This is a guest article from Darren McCammon. Darren runs the highly successful Cash Flow Kingdom on Seeking Alpha. We are paying-members of Darren’s service, and appreciate the high quality investment ideas he shares. This particular article is about an attractive, taxed-advantaged, maritime shipping company that currently offers a yield in excess of 10%.
What follows is Darren's write-up about...
Capital Product Partners (CPLP), Yield: 10.5%
Guest Article: Sailors Delight, a 10%+ tax advantaged distribution
- Capital Product Partners offers a well-covered attractive dividend and is expected to release Q2 earnings sometime during the week of July 27th.
Message from Darren: I’ve been a long-term member of Blue Harbinger Research and am thankful for the excellent coverage here which helps to provide diversity for my own personal portfolio. In appreciation for the great suggestions I’ve received, I’d like share one of my better ongoing ideas, Capital Product Partners. If you’d like to see more opportunities like these in the future, please consider joining us at Cash Flow Kingdom. We focus on small cap companies with strong, sustainable cash flows, some of which also have good growth potential. Feel free to send a private message anytime and I’ll be sure to answer any comments below as well. Note: I plan on releasing this article publicly on Seeking Alpha this weekend.
General Market Overview
Energy is a critical resource which is normally produced far from where it's refined and consumed. For all the talk about alternative energy sources over 80% of the worlds energy consumption remains from fossil fuels with world oil consumption continuing to grow at a steady pace.
Source: US Energy Information Administration ‘EIA’
Because of this, pipelines, tanker ships, and other critical infrastructure in the energy value chain continues to be in demand. Companies which supply energy transportation and services are commonly referred to as "midstream" companies because they are in the middle between the "upstream" producers and the "downstream" end product sellers and consumers. Generally speaking, pipelines are used to transport oil, natural gas, and other energy products within a given region. Tanker, LNG and product ships are used for trade between regions of the world. While energy service and equipment companies are the necessary glue that allow the whole process to happen.
Source: Teekay Tankers website
Popular publicly-traded pipeline names include Enterprise Product Partners (NYSE:EPD), Magellan Midstream Partners (NYSE:MMP) and Kinder Morgan (NYSE:KMI). However, if you like the 4-6% distributions typically available from these U.S.-based midstream companies, you might really like the 10% distribution currently available from Capital Product Partners especially since 2/3rds of this distribution was tax deferred last year.
Source: CPLP website
Investors tend to think of CPLP as a product tanker company because from a number of ships point of view that category dominates; however, when you look at either deadweight volume ‘DWT’ or revenue produced you will see it is actually more diverse. Furthermore, by maintaining fairly diverse shipping types as well as staggered lease expirations, CPLP seeks to mute the inherent volatility in the shipping industry, seeking to stabilize cash flows and hopefully also distributions (more on this later).
- Product tankers are used to transport refined oil products (gasoline, diesel, kerosene, jet or fuel oil) to the market. They range in size from 5,000 DWT (Deadweight Tonnage) to around 80,000 DWT. One traditional trading route for product tankers is between North America Gulf State refineries and Europe. An increasingly interesting new route if from newly built refineries in the Middle East to various Asian ports of call.
- Crude tankers are mainly used for the deep-sea transport of crude oil from production sites to refineries. They range in size from 55,000 DWT up to around 450,000 DWT. The main trading routes are from the production areas in the Arabian Gulf and West Africa to China, the rest of Asia, and Europe. More recently, crude exports are also starting to come out of the US ports along the Gulf of Mexico. This source of transportation demand is expected to provide a lot if not most growth in the sector in the middle term but is currently being bottlenecked by a lack of infrastructure (both in port facilities and pipeline capacity).
- Container ships transport standardized steel containers throughout the world. These are then typically trans-loaded on to trucks and trains for transport to their final location. A standardized container may be filled with finished goods from a factory in China, transported via ship, then rail, then truck to finally be unloaded at your local Wal-Mart (It's really an amazing process when you think about all the canals, overhead power and telephone lines, equipment, bridges, etc. throughout the world which have been built or modified to allow efficient transport of these containers). Container ship rates were at new highs prior to the 2008 crash but fell drastically when that crash caused consumer demand to plummet. Recently lease rates have been improving but are threatened by the possibility of a US – China tariff war.
- Dry bulk carriers transport bulk items like iron ore, coal or grain from one region to another (example iron ore from Australia to China). Dry bulk rates also crashed during the Great Recession, have subsequently improved, but now may be challenged by a potential trade war (or not?).
It is much less clear how much a trade war would hurt dry bulk rates in the short term. In the long run, recession would decrease demand in general and therefore transport. However, in the short term it may be more a reconfiguration of routes than less actual ton-mile demand. For example, assume the US supplies a load of soybeans to China, while Brazil supplies a load of them to Argentina. If China instead orders them from Brazil someone is going to need to fill the Argentina order that has been displaced. That someone could be the US. In this example, the ton miles demanded actually increases mainly because the US to Argentina route is longer than the Brazil to Argentina route while the US to China and Brazil to China routes are about the same.
