Description

ATSG Investment Summary

Air Transport Services Group (ATSG) is a leading provider of aircraft leasing and air cargo transportation & related services. We have been involved with ATSG since 2017 and invested across its capital structure at various points in time. While management has made some minor missteps in 2023, the share performance (down 40% YTD) is a massive overreaction, providing the most attractive entry point since we have been involved. While our typical investment horizon is two to three years, we see multiple paths to ATSG generating approx. 50% IRR over the next 12 months:

1. Our research indicates there are both strategic and financial investors that would be interested in acquiring the company. Specifically, we heard from a key customer of private equity interest which is not surprising given the recent acquisition of Atlas Air by financial buyers. We also believe ATSG is an attractive asset for a strategic acquirer as the largest lessor of cargo freighters and the largest operating partner for Amazon and DHL.
2. We believe this investment idea will be attractive to activists as there are multiple levers to unlock value, including a break-up of the two business divisions (goodco/badco), forcing a sale or a large tender.
3. We expect a meaningful rerating in the coming quarters once the market realizes that the core business is not only not impaired but has a significant growth opportunity (growth capex masking true earnings power).  We expect the company to beat their lowered 2023 guidance.

The risk-adjusted returns of this investment are particularly compelling as we see minimal probability of capital impairment at the current price.

Investment overview

ATSG currently represents a rare opportunity to buy a business with a proven ability to generate mid-teens ROIC that will grow EBITDA by an approximately 10% CAGR over the coming years, while trading at a dislocated 4x EV/EBITDA multiple. Our differentiated view on ATSG represents a couple key investment frameworks we have successfully employed in the past: (i) growth capex masking true earnings power and (ii) goodco/badco.

ATSG is currently in the middle of a major investment cycle which will produce significant earnings growth in the years to come. The market does not appreciate that ATSG's current investment cycle will only slightly increase leverage, while locking in predictable and profitable growth in sales and EBITDA for many years, regardless of the macro-economic backdrop.

While the company has not seen any weakness in Aircraft Leasing (where the majority of earnings, growth, and value lies), its Aircraft Operations/Services segment has faced tough comps this year and declining earnings amid macro weakness, leading to the first downward revision of guidance in a decade. While we are disappointed by the Aircraft Operations/Services results, we see these trends as a normalization from a period of over-earning and not indicative of a secular decline or permanent impairment of the business.

Business Description

ATSG is the largest global lessor of freighter aircraft with 129 aircraft in service (including 18 passenger) with an additional 27 awaiting conversion to cargo. ATSG primarily operates in two businesses: Aircraft Leasing and Aircraft Operations/Services.

• Aircraft Leasing (63% of EBITDA): ATSG buys 15- to 20-year-old passenger aircraft, has them converted into cargo aircraft, and then leases them out to customers through its subsidiary Cargo Aircraft Management (“CAM”). CAM is a high-quality, non-economically sensitive business, with long-term contracted revenue providing stable, predictable earnings and high ROIC into the next decade. Because of the current high demand for cargo aircraft and wait times to get planes converted, CAM already has visibility into incremental leases going into 2028 supported by customer commitments and deposits. CAM has historically focused primarily on the medium wide-body 767 which is the aircraft of choice for express and e-commerce air cargo networks such as DHL and Amazon Prime Air. Over the next few years, ATSG will continue to lease 767s but is also adding both the A321, a smaller but still medium-range aircraft in high demand for shorter routes, as well as the A330, which long-term should replace the 767 as the medium wide-body aircraft of choice. With very good visibility into stable and growing earnings, we view CAM as a “goodco” despite being a capital-intensive business.
• Aircraft Operations/Services (32% of EBITDA): ATSG offers aircraft, crew, maintenance and insurance (“ACMI”) as well as crew, maintenance and insurance (“CMI”) services through its three wholly owned airlines (ABX, ATI, and Omni), and support services, such as aircraft maintenance and repair, ground support, crew training and freighter modification. While contracts with Amazon and DHL are long-term in nature, ATSG airlines are more subject to volatility in demand. And while cost escalators are built into contracts, they tend to reset annually and may not always be directly tied to inflation leading to cost pressures in the short term. Because ATSG is effectively a price-taker with less visibility, we view this segment as the “badco” and discount its valuation accordingly.

