Kirby - Q3 2017

Transcript

Operator (participant)

Good morning, and welcome to the Kirby Corporation 2017 Third Quarter Earnings Call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. We ask that you limit your questions to one question and one follow-up. To ask a question, you may press star, then One on your touch-tone phone. To withdraw your question, please press star, then two. Please note, this event is being recorded. I would now like to turn the conference over to Mr. Brian Carey, Kirby’s Manager of Investor Relations and Corporate Finance. Please go ahead, sir.

Brian Carey (Manager of Investor Relations and Corporate Finance)

Thank you, and good morning, everyone, and we appreciate you joining us today. With me today are Joe Pyne, our Chairman, and David Grzebinski, Kirby's President and Chief Executive Officer. During this call, we may refer to certain non-GAAP or adjusted financial measures. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures is included in our third-quarter earnings press release and is available on our website at kirbycorp.com in the Investor Relations section under Financial Highlights.

Statements contained in this conference call with respect to the future are forward-looking statements. These statements reflect management's reasonable judgment with respect to future events. Forward-looking statements involve risks and uncertainties. Our actual results could differ materially from those anticipated as a result of various factors. A list of these risk factors can be found in Kirby's Form 10-K for the year ended December 31, 2016, filed with the SEC. I'll now turn the call over to Joe.

Joe Pyne (Chairman)

Okay, thank you. Thank you, Brian, and good morning. Yesterday afternoon, we announced 2017 third-quarter earnings of $0.52 per share, including a net $0.03 per share of lost revenue and costs from the hurricanes we experienced in the quarter. Stewart & Stevenson, acquired on September 13, contributed $0.03 per share to the quarter as it saw elevated demand for rental generators in response to the storm, and some pent-up demand for service work once facilities reopened. The third quarter results of $0.52 per share are within our guidance range of $0.40-$0.55 per share. The 2016 third-quarter results were $0.59 per share.

After considering the impact of the storm and the addition of Stewart & Stevenson, the results in the quarter mirrored the underlying fundamentals we observed in the first half of this year. The inland marine tank barge market experienced an uptick in demand after Hurricane Harvey, as refineries and petrochemical plants returned to service, increasing inland barge utilization into the fourth quarter. It is too early to determine the duration of this recent increase, but it is continuing.

The coastal markets continue to be challenging as the market has absorbed new builds, and the crude oil moves planned for these new builds have not materialized. We do believe that pricing at current levels, maintenance decisions, and ballast water treatment decisions will force a rationalization in this fleet. The land-based distribution and service business experienced consistently strong service demand.

We are seeing modest orders for new pressure pumping equipment and new products. We believe this cycle will be more ratable, helped by better capital discipline, which forces much more rebuilding than just replacing. U.S. rig count stayed relatively flat during the quarter, as E&P companies are showing a preference for returns over just growth. Profitability of our customer base is improving as demand for pressure pumping services remain tight from the backlog of completion activity.

Stewart & Stevenson has quickly shown encouraging results in our brief period of ownership during the third quarter, as they mobilized their rental equipment fleet in response to hurricanes and had healthy demand for service work, parts sales, and the manufacture of pressure pumping equipment. In summary, our marine transportation markets continue to be challenging, but our ability to contain cost is helping hold profitability steady.

Post Stewart & Stevenson, our balance sheet remains available for marine consolidation opportunities, as many interested industry participants are experiencing significant distress. Our land-based distribution and service business has maintained the momentum built since the green shoots of recovery, which appeared third quarter of last year. With Stewart & Stevenson in the fold, we're seeing early benefits of its scale and scope of product offering to our distribution and services segment. I'll now turn the call over to David.

David Grzebinski (President and CEO)

All right. Thank you, Joe, and good morning, everyone. Thank you for joining us today. I'd like to start by commending the Kirby team, our customers, and the communities affected by hurricanes Harvey, Irma, and Maria, for their tremendous resiliency and generous spirit in the face of these major storms. Hurricane Harvey was particularly devastating to many communities where we live and work, as the storm landed in the Corpus Christi area and moved east to Houston, all the way through to Louisiana.

It caused significant damage to western parts of the Intracoastal Waterway system and shut down many of our petrochemical and refining customers' facilities. Many of our employees were personally impacted by high floodwaters and property damage. Hurricanes Irma and Maria had a lesser impact than Harvey, but still disrupted our coastal marine operations and distribution and services businesses along the East Coast.

Through it all, our operations and commercial teams operated safely and worked diligently and creatively to meet our customers' needs as customers managed the disruption to their supply chains and brought their plants and refineries and facilities back online. So thank you to all those involved in the recovery and, and response to the hurricanes. Let me now move on to a recap of our third quarter results. I'll conclude with an update on, on our guidance, and then we'll go to, to Q&A. In the 2017 third quarter, Marine Transportation segment revenue declined $40 million, or approximately 11%, and operating income declined $19.4 million, or 35%, as compared with the 2016 third quarter. The declines were mainly due to continued lower pricing in both marine markets and lower coastal marine utilization.

The Marine Transportation segment's operating margin in the quarter was 11%—11.3% compared to 15.4% in the 2016 third quarter. In the inland marine transportation market, the third quarter operating conditions deteriorated significantly after Hurricane Harvey made landfall on the Gulf Coast at the end of August. Unrelated and coinciding, upriver infrastructure repairs further decreased operating efficiency in September. So delay days in the third quarter were just under 2,000 days, roughly double from a year ago level. This led to a marked increase in inland tank barge utilization post-Harvey, with utilization going from the mid-80% range to the mid-90% range during the third quarter. Initial net loss revenues and higher costs from the hurricane totaled approximately $0.07 per share for the quarter.

