ERICKSON AIR-CRANE INC EAC S
February 01, 2014 - 3:36pm EST by
MiamiJoe78
2014 2015
Price: 19.32 EPS $0.93 $0.12
Shares Out. (in M): 14 P/E 20.8x 161.0x
Market Cap (in $M): 267 P/FCF -7.1x 267.0x
Net Debt (in $M): 420 EBIT 45 37
TEV ($): 687 TEV/EBIT 15.2x 18.8x
Borrow Cost: NA

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  • Poor management
  • Failed Acquisition

Description

Erickson Aircrane (EAC) is a helicopter service provider for commercial and government customers based in Portland, Oregon.  It came across our desk initially because its minority shareholders seemed to be the victims of a particularly egregious act of double dealing on the part of EAC’s majority shareholder (ZM Funds).  The potential double-dealing occurred in May, 2013 when EAC purchased a financially distressed helicopter service company (Evergreen helicopters also based in Oregon) in which ZM Funds held a significant amount of their 2nd lien debt.  

As we dug further into the transaction, we discovered that not only was this purchase highly suspect given the conflict of interest represented by ZM funds, it also was not the accretive acquisition that EAC management has claimed it represented on its many investor roadshows since May.  In fact, we believe EAC’s purchase of Evergreen Helicopters, Inc. diminishes the otherwise solid legacy assets of EAC and places the company in a much more vulnerable financial position.  We think the current share price of EAC (~$19.50/share) does not reflect this new reality and once the market fully comprehends the value destruction of the Evergreen acquisition, it will value EAC’s common stock at much lower prices.  Our target price for EAC is ~$12/share, a 38% decline from today’s price.

Introduction to Erickson - Description of the S-64 Aircrane

Erickson started operations in 1971 as a heavy timber mover in the Pacific North-West.  Helicopters allowed timber harvesters to “surgically” remove high-value timber from inaccessible areas.  Erickson also contracted with utility companies to move large and heavy electrical transmission equipment to more remote parts of the United States and Canada.  Erickson utilized an unique type of helicopter, called the S-64 aircrane, that originally was built by Sikorsky in which the area normally reserved for passengers had been removed leaving the aircraft lighter and more powerful.  The S-64 has a maximum lift capability of 25,000 lbs. that is unmatched by other heavy-lift helicopters.  The S-64 also contains an aft (rear) facing pilot station that gives the rear pilot an unobstructed view of the target load which further improves its ability to surgically haul cargo.  In 1992 Erickson bought the Type Certificate (the right to manufacture and sell the helicopter) of the S-64 from Sikorsky and now is the sole manufacturer of the S-64 in the world.

Over time, Erickson developed a 2,650 gallon water tank that attached to the helicopter’s belly (where the passenger area would normally be) along with a “hover snorkel” that resembles an elephant trunk that allows the aircrane to reload its water tank from any body of standing water without landing the aircrane.  This innovation made the Aircrane an ideal piece of technology to fight wildfires and Erickson quickly partnered with most of the major government forest fire agencies in the world, primarily the United States Forest Service, the Australian Forest Service, the Italian Forest Service and NATO.  It also contracted with local and state agencies located in forest-fire intense regions in the United States; including San Diego Gas & Electric and Los Angeles County.   

By 2012, Erickson’s main business model focused on firefighting (57% of total FY12 revenues) which it supplemented with timber transport (18% of FY12 revenues) and infrastructure transport which includes their traditional utility business as well as a growing business for oil & gas E&P companies in more remote parts of South America (16% of FY12 revenues).  Finally, it operates maintenance and repair operations for its own Aircranes as well as for Aircranes it has sold to 3rd parties (9% of FY12 Revenues).

Before its 2013 acquisitions of Evergreen, Erickson only operated and maintained Aircranes, of which it owns 20.  They have sold 9 Aircranes in their entire operating history, but only one since 2009 which they repurchased from San Diego Gas & Electric in 2012.  

The Economics of Commercial Helicopter Service Operators

For commercial operators of helicopters the highest and best use of their assets is to transport humans, particularly in dangerous or life threatening situations.  Search and rescue operations, secondary military operations (where they deliver troops and support staff to military bases in hostile territory) and emergency health transport all represent high margin work.  The next highest margin work comes from transport of people to areas inaccessible by other means of transportation, primarily offshore oil & gas platforms, followed by transport of people in developed areas that value speed over cost (Wall Street bankers renting helicopters to fly from Lower Manhattan to Laguardia).  Operating margins decline once the operators transport cargo instead of people.  The highest margin cargo business comes from the most difficult requirements (moving cargo 250 miles off-shore) and declines with less difficult work (moving an electrical transmission tower across land).  

Challenges to Erikson’s Legacy Business

Erikson’s S-64-centric business model faces seasonal, cyclical and locational challenges.  Its greatest source of demand and highest margin business (fighting fires) typically only lasts 4-6 months per year (May to October in the northern hemisphere and December to March in the southern hemisphere).  In addition, the actual firefighting demand fluctuates year over year.  Although 2012 was a record year in the United States in terms in of total number of acres burned due to wildfires (~ 9.2mm acres, only surpassed by 9.3 and 9.8 mm acres respectively in 2007 and 2006), 2013 was a more normal year in which only 4.1mm acres burned in the US.  

Erickson has diversified its revenue streams to lessen the seasonality and cyclicality of its northern hemisphere fire-fighting.  It has successfully grown its firefighting business in Australia (it plans to increase the number of Aircranes stationed there from 5 to 6 in 2014).  It has maintained its timber and infrastructure business in N.America and Malaysia and has meaningfully increased its share of the oil & gas market in S.America.  

