KNOP - Undervalued Dividend Monster

Summary

• Knight Offshore Partners (KNOP) is a limited partnership managed and operated by Knutsen NYK (KNOT).
• KNOP competes in a niche industry (shuttle tanker transport) with very favorable competitive characteristics.
• These characteristics, plus the firm’s strong balance sheet and counterparty credit ratings augur for a low risk dividend producer.
• Valuation using an perpetuity pricing model indicates that KNOP is undervalued by the market.
• KNOP must be viewed as a Return of Capital, and a Return of Capital (depreciation) when valuing the units and the dividend.

Shuttle Tanker Industry:

Recent articles on Seeking Alpha have described this company in detail:

10% Yield, 1.46X Coverage, No K-1, Robust Earnings, Selling At Book Value: KNOT Offshore Partners LP

KNOT Offshore Partners: A Conservative Fixed-Income Dream Stock

3 Stable High-Yield Plays: Beating The Market YTD

For those unfamiliar with KNOP, the following is a brief discussion of the Shuttle tanker industry.

Shuttle tankers transport crude oil/condensate from remote offshore oil fields to a marine terminal or refinery.

The shuttle tanker industry is a very small niche, notably distinct from the Crude Oil and Product Tanker industry. In 2017[1], the entire shuttle tanker industry was comprised of 74 vessels. In contrast, the Crude oil tanker (VLCC) industry at the time was +/- 5,600 vessels. The shuttle tanker industry has nine identified competitors. KNOT/KNOP and TEEKAY comprise a duopoly, owning market shares of 38% and 36% respectively. All other competitors have 7% share or less.

Entrance to the industry is difficult.

• Shuttle tankers have specialized mooring and directional control systems allowing them to remain “On Station” in rough seas.
• Existing ships from the world’s crude transportation fleet cannot be refitted to shuttle service economically.
• Shuttle tankers are subject to a rigorous inspection/maintenance schedule[2].
• Shuttle tanker crews have specialized training and certification.

As a result, shuttle tankers are built to contract, operated to contract. Typical contract terms, or charters, are 5-15 years in length, with renewal periods after the primary term. In contrast, VLCC’s are usually built to spec, operated to spec, based upon the market view of the shipping company owning the vessel. The skill level of crews and captain are usually less than shuttle tankers. Charter contract structure is important, as full life cycle economics form the pricing structure of the shuttle tanker charter contracts. VLCC’s operate in a dog eat dog competitive spot market. KNOP has an average vessel charter term of 3.9 years remaining[3].

It it is difficult to steal existing business from a shuttle tanker competitor, as the charter cost of newbuild vessels is always higher than the charter cost possible from a partially depreciated incumbent vessel. Also, the order to delivery cycle for a shuttle tanker is about 2-3 years. The existing fleet operates at very high utilization percentages.

Shuttle tankers (indeed, all crude carrying vessels) are wasting assets. Shuttle tankers have 20-25 year life spans. Depreciation occurs from hull fatigue, equipment wear, and technical obsolescence. Vessels are removed from service as a liability control measure, and the increased frequency (and cost) of dry-dock surveys to ascertain seaworthiness.

KNOP’s customers are offshore oil and gas exploration companies. These offshore projects are mega $, mega risk endeavors, undertaken by entities with strong credit ratings and massive balance sheets. KNOP counts Shell (NYSE:RDS.B), Exxon Mobil (XOM) , Repsol (OTCQX:REPYF), ENI (ENIA), Transpetro Parent: Petrobas (PBR) , Repsol(OTCQX:REPYF), and Galp Energia (OTC:GLPEF) as customers.

In summary, the shuttle tanker biz has very favorable competitive characteristics. All of the business occurs on a term basis, ships aren’t built on spec, pricing reflects full cycle economics, and excess capacity rarely if ever develops given the depreciation burn of the world’s fleet.

Investment thesis for KNOP:

Unitholders in KNOP are investors drawn to high dividend payouts (as of 1/2/2019, 11.5%/year dividend yield) with an underlying business that very supportive of that high coupon rate. Dividends are currently covered 1.46 x by earnings[4].

