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Air Transport Services Group (NASDAQ:ATSG)

Q3 2013 Earnings Call

November 07, 2013 10:00 am ET

Executives

Joseph C. Hete - Chief Executive Officer, President, Director, Member of Executive Committee and Chief Executive Officer of ABX Air Inc

Quint O. Turner - Chief Financial Officer and Principal Accounting Officer

Richard F. Corrado - Chief Commercial Officer, President of Cargo Aircraft Management Inc and President of Airborne Global Solutions Inc

Analysts

Jack Atkins - Stephens Inc., Research Division

Helane R. Becker - Cowen and Company, LLC, Research Division

Adam Ritzer

Operator

Hello, and welcome to the Q3 2013 Air Transport Services Group, Inc. Earnings Conference Call. My name is Mayesha. I will be your operator for today's call. [Operator Instructions] I will now turn the call over to Mr. Joe Hete, President and Chief Executive Officer of Air Transport Services Group. Mr. Hete, you may begin.

Joseph C. Hete

Thank you, Mayesha. Good morning, and welcome to our Third Quarter 2013 Earnings Conference Call. I'm Joe Hete, President and Chief Executive Officer of ATSG. With me today are Quint Turner, our Chief Financial Officer; Joe Payne, our Senior Vice President and Corporate General Counsel; and Rich Corrado, our Chief Commercial Officer.

We issued our third quarter earnings release and filed our 10-Q with the SEC yesterday afternoon. You can find both on our website, atsginc.com.

Our results for the third quarter represent progress against the new 2013 guidance we provided in August and represent a significant improvement over second quarter 2013 results. We have completed the principal regulatory matters involving the transition to our 757 combis that we discussed with you last quarter. That includes certification of our third 757 combi in September and approval earlier this week for them to fly to all the remote military destinations we serve. We have also integrated more of the administrative and accounting functions at ATI through implementation of a shared services approach at corporate, providing additional cost savings. We're are also achieving consecutive quarter growth in both revenues and earnings and are continuing to work towards executing agreements with potential customers, most of which are outside the U.S.

In a nutshell, we are on track to achieve greater returns from the assets we have today even in a market that remains especially challenging for all but particularly for those more heavily dependent on commercial charter volumes and military cargo moves related to the Mid East conflict. The consistent revenue contributions from our leased aircraft portfolio and its expressed network base CMI and ACMI operations have proven to be more resilient than revenue streams driven strictly by commercial cargo demand.

Quint is ready to review our third quarter results including a balance sheet update. I'll follow him with another update on our major developments during the quarter, expand on what I expect in the current quarter and offer some perspective on current and future market conditions before I take your questions. Quint?

Quint O. Turner

Thanks, Joe, and good morning, everyone. Let me begin by advising you that during the course of this call, we will make projections or other forward-looking statements that involve risks and uncertainties. Our actual results and other future events may differ materially from those we describe here. These forward-looking statements are based on information, plans and estimates as of the date of this call. And Air Transport Services Group undertakes no obligation to update any forward-looking statements to reflect changes in the underlying assumptions, factors, new information or other changes. These include, but aren't limited to, changes in the market demand for our assets and services; timely completion of final Boeing 757 combi certifications and deployment of aircraft to customers; continued achievement of the benefits we anticipated from the merger of 2 of our airline businesses; and our operating airline's ability to maintain on-time service and control costs. Other factors are contained from time to time in our filings with the SEC, including our 2013 third quarter Form 10-Q, which we filed yesterday afternoon and is available on our website.

We will also refer to non-GAAP financial measures from continuing operations, including adjusted EBITDA and adjusted pretax earnings, which management believes are useful to investors in assessing ATSG's financial position and results. These non-GAAP measures aren't meant to substitute for our GAAP financials. We advise you to refer to the reconciliations to GAAP measures, which are included in our earnings release and also on our website.

