Date: Monday, February 27, 2023
Air Transport Services Group, a freighter leasing and airline services company best known for operating dozens of cargo jets for Amazon, said it expects slower growth this year after generating record revenue in 2022, because weaker economic conditions mean there is less need for its aircraft.
It will also be a big year for investment in new aircraft as management bets on the air cargo industry long-term upside, which could increase debt leverage.
The air logistics specialist on Thursday reported earnings showing 11% growth in revenue to $530 million and adjusted earnings before accounting measures of $163 million, up 5% year over year. For the full year, revenue and adjusted profits both grew 18% to $2 billion and $641 million, respectively.
ATSG attributed increased revenue to full-year contributions from new leases of Boeing 767-300 freighters. In 2022, ATSG leased six more 767-300s and flew seven more aircraft provided by customers.
President and CEO Rich Corrado said ATSG’s aircraft leasing operations, including its engine maintenance services, are expected to generate substantially more profit over the next five years, but reductions in long-term charter activity will be a limiting factor.
ATSG, already the largest lessor of freighter aircraft in the world, plans to increase capital expenditures by 44% this year to $850 million, including $590 million for fleet growth. The scale of fleet investments will be much larger for several more years, executives added. The money will be used to buy more feedstock aircraft, pay aerospace manufacturing firms to convert them to dedicated freighters and cover heavy maintenance.
ATSG’s stock (NASDAQ: ATSG) was down nearly 19% in Friday trading, reflecting investor worries that returning cash to shareholders and returns will be lower than in the past because of the heavy capital outlays and aircraft placement with smaller customers that may not be able to weather market dips as well as express network operators like Amazon.
The diversified aviation services company fared better than all-cargo carrier Atlas Air, which reported the same day a 24% decrease in adjusted earnings in the fourth quarter. But Atlas Air leases far fewer aircraft than ATSG and therefore is more susceptible to volatility in the air cargo market, which has swooned since last March.
ATSG, which has 110 cargo and 18 passenger aircraft in service, lowered its 2023 guidance to $650 million to $660 million in adjusted earnings before interest, taxes, depreciation and amortization — barely above last year’s level. Executives said they expect cargo aircraft utilization measured in hours to be down about 5% year over year but still compare favorably to other periods.
Besides a weakening air cargo market, other operational risks this year come from higher costs associated with labor, travel to reposition pilots, maintenance and interest rates on loans for aircraft, as well as negotiations for new pilot contracts at two of its three airlines.
ATSG foreshadowed a deceleration in growth early this month when it said Amazon and DHL Express are reducing flight schedules for aircraft operated by Air Transport International (ATI) and ABX Air. It also warned that Amazon might not renew leases on five aircraft, while three others would be retired because they’d reached airframe age limitations. On Friday’s earnings call with market analysts, management was more definitive that Amazon would return all eight Boeing 767 freighters, which will pause revenue generation until new customers are lined up. The pullback follows news that Amazon had pumped the brakes months ago on the breakneck expansion of its Amazon Air network, postponed new warehouse construction and laid off thousands of workers.
Amazon insists it scaled back first-quarter flight activity for maintenance reasons and not because of a drop in online retail transactions.
But retail spending online has fallen from its extraordinary growth rate during the pandemic when people were isolated at home, pocketing government subsidies and buying goods to better enjoy their home environments.
Annual online sales growth is back down to 11% from 26.4% in 2020, but that is faster growth than in the overall retail sector. And in some emerging economies, e-commerce growth is in the 20% to 30% range. Global e-commerce sales topped $5 trillion last year for the first time and are projected to reach $7.4 trillion in 2025, according to eMarketer. By 2025, e-commerce is expected to represent nearly 24% of total retail sales, up from 17.9% in ’20.
That is the main reason ATSG is still confident leasing activity for its converted freighters will continue unabated, despite short-term reductions in aircraft utilization and revenue within its long-term air charter business.