Significant risks to the KNOP investment thesis are:

• Depletion of customer oil reserves at rates higher than foreseen at the time of vessel dropdown. Shorter reserve life = shorter charter term. Management is aware of this, obviously, and models depletion rates in a conservative manner[5]
• Interest Rates: KNOP Debt/Total Capital has been steady at 36-38% since mid-2013. As of November 26, 2018, 536.4/1,000 or 54% of KNOP’s long term debt is hedged with derivatives. or fixed interest rate debt instruments[6].
• Debt Structure: Note that much of the debt is in the form of a balloon note, which could be problematic if the vessel is not under charter at the time of note renewal, or if the corporate debt market is illiquid at the time of renewal. Most of these long term debt instruments have balloons in 2023-2024.
• Depreciation: As I said earlier, depreciation is a real concern for shuttle tanker owners. In 2018, KNOP's deprecation averaged 3.57%[7] of the book value of the fleet. To maintain KNOP’s earning power, the fleet must be “recharged” with new vessels dropped down by the General Partner KNOT. This is not really a “risk” – it will happen – but it must be managed successfully or the revenues available for dividend distribution will decline.
• KNOP Unitholder Dilution: In the past, vessel dropdowns from KNOT have been funded through additional unitholder offerings to the market + additional debt, holding the debt/total capital ratio more or less constant. Historically, if the units trade much above $22.50/share, KNOP management has let additional units to the market. Recently, KNOP has had some minor unit holder buybacks. Frankly, I don't understand the management rationale for this, but they did it. When thinking about additional share offerings by KNOP, it should be noted that the dilutions always bring new revenue (vessel dropdowns come with term charters attached), so the revenue of current unitholders is not at risk.
• Dividend coverage: Is not a significant risk in my view. Dividend coverage (Dividends/Distributable Cash Flow) was 1.46x in Q3-18, and has run around 1.26x-1.50x the last 5 quarters[8].
• IDR’s: Incentive Distribution Rights (IDR’s) are the bane of MLP investors. I won't go into this too far. Suffice it to say that IDR's skim the cream of MLP's when the MLP's business performs very well. Common shareholders/unitholders stand in line behind the IDR holder. KNOP has IDR's, but they are relatively insignificant below dividend rates of $0.5625/quarter.[9]
• Small Market Cap, Institutional holders: 76% of KNOP shares are held by 10 institutional investors[10]. Moreover, as of January 2, 2019, the market cap was $601 MM.

In summary, the risks idiosyncratic to KNOP/KNOP unitholders appear to be known and managed. Interest rate risks and credit liquidity risks are the most concerning issues to me. I’d like to see KNOP work on extending and laddering their long term debt.

Thoughts on the Dividend:

As mentioned earlier, shuttle tankers are wasting assets, depreciating in value, and out of service in 20-25 years. In my opinion, the dividend received by unitholders must be viewed, in part, as a return of capital. If new vessel dropdowns (to KNOP) require financing, then new KNOP units are proffered to the market. With the advent of additional new KNOP unitholders, the current KNOP unitholders own a smaller percentage of a larger pie. Sure, current unit holders see the mean age of their owned fleet drop, but the cashflow to current unitholders remains the same, more or less. If there are no shuttle tanker dropdowns to KNOP, the KNOP fleet gets older, one day closer to obsolescence every day. Either way, KNOP unitholders must think of their dividends as a return of capital as well as a return on capital.

What is an appropriate dividend rate for KNOP?

• Return on Capital should be commensurate with the risk, of course. The only obligation to pay the dividend is a moral one. The dividend could be cut at any time for a legitimate business reason. So, I view the appropriate KNOP unitholder Return on Capital to be one slightly higher than covenant-lite debt, keeping in mind that the underlying industry structure and company are strong financially. I use BBB coupon rates as a proxy for covenant lite debt.
• Return of Capital should be equal to depreciation rate. Since 2012, KNOP's average depreciation rate has been 3.56%/year. However, KNOP has grown considerably in the period, so depreciation lags a bit. Computing KNOP's depreciation rate (as a percentage) using the previous year’s book value as the denominator gives an average of 4.53%/year. This seems to be closer to actual KNOP depreciation, as a vessel life of 25 years and depreciation of the betterments (vessel improvements attributable to vessel drydock surveys) should be north of 4% per year. I note that about half of the KNOP dividend is not taxable, which is an implicit indication that the dividend is a return of capital, in part[11].

