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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

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Form 10-Q

(MARK ONE)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2014

or

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM _________ TO _________

Commission File Number 001-36260

CYPRESS ENERGY PARTNERS, L.P.

(Exact name of Registrant as specified in its charter)

Registrant’s telephone number, including area code: (918) 748-3900

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes x   No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes x   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o   No x

The registrant's common units began trading on the New York Stock Exchange on January 15, 2014.

As of August 12, 2014, the registrant had 5,913,000 common units and 5,913,000 subordinated units outstanding.

 

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DOCUMENTS INCORPORATED BY REFERENCE:   None.

CYPRESS ENERGY PARTNERS, L.P.

Table of Contents

 

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NAMES OF ENTITIES

Unless the context otherwise requires, references in this Quarterly Report on Form 10-Q to “Cypress Energy Partners, L.P.,” “our partnership,” “we,” “our,” “us,” or like terms, refer to Cypress Energy Partners, L.P. and its subsidiaries.

 

References to:

·

“General Partner” refers to Cypress Energy Partners GP, LLC, a subsidiary of Holdings II;

·

“Holdings” refers to Cypress Energy Holdings, LLC, the owner of Holdings II;

·

“Holdings II” refers to Cypress Energy Holdings II, LLC, the owner of 671,250 common units representing 11.4% of our outstanding common units and 4,939,299 subordinated units representing 83.5% of our subordinated units;

·

“CEM LLC” refers to Cypress Energy Management, LLC, a wholly owned subsidiary of Holdings II;

·

“CEP LLC” refers to Cypress Energy Partners, LLC, which became our wholly owned subsidiary at the closing of our initial public offering (“IPO”);

·

“CEP-TIR” refers to Cypress Energy Partners – TIR, LLC, an indirect subsidiary of Holdings, and an owner of 673,400 common units representing 11.4% of our outstanding common units, 673,400 subordinated units representing 11.4% of our subordinated units and an owner of a 36.2% interest in the TIR Entities;

·

“CES LLC” refers to Cypress Energy Services, LLC, our 51.0% indirectly owned subsidiary that performs management services for 11 salt water disposal (“SWD”) facilities in North Dakota – seven of which are owned by CEP LLC.  SBG Energy Services, LLC (“SBG Energy”) owns the remaining interests and CES LLC has the right to acquire such interests;

·

“Partnership” refers to the registrant, Cypress Energy Partners, L.P.;

·

“Predecessor” refers to CEP LLC, the predecessor for accounting purposes of the Partnership;

·

“TIR LLC” refers to Tulsa Inspection Resources, LLC;

·

“TIR-Canada” refers to Tulsa Inspection Resources – Canada ULC, a Canadian subsidiary of TIR Holdings;

·

“TIR Entities” refer collectively to TIR LLC and its subsidiary, TIR Holdings and its subsidiaries and TIR-NDE, all of which are 50.1% owned by CEP LLC, 36.2% owned by CEP-TIR, 10.6% owned by Charles C. Stephenson, Jr. and 3.1% owned by Cynthia Field;

·

“TIR-Foley” refers to Foley Inspection Services ULC, a Canadian subsidiary of TIR Holdings;

·

“TIR Holdings” refers to Tulsa Inspection Resources Holdings, LLC;

·

“TIR-NDE” refers to Tulsa Inspection Resources – Nondestructive Examination, LLC; and

·

“TIR-PUC” refers to Tulsa Inspection Resources – PUC, LLC, a corporate subsidiary of TIR LLC.

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CAUTIONARY REMARKS REGARDING FORWARD LOOKING STATEMENTS

The information discussed in this Quarterly Report on Form 10-Q includes “forward-looking statements.”  These forward-looking statements are identified by their use of terms and phrases such as “may,” “expect,” “estimate,” “project,” “plan,” “believe,” “intend,” “achievable,” “anticipate,” “continue,” “potential,” “should,” “could,” and similar terms and phrases.  Although we believe that the expectations reflected in these forward-looking statements are reasonable, they do involve certain assumptions, risks and uncertainties and we can give no assurance that such expectations or assumptions will be achieved.  Important factors that could cause actual results to differ materially from those in the forward-looking statements are described under “Item 1A – Risk Factors” and “Item 7 – Management's Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2013, and in this report.  All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements in this paragraph and elsewhere in this Quarterly Report on Form 10-Q and speak only as of the date of this Quarterly Report on Form 10-Q.  Other than as required under the securities laws, we do not assume a duty to update these forward-looking statements, whether as a result of new information, subsequent events or circumstances, changes in expectations or otherwise.

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PART I.  FINANCIAL INFORMATION

ITEM 1.

Condensed Consolidated Financial Statements

CYPRESS ENERGY PARTNERS, L.P.

Condensed Consolidated Balance Sheets

As of June 30, 2014 and December 31, 2013

(in thousands, except unit data)

(unaudited)

 

See accompanying notes.

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CYPRESS ENERGY PARTNERS, L.P.

Condensed Consolidated Statements of Income

For the Three and Six Months Ended June 30, 2014 and June 30, 2013

(in thousands, except unit and per unit data)

(unaudited)

See accompanying notes.

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CYPRESS ENERGY PARTNERS, L.P.

Condensed Consolidated Statements of Comprehensive Income

For the Three and Six Months Ended June 30, 2014 and June 30, 2013

(in thousands)

(unaudited)

See accompanying notes.

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CYPRESS ENERGY PARTNERS, L.P.

Condensed Consolidated Statements of Cash Flows

For the Six Months Ended June 30, 2014 and 2013

(in thousands)

(unaudited)

 

See accompanying notes.

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CYPRESS ENERGY PARTNERS, L.P.

Condensed Consolidated Statement of Owners’ Equity

For the Six Months Ended June 30, 2014

(in thousands)

(unaudited)

 

		Parent Net				Parent Net				Owner’s Equity
		Investment				Investment																Accumulated
		Attributable to				Attributable to																Other				Non-				Total
		Controlling				Non-controlling				General				Common				Subordinated				Comprehensive				controlling				Owners’
		Interest				Interest				Partner				Units				Units				Income (Loss)				Interests				Equity
Balance, December 31, 2013 (Recast – Note 2)		$	130,012			$	719			$	4,816			$	-			$	-			$	-			$	-			$	4,816
Net income attributable to the period from January 1, 2014 to January 20, 2014			1,092				(6	)			(446	)			-				-				-				-				(446	)
Foreign currency translation adjustment attributable to the period from January 1, 2014 to January 20, 2014			(304	)			-				-				-				-				-				-				-
Net distributions to members			(168	)			-				-				-				-				-				-				-
Contribution attributable to general partner			-				-				482				-				-				-				-				482
Contribution of predecessor and 50.1% of TIR Entities in exchange for units			(130,632	)			(713	)			-				22,491				82,470				(208	)			26,592				131,345
Proceeds from initial public offering, net of offering costs			-				-				(2,853	)			80,213				-				-				-				77,360
Distribution of initial public offering proceeds to Cypress Energy Holdings, LLC			-				-				-				(80,213	)			-				-				-				(80,213	)
Equity-based compensation			-				-				-				195				229				-				-				424
Net income attributable to the period from January 21, 2014 to June 30, 2014			-				-				-				2,889				2,889				-				2.028				7,806
Distributions to limited partners			-				-				-				(1,783	)			(1,783	)			-				-				(3,566	)
Distributions to non-controlling members of the TIR Entities			-				-				-				-				-				-				(1,293	)			(1,293	)
Foreign currency translation adjustment attributable to the period from January 21, 2014 to June 30, 2014			-				-				-				-				-				130				130				260
Balance, June 30, 2014		$	-			$	-			$	1,999			$	23,792			$	83,805			$	(78	)		$	27,457			$	136,975

