SOURCE: Bastogne Capital Management, LLC

Bastogne Capital Management, LLC

April 01, 2015 08:30 ET

Bastogne Capital Issues Open Letter to James H. Carey, Chairman of the Board of Air Transport Services Group Inc.

Calls on the Board to Explore a Levered Share Repurchase to Address and Rectify the Equity's Large Discount to Intrinsic Value; Highlights the Massive Valuation Discount Versus Comparables; Lays Out a Roadmap for a Share Repurchase That Would Allow for a Significant Premium and Massive Accretion to Cash Flow per Share

STAMFORD, CT--(Marketwired - April 01, 2015) - Bastogne Capital Management, LLC ("Bastogne"), as the investment advisor to a fund that is a significant shareholder in the common stock of Air Transport Services Group Inc. ("ATSG" or the "Company") (NASDAQ:ATSG), today issued an open letter to James H. Carey, Chairman of the Board of Directors of ATSG, calling for the Board to immediately take action to address the large discount to intrinsic value represented by the trading price of the Company's equity. In the letter, Bastogne outlined a specific proposal that would allow the Company to repurchase over 35% of its equity at a 30% premium to the market price while still creating over 30% accretion in cash flow per share.

The full text of the letter follows:

April 1, 2015

Mr. James H. Carey Chairman of the Board
Air Transport Services Group Inc.
145 Hunter Drive
Wilmington, OH 45177

Dear Mr. Carey:

Bastogne Capital Management, LLC ("Bastogne") is the investment advisor to a fund that owns common stock of Air Transport Services Group Inc. ("ATSG" or the "Company"). Since our initial purchases in early 2013, management has done a solid job of executing the Company's business plan and bringing a substantial level of stability to the operating results. The recently executed extension of the DHL relationship and other new dry lease commitments have demonstrated the attractiveness of the Company's assets while removing significant volatility from the future cash flows. Unfortunately, while these laudable efforts have caused ATSG's stock to rise slowly over time, they have not narrowed the major valuation discount suffered by the Company's shareholders. While we will discuss in some detail the significant gap between the Company's market valuation and its intrinsic value below, perhaps the most damning metric comes from the Company's own investor presentations. According to the Company's slide presentation delivered at the BB&T Capital Markets' Transportation Services Conference on February 11, 2015, the Company's lenders (who will no doubt speak conservatively) value its aircraft fleet at approximately $880 million; given the Company's current stock price indicates a total enterprise value of just under $920 million, the market is therefore only ascribing approximately $40 million of value to the Company's business and ability to generate significant cash flows.

We are not writing this letter simply to express our frustration with the continued depressed trading levels of the stock, but rather to bring to the board's attention a plan which we believe will address the widespread misunderstanding of ATSG's intrinsic value. As of December 31, 2014, the Company had net indebtedness of roughly $313.5 million, implying net leverage of less than 1.75x EBITDA and a net debt to collateral value ratio of under 36%. By comparison Atlas Air Worldwide Holdings, Inc. ("Atlas") has a net debt leverage ratio of over 5.0x, greater than ATSG's enterprise value to EBITDA ratio. The extension of the DHL relationship and the execution of new dry lease arrangements have brought a significant level of stability to the Company's cash flows, and this should allow the Company to add leverage comfortably and at attractive levels. As we will detail below, we believe the Company could borrow an additional $300 million of debt, remain conservatively levered, repurchase $300 million worth of shares at $12 (30% premium to current market) in a dutch tender and create over 30% free cash flow per share accretion for all remaining shareholders. We call on the board to immediately explore this and other options to remove the significant discount in the Company's stock price when compared to intrinsic value.

ATSG Is Grossly Undervalued on a Relative and Absolute Basis

Based on conservative assumptions taken directly from management comments, ATSG is trading at roughly 5x EBITDA and free cash flow. As demonstrated in the tables below, the EBITDA valuation trails that of Atlas by roughly 3 turns; at the same 2015 EBITDA multiple as Atlas, ATSG stock would trade at over $17 per share. While Atlas appears to be growing EBITDA more quickly in 2015, its growth slightly lags in comparison to ATSG once adjusted for non-recurring items. The extension of the DHL contract will cost ATSG $5-$10 million on an annualized basis; we estimate nine months of impact in 2015 as $5.6 million at the midpoint (75% of $7.5 million). The final maturity of the DHL note costs the Company $4.7 million of EBITDA for 2015, and the increase in book, non-cash pension expense is another $4.3 million headwind. After adjusting for these non-recurring items, we project ATSG EBITDA to grow roughly 9% from 2014 to 2015 on an apples-to-apples basis at the baseline projection of $180 million, slightly ahead of Atlas' 8.4% growth.

