Dynagas: Another Well-Covered Preferred Yielding 10.4%

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About: Dynagas LNG Partners LP (DLNG), DLNG.PA, DLNG.PB, Includes: GLOP, GLOP.PA, GLOP.PC, HMLP, HMLP.PA
by: Rubicon Associates
Summary

For those investors who emphasize income, it is often difficult to find a high-yield investment that doesn't contain outsized risk.

While the shipping sector has gotten some traction lately, the yields continue as attractive.

I present you with one way to get a 10%+ yield, while mitigating the risk and volatility.

If you own the Series A preferred, there is a "swaportunity" for you.

Lately, I have been focused on maritime investments for both growth opportunities and yield. I have followed "shipping" (I will call it shipping although some may disagree technically) for some time and have had investments in the space for years (I started a long time ago with Frontline (FRO) and have been a fan ever since). My current focus is on LNG transport as I see the most stable growth in this sector over the next few years.

I recently wrote a research note on GasLog Partners (GLOP)(GLOP.PC) and I will continue the coverage with Dynagas LNG Partners (NYSE:DLNG).

Okay, I know the following note is long, but I try to provide enough information to get investors started down the road on a company. Please bear with the length.

Thesis

The thesis backing this recommendation is two-pronged.

The first prong is the demand growth for LNG. LNG demand growth was strong and broad-based during the first nine months of 2018, growing 7% over the same period of 2017, according to data from Poten. LNG demand growth was led by China which grew approximately 42% year over year or nearly 11 million tonnes per annum (“mtpa”) as the country continues to grow its natural gas usage as a percentage of its total energy consumption. Moreover, demand from South Korea, India, Pakistan and Taiwan grew by 14%, 20%, 63%, and 8%, respectively, or a combined total of approximately 10 mtpa. The outlook for future demand growth continues to be robust, with over 6% per annum projected for 2018-2023, and more than two-thirds of this demand growth coming from countries in South East Asia and Europe, according to estimates from Wood Mackenzie.

Headline spot shipping rates for TFDE LNG carriers as reported by Clarksons averaged $82,000 in the third quarter of 2018, compared to $42,000 in the third quarter of 2017. Rates continued to exhibit counter-seasonal strength through the third quarter of 2018, rising to $95,000 per day in late September from $78,000 per day at the beginning of the quarter. Since the end of the third quarter, spot rates have continued to increase, now assessed at $147,000 and approaching the record high as reported by Clarksons of $150,000 set in July of 2012 (source: GLOP quarterly report).

The second prong of the thesis is that LNG demand will be met with supply that needs to be transported, in large part, by maritime means. Due to the volatility and cyclicality of the maritime sector, the sector typically offers investors high yields upside potential (cycle-dependent, of course). High yields are not free, however, as voyage revenues can be volatile, debt can be onerous and related parties (one downside of the sector) often do not have investors' best interests in mind. The key is to find those companies that produce stable enough, and strong enough, distributable cash flow to cover their distribution requirements through the cycle. I believe Dynagas can provide investors with this strength.

It may seem like this note (as well as the GasLog) is late to the party, but I would rather leave a little on the table than eat a significant loss.

Company Description

Dynagas LNG Partners LP is a limited partnership focused on owning and operating LNG carriers. The company's fleet currently consists of six vessels that are currently employed or contracted to be employed on multi-year time charters (charters with an initial term of two years or more) with international energy companies, such as Gazprom (OTCQX:GZPFY) (BBB- / Baa3), Equinor (EQNR) (previously named Statoil ASA, ratedAA- / Aa3) and Yamal (a LNG project).

The company and its obligations are structured in the following manner:

Source: 9/18 company presentation

It is worth noting that Dynagas is a 1099 filer, not a K-1.

The Fleet

As of October 11, 2018, the fleet consisted of three modern steam turbine LNG carriers (the Clean Energy, the Ob River and the Amur River), and three modern tri-fuel diesel electric (TFDE) propulsion technology Ice Class LNG carriers (the Arctic Aurora, the Yenisei River, and the Lena River). As of October 11, 2018, the vessels in its fleet had an average age of 8.2 years and are contracted under multi-year charters with an average remaining charter term of approximately 10.0 years, including the charter agreements into which DLNG has already entered but whose terms have not yet commenced. As of October 11, 2018, the estimated contracted revenue backlog of the fleet was approximately $1.43 billion.

All of the vessels in its fleet other than the Clean Energy have been assigned with Lloyds Register Ice Class notation 1A FS, or Ice Class, designation for hull and machinery and are fully winterized, which means that they are designed to call at ice-bound and harsh environment terminals and to withstand temperatures up to minus 30 degrees Celsius. According to Drewry Shipping Consultants, Ltd., as of September 7, 2018, only 18 LNG carriers, representing 3.6% of the LNG vessels in the global LNG fleet, have an Ice Class 1A (11 carriers) or ice-class 1A super designation (7 carriers) or equivalent rating.

