Don't Be Fooled By Teekay's Yield

| About: Teekay LNG (TGP)

Summary

Teekay boasts long-term, fixed-rate contracts that typically extend for 10-25 years and is well-positioned to capitalize on global demand for LNG.

Management points to a business that generates stable cash flows and is supported by long-term fee-based contracts, and we view these dynamics as two distinct positives for distribution health.

Long-term debt approaching $2 billion and hefty outlays associated with expenditures for equipment dampens our excitement around its payout. As with most MLPs, Teekay's distribution is dependent on capital markets.

Let's take a look at the firm's investment considerations as we attempt to uncover the drivers behind its Dividend Cushion ratio.

Retirees know that a dividend cut could be disastrous to their income portfolio, as future income is not only reduced, but it is also very likely that capital is permanently impaired. The Valuentum Dividend Cushion ratio, a very simple coverage metric, is designed to provide the income investor with a trusted and independent opinion of the safety and future growth potential of a firm's dividend. It not only has shown to predict dividend cuts, but the 'cushion' behind the Valuentum Dividend Cushion reveals just how much capacity a firm has to continue growing its dividend into the future.

Technically speaking, the Valuentum Dividend Cushion ratio considers the firm's net cash on its balance sheet (cash less debt) and adds that to its forecasted future free cash flows (cash from operations less capital expenditures) and divides that sum by the firm's future expected cash dividend payments over a discrete five-year period. At its core, it tells retirees whether the prized stock in their income portfolio has enough cash to pay out its dividends in the future, while considering its debt load. If a firm has a Valuentum Dividend Cushion ratio above 1, it can cover its dividend, in our view, but if it falls below 1, trouble may be on the horizon.

Let's take a walk through an assessment of Teekay LNG Partners (NYSE:TGP) dividend health in this article.

Key Investment Considerations

• 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. The firm boasts long-term, fixed-rate contracts that typically extend for 10-25 years and is well-positioned to capitalize on 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.

• We're not too fond of Teekay's weak free cash flow generation (CFO less all capex) and high financial leverage. Although this combination does not guarantee financial problems down the road, it could potentially be a recipe for disaster during tough economic times.

• We're building in some excellent revenue and 'earnings before interest' growth for Teekay, and shares are trading in line with our 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 future share issuance to (in part) fund dividend expansion.

Note: Teekay LNG Partners' dividend yield is far above average, offering a 11.6% annual yield at recent price levels. Though we prefer yields above 3% and generally don't include firms with yields above 2%, other factors keep Teekay from fitting the bill for addition to the Dividend Growth Newsletter portfolio. This article explains why.

Dividend Strengths

Teekay LNG's outsize yield is a huge draw for income investors, but our experience tells us that a yield in excess of 7%-8%, and particularly in excess of 10%, is likely not sustainable in the current prevailing interest rate environment of near-0%. Management points to a business that generates stable cash flows and one that is supported by a portfolio of long-term fee-based contracts, and we view these dynamics as two distinct positives for distribution health. The MLP's forward revenue from existing operations and growth projects are notable, but free cash flow trends (CFO less all capex) aren't the most comforting.

Dividend Weaknesses

Strong LNG trade growth through 2020 should help fuel demand at Teekay, but we're more concerned with the capital intensity of its business and the leverage it holds on the books. The MLP has a number of joint ventures, and charter contract terminations (e.g. Magellan Spirit) can impact internal measures of 'distributable cash flow' in any given period. Long-term debt that is approaching $2 billion and hefty outlays associated with expenditures for vessels and equipment dampens our excitement around its payout. As with most other MLPs, Teekay's distribution is dependent on the capital markets. Note: The analysis that follows is based on Teekay's raw, unadjusted Dividend Cushion ratio.

Dividend Safety

We think the safety of Teekay's dividend is poor. Hold on, let us explain. There are a couple important caveats with respect to MLPs that we want to talk about. Before we get into them, let's first walk through how we think about the concept of "dividend safety" as it relates to corporates. Then we'll expand how we make adjustments for the MLP business model. We provide two Dividend Cushion ratios for MLPs, one that is adjusted and one that is raw, unadjusted.

For corporates (not MLPs), we measure the safety of the dividend in a unique but very straight forward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Companies can also encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.

That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. For corporates (not MLPs), the measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.

As income investors, however, we'd like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend payer has in boosting the dividend in the future.