However, as the quarter concluded, approximately $0.04 per share was offset as a result of cost recoveries from marine customers for delays, an increase in utilization in our inland business due to pent-up demand, and higher demand as pricing for our customers' products improved and drove natural demand. Demand for transportation by inland tank barge in the quarter was higher than in the third quarter of 2016. The inland sector contributed slightly more than two-thirds of marine transportation revenue during the 2017 third quarter. Long-term inland marine transportation contracts, those contracts with a term of one year or longer in duration, contributed approximately 75% of the revenue, with 48% attributable to time charters and 52% attributable to affreightment contracts. Pricing on term contracts continued to deteriorate due to the excess capacity in the system.

Contracts that renewed during the third quarter were down in the mid- to high single digits compared to the 2016 third quarter. As we've discussed before, term contract renewals can have a lag effect on earnings, as it takes a year to see the full impact to Kirby's earnings. Spot contracts were consistent with the first six months of 2017. The inland sector generated an operating margin in the mid- to high teens for the quarter. In our coastal marine transportation sector, the oversupply of barrel capacity in the market was exacerbated by, in the third quarter, by new equipment entering service. Including temporary laid-up barges, Kirby's coastal tank barge utilization was in the low to mid-60% range during the quarter.

Revenues from the coastwise transportation of refined petroleum products and black oil were lower compared to the 2016 third quarter, while revenues for the transportation of petrochemicals were stable. We continue to evaluate the commercial viability of each piece of coastal equipment if it moves from a term contract into the spot market, and we temporarily lay up equipment when it makes commercial sense. Our aggressive actions to manage costs, starting in the first quarter of 2017, have somewhat stabilized margins in the face of this deteriorating utilization. Regarding coastal market pricing, generally, spot contract rates remain below term contract rates, the degree of which varies based on geography, vessel size, vessel capabilities, and the product being transported.

As an example of where spot pricing was in the third quarter, spot rates for vessels in the 80- to 100,000-barrel range in clean service were approximately 15% lower than the third quarter 2016. However, pricing on both term and spot contracts was stable compared to the 2017 second quarter. The percentage of coastal revenue under term contracts was consistent with the 2017 first six months at approximately 80%, mainly as a result of lower revenue for spot equipment. The third quarter negative operating margin for the coastal sector was in the mid-single digits. In regards to our marine construction and retirement plans, we took delivery of two 30,000-barrel inland tank barges and retired 16 over the course of the third quarter.

After folding in the 13 barges from the asset acquisition that closed early in the quarter, the net result was a decrease of one tank barge in our inland tank barge fleet for a total reduction of approximately 15,000 barrels of capacity. For the remainder of the year, we expect to take delivery of 1 additional 30,000-barrel inland tank barge and retire four more barges with approximately 57,000 barrels of capacity. Net, we expect to end 2017 with a total of 845 barges, representing 17.3 million barrels of capacity. In the coastwise transportation sector, we took delivery of one 155,000-barrel ATB unit, our final new addition to the coastal fleet, and we scrapped 1 45,000-barrel barge during the quarter, ending the quarter with approximately 6.2 million barrels of capacity.

Moving on to our distribution and services segment, revenue for the 2017 third quarter increased 194% from the 2016 third quarter, and operating income for the quarter was $22 million, as compared with operating income of $4.6 million in the 2016 third quarter. The segment's operating margin was 9.9%, compared with 6.1% for the 2016 third quarter. Our land-based operations, including S&S, made up approximately 80% of the distribution and services segment's revenue in the third quarter, with an operating margin in the high single digits. The revenue and margin composition of the legacy business for the third quarter was largely similar to the first two quarters of 2017.

Pressure pumping unit remanufacturing remained strong as the number of units on premises for remanufacture was comparable to the first half of 2017 and the fourth quarter of 2016. In terms of new equipment manufacturing, we continue to build and deliver new frac equipment throughout the quarter. Demand for rebuilt transmissions remained elevated in the third quarter, surpassing our all-time high set in the second quarter. We also saw increased demand for the sale of new transmissions in the third quarter, as customers have started depleting their stocks of transmissions as this expansion matures. At S&S, rental revenues from standby generation demand were elevated as the result of hurricane-related demand in both Texas and in Florida. The remainder of S&S distribution and services revenues were in line with our expectations based on pre-closing forecasts that we received.

In our marine distribution and services business, performance was slightly weaker year-over-year and sequentially, primarily due to increased deferrals of major overhaul projects, consistent with continued weak demand in the inland tank and dry cargo barge markets, in the coastal marine markets, and in the offshore oil and gas services markets. Service activity and parts demand in the power generation market was slightly lower than the 2017 second quarter and 2016 third quarter, due primarily to the timing of major projects and a lack of new engine sales. Operating margins for the marine distribution and services business were slightly lower sequentially and year-over-year. On the corporate side of things, we incurred approximately $0.01 per share in acquisition-related charges in the third quarter for S&S acquisition. This amount is included in the $0.03 per share contribution for S&S in the third quarter.

Our capital spending guidance for 2017 is updated to $175 million-$185 million, compared to prior guidance of $165 million-$185 million. We do not expect any changes to our tax rate. Our guidance uses a rate of approximately 38% for both the fourth quarter and the full year of 2017. As of September 30, 2017, total debt on our balance sheet was $1 billion, a $300 million increase from December 31, 2016, mainly as a result of the S&S acquisition. Our debt-to-total cap ratio at the end of the third quarter was 26.4%, a 3.3% increase from December 31, 2016. As of today, our debt stands at $1.02 billion.

I will now move on to our fourth quarter outlook. In our press release last night, we announced our 2017 fourth quarter guidance of $0.40-$0.55 per share and updated our full-year 2017 guidance to $1.90-$2.05 per share, from $1.80-$2.10 per share. You will recall our fourth quarter is almost always seasonally our weakest quarter. So this guidance includes approximately $0.03-$0.05 per share impact from S&S for the fourth quarter and considers the impact of increased interest expense and a higher average shares outstanding due to the share issuance in the S&S acquisition. In the marine inland transportation market, we expect utilization in the mid-80% to the mid-90% range for the fourth quarter, a range that assumes stable demand across the inland fleet.

