CPLP Overview – 11.5% Yield, Conservative Posture
Image Credit: CPLP, Q2-18 Earnings Presentation
Capital Product Partners LP (NASDAQ:CPLP) is a shipping holding company specializing in vessels with medium and long-term charter contracts, primarily in the product tanker and container sectors. CPLP has superior forward revenue visibility due to the nature of its contracts and staggered roll-offs. This allows it to appeal to more income-focused investors versus direct rate speculators. Despite this strength and a very strong balance sheet, the stock has been trading terribly towards the end of summer 2018.
This report will examine current asset values, cash flow potential and long-term sustainable payout levels. Current NAV is over $4/unit, even with underlying asset values near record lows.
CPLP currently trades at $2.79 with approximately 130 million common units outstanding, for a current market capitalization of just over $360 million. It also has nearly 13 million convertible preferred units (privately held), with a par value and conversion at $9/unit. CPLP common units currently offer a quarterly distribution of $0.08 for a current yield of 11.5%.
Fleet and Employment Overview
CPLP has a fleet of 37 vessels, primarily made up of product tankers and containerships on medium- and long-term charters. The majority of these vessels are on fixed charters to top-tier counter-parties, with current employment shown below.
Source: Capital Product Partners, Q2-18 Presentation, Slide 8
The primary exceptions are its 4 Suezmax crude tankers, of which 3 are on weak spot rates and 1 is on a weaker short-term charter. These weaker rates have been holding back cash flows, but spot rates have recently improved, and I expect significantly better performance by Q4-18.
Fleet Values and Balance Sheet
Although income vehicles are traditionally valued on yield, the underlying asset values are important to intrinsic value. Most high-yield companies have unsustainable payouts backed by weak assets. That’s not the case at CPLP.
We can calculate CPLP’s “intrinsic worth” by figuring out net asset value (“NAV”), which is similar to tangible book value. For shipping firms, this is essentially fleet valuations minus net debt.
According to VesselsValue, our preferred source of live valuations, the current fleet is worth $914 million. Additionally, CPLP has above-market charters (very lucrative charters on 8 containerships and 1 dry bulk vessel), which I value at $208 million using a 10% discount rate to EBITDA, adjusted for vessel depreciation.
Source: VesselsValue, CPLP Fleet Overview
For the liabilities side of the house, as of Q2-18, CPLP reported net debt (6-K, page 2) of roughly $449 million. It also had $117 million in par value of preferred equity. Altogether, the company’s NAV is about $556 million ($1.12 billion in assets minus $566 million in liabilities).
With 129.7 million units outstanding (127.25 million common and 2.44 million GP), current adj. NAV at CPLP is about $4.30/unit, which means the current units trade at a huge 36% discount to intrinsic value. Unlike the vast majority of high-yield plays, CPLP’s yield is simply high due to a weak price, not because of weak assets or unsustainable payouts.
Significant Asset and Yield Upside
CPLP’s current NAV is based on underlying asset values that are near all-time adjusted lows. Sentiment has been terrible after several rough market years, and ship prices reflect this.
If product tanker markets recover substantially by 2020, I anticipate that as earnings increase, the company’s underlying fleet values could surge by $200-300 million and NAV could easily surpass $6/unit. In such a market environment, which I believe is very likely prior to 2020, CPLP’s payout could see significant increases. If an eventual refinancing is achieved, a doubling is possible.
The IMO 2020 regulations, which limit the use of high-sulfur fuel to a maximum of 0.5%, go into effect in just over 15 months. This new regime will force shipowners to pursue regulation-compliant blends and is poised to add significant demand to the product tanker sector. This is CPLP’s primary exposure, and almost all of its containerships are also on long-term contracts (which means CPLP doesn’t pay for rising fuel costs), so unlike many other shipping companies, its net impact is clearly skewed positive.
On its Q2-18 conference call, Ardmore Shipping (NYSE:ASC), a product tanker peer, shared the following guidance:
… IMO 2020 sulphur regulations are expected to have an impact from mid-2019. The initial estimates suggest that approximately 2 million barrels a day of refined products will display high sulphur fuel oil, with the majority of this moving at sea and over longer distances, with some analysts calling for a 10%-plus increase in product tanker demand.
This surge will likely occur right as CPLP begins to roll over lots of its contracts. It is very possible we could see a surge in DCF, which further strengthens CPLP’s hand towards longer-term deals and potential refinancing.
