Boring Selling Atlas Air
November 18, 1998
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Trade: Selling 150 shares Atlas Air (Nasdaq: ATLS)
Bought on March, 5 1997 at $22 7/8
Current Price: $37 7/16
Gain to date: +63%
S&P over period: +42%
On Monday (see below for Monday's Boring report), Alex and I started to explain the reasons why we don't want to hold onto Atlas Air Inc. (NYSE: CGO). Today, we'll conclude our deliberations on the company and announce that we will be selling Atlas within the next five days, pursuant to the transaction guidelines of all the Motley Fool's portfolios. To reiterate an important point on that policy, we're not going to front-run you by making a purchase and then telling you what we've done. We make all of our decisions to acquire a stock or sell a stock a matter of public record before doing so.
Our main objections to owning this company have to do with its failure to generate a return on all capital invested in the business. One can say that this is a company that generates a 15% return on equity, so it's doing a great job. We think that's not the best way to look at the business. We want to know the return on all capital invested in a business, not just on the equity invested in the business. Only in the case of financial services companies will we focus more closely on return on equity as the key characterization of return on capital.
Atlas fails the test of a company that can show return on capital before leverage is applied. What this means is this: Leverage increases return on equity:
Return on equity is a function of three variables: 1) Asset turnover, 2) Net margin, and 3) Financial leverage. As an equation, ROE looks like this:
Revenues Net Income Assets ---------- x ------------ x --------- Assets Revenues SE
So, by increasing assets by way of increasing debt, a company can pump up return on equity, turning marginal unleveraged economics into attractive-looking economics when leverage is applied. Leverage doesn't create good economics. It can enhance shareholder value when applied properly, but it doesn't turn poor economics into great economics. For instance, you can leverage the hell out of something like RJR Nabisco and it can still survive. You can leverage cosmetics company Revlon pretty deeply, and it will survive. But when you apply tons of leverage to airline companies, you're basically asking for trouble. Think Eastern Airlines, TWA, USAirways, and all the capital-intensive transports that went under.
One thing I didn't like in reading Atlas' third quarter conference call was the statement: "It should be kept in mind, however, that Atlas's debt is backed up by hard assets, in the form of the aircraft." That rationale has been used more than once in the airline industry, and I don't think it's any different in the air transport business. At the very moment that debt becomes such a worrisome thing in the air transport business, the aircraft are going to be selling at depressed values. I don't share the reasoning that equity holders are insulated from Atlas' debt just because aircraft happen to be hard assets. If a buyer decreases his or her assumptions about the cash flows that aircraft can create, then the aircraft can sell below book value and below the value of the debt. That eats into the equity holder. Plus, this reasoning was used by countless airline leveraged buyout artists in the 1980s who later filed for bankruptcy. It's a poor reason for over-leveraging a business that shows bad economics.
Getting back to the competitive position of this company, we reiterate that we realize it's well run and we hear that it's one of the best companies in its industry. We also realize that there aren't many companies that trade in the U.S. that are similar to this company. FDX Corp. (NYSE: FDX), otherwise known as FedEx, is not just an air carrier, nor is Airborne Freight (NYSE: ABF). These are the industry comparables that you see mentioned, but the sets of assets these companies use and the services they provide are much different than Atlas. Leasing planes and running them under ACMI (Aircraft, Crew, Maintenance and Insurance) contracts is different than what FedEx does. So, it's not easy for us to pin down exactly how well-positioned this company is vis-a-vis the competition.
But again, we have to turn to the point that there are, in the long-run, enough aircraft, pilots, capital, and good transportation industry management talent that it's hard to add value to capital in this industry. The barriers to entry are too low -- supernormal profits in an industry such as this would not attract new investments in capacity. In the short run, shortages of the proper aircraft, pilots, or capital can improve or hurt a particular company's situation, as we see with the stage 3 noise regulations, which are reducing capacity in the industry.
Indeed, Atlas has generated a return on invested capital of 6.63% over the last twelve months. That means if it were to stop growing today and invested enough to maintain its position, the cash return on cash invested in this business would amount to about 10.5% pre-tax and 6.63% after-tax. With Atlas hitting on all cylinders, we're not happy with that sort of performance and wonder what kind of return we could expect when times get tougher.
