ATSG - Air Transport Services Group: Is All The Bad News Priced In?

2023-11-30 06:45:15 ET

Summary

• Air Transport Services Group reported disappointing earnings, causing the stock to drop nearly 19% and reach its lowest levels since early 2020.
• The company's reduced guidance and challenges in the ACMI segment have significantly reduced growth and earnings prospects for the foreseeable future.
• Management has a lot of work to do to restore its credibility with investors.

I previously wrote about Air Transport Services Group (ATSG) on a few occasions. The company reported earnings a few weeks ago, and the stock took a huge hit, more or less revisiting its lows back in May following its disappointing first-quarter results. These reports, if possible, were even more disappointing than those from earlier in the year.

I'm still very wrong on this one, unfortunately - clearly, the downturn in the air cargo and ACMI markets is more pronounced than the company previously indicated, even as recently as its Investor Day in late September. I do believe that air cargo growth prospects over the long term are positive, but ATSG is going to have to navigate a period of below-trend growth while digesting a significant amount of CapEx on additional aircraft. In addition, it appears that they made a necessary change at the top of the house, as the company has not executed its strategy well in several respects.

My thoughts on the company's results and the forward outlook can be found below.

Third-quarter overview and revised projections

I would strongly encourage any interested investor to listen to the recent earnings call . It was a doozy. You don't often hear management as apologetic as they were, and the shock of the analyst community was palpable. Anyway, let's dive right into the call, earnings release, and overall outlook.

Here's what management had to say about its customer base in their earnings release:

" In mid-October, certain airlines that lease aircraft from CAM to serve international routes expressed that they are experiencing weaker customer demand, impacting their recent financial performance and outlook. We expect this to disrupt future leasing revenues from those customers."

There are two sides to this. The good news is that DHL, Amazon (AMZN), and DoD remain the company's top three revenue sources by far, accounting for 75-80% of overall revenues. While highly concentrated, these relationships are longstanding and subject to long-term contracts that should provide some degree of revenue stability. However, the other 20-25% was where CAM. This seems to be impacting the 767-300s in particular, the workhorse of ATSG's fleet and the midsize air cargo market globally, and even this aircraft will not be easy to remarket if the demand is not there. It also may impact the company's expansion into the A330 and A321-200 product lines, and these markets, while rife with potential, are still in their nascent stages and without broad distribution amongst potential lessees. And furthermore, the company has been stuck on "around 20 commitments" for A330 freighters for the better part of the past year, so any update here would be most helpful as it would further illuminate the degree to which the market has dried up.

So to the extent that any of these customers restructure their payments or ultimately fail, it may be difficult for the company to redeploy these assets, particularly in a softer macroeconomic backdrop. It also potentially calls into question the value of some of the company's aircraft, and whether impairments may be necessary in the coming quarters. It would be nice to see the company look into the disposition of select assets, if for no other reasons than to reassure investors that its carrying values are appropriate, if not attractive.

The company also may need to look into deferring, or even cancelling (if possible and prudent to do) some of its conversion slots with the different maintenance facilities if they are not able to profitably deploy these assets to new and/or existing customers.

There was this comment as well:

" ATSG expects the conflict in Israel to affect Omni's customer requirements in the near-term. In addition, the Company expects fewer 767-200 aircraft sales and lower engine revenues versus our plan for this year. ATSG's domestic air express operations, in support of the e-commerce networks of DHL and Amazon, are on track with earlier expectations."

While the geopolitical events were understandably not foreseen by management, they've been talking about the return of many 767-200 aircraft from Amazon for months now, so for that to be cited as a reason for the miss is cause for concern. Even if the market backdrop were more constructive, the 767-200 is older, less efficient, and less popular than the 767-300. It stands to reason that ATSG's base case should not have assumed significant revenue generation from those assets once returned by Amazon. This, if true, was a clear error in judgment. However, if this is just a matter of timing of asset sales, which management at least hinted at on the earnings call, then perhaps this will provide a slight boost in the coming few quarters.

In addition, the company is planning to reduce 2024 growth capex by $100 million (~16% reduction) from the plan as of September. This reduction reflects " fewer conversions and feedstock purchases due to softening demand " and is somewhat of an indictment, at least in the near term, of the company's aggressive push to expand its fleet.

Significant pressure on expenses

While revenues were somewhat stable, the company is taking a hit in various components of its expenses. Spend on Maintenance, materials and repairs was up ~30% year-over-year through September. This is a line item that is in the same category as what the company calls "Sustaining CapEx" which naturally should fluctuate somewhat, but the level of increase is alarming. Additionally, SG&A and Travel were also up materially y-o-y, as was interest expense.

The interest expense issue is likely driven by the higher cost of the convertible notes issued over the summer (3.875%) relative to its 2017 notes (1.125%) - and why they bought them back early is another question worth asking - as well as, more significantly, the company's reliance on its floating rate revolving credit facility as a funding source. I have previously pointed out my concerns about this approach in my articles on Air Lease Corporation (AL); however, the situation for ATSG is significantly more challenging. As of 9/30/23, ATSG had $660 million of capacity drawn under this facility. While Air Lease's revolver draw represents something like 5-10% of its total debt outstanding (and is unsecured at that), ATSG's secured revolver accounts for a staggering 39% of its debt liabilities! And unfortunately, it is severely underhedged, with only $200 million of notional swaps through 2026, while the facility matures in October 2027. Its interest rate may vary based on the company's leverage ratio, which has increased from ~2.2x to ~2.9x at the end of the most recent quarter, and should be monitored closely going forward. This is further compounded by the fact that their lease revenues are likely mostly fixed rate in nature, and so do not rise with interest rates, so it's a double whammy of stable revenues and increasing capital costs.

Update on share buybacks

Management continued to repurchase shares, buying back over 5 million shares in the third quarter, and 9.4 million shares since September 2022. Diluted average share count is down by 16 million, nearly 18% y-o-y, between the repurchases and convertible note retirements. I'm usually a big believer in share repurchases and capital returns, but I question whether that's the best use of proceeds at the current time given the market uncertainty. To the extent that the company does generate ample free cash flow, it would be nice to see them direct it towards debt repayments, both to bring its leverage metrics back to 2021-22 levels and to reduce the interest cost burden that is weighing on results.

Risks to investment thesis

1. Economic recession

2. Ongoing development of markets for new aircraft types (A321-200, A330)

3. Potential customer payment restructuring and defaults

4. Geopolitical developments

Conclusion

ATSG has its work cut out to reestablish its credibility with investors, shore up its strategy, improve its capital allocation, and ultimately better deliver for shareholders. While the company should have long-term tailwinds at its back as the global economy and e-commerce continue to grow, it has a long and uncertain road ahead. I'll continue to keep an eye on it but I seriously struggle with the investment case until both the company and its various markets get to steadier ground.

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