Description

*Note - I have written this in narrative form to (hopefully) make it more entertaining. Thanks!

Cargojet: Pie in the Sky

“Cargojet Announces Strategic Agreement with Amazon to Provide Air-Transportation Services,” read the headline to Cargojet’s August 23, 2019 press release. “Cargojet expects the agreement to generate additional revenue growth and be meaningfully accretive to Cargojet’s earnings and cash flows over time,” concludes the opening paragraph of the announcement. Sounds fantastic! Contingent on Amazon doing a certain level of business with Cargojet over the next seven and a half years, Amazon would receive warrants to purchase 15% of the airline. The company hosted a call with analysts to review the exciting news that morning:

Analyst: “My first one relates to pricing on the incremental volumes. Did you have to give up on price as I know your pricing is sort of based on the amount of volume each customer has?”

Ajay Virmani, CEO: “This agreement is strictly strategic and long term off a relationship and not a commercial agreement. So the commercial agreement is already in place. And this is not an area that we dealt with while negotiating this. We already have a customer agreement which deals with the commercial aspects that’s based in pricing. That remains in place. That has been in place for a while and there’s no changes to that.”

Later in the call, another analyst probed further:

Analyst: “So I’m just trying to understand what we should be thinking about in terms of what’s incremental to the existing growth expectations provided. Is there any way you can help us think about that?”

John Kim, CFO: “I don’t think this necessarily changes how we view growth and how we plan for our fleet as Ajay mentioned. But it certainly gives us more confidence that we will continue to be a partner of Amazon and delivering their services in Canada. But in terms of what does this – does this change our outlook for what we expect the growth of e-commerce to be in the next few years? I don’t think that really changes that picture.”

Confusing, huh? Management’s comments on the call seem to suggest that the fantastic sounding expectations for additional revenue growth and accretion to the bottom-line were, in fact, fantastical. What should investors make of this strategic agreement between Cargojet and Amazon? Why are the investment prospects for Cargojet shares so tied to the concept of reflexivity? And what does a best-selling Canadian rap artist have to do with any of this?

***

Cargojet was founded in 2002 by CEO Ajay Virmani. At the core of the business is the overnight air cargo network servicing 12 Canadian cities nightly. The company has gradually consolidated the domestic air cargo market to the point where it now has something approaching 90% market share. Along the way, Cargojet has expanded and up-gauged its fleet of aircraft now comprised of 8 757s and 15 767s.

The domestic network is somewhat protected from competition by a regulatory quirk known as cabotage. Under this rule, foreign airlines are not permitted to fly point-to-point within Canada. There should also be some economies of scale in this business – the more volume on the network, the larger and more cost-effective the planes that can be flown and the fuller they should be. It seems possible at least that Cargojet, as the largest player by far, would possess competitive advantage.

However, the history of financial returns at the company does not suggest the existence of any competitive advantage. After-tax returns on invested capital consistently land in the mid-single-digit range. Something is holding returns in-check despite Cargojet’s dominant market share and the answer can be found by digging deeper into the Amazon agreement.

***

If the Amazon agreement didn’t bring additional revenue to Cargojet, then why sign it? We get the answer towards the end of the call:

Analyst: “…how did this come together? And why is this the right time to kind of engage with Amazon more strategically?”

Jamie Porteous, EVP & CCO: “…the other risk that we’ve had is from an e-commerce standpoint, Amazon is a growing customer and was there a risk for them to go away. This was a strategic arrangement to ensure that they were partnered with Cargojet going forward and not looking at potentially another operator to operate the network for them.”

So Cargojet gave Amazon warrants for 15% of the stock to deter the online retailer from moving to a competitor. You’re excused if that’s not the impression you received from the press release. Let’s dig a bit deeper. The warrants to Amazon were issued in two tranches. The first tranche, for 10% of the company, vests gradually over six and a half years with a strike of $91.78 and contingent on hitting $400 million of revenue. The second tranche, for 5%, would vest over seven and a half years with a strike set at the second anniversary of the warrant based on trading prices for the stock at that time and is contingent on an additional $200 million of revenue.

At the time of issue, the two tranches of warrants were valued by Cargojet at $52 million and $21 million respectively. On $400 million of revenue, the value of the first tranche equates to an effective 13% discount to Amazon for shipping on Cargojet while for the second tranche it’s 10%. Cargojet’s consolidated operating margin in 2019 was 11.7%. Rather than simply provide Amazon with a 10-13% rate discount and hammer reported operating profits, Cargojet effectively moved the cost of this retention discount into the share count.

Importantly, Amazon has no obligation to ship any volumes with Cargojet under this agreement. But they will forfeit the warrants if they don’t hit the revenue thresholds. If the warrants lose value because the share price declines, Amazon would seem to have less incentive to move volumes with Cargojet. This introduced an interesting piece of “reflexivity” in the business – what happens with the share price may actually impact the business fundamentals. More on this later.

