Kirby’s (KEX) stock is still down over 50% from its January highs and hasn’t participated in the V-shaped stock recovery which rest of the market has seen. I don’t blame the investors. Things are really going tough for the company, and while the business has stabilized, Kirby isn’t seeing any meaningful recovery as yet. The company recently reported its second quarter results which missed the consensus expectations with revenues declining ~29.8% year over year. This was expected given COVID-19 related shutdowns in the last quarter and their impact on the demand. However, the company’s third quarter guidance was equally disappointing, with management suggesting that inland marine revenues and operating income will sequentially decline in the third quarter.
Before the pandemic began, the company’s inland barge business was seeing strong utilization in low to mid 90s. Usually, utilization over 90% is very positive for pricing, and the company was seeing double-digit pricing increases in spot markets and mid to high single-digits pricing increases in contract business. As pricing almost completely flows to the operating income line, investors were expecting significant improvements in profits over the next few years. However, COVID-19 has disrupted this growth.
As the quarter progressed, the company’s utilization dropped from low 90s at the beginning of the quarter to mid-70s in June. This mimicked decline in refineries and chemical plants utilization which are the company’s primary customers. So, the average barge utilization was in mid-80s. While the macros have stabilized and there are some signs of improvement, it’s just a modest improvement, and barge utilization is still in mid to high 70s. I believe this is the primary reason management has guided for sequential decline in the third quarter.
For the company’s stock to recover completely, we need to go back to a strong pricing environment which requires utilization back in low to mid 90s. I don’t think the company’s end customers like refineries will go back to their pre-COVID-19 utilization unless the travel demand recovers. So, the full recovery in stock price might take a couple of years. Management has done a good job in terms of taking cost out of the business, and it was still able to improve margins. So, once the demand and pricing power comes back, we may see better margins and earnings profile for this business.
Kirby’s coastal business is seeing similar dynamics with reduced consumer demand for refined products and black oil impacting volume and spot pricing. In the coastal market, approximately 85% of the revenues are under long-term contracts, which have minimal renewal exposure prior to the end of 2020. So, the disruptions are limited to spot market business.
I expect a good demand recovery in this business as the economy recovers from coronavirus shock. Unlike some of the other bigger shipping companies, Kirby coastal tank barge business doesn’t have any direct exposure towards domestic crude oil production. This business consists of coastal tank barges in the 195,000 barrel or less category and is mainly involved in regional marine transportation distribution of bulk liquid cargoes (primarily refined petroleum products and black oil) along the United States’ Atlantic, Gulf and Pacific coasts, in Alaska and Hawaii and, to a lesser extent, on the Great Lakes.
In general, lower energy prices are good for the United States economy and typically translate into increased petrochemical and refined product demand and, therefore, increased demand for tank barge transportation services. The concerns that lower crude oil prices may result in lower domestic crude oil and natural gas condensate production and cause some crude oil-related demand to vanish for Kirby are not correct. The number of coastal tank barges in the U.S. that operate in the 195,000 barrel or less category is approximately 280, of which just five were involved in transporting crude oil and natural gas condensate at the end of the last year. This is a small number to have any meaningful impact on Kirby’s business or coastal tank barge industry in general.
Looking forward, $150 bn + of U.S petrochemical investment (see slide 15 of Kirby’s Feb. 2020 investor presentation) and upcoming chemical facilities along the Gulf Coast means increased demand for barge transportation. So, once coronavirus-related distractions are gone and Kirby’s coastal contracts come for renewal, I believe it will be able to get a reasonable pricing. I believe management will consider the upcoming capacity expansions over the next three to four years while signing renewal contracts and may choose to move some of the capacity to spot market or sign shorter term contracts, if the company is not getting reasonable pricing next year.
On the margin front, the company is retiring one additional large capacity vessel, and management expects reduced shipyard maintenance in the third quarter. As a result, third quarter coastal operating income is expected to modestly improve sequentially.
Overall, I believe the issue with Kirby’s marine segment is a demand side one with its customers working at low utilization, which in turn is resulting in fewer requirements for its barges and vessels. The market is not oversupplied in a way that it was a few years back. So, as soon as the demand comes back, this segment should recover. It might take a couple of years. So, I am expecting a U-shaped recovery for this business.
Distribution and services business
Distribution and services business was already under pressure even before COVID-19 hit. However, COVID-19 related shutdown and demand impact caused dramatic decline in oil and gas market with the U.S. rig count down ~50% and fracking activity down ~80%. This resulted in ~56% yoy decline in the segment sales. A couple of quarters back, oil and gas end market was ~47% of the segment sales. It has now reduced to just ~19% of the segment sales.