 

See accompanying notes.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

1.  Organization and Operations

Cypress Energy Partners, L.P. (the “Partnership”) is a Delaware limited partnership formed on September 19, 2013 to provide saltwater disposal (“SWD”) and other water and environmental services to U.S. onshore oil and natural gas producers and trucking companies and to provide independent pipeline inspection and integrity services to producers and pipeline companies.  On January 21, 2014, we completed the initial public offering (“IPO”) of our common units representing limited partner interests. In connection with the IPO, Cypress Energy Holdings II, LLC (“Holdings II”), a wholly owned subsidiary of Cypress Energy Holdings, LLC (“Holdings”), conveyed a 100% interest in Cypress Energy Partners, LLC (“CEP LLC”), our predecessor for accounting purposes, in exchange for (a) an aggregate 47.8% interest in the Partnership comprised of 671,250 common units and 4,983,750 subordinated units, and (b) the right to receive the proceeds of the IPO.  Prior to its contribution to the Partnership, CEP LLC distributed to Holdings its interest in SBG Sheridan Facility, LLC, which owns and operates a SWD facility in Sheridan, Montana as well as its interest in three other non-operating subsidiaries.  In addition, affiliates of Holdings, conveyed an aggregate 50.1% interest in Tulsa Inspection Resources, LLC (“TIR LLC”), Tulsa Inspection Resources – Nondestructive Examination, LLC (“TIR-NDE”) and Tulsa Inspection Resources Holdings, LLC (“TIR Holdings”) (collectively, the “TIR Entities”) to the Partnership in exchange for an aggregate 15.7% ownership in the Partnership comprised of 929,250 common units and 929,250 subordinated units.  Affiliates of Holdings hold the remaining 49.9% interest in the TIR Entities not contributed to the Partnership.  The Partnership subsequently conveyed its interest in the TIR Entities to CEP LLC.  Together CEP LLC and the TIR Entities are hereafter collectively referred to as the “Contributed Entities”.

Our business is organized into the Water and Environmental Services and Pipeline Inspection and Integrity Services reportable segments.  The Water and Environmental Services segment provides services to oil and natural gas producers and trucking companies and consists of the operations of CEP LLC, which owns and operates seven commercial SWD facilities in the Bakken Shale region of the Williston Basin in North Dakota and two in the Permian Basin in Texas.  All of the facilities currently utilize specialized equipment, full-time attendants, and remote monitoring to minimize downtime and increase efficiency for peak utilization. These facilities also contain oil skimming processes that remove any remaining oil from water delivered to the sites.  In addition to the SWD facilities, our consolidated 51% subsidiary, Cypress Energy Services, LLC (“CES LLC”), provides management and staffing services for three additional SWD facilities in the Bakken Shale region, pursuant to management agreements.  CES LLC also owns a 25% member interest in one of the managed wells.

Our Pipeline Inspection and Integrity Services segment provides services to various energy, public utility and pipeline companies in both the United States and Canada and consists of the operations of the TIR Entities. The inspectors perform a variety of inspection and integrity services on midstream pipelines, gathering systems and distribution systems, including data gathering and supervision of third-party construction, inspection, and maintenance and repair projects. Services are provided in Canada through two wholly owned subsidiaries of TIR Holdings – Tulsa Inspection Resources-Canada, ULC (“TIR-Canada”) and Foley Inspection Services, ULC (“TIR-Foley”) – both Canadian unlimited liability corporations.

2.  Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The  Condensed Consolidated Financial Statements for periods prior to the IPO reflect the results of our predecessor and the TIR Entities and were prepared using the historical basis in the assets and liabilities of the predecessor and the TIR Entities. We have recast prior period financial information to reflect the conveyance of the Contributed Entities to the Partnership at the closing of our IPO, as if the contribution of CEP LLC had occurred as of January 1, 2013 and the contribution of the TIR Entities had occurred as of June 26, 2013, as Holdings and its affiliates did not acquire a controlling interest in the TIR Entities until June 26, 2013. All significant intercompany transactions and account balances have been eliminated. We have made certain reclassifications to the prior period financial statements to conform with classification methods used in the current fiscal year. These reclassifications had no impact on previously reported amounts of total assets, total liabilities, owners’ equity, or net income.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

The accompanying  Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim consolidated financial information and in accordance with the rules and regulations of the Securities and Exchange Commission. The  Condensed Consolidated Financial Statements include all adjustments considered necessary for a fair presentation of the financial position and results of operations for the interim periods presented. Such adjustments consist only of normal recurring items, unless otherwise disclosed herein. Accordingly, the  Condensed Consolidated Financial Statements do not include all the information and notes required by GAAP for complete consolidated financial statements. However, we believe that the disclosures made are adequate to make the information not misleading. These interim  Condensed Consolidated Financial Statements should be read in conjunction with our audited financial statements as of December 31, 2013 and for the period from September 19, 2013 through December 31, 2013, the audited consolidated financial statements of CEP LLC as of December 31, 2013 and 2012 and for the years ended December 31, 2013 and 2012 and for the period from June 1, 2011 (Inception) to December 31, 2011, the audited combined financial statements of the TIR Entities as of and for the year ended December 31, 2013, and the audited consolidated financial statements of Tulsa Inspection Resources, Inc. as of and for the years ended December 31, 2012 and 2011 included in our Annual Report on Form 10-K for the year ended December 31, 2013. The results of operations for interim periods are not necessarily indicative of the results to be expected for a full year.

Use of Estimates in the Preparation of Financial Statements

The preparation of the Partnership’s  Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in these financial statements and accompanying notes. Actual results could differ from those estimates.

Significant Accounting Policies

Our significant accounting policies are consistent with those disclosed in Note 2 of each of the audited financial statements described above included in our Annual Report on Form 10-K for the year ended December 31, 2013.

Unit-Based Compensation

Cypress Energy Partners GP, LLC (“General Partner”) adopted a long-term incentive plan (“LTIP”) in connection with the IPO.   The cost of employee services received in exchange for equity instruments is measured based on the grant-date fair value of those instruments. That cost is recognized straight-line over the requisite service period (often the vesting period) as discussed in Note 7.

Offering Costs

Incremental costs directly attributable to an offering of equity securities are deferred and charged against the gross proceeds of the offering as a reduction in owners’ equity including underwriter fees, legal and accounting fees associated with the preparation of the registration statement, and other costs related to the promotion of the offering. All other costs that are not directly related to the offering are expensed as incurred.

