Description

ABX Air has an extremely compelling valuation of ~5.9x 2007E after-tax, un-levered free cash flow and a clean balance sheet with zero net debt on a pro-forma basis at the end of 2006. Its main business has low downside risk and the company has major growth opportunities it will likely realize over the next 3-4 years. We believe ABXA has the potential to double in value over the next 12-24 months using conservative, realistic assumptions (a 12x multiple on 2007E FCF results in a $15+ stock price). The risk of capital impairment should be low given ABXA is trading at ~9.4x TTM after-tax, un-levered free cash flow. We view an investment in ABXA as an inexpensive, low-risk opportunity to benefit from the growth in global envelope/package shipments, particularly from China to the U.S. and vice versa. ABX Air also offers an embedded call option on the growth of its largest customer, DHL. DHL is 100% owned by Deutsche Post World Net, a German services and logistics company.

Pro-Forma Enterprise Value (Balance Sheet data as of 9/30/05)

Price (2/10/06)---------------------------------------------$7.58
Shares Outstanding------------------------------------------58.3 mm
Market Capitalization---------------------------------------$442 mm
*Add: PV of DHL Note (due 2028)-------------------------------$10 mm
*Add: PV of future non-DHL plane purchases (2006-2008)-------$177 mm
Less: Cash--------------------------------------------------($59 mm)
*Less: PV of NOLs (2006-2009)--------------------------------($66 mm)
**Total: Enterprise Value-------------------------------------$504 mm

TTM 2006E 2007E 2008E 2009E
Pre-tax (Reported) EPS: $0.65 $0.87 $0.96 $1.05 $1.09
P/E multiple: 11.7x 8.7x 7.9x 7.3x 6.9x
***After-tax FCF/share: $0.81 $1.08 $1.27 $1.42 $1.50
P/FCF multiple: 9.4x 7.0x 5.9x 5.3x 5.0x

* A 10% discount rate is used for the calculation of present values
** ABX Air’s pension is funded by DHL and thus is not factored into the calculation of EV.
*** D&A expense for FY2006 assumes 89.5 planes in use under the ACMI (Air Services) segment, resulting in about $40mm; management stated maintenance capital expenditures (used for calculating free cash flow since the growth capex spend is already factored into the EV) is $10-15mm per year—we use $15mm to calculate after-tax FCF; estimated Reported EPS/after-tax FCF does not have interest income since the cash reduces the EV, nor does it have interest expense since DHL reimburses ABX Air for it.

ABX Air has been written-up twice on VIC. This write-up will attempt to explain what is different now, why significant upside remains, and why the downside is still well protected. The company has changed considerably from May 2004 when pgu103 last wrote up ABX Air. There are certain new business opportunities ABX Air is trying to execute over the next 3-4 years that were not a focus from the onset of being spun-off from DHL in August 2003.


ABX has two main business units and various sub-units:

1. DHL Business (~80% of 2006E free cash flow)

a) ACMI (~45% of 2006E free cash flow): ABX Air currently flies 108 planes (DC 8s, DC 9s, and Boeing 767s) for DHL. ABX Air flies packages to and from its hub in Wilmington, OH to and from its regional hubs across the U.S. Since foreign entities are not legally permitted to own more than 25% of a U.S. airline, DHL’s parent Deutsche Post was forced to spin-out this business into ABX Air when DHL acquired Airborne Express in April 2003. ABX is compensated by DHL on a cost-plus agreement where ABX has no fuel risk since it is a complete pass through. ABX is also eligible for an incremental mark-up based on on-time efficiency.

b) Hub Services (~35% of 2006E free cash flow): ABX currently sorts DHL’s packages at its main hub in Wilmington, OH as well as at all of the regional hubs. Unlike the ACMI business, DHL could perform this function in-house. Not only has DHL continued to use ABX Air, DHL has decided to consolidate hubs by closing down its original one in Cincinnati and increase the volumes allocated to ABXA by almost 50% going forward. This is a huge vote of confidence in ABX’s value proposition. ABX is compensated by DHL on a cost-plus agreement and is eligible for an incentive fee based on on-time efficiency and cost/package. Upon our visit to the Wilmington hub, it was apparent that DHL is very committed to this facility evident by the increase in state-of-the-art infrastructure (~$250-300mm capital investment) for sorting with an emphasis on increasing international sorting capacity. This capacity will should come on-line throughout 2006 and could result in incremental volume increases not factored into our estimates.

