Say what you will about Kirby (NYSE:KEX) and its historically robust valuation metrics, but the shares have at least held up despite operating conditions getting even worse and estimates heading down. Since my last update, the shares are more or less flat despite ongoing industry-wide weakness in barge utilization and pricing, and there may be some tentative signs of bottoming out in two of its key markets.
The Street has historically rewarded Kirby's significant scale and respectable operating history with rich multiples, but there could still be some upside here if 2017-2018 does indeed mark a low point in the cycle. Although Kirby doesn't have as much leverage to potential chemical capex expansion as you might hope, the company should nevertheless benefit from volume growth, while an expanded DES business seems poised to benefit from a recovery in U.S. onshore oil/gas activity.
Inland Seems To Be Getting Better, But Is The Upside All That The Bulls Hope?
Kirby's inland barging business remains the key operation for the company, generating close to 60% of the company's overall revenue and a higher proportion of operating income. Conditions are challenging here now, but not disastrous – the first quarter saw utilization move into the high-80%'s to low-90%'s after dipping into the low-to-mid 80%'s in 2016, but renewal pricing is still weak (declining in the mid-single digits) as new pipeline capacity and exports alter the supply-demand balance.
The near-term outlook is still shaky. Oil production in the U.S. was down slightly in the first quarter of this year, though up about 7% from the 2016 low; while crude oil is a relatively small part of Kirby's direct inland business, it is an important “swing factor” for overall inland barge utilization and pricing. More encouragingly for Kirby, chemical production was up close to 2% in the first quarter of 2017, and various chemicals (including benzene, styrene, and methanol) make up more than half of inland volumes.
There are still some reasons to be encouraged. First, it looks as though the industry is responding to weak pricing (spot rates close to cash breakeven rates) by taking capacity off the market – at least as of now, it looks like there will be a small net reduction in the U.S. onshore fleet as more barges are retired and scrapped than brought into service. There are also signs that companies are willing to bite the bullet and sell assets - Savage acquired assets from Settoon (a relatively small, but still top 20, inland player) earlier this year and Kirby recently announced the acquisition of 13 barges from a competitor. Consolidation could help the market come into balance a little faster, though I expect many operators to be reticent to sell given that bid prices are below replacement value.
Further expansion of U.S. chemical capacity is a more mixed driver for the inland business. Over $170 billion of projects are still listed as in development, concentrated in areas that Kirby services like the Gulf Coast, Mississippi and Ohio River. The “but” is that these new plants aren't like the old plants; a higher skew toward ethane and propane will likely mean that this new capacity produces lower liquid volumes that Kirby can transport “on a dollar for dollar” basis than in the past. I still believe that these expansions will underpin volume growth for Kirby in the future; just not at the rate that the headline dollar amounts might suggest.
Coastal – It's Going To Be Choppy A While Longer
Ongoing single-digit volume growth in chemical production and recovering U.S. onshore oil production should support an improving environment for the inland business (and chemical production volumes should be supported by improving industrial demand/operating conditions). Unfortunately, this outlook doesn't extend to the coastal business.
Kirby has seen the coastal business get pretty ugly, with utilization in the mid-70%'s to low 80%'s in the first quarter and spot pricing down 20% or more from the prior year. Although Kirby still has solid contract coverage (around 80%, 80% of which is time charter), more and more customers are electing to go to spot upon contract expiration. With that, Kirby is seeing its first losses in this business since it got in around six years ago.
And it's not likely to get substantially better anytime soon. Ample new capacity has come into this market recently, while demand has not been keeping up. Kirby is stacking some equipment (and letting go of personnel) and there are some old barges (35 yrs or older) in the industry fleet that could get scrapped rather than spend the $1M-plus to comply with water treatment regulations, but it seems unlikely that the market will firm up until 2018 without a serious external market shock.
This will test management's capabilities. Part of the problem, for both the industry and Kirby, is that long-term contracts are keeping a lot of barges in operation. Nevertheless, I will be watching to see if Kirby can cut costs enough to minimize the damage during this downturn.
A New Day For DES
Kirby's Diesel Engine Service business has long been an odd part of the business. Although it contributes around 30% of total revenue, it has typically been seen as non-core and a business that only adds to the company's cyclical volatility. Even so, this is now a more important driver in Kirby's outlook.