Stable Results and Long-Term Coverage Capacity
CPLP recently produced steady Q2-18 results, demonstrating strong cash flow even as all other product tanker peers have struggled due to weak spot markets. The company was able to secure strong employment for eight of its product tanker vessels by offering 2-3 year contracts to Petrobras (NYSE:PBR).
Despite arguably strong results, CPLP investors have grown concerned with reported distribution coverage, with the company announcing 1.0x coverage for Q1-18 and 0.9x coverage for Q2-18. The most recent breakdown is shown below. Pay close attention to the line items “capital reserve” and “decrease in recommended reserves.”
Source: Capital Product Partners, Q2-18 Presentation, Slide 5
Why was coverage lower? Suezmax Crude and LIBOR Rise
The primary reason CPLP’s coverage was weaker is due to the very weak Suezmax tanker markets (as noted earlier), where the company has had 4 vessels roll off from $21-26k/day charters into a spot market with Q2 performance around $10k. Three of these vessels are currently operating in the spot markets and 1 vessel is employed with an $18k/day contract.
This impact alone is set to drop cash flow by nearly $4 million a quarter, around 3-4 cents per share. This was slightly offset by a new Aframax dropdown and improved containership rolls, but challenging product tanker markets have left CPLP’s core fleet mostly treading water. The good news is that Suezmax spot rates have stabilized and are set to increase into Q4.
Interest expenses are set to decrease q/q going forward from Q2; however, the y/y comps are difficult because the credit facility is tied to LIBOR, specifically L+325 basis points (3.25%). As the chart below shows, LIBOR shot up in early 2018, but has now stabilized. Assuming $450 million of long-term debt, the increase in LIBOR by roughly 100 basis points (1%) since last year adds nearly $5 million in annual costs, or about 1 cent per quarter.
Source: St. Louis Fed, 3-month LIBOR Chart
The combination of these two negative impacts have been the primary reason why CPLP’s coverage has been reduced. Operating performance has generally been quite strong, but these are difficult markets.
Forward Challenges? Slight Dip in Product Tankers
Product tanker markets are difficult, but medium and long-term charter rates have been mostly stable for the past two years. CPLP has a few challenging forward rolls, such as the 5 product tankers shown below, but with my current market estimate at around $15k/day, we’re looking at roughly a 1 cent impact per quarter, easily offset by just the recent improvements in Suezmax conditions alone.
Source: Capital Product Partners, Q2-18 Presentation, Slide 9
With all of the facts described above, I expect overall reported coverage for both 2018 on average, and most of 2019, to be very close to 1x. The 4 Suezmax crude tankers offer a chance for higher coverage if CPLP can improve those charters. There will also be a natural improvement in reported coverage, as debt loads are reduced and LIBOR rates seem to have plateaued for now.
The rest of the report will discuss how the company’s current reported coverage is incredibly conservative and long-term sustainable levels are actually much higher.
CPLP’s Current Credit Facilities and Repayments
Under its current financing structure, announced in October 2017, and also disclosed in its annual report (20-F, page 92), CPLP must repay $12.9 million per quarter, split into two primary tranches. (Note: Originally it was $13.2 million/qtr, but now it is $12.9 million following the 25th April, 2018, sale of the 2013-built Aristotelis for $29.4 million and the associated $14.4 million debt repayment.)
The full amortization split is also disclosed in its most recent quarterly filings, which shows the impact of these payments.
Source: CPLP Q2-18 SEC Filings, Page 8
As can be seen, the 2015-built “Amor,” the 2016-built “Anikitos” and the 2017-built “Aristaios” each have their own credit facilities of $15.8 million, $15.6 million and $28.3 million respectively. Compared to recent valuations, these three facilities carry leverage of 59%, 56% and 71% respectively, all of which are very typical levels for modern assets. (Note: The Aristaios is on a lucrative 4-year charter, so banks allow slightly higher leverage.)
2017 Credit Facility – Assets and Coverage
Setting those 3 minor facilities aside, we are left with $419 million of debt ($406 million after the July 2018 payment), attached to 34 vessels worth $822 million, and around $200 million worth of above-market charters. Total leverage is a fairly paltry 40%, or a moderate 49% even if charters are excluded.
This facility is split into two parts: Tranche A, covered by 10 modern vessels, and Tranche B, covered by 24 middle-aged vessels.
Tranche A: 54% Leverage, 10 Modern Assets
Tranche A currently carries an estimated $231 million balance and will be repaid through 2023 ($187 million due in 2023). As shown below, the current fleet values for this basket of assets is about $427 million, and leverage is 54%.
