Description

The current confusion and sell off in ABX Air (ABXA) has created a buying opportunity with no downside. The liquidation value today is $4.69 versus a current stock price of $3.65…and I don’t think liquidation is even a remote possibility. My worst case scenario value for the business as a going concern is $4.90 ($3.79 per share from net cash and future depreciation reimbursements due from DHL, $1.11 per share from the ACMI agreement and no value assigned to the Hub Services agreement).

What do I think the stock is worth? My base case is $7.89 per share ($3.79 per share from net cash and future depreciation reimbursements due from DHL, $3.11 per share from the ACMI agreement and $.99 per share from the Hub Services agreement). So this idea has 120%+ upside (to the base case) with downside of +30% (to the liquidation value). Pretty good risk/reward in my opinion.

Brian755 first wrote up ABXA on VIC on 8/22/03 at $1.84. Great call. ABXA is really a simple business but is difficult to understand in many respects. ABXA is basically a fee business that does not require ABXA to ever spend another dime of its capital to generate the income so the incremental ROIC can’t even be calculated…it’s off the charts! Hopefully I can shed some light on it and why now is a buying opportunity.

What is ABXA?

ABXA is an airline that was spun-off when DHL bought Airborne Express last year. ABXA owns or leases 115 aircraft. Until its spin-off, ABXA operated exclusively for the benefit of and as a subsidiary of Airborne. Given foreign ownership limitations on airlines, ABXA was spun-off to U.S. shareholders.

Basically ABXA provides the pilots and the planes and flies between cities each night carrying packages (primarily DHL packages for now) pursuant to an ACMI (aircraft, crew, maintenance and insurance) agreement. At the hubs, ABXA provides package sorting, warehousing, and line-haul logistics as well as airport, facilities and equipment maintenance services pursuant to the Hub Services agreement.

Here’s the interesting part. ABXA is reimbursed for 100% of its expenses by DHL and most costs are reimbursed on a cost-plus basis. ABXA’s costs are generally marked up 1.75% and recorded in revenues. DHL even reimburses ABXA for depreciation expenses (with a mark-up)—more about that later. Under the ACMI and Hub Services agreements, if certain cost and service goals are met, the mark-up increases from the base of 1.75% up to 3.35% and 3.85%, respectively. Certain costs, the most significant of which include fuel, rent, interest on a promissory note to DHL, ramp fees and landing fees are reimbursed dollar-for-dollar and receive no mark-up. How many other airlines do you know that have no fuel risk?

The ACMI agreement has an initial term of seven years; however, after August 15, 2004, DHL can reduce the air routes or remove ABXA aircraft from service (remember this for later). For any aircraft removed from service during the term of the ACMI agreement, ABXA can put the aircraft to DHL at the lesser of book value (BV) or FMV. If FMV is less than BV, any debt owed to DHL by ABXA is reduced by the amount that BV exceeds FMV. Basically, as long as there is debt owed by ABXA to DHL, the effective put price is BV.

The Hub Services agreement has an initial term of three years; however, after August 15, 2004, DHL has the option to terminate any or all of the agreement (again, remember this for later).

When I first looked at ABXA, I expected to see a very volatile earnings stream given that it’s an airline (I hate the airlines, lousy unions). The earnings stream has been amazingly consistent given the cost-plus arrangement.

Up until the time of the spin-off, Airborne was basically ABXA’s only customer. After the spin-off, ABXA is free to pursue new third-party business. Examples of third-party business are providing charter services (ABXA’s planes essentially fly the same routes every night and have day time capacity free) or carrying freight for third parties using ABXA’s excess cargo capacity (DHL is growing but there is a lot of room left on the planes for other cargo). Third party business is extremely high-margin as there are not a lot of incremental costs associated with the revenue. ABXA is basically just utilizing space that would otherwise go unutilized. The third party business could provide a significant amount of upside to ABXA’s earnings if it is successful at winning new business. In the short time since the spin-off, ABXA has had some success in this area including winning some USPS business.

What created the confusion and uncertainty?

As noted above, DHL can modify the ACMI agreement after August 15, 2004 and can completely terminate the Hub Services agreement after such time. DHL has publicly stated that it plans to integrate the former-DHL U.S. operations with Airborne. There is one other airline, Astar (privately-owned), that provides ACMI services to DHL and operates approximately 30 aircraft. As part of its integration plans, it is possible that DHL reduces the number of routes flown by ABXA and gives those routes to Astar. Of course it’s also possible that DHL takes routes away from Astar and gives them to ABXA. Under the Hub Services agreement, DHL can effectively cancel the agreement after August 15, 2004. DHL has not finalized its integration plans so nobody (not even DHL) knows what the outcome will be. So there is uncertainty which of course the market hates, which creates the confusion and the opportunity.

