Why Atlas Air’s freight business will support recovery in 2H2014

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Risk Factors

Leverage

The equity cushion is near historical lows, as management anticipated they would have hit peak leverage and de-levered sooner than this. There are some levers that can be pulled in lieu of a few unencumbered aircraft and the relative value of putting back long-dated operating leases, even after eating breakage costs.

Atlas CMI

Cargo trends

All eyes remain on performance of the transpacific trade routes as seasonal perturbations around U.S. weather and the Chinese New Year gradually subside. I am not bullish on the early 2014 picture, with Chinese PMI remaining depressed, but the second half is generally the real seasonal test as the company rounds into the holiday season. My broad view is that freight will be sideways to slightly down in the near term, but that Atlas should be able to manage through as it ramps dry leasing business.

Slack capacity

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Atlas has played the “swing supplier” game for a long time now, and there have been both good and bad years for chartered business of late. Q4 provided a nice bounce back on that segment after a very rough 2013, but it is difficult to gauge visibility into this aspect of Atlas’ P&L given the short lead times.

Secular—Sea/land, belly

My general impression is that the miniaturization theme has played out in this phase of the secular shifts to other modes of transport and that air will remain an eminent value proposition for niche aspects of cargo. Within freight, belly is somewhat capacity-constrained by the relatively low attachment rates for cargo, and the historical trend appears to support the bullish view that incremental mix shift is limited.

Conclusion

Atlas is not a straightforward recovery story, and it will likely require some patience this year, but the underlying sector and company themes suggest the worst may be behind management. There appears a good deal of support to countervail impressions of a value trap. I think that the eminent first catalyst will be seeing how the ramp-up of dry leasing business impacts the quality of earnings in Q1 against the backdrop of the AMC drawdown. On a thematic basis, I believe that freight will begin to assert and support more assured recovery in the second half of the year. CMI is capably poised and I would fully expect management to try and push this business further in lieu of reducing asset intensity.

The Market Realist Take

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Atlas said that at this point of the year, there is limited visibility into second-half airfreight market demand. It expects to be profitable in the first quarter, which is usually the lowest volume-generating and highest maintenance expense quarter of the year. Typically, the majority of its earnings are generated in the second half.

For the full year, Atlas expects total block hours to be several percentage points lower than 2013 block hours, with more than 70% in ACMI, less than 10% in AMC Charter, and the balance in Commercial Charter. The Dry Leasing segment should show dramatic growth. Depreciation and heavy maintenance expense should each increase by about $10 million over 2013. As always, line maintenance will depend on block hours operated. Plus, Atlas anticipates an effective book income tax rate of approximately 30%.

Among the few pure-play or “close-fit” ACMI public comps, Air Transport Services Group (ATSG) is Atlas’ closest peer. ATSG reported a decline in its ACMI Services revenue due to operation of fewer international cargo planes for its customers, including the U.S. military, as well as fewer ad hoc charters. In general, Atlas’ business relates mainly to dry lessors like AerCap (AER), Air Lease Corp. (AL), Aircastle (AYR), and freight forwarders such as FedEx (FDX), United Parcel Service (UPS), and UTi Worldwide (UTIW). The former still are a smaller component of the business, and the latter are Atlas’ primary customer base.

AerCap’s acquisition of International Lease Finance Corp. last year prompted industry experts to conclude that the aircraft leasing industry will see further consolidation. Air Lease, which leases commercial jet transport aircraft, also said on its earnings call that over the past few years, the industry has witnessed an emergence of agent-based lessors, acquisitions of leasing franchises, and consolidations. Aircastle said that air cargo market remains weak, with a modest improvement in demand during the past year. But oversupply remains the biggest issue, and it will take a while to work through the supply of available aircraft. Freight forwarder UPS said its fourth quarter results were negatively impacted by excess operating costs due to significantly higher-than-predicted volume and inclement weather in the U.S. Both UPS and FDX have announced increases to freight rates despite international customers moving towards cheaper shipping services.

To learn more about investing in aerospace companies, see the Market Realist and Interactive Buyside series Equity research: Does Erickson Air Crane present a good investment?

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