Dynagas also has the option to acquire four LNG carrier vessels from Dynagas Holdings ("Holdings) and the right to acquire from its Holdings its interest (49%) in each of the five entities that each owns a 172,000 cubic meter ARC7 LNG carrier, either on water or currently under construction. Sinotrans and China LNG Shipping equally split the remaining 51% ownership in the joint venture. Two of these vessels have been delivered to the JV and the remaining three are scheduled to be delivered in the first quarter of 2019.

The optional vessels have the following characteristics:

Source: Series B prospectus

And the additional optional vessels:

Source: Series B prospectus

The purchase rights relating to the Initial Optional Vessels each expired 24 months following the respective delivery of each Initial Optional Vessel from the shipyard, but were extended until December 31, 2018. The status of these options should be disclosed on the next quarterly call.

As stated earlier, DLNG currently has six vessels in its fleet. Vessel details are as follows:

Source: 9/18 company presentation

Shown differently:

Source: Series B prospectus

It is expected that Lena River will commence her 15-year contract with Yamal LNG between July 1, 2019, and December 2019, closer to July 2019.

The Arctic Aurora was delivered to Equinor in August 2018 under a time charter contact with a firm period of three years +/- 30 days. This charter is in direct continuation of the vessel’s previous charter with Equinor. Equinor will have the option to extend the charter term by two consecutive 12-month periods at escalated rates.

Unlike a growing percentage of the LNG tanker market, DLNG has no exposure to spot rates, instead focusing on longer-term contracts. While these longer-term contracts may not be as lucrative (currently), they do provide decent visibility for near-term revenues.

Financial And Distribution Review

Before looking at the investment opportunities available from the company, the condition of the financial should be reviewed and it should be determined how secure the company and the distribution are (as a cut in the distribution will reduce yield (for existing owners) and will typically cause a significant downward repricing in the common units). In order to do this, a look at the distribution relative to distributable cash flow is in order.

Source: author spreadsheet

The shipping sector has historically run into trouble when coming up against larger debt maturities (the debt wall). At 7.1x 12-month EBITDA and 72% of capitalization, DLNG is highly levered.

DLNG has The following maturities:

  • $250 million 6.25% senior unsecured notes due October 2019, and
  • $450 million secured Term Loan B with a May 2023 maturity

Source: company presentation

In October of 2018, the company completed a $55.0-million public offering of preferred units whose proceeds were slated for 2019 debt funding. While $250 million is a decent debt slug to overcome, I believe the company will be able to refinance this amount through the preferred market, secured term loan market, 2nd lien notes or a private placement.

The existing 2019 bonds trade as if there is no distress:

Source: author spreadsheet

The company has maintained that it is focused on reducing the leverage of the organization.

From the second quarter earnings call:

Capital structure is very important to us and longer term focusing on improving leverage metrics will be a top priority.

From the third quarter call:

With respect to the refinancing of our $250 million unsecured notes, we are exploring a number of alternatives and are keeping all of our options opened. As part of this exercise, we’re currently performing a strategic review, which will also encompass our financial objectives with respect to improving our financial credit profile, our liquidity and growth prospects.

From a distribution coverage standpoint, the preferred distribution has a healthy coverage ratio of 4.4x as of 9/30/18 and 2.6x if the December Series B is included as a full third-quarter preferred dividend with no use of proceeds considered. The equity is covered 0.7x (net of preferred) by DCF as of 9/30/18 and would be covered 0.5x if the December Series B is included as a full third-quarter preferred dividend with no use of proceeds considered. The common dividend was cut in the first quarter of 2018 in order to create a sustainable dividend, but the current share price seems to discount the sustainability of the lower dividend. That said, drydocking and special survey costs in the second and third quarter were higher than normal, which resulted in lower coverage ratios. Had the company been running at its average $11mm DCF/q, common unit coverage ratios would have been 1.08x and 0.95x, respectively.

Due to the current coverage level and focus on deleveraging, I am not sure how DLNG will be able to option the additional four vessels from the parent. Until there is more clarity on this, I will assume the fleet will be limited to the existing six vessels and, therefore, growth will be constrained.

As the coverage ratio on the common is a bit skinny (although I think it will be maintained and I took a smaller position in the equity as a result), the investment opportunity that I will review is the preferred stock - which is more risk-aligned with many investors.

A good summary of concerns regarding the common dividend can be found in this article, with some strong color in the comment section (@billgatesisevilus love the color you always provide).

The company has also spoken to this over the last few quarters. From the second-quarter 2018 call:

I think we've been quite clear from prior conference calls that the distribution coverage is going to be below 1, but that this is not the relevant to the distribution levels. So the distribution, the current distribution, the new distribution of $0.25 a quarter is safe. We don’t - we’re unaffected by the fact that we're trading below onetime distribution coverage because if you look at the cash coverage, on a cash coverage basis, we're trading above 1 times and we also have adequate liquidity to pay that current distribution.