2. Non-DHL Business (~20% of 2006E free cash flow)

a) Air Freight: This is the main growth opportunity for ABX that many have overlooked. Currently, ABX uses idle DC 8 and 9 planes as well as one Boeing 767 plane for this business, but has agreed to purchase 11 more used Boeing 767s from Delta over the next three years: 1 at the end of 2005, 4 in 2006, 3 in 2007 and 4 in 2008. An example of a customer according to management is a large produce grower that uses ABX Air to fly produce from Costa Rica to its regional hub in Miami, FL. ABX Air’s main competitive advantage in this business is that its cost to fly should be relatively low compared to its competition. First, as long as no more than 10% of its revenues (not expected) are derived from non-DHL customers, DHL reimburses ABX for all of its SG&A. Second, it has the existing network of regional hubs to fly to and from for DHL. Third, it has the in-house maintenance capability that allows for lower costs and less down time for flying. Fourth, the Boeing 737 is among the most fuel efficient planes, which saves its customers money given current oil prices. The ability to leverage existing overhead will allow for very high incremental margins in the non-DHL business.

b) Maintenance of planes for other airlines: Delta and Northwest are two companies that have outsourced maintenance of some of its DC planes to ABX Air. Unfortunately, just after ABX Air began serving these two carriers, both filed for chapter 11 resulting in a charge against accounts receivable of $0.6mm in Q3’05.

c) Hub Services: ABX performs sort operations for the U.S. Postal Service at one location. Management stated USPS has another 13-17 facilities with outsourced sort operations and has asked ABX to bid on future contracts regarding these facilities since it is extremely pleased with the job it has done. This combined with the fact that DHL chooses not to do its hub services in-house leads us to believe that ABX Air is a very reliable, efficient operator.


Reasons Why ABXA is Undervalued

1. ABXA is an orphan stock with no direct public comparables. Very few traditional money managers own ABXA. Oppenheimer’s special situation group is the only sell-side coverage and has a Buy rating and price target of $11.50.

2. The story is extremely confusing. The company has five different business units with various moving parts within certain units.

a) For example, the ACMI business went from flying 115 planes to currently 108 planes and will likely end up flying 89-90 planes due to the consolidation of hubs.

b) In addition, the DHL Hub Services business has had some difficulty consolidating the business into one hub at Wilmington, which resulted in higher cost/package sorted as well as a drop in on-time service levels from 97% to as low as 68% over the span of the six-week consolidation period. However, this was temporary as on-time efficiency came back up in November, closer to previous levels, which means that margins should get back to previous levels as it recoups the base and incremental mark-up fees it realized in the past. Given that volumes/revenues have increased by almost 50% this should ultimately result in a nice boost to earnings in 2006. This will be important in changing investor perception.

c) ABX has committed to invest approximately $191mm in buying and converting 11 planes from Delta in order to increase its air freight business. There is some skepticism that this is a poor investment decision given that it is not allowed to buy-back stock and/or pay more than $1mm out in dividends until it pays off a ~$92mm note (that bears no interest) owed to DHL due in 2028. However, we are confident ABX will earn a very strong return on capital from these plane purchases.

3. Management recently began holding public conference calls, which occurred for the first time regarding Q2’05 operations.

4. Management does not give EPS guidance. A main reason for this likely stems from the fact that only this past year did ABX Air institute a stock compensation program. Given the likely major ramp in EPS, management has minimal incentive to have its stock appreciate immediately. At the same time, it is able to fund all of its growth capital expenditures from free cash flow.

5. Management is difficult to reach in order to ask questions. This likely stems from the aforementioned lack of incentives. Phone calls are typically not returned promptly and questions are often answered with a referral to the 10-K and 10-Q. This prompted us to visit the company in Wilmington, OH. We were finally able to get our questions answered and the tour as well as the meeting was extremely helpful in order to better understand the various businesses and future prospects of each. In addition, the former CFO who held the title for less than 1.5 years was hired as an outsider and was forced to resign due to unknown and alleged improper conduct at his previous company. The new CFO hired in December 2004, Quint Turner, was recruited from within the company having been there since 1988. The CEO likely feels he can trust him and probably has told him to err on the side of caution when communicating with the investor community.