Joe's overview comments that we're on track, making progress toward our updated 2013 adjusted EBITDA goal is evident from a review of our results. Our revenues on a consolidated basis were $140.9 million, up $2 million from the second quarter and down $13 million from a year ago. We had fewer aircraft and service during the third quarter than we did a year ago and are serving fewer high-revenue international routes. So we also picked up more ad hoc ACMI and charter revenue than we had in the second quarter and benefited from some good growth in our other businesses.

Net earnings from continuing operations for the quarter were down 33% to $7.8 million or $0.12 per share. That's up $0.01 from the second quarter but down $0.06 year-over-year. Again, we are not currently a cash taxpayer and don't expect to become one until 2016.

Third quarter adjusted EBITDA, which excludes derivative gains or losses, was $40 million, down about $3.4 million year-over-year and up $4 million sequentially. We were at $113.3 million of EBITDA through 9 months.

Third quarter expenses are down by $7 million year-over-year and flat with the second quarter. They're down nearly $20 million year-to-date. Principal cost savings versus the third quarter last year were a $3 million reduction in the salary line from a year ago to $41.5 million, including $0.5 million lower than the second quarter; $2 million less in maintenance expense, which reflects the net effect of fewer but more extensive airframe maintenance checks compared to a year ago and higher rates for engine maintenance; and a $3 million reduction in flight-related costs for travel, landing and ramp, and insurance, which were roughly flat with the second quarter, reflecting a lower level of flight operations and lower costs for domestic operations versus international.

Turning to our segment results. Our leasing business, CAM, had pretax earnings after interest expense of $15.9 million for the quarter, which was down both on a consecutive and year-over-year basis. Higher depreciation and interest expense plus expenses to support the additional freighters, our [ph] revenue gains from our more modern fleet versus those prior periods. CAM added 1 767-300 freighter, 1 757 freighter and 3 757 combis in the 12 months ended September 30 of this year. It also removed 8 legacy 727 and DC-8 aircraft from service. At the end of the quarter, CAM owned 50 aircraft available for service. 20 of those were leased to external customers and 30 to our airlines. We anticipate dry leasing an additional 767, a 300 series, to a European operator under a multi-year term, starting before the end of the year. This would bring the number of externally leased 767s to 21.

In ACMI Services, we had a pretax loss for the quarter of $7.1 million compared to a loss of $1.7 million for the third quarter of 2012 and a $9.1 million pretax loss in the second quarter this year. We continued to have expense effects from delays in our 757 combi rollout, including higher cost to maintain additional DC-8 crews and maintenance capabilities.

Airline services revenues, which exclude fuel and other reimbursables, were down $9 million year-over-year but up $3 million from the second quarter. A portion of the revenue shortfall in the segment stemmed from reduced results from charter and other ACMI operations at both airlines, especially over international routes. ATI, in particular, grew its revenue from the second quarter to the third, thanks to additional ad hoc business, and also increased its military flying with the additional availability of 757 combis.

ACMI block hours for both airlines declined 14% year-over-year in the third quarter but were up 2% from the second quarter. The reduction versus the prior year period mainly reflects fewer long-distance international routes operated in favor of more shorter route domestic flying.

Pretax earnings from our other business activities, driven largely by our maintenance, MRO and postal operations, were $4.4 million for the quarter, up significantly from the $3.4 million we had in the same quarter last year. Revenues in earnings from our maintenance and sorting-center management for the U.S. Postal Service were up sharply on increased volumes.

We are on schedule for the completion of the new hangar facility here in Wilmington, which will better match our maintenance capacity to our fleet size and give us room to take on more third-party work as well. We hope to begin operations there in the second quarter next year.

Net cash flow provided by operating activities through 9 months of 2013 was $61.5 million, down from $87 million for the same 2012 period. Higher pension contributions and lower payments from DHL were the principal change factors.

