Description

PHIIK presents what we believe to be a conservative way to invest in two out of favor industries at a substantial margin of safety, run by a conservative owner/operator who owns 20% of the company and has recently purchased over $1.9M of stock since the beginning of the year, and over $20M of stock since December 2012.  We believe the stock has been unfairly punished due to the weak performance of their offshore oil services business, which has masked the excellent performance of their air medical business.  If all you can do is get comfortable with the value of PHIIK’s Air Medical business and the implied liquidation value for the PHIIK oil & gas  business through the bonds of their comp, BRS, then we believe PHIIK would be worth $32.50 a share (up 78%).  To the degree many of these peer valuations are depressed vs. historical multiples, there exists substantial further upside if investor sentiment or end-market demand improves.  If PHIIK were to trade to the level implied by BRS’s bonds being worth par, and the air medical business were to trade in line with the low end of what consolidators have paid in the last few months, we believe the stock would be worth closer to $47.50 a share (up 160%).

We would further argue that PHIIK’s air medical business is a better business than its main comp, Air Methods (which we are short), and on the oil and gas side would argue PHIIK is a unique position vs peers to benefit from the H225 grounding given the recent noted tightness in the heavy helicopter market, that we believe has helped to substantially reduce the overcapacity in the industry.  PHIIK is the only major helicopter operator with no H225s and has the second largest fleet of S-92s (the only directly comparable aircraft to the H225) outside of Bristow (BRS).  With 46% of the heavy helicopter fleet worldwide in off-shore oil and gas now grounded since June, we believe this should eventually result in a substantial tightening in the market that should begin to reflect itself in higher asset utilization and a firming of pricing in the coming quarters for PHIIK in particular.

Situation Overview:

PHIIK is composed of two helicopter-based businesses – an air medical business that transports patients from scenes or smaller hospitals to larger hospitals best equipped to deal with a patient’s emergency medical issues, and an oil & gas business in the Gulf of Mexico that transports oil workers to and from off-shore projects.  PHIIK owns the vast majority of its fleet.

The oil & gas business has been crushed as a combination of lower offshore activity, pricing pressure, and efforts to more efficiently run offshore operations utilizing less helicopter flights have reduced demand for helicopter services and created substantial overcapacity in the marketplace for all helicopter types in all offshore regions.  One of the large players (CHC) is in bankruptcy, another small player (Erickson Air Crane) is on the verge of bankruptcy, and the largest public traded player (BRS) has debt yielding in the teens.  There has been substantial discussion on the industry in the BRS thread on VIC, which is a good sampling of the pros / cons people see in the industry today – for a variety of reasons we will get into later, we think PHIIK is a more attractive / safer way to invest in this market than BRS’s bonds, and certainly its equity.

The Air Medical transport industry has also been an area of investor contention – despite substantial private equity interest in the space, the largest public player, Air Methods, trades at what looks to be 6x forward EBITDA and has short interest above 30%.  Although there are certainly some issues with the air medical industry, we think these issues are much more pronounced with Air Methods in particular and less relevant/meaningful to PHII.

Air Medical Business – Why we believe this is a very good business (but not without risks):

The air medical business is a very simple business.  There are two primary business models: in the traditional method, which is about 30% of PHIIK’s air medical revenues, Air Methods operates helicopters on behalf of a specific hospital.  They are paid a fixed amount per flight for this service, and the hospital takes the responsibility for billing and collecting from insurance.  This business is lower margin, but collections are fast and risk is minimal.  In the “independent business”, PHIIK operates its own bases, often near hospitals, and accepts inbound calls as they come in.  Because the hospital isn’t on the hook for the bill, they tend to work with whomever provides the best service and is most responsive, and do not care about price, which ultimately rests on the payor.  Because helicopters are typically used in emergency situations where time can mean the difference between life and death, it is difficult to get the typical pre-approvals or for the insurance carrier to shop on price.  About 75% of industry volumes are Medicare / Medicaid / uncompensated, on which the operators typically lose money.  The balance is largely commercial insurance, where rates are often 4-5x Medicare rates, and is where everyone makes their money.  Pricing has increased substantially on the commercial side over the last few years, as it was historically a small line item and not something commercial insurers were particularly focused on.