Background

Prior to 2016, ATSG was a stable but unexciting business, heavily dependent on DHL which accounted for more than half its revenue. In early 2016, ATSG announced that it would begin providing services to Amazon to support the build-out of its air cargo network Amazon Prime Air (initially 20 planes and related airline operations). While ATSG shares jumped on the Amazon announcement, we believe the market never properly came to appreciate this transformative event and the subsequent growth it would bring. From 2017-2022, ATSG spent $1.8bn on growth capex and $900mm on the acquisition of Omni. During this period, ATSG doubled its fleet and tripled its revenue, EBITDA, and maintenance FCF while maintaining leverage ratio around 2x (peaked in 2018 at ~3.4x after the Omni Air acquisition and subsequently de-levered).

Today, ATSG’s major customers are Amazon (34% of rev), the US Department of Defense (DoD) (30%) and DHL (12%).

• Amazon: CAM leases 42 767s to Amazon with expirations between 2023 and 2031. ATSG flies all the CAM-leased aircraft as well as an additional seven 767s that are leased from others or owned by Amazon. Amazon currently owns 14mm shares (19.9% of the company) and has warrants to purchase an additional 22mm shares (with a strike price of $21). While Amazon could continue to grow with ATSG (leasing/upgrading additional planes or flying more planes on a CMI basis), the significant growth we are underwriting over the next three years does not assume incremental leases from Amazon directly (though some ATSG lessees could be flying planes for Amazon in international markets). A senior Amazon logistics manager recently told us that ATSG is a “key, key supplier” at Amazon.
• DHL: CAM leases 14 767s to DHL with expirations between 2023 and 2028.  We expect that these will all easily be re-leased. ATSG flies 10 of the CAM-leased aircraft and an additional six DHL-supplied aircraft. In February 2022, DHL extended its CMI agreement through 2028. A senior DHL manager recently confirmed that while 2023 is a transition year for DHL, they do not see much impact on ATSG and expect to continue growing with them in the future.
• US DoD: ATSG flies passenger and cargo aircraft for the DoD primarily through its Omni airline. The contracts are typically for one- to two-year periods but Omni has been operating contracts since the 90s and we believe this non-economically sensitive business has greater stability than the market gives the company credit for. In 2022, Omni had a record year that benefited from competitors shifting away from military flying in favor of higher margin cargo charter flying. In 2023, Omni has faced headwinds from lower overall DoD demand, competitors re-allocating planes back to military flying, and higher costs. While tough comps are the primary cause for a disappointing 2023, this is not indicative of secular decline at Omni as the airline is now flying closer to minimum guaranteed levels from the DoD.

Over the next few years, contracted growth at CAM with new international customers will reduce customer concentration and diversify geographic mix. The huge demand in international markets is being driven by the same e-commerce tailwinds that drove growth for ATSG in the US over the last decade. While the same global e-commerce and express players are building out time-definite air delivery networks around the world, local airlines are the domestic operators due to cabotage rules and are often the ATSG lessee.  Examples of international customers include ASL Aviation (billion dollar PE-backed European airline that flies for Amazon in Europe and Asia), Astral Aviation (Kenya airline for DHL), CargoJet ($2bn Canadian cargo airline that flies for Amazon and DHL), Maersk/Star Air (subsidiary of $40bn shipping giant, operates for UPS in Europe), MasAir (Mexico airline for DHL), and Raya Air (Malaysian airline for DHL and UPS). 

Competition is not a major risk for ATSG. While owning and leasing air cargo freighters may appear somewhat commoditized at first glance, there are two key bottlenecks that prevent competitors from entering the space.  They are (i) supply of passenger aircraft to be converted and (ii) slots at the conversion houses. ATSG has been active in acquiring feedstock and already owns or has the rights to own 38 of the 42 planes it plans to lease through 2024. ATSG has also locked up 77 conversion slots for its planned fleet expansion including 36 767, 11 A321, and 30 A330 conversions through 2028.

On the demand for converted air cargo freighters, ATSG has customer commitments for almost all the expected leases through 2024 and many of the A330s through 2028. The additional conversion slots and options for future conversion slots show management’s confidence in growth well beyond our investment horizon. This is an industry where supply is constrained and demand remains high despite general macro-economic weakness. Customers looking for cargo planes need to plan for the fleet expansion or upgrades many years out, providing ATSG good long-term visibility. If a customer chooses not to take a converted freighter after it pays a deposit (which has never happened in ATSG history), there is plenty of demand from other customers who are ready to take the plane now rather than wait. Management has also confirmed that the growth capex in 2024 and beyond can be easily pulled back if returns are not meeting their expectations.