As we look forward at funding requirements under our pension plans in 2014, we are encouraged by the interest rate trend prevailing so far this year and its likely effect on our funding requirements and balance sheet. Long-term rates are trending around 75 basis points higher than a year ago. If that persists, it could mean our obligation to fund our pension plans could be half or less of the $27 million we've invested so far this year.

We also expect a significant reduction in our balance sheet post-retirement obligations at year end due to the sensitivity of those obligations to long interest rates. As an example of that sensitivity, each 50-basis-point increase in the interest rate as compared to a year ago is anticipated to lower our pension obligation and improve our year-end equity by approximately $60 million. We will be able to give you the specifics about that significant equity improvement during our fourth quarter call next year.

Capital expenditures through September remained on track with the plan we outlined for you on our prior quarter filings of $110 million for the full year. We spent $97 million through September versus $108 million for the first 9 months of 2012. The bulk of the capital spend was for fleet modernization, including the 2 757 combis we bought back in January plus modification costs for the last of our 767-300s.

Today, the major remaining non-maintenance pieces of that budget are our new hangar here in Wilmington and the completion of our 2 767-300s. We do not plan to acquire more aircraft assets without a specific multi-year customer commitment. That does not rule out, however, the possibility of strategic investments where we believe they would expand our set of related capabilities, reduce our costs or expand our access to new markets.

Through September, our revolver balance dropped to $190.5 million from a third quarter peak of $200 million, the net of both incremental spending and repayments. As you may have noticed in our 10-Q, our bank syndicate has agreed to make another $50 million available to us as provided under the accordion feature of our credit facility, raising the aggregate funds available to us to $275 million under that revolver. We don't have any current plans to exercise that additional capacity, but we considered it prudent to take advantage of the flexibility it provides at minimal incremental cost. There now is no additional accordion option under the current credit agreement, which runs through July 2017. Our current debt-to-EBITDA ratio of 2.49 continues to qualify us for a low interest rate of 2.56% on our revolver and term loan throughout the fourth quarter.

That's a summary of our position at the end of the first 9 months. Joe will guide you through the events of the quarter, including the progress we have made in completing the combi upgrade program and our near- and longer-term business opportunities. Joe?

Joseph C. Hete

Thanks, Quint. The quarter we just completed was a time for winding up the key elements of the last of our 2 principal 2013 projects, the modernization of our combi fleet and for beginning to restore the profitability of our ACMI Services segment. Those 2 elements are closely related. Delays in our combi program have hurt the performance of our ACMI Services segment, particularly as it affects EBITDA. In fact, it's the one factor not subject to broader market forces and the one we can say with certainty will be fixed soonest.

Our combi program for the U.S. Military does not serve active military operations in the Mid East and cannot be easily replaced by any aircraft in the military zone fleet. These aircraft are specifically designed to provide a regular resupply and personnel ferrying service between some of the most remote military facilities around the world from Greenland in the north to islands of the South Pacific in Indian Ocean.

The challenge has been to implement a completely new 757 combi operation within ATI, while simultaneously bearing the costs of maintaining strong service levels with the DC-8s and related personnel. Our plans for 2013 had this process moving forward in the early part of the year with the full cooperation and support of the FAA. Their extended review, along with additional crew training they required, pushed us off schedule by almost 2 months.

We deployed our first 2 combis in late June and early July and the third in September. The sole remaining regulatory issue has been the FAA's assessment of the 2-engine 757 combi for extended range twin operations or ETOPS certification for its longest Pacific and Indian Ocean routes. When we talked to you in August, those evaluation flights were scheduled to take place before the end of the government's fiscal year in September. They were, however, delayed by the shutdown. I am pleased to report we completed our final proving run this week over the Indian Ocean and have now completed ETOPS and all of the 757 operating requirements.

The operating cost reductions these aircraft bring and are driving our second half EBITDA gains are already flowing through our results. The cost savings from retiring the DC-8s are beginning to arrive as well. We are finally at the point where we can claim that our all Boeing 767 and 757 fleet is achieving the efficiency, reliability and fuel savings we projected a year ago.