However, these solutions also create another challenge, that of location.  In order to fully utilize their Aircranes, Erickson must sacrifice margins to find work for its aircrane in the off-season.  This entails either moving some of the aircraft over large distances every 6 months (from N.America to Australia or S.America and vice-versa) and incurring transportation costs as well as a lack of scale for their maintenance operations.  Or it forces Erikson to accept lower margin (or lower frequency) piece-meal work that is closer to the firefighting base.  Erickson has stated that 70% utilization is the maximum level they expect for their Aircranes, given the limitations of their model.  

Valuation of Erickson’s Legacy Assets

Despite its challenges, the S-64 provides Erickson with a reasonably consistent and protected cash flow over time, particularly with the tailwind of climate change and its likely increase of forest fires.  In general, fire fighting revenue should fluctuate between $75mm and $85mm plus $9-$10mm of crewing revenue (Erickson supplies pilots and maintenance for Aircranes they sold to 3rd parties).  Timber and infrastructure should remain constant with expected FY13 levels of $35mm and $46mm, respectively, given the utilization limits of the Aircrane.  MRO should probably also stay relatively constant with FY13 expected levels of $13mm.  Below are our estimated NTM $ revenue for the legacy asset segment (we grow the non-firefighting revenues at 5% from FY13 levels).


EAC FY14 Legacy Asset’s Revenue:
  • Firefighting          $80mm  (Revenue probably lower given outsized 12/13 fires season)
  • Crewing              $  9mm  (Italy reduced demand in FY13 due to austerity)
  • Timber                $33mm  (Timber correlated to housing but EAC aircrane constrained)
  • Infrastructure      $45mm  (Infrastructure constrained by Aircrane supply)
  • MRO                   $13mm  (Maintenance should remain constant)
  • Total                  $180mm
Erickson’s adjusted ebitda margin (for the rest of the write-up we define adjusted ebitda margin as ebitda + stock comp) equaled 21.5% in FY12 as its firefighting in N.America reached all-time highs.  Firefighting represents its highest margin work (except for one-off infrastructure jobs) and if Erickson ever sacrifices firefighting revenue for more consistent infrastructure or oil & gas revenue, adjusted ebitda margins should decline.  This reflects industry averages where the average adjusted ebitda margins of Erickson’s four largest public competitors is 19%.  The competitors’ LTM adjusted ebitda margin averages along with their EV/trailing FY FCF multiples are as follows:

Company               Margin             EV/NTMEbitda     EV/FCF

AAR corp                    11.3%                 7.2X                      13.1x

Air Methods               26.5%                 9.9X                      15.6x

Bristow                      22.0%                 9.4X                      19.1x

PHI Corp                   16.3%                  6.2X                      18.1x

Average                                      8.2X                 16.4X


Air Methods model is entirely medical transport while Bristow’s model focuses primarily on offshore transport to oil & gas platforms, both represent significantly higher margin businesses than other helicopter commercial services.

In order to value the legacy assets, we think Erickson’s long term legacy adjusted ebitda margin should average 20%.  We also assume, based on mgmt guidance that forward legacy tax rates would have equaled 35%.  In order to calculate enterprise value we assume the actual net debt level of Erickson in March 2013 (immediately preceding the Evergreen acquisition) of $100mm which generated ~$6.5mm of interest expense.  We also assume the share count as of 3/1/2013 of 9.765mm shares outstanding. 

We estimate Erickson’s legacy assets should average $180mm in revenue with 20% ebitda margins going forward.  We assume $6.5mm interest expense, $6.8mm of cash taxes (net of $10mm of D&A) and $8mm of maintenance cap ex and calculate a free cash flow of $14.4mm/year.  We did not use EV/Ebitda to value Erickson for two primary reasons 1) it’s leverage was significantly higher for its legacy assets than its peers and 2) ebitda didn’t measure the actual investment Erickson needed to make in its legacy assets in order to fully utilize them.

The average EV/FCF multiple of its four competitors equals 16.4X which when applied to Erickson would generate a target share price for its legacy assets of ~$15/share with the high end of the multiple range (19x) generating a $19/share price.  At the time of its 4QFY12 conference call (3/13), Erickson’s shares traded around $14 which provided investors with a fair to slightly cheap valuation, although if Erickson used its free cash flow to pay off debt rather than acquire new assets, shareholders would have had a tangible catalyst for potentially higher shares prices in the future.

Erickson’s acquisition of Evergreen Helicopters

On March 18, 2013 Erikson acquired Evergreen Helicopters, a subsidiary of a Evergreen International Aviation (EIA), for $250mm which represented a combination of $185mm in cash, $17.5mm of unsecured debt and $47.5mm of mandatorily convertible preferred stock (4,008,439 shares valued at $11.85/share of EAC shares).  

At the time of purchase EIA owed $192mm of first lien debt and $125mm of second lien debt and Evergreen helicopters was contractually responsible for the repayment of both debt tranches.  EIA had suffered significant financial setbacks through the latter half of 2012 and through the first quarter of 2013.  It had working capital of -$14mm by year end 2012 and it was also in default of both its first and second lien debt tranches.  On March 22, 2013 EIA’s auditor issued a going concern letter to its board of directors.  

In the midst of these defaults, according to Erickson management, EIA held a formal auction of its Evergreen helicopter division in order to use the proceeds to alleviate its financial illiquidity.  The auction was managed by Goldman Sachs and there were a total of four bidders including Erickson.  Erickson placed the winning bid for Evergreen’s helicopter division.

At the time of the acquisition and over the next 6 months (via seven sell-side investor conferences) Erickson management consistently stressed the highly accretive purchase price of 5x EV/Ebitda that Erickson paid for Evergreen’s assets, which included the Part 135 Aviation Operating Certificates certified by the commercial airlift review board which allows the holder to fly commercially for US government agencies.

