KNOT Offshore Partners: 3 Reasons Not To Jump Aboard This Ship (NYSE:KNOP)

Introduction

Well, the last week will certainly not be one the unitholders of KNOT Offshore Partners (NYSE:KNOP) will soon forget, as much to their displeasure their once very desirable distributions were cut. Whilst their distributions did not quite fall to zero as my previous article warned was possible, I am sure the 95% cut feels almost identical for their unitholders. Seeing as their unit price subsequently lost more than 40% of its value in merely days, it seems the market was not fully pricing this outcome. Following this brutal sell-off, I would like to quickly follow up with three reasons not to jump aboard this ship, ahead of reviewing their results for the fourth quarter of 2022 that are presently about one month away.

Reason One

Since their backstory is already well discussed throughout previous articles, both from myself and those from other authors, it seems best to jump straight into new content, if any new readers are interested in further details, please refer to my library of articles. The first reason not to jump aboard this ship relates to their future earnings outlook or perhaps I should say, the lack of it. When cutting their distributions, management flagged their “lack” of “forward visibility on earnings” as one of the primary reasons, which is definitively valid and apt. Although more worryingly, their visibility for earnings in future years is not looking any better and if anything, it appears even more uncertain and thus raises the prospects of a prolonged and painful road to recovery.

When looking at their latest charter backlog, the gap in 2023 is easily apparent and thus was already discussed within my previously linked articles. More so, right now the greater concern relates to 2024 that sees even fewer charter contracts for their vessels, thereby making it more likely to see a larger black hole in their work.

Whilst yes, they are likely to fill some of these gaps as 2023 progresses, as it presently stands, I count seven of their total eighteen vessels without charter contracts. Plus, a further three only carry the option for the charterer, not a firm commitment; being the “Windsor”, the “Carmen” and the “Anna”. Given the present soft operating conditions they face, it raises the prospects of struggling to plug most of these gaps with charter contracts that are sufficiently attractive, even if they can manage to find any work.

Quite unsurprisingly, this outlook does not strengthen even when looking further afield into 2025 and beyond with more vessels ending their charter contracts. I am not suggesting they cannot necessarily turn a profit, although it may be quite difficult, more so I am highlighting this is not simply a blip on the radar due to a little unfortunate luck but rather, a structural issue that presently sees no end in sight.

Reason Two

Whilst their lack of earnings visibility is certainly concerning, I nevertheless feel the bigger risk that ultimately pushed their hands to cut the distributions was their debt covenant, which they risk breaching if they do not take action. When conducting the previous analysis, this was highlighted as the primary reason why I expected their distributions to be cut and importantly, it also relates to the upcoming third reason.

To provide a quick refresh, similar to many small companies and partnerships, they are required to meet various financial covenants from their lenders. These are detailed within their 2021 20-F and conveniently, all of their debt shares the same three covenants, the most alarming and risky of which relates to a requirement of maintaining a book equity ratio of 30% or higher. When their most recent results for the third quarter of 2022 were released, their equity was $581.7m and their total assets were $1.757b and thus resulting in a book equity ratio of only circa 33%, which is barely above this covenant.

If breached, a debt covenant is a severe risk and often fatal problem because without receiving prior relief from lenders, they are forced to either repay their debt immediately or file for bankruptcy, as would be the case in this situation. On this front, I see no updates from management regarding relief from their lenders and thus, it leaves this metaphorical sword hanging above their head.

To be clear, I am necessarily not suggesting they are heading for bankruptcy but at the same time, the risk is not impossible and technically, they are scarily close to this outcome. Especially because only a minor impairment to the carrying value of their vessels would see their debt covenant breached, as per my previously linked article outlined.

Even if bankruptcy were averted, it would not be surprising to see lenders imposing restrictive terms upon any refinancing and relief package that would inhibit their ability to pay distributions or conduct unit buybacks. An example that comes to mind is NGL Energy (NGL), who sought refinancing relief from lenders two years ago in early 2021 that in turn saw the suspension of their distributions and fast-forward to the present day, they have still not escaped this burden. As a result, this raises the downside risk of holding onto their units, despite their recent heavy losses as the market wakes up to these worrying facts.

Reason Three

The third and final reason relates to deleveraging because to fully resolve the risks stemming from their debt covenant, they realistically need to slash debt. Furthermore, this would also remove a degree of the burden imposed by their interest expense as well as boost their operational flexibility during these uncertain times.

Whilst a fairly simple and straightforward path, alas it is not likely to be quick nor pain-free, especially for unitholders who are left waiting around in the background because their balance sheet carries net debt of $1.009b, following the third quarter of 2022. To fully resolve their debt covenant issues, it would require shaving away at least one-third or circa $333m of their net debt, thereby boosting their aforementioned equity to circa $900m and thus in turn, lifting their book equity ratio to a much safer circa 50% from its current circa 33%.

The exact timeline to shave away one-third of net debt is currently uncertain given their previously discussed earnings outlook, although the estimates are concerning. To start as a basis point, we can utilize their free cash flow of circa $150m during 2021, as per the data within my previously linked articles. Even under this unrealistically bullish scenario, it would still take around two years to achieve this deleveraging. Since their new quarterly distributions are insignificant, they can effectively be ignored as their effect on this timeline pales in comparison to other variables. That said, the loss of several charter contracts and soft operating conditions makes this scenario impossible and thus this timeline is going to be much longer.

When looking at the first nine months of 2022 as their financial performance began weakening, they only generated free cash flow of $76.3m, which annualizes to circa $100m. Since 2023 and beyond sees even more disruptions from the gaps in charter contracts, it seems that as little as circa $75m per annum of free cash flow is quite possible and if so, this would push out the deleveraging timeline to four years.

Once again, this is assuming they avoid impairments that reduce their aforementioned total assets of $1.757b and thus, this already prolonged timeline may ultimately be pushed out even further, possibly materially past five years. In my eyes, the prospects of avoiding impairments on their vessels is looking increasingly unlikely given their lack of earnings visibility. Whilst yes, a recovery would see this timeline shorten as their free cash flow heads back towards its previous levels, given the gaps in the charter contracts, I feel it is far too premature to include as a scenario.

Conclusion

Even though it feels somewhat vindicating to see my warnings come to pass, it is nevertheless disappointing to see a once very desirable double-digit distribution yield disappearing overnight. I imagine that many of their unitholders are hoping for a swift recovery, although disappointingly, the facts do not portray such an outlook. Their earnings visibility only gets worse the further afield one looks, they continue facing a severe risk from their debt covenant and just as bad, it could take the better part of a decade to deleverage sufficiently and restore their distributions anywhere near their former glory. Following the sharp and painful sell-off their unit price endured in the last few trading sessions, I now believe that upgrading to a hold rating is appropriate whilst we await to see further guidance from management.

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