For starters, revenue was up 84% in the first quarter and segment margin improved to over 8% as recovering U.S. onshore rig counts are leading to more business overhauling and refurbishing pressure pumping units. Spreads still aren't great, but more operators are spending money to get equipment ready to get back to work. With roughly 20%-25% market share in servicing pressure pumping rigs, Kirby has strong potential leverage if and when the increase in drilling is followed by an increase in completions (which is/will be tied to better oil prices).
Kirby isn't just waiting for the oil market to get better, though. Management has elected to actively expand the scope of this business – acquiring Stewart & Stevenson for $710 million in cash and stock. Kirby is paying 11x EBITDA for this business, or 8x (or less) if and when management hits its synergy targets. S&S is a sizable distributor of products for industrial markets including oil/gas, marine, and power (all markets that Kirby's DES business serves today), as well as transport, mining, construction and ag. S&S has a machine rental business, as well as a manufacturing business – it is the largest manufacturer of well-servicing equipment in the country.
Based upon old SEC filings, manufacturing was around 40% of the business back in 2011, with the company manufacturing equipment for fracking, stimulation, workovers, and interventions. It was a decently profitable business back in the 2008-2012 time frame (operating margins in the mid-single digits, with peak margins close to double digits), and there should be meaningful synergy opportunities here.
In adding S&S's distribution business, I don't believe that Kirby is necessarily adding a significantly higher-margin business (manufacturing margins can be better in the good times, and sometimes a lot better), but it is adding a more consistent business to the mix. What's more, S&S will add a lot of new customers and geographic territories to the DES segment, as well as create meaningful cross-selling opportunities.
I can't say for certain whether Kirby will follow this up with additional deals to build up DES further. There are a lot of similar businesses in the marine and power-gen segments that are having a hard time in this downturn and Kirby could see those as opportunistic plays on eventual recoveries. The market wasn't exactly overjoyed with this deal, though, and I think Kirby's high historical multiples have come as a result of investors prizing the company's strong barge business. Diluting that with additional deals in the diesel/industrial equipment space could well prove opportunistic (buying at or near the bottom and into an upswing), but could come at the cost of overshadowing what many investors have long treated as the crown jewel.
I do expect a slow ongoing recovery in U.S. crude production and I likewise believe that an industrial recovery in the U.S. (as well as cost advantages that favor exports) will support ongoing growth in chemical production. New U.S. chemical-producing capacity may not be as favorable to Kirby's volumes as in the past, due to a different product/production mix, but I believe it's enough to support a recovery in the inland market. I am also concerned about the impact of crude oil exports and additional pipeline capacity, but I think those risks are well-understood. I likewise believe that Kirby remains on the prowl for assets/consolidation opportunities in the inland space.
The coastal market will be ugly for at least another year or so in my opinion, and the biggest upside I see is management figuring out how to minimize the damage to margins. Longer term, I think the hostility to new refinery and/or pipeline construction in areas like New England and Florida will support ongoing demand for coastal transport of refined products, and the market will eventually absorb the current excess capacity.
DES is harder to predict. If I completely trusted my ability to predict oil prices, I'd spend my days trading oil. I do believe the U.S. onshore market is recovering, though, and that the increase in drilling rigs will eventually be followed by working through the growing backlog of completions. Moreover, I think this expanded business platform can participate more broadly in the recovery and I expect Kirby to get better margins out of this expanded segment, even if a recovery in the marine/power-gen side takes longer.
All told, I'm looking for long-term revenue growth in the mid-to-high single digits, with a few strong recovery years on the way. I still believe that long-term FCF margins can hit the double digits, but I'm incrementally less confident of that than in the past (in part because of the expanded DES business). Discounting those cash flows gives me a fair value of about $65 today. An EV/EBITDA approach is a little more problematic; I don't think it's fair to use Kirby's long-term average multiple on 2017 EBITDA (likely to be a trough number), and a 12x multiple (my growth rate assumption for the next three years) supports a fair value of $60 … but this also underlines how arbitrary EV/EBITDA can be.
The Bottom Line
All things considered, I believe Kirby has been managing its way through this downturn relatively well. Expanding the DES business is a bold and risky move, but it could well prove prescient if U.S. onshore activity stages a strong recovery in the next few years. With the barging business, I think management is acting responsibly by scrapping and stacking in the face of weak prices, as well as staying price-disciplined while hunting for consolidation opportunities. Kirby doesn't necessarily look like a slam-dunk today, but if you believe that U.S. industrial activity will continue to improve and U.S. onshore energy production will continue to recover, it is not unreasonable to buy Kirby on the expectation that the Street will run these shares higher on the back of improving prospects.
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