This volume decline as well as a $3.3 mn in bad debt expense from a customer bankruptcy caused the segment to post an operating loss of $14.1 mn. The company has taken steps to rationalize this segment’s cost structure, according to current volume levels, and I believe its losses will narrow as the year progresses. However, I am not too optimistic about oil and gas industry and fracking, and don’t see this business returning to its previous highs. I don’t think investors have any major expectations from this business. Since this business is already posting heavy losses, trajectory can only improve from here.
The good thing about this business is it requires very little capital, and the company can easily adjust its cost structure to new level of volumes. The bad thing about this business is it is cyclical and can increase the cyclicality of overall business if it is in a downtrend at the same time as marine business.
I believe management should consider divesting this business once the recovery happens. The company has a very good inland barge business where it has a leadership position and a very good track record. I don’t see how its distribution business complements marine business or add any strategic value. If the company wants to diversify its business, it should identify a good defensive industry which can offset the cyclicality of marine business and reduce overall volatility.
Medium-term EPS estimates in demand recovery scenario
The second quarter was very challenging for Kirby, and the condition will likely be tough in the third quarter as well. However, for long-term investors, there might be an opportunity here.
As discussed above, the problem with Kirby’s marine business is a demand side one and not the issue of excess supply. So, I believe the segment results will see improvement once the demand for refinery products improves. This will likely take a couple of years as the vaccine develops and travel industry recovers. But I believe earnings in this business will come stronger than before, given the cost reduction measures management has taken.
Before COVID-19 hit, management was expecting marine segment revenues to grow between high single digit to low teens. The midpoint of this range will be somewhere near 11.5% percent growth over FY2019’s sales of $1,587 mn. This gives us $1,770 mn in revenues in a full demand recovery scenario. I believe the company will be able to reach this level of revenues over the next three to four years as demand recovers. In the last cycle operating margin of marine segment reached ~24% during FY2013 and FY2014 period. Management was targeting high teen operating margin for this business over the next couple of years, and I believe the recent cost cut along with demand recovery can help it reach there. An 18% margin on $1,770 mn sales gives us $318 mn in operating profit in a full recovery scenario for this segment.
For distribution and services segment, revenues will improve from here, but its oil and gas business is unlikely to reach previous levels. This segment’s FY19 revenues were $1,251 mn. Last quarter, segment sales were just $160.2 mn or an annualized rate of $640.8 mn (multiplying by four). I am assuming it will recover only half of the volume decline it has witnessed. This gives us $945 mn in segment revenues (average of FY19 and the current annualized run rate). However, I do believe management will be able to adjust cost structure, and the segment’s operating margins will be able to reach high single-digit levels over the next few years. I have assumed ~8% operating margin for this segment, which gives~$76 mn in operating profit based on $945 mn in revenues.
So, total segment operating profit Kirby can achieve over the next few years as demand recovers is ~$394 mn (=$318 mn + $76 mn) as per my assumptions. Last quarter, the company incurred general corporate expenses of ~$2.79 mn. Annualizing this, we have ~$11 mn in annual corporate expenses. The company also incurred $12.7 mn in interest expense, and annualizing this gives us $50.8 mn in annual interest expense. The company is generating strong cash flow, and management intends to reduce leverage by paying down debt. For the current year, management has given an FCF guidance of between $250 mn and $350 mn. The company has a total debt of $1.64 bn, and I believe it can reduce it by ~20% over the next couple of years. I believe interest expense will also reduce proportionately, and hence, assuming $40 mn in interest expense over the medium term. These assumptions give us ~$4.29 in EPS when demand recovers. [Calculations: Profit before tax = $394 mn (Segment operating profit) – $11 mn (corporate overheads) – $40 mn (interest) = $343 mn. Assuming tax rate of ~25%, we get a net profit of ~$257 mn or an EPS of $4.29 based on ~60 mn share count.]
The stock has traded over 20x P/E, given the company’s leadership position in inland barge business. However, even if we assume 18x multiple, we get a target price of $77, which implies ~75% upside. If we assume that it will take three to four years for the demand to recover, we get an annual return in mid-teens to low 20s range, which is very attractive, and hence, I believe the stock is a good buy at current levels.
On the downside, the company has a tangible book value of around $38.6, which should provide a strong support. Over the last five years, the stock has traded between 1.5x and 2.8x tangible book value with an average around 2x.
Chart 1: Kirby’s Price to tangible book value (Source: Seeking Alpha charting tool)
This also gives a target price in mid to high 70s for the stock. Hence, I find risk reward attractive.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.