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We have been following FTAI since 2013, before the company went public in 2015. Looking back over the last five years, we believe today is the most attractive risk/reward setup we've had. While the stock has had a nice run YTD, it is still below its IPO price, and we see a 43% IRR out to 2019, excluding its 8% dividend yield. Cash flow is about to significantly inflect and most investors haven't put the disparate pieces together.

lpartners wrote up FTAI early last year, but an update is justified given the new dynamics. The write-up is topical, given the recent VIC write-ups on Air Lease and Aercap. We believe we have a differentiated view on the industry. FTAI is an overlooked small-cap industrial focusing on an aviation strategy, but with lower risk, higher returns, and in a more differentiated, less crowded market.

Fortress Transportation & Infrastructure Investors LLC (NYSE: FTAI) Long Thesis

Fortress Transportation (FTAI) was formed in February 2014 and went public in May 2015 at $17.00 per share. FTAI is externally managed by Fortress Investment Group, a global investment management firm with approximately $70B of assets under management. FTAI is led by Joe Adams, who joined Fortress in 1994. Adams previously headed the Transportation industry group at DLJ and built up Aircastle (NYSE: AYR), an aircraft lessor, before selling Fortress’ stake to Ontario Teachers’ in 2012.

FTAI owns and acquires high-quality infrastructure and equipment across four primary sectors: aviation, energy, intermodal transport, and rail. FTAI consists of two strategic business units – Infrastructure and Equipment Leasing.

FTAI’s Infrastructure business acquires long-lived assets that are essential for the transportation of goods. FTAI targets operating businesses with strong margins, high barriers to entry, and stable cash flows, backed by take-or-pay contracts. The Equipment Leasing business primarily focuses in aviation by acquiring and leasing out older aircrafts and jet engines. Due to its differentiated strategy within aviation, FTAI’s leases provide for high cash-on-cash yields and represent recurring, long-term contractual cash flows with low volatility.  

Exhibit 1: FTAI Overview

         Source: FTAI 1Q17 Earnings Supplement

Investment Thesis Summary

1. Short-term opportunity created by confusion re: dividend and the cash flow opportunity within Aviation.

FTAI was a “busted” IPO, which traded to a 13% dividend yield in mid-2016. The primary fear from the investment community was that the dividend would be cut. Even as recent as this past quarter (1Q17), the dividend was still not covered by its run-rate cash flow. However, this shortfall has been improving every quarter and we see a clear runway for it to be 1.7 – 1.8x covered on a run-rate basis by YE2017, which will facilitate yield compression.

As the dividend coverage substantially improves and eclipses 2:1, and as dry powder is deployed, we expect FTAI to begin a consistent program of dividend increases starting sometime around 1Q18. At a fully covered dividend, we see potential yield compression from 8.3% today, to 6.5%, which implies a ~$23 stock in 2018 (+43% return) and ~$30 stock in 2019 (+90% return). The risk-reward is asymmetric with a Bear/Base/Bull return profile out to YE18 of -11%, +26%, and +74%, respectively. As free cash flow inflects in 2018-2019, the return profile improves further if one looks out an additional 12 months to 2019.

2.     Jefferson will transform from cash drag to $100M+ in EBITDA over next three years.

FTAI is often passed over by investors in infrastructure and industrials, as it’s an early-stage portfolio. It does not “screen” well for hard-asset investors, as the dividend is not yet currently covered. In addition, there are several moving pieces, most notably its Jefferson port terminal is shifting from being a cash drag to a material contributor.    

We see a three-year pathway for Jefferson to transform from being a negative contributor to producing $100M+ in adjusted EBITDA by signing additional contracts related to: 1) liquids storage, 2) moving refined products to Mexico, 3) moving Western Canadian crude to the U.S. Gulf via rail, and 4) ethanol. Longer-term optionality exists within FTAI’s other port and logistics assets. FTAI currently trades at an 8.3% dividend yield and 1.2x Price/Book, versus more highly levered peers such as Brookfield Infrastructure Partners (NYSE: BIP), which trades at 4.3% and 2.1x, and Macquarie Infrastructure (NYSE: MIC), which trades at 6.9% and 2.2x, respectively.

1. Short-term opportunity created by confusion re: dividend and the cash flow opportunity within Aviation

The biggest macro driver for this segment is passenger traffic growth globally, as this fuels demand for aircrafts. Since 1980, passenger traffic growth, defined as revenue passenger miles flown, has consistently grown 5% per annum, but this has increased recently driven by the emerging middle class populations in India, China, and Africa. This year global passenger traffic has accelerated to ~8% year-over-year growth, with higher low-double-digit passenger growth in the Middle East, Asia Pacific, and Africa, all markets that FTAI focus on.

                                                                Exhibit 2: Global Passenger Traffic since 1980

          Source: Aercap 2017 Investor Day presentation; ICAO and IATA data

The macro backdrop is currently very favorable. Low oil prices lead to increased traffic levels while reducing the advantage of newer, more fuel-efficient engines. In addition, growth in e-commerce generates demand for air cargo which can extend aircraft life to beyond 25 years. This is an important element of FTAI’s aviation strategy.