Given our experience with this conservative management team, we believe they will deliver similar mid-teens returns in a very favorable demand environment. The market on the other hand has punished ATSG shares, providing us an opportunity to acquire shares of a business generating significant and growing free cash flow at a fraction of its intrinsic value.

Outlook and valuation

Given the high visibility into the earnings growth over the next few years, we expect ATSG will be generating close to $800 million of EBITDA by 2026.

In 2022, free cash flow after growth capex was close to breakeven, suggesting an inflection toward profitability the following year. However, in February 2023, ATSG announced a new capital investment program, whereby the company would spend $1.2bn in growth capex over the next two years and close to $2bn over the next four years. This announcement, in conjunction with a 6% reduction in 2023 EBITDA outlook in May, has caused the stock to sell-off dramatically this year. We believe the market is overly punitive toward ATSG and ignoring the highly predictable double-digit EBITDA growth ahead in 2024 and 2025.

The shares have fallen to now trade around 4x 2023 EBITDA, an unjustifiable discount to intrinsic value, and a steep discount to its historical 5-7x EBITDA range, which itself reflects a company in secular decline and not one that will grow at double-digit rates. We rarely find a business that has such locked-in future growth with visibility into earnings many years out. The combination of the quality of earnings and the valuation makes us extremely excited about this investment.

We believe the reason the market has historically attributed this type of valuation to ATSG is that the company does not show any positive free cash flow and there may be a view that there isn’t any. Our view, on the other hand, is that maintenance free cash flow (EBITDA less maintenance capex, interest expense and taxes) is a better indicator of the true earnings power of the business. ATSG has shown an ability to consistently generate and grow maintenance free cash flow, a result of the solid returns generated from the growth capex being deployed.

After the earnings growth from the fleet begins to be reflected in the financials and ATSG inflects towards positive free cash flow after growth capex, we expect the shares will trade at or above the high end of their historical range. At 6.5x 2026E EBITDA (or a 10% maintenance FCF yield), the shares would be more than a double from today’s price, representing a 35% IRR through the end of 2025, though we see multiples catalysts to achieve this return within the next twelve months

Another way we have looked at the valuation is using a sum of the parts analysis to split the CAM leasing business (goodco) from the aircraft operations/services business (badco). The leasing business currently generates approx. $400mm of EBITDA based on the 129 aircraft in service with an additional 27 aircraft that have been purchased and are in or awaiting conversion. Using a conservative 6x EBITDA for the existing CAM business ($2.4bn TEV) and adding the value of the planes in/awaiting conversion at cost ($500mm) would result in a TEV of $2.9bn (~$26/share) without assuming any value for ACMI or any excess returns from the planes in conversion. In a downside scenario, if ATSG trades at 5x 2026 EBITDA for CAM alone (no value for ACMI or growth), the stock would be at current market prices.

Another way to triangulate a downside would look at the market value replacement cost for the current fleet (approx. $3bn) which would also result in ~$20/share to the equity.

Conclusion

To summarize our outlook, there’s great visibility into a case where the shares more than double with a significant margin of safety based on the current fleet value or CAM earnings alone. While we believe there is optionality to grow earnings even faster or see greater multiple expansion, these levers are not necessary for an already compelling risk-adjusted return.

We aren’t the only ones who believe the stock is cheap. The company, which had previously been restricted from share repurchases as a recipient of CARES Act funding, was able to begin repurchasing shares in October 2022. The company repurchased 3mm shares (4% of outstanding) at prices much higher than today and clustered insider buying has started after the stock began to sell off this year. We believe management will continue to be opportunistic buyers given the strong balance sheet and confidence they have in the future of the business.

We also know that ATSG has attracted private equity in the past and that the recent sell-off has renewed interest. Apollo recently acquired Atlas Air (the closest competitor to ATSG, although not an ideal comp). We would argue that ATSG is a higher quality asset due to the greater stability/visibility of ATSG’s earnings stream. Atlas as a strategic acquiror would make a lot of sense given the fleet commonality and complementary assets that ATSG would provide (MRO business, conversion JV, higher mix of leasing/long-term earnings visibility).

We also believe this investment idea will be attractive to activists as there are multiple levers to unlock value, including a break-up of the two business divisions, a large tender and speeding up a sale.

Catalyst

-Takeout
-Company beats its 2023 guidance
-Increase in buybacks