Income Taxes

As a limited partnership, we generally are not subject to federal, state or local income taxes.  The tax on net income is generally borne by the individual partners.  Net income for financial statement purposes may differ significantly from taxable income of the partners as a result of differences between the tax basis and financial reporting basis of assets and liabilities and the taxable income allocation requirements under our partnership agreement. The aggregated difference in the basis of our net assets for financial and tax reporting purposes cannot be readily determined because information regarding each partners’ tax attributes in us is not available to us.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

On December 9, 2013, the TIR Entities converted from corporate status to pass-through entities for U.S. federal income tax purposes.  The Partnership made a payment of $15.0 million for income taxes associated with the gain on this conversion in the first quarter of 2014.  The TIR Entities that have Canadian activity remain taxable in Canada.  In addition, effective January 1, 2014, the TIR entities formed a wholly owned subsidiary, Tulsa Inspection Resources – PUC, LLC (“TIR-PUC”), which has elected to be taxed as a corporation for U.S. federal income tax purposes.  Income tax expense reflected on the Condensed Consolidated Statements of Income for the three and six months ended June 30, 2014 differs from an expected statutory rate of 35% due primarily to the non-taxable nature of partnership earnings for both U.S. federal and state income tax purposes (pass-through status) offset by the corporate income taxes of TIR-PUC, the Canadian income taxes related to the TIR Entity foreign operations and any applicable state business activity and franchise taxes.

A publicly-traded partnership is required to generate at least 90% of its gross income (as defined for federal income tax purposes) from certain qualifying sources. Income generated by TIR-PUC is excluded from this qualifying income calculation as a result of management’s election to treat the entity as a taxable corporation.    Distributions of after tax earnings from TIR-PUC to TIR LLC would be considered qualifying income.  We believe that at least 90% of our gross income has been qualifying income since our IPO.

We evaluate uncertain tax positions for recognition and measurement in the Condensed Consolidated Financial Statements. To recognize a tax position, we determine whether it is more likely than not that the tax position will be sustained upon examination, including resolution of any related appeals or litigation, based on the technical merits of the position. A tax position that meets the more likely than not threshold is measured to determine the amount of benefit to be recognized in the Condensed Consolidated Financial Statements. We had no material uncertain tax positions that required recognition in the Condensed Consolidated Financial Statements at June 30, 2014.

Non-controlling Interest

The Partnership holds a controlling interest in several entities which are not wholly owned. The Non-controlling interests shown in our Condensed Consolidated Balance Sheet at June 30, 2014 reflects the 49% membership interest in CES LLC that is owned by SBG Energy Services, LLC (“SBG Energy”) and the 49.9% interest in each of the TIR Entities that is owned by affiliates of Holdings.  The Net income attributable to non-controlling interests shown in our Condensed Consolidated Statements of Income reflects 49% of the net income of CES LLC for the three and six months ended June 30, 2014 of $0.1 million and $0.2 million, respectively, and 49.9% of the net income of the TIR Entities for the three months ended June 30, 2014 and for the period from January 21, 2014 through June 30, 2014, as adjusted in accordance with our partnership agreement, of $1.1 million and $1.8 million, respectively.

New Accounting Standard

The Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2014-09 – Revenue from Contracts with Customers in May 2014.  ASU 2014-09 is intended to clarify the principles for recognizing revenue and develop a common standard for recognizing revenue for GAAP and International Financial Reporting Standards that is applicable to all organizations.  The Partnership will be required to comply with this ASU beginning in 2017.  We are currently evaluating the impact of this ASU on the financial information of the Partnership.  We do not anticipate that the adoption of this ASU will materially impact our financial position, results of operations or cash flows.

3.  Initial Public Offering

On January 21, 2014, the Partnership completed its IPO consisting of 4,312,500 common units representing limited partner interests in the Partnership at a price to the public of $20.00 per common unit ($18.70 per common unit, net of underwriting discounts, commissions and fees) which included a 562,500 unit over-allotment option that was exercised by the underwriters.  We received net proceeds of $80.2 million from the IPO, after deducting underwriting discounts and structuring fees.  The net proceeds from the IPO were distributed to Holdings II as reimbursement for certain capital expenditures it incurred with respect to assets contributed to us.

Total deferred offering costs of $2.9 million, including costs incurred during the six months ended June 30, 2014 of $0.3 million, were charged against the proceeds of the IPO.  In addition, the Partnership incurred $0.4 million of offering costs during the six months ended June 30, 2014, that were expensed as incurred.  No offering costs were incurred during the three months ended June 30, 2014.  These non-recurring costs are reflected as offering costs in the Partnership’s Condensed Consolidated Statements of Income for the six months ended June 30, 2014.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

4.  Business Combination

As discussed in Note 2, we acquired a controlling interest in Tulsa Inspection Resources, Inc. and its subsidiaries (“TIR Inc.”) on June 26, 2013.  This transaction qualified as a business combination and therefore the assets and liabilities were recorded at their fair value.  On December 9, 2013, TIR Inc. merged into TIR LLC at which time, we acquired the remaining interests in TIR Inc.  We used various measurements to determine fair value including replacement costs, liquidation values, future cash flows on a discounted basis, payoff values, average industry royalty rates, among other measurements.  Due to the unobservable nature of these assumptions, these fair value measurements are considered to be Level 3 fair value estimates.

The fair value of the assets and liabilities acquired as of June 26, 2013 were as follows:

The following summarized consolidated income statement information for the three and six months ended June 30, 2013 presents the pro forma results of operations as if the acquisition of the TIR Entities was completed on January 1, 2013:

These pro forma results are for comparative purposes only and may not be indicative of the results that would have occurred had the acquisition been completed on January 1, 2013, or the results that will be attained in the future.

5.  Contingent Consideration

On December 31, 2012, CEP LLC acquired 100% of the membership interests in six operating commercial SWD facilities and other businesses and assets from SBG Energy.  The purchase agreement called for contingent consideration to be paid to SBG Energy based on the acquired wells meeting certain profitability thresholds in 2013. CEP LLC initially recorded a liability for the contingent consideration totaling $11.25 million. The acquired wells did not meet the profitability thresholds and the contingent liability was reversed in full during the quarter ended June 30, 2013 and was recorded in the Condensed Consolidated Statements of Income as a Gain on reversal of contingent consideration.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

6.  Credit Agreement

In December 2013, we, along with our affiliate Cypress Energy Partners – TIR, LLC (“CEP-TIR”), (together, the “Borrowers”), entered into a $120.0 million secured credit agreement as co-borrowers and co-guarantors. The credit agreement matures in December 2016 and consists of a $65.0 million senior secured working capital revolving credit facility and a $55.0 million senior secured acquisition revolving credit facility.  At June 30, 2014 and December 31, 2013, there were outstanding borrowings under the credit agreement of $70.0 million and $75.0 million, respectively.  Borrowings under the credit agreement are due at maturity. If at any time outstanding borrowings exceed the combined borrowing base of the Borrowers, principal in the amount of the excess is due upon submission of the borrowing base calculation. We had $30.0 million of availability under the acquisition revolving credit facility and $20.0 million of availability under the working capital revolving credit facility at June 30, 2014.  The obligations under our credit agreement are secured by a first priority lien on substantially all assets of the Borrowers.

All borrowings under the credit agreement bear interest, at our option, on a leveraged based grid pricing at (i) a base rate plus a margin of 1.25% to 2.75% per annum (“Base Rate Borrowing”) or (ii) an adjusted LIBOR rate plus a margin of 2.25% to 3.75% per annum (“LIBOR Borrowings”). The applicable margin is determined based on the combined leverage ratio of the Borrowers, as defined in the credit agreement. For the three and six months ended June 30, 2014, the interest rate on credit agreement borrowings ranged between 2.7% and 3.5%.  Interest on Base Rate Borrowings is payable monthly.  Interest on LIBOR Borrowings is paid upon maturity of the underlying LIBOR contract, but no less often than quarterly.  Commitment fees are charged at a rate of 0.50% on any unused credit and are payable quarterly. Interest paid during the three and six months ended June 30, 2014 was $0.5 million and $1.1 million, respectively, including commitment fees.

