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KNOT Offshore: Tempting 10.3% Yield, But Know The Risks

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In addition to the outsized 10.3% yield, Knot Offshore has a variety of attractive things going for it. But before diving in headfirst, investors may want to consider the 7 significant risk exposures described in this article.

About:

KNOT Offshore Partners LP (KNOP) engages in the business of owning, operating and acquiring shuttle tankers under long-term charters. It intends to have a modern fleet of shuttle tankers that will operate under long-term charters with major oil and gas companies engaged in offshore production. The company was founded on February 21, 2013 and is headquartered in Aberdeen, the United Kingdom.

KNOT’s Attractive Qualities

(1) 10.3% Dividend Yield: If you are an income-focused investor, it’s hard not to notice the 10.3% dividend yield offered by this niche shuttle tanker company. And perhaps even more attractive to you is the fact that the dividend is well-covered by distributable cash flow as shown in the following table.

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(2) No K-1 at Tax Time: Completing your taxes is a hassle for most people, and no one likes the added distraction of receiving a K-1 statement (for Unrelated Business Taxable Income (“UBTI”)) that comes with owning most MLPs. However, KNOT is a rare MLP that does NOT send K-1 statements. Per KNOT: “The Partnership has elected to be treated as a C-Corporation for tax purposes (our investors receive the standard 1099 form and not a K-1 form).” This is a nice reduced hassle at tax time, and it makes it possible for more investors to own KNOT in a tax-exempt IRA, if they so choose.

(3) Attractive Supply and Demand: Another thing KNOT has going for it is that demand in the shuttle tanker industry is expected to grow in the coming years, as shown in the following chart.

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Additionally, higher oil prices have helped keep demand strong in this niche shuttle tanker industry over the last year. Conditions (energy prices have improved significantly since the big declines that started in the second half of 2014 through 2015, 2016 and into 2017.

Further still, KNOT is in an attractive position on the supply side considering it is the second largest player in the niche shuttle tanker industry.

(4) Duopoly: The shuttle tanker industry is essentially a duopoly with Teekay Offshore (TOO) leading the way, followed closely by KNOT. In fact, according KNOT’s annual report:

“as of February 6, 2018, there were approximately 82 vessels in the world shuttle tanker fleet (including 6 newbuilds on order). Teekay Offshore Partners L.P. is the largest owner in the shuttle tanker market with approximately 33 shuttle tankers (including 5 newbuilds on order). KNOT is the second largest owner of shuttle tankers with 29 shuttle tankers (including our vessels). American Eagle Tankers (AET) is the third largest owner of shuttle tankers with 6 vessels (including 2 newbuilds on order). Petrobras, which owns two vessels, employs a total of 24 existing shuttle tankers through long-term bareboat and time charters. There are other shuttle tanker owners in the industry, but the majority of such owners have a limited fleet size and have chartered vessels out for the long term.”

This industry dynamic bodes well for KNOT (and Teekay) because as demand grows, they’ve already build strong relationships with customers (large Offshore E&P companies) that will make them the obvious choice for new business.

These Are The Big Risks:

(1) Competition from Teekay: As mentioned above, the shuttle tanker industry is essentially a duopoly with Teekay being the biggest then followed by KNOT. And in addition to being larger, the Teekay family of company’s has more financial resources that may make them more attractive to some customers. For example, according to KNOT’s annual report:

“Our debt level may make us more vulnerable than our competitors with less debt to competitive pressures or a downturn in our industry or the economy generally.”

KNOT’s position as the #2 shuttle tanker business puts them at a disadvantage to Teekay in terms of both financial strength and customer relationships.

(2) Shipping Contracts Ending: Another risk factor to be aware of is that KNOT has multiple long-term contracts that will end soon, as shown in the following graphic:

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For example, the contracts associated with several of KNOT’s shuttle tankers end within the next year. And while these contracts can be extended (i.e. see the “option period” in the above graphic) there is no guarantee that the business will continue. Failure to renew these contracts and future contracts creates uncertainty and it’s a risk factor for KNOT.

