Analysis: is ATSG an attractive prospect for private equity now it has Amazon on board?

© Ivan Cholakov

“ATSG needs organic growth, and lots of it, to deliver more value to investors” was the headline of a column The Loadstar published on 24 August, when ATSG shares traded at just under $9.

Fast-forward, and the stock has been trading between $14 and $15 for a month, spurred by a huge aircraft leasing deal with Amazon inked in early March.

The agreement allows it to benefit from a partnership with a powerhouse in last-mile retail distribution, and comes at a time when ATSG management is still addressing its capital structure.

As CFO Quinn Turner reminded analysts in the latest earnings call, leverage is manageable and new heavy investment is on its way up.

So, its growth trajectory could well accelerate quite rapidly – and now it is obvious to wonder whether, in this growth-starved world, ATSG could be a compelling target for private equity.

Leverage and investment

“Our debt-to-Ebitda ratio at the end of 2015, was a conservative 1.6 times, as a result of strong operating cash flow, coupled with debt repayment during the year,” Mr Turner recently said, adding that some $290m was budgeted for capital expenditures this year after ATSG spent less than expected on capex ($159m) in 2015, when it acquired four 767-300 aircraft.

Mr Turner has pencilled-in $215m “for growth”, and the remainder “for maintenance capex; that’s $10 million more than we had in our earnings release last night”. That difference is for equipment it “will acquire to support the Amazon Air network, which we weren’t prepared to include until the deal was signed”.

Given Amazon’s negotiating power, analysts have found it hard to quantify the benefits of additional investment to revenue and earnings, and how the Amazon deal would impact ATSG’s core operating margin. When asked about core cash flow profitability, Mr Turner didn’t provide a straight answer – but undoubtedly, this could be one of its most appealing features as a takeover target.

And the rumour mill has it that private equity is sniffing around the aviation group.

The deal

One source told The Loadstar private equity is eyeing ATSG, “so there must be an offering out there”.

He added: “The fleet is old and needs replacement. Amazon taking a share is news, but very smart. ATSG has a winner here.”

Last year,  Amazon forked out $4.17bn in shipping costs, and analysts predict this deal will lower Amazon’s costs by moving some 15% of its package traffic in-house. No doubt Amazon wants an even higher amount in future.

Trends for revenues, adjusted earnings, and margins are surely encouraging, yet we are in unchartered territory on the macroeconomic front, and the disconnection between several asset classes, rather than funding hurdles, could prevent private equity buyers from showing interest in ATSG.

Still, the group has sailed unscathed though recent stock market weakness, proving it to be more defensive than similarly cyclical businesses, thanks to a strong, diverse and growing portfolio of clients.

Solid fundamentals back the surge in its equity valuation (+52% since the turn of the year), which looks pricier in terms of earnings than cash flows – an element that works in favour of a private equity take-out likely being conceived as a trade on stock multiples arbitrage.

Growing adjusted operating cash flow, or Ebitda, and rising underlying margins would determine a future premium in its shares, even assuming constant cash flow multiples – which could rise further, though, if ATSG’s rate of growth accelerates or constantly beats estimates.

LBO

Taking ATSG private today would be a big bet both on its growth prospects and the implied premium that will eventually be priced into its valuation, once a private equity buyer becomes a seller. ATSG has not been able to beat the market in recent years, as the chart below indicates.

But is that a warning sign for a leveraged buyout (LBO)?

Well, ASTG has changed a lot and has delivered in recent years, and that shows in its financials.

A 30% equity premium would put a value on the enterprise, as gauged by market value plus net debt, of about $1.6bn. Based on our calculations, such a price tag would buy three years of growth –  and that might just be enough to carry an LBO over the finishing line.

ATSG recently reported Ebitda of $198m, and has guided the market for $208m in 2016.

On a pro-forma basis, the resulting entity would carry $1bn of net debt, up from its current $300m. Ruling out a private-equity consortium, a sole buyer could afford to write a cheque for half a billion dollars, and there are several reasons why ATSG could attract arbitrage capital: one being that private equity could “fare better than current management”, a banker told me today.

However, not only have executives done an outstanding job to turn it around in recent years, but they have also now projected it into a new dimension, where the partnership with Amazon, which has a warrant to acquire a stake of up to 20% in the aviation group, could bring in even more lucrative business.

Management sounded particularly upbeat on the call in this respect. And on top of that, it has already proved it can handle the pressure of quarterly scrutiny, while public markets give it funding options.

But ATSG generates very little free cash flow, and heavier capital investment would put more pressure on its cash flow profile in the near term, unless a grace period is secured on debt repayments related to the LBO.

Otherwise, an LBO could become a difficult de-leveraging story to execute, particularly when you consider that additional interest costs stemming from a 70% debt-financed LBO would amount to between $20m and $30m, according to our estimates – and, including one-offs, it could even throw ATSG into the red after a year during which it reported $41m of net income.