Our credit agreement contains various customary affirmative and negative covenants and restrictive provisions. Our credit agreement also requires maintenance of certain financial covenants, including a combined total adjusted leverage ratio (as defined in our credit agreement) of not more than 4.0 to 1.0 and an interest coverage ratio (as defined in our credit agreement) of not less than 3.0 to 1.0.  At June 30, 2014, our total adjusted leverage ratio was 0.79 to 1.0 and our interest coverage ratio was 5.78 to 1.0, pursuant to the credit agreement.  Upon the occurrence and during the continuation of an event of default, subject to the terms and conditions of our credit agreement, the lenders may declare any outstanding principal of our credit agreement debt, together with accrued and unpaid interest, to be immediately due and payable and may exercise the other remedies set forth or referred to in our credit agreement.

In addition, our credit agreement restricts our ability to make distributions on, or redeem or repurchase, our equity interests.  However, we may make distributions of available cash so long as, both at the time of the distribution and after giving effect to the distribution, no default exists under our credit agreement, the borrowers and the guarantors are in compliance with the financial covenants, the borrowing base (which includes 100% of cash on hand) exceeds the amount of outstanding credit extensions under the working capital revolving credit facility by at least $5.0 million and at least $5.0 million in lender commitments are available to be drawn under the working capital revolving credit facility.

7.  Equity Compensation

Effective at the closing of the IPO, our General Partner adopted a long-term incentive plan (“LTIP”) that authorized up to 1,182,600 units representing 10% of the currently outstanding units.  Certain directors and employees of the Partnership have been awarded Phantom Restricted Units (“Units”) under the terms of the LTIP. The fair value of the awards issued is determined based on the quoted market value of the publically traded common units at each grant date, adjusted for a forfeiture rate, and other discounts attributable to the awarded units. This valuation is considered a Level 3 valuation under the fair value measurement hierarchy.  Compensation expense is recognized straight-line over the vesting period of the grant. Holdings reimburses the Partnership for the direct expense of the awards and reallocates the expense to us through the annual administrative fee provided for under the terms of the omnibus agreement (Note 8).  For the three and six months ended June 30, 2014, the Partnership recognized $0.1 million and $0.2 million, respectively, in compensation expense under the LTIP. The following table sets forth the grants and forfeitures of Units under the LTIP for the period from January 1, 2014 through June 30, 2014:

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

 

Outstanding Units issued to directors vest ratably over a three-year period from the date of grant.  The remaining Units granted to employees vest over a five-year period from the date of grant, with one third vesting at the end of the third year, one third at the end of the fourth year and one third vesting at the end of the fifth year or will vest in full upon the occurrence of a Fundamental Change, as defined in the LTIP agreement.

In conjunction with the IPO, phantom profits interest units previously issued under our predecessor’s LTIP were exchanged for 44,250 Units under the LTIP. Vesting under all of the predecessor’s exchanged awards is retroactive to the initial grant date.  The awards will be considered for all purposes to have been granted under the Partnership’s LTIP.  In addition, at IPO, certain profits interest units previously issued under the predecessor’s LTIP were converted into 44,451 subordinated units of the Partnership outside of the LTIP.  Vesting for the subordinated units is retroactive to the initial grant date.  The exchange of the phantom profits interest units and the profits interest units resulted in the reversal of the existing equity compensation liability of $0.1 million in the first quarter of 2014 as the new awards are accounted for as equity.

8.  Related-Party Transactions

Omnibus Agreement

Effective, as of the closing of the IPO, we entered into an omnibus agreement with Holdings and other related parties that govern the following matters, among other things:

·

our payment of an annual administrative fee, initially in the amount of $4.0 million to be paid in quarterly installments (pro-rated in 2014 from the IPO date) to Holdings for providing certain partnership overhead services, including certain executive management services by certain officers of our General Partner, and compensation expense (including equity-based compensation) for all employees required to manage and operate our business. This fee also includes the incremental general and administrative expenses we incur as a result of being a publicly traded partnership;

·

limitations on the amount of indebtedness CEP-TIR may incur under our credit agreement and the allocation of certain interest expenses to the TIR Entities;

·

our right of first offer on Holdings’ and its subsidiaries’ assets used in, and entities primarily engaged in, providing SWD and other water and environmental services and pipeline inspection and integrity services, including the remaining interest in the TIR Entities; and

·

indemnification of us by Holdings for certain environmental and other liabilities, including events and conditions associated with the operation of assets that occurred prior to the closing of the IPO and our obligation to indemnify Holdings for events and conditions associated with the operation of our assets that occur after the closing of the IPO and for environmental liabilities related to our assets to the extent Holdings is not required to indemnify us.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

So long as Holdings controls our General Partner, the omnibus agreement will remain in full force and effect, unless we and Holdings agree to terminate it sooner. If Holdings ceases to control our General Partner, either party may terminate the omnibus agreement, provided that the indemnification obligations will remain in full force and effect in accordance with their terms. We and Holdings may agree to amend the omnibus agreement; however, amendments that the General Partner determines are adverse to our unitholders will also require the approval of the Conflicts Committee of our Board of Directors.

The amount charged by Holdings for the three and six months ended June 30, 2014 was $1.0 million and $1.8 million, respectively, and are reflected in General and administrative in the Condensed Consolidated Statements of Income.

Allocated Expenses

Prior to the IPO, the Partnership reimbursed certain affiliated entities for general and administrative expenses, primarily management labor expenses, totaling $0.1 million, which is reflected in General and administrative in the Condensed Consolidated Statements of Income for the six months ended June 30, 2014.  During the three and six months ended June 30, 2013, our predecessor allocated certain general and administrative expense to affiliates totaling $0.2 million and $0.3 million, respectively, which were recorded as a reduction of General and administrative expenses.

Distributions to / Advances from Parent

Prior to the IPO, our predecessor provided treasury and accounts payable services for Holdings and other affiliates. Amounts paid on behalf of Holdings and its affiliates, net of cash transfers from Holdings, are treated as a component of Parent Net Equity. Net distributions to Parent were $0.2 million for the six months ended June 30, 2014.  There were no net distributions / advances during the three months ended June, 30, 2014.  Net distributions to Parent were $0.2 million for the six months ended June 30, 2013.  There were no net distributions / advances during the three months ended June 30, 2013.

Other Related Party Transactions

A current board member and business partner in North Dakota has an interest in several entities with which the Partnership does business including the following:

·

SBG Disposal, LLC (“SBG Disposal”) – Prior to the acquisition of certain assets and management fee contracts by CES LLC effective October 1, 2013, SBG Disposal provided staffing, management and back office services for a portion of the Partnership’s SWD facilities.  SBG Disposal is a wholly owned subsidiary of SBG Energy and provided services to our predecessor totaling $0.6 million and $1.3 million for the three and six months ended June 30, 2013, respectively.  These costs are included in Costs of services on the Condensed Consolidated Statements of Income.