ATSG Valuation
($ in millions, except per share data)
Price Per Share    $9.22  
Diluted Shares Outstanding using Treasury Method     65.4  
 Fully Diluted Market Capitalization     602.9  
Plus: Debt     344.1  
Less: Cash     (30.6 )
 Total Enterprise Value    $916.4  
Enterprise Value / 2014 Adjusted EBITDA $179.5  5.1x  
Enterprise Value / 2015 Baseline Adjusted EBITDA $180.0  5.1x  
Enterprise Value / 2015 Consensus EBITDA $182.7  5.0x  
Atlas Valuation 
($ in millions, except per share data) 
Price Per Share    $43.02  
Diluted Shares Outstanding using Treasury Method     24.8  
 Fully Diluted Market Capitalization     1,067.2  
Plus: Debt     1,973.1  
Less: Cash     (316.4 )
 Total Enterprise Value    $2,723.9  
Enterprise Value / 2014 Adjusted EBITDA $314.3  8.7x  
Enterprise Value / 2015 Consensus EBITDA $340.6  8.0x  

The true nature of ATSG's absurd valuation is only revealed when looking at its free cash flow yield, particularly given its low leverage. The Company currently trades at a free cash flow yield of over 20%; yields this high are typically reserved for either highly levered companies or those in declining industries (e.g., newspaper, printing or radio companies). Our calculation of just under $124 million in free cash flow to equity in a normalized state is based on conservative assumptions driven by management comments. We begin our calculation of free cash flow with EBITDA and subtract maintenance capital expenditures, cash interest, cash pension contributions (net of book expense or gain) and cash taxes. We believe that this method, which is generally accepted by investors, provides a true reflection of the cash flow available to management for discretionary purposes such as debt repayment, growth capital expenditures or share repurchases. We will detail our assumptions and justifications for each of these line items below.

EBITDA: We start the analysis with the Company's official outlook "that its baseline Adjusted EBITDA from Continuing Operations for 2015 will be approximately $180 million..." from the fourth quarter earnings release dated March 5, 2015. We have not increased this number despite President and Chief Executive Officer Joe Hete's comments on the March 6, 2015, earnings call that "there is upside potential in that number based on new business that we will sign up that we don't have under contract today." The Company achieved $179.5 million of adjusted EBITDA in 2014 after initially guiding to $165-$170 million, so we believe, along with Mr. Hete, that $180 million is a very conservative assumption.

Maintenance Capital Expenditures: Maintenance capital expenditures are used in this analysis as they reflect the spending required to sustain the current business; any growth capital expenditures would drive additional EBITDA and affect the above assumption. We use $37.5 million of maintenance capital expenditures, based on comments from the last three earnings calls. During the August 6, 2014, second quarter earnings call, Mr. Hete stated "if you look at the CapEx requirement for next year, our maintenance CapEx number is in the, call it, the $30 million or $40 million range on an annualized basis." On the November 6, 2014, third quarter earnings call, Mr. Hete amended his range by stating "so, you're looking at a maintenance CapEx level of, call it, $35 million, $40 million is what absent adding in some growth investments in the mix." Finally, on the March 6, 2015, fourth quarter call, Mr. Quint Turner, the Company's Chief Financial Officer, responded to a question regarding the level of maintenance capital expenditures by saying "we say it's $35 million to $40 million is kind of where it's been." Consequently, we chose the midpoint of the last two ranges given.

Cash Interest: We have calculated the Company's cash interest at $9.9 million based on debt balances as of December 31, 2014, and prevailing interest rates cited in the Company's 10-K and credit agreement. The 10-K states that "at the Company's current debt-to-EBITDA ratio, the LIBOR based financing for the unsubordinated

term loan and revolving credit facility bear a variable interest rate of 2.17% and 2.17%, respectively," implying $6.4 million of interest expense on the $296.3 million of indebtedness. The 10-K further states that the "unused revolving credit facility totaled $86.0 million," and we have used a 0.25% commitment fee on this balance per the pricing grid in the Company's third amendment to its credit agreement dated May 6, 2014. Finally, we have used an interest rate of 7.05% on the Company's aircraft loans based on the 10-K disclosure that these loans' "interest rates range from 6.74% to 7.36% per annum payable monthly."

