Cargojet Income Fund CJT-UN.TO
November 13, 2006 - 2:16am EST by
incognito893
2006 2007
Price: 8.15 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 73 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Cargojet trades at 6x 2007 FCFE (16.7% FCFE yield) and currently pays a 13%+ cash distribution, after applying a 20% tax discount due to recent tax legislation regarding Canadian income trusts.  Before taxes, the company trades at 4.8x FCFE.  We strongly believe that Cargojet is grossly undervalued considering its 50% market share in a cyclical, but growing industry with high barriers of entry and its highly experienced and incentivized management team, which collectively owns 30% of outstanding shares.
 
 
Quick Metrics (All figures in $CDN)
Market Cap: $73 mil @ $8.15
Net Debt: $19 mil
FCFE: $15 mil ($12 mil, adjusting for 20% tax discount)
 
 
Business
Cargojet flies to and from 13 Canadian cities using its fleet of 12 B727-200 dedicated cargo aircraft and hauls 550,000 pounds of overnight cargo per day for clients such as UPS, DHL, Eagle Global Logistics, British Airways, and Air India.  This represents approximately 50% of the domestic Canadian time-sensitive dedicated overnight delivery market, a premium priced niche within the larger air cargo market.  Another 10% of the company’s revenue comes from ACMI passenger and ACMI cargo business, where the company provides the aircraft, a crew, and maintenance in a cost plus arrangement.
 
 
Why is it cheap?
Besides the current turmoil in the Canadian income trust sector (Google “income trust” to read all about it) and the company’s micro cap status, we believe the company’s poor performance in 05Q4 and 06Q1, as presented below, has created a significant buying opportunity for investors willing to analyze the moving parts within the most recent quarterly financials.
 
 
05Q1
05Q2
05Q3
05Q4
06Q1
06Q2
06Q3
06Q4E
07Q1E
2007E
 Revenue
27.4
28.1
29.5
32.9
31.4
33.6
34.0
 
 
 
 EBITDA before Heavy Maint. Accrual
4.2
3.6
4.8
3.1
3.4
5.8
5.7
5.7
4.4
22.2
 - Heavy Maintenance (normalized)
0.6
0.6
0.6
0.6
0.6
0.6
0.6
0.6
0.6
2.4
 - Maint. CapEx - Engine Purchases
0.3
0.3
0.3
0.3
0.3
0.3
0.3
0.3
0.3
1.2
 - Maint. CapEx - Other Than Engine
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
0.5
2.0
 = FCFF
2.8
2.3
3.4
1.8
2.1
4.5
4.3
4.3
3.0
16.6
 - Interest Expense
0.4
0.4
0.4
0.4
0.4
0.4
0.4
0.4
0.4
1.6
 = FCFE
2.4
1.9
3.0
1.4
1.7
4.1
3.9
3.9
2.6
15.0
    LTM FCFE
 
 
 
8.7
7.9
10.1
11.0
13.6
14.5
15.0
 
- EBITDA before Heavy Maintenance Accrual = Revenue - Direct Expenses – Sales & Marketing – G&A + imbedded Depreciation in Direct Expenses + Heavy Maintenance Accrual
- Heavy Maintenance and Capital Expenditures are normalized to be spread evenly throughout the year.  These figures are in line with both management guidance and historical expenditures.
- The 06Q3 FCFE shown above is understated due to a $400,000 accrual for a one-time incentive payment, based on management’s ability to improve over target cash flows.  If management is not able to grow cash flow further, there will significantly less or no accruals in the future.
- Seasonality: 3Q and 4Q are the strongest, 2Q is relatively strong, 1Q is weak.
 
 
Poor 05Q4 Results
Listed are the one-time items that impacted 05Q4 results:
 
 
Expense
Comment
ACMI-Related
400
Our estimate, Conversion of an aircraft from ACMI to the overnight cargo network and 45 day closure of another aircraft in order to switch ACMI routes.
Start-Up Costs for New Int’l Route
500
Our estimate.  Cargojet’s first international route.
One-Time Credit
400
As part of a 3-year contract extension and to secure increased contractual volume for a large client
Deicing
200
Higher than expected deicing expenses.
Negative impact on FCFF
1,500
 
 
This would imply that Cargojet’s core/normalized FCFF was $3.3 mil, which is a $0.5 mil YoY improvement.  05Q4 Core FCFF was most likely higher since FCFF improved an average $1.3 mil YoY per quarter for the first 3 quarters ($3.9 mil total for first 9 months) or on a percentage YoY basis, 86% for 1Q, 35% for 2Q. and 131% for 3Q.
 