·

Rud Transportation, LLC (“Rud”) – Rud, a wholly owned subsidiary of SBG Energy is a trucking company that has various energy company customers that retain their services to haul and dispose of produced water and flowback water.  The water is sometimes hauled to the energy customers’ own SWD facilities, third party SWD facilities and / or SWD facilities owned by the Partnership.  Total revenue recognized by the Partnership from Rud was $0.8 million and $0.3 million for the three months ended June 30, 2014 and 2013, respectively, and $1.4 million and $0.8 million for the six months ended June 30, 2014 and 2013, respectively.  Accounts receivable from Rud was $0.9 million and $0.4 million at June 30, 2014 and December 31, 2013, respectively, and is included in Trade accounts receivable, net.

Effective October 1, 2013, the Partnership, through CES LLC, provides management services to its 25% owned investee company, Alati Arnegard, LLC (“Arnegard”).  Management fee revenue earned from Arnegard totaled $0.2 million and $0.3 million for the three and six months ended June 30, 2014, respectively.  Accounts receivable from Arnegard totaled $0.1 million at June 30, 2014 and December 31, 2013 and are included in Trade accounts receivable, net in the Condensed Consolidated Balance Sheets.

 

CES LLC outsources employee management and related costs to an affiliated entity, Cypress Energy Management – Bakken Operations, LLC (“CEM-BO”)  CEM-BO is owned 49% by an affiliate of SBG Energy.  Total employee related costs paid to CEM-BO were $0.8 million and $1.5 million for the three and six month periods ended June 30, 2014.  Included in Accounts payable on the Condensed Consolidated Balance Sheets was $0.2 million and $0.1 million at June 30, 2014 and December 31, 2013, respectively, related to this arrangement.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

9.  Earnings per Unit and Cash Distributions

Subsequent to the IPO, the Partnership presents earnings per unit information in accordance with ASC Topic 260 – Earnings per Share.

Net income per unit applicable to limited partners (including subordinated unitholders) is computed by dividing limited partners’ interest in net income, after deducting the General Partner’s incentive distributions, if any, by the weighted-average number of outstanding common and subordinated units.  Diluted net income per common unit includes the dilutive impact of unvested Units granted under the LTIP.  Our net income is allocated to the common and subordinated unitholders in accordance with their respective partnership percentages, after giving effect to priority income allocations for incentive distributions and other adjustments, if any, to our General Partner, pursuant to our partnership agreement. Net income per unit is only calculated for the Partnership subsequent to the IPO as no units were outstanding prior to January 21, 2014. The excess or shortfall of earnings relative to distributions is allocated to the limited partners based on their respective ownership interests. Payments made to our unitholders are determined in relation to actual distributions declared and are not based on the net income allocations used in the calculation of net income per unit. For the three and six months ended June 30, 2014, the weighted-average number of units outstanding was 11,826,000, comprised of 5,913,000 common units and 5,913,000 subordinated units.

In addition to the common and subordinated units, we have also identified incentive distribution rights as participating securities and use the two-class method when calculating the net income per unit applicable to limited partners, which is based on the weighted-average number of units outstanding during the period.

Our partnership agreement calls for minimum quarterly distributions.  The following table summarizes the distributions declared since our IPO.  There were no Partnership distributions declared or paid prior to these distributions.

(a)

Reflects a proration of the targeted minimum quarterly cash distribution of $0.3875 for the period from the closing of the Partnership’s IPO on January 21, 2014 through March 31, 2014.

(b)

Our Board of Directors declared this cash distribution on July 29, 2014 to be paid on August 14, 2014 to unitholders of record at the close of business on August 8, 2014.

Currently, approximately 63.5% of the Partnership’s outstanding units are held by affiliates.  As such, $2.3 million and $3.0 million of the distributions paid on May 15 and August 14 (see note (b) above), respectively, were distributed to affiliates of the Partnership.

In addition, the TIR Entities made cash distributions totaling $3.0 million during the second quarter of 2014, of which $1.7 million was distributed to the Partnership and the remaining $1.3 million distributed to non-controlling members of the TIR Entities.

10.  Commitments and Contingencies

Letters of Credit

The Partnership has various performance obligations which are secured with short-term security deposits of $0.4 million at June 30, 2014 and December 31, 2013 included in Other current assets on the Condensed Consolidated Balance Sheets.

Employment Contract Commitments

A subsidiary of the Partnership has employment agreements with certain of its executives.  The executive employment agreements are effective for a term of two-to-five years from the commencement date, after which time they will continue on an “at-will” basis.  These agreements provide for minimum annual compensation, adjusted for annual increases as authorized by the Board of Directors.  Certain agreements provide for severance payments in the event of specified termination of employment.  As of June 30, 2014, the aggregate commitment for future compensation and severance was approximately $0.9 million.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

Compliance Audit Contingencies

Certain customer master service agreements (“MSA’s”) offer our customers the opportunity to perform periodic compliance audits, which include the examination of the accuracy of our invoices.  Should our invoices be determined to be inconsistent with the MSA, or inaccurate, the MSA’s may offer the customer the right to receive a “credit or refund” for any overcharges identified.  At June 30, 2014 and December 31, 2013, the Partnership had contingent liabilities of approximately $0.3 million and $0.4 million respectively, associated with the probable settlement related to ongoing customer audits of various charges previously approved by customer representatives reflected in Accrued payroll and other on the Condensed Consolidated Balance Sheets.  The liabilities related to these audits are expected to be resolved before the end of the year.

Legal Proceeding

On July 3, 2014, a group of former minority shareholders of TIR Inc., formerly an Oklahoma corporation, filed a civil action in the United States District Court for the Northern District of Oklahoma against TIR LLC, members of TIR LLC, and certain affiliates of TIR LLC’s members.  TIR LLC is the successor in interest to TIR Inc., resulting from a merger between the entities that closed in December 2013 (the “TIR Merger”). The former shareholders in TIR Inc. claim that they did not receive sufficient value for their shares in the TIR Merger and are seeking rescission of the TIR Merger or, alternatively, unspecified compensatory and punitive damages.  The Partnership is not named as a defendant in this civil action.

In the second quarter of 2013, the former shareholders offered an acquisition proposal to TIR Inc. that was rejected as inferior by TIR Inc.’s management and founders and a control block of its then current shareholders, compared to an offer to obtain a controlling position made by an affiliate of the Partnership.  As previously disclosed, in December 2013, TIR Inc. was merged into TIR LLC.  The former shareholders in TIR Inc. were given the right to receive cash upon delivery of their TIR Inc. shares or the right to exercise statutory appraisal rights under Oklahoma law.  The former shareholders elected not to pursue their appraisal rights and accepted the cash payment, pursuant to the terms of the merger agreement.

TIR LLC and the other defendants have been advised by counsel that the action lacks merit. We believe that the possibility of the Partnership incurring material losses as a result of this action is remote.  In addition, the Partnership anticipates no disruption in its business operations or those of TIR LLC related to this action.

11.  Reportable Segments

The Partnership’s operations consist of two reportable segments: (i) Water and Environmental Services segment and (ii) Pipeline Inspection and Integrity Services segment.  We have recast segment financial information to reflect the conveyance of the entities comprising our reportable segments to the Partnership as of the closing of our IPO (see Note 3).