So - if you are with me to here, KNOP dividends should be equal to Return on Capital + Return of Capital.

Average yield (2018) on Aaa Corporate debt is 4.13%. For Bbb Corporate debt (2018) it’s 4.71%[12]. I expect Return of Capital to be a bit above 4.71%

If KNOP dividends are Return on Capital + Return of Capital, and Return of Capital is slightly above BBB Coupon Rates, then

KNOP Return of Capital should be:

KNOP Dividend - BBB Coupon Rates - KNOP Depreciation Rate

Solving:

KNOP Current dividend yield (1/3/2019) = 11.5%

KNOP Current depreciation rate = 4.53%

BBB Debt coupon rate = 4.71%

KNOP risk premium (1/3/2019) = 11.5% - 4.53% - 4.71% or 2.26%.

Is this a fair discount? I say NO!

Consider the following chart, which takes KNOP dividend return (Annual Div/that day's closing Unit Price), and subtracts the contemporaneous coupon rate of BBB Corporate debt.

Source: Yahoo Finance, St. Louis Fed.

While the correlation between BBB Coupon Rates and KNOP dividend Return on Cost have low correlation (R^2 = 0.335 for the last 2 years), there are long periods of time where KNOP premium is about 6% over BBB Coupon rates. Which means that Mr. Market has thought that 1.47% (6% less the depreciation rate of 4.53%) is the appropriate risk premium for KNOP common units. So, current yield pricing is 79 basis points (0.79%) too harsh.

Perpetuity Pricing Model:

If you considered KNOP to be a stream of dividends extending indefinitely into the future(and yes, I know that is a simplification/inaccuracy) , the fair value would be

Unit Value = Dividend ($/Year)/Dividend Yield (%/Year)

I am making the modification that depreciation (Return of Capital) must be recovered contemporaneously with Return on Capital payments, so

Unit Value = (Dividend)/(Return of Capital + Return of Capital)

Fair value would be at the share price that creates a yield above deprecation that is commensurate with similar risk financial alternatives. As I said earlier, KNOP looks like a covenant lite debt instrument in many ways. So,

Backing into the appropriate unit share price, using a $0.52/quarter dividend rate, the appropriate share price should be between

Unit price (High yield) = ($0.52 x 4)/(4.53% + 4.71%) = $22.51/unit

Current Unit price is (close, 1/2/2019) = $18.07/unit.

My yield calculations appear to be on the optimistic side of things. KNOP’s 52 week Hi/Lo is $22.60/$17.18 per unit. I note that the KNOP unit price spent most of 2018 hovering around $22/unit (9.45% yield) if you exclude the October-December 2018 market sell off.

That said, the current 11.5% yield is crazy cheap. Granted, oil prices are down. Granted, the stock market is down. But this is a midstream investment, not dependent on oil prices in the immediate term. Investors get paid 11.5% on their cost, which is a worthwhile compensation.

Conclusions:

• KNOP dividends must be viewed as a return of capital and a return on capital.
• KNOP units are similar to risky debt by their nature and valuation.
• KNOP represents an attractive risk/yield proposition. KNOP is currently undervalued.
• KNOP’s greatest risks appear to be interest rates and the overall structure (tranche durations, and overall "laddering") of its long term debt.
• KNOP’s industry structure is very attractive for KNOP/KNOT, and it’s primary competitor Teekay.

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[1] KNOP Presentation to MLPA Conference, June 2017

[2] Vessels are subject to surveys every 5 years up to age 15, and every 2 years until they are decommissioned.

[3] KNOP SEC Form 6-K dated November 26, 2018

[4] Trailing 12 month average as calculated from 10-Q’s

[5] See slide 16, KNOP Presentation to MLPA Conference, June 2017

[6] KNOP’s SEC form 6-K dated November 26, 2018

[7] As of Q3-18. Source: KNOP Quarterly Financials spreadsheet downloaded from their website.

[8] Q3-18 KNOP Analyst Call Presentation

[9] KNOP 2017 10-K

[10] KNOP Website.

[11] KNOT Offshore Partners LP - Investor Relations - Unitholder Information - US Tax Information

[12] Arithmetic average of yields published by the St. Louis Fed between Oct 17 and Dec 31, 2018.

Analyst’s Disclosure: I am/we are long KNOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.