So why are returns on capital so pedestrian despite a dominant market share and regulatory protection for the business? I suspect it’s a function of customer power. Cargojet’s top three customers accounted for 60% of revenue in 2019. Any one of these customers likely has sufficient volume to seed the formation of a viable competitor and so Cargojet must bend over backwards to retain them. Outside of the core overnight network, Cargojet has been expanding its international presence. That is, flying on a scheduled or ad-hoc basis to other countries. This business is even more competitive than the overnight domestic network as it’s subject to competition from cargo and passenger airlines globally. International expansion will not boost return on capital.

For a business with such middling returns, the market is valuing Cargojet very generously. The stock trades at about 12 times the tangible book value of $250 million or about 4 times enterprise value to invested capital. We could recreate Cargojet’s physical infrastructure by cutting an equity cheque for a few hundred million – 90% less than the current market value. The stock should only trade at a material premium to tangible book value if there are intangibles – scale economies, customer switching costs – that will permit the generation of attractive returns on capital for years to come. There is nothing in the track record of the business to suggest that such intangibles exist.

***

The “reflexivity” at Cargojet extends beyond the Amazon warrants. The company has $300 million of outstanding hybrid debentures maturing from 2024 – 2026. They can elect to repay these either with cash or with shares issued at a 5% discount to the market price at the time of maturity.

Let’s assume the debentures are redeemed at the current share price of $192. This would drive the issuance of 1.65 million shares plus an additional 200,000 warrants (the Amazon warrants have an anti-dilution provision). Total dilution to existing shareholders using only the first tranche of the Amazon warrants and assuming a cashless exercise would be 14%. In this scenario, the first tranche of the Amazon warrants are worth about $180 million or 45% of the $400 million revenue minimum. Cargojet can rest assured that Amazon will be sending them $400 million of business.

But the high share price also helps to back-fill book value. At current levels, tangible book value per share would almost double to about $30 if the debentures were repaid in stock. Perhaps the most intelligent course of action for the company at this time would be to issue equity, as much as the market could absorb. With the shares where they are, it’s as if Cargojet has an alchemy business on the side where they can turn dimes into dollars. The company could repay all of its debt and finance leases with a $300 million raise, a mere 10% of the market cap, and double tangible book value per share.

Let’s instead assume that the share price plummets to tangible book value of about $15 per share, a not unreasonable estimate for the fair value of the stock. At that price not only would the debenture redemption with stock be far more painful but Amazon’s warrants would be worthless, removing Amazon’s added incentive to ship via Cargojet. At that price, dilution from the debentures would be about 55% – the share count would more than double. Going further, without an equity raise, it appears quite likely that Cargojet will in fact be forced to redeem the debentures with shares. The company has $300 million of debt and finance leases with the obligation to purchase at least another five 767s off-lease over the next few years against $48 million of 2019 “adjusted free cash flow”. It will be a stretch to finance the redemption of $300 million of debentures out of operating cash flow and so the value of the company depends critically on the share price. I hope your version of Excel can handle circular references!

***

Cargojet stock has had an epic run from the 2005 IPO price of $10. For more than a decade, management has been able to hold out the promise of additional growth to distract investors from the poor returns on capital and minimal free cash flow generation. With the Canadian air cargo market now essentially consolidated, this game is over. This is not a great business. The promise was never anything more than a pie in the sky.

It looked like we were in the ninth inning of the ballgame heading into this year. A few weeks after the Amazon press release, CEO Ajay Virmani sold over 40% of his shares in the company for proceeds of $68 million. In December 2019 and March 2020, Chairman Jim Crane sold virtually his entire holdings of Cargojet for about $10 million. Then covid took us into extra innings. Aircraft were chartered to fly in emergency supplies from Asia. Less belly space was available for international air cargo as passenger planes were no longer flying. So Cargojet crushed it in Q2. But this is largely temporary. The demand for emergency flights is normalizing. And while the disruption to international travel may linger, this piece of Cargojet’s business will eventually return to earth.

Cargojet’s stock is very overvalued. Like gravity, the fundamentals will eventually win-out and bring the shares down to a more reasonable level. In the meantime, the high share price offers management a compelling opportunity to back-fill some value and to clean-up the balance sheet. They would do well to seize it.

Oh, and about Drake. On May 10, 2019 Cargojet announced, via press release, a partnership with the multi-award winning artist. The purpose of said partnership was left ambiguous in the release. A few weeks later, in early June, it surfaced through media reports that Cargojet had given Drake a 767 aircraft for his personal use, apparently free of charge.  

Catalyst

Covid tailwind has peaked. 

Limited growth left in the domestic market.