I am a big fan of Mohnish and his book the Dhandho investor still remains my favorite and best read so far. I am writing this article only to reflect my opinion & perception of what value Mr. Pabrai may have seen in ATSG stock (Air Transport service group) and does not really reflect Mr. Mohnish's idea or thoughts.
Why am I writing this article when this opportunity is already lost? For me it is very simple, there is always a learning. Just like many investors who learnt from Warrant Buffets ideas, this is a learning exercise for me and rest of folks who are interested in reading this article.
Before we go into the analysis of ATSG, I happen to read about Mr. Mohnish (he usually does not discuss his investment ideas) and this one is a exception. I read his investment thesis in Frontline which is available at http://manualofideas.com/blog/2010/06/pabrai_on_frontline_nysefro_ha.html
and I would recommend the readers to check out his investment thesis in Frontline before you further read my postmortem on ATSG position. I always think the Frontline idea may have played a important part in Mohnish’s making an investment decision when buying ATSG.
I wish he does disclose more of his ideas like he did for frontline investment, so people like me can learn from him.
ATSG - Air Transport Services Group
A quick background on ATSG: formerly known as ABX Air, the company was spun off from Airborne Inc. after DHL Worldwide Express bought Airborne’s U.S. ground operations in 2003. As a foreign entity, DHL was required to divest the U.S.-based air freight operations and hence ABX Air was spun off.
The company retained the DHL contract, which represented near 100% of revenues (consistently over $1b) from 2003 to 2008. In Q4/07, ABX Air acquired Cargo Holdings Int’l (“CHI”) for $340m thereby meaningfully diversifying the customer mix, service offerings and revenue base. Reflecting this, the company was renamed Air Transport Services Group in May 2008.
As the global economic and financial crisis began to accelerate, DHL almost completely eliminated its presence in the U.S. and severed the ATSG contract.
Mohnish Pabrai's Investment:
Based on Gurufocus.com, Pabrai funds (run by Mohnish) bought a position in ATSG during Q2 of 2008 with a entry Price of around 2.7 and DHL Contract was severed in May 2008 after Pabrai funds bought its position if I have my dates right.
DHL – ATSG Relation & Contracts: The real value play
Before we get into the Value play by Pabrai funds, I would like you to understand the DHL & ATSG relation/contracts. Based on the 10K and 10Q available at the point in time, DHL was ATSG’s biggest customer with more then 70% of revenue generated from DHL
Based on 2007 10K, ATSG ( ABX Air) and DHL operate under two commercial agreements. The aircraft, crew, maintenance and insurance agreement (“ACMI agreement”) and a hub services agreement (“Hub Services agreement”). Under these agreements, we provide services to DHL on a cost-plus basis.
Air cargo transportation services are provided to DHL under the ACMI agreement on a cost-plus pricing structure. Costs incurred under the ACMI agreement are generally marked-up 1.75% and recorded in revenues. By achieving certain cost-related and service goals specified in the agreement, the mark-up can increase from a base of 1.75% up to approximately 3.35%.
Hub Services Agreement
Under the Hub Services agreement, we provide staff to conduct package sorting, warehousing, and logistics services, as well as airport, facilities and equipment maintenance services for DHL. Costs incurred under the agreements are generally marked-up 1.75% and included in revenues. By achieving certain cost and service goals specified in the agreement, the mark-up can increase from a base of 1.75% up to approximately 3.85%.
What is the importance of the above cost plus pricing structure?
This means ATSG will be reimbursed for all the costs it incurred and will always have a margin of 1.75% and can better it by meeting certain service goals.
Then the most important sentences in the agreement:
The initial term of the ACMI agreement expires August 15, 2010 and automatically renews for an additional three years unless a one-year notice of non-renewal is given. DHL may terminate the ACMI agreement if, after a cure period, ABX is not in compliance with applicable performance standards specified in the agreement. The agreement allows DHL to reduce the air routes that we fly or to remove aircraft from service. For any aircraft removed from service during the term of the ACMI agreement, the agreement allows us to put the aircraft to DHL, requiring DHL to buy such aircraft from us at the lesser of book value or fair market value. If our stockholders’ equity is less than or equal to $100 million at the time of sale, any amount by which the appraised fair market value is less than net book value would be applied to a promissory note we owe to DHL. However, if our stockholders’ equity is greater than $100 million, as it is at this time, any amount by which fair market value is less than net book value would be recorded as an operating charge. For purposes of applying the $100 million stockholders’ equity threshold, ABX’s stockholders’ equity will be calculated after including the effect of any charges caused by the removal of aircraft.
The above statement holds the Key to the whole investment thesis and means that in the event DHL terminates the contract with ATSG, ATSG can use its put option and DHL is obliged to purchase the planes.
Now lets examine the asset side of the equation on what ATSG.
ATSG had the following assets as of Q2 2008:
40 Boeing 767 Airplanes
14 Boeing 727 Airplanes
57 DC 9 Airplanes
16 DC 8 Airplanes
Total of 127 Planes plus 8 Additional Boeing 767’s in modification.
Usually the cargo planes are modified versions of passenger planes where the doors & some structural changes are made to fit the cargo needs and this modification is a value add and costs money to the extent of 4 to 6 million per each aircraft.
On top of the above assets, ATSG owned other businesses
- Mail delivery & sorting facility/contract with USPS
- Aircraft maintenance facility to service other airlines, Charter services, equipment leasing Fuel sale etc
Now lets value the assets> Based on 2007 10K, the management has purchased new boeing 767’s (as they are in demand) and paid 25 million a piece plus some modification costs.