Big orders tend to dominate aviation headlines, as do high-profile launches of new airplane models. FTAI’s aviation strategy is different from AerCap (NYSE: AER), Air Lease (NYSE: AL), and other traditional scale players. These peers historically earn a ~3% unlevered return on their leased planes, a low double-digit return on equity, and trade on average at 1.0x book value. With a focus on used mid-life aircrafts, FTAI has achieved 21-25% unlevered cash-on-cash returns over the current cycle, which we expect to continue for the foreseeable future, absent a sustained recession. FTAI targets 18-25% unlevered returns on the leasing of its planes and 25-30% unlevered returns on the leasing of its jet engines, which on a blended basis gets to the 21-25% unlevered returns in aviation FTAI has historically achieved.

FTAI’s larger competitors focus on newer equipment, which is very competitive. Prices are high, as capital chases these opportunities, depressing yields. It is only possible for peers following this strategy to achieve double-digit ROEs by applying leverage. FTAI’s strategy is to buy aircrafts that are on average 13-15 years old. Increasingly, FTAI is taking the airplane and selling the airframe to the lessee (which is often sold for 40-50% of the purchase price), while leasing out the engine until it needs to be overhauled. FTAI cannot deploy capital as quickly as its larger peers, but its strategy offers economics comparable to leasing an entire aircraft, but with lower risk, higher returns, and in a more differentiated, less crowded market. FTAI receives ~$60,000 in monthly rent per jet engine, which makes this strategy simply not scalable for larger peers such as Aercap managing a $40B asset portfolio.

In spite of the positive macro backdrop, there are industry concerns about OEM production levels, overcapacity, and new entrants chasing deal flow in newer planes. As such, airline lessors have under-performed since FTAI’s IPO in May 2014. While the S&P500 is up 14% and the S&P500 Industrials is up 19%, FTAI and its lessor peers are down ranging from (4%) to (14%). This is one reason why the opportunity in FTAI exists.

                                                             Exhibit 4: Aviation Lessor Stock Performance

     
   

FTAI targets 737-700s/800s, 767s, and 757s, which can be converted to freighter aircraft, as e-commerce fuels new demand. These planes as reconstituted will be flying for up to thirty more years. These four markets comprise approximately 7,000 aircrafts flying around the world. Each of these planes possess two engines, which represents a $50B market opportunity in engines alone. FTAI has runway over the next decade to continue scaling this business from a relatively low starting point. As the CEO highlighted on FTAI’s 1Q17 call:

“If there is a deal anywhere in the world for 12 to 20-year-old commercial aircraft, we're almost always on a shortlist and are often the first call. The yield compression which is manifesting itself in the more standard new aircraft leasing market is not being seen in our market.”

We believe FTAI can scale its aviation portfolio from ~$800M today (this includes $220M in its pipeline as of 1Q17) to $2B over time without seeing any diminution in returns.

Fortress is starting to acquire a brand in the space, as its team, capital structure, and focus create a unique narrative and sustainable competitive advantage. Castlelake and Apollo Aviation (no association with Apollo Management) are its two closest competitors. Both play in mid-life aircrafts, but they do very little business in engines and run levered portfolios.

When you have 1,000 airplanes, an airline or lessor does not want to worry about a 15-year old airplane. New airplanes have fewer complexities so they would rather sell an older plane to a group like FTAI and move on. The industry often defines a mid-life aircraft as one entering its second lease, which typically occurs after an initial lease term of 8-12 years. Second leases can be renewals by the existing operator, but mid-life aircraft also are sought to meet short-term capacity requirements or are converted to freighters. The owner (FTAI) will decide whether it is worth more to part out the plane or lease it again. Much of this decision hangs on the condition of its engines, which represents more than 80% of the total residual value of these mid-life aircrafts. The value of older aircrafts is linked to its parts and in particular, its engine components.

In-service airline engines need to come off the fleet for maintenance and refurbishment every four to five years and this is where FTAI steps in by providing a replacement. FTAI charges rent and maintenance reserves when it leases out equipment and the lack of transparency on maintenance reserves for these type of older assets helps drive returns. If an aircraft meets its lease-return conditions, the lessor (FTAI) is usually entitled to any money remaining in the maintenance reserves.

FTAI can achieve 20%+ unlevered returns on its aviation portfolio, while historically running its engine portfolio at less than a 60% utilization rate. FTAI intentionally maintains its engine utilization at such levels in order to have enough equipment laying around for less price sensitive lessees or to make an opportunistic sale or module swap. The average lease term on engines is 10 months versus 32 months for its aircrafts, which historically have a utilization rate north of 90%.

FTAI occasionally finds it more profitable to sell the airframe or engine than to lease it. Since going public, FTAI has sold over twenty engines at a combined 1.2x multiple of book value. When FTAI purchases aircrafts, the assets typically have either short-term leases attached or none at all, which makes it difficult for competitors to finance these type of deals. This lowers asking prices and helps prevent excess capital from flowing in, while allowing FTAI to structure its own longer-term leases. Competitors prefer assets with long-term leases, as they will place them in securitizations. For example, it costs competitors $45 - $50M to purchase a new aircraft, while earning ~$300,000 in rent on a monthly lease. This equates to a lease rate factor of less than 0.7% ($300,000 monthly rent divided by $45M purchase price), or a ~8.0% annual yield. Once you subtract aircraft depreciation of ~3% and a cost of debt of ~3%, an investor is achieving an unlevered return close to 2.0%.

