DPSTF - Cargojet: The 5.85% Bond Yield Is Attractive For Fixed Income Investors

Summary

• Cargojet is Canada's largest cargo-only airline.
• The company is adding more planes to its fleet and will increase its capacity by over 50% in the next 2.5 years.
• The stock isn't expensive, but don't ignore the debentures.

Introduction

Cargojet ( CGJTF ) ( CJT:CA ) is Canada's largest cargo airliner. With long-term contracts with for instance Amazon and DHL ( DPSTF ) ( DPSGY ), the visibility of contracted revenue is pretty strong and this helped the company make the decision to increase its fleet from 34 planes right now to 50 by the end of 2024. In a previous article I discussed the company's publicly-listed debentures, and I still think they offer good value. The sector was recently in the news when a consortium reached an agreement to take Atlas Air Worldwide ( AAWW ) private in an all-cash bid .

Cargojet's main listing is in Canada where it's trading on the TSX with CJT as its ticker symbol . The average daily volume in Canada is approximately 75,000 shares per day for a monetary value of in excess of C$10M.

The Q2 results were satisfying, and the balance sheet remains strong

Cargojet is converting its capacity growth in revenue growth and subsequently into a net income and free cash flow increase.

During the second quarter, the company saw its revenue increase from just C$172M in Q2 2021 to almost C$247M in the second quarter of this year. A portion of this revenue increase was real organic growth but another substantial portion was generated through passing on higher operating expenses to its customers as the company hiked the fuel surcharges. Rightly so, because if you look at the breakdown of the operating expenses below, the fuel costs have increased by a factor of in excess of 150% compared to Q2 2021 (of course this is also partially due to the company's growth curve) while there was a 30% increase compared to the first quarter of this year.

As you may remember from my previous article, the company is acquiring younger planes and the fuel efficiency of the fleet should improve as the older gas-guzzling planes are retired in the future (but that will obviously not happen immediately). Three Boeing 767s are over 30 years old and although I thought the 37-year-old plane was likely on its way to retirement, Cargojet extended the lease agreement by another three years until 2025, at which point the plane will be 40-years-old.

Cargojet posted excellent net income of about C$160.9M, but as you can see below, this included a non-cash gain on the fair value of stock warrants to the tune of almost C$135M. The explanation is pretty simple: When Cargojet secured its large Amazon ( AMZN ) and DHL orders, it issued share purchase warrants to those companies. As Cargojet's share price came under pressure, the likelihood of the warrants being exercised decreases, thus creating an accounting profit. If Cargojet's share price increases in the current quarter, the impact will be reversed as the company will record a loss on these warrant value fluctuations.

As you can see, those warrant liabilities make the bottom line very volatile. In both H1 2022 as well as H1 2021, there was a positive impact of C$47-48M, and as the company has just 17.3M shares outstanding, the impact on the pre-tax income in H1 was approximately C$2.5/share in both years.

This means we should take the reported EPS with a grain of salt and prioritize Cargojet's cash flow results.

In the first semester, Cargojet reported an operating cash flow of C$154M before changes in the working capital position, and as you can see below, the C$48M benefit from the fair value change of the warrants has been deducted again. On the other hand, the C$20M in deferred taxes was added back to the equation. To be fair, I will deduct both the taxes as well as the almost C$12M in lease payments again, resulting in an adjusted operating cash flow of C$122M.

The total capex in the first semester was C$332M but this includes the purchase of new planes and those acquisitions should obviously be seen as growth capex and not as a sustaining capex. If you scroll back to the fleet overview, you'll see the company operated 34 planes in Q2 and expects to boost this to a total of 50 by the end of 204.

Fortunately, Cargojet does a good job in breaking down the capex into sustaining capex (maintenance capex) and growth investments. In the first six months of the current financial year, Cargojet reported a C$67M maintenance capex which means the underlying free cash flow result was C$55M or just over C$3/share.

The three listed debentures are still offering good value for money

That's great but I'm mainly keeping an eye on the company's listed debentures as they provide good value for money. The company can repay the debentures either in cash or stock, and the stock option offers a 5% discount to the market price of the shares. Only the company has the option to repay the debentures in stock. Debenture holders have no choice.

Although the debentures rank junior to other debt, it's important to understand there's very little other debt on the balance sheet. As you can see below, there's only C$131M in bank debt that ranks senior to the debentures, and considering the company has C$1.44B in equipment, it will have no issue to repay the bank debt.

I do anticipate the bank debt will increase further as Cargojet adds more owned planes to its fleet, but that also means the total amount of assets on the balance sheet will continue to increase. Long story short, I have no issues with this type of balance sheet at all.

There are three issues of debentures outstanding. Note, the "balance" below is based on the market prices. The total amount of principal value of the three debentures is C$316.3M.

Thanks to the increasing interest rates, two of the bonds are now trading below par while the 2024 bond is trading at par.

This results in a YTM of 5.75% for the D and E series

of the debenture, and using a price of 98 cents on the dollar for the lower-yielding F-series the yield to maturity is just over 5.8%. This compares favorably with the Canadian government bonds on similar maturities. The current two-year government bond has a yield of 3.65% while a four-year bond has a yield of 3.54% so the debt issued by Cargojet is trading at a 200-225 base points markup to what's supposed to be the risk-free interest rate.

Investment thesis

Cargojet offers an interesting dual investment proposition. Investors trying to get exposure to the rather aggressive growth plans of the air cargo operator could easily buy the common shares. Those are currently trading at a relatively high multiple of about 15 times the normalized net income. We can expect the revenue, EBITDA and net income (and free cash flow) to increase by double digit percentages in the next two to three years as new planes get added to the fleet.

Personally, I'm not sure about having exposure to the equity of the operator of a cargo airline, notwithstanding the excellent contracts with Amazon and DHL. I do like the debentures as the 5.75-5.85% YTMs are quite appealing given the robust balance sheet and the mark-up vs. the risk-free interest rate. For some income-oriented investors it could make sense to try to get exposure to the bonds when they're trading under par.

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