- LNG carriers carry liquified natural gas. In my opinion, worldwide LNG transportation demand is in a secular uptrend due to technological improvement (fracking, FSPO's, FLNG's, etc.) and environmental concerns leading to increasing sources of supply, demand, export, and import. Typical routes are Qatar, Australia, and increasingly the US to Asia. Capital Product Partners does not currently have any LNG ships; however, its parent Capital Maritime ‘C-Mar’ recently signed a letter of intent for up to ten newbuilds. Some of these may eventually find their way to CPLP as drop-downs.
Similar to pipelines, although shipping stock frequently move up and down with energy prices, shipping lease rates actually have little to do with the price of the product being transported. Rather it is the ton-miles demanded (a ton-mile is one ton of something moved one nautical mile) and supplied which primarily affect shipping transportation rates. It's like owning a bridge or toll road. The toll taker, CPLP in this case, doesn't care if it’s a beat up old Pontiac or a Lamborghini seeking to use its service it just cares that that someone wants to get from A to B and is willing to pay for it. Supply and demand for ships and alternatives of transport available are what mostly affect the price negotiated in shipping contracts. In the case of CPLP these are typically one-year to multi-year contracts signed with various customers, though they currently also have a few ships on spot (spot is a contract for one specific voyage only).
Source: CPLP website
As you can see from the chart above, the net effect is a staggering of lease expiration periods. Importantly, and more than most other shipping companies, this makes it unlikely one will ever see revenues fall off a cliff and helps ensure relative stabilization in overall cash flows.
Evangelos Marinakis owns over 17.7% of CPLP shares. Normally this would produce very good alignment. However, in this case these shares are owned by Capital Maritime, the parent of CPLP, which in turn is 100% owned by Mr. Marinakis. Since Mr. Marinakis is a billionaire, an $70 million+ stake in CPLP might not be that significant a portion of his overall net worth.
Thus, while I feel there is generally good alignment; there can be potential conflicts when the interests of the parent do not necessarily correspond with the best interests of CPLP.
An obvious example of potential mis-alignment, as it would be with any external manager parent, is the pricing of drop-downs. The parent benefits from higher priced drop-downs, the child from a lower. Though theses drop-downs go through an independent committee review, it behooves us as investors to also check that they are being done appropriately (so far, they have been).
A more concerning example of misalignment for me has been CPLP not using excess cash flow to buy back shares. CPLP has periodically had both excess available cash flow, and a 25%+ CAD yield. In such a situation the obvious best choice is not to pay a distribution, drop-down ships, nor pay down debt, but instead to capture that 25%+ guaranteed yield via share buybacks. Unfortunately, however this is not what has happened, in fact the exact opposite.
Share buybacks don’t help Capital Maritime, at least not directly, because they shrink CPLPs capital and use it for purposes other than drop-downs. Since Capital Maritime owners likely see CPLP primarily as a financing vehicle for ship drop-downs, not a stock to maximized, buybacks likely defeat their original intent. Indeed, management chose to do the exact opposite, issuing a small amount of shares via ATM in order to facilitate refinancing and drop-downs rather than buying shares back (6% dilution over the last three years).
It is unclear to me whether management intends to continue to use the ATM. I think we have to assume so until we hear otherwise. This is very unfortunate, because it neither maximizes CPLP potential nor really serves a purpose for Capital Maritime. Traders such as myself quickly realized CPLP was issuing shares in the $3.60 range and sold just prior to this range being achieved. We then proceeded to try to sell in front of each other, causing the shares to slowly enter a downward triangle formation with a hard stop near $3, where it seems to remain today. Thus, the ATM has served little purpose for CPLP as far as I can tell, but it still remains and, in my mind, caps the upside on the stock. This however doesn’t prevent me from enjoying a 10%+ tax advantage distribution while I wait for something more conducive for share appreciation to occur. If for instance management simply stated they no longer had any intention to utilize the ATM at prices below NAV, I think the shares would quickly break above $4. My current fair value target is $4.10, but it could easily exceed that value if shipping lease rates start to improve.
CPLP has IDR’s, but the 8¢ distribution is nowhere near the 25¢+ range necessary for them to really kick in.
I still mention them however because were CPLP and Capital Maritime to one day recombine, there would be some value assigned to these IDR’s (CPLP could easily exceed $1 in DCF generation in an improving ship lease rate market). Also, in a somewhat counter-intuitive way, the IDR’s actually discourage significant near-term distribution increases. From management’s point of view, it may be better to let cash flows continue to increase potential, waiting until the company can take the distribution above 25¢ per share in one fell swoop, before doing anything significant with it.
A number of external factors in combination have served to drive down the price, and eventually the distribution, of CPLP despite respectable ongoing business fundamentals.
