Introduction
At High Dividend Opportunities, our main aim is to identify solid high-yielding investments to buy and hold for the long term. From time to time, however, various events cause short-term mispricing opportunities that are just too good to pass up. Today, we present another opportunity which is the result of the large Preferred Stock ETF, the iShares U.S. Preferred Stock ETF (PFF), switching indexes. This switch by PFF has caused several such mispricing opportunities as it unloads preferred shares that are not in the new index it will be tracking.
The latest such opportunity has arisen with some of the preferred shares of Tsakos Energy Navigation Limited (TNP). TNP currently has five preferred issues being publicly traded, and because of PFF selling, two of the preferred stocks are trading at artificially low prices. This is a mispricing opportunity that will likely not last long.
PFF has been selling two TNP preferred stocks:
- Tsakos Energy Navigation Ltd, 9.25% Ser E Fixed/Float Cumul Red Perp Prfd Shares (TNP.PE) - Yield 10.6%
- Tsakos Energy Navigation, 9.50% Ser F Fixed/Float Cumul Red Perp Preferrd Shares (TNP.PF) - Yield 10.8%
Our target price for both TNP-E and TNP-F is $24.00 per share or higher by 9% in addition to the 10.5% dividend yield. They offer investors the opportunity to make 19% returns in a period of 12 months.
The Company
Because this is a short-term mispricing opportunity, rather than as a long-term investment, what we need to look at is TNP's ability to generate the cash needed to pay the distribution on its preferred units rather than its longer term ability to support (and possibly grow) the distribution on the common units. To do that we will look at three things:
- Cash on hand and other resources (to fund the call of the two issues that are likely to be called in the near future).
- Cash flow coverage to pay the preferred distributions.
- Asset coverage of the preferred in case the worst happens.
Cash On Hand
For Q3, TNP reported having $232.5 million in cash, an increase of almost $130 million since the start of the year, while also reducing debt $190 million. 2018 was a very tough year as tanker rates hit historic lows. Despite that, TNP was able to maintain strong liquidity. With charter rates much higher than earlier in the year, this cash should still be available if needed to retire the preferred shares that have a failure to redeem clause. While these two issues do not have to be called, the failure to redeem clauses are such that TNP is fairly certain to call them given it has the resources to do so.
Having significant liquidity provides security for preferred shareholders and we really like management’s view of cash on hand. Asked in a recent conference callabout using some of that cash for common share buybacks, Nicolas Tsakos said,
Well, the – I would say, the motto of this company and I – the motto of this company is you only appreciate cash when you do not have it. And we have remained for the last 35 years, and then we decided not to try this motto. Because having ample liquidity, of course, it puts us in a strong position and gives us the flexibility to move in acquisitions.”
TNP has a well-laddered debt maturity schedule.
Their annual debt maturities are consistently around $250 million. Their significant liquidity should provide them flexibility in refinancing or partially paying off their debt maturities.
The two preferred issues that need to be redeemed, B and C, have 4 million shares outstanding. Redeeming them will require $100 million. The Series B ($50 million) will need to be redeemed by July 2019 and the Series C will need to be redeemed by October 2020. With a significant amount of cash on hand, and management’s intent to keep significant cash on hand, we believe that TNP will have no issues redeeming both.
Improving Cash Flow
Tsakos, along with their peers, struggled in the first nine months of the year because tanker lease rates were at historic lows. These low rates were driven by the trade war and slowing oil trade. Q4 saw significant increases in tanker lease rates on the spot market. The market remains volatile, with rates dropping again early in 2019 (but remained above the lows from 2018). Many experts remain bullish that rates will spike in 2019 as the IMO 2020 Global Sulfur Cap is implemented.
Additionally, Tsakos also is adding new vessels. Adding vessels at a time when rates are recovering should increase revenues, profits and cash flow going forward.
TNP has a nice mix of both long-term charters and availability to take advantage of increases in spot market prices. Charter prices look to be on an uptrend for the next couple of years, so this looks prudent.
TNP reported generating EBITDA of $124.5 million over the first nine months of 2018. Interest and preferred stock dividends totaled $74.14. Therefore, the preferred stock dividend coverage was 1.68X. Given the big increase in spot rates, EBITDA should come in higher than the $40.4 million generated in Q3, so the preferred dividend coverage should improve in Q4.
We expect cash flow coverage to continue to strengthen through 2019. If TNP chooses to redeem the Series B preferred shares with cash, that will improve coverage even further by lowering their dividends payable each quarter.
Assets
Looking at the balance sheet, the difference between assets and liabilities is $1,588.2 million. The preferred shares have a par value of $420 million. That gives an asset coverage ratio of 3.78x.
We expect the earnings report to be out before the end of the month. This should provide good news and we expect the share prices of the preferred and the common to increase when that report is released.
The Opportunity: TNP-E and TNP-F
Tsakos Energy Navigation has five preferred issues currently available. All pay a very nice 8%-plus yield that is eligible for the 15% dividend tax rate. While all five could be good investments, two issues are currently mispriced and offer a good short term trading opportunity.
