The Stock

What to Buy: Capital Product Partners LP (NYSE: CPLP) @ 9.50

Why Now: With a still sluggish global economy depressing shipping activity and contract renewals coming up, the tanker business has been a tough place to make money the past couple years. That caught up to Capital Product Partners in April, as slumping cash flows triggered a 45 percent dividend cut.

Since then, however, business has stabilized. The company has added vessels and signed contracts. There’s even been a modest dividend increase of 3.3 percent, effective with the November payment. The unit price, however, is still scraping along under $10, as it’s been for more than two years. Renewed growth and a yield of more than 10 percent promise solid total returns.

The Story

Roger: Can I just say again how much I like it when a well-run master limited partnership (MLP) issues equity in this environment? Not only does it mean more low-cost capital to build or buy cash-generating assets, and higher dividends. But the institutions that run this market are so dilution-phobic they dump what they’ve just bid to the sky, so I get another chance to recommend it at a bargain price. It’s a gift that keeps on giving.

David: I’ve been curious why we haven’t talked about some of these MLPs for Big Yield Hunting. It’s true there aren’t as many super yields around as there were a year ago, when unit prices were a lot lower. But there are still some I’ve noticed. Take Capital Product Partners LP (NYSE: CPLP)…

Roger: Let me stop you right there, because this one has also caught my eye. For one thing, the yield meets our lofty standards for Big Yield Hunting at more than 10 percent. But more important, they just increased the payout by a little more than 3 percent. That’s not a whole lot, but it is a definite reversal of fortune for this company–in the right direction.

David: I started to say that Capital Product Partners did go through some hard times. Capacity and contract rates in the product tanker market have been at multi-year lows. And even an owner of double-hulled vessels like Capital Products has suffered.

But Ioannis Lazaridis–the general partner’s CEO and CFO–says the long-term product tanker supply picture has been steadily improving. It also looks like profits are covering the distributions comfortably.

Roger: I see from your notes you’re using “operating surplus” as the best measure of this company’s profitability. That was roughly $12.4 million in the third quarter, versus a payout of around $9 million in distributions. And they set aside $2.9 million for what they call “replacement capital expenditures” as well as $0.5 million in other reserves.

That’s basically a payout ratio of 96 percent or a coverage ratio of 1.04-to-1 after capital needed to keep the enterprise going. It’s a little more than I’m really comfortable with. But then again, the thin margin for error is a major reason Capital Product Partners yields more than 10 percent, even after boosting its distribution.

David: I was troubled by a couple of numbers. One is the big increase in partners’ capital, after a series of equity issuances earlier this year. The other is an increase in operating expenses.

I know you like it when companies with sound investing records raise equity. This company though got caught out being too aggressive when the energy market crashed a couple years ago. And they’ve had to recharter vessels at rates far less than they initially anticipated. But despite that, they’ve kept right on expanding, issuing stock to buy more vessels this year.

Does that concern you?

Roger: Those are all good points. The combination of more equity outstanding and lower charter rates certainly has cut back Capital’s profit this year, relative even to 2009 levels. And anytime a company buys or builds an asset, there’s a chance it won’t operate as well as planned.

But management has been able to expand the fleet and improve quality as well. There are now 21 vessels with an average age of just 3.9 years, well below the industry average. The new vessels are also going out at better rates than older ones, and the average remaining charter duration is four years. The company has locked in contracts for 64 percent of overall fleet capacity in 2011.

Actually, even the rise in operating expenses is bullish, as it’s relatively low compared to the assets added.

David: That all sounds good. But then you read down to the increase in equity capital to $240 million from $157.1 million. That’s more than half again in additional equity in a very short period of time.

Roger: Whether that capital raise pays off or hurts will depend over the next year on how well the global oil market performs. The tankers they’ve most recently purchased are contracted to BP (NYSE: BP) and Petrobras (NYSE: PBR), so there’s not much risk there.

More than a third of the fleet, however, isn’t fully contracted for 2011. Rates have noticeably improved in the second half of 2010, in large part because industry has revised upward its targets for output and transport demand for refined products. Asset prices have also risen 10 to 15 percent this year. It really does look like this market bottomed in late 2009. One of the good things about the tanker business is you can get a pretty good read on how profitable a contract will be before the ink dries on the documents.

Yes, the new equity is dilutive if it’s not invested expeditiously in a ship with a profitable contract. But the acquisitions of the Anemos and Apostolos ships this year are demonstrably accretive to cash flow in both the near and longer term. They also hold open the possibility of more deals with Super Oils, which are after all the tanker/transport industry’s most reliable customers.

