Teekay Offshore: Better Support Was Sold Off; An 11%+ Yield Opportunity

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About: Teekay Offshore Partners L.P. (TOO), TOO.PA, TOO.PE, Includes: BBU, DLNG, GLOP, TNP, TNP.PE
by: Rubicon Associates
Summary

Teekay Offshore cut its common dividend to zero in order to shore up their balance sheet and fund growth.

The equity shrugged the news off, the preferred stock did not. The preferred sold off.

My thoughts on the preferred stock of Teekay Offshore Partners.

RISK WARNING: The following preferred stock update concerns an offshore maritime midstream company which is higher risk and has an above average probability of loss. This has to be stated upfront. Conservative or risk-averse investors may not want to continue reading or to read the note with this fact in mind.

Okay, I feel like the surgeon general for the risk warning, but I believe it is appropriate. The following is about a company I am long (common and preferred) and I noticed an interesting price action which I believe warrants mention and consideration for at risk/high risk capital.

Teekay Offshore (TOO) is an international midstream services provider to the offshore oil production industry focused on the ownership and operation of critical infrastructure assets in offshore oil regions of the North Sea, Brazil and the East Coast of Canada. TOO operates shuttle tankers, floating production, storage and off-loading ("FPSO") units, floating storage and off-take ("FSO") units, a unit for maintenance and safety ("UMS"), long-distance towing and offshore installation vessels and conventional crude oil tankers. As of September 30, 2018, their fleet consisted of 36 shuttle tankers (including six newbuildings which are scheduled for delivery in late-2019 through 2021, two chartered-in vessels and one HiLoad Dynamic Positioning unit), eight FPSO units, six FSO units, ten long-distance towing and offshore installation vessels, one UMS and two chartered-in conventional oil tankers, in which their interests range from 50% to 100%.

In September 2017, affiliates of Brookfield Business Partners L.P. (BBU) purchased from Teekay Corporation a 49% interest in TOO's general partner and purchased approximately 60% of their common units and certain warrants to purchase additional common units. In early-July 2018, Brookfield exercised its option to acquire an additional 2% interest in the GP. After exercising this option, Brookfield holds 51% of the GP interest and has the right to appoint a majority of the members of the Board. Teekay Corporation will continue to have the right to appoint two members of the Board so long as it owns at least 10% of the outstanding common units. These transactions were part of a comprehensive solution intended to strengthen their balance sheet and fully fund their existing growth projects.

The scared straight chart (otherwise known as a five year chart of TOO equity):

Chart TOO data by YCharts

Teekay Offshore has clearly underperformed their market.

Teekay is down nearly 50% over the last year - again underperforming their broader market:

Chart TOO data by YCharts

Recall that what got TOO in trouble (primarily) was their leverage (as happens all too often in the sector) and the possible debt wall. When reading the 2018 third quarter 10-q, one would have read the following:

Despite generating $75 million of cash flows from operating activities during the nine months ended September 30, 2018, the Partnership had a working capital deficit of $426 million as at September 30, 2018. This working capital deficit primarily relates to the scheduled maturities and repayments of $556 million of outstanding debt during the 12 months ending September 30, 2019, which amount was classified as current as at September 30, 2018. The Partnership also anticipates making payments related to commitments to fund vessels under construction during 2018 through 2021 of approximately $795 million.

And seen the following:

Source: company Q3 10-q

The simple truth is that the $75 million of CFO would barely make a dent in their debt payments (which, incidentally, didn't include the $165 million to service outstanding debt) and the loan market has been curtailed as banks have left the business. This is where having Brookfield as a GP came in very handy. From their July 2018 release:

Teekay Offshore Partners L.P. announced today the pricing at par of its previously announced private placement of 8.5% senior unsecured notes due 2023. The Partnership upsized the offering amount from $500 million to $700 million in aggregate principal amount. Brookfield has agreed to purchase $500 million principal amount of the Notes in the Offering.

The private placement shifted a large amount of their 2019 debt to 2023 and helped lower the debt/obligation wall:

Source: Q3 company presentation

This is not to say that the company is out of the woods yet, it still has newbuilds to pay for (emphasis mine):

In 2017, the Partnership entered into shipbuilding contracts with Samsung Heavy Industries Co., Ltd. to construct four Suezmax Dynamic Positioning 2 (or DP2) shuttle tanker newbuildings, for an aggregate fully built-up cost of approximately $601 million. Upon expected delivery in late-2019 through 2020, these vessels are to provide shuttle tanker services in the North Sea, with two to operate under the Partnership's existing master agreement with Equinor, and two to operate directly within the North Sea CoA fleet, which will add vessel capacity to service the Partnership's CoA portfolio in the North Sea. As at September 30, 2018, payments made towards these commitments were $63.3 million and the remaining payments required to be made are estimated to be $26.7 million (remainder of 2018),$321.5 million (2019) and $189.0 million (2020). The Partnership expects to secure long-term debt financing related to these shuttle tanker newbuildings.