 
Poor 06Q1 Results
Aside from it being the seasonally weakest quarter, 06Q1 had material downtime and one-time expenses related to the new international route, an additional scheduled flight, and a new ACMI contract.  We believe 07Q1 will be approximately $0.9mil better due to the reasons mentioned below.
 
 
Improved 06Q3 & 06Q4 Results & Quick Valuation
We believe that the market overreacted to these 2 consecutive quarters and that the 2nd and 3rd quarter are much better representations of Cargojet’s future profitability.  In these quarters, the company had no one-time expenses and enjoyed the benefits of the following:
  • the new international route and scheduled flight began to produce cash flow instead of draining it.
  • a 10% price hike in non-contracted volume earlier this year.
  • overall growth in air cargo volume due to the expanding Canadian economy.
The company produced approximately $4 mil FCFE per quarter in the 2nd and 3rd quarter and management guided in the most recent conference call that the 4th quarter cash flow will also produce FCFE in the same range ($4 mil).  We believe that given a moderate economic climate, 2007 FCFE will be approximately $15mil, which represents a 20.8% FCFE yield (4.8x) before tax and a 16.7% FCFE yield (6x) after a 20% income trust tax discount (we discuss the new tax laws later).
 
 
Annual Data:
 
2002
2003
2004
2005
2006E
2007E
Revenue
53.7
78.5
101.0
117.9
134.4
 
EBITDA before Heavy Maintenance Accrual
 (0.9)
11.3
13.0
15.7
20.6
22.2
FCFE
(5.5)
5.2
5.8
8.5
13.4
15.0
 - 2002 & 2003 data from Long Form Prospectus.  Company began operations in mid 2002. 
 - 2004 & 2005 data taken from 2005 Annual Report
 - Maintenance CapEx and Heavy Maintenance Accruals were pro-rated with revenue for 2002 and 2003.
 
 
Risk 1: Losing a Contract
Cargojet’s 3 largest clients are DHL, UPS, and Sameday, each representing 15% of Cargojet’s Canadian overnight revenue base.  70-75% of overnight revenue is generated from contractually guaranteed volume in 3-5 year contracts that include CPI-related annual price increases.  Contract extensions were successfully negotiated with Cargojet’s 2 largest customers during 2005.  There are no major customer contracts up for renewal in 2006.
 
That being said, it is difficult to find a good reason why a customer would leave Cargojet in the longer term.  With approximately 50% market share of Canada’s domestic dedicated overnight air cargo market, Cargojet has the lowest cost basis and highest value offering in the industry.  Its 13 destinations cover the overwhelming majority of Canada’s population, and its size allows it to fill low-demand routes that are not economic to other air cargo companies, which in turn is the reason why clients choose Cargojet.  In fact, Cargojet is the exclusive Canadian overnight air cargo provider to most of its customers, including UPS. 
 
Economies of scale also allows the company to maintain one aircraft and crew on standby in case an aircraft is immobilized (which we know happens more often than we’d like).  This has resulted in more than 98% of Cargojet’s flights arriving within 30 minutes of its scheduled times.  Cargojet has also won Shipper’s Choice Award for Cargo Airline of the year for 2002, 2003, and 2004 – the only Canadian carrier selected to receive the award for the third time.  As one might expect, customers in the overnight delivery market care most about getting their cargo quickly and consistently, with price coming second.  Many customers have also indicated that switching costs are high due to logistical challenges.
 
Furthermore, Cargojet is the only company that offers on a national scale, dedicated space to multiple customers on the same aircraft(sometimes referred to as a neutral co-load network).  This means Cargojet is the only company that can pass on the savings of fully utilizing cost-efficient widebody aircraft on overnight deliveries to smaller customers with low volume needs and both smaller and larger customers on low demand routes.  We expect that replicating such a network infrastructure, acquiring widebody aircraft, high initial insurance costs, and initial low capacity utilization all point to a very expensive undertaking for new entrants, and creates significant risks for a large client to switch to an unproven company.
 