Although current management has been involved with ABXA for a long time, they have no experience running a public company and dealing with investors. Last Friday afternoon, ABXA filed its 10-Q and included new language that said the following:
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As a result of their merger, DHL and Airborne are in the process of integrating their combined product offerings, sales, marketing, administrative and operating resources. After August 15, 2004, Airborne may terminate specific ACMI aircraft, add to, delete or modify the air routes we operate under the ACMI agreement and add to, delete or modify services we provide under the Hub Services agreement. DHL has informed ABX that, in an effort to eliminate duplicate costs, it is developing plans to better integrate its U.S. operations (both air and ground). We anticipate that plans will be finalized later this year for implementation during late 2005 and early 2006 that will call for a reduction in the number of aircraft provided to Airborne by ABX under the ACMI agreement. At this time, it is uncertain to us how many ABX aircraft will eventually be removed from service and the timing of the reductions. Additionally, DHL is developing integration plans that would consolidate the operations of the Wilmington hub, which we operate, and the Northern Kentucky hub, which it operates. While the financial impact of any changes in ACMI or hub services that we provide will vary with the integration plans ultimately adopted by DHL, we currently expect that, when implemented, the integration plans will significantly affect our operations and may materially reduce our net earnings.

Pursuant to the terms of the ACMI agreement, we have certain rights to sell to Airborne the aircraft that are removed from service. We anticipate that the approximate number of aircraft to be removed from service and a final decision regarding the consolidation of the hub operations will be disclosed by DHL by the end 2004.
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This language was sufficient to create a panic and ABXA’s stock plummeted. Interestingly, DHL’s management team spoke at a Bear Stearns conference the day before last Friday and said much of the same thing. I spoke with management last Friday and they confirmed that they have not been given any specific plans by DHL so the language was intended to be cautionary in nature. ABXA management figured that since DHL has publicly discussed its plans to integrate DHL and Airborne, they should start including a strengthened version of this language (similar language has been in every other SEC filing and press release). I guess they don’t appreciate the shock value of statement such as “the integration plans will significantly affect our operations and may materially reduce our net earnings” and releasing such a statement on a Friday afternoon. The truth is they just don’t know at this point.

Why is ABXA mis-priced?

OK, so you are probably asking yourself, “If management doesn’t even know how much business it is going to lose, how would I ever figure that out and what does pgu103 think he knows?”. Here is what I know. It is possible to assume an absolute worst case scenario and still get a very compelling valuation. Also, I know that ABXA is a simple story to understand but very difficult to understand the true economics. Here’s my attempt to explain it.

First, it is important to look at ABXA in two pieces: (1) the ongoing business (the ACMI and Hub Services agreements) and (2) the cash flow run off from the existing assets. My valuation is based soley on DCF analysis. Really you have three components of value for ABXA: (1) the ACMI agreement, (2) the Hub Services agreement and (3) the cash flow from the existing assets. Then I look at the sum of these three parts.

Let me first explain the cash flow from the existing assets. As of 12/31/03, ABXA had PP&E with a net book value of $312 million. Over time, ABXA will be reimbursed fully for this BV through the depreciation reimbursements. One can construct a depreciation schedule to determine the timing of those reimbursements.

What about maintenance capex and aircraft replacement going forward you ask. The answer is it doesn’t matter. DHL reimburses ABXA for every capital expenditure through this depreciation reimbursement. Furthermore, DHL reimburses ABXA for interest expense related to the ACMI agreement. The net effect is that although ABXA may spend money for maintenance capex and new planes, DHL is the one really bearing the economic burden—they are funding the expenditure and the cost to finance such expenditure.

What’s special about the assets that existed on 12/31/03 (the “existing assets”) is that ABXA gets reimbursed over time for the remaining book value of the existing assets but doesn’t have to spend any of this money to replace the assets as the future capex is effectively funded by DHL. The cash flow from the existing assets is ABXA’s to keep forever after ABXA pays off its current debt.

Now is probably a good time to discuss ABXA’s current capital structure. ABXA has cash of $70 million, a note payable to DHL of $93 million and capital leases of $94 million. The DHL note has a 24 year term remaining. DHL reimburses ABXA for the interest expense on the DHL note so the note is essentially interest-free or zero-coupon note. The present value of the liability (assuming a 24 year-term and a 10% discount rate is $9.4 million). The capital leases relate to five 767s and DHL reimburses ABXA for the lease payments so I don’t view this as a true liability of ABXA. Bottom line is that ABXA has cash of $70 million and a note payable to DHL with an approximate present value of $9.4 million.

Based on a DCF analysis of the cash run-off from the existing assets, I calculate a present value of the cash flows of $160.4 million or $2.75/share using a 7% discount rate. I use a 7% discount rate because these are essentially contractual cash flows from DHL to ABXA. DHL is an A1/A credit so 7% seems appropriate to me. If you used an 8% discount rate, the PV would be $155.5 million or $2.67/share. At a 10% discount rate, the PV would be $146.5 million or $2.51/share See bottom of write-up for my basic depreciation assumptions.