Evergreen helicopter generated ~$49mm in adjusted ebitda in CY12 or 24% of $201mm in revenue.  Over 95% of the revenue was generated from the US Department of Defense (DoD) and 50-60% of the total revenue was generated through the Fluor Corporation as the general contractor to the DoD, with the balance contracted through Dyncorp as the general contractor to the Dod.  A small amount of the revenue (less than 10%) was directly contracted with the DoD, according to Erickson management.  

The role of ZM Private Equity in both Erickson and Evergreen

ZM funds initially purchased Erickson for $93.1mm on September 27, 2007, along with a smaller equity partner which ZM eventually bought out in 2010.  Over the ensuing 4 years, ZM funds also lent Erickson ~$20mm in high yield unsecured, subordinated notes (coupon rates ranged between 10-20%).  When Erickson eventually executed its IPO in April, 2012 weak demand caused ZM to purchase 1.05mm of the 4.8mm total shares issued at $8/share.  Following the IPO, ZM owned 61% of Erickson’s outstanding shares of common stock.  Along with its majority ownership position, ZM also structured Erickson’s certificate of incorporation to limit the power of minority shareholders; excluding any shareholder other than ZM to call a special meeting and allowing ZM to nominate directors or issue stockholder proposals without any advanced notice.  In their April, 2012 13-D filing, ZM acknowledged that they elected all of Erickson’s directors.

ZM funds, as of March 18, 2013, also owned $62.5mm of EIA’s $125mm second lien debt, according to the class action complaint filed against Erickson by shareholders in August, 2013.  Upon the consummation of the Evergreen acquisition, Erickson exchanged 3,375,527 shares of EAC preferred stock with a conversion price of $11.85/share with several EIA second lien debt holders for the par amount of their second lien debt.  ZM funds exchanged $20mm of their second lien debt for $20mm of the preferred shares. On August 20, 2013 Erickson obtained stockholder approval (they required a majority of shareholders which they easily accomplished given ZM’s 51% ownership) to issue common stock for an equal number of its preferred shares upon conversion of the preferred shares by the holders.  At the time of this writing, with EAC common at $21.25, ZM’s preferred shares are worth $35.8mm.   

Erickson also issued a total of 632,911 preferred shares to holders of EIA’s first lien debt (first lien holders received this in addition to $185mm of cash and $17.5mm of purchase price notes with Erickson as the obligor).  After Erickson announced the acquisition, ZM funds opportunistically purchased 250,941 preferred shares from first lien debt holders at $11.95/share (even though EAC common traded at $13.52 the day before the announcement and proceeded to increase to $28/share within the next 3 months).  According to subsequent Form 4 filings filed by Erickson, ZM converted and sold these preferred shares in May, 2013 at prices ranging between $24-$28/share, generating gains in excess of $3.5mm.

Erickson issued $400mm of 8.25% second priority senior secured notes in May, 2013 to refinance their outstanding debt as well as to finance the Evergreen transaction.  Erickson utilized some of the proceeds of the debt issue to repay the unsecured, subordinated notes that ZM funds issued to Erickson in 2010.  These notes equalled $20mm as of May, 2013.  In addition, ZM funds remaining balance of EIA second lien debt (~ approximately $42.5mm) was now the highest priority debt of EIA (given that the 1st lien debt was eliminated, along with $40mm of the second lien debt).  Finally, Erickson paid a $2.5mm advisory fee to an affiliate of ZM funds for services related to the recapitalization.  

Regardless of their motivation to approve the acquisition of Evergreen, ZM funds clearly benefited from the transaction in significant and multiple ways that any prudent, independent observer might conclude as inappropriate if not an outright violation of their fiduciary duty as the controlling shareholder and dominant Board member of Erickson.

The actual cost of the Evergreen acquisition

On March 19, 2013 Erickson issued a press release that announced it had executed a stock purchase agreement for Evergreen helicopters for $250mm, with the costs detailed as follows:

  • $185mm of cash

  • $17.5mm of purchase price notes issued by Erickson

  • 4.08439mm shares of Convertible Preferred Stock which they valued at $47.5mm given the shares, upon Erickson shareholder approval, converted into stock at $11.85/share

Unfortunately for Erickson shareholders the actual cost of Evergreen was materially higher.  With the common stock around $20/share the preferred shares actually cost $80.168mm.  In addition, there were several contingent costs that materialized post the a  cquisition announcement.  
  • Erickson had the ability to reduce the cash portion of the purchase price of Evergreen if Evergreen’s working capital was below the “lower target” of $3.1mm (according to the complaint filed by Erickson shareholders) but instead Erickson amended the SPA to lower the working capital target up to a maximum of -$6.15mm which Erickson would lend to Evergreen.  Ultimately, Erickson issued a promissory note to EIA for $6.15mm as Evergreen’s working capital deficit exceeded $-10mm

  • Erickson agreed to purchase 9 aircraft from EIA for $13mm (in addition to the 64 aircraft they received from Evergreen which were 50% utilized and Erickson used 3 for spare parts)

  • Erickson prepaid $6.8mm of an aircraft lease owed by EHI on aircraft which Erickson then returned to the Lessor without any compensation

  • Erickson prepaid $2.6mm on the three year lease of the Evergreen HQ even though Erickson will not be allowed to occupy the HQ for more than the first 12 months of the lease

  • Erickson has estimated that the Evergreen fleet required ~$20mm in repairs to become operable (by 3Q13 Erikson has spent $6mm of the $20mm)

  • Erickson had to take on a $18.3mm liability from Evergreen for an uncertain tax liability that Evergreen acquired during its operations and hasn’t resolved.


The contingent, incremental acquisition costs are detailed below:

  • $185mm of cash

  • $17.5mm of purchase price notes

  • $80.2mm of convertible preferred ($20/share)

  • $6.15mm of a working capital promissory note

  • $13mm for 9 additional aircraft

  • $6.8mm lease prepayment

  • $2.6mm HQ lease prepayment

  • $20mm of repairs

  • $18.3mm uncertain tax liability


In total Erickson actually paid $349.5mm for the Evergreen assets, a significant difference from their originally announced $250mm purchase price (Erickson actually details most of the contingent costs in their amended 8-K filing on 5/8/13 , page #70).