6. ABX had a sub-par Q3’05 earnings report given the revenue growth in DHL Hub Services and its non-DHL businesses. Revenues tied to the DHL business increased 22.4% QoQ—1.1% growth at ACMI and 46.5% growth at hub services. Due to the hub services integration cost and service issues in Q3’05, segment margins declined and thus DHL related earnings only increased by 10.0%. Also, non-DHL revenues grew 31.9% QoQ, but pre-tax earnings declined by 36.9% QoQ. There was a $0.6mm bad debt charge due to Northwest’s and Delta’s chapter 11 filings and $0.3mm for additional compensation expense that was not available in Q3’04. Even after adding back the $0.9mm, non-DHL pre-tax earnings would have only increased by about 2.6%. The main reason is due to one Boeing 767 in service for the air freight business, which has a sizeable D&A expense charged to that segment. On an EBITDA - maintenance capex basis, QoQ growth for this business would be in-line with revenue growth.

7. DHL cut back the base mark-up and increased the incremental mark-up percentage in Q3 and Q4 of 2005 for ABX—in essence shifting more of the earnings risk/variability on to ABX Air. This is due to the hub consolidation, which hurt on-time efficiency and cost/package. ABX had to hire and train a large number of people in a short period of time. However, the economics of the base and incremental mark-up will revert back in 2006 to the way it was before Q3’05 prior to the hub consolidation. Investors may be worried that DHL might change the economics going forward, but this seems highly unlikely.

8. ABX Air reports earnings with zero expense for income taxes. This is due to the massive write-down stemming from major declines in ABX’s aircraft values after 9/11. Investors do not know exactly when ABX will be a cash tax payer; management claims a minimum of four more years of not paying taxes—we assume four more years.

9. Customer concentration risk is a major issue for many investors. On a TTM basis, non-DHL customers represented about 11% of free cash flow. Based on the growth in its air freight segment, its business mix will change dramatically and ultimately have about 39% of its FCF coming from non-DHL customers in 2009. Once the market realizes ABX has a more diversified earnings stream, its P/E multiple is likely to expand.


Reasons Why ABXA Has Limited Downside

Regarding the ACMI (air services) business, DHL has no choice but to outsource this function. ABX Air has a long track record of successfully operating this business. DHL uses two operators for its ACMI business—ABX Air and Astar. Both companies had its fleet of planes reduced when DHL eliminated the Cincinnati hub and consolidated operations into Wilmington. There is little in the way of cost saving incentives to use another operator besides these two companies or change the allocation of business between them assuming service quality remains status quo.

With respect to DHL Hub Services, DHL could take this business in-house, but it chooses to outsource it to ABX and give the Company more business. At the same time the USPS has outsourced a facility to ABX for hub services and wants ABX to bid on future contracts for other facilities. This likely indicates that ABX Air has expertise in managing this business.

More importantly, most investors do not understand the long-term strategy of DHL’s owner Deutsche Post and how ABX Air fits within it. Deutsche Post, a $30 billion+ German company privatized by the government in November 2000, has decided that its long-term future growth strategy will focus on building a dominant, world-wide shipping network. Its subsidiary, DHL, acquired Airborne Express in April 2003 for $1.05 billion. In December 2005, DHL acquired UK based Exel, which specializes in air freight and contract logistics for $6.7 billion. These acquisitions were not difficult to finance given Deutsche Post’s underleveraged balance sheet and 2005E EBITDA of $6.4 billion. The $250-300mm estimated investment DHL has made in the Wilmington, OH hub is peanuts compared to these acquisitions and current U.S. losses. To put this in perspective, the $40-50mm in free cash flow ABX Air will generate from the DHL related business is only 1% of Deutsche Post’s 2005E free cash flow. DHL is most interested in making sure ABX Air provides it with low cost, on-time service, which will help DHL gain more customers and reduce U.S. losses.

DHL’s U.S. operations are expected to lose about $300mm in 2006 after the hub consolidation. The main reason is that DHL lacks scale in the U.S. in terms of package/envelope volumes. Some may fear that DHL may shut down the U.S. operations at some point given the losses, but the odds are extremely low, which is why an investment in ABX Air will likely be profitable. Even though DHL ranks third in market share in the U.S. behind FedEx and UPS, the U.S. is an extremely important strategic country DHL must serve in breadth. DHL may have the least amount of market share in the U.S., but it has the most market share in Europe, China and across Asia. Many of DHL’s customers are global and there is more package volumes going from the U.S. to Asia and vice versa. Even though DHL may lose a little money in the U.S. post hub and fleet consolidation, a major global account is likely very profitable. If a large global customer has U.S. shipping needs, DHL must be able to provide outstanding service in the U.S. or else their competitive advantage could deteriorate.


