Value Creation in the Transportation Industry
Analyzing a company’s capital allocation decisions and opportunities is an important part of Diamond Hill’s process of estimating a company’s intrinsic value. The amount of free cash flow a company generates and how that free cash flow is allocated produces much of a company’s value over long periods of time. We consider both management’s historic track record as well as the prospective opportunities for management to reinvest cash flow. Kirby Corp. (KEX) is a transportation company with a strong track record of capital allocation. Through opportunistic capital allocation, it has been able to build leading competitive positions in its primary markets and repurchase stock at attractive prices. Management has grown the intrinsic value of Kirby by around 15% per year over the last two decades while operating in an industry that has grown in the low single digits. Much of this value has been created during difficult times in the industry, with management taking advantage of downturns to opportunistically buy competitors, repurchase stock, and acquire additional services.
Kirby is a tank barge operator in the United States and is the largest player in both of its main marine markets (inland and coastal) with approximately 25% market share in each. The company is twice the size of the largest inland competitor, and we estimate Kirby’s operating margins are materially higher than its competitors, partially due to this scale. The company transports bulk liquid products throughout the Mississippi River System, on the Gulf Intracoastal Waterway, along all three coasts, and in Alaska and Hawaii. About half of this cargo is petrochemicals, 25% is refined product, and the balance is black oil and agricultural chemicals. Kirby operates a fleet of 912 inland tank barges with around 18 million barrels of total capacity and 70 coastal tank barges with 6 million barrels of total capacity. Kirby also operates a diesel engine services business, which primarily provides after-market services for diesel engines in the marine and power generation industries, as well as manufacturing and remanufacturing oilfield service equipment.
History of Rational Capital Allocation
Kirby’s management team views all capital allocation opportunities in a similar manner, using the same hurdle rate for potential investments whether organic growth, acquisitions, or share repurchases. Management often states, “There is a time to buy barges, a time to acquire companies with barges, and a time to buy our stock.” If there are no attractive reinvestment opportunities, management is content to pay down debt and increase dry powder for future opportunities. This results in opportunistic, and often counter cyclical, capital allocation. For example, Kirby made several acquisitions in 2006 but when opportunities meeting their return hurdle dried up over the next few years, the company primarily used operating cash flow to reduce leverage and increase its cash balance. With a strong balance sheet and ample liquidity heading into the economic downturn, Kirby was able to acquire competitors opportunistically at more attractive valuations. Between 2011 and 2012, management made $1.2 billion of acquisitions in the company’s core inland market as well as in the coastal tank barge market and diesel engine services. Management has also opportunistically repurchased shares over the years, doing so only when the expected return hits their hurdle rate and is the best risk-adjusted return in their view. While not all of management’s capital allocation decisions have been correct (the diesel engine services acquisition in the oil and gas sector certainly looks questionable at the moment), we are very comfortable with their process and the aggregate result has been more than satisfactory over time as measured by the company’s growth in intrinsic value.
While examining management’s track record is important, it is only instructive in that it informs us of how capital is likely to be allocated in the future. Our view is that current fundamental weakness in the tank barge industry could provide management with attractive reinvestment opportunities ahead of a positive inflection in demand for the inland barge business.
The pricing environment for inland tank barge transportation has deteriorated over the last two years. Incremental capacity entered Kirby’s key petrochemicals market as competitors cleaned and repurposed tank barges previously dedicated to shipments of crude oil. Approximately 375 tank barges have been repurposed from crude shipments to other liquid commodities, which represents around 10% of industry capacity. As a result, pricing and margins have been under pressure in the inland business, significantly eroding Kirby’s near-term earnings power. Exacerbating the pressure in the inland market, the oil and gas segment of Kirby’s diesel engine services business has been losing money due to the decline in drilling activity. As near-term earnings have declined, the stock price declined more than 50% between late 2014 and the first two months of 2016, presenting us with an attractive opportunity to invest in a well-positioned company with the ability to add value through capital allocation ahead of improving industry fundamentals.
We anticipate significant improvement in inland tank barge fundamentals over the next few years as the over-supply of tank barge capacity reverses. Approximately 175 inland barges remain in crude service compared to 550 at the peak during 2014, reducing the potential incremental supply overhang. On Kirby’s first-quarter earnings call, management said they have seen very few conversions during the last few months, possibly indicating an end of the incremental capacity additions from the crude market. Further, the new barge order book implies new barges in line with historical scrappage trends, signaling flat to negative supply in the near future. At the same time supply is leveling off, we should begin seeing incremental demand for petrochemical shipments. Over $100 billion of petrochemical plant capacity additions have been announced along the U.S. Gulf Coast driven by ample natural gas supply in the United States. These capacity additions are scheduled to begin coming online in the 2017 to 2020 timeframe. Kirby is well-positioned to benefit from this as the largest player in the market, with petrochemical shipments representing two-thirds of Kirby’s inland volumes. It is too early to tell exactly how much of this additional petrochemical capacity will be shipped by barge, but management estimates it could accelerate demand by 2% to 5% per year over its historic GDP growth rate.
In the meantime, Kirby is generating over $150 million in free cash flow, which should grow as capital expenditures decline during the next two years. This cash is available for management to deploy via the same playbook they have used in prior downturns. The pipeline for acquisition opportunities is improving as smaller competitors are likely facing financial stress in the current environment. Competitors do not have the benefit of Kirby’s scale and resulting profit profile. Further, others in the industry do not have the same access to capital as Kirby, which possesses the only investment grade balance sheet in the industry. Thus, while the downturn has dented Kirby’s profits, the situation is likely much more dire for its smaller private competitors. As the only logical strategic acquirer with the financial capacity to make significant acquisitions, Kirby may have the opportunity to put material capital to work if industry weakness persists much longer. It has made one acquisition so far in 2016, purchasing the tank barge operations of SEACOR for $88 million. Also, the decline in Kirby’s stock price presented management with the opportunity to repurchase shares at more attractive levels. The company repurchased over $250 million of stock in late 2014 and 2015 as the stock price declined. This was its first major share repurchase activity in over five years.
Kirby is well-positioned to benefit from growth in the U.S. petrochemical industry. The near-term decline in inland barge fundamentals could provide attractive reinvestment opportunities for a company with a history of rational capital allocation. As long-term investors, we welcome near-term weakness in the industry given the capital deployment opportunities it presents.
Originally published on June 15, 2016
The views expressed are those of the research analyst as of June 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.