Summary
- Air Transport Services Group is in the midst of a multiyear growth trajectory which should deliver strong returns to shareholders.
- Long-term lease contracts and presence of Amazon, DHL and the US DoD as its three largest customers provide a level of stability that should reduce volatility notwithstanding potential economic slowdown.
- Significant commitments already achieved on new Airbus product lines which will grow and diversify the company's revenue streams, while the company began to repurchase shares in the third quarter.
- We rate ATSG as a Buy, with a price target of $40 per share, approximately 13.5 times our 2023 earnings estimate.
We are recommending a Buy rating on the shares of Air Transport Services Group (ATSG), with a price target of $40 per share, approximately equal to 13.5 times forecast 2023 diluted earnings per share. The company delivered strong third-quarter results and reaffirmed their 2022 targets. They continue to demonstrate meaningful growth in revenues and an increasingly attractive pipeline that validates their plan to both expand and diversify their product offerings. Management has begun repurchasing shares again, and has already bought back ~2% of outstanding stock since the end of September. Its backlog as of 9/30/22 consists of the following:
- 21 aircraft (14 767, 7 A321) in or awaiting the freighter conversion process and
- Commitments to buy another 25 aircraft (17 767, 2 A321, 6 A330) through 2024
Company and industry overview
ATSG is a leading provider of aircraft leasing and air cargo transportation and is the world's largest owner and operator of converted Boeing 767 freighter aircraft. The company is a fully integrated provider of aircraft and aviation services, and offers both "dry" leasing (aircraft only) through its Cargo Aircraft Management subsidiary, as well as ACMI (aircraft, crew, maintenance, insurance) leasing through its wholly-owned airlines (ABX Air, Air Transport International, and Omni Air International). Cargo aircraft leasing is a niche business, but a growing one, driven by the "Amazon effect" that has directly benefitted ATSG and the secular growth of e-commerce worldwide. Boeing's latest forecast identifies a need for almost 2,800 additional freighters over the next 20 years, two-thirds of which will be converted from passenger configuration.
For the 2021 fiscal year, approximately 72% of ATSG's revenues were provided by Amazon (AMZN) (35%), DHL (DPSGY) (26%) and DoD (12%). The relationships with each of these critical customers are substantial and primarily involve long-term contracts which increase predictability of these revenues for at least the next few years.
ATSG recently extended its DHL contract by six years and added aircraft to its agreement. In the case of Amazon, 30 of the 42 aircraft leases to Amazon do not expire until 2026 or later. The near-term lease expiries are of 767-200s which, if not extended, may be redeployed or retired from service, negating their impact on results. The company continues to add 767-300s to its portfolio, and this aircraft increasingly forms the backbone of the expanding global cargo aircraft fleet.
ATSG is adding two new freighter types to its fleet - the Airbus A321-200 and A330 family aircraft. Initial results for both programs have been encouraging. In the case of the A330, ATSG expects to take delivery of its initial batch of converted aircraft in the 2024-27 timeframe, and already has secured customers for approximately 20 of its 29 slots. While they have not disclosed the identity of the customers, they have noted that they are external customers, and this level of commitment is a strong endorsement of ATSG's move into this product line. This move should serve as a win-win since a group of new customers would at least partially reduce ATSG's dependence on Amazon, while ATSG will still have every opportunity to lease A330 aircraft to Amazon in the future.
The uptake of the A321-200 has been a bit slower than the A330 thus far. A few months ago the company announced it would lease its first A321-200s to ASL Aviation Holdings. This will represent ATSG's first Airbus deliveries, and will also be ASL's first move away from an all-Boeing freighter fleet. ATSG also announced an agreement with Vietnam Airlines to purchase, convert and lease back two A321-200s, a similar structure to what it agreed with Air Canada on 767-300s.
The company wisely tapped the unsecured bond market for the first time in 2020 in an amount of $500 million at an attractive coupon of 4.75%. It did a $200 million follow-on offering at a premium to par in 2021, locking in low-cost, long-term financing to fund its growth plans. Beyond that, the company has maintained a disciplined approach to its capital structure. ATSG's debt of $1,369 million as of September was over $100 million below December 2020 levels despite the fact that the company's fleet count had increased by over 20 aircraft. This is a resounding endorsement of ATSG's strong cash flows which should allow for substantial returns of capital to shareholders via dividends and/or share buybacks. Indeed those buybacks have begun, as the company has already repurchased over 1 million shares since restrictions were lifted on 9/30/22.
ATSG shares took a hit upon the announcement that Amazon and Hawaiian Airlines reached an agreement whereby Hawaiian will operate 10 A330 cargo aircraft for Amazon. As with Amazon's other aircraft leasing agreements, including its pact with ATSG, it involved the issuance of warrants by Hawaiian to Amazon, and the market's initial reaction showed it perceived the agreement as a shot across the bow to the growth prospects of ATSG's relationship with Amazon. However, there are various reasons why ATSG shareholders should not be overly concerned by Amazon's pivot, and why the company is set up to thrive notwithstanding this somewhat negative news.