As of 1Q17, FTAI’s aviation portfolio represented $567M of average book value, with aircrafts 69% and engines 31% of the total. Using zero debt, FTAI has doubled the invested capital in its aviation portfolio from 2Q15 to 1Q17, while increasing the portfolio’s cash-on-cash returns during this period.

Exhibit 5: Fortress Aviation Leasing Historical Returns

Note: Average Book Equity is determined by taking the average total equity excluding non‐controlling interest
for the two most recently completed periods. Source: Fortress 1Q17 Earnings Supplement.

Aviation’s 1Q17 unlevered return of 21.3%, while enviable to most, were actually temporarily “depressed” by FTAI’s standards. Results should improve in 2H17 to its targeted 23-25% unlevered return profile, as five aircraft that were purchased from Air China in 1Q17 were off-lease and will be leased by the end of 2Q17.

Recently, FTAI has been able to extend the duration of its lease book without compromising its return profile, an emerging positive dynamic. For example, in 4Q16, FTAI finalized the purchase of 11 aircrafts from Air China (eight 737-800s and three A320s). Evidenced by the market demand for these aircrafts, FTAI was able to negotiate six-year leases covering nine aircrafts, with six different airlines. The duration of these leases are more than 2x the weighted average term of its current aircraft portfolio. Once this asset portfolio is fully leased in 2Q18, FTAI’s average remaining lease term will lengthen from 32 months today to ~46 months.

In 2008/2009, rents dropped on some older plane models between 10 to 20%. However, there are several mitigants, which made the actual effect much less severe. First, not all leases expire at the same time. FTAI also manages an unlevered portfolio. Third, these aviation assets operate in a global marketplace, all moving in different directions with varying demand curves. As noted, FTAI has recently been successful in lengthening the duration on its leases, which reduces short-term cyclicality. Fifth, its jet engine portfolio has counter-cyclical characteristics.

When times are tough, many airlines do not want to spend several million dollars overhauling each engine, which they have to do every four or five years. They want to conserve capital. Hence, they are compelled to lease replacement engines in the market, driving up demand and lease rates. In good times, airlines need lessors for additional capacity, and, in bad times, airlines need lessor balance sheets. The big picture is that lessors have performed well through aviation cycles because of the resiliency of passenger traffic.

Even though many of its customers are international airlines, FTAI receives payment in U.S. dollars and therefore does not take currency risk. If lessees get into financial difficulty, which does happen often in the airline business, FTAI has maintenance reserves (which are typically equal to the monthly lease amount), security deposits, and other structured enhancements that protect them as a lender. In the last four years, the combined bad debt expense on its aviation portfolio was less than $150,000.

Exhibit 6: Uncollected Receivables – Aviation

                                             Source: FTAI Annual Report


Longer-term, FTAI has opportunities to widen the moat around its leasing business while pursuing new and differentiated growth avenues. FTAI is seeking additional partnerships with other maintenance and repair (MRO) vendors that they believe will lower costs. An additional benefit is that MRO partners re-market FTAI’s leased engine inventory to their own customers – as these relationships grow, FTAI’s potential leasing channels increase.

Also, with little notoriety, FTAI established a JV in 4Q17 with a leading aftermarket maintenance solutions provider for advanced engine repairs. The JV will service the large and growing pool of 737 and A320 aftermarket engines, which opens up a whole new market opportunity outside of FTAI’s traditional bread-and-butter leasing business. If this is a business that FTAI ultimately pursues, it will become a larger opportunity over time, as Boeing and Aerbus, respectively, recently debuted their new Boeing 737 MAX and A320new programs. Production of their legacy 737 and A320 models have ceased as these new programs ramp.

Excluding these longer-term opportunities, we see the aviation business ramping to a position in 4Q17 where by itself it can sustain the dividend with 1.6x coverage in our Base Case. We should note that FTAI’s aviation business is based in Bermuda and thus pays no cash taxes.

Exhibit 7: Dividend Coverage – Aviation alone – Base Case

Throughout this write-up, we will reference Funds Available for Distribution (“FAD”), which is a term the company uses in evaluating its ability to meet its stated dividend policy. FAD is equal to cash flow from operations, plus proceeds from assets sales, minus debt repayment, and excludes changes in working capital. We adjust FAD in all of our projections to exclude proceeds from asset sales.

Our base case projects that FTAI will exit the year with $200M in FAD from its aviation business, which is quite extraordinary.

In the span of three quarters (1Q17 to 4Q17) FTAI will transform from having its dividend not covered by cash flow to having the aviation segment alone cover the dividend by 1.6x, assuming all other segments contribute zero.  In fact, we expect all of the other segments to individually be positive contributors in 4Q17.

We believe the assumptions in aviation we are using for the remainder of the year are quite conservative. FTAI currently has $220M of assets in its pipeline which are expected to fund by the end of 3Q17. The company said on its 1Q17 earnings call it expects to exit the year at $200M in run-rate aviation cash flow once all of its $220M investment pipeline is deployed.