CEO Lazaridis was asked in the company’s most recent conference call about the prospects for re-contracting two of the existing tankers. He responded with two key facts. First, contract rates have rebounded more than 20 percent for three-year deals and 13 percent for one-time charters since the beginning of 2010. Second, charter activity is now back to levels similar with 2008, and well above 2009.

Negotiations haven’t as yet been concluded. But they’re in full swing, and these appear to be high-quality vessels. The question isn’t really whether they’ll be contracted, but at what price.

David: Wall Street seems to be of at least two minds on the company. You’ve got two buy ratings, six holds and two sells on it now, and 12-month target prices anywhere from $6 to $10.50. Clearly, people haven’t really made up their minds on this one.

Then there’s the fact that Capital Product Partners units have underperformed the Alerian MLP Index by more than 80 percentage points since it started up operations in early 2007. It’s lost nearly 10 percent thus far this year. And it’s underperformed another tanker company I know you like–Navios Maritime Partners LP (NYSE: NMM)–by 34 percentage points in 2010. That’s a lot of underperformance.

What are all these people missing?

Roger: First, investors are very unforgiving of dividend cuts in this market, and this company cut its payout by more than 45 percent just a few months back.

Second, Capital Product Partners is far from the only tanker company to run aground the past couple years. In fact, Navios is a major exception, not the rule. Investors are skeptical about the industry’s ability to renew contracts at anything approaching prior years’ levels. And if companies can’t extend, cash flow is going to drop, and dividend cuts won’t be far behind.

I think Capital Product has answered these questions about it business and is certainly putting its money where its mouth is with the dividend increase. There are no guarantees, and anyone who’s really conservative and wants to play here should probably stick to Navios.

But this company trades at just 1.28 times book value, versus 2.3 times for Navios. And it yields a couple percentage points more as well, so it’s decisively cheaper, too. If they do show they can hold this dividend level–or even increase it as they add new vessels–we’re going to see some capital gains here as well.

David: What about debt? It’s 62 percent or so of assets, and I notice they have some credit tranches that run until 2017-18. It also looks like they’ve structured debt that starts to amortize in mid-2012, and I’ve seen some analyst opinion that suggests they may have to devote a lot of spare cash to paying that down, which would reduce prospective dividend growth.

Roger: Sixty-two percent of assets isn’t that out of line with many master limited partnerships. Keep in mind that these outfits are able to use the tax system to minimize taxable earnings per share, which is why we never use earnings per share (EPS) to measure profitability.

Capital Product’s debt load is higher than what we see for many MLPs, and I don’t particularly like it at that level. But it is tied to the tankers and the maturities don’t look too onerous. They only have a little more than half of the $720 million credit tranches drawn now, for example, and the interest rate is fixed.

Is this the company in this industry that I’d want to own if the global economy slips back into recession and the energy market crashes? No way. But as long as business conditions for shipping refined oil products continue to improve, I think its fortunes will too. Also, this company is 31.8 percent owned and backed financially by Capital Maritime & Trading Corp, which is a much bigger outfit.

David: What about the fact that this company is organized as a partnership? Doesn’t this mean additional complications for investors, like filing a Form K-1 with their taxes?

Roger: Actually, like many other tankers, Capital Product Partners has elected to be treated as a C-corporation for US federal income tax purposes. Investors receive the standard Form 1099 instead. Part of the payout is a qualified distribution and part of it is a non-dividend distribution. Tax treatment will vary with the individual investor.

David: Here are some additional facts. The company is based in Piraeus, Greece, but it has New York City-based investor relations contact, Nicolas Bornozis (212-661-7566). There’s also a fair amount of information on the website (www.capitalpplp.com).

Roger: I advise anyone buying this one to check out that information and get a little more familiar with the operation. Also, as is always the case with Big Yield Hunting, no one should overload on Capital Product Partners, and no one should invest without full recognition this is an aggressive investment.

David: Anything else?

Roger: Yes. Capital Product Partners has a market capitalization of just $338 million. Though volume appears to be generally good, I do want to caution investors against chasing it above our buy target of $9.50.

We’ve seen a couple of Big Yield Hunting recommendations really blast off following our writeups, some well above our target entry points. If that happens with this one, investors are definitely better off being patient. There’s always another train leaving the station and a stock that goes up purely on our recommendation will almost certainly come back to earth eventually, giving everyone another chance to buy at a good price.

David: That’ll do it. With a yield of 10.4 percent and solid growth prospects, Capital Product Partners LP is a buy up to 9.50.

Open Positions

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