The Series B and Series C issues are very similar. Both offer a fairly decent coupon and trade just below par. Each also is past its call date so Tsakos is free to call them at any time. Each has a “failure to redeem” covenant that we believe will ensure they are called before that date (see the summation table at the end of this section for the specific date). Trading as close as they are to par and with such a short time until they are likely called, we do not believe these are a good use of cash at this time. We think other issues from Tsakos offer better opportunities.
The Series D issue offers a higher coupon than the B but lower than the C. It also lacks the “failure to redeem” of those two issues. The D issue trades around $2.50 below par and has about two years before it can be called. It has a fairly decent current yield, but not the best for TNP preferred shares. Right now the E and the F have much higher yields, but if that changes it could be that the D shares could be a good choice.
The E and F issues are mis-priced relative to the other preferred due to the selling by PFF:
- Tsakos Energy Navigation Ltd, 9.25% Ser E Fixed/Float Cumul Red Perp Prfd Shares (TNP.PE) - Yield 10.6%
- Tsakos Energy Navigation, 9.50% Ser F Fixed/Float Cumul Red Perp Preferrd Shares (TNP.PF) - Yield 10.8%
Both TNP-E and TNP-F are fairly similar in that both have a coupon over 9% and convert to a floating rate in the future. The E issue converts in 2027 while the F issue switches in 2028. At this point these two issues pay the largest cash dividend while selling for the lowest price. As long-term investments, we do not like the conversion to a floating rate.
Over the near term, we believe they should trade much closer to the D shares in price. They did in fact trade close in price to the D issue back in September of last year. We expect TNP’s Q4 earnings report to be a strong positive catalyst.
Currently the three-month LIBOR rate is 2.64%. Using the current LIBOR rate, the variable rate for the E series is 9.521% and for the F series is 9.18%. This gives a slight edge to the E series shares, but we don’t expect that to come into consideration for several years yet. We expect the Q4 earnings report to be a catalyst and do not expect this mispricing to last a long time.
PFF iShares US Preferred Stock ETF and TNP Preferreds
Again, PFF offers buyers of preferred shares a good deal. On Jan. 31, PFF owned ~775K of shares divided nearly equally between the E and F issues. As of Feb. 14, that count was down to ~500K. By Feb. 22, the count was down to 25,000. And the share prices were down by close to $2 each. In September, before the big sell off in preferred shares and well before PFF sold off around a third of its holdings, these issues were trading very close to par.
Our Price Targets
On the chart above you can see both the price drop and the increase in volume over the last two weeks of TNP-E as PFF unloads shares. Prior to those sales, TNP-E had recovered about half of the drop it suffered at the end of last year. We expect TNP-E to return to around the range it was trading at before the end-of-the-year drop. That looks like a price in the range of $24 to $25.
Again on the chart you can see both the price drop and the increase in volume over the last two weeks of TNP-F as PFF unloads shares. Prior to those sales, TNP-F had recovered about half of the drop it suffered at the end of last year. We expect TNP-F to return to around the range it was trading at before the end-of-the-year drop. That looks like a price of TNP-E and TNP-F are in the range of $24 to $25.
Using a target price of $24.00 a share, which is the low-end of the price range, investors are set to generate returns of +19% including dividends if held for a period of one year.
Risks
The shipping sector is inherently risky due to low barriers to entry and high competition. Therefore shipping stocks are generally not ideal as a "buy and hold" type investment for the long term. We recommend to keep your exposure to these preferred stocks small not to exceed 2% to 3% of your overall portfolio. This is a mis-pricing opportunity and should be viewed as a medium term investment only. Still, there are many mitigating factors for investing in these preferred stocks which include a positive outlook and high insider ownership which we will discuss in the paragraph below.
High Insider Ownership
TNP is essentially a family-owned company as the Tsakos family owns more than 60% of the common shares (approximately 53 million). The family also owns approximately 864,000 preferred stock. This aligns management very closely with shareholders and ensures that even the interests of the preferred shareholders is considered by the family. We specifically like the fact that insiders own a large amount of the preferred shares.
Conclusion
The realignment of PFF continues to offer solid opportunities for those investors who purchase preferred issues. TNP-E and TNP-F are currently mispriced and as such offer a very good short-term opportunity.
We expect that the shipping market is going to have a solid recovery in 2019. We see TNP, particularly the preferred shares, as well positioned to take advantage of the recovery.
- Over $230 million in cash on hand provides them flexibility for acquisitions, paying off debt and redeeming preferred shares.
- Shipping rates had a strong recovery in Q4 of 2018 and we believe they will continue to recover, especially in late 2019.
- TNP will benefit from increasing rates with their current ships, as well as new ships that will be deployed.
- EBITDA coverage of preferred dividends was at 1.68x the first nine months of 2018, during a period when the market was very weak. As the market strengthens, their already strong coverage will improve.
TNP-E and TNP-F offer shareholders with a dividend yield of 10.5%, plus 10% upside, for a total return of 20% over the next 12 months.