Our numbers for 2017 assume that FTAI acquires an incremental $260M of aviation assets by year-end, or an incremental $40M beyond its current pipeline. Considering that FTAI’s run-rate aviation cash flow (when including the closure of its pipeline) grew from $160M in 4Q16 to $200M in 1Q17, or +$40M over the course of one quarter, we believe exiting 2017 at $200M in run-rate aviation FAD is very achievable, if not conservative.

                                                                      Exhibit 8: Aviation Scenario Analysis

We forecast that the dividend ramps above 1x coverage next quarter (2Q17). In our Base Case, the dividend coverage continues a steep climb above 2x coverage by 4Q18.

Exhibit 9: Aviation Dividend Coverage on an Annualized Run-rate basis – Scenario Analysis

The chart above shows the dividend coverage from aviation alone, assuming every other segment contributes zero cash flow. Incremental interest expense is the largest offset as we assume the aviation portfolio is funded exclusively with debt starting in 3Q17. Management fees grow nominally as retained earnings grow. We forecast that FTAI will begin paying a 10% incentive fee in 1Q19.

As noted, we believe FTAI can scale its aviation portfolio from ~$800M today to ~$2B over time without seeing any diminution in returns. At a $2B aviation portfolio, we believe FTAI can produce comfortably north of $400M FAD per annum. In our Base Case, we model aviation growing to a $1.2B portfolio by YE18 and to a $1.6B portfolio by YE19.

                                                           Exhibit 10: Aviation Cash Flow/FAD – Base Case

                
                  

Our main assumptions are:

• No asset sales

• An unlevered IRR of 23% on the entire aviation portfolio from 1Q18 forward

• L+275 cost of debt (recently raised a $75m revolver at L+275)

• Asset purchases are funded in the middle of 3Q17 with solely debt going forward

At a fully covered dividend, thanks to aviation alone, we see potential yield compression from 8.3% today, to 6.5%, which implies a ~$23 stock in 2018 (+43% return, excluding dividends) and ~$30 stock in 2019 (+90% return, excluding dividends). Even though it’s not accounted for in the analysis above, we expect all other segments to be positive contributors, especially Jefferson, where a steep ramp is currently occurring.

2. Jefferson will transform from a cash drag currently to $100M+ in EBITDA over next three years.

FTAI’s aviation business and its Jefferson terminal will comprise over 95% of total cash flow in 2018. While FTAI’s other port and logistics assets present interesting long-term opportunities, the bulk of our write-up will focus on aviation and Jefferson, as they are critical to the 1-3 year ramp.

FTAI owns four port and rail terminals in North America: 1) Jefferson, 2) Repauno, 3) CMQR and 4) Hannibal.

The common theme with these properties is locations in growing industrialized areas combined with excellent rail, water, and road connectivity. Jefferson, a crude oil and refined products logistics terminal at the Port of Beaumont, Texas, has a unique combination of direct rail service from three Class I railroads (UP, KC, BNSF), barge docks, and deep water ship loading capacity. It is a prime location close to Port Arthur and Lake Charles, which makes it ideally suited to provide logistics solutions to local refineries in one of North America’s largest oil refining regions. FTAI currently owns 60% of Jefferson and its results are fully consolidated on FTAI’s books.

Despite having great features on paper, Jefferson was slow to start signing contracts after being purchased in August 2014. Up until last year, Jefferson was a ($25M) drag per annum on cash flow when fully consolidated. It weighed heavily on the dividend coverage and represented the prime reason why bears legitimately questioned the dividend’s sustainability. Similar to the ramp in aviation, Jefferson is transforming from being a cash drag to producing $15-20M of run-rate EBITDA on a consolidated basis by 4Q17.  

Jefferson has four pockets of opportunity: 1) refined products to Mexico by rail, 2) ethanol by rail, storage, and distribution, 3) Canadian crude by rail, and 4) crude blending and storage.

I. Refined products to Mexico by rail

One major macro factor driving value at Jefferson is the de-regulation of the Mexican energy market. Since 2014, the Mexican government has gradually relaxed Pemex’s monopoly and is opening itself to outsiders, ending the 75-year old monopolies held by its state-owned producers. Mexico was driven to make market reforms, as they lack sufficient diesel and gasoline due to Pemex’s history of under-production. We expect this issue to persist due to the depletion of known resources, lack of new exploration, and Pemex’s high debt levels ($87B in 2016).

U.S. Gulf Coast refineries see Mexico as a new end market for their refined products. Of all the alternatives, transporting crude via rail is the least hazardous. Trucking crude oil has safety issues and the pipeline infrastructure between the U.S. Gulf Coast and Mexico is inadequate and leads to a huge amount of gas being pilfered. The number of illegal taps has soared over 3,500% since 2000, according to data provided by Pemex. An average of 20,000 bpd of fuel is stolen in Mexico.

A safer and more predictable alternative, Jefferson offers the ability to store a local refinery’s diesel and gasoline product and then load it onto Kansas City Southern’s railcars for shipment to Mexico, one of the biggest markets in the world for importing refined energy products. Mexico does produce oil, but their refining capacity keeps declining, making them a bigger importer over time. In addition, FTAI will also transport products via barge, especially to Mexico’s coastal cities, where barge costs less to transport than via rail.