The chart above shows CPLPs price per share, Cash Available for Distribution per share ‘CAD’, and its actual dividend since the beginning of 2014. As you can see the price of CPLP (green line) began falling in Q2 2014 despite the Distribution per share (dotted blue line) and CAD (solid blue line) both being reasonably steady.
This decline in stock price was caused first by a sharp fall in oil prices which resulted in investors indiscriminately selling off sector stocks regardless of how effected they actually were by oil price declines. CPLP's price fell over 30% in the beginning of the oil crash despite its revenues, profits and CAD continuing to hold up (again thanks to longer-term, staggered leases, whose rates having almost no correlation with oil prices). A fear of Grexit also caused skittish investors to further sell off anything Greek sounding, even when such an exit would be very unlikely to have any effect. Later, a fear that the US opening up crude exports might lead to lower lease rates for product carriers, and a more valid concern that five lucrative Hyundai Merchant Marine (HMM) containerships contracts might go into default affected the stock’s price (HMM ultimately gave CPLP over $29 million worth of HMM shares in order to buy down the rate on these contracts for a period of time).
For these various reasons, from the second half of 2014 to the beginning of 2016 CPLPs price fell from over $10 per share to under $3 per share despite CPLP continuing to issue 93¢+ per share in annual dividends covered by over $1 in CAD. Let me restate that again for emphasis, CPLP shares fell over 70% in price, despite cash flows and CAD per share remaining essentially at the same 25¢+ per quarter every quarter the entire time (please see chart above again).
Eventually in Q2 2016, management decided enough was enough and cut the distribution from 24¢ to 7.5¢ per quarter (a similar 70%) using the potential of lost HMM revenues as an excuse. (Note: the final deal with HMM was actually a benefit to CPLP, netting them over $29 million upfront which was used for debt paydown.) This is my opinion, but I think management essentially gave up on fickle shareholders, figuring if they weren’t going to be rewarded for paying out a high dividend, they might as well not pay it. Instead they cut the distribution and used the excess cash to pay down debt and drop-down ships instead. As we have subsequently seen with many other MLPs, management decided to make the company’s operations self-funding.
And that essentially brings us to where we sit today with CPLP shares oscillating in a $3 - $3.50 trading range, or a 9-11% distribution yield. While CPLPs CAD has declined a bit this year due to a combination of the HMM deal reducing quarterly cash flows, share count going up 6% via ATM share issuance, and general shipping lease challenges (particularly for crude shipping lease rates), CPLP continues to retain the ability to pay more than twice the current distribution.
Also contributing to CPLPs tendency to be undervalued is management systematically understating CAD.
Most companies calculate CAD as net income + depreciation and amortization - preferred payouts. Under this formula CPLP’s distribution coverage is stellar, even excessive. Last quarter’s 18¢ CAD calculated under this formula was also negatively affected by: 4 special survey’s, greater one-time repair costs than normal, and an unplanned, expensive prolonged ballast leg taken by a ship being sold. However, even with these high one-time costs, CAD still exceeded the 8¢ quarterly distribution by more than 2x. This in the worst quarter CPLP has had in more than three years.
Source: 10Qs and Authors calculations
CPLP however does not calculate CAD in the way I just stated; the way most companies do. Instead they choose to apply first a Capital Reserve charge (blue arrow below), and then a Recommended Reserve charge (green arrow below) before finally arriving at reported CAD.
If you do the math, the Capital Reserve charge (green arrow) originally appears to have been designed as sufficient to pay off all debt by the time the ships turned 15 years of age. Or put another way, all debt could be paid off in less than 4 years if you actually used this Capital reserve plus the scrap value of the fleet to pay it off.
Source: 10Q and Authors Calculations
This is very conservative since most ships last to 20+ years of age. More conservative than any other shipping company I am aware off. I calculate a more appropriate Capital Reserve charge (or Sustainability Maintenance charge as I prefer to call it) would be about $8.4 million or 6.6¢ per share per quarter. Utilizing this figure and getting rid of the completely unwarranted additional “Recommended Reserve” we get a more appropriate Q1 unit coverage of approximately 1.5x.
This is 1.5x coverage despite $2.6 million in reduced operating surplus due to the temporary buydown of HMM’s charter rate (through December 2019), and the greater than typical one-time expenses I outlined previously. Normalize these and you would once again be at about 2x coverage including an appropriate Capital / Sustainability Reserve charge.
While I can’t say what management is likely to do with excess cash flow in the future, I can say CPLP is likely to continue to more than cover its current distribution. Additionally, I can say with a fair amount of confidence that CPLP would go up at least 20% in price if management simply stated, “we no longer intend to use the ATM to issue shares below NAV”. A 10%+ well covered, tax advantaged, yield with 20% potential price upside is good enough for me. How about you?
Capital Product Partners Q2 2018 earnings are expected to be released the week of July 27th.
Disclosure: Darren (the author of this article) is long CPLP.