Description

Hoegh LNG Partners, LP (HMLP)

Summary

HMLP is a “newly issued” MLP formed by its parent to finance future growth projects. Its parent company, Hoegh LNG Holdings (HLNG), is one of four operators of floating storage regasification units (FSRUs). FSRUs are off-shore alternatives to land-based liquefied natural gas (LNG) import terminals. They are an attractive option for countries that wish to import natural gas but lack existing natural gas infrastructure. In addition to being lower cost than land-based terminals, their portability makes them a much more versatile infrastructure option. The parent company has substantial, capital-intensive growth and aims to use the MLP structure to finance its growth. I think the parent company is more committed to the MLP than most. The assets are well suited for the structure thanks to their long-term, take-or-pay contracts and reasonably attractive ROE dynamics, which should support a fully loaded LP/GP cost of capital.

In sum, I think HMLP is an attractive investment because:

-          It is cheap – trading at a 7.2% current yield

-          It will grow – growth at the parent company will support +15% distribution growth over the next few years

-          It is low risk – the average contract duration is 16 years; contracts are with government-backed utilities and the gas provided by the FSRUs is a “must have”

-          There is a catalyst – the first asset drop down has been delayed due to ownership complications; it should occur this quarter and, as it is debt-financed, it will be 15% accretive to current distributions

At a high level, I think an investment in HMLP offers a base-case ~30% annualized return over the next two and a half years as the distribution increases 50% to its “high splits” and the company gets valued as a stable, modestly growing mature MLP yielding ~7.5%. While this return may not excite, I think there is a very reasonable chance that the return is pulled forward and, most important, the risk of a loss of capital is very low. From a risk perspective, this is basically like buying a portfolio of government backed securities at a +250 bps spread to their current YTM. Also, there is the potential for a home run if floating liquefied natural gas (FLNG) export projects are found to be commercially viable.

Industry Overview

We prefer to focus in industries experiencing long-term secular growth, and then identify companies positioned to benefit by way of strong market positions and existing barriers to entry. LNG and HMLP fit pretty well into this process. LNG volumes are growing at “greater than GDP” levels due to organic demand drivers and market share gains. I once read that LNG is to the energy market what salt is to the food market – small, but absolutely necessary. LNG fills less than 10% of global energy demand, but its flexibility as a fuel source that requires minimal fixed infrastructure makes it a very important option for emerging economies and regions experiencing significant power interruption (eg – Fukushima meltdown). Furthermore, natural gas is poised to gain significant share in the global energy market as US-based production starts to find an end market in exports. Natural gas demand is growing around 2%/year. Conservatively, LNG volumes should grow +6%/year for a very long time. There are many scenarios where LNG demand grows much much faster (Golar suggests that the market could grow +350% http://hugin.info/133076/R/1904990/677798.pdf), but I don’t want to get distracted by blue skies.

A 6% CAGR implies annual volume growth of around 25 million tons per annum (mtpa). There aren’t any great estimates for pinning down how much of this growth will require new FSRUs. But based on my conversations, around half to two thirds isn’t crazy. Land-based import facilities generally have a lot of excess capacity and they are located in more developed regions. They have excess capacity because they aren’t growing. When it comes to newbuilds, FSRUs will win the lion’s share of the market because they are cheaper and much more versatile. Since 2007, over 75% of new import facilities have been FSRUs. See below.

Average FSRU capacity is 3-4 mtpa, suggesting 3-4 new FSRUs per year. Notice, I just defined a total addressable market with a number that can be represented with one hand. If the LNG market is the food industry equivalent of salt, then the FSRU market is semi-coarse Himalayan sea salt. The good thing about this is that the size of the market severely limits the number of potential participants. Presently, it’s really only three – Hoegh, Exelerate and Golar (BW has two new builds but they’ve had a hard time getting contracts due to their inexperience and probably won’t be ordering new ships soon). Today there are 20 operating FSRUs. Hoegh operates 5, Golar has 6 and Excelerate has 9. What’s notable is that Hoegh has a very high market share of newbuilds, they’ve added three in the last year, while Excelerate hasn’t contracted a newbuild since 2009 and Golar has only one, likely due to the fact that their hands are full with FLNG. HLNG has articulated a plan to double its fleet by 2019. This would mean adding 1-2 newbuilds per year. Dropping down 1-2 ships per year at 10x EBITDA supports our base case double digit distribution growth for the next several years. While there is some risk associated with adding newbuilds on spec (ships are built and then contracts are signed), this risk is borne at the parent. The parent has communicated that only assets with greater than five year contracts will be considered for dropdown into the MLP.