Valuation of Evergreen Assets

Erickson management in their investor presentations consistently markets that they paid 5X Ebitda for Evergreen’s assets, implying the acquisition was obviously accretive to Erickson’s business model.  However, we have concluded after reviewing Evergreen’s historical and more recent results along with guidance provided by their two largest customers, that the acquisition actually destroys shareholder value.

For the $348mm purchase price Erickson received 64 aircraft (of which 31 are owned and the balance leased, with an average of 3-5 years remaining on the leases).  The company plans to use 3 of the owned aircraft for spare parts as they are “beyond economic repair” and 50% of the Evergreen fleet is currently unutilized.  Erickson released Evergreen helicopter’s historical revenue and ebitda figures and they are detailed below:

                                                     2/28/2010         2/28/2011       2/28/2012               12/31/12

Revenue (in $mm)                         $123.4             $118.46           $169.52                   $201.23

Adjusted Ebitda (in $mm)              $ 12.49            $  20.42           $  42.67                   $  48.78

Adj. Ebitda Margin                        10.1%              17.2%               25.2%                     24.2%


Based on the 12/31/12 ebitda and the $349mm purchase price, Erickson paid a little over 7X trailing ebitda for Evergreen.  This might seem reasonable for access to the well-protected revenue streams of US Military contractors, however based on the guidance of two of the larger US government DoD contractors (and Evergreens’ two largest customers), Evergreen’s projected ebitda for 2014/15 will face significant headwinds.  

Fluor predicts revenue from LogCap IV, the US Gov’t program that provides logistical support for the Department of the Defense, in 2014 will equal $1bln (down from $1.6bln in 2013 - a 40% year over year decline).  Dyncorp (a private company with public debt) also serves under the LogCap IV contract and reported a decline in total revenues through the first three quarters of 2013 of 24% and a decline in ebitda of almost 50%.  They guided that their footprint in Iraq and Afghanistan represents headwinds for FY14.

Although Evergreen’s YTD FY13 revenue and ebitda are difficult to calculate because they were purchased in mid-May 2013, Erickson guided to a firm wide (including Evergreen) pro-forma revenue of $390mm and an adjusted ebitda of $104-110mm for FY13.  These forecasts imply Evergreen will generate $200-$210mm in revenue and ~$60mm in ebitda in FY2013.  Both seem improbable.  

Erickson already announced that Evergreen failed to renew two contracts for $30mm in revenue for FY14.  Erickson also utilizes an adjusted ebitda number that does not include a recurring operating expense (amortization of aircraft parts used in the overhaul of aircraft) that other helicopter companies include in their adjusted ebitda.  We include this number in our adjusted ebitda but even if we excluded it in our adjusted ebitda figure ($6mm), we would still not be able to reach their number.  Incredibly, their FY13 adjusted ebitda forecast generates a margin of 27% which is significantly higher than the 19% average of its comps and even higher than the 26% posted by Air Methods.

We think a more realistic way to calculate Evergreen’s next twelve months (NTM) adjusted ebitda and free cash flow is to assume a 10% decline from its reported FY12 revenue (we think a very optimistic assumption given its customers’ guidance) and a 25% ebitda margin (very optimistic given Erickson’s and the industry average).  This produces $44mm in adjusted ebitda.  Erickson borrowed $267mm (@ 8.25%) debt to finance the acquisition (they financed the balance through preferred shares) which results in $22mm of annual interest expense.  Management also guides to maintenance cap ex for the entire company of $40mm for “the next few years”.  We assume that Evergreen will absorb $32mm of that amount (the legacy Erickson assets required $8mm of main cap ex per management).  Erickson also should generate $5mm in cash taxes per mgmt guidance (we allocate $3mm to Evergreen).  The net effect is a FCF of -$12mm.  

Evergreen FY12 Rev:             $201mm

Evergreen NTM Rev:              $180mm ($200mm X .9)

Evergreen Ebitda margin:       25%

Evergreen Ebitda:                 $45mm

Interest Expense:                -$22mm

Main Cap Ex:                        -$32mm

Cash Taxes:                         -$3mm

NTM FCF                               -$12mm

We think this annual FCF contribution from Evergreen will extend far into their FY15 and has a reasonable probability to equal a larger negative FCF in FY14 as Erickson moves their underutilized aircraft from Afghanistan to other parts of the world.  Ultimately, we think the Evergreen acquisition will destroy much of the value from the Erickson Legacy assets for several years.

Valuation - Conclusion

We assume that the market will discount Erickson’s lack of free cash flow (at least for the near term) as a necessary evil of their acquired growth and instead focus on their adjusted ebitda.  If you assume the Erickson Legacy assets generate ~$39mm of adjusted ebitda (an amount that matches their above-average fire year of 2012) and you assume a 10% decline from Evergreens FY12 adjusted ebitda of $49mm or ~$45mm, Erickson should generate $84mm of adjusted ebitda for the next twelve months.  At 8X Ebitda, this generates a share price of $18.21/share or a 7% decline from $19.50 (this calculation uses 13.8mm shares and net debt of $420mm).