Preferred Stock

Dynagas LNG Partners has the following series of preferred stock outstanding: Source: author spreadsheet

Which has the following pricing:

Source: author spreadsheet

From the table above, my choice is clear, the Series B (DLNG.PB). The Series B has the following advantages over the Series A (DLNG.PA):

  1. Higher stripped yield (10.73% vs. 9.53%).
  2. Greater call protection (2023 vs. 2020).
  3. Fixed to float structure rather than fixed (the floating rate is LIBOR plus a spread of 559 bps). This limits the duration impact.
  4. Lower dollar price ($20.39 vs. $23.61).
  5. Higher yield-to-call (14% vs. 13%), and
  6. Higher volume traded.

It is rare the choice is so obvious - or perplexing. I can find no difference - fundamentally - for the difference in yield/price between the series. The Series A is a fixed rate with no rate adjustment and the B is pari passu with the As. One might think it is because the Series A is callable next year, but the chance of it calling the preferred seems slim as to lower its cost of capital, it would have to issue more debt despite the fact it wants to delever. I would posit that the company would rather keep the 9% rate of the Series A in place and buy optional vessels.

The price between the Series A and Series B (and the spread):

Source: author spreadsheet

The stripped yield of the Series A and Series B (and the spread):

Source: author spreadsheet

Bottom Line: The Series B seems like a no-brainer here unless I have missed something fundamentally different between them.

Of course, there are options available to investors in shipping - both in the LNG sector and the broader market.

Source: author spreadsheet

As the table above shows, the Dynagas Series B is now the highest yielding preferred in the LNG sector.

Interestingly, the Dynagas Series A has rallied significantly and is now trading closer to "in-line" with peers, while the Series B has not.

The DLNG Series A versus the GasLog Partners Series A (GLOP.PA):

Source: author spreadsheet

A similar trend is seen in the spread between DLNG Series A and Hoegh Partners (HMLP) Series A (HMLP.PA):

Source: author spreadsheet

It is often helpful to look at the yield spread between preferred and common stock. The spread is a balance between the preferred's lack of upside versus the common (and voting rights) and the stability of the preferred dividend (as it has a stated rate, although it still has to be declared).

The shipping sector has preferred stocks with yields commonly below the equity due to the stability of the dividends and the greater cushion (distributable income coverage). DLNG is currently no different, but it is somewhat extreme. It is semi-attractive at this level versus its historical relationship and versus peers.

Source: author spreadsheet

Spread to equity graphically:

Source: author spreadsheet

NOTE: the DLNG spread has been curtailed at 5% in the graph in order to maintain a semblance of scale on the chart.

Over the last month, the DLNGpB has outperformed the peer group:

Source: author spreadsheet

It was driven, in large part, by the last week:

Source: author spreadsheet

Preferred Bottom Line: I like the DLNGpB and see no reason it trades where it does relative to the Series A or the sector. While the preferred has rallied (along with the common), I believe there is still value at these prices.

The equity has been either horrific or splendid, depending on when you bought it (recent buyers are on the splendid side).

Source: author spreadsheet

Recall that in the fourth quarter of 2018, the table looked significantly different where DLNG was concerned (from my GLOP note):

Source: author spreadsheet

The underperformance (and subsequent snap-back in the common) is shown in the following chart.

Chart DLNG data by YCharts

The dividend yield, despite the snap-back, is still monstrous - primarily as the sustainability of the distribution is being questioned.

Chart DLNG Dividend Yield (TTM) data by YCharts

Bottom Line: The equity is a riskier play on the name as the distribution has been questioned. For most investors, the preferred stock is the way to go, offering over a 10% yield and well covered by DCF. While the preferred has risen over the last week, we can't trade the past, we can only trade the future. Looking forward, I believe that the Dynagas Partners Series B preferred offers a compelling value for investors and believe current valuations warrant an Overweight rating.

True "at risk, high risk" capital might also consider the common units as the company could continue to maintain the distribution, which could result in a 50% upside.

Helpful Links

Series B preferred term sheet

Series B preferred prospectus

Series A prospectus

September 2018 company presentation

9/30/18 Earnings and financials

9/30/18 Earnings slide deck

2017 20-F

Dynagas (GP) "about us" presentation

The Yamal LNG Project:

Yamal refers to the LNG production terminal on the Yamal Peninsula in Northern Russia utilizing the resources of the South Tambey field. The South Tambey Field Development License, held by Yamal LNG, is valid until December 31, 2045. The terminal consists of three LNG trains with a total capacity of 16.5 million metric tons of LNG per year, that will require ice-class designated vessels to transport LNG from this facility, and for which two of the vessels in DLNG's fleet and each of the optional vessels have been contracted. The Yamal LNG Project is a joint venture between NOVATEK (50.1%), TOTAL E&P Yamal (20%), China National Oil & Gas Exploration and Development Corporation (CNODC) (20%) and Yaym Limited (9.9%).

The field’s proven and probable reserves, by PRMS standards, are estimated at 926 billion cubic meters.

Disclosure: I am/we are long HMLP, HMLP.PA, DLNG, DLNG.PB, GLOP.PC, GMLPP, CMRE, CMRE.PC. 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.

Additional disclosure: At current prices, I will initiate a position in the DLNGpB.