Air Transport Group: Warning, Contents Have Shifted In Flight

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About: Air Transport Services Group, Inc (ATSG), Includes: AAWW, AMZN, BA
by: Stephen Simpson, CFA

Summary

Air Transport makes an unexpected move by acquiring Omni Air for $845 million and expanding its passenger-oriented ACMI/chartering operations.

Omni Air generates healthy EBITDA margins and should produce double-digit FCF margins absent growth capex investments, boosting the FCF profile of Air Transport.

Omni Air reduces the significance of Amazon (and DHL) in Air Transport's mix and brings 777 aircraft into the fleet; perhaps expanding the company's long-term fleet options.

Acquiring Omni Air boosts Air Transport's fair value into the high $20's, but there's potentially greater operating/execution risk now and ongoing cargo demand risk from global trade disputes.

Air Transport Group (ATSG) has chosen to alter its business in a pretty significant way with the $845 million acquisition of Omni Air. With this acquisition, Air Transport will be far more exposed to passenger-oriented ACMI and charter services, and the company will also add Boeing (BA) 777s to its owned and operated fleet.

I’m not unreservedly bullish about this deal, as I believe it adds operating complexity to a company that already had a track record of so-so execution in its core operations. It also likely takes an Amazon (AMZN) acquisition off the table (however likely that really was) and could lead Amazon to turn more toward Atlas (AAWW) as its provider of choice for future air cargo expansion needs. Adding government-funded charter services does help mitigate some of the ongoing cargo demand risks, though, and I do believe the shares remain undervalued below the mid-to-high $20’s.

Shifting The Business With A Significant Acquisition

Although investors had been looking forward to increased capital returns to shareholders in the coming years as Air Transport leveraged its sizable relationship with Amazon and looked to grow its in-service cargo fleet, management has chosen instead to make a substantial capital allocation toward M&A with the $845 million acquisition of Omni Air.

In some respects, Omni Air’s model is similar to Air Transport, in that it provides “wet lease” ACMI (aircraft, crew, maintenance, insurance) services, but the difference is that while Air Transport is largely focused on cargo transport, Omni is focused on passenger ACMI and charter services. Air Transport flies boxes; Omni flies people.

In the case of Omni Air, about 70% of the company’s revenue comes from the U.S. Department of Defense. A significant participant in the Civil Reserve Air Fleet, Omni Air transports about half of all CRAF-assigned troop movements and this is a relatively dependable business for Omni given how it has scaled the business (even outside of major military operations, there is always demand for troop/personnel movements). The remainder of Omni’s business consists of providing similar services for other government agencies and civilian contractors, as well as charter air services for companies like the NFL and vacation package providers (like Vacations Hawaii).

In practice, the two operations aren’t all that much different, though wet leasing typically has been much less profitable for Air Transport over the years -- the profits Air Transport has been seeing from ACMI operations in 2018 are the first profits in many years, and the margins are still pretty weak compared to the dry leasing operations. For Omni, the company generates comparable EBITDA margins to Air Transport (low to mid 30%’s) on a smaller revenue base of $430 million.

Air Transport said they’re paying a little under 6x trailing EBITDA including the value of some tax benefits, which suggests a multiple in the mid-6’s excluding those benefits. Air Transport is clearly paying for the ongoing operations of Omni Air, as the underlying fleet value would appear to be in the neighborhood of $400 million to $425 million. Although cargo airlines have traded as low 2.5x to 4x forward EBITDA in the past, a range of 5x to 8x is relatively normal, and I don’t think Air Transport is paying an unreasonable price.

Was This The Right Move?

Although Omni Air generates considerably better margins from its passenger-oriented services than Air Transport has historically generated from its ACMI business (which also includes revenue from services provided to the U.S. DoD), I’m not completely sold on this move and the change in strategy it represents.

