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

Daniel Thurecht profile picture

Inna Dordor

Introduction

The elimination of incentive distribution rights is generally viewed favorably by investors, although in the case of KNOT Offshore Partners (New York Stock Exchange: KNOP), seemed to be preparing for a distribution cut in the future given the how the transaction was structured for its parent company, such as my Previous article explained. After a weak start to 2022, there is a worrying outlook for its charter contracts as we head into 2023 and, as a result, it is now prudent for unitholders to prepare for a distribution cut, possibly as soon as their next third quarter of 2022. results, as discussed in this updated analysis.

Summary of Coverage and Qualifications

Since many readers are likely to be short on time, the following table provides a brief summary and ratings for the main criteria evaluated. If you are interested, this google doc provides information about my rating system and, more importantly, links to my library of peer reviews that share a comparable approach to improve comparability across investments.

KNOT Offshore Partner Ratings

Author

Detailed analysis

Cash flows from KNOT's offshore partners

Author

Despite its resilient cash flow performance during the economic crisis of 2020 and the bumpy recovery of 2021, unfortunately, 2022 started weak with its operating cash flow of $54.1 million during the first half almost a third less than its result. previous $79.8 million during the first half. the first half of 2021. On the surface, they still saw a strong distribution coverage of 131.50% during the first half of 2022 despite their weak operating cash flow, although this was simply due to their almost non-existent capex under just $1m which is obviously not sustainable.

If you look at your distributable cash flow that works on the accrual principle, your sustaining capital expense was $19.1 million for each of the first and second quarters of 2022, according to slide eight of your 2022 earnings presentation. second quarter 2022. This adds to $38.2 million, but includes its $11.3 million dry-docking expenses that were already included within its operating cash flow, resulting in an estimated sustaining capital expense of $26.9 million. If subtracted from your operating cash flow of $54.1 million, it would have left your free cash flow at only $27.2 million, and thus would only provide a very weak hedge of about 69% to your payments. distribution of $39.7 million.

KNOT Offshore Partners Operating Cash Flows

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Even without the impacts of working capital movements, its underlying operating cash flow was virtually unchanged compared to reported results during the first half of 2022, as its $9.2 million working capital creation during the first quarter practically made up for his subsequent withdrawal of $9.8 million during the second quarter. Interestingly, this is similar to the previous year during the first half of 2021, when its working capital of $10.5 million during the first quarter more than offset its creation of $11.2 million during the second quarter. This means that its weak cash flow performance during the first half of 2022 was critical, which was due to its abnormally high number of dry docks.

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KNOT Offshore Partner Fleet

KNOT Offshore Partners Second Quarter 2022 Results Presentation

Examining its fleet deployment, three dry-docks were completed in the first half of 2022 and another two were started that should be completed during the third quarter, causing its weak financial performance. While this was only a temporary setback, the outlook for its charter contracts is worrying and therefore creates bigger problems looking ahead, which risks prolonging its weak financial performance.

Unless they can quickly secure new charter contracts, they face a large portion of their fleet sitting idle starting in Q4 and getting worse throughout 2023, as indicated by the red ticks in the chart above. These make up six of their fleet of 18 vessels with a further five at risk of becoming idle at the charterer’s choice, as indicated by the blue ticks in the graphic above. When combined, this is more than half of its fleet that is losing work or could lose work, which would likely have an even worse impact on its financial performance than the three to five dry docks during the first half of 2022. Not to mention, they also face another two dry docks during 2023, leading to additional costs, as indicated by the green squares in the chart above.

The oil market remains very strong and therefore supportive, although a very large part of its fleet is looking for new charter contracts at the same time. Even if possible, it increases the margin for less profitable conditions given the laws of supply and demand, according to which more boats available equal lower prices. When they publish their next results for the third quarter of 2022, the new charter contracts will be the most important aspect to monitor because, unfortunately, they do not have the necessary financial resources to close the prolonged gap in their distribution coverage that would occur if the majority of these ships are inactive. While the third quarter saw another rollout acquisition from Synnove Knutsen, which thankfully sees charter deal coverage through 2027, this alone cannot make up for another ten or so potentially idle ships.