The next key objective is growing our consolidated top line and capturing the margin benefits on new revenue from both leasing and operations that our fleet upgrades and airline merger were intended to yield. That's been a challenge for us and as for most other cargo airline companies.

We continue to have 4 767s, not including the 2 completing mod that are underutilized. In that regard, some of the best opportunities we are seeing are coming from established operators outside the U.S. who want to establish links to markets in the Americas and among carriers currently operating in Europe and the Mid East. One such opportunity involving the lease of a 767-300 freighter could be finalized before year end.

Rich Corrado is just back from some industry conferences and customer meetings and during Q&A, he will be happy to provide you with his fresh assessment of how the markets we serve are developing. But no matter when consistent growth returns to the airfreight market, our progress is likely to be more rapid than some because we have already made investments in growth assets, and we're not directly affected by aggregate freight volumes or yield volatility.

The majority of our aircraft, our 767-200 series, are best suited for hub-and-spoke service within networks. And the current airlines in those networks may be changing. Our service record, fleet quality and strong balance sheet position us well to play a role in these other networks.

The final piece of our strategy involves the appropriate allocation of our cash flow among a range of strategic options. I'm not going to forecast how much free cash we will generate next year, although we have said it could be more than $1 per share. We're sticking to our principles on additional aircraft purchases, which means that we're not in the market for more of them except on behalf of a customer willing to back stop the investment. And as Quint mentioned, we're expecting that higher interest rates will reduce the size of our required investment in our post-retirement plans in 2014.

We're hearing regularly from those of you who feel strongly about a cash return for shareholders. Your case has merit, but we continue to give equal weight to deleveraging and growth investments whether on customer-backed purposes of aircraft we don't have today or acquisitions that enhance our value or open new markets for our fleet. Capital allocation decisions will always turn on which option delivers the best long-term return for shareholders.

Before we turn to your questions, I want to express our appreciation for your continued strong support as evidenced by the sharp rebound in our stock price since our last call in August. We're confident that we'll resolve the major internal issues we face. All that stands between us and an acceleration on our earnings is a recovery of the markets we serve, and we are determined to seize the opportunities that recovery presents.

And now Mayesha, we're ready for the first question.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jack Atkins from Stephens.

Jack Atkins - Stephens Inc., Research Division

So I guess, to start off with here on the ACMI segment, the operating losses there improved sequentially. But Joe, I guess, in your mind, what needs to happen to get that segment back to profitability on a stand-alone basis? Is it just a function of getting those underutilized assets flying again? Or do you think there are additional cost actions that you can take to rightsize that?

Quint O. Turner

Look, there -- Jack, there's a couple of opportunities for some further cost reductions, but the key is, as you've hit early on, was we've got to get the assets that are underutilized today deployed. We're carrying the cost for those assets whether it's on the lease side of the equation or the amortization of the -- some of the heavy maintenance items. So the revenue stream is certainly critical.

Jack Atkins - Stephens Inc., Research Division

Got you. Got you. And then, Joe and Quint, you both mentioned strategic investments as far as the potential use of cash. Could you maybe -- I know you don't get into specifics, but could you maybe highlight a couple potential avenues that you would view as strategic just for the folks on the call just to kind of understand what you guys are looking at as potential uses of cash?

Quint O. Turner

From our standpoint, we'd look at things that would be synergistic to the operations we have, whether it's on the airline operation side or on the maintenance side, is -- are the 2 largest areas, obviously, in terms of things that would be synergistic. We also, as you know, do some work for the U.S. Postal Service, which is nice little piece of business for us, not a key driver, but it certainly generates some nice cash flow. So anything that would be dovetailed with any 1 of those 3 areas would be the ones we'd focus on from an opportunity standpoint.