Private equity has been very active in the space – the #2 player in the market is Air Medical, which has traded PE hands twice.  Most recently it was acquired for an estimated 10x EBITDA by KKR and, prior to that, was owned by Bain.  Smaller transactions, like Air Methods recent acquisition of Tri-state, and Air Medical’s acquisition of Reach Medical, occurred closer to 8-9x.  PHIIK is the #3 player and has a solid reputation in the market.  Based on conversations with PE and industry executives, we think there would be substantial demand for PHIIK’s air medical business in a sale process in the 8x+ of an EBITDA multiple by Air Methods, Air Medical, or a PE player.  There would be substantial synergies in terms of base overlap with either Air Medical or Air Methods, both of whom have been very acquisitive and have expressed a strong interest in acquiring PHII’s air medical business.  There could also be interest from PE to create a third national platform.  In the absence of a transaction, we expect the business to continue to grow low single digits as pricing levels off and volumes continue to inch up slowly.

Although the Air Medical industry has been able to push substantial price increases over the last few years, there are increasingly reasons to believe that pricing will no longer go up and may even start to decline somewhat.  We believe PHIIK has less exposure to this issue than AIRM, and are short AIRM to help to hedge against the risk that the impact is greater than we expect.  We can discuss our thoughts on this more in Q&A (it’s complicated), but will give the basics of the situation below.

There are three main payors of air medical transport – Medicare, Medicaid, and commercial insurance.  Medicare reimburses at about $6,500 per flight and Medicaid at $3,000 per flight, though this can vary by state.  Commercial insurance, on the other hand, tends to pay out between $20-35k per flight.  We calculate that PHIIK receives about $25k from insurance per flight from commercial insurance, vs. AIRM who books as revenue 33k/flight (but collects less than that, as seen in their increasing DSOs).  From conversations with Air Medical Group, we believe they are around the $25k level as well.  Given the massive increase in prices over the last several years, insurance companies are finally pushing back in some cases, and we believe have been getting net payments closer to $20-25k recently, which they view as an acceptable level.  We think over the next 2-3 years it is likely pricing settles more into this range – for PHIIK the impact would likely be minimal as they are already in this band.  For AIRM, a decline to PHIIK’s level of revenue/flight would impair their EBITDA by 40%.  

AIRM pricing is an outlier in the industry, at least amongst the big three players.  We have reviewed several bills from PHIIK / Air Medical / Air Methods and note that Air Methods bills (gross amount) are typically 20%+ higher.  This also matches up with numbers we can back into in terms of gross billings / transport, which are $46.3k for AIRM and 38.8k for PHIIK (~20% higher).  The short answer is that AIRM has been pushing the boundaries of how much pricing they can get from commercial carriers, and has been most aggressive in “balance billing” patients when insurance doesn’t pay, in many cases suing patients (or their widows) who do not pay their bills.  For this reason they have the highest net revenues per transport, but also the worst reputation in the industry and the most to lose from commercial pushback or regulatory change.  By comparison PHIIK does not sue people who can’t pay and in general is less aggressive than AIRM.  They have not raised prices since 2014 whereas AIRM has raised prices at a clip of 10-20% a year for the last several years.

What we are paying for the oil & gas business today:

We are comfortable putting 7.5x on PHIIK’s Air Medical business, which is arguably conservative, but helps to price in some of the industry / tail risk here.  If you take another 7x for their small technical services business, apply 7x to corp cost, and value their NWC (mostly A/R from big oil & gas companies and spare parts) at 60% of book, we arrive at an implied value of about $85M for PHIIK’s fleet, or a little over 12% of Tangible book value.

Whether PHIIK’s upside is modest or substantial rests in large part on what you believe the oil & helicopter business is worth.  It’s unclear how much upside there is, but what we do feel confident about is that the price currently ascribed to the PHIIK oil & gas business is too low – we can do this by benchmarking value vs. peers, as well as analysis we have done on an asset value basis for the fleet, which takes into the account the fact that large pockets of the helicopter markets are essentially illiquid / closed at the moment.  

Oil & Gas – Overall Situation:

Lets get this out of the way – we are not macro experts, nor do we have a strong view on oil price or the short or medium-term demand dynamics for offshore oil & gas in the Gulf of Mexico (PHIIK’s primary market).  That said, we have done a substantial amount of work on the supply side of the equation, asset value of PHIIK’s helicopter fleet, and ability to sell / part-out aircraft if the environment never recovers.  We refer you to Skierholic’s Jan 26th BRS VIC write-up for a broader overview of the industry.

