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Air T, Inc (NASDAQ: AIRT) operates in the air express delivery business. Additionally, via its subsidiaries, it manufactures ground equipment, such as mobile de-icers, and provides support and logistics services to third parties. The company trades at a market cap of $19.35 million, relative to NCAV of $22.03 million and book value of $25.92 million. Given the discount to assets, I thought it would be worth taking a closer look to see whether AIRT provides a good value opportunity.

First, let’s look at the company’s returns over the last decade:

Air T, Inc. - Returns, 2001 - 1Q 2012

Air T, Inc. - Returns, 2001 - 1Q 2012

As you can see, there has been a dramatic decline in returns over the last three years. Let’s see what has been causing this:

Air T, Inc. - Revenue and Margins, 2001 - 1Q 2012

Air T, Inc. - Revenue and Margins, 2001 - 1Q 2012

Here we see that the company’s revenues have been in a fairly tight range over the last four years and that margins have declined only slightly in the last year. From this, we can conclude that the decline in returns shown above has not been the result of declining profitability (the numerator), but rather increasing equity (and capital employed and invested capital) (the denominator).

From 2008 to the end of fiscal 2011, the company increased its equity position by $8.5 million, or 48.1%, resulting in large part from exceptionally strong growth in the company’s cash balance. Let’s look at the company’s free cash flows.

Air T, Inc. - Free Cash Flows, 2001 - 1Q 2012

Air T, Inc. - Free Cash Flows, 2001 - 1Q 2012

The dramatic decline in free cash flow in 2011 was the combined result of increasing accounts receivables and inventories. This can sometimes signal problems relating to the quality of a company’s sales (as readers of Financial Shenanigans know), so let’s look at the company’s cash conversion cycle to identify any potential problems.

Air T, Inc. - Cash Conversion Cycle, 2001 - 1Q 2012

Air T, Inc. - Cash Conversion Cycle, 2001 - 1Q 2012

Up to the most recent quarter, it appears there is nothing wrong with the components of the company’s cash conversion cycle. The increase in inventories is barely noticeable. However, the most recent quarter does appear to be cause for concern. From the company’s 10-Q, it is clear that the growth in inventories is the result of “Work in Process” inventory, possibly signalling that the company has high expectations for future sales. In support of this is that the company’s equipment sales backlog increased from by $1.3 million over the last year.

Let’s take a look at the company’s capital structure.

Air T, Inc. - Capital Structure, 2001 - 1Q 2012

Air T, Inc. - Capital Structure, 2001 - 1Q 2012

This chart shows all the markings of a strong balance sheet, with consistently high levels of cash and negligible levels of debt and capital leases.

Let’s turn to valuation. I valued AIRT with both single period and multi-period DCF models, under a variety of scenarios both with and without growth assumptions. I found AIRT to be significantly undervalued in most scenarios, and moderately undervalued in even my bearish scenarios. There is one problem though. My bearish scenarios assume declining revenues of various rates, whereas AIRT’s true nightmare scenario is much more binary.

You see, AIRT’s fortunes are largely tied to one other company: Fedex (NYSE: FDX). Anywhere between 55-65% of the company’s overnight air cargo segment revenues (which account for about half of overall revenues) are derived from Fedex in any given year. The company’s contracts with Fedex can be terminated at any time on just 30 days’ notice – a scary thought indeed. Somewhat balancing this risk is the fact that Fedex has been a customer of the company for more than 30 years, so one could expect this to continue. Given the company’s reliance on Fedex, we have a situation where the company is absolutely undervalued should it maintain its relationship with Fedex going forward, but suddenly becomes drastically overvalued if you assume that relationship will end at any point during your investment holding period.

The mitigating factor here is that the company is trading below its liquidation value (recall, it is trading at a significant discount to book, and even below its NCAV). Thus, if the Fedex contracts disappeared, management could wind up the company and return to shareholders cash in excess of the current share price. But there is no guarantee this would happen. Sometimes (most times) management will continue operating the business (especially where, like in AIRT’s case, insiders own a small percent of the company), depleting the company’s asset value while searching for new revenue streams (We saw this with Belzberg Technologies, which turned out extremely poorly for shareholders, myself included).

So let’s sum up. If the company maintains its relationship with Fedex, then the company is ridiculously cheap and should provide nice returns. If, on the other hand, the company loses its contract, then shareholders stand to lose significantly, as there is little indication the company would be capable of quickly finding revenue sources to replace such a large customer, and while searching for new sources management may reduce the company’s liquidation value to below the current market cap. Quite a quandary indeed. For my money, I am staying out until the company manages to diversify its revenue base.

One more thing. The company issues dividends once a year and has done so in all but one year since 1992. Over that period, the company has paid out $5.82 million. Not bad, however I think this is the wrong capital allocation strategy. The more effective use, especially when the company is trading for less than its NCAV, would be to use that capital to repurchase the company’s own shares. This would provide greater “bang for the buck” for shareholders.

What do you think of Air T?

Disclosure: No position

Source: Air T: Profitable With Substantial Discount To Assets