Cargojet’s two largest competitors exclusively serve a single courier and it is our understanding that they are contractually forbidden from accepting cargo from competing couriers.  The only real threat is Kelowna Flightcraft, which exclusively serves Purolator.  Morningstar Air Express, which serves Fedex, is less than one third the size of Cargojet and we do not perceive them as a major threat.  If either company wanted to “steal” a client from Cargojet, they would have to adapt their systems to accept cargo from multiple companies, something they have never done before (and which Purolator or FedEx may not want for competitive reasons).  The remaining competitors are mostly niche regional players or are involved in smaller charter arrangements.
 
Competitors
Customer Base
daily volume (lb)
Key Operating Facts
Cargojet
Multiple customers
              550,000
 
Kelowna Flightcraft
Purolator
              400,000
Mutually exclusive contract with Purolator
Morningstar Air Express
FedEx
              150,000
Exclusive contract with Federal Express
* Daily volume was inferred from using various publicly available resources
 
There is some cooperation amongst industry participants, particularly on low demand routes, where two competitors flying the same route with low capacity utilization agree to share one aircraft with the combined cargo.  The firms share the savings and monopolize the route at the same time.  Cargojet has been involved in this activity and it has improved their bottom line over the last year.
 
 
Risk 2 : Open Skies Agreements
 
Open Skies Agreement with the US
Starting September 1st, 2006, a new Open Skies Agreement between Canada and the US took effect.  The most important thing here is that cabotage, the practice of acquiring cargo at one point and dropping it off at another point within the same country, remains illegal.  The agreement made 2 large changes:
 
Co-Terminalization – Allows for an aircraft to make 2 stops in a foreign country from the currently permitted limit of one stop.  However, cabotage is still restricted.  i.e. – US Carrier flying from New York to Toronto to Vancouver.  The aircraft can only drop off in Toronto and Vancouver cargo acquired in New York.  Cargo acquired in Toronto CANNOT be dropped off in Vancouver.  Since flying a cargo aircraft half empty is not very economic, we don’t expect significant incoming competition in this space.
 
Fifth Freedom - Allows for an aircraft to fly from its home country to a foreign country, drop off and acquire cargo, and then continue to a third country.  The home country must have an “open skies” agreement with both foreign nations.  i.e. - New York - Toronto - Seoul (can pick up and drop off all cargo at any of these 3 locations, since the US has an open skies agreement with all 3 countries).  Since virtually all of Cargojet’s cargo originates in and is destined within Canada, and Canada only has “open skies” agreements with the US and UK, there should be almost no impact.
 
 
Future Open Skies Agreements
The last Open Skies Agreement between the 2 countries was signed in 1995.  This gives us an idea of the pace of change in international aviation agreements.  However, what makes us truly feel safe is a statement made in an October press release by Transport Canada (FAA equivalent) regarding future liberation of bilateral air transport agreements:
 
“Under no circumstances would the proposed approach include cabotage rights – the right for a foreign airline to carry domestic traffic between points in Canada.”
http://www.tc.gc.ca/pol/en/ace/consultations/airTransportationPolicy.pdf
 
The bottom line is cabotage is extremely rare (there are a few exceptions, including the EU, and between New Zealand and Australia) and will not be a threat during our holding period.
 
 
Risk 3: Cyclicality
While air transportation of passenger tends to be extremely cyclical, we found much more stability in Canada’s air cargo market, according to two sources. This stable stream of cargo volume, along with Cargojet’s 50% market share and  special status as the sole national co-load overnight operator, should leave Cargojet is in a strong position to lower supply and maintain prices if the economy were to enter a recession.  Historical financials are not very valuable since the company in its current form was founded in 2002.
 