Water and Environmental Services segment – This segment consists of nine operating SWD facilities, as well as other managed SWD facilities.  We aggregate these operating entities for reporting purposes as they have similar economic characteristics and have centralized management and processing.  Segment results are driven primarily by the volumes of produced water and flowback water we inject into our SWD facilities and the fees we charge for our services. These fees are charged on a per barrel basis and vary based on the quantity and type of saltwater disposed, competitive dynamics and operating costs. In addition, for minimal marginal cost, we generate revenue by selling residual oil we recover from the flowback and produced water.

Pipeline Inspection and Integrity Services segment – This segment consists of the TIR Entities.  We aggregate these operating entities for reporting purposes as they have similar economic characteristics, including centralized management and processing.  This segment provides independent inspection and integrity services to various energy, public utility and pipeline companies. The inspectors in this segment perform a variety of inspection and integrity services on midstream pipelines, gathering systems and distribution systems, including data gathering and supervision of third-party construction, inspection, and maintenance and repair projects. Our results in this segment are driven primarily by the number and type of inspectors performing services for customers and the fees charged for those services, which depend on the nature and duration of the project.

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

The following tables show operating income by reportable segment and a reconciliation of combined total segment operating income to net income before income tax expense:

(a)

Three month period ended June 30, 2013 for the Pipeline Inspection and Integrity Services segment represents activity from June 26, 2013 (date of acquisition of the TIR Entities) through June 30, 2013 (4 days).

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CYPRESS ENERGY PARTNERS, L.P.

 Notes to the Condensed Consolidated Financial Statements

 

(a)

Six month period ended June 30, 2013 for the Pipeline Inspection and Integrity Services segment represents activity from June 26, 2013 (date of acquisition of the TIR Entities) through June 30, 2013 (4 days).

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements that reflect our future plans, estimates, beliefs and expected performance. The forward-looking statements are dependent upon events, risks and uncertainties that may be outside our control, including among other things, the risk factors discussed in the IPO prospectus, “Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2013 and this Quarterly Report on Form 10-Q. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, market prices for oil and natural gas, production volumes, capital expenditures, weather, economic and competitive conditions, regulatory changes and other uncertainties, as well as those factors discussed below and elsewhere in our Annual Report on Form 10-K for the year ended December 31, 2013 and this Quarterly Report on Form 10-Q, all of which are difficult to predict. In light of these risks, uncertainties and assumptions, the forward-looking events discussed may not occur.  See “Cautionary Remarks Regarding Forward-Looking Statements” in the front of this Quarterly Report on Form 10-Q.

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains a discussion of our business, including a general overview of our properties, our results of operations, our liquidity and capital resources, and our quantitative and qualitative disclosures about market risk.  At the closing of our IPO on January 21, 2014, CEP LLC and a 50.1% interest in the TIR Entities were contributed to us and became our Water and Environmental Services segment and our Pipeline Inspection and Integrity Services segment, respectively.   On June 26, 2013, Holdings and its affiliates acquired a controlling interest in the TIR Entities.  The contribution of the TIR Entities was treated for accounting purposes as a combination of entities under common control and the results of the TIR Entities are included in our financial statements for periods subsequent to June 26, 2013.  Accordingly, as discussed in Note 2 to the Condensed Consolidated Financial Statements, we have recast our prior period financial information to reflect this contribution of entities under common control as if the contribution of CEP LLC had occurred at January 1, 2013 and the contribution of the TIR Entities had occurred at June 26, 2013, the date we obtained control. The financial information for our Water and Environmental Services and Pipeline Inspection and Integrity Services segments included in “Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be read in conjunction with the interim financial statements and related notes included elsewhere in this report and prepared in accordance with accounting principles generally accepted in the United States of America and our audited financial statements as well as the audited financial statements of CEP LLC as of December 31, 2013 and 2012 and for the years ended December 31, 2013 and 2012 and for the period from June 1, 2011(Inception) to December 31, 2011,  the audited combined financial statements of the TIR Entities as of and for the year ended December 31, 2013, the audited consolidated financial statements of Tulsa Inspection Resources, Inc. as of and for the years ended December 31, 2012 and 2011, Management’s Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2013.

Overview

We are a growth-oriented master limited partnership formed in September 2013.  We provide SWD and other water and environmental services to U.S. onshore oil and natural gas producers and trucking companies through our Water and Environmental Services segment.  The Water and Environmental Services segment is comprised of the historical operations of CEP LLC, with the exception of one SWD facility and a permit which were not contributed to us.  We operate nine SWD facilities, seven of which are in the Bakken Shale region of the Williston Basin in North Dakota and two of which are in the Permian Basin in west Texas. We also manage four other SWD facilities in the Bakken Shale region. Our Water and Environmental Services segment customers are oil and natural gas exploration and production companies and trucking companies operating in the regions that we serve.  We also provide independent pipeline inspection and integrity services to various energy, public utility and pipeline companies through our Pipeline Inspection and Integrity Services segment.  The Pipeline Inspection and Integrity Services segment is comprised of the historical operations of the TIR Entities. In both of these business segments, we work closely with our customers to help them comply with increasingly complex and strict environmental and safety rules and regulations applicable to production and pipeline operations, and reduce their operating costs.

Our Initial Public Offering and Restructuring

On January 21, 2014, the Partnership completed its IPO of 4,312,500 common units representing limited partner interests in the Partnership at a price to the public of $20.00 per common unit ($18.70 per common unit, net of underwriting discounts, commissions and fees) which included a 562,500 unit over-allotment option that was exercised by the underwriters.  The initial yield was 7.75% with a first year estimate of distributable cash flow per unit of $1.55 for the full calendar year of 2014.  We received net proceeds of approximately $80.2 million from the IPO, after deducting underwriting discounts and structuring fees.  The net proceeds from the IPO were distributed to Holdings II as reimbursement for certain capital expenditures it incurred with respect to assets contributed to us.

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At the closing of the IPO, Holdings II conveyed its 100% member interest in CEP LLC to the Partnership in exchange for (a) an aggregate 47.8% interest in the Partnership, and (b) the right to receive the proceeds of the IPO. Holdings II subsequently conveyed a 0.4% interest in the Partnership to certain members of management.  Prior to the contribution of CEP LLC to the Partnership, but subsequent to December 31, 2013, CEP LLC distributed its 100% member interest in four limited liability companies, only one of which had operating activities, to Holdings II. One of the distributed entities, SBG Sheridan Facility LLC, contains the assets and liabilities of an SWD facility that was previously operational but has been non-operational since June 2013 and is undergoing repair work. The historical operating results of these distributed entities were previously included in the historical financial results of CEP LLC.  The historical results of the Partnership and our Water and Environmental Services segment have been recast to exclude the results of the Sheridan facility as if the distribution occurred at the beginning of the earliest period presented.

 

Affiliates of Holdings II, conveyed an aggregate 50.1% interest in the TIR Entities to the Partnership in exchange for an aggregate 11.4% ownership in the Partnership.  The Partnership subsequently conveyed its interest in the TIR Entities to CEP LLC.

