What is Air Transport Group (Nasdaq:ATSG) really worth? It sounds like a straightforward question, but it is really anything but straightforward. While there are certainly several positive aspects to this business, and legitimate reasons for thinking it undervalued, there are also several significant drawbacks and concerns about the long-term economic returns from the business model.
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Air Freight a Bumpy Growth Story
It likely will not surprise anyone that air freight is typically the most expensive way of shipping products, particularly those with low value-to-weight ratios. Said differently, nobody would think of shipping coal, frozen chicken breasts or family sedans by cargo plane - that's what rail, trucks and ocean-going cargo ships are for.
Instead, air freight fills a niche where time-to-delivery, product sensitivity and product value all make a significant difference. Apple (Nasdaq:AAPL) does not want its iPads kicking around in a containership for a two-month cruise, nor do most people want their letters taking the slow boat to China. (For related reading, see 2011 In Review- Shipping Hit The Iceberg.)
This makes air cargo an economically-sensitive and erratic business. Although businesses like FedEx (NYSE:FDX) and UPS (NYSE:UPS) are large enough that their sheer scale tamps down some of this volatility, Air Transport is not and that volatility is further enhanced by periods of "one-off" activity in military traffic.
A Prisoner's Dilemma?
Air Transport's operations are not helped by the fact that two customers - DHL and BAX Schenker - account for more than 60% of the company's revenue base. As such large customers, they can (and have) significantly impact this company and stock when it comes time to renew or renegotiate their contractual relationships.
Oddly enough, though, they both need each other. Because of United States law, neither DHL nor BAX Schenker can operate their own aircraft in U.S. territory. Moreover, DHL and BAX aren't likely too eager to deal with FedEx or UPS more than they have to, as they're also competitors. So, there's a delicate balancing act between DHL, BAX, Air Transport and rival carrier Atlas Air Worldwide (Nasdaq:AAWW) that can decidedly unbalance these companies from time to time.
The State of 2012
Looking into 2012, figuring out the air cargo market looks like an enigma wrapped in a riddle and dropped down a well. Air cargo traffic to and from Asia has been growing and shows the best growth rates of any of the regional routes. As Apple, Samsung, HTC and the like all look to ship more product, that should be supportive for demand. On the other hand, China's housing market is wobbling and it is not as though U.S. consumer demand has been red-hot of late.
With quite a lot of available capacity, pricing can be tricky. In the last FedEx quarter, for instance, international priority volume was down 3%, while pricing was up 11%. Keep in mind, too, that fuel prices can make or break a year's profits.
The Valuation Problem
So, is Air Transport cheap or not? Discounted free cash flow models almost never look very favorable for companies like FedEx, UPS or Air Transport unless the economy is in real trouble and valuations are very depressed indeed. Some of this is due to the high ongoing capex needs of the business and it creates a quandary - clearly there are people who get rich from owning shipping and transport businesses, but the cash flow models suggest that should be very difficult indeed.
The Bottom Line
Because of the limits of free cash flow models, analysts and investors often use EV/EBITDA models for transportation companies like rails, trucks, shippers and air cargo carriers. By that metric, Air Transport looks attractive indeed. Analysts expect about $200 million in EBITDA for the company next year and a five times multiple delivers a nearly $11 target. Working backwards, today's price suggests just a four times multiple on $155 million of EBITDA in 2012 - a level that would be about 13% below the trailing 12-month run-rate. With that sort of skepticism in the stock, a healthy global economy in 2012 could mean real opportunity in this stock. (For related reading, see Relative Valuation Of Stocks Can Be A Trap.)
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.