Why you Should Invest in ATSG

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With e-commerce now an embedded trend globally, where can we find value besides the traditional big tech e-commerce names? Rather than focusing on the first order impacts, we try to understand how this trend can and will impact/extend to other sectors.

In this article, we introduce a relatively non-mainstream way to bet on the e-commerce trend: logistics. Specifically, we explain why you should invest in ATSG, or Air Transport Services Group (ATSG). More importantly, we are also adding this stock to our portfolio.

ATSG flies under the radar of many institutional investors due to its market cap. In addition to the secular trend of e-commerce, what if I told you that there’s a high probability that ATSG will be acquired by a big tech name we all are too familiar with?

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    Who is ATSG?

    Air Transport Services Group (ATSG) is a Wilmington, Ohio-based aviation holding company which provides air cargo transportation and related services to domestic / foreign air carriers and other companies that outsource their air cargo lift requirements. It also owns 25% of West Atlantic Group, a European-based air cargo logistics business. ATSG is one of the largest global lessor of freighter aircraft. It owns an aircraft portfolio focused on mid-size freighters.

    How do they make money

    ATSG derives its revenue via three key categories:

    • Aircraft leasing: Largest segment of the business, this involves leasing its own cargo freighters. ATSG adds value through identifying suitable passenger aircrafts to convert them into cargo freighters. In fact, aircraft freighters that are converted from passenger aircraft can be deployed into markets more economically relative to newly-built freighters.
    • Aircraft operations: Like any other leading airlines, but tend to be private charter. Carrying both freight and passengers for a variety of customers, including private sector companies and governmental organizations.
    • Support services: Air transportation related services such as aircraft maintenance and modifications, ground handling and crew training. Typically client base includes, delivery companies, e-commerce companies, freight forwarders and other airlines.
    ATSG 2019 Revenue split
    ATSG 2019 revenue split by customers. Source: Company report.

    ATSG’s client base is largely concentrated. Crucially, 71% of ATSG’s 2019 revenue comes from its top three clients.

    Why you should invest in ATSG

    E-commerce: the trillion dollar opportunity

    The global e-commerce growth trend has never been in more important today. With Covid-19 crisis still looming, it continues to act as a catalyst for the explosive growth we have experienced since March 2020.

    Nevertheless, the pandemic has completely changed the landscape of how people shop (perhaps forever), in our view. Even with the existence of a Covid-19 vaccine, we expect this trend to continue, driven by the structural shift of retailers towards digitalization and the exponential growth in e-commerce penetration globally.

    Naturally, ATSG is significantly exposed to e-commerce, with ~37% of its revenue from DHL and Amazon. We expect Amazon’s market share of its revenue to double in the next 5 years.

    Defensible business model with a proven track record

    Founded in 1980, ATSG has a proven track record of delivering value to both its customers and shareholders since its listing in 2003.

    The company operates in a capital intensive yet competitive environment. But, this is also where ATSG carves its niche. ATSG targets its aircraft leases to cargo airlines and delivery companies seeking medium wide-body aircraft.

    Boeing 767 Freighter ATSG AAWW
    ATSG is the world’s largest owner and operator of Boeing 767 freighter, a wide-body aircraft.

    The increased in e-commerce has vastly increased the competition for cargo volumes among passenger airlines. Not only does it push prices up, evident by UPS and FedEx’s move, but also caused a spillover effect onto the cargo carriers. Consequently, increased cargo demand benefits ATSG.

    The Amazon option

    In our forecasts, we expect Amazon’s share of ATSG’s revenue to double in the next five years. As it stands, Amazon’s leasing commitment with ATSG will rise to 42 aircraft by the end of 2021. This is just around half of all aircraft owned by ATSG and Amazon, 98 and 80 aircraft, respectively.

    Recently, it has been reported that Amazon Air is rapidly expanding, even adding its own 767 cargo plane. Up till now, Amazon Air run its air cargo business through lease deals with ATSG, Atlas Air (AAWW) and Sun Country.

    Some may think that because Amazon is gradually building its own fleet, it diminishes the need to lease aircraft. We beg to differ, here’s what we think.

    First, Amazon and ATSG’s lease commitments is a 10 year contract. We see this as sign that Amazon Air’s path (if it is true) to independence may take some time to execute. Secondly, perhaps the most important part of our thesis, Amazon indirectly owns ATSG.

    As part of an Investment Agreement and a Stockholders Agreement, ATSG granted/issued several tranches of warrants to Amazon. Here’s a rough idea of warrants issued to Amazon.

    Based on our calculations, Amazon indirectly owns just under 40% of ATSG, assuming the warrants are exercised. We think that because the stock is owned indirectly, ie via warrants, it has not capture the attention of the investing world.

    In short, we think an acquisition of ATSG by Amazon is highly likely given its ambition to build its logistic arm, Amazon Air. There’s little reason for Amazon to own ~40% indirectly of a company that has a market cap of ~$1.5b.

    ATSG Amazon warrants
    Issuance of ATSG warrants to Amazon. Source: Company report and estimates.

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    Financials and valuations

    ATSG income statement
    ATSG income statement. Source: Company report.
    ATSG key business metrics
    ATSG key business metrics. Source: Company report and estimates.
    • Attractive valuation: ATSG trades at a reasonable ~15x TTM P/E. Equivalently, it trades ~6x EV/EBITDA, significantly below the industry average of ~10.5x for its peer group.
    • Stable EBITDA margin. Normalized EBITDA margins are stable, despite the fluctuations in oil prices. This stems from its customers procuring their own aircraft fuel necessary for their flights. ATSG’s agreement with the US Military is based on a preset pegged fuel, which also includes a true-up to the actual fuel prices.
    • High cash conversion business. A high cash conversion business, ranging from 87% to almost 100% since 2017. This highlights the company’s continued efficiency in turning EBITDA into cash (measured by operating cash flow).
    • Arguably high leverage. ATSG operates with a relatively high leverage. As part of its debt pile, specifically, its Senior Credit Agreement, interest payable on this portion are adjusted quarterly based on i) current debt-to-EBITDA ratio; ii) LIBOR. Naturally, ATSG benefits from lower interest expense with higher EBITDA.

    Summary

    We like the term used by Howard Marks on second level thinking, which we try to emulate in some forms in this thesis. There are many ways to bet on the e-commerce trend today, with the obvious ones being Amazon, Shopify, SEA Limited etc, just to name a few.

    Interestingly, the idea of betting on the e-commerce trend via ATSG is less obvious, which is why we like it. Less crowded and relatively small cap means that it rarely appears on investors’ radar. To summarize, we believe ATSG offers an asymmetric risk-reward profile, with continued tailwinds from the e-commerce trend and as a potential takeover candidate.

    Furthermore, ATSG operates a defensible business model build over 40 years, where its specialism in converting passenger aircraft into medium-body freighters will be difficult to replicate. With this, we will be adding ATSG to our portfolio.

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