Cash Pension Contributions: We have assumed $9 million for the cash pension funding adjustment, based on $6 million in actual funding and reversing the book gain embedded in EBITDA. This was confirmed by Mr. Turner's statement on the fourth quarter call that "the gain, if you think about it, you have to add that back. So it'd be the $6 million plus the gain, it'd be $8 million to $10 million, call it."

Cash Taxes: On the fourth quarter call, Mr. Turner stated "based on our latest calculations and estimates, we don't expect to pay any significant cash federal income taxes until at least 2017, which is one year later than we have previously estimated;" therefore, we have assumed zero cash taxes.

As you can plainly see, we have taken an extremely conservative view of the business' cash flows, and we still calculate free cash to equity of almost $1.90 per share.

Free Cash Flow Per Share 
($ in millions, except per share data) 
2015 Baseline Adjusted EBITDA $180.0  
Less: Maintenance Capital Expenditures  (37.5 )
Less: Cash Interest Payments  (9.9 )
Less: Cash Pension Funding, net of Book Gain  (9.0 )
 Free Cash Flow to Equity $123.6  
Free Cash Flow Per Fully Diluted Share $1.89  
Free Cash Flow Yield  20.5 %

In our view a company should not trade at these levels without significant leverage or serious industry headwinds. The Company recently renewed the DHL contract through March 2019, giving it 4 years of predictable cash flows; over the life of the contract, the Company could dividend or repurchase 80% of its market capitalization with no growth from other areas. ATSG trades like a secularly challenged company, not a thriving air freight provider that has been growing cash flows and exceeding expectations.

The Board Should Immediately Explore a Levered Share Repurchase

Wishing and hoping are not strategies for correcting the serious discount in the Company's valuation. Frankly, since the market apparently is intent on undervaluing ATSG, we should see this as an opportunity to repurchase shares at attractive levels. The Company has completed its needed fleet upgrades and will not require significant additional capital for aircraft for at least another five years; as the Company's own investor presentation states, "reduced capital commitment as fleet upgrades completed; greater opportunity for other free cash allocation options." We were pleased to see that the Company took some steps towards capital returns to shareholders by announcing on August 5, 2014 that the board had authorized the purchase of up to $50 million of the Company's shares; unfortunately, the presence of the DHL note was a convenient excuse for delaying the implementation of the buyback. With the DHL note having been fully amortized by the end of March 2015, we were further heartened by the statements Mr. Hete made indicating that the long-awaited share repurchase would begin in the second quarter of 2015. Mr. Hete stated in the January 15, 2015, press release announcing the extension of the DHL contract that "we intend to begin returning capital to our shareholders through our share repurchase program starting in the second quarter of 2015," and he stated in the March 5, 2015, earnings release "at the same time, in the second quarter, we plan to initiate the share repurchase program that our Board authorized last summer."

Unfortunately, this path of capital return seems to be an effort to achieve the bare minimum while failing to take advantage of robust balance sheet capacity and financing markets; furthermore, it will be very difficult to implement given the trading liquidity of the equity. ATSG common equity has traded an average of just over 160,000 shares of stock per day over the last six months. Management has indicated a desire to return capital to shareholders through a consistent open market buyback as opposed to a more aggressive dutch tender; however, assuming the buyback should be no more than 15% of the average daily trading volume, the $50 million repurchase would take over 200 trading days to complete at current market prices. While the presence of a never-ending bid in the market will no doubt support the trading price, it will fail to repurchase shares at attractive levels; furthermore, we fear the trading liquidity could become the latest excuse for why shares are not repurchased. The board should be seeking an aggressive path to repurchasing depressed shares, not looking to the bare minimum allowed by the current credit agreement. The debt financing markets are extremely attractive, especially for asset rich borrowers, and this presents a unique and accretive opportunity that we will elucidate below.