Jack Atkins - Stephens Inc., Research Division

Okay, great. And then last question from me and I'll jump back in the queue. Quint, you mentioned the potential EBIT tailwind from lower pension expense because of the changes in interest rates. Could you maybe go through that math one more time? And if we were to see that 75-basis-point higher rate sustain itself through the end of the year, what's the potential, I guess, P&L tailwind again?

Quint O. Turner

Well, from the P&L standpoint, Jack, it's probably a few million dollars compared to the 2013 run rate, call it, maybe as much as $3 million. The real big benefit, of course, at least in terms of the -- is the obligation -- the reduction in the obligation itself on the -- and the increase in equity correspondingly. As I say, there's a lot of leverage and a lot of sensitivity to that rate in that obligation. And if you're talking 75 basis points, you could see $80 million, call it, $80 million swing in the equity and in lowering the obligation on the balance sheet, which is pretty significant certainly. The piece that goes with that, Jack, is also, as we noted, the cash contributions for next year would be significantly less than what they were this year.

Joseph C. Hete

Yes. We'll be putting in about, as we said, about $27 million between the qualified plans and the non-qualified plans. And the current year, next year, we could see that drop to half or less of that $27 million.

Operator

Our next question comes from Helane Becker from Cowen.

Helane R. Becker - Cowen and Company, LLC, Research Division

Just a couple of little questions here. In terms of the guidance, I was just kind of wondering about this language where you talk about the seasonal opportunities. Can you kind of break out what it would look like, the core business for the fourth quarter versus the seasonal opportunities? In a sense, are the seasonal opportunities better or worse than last year?

Quint O. Turner

I think from a seasonal standpoint, Helane, they're probably about the same. We have -- our core customer, DHL, has some peaking but not nearly what you would see out of a, call it, FedEx or UPS. And of course, we have, for years, supplemented the UPS network with some additional lift during the holiday season. So I'd say it'd be roughly equivalent to what we had last year.

Helane R. Becker - Cowen and Company, LLC, Research Division

Okay. So if we looked at the business -- I guess, then what -- if we looked at what it was last year, assumed it was the same and kind of backed that out, we'd get what the core business was looking like I guess. Thinking out loud there.

Quint O. Turner

That would be a good way to look at it.

Helane R. Becker - Cowen and Company, LLC, Research Division

And then my other question is, I was reading in the trade magazine the other day that D.B. Schenker is looking at their network because, I guess, they've got some contracts that are up for renewal next year, and they're looking at their network trying to ascertain what they intend to do. Do you still have anything outstanding with them? I know they kind of pulled down a lot of their operation, but I don't remember whether there's still some stuff out there. And would you be included in that evaluation for next year?

Quint O. Turner

Well, as far Schenker goes, in terms of anything that was contracted directly with them, that ended at the end of 2011. They did, however, transition some of their volume to DHL, which increased by a couple of aircraft, the number that we had in the DHL fleet at the beginning of 2012. And certainly, if they were looking for any kind of dedicated lift, we'd be right there front and center saying we have some assets available. And of course, when you look at the 767 and/or the 757, it's perfect for those kind of route structures dealing with the domestic side of the equation whether it's within the U.S. or inter-Europe or even inter-Asia.

Operator

Our next question comes from Adam Ritzer from Pressprich.

Adam Ritzer

Just a couple of things. Do you have any planes coming off lease in 2014?

Quint O. Turner

From a dry lease standpoint, Adam? Or are you talking about on the ACMI side?

Adam Ritzer

Either side. Just wanted to see if there's anything we need to look forward to if anything's coming off.

Quint O. Turner

No, the dry lease side of the equation, no, nothing comes due in 2014. On the ACMI side, contracts are generally more like 1 year in duration, so they're constantly rolling over. But I think we've got a pretty stable book of business right now on the ACMI side of the equation. A thing we noted is we've got, in our remarks, is that we hope to be able to get to where we can announce some additional opportunities before the year is out.