MLPs are Different in the Dividend Cushion Methodology

Though we tend to believe cash is cash regardless of an entity's business structure, we apply a modification to the raw, unadjusted Dividend Cushion ratio methodology that we defined above and that is used for corporates for MLPs.

The adjustments give MLPs a boost in the numerator of the construction of what we then describe as the adjusted Dividend Cushion ratio. Though the raw, unadjusted Dividend Cushion ratio is helpful in assessing balance sheet leverage and the capital market dependency of MLPs, when we speak of MLPs relative to corporates, we use an adjusted Dividend Cushion ratio.

In the adjusted Dividend Cushion ratio for MLPs, we systematically assume 20% of a MLPs net debt position can be refinanced given relationships with creditors, and as a result, account for only 20% of a MLPs net debt position. We also give a MLP credit for future equity issuance in the numerator. These changes result in a higher adjusted Dividend Cushion ratio than the "Bridge" and "Deconstruction" information shown below, which is based on the raw, unadjusted Dividend Cushion ratio.

In each one of the dividend reports on our website, we disclose both a MLP's 1) adjusted and 2) raw, unadjusted ratio, as we think both are meaningful. The first helps us convey that while the latter considerations are vitally important, as long as the capital market gives the MLP credit for its unencumbered assets and ability to raise capital, the dividend should be safe. The latter explains what might happen if those two conditions prove not to be true.

For Teekay, its adjusted Dividend Cushion ratio is 0.9 (remember this includes two important boosts), revealing that on its current path the is on par to covering its future dividends and growth in them with net cash on hand and future free cash flow (a ratio close to 1 speaks to that dynamic). However, Teekay's raw, unadjusted Dividend Cushion ratio is far below 1, suggesting that if the capital markets sour on MLPs, its capital-market dependency could become a severe hindrance to both its dividend but more importantly, its financial well-being.

Raw, Unadjusted Dividend Cushion Ratio Cash Flow Bridge

Note: This section corresponds to the raw, unadjusted Dividend Cushion ratio, not the adjusted one. We think looking at the raw financials, as if Teekay were still a corporate is quite informative, particularly in light of the publication of the adjusted ratio, which considers a number of relevant adjustments. Both have informative value.

The Dividend Cushion Cash Flow Bridge, shown in the image to the right, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Teekay's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.

Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.

Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend.

Note: Though not shown in this article, the Adjusted Dividend Cushion Cash Flow Bridge would include a boost from a reduction in net debt and from the proceeds of new equity issuance. The adjusted "blue bar" would be positive.

Raw, Unadjusted Dividend Cushion Ratio Deconstruction

Note: This section corresponds to the raw, unadjusted Dividend Cushion ratio, not the adjusted one. We think looking at the raw financials, as if Teekay were still a corporate is quite informative, particularly in light of the publication of the adjusted ratio, which considers a number of relevant adjustments. Both have informative value.

The Dividend Cushion Ratio Deconstruction, shown in the image to the right, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Teekay's numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.

Note: Though not shown in this article, the Adjusted Dividend Cushion Ratio Deconstruction would include a boost from a reduction in net debt and from the proceeds of new equity issuance.

Please note that to arrive at the Dividend Cushion score, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks." The below represents Teekay's raw, unadjusted Dividend Cushion ratio.

Dividend Growth

Now on to the potential growth of Teekay's dividend. As we mentioned above, we think the larger the "cushion," the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend.

To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we would characterize its future potential dividend growth as excellent. This is not the case for Teekay LNG's dividend, which we rate as very poor. We base this assessment "growth" assessment on the adjusted ratio, but we think the risks highlighted by the raw, unadjusted ratio shouldn't be completely ignored.

Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Teekay's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low. Our valuation assumptions for Teekay can be found on our website.

Wrapping Things Up

There is plenty to like about Teekay LNG Partners, particularly its long-term, fixed-rate contracts that typically extend for 10-25 years. We think the company is well-positioned to capture global demand for LNG moving forward. However, we are not particularly fond of its dividend, no matter how high the yield. Long-term debt of nearly $2 billion and sizeable capital requirements are the key reasons we think there are better dividend growth options available on the market. The increased risk of a coming interest rate hike does not benefit the MLP's dividend prospects, which are dependent on the capital markets.

Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion™. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. For more information about Valuentum and the products and services it offers, please contact us at info@valuentum.com.

Disclosure: I/we 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.

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