In July 2018, the Partnership entered into shipbuilding contracts with Samsung Heavy Industries Co. Ltd., to construct two Aframax DP 2 shuttle tanker newbuildings, for an estimated aggregate fully built-up cost of $270 million. These newbuildings are also being constructed based on the Partnership's new Shuttle Spirit design. Upon delivery in late-2020 through early-2021, these vessels will join the Partnership's CoA portfolio in the North Sea. As at September 30, 2018, payments made towards these commitments were $11.9 million and the remaining payments required to be made are estimated to be $0.6 million (remainder of 2018), $55.9 million (2019), $122.7 million (2020) and $78.7 million (2021).

And the icing on the cake came on January 8, 2019 (emphasis mine):

Teekay Offshore GP LLC, the general partner of Teekay Offshore Partners L.P., today announced that the Partnership is reducing its quarterly common unit cash distributions to zero, down from $0.01 per common unit in previous quarters, in order to reinvest additional cash in the business and further strengthen its balance sheet. There are no changes to the quarterly cash distributions relating to any of the Partnership's outstanding preferred units, which were declared today and announced under a separate news release.

The result:

Source: author spreadsheet

The common shares essentially shrugged off the news, as they went from a token distribution to no distribution (doesn't hurt the majority owner made the move). The preferred shares, however, dropped over six percent. The company cut its common dividend and reaffirmed their preferred dividend. This creates a bigger cushion for the preferred stock and it sold off over six percent. Nothing else changed, the cushion got bigger and the preferred sold off.

Time to look at the preferred stock.

Teekay Offshore has the following series of preferred stock outstanding:

Source: author spreadsheet

The outstanding series have the following market characteristics:

Source: author spreadsheet

From the tables above, my preferred choice is the Teekay Offshore 8.875% Series E fixed to float perpetual preferred (TOO.PE). Up front and out loud, I am long the Series E preferred and the common (the preferred position dwarfs the common by 8x).

I chose the Series E for its higher stripped yield, fixed to float structure and longer lock-out period until the optional redemption. The Series A (TOO.PA) trades $2.50 lower on dollar price, but I will not sacrifice yield at the altar of dollar price.

The TOO preferred stripped yield, graphically:

Source: author spreadsheet

The TOO preferred price, graphically:

Source: author spreadsheet

If the choice was between the two higher yielding preferreds of TOO, we would see the following stripped yield relationship:

Source: author spreadsheet

Based on the relationship between the two, the Series E is trading near its yield wides compared to the Series B. Cheaper is always better.

Of course, investors have other investment options and TOO should not be considered in isolation. The following table lists other companies involved in maritime midstream as well as product tankers.

Source: author spreadsheet

As the table above, and charts below, show, TOO is one of the highest yielding names of the peer group - second only to Tsakos Energy (TNP), (TNP.PE). While the business lines of the various companies above are not always similar (actually, TOO is kind of a unique beast in the group), the sector comparison should help put things in a greater context.

The stripped yields, graphically:

Source: author spreadsheet

The stripped price, graphically:

Source: author spreadsheet

All the companies listed have their own stories and profiles and attendant risk profile. I recently wrote on Dynagas (DLNG) and Gaslog Partners (GLOP) which have lower yields, but I like the sector better. That said, I am a fan of diversification and own those and others in the maritime industry. Don't let the higher yields available limit your exposure to only the highest yielding.

Earlier I mentioned that Tsakos Energy Series E was higher yield than TOO. The following charts show how they compare (keep in mind their business are different).

Price basis:

Stripped Yield basis:

As the charts show, the price action in TOO's preferreds (in this case the Series E) removed a significant amount of the yield differential between TNP and TOO, with the spread dropping from the recent wide of 144 basis points to the current 55 basis points.

The perceived "riskiness" of an investment can often be viewed in its spread to the risk-free rate (I use the 10 year Treasury). The following table and charts show the peer group spread to the risk-free rate.

Source: author spreadsheet

Graphically:

Source: author spreadsheet

As the following chart illustrates, TOO's spread to the risk-free rate has narrowed, even after the sell-off today.

Source: author spreadsheet

It is often helpful to look at the return on the first loss piece (the equity) to get a sense of the market's perception of the company and the sector. As the following table shows, shipping had a tough year during 2018 but is up significantly over the last three years (the volatility in the sector can be significant):

Source: author spreadsheet

Graphically, the one-year total returns:

Source: author spreadsheet

And the year-to-date total returns:

Source: author spreadsheet

Bottom Line: While Teekay Offshore is a higher risk company with challenges ahead of it, I believe the preferred is safe over the near-term and the price action on the equity dividend elimination could provide a good entry spot into the name. Ultimately, Brookfield has shown themselves to be a strong sponsor of the company (they did $500mm of unsecured notes rather than 1st or 2nd lien) and I believe they have bigger plans for the company (relying on them completely, however, is not the reason to invest in TOO, it ultimately has to be premised on the viability of the company itself). That said, limit orders are important to use in preferred stocks and I don't foresee a "snap-back" in the preferred shares, so time is on your side in terms of execution. It is often wise to leg into volatile positions, and that is how I have established my position in the name.

The Partnership has elected to be treated as a C-Corporation for tax purposes (investors receive the standard 1099 form and not a K-1 form).

HELPFUL LINKS

2018 Q3 presentation

2018 Q3 financials

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