We look for delay days in the fourth quarter to be comparable to the third quarter, as operating conditions reflect normal winter weather seasonal patterns and mirror the effect of operating conditions caused by hurricanes in the third quarter. Our updated guidance contemplates a similar pricing environment to what we have experienced throughout 2017. The pain inflicted on the inland barge industry as a result of excess industry capacity grows more acute the longer it persists, as pricing remains unsustainably low. We continue to assess opportunities to grow our inland marine franchise, and we fully expect to emerge from this cycle larger and stronger. In the coastal market, our guidance range contemplates utilization, including temporary laid-up equipment, in the low- to mid-60% range for the quarter. We assume flat pricing on term and spot contracts, and that renewing contracts reprice at spot levels.

We are guiding to a full year mid-single digit negative operating margin for the coastal business. We do maintain an aggressive focus on costs and optimizing the equipment available and marketed commercially in this coastal business. For our distribution and services segment in our legacy land-based sector, we expect service work from pressure pumping unit remanufacturing and new manufacturing of frac equipment in the fourth quarter to remain consistent with recent trends. We expect demand for transmission overhauls to lower slightly as sales of new transmissions replace some overhauls. We anticipate we will see some incremental demand for the sale of new engines and parts in the fourth quarter. Regarding S&S, we are guiding to $0.03-$0.05 per share for the fourth quarter, up from our prior guidance of $0.02-$0.04 per share.

While we anticipate demand for rental equipment will return to normalized levels, we expect demand levels for its distribution and services offerings will maintain current levels in the fourth quarter. Though there remains much integration work to do, we are encouraged by the early signs of the potential for the combined land-based distribution and services business, and have already started improving our ability to meet our customer needs by optimizing available capacity to improve delivery times on some customer orders. In our marine distribution and services market, we expect a seasonal decline in revenue and continued deferrals by our customers. In the power generation market, we expect results that are slightly lower than the 2016 fourth quarter, though slightly higher sequentially, due to the timing of major projects.

In summary, the fourth quarter, 2017, should generally mirror trends seen over the last three quarters in all of our markets. The inland marine business is maintaining profitability in an oversupplied capacity market, while safely meeting our customer needs. The coastal marine business has demonstrated resiliency in its performance by aggressively managing costs and optimizing equipment in the face of very sloppy market fundamentals. The land-based distribution and services business continues to execute well in an oil services cycle that so far has been more ratable and tempered than prior cycles. The addition of S&S to the mix has already provided encouraging evidence of the benefits of its scale, scope of product offerings, and geographic breadth. In conclusion, our financial position is strong, with free cash flow, excluding acquisitions, expected to be comparable to 2016.

We have a clean balance sheet that affords us plenty of dry powder for consolidating acquisitions. Our debt-to-cap ratio of 26 remains low even after the S&S acquisition, and we are committed to our established strategy of building out our inland marine franchise through acquisitions, and we are in a prime position and environment to do so. So with that, operator, that concludes our prepared remarks. We're now ready to take questions.

Operator (participant)

We will now begin the question and answer session. To ask a question, you may press star, then one on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. As a reminder, we ask that you please limit your questions to one question and one follow-up. The first question comes from Jon Chappell with Evercore. Please go ahead.

Jon Chappell (Senior Managing Director and Senior Equity Research Analyst)

Thank you. Good morning, guys.

David Grzebinski (President and CEO)

Hey, good morning, Jon.

Jon Chappell (Senior Managing Director and Senior Equity Research Analyst)

Congratulations on the Astros. Great series.

David Grzebinski (President and CEO)

Yeah, thanks.

Jon Chappell (Senior Managing Director and Senior Equity Research Analyst)

In terms of the community down there, too, I'm sure. First question, on the inland side, so it's a kind of a two-parter. Last quarter, I think Joe was talking about the pain threshold kind of, getting there, where some of the, maybe less well-capitalized companies are starting to bend a little bit. So, the first part is this little boost in utilization to the mid-90s, is that kind of giving a reprieve to some of these guys and, and helping them to hold on and, and maybe pushing back some of the, opportunities that you see there?

And then also, speaking of pushing back, petrochemical capacity supposed to come online is continuing to shift to the right, whether that was Harvey-related or just kind of delays in that. And you spoke about the kind of lagged impact of pricing on the bottom line. Does this seem like that's more of a 2019 recovery as opposed to a mid-2018 recovery now?

David Grzebinski (President and CEO)

Yeah, so let me take those in order, and I, and I'll have Joe chime in on the pain threshold in particular, and what we've seen in past cycles. It, you know, the pain threshold continues because spot pricing is basically down near cash breakeven. So, we may be busier, but pricing is still low, and, you know, for some carriers, it's unsustainably low. We have heard anecdotes of companies in trouble. We heard of a repossession of some equipment from one of our smaller competitors here recently. So, it even though we're a little busier, it's still very painful. However, that said, if this demand continues, and the market believes that it's gonna be sustained there, it sure gets us a lot closer to that inflection point on pricing.

Because, as you know, you've got to have the higher utilization and the belief that there's gonna be sustained demand, and then we'll be able to push pricing. So, there's still a lot of pain out there, and, you know, even though we're a little busier, it hasn't helped a whole lot for some of the competitors. And, you know, but the encouraging thing is, if the demand stays up, it leads us to a better pricing environment sooner rather than later. I'll come back to the petrochemical shift in another question, but I'll ask Joe if he's got any comments on the, kind of the his-

Joe Pyne (Chairman)

David, I think you answered John's question well. You know, when will the market turn? Well, the market will turn as we come into balance and, you know, certainly, the higher utilization after the storm and its prolonged utilization rates into the fourth quarter are encouraging. But you need that the market will need to have the sense that the business is indeed gonna get better, and these utilization rates are gonna be maintained before I think you see any inflection in pricing.

