KNOT Offshore ($KNOP) — Initiation (12/25/21)

Price: $13 Market Cap: $445m Valuation: 6.8x EBITDA / 16% dividend yield Category: General

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KNOT Offshore Partners LP ($KNOP) is a shipping company in the oil & gas supply chain. They operate shuttle tankers — described as “floating pipelines” — which transport oil from deepwater oil rigs to onshore storage terminals. It’s an interesting and very specialized portion of the shipping market. The entire shuttle tanker industry has a fleet of some 70-80 ships vs. 5000+ in the conventional tanker market (which transports crude from terminals to refineries for processing).

KNOP came public in 2013 as a drop down vehicle for largest shareholder Knutsen NYK — which itself is a JV between Norwegian shipping company Knutsen OAS and Japanese shipping company NYK. I’ll refer to Knutsen NYK as KNOT and KNOT Offshore Partners as KNOP from here on out.

My investment criteria nearly always requires an attractive valuation (which KNOP has in spades) but I like the niche focus and quality of management as well.

The stock is pretty beaten up lately. Most likely from some near-term worries around contract renewals, vessel replacements/acquisitions, and the magnifying effect of leverage.

Shares are down from $20 to $13 today and I think it’s likely they’ll creep back toward that $20 level in 2022 while continuing to pay the lofty dividend (16% yield).

Niche market

To get a sense for how small the industry is, KNOP has 17 tankers generating ~$280m in annual revenue and they control roughly 22% of the market (17 of 77 ships). This means the entire industry is probably less than $1.5bn in annual revenue.

Ships are only built with a contract in-place so there isn’t any speculative construction going on. These ships are also incredibly expensive relative to traditional tankers at a cost of $115m vs. $60-65m. High cost to build and small market means very stable supply / demand dynamics.

The stability of cash flows are incredible. KNOP’s daily rates per vessel are virtually unchanged from 2011 to 2021 at ~$48,000 per operating day. You’d never believe the industry experienced a downturn in 2014-2016 by looking at long-term financials.

Long-term outlook for shuttle tankers is excellent. The 2 main geographic areas served are deep and ultra deep waters in Brazil and the UK/Norway North Seas. Deepwater oil has some long-term benefits in that the marginal production cost is very low once the wells are operating and the oil reserves in deepwater fields are massive. Unlike shallow water fields such as those on the Gulf of Mexico shelf, pipelines can’t be used to transport the oil from deepwater rigs to onshore terminals. Shuttle tankers have specialized equipment for stabilization while loading oil.

As another reference point — Rig owners like Valaris and Transocean have shifted their portfolios to deep/ultradeep water rigs. And oil companies like Petrobras are investing heavily in deepwater production.

Insider ownership & management

Knutsen NYK (KNOT) owns roughly 10m shares for a 29.2% stake in KNOP following the recent elimination of incentive distribution rights.

It’s important to note here that KNOP is more like a leasing company than an actual operating business. KNOP has only 1 employee — Gary Chapman who acts as CEO, CFO, and all things “management.” The underlying operations, staffing, maintenance of the vessels are handled via operating agreements with KNOT. From a financial statement perspective, KNOP doesn’t have much capex or working capital. You can think of “capex” here as the need to acquire additional ships from KNOT (i.e. asset drop downs) which is paid for via cash, equity raises, and/or assuming debt on the acquired ships.

Financials & valuation

So we’ve established that the industry has stable cash flows and a reasonable long-term outlook. Despite that, the share price tends to be pretty volatile around oil prices and sentiment. This leads to periodic opportunities to pick up shares on the cheap. Today feels like one of those opportunities!

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At $13/share, KNOP is a $440m market cap with $920m or so in net debt for a $1.36bn enterprise value. Operating cash flow has been at $160m+ the past few years and is likely to stay there for 2021. Right off the bat, we’re looking at less than 3x P/CFO and 5.6x debt/CFO.

