Earlier this year Atlas Air Worldwide agreed to lease 20 cargo planes to Amazon. The deal will significantly expand Atlas’ asset and revenue base, but it will also accelerate the company along a path of shareholder value destruction – a path that has been well worn by Atlas before. Perversely, the senior management team has guaranteed its own financial prosperity in the process. Our eyebrows and a major red flag were raised recently when we learned more about the deal terms.
Atlas was founded in the United States in 1992 with a single Boeing 747 to provide wet leasing of cargo aircraft to airline operators. At the time air freight haulage was largely an afterthought for passenger airlines that sold their left over belly capacity below deck, and a limited number of dedicated air freighters were permanently full.
Today Atlas is the leading provider of outsourced aircraft and aviation solutions to the $6 trillion global airfreight industry, and the world’s largest operator of Boeing 747 freighter aircraft. Atlas operates a fleet of more than 80 planes. Most of the planes are wet leased to air shipping and airline customers under multi-year contracts where Atlas also provides crew, maintenance and insurance. DHL, the global logistics giant, is Atlas’ largest customer and accounts for about a quarter of the company’s profits. Wet leasing in total accounts for more than half of Atlas’ earnings. In addition, Atlas provides charter services (around a third of earnings) and a smaller amount of dry leasing (or plane-only) operations.
As much as Atlas’ business has changed from its humble beginnings more than two decades ago, so too has the air cargo industry. Unfortunately for Atlas, recent industry changes have primarily been for the worse. To begin with the share of cargo that is being shipped by air has declined. Certainly there has been growth in commodities and low value products that naturally lend themselves to being shipped by sea or by rail. But this only accounts for half the loss in air cargo share. Modal shift from air to sea has been just as large a detractor and has been exacerbated by an oversupply of container ships. Too much capacity on the high seas has meant intense price competition between the container ship operators. Ocean shipping rates have halved in the past year in an attempt to fill otherwise empty ships and are now 10 times cheaper than the equivalent rate to ship goods by air.
Deteriorating conditions for ocean freight has flattened demand for air freight
Even as the ocean has pulled cargo demand away from the air, cargo plane capacity has continued to expand. Big passenger airlines operate dedicated cargo businesses in competition with Atlas and have continued to take delivery of new freighters. At the same time these airlines have been expanding their passenger operations with new widebody (or double aisle) aircraft which have large bellies that can be filled with all sorts of freight at very cheap rates to earn airlines an extra few dollars. Whether deliberately insidious or not, the effect on the air cargo industry is the same. At a time when air cargo demand has slowed to a halt there has never been more space available on cargo planes. Load factors in the low 40% range are near trough levels of the financial crisis and pricing has been pressured.
More dedicated freighters and big bellies of widebody planes are oversupplying the market
Air shipping rates are sliding
At first blush, the deteriorating industry dynamics underlying Atlas’ business are not obvious. Over the past five years Atlas has grown revenues by 36% and profit margins have expanded from a low 15% of revenues in 2011 to more than 20% today. Sellside analysts expect robust growth to continue with revenue growth forecasts of up to 10% per annum over the next few years. But revenues and earnings only tell one side of the story. When we factor in the reinvestment into its fleet in order to achieve this performance the result is far from attractive.
Over the same five year period, returns on Atlas’ asset base have declined (and they weren’t that high to start with) from 10% to around 6%. This means that the return on the incremental $2 billion investment into the business has been zero! The problem runs deeper. While Atlas management has deployed $2 billion of capital since 2010, total earnings before interest and taxes have totalled just $1 billion. This means that shareholders are ploughing all their profits and more back into the business for nothing in return but a larger debt burden to bridge the funding gap!
Atlas’ debt has been on the rise
Said another way, while we do not doubt that Atlas might be able to continue growing its revenues and earnings, we do think that the market is missing the enormous capital reinvestment that is required. It is clear to us that the cost of adding more planes to the fleet is not being compensated adequately – or at all!
The inherent uneconomic nature of Atlas’ business was most recently highlighted to us when we examined the terms of its recent deal with Amazon. At the time of Atlas’ first quarter results in May management announced that they had agreed to supply Amazon with 20 planes through 2018, taking Atlas’ fleet to over 100. As part of the arrangement Atlas also granted Amazon warrants to acquire common shares in the company at a strike price of $37.50 per share, around the Atlas share price at the time. The number of shares represented by the warrants would correspond to 20% of the shares outstanding once exercised by Amazon, with half the warrants received immediately and the other half vesting over the delivery of the second ten planes. Amazon could also be granted additional warrants representing 10% of Atlas’ common stock as it does more business with Atlas. The market was clearly excited by the partnership with Amazon and the growth trajectory ahead, and the stock price rallied 27% on the day to almost touch $50.
Management was also upbeat, with the CEO saying: “Amazon is providing value to Atlas, Atlas is providing value to Amazon…We think it’s a great transaction for us. We hope it’s a great transaction for Amazon, we are both really excited about it”. We were less enthusiastic and viewed this deal as a continuation of bad business, where Atlas pays for the planes and Amazon gets to use them on the cheap. Owing to Amazon’s heft, we are yet to find a supplier that easily extracts high returns from the internet giant (our phone lines and email are open if our readers know of any). But we would wait for the company’s proxy filing to learn more.
On a Friday afternoon late in July, Atlas’ management submitted a proxy filing to the Securities and Exchange Commission (SEC) in the United States to notify shareholders of a special meeting in late September to vote on the issuance of shares to Amazon upon exercise of the warrants granted. It was an orange flag (if not red) to us that the filing was made late on a Friday, where companies typically bury news and details that aren’t so pleasing, but that was just the beginning. We note two key elements of the Amazon deal which are concerning:
- All of the benefits and optionality accrues to Amazon. Particularly confronting is the right granted to Amazon to terminate the agreement for “convenience by providing 180 days’ notice”. There is an undisclosed fee payable on termination, but the point still stands. Amazon can opt out of this deal whenever they want for whatever reason. If someone offers a better deal or Amazon just wants to pay less, they can always use the threat of walking away. This indicates to us that Amazon had all the bargaining chips going into the negotiation and Atlas were just happy to be at the table.
- The financial interests of the senior management team have been put ahead of shareholders. If shareholders approve the Amazon deal a substantial amount of stock will be acquired by Amazon through the warrants, such that the company’s definition of a “change of control” will be triggered. Put simply, this provision means that the CEO could realise as much as $21 million and his top four lieutenants could be eligible for more than $10 million each (to be as fair as possible there are a range of scenarios and stock prices where the payout may be less, but again, the point still stands). Of course the shareholders don’t have to vote for the deal, but then management has granted Amazon so many options to walk away that Atlas would lose its coveted partnership.
At the beginning of August Atlas reported its second quarter results. Unsurprising to us the financial performance for the quarter and the outlook were both weak. Management spoke about “a slower pace in general commercial cargo” which saw plane utilization down by around 6% compared to the same quarter a year ago. In fact, one customer returned a plane to Atlas during the quarter, with no further need for the capacity. Perhaps more interesting to us however was the second driver of the weakness. In management’s words “the start up expenses for Amazon have been coming in a little higher than we had anticipated”.
In the space of just a few months there are already several indications that the Amazon deal is cracking and will eventually result in poor economics for Atlas shareholders. The initial market euphoria surrounding the deal has also dissipated and the stock price has fallen 29% from its high in May. We believe there is more to come in this story and continue to hold a short position in the common stock of Atlas.
Atlas stock price performance 2016 YTD
Montaka is short the shares of Atlas Air Worldwide.
Christopher Demasi is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.