuance, are non-operating transactions (and do not generate economic value). See examples of the firm's recent equity issuance here and here. We don't think holders of Teekay's equity care too much about its underlying valuation, and perhaps are too focused on the firm's contract structure and distribution yield. We think this will come home to roost eventually.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Teekay's 3-year historical return on invested capital (without goodwill) is 4.3%, which is below the estimate of its cost of capital of 8.9%. As such, we assign the firm a ValueCreation™ rating of POOR. However, we're expecting some improvement in its economic returns in the years ahead. In the chart below, we show the probable path of ROIC, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Teekay's free cash flow margin has averaged about 2.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com.

Valuation Analysis

Our discounted cash flow model indicates that Teekay's shares are worth between $26-$44 each. Shares are trading at nearly $44 each at the time of this writing. The fair value range is admittedly wide, but the company has a mountain of debt (which adds significant enterprise risk). The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $35 per share represents a price-to-earnings (P/E) ratio of about 12.3 times last year's earnings and an implied EV/EBITDA multiple of about 17 times last year's EBITDA. At the risk of stating the obvious, Teekay's shares are trading materially higher than our fair value estimate of them. Our model reflects a compound annual revenue growth rate of 4.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.2%. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.5% for the next 15 years and 3% in perpetuity. For Teekay, we use an 8.9% weighted average cost of capital to discount future free cash flows. We award Teekay a below-average discount rate due to its relatively stable performance.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Teekay to peers SEACOR Holdings (NYSE:CKH) and Kirby Corp. (NYSE:KEX), among others. Teekay's valuation multiples are simply off the charts relative to peers', supporting its unattractive relative valuation assessment.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $35 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Teekay. We think the firm is attractive below $26 per share (the green line), but quite expensive above $44 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Teekay's fair value at this point in time to be about $35 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Teekay's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $39 per share in Year 3 represents our existing fair value per share of $35 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.