Of that $160m per year in cash flow, $80m or so goes toward the common and preferred dividends. [Reminder — the dividend of $2.08/share is a 16% yield at today’s price.] This leaves another $80m for other capital allocation purposes — namely, repaying debt or acquiring new vessels.

Net income (including deprecation expense) has been $60-70m the past few years and might be the best way to view true earnings power of the business given the need to replace vessels over time. In that scenario, KNOP is actually outspending earnings by $10-20m per year through the dividend; a portion of which should be viewed as a return of capital and not a return on your capital. If we’re strictly looking at valuation on net income, then KNOP is trading at 6-7x earnings.

I don’t find EBITDA to be a super helpful metric in this business. Since it’s an MLP, they pay no taxes. There’s hardly any working capital here as well. So EBITDA is essentially the same as operating cash flow plus interest expense. But we’ll look at it anyway...

At the time competitor Teekay Offshore was acquired by Brookfield, the fairness opinion conducted by Evercore included comparables and transaction analysis. They came to forward EBITDA multiples of 7.5x to 8.5x and shuttle tanker transactions at 10x EBITDA. With a $1.36bn EV and $200m in trailing EBITDA, KNOP trades at 6.8x — using the 7.5x to 10x EBITDA multiples from Teekay would yield a share price of $17-30 for KNOP.

Taking a quick look at the sources and uses of cash flow…

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As mentioned, it is a high operating cash flow business with “capex” coming from new vessel acquisitions. Debt repayments are misleading here since the company has used debt assumptions as a form of acquiring vessels. Digging into that further, we can see that 2012-2020 had $1.3bn in debt assumed vs. $670m repaid for a net increase of $680m.

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Re-contracting vessels

Day rates have been stable in the industry but there are still short-term risks in securing new contracts for vessels.

There are a handful of vessels with expiring contracts throughout 2022. I felt the latest earnings release discussed the situation well...

Outlook

The Partnership’s earnings for the fourth quarter of 2021 will be affected by the planned 5-year special survey dry docking of the Tordis Knutsen which will be off-hire from mid-December 2021 for the start of its mobilization trip to Europe where the vessel will undergo the dry docking. The work is expected to take approximately 60 days to complete, including mobilization time to and from Brazil.

As of September 30, 2021, the Partnership’s fleet of seventeen vessels had an average age of 7.8 years and had charters with an average remaining fixed duration of 2.1 years. In addition, the charterers of the Partnership’s time charter vessels have options to extend their charters by an additional 2.7 years on average. As of September 30, 2021, the Partnership had $592 million of remaining contracted forward revenue, excluding options.

Except for the Tordis Knutsen (for its planned scheduled drydock in the fourth quarter), the Partnership’s entire fleet is fully contracted for the remainder of 2021 and therefore the Partnership expects its distribution coverage ratio to remain strong for the fourth quarter.

Shuttle tanker demand continues to reflect the delays to offshore project development timelines following from the dramatic capex reductions instituted by offshore oil producers during the early days of the COVID-19 pandemic. Despite the resumption of offshore development activity in response to the strong recovery in oil demand, the lag effect introduced by the delay in capex deployment continues to have an impact on the shuttle tanker charter market.

Low vessel newbuilding prices which existed throughout 2019, 2020 and into 2021 have also impacted the competitiveness of the Partnership’s fleet during charter renewal discussions, relative to the ordering of newbuildings. However, vessel newbuilding prices have increased significantly over the previous six months and a number of older shuttle tankers have been retired, in particular in the North Sea. While there remains softness in short-term demand for shuttle tankers, and the Partnership expects this could continue through at least some portion of 2022, several opportunities are being discussed with customers and the Partnership remains optimistic that it can secure profitable charters for its vessels in the intervening periods, such as the charter recently agreed for the Windsor Knutsen with PetroChina. Due to the niche nature of the shuttle tanker market, the integral role that shuttle tankers play in customers’ supply chains and the absence of speculative ordering (meaning that the vast majority of the global fleet are not ‘in the market’), the Partnership believes that there are several potential drivers for a material strengthening in the near-to-mid-term market environment.

