<THE BORING PORTFOLIO>
Will Atlas Stay Boring?
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Nov. 16, 1998) -- Returning to the question of Atlas Air (NYSE: CGO) today, we're pretty much closing in on selling our holdings there. So far, we're not convinced that there's anything terribly attractive about the industry. The fact that the company has long-term contracts to provide service does not make us any more comfortable with the company. There are lots of industries where services are sold on a long-term contract basis, such as oil services, where the long-term nature of the contracts does not insulate investors from high variability on operating results. Investors will start to discount poor results long before earnings turn down because of poor pricing and capacity utilization in capital intensive industries.
Furthermore, the company is recording record results at the moment, but it only generates a 3% return on assets. That's not our style. We like companies that can generate a return on assets that doesn't take much leverage to translate into a good return on equity. To make sense of that sentence, please see our four-part series on return on equity: Part 1, Part 2, Part 3, Part 4. We're really not fans of companies that are highly leveraged to the business cycle and that require the company to borrow $4 1/2 for every dollar in equity to create a good return on equity at the top of the business cycle.
While one could interject that banks operate with much more leverage, this isn't a bank. Banks can re-price billion dollar credit card portfolios within 30 days and can also benefit very quickly from the market's repricing the cost of capital during a downturn. A company with huge borrowings to support large fixed asset bases can't reprice the yield on its assets every couple of months. In addition, some foreign company would find it hard to come into your neighborhood, plunk down a new bank branch, and grab your mortgage, auto loan, or mutual fund business. The air transport business is more easily invaded by competitors and is very much subject to highly competitive pricing.
Some people have objected to our not liking Atlas by saying it's the best company in the industry. That's fine. We just don't like the industry. If the best company in this industry cannot generate a return on invested capital that is sufficient to cover the cost of its capital, what is there to like? Return on equity is not a sufficient way to measure the quality of a business. If it were, Long-Term Capital Management would not have gone out of business and all the S&Ls in the 1980s would not have gone under. I make that point because we look at companies based on how they can do without leverage.
That's where return on invested capital comes in. ROIC measures the return from capital that could be generated without any leverage, and thus gives a better picture of the economics of a given industry than ROE does. Atlas generates a fine ROE, but one has to realize that the high ROE comes with the risk of a significant downturn eating into equity. Though we don't use this balance sheet metric all that much, consider that the company's debt to equity ratio is 455%. Alex and I aren't debt averse. But there are certain industries where you can leverage up the business with less risk to equity holders and there are certain industries where fundamental economics leave you little choice but to leverage up if you want to generate a return on equity.
In the company's most recent conference call, management said as much:
Atlas is mindful of its leveraged balance sheet. It should be kept in mind, however, that Atlas's debt is backed up by hard assets, in the form of the aircraft. Fairly high leverage is not unusual in the airline industry. That said, at some stock price level, the company would consider replacing some of the debt with equity.
That's not really comforting. Aircraft are not assets during recessions or cyclical downturns -- they become liabilities if you can't generate a decent financial return on them. In addition, if global air carriers go into a slump, that's extra capacity that comes out of the woodwork. Say you run KLM and can't fill your 747-200s on international routes. What do you do with that capacity if Atlas is out there generating decent returns on its fleet? You convert your older 747s. So while Atlas is not itself a passenger airline, its economics are dictated to some extent by the health of its customers, which include passenger airlines. Atlas probably cannot escape the effects of slack conditions in that business, which history tells us is more of a certainty every once in a while than just a remote possibility.
Atlas Air is a well-run company from everything we can see. The company has an excellent fleet of aircraft that is ready to deal with Stage 3 noise regulations and it has turned in an impressive performance in lowering operating costs per block hour of operation. This has translated into better margins and better financial performance overall. In addition, the company has grown very rapidly and profitably, which is always a challenge. Nevertheless, we are not comfortable owning this type of company because 1) We're not familiar with the industry's economics, 2) We don't want to become highly familiar with the industry's economics based on what we can see, and 3) we view the stock as being fully valued based on a couple of different ways of looking at it.
The attached spreadsheet -- Click here for Excel 7.0/97... or click here for Excel 5.0/95 -- shows a couple ways to look at the company (if you can't download the spreadsheet, email me at: email@example.com). There is a discounted earnings model and two EVA models that reflect not only very high growth rates but much better returns on capital than the company has shown so far. This is because we assume that eventually the company will get to a state where it's meeting its cost of capital. In both of these models, the stock is overvalued and in the discounted earnings model, we see the stock at fair value.