Adam Ritzer

Right. It looked like you said you might have one before year end. And maybe would this be a good time to have Rich say something? You said he was just back from some conferences.

Quint O. Turner

Yes, he's sitting right here. Rich, go ahead.

Richard F. Corrado

Yes, I guess, Adam, just from a general market overview, I think it's pretty well publicized the cargo market's still in a -- in more or less stagnant mode, principally because of the slow economic growth. That really hasn't changed. However, if you look at the granularity of the data and also from discussing with both prospects and customers, there is a more upbeat view, particularly as it relates to volumes in and out of Europe both to the Middle East and back to the Americas. We've got a number of prospects and existing customers that we're talking about, particularly in the EU where they haven't added any capacity there for over 2 years. And even from a fleet optimization standpoint, they're looking at additional aircraft to take advantage of some economies. So there's some good activity out of Europe. There's been real solid activity going between North and South America as well. We've got some good opportunities looking into the first quarter of 2014 that we're pretty high on. So continuing to look for the profitable pockets of prosperity, as we like to call them, in the overall market that may be stagnant is really what we're charged with from a business development standpoint. We've done a lot with putting multiple customers together to try to build up lanes and opportunities. And given that we're -- we do heavily leverage relationships with the integrators in certain parts, we're able to put forward, as integrators, together to try to build a lane, which is simpler to do with a medium-range, medium widebody aircraft than it would do in some of the larger aircraft waves. So I think the market, overall, in talking with -- and in talking with other folks in the industry, people are feeling somewhat of a bit of loosening up, if you will, of some of the views towards investment in networks, which is really good for us. There had been about 4 straight months where the growth has not been negative, and in fact, the August growth was over 3%. And so if you look at that and you look at some of the things that are going on in Europe, I think there's -- people are a lot closer to pulling the trigger on some things than they have been rarely in the past couple of years.

Adam Ritzer

Okay, that sounds a little better. And maybe, Quint, can you talk about -- you have a current portion of debt in a little over $23 million. Is that what you expect over the next 12 months? Or is there anything additional that you have to pay down on your credit lines?

Quint O. Turner

No, Adam, that would be the next 12 months, and it's mostly the programmed principal payments on the term loan, asset-backed loans. So...

Adam Ritzer

Okay. So we had that. And what do you think maintenance CapEx is going to be next year?

Quint O. Turner

Probably about $30 million , $35 million.

Adam Ritzer

Okay. $30 million, $35 million. Okay. And really, with the 2.5% rate on your debt, is there any reason to pay down more than that $23 million, $24 million the way you look at it?

Quint O. Turner

Well, it just -- it, again, depends on, I guess, what -- you certainly -- compared to what you get with cash in the bank, if you're not doing anything with it except storing it in the bank, there is a little bit of upside, but it's a pretty low rate. And also, it allows you to reduce the debt-to-EBITDA leverage tranches. We're priced -- our debt is priced based on our leverage. And so when you pay down your revolver and you get your total debt into a lower tranche, you pick up pricing leverage on the full debt amount, which can be pretty, pretty significant. And keep in mind, Adam, the bulk of our debt is in the revolver side, so if you pay it down, it's still there if you need to pull it back at some point in time later. So it's not like the fixed portion where you pay it down, you can't redraw it. So...

Operator

I would now like to turn the call back to Mr. Hete for closing comments.

Joseph C. Hete

The progress we made in the third quarter in our ACMI Services business put us on a much more positive trend heading into the fourth. As you recalibrate your models for the rest of the year in 2014, I'm sure you want to factor in the continuing benefits of our ongoing cost reductions and the upside potential that are our available aircraft represent to an already positive cash flow outlook. I'm sure I'll be seeing some of you as we go on the road between now and our fourth quarter call, but until then, I want to thank you for your continued confidence in ATSG. Have a quality day.

Operator

Thank you, and thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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