Omnibus Agreement

 Effective as of the closing of our IPO, we are party to an omnibus agreement with Holdings, CEM LLC, CEP LLC, our General Partner, CEP-TIR, the TIR Entities, Charles C. Stephenson, Jr. and Cynthia Field that govern the following matters, among other things:

·

our payment of an annual administrative fee, initially in the amount of $4.0 million to be paid in quarterly installments (pro-rated in 2014 from the IPO date) to Holdings for providing certain partnership overhead services, including certain executive management services by certain officers of our General Partner, and compensation expense (including equity-based compensation) for all employees required to manage and operate our business. This fee also includes the incremental general and administrative expenses we incur as a result of being a publicly traded partnership;

·

limitations on the amount of indebtedness CEP-TIR may incur under our credit agreement and the allocation of certain interest expenses to the TIR Entities;

·

our right of first offer on Holdings’ and its subsidiaries’ assets used in, and entities primarily engaged in, providing SWD and other water and environmental services and pipeline inspection and integrity services, including the remaining interest in the TIR Entities; and

·

indemnification of us by Holdings for certain environmental and other liabilities, including events and conditions associated with the operation of assets that occurred prior to the closing of the IPO and our obligation to indemnify Holdings for events and conditions associated with the operation of our assets that occur after the closing of the IPO and for environmental liabilities related to our assets to the extent Holdings is not required to indemnify us.

So long as Holdings controls our General Partner, the omnibus agreement will remain in full force and effect, unless we and Holdings agree to terminate it sooner. If Holdings ceases to control our General Partner, either party may terminate the omnibus agreement, provided that the indemnification obligations will remain in full force and effect in accordance with their terms. We and Holdings may agree to amend the omnibus agreement; however, amendments that the General Partner determines are adverse to our unitholders will also require the approval of the conflicts committee.

Water and Environmental Services Segment

We generate revenue in our Water and Environmental Services segment primarily by treating flowback and produced water and injecting the saltwater into our SWD facilities. Our results in the Water and Environmental Services segment are driven primarily by the volumes of produced water and flowback water we inject into our SWD facilities and the fees we charge for our services. These fees are charged on a per barrel basis under contracts that are short-term in nature and vary based on the quantity and type of saltwater disposed, competitive dynamics and operating costs. In addition, for minimal marginal cost, we generate revenue by selling residual oil we recover from the flowback and produced water.  Through our 51.0% ownership interest in CES LLC, we also generate revenue managing SWD facilities for a fee. Revenues in this segment are recognized when the service is performed and collectability of fees is reasonably assured.

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The volumes of saltwater disposed at our SWD facilities are driven by water volumes generated from existing oil and natural gas wells during their useful lives and development drilling and production volumes from the wells located near our facilities. Producers’ willingness to engage in new drilling is determined by a number of factors, the most important of which are the prevailing and projected prices of oil, natural gas and NGLs, the cost to drill and operate a well, the availability and cost of capital and environmental and governmental regulations. We generally expect the level of drilling to positively correlate with long-term trends in prices of oil, natural gas and NGLs. Similarly, oil and natural gas production levels nationally and regionally generally tend to positively correlate with drilling activity.

Approximately 25% and 27% of our revenue for the three and six months ended June 30, 2014, respectively, in our Water and Environmental Services segment was derived from sales of residual oil recovered during the saltwater treatment process. Our ability to recover sufficient volumes of residual oil is dependent upon the residual oil content in the saltwater we treat, which is, among other things, a function of water type, chemistry, source and temperature. Generally, where outside temperatures are lower, there is less residual oil content and separation is more difficult. Thus, our residual oil recovery during the winter season is usually lower than our recovery during the summer season in North Dakota.  Additionally, residual oil content will decrease if, among other things, producers begin recovering higher levels of residual oil in saltwater prior to delivering such saltwater to us for treatment.

Pipeline Inspection and Integrity Services Segment

We generate revenue in our Pipeline Inspection and Integrity Services segment primarily by providing inspection and integrity services on midstream pipelines, gathering systems and distribution systems, including data gathering and supervision of third-party construction, inspection, and maintenance and repair projects. Our results in the Pipeline Inspection and Integrity Services segment are driven primarily by the number of inspectors that perform services for our customers and the fees that we charge for those services, which depend on the type and number of inspectors used on a particular project, the nature of the project and the duration of the project. The number of inspectors engaged on projects is driven by the type of project, prevailing market rates, the age and condition of customers’ midstream pipelines, gathering systems and distribution systems and the legal and regulatory requirements relating to the inspection and maintenance of those assets. We charge our inspectors’ services out to customers on a per project basis, including per diem charges, mileage and other reimbursement items.

Outlook

 After an unusually harsh winter that negatively impacted our customers and our SWD volumes in the first quarter of 2014, we have seen sequential improvement throughout the second quarter and into the beginning of the third quarter in our Water and Environmental Services Segment.  Additionally, we have been awarded several new Master Service Agreements with new customers in our Pipeline Inspection and Integrity Segment and expect the impact to be reflected in higher inspector headcounts and revenues in future quarters.

We continue to evaluate a number of potential acquisition opportunities in both of our segments.  The combination of organic growth and new acquisition opportunities will influence our future partnership distributions. Based upon the 2.41% increase above our second quarter minimum quarterly distribution, we now expect to exceed our distribution forecast for the year ending December 31, 2014 as outlined in the IPO prospectus.

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Results of Operations

Factors Impacting Comparability

The historical results of operations for the periods presented may not be comparable, either to each other or to our future results of operations, for the reasons described below:

·

At the closing of the IPO, we acquired a 50.1% interest in each of the TIR Entities with Holdings and certain affiliates continuing to hold the remaining 49.9% interest (“Retained Interest”).   The non-controlling interest of the non-controlling members of the TIR Entities are reduced by certain interest charges as outlined in the omnibus agreement.  The contribution of interests in the TIR Entities to the Partnership has been treated as a reorganization of entities under common control.  Accordingly, the results of operations and assets and liabilities of the TIR Entities will be included in the historical financial information of the Partnership for periods from June 26, 2013, the date Holdings obtained control of the TIR Entities.

·

Historical results of CEP LLC, as presented in our Annual Report on Form 10-K for the year ended December 31, 2013, included results of an SWD facility located in Sheridan County, Montana and a permit relating to a potential SWD facility that was distributed to Holdings prior to the closing of our IPO (“Non-contributed Properties”).  The distribution of these properties has been treated as a reorganization of entities under common control.  Accordingly, the historical results of these Non-contributed Properties are not reflected in the historical financial information of the Partnership or in the results of operations of our Water and Environmental Services segment included herein.

·

The effective date of the acquisition of our 51% ownership of CES LLC was October 1, 2013; accordingly, the financial data presented below does not reflect the results of operations of CES LLC for the three or six months ended June 30, 2013.

·

General and administrative expenses will increase as a result of operating as a publicly traded partnership.  At the closing of the IPO, CEP LLC, the Partnership and other affiliates entered into an omnibus agreement with Holdings.  Among other things, the agreement calls for an annual administrative fee to be paid by the Partnership in the amount of $4.0 million.  The fee will be paid in quarterly installments to Holdings for providing the Partnership with certain overhead services, including executive management services by certain officers of our General Partner, compensation expense, including stock-based compensation expense for employees required to manage and operate our business as well as the costs of operating a publicly traded partnership, including costs associated with SEC reporting requirements, tax return and Schedule K-1 preparation and distribution, independent registered public accounting firm fees, investor relations activities and registrar and transfer agent fees.

·

Interest expense will not be comparable between the periods presented as a result of our new credit agreement entered into in December 2013 that resulted in more favorable credit terms as compared to previous periods.  Borrowings under the credit agreement were used to, among other things, refinance outstanding obligations of the TIR Entities which had significantly higher interest rates.