David Grzebinski (President and CEO)

Yeah, John, I'll come back to your petrochemical shift question. Yeah, what I'm hearing from our customers is still a lot of excitement about the build-out. I think what we're seeing... Well, the hurricane didn't help at all, to be clear, disrupted not only the normal operations, but the construction of a lot of plants and shut down a lot of things, as you would expect. But what I think we're seeing is kind of that normal shift to the right in projects. They just tend to take longer than everyone's ambitious plans.

I will say this, you know, I recently had dinner with the CEO of a major chemical company, and, you know, there's tremendous amount of excitement to continue these projects and, in fact, even looking at adding some projects. So, I think we're seeing more projects added, and almost none canceled. We are seeing them pushed out. I think that's all positive because, you know, as we talk about coming back into balance here, you know, our volumes typically grow with GDP, and GDP is doing okay. And if you add a little bit more for chemicals, I think that helps soak up capacity as we move forward. So, you know, we could have 2%-5% kind of volume growth as we go forward into 2018.

Then, if you get supply contraction, which I fully expect, we haven't heard of any new building announced for 2018 thus far. And we know a lot of us are retiring inland capacity in particular. I think our forecast right now is that we'll retire by the end of the year 49 barges in total. I think we're actually in the high 40s right now, and what we've retired through the third quarter. So with supply contraction, a little demand input pick up, and if this utilization trend kind of stays where it's at, you know, we could be a lot closer to that inflection point. That said, it's still very, very painful out there at these price levels.

Jon Chappell (Senior Managing Director and Senior Equity Research Analyst)

Right. That's super helpful. Hopefully, my follow-up's a lot quicker than that, but I appreciate that, that insight. On the coastal side, as you mentioned in your comments, David, you've been able to kind of maintain this margin, kind of negative mid-single digits. And it seems like kind of temporary things like laying up equipment, et cetera. If this market deteriorates further, most likely because of the continued onslaught of new capacity, is mid-negative single digits still kind of the right way to think about it, or potentially could it get worse? Or if you kind of make a shift to more kind of fixed cost removal, could that even improve, in the same type of utilization or even a lower utilization environment?

David Grzebinski (President and CEO)

Yeah, I mean, the short answer, the margin are probably gonna be in this range. It could go up and down. But let me just comment a little bit about the coastal market and kind of the trends. There are only, I think, in our mind, about five pieces of equipment, new pieces of equipment to come into the market left. The bulk of the equipment's been delivered. You know, we could be off of one or there, but the bulk of the new equipment has delivered. There's a few left to come in. And you know, scrapping is starting. So far this year, we'll have basically sold, or mostly to scrap, four barges. So we're taking out our capacity.

I think other people are in the process of doing it. And, you know, as Joe mentioned in his opening comments, this ballast water treatment process that we're going to have to go through is going to require a lot of capital, and that's going to actually help accelerate some retirements, including for Kirby. So, yeah, you know, I think the supply and demand situation is not going to get a lot worse from this point.

We should see some demand growth just with GDP. You know, on what we can control, we continue to look at costs and take it out. I wouldn't expect utilization to get any worse than where we're at now. If anything, you know, as we move into 2018, it could start getting a little better. But, your assumption of margins in this range is probably a good one for the near term, at least.

Jon Chappell (Senior Managing Director and Senior Equity Research Analyst)

All right. Super helpful. Thanks, David. Thanks, Joe.

David Grzebinski (President and CEO)

Thanks, Jon.

Operator (participant)

The next question comes from Jack Atkins with Stephens. Please go ahead.

Jack Atkins (Research Analyst)

Great. Good morning, guys. Thanks for the time.

David Grzebinski (President and CEO)

Hey, good morning, Jack.

Jack Atkins (Research Analyst)

You know, David, I guess just to follow up on the inland commentary, and I appreciate all of that detail that you provided with John's question. But I guess just sort of thinking about how, you know, I guess we're trending going into 2018, with pricing renewing in the third quarter and down in the mid- to high-single digits on the inland side. And you know, you referenced the sort of lag effect given the contractual nature of that business.

Yeah, I guess can you kind of, without providing 2018 guidance, obviously, can you kind of help us think through how we should be framing up the profitability trajectory of the marine segment kind of going into 2018? Because I would think that, you know, it, as we push out that pricing recovery, we're really sort of probably pushing out any sort of recovery in the underlying profitability of that segment. But I would just like to sort of get your take on how you guys are thinking about that going into next year.

David Grzebinski (President and CEO)

Yeah, no, it's a great question, Jack, because as you, as you know, and we, we called it out on the script here, we do get a full year effect, right? We're renewing, as you heard in our comments, contracts are down year-over-year, and then that translates into a full year effect in 2018. So that, you know, that, that is math, right? I think everybody kind of gets that math.

That said, what we don't know is when the inflection will happen and the magnitude of it. You know, the, you know, the earlier in the year it happens, the better. We still have significant spot exposure, and then, you know, contracts do renew throughout 2018. But your premise is spot on. We do have that full year effect, and, you know, it's just the mathematics of these contract renewals.

Joe Pyne (Chairman)

Yeah, and, Jack, also remember that, you know, 60%-70% of our business is exposed to rate increases or decreases on a given year. Contracts will renew through the year, but you also have your spot exposure that reprices strip by strip. So depending on, as David suggested, depending on when the turn is, it could offset, you know, some of the deterioration that is occurring in 2017.

Jack Atkins (Research Analyst)

Okay. Okay, that's helpful. And then, I guess, just want to follow up with the distribution segment. Now that you have S&S in the fold, could you kind of give us a just sort of some framework around how we should be thinking about the revenue run rate of that segment, sort of going forward with Stewart & Stevenson and the legacy businesses combined now?