This new stream of imported fuel from private players, such as FTAI, in an open market, will help Mexico, which has been hit by sporadic shortages. This has created opportunities for Jefferson to work with local Gulf Coast refineries to supply the large inland markets in Mexico with refined products by rail. FTAI is currently developing direct pipeline connections to local refineries, which will provide them with a lower cost of transportation to and from the terminal. FTAI has a long-term contract with a local refinery to load both gasoline and diesel for transport to Mexico by rail. This contract is expected to start contributing in late 3Q17 and produce fully-consolidated EBITDA of $10 to $15M per annum. This contract comprises the bulk of Jefferson’s total $15-20M run-rate 4Q17 EBITDA guidance.

FTAI’s current rail loading system allows them to deliver 20,000 bpd of multiple grades of refined product. If the market demand continues to increase, we believe for an incremental $25M investment, FTAI could double its capacity and generate an incremental $10 to $15M of EBITDA.

II. Ethanol by rail, storage, and distribution

Jefferson signed a JV with Green Plains (NASDAQ: GPRE) in June 2016. Phase 1 of this project will entail approximately 500,000 barrels of storage, with construction completed in 2Q17. FTAI envisions Jefferson becoming a major ethanol export hub, as well as distributing regionally via the nearby class 1 railroads. This contract should contribute $8 to $10M of EBITDA, with the potential to double storage capacity and EBITDA. As the CEO said on its 1Q17 call:

“Demand for ethanol, especially in the international markets, is growing beyond what we and Green Plains had originally envisioned. If this demand continues to manifest itself, we and Green Plains may expand our already expanded plants once again and we will commence our ethanol operation in July of this year. The macroeconomics for export of ethanol to Brazil, India, the Philippines and South Korea has never been better.”

III. Canadian crude by rail

Jefferson is the only terminal in the vicinity with the heated system capabilities of handling heavy crude. U.S. Gulf Coast refineries want heavy crude (extra heavy crude is known as ‘bitumen’) because it’s the cheapest barrel of crude available. As the U.S. does not produce any significant quantity of heavy crude, these U.S. Gulf Coast refineries are compelled to source their heavier blends of crude from Mexico or Venezuela, where heavy crude production is expected to continue to decline.

As a result, Jefferson is speaking with producers in Alberta and refineries in the Gulf Coast to bring heavy crude from Western Canada down to the U.S. Gulf via rail. We also believe Fortress is speaking with Asian-based refineries who are interested in receiving crude via tanker. A recent Wall Street Journal article highlighted this growing interest from Asia. In all of these cases, FTAI would receive a spread and be responsible for handling and transloading. Once Jefferson has received the crude in its terminal, they could offload it, blend it, and pipe it back to the refinery, or export it on KCS’s railcars.

As Canadian production grows in 2017 and 2018, pipelines are becoming increasingly constrained, which makes rail an increasingly attractive option. Apportionment, which occurs when crude supply exceeds pipeline takeaway capacity, is becoming an increasingly important macro driver. There won’t be any new pipelines built to relieve the congestion until 2020 at the earliest. Jefferson already has infrastructure in place to handle two unit trains (240 cars) per day of light crude oil or one unit train (120 cars) of heavy crude oil/bitumen requiring heating.

In terms of the sensitivity, one unit train per day would generate approximately $30M in annual EBITDA (fully consolidated). Because the supporting infrastructure for one to two units train is already in place at Jefferson, the ramp-up time required to achieve a full run-rate would be very quick.

The nameplate design capacity of existing Western Canadian crude oil pipelines is 4.0M bpd. However, the estimated available capacity for Canadian crude oil exiting Western Canada on the major pipeline systems is only 3.3M bpd after operational downtime, downstream constraints, and the capacity allocated to refined petroleum products as well as U.S. Bakken crude oil that shares pipeline capacity.

Exhibit 11: The Takeaway Capacity of Crude Oil Pipelines Exiting Western Canada

        
                      Source: Canadian Association of Petroleum Producers (CAPP), Publication #: 2017-0009, June 2017

Meanwhile, the available supply of Western Canadian crude oil supply in 2016 was 3.91M bpd, however, this is forecasted to increase by about 600K bpd to 4.52M bpd in 2018.

Exhibit 12: CAPP Western Canadian Crude Oil Supply Forecast 2017-2020

                    Source: Canadian Association of Petroleum Producers (CAPP), Publication #: 2017-0009, June 2017

A portion of the 4.5M bpd volume supplies refineries in Alberta and Saskatchewan (approx. 523,000 bpd). Taking all of this into account, CAPP has forecasted a pipeline deficit in 2018 of ~0.7M bpd (4.5M bpd of supply minus 0.5M bpd used in Alberta and Saskatchewan refineries minus 3.3M bpd of actual pipeline capacity).

Because there are no new pipeline projects coming in-service before 2020 at the earliest, rail transport will need to significantly increase to fill the gap and relieve the congestion on existing lines. The current rail loading capacity originating in Western Canada is 754,000 bpd and crude transport by railcars was ~100,000 bpd in 2016. Hence, we know there is ample idle railcar capacity waiting to be filled once the demand arises. We are starting to see evidence of increased railcar usage, as ~140,000 bpd were transported by rail in 1Q17.