Earnings and cash flow projections
ATSG reaffirmed its guidance of $640 million in adjusted EBITDA with its third quarter earnings call. Looking out a few years, as ATSG's CapEx starts to produce sustained cash flows, we expect both EPS and EBITDA to surge in the coming years:
2022E | 2023F | 2024F | 2025F | |
GAAP EPS | $2.00 - $2.20 | $2.75 - $3.00 | $3.00 - $3.25 | $3.50 - $4.00 |
EBITDA | $600 - $610 | $700 - 750 | $800 - $850 | $850 - $900 |
Source: Author's own calculations
This implies that shares are currently trading at approximately 13-14 times our 2023 EPS and about an EV/EBITDA multiple of approximately 5 times. We believe our forecast of future earnings and EBITDA is on the conservative side for numerous reasons:
Limited further growth assumed
We assume that, beyond the contracted backlog mentioned above, the company has little additional growth. That means that 7-8 initial A330 slots will go unfulfilled, the company will acquire no more 767s, and the A321-200 will never establish itself as a serious competitor to the 757-200 and 737-800. Since ATSG already has commitments for around 20 of its 29 A330s and has several years to fill in the remainder, let alone expand on its presence in this burgeoning market.
In addition, we assume relatively modest growth in ACMI Services revenue of approximately 6% per year, while CAM drives growth with revenue CAGR of 18% during the same period. While ACMI still represents the majority of ATSG's revenues, the gap narrows from 69% ACMI / 20% CAM in 2022 to 63% AMCI / 26% CAM in 2026. To reiterate, this does not assume further growth in the aircraft backlog, for CAM or otherwise, which is possible but conservative at a minimum.
A more detailed walkthrough of my 2023-2025 projections can be found below:
2023 | 2024 | 2025 | |
CAM | |||
Total CAM | 474,280 | 588,880 | 664,180 |
ACMI Services | 1,536,533 | 1,582,629 | 1,630,108 |
Other Activities | 425,898 | 447,192 | 469,552 |
Total Revs | 2,436,711 | 2,618,702 | 2,763,840 |
Eliminate internal revenues | (194,937) | (196,403) | (193,469) |
Net Revenues | $ 2,241,774 | $ 2,422,299 | $ 2,570,372 |
OPERATING EXPENSES | |||
Salaries, wages and benefits | 646,987 | 659,926 | 673,125 |
Depreciation and amortization | 362,251 | 396,338 | 430,901 |
Maintenance, materials and repairs | 220,391 | 250,956 | 291,173 |
Fuel | 277,760 | 277,760 | 277,760 |
Contracted ground and aviation services | 93,046 | 108,069 | 127,895 |
Travel | 121,169 | 143,398 | 154,347 |
Landing and ramp | 19,930 | 23,586 | 25,387 |
Rent | 31,134 | 36,526 | 41,126 |
Insurance | 16,540 | 19,404 | 21,848 |
Other operating expenses | 85,642 | 100,473 | 113,126 |
1,874,849 | 2,016,437 | 2,156,689 | |
OPERATING INCOME | 366,926 | 405,862 | 413,683 |
OTHER INCOME (EXPENSE) | |||
Interest income | 2,960 | 8,077 | 7,882 |
Debt issuance costs | (1,500) | (5,094) | (3,500) |
Interest expense | (52,918) | (76,874) | (100,185) |
(51,458) | (73,892) | (95,803) | |
EARNINGS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES | 315,468 | 331,971 | 317,880 |
INCOME TAX EXPENSE | (72,558) | (76,353) | (73,112) |
EARNINGS FROM CONTINUING OPERATIONS | 242,910 | 255,617 | 244,767 |
EARNINGS FROM DISCONTINUED OPERATIONS, NET OF TAXES | 1,000 | 1,000 | 1,000 |
NET EARNINGS | $ 243,910 | $ 256,617 | $ 245,767 |
TOTAL DILUTED EARNINGS PER SHARE | $ 2.90 | $ 3.16 | $ 3.72 |
Source: Author's own calculations
Potential refinancing alternatives
ATSG's cost of debt is low and a testament to savvy management of its liabilities. However, given the strength of a customer roll that includes the likes of Amazon, DHL, and UPS, to name a few, they may be able to raise secured debt at particularly attractive rates. This debt could be used to fund incremental acquisitions of aircraft and/or shares.