David Grzebinski (President and CEO)

Yeah, unfortunately, Jack, I'm not prepared to give you that revenue guidance. Yeah, I think what we've seen so far has just been very encouraging. And that's all I can really... We're just not prepared to give you revenue guidance or margin guidance, but the early indications are this is going to be what we expected. We're seeing great synergies as we put the organizations together, and you know, we had a great customer win here recently by being able to collaborate between the two organizations and now become one, and we're able to meet some customer needs that either organization couldn't have done on its own.

So, we're very excited about the potential of the distribution services business as we continue to integrate it. And you saw, we get, you know, there's some pleasant upsides. I think, you know, we all did not like the hurricanes at all, but, you know, if there's a silver lining, that rental fleet that they have, it was a nice addition. So, yeah, it's a long way of saying I'm not giving you an answer, but we like what we see so far.

Jack Atkins (Research Analyst)

Well, that's a very elegant way of saying it as well, David. So, thanks again for the time, and talk to you soon.

David Grzebinski (President and CEO)

All right. Take care.

Operator (participant)

... The next question comes from Greg Lewis with Credit Suisse. Please go ahead.

Greg Lewis (Senior Research Analyst)

Yeah. Hi, thanks, and good morning.

David Grzebinski (President and CEO)

Hey, good morning, Greg.

Greg Lewis (Senior Research Analyst)

Could you talk a little bit about, I mean, clearly, we've seen, you know, Kirby utilization was, you know, pre-hurricane, looked like it was firming. Out of the hurricane, it got even firmer. Is part of the issue with the ability to push pricing the fact that while Kirby's utilization is in that, you know, that ninety-plus sweet spot, that the rest of the industry just is that far behind?

David Grzebinski (President and CEO)

Yeah, I think that's part of it. Yeah, we don't know exactly where everybody's utilization is. You know, our sense is it may be anywhere from a couple points lower, maybe in some cases, 5%, 5+% . But that is absolutely part of it, Greg. But, you know, their utilization, in general, should be up like ours is in terms of relative moves. If we're up about 5% utilization, I would think their relative utilization is up in about 5%. So we're, you know, it's very encouraging. You know, I think part of the demand or the demand that we're seeing is, you know, crude prices are a little higher. Some of the end product pricing's a little higher, so there's a little more profitability out there for our customer base.

You know, the traders are making a little more money. We've got a kind of a spread between WTI and Brent now that's actually helping some of the arbitrage plays out there. So, you know, we'll see how long this demand holds. It's been encouraging so far. Clearly, some of it is temporary because there was, with all the refineries down and some of the chemical plants down and, certain maintenance activities that had to happen, or recovery activities that had to happen, we had a pent-up demand. But, we're seeing a little more than just, you know, hurricane fallout now. You know, we're encouraged by it. Don't know if it'll hold, but we remain hopeful. If it does hold, it certainly gets us into a better possibility to raise prices.

Greg Lewis (Senior Research Analyst)

Okay, great. And then you actually led into my second question, which was around the Brent WTI spread. I mean, it doesn't look like there's any benefit that is happening in the coastal market, based on your commentary. But is there any benefit that we're seeing on the inland side, at least?

David Grzebinski (President and CEO)

Yeah, yeah, we've seen a little tick-up in crude moves, particularly out of the upriver locations, Utica and Marcellus. We've seen, you know, a nice little pick-up. It's not meaningful yet, but yeah, you know, we were getting down at one point to a handful of barges, and now that's going the other way. So we've seen it, and I think that is part of that is a higher absolute level.

And then there's, you know, with some of the byproducts, I think there is an arbitrage going on between WTI and Brent. Now, on the coastal market, you know, at some point, if that differential maintains itself, I would imagine on the East Coast that that price differential plus transportation out of start backing out some Brent. But to your point, we haven't really seen that yet, but you would expect that it may come if the differential holds for a while.

Greg Lewis (Senior Research Analyst)

All right. Fingers crossed. All right, guys. Thanks for the time.

David Grzebinski (President and CEO)

Hey, thanks, Greg.

Operator (participant)

The next question comes from Kevin Sterling with Seaport Global Securities. Please go ahead.

Kevin Sterling (Managing Director and Senior Analyst)

Thank you. Good morning, gentlemen, and go Astros!

David Grzebinski (President and CEO)

Yeah, thanks, Kevin.

Kevin Sterling (Managing Director and Senior Analyst)

And David, as a coastal business, do you think it's deteriorated a little more than you thought? You know, kind of utilization in the low 60s and just all the, you know, moves we're seeing more to spot market versus contract. You know, I haven't seen it this bad. I'm just curious, have you seen it this bad before? I'd love your thoughts around it.

David Grzebinski (President and CEO)

Yeah, no, it has deteriorated more than we expected. And if you go back and you look, you know, back into the K-Sea timeframe, you go back, this is below what they saw then. You know, I think they got into the low 70s. There was a high 60s for one quarter, I think, back in K-Sea's public days. So this is pretty bad. I think, well, you know what happened, Kevin. It was a lot of new builds. A lot of the new builds were in anticipation of crude moves and crude projects on the coasts that didn't materialize. There was, you know, there was supposed to be some crude by rail going to terminals on the water, and that was gonna drive a number of coastwise moves.

You know, a lot of those projects, I think, you know, our team, Christian, Bill, have seen a list of about six or eight projects that were canceled that had significant crude volumes being moved by water. That's unfortunate. So we had, you know, demand didn't materialize as expected, and the capacity came on. So that has led to probably one of the worst markets in the coastwise business that I'm aware of. But I would say this: there's still a lot of old equipment out there.

You know, I think we're tracking over 30 barges that are over 30 years old, and it will come out. In this market, it's starting to get very painful. And ballast water treatment. You know, we're all going through our fleets and looking at our fleets and saying, "Okay, is this barge worth putting ballast water treatment system on it?" And as you can imagine, the older the barge is, the more likely that the answer is, it's not worth it.