The primary reason that FTAI and others have not yet signed contracts is because the WCS/WTI spot differentials have narrowed from $20/bbl in 2015 to ~$10/bbl today. A spread of $14-15/bbl is an important hurdle to surpass because that is the approximate cost to move crude by rail from western Canada to the U.S. Gulf. We would highlight that the forward curve currently reflects a widening of differentials to ~US$14/bbl by 1Q18.

Exhibit 13: WCS/WTI Differentials out to YE18

   Source: WTI Source: U.S. Energy Information Administration. WCS Source: Alberta Energy.

As Canadian crude production volumes build, there will be increasing stress on pipelines out to 2020. We believe this will widen the discount on Canadian crude, making crude by rail a more economically feasible alternative. Combined with concerns over falling production from Mexico and Venezuela and the simultaneous expansion of Gulf Coast refineries, we expect the desire for a more predictable supply will entice producers and refiners to commit with FTAI.

IV. Crude blending and storage

Exxon’s CEO, Darren Woods, recently announced that $20B was going to be invested in the U.S. Gulf Coast and the majority of it would be in the Beaumont area. By filing for certain permits, Exxon is initiating the process to expand its refinery. The significant level of investment in Gulf Coast refineries is a macro factor driving demand for all terminal services in the area, especially storage. FTAI’s CEO, Joe Adams, said on its 1Q17 call that “an expansion of that [Exxon terminal] given the proximity to our terminal means that there'll be additional demand for more storage of really everything going in and everything going out.” Further, the growth in export activity of both crude and refined products from the Gulf following the lifting of the 40-year old export ban in December 2015 is generating meaningful additional demand for storage and port facilities in the Beaumont/Port Arthur area.

By the end of 2017, FTAI expects to store ~1.5M barrels of crude oil and refined products, which will generate $15M+ of annual run-rate EBITDA at full ramp. A good rule-of-thumb is that each 1M barrels of storage equates to ~$10 to $12M of EBITDA. In addition to being a steady cash flow business, storage drives blending, a higher margin business, and additional transportation revenues for the terminal. Besides Jefferson’s crude by rail opportunity, which translates into $30M of fully-consolidated EBITDA per unit train, storage represents Jefferson’s best long-term opportunity to drive the terminal’s EBITDA in excess of $100M per year.

This would represent quite the transformation from the cash-drag Jefferson represented not that long ago.

We believe there is an opportunity over the next 3-4 years to grow the storage capacity from ~2M bbls to ~24M bbls, which we estimate would require ~$900M of incremental cap-ex (of which FTAI would be responsible for 60% of) and equate to ~$300M of fully-consolidated EBITDA. None of this would be built speculatively, meaning FTAI would break ground only after securing a binding take-or-pay contract. To accelerate this process, FTAI would likely seek over time to build a pipeline that connects into TransCanada or Phillips.

Storage contracts are high margin cash flows, which should elevate FTAI’s overall valuation multiple. In addition, if this large opportunity were to be realized, it would diversify FTAI’s cash flow stream, lessening its reliance on its aviation segment to drive returns. Interestingly, there were two recent acquisitions of terminals in the Houston area – Oiltanking Partners (NYSE: OILT) and the Houston Fuel Oil Terminal Company.

OILT owned terminals in Houston and Beaumont with a total storage capacity of 26.0M bbls. OILT was acquired by Enterprise Products Partners (NYSE: EPD) for $5.9B in early 2015, which represents a ~19x multiple on 2016 estimated EBITDA of ~$315M.

More recently, SemGroup Energy Partners (NYSE: SEMG) announced in June 2017 that it will acquire Houston Fuel Oil Terminal Company (private) for $2.1B. This asset has ~17M bbls of storage capacity, with 1.5M bbls of additional storage under construction, and will produce $150M of PF EBITDA, which includes $35M of future EBITDA from assets under construction. Including the $100M capex required in 2017-2018 to compete the projects under construction, the acquisition represents a 14.7x PF EV/EBITDA multiple ($2.2B / $150M).

Even at such an elevated valuation multiple, HFOTC did not have long-term contracts with customers; 85% of its contracts were of 1yr duration. However, these type of terminal businesses are very sticky, as customers typically rollover contracts.

Applying a similar 14.7x multiple on the $300M EBITDA storage opportunity represents an EV of $4.4B, and this ignores all the three other business opportunities at Jefferson. FTAI has multiple financing options for such an accretive project, including debt, some equity, and even selling its energy and railroad assets.

Jefferson – wrapping it all up

Assuming continuing test crude by rail trains from Canada, compounded with the start of the ethanol JV in September and previously announced crude storage deals, and layering on Phase 1 of the refined products to Mexico business, FTAI expects combined annual run rate EBITDA by 4Q17 to be approximately $15M to $20M (fully consolidated). We believe this is conservative and that actual performance could exceed guidance, given that 1.8M bbls of storage, alone, equates to $15M+ in annualized EBITDA.

As previously noted, FTAI owns a short line railroad from Montreal to Maine which was bought of bankruptcy and is carried on the books at its cost of $10M, but could be sold for ~$80M to ~$100M. We believe this railroad will do ~$8M to ~$10M in EBITDA next year.