However, if you account for several headwinds that will challenge Erickson for the next several years, an average year of $84mm in adjusted ebitda may actually be above-average.  The first headwind is management.  The company replaced its CFO in September and so far has not produced any of the strategic synergies they promised when they purchased Evergreen (like utilizing its legacy Aircrane manufacturing facilities for Evergreen aircraft, which are significantly different types of aircraft).  They also purchased a small helicopter service company called Air Amazonia in the summer of 2013 that was the helicopter subsidiary of the Brazilian oil & gas company HRT Participacoes em Petroleo.  Erickson paid $23mm for 6 helicopters and a contract with HRT that guarantees one year revenue of $29mm.  This acquisition was previously announced in March for a much higher amount but was scaled back because HRT has found zero oil after drilling 14 wells since 2009 and its equity value has declined from $4.6bln to $125mm.  Erickson management defends the acquisition as “worst case” they receive 6 helicopters and a foothold in the Brazilian market but they already have 50% underutilized aircraft and without a Brazilian partner Erickson will face a politically challenged market for foreign firms.  


The second headwind is leverage.  Erickson was already levered before they purchased Evergreen but post-acquisition they are very levered.  Their current debt represents 59% of their enterprise value vs the industry average of 25.6%.  Their debt to ebitda ratio is 4.9x vs the industry average of 2.6X.  Erickson’s fire fighting business is fairly stable although it can vary year to year but their defense business faces a much more austere future as the US government attempts to reduce its deficit and placate a war-weary populace.  Their other businesses; oil & gas, timber and infrastructure are all very cyclical and do not fare well in economic downturns.  If Erickson doesn’t quickly transition away from the Afghanistan theatre they run the very dangerous risk of having an economic downturn force their highly levered model into default.


The final headwind are the primary owners of EAC, the ZM funds.  They originally purchased Erickson in 2007 and are now in their 7th year of ownership, typically the exit period for a private equity investment.  On June 10th, with the stock at $25.50/share ZM funds filed a S-3 registration to register 5.6mm of their 6.9mm EAC shares.  The company also filed a S-3 to register 4mm new shares for resale (with the implicit goal to repay some of their debt).  


At $21/share, ZM would generate a 50% gross return on their EAC investment (not including their interest payments on debt).  If ZM funds include the gains on their Evergreen investment, the gross returns exceed 70%, certainly a respectable amount given the 07 timeframe of the original investment.  We think it more than likely that both groups are sellers of their shares around $25 and as the average life of ZM’s investment runs longer than 7 years, we think it more than likely that their price target moves lower.  


We feel the combination of these headwinds along with a defense business that may have peaked in 2012 will ultimately compel the market to award Erickson with a lower multiple than its peers.  At 7X their NTM average adjusted ebitda of $84mm Erickson is worth $12.17/share.  We think this price much more accurately reflects Erickson’s potential value within the next 24 months.


I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

  •   4QFY13 earnings announcement for Erickson - they should update investors on their financial guidance for FY14
  •   Updated guidance from defense contractors Fluor and DynCorp over the next several months
  •   Fire Season in Austrailia (from Dec - March) and the US and Europe (June - Oct)
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    Description

    Erickson Aircrane (EAC) is a helicopter service provider for commercial and government customers based in Portland, Oregon.  It came across our desk initially because its minority shareholders seemed to be the victims of a particularly egregious act of double dealing on the part of EAC’s majority shareholder (ZM Funds).  The potential double-dealing occurred in May, 2013 when EAC purchased a financially distressed helicopter service company (Evergreen helicopters also based in Oregon) in which ZM Funds held a significant amount of their 2nd lien debt.  

    As we dug further into the transaction, we discovered that not only was this purchase highly suspect given the conflict of interest represented by ZM funds, it also was not the accretive acquisition that EAC management has claimed it represented on its many investor roadshows since May.  In fact, we believe EAC’s purchase of Evergreen Helicopters, Inc. diminishes the otherwise solid legacy assets of EAC and places the company in a much more vulnerable financial position.  We think the current share price of EAC (~$19.50/share) does not reflect this new reality and once the market fully comprehends the value destruction of the Evergreen acquisition, it will value EAC’s common stock at much lower prices.  Our target price for EAC is ~$12/share, a 38% decline from today’s price.

    Introduction to Erickson - Description of the S-64 Aircrane

    Erickson started operations in 1971 as a heavy timber mover in the Pacific North-West.  Helicopters allowed timber harvesters to “surgically” remove high-value timber from inaccessible areas.  Erickson also contracted with utility companies to move large and heavy electrical transmission equipment to more remote parts of the United States and Canada.  Erickson utilized an unique type of helicopter, called the S-64 aircrane, that originally was built by Sikorsky in which the area normally reserved for passengers had been removed leaving the aircraft lighter and more powerful.  The S-64 has a maximum lift capability of 25,000 lbs. that is unmatched by other heavy-lift helicopters.  The S-64 also contains an aft (rear) facing pilot station that gives the rear pilot an unobstructed view of the target load which further improves its ability to surgically haul cargo.  In 1992 Erickson bought the Type Certificate (the right to manufacture and sell the helicopter) of the S-64 from Sikorsky and now is the sole manufacturer of the S-64 in the world.

    Over time, Erickson developed a 2,650 gallon water tank that attached to the helicopter’s belly (where the passenger area would normally be) along with a “hover snorkel” that resembles an elephant trunk that allows the aircrane to reload its water tank from any body of standing water without landing the aircrane.  This innovation made the Aircrane an ideal piece of technology to fight wildfires and Erickson quickly partnered with most of the major government forest fire agencies in the world, primarily the United States Forest Service, the Australian Forest Service, the Italian Forest Service and NATO.  It also contracted with local and state agencies located in forest-fire intense regions in the United States; including San Diego Gas & Electric and Los Angeles County.   

    By 2012, Erickson’s main business model focused on firefighting (57% of total FY12 revenues) which it supplemented with timber transport (18% of FY12 revenues) and infrastructure transport which includes their traditional utility business as well as a growing business for oil & gas E&P companies in more remote parts of South America (16% of FY12 revenues).  Finally, it operates maintenance and repair operations for its own Aircranes as well as for Aircranes it has sold to 3rd parties (9% of FY12 Revenues).