The company also benefits from its assets mostly being used in express networks where aircraft have to service regions every day — no matter how full the planes are — to meet time-definite and day-definite package delivery commitments. ATSG last year executed a six-year extension and expansion of its contract with DHL Express. The number of 767s ATSG airlines operate for DHL has more than doubled since the beginning of 2021.
In addition to lease-operate contracts with Amazon, DHL and UPS during peak season, many ATSG customers that lease stand-alone aircraft fly them in express networks too. Raya Airways in Malaysia, for example, flies for DHL. Maersk Air Cargo is a UPS vendor in Europe. And ASL Aviation is the largest contract carrier in Europe, with several airlines that fly freighters for multiple express delivery companies.
“These lessees are diversifying us globally. And although they may not be your household name of DHL, UPS or FedEx, they fly for those people. So the credits that they represent are very strong in relation to just the general airline that’s out there,” said Corrado, addressing concerns about debt ratios. “So we have a lot of confidence. We do a lot of vetting of airlines in terms of what they’re going to do with the airplane.”
Manufacturers Boeing and Airbus have forecast express air volumes will grow at a compound annual rate of 5% or more, one or two points greater than the market for general cargo.
And, ATSG is gaining business from new customer breeds: passenger airlines starting freighter divisions to capitalize on demand for air cargo and diversify their revenues, and a few ocean carriers that want full control of their network to provide end-to-end supply chain choices for big shippers. It conducted a sale leaseback with Air Canada for two 767s, for example, and is now doing the same thing with Vietnam Airlines for a couple of A321s it purchased from the carrier.
ATSG said this month it expects to lease the same number of aircraft over the next couple of years as previously projected.
“Growth in e-commerce, particularly outside the U.S., is driving the growth of air express networks around the world. That trend, and replacement of older cargo aircraft postponed during the pandemic, are compelling drivers for growth in our leasing demand,” Corrado said in the earnings report.
However, ATSG is still much more profitable with about 7% profit margins versus 5.3% in 2019, Stifel equity analyst Frank Galanti wrote in research note. The business is expected to maintain those margins because contracts were set at higher prices and longer durations during the past three years and Amazon is providing more of its own planes for crew service, which should be a more profitable mix, he said.
Transition to Airbus freighters
Cargo Aircraft Management (CAM), ATSG’s leasing arm, buys used passenger aircraft and sends them to overhaul specialists to be modified for carrying large containers on the main deck before renting them to airline customers. It has 22 aircraft ready to be converted.
It expects to deliver 14 767-300s this year and 16 next year, most of which have already been placed with customers.
ATSG has during the past couple years begun to shift its focus to overseas markets. The majority of 767s released last year went to non-U.S. customers that are growing their express and cargo networks.
International opportunities and a shrinking feedstock for 767 conversions have pushed ATSG to offer customers other freighter types, like the A321 and the A330-300, a medium widebody jet that is slightly larger than the 767. The company’s first six Airbus A321-200 narrowbody aircraft are anticipated for delivery this year to customers in Europe and Asia once the retrofit is certified by aviation authorities.
The 20 new aircraft on track to be leased this year represent about $70 million in annualized revenue, CFO Quint Turner said.
CAM will begin the passenger-to-freighter conversion of the first two of its A330s for lease delivery in 2024. It is investing in 30 A330 passenger-to-freighter conversions for delivery through 2028. Two-thirds of those are already backed by customer commitments.
Twin-engine, medium widebody planes like the 767 — and soon the A330 — are the mainstay of ATSG’s fleet because they are well suited for regional express networks in terms of payload capacity and efficiency. DHL Express, for example, already operates the A330 and has ordered several more converted jets from ATSG.
The A321 is a highly capable alternative to the Boeing 737-800 converted freighter, especially since it is able to fit smaller, standardized containers in the lower hold — not just loose cargo. It also is seen as a replacement for the Boeing 757, a large narrowbody jet that is in short supply for conversions and approaching the end of its life cycle. The A321 has nearly as much volume as the 757 and burns 12% to 15% less fuel, making it a better financial option if the same range and payload aren’t needed.
ATSG has customers for more than 50 conversion slots on which it has placed deposits.
