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Why Atlas Air remains very capable in a difficult freight economy

Stilian Morrison of Interactive Buyside

Equity research: Does Atlas Air Worldwide present a good investment? (Part 5 of 7)

(Continued from Part 4)

Atlas Air’s management

Atlas’ management team has no doubt made a major capital bet over the last few years. Their flagship 747-8 fleet, notwithstanding obvious merits to long-haul airfreight, has encountered resistance from loose capacity and several years of flat trade volume growth. Some airliners, like British Airways, seem to be exiting ACMI and pure freight business in favor of belly capacity. However, through all this relative adversity, I want to highlight a few reasons why I believe the Atlas shares are a potential bargain, not a value trap.

The company is ramping up its dry leasing business following the purchase of three 777-200 freighters from Guggenheim. They’re inheriting the lessee (a European airline) under attractive 2011 terms, and I believe the mix shift should meaningfully improve the quality of earnings profile. Back in 2009, 41% of direct contribution was from stable ACMI and dry leasing business. In 2013, mix was 81%. By 2015, I expect it to be over 90%, with dry leasing representing some 20%. Said another way, over 90% of Atlas’ profitability will not be (directly) exposed to fuel, demand, or yield risk. ACMI/CMI is still volume-driven, albeit subject to a minimum block hour requirement, but dry leasing is a pure annuity stream with standard breakage costs structured in to mitigate early termination. Furthermore, the expansion of this business line is likely to offset much of the aforementioned AMC loss.

While some investors shun the current asset picture as too capital-intensive, I am encouraged by management’s progress in expanding the asset-light CMI business. Of the company’s 55 aircraft-equivalent fleet in use as of December 31, 2013, CMI-provided aircraft accounted for an equivalent of ~12 (22%). CMI segment financials are not publicly disclosed, but I estimate as a general rule of thumb that revenue and direct contribution mix are 14% and 19%, respectively, of 2013 consolidated. I further expect that CMI direct contribution margins would be lower than ACMI at around 24% to 25% due to the lack of beneficial operating leverage on the aircraft lease rate (“A”) component (for more detail, please see the last part of this series). The CMI business is cargo-heavy and leveraged to DHL domestic/intra-Asia business and Boeing’s manufacturing logistics. In the latter case, there has been meaningful acceleration of late as Boeing increases its CMI Dreamlifter business with Atlas and other carriers to transport parts for producing its 787 Dreamliner.

Management is aware that they can’t count on charter volume to backfill all slack capacity in this tepid cargo market and they have consequently de-leveraged where they felt appropriate. They grounded one of their converted freighters last year and mentioned on the conference call that they would consider the option of a sale at appropriate economics. They also executed early termination of leases on two other 747-400 converted freighters for a one-time charge of ~$18 million. Net-net, the lease put-back reduced cumulative commitments by $135 million. The remaining operating lease burden comprises $1.3 billion committed against long duration (2020–2025) expirations on 13 747-400 freighters. Assuming early termination costs are 12% of commitments, a full put-back would theoretically move the company from 6.6x lease-adjusted leverage to 5.9x corporate leverage on a depressed 2014 level.

In general, as the older-generation fleet is being wound down in lieu of soft cargo trends and general age, there is palpable concern that freighter owners like Atlas might be running a largely defunct fleet of nominal value (e.g. twin-aisle 747s). A 2013 Boeing white paper concluded that the economic life of aircraft tends to be cyclically resistant and that freighters tend to be over 30 years old by the time they leave service, which is typically before scrapping in soft markets. Atlas’ oldest freight category of fleet is one 757-200 cargo plane at 24.4 years. On average, the company’s owned fleet of 33 planes are ten years old, of which 15 are young (less than five years old) current-generation units (747-8F and 777-200LRF) and which I estimate to represent some 95% of replacement value.

My cursory impression of management is that they seem to know their business fairly well and command respect among their vendors (Boeing) and customers or partners (DHL). The feedback that I received from Boeing was that CEO Flynn and CCO Steen bring strong backgrounds from freight forwarding and are well adjusted to managing the increasingly pertinent logistics of deadhead. Insider selling has been nominal, at 0.1% of float, but still prevalent of late with small lots sold around the Q4 release. This suggests that there may be a bit more heartburn as the business finds its bottom during the course of the year.

The Market Realist Take

Atlas Air Worldwide’s management said on their 4Q earnings call that given the business initiatives the company has undertaken, and the investments it has made, the company has been transformed to deliver meaningful earnings in any environment. Atlas Air’s current outlook reflects two primary considerations. Firstly, as military activities overseas scale down, the demand for cargo airlift also declines. Atlas Air believes this decline will be steeper and faster than previously forecast by the military. For 2014, it estimates that this decline will reduce earnings by approximately $0.70 per share from 2013 levels.

Secondly, global air freight volumes have been essentially flat for the last three years. Atlas Air said it has remained healthy and profitable throughout this period by capitalizing on strategic initiatives to strengthen and diversify its business mix, expand customer base, generate operating efficiencies in continuous improvement savings, and enhance its portfolio of assets and services. If 2014 is the inflection point when growth returns to commercial airfreight, Atlas Air’s business initiatives and the investments that the company has made have positioned it to be one of the prime beneficiaries.

Among the few pure-play or “close-fit” ACMI public comps, Air Transport Services Group (ATSG) is Atlas’ closest peer. ATSG reported a decline in its ACMI Services revenue due to operation of fewer international cargo planes for its customers, including the U.S. military, as well as fewer ad hoc charters. In general, Atlas’ business relates mainly to dry lessors like AerCap (AER), Air Lease Corp. (AL), Aircastle (AYR), and freight forwarders such as FedEx (FDX), United Parcel Service (UPS), and UTi Worldwide (UTIW). The former still are a smaller component of the business, and the latter are Atlas’ primary customer base.

AerCap’s acquisition of International Lease Finance Corp. last year prompted industry experts to conclude that the aircraft leasing industry will see further consolidation. Air Lease, which leases commercial jet transport aircraft, also said on its earnings call that over the past few years, the industry has witnessed an emergence of agent-based lessors, acquisitions of leasing franchises, and consolidations. Aircastle said that air cargo market remains weak, with a modest improvement in demand during the past year. But oversupply remains the biggest issue, and it will take a while to work through the supply of available aircraft. Freight forwarder UPS said its fourth quarter results were negatively impacted by excess operating costs due to significantly higher-than-predicted volume and inclement weather in the U.S. Both UPS and FDX have announced increases to freight rates despite international customers moving towards cheaper shipping services.

Continue to Part 6

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