Kevin Sterling (Managing Director and Senior Analyst)

Yep. So, so in the coastal market, I hear you on scrapping, and obviously, if we get accelerated levels of scrapping, that'll help. But do we need consolidation as well to really kind of get this market moving higher? Or do you think if we get meaningful scrapping, that that'll really kind of help turn the tide?

David Grzebinski (President and CEO)

Well, I think it's really about scrapping, 'cause even if you get consolidation, you gotta take the capacity out, so it's more about the scrapping of the older equipment. Consolidation always helps, but you know, it's a pretty painful market, and... As you've heard us say time and again, you almost have to be coming out of the market to get the consolidation done. Rarely happens it kind of at the bottom, so.

Kevin Sterling (Managing Director and Senior Analyst)

Yeah. And last question here, David. You mentioned, and I've heard kind of similar anecdotes, that you know some of the inland players are obviously really struggling and things like that. You mentioned repossession of some equipment on the inland side. Do you know if that equipment was sold back into the market, or was it scrapped? Kind of keeping on this scrapping theme.

Joe Pyne (Chairman)

Additionally sold.

David Grzebinski (President and CEO)

Yeah, don't know the details of where the equipment ended up, but yeah, it may have been sold. Somebody may try and put it to work, but I, you know, it would probably lend at a very low value, and some of it may end up being scrapped anyway. Yeah, look, it's tough. You know, it's tough on the whole industry. It's, you know, there's some wage cuts going on out there. There's certainly layoffs in the industry, and these prices are just unsustainable. They're, you know, in some cases, some deals are being done at below cash cost, which is, as you know, not a good plan. Yeah, for a long, long run business. So, the pain continues, and yeah, out of all this, there should be some opportunities for Kirby, to be sure.

Kevin Sterling (Managing Director and Senior Analyst)

Yeah. The low value of equipment, is that just keeping banks from maybe taking repossession of that equipment, just because they'd have to take such a huge write-down on their loans? Do you think that's part of the issue?

David Grzebinski (President and CEO)

I, I absolutely believe that's part of the issue, that the, yeah, the banks don't really want the equipment either, right? So.

Kevin Sterling (Managing Director and Senior Analyst)

Right.

David Grzebinski (President and CEO)

You know, when you got a bunch of equipment out, what are the banks gonna do with it then? Yeah, it's, it's just sloppy.

Joe Pyne (Chairman)

Yeah. Yeah, I think, I think some of this is getting shorted out now. You know, you, yeah, we're, we're at the part of the cycle that the banks and operators are making decisions with respect to their sustainability. So, yeah, I think you need to give it another six months before we, we truly understand what's gonna happen.

Kevin Sterling (Managing Director and Senior Analyst)

Gotcha. Gotcha. Well, Joe and David, I really appreciate your insight, insights, as always. Thank you so much for your time this morning.

David Grzebinski (President and CEO)

Thanks, Kevin.

Operator (participant)

The next question comes from Ken Hoexter with Merrill Lynch. Please go ahead.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

Great. Good morning.

David Grzebinski (President and CEO)

Hey, good morning.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

I just want to revisit the, the contract pricing for a quick second, just to understand your, I guess, your more immediate view. I think the last two quarters, we've actually seen margins maybe tick up slightly on the inland or fairly stable. But is this kind of an acceleration of the pricing decline on the contract side that you're talking about? Because I want to understand, as you look to fourth quarter, I know you said seasonally, typically the weakest, but I want to understand kind of magnitude, maybe near term, in terms of how quickly we should expect maybe some pressure on those margins, or is this just kind of what you're talking about into 2018?

David Grzebinski (President and CEO)

Yeah, no, the margin comments were really about into 2018 as you get the full year effect. I would say our margins did tick up a little bit in the third quarter on the inland side, principally because we got some cost recoveries there, that when we're not moving and we get the cost recoveries, it's, you know, the revenue is a little lower, and but the recovery still happens, so that helps the margins a little bit. I think what we're talking about mostly here is as these contracts have rolled over, as you heard, down quite a bit from a year ago, you get the full year effect of that going into 2018. That was principally our comment, Ken.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

Okay. Dave, on the S&S deal, I guess two parts to the question, but one, can you... I know you said you can't talk about revenue growth for 2018, but can you talk about the seasonality in the business, how we should think about that, you know, as you look into the fourth quarter? And maybe within that, can you talk about the rationale? How do you want investors to focus on you now that you've acquired S&S and integrated it? Is it one consolidated kind of entity, or are you in oil? So are you moving more toward oil services, or is it the transportation? Just how should we kind of look at what the service target is?

David Grzebinski (President and CEO)

Yeah, good question, Ken. I would say this. I don't think there's a lot of seasonality in the distribution services business. Yeah, there may be a little bit. We do take care of some, you know, pleasure crafts in Florida, for example, and there may be some seasonality there. But when you put it all together, I don't think there's much at all seasonality for the distribution and services business. But as you know, about 80% of the revenues are land-based and in that business. So a good portion of that is oil field service related. But there is also an on-highway portion and a rental portion and other ancillary industrial equipment, whether it's standby generation, power, et cetera.

You know, we service, as I just mentioned, the pleasure boat market in Florida. That's a big part of it. You know, that's a $100 million business there. We do up in the Northeast. We have a, you know, kind of a on-highway service business there. So there, it's not just oil service, to be clear, but certainly there is a significant exposure to the oil service, as you could hear, frac spreads and remanufacturing. So, a healthy part of the growth that we've seen and kind of the rebound. You had seen that with United before, obviously. I would say we're gonna treat this as just one business.

It's, you know, we'll talk about it because as one single business, because we're integrating everything, as you might imagine. There's some branch integration that we've got to do, certainly back office integration. The sales team is already working very well together in trying to jointly attack opportunities out in the marketplace and service the customers where, because the joint capability of Kirby now is stronger. So we're able to take bigger orders and meet shorter time delivery requirements. So it's very encouraging. You know, in terms of how to think about it with respect to Kirby, you know, look, it's gonna be a big business. It's a $1.5 billion, probably, revenue business, and the marine business is probably that same order of magnitude.