So before we even get to the continuing operations from ACMI and Hub Services, we have a PV of $221 million ($70mm cash-$9.4mm PV of DHL note+$XX PV of cash run-off on existing assets) or $3.79. Oh, and this assigns no value to salvage value of the planes.

Discussion of Continuing Operations

As far as the continuing operations are concerned (this is really where all the uncertainty exists), three reasonable scenarios for each of ACMI and Hub Services exist.

For ACMI, here are my different scenarios and the resulting DCF values:

Base – continue to operate ACMI in perpetuity. EBIT equals 1Q04 annualized (with annual incentives factored in based on 1Q04 run rate) with 2.5% annual growth. Third party business EBIT equals 1Q04 annualized with 2.5% growth. We discount cash flows from years 1-10 and then use a 10X terminal value. Discount rate = 12%. NPV = $181.4 or $3.11/share.

Downside - continue to operate ACMI in perpetuity. EBIT equals 75% of base case EBIT (basically this assumes all overlapping routes go to Astar). Third party business EBIT equals base case. We discount cash flows from years 1-10 and then use a 10X terminal value. Discount rate = 12%. NPV = $149.1 million or $2.56/share.

Worst - continue to operate ACMI for seven years. EBIT equals 65% of base case EBIT (basically this assumes all overlapping routes go to Astar and then some). Third party business equals base case. We discount cash flows from years 1-7 and have no terminal value. Discount rate = 12%. NPV = $64.8 million or $1.11/share.

These values are just for the ACMI business.

For Hub Services, here are my different scenarios and the resulting DCF values:

Base – continue to operate Hub Services for seven years. EBIT equals 1Q04 annualized (with annual incentives factored in based on 1Q04 run rate) with 2.5% annual growth. We discount cash flows from years 1-7 and have no terminal value. Discount rate = 12%. NPV = $57.4 million or $.99/share

Downside – continue to operate Hub Services for two years. EBIT equals base case. We discount cash flows from years 1-2 and have no terminal value. Discount rate = 12%. NPV = $20.2 million or $.35/share

Worst - no value assigned to Hub Services at all

Summary of Continuing Operations Valuations

Base – Combined ACMI and Hub Services value of $238.8 million or $4.10/share

Downside – Combined ACMI and Hub Services value of $169.3 million or $2.90/share

Worst – Combined ACMI and Hub Services value of $64.8 million or $1.11/share

Liquidation Analysis

Assuming an A-bomb scenario and ABXA goes away tomorrow (this is ludicrous but let’s look at it anyway just for grins) and we put all the planes and equipment to DHL pursuant to the put agreement in place, I get a net value to equity holders of $273.4 million or $4.69/share. This assumes that ABXA could settle the DHL note for $9.4 million (which is the PV of the note at 10%). If the DHL note was settled for $50 million (based on negotiations), I get a value of $232.8 or $4.00/share. If the DHL note was settled for $93 million (i.e., face value), I get a value of $189.9 million or $3.26/share.

Summary

The panic is understandable, the current valuation is not. As the market begins to understand the economics of the business, ABXA should at least trade north of its worst case and liquidation values.

Here are the combined values per share of the cash flows from the remaining assets and the ongoing businesses:

BASE: PV of cash flows from remaining assets + base case on continuing operations = $7.89/share, or 120% upside from here.

PV of cash flow from existing assets+net cash = $3.79/share
PV of ACMI agreement = $3.11/share
PV of Hub Services agreement = $0.99/share
Total = $7.89/share

DOWNSIDE: PV of cash flows from remaining assets + downside case on continuing operations = $6.70/share, or 86% upside from here.

PV of cash flow from existing assets+net cash = $3.79/share
PV of ACMI agreement = $2.56/share
PV of Hub Services agreement = $0.35/share
Total = $6.70/share

WORST: PV of cash flows from remaining assets + base case on continuing operations = $4.90/share, or 36% upside from here.

PV of cash flow from existing assets+net cash = $3.79/share
PV of ACMI agreement = $1.11/share
PV of Hub Services agreement = $0.00/share
Total = $4.90/share

Depreciation Assumptions

Based on conversations with management, following are the approximate gross book values of the various assets:

17 DC-9s@$500K each = $8.5 million, depreciable life = 5 years, salvage value = $500K/plane

74 DC-9s @$900k each = $66.6 million, depreciable life = 7 years, salvage value = $500K/plane

19 owned 767s = $323 million, depreciable life = 15 years, salvage value = $1mm/plane

2 owned converted 767s = $42 million, depreciable life = 15 years salvage value = $1mm/plane

Other PP&E = $44.4 million, depreciable life = 5 years, salvage value = none

We allocated $6.6 million of the accumulated depreciation to the 74 DC-9s and the remainder pro-rata between the 19 767s and the PP&E. Then we rolled out the depreciation schedule until the salvage values were hit.

Catalyst

Better understanding of economics and valuation by market
Clarity on DHL integration
Quantification of true downside by market