    Before its 2013 acquisitions of Evergreen, Erickson only operated and maintained Aircranes, of which it owns 20.  They have sold 9 Aircranes in their entire operating history, but only one since 2009 which they repurchased from San Diego Gas & Electric in 2012.  

    The Economics of Commercial Helicopter Service Operators

    For commercial operators of helicopters the highest and best use of their assets is to transport humans, particularly in dangerous or life threatening situations.  Search and rescue operations, secondary military operations (where they deliver troops and support staff to military bases in hostile territory) and emergency health transport all represent high margin work.  The next highest margin work comes from transport of people to areas inaccessible by other means of transportation, primarily offshore oil & gas platforms, followed by transport of people in developed areas that value speed over cost (Wall Street bankers renting helicopters to fly from Lower Manhattan to Laguardia).  Operating margins decline once the operators transport cargo instead of people.  The highest margin cargo business comes from the most difficult requirements (moving cargo 250 miles off-shore) and declines with less difficult work (moving an electrical transmission tower across land).  

    Challenges to Erikson’s Legacy Business

    Erikson’s S-64-centric business model faces seasonal, cyclical and locational challenges.  Its greatest source of demand and highest margin business (fighting fires) typically only lasts 4-6 months per year (May to October in the northern hemisphere and December to March in the southern hemisphere).  In addition, the actual firefighting demand fluctuates year over year.  Although 2012 was a record year in the United States in terms in of total number of acres burned due to wildfires (~ 9.2mm acres, only surpassed by 9.3 and 9.8 mm acres respectively in 2007 and 2006), 2013 was a more normal year in which only 4.1mm acres burned in the US.  

    Erickson has diversified its revenue streams to lessen the seasonality and cyclicality of its northern hemisphere fire-fighting.  It has successfully grown its firefighting business in Australia (it plans to increase the number of Aircranes stationed there from 5 to 6 in 2014).  It has maintained its timber and infrastructure business in N.America and Malaysia and has meaningfully increased its share of the oil & gas market in S.America.  

    However, these solutions also create another challenge, that of location.  In order to fully utilize their Aircranes, Erickson must sacrifice margins to find work for its aircrane in the off-season.  This entails either moving some of the aircraft over large distances every 6 months (from N.America to Australia or S.America and vice-versa) and incurring transportation costs as well as a lack of scale for their maintenance operations.  Or it forces Erikson to accept lower margin (or lower frequency) piece-meal work that is closer to the firefighting base.  Erickson has stated that 70% utilization is the maximum level they expect for their Aircranes, given the limitations of their model.  

    Valuation of Erickson’s Legacy Assets

    Despite its challenges, the S-64 provides Erickson with a reasonably consistent and protected cash flow over time, particularly with the tailwind of climate change and its likely increase of forest fires.  In general, fire fighting revenue should fluctuate between $75mm and $85mm plus $9-$10mm of crewing revenue (Erickson supplies pilots and maintenance for Aircranes they sold to 3rd parties).  Timber and infrastructure should remain constant with expected FY13 levels of $35mm and $46mm, respectively, given the utilization limits of the Aircrane.  MRO should probably also stay relatively constant with FY13 expected levels of $13mm.  Below are our estimated NTM $ revenue for the legacy asset segment (we grow the non-firefighting revenues at 5% from FY13 levels).


    EAC FY14 Legacy Asset’s Revenue:
    Erickson’s adjusted ebitda margin (for the rest of the write-up we define adjusted ebitda margin as ebitda + stock comp) equaled 21.5% in FY12 as its firefighting in N.America reached all-time highs.  Firefighting represents its highest margin work (except for one-off infrastructure jobs) and if Erickson ever sacrifices firefighting revenue for more consistent infrastructure or oil & gas revenue, adjusted ebitda margins should decline.  This reflects industry averages where the average adjusted ebitda margins of Erickson’s four largest public competitors is 19%.  The competitors’ LTM adjusted ebitda margin averages along with their EV/trailing FY FCF multiples are as follows:

    Company               Margin             EV/NTMEbitda     EV/FCF

    AAR corp                    11.3%                 7.2X                      13.1x

    Air Methods               26.5%                 9.9X                      15.6x

    Bristow                      22.0%                 9.4X                      19.1x

    PHI Corp                   16.3%                  6.2X                      18.1x

    Average                                      8.2X                 16.4X


    Air Methods model is entirely medical transport while Bristow’s model focuses primarily on offshore transport to oil & gas platforms, both represent significantly higher margin businesses than other helicopter commercial services.

    In order to value the legacy assets, we think Erickson’s long term legacy adjusted ebitda margin should average 20%.  We also assume, based on mgmt guidance that forward legacy tax rates would have equaled 35%.  In order to calculate enterprise value we assume the actual net debt level of Erickson in March 2013 (immediately preceding the Evergreen acquisition) of $100mm which generated ~$6.5mm of interest expense.  We also assume the share count as of 3/1/2013 of 9.765mm shares outstanding. 

    We estimate Erickson’s legacy assets should average $180mm in revenue with 20% ebitda margins going forward.  We assume $6.5mm interest expense, $6.8mm of cash taxes (net of $10mm of D&A) and $8mm of maintenance cap ex and calculate a free cash flow of $14.4mm/year.  We did not use EV/Ebitda to value Erickson for two primary reasons 1) it’s leverage was significantly higher for its legacy assets than its peers and 2) ebitda didn’t measure the actual investment Erickson needed to make in its legacy assets in order to fully utilize them.

    The average EV/FCF multiple of its four competitors equals 16.4X which when applied to Erickson would generate a target share price for its legacy assets of ~$15/share with the high end of the multiple range (19x) generating a $19/share price.  At the time of its 4QFY12 conference call (3/13), Erickson’s shares traded around $14 which provided investors with a fair to slightly cheap valuation, although if Erickson used its free cash flow to pay off debt rather than acquire new assets, shareholders would have had a tangible catalyst for potentially higher shares prices in the future.

