ATSG - Air Transport Services Group: Near-Term Challenges Dominate But Long-Term Potential Remains

Summary

• Air Transport Services Group reported fourth-quarter 2022 results and provided its 2023 outlook, both of which were panned by the market.
• Cost pressures and reduction in ACMI revenues will serve as a headwind to earnings for the time being, at a minimum.
• CAM segment continues to grow, with feedstock secured and significant lease commitments that should provide substantial cash flows to the business for patient investors.
• Reiterate a Buy rating, but with a lower $25 price target, reflecting the diminished outlook.

I previously wrote about Air Transport Services Group (ATSG) in November. The company reported earnings on Friday, and the stock was crushed, down nearly 19% and hitting its lowest levels since early 2020. In retrospect, their announcement about fleet changes a few weeks back appears to have been a sort of teaser for their reduced guidance, though the market was clearly not prepared for the extent of ATSG's disappointing release. I was disappointed too, and accordingly am reducing my price target to $25, or approximately 12 times my 2024 EPS estimates and approximately 5x my forecast for 2024 EBITDA.

Put simply, I got this one wrong - the company has some challenges it will have to work through, and the shares responded accordingly. That said, I think that the overall thesis related to the benefits of secular e-commerce and on-demand delivery growth remains intact, but the timeline has been extended due to the issues in ACMI as well as some of the delays the company is encountering with getting aircraft converted in a timely manner.

I summarize various thoughts on the company's results and earnings call below. They will release their 10-K next week which may contain additional relevant details.

Revised earnings and cash flow projections

ATSG provided 2023 guidance for $650-660 million in adjusted EBITDA. Despite the setbacks it has currently faced, as its CAM segments puts more aircraft into service with third-party customers, EPS and EBITDA should respond positively:

Prior forecast

Updated forecast

Source: Author's own calculations

Shares are currently trading at only ~10 times the company's 2023 EPS guidance and about an EV/EBITDA multiple of approximately 5 times.

Surge in sustaining CapEx

The company guided to $590mm in acquisition and conversion expenditures and a sustaining CapEx figure of $260 million for 2023. The acquisitions are for CAM's growing fleet of converted freighters. They will help to grow EBITDA and net income in 2024-25 and beyond, and the customer commitments already secured for this equipment are an encouraging sign. However, the concerning increase in sustaining CapEx by a massive $75mm (~40%) year-over-year represents an estimated ~10% of net PP&E. This is materially above the 2019-2022 average of ~8% of net PP&E. While it may just be a coincidence that the company has significant engine and airframe maintenance occurring within the year, and while this CapEx allows the company to keep its assets deployed and generating revenue, the combo of elevated acquisition and sustaining CapEx will serve as a near-term cash drain and will inhibit the company's ability to return cash to shareholders in the coming months.

Update on share buybacks

Management continued to repurchase shares, buying back around 2 million shares (~3% of outstanding) in the fourth quarter. Even after their recent activity, ATSG still has around $100 million remaining under the recently authorized share repurchase program, so there is ample room for at least some buybacks at today's depressed levels.

Amazon

Given the swift decline in shares, you are now able to buy into the company at a cost basis below the price of Amazon's (AMZN) most recent tier of warrants, which have a weighted average strike price above $21. As before, Amazon has until December 2025 to exercise these warrants (or not), and its intent to reduce flying and return some of its leased 767-200s could be seen as an ominous sign. However, most of Amazon's contracts with ATSG still have many years remaining in their lives, and involve the 767-300, the backbone of Amazon's fleet and the midsize freighter fleet globally.

While Amazon should be expected make certain changes to capacity in response to market conditions, the aircraft it is shedding were always likely to be the first casualties in its ATSG relationship. ATSG management has already confirmed that it will harvest the engines from some of these 767-200s to generate additional revenues and avoid unnecessary maintenance expenses, so that will at least partially offset lost lease revenue from Amazon. It will sell or re-lease the remaining assets.

Conclusion

The earnings call was a sign for shareholders that the company is going to have to navigate an increasingly uncertain macro backdrop while under some pressure on both the cost and revenue side. Their high-margin CAM business is the crown jewel of the company and is still well-positioned to thrive in the coming years as it acquires, converts and deploys additional aircraft to existing and new customers. Combining the current headwinds and extended timeframe for some of these positive catalysts to emerge, a significant reduction in price target is appropriate, in my view. A close review of the 10-K will help in understanding if there are any additional causes for concern or optimism related to ATSG shares. In addition, it would make sense for investors to keep close tabs on results from the likes of FedEx (FDX) and United Parcel Service (UPS) as several of ATSG's current and prospective customers operate on behalf of these companies and their peers. To the extent they see materially weakness in certain regions or overall, there is at least some chance that that may have an impact on their demand for capacity from local and regional carriers, which could further dampen ATSG's prospects in the coming months.

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