Asset sales and joint ventures
ATSG has historically been a long-term owner of its fleet. While this strategy has served the company well, it might be interesting to pursue alternatives involving the monetization of some portion of the CAM fleet. Some of this will be encumbered by the company's revolving credit facility, but it may be interesting for ATSG to pursue either a joint venture or sidecar vehicle in which to sell some of its exposure. They could potentially manage the fleet and earn fee income while also profiting from the sales and maintaining the customer relationship. This can potentially be funded by a structured product (ie ABS) but does not need to be, particularly if some of the company's higher-quality customers are involved in the fleet. We've assumed no gains on sale, so anything considered here would be 100% upside.
We've also assumed no contribution to earnings from ATSG's joint ventures with GA Telesis or Precision Conversions which errs on the conservative side. Although all of them require a reasonable upfront investment, over time there is a good likelihood that they will contribute, perhaps materially, to the bottom line.
Level of share buybacks
Based on the amount of cash flow forecast to be generated by the business, there should be an ability to buy back a lot of shares. Management wasted no time in starting its buybacks as soon as it was allowed, both from Amazon and in the market, which is an encouraging sign. We estimate that on average the company will conservatively have $100-$200 million of excess cash annually after CapEx that would be available for distribution. With a market cap just over $2 billion, this would enable management to buy back a significant portion of outstanding shares over the next few years. Once more of the aircraft acquisitions have been digested, perhaps a special dividend could be considered as well.
Risks to investment thesis
Economic recession
Unlike the COVID slowdown, which was a boon for cargo businesses worldwide, a more normal course recession would likely come with some decline in demand for air cargo services. That said, much of the growth is being propelled by the secular increase in e-commerce and time-sensitive deliveries which should at least partially insulate ATSG's vulnerability to a slowdown. The company also benefits from a high-quality customer base and a large portion of long-term contracts that should allow it to thrive through market cycles. A slowdown could also accelerate retirement of more passenger 767-300, A321-200 and A330 aircraft that would likely reduce market values and allow for ATSG to acquire more feedstock at a lower cost.
Customer concentration
ATSG's revenue base is highly concentrated within its top three customers, which at a minimum warrants monitoring for changes. It is unlikely for any material ones to take place for at least a few years. Both Amazon and DHL are locked into multi-year agreements, and while DoD flying is predominantly comprised of annual contracts, the relationship with the DoD goes back to the 1990s. The defense budget is more likely to increase then decrease over the long term, so the likelihood of this contract at least remaining around its current level seems probable.
Transition into new aircraft types
The A321-200 and A330 cargo conversion programs are still relatively new, especially when compared to the 767-300, 757-200 and 737-800, the main Boeing models that they compete with. There is risk in whether they are widely adopted and ATSG is successful in growing this part of its business. In addition, it appears that they represent the first Airbus aircraft that ATSG has owned at any time. Fortunately, attractive 767-300 feedstock is low and only getting smaller. Delta and United's fleets are the largest still operated but are beyond the typical sweet spot for cargo conversion, and other carriers are retaining their aircraft and in some cases converting them to cargo themselves. The A330 remains the logical aircraft to pick up the slack from the lack of supply in the mid-size cargo aircraft domain and ATSG's slots are not until 2024 and beyond, giving them ample time to secure customers for the 10 or so units they've yet to lock down. The A321-200's operating economics compare favorably to the aging 757-200 fleet and should be particularly interesting to Airbus operators looking to expand their cargo operations as has been seen in the adoption by Qantas and Smartlynx (an A330 customer for ATSG) among others. These programs should provide useful diversification for ATSG.
Amazon ownership stake
Amazon's ownership and expansion of its ties to ATSG has been a very positive one thus far. However, they currently hold 21.8 million vested warrants in ATSG at a weighted average cost of just over $21 per share. At the moment, these warrants are solidly in the money, so even if Amazon was not interested in expanding its relationship with the company, it would make sense to exercise the warrants, or to receive compensation from ATSG in order to forgo them. A full exercise would be somewhat dilutive to existing shareholders, but Amazon has showed a measured approach to their ownership stake thus far. They have kept it below 20% by both forfeiting prior warrants via cashless exchange as well as selling back 250,000 shares directly to the company last month. It seems likely that an incremental investment of up to $461 million by Amazon (assuming they exercise all currently vested warrants) would not be made in isolation, but as part of the next stage of growth in the relationship. That said, Amazon has until December 2025 to exercise them so it is hard to say when or how this may play out.
Conclusion
It is these dynamics which should allow ATSG to grow its profitability and EBITDA for the next several years. ATSG has laid the foundation to succeed in multiple different scenarios and notwithstanding some potential economic turbulence. The impact of the company's growth is going to take some time to materialize, so we could see the stock languishing for some time in light of that, the uncertain macroeconomic environment and the volatility in capital markets. However, looking beyond the near-term, it's not difficult to get excited about the company's prospects.
For further details see:
Air Transport Services Group: Amazon Snub Should Not Dim Long-Term Prospects