The Board continues to expect significant mid to long-term expansion of deep and ultra-deep water offshore oil production in areas such as Pre-salt Brazil, the North Sea and the Barents Sea that will drive demand for existing and for newbuild shuttle tankers. Such production areas have supportive project economics and competitive marginal oil production costs and today there are significant orders of contracted FPSO’s to support the premise that projects will go ahead. Our customers’ publicly stated commitment to focusing on such deep-water production strategies also supports the Board’s view that shuttle tanker demand growth is projected to outpace net shuttle tanker supply growth during this decade. As such, the Board remains very positive with respect to the mid-to-long-term outlook for the shuttle tanker market and remains of the view that any near-to-mid-term market softness is largely transitory in nature.

Without some activity, KNOP is in for a choppy 2022-2023 period financially. This likely has investors spooked and “waiting to see” what will happen with renewal discussions.

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Vessel replacement costs

Technically, if building a new vessel runs $115m and they have a useful life of ~20 years = $6m annual depreciation (rounding up). Multiply by 17 vessels and you get $100m in true depreciation costs. Depreciation is running at $85m a year; so a bit short of where it might need to be for the entire fleet.

Without acquiring new vessels, KNOP is essentially in run-off with the current fleet. Management has taken a mixed approach to buying new vessels from KNOT. Issuing equity has been a key piece of that equation but strictly at prices that justify the equity issuance. In December 2020, with share prices below $20, management opted to use a combination of debt and cash on hand in lieu of an equity offering.

There are 3 vessels available to acquire from KNOT right now and 6 total available in the future. The challenge is capital availability. As an MLP they rely on dividends to attract investors. Retaining earnings is minimal. With the stock price low, management is reluctant to issue new equity which further stifles growth.

Other tidbits

I found this excerpt from the 3Q17 Brookfield Business Partners shareholder letter to be a great synopsis of the KNOP investment — Brookfield acquired close competitor Teekay Offshore; and here’s how they described the business:

In September, we closed our acquisition of Teekay Offshore, a leading provider of critical transportation and production services to the offshore oil industry. Teekay Offshore has several attributes that we believe are attractive. It is a market leader in offshore production services, controlling approximately 40% of the global fleet in the shuttle tanker market and is among the largest players in the FPSO (floating production, storage and offloading) market with a focus on mid-size projects. It generates stable cash flows underpinned by diverse medium to long term, fixed rate contracts with high quality, primarily investment grade counterparties. As a fee-based business, it has limited direct commodity exposure and its customers have competitive operating costs supportive of continuing production, even in a lower oil price environment. This is a well-managed business at the operating level that experienced liquidity constraints with an overleveraged balance sheet. We were able to provide new capital to Teekay Offshore to address their balance sheet leverage and provide liquidity to execute their strategic plan.

As an added bonus to the situation — KNOP elects to be treated as a C-Corp for US unitholders. This means no finnicky K-1s and instead you’ll receive a regular 1099 for dividends just like any plain vanilla public company.

Final thoughts

Now we have the full background and all of the facts…

My take is that 2022 will see cash flow down from 2021 (see the gaps in the chart above) as contracts are negotiated for a 2023 start date. Because management sees this coming, they’ve been reluctant to spend the balance sheet on a new vessel (even though they have capacity for it).

My simplistic estimate for 2022 — there are 10 ships that have nearly a full year of activity booked and another 6 with contracts running one quarter to one half of 2022. This looks a lot like FY2017 which had $167m in EBITDA. Back out $30m in interest expense and you’d have $137m or so in free cash flow. Rounding down to $130m FCF leaves $50m available for debt reduction or vessel acquisitions after the dividend.

So sit back, enjoy the dividend and a potentially choppy ride in 2022. Just know that the business and industry have solid long-term value and shares will eventually reflect that reality. This could happen faster with a few major renewals in the bag too.