Description

Kirby Corp. (KEX)

Kirby Corp is an attractive short at $62 as it has experienced unwarranted multiple expansion YTD driven by an increase in oil prices.  This is while its fundamental outlook has deteriorated due to an oversupply of Jones Act barges.  Investors are currently trading KEX as if it is a cyclical oil service stock on the verge of significant recovery in earnings.    We believe their shipping business will face headwinds for the next several years, making EPS growth from today’s levels difficult even assuming a cyclical recovery in their diesel engine business.  Currently at 21x consensus 2016 EPS and 18.8x 2017 we believe KEX will derate once it becomes apparent investors are overly optimistic on 2017 earnings recovery.

We believe a conservative fair value case is $49 or 17x our 2017 EPS with a downside case of low 40s.

Company Overview:

Kirby Corp. is a $3.3bln market cap ($4bln EV) inland & costal tank barge operator (80% of rev) with a modest size diesel engine servicing business.  KEX trades around $40mln per day and is GC to borrow.    

The core tank barge business transports petrochemicals (50% of volume) and other refined products/black oil (22%/27% of volume) along the US inland waterway system and along the Gulf/East Coast.  Kirby operates under the Jones Act, meaning they operate between US ports with US built, flagged and crewed boats.  This requirement acts to protect the industry from foreign competition, preserving the US shipbuilding capability.  Kirby operates the largest fleet of inland and costal tank barges.  Approximately 65% of the marine business revenue comes from inland barges.  KEX has 912 inland tank barges and 70 costal tank barges.  Kirby is the largest operator in a space with around 25% of the market. Roughly 80% of inland and costal revenues are under term contracts of 1 yr or longer.  Each year they renew 1/3rd of half of the term contracts, the other half renews every year. 20% of the business is spot.  This implies that 70% of the business gets repriced yearly.

The diesel engines business (~20% of rev) overhauls and provides replacement parts for land based, power and marine engines.  The business represents ~20% of revenue and is currently losing a small amount of money due to the decline in demand from pressure pumping fleets that are currently operating at low utilization rates.  The segment made 7-8% EBIT margins in 2013/14 and should be able to regain that level of profitability in a modest recovery in drilling activity.   

Shale oil boom & bust

The shale oil production boom created significant basin differentials which incentivized the movement of crude via traditionally more expensive modes such as rail and barge.  This extra demand combined a generally positive chemical demand environment allowed KEX to increase inland pricing 5% per year from 2012-14 and 8% per year over the same time frame in their costal business.  This created a supply response, which given the time to construct and relatively limited number of domestic shipyards lagged demand.  Since 2012 the inland fleet has grown 20% and the costal fleet has grown 5%.  Currently the order book for the Costal fleet implies another ~6% supply growth before any scrapping in the next  year, while the inland order book is in a bit better shape at 2% of the current fleet.  The table below summarizes KEX’s KPIs for each of their marine business lines since 2012 along with industry fleet size.  Note how the increase in rates caused lagged building boom in both segments.

Unfortunately for those ordering barges in 2013/14 the good times didn’t last.  The combination of falling oil prices and production combined with increased pipeline capacity eliminated the significant basin differentials that created the Jones Act tanker boom in the first place.  For example, oil volume moved from the Midwest to the Gulf Coast via barge has fallen 80% from its 2013 peak (see chart below).  The end of the crude export ban also lessened the need to ship oil between US ports as there are now export options available. While oil volumes were never more than 10% of KEX’s volume and 15% of industry volume the excess capacity created by less oil demand and a growing fleet have pressured pricing.  This has resulted in inland spot rates that are ~10-20% off of their peak according to KEX.  Costal rates have yet to fall off, but given the continued increase in supply there it makes sense that they should also start to weaken.  

Bulls and the company point to the coming chemical pant build cycle as demand catalyst.  We are skeptical this will have any medium term impact given most plants are starting up in 2018.  It is also impossible to know how much of the new chemicals produced will end up in Jones Act shipping lanes. KEX management will admit they don’t have any idea how much demand they will capture as a result of the new plants opening later this decade.

Valuation analysis & target:

Given the multiple expansion that KEX has experienced this year (chart below is forward p/e) we believe investors are viewing 2016 as a trough in this cycle for KEX.  We believe 2016’s earnings represents more of a mid-cycle earnings potential for the company as a modest recovery in the diesel engine business will be offset by the continue contraction in the marine business as contracts roll to lower spot rates in 2017.

We valued the company under 3 different cases, a base, bull and bear case. As the table below shows we think this should be trading in the md to high $40s vs $62 today based on our outlook for the marine business and allowing for a recovery in the diesel engine business.

Base Case: Under our base case we assume the diesel engine business recovery back to 75% of its 2014 peak and margins are around where they were in 2013.  We assume the inland segment of the marine business rolls down its contracts to current spot rates and that there is a moderate weakening of costal fundamentals in 2016/17.  This gets us to the low end of management’s guide for this year and little EPS growth next year despite the significant recovery in their diesel engine business.   Consensus is calling for earnings to grow to $3.30/shr in 2017 on a modest recovery in the marine business.  We think once investors begin to appreciate the lack of recovery in marine, KEX will derate to a more normalized multiple on a sub $3/shr EPS number.  Historically the business trades 16-17 forward, which would imply a high 40s target price.

Downside Case: In our downside case we factored in a more modest normalization of the diesel business and a sharper downturn in the marine business, led by the costal segment.  This results in EPS falling to 2.20/shr in 2017. Even allowing for some multiple expansion to account for investors viewing marine as at trough gets you to the mid 40s.   

Upside Case: Factoring in a larger recovery in the diesel engine business and assumed a resumption of rate growth in line with pre oil boom levels for both segments.  That results in EPS just above the high end of management’s guidance for 2016 and ~$4.60/shr in 2017. Keep in mind this assumes the diesel business is effectively operating at near peak margins.  Unless you believe the business should trade north of 17x, its hard to believe the stock is worth more than the mid 70s.  

Historic forward p/e multiple:

Risks:

·         Healthy balance sheet enables purchase of distressed assets from smaller players.

o    While KEX will survive this cycle and continue to act as a consolidator, further distressed purchases would imply distress in the industry, and a delay in earnings recovery. 

·         Quicker than expected retirement of older assets reduces oversupply, allowing for a resumption of rate growth. 

o   Likely need to see further decline in rates to incent an acceleration in asset retirement. 

·         Petchem build cycle results in more robust demand.

o   Possible, though even KEX management has no idea where the volumes will end up. 

Catalyst

Upcoming quarter report and likley reduction in full year guidance range.