In addition, a company cannot keep up growing invested capital and earnings at a rate it has been and a rate analysts project without taking on more debt or issuing more equity. Either way, you further leverage the company or you increase your cost of capital, because equity costs more than debt and the cost of equity also increases the more leveraged that equity is. If that increased cost of capital is offset by increased return on capital due to operating efficiencies, then it should not do a whole lot of damage to the value of the company, but you decrease your margin for error. We like to shoot for the side of the green where with the shallow sandtraps and low-cut rough, not the side of the green with pot bunkers and alligator-infested waters.
On Monday, we included a rundown of what the company has done over the last twelve months. That's our standard "tear-sheet" on a company that helps us assess the economics of an enterprise and what we're paying for the current earnings and capital that's been put into the business. A couple of things stand out. We look at a company as if we were going to acquire it, lock, stock, and barrel. The economics of such a transaction would not matter if we were a company acquiring Atlas in a stock swap or with cash or in a pooling of interests or purchase transaction. In either case, the return on capital we have issued to acquire the company would be dictated by the company's current valuation.
Looking at it in that case, there are a couple ways to see it. The Boring Ratio shows us what kind of return on investment we are buying when we deploy capital in an acquisition. The ratio sets up like this:
Net operating profit after taxes/ average invested capital --------------------------------------------------------- Enterprise value/Invested capital
This depicts the price we're paying for capital invested in the business divided by the company's current return on invested capital.
Net operating profit after taxes (NOPAT/ Enterprise value net operating profit after taxes (NOPAT). This is basically an earnings yield that measures how much we are paying for a dollar of earnings before considering the costs of capital. In the case of Atlas at present, the ratio looks like this:
$73.43 / $1,107.96 ----------------------- $2,051.33 / $1,271.93
This works out to 4.1%
We can also work through this using return on equity as the basis for capital and return on capital:
Net income / average shareholders' equity ------------------------------------------- Market cap / shareholders' equity $37.30 / $245.62 -------------------- $846.43 / $264.89
This works out to be 4.7%.
Notice in both of these that the invested capital and shareholders' equity elements of the numerators are close to being the same, but aren't quite the same. In both the numerators, we're looking at average amounts of capital. In the denominators, we're looking at ending amounts of capital. Nevertheless, these are calculations that show us the approximate yield on the purchase price of the company that we could expect if the company's profits grow at the same rate as invested capital.
Note that the current yield on this business is not really different than risk-free short-term interest rates. Earnings divided by price is an earnings/price ratio. Invert that, and you've got a P/E ratio of approximately 21.3, which is actually a hair lower than the current P/E of 22.7 because of the way the two ratios are calculated. The current earnings yield on this business is the classic case of fixed-income versus equity investments. From a government note, you can expect a risk-free income stream equal to the yield on this business. While you know that you'll get your principal back, you also know that the income stream will stay the same for the duration of the bond. You might also get to reinvest those interest payments at either higher or lower rates. With owning a business, you have the prospect of the yield on invested capital growing, but the yield can also shrink. And there's no guarantee that you can get all of your capital back.
In light of our view of the uncertainty in this industry and our lack of confidence in our ability to foresee the future in this industry, we don't view the yield as being compelling enough for us to risk the capital.
Further Valuation Models
The models above depict what you might expect if the company did not have any growth plans. After all, there are tons of companies out there that wouldn't carry much value if future earnings were not taken into account. We did three long-term valuation models on the company, which you can download. Click here for the Excel 5.0/95 spreadsheet and click here for the Excel 7.0/97 spreadsheet. In the two EVA valuation models, we modeled very positive scenarios for the company. Given our biases about this sort of company, it would be easy to model growth stalling out and poor returns on capital. But what we did was model extremely high growth scenarios and much improved returns from the business in future years to match the assumptions one could make about future operating efficiencies.
