KNOT Offshore Partners: Prepare for a Cut in Distribution (NYSE:KNOP)

Inna Dodor

introduction

The elimination of incentive distribution rights is usually viewed positively by investors, although in the case of KNOT Offshore Partners (NYSE:BUTTON), it appeared to be heading towards a cut in distribution in the future way the transaction was structured for their parent company, like my previous article explained. After a weak start to 2022, there are worrying prospects for their charters as we move into 2023 and as such it is now prudent for shareholders to brace for a payout cut, possibly as early as the forthcoming third quarter 2022 results, as discussed in this updated analysis.

Coverage summary and ratings

As many readers are likely to be short on time, the table below provides a brief summary and ratings for the main criteria assessed. If interested this Google Doc provides information on my rating system and, more importantly, links to my library of equivalent analyzes that share a comparable approach to improve comparability between investments.

Reviews from KNOT Offshore Partners

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Detailed analysis

Cash flows from KNOT offshore partners

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Unfortunately, despite their robust cash flow performance during the economic turmoil of 2020 and the bumpy recovery of 2021, 2022 got off to a weak start as their operating cash flow of 54.1m in H1 2021. On the surface they posted H1 2022 despite their otherwise weak operating cash flows still have strong payout coverage of 131.50%, although that was simply due to their almost non-existent low capital expenditures of just $1m, which is obviously unsustainable.

Looking at their distributable cash flow, which is on an accruals basis, their maintenance investments for both the first and second quarters of 2022 were $19.1 million, as shown on slide eight second quarter of the 2022 earnings presentation. These total $38.2 million but include their dry dock costs of $11.3 million which were already included in their operating cash flow resulting in an estimated maintenance investment of $26.9 million leads. If subtracted from their $54.1 million in operating cash flow, it would have left their free cash flow at just $27.2 million, very weakly covering about 69% of their $39.7 million payout. USD provided.

KNOT Offshore Partners Operating Cash Flow

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Even excluding the impact of working capital movements, their underlying operating cash flow was virtually flat from reported results in H1 2022 as a result of the working capital build of 9.2 million in the second quarter. Interestingly, this is similar to a year earlier in the first half of 2021, when the $10.5 million working capital draw in the first quarter largely offset the $11.2 million build in the second quarter. That means her weak cash flow performance in the first half of 2022 was fundamental, driven by her unusually high number of dry docks.

Fleet of KNOT offshore partners

Presenting KNOT Offshore Partners second quarter 2022 results

Reviewing the deployment of her fleet, three dry docks were completed in the first half of 2022 and two more started due for completion in the third quarter, resulting in her weak financial performance. While this was only a temporary setback, the prospects for their charter deals are troubling and therefore create greater problems as they look ahead, risking their poor financial performance being prolonged.

If they cannot secure new charter deals quickly, they face a large portion of their fleet being idle as of Q4 and deteriorating throughout 2023, as indicated by the red markers in the chart above. This is a total of six of her fleet of 18 vessels, with a further five at the charterer’s option at risk of lying idle as indicated by the blue markers in the chart above. Combined, that’s more than half of their fleet either losing or likely to lose work, which would likely have an even worse impact on their financial performance than the three to five dry docks in the first half of 2022. Not to mention, they’re standing in 2023 also ahead of two other dry docks, which entails additional costs, as denoted by the green squares in the graphic above.

The oil market is still very strong and therefore supportive, although this is nonetheless a very large part of their fleet looking for new charter contracts at the same time. Even if possible, given the laws of supply and demand, the scope for less profitable terms increases, with more available vessels equaling lower prices. When they release their forthcoming Q3 2022 results, new charters will be the most important aspect to monitor as unfortunately they do not have the financial resources needed to fill the ongoing gap in their distribution coverage that otherwise occurs would these vessels are idle. While the third quarter saw another Drop-down acquisition the Synnove Knutsen, which happily sees charter coverage through 2027, this alone cannot possibly offset ten or more vessels potentially idle.