(3) Drydocking: Drydocking of ships has recently extended longer than expected, and this has negatively impacted distributable cash flows as shown in our table earlier in this report (see: Estimated maintenance and replacement capital expenditures (including drydocking reserve) earlier). And on the last earnings conference call, KNOT stated:

There are four first special survey dry-dockings in 2018, one third of the time charter fleet. Three of these vessels operate in the North Sea, Hilda, Torill, and Ingrid, and one, Brasil Knutsen, all will dry-dock in Europe. The vessels will go off-hire and the positional bunker costs are expensed.

These dry-dockings will impact cash flow, and could cause volatility in the share price.

(4) Debt Maturing: The upcoming debt maturity schedule poses another risk for KNOT. For example, the company has a significant amount of term loans maturing in 2019, as shown in the following table.

Interest rates have continued to rise in recent years thereby making financing more expensive for KNOT. KNOT’s outstanding debt has increased in recent years (but so too have assets) as shown in the following graphic.

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And the maturing debt (mentioned above) also creates an interesting dynamic considering several tanker contracts expire over the next 12 months, and a failure to extend this expiring businesses could quickly make the 2019 debt maturity considerably more challenging to deal with.

And related to debt maturities, KNOT explained on its last quarterly call:

We also see rising interest rates in the U.S. in 2018 and 2019 together with increasing replacement CapEx provisions charged on our vessels as they get older. However, our coverage should be significantly better this year and in 2019. KNOP has a significantly elevated yield compared to most MLPs, and we continue to remain focused on firstly building coverage and then deleveraging when not making accretive investments.

(5) Customer Concentration: KNOT currently derives all of its time charter and bareboat revenues from seven customers, and the loss of any customers could result in a significant loss of revenues and cash flow. Specifically, Eni Trading and Shipping S.p.A. (“ENI”), Fronape International Company, a subsidiary of Petrobras Transporte S.A. (“Transpetro”), Statoil ASA (“Statoil”), Repsol Sinopec Brasil, S.A. (“Repsol”), Brazil Shipping I Limited, a subsidiary of Royal Dutch Shell, formerly BG Group (“Shell”), Standard Marine Tønsberg AS a Norwegian subsidiary of ExxonMobil (“ExxonMobil”) and Galp Sinopec Brazil Services B.V (“Galp”) accounted for approximately 22%, 21%, 11%, 13%, 24%, 8%, and 1%, respectively, of KNOT’S revenues.

(6) Management Conflicts of Interest: This is one of the biggest risk factors that investors need to be aware of before investing in KNOT. For example, KNOT’s sponsor is Knutsen NYK Offshore Tankers, and this sponsor owns a 25.7% limited partner interest in KNOT as well as owning and controlling KNOT’s general partner (the GP owns a 1.85% general partner interest in KNOT and a 0.3% limited partner in KNOT). The problem is that this particular GP will NOT always act in the best interest of KNOT because of the conflicts of interest. Here is what KNOT’s annual report has to say about this:

“KNOT… affiliates own a substantial interest in us and have conflicts of interest and limited fiduciary and contractual duties to us and our common unitholders, which may permit them to favor their own interests to the detriment of our unitholders. As of April 25, 2018, KNOT [affiliates] owned 26.2% of our common units and owned and controlled our general partner, which owns a 1.85% general partner interest in us and 0.3% of our common units. Certain of our directors are directors of KNOT or its affiliates, and, as such, they have fiduciary duties to KNOT or its affiliates that may cause them to pursue business strategies that disproportionately benefit [affiliates]… which otherwise are not in the best interests of us or our unitholders. Conflicts of interest may arise between KNOT and its affiliates (including our general partner), on the one hand, and us and our unitholders, on the other hand. As a result of these conflicts, our general partner and its affiliates may favor their own interests over the interests of our unitholders. Please read “—Our partnership agreement limits our general partner’s and our directors’ fiduciary duties to our unitholders and restricts the remedies available to unitholders for actions taken by our general partner or our directors.”

In laymen’s terms, this basically means KNOT investors will get thrown under the bus if it saves the hides of the conflicted management team and the general partners other interests. One clear example of this is “incentive distribution rights.”