Instead, we assumed that the company will get its return on invested capital up past 7% next year with a steady climb to 11% through year 11. As in all discounted cash flows or EVA models we do, we also modeled in a rocky period in one of the cash flows to reflect the possibility of a recession, bad execution, or whatever other risks to a company you could imagine. But in the rest of the years, we assume that the company's ROIC is much better than it's showing now, which is a generous assumption, we believe.
In the first model (EVA), we assume growth in invested capital of at least 20% though year 6, 15% for the following two years, 10% for the next two years, only one year in which invested capital falls 3%, then a cyclical bounceback to 10% growth and a steady state of growth through year 18. For the majority of the years in this model, the company's ROIC is 11% and there are only four years in which the company's return on invested capital does not beat its cost of capital. Sorry if this is prosaic, but if you can't get the spreadsheet, we want to share our assumptions. The bottom line with this model is that intrinsic value of the firm is $1.88 billion and the value of the equity in the firm is $29.82 per share. That's overvalued by between 9% and 26%, depending upon whether you're measuring the company's enterprise value (which includes debt) or just the equity market capitalization.
In the second model (EVA2), we assumed no years in which the company runs into a major glitch and loses money. In only three years does it fail to cover the cost of its capital, and these dropouts take very little value away from the company's valuation. Again, this is highly generous. There are some years in this model where the company's growth in invested capital stops and actually drops for two years, but by only 5%. We assume in this model that the company does this as a way to improve its economics, as many well-run companies will slow down to consolidate what they have built before moving on. This model shows the company as being fairly valued right here.
An alternative way of looking at the two models is not to look at the intrinsic value product as the end-result, but to look at the assumptions that are being made. If these models show the company to be fairly valued to slightly overvalued here, what can we make of these assumptions? This is one way we look at the assumptions that are imbedded in a company's current stock price. Both Alex and I believe that the assumptions in these models are overly generous and don't even reflect the possibilities of really bad years. Over the next 18 years, we think there's a good possibility that this company will have a really bad year or two, not because of its management, but because of the overriding economics of the industry.
Finally, we did a simple discounted earnings model in which we assumed the following earnings growth rates in a 15-year model:
In this model, we follow the mean 5-year growth estimate indicated by Zacks.com, then we bring it down to 14% and assume a cyclical downturn followed by a return to growth. Again, we feel that these are generous assumptions. The discount rate for the net present value of earnings is 13% and the sensitivity of the model to the terminal capitalization of earnings showed the company's valuation as being undervalued/overvalued at the following terminal capitalization rates (earnings multiples):
20......Undervalued by 18.5%
15......Undervalued by 8.2%
10......Overvalued by 5.1%
Taking the model with the 15-times earnings capitalization of the residual and assuming more of a steady growth rate in the out-years and still assuming two bad years in year 9 and 10, we show overvaluation of 11.5%.
The final test in what we do is ask this: Would we pull "X" dollars out of our pockets to acquire this company? It's a very simple question, always asked with the implicit premise that there are lots of other business opportunities out there. Our answer is "no." This is a business that ate up $209 million in free cash flow last year and shows unattractive economics, in our opinion. The return on equity is created at such a financial risk that we don't find that return attractive. Our valuations show that we are receiving fair value for this asset in selling it. We also believe that the assumptions implicit in the market valuation of this company are unrealistically high, even though earnings are exploding in the near term. We don't believe that near-term earnings growth demands a high earnings multiple because if we were to own this business we'd have to live with both near-term earnings growth and the long-term prospects for the company. Not liking the latter, we can't warm up to the former. Therefore, we will be selling Atlas Air within the next five business days.
Part Two of Sell Report
November 16, 1998 Boring Report on Atlas Air
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: firstname.lastname@example.org). 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)
Days Sales Outstanding...59.76
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
Cash & Equivalents...$253.35
Last Yr receivables...$54.96
Last Yr Shareholder's Eq...$226.35
Last Year Assets...$1,231.00
Last Year PP&E...$1,004.64
Average share equity...$245.62
Working Capital Change...-$23.01
Net Op. Cash Ex. WC Change...$107.04
Net Cash from Operations...$84.03
Cap Ex/Begin Invested Capital...23.03%
Principal Repayments+New Debt...$325.33