PHIIK operates almost exclusively in the Gulf of Mexico.  It competes primarily against ERA and BRS, both of whom are publicly traded.  Light helicopters or OSVs are typically utilized to transport passengers relatively close offshore.  The farther you go out, transportation tends to migrate to mediums (S-76 C++ and AW-139).  Once you go out beyond 100 miles, you are typically utilizing S-92s, H-225s, AW189s, or AS332s because they are the only helicopters with range.  PHIIK generates the bulk of its revenue from S-92s, AW-139s, and S-76C++s (mediums and heavies).

The H225 accident and what it means for available supply of heavy helicopters:

Although the market for oil & gas helicopters has generally been depressed for much of the last year, we believe there has recently occurred an important, overlooked dynamic in the heavy helicopter market that is in the process of changing the supply/demand dynamic for heavy helicopters globally, for which PHIIK is the main beneficiary.  On April 29, 2016, a CHC operated H225 (also known as EC225) crashed, killing all 13 people on board.  

This is not the first time an H225 has crashed, unfortunately – it is the 3rd time in about 4 years.  To put this in context, the entire H225 oil & gas operating fleet is 111 units – those odds don’t look very good for you if you are a pilot or offshore oil worker. After initial investigations by the European regulator, it was found that an issue with the gearbox design likely led to the crash.  This is important because the two other crashes that occurred were also related to the gearbox, but was apparently fixed after the last crash.  On June 2nd, the European regulator ordered the grounding of all H225s in Europe.  Subsequently, every major operator grounded all H225 aircraft in oil & gas and search and rescue operations.  We believe that 82% of the global H225 fleet, and nearly 100% of that used in civil / oil & gas operations have been grounded.  Further, most all AS332’s (also manufactured by Airbus and a related helicopter to the 225) have been grounded, and given those are closer to end of life given their age they will probably in short order make their way out of the market even if they are ungrounded at some point.

Based on conversations with numerous customers, leasing companies, and operators, we believe there is a good chance the H225 never flies again in an oil & gas setting.  At minimum, we believe they will effectively be out of the market for a couple years, at which point the supply/demand situation for offshore helicopters has hopefully improved.  

The H225 accident and what it means for available supply of heavy helicopters:

We estimate with the H225 accident, that nearly 50% of supply has now come out of the market:

That said, there is some substitution that can occur on the heavies especially with the super mediums.  In some situations, an AW-139 can replace an S92, but can only accommodate about 2/3rd the amount of passengers (13 vs. 19).  Assuming all the AW139s could be used to replace H225s, about 30% of seat capacity would have exited the market.

Ultimately this all has knock-on effects, if more AW139s are used to alleviate the heavy shortage, that should eventually trickle down into the medium market.  One way to look at this is to look at the combined heavy & medium market, from a seat capacity perspective, and see how many seats were taken out.  We estimate approximately 17% of seat capacity has exited the market.  While this certainly doesn’t solve the industry’s problems overnight, it certainly should help.

S-92 Tightness in the market confirmed by competitors:

PHIIK has 3 primary peers that are publicly traded: Bristow, Era, and Bond Helicopters (owned by Babcock in the UK).  Recent conference calls from all 3 players cite a tightening of the market, especially for S92s, since the grounding of the H225.  We believe this should eventually be positively reflected in PHIIK’s numbers.

Babcock Call July 21 2016:

“…the other difficulty on it is that the recent helicopters, between the EC225, which has all been grounded; and actually, trying to find enough S-92 to do the work is actually the issue. So I don't recognize the overcapacity questions that you raised. I think the issue is about getting enough S-92s out there to meet the demands that are currently there is actually what are -- what -- is what we are seeing.”  

Era Call August 3 2016:

“The suspension of H225 and AS332 L2 operations has removed approximately 180 aircraft from the marketable supply of heavy helicopters, which has diminished much of the excess capacity of new generation heavy and medium helicopters that had developed since the beginning of the current oil and gas market downturn. This has increased demand for offshore -- for other helicopter models, particularly the S92 and AW139 models to fill the gap.”

“The market today for S92s is quite tight with the exception of some frictional market inefficiencies in some jurisdictions where you might have had idle S92s with operators who don't have AOCs or operations in other markets to which they can move those aircraft. But those who have the flexibility to move S92s to markets to replace 225s, that's largely happened and the market there has tightened considerably.”