(7) Incentive Distribution Rights (“IDRs”): IDRs are basically a way for management owners to share in a disproportionately large percentage of an investment’s upside (in this case KNOT), while allowing non-IDR investors to own a disproportionately large percentage of an investment’s downside (i.e. you, if you invest in KNOT).

Here is what KNOT’s annual report has to say about IDRs (it’s long, but worth reading):

Incentive distribution rights represent the right to receive an increasing percentage of quarterly distributions of available cash from operating surplus after the minimum quarterly distribution and the target distribution levels have been achieved.

The following table illustrates the percentage allocations of the additional available cash from operating surplus among our unitholders, our general partner and the holders of the incentive distribution rights up to the various target distribution levels. The amounts set forth under “Marginal Percentage Interest in Distributions” are the percentage interests of our unitholders, our general partner and the holders of the incentive distribution rights in any available cash from operating surplus we distribute up to and including the corresponding amount in the column “Total Quarterly Distribution Target,” until available cash from operating surplus we distribute reaches the next target distribution level, if any. The percentage interests shown for our unitholders, our general partner and the holders of the incentive distribution rights for the minimum quarterly distribution are also applicable to quarterly distributions that are less than the minimum quarterly distribution. The percentage interests set forth in the table below assume that our general partner owns a 1.85% general partner interest and that we do not issue additional classes of equity securities.

 

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IDR’s are just one example of the conflicts of interest that exist between KNOT management and unitholders/investors. If you are an income-focused investor, and as long as market conditions remain relatively healthy, KNOT may be a worthwhile investment for you because KNOT will keep paying you those big dividends. However, you won’t fully participate in any huge upside because of the IDRs. And if/when the stuff hits the fan, KNOT management will be quick to act in their own best interest NOT yours (i.e. they’ll be looking for a way to protect their investment at your expense).

Valuation:

For most KNOT investors, their main focus is on the safety of the big dividend (i.e. can KNOT keep covering the dividend payments to investors). And a little capital appreciation is the secondary objective.

From a dividend coverage standpoint, we saw earlier in this report that the dividend is very well covered (i.e. the dividend coverage ratio has a lot of cushion). However, this can change quickly from unforeseen drydocking, if contracts expiring don’t get renewed, and if refinanced debt comes at a significantly higher interest rate, to name a few. The good news is that the market appears healthy based on supply/demand dynamics and higher oil prices. Further, as management mentioned on the last call:

KNOP has a significantly elevated yield compared to most MLPs, and we continue to remain focused on firstly building coverage and then deleveraging when not making accretive investments.

Also, assuming conditions remain healthy, and the dividend remains well covered, the price of KNOT does have some room to increase. For example, KNOT currently trades just over its book value, which is very reasonable, in our view (however it did trade much lower during the energy market distress of 2016-2017).

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Similarly, KNOT trades near the lower end of its recent forward EV/EBITDA and below Teekay Offshore (although that’s not an apples-to-apples comparison considering Teekay is more diversified than only shuttle tankers. Teekay Offshore segments include Floating Production, Storage and Offloading; Shuttle Tanker; Floating Storage and Off-Take; Unit for Maintenance and Safety; Towage; and Conventional Tanker).

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For added perspective, of the four Wall Street analysts that currently cover Teekay, there are zero sell recommendations, and the average price target is over $23, thereby suggesting the shares have 15% upside in the near-term.

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Conclusion:

We’re not opposed to owning these shares, but keep in mind the yield is high for a reason (i.e. the market is perceiving risk, as described in this article). We also believe in the importance of achieving a high-yield by diversifying your investment portfolio across a variety of income-paying market categories (e.g. REITS, BDCs, CEFs, MLPS, and others). In addition too KNOT, you can read our recent articles on Teekay here:

KNOT is expected to release its financial results for the First Quarter of 2018 before opening of the market on Wednesday, June 6, 2018; and if new information and/or a significant share price move comes to fruition, we’d consider adding KNOT (KNOP) to our diversified income-focused investment portfolio. You can view all of our current holdings here.

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