Given the current set of circumstances, the Company should immediately optimize its balance sheet and aggressively repurchase shares at attractive levels. Management indicated a willingness to consider this option on the fourth quarter earnings call as Mr. Turner stated "we agree that the leverage is less than optimal... we have the capital and, as you say, the balance sheet flexibility to do both to look at accretive repurchases of shares along with growth options." Given the demonstrated free cash flow yield of over 20% on the Company's equity, cash flow and balance sheet options should be focused on share repurchases since more attractive investments with higher cash-on-cash returns will be difficult to find. Mr. Hete acknowledged the lack of good investment opportunities on the March 6, 2015, earnings call when he responded to a question regarding feedstock availability by stating, "right now, still a little tight... I know, probably a year or two ago, we figured both deliveries of 787s picking up that we'd see a lot more feedstock out there, but finding something that fits our profile to where it makes sense for us to convert it and put it into service, our return hurdle rates is still a little bit difficult." The Company's current credit agreement limits the Company to only $50 million of annual repurchases, but this condition could easily be waived given the strong asset coverage. According to the 10-K, "under the amended terms of the Senior Credit Agreement, the Company is required to maintain collateral coverage equal to 150% of the outstanding balances of the term loan and the maximum capacity of revolving credit facility or 175% of the outstanding balance of the term loan and the total funded revolving credit facility, whichever is less," and the current coverage is 230% of the outstanding balances of the term loan and the maximum capacity of revolving credit facility and 297% of the outstanding balance of the term loan and the total funded revolving credit facility. Clearly, the secured credit facility lenders are more than adequately covered by the asset value. The Company will also need to secure an amendment to section 9.4(i) of the credit agreement which limits other indebtedness of the Company to no more than $100 million. While this covenant may seem daunting in isolation, Section 9.4(h) provides a carve-out for $250 million in capital lease debt, implying the lenders are amenable to an additional $350 million of indebtedness so long as it does not dilute their collateral coverage.

Our example below involves the Company borrowing an additional $300 million of debt subordinated to the credit agreement at an assumed interest rate of 7%; while we believe the Company could borrow more attractively, we have assumed this rate to be conservative. We have also assumed that the Company is required to increase the rate on its existing debt by 1% to secure the amendments alluded to in the prior paragraph. As illustrated below, these actions leave the Company levered approximately 3.4x on a net debt basis and less than 70% on a net debt to collateral value basis. We have also assumed that the Company uses the $300 million in proceeds to repurchase stock at $12, or roughly a 30% premium to the existing stock price. All told these actions would increase the free cash flow per share by over 30%, and the Company would still generate almost $100 million of free cash flow per year; the incremental debt could be repaid prior to the expiration of the renewed DHL contract with room to spare.

Levered Repurchase Scenario 
($ in millions, except per share data) 
New Debt Borrowings $300.0  
Total Pro Forma Net Debt  613.5  
Pro Forma Net Leverage  3.4x  
Pro Forma Net Debt/Collateral Value  69.7 %
Assumed Interest Rate on Net Debt  7.0 %
Increased in Rate on Existing Debt to Secure Amendments  1.0 %
Pro Forma Free Cash Flow to Equity  99.6  
Assumed Repurchase Price $12.00  
Shares Repurchased (in millions)  25.0  
Pro Forma Fully Diluted Shares Outstanding  40.4  
Pro Forma Free Cash Flow Per Fully Diluted Share $2.47  
Free Cash Flow per Share Accretion  30.5 %

The table below presents a sensitivity analysis based on different assumptions for the interest rate and stock repurchase price; as you can see, the deal is accretive even at a $15 repurchase price and 9% interest rate.

Free Cash Flow Accretion Sensitivity Analysis
    Stock Repurchase Price
     $10.00  $11.00  $12.00  $13.00  $14.00  $15.00
  6.00%   53.4%   42.5%   34.4%   28.3%   23.5%   19.6%
  6.50%   51.2%   40.4%   32.5%   26.5%   21.7%   17.9%
Interest 7.00%   49.0%   38.3%   30.5%   24.6%   19.9%   16.1%
Rate on 7.50%   46.7%   36.2%   28.5%   22.7%   18.1%   14.4%
New Debt 8.00%   44.5%   34.1%   26.6%   20.8%   16.3%   12.6%
  8.50%   42.2%   32.0%   24.6%   19.0%   14.5%   10.9%
  9.00%   40.0%   30.0%   22.7%   17.1%   12.7%   9.1%

As can be plainly seen above, the potential accretion is too compelling to ignore. We are calling on the board to immediately engage an investment banking firm to explore a levered share repurchase to correct the persistent discount in the Company's equity. We would be happy to discuss our thoughts with you further on a non-confidential basis.


Vikas Tandon
Managing Member
Bastogne Capital Management, LLC

About Bastogne Capital Management, LLC

Bastogne Capital Management, LLC is a private, alternative asset management firm specializing in multi-strategy investing with a strong focus on equity special situations and distressed credit opportunities. Bastogne Capital Management, LLC was founded in 2012 by Vikas Tandon and has offices in Stamford, CT.

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