“It’s important to understand that the surge in U.S. ecommerce activity that preceded and soared during the pandemic is only now beginning to surge in other parts of the world. The e-commerce portion of retail sales is still growing rapidly elsewhere, including Eastern Europe, Asia, Africa, and Latin America,” Corrado said in the earnings briefing.
Management said vendor and regulatory issues prevented the company from leasing as many freighters last year as originally planned. Its principal conversion house for 767s, Israel Aerospace Industries, faced ongoing supply chain problems obtaining fabricated parts and material from suppliers in other countries — a situation that has delayed production time across the conversion industry. In response, ATSG booked several conversion slots with Boeing’s program, which is experiencing fewer delays because it still makes factory-built 767 freighters and military tankers that attract a captive supply base.
Chief Strategy Officer Mike Berger said the additional production slots and easing of bottlenecks are expected to allow ATSG to meet its fleet expansion goals this year.
321 Precision Conversions, a Florida-based joint venture between ATSG and an airframe modification specialist, has had difficulty getting approval to put the A321 conversions in service. (ATSG also uses Airbus affiliate EFW to convert A321s.) Berger said two aircraft allocated to ASL Aviation in Ireland are finished and ready for delivery. Many aviation safety authorities have been stretched thin by higher workloads since the Boeing MAX crisis and attrition during the pandemic, industry experts say.
The European Union Aviation Safety Agency is expected to sign off on the conversion by midyear, Berger said.
Management has previously downplayed Amazon’s new partnership with Hawaiian Airlines as a serious threat, saying the retailer tends to select carriers that already have an aircraft type on their operating certificate because it takes about 10 months, and $6 million to $8 million, to get regulatory approval to add one. Hawaiian operates several A330s in its long-haul passenger network, which put ATSG at a disadvantage in bidding for the 10-plane transport contract.
Corrado in November said Amazon’s decision to go with Hawaiian increased the urgency of an internal review to determine if operating the A330, in addition to dry leasing the aircraft, makes financial sense for the company.
ATSG charter airlines ABX Air and ATI currently operate 49 767 freighters for Amazon Air — 42 leased by Amazon and seven provided by the online retailer. Most of them are 767-300s. By adding the A330, Amazon — like ATSG — is future-proofing its fleet with a newer, more plentiful airframe.
ATSG estimates there are 1,500 A330 passenger jets in the market available for conversion compared with a couple hundred remaining 767-300s.
The union representing ATI pilots on Friday criticized management for dragging its feet after 2.5 years of talks to amend their contract, saying they have helped deliver record results during the pandemic without always having good support.
Negotiations have stalled over issues such as compensation and retirement. The Air Line Pilots Association said ATI is experiencing higher than normal pilot attrition with 126 pilots leaving last year for better opportunities. To compensate, ATSG hired 176 new pilots last year, which has added additional costs and put extra stress on the company’s training programs, it said.
“It’s not surprising that ATI is having trouble attracting and retaining pilots. Poor crew planning, poor treatment of pilots, poor working conditions, an outdated contract, and an inability to support flight operations due to overworked and underpaid ATI staff across the board have all contributed to a significant number of pilots leaving,” said Capt. Mike Sterling, chair of the ATI unit at ALPA. “The Company has been unable to resolve the deteriorating conditions because they continually fail to recognize that a next level contract is the only solution. ALPA remains committed to achieving a contract that will attract and retain pilots and restore our ability to provide superior service to ATI’s customers.”
Hawaiian Airlines pilots recently inked a new contract that puts them at the top of the heap for cargo airlines. FedEx pilots, who also belong to ALPA, are also becoming more agitated about the pace of contract talks.
Berger said the sides are meeting multiple times a month, but that no resolution is in near sight.
“We have always taken the position that we need a pilot contract that pays the pilots well enough that we can retain and attract pilots but also gives us the cost structure required that we compete for business. And we’ve always been able to make those two positions meet at some point,” he said.
ATSG has not had any problem attracting pilots over the past year and has been able to get new recruits trained without any impact to its flight schedules, Berger added.