Domestic Canadian Cargo Volume Measured in Metric Tonnes
 
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Domestic*
 401
 424
 427
 440
 489
 493
 505
 510
 491
 
   % Chg
 
6%
1%
3%
11%
1%
2%
1%
-4%
 
Domestic**
401
424
427
449
513
500
521
517
504
507
   % Chg
 
6%
1%
5%
14%
-3%
4%
-1%
-3%
1%
- * Source: Statistics Canada, Canadian Civil Aviation, Cat. 51-206; Aviation Service Bulletin, Cat. 51-004, and special tabulation for revised data. http://www.tc.gc.ca/pol/en/Report/anre2005/add/taba911.htm   
- ** Source: Canadian Civil Aircraft Register http://www.transport-canada.org/pol/en/report/anre2003/add/taba911.htm
 
 
Income Trust Tax Legislation
At the end of October, the Finance Minster of Canada announced that he would propose new legislation that would tax Canadian Income trusts, such as Cargojet.  His proposal would affect Cargojet in the following manner:
 
1) For the next 4 years nothing changes.  Cargojet pays no taxes and the flow-through-entity status continues.
 
2) Starting in 2011, Cargojet pays a 30% tax on distributed cash.  Cargojet may or may not have the ability to defer cash taxes.  The company has $75 mil in intangibles available for amortization (at the current rate of $10 mil a year, there is 7.5 years remaining.  Amortization for tax purposes still applies in Canada), accelerated depreciation from a slightly asset intensive balance sheet, and the ability to categorize a portion of its distributed cash as “return of capital” which is tax-free.
 
If you apply a 10% discount rate to a $10 mil per annum stream of tax-free cash flows for the first 4 years and 30% fully taxed cash flows per annum thereafter, you will find a PV that is 20% lower than a perpetual tax-free stream of $10 mil per annum ($80 mil vs. $100 mil).  In other words, the appropriate discount is 20% of the tax-free situation.  Also, if you raise the discount rate to 15%, the discount falls to 17%.
 
Please keep in mind that this tax legislation is not yet law, but will most likely be 1) implemented or 2) implemented in a modified form that won’t hurt income trust holders as much.  We are being conservative and assuming 100% chance of a 30% cash tax starting 2011 with no deferred tax rights.
 
 
Growth Trends
Cargojet benefits from multiple smaller growth trends which compound to a mid to high single digit revenue growth potential.

Industry Growth - The Boeing World Air Cargo Forecast estimates that the Revenue Tonne Kilometres for the Canadian domestic air cargo market will grow 2.6% annually for the 10-year period from 2003 to 2013.  Airbus Global Markets places the growth at 4% for domestic Canadian air cargo industry growth.
 
Demand Shift from Airlines - Over the past several years, the amount of cargo capacity on passenger airlines has been decreasing as airlines replace older, wide-body aircraft with newer generation, narrow-body aircraft, which have significantly less underbelly capacity per passenger.
 
Security Measures Shift Cargo from Airlines – An increased emphasis on cargo security for passenger airlines may result in higher costs and delays for operators and their passengers – enough that they may reduce their market share and give it away to dedicated cargo companies such as Cargojet.
 
Interline Revenue – International airlines that drop off Canada-bound cargo in major airports such as Toronto and Vancouver are hiring Cargojet to deliver the final leg to other Canadian cities.  Cargojet is currently signing 5 to 10 new deals each year.  Although this currently is less than 5% of revenue, the additional volume comes with virtually no incremental cost, since these routes already exist and are running below full capacity.
 
International Routes – The company may opportunistically enter certain routes in the Carribean market, where there have been successful with their route to Bermuda.
 
 
Management
The management team is stellar and I’ve included shortened bios for each.  The CEO wants to expand the business, but is currently holding back due to rising prices for aircraft and lower returns.  The management team’s timeliness in its formation of Cargojet in 2002 signals to us their opportunistic and disciplined approach.  In other words, we don’t expect management to go on crazy empire building negative ROI spending sprees.  The lead pilots seem to be great at motivating and training their teams as well.  George Sugar, VP of Flight Operations, and David Moore, Chief Pilot, are ranked #1 and #3 as in a poll of best Chief Pilots in Canada according to this ranking (http://www.avcanada.ca/forums2/viewtopic.php?t=13215&highlight=cargojet)
 
Ajay Virmani, CEO, (28 yrs in transportation industry, owns $17 mil worth of shares) served as SVP of Cottrell Transport from 1977 to 1990, when he left Cottrell to form Commercial Transport International and Fastair Cargo Systems.  Over 10 years, he built CTI/Fastair to a 400 employee $100 mil revenue company until it was sold in 2000 to Eagle Global Logistics, where he served as President from 2000 to 2001.  In 2002, he founded what is now Cargojet with
 