In addition, FTAI could sell its energy portfolio for below book value and receive ~$100M to ~$120M in proceeds.

Combined, these two divestures would clean up the story, particularly exiting energy, which has been a small drain on cash flow. Together, these divestures would provide $200M+ of liquidity to deploy elsewhere. In a staged construction process, FTAI could theoretically raise ~$250M of debt/project finance and ~$100M of equity, which along with the divestures, would finance the entirety of the total ~$550M capital required by FTAI to ramp its storage business to ~$300M of EBITDA. We put no probability on the sale of the railroad, but we believe there is a high likelihood that FTAI divests of its energy assets by year-end.

While getting a sum-of-the-parts discount today, we believe Jefferson will eventually become a crown jewel. We forecast a Base Case in which EBITDA at Jefferson ramps up from ~$40M in 2018 to ~$70M of EBITDA in 2019 (fully consolidated). Executing on two crude by rail contracts would alone exceed our 2019 Base Case estimates.

Upside optionality through other port and logistics assets

I. Repuano

Elsewhere in its portfolio, FTAI owns other interesting port and logistics assets, including Repuano, a 1,630 acre deep-water seaport and logistics hub on the Delaware River near Philadelphia. Repuano is well-suited to become a thriving port, with rail connectivity to Conrail, access to the coastline and major highways, and an active industrial market in the area. FTAI is exploring opportunities to store and distribute NGLs coming from the Marcellus/Utica. Over time, FTAI would like to build 2M barrels of storage at the site. FTAI is also in negotiations for an auto import/export facility which FTAI has said on a recent earnings call “they hope to have something concluded by Q3 of this year.”

This quarter FTAI will complete the preparation of an 186,000 barrel underground cavern for butane storage, which will generate $2M in EBITDA per annum going forward. We believe over the next two years that Repuano has the capability to generate over $20M in cash flow/FAD.

II. Hannibal

FTAI also owns Hannibal, a 1,660 acre industrial port and rail facility in the heart of the Marcellus and Utica shale in Hannibal, Ohio. FTAI is permitting a 485 MW gas-fired (CCGT) power plant, which will take advantage of the site’s strategic location and access to low-price gas. Making the project even more attractive are a number of announced plant closures of coal-fired plants in the area. FTAI expects to complete the permitting by 3Q17 and start construction in 4Q17 after sourcing financing/equity partners and making a final investment decision. The investment in the plant will total ~$500M and once completed should generate approximately $70M in annual EBITDA. Construction is expected be completed in late 2019 or early 2020.

FTAI is also exploring the potential for a NGL logistics facility at Hannibal and integrating it with Repuano. One hypothetical example would have NGLs being processed at Hannibal, shipped to Repuano, and then transported regionally or exported. Absent any growth cap-ex, Hannibal should generate $1M in cash flow/FAD in 2018 from frac sand and industrial storage tenants for the oil and gas industry.

Longer-term, we see the NGL opportunity ramping at Repuano in 2019 and the power plant at Hannibal hitting in 2020. The larger point is that Repuano and Hannibal represent the increasing competition for capital. FTAI is looking for a 15-20% unlevered IRR before they invest in any project and we believe all of these projects at least meet that hurdle.

Valuation

Why does this opportunity exist?

We believe one of the reasons this opportunity exists is because lessor stocks historically have wrestled with finding a natural stockholder base. In addition, FTAI is a rather unique story compared to other publicly traded lessors. Do financial, industrial, or aerospace/airline investors track lessors? That explains a bit of the problem.

Furthermore, FTAI’s port and logistics assets are not “traditional” infrastructure assets, as Jefferson in particular is early-stage and undergoing a massive ramp in cash flow. One can begin to see why FTAI does not “screen” well for any type of natural stockholder base.

With that said, we are cash flow-based investors at the end of the day. This underscores why this opportunity exists, as the company’s true recurring free cash flow is temporarily being obfuscated by the large ramp in growth cap-ex. Over time, as cash flow grows and investment growth tapers, real cash generation will flow through the model. As this happens, we believe investors will gradually stop conflating FTAI’s unique aviation strategy with other traditional lessors. One important milestone in this process is when the dividend is covered starting next quarter (2Q17).

At the same time, Jefferson is in the process of inflecting from a ($25M) cash flow drag at its peak last year to a +$15M to +$20M contributor on a run-rate basis by 4Q17. Beyond that, we have a three-year window to seeing EBITDA grow at Jefferson to over $100M through its various projects.

FTAI’s under-capitalized balance sheet is a strategic asset it will use as it funds projects across its portfolio. It has a 0.3x debt/total cap versus a long-term target of 0.5x. By that math, FTAI has ~$650M of debt capacity and ~$100M of excess cash on the balance sheet. In addition, FTAI has potential divestures of $200M (railroad + energy), which total out to ~$950M in dry powder, excluding any future cash flow.

Setting the baseline

FTAI’s dividend payments are currently $100M per annum. For its dividend to be covered, FTAI needs aviation to produce $135M in cash flow per annum (or $34M per quarter), as corporate overhead is $35M per year. Corporate overhead includes unallocated corporate general and administrative expenses and management fees. We forecast that FTAI produces over $34M in aviation cash flow next quarter, covering the dividend. This assumes everything else is break-even (Jefferson, energy, the railroad, and Hannibal/Repuano).

