Analysis: ATSG needs organic growth, and lots of it, to deliver more value to investors

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There are companies that need growth to survive in difficult market conditions, while others have to reinvent themselves to thrive. US-based Air Transport Services Group is of the latter kind.

Judging by its performance on the stock exchange since March 2009, nothing could go wrong with this relatively small company, which has a market cap of $600m.

Its equity valuation has risen by an astonishing 4,585% since the bull market began six years ago, and although its stock is now priced at a healthy 15 times forward p/e multiple, it is not always been a smooth ride for shareholders.

Since the early years of the century, ABX Air – as ATSG was formerly known – provided most of DHL’s US domestic express lift, and it was ABX’s only customer. As it turned out, DHL’s foray in the US domestic express arena was not successful, and after years of staggering losses, the German group pulled out in 2008, keeping only its international business.

This would have left ABX in a difficult position had the airline not seen the writing on the wall: it reacted by acquiring other airlines and airfreight businesses, which now operate under the umbrella of ATSG.

DHL remains its largest customer. Relationships were strengthened in the second quarter, when the parties agreed that ATSG would support DHL’s air cargo network in the US at least until March 2019.

In most recent years, key to value creation has been management’s ability to preserve revenues – which are still below 2012 levels – while focusing on the opportunities offered to CAM, its leasing unit, which has become the most important earnings contributor.

At group level, pre-tax earnings from continuing operations rose 17% to $17.2m in the second quarter. CAM represents only about 25% of revenues, but it is the unit behind that strong growth rate; its pre-tax earnings were up 35.4%, driven by eight additional freighters leased to external customers, and amount to 80% of the group’s pre-tax income in the quarter.

Essentially, challenging conditions in the long-haul cargo market opened the door to more opportunities in the integrated and regional cargo networks, which now represents ATSG’s focus. The man behind all this is Joe Hete, who has been president and chief executive of ATSG, since September 2007 and chief executive of ABX since August 2003.

ATSG’s Joe Hete

  Financials and outlook

Only a couple of years ago, things were very different: ATSG had a poor 2013, but the group swiftly bounced back under Mr Hete’s stewardship.
Although heavy investment is up, the group seems to be efficiently managed with regard to its capital deployment strategy.

According to my calculations, ATSG comfortably makes its weighted average cost of capital (WACC) of about 6%. At 7%, its pro-forma return on
invested capital could continue to rise beyond that WACC threshold if the group is quick to secure more deals in the growing mid-size freighter
market.

One caveat is that its risk profile becomes less appealing to income investors who are eager to pocket some yield from dividends, currently at zero, but cash returns will be limited for some time.

The terms of its senior debt obligations limit the amount of dividends it can pay and the amount of stock it can repurchase “to $50m during any calendar year, provided the company’s total debt to Ebitda ratio is under 2.5 times, after giving effect to the dividend or repurchase,” ATSG said in its latest trading update.

That’s why its stock price has risen only 10% over the last 12 months – so, ATSG needs organic growth, and lots of it, to deliver more value to its shareholders.

In a recent call with analysts, Mr Hete said the second-quarter trading update confirmed what management had predicted in May, and “2015 is shaping up to be a very good year for ATSG”.

CAM is behind a performance that prompted management to raise its Ebitda guidance to $195m from $190m, which could still be a conservative estimate. In fact, its aircraft leasing portfolio is changing “not just in numbers, but also in customer mix,” Mr Hete pointed out.

E-commerce trends and rising regional and network demand are seen as key elements in order to exploit current market conditions, along with a business model where core assets (ACMI, about 57% of revenues) have become less core over time.

Quint Turner, chief financial officer, said: “The key to the outlook (…) and once again the driver of our second quarter gains is the growth in the freighter leasing business and the flexibility,” noting that a differentiated business model “affords us to shift our aircraft between our leasing and airline businesses as demand warrants”.

As a result, ATSG increased its 2015 capex guidance to $150m from $80m, which “reflect the two 300s we bought recently, plus engines, mod cost, and capitalise maintenance for our expanding fleet,” Mr Turner noted.

A smart business model

Although management would not be drawn into discussing capex guidance for 2016, a number “that certainly exceeds the $100m next year” should be expected. Additional growth is backed by record operating cash flow, partly spurred by working capital inflows, which testifies to discipline in cash management and a decent capital structure.

ATSG’s net leverage, as gauged by net debt/Ebitda, stands at 1.5x, including an unused revolving credit facility of $151m that will likely be drawn in future. Management says that such a leverage ratio qualifies ATSG for a sub 2% interest rate on variable rate debt leaving it well-positioned to implement its balance capital allocation strategy, which includes buybacks.

The group has spent $3.9m to repurchase shares, including $2.6m in May and June.

“We will continue to repurchase shares consistent with our goal to maximise the value of your investment in ATSG,” management said, but value may reside elsewhere, and excess cash could be invested in airlines both in Europe and Asia.

And here’s how it works: ATSG invested $15m to acquire a minority interest last year in West Atlantic, “which led this year to West Atlantic’s commitment to two 767 dry leases with CAM.”

“We think that our West Atlantic partnership serves as a good model for our next phase of growth.”

It also won an airfreight maintenance service contract with Delta Airlines for its fleet of Boeing 717, which runs for five years, and there “are definitely other opportunities out there and those would require expansion of our current facilities here in Wilmington”.

Before that’s sorted out, however, its current strategy must pay off, I’d argue.