    Erickson’s acquisition of Evergreen Helicopters

    On March 18, 2013 Erikson acquired Evergreen Helicopters, a subsidiary of a Evergreen International Aviation (EIA), for $250mm which represented a combination of $185mm in cash, $17.5mm of unsecured debt and $47.5mm of mandatorily convertible preferred stock (4,008,439 shares valued at $11.85/share of EAC shares).  

    At the time of purchase EIA owed $192mm of first lien debt and $125mm of second lien debt and Evergreen helicopters was contractually responsible for the repayment of both debt tranches.  EIA had suffered significant financial setbacks through the latter half of 2012 and through the first quarter of 2013.  It had working capital of -$14mm by year end 2012 and it was also in default of both its first and second lien debt tranches.  On March 22, 2013 EIA’s auditor issued a going concern letter to its board of directors.  

    In the midst of these defaults, according to Erickson management, EIA held a formal auction of its Evergreen helicopter division in order to use the proceeds to alleviate its financial illiquidity.  The auction was managed by Goldman Sachs and there were a total of four bidders including Erickson.  Erickson placed the winning bid for Evergreen’s helicopter division.

    At the time of the acquisition and over the next 6 months (via seven sell-side investor conferences) Erickson management consistently stressed the highly accretive purchase price of 5x EV/Ebitda that Erickson paid for Evergreen’s assets, which included the Part 135 Aviation Operating Certificates certified by the commercial airlift review board which allows the holder to fly commercially for US government agencies.

    Evergreen helicopter generated ~$49mm in adjusted ebitda in CY12 or 24% of $201mm in revenue.  Over 95% of the revenue was generated from the US Department of Defense (DoD) and 50-60% of the total revenue was generated through the Fluor Corporation as the general contractor to the DoD, with the balance contracted through Dyncorp as the general contractor to the Dod.  A small amount of the revenue (less than 10%) was directly contracted with the DoD, according to Erickson management.  

    The role of ZM Private Equity in both Erickson and Evergreen

    ZM funds initially purchased Erickson for $93.1mm on September 27, 2007, along with a smaller equity partner which ZM eventually bought out in 2010.  Over the ensuing 4 years, ZM funds also lent Erickson ~$20mm in high yield unsecured, subordinated notes (coupon rates ranged between 10-20%).  When Erickson eventually executed its IPO in April, 2012 weak demand caused ZM to purchase 1.05mm of the 4.8mm total shares issued at $8/share.  Following the IPO, ZM owned 61% of Erickson’s outstanding shares of common stock.  Along with its majority ownership position, ZM also structured Erickson’s certificate of incorporation to limit the power of minority shareholders; excluding any shareholder other than ZM to call a special meeting and allowing ZM to nominate directors or issue stockholder proposals without any advanced notice.  In their April, 2012 13-D filing, ZM acknowledged that they elected all of Erickson’s directors.

    ZM funds, as of March 18, 2013, also owned $62.5mm of EIA’s $125mm second lien debt, according to the class action complaint filed against Erickson by shareholders in August, 2013.  Upon the consummation of the Evergreen acquisition, Erickson exchanged 3,375,527 shares of EAC preferred stock with a conversion price of $11.85/share with several EIA second lien debt holders for the par amount of their second lien debt.  ZM funds exchanged $20mm of their second lien debt for $20mm of the preferred shares. On August 20, 2013 Erickson obtained stockholder approval (they required a majority of shareholders which they easily accomplished given ZM’s 51% ownership) to issue common stock for an equal number of its preferred shares upon conversion of the preferred shares by the holders.  At the time of this writing, with EAC common at $21.25, ZM’s preferred shares are worth $35.8mm.   

    Erickson also issued a total of 632,911 preferred shares to holders of EIA’s first lien debt (first lien holders received this in addition to $185mm of cash and $17.5mm of purchase price notes with Erickson as the obligor).  After Erickson announced the acquisition, ZM funds opportunistically purchased 250,941 preferred shares from first lien debt holders at $11.95/share (even though EAC common traded at $13.52 the day before the announcement and proceeded to increase to $28/share within the next 3 months).  According to subsequent Form 4 filings filed by Erickson, ZM converted and sold these preferred shares in May, 2013 at prices ranging between $24-$28/share, generating gains in excess of $3.5mm.

    Erickson issued $400mm of 8.25% second priority senior secured notes in May, 2013 to refinance their outstanding debt as well as to finance the Evergreen transaction.  Erickson utilized some of the proceeds of the debt issue to repay the unsecured, subordinated notes that ZM funds issued to Erickson in 2010.  These notes equalled $20mm as of May, 2013.  In addition, ZM funds remaining balance of EIA second lien debt (~ approximately $42.5mm) was now the highest priority debt of EIA (given that the 1st lien debt was eliminated, along with $40mm of the second lien debt).  Finally, Erickson paid a $2.5mm advisory fee to an affiliate of ZM funds for services related to the recapitalization.  

    Regardless of their motivation to approve the acquisition of Evergreen, ZM funds clearly benefited from the transaction in significant and multiple ways that any prudent, independent observer might conclude as inappropriate if not an outright violation of their fiduciary duty as the controlling shareholder and dominant Board member of Erickson.

    The actual cost of the Evergreen acquisition

    On March 19, 2013 Erickson issued a press release that announced it had executed a stock purchase agreement for Evergreen helicopters for $250mm, with the costs detailed as follows:

    Unfortunately for Erickson shareholders the actual cost of Evergreen was materially higher.  With the common stock around $20/share the preferred shares actually cost $80.168mm.  In addition, there were several contingent costs that materialized post the a  cquisition announcement.  