Dan Mills, CFO, (19 yrs in transportation industry, owns $2.4 mil worth of shares) was VP of Finance for Cottrell from 1986 to 1991 and was later General Manager from 1992 to 1995.  In 1995, Mr. Mills joined CTI/Fastair when they acquired Cottrell and was made a partner.  From 1995 to 1999, he was Director of the Hi-Tech Forwarder Network, an international freight forwarding association.  In August 2001, Mr. Mills co-founded Canada 3000 Cargo Inc, a predecessor to Cargojet.
 
Jamie B. Porteous. VP of Sales, (20 yrs in airlines industry, owns $2.1 mil worth of shares) was Director of Operations at Air Canada where he was responsible for cargo movement control on a global basis. When Air Canada sold its cargo aircraft fleet, Mr. Porteous moved to the customer side of the business, spending three years as consultant and director of a full-service transportation business.  In 1996, Mr. Porteous was appointed Director of Sales & Operations for CanAir Cargo Ltd. (a predecessor of Cargojet), Canada’s only all cargo overnight carrier at that time.  In 1997 CanAir Cargo Ltd. was acquired by Royal Aviation Inc. where Mr. Porteous assumed the role of Vice President, Sales & Service.  In August 2001, Mr. Porteous co-founded Canada 3000 Cargo Inc, a predecessor to Cargojet.
 
 
Other
 - There is 100% fuel surcharge pass-through.  RBC calls it the most robust fuel pass-through in the transportation sector.
 - The average age of Cargojet’s fleet is 25 years, while expected lifespan is 35 years.
 - Cargojet owns 6 Boeing 727-200, has 1 lease that expires in 2007, 2 leases in 2008, and 2 leases in 2010.
 - 2 analysts, RBC and BMO, cover the stock.
 
 
Comps
There are a real lack of comparable firms, especially in the Canadian market.  However, we have established that this is not a single-customer air transportation company, such as ABX Air (ABXA) or ExpressJet (XJT), which get rather low multiples (5 to 7 range if I recall correctly), since a single customer can pull the rug and destroy them (some VIC members will kill me for saying this).  Most trucking companies, also with low multiples, are also not comparable since Cargojet’s market position and barriers to entry are much more desirable.  However, we doubt that it deserves a multiple like Expeditors International (EXPD) at 25x.
 
In fact, we’re not sure what market value a 50% market share overnight air cargo company would receive in the US markets, but we are sure it would be above 10x FCFE and most likely around the market average of 15-17x FCFE.  Either way, at 6x FCFE (net of 20% tax discount), we have a long ways to go before we start arguing that it’s overpriced, as most things in the markets feel to be. 
 
 
Appendix
 
Company Background
Company was founded in 2002 when it converted from being a marketer of cargo belly cargo capacity on passenger aircraft to a full scale national dedicated cargo operator. taking advantage of low prices for aircraft.  To do this, management purchased 3 B727-200’s and bought out an existing airline.  Additional aircraft and new clients were brought on in  2003, 2004, and 2005.
 
 
Client Breakdown
In terms of client type, Cargojet’s revenue is composed of 60% Courier, 29% Freight Forwards, 7% Manufacturers, with the balance in specialty and interline (int’l airlines).
 
 
Additional Sources
For those that want to pursue this idea further…
Interview - http://www.ctl.ca/execfile/avirmani.asp
Interview 2 - http://www.ctl.ca/execfile/virmaniRidell.asp
Interview 3 - http://www.aircargoworld.com/features/0806_1.htm
Article - https://secure.globeadvisor.com/servlet/ArticleNews/story/gam/20051024/RCARGOJET24
Canadian Aviation Forum - http://www.avcanada.ca/forums2/

Catalyst

- Rational investors discover Cargojet and its attractive valuation as Income Trust fiasco cools down.
- 4Q Earnings shows significant improvement year over year and an annual report will make the full year's performance easy to assess.
- Sell-side analysts reports reveal the improving story.
- Be paid 1%+ cash distribution per month (13%+ annually) while you wait for the stock to appreciate.
- At this price, a management buyout is possible, but we don’t need that to make money here.
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