Capital structure of KNOT Offshore Partners

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Thanks to its near-non-existent investments helping to offset its otherwise weak cash flow performance, its net debt was still falling, albeit by a very small amount, in the first half of 2022, surpassing its last level of $893.1 million .USD was slightly below its previous level of $904.8 million at the end of 2021. Following the release of its upcoming third quarter 2022 results, its net debt should increase by an additional $119 million, net of all immaterial ones, due to the Synnove Knutsen acquisition associated retained free cash flows. As they look ahead to the fourth quarter and 2023, their net debt is likely to rise and put pressure on their financial position unless they sign more charters or cut their payouts.

Leverage from KNOT offshore partners

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As 2021 ended, their leverage spread across the high and very high territories as their net debt to EBITDA of 4.48 and net debt to operating cash flow of 5.44 are still either side of the 5.01 threshold for the very high area. Unsurprisingly, given their poor financial performance, both climbed higher to 5.40 and 8.34 in the first half of 2022, now apparently crossing the very high area threshold.

Whilst this instance of very high leverage would not normally be too worrying as it is due to an unusually high number of dry docks, the questionable outlook for their charter contracts creates uncertainty which could result in continued very high leverage. Disappointingly, this leaves little to no room for debt to fund distributions, even for a year, at least not for sure, and is further compounded by the rapid tightening of monetary policy and, as discussed later, the lack of available debt financing.

Debt Service Ability of KNOT Offshore Partners

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Due to their poor financial performance, their debt-servicing ability followed in tandem with their indebtedness and deteriorated in the first half of 2022, which is increasingly important given the rapid rise in interest rates. This sees its interest coverage in comparison to the EBIT with a result of 2.06 only just sufficient, compared to the operating cash flow, however, a better, but still only sufficient result of 3.62. Given the prospects of continued weak financial performance, their ability to service their debt could decline slightly and become dangerous in 2023, putting further pressure on their financial position.

KNOT offshore partner liquidity

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Thankfully, despite their very high leverage, their liquidity still has a current ratio of 0.94 and, more importantly, a liquidity ratio of 0.76. On the surface this appears positive, but as mentioned, significant issues remain when looking at their available debt financing following the acquisition of Synnove Knutsen, which has used up most of its available credit facilities, as reflected in the quote below.

“As of June 30, 2022, the partnership had $123.5 million in available liquidity comprised of $88.5 million in cash and cash equivalents and $35.0 million in capacity under its revolving Credit facilities were in place, a portion of which was used to purchase Synnøve Knutsen on July 1, 2022.”

-KNOT offshore partners Q2 2022 6K.

The total cost of $119 million for the Synnove Knutsen acquisition includes $87.7 million of debt assumption and thus sees the cash cost at $31.3 million, nearly complete the availability of $35 million of credit facilities is used up. As a result, they depend almost entirely on their cash balance, which at $88.5 million is breathing room, to survive, but at the same time pulling it down to plug holes in distribution coverage is risky, even in the short term. If they decide to go this route, their currently high level of liquidity would quickly deteriorate and the company’s continued existence might be jeopardized.

To make matters worse, it’s hard to imagine debt markets being willing to provide more funds to allow an already heavily indebted company struggling with demand for its ships to return cash to its shareholders, especially as central banks tighten monetary policy tighten quickly. Meanwhile, they also face $332.2 million in debt in 2023 that obviously can’t be repaid through free cash flow, regardless of their payouts. Aside from turning to the debt markets for help funding their payouts when their ships are idle, they still go to the debt markets and ask for refinancing as well, making this an even bigger hurdle.

KNOT Offshore Partners Debt Maturities

KNOT Offshore Partners Q2 2022 6-K

Conclusion

Failure to quickly secure new charter deals for a larger proportion of their fleet makes distribution likely to be cut as 2023 approaches, as they clearly do not have the financial resources needed to fill a prolonged gap in their coverage . While their third-quarter 2022 results could show decent financial performance, I wouldn’t be surprised if management took preemptive action to shore up its financial position by cutting its payouts sooner rather than later. While they offer a double-digit payout yield, I still believe a downgrade to sell is appropriate as the risks are on the downside.

Notes: Unless otherwise noted, all figures in this article are from KNOT Offshore Partners’ SEC Filingsall calculated figures were performed by the author.

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