We would highlight that we are not including maintenance capex in our definition of FAD. We acknowledge doing this does not accurately represent recurring cash flow, but in order to make projections based on a target dividend yield, we want to analyze the level of a proper dividend using the same policy framework as the company. It makes forward projections much cleaner and simpler. FTAI’s public dividend policy is to maintain a 2:1 dividend coverage and they base this calculation off FAD. As noted, the only difference is that we do not account for any aviation asset sales going forward. Also, we would emphasize that maintenance cap-ex is not onerous – we expect it to range in the amount of $10 to $15M per annum for the next two years.

FTAI is entitled to a 10% income incentive fee based on an 8% ROE hurdle. We assume that FTAI starts to pay a full incentive fee in 1Q19. FTAI also is entitled to an incremental 10% incentive fee based on realized proceeds. Since we do not forecast material proceeds occurring out to YE19, this does not factor into our projections.
 

Exhibit 14: Peer Comparison

  Source: Bloomberg

On the following page, we based our valuation of FTAI on several metrics, including 1) EBITDA, 2) free cash flow (cash flow from operations minus maintenance cap-ex), and 3) a target dividend yield.

Exhibit 15: SOTP Valuation Table -– Scenario Analysis

We believe 9x EBITDA is a fair and reasonable approximation to what FTAI can achieve. If you compare FTAI to its peer group, this roughly equates to a multiple 70% weighted to Aercap/Air Lease and 30% weighted to Macquarie Infrastructure. Over time, we would argue that as Jefferson ramps, FTAI deserves to trade at a multiple that is closer in-line with MIC.

We also separately value FTAI on the basis of its dividend yield. We assume that FTAI maintains its current dividend yield of 8.3%, while growing the dividend as it exceeds its stated policy goal of a 2:1 dividend coverage level. We believe this is a conservative projection in our Base Case, given that we expect to see some amount of yield compression as FAD ramps to ~$300M in 2019. We model a dividend yield of 7.0% in our Bull Case, which is in-line with Macquarie’s current dividend yield of 6.9%, even though MIC has higher leverage and a higher payout ratio.

Macquarie has great assets subject to ~20-yr leases and has grown its dividend at a 12% CAGR since 2013. Of MIC’s 10-15% projected FCF growth over the next two years, only 3-5% is organic, with the majority of FCF growth coming from cost savings and the optimization of its capital structure. This is not a hit piece on MIC, which we believe has extremely high-quality assets. We just don’t believe the gap in quality is wide enough to justify a 3x-plus turn premium.

We would also argue that EV/EBITDA fails to capture the value of FTAI’s tax structure, as FTAI pays no cash taxes in its aviation business.

Our Bear, Base, and Bull Case price targets are calculated as an average of our three valuation methods.

Alternatively, we see a Bear Case return of (9%) out to YE18 if we assume that FTAI trades at 1.0x book value, similar to other aircraft lessors (this excludes dividend payments).

The risk-reward is asymmetric with a Bear/Base/Bull return profile out to YE2018 of -11%, +26%, and +74%, respectively. As FCF inflects in 2018-2019, the return profile improves further if one looks out to 2019.

Risks

1. Slowdown in aviation. Within aviation, a clear risk is of a sustained economic downturn that impairs global passenger traffic. As e-commerce becomes a more important macro driver in the segment, trade wars that harm the flow of goods would be a negative surprise to the aviation business. The industry concerns around an aggressive order-book, which could impair residual values, is of lesser concern to FTAI because of its unique strategy focusing on mid-life aircrafts.

    

2. Construction delays and/or delays in signing contracts at Jefferson. Within Jefferson, there is execution risk as it ramps. Management stated on its last conference call that they are currently on budget and on-schedule, however this is something we are monitoring. In order for Jefferson to sign crude by rail contracts, we believe differentials need to widen from ~$10/bbl to ~$13-$15/bbl, which the futures curve currently implies will happen in 1Q18. Longer-term, as new pipelines come online in 2020+, this could obviate the need for railcars to transport discounted Canadian crude, as the differentials should theoretically narrow as new pipeline capacity comes online. If FTAI can invest in a pipeline that hooks into Phillips or TransCanada, then it mitigates the need for Canadian crude transported south by railcar, as the need for storage and other logistics solutions materially grows.

Conclusion

FTAI is an overlooked small-cap industrial. Moreover, we believe we understand the reasons for the company’s mis-pricing. With 26% of upside looking out to 2018 in our Base Case (+17% IRR) and 69% of upside looking out to 2019 (+43% IRR), excluding dividends, we believe FTAI will start to gain a more natural stockholder base and find investor’s attention as both aviation and Jefferson ramps over the next 12 months.

Catalyst

- Dividend covered next quarter for first time in its history (2Q18)
- Cash flow inflection in 2H18 and 2019 as aviation ramps and Jefferson becomes a +'ve contributor in 4Q18
- Crude by rail contracts at Jefferson (one unit train per day contributes ~$30m of EBITDA, fully consolidated) and other biz dev at Jefferson
- Dividend raises in 2018
- Sale of energy business