As you know, the marine business tends to have better margins over time, through the cycle. But, you know, we'll try and give you as best we can in our calls and our commentaries and our guidance, how best we think about those businesses. But, they are, you know, they're both gonna be significant going forward.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

That's great insight. If I could just get a quick softball for you, though. You bought a bunch of vessels, and then you retired a bunch of inland vessels, and it seemed like it netted out to one change. I presume this was a younger, more profitable fleet. I guess, is that a simple answer as to why?

David Grzebinski (President and CEO)

Yeah, some of it, there were four very young, 30,000-barrel barges in that, but there was some pressure equipment. So we retired kind of the equipment that was surplus, which is older, 30,000-barrel barges and some older tens. And we bought some young, four young, 30,000-barrel barges, and then we bought the rest of the, the purchase was pressure equipment, which is very, very specialized.

And the pressure market is kind of its own little submarket, if you will, which, with these chemical plants coming on, in particular, there's things like butane and butadiene moves and other pressure cargoes, propylene and whatnot, that, you know, our customers are already starting to talk to us about making sure they have pressure barges for those moves. Also with that transaction, we got three new boats, which were kind of younger, which are good to put in our fleet.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

Thanks for the time and insight, Dave. Appreciate it.

David Grzebinski (President and CEO)

Thanks again.

Operator (participant)

The next question comes from David Beard with Coker & Palmer. Please go ahead.

David Beard (Equity Research Analyst)

Hey, good morning, gentlemen. Thanks for squeezing me in.

David Grzebinski (President and CEO)

Oh, you bet.

David Beard (Equity Research Analyst)

A bigger picture question on capital allocation. Just what absolute level of debt would you target? I mean, I know your metrics are good, but would you want to bring the $1 billion down to a certain number or some color there? That was my first question on capital allocation.

David Grzebinski (President and CEO)

Sure. Look, we tend to take acquisitions and build when it makes sense. I think as you've seen us do in the past, if and when we get some consolidation opportunities, and we think in the inland side there, sooner rather than later, we'll use our balance sheet and we'll lever up. I think we'd be comfortable getting up into the 40, high 40s, you know, maybe for the right acquisition, into the 50s. And then, as we've done, we'll use our debt, our cash flow generation to pay down our debt quickly to get the balance sheet back into shape for the next opportunities. Yeah, there's never an absolute target.

You know, I guess theoretically, if you do that weighted average cost of capital, you'd want a 40%-45% debt to total cap. But that's really not the way we think about it. The way we think about it is having balance sheet dry powder, so when the opportunities exist, we can move, and we can move quickly. And, you know, at 26% debt to total cap, we've got some dry powder, and, you know, we remain hopeful to put that to work in the near term.

Joe Pyne (Chairman)

You know, I would just add that the other thing that's important is to maintain our investment-grade rating, because cost of debt is a competitive advantage. We have been as high as 60%, after the Hollywood Marine acquisition. I'm not suggesting that we'd go to that level, but we did that and still maintained the investment-grade rating. So there's, you know, there's plenty of capacity. 26%, that's the total cap, you know, is very reasonable, and you know, the balance sheet can support more debt if there's a good opportunity that's gonna add value in the future.

David Beard (Equity Research Analyst)

Okay, good. And as a follow-up, should we be even thinking that coastwise acquisitions, you know, make sense relative to incremental return on capital, or do you feel that business might not offer a full cycle return relative to making acquisitions in inland?

David Grzebinski (President and CEO)

Yeah, no. Look, our first priority would probably be inland. It's about to come out of the cycle. That would be, you know, the timing makes sense. I think, as we talked about, the coastwise business is probably in a little longer term downturn. But, yeah, it all depends on what the opportunity is. But I would say our preference right at the moment is to consolidate the inland side. Yeah, I think that's where the real opportunities are in the near term.

David Beard (Equity Research Analyst)

No, that's helpful. Appreciate the color.

David Grzebinski (President and CEO)

All right. Thanks, David.

Operator (participant)

The next question comes from Bill Baldwin with Baldwin Anthony Securities. Please go ahead.

Bill Baldwin (Partner, Principal, and Research Analyst)

Good morning.

David Grzebinski (President and CEO)

Hey, good morning, Bill.

Bill Baldwin (Partner, Principal, and Research Analyst)

Couple things here, gentlemen. Can you bring us up to date on your CFO search, David, kind of where that stands?

David Grzebinski (President and CEO)

Sure. Yeah, as you know, it takes a while. The hurricanes didn't help our search process. You know, we've got a number of good candidates, a handful of good candidates that we've been interviewing, and we continue to narrow that field. And you know, I'm hopeful that certainly by the end of the year, I'd like to have somebody on board.

Bill Baldwin (Partner, Principal, and Research Analyst)

Well, good luck to you on that. I know you'll get the kind of person you're looking for. Secondly, on the, you know, vessel personnel, on your barges, particularly the inland barges, as this business picks up and, with all the construction activity on the rebuilds and so forth going on down there in the Gulf States, Gulf States area, is that gonna present any particular supply issues, you think, for personnel to work on your boats? Are you seeing anything? Are you anticipating anything yet?

David Grzebinski (President and CEO)

Yeah. You know, not as of yet. You know, it's... Well, frankly, some of our competitors have been laying off, but as you know, at the root of your question is, when things start coming back, how quickly will we get tight? Is probably at the root of your question. We continue to use our training center. Our team has been training people, but we're running pretty tight on, you know, staffing. We don't wanna have too many people because, you know, there's costs associated with that. But right now, I don't think there's an issue with staffing. As we rebound, I still think, given the number of layups that have occurred in the industry, I think we'd have time before we get crunched for qualified people.