Source: VesselsValue, CPLP Fleet Valuations
Tranche B: 44% Leverage, 24 Middle-Aged Assets
Tranche B has an estimated balance of $176 million and will be 100% repaid by Q4-2023 (repaid in 24 equal quarterly installments of $8.4 million). As shown below, the combined fleet valuations are about $395 million. Based on the rigorous amortization schedule, demolition values alone will surpass the corresponding debt by mid-2019, but only one vessel (“Amore Mio”) is even remotely a demolition candidate until at least 2026. This is an unprecedentedly conservative financing facility.
Source: VesselsValue, CPLP Fleet Valuations
Tranche B Amortization: A Major Short-Term Drag
I walked through each of the financing facilities to give a clear fleet picture for CPLP, but the newest 13 vessels all have pretty traditional financing and there’s not much to discuss.
The significant disconnect is related to the 24 older vessels secured by the “Tranche B,” which is so incredibly conservative that demolition values will surpass total debt by April 2019. Based on the current draconian debt paydown structure, CPLP’s core fleet will be entirely debt free by late 2023, but the majority of the fleet has significant life remaining.
A normal expectancy for a product tanker and dry bulk carrier is 20-25 years depending on markets, and containerships should easily do 25-30 years of service. This means that even in heavily bearish outcomes, CPLP doesn’t need to replace much of its fleet until 2026. The sole exception is the 2001-built “Amore Mio,” which is likely to be scrapped in the next few years. This vessel is currently valued at $10.4 million and is likely to generate nearly $10 million from demolition, so there’s virtually no risk here.
Why is this facility a “drag?”
The Tranche B results in distorted reported coverage levels because it forces CPLP to funnel cash to the banks instead of either investing in more growth (dropdowns) or shareholder returns (distributions). Obviously, older vessels need more conservative financing, but to be unable to borrow in excess of demolition levels is more extreme than common sense would dictate.
I believe that once market levels stabilize, rates improve and CPLP locks many of these vessels on medium-term and long-term employment, there is a clear path to a refinancing that could easily result in a $100 million or larger cash-out. Unfortunately, in 2017, spot rates were terrible and the company wasn’t bargaining from a position of strength, so it got stuck with this stinker for now…
If rates improve in 2019-2020, I expect CPLP will be able to easily secured an enhanced financing deal with both lower amortization and a higher overall balance (i.e., enough to pull fresh cash out).
Credit Facilities vs. Long-Term Coverage
Recall earlier, when I highlighted CPLP’s sort of odd distribution coverage chart. We’re now going to dive into the calculations and illustrate how the company is presenting overly conservative numbers, effectively sandbagging its own results.
“Capital Reserve” – What is This?
Virtually every other MLP or LP structure utilizes line items called “maintenance capital reserves” and “replacement capital expenditure reserves.” They are often combined into one line. This is how KNOT Offshore Partners (NYSE:KNOP), Hoegh LNG Partners (NYSE:HMLP), GasLog Partners (NYSE:GLOP), Golar LNG Partners (NASDAQ:GMLP) and Dynagas LNG Partners (NYSE:DLNG) all report their results.
These levels are based on calculations describing what it costs to maintain and what it costs to replace assets down the road. Maintenance is relatively simple: it comes down primarily to drydocking and special surveys. Replacement is the annual allotment required for CPLP or others to set aside to buy a new product tanker in 25 years, a new containership in 30 years, etc.
CPLP does something different: the company reports real-time bank amortization, presenting a sort of “free cash flow” instead of “distributable cash flow.” The difference might appear subtle or meaningless, but it makes a legitimate huge long-term difference. DCF should, in theory, showcase exactly what is a sustainable long-term payout level. Whereas CPLP’s method of FCF only shows what is payable based on that exact quarter of results and debt structure.
Current bank amortization shouldn’t be relevant to long-term DCF. Otherwise, a company can simply buy modern assets, sign a goofy financing deal with almost zero upfront debt payments, and then tout a blatantly bloated number as its DCF. Conversely, if bank amortization is draconian, the reported DCF is sandbagged, because it under-reports the true long-term payout potential. Simply put, CPLP reports these coverage metrics differently than virtually every single peer out there.
In the long term, I believe this is because the company is hopeful it can refinance down the road and secure enough “friendly” bank facilities that its DCF and coverage ratios will soar; however, in the immediate term, the net result is that CPLP drastically under-reports its DCF compared to peers.