Bristow August 5th 2017:

Jonathan E. Baliff

“I would say that [the s92 market] is tighter, but I wouldn't call it tight. Because I remember when the market, 5 or 6 years ago, that was a tight market, right? When the S-92 was used to replace the 225s when they were grounded before, that was a very tight market. I would not call this market that tight. I would just say it's tightening. And so again, that's just what we're seeing globally.

What is the oil & gas business Worth:

There is no easy way to value the oil & gas helicopters businesses today, in our view.  Book value / replacement value is tough to take much comfort in because it is unclear if/when the industry will once again deliver a return on capital that justifies trading at or above these levels, and the entire offshore oil & gas services complex is trading well below book value.  Values from third party appraisers are suspect because the resale markets are exceptionally illiquid, and any mass fleet liquidation would likely occur at a substantial discount to those prices.  A normalized EBIT or EBITDA approach could make sense, but it is unclear what normalized will be for this business going forward and if the past is a good guide.  Although we aren’t sure exactly how much the oil & gas helicopter business is worth, there are several ways we look at value, all of which get us to materially higher values than where PHIIK trades today.   We’d also point out that, unlike many other parts of the offshore services market (e.g. rigs & OSVs), there are actually alternate uses for helicopters vs. other assets that are oil & gas end use only.

Implied value of PHIIK assets based on where BRS bonds trade

I actually think the exercise of valuing recovery to the Bristow bonds is really complicated.  Although I do think it is fair to carve out the SAR business value (assuming you ding them for the associated asset value), the treatment of leases in a bankruptcy and all the different subsidiaries make recovery analysis exceptionally difficult.  By comparison, PHIIK has a simple capital structure and an immaterial foreign JV.  For simplicities sake, we calculate the creation price of BRS through the bonds at ~900M, which takes into account the current bond price (76), treats all more senior debt at par, and gives them credit for cash and 60% of their NWC balance. It assumes lease liabilities / JV interest / other assets cancel each other out and are worth nothing.  This exercise implies a value of about $318M for PHIIKs fleet.

Note estimates above are derived from numerous conversations with helicopter appraisers, lessors, and operators.  In most cases we took what we believed to be the most conservative values we could.  We think this is the simplest – if not most accurate – way to look at the value of PHIIK’s oil & gas helicopter fleet.  If you think that the BRS bonds are worth closer to par, or that there is value to the equity, clearly the implied value for PHIIK’s oil & gas business should be substantially higher (closer to 500m).  For what it’s worth, in all discussions, people generally felt that $100M for the fleet of PHIIK was an exceptional deal, no matter how bearish they are on oil & gas prospects.  We believe in a draconian scenario where there is never any further drilling in the gulf, that there would be substantially military demand for PHIIK’s S-92s at $8-10M, which alone would get you over $100M of value and covers you in a really bad scenario.

Historical multiples of book value

The industry has historically traded at anywhere from .5x to 2x tangBV.  Today BRS trades at about .3x TangBV, ERA at .35x, and PHIIK at .5x.

PHIIK is skewed because their air medical biz has relatively low book value but high profits.  Excluding our estimate of fair value for the air medical business we believe PHIIK is trading at about .15x book value with a substantially less levered balance sheet, making tangbv less sensitive relative to more levered named (we acknowledge much of the offshore oil & gas complex trades at a fraction of book, but most of these names are highly levered).  Regardless, we have about 25 years of data on valuations, and we are at an absolute low.  At .5x TangBV for PHIIK’s oil & gas business, it would be worth about 350M.  If you think at some point the industry recovers and it gets back to book value, its worth $720M. Note the industry has traded above book more than it has traded below book over time.

Normalized Analysis

In a cyclical business like this one, it’s useful to just step back and look at the long-term financials.  Below are PHIIK’s oil & gas segment and profitability metrics going back nearly 20 years.

Pick your numbers.  If you assume 15% EBITDA margins on 400M of revs and put 6x on the resulting EBITDA (about what you would get if you do the math on Bristow equity) it would imply 360M of value for PHIIK’s helicopter business.  Note revenue is much higher today than historically primarily because larger helicopters are needed to do more deep water work, and with those capital cost increases have come increased pricing to compensate for the higher capital investment.

Putting it all together – Valuation:

Pick your poison from the above and haircut as you see fit, but we find it very hard to get a fair value for the business being less than low $30 a share.

Catalyst

Sale of Air Medical business

Sale or lease of idle S92 aircraft

Higher oil prices at some point in the future