Risks: The biggest, most realistic risk to the investment thesis is that DHL loses market share world-wide and thus has a need to fly fewer planes and sort fewer packages and envelopes in the U.S. However, these possible negative changes would likely happen gradually and not affect ABX’s business too dramatically, too quickly. The other realistic risk is that the decision to purchase 11 used 737 planes for $191mm over the next three years proves to be a poor one if ABX cannot get the anticipated levels of business at the price points it assumes it can. Another risk is that for 2008 and beyond DHL could reduce the base mark-up and increase the incremental mark-up as it did for Q3 and Q4 of 2005, which only negatively affects earnings if service and efficiency levels by ABX are poor. The other risks with low odds of occurring is DHL takes hub services in-house, ABX loses existing USPS contract, Northwest/Delta take back outsourced aircraft maintenance business and/or Deutsche Post gives up on the U.S. all together due to sustained losses.

The 26 planes assumed to be removed are the most heavily depreciated ones in the fleet with a total of $2.7mm of D&A expense, on which ABX receives a mark-up; ABX Air will be adding at least one Boeing 767 plane (that has much higher D&A expense mark-up) dedicated to DHL in mid-2006, which helps off-set the mark-up lost on those 26 planes

Even if none of the growth opportunities we discussed materialize, the stock is still likely to be undervalued. On the ACMI segment we assume that all 26 of the planes DHL said it would take out of operations occurs on January 1, 2006—as of November 11, 2005 it had only removed 7. Regarding DHL Hub Services we assume minimal increases in volumes after 2006 from what was realized in Q3’05; however we do assume margins revert back to what it realized in 2004 before the hub consolidation. In addition, we do not assume ABX gets any more hub services business from the USPS nor do we assume it grows its third-party aircraft maintenance operations. For the cargo business growth, we used the average number of planes in service during the year and the mid-point of management’s economic estimates—2,250 block hours per plane flown, $3,300/hour in revenue, 50% EBITDA margins, $2.5mm in D&A/plane/year, $0.9mm in maintenance capex/plane/year—this results in a 13.5% after-tax ROIC. So the question is what should the market pay for a company that will likely have compounded earnings growth of around 15% for the next 3-4 years with low downside risk to its core business and a clean balance sheet with practically no leverage? VIC members can decide for themselves, but we believe it is far more than 5.9x FY2007 after-tax FCF.

2004 TTM 2006E 2007E 2008E 2009E Avg. # of ACMI planes in use: 115.0 113.3 89.5 90.0 90.0 90.0
ACMI revenues ($mm): 483.1 490.0 413.0 423.8 432.1 440.4
ACMI after-tax FCF ($mm): 25.0 27.8 28.1 28.8 29.2 29.5
Hub Services YoY volume growth (%): ---- 29.4 13.2 2.0 2.0 2.0
Hub Services revenues ($mm): 447.8 579.5 656.2 669.3 682.5 695.6
Hub Services after-tax FCF ($mm): 13.0 14.1 21.7 22.6 23.4 24.1
Avg. # of non-DHL 767 planes in use: 0.0 0.1 2.5 6.5 9.5 11.0
Non-DHL based revenues ($mm): 26.7 35.1 53.6 83.3 105.6 116.8
Non-DHL based after-tax FCF ($mm): 5.4 5.2 13.1 23.0 30.4 34.1
Total after-tax FCF ($mm): 43.4 47.2 62.8 74.3 83.0 87.7

Catalyst

The hub consolidation has largely been completed and the air fleet rationalization should conclude in the beginning of 2006. The major integration issues are now behind ABX Air. On-time and cost efficiency should come back to pre-consolidation levels in conjunction with the compensation structure reverting back to the normal, post-spin formula for 2006 and beyond. The hub services segment has a run-rate QoQ revenue growth of 46.5% resulting from the hub consolidation that it only realized in Q3'05 and should continue to show the same year-over-year increases in Q4'05 through Q2'06. Margins for the segment should return back to pre-integration levels. Based on the growth in its non-DHL air freight segment, its business mix will change dramatically and ultimately have about 39% of its FCF coming from non-DHL customers in 2009. Once the market realizes ABX has a more diversified, less customer concentrated earnings stream, its P/E multiple is likely to expand.