·

We incurred and expensed non-recurring costs associated with our IPO totaling $0.4 million for the six months ended June 30, 2014.

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Consolidated Results of Operations

The following table summarizes our historical Condensed Consolidated Statements of Income for the three and six month periods ended June 30, 2014 and 2013:

(a)

Activity for 2013 includes four days of operations of our Pipeline Inspection and Integrity Services segment from the June 26, 2013 acquisition date through the end of the period.

See the detailed discussion of revenues, cost of sales, gross margin, general and administrative expense and depreciation, amortization and accretion by reportable segment below.  The following is a discussion of significant changes in the non-segment related corporate other income and expenses during the respective periods.

 Interest expense.  Interest expense primarily consists of interest on borrowings under our credit agreement entered into in December 2013 ($0.5 million for the three months and $1.1 million for the six months ended June 30, 2014) as well as amortization of debt issuance costs and unused commitment fees ($0.3 million for the three months and $0.5 million for the six months ended June 30, 2014).  Average debt outstanding during the three months ended June 30, 2014 was $70.0 million.  Average debt outstanding for the six months ended June 30, 2014 was $70.1 million.

 

Offering costs.  We expensed costs of $0.4 million during the six months ended June 30, 2014 related to our IPO.  No offering costs were expensed during the three months ended June 30, 2014 or during the three or six months ended June 30, 2013.

Gain on reversal of contingent consideration.  During the second quarter of 2013, the Water and Environmental Services segment recognized a non-recurring gain of $11.3 million as a result of the reversal of a previously recorded contingent purchase price liability.

Income tax expense.   We believe that we qualify as a partnership for income tax purposes and therefore, generally do not pay income tax.  Rather, each owner reports his or her share of our income or loss on his or her individual tax return.  However, income tax expense includes income taxes related to one taxable corporate subsidiary in the United States and two taxable corporate subsidiaries in Canada in our Pipeline Inspection and Integrity Services segment, as well as business activity, gross margin, and franchise taxes incurred in certain states.

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Net income attributable to non-controlling interests.  At June 30, 2014, non-controlling interests include a 49.9% interest in each of the TIR Entities within our Pipeline Inspection and Integrity Services segment owned by Holdings and its affiliates, as well as a 49% interest in one consolidated subsidiary in our Water and Environmental Services segment, CES, LLC, owned by SBG Energy.  The non-controlling interest holders of the TIR Entities within our Pipeline Inspection and Integrity Services segment are charged directly for certain financing expenses of the Partnership.  These charges are reflected as a direct reduction of their proportionate share of net income.

 

Segment Operating Results

Three Months Ended June 30, 2014 Compared to the Three Months Ended June 30, 2013

Water and Environmental Services Segment

The following table summarizes the operating results of our Water and Environmental Services segment for the three months ended June 30, 2014 and 2013:

 

(a)

Average revenue per barrel disposed is calculated by dividing revenues (which includes flowback, produced water, residual oil sales and management fees) by the Total barrels of saltwater disposed.

 

Segment operating income.  Operating income increased $0.9 million due primarily to an increase in revenue from 2013 to 2014. 

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		Three Months Ended June 30,
		2014				% of Revenue				2013 (a)				% of Revenue
		($ in thousands, except average revenue and inspector data)
Revenues		$	87,727							$	4,107
Costs of services			79,505								3,725
Gross margin			8,222				9%				382				9%
General and administrative expense			4,151				5%				170				4%
Depreciation, amortization and accretion			636								33
Operating income		$	3,435				4%			$	179				4%
Operating Data:
Average number of inspectors			1,434
Average revenue per inspector per week		$	4,706

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
						(Recast)								(Recast)
		(in thousands)
Net income		$	4,929			$	12,824			$	8,446			$	15,056
Add:
Interest expense			772				53				1,557				53
Depreciation, amortization and accretion			1,616				975				3,226				1,876
Offering costs			-				-				446				-
Income tax expense			96				53				241				53
Less:
Gain on reversal of contingent consideration			-				11,250				-				11,250
Adjusted EBITDA		$	7,413			$	2,655			$	13,916			$	5,788

		January 1, 2014 through  January 20, 2014				January 21, 2014 through  June 30, 2014				Six Months  Ended June  30, 2014
		(in thousands)
Net income attributable to partners		$	646			$	5,778			$	6,424
Add:
Interest expense attributable to partners			182				390				572
Depreciation, amortization and accretion attributable to partners			349				2,253				2,602
Offering costs			446				-				446
Income tax expense attributable to partners			28				116				144
Adjusted EBITDA attributable to partners		$	1,651			$	8,537			$	10,188

		Six Months Ended June 30,
		2014				2013
		(in thousands)
Cash flows provided by operating activities		$	12,818			$	5,087
Changes in trade accounts receivable			(10,164	)			4,790
Changes in prepaid expenses and other			(117	)			(15	)
Changes in accounts payable, accrued payroll and other			(6,245	)			(4,127	)
Change in income taxes payable			16,083				(53	)
Loss on asset disposal			(3	)			-
Equity earnings in investee company			16				-
Offering costs			446				-
Equity-based compensation			(424	)			-
Interest expense (excluding non-cash interest)			1,190				53
Income tax expense (excluding deferred tax benefit)			316				53
Adjusted EBITDA		$	13,916			$	5,788

Period

Date Declared

Record Date

Date Paid

Amount Per Unit

Amount Paid Limited Partners

(in thousands)

First Quarter

April 25, 2014

May 6, 2014

May 15, 2014

$

0.3014

(a)

$

3,566

Second Quarter

July 29, 2014

August 8, 2014

August 14, 2014 (b)

$

0.3968

$

4,693

		Six Months Ended June 30,
		2014				2013
		in thousands)
Net cash provided by operating activities		$	12,818			$	5,087
Net cash (used in) provided by investing activities			(392	)			8,511
Net cash used in financing activities			(10,142	)			(233	)
Effect of exchange rates on cash			(39	)			-
Net increase in cash and cash equivalents		$	2,245			$	13,365

Exhibit Number		Description
3.1		First Amended and Restated Agreement of Limited Partnership of Cypress Energy Partners, L.P. dated as of January 21, 2014  (incorporated by reference to Exhibit 3.1 of our Current Report on Form 8-K filed on January 27, 2014)
3.2		Amended and Restated Limited Liability Company Agreement of Cypress Energy Partners GP, LLC dated as of January 21, 2014 (incorporated by reference to Exhibit 3.2 of our Current Report on Form 8-K filed on January 27, 2014)
31.1*		Chief Executive Officer Certification Pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*		Chief Financial Officer Certification Pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1**		Chief Executive Officer Certification Pursuant to Exchange Act Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code, as Adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2**		Chief Financial Officer Certification Pursuant to Exchange Act Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code, as Adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101 INS†		XBRL Instance Document
101 SCH†		XBRL Schema Document
101 CAL†		XBRL Calculation Linkbase Document
101 DEF†		XBRL Definition Linkbase Document
101 LAB†		XBRL Label Linkbase Document
101 PRE†		XBRL Presentation Linkbase Document

Cypress Energy Partners, L.P.
By:	Cypress Energy Partners GP, LLC, its general partner
/s/  Peter C. Boylan III
By:	Peter C. Boylan III
Title:	Chief Executive Officer and Chairman of the Board
/s/  G. Les Austin
By:	G. Les Austin
Title:	Chief Financial Officer