“Decrease in Recommended Reserves” – What is This?
When CPLP reports an amount here, it is showing the cost of the distribution in excess of quarterly generated cash flow. Therefore, the company was $1.5 million short during Q2-18. Its immediate FCF supported a 7 cent payout, whereas 1 cent came straight off balance sheet cash.
CPLP had $51 million in cash as of 30th June, so a $1.5 million draw is almost insignificant, but it’s still worth keeping an eye on. Bearish folks would point to this as a major weakness of CPLP, but what these folks are ignoring is the massive underlying asset values and conservative debt structures.
Without full access to CPLP’s internal calculations, it is difficult to calculate a 100% accurate “correct DCF,” but if we utilize a 20-year replacement curve for crude tankers (4x Suezmax – $55 million, 1x Aframax – $45 million), a 25-year replacement curve for bulkers (1x Capesize – $45 million), 25-year for product tankers (6x MR1 – $30 million, 15x MR2 – $35 million) and a 30-year replacement curve for containers (10x – $50-80 million), then we come up with a replacement valuation of nearly $1.7 billion, or about $1.4 billion net of demolition recoveries.
I’ve designed a spreadsheet that calculates each vessel’s annual replacement reserve against the above inputs, and we reach a required replacement reserve of $54 million. However, this is an overly simplistic calculation which does not discount back for retained fund investment.
Investment of Retained Funds
When you keep a replacement reserve, these funds are not simply stuck on a shelf or hidden in a mattress. They are instead continually invested into new assets. MLPs must use a calculation for the expectation of investment returns beyond general inflation – a general benchmark is to use a 5% annual return placeholder.
When we utilize this same system for CPLP, we reach an annual requirement of $24.5 million in retained funds. Therefore, the “true” replacement reserve calculation is about $6.1 million per quarter.
What About Maintenance Reserves?
This is an important calculation as well. CPLP must include a reserve to fund dry docks, special surveys and regulation compliance (i.e., ballast water treatment). These requirements differ by asset type, but I estimate them to range from about $200k/year for the smallest MR1 assets to about $500k/year for the larger tankers and containerships. Using these assumptions, the company must retain close to $12 million per year. Therefore, the “true” maintenance reserve calculation is about $2.9 million per quarter.
Bringing Them Together – Adjusted Coverage Ratio (1.26x)
When these two buckets are combined ($6.1 million replacement reserve + $2.9 million maintenance reserve), we realize CPLP needs to retain about $9 million per quarter, which is significantly less than the $13.2 million currently earmarked for “capital reserve.” Altogether, this means its long-run DCF capacity is at least $0.03/qtr higher than currently suggested.
Source: Capital Product Partners, Q2-18 Presentation, Edits by Author
CPLP is inherently safer than most of its peers due to the strong NAV levels and contract fixtures; however, the company isn’t totally immune from a prolonged market downturn. If the current trade war concerns lead to a major global slowdown or recession, CPLP’s fleet values would likely drop by at least another 10-20%.
As product tankers contracts roll off into this potential weaker market, DCF would also drop, and in the absolute worst case, $0.08/qtr might not be covered in the short term. To model such an impact, we need to consider what happens to fleet values with a 20% haircut, which would reduce NAV by around $183 million ($914 million down to $731 million). That’s a haircut of about $1.40 per units, which brings CPLP’s NAV down from $4.30 to $2.90.
If we add another 25% discount onto the $2.90 NAV to account for market uncertainty and general pessimism, that gets us to about $2.20, which is what I would use as a bear-case terrible market target.
Conclusion: Solid Long-Term DCF and Underlying Value
We’ve approached CPLP both from long-term yield potential and underlying asset values. Our yield analysis shows that the current annual payout of $0.32 is covered by nearly 1.3x under current market conditions, leading to a current DCF yield of nearly 15%. Obviously if market conditions improve, I expect this number to increase significantly.
Our value-based analysis demonstrates that CPLP is worth about $4.30, which is substantially higher than the current pricing. In a full bear scenario, our target price is about $2.20, based off a projected NAV of $2.90. Therefore, we see over 50% upside potential versus about 20% of downside risk.
Bottom line: CPLP is cheap, the balance sheets and payouts are conservative, and I believe there’s around 50% upside potential to base-case markets. My target price is $4.30, which is based on current NAV.
J Mintzmyer collaborates with James Catlin and Michael Boyd on his Marketplace service.
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Disclosure: I am/we are long CPLP.
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.