I understand that Air Transport had limited near-term options with its traditional business. Air Transport has historically operated 767’s and those planes are much harder to source (although management announced with second quarter earnings that it had secured another five, with upside to 10 over the next year). The company has a joint venture aimed at converting Airbus A321s to cargo use, but that is unlikely to produce usable planes before 2020. Likewise, the aircraft maintenance business is lumpy and unpredictable.

Even so, I believe this move alters some of the long-term prospects of the business. For starters, I believe it takes hopes for an Amazon acquisition off the table. I had never considered such a move a “done deal” by any stretch, but I could see some logic in the argument that Amazon could consider such a move once it had essentially proven out the concept of handling a significant portion of its own air cargo needs. With the bigger skew toward passenger service, I don’t believe Amazon would be interested anymore.

I am also somewhat considered that this move could split management’s focus at a pretty important time in the company’s life. I believed that Air Transport needed to start considering adding additional plane types to its fleet to maintain its growth prospects and diversify its options with Amazon and other clients (Atlas operates a wider range of aircraft). Omni does add 777s to the fleet, but I believe there will now be competing alternatives for further capital between cargo and passenger capacity (and the two are not quickly interchangeable). Omni management will be remaining in place, and I consider that a net positive for the business.

On the other hand, this may well prove to make the business at least somewhat more consistent. Amazon will drop from about 30% of the business to 20% and DHL will drop similarly, while the DoD jumps from 11% to 33%. While such a large skew toward the government may seem to put the company at risk from government spending cuts, the reality is that the CRAF program guarantees certain minimums for participating providers and typically grants business beyond those guaranteed minimums. As I said, there is always a baseline level of required capacity for the government, and I don’t see that changing all that much in the foreseeable future. In contrast, cargo transport can be a volatile, economically-sensitive business and one that currently looks a little shakier given the trade disputes going on.

This deal will bring 777s into the fleet, giving management invaluable experience with this type of aircraft and perhaps creating more long-term comfort for expanding the cargo fleet in that direction. There could also be longer-term opportunities to take the 767s in Omni’s fleet and convert them to cargo freighters, with management either winding down certain service operations or replacing the converted aircraft with other airframe types.

The Opportunity

While Omni will certainly boost Air Transport’s revenue and EBITDA, I don’t see it fundamentally changing the long-term growth opportunities all that much. The growth outlook for Air Transport was, and still is, driven more by management’s ability to allocate more capital to cashflow-generating assets than underlying end-market growth, though a sharp decline in near-term air cargo demand would certainly be a meaningful negative development.

I’m having to make assumptions regarding the underlying FCF margins of the Omni business, but I believe this deal will be FCF margin accretive for the business. That assumption very much depends on whether management chooses to allocate significant growth capex to the business, but I believe Omni could/should generate double-digit FCF margins without investing in additional capacity. I’m assuming low-to-mid single-digit revenue growth with Omni, as I’m not modeling explicit capacity additions and instead basing assumptions on underlying charter demand and rate inflation. Combined, I’m looking for forward revenue growth in the mid-single-digits, with high single-digit to low double-digit FCF growth. I’d also note that Air Transport will have a debt load in the neighborhood of 3x forward combined EBITDA, though higher cash flows should help the company deleverage.

The Bottom Line

The new cash flow model bumps my fair value into the high $20’s (around $28), and likewise bumps my EBITDA-based fair value higher (to around $29) even with a lower forward multiple to account for the lower multiple generally given to passenger-centric businesses versus cargo-centric. Clearly the market is well below that assessment, and that may reflect higher skepticism regarding the health of the underlying cargo markets and Air Transport’s ability to execute. Although I have some mixed feelings about this latest strategic decision, and I’d note that the company came in short of expectations again in the second quarter, I do believe the market is not giving much credit for Air Transport’s ability to deploy capital into value-creating aircraft opportunities or execute on its opportunities with Amazon, DHL, smaller cargo clients, and/or Omni.

Disclosure: I/we 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.