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Capital structure of KNOT offshore partners

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Thanks to its almost non-existent capex that helped offset its weak cash flow performance, its net debt still declined during the first half of 2022, albeit only to a very small extent with its last level of $893.1m slightly down. from its previous level. of $904.8 million at the end of 2021. Following the release of upcoming third quarter 2022 results, its net debt should increase another $119 million due to the acquisition of Synnove Knutsen, less any retained free cash flow that would accompany. Looking ahead to the fourth quarter and 2023, unless they secure more charters or reduce their distributions, their net debt is likely to increase and put pressure on their financial position.

Leverage of KNOT's offshore partners

Author

As 2021 ended, its leverage was spread between high and very high territories due to its net debt to EBITDA of 4.48 and net debt to operating cash flow of 5.44 still on both sides of the 5.01 threshold for the very high territory. Unsurprisingly, their weak financial performance during the first half of 2022 saw both rise to 5.40 and 8.34, obviously now breaking the threshold of very high territory.

While this very high leverage case would not normally be too worrisome because it came from an abnormally high number of dry docks, the questionable outlook for its charter contracts creates uncertainty that prolonged very high leverage could create. Unfortunately, this leaves little or no room to finance distributions through debt, even for a year, at least not safely, and is compounded by the rapid tightening of monetary policy, furthermore, as discussed below, their lack of available debt financing.

KNOT Offshore Partners Debt Service

Author

Due to its weak financial performance, its debt repayment capacity continued along with its leverage and deteriorated during the first half of 2022, which becomes increasingly important to consider as interest rates rise rapidly. This now sees its interest coverage barely sufficient compared to its EBIT at a result of 2.06, while compared to its operating cash flow it sees a better but still sufficient result of 3.62. Given the prospect of prolonged weak financial performance, its debt service could easily decline and become dangerous during 2023, thus putting further pressure on its financial position.

KNOT Offshore Partners Liquidity

Author

Despite its very high leverage, its liquidity fortunately continues to show a current ratio of 0.94 and more importantly a cash ratio of 0.76. On the surface, this looks positive, but as mentioned above, significant issues remain when considering its available debt financing following the acquisition of Synnove Knutsen, which exhausted most of its credit facility availability, as quoted. includes below.

“As of June 30, 2022, the Company had $123.5 million in available liquidity, consisting of cash and cash equivalents of $88.5 million and $35.0 million of capacity under its revolving credit lines, part of which was used to purchase Synnøve Knutsen on July 1, 2022.”

-KNOT Q2 2022 6-K offshore partners.

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The $119 million total cost of its acquisition of Synnove Knutsen includes $87.7 million of debt assumption and thus sees the cash cost at $31.3 million, thus almost completely depleting its line availability. credit of $35 million. As a result, they rely almost entirely on their cash balance to survive, which at $88.5 million provides breathing space but, at the same time, withdrawing it to plug holes in distribution coverage is risky even in the short term. If they choose this path, their current strong liquidity would rapidly deteriorate, potentially jeopardizing their ability to remain a going concern.

To make matters worse, it’s hard to imagine debt markets willing to extend more funds so that an already heavily indebted company experiencing problems with demand for its ships can return cash to its shareholders, especially as central banks rapidly tighten monetary policy. . Meanwhile, they also face $332.2 million of debt maturing through 2023 that obviously cannot be paid through free cash flow, regardless of their distributions. As well as asking the debt markets to help finance their distributions if their ships are idle anyway, they also go to the debt markets to ask for refinancing, which makes this an even bigger hurdle.

KNOT Offshore Partners Debt Maturities

KNOT Q2 2022 6-K Offshore Partners

conclusion

Unless they can quickly secure new charters for more of their fleet, distribution is likely to be cut off as 2023 approaches because they clearly don’t have the financial resources to close any protracted gaps in their coverage. While the upcoming third quarter 2022 results may show a decent financial performance, I wouldn’t be surprised to see management move preemptively to shore up their financial position by cutting their distributions sooner rather than later. Although they offer a double-digit distribution yield, I still believe downgrading to a sell rating is appropriate as risks are skewed to the downside.

Notes: Unless otherwise specified, all figures in this article were taken from KNOT Offshore Partners’ SEC filingsall calculated figures were made by the author.

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