Joe Pyne (Chairman)

Yeah, and Bill, as you know, we produce most of the people that we employ, and-

Bill Baldwin (Partner, Principal, and Research Analyst)

Right. I know you do, and that's kind of getting around to, you know, the kind of the quality of the candidates you're seeing today versus a while back. I mean, are you still getting the folks in there that you'd like to have come into your training program?

David Grzebinski (President and CEO)

Oh, yeah. Yeah, absolutely.

Joe Pyne (Chairman)

Yeah, we're—I'll tell you, I'll tell you where you get into trouble is after, like, an event like Katrina, where you have so much infrastructure disruption, and you're using marine equipment to repair it, and that... And, you know, the market immediately tightens up. That did not happen in Harvey. Harvey was a more water issue than a kind of infrastructure destruction issue. So, you know, I think if you have more ratable demand, you can gear up your training efforts to produce the people that you need.

Bill Baldwin (Partner, Principal, and Research Analyst)

Are you seeing just a change quickly here, but are you seeing the kind of labor force you need on the S&D side, on the you know, the work in your Stewart & Stevenson plants and Kirby plants as demand picks up for the fracking equipment and overhaul and so forth?

David Grzebinski (President and CEO)

Yeah, no, that's a good question, Bill. We, we have been, you know, we've ramped up several hundred people in our United organization, and we're ramping up a little, a little in the S&S organization now, even as we speak. So far it's been pretty good, but it's starting to get tighter, is the short answer. And there's a little more competition. As the oil field has been rebounding here, it's starting to get a little tighter.

Bill Baldwin (Partner, Principal, and Research Analyst)

Well, thank you very much for your time, and.

David Grzebinski (President and CEO)

All right.

Bill Baldwin (Partner, Principal, and Research Analyst)

Best of success.

David Grzebinski (President and CEO)

Thank you. Thanks, Bill.

Operator (participant)

The next question comes from Michael Webber with Wells Fargo. Please go ahead.

Michael Webber (Director and Senior Equity Analyst)

Hey, good morning. Thanks for the time, guys.

David Grzebinski (President and CEO)

Hey, good morning, Michael.

Michael Webber (Director and Senior Equity Analyst)

Hey, David, just wanted to follow up on inland pricing. I know you've touched on it a couple times already, but, you know, in the past, you know, we've heard a fair amount about irrational pricing from certain players in the space. Curious to what degree you're still seeing that, and then specifically, you know, to the extent that you can get color on it, has that been more on a spot or on a term basis? And I'm specifically kind of thinking about if we do get, you know, some kind of bump, are the less rational players gonna be a bit more termed out at that point?

David Grzebinski (President and CEO)

Yeah, most of it's been in the spot market, to be honest. There's been a couple deals that have been termed up at these really ridiculous rates. But, you know, we're hearing anecdotes that, you know, that some of the low pricers are pretty much booked up now. But it's, you know, it's a fluid situation. But I would say most of that really low pricing is in the spot market, and there are very few long-term contracts being done at that level. It just doesn't make sense. There are a few that are getting done at that level, but I, you know, you gotta wonder whether that's a good long-term business decision. Clearly, Kirby doesn't like it and wouldn't do that kind of thing.

Michael Webber (Director and Senior Equity Analyst)

At this point, all pricing is irrational.

David Grzebinski (President and CEO)

Yeah.

Michael Webber (Director and Senior Equity Analyst)

Right. I've just given the nature of some of those businesses, I thought maybe they'd be reaching for some term, but it doesn't sound like it. Let's follow up on coastal, and I know you've touched on, obviously, the state of that market, and I think I believe you got questions on ballast water treatment and I guess scrapping. If you look, though, at the actual special survey dates of most of the older ATB tonnage, you know, that's not-- Most of them are 2019, 2020.

And as you guys know well, obviously, just because scrapping happens, it makes sense at the time on paper, there's usually a multiyear lag between, you know, when that actually happens versus when it starts making sense in a model. I guess my question is, is there really, I mean, a realistic scenario, or is it realistic to think that coastal market could improve without that ultra old tonnage coming out of the market at that special survey date, which is 2019 and 2020?

David Grzebinski (President and CEO)

Yeah, no, I think the capacity's gotta come out. I do think it will come out probably ratably over the special survey dates, to be sure. But there are some older pieces that just can't even earn the cost of their cash costs right now. And, you know, that may force a retirement before the special survey. So it's not just the ballast water treatment situation, which will help drive it, because if you're gonna bring it into a shipyard, you're not gonna wanna spend that additional money. But there are some decisions that you won't even bring it in for the special survey shipyard. You'll just retire it because it's older. You know, frankly, we've retired some very old equipment that we could have taken into the shipyard and extended its life.

It just doesn't make economic sense, and so we're not gonna do it. You know, working at 50% in the spot market at prices that barely cover your cash costs, it becomes pretty easy if you're thinking about a shipyard or even still running the equipment. Does it make sense to keep a crew and fully engaged on that piece of equipment? So, I think you'll see equipment retired irrespective of the shipyard cycle. It'll just happen. You know, there's 4.5 million to almost 5 million barrels of capacity that's well over 30 years old, that's just gotta come out. Kirby had-- Kirby has one that, you know, it's a 180,000-barrel one that's gonna have to come out soon, and we're not gonna extend the life. And that's irrespective of the ballast water treatment.

Michael Webber (Director and Senior Equity Analyst)

Okay. All right. That's helpful. Thanks, guys.

David Grzebinski (President and CEO)

All right. Thank you, Mike.

Operator (participant)

This concludes our question and answer session. I would like to turn the conference back over to Mr. Brian Carey for any closing remarks.

Brian Carey (Manager of Investor Relations and Corporate Finance)

Thank you very much for your interest today in Kirby Corporation and for participating in our call. If you have any additional questions or comments, please reach out to me at 713-435-1413. Thank you, and have a great day.

Operator (participant)

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.