So lets take out some depreciation on used planes of ATSG and using a 15 million per plane (including modifications) bring abt 40 + 8 (under modification) so total 48 * 15 = 720 Million
Some research into 727 used prices show that they can be sold at about 8 million a piece, but using a conservative 5 million , we get 14 * 5 = 70 Million
DC 9 & DC 8 planes in the fleet are a bit aged and looking at the valuations show about 1 to 2 million a piece, using a conservative 1 million , gives as 73 million
That puts the total plane valuations around $863 million.
Apart from that ATSG @ end of 2007 had 200 million cash+short term and 40 million in TAX assets, so a total of 863+200+40 = 1103$ assets.
Looking at the liabilities (including the underfunded pension) around 950 million.
ATSG has 63 million shares and @ price of 2.7 gives a market cap of 170.1 million.. adding total liabilities gives us 170.1+950 = 1120.1 $
Based on above valuations, you have ATSG trading @ almost or less then liquidation value (we were very conservative in estimating the aircraft prices) and the business was cash flow +ve and had +ve earnings (despite slow down), Management was seeing a demand in asia for the 767 carriers and purchasing new airplanes & also moving some of leased DHL 767 planes to serve other customers.. despite the economy slow down in the US. Plus Management which is aware of customer concentration risk with DHL and had already initiated the diversification process through acquired CHI
Would you buy the above business based on the above … If yes.. then what if I gave you the below 3 more options..
- On top of all the above, you always have an option to Liquidate (through the DHL put option on the contract to sell majority of airplanes to DHL incase of any unforeseeable slowdown in the economy
- You get other additional services business (USPS sorting facility, Plane repair/Equipment leasing, Plane charting, Fuel sales) all which generate about 20 million revenues annually.
- Though the intangibles like goodwill may not be of much value, how abt FAA licenses, Flight routes, international & domestic landing facilities etc? They might be worth something..
Does the sound like Heads I win, Tails I don’t loose much (infact I win on tails too??) which is what Mohnish teaches in the Dhandho investor.
How did the investment playout when DHL terminated the contract (which was a –ve)?
If you look at the 10Q filings dated 11/14/2008 by ATSG under note B Significant customers DHL, here is what management is proposing to do?
On May 28, 2008, DHL announced a plan to restructure its U.S. business and negotiate an agreement with United Parcel Service Inc. (“UPS”) to provide air uplift and other services for DHL’s U.S. domestic and international shipments within North America. Additionally, under that plan, DHL would take over management of the regional hubs currently managed by ABX throughout the U.S. If DHL and UPS successfully negotiated an agreement, the Company expected that substantially all of the services that ABX provides to DHL would be
transitioned to UPS or DHL by the middle of 2009. Approximately 6,000 ABX employees in Wilmington, Ohio would have been affected. Since May 2008, DHL has experienced a precipitous drop in its domestic freight volumes. On November 10, 2008, DHL announced a revised plan in which DHL will discontinue intra-U.S. domestic pickup and delivery services in January 2009. DHL would instead provide only international services to and from the U.S. Under this plan, the regional hubs will be closed and the sort operations in Wilmington will be downsized to approximately 600 ABX employees to process international shipments. DHL continues to pursue a contract with UPS to provide air and ground transportation for DHL’s international shipments only. The Company has attempted to present its own revised U.S. network plan to DHL, containing significant cost savings. However, DHL has indicated that it is unable to discuss the plan with ABX while DHL is in negotiations with UPS. ABX cannot reasonably predict how long
negotiations between UPS and DHL may last, to what extent they may reach an outsourcing agreement or a transition timetable. ABX has begun to discuss and negotiate termination and wind-down costs with DHL, including employee severance and retention arrangements. In
August 2008, ABX and DHL executed a severance and retention agreement. The agreement specifies employee severance and retention benefits that DHL will pay to ABX in conjunction with its U.S. restructuring plan. DHL will reimburse ABX for the cost of non-union employee severance and retention benefits paid in accordance with the agreement. The same agreement includes provisions to pay ABX for crewmember benefits if ABX and the collective bargaining unit for the crewmembers can reach an agreement in regards to the use of those funds for severance, retention or other issues arising from DHL’s U.S. restructuring plan.
ABX management is accelerating and expanding its diversification plans. In the absence of operating such a large aircraft fleet for DHL, management anticipates that it will sell nearly all of the remaining DC-9 aircraft to DHL as they are removed from service under the aircraft put provisions of the ACMI agreement. Additionally, management expects to put to DHL several of the 23 non-standard freighter Boeing 767 aircraft that are currently in service to DHL under the ACMI Agreement. The proceeds from these aircraft would be used to help finance the modification of certain remaining Boeing 767 aircraft from a passenger door loading system to a standard freighter configuration. The Company is in discussions to redeploy a significant number of Boeing 767 aircraft on a more profitable basis, with both new and existing customers under dry lease or ACMI arrangements. Other business development opportunities for ABX include expanded aircraft maintenance and repair operations and additional mail sorting and mail transport contracts with the USPS. If DHL completes its plan with UPS or otherwise substantially reduces its operations in the U.S., ABX will need to significantly restructure, downsize and achieve wage concessions in order to competitively pursue new business development.
Basically despite loosing the biggest customer there was not much risk associated with the investment and even though the market over reacted a bit initially.