K-Sea Transportation: Expect KeyCorp, Wells Fargo to Protect Credit Risk

Includes: KEY, KSP, WFC
by: Dan Plettner

Thesis: Dilution will be painful and the stock price will decline very significantly, but if K-Sea (NYSE:KSP) and creditors act prudently and promptly to shore up its balance sheet, they can still save K-Sea’s stakeholders from the same fate of U.S. Shipping (USS). While bankruptcy should be avoided, it may require a misplaced faith in non-fungible asset values to perceive the current equity as having any meaningful intrinsic value.

K-Sea sent out a 10-Q filing alert Friday evening, which expands on the recently announced surprisingly severe 3rd quarter operating loss. The 10-Q is a worthy read. Buried in paragraph five of the press release had been an admission especially problematic for holders of the limited partner units (KSP) and creditors. K-Sea Transportation Partners anticipates breaching its newly amended debt and lease agreement covenants and needs to amend those covenants for the 2nd time this year.

K-Sea has used a bank credit facility which includes lead arranger Key (NYSE:KEY) and a Wells Fargo (NYSE:WFC) entity for the leverage to finance its business. Covenants exist because those banks primary duties are to their own shareholders. Banks need to protect themselves from the prospect of never being paid back, with insufficient liquidation value in the event of bankruptcy. When fixed charge coverage or total funded debt to EBITDA covenants get breached, such signals that there is too much debt with insufficient equity on the company’s balance sheet.

In the case of K-Sea, this latest covenant breach warning is especially suggestive of insufficient equity because the last covenant amendment provided KSP a significant step up in allowed debt-to-EBITDA leverage to 5:1 with one (among many) condition being that the allowed leverage step back down to a permanent 4.5:1 at September 30th. The apparent June 30 breach is to exceed a leverage threshold that would have been allowed above the lenders’ acceptable permanent leverage.

Neither banks nor KSP holders should rely on book value for Jones Act companies. Banks should know the asset side of the balance sheet is cluttered with what can be arbitrary numbers. There is not a fungible market for K-Sea’s assets. Jones Act vessels typically carry twice the cost of building a like brand new vessel in Korea, but that doesn’t mean there is a buyer. I spoke to two equity analysts covering KSP and neither could offer even a rough estimate as to what the assets are really worth. One acknowledged he couldn't hazard a guess as to “above or below 50%” of the value carried on the balance sheet.

Liquidation would surprise me because such would be a bad solution for the banks, too. It is hard to say whether liquidation might even cover the debt. Although it went unmentioned in analyst reports, the last convent amendments required additional security to be assigned to the security trustee under the revolving credit agreement. The banks don’t share their estimates of assets’ value with KSP investors, analysts, or even me.

These particular assets’ illiquidity is most problematic in an uncertain global growth environment and may be best summarized by Maritime business expert and writer Barry Parker. “Vessel assets are always illiquid. In the Jones Act- for US deepsea assets, the problem is exacerbated because of the limited number of players and equipment.” K-Sea’s private Jones Act peers are levered themselves, and in no position to buy K-Sea’s Vessels.

K-Sea needs to raise equity in the interest of all its long term stakeholders. Assuming that Key, Wachovia, and LaSalle prioritize the safety of their own shareholders and balance sheets, the banks will force K-Sea to raise equity whether KSP management and current unit holders desires the dilution that comes with a less levered balance sheet, or not.

K-Sea’s operating business is in terrible shape. By the end of this year KSP anticipates nearly 50% of its business once dominated by contracts to come from the spot market. Rates and utilization are down. Visibility is deteriorating and broad economic uncertainty adds to the problem. K-Sea is a public company competing with private operators like Reinauer, Moran, and Vane Brothers.

With customer knowledge of K-Sea’s leverage and credit term problems, a competitive market perpetuates a vicious cycle of a worsening business mix and operating results. Not that customers like BP are in ideal position to be renewing contracts in the uncertain environment anyway. A “call” payment to K-Sea’s mutual insurance carrier is scheduled for August 2010 and the prospect of future calls caused by the nature of K-Sea’s insurance choices is alarming.

K-Sea can ill afford to further barter with still higher cost of capital. The cost of K-Sea’s financial leverage is already too high because of the risk previously known to be inherent in the magnitude of leverage. If the banks accept a resolution involving further rate modifications rather than a safer balance sheet, the effects on the financial performance further magnify. While analysts may focus unit-holders on EBITDA, K-Sea is a very capital intensive business and rates matter. The “BI” of EBITDA stands for “Before Interest”.

Creditors should be, and do appear intent on the safety cushion associated with new equity, rather than using rates to achieve a larger slice of increasingly risky pie. The prior amendment is very relevant. In addition to increasing the rate commensurate with risk, it 1) decreased the available credit, 2) eliminated an accordion feature, 3) put controls on distributions to KSP unit-holders, and 4) required additional security to be assigned to the security trustee, and perhaps most telling 5) hastened the credit facility maturity by more than two years. The facility now matures July 1, 2012.

There is little institutional ownership in KSP because many institutional investors would recognize the books’ asset values as irrelevant to liquidation value. For an institutional investor to take a private placement in KSP shares, one should expect the deal to be done at a significant discount to prevailing market price where the shares are valued much like an option. Retail investors may lack the savvy to demand the appropriate pricing in a follow on offering. Pricing will affect the extent of dilution but is irrelevant to the limited scope of options. The banks’ interests, and the interests of all the company’s stakeholders should be aligned in the need to raise equity capital to decrease the leverage and avoid an eventual value-destructive liquidation.

I’ve found in speaking with analysts their conviction to be in the directional call, not any particular price target. Models with target valuations output based on discounted cash flow assume no dilution, assume a distribution to unit holders will be restored, and theorize the timing of such. The analysts openly acknowledge their models assume a lot of best case scenarios. None of their models had discriminated asset values. I can’t myself guess whether the (KSP) limited partner units might justify a price of more or less than $4 until knowing that sufficient equity is going to get raised, and the dilution associated with the price.

A Few Words About K-Sea's MLP Classification

KSP is a Master Limited Partnership (“MLP”). Up until four or five years ago it was tough for shipping companies to attract capital. Investors today have had a great affinity for MLPs but would be wise to better understand them and ask whether the capital structure suits the business. Barry Parker says

Shipping is capital intensive and full of surprises, so reserves are always needed. This fact of life has been incompatible with full dividend payout companies, and with MLP’s- which are committed to making distributions.

Hard to say whether KSP could have possibly grown at the pace it did absent the investor interest in its MLP distributions (when it was paying them).

KSPs current leverage problems may have nothing to do with its MLP classification. Broadly speaking, I have come to believe investors should pay exceptionally close attention to risks associated with any MLP investments. MLPs in general are rife with Conflicts of Interest. Incentive distributions to the general partner can create a motivation which opposes more prudent businesses interests. While MLPs are attractive because distributions do not trigger taxation, prospective investors should consider that distributions are paid from cash flow, not earnings. That cash flow is often needed by the business to protect longevity in a capital intensive industry.

My short position in KSP along with other portfolio and trading activities are licensed as data to Covestor Ltd. (“Covestor”). Covestor is a Registered Investment Advisor that uses my trading data in effort to replicate my actions for its retail investing clients. This short position in KSP is among portfolio data licensed to Covestor's Plettner Long/Short Opportunity Model. None of the long only models: Plettner Core Total Return, Plettner Taxable Income, or Plettner Tax Advantaged Income have any MLP positions. Inquiries relating to Covestor, or originating from Covestor clients and prospective clients must be directed to Covestor Client Services.

Disclosure: Author holds a short position in KSP