Asset Summary

Out of the gate, HMLP owns proportional assets in two FSRUs and 100% interest in one asset, as well as a $140MM loan receivable from its parent company. The following give an overview of the assets and their counterparties:

The business is not riskless, but it is close. The terms of the leases require the charterers to reimburse Hoegh for all operating expenses and any maintenance related capital expenditures. The revenue recognized from the lease is essentially pre-G&A EBITDA. Hoegh carries insurance in the event of a natural disaster or geopolitical catastrophes.

The IPO proceeds were effectively the equity raise for HMLP’s first dropdown. Of the $180MM received, $140MM was directed to funding a note receivable from the parent company. The note pays a 5.5% interest rate and will be used as consideration for a portion of the dropdown of the recently completed FSRU named “Independence”, which I will discuss later.

The following table highlights parent company assets, as well as which assets are being considered as potential dropdown candidates. The important take away here is that HLNG already has four FSRUs which can be dropped into the MLP. With several years of dropdown inventory already on hand, and a fairly low risk path to re-filling it, the dropdown story is very straightforward. If FLNG is commercially successful then HLNG will become a much larger company and the dropdown inventory will grow very rapidly.

Drop Down Economics

A typical FSRU newbuild costs $300MM and generates $40MM of EBITDA. The assets are expected to have a 35 year useful life, which suggests a ~10% unlevered return. While this rate implies some “excess return” that makes a fully loaded LP/GP cost of capital work, it’s not so high that it will attract substantial new competition and there are barriers to entry from an operational perspective (eg – this isn’t as simple as owning tankers). HLNG plans to use HMLP as its exclusive source of funding for newbuilds. The general plan is to build at 7.5x EBITDA and drop assets at 10x. The parent expects that the WACC of HMLP will be 7.5-8.5%. Using 50% debt at 6%, that gets an equity return of around 10%. Running a dropdown scenario of 1.5 FSRUs per year through our model, we think that the spreadsheet math supports a 5 year 10% distribution CAGR. In their analyst day, Hoegh LNG said that they underwrote the MLP vehicle at around a 7% yield. While the units currently trade at 7.1%, I don’t think that the weakness in the price threatens the viability of the model.

First Dropdown

As previously noted, the IPO proceeds were effectively use to fund the first asset purchase from Hoegh LNG. Their FSRU called “Independence” was recently put into service with the Lithuanian government utility, Klaipedos Nafta, on a ten year charter. It’s a strong credit counterparty (near 3% long-term cost of debt) and it will be a great asset for the MLP. The company has stated that this drop will result in a 15% increase from the $1.35 initial distribution. Many expected that this asset would be dropped into HMLP early in Q1 2015. We are still waiting for the drop to occur. The problem was that the parent company did not put in place the proper asset transfer documentation with the lenders/customers etc. The important thing is that the delay was not because of operational problems and this is a matter of when (defined in weeks/months) not if. Based on our recent conversations with the CEO I believe we are near a resolution, which should be a positive catalyst for the stock.

Financial Modeling

The following highlights our financial modeling. Our base case inputs are as follows:

-          1-2 FSRUs dropped down each year at a 10x EBITDA multiple

-          50% debt at a 6% cost and 50% equity at a 7% yield that rises to 7.5%

-          14% of EBITDA reserved for replacement cap ex

Conclusion

I like HMLP because it is a cheap stock with limited downside benefiting from a low risk secular growth story. I believe my “worst case” scenario is that only the pre-funded drop occurs and I sit around collecting an 8.4% dividend for the next +10 years. My base case scenario is that my distribution grows to just over $2 by the end of 2017 and I sell the stock for ~$27, earning a ~30% IRR. My best case scenario is that FLNG works, HMLP gets valued like a long-term dropdown story with a 5% yield, I sell the stock at $40 and my hometown sports teams win all the championships. I said best case, not pretty good case.

Risks

Capital markets – you have to be able to access equity and debt markets for newbuild/dropdowns to work

LNG Demand/Commodity Prices – the oil rout has caused many would be LNG buyers to move to the sidelines before committing to long-term deals

Interest rates – if rates move much higher then debt will be more expensive and yield-oriented securities might sell off (in this environment you are also likely seeing higher commodity prices/demand, so there is an offset)

Catalyst

Drop down of FSRU Independence

Subsequent distribution increases

Potential FLNG developments