Also included in the spreadsheet and below is the company's trailing twelve months' financial performance, which is the product of our analysis of the company's financial statements. Any errors are solely our fault, and where net income or other results differ from Generally Accepted Accounting Principles, that is the result of the way we look at things. In other words, these analyses may contain estimates or other re-arrangements for which we take full responsibility for the purposes of our analysis. We don't claim that the analysis is complete or correct; rather, it's the product of our diseased minds.
In summary, we will be making a decision on the company in the next few days and again we invite any comments about the way we're looking at the situation. As always, we are happy to hear from you on the Boring Stocks board and appreciate counterpoints or comments.
($ in millions) Market Cap...$846.43 Enterprise Value...$2,051.33 EV/Revenues...5.16 EV/Invested Capital...1.61 EV/Assets...1.24 Price/Book Value...3.20 PSR...2.13 EPS...$1.66 P/E...22.69 EV/Operating...17.60 EV/Net Income...54.99 EV/FCF...-9.82 EV/NCFO...24.41 Diluted Sharecount...22.53 ROIC...6.63% Working Capital...170.91 Capital Turnover...0.3 Days Sales Outstanding...59.76 Asset Turnover...0.28 Assets/Equity...5.88 PP&E Turnover...0.34 Net Margin...9.38% ROA...2.58% ROE...15.19% DuPont ROE...15.19% Cash/Share...$11.24 Current Ratio...2.16 Quick Ratio...2.16 LT Debt/Equity...454.87% Debt/Total Capital...58.74% Insider Holdings61.6% Begin Invested Capital...$944.00 End Invested Capital...$1,271.93 YOY IC Growth...34.74% Avg. Invested Capital...$1,107.96 Invested Capital Turnover...0.36 ATOI...$73.43 Tax Rate...37.00% Income Statement Trailing Revenues...$397.67 Operating Earnings...$116.56 Net Income...$37.30 Depreciation...$69.82 Operating Margin...29.31% Net Margin...9.38% Balance Sheet Cash & Equivalents...$253.35 Receivables...$65.11 Last Yr receivables...$54.96 Payables...$82.86 Current Assets...$318.46 Current Liabilities...$147.55 Long-Term Debt...$1,204.90 Shareholder's Equity...$264.89 Last Yr Shareholder's Eq...$226.35 Total Assets...$1,656.33 Last Year Assets...$1,231.00 PP&E...$1,310.78 Last Year PP&E...$1,004.64 Avg. Assets...$1,443.67 Average receivables...$60.03 Average Assets...$1,443.67 Average share equity...$245.62 Cap Ex...$292.89 Working Capital Change...-$23.01 Net Op. Cash Ex. WC Change...$107.04 Net Cash from Operations...$84.03 NCFO/Reported Earnings...225.27% Cap Ex/NCFO...348.54% Cap Ex/Begin Invested Capital...23.03% FCF...-$208.86 Principal Repayments+New Debt...$325.33 FCFE...-$45.24
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Stock Change Bid ANDW - 7/16 18.06 CGO + 1/16 37.63 BGP - 1/2 22.31 CSL + 1/2 45.56 CSCO +1 13/16 68.75 FCH + 1/8 22.25 PNR - 7/16 39.75 TBY - 1/16 6.50
Day Month Year History BORING +0.31% 3.45% -5.37% 19.08% S&P: +0.30% 3.70% 17.40% 83.28% NASDAQ: +0.90% 6.05% 19.62% 80.46% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 68.75 186.99% 2/28/96 400 Borders Gr 11.26 22.31 98.22% 8/13/96 200 Carlisle C 26.32 45.56 73.08% 3/5/97 150 Atlas Air 23.06 37.63 63.17% 4/14/98 100 Pentair 43.74 39.75 -9.13% 1/21/98 200 Andrew Cor 26.09 18.06 -30.77% 5/20/98 400 TCBY Enter 10.05 6.50 -35.29% 11/6/97 200 FelCor Sui 37.59 22.25 -40.81% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 15468.75 $10078.76 2/28/96 400 Borders Gr 4502.49 8925.00 $4422.51 8/13/96 200 Carlisle C 5264.99 9112.50 $3847.51 3/5/97 150 Atlas Air 3458.74 5643.75 $2185.01 4/14/98 100 Pentair 4374.25 3975.00 -$399.25 5/20/98 400 TCBY Enter 4018.00 2600.00 -$1418.00 1/21/98 200 Andrew Cor 5218.00 3612.50 -$1605.50 11/6/97 200 FelCor Sui 7518.00 4450.00 -$3068.00 CASH $5750.59 TOTAL $59538.09
</THE BORING PORTFOLIO>