In a time when it seems that almost any stock has gone up, Air Transport Group's (NASDAQ:ATSG) 13% decline since my last write-up is particularly disappointing. I continue to believe that this is a well-run air cargo company with meaningful opportunities to improve EBITDA and cash flow, but management must convert "opportunity" to results for this stock to perform better. A couple of recent developments should encourage bulls, and the stock remains at a valuation where I think a closer look is warranted.
Weak Air Cargo Casting A Shadow
Air Transport, like its larger rival Atlas Air Worldwide (NASDAQ:AAWW) has had a pretty miserable start to the year, with both stocks down more than 20%. Much of this can be blamed on a weak air cargo market, as Cathay Pacific's revenue tonne kilometers (or RTK) fell more than 4% in December to close a pretty lackluster year.
Although RTKs improved 4% in January, the outlook for air cargo is not particularly healthy right now. With fewer must-have hot consumer products and a wide gap between air cargo and ocean cargo, many customers have traded down to the cheaper ocean-going freight option. At the same time, larger passenger planes with greater cargo capacity have been taking away incremental business from dedicated air cargo operators.
This is not a healthy backdrop, but I think Atlas Air is more vulnerable than Air Transport. The Boeing 747 planes that Atlas Air operates are considerably larger than Air Transport's B-767 aircraft and more expensive to operate - making it harder for Atlas Air to fill their planes and operate them profitably compared to Air Transport. It's also worth noting that Atlas Air saw a large customer defection (British Airways canceled a lease for three 747-8F planes) that does not pertain to Air Transport, other than to serve as a reminder of the risks of customer concentration.
Two New Opportunities To Consider
One of the challenges facing Air Transport is maximizing the utilization of its fleet - just as for passenger aircraft lessors like AerCap (NYSE:AER) or Air Lease (NYSE:AL), a plane that isn't flying isn't earning. With that, Air Transport exited the third quarter of 2013 with four "under-utilized" B767-200's and two incoming B767-300 conversions, and the company's wet leasing operations (aircraft, crew, maintenance, and insurance or ACMI) are still in the red.
Two recent developments could turn this situation around relatively promptly.
First, the company acquired a 25% stake in Sweden's West Atlantic AB, a European regional cargo aircraft leasing company with 40 planes. Air Transport declined to specify the price of this stake, other than to say it was "significantly less than ATSG's historical cost to purchase and modify a single 767 aircraft". The cost to purchase/modify a 767 is likely around $30 million, so depending upon a reader's definition of the word significantly, a price in the neighborhood of $20 million may not be unreasonable.
The real key to the West Atlantic deal is whether it spurs increased business activity for Air Transport, either through dry leasing or wet leasing. West Atlantic has historically operated smaller planes than the 767 and adding 767s to the fleet appears to be a strong part of West Atlantic's motivation to do this deal. As each 767 put into service is worth about $4 million to over $6 million in incremental EBITDA, it wouldn't take much for this to deal to add value for Air Transport.
A second transaction in the space may also lead to greater demand for Air Transport's fleet. Canada's Cargojet (OTC:CGJTF) recently won a seven-year deal with Canada Post worth around $900 million. Cargojet is a long-time customer of Air Transport, currently dry leasing two 767s through 2015. Cargojet talked about significant expansion of its network to handle this added volume, and I don't think it is unreasonable to suggest that Air Transport could be a beneficiary of that expansion.
Looking For Growth Amidst A Changing Market
As BA's recent cancellation of leases with Atlas Air shows, nothing can be taken for granted in this space. DHL still represents more than half of Air Transport's revenue and though that deal runs through 2015, it may not be too soon to start asking what happens in 2015. The same holds true for the company's relationship with the U.S. military. I wouldn't think the military would cancel the wet leasing agreements with Air Transport that service remote bases in Greenland, Diego Garcia, and Ascension Island (facilities that aren't tied to the wind-down in Afghanistan), but that cannot be considered risk-free either.
I like Air Transport's policy of buying and retrofitting passenger 767s, and I think Air Transport is in a better position with its fleet than Atlas Air is with its 747s. I also believe that the recent win at Cargojet could mean more business for the company and that the partnership with West Atlantic could get some of those idle 767s into productive leases. Unfortunately, "think", "believe", and "hope" are not going to be enough to get the stock moving in the right direction.
Analysts are currently looking for mid-single digit EBITDA growth in 2014, which works out to about two or three incremental leases. With the company reporting earnings in just two days, we will all know more about the company's prospects in short order and stronger/bullish guidance on leasing activity would be a big potential boost for the stock. Analysts are also looking for the company to do "something" with its capital structure - including initiating a dividend or re-leveraging the company to support a special one-time payment.
The Bottom Line
Given the unimpressive state of the air cargo market, I'm sticking with a 5x multiple to forward EBITDA. These shares have traded at multiples as high as 8x in the not-too-distant past, but it's going to take better utilization and pricing (not to mention profitability in ACMI) to move the needle that far. Even a 5x multiple suggests that these shares are worth a look though, as it leads to a fair value estimate in the mid-$7s with potential catalysts in leasing and shareholder capital.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.