    The contingent, incremental acquisition costs are detailed below:


    In total Erickson actually paid $349.5mm for the Evergreen assets, a significant difference from their originally announced $250mm purchase price (Erickson actually details most of the contingent costs in their amended 8-K filing on 5/8/13 , page #70).


    Valuation of Evergreen Assets

    Erickson management in their investor presentations consistently markets that they paid 5X Ebitda for Evergreen’s assets, implying the acquisition was obviously accretive to Erickson’s business model.  However, we have concluded after reviewing Evergreen’s historical and more recent results along with guidance provided by their two largest customers, that the acquisition actually destroys shareholder value.

    For the $348mm purchase price Erickson received 64 aircraft (of which 31 are owned and the balance leased, with an average of 3-5 years remaining on the leases).  The company plans to use 3 of the owned aircraft for spare parts as they are “beyond economic repair” and 50% of the Evergreen fleet is currently unutilized.  Erickson released Evergreen helicopter’s historical revenue and ebitda figures and they are detailed below:

                                                         2/28/2010         2/28/2011       2/28/2012               12/31/12

    Revenue (in $mm)                         $123.4             $118.46           $169.52                   $201.23

    Adjusted Ebitda (in $mm)              $ 12.49            $  20.42           $  42.67                   $  48.78

    Adj. Ebitda Margin                        10.1%              17.2%               25.2%                     24.2%


    Based on the 12/31/12 ebitda and the $349mm purchase price, Erickson paid a little over 7X trailing ebitda for Evergreen.  This might seem reasonable for access to the well-protected revenue streams of US Military contractors, however based on the guidance of two of the larger US government DoD contractors (and Evergreens’ two largest customers), Evergreen’s projected ebitda for 2014/15 will face significant headwinds.  

    Fluor predicts revenue from LogCap IV, the US Gov’t program that provides logistical support for the Department of the Defense, in 2014 will equal $1bln (down from $1.6bln in 2013 - a 40% year over year decline).  Dyncorp (a private company with public debt) also serves under the LogCap IV contract and reported a decline in total revenues through the first three quarters of 2013 of 24% and a decline in ebitda of almost 50%.  They guided that their footprint in Iraq and Afghanistan represents headwinds for FY14.

    Although Evergreen’s YTD FY13 revenue and ebitda are difficult to calculate because they were purchased in mid-May 2013, Erickson guided to a firm wide (including Evergreen) pro-forma revenue of $390mm and an adjusted ebitda of $104-110mm for FY13.  These forecasts imply Evergreen will generate $200-$210mm in revenue and ~$60mm in ebitda in FY2013.  Both seem improbable.  

    Erickson already announced that Evergreen failed to renew two contracts for $30mm in revenue for FY14.  Erickson also utilizes an adjusted ebitda number that does not include a recurring operating expense (amortization of aircraft parts used in the overhaul of aircraft) that other helicopter companies include in their adjusted ebitda.  We include this number in our adjusted ebitda but even if we excluded it in our adjusted ebitda figure ($6mm), we would still not be able to reach their number.  Incredibly, their FY13 adjusted ebitda forecast generates a margin of 27% which is significantly higher than the 19% average of its comps and even higher than the 26% posted by Air Methods.

    We think a more realistic way to calculate Evergreen’s next twelve months (NTM) adjusted ebitda and free cash flow is to assume a 10% decline from its reported FY12 revenue (we think a very optimistic assumption given its customers’ guidance) and a 25% ebitda margin (very optimistic given Erickson’s and the industry average).  This produces $44mm in adjusted ebitda.  Erickson borrowed $267mm (@ 8.25%) debt to finance the acquisition (they financed the balance through preferred shares) which results in $22mm of annual interest expense.  Management also guides to maintenance cap ex for the entire company of $40mm for “the next few years”.  We assume that Evergreen will absorb $32mm of that amount (the legacy Erickson assets required $8mm of main cap ex per management).  Erickson also should generate $5mm in cash taxes per mgmt guidance (we allocate $3mm to Evergreen).  The net effect is a FCF of -$12mm.  

    Evergreen FY12 Rev:             $201mm

    Evergreen NTM Rev:              $180mm ($200mm X .9)

    Evergreen Ebitda margin:       25%

    Evergreen Ebitda:                 $45mm

    Interest Expense:                -$22mm

    Main Cap Ex:                        -$32mm

    Cash Taxes:                         -$3mm

    NTM FCF                               -$12mm

    We think this annual FCF contribution from Evergreen will extend far into their FY15 and has a reasonable probability to equal a larger negative FCF in FY14 as Erickson moves their underutilized aircraft from Afghanistan to other parts of the world.  Ultimately, we think the Evergreen acquisition will destroy much of the value from the Erickson Legacy assets for several years.

    Valuation - Conclusion

    We assume that the market will discount Erickson’s lack of free cash flow (at least for the near term) as a necessary evil of their acquired growth and instead focus on their adjusted ebitda.  If you assume the Erickson Legacy assets generate ~$39mm of adjusted ebitda (an amount that matches their above-average fire year of 2012) and you assume a 10% decline from Evergreens FY12 adjusted ebitda of $49mm or ~$45mm, Erickson should generate $84mm of adjusted ebitda for the next twelve months.  At 8X Ebitda, this generates a share price of $18.21/share or a 7% decline from $19.50 (this calculation uses 13.8mm shares and net debt of $420mm).


    However, if you account for several headwinds that will challenge Erickson for the next several years, an average year of $84mm in adjusted ebitda may actually be above-average.  The first headwind is management.  The company replaced its CFO in September and so far has not produced any of the strategic synergies they promised when they purchased Evergreen (like utilizing its legacy Aircrane manufacturing facilities for Evergreen aircraft, which are significantly different types of aircraft).  They also purchased a small helicopter service company called Air Amazonia in the summer of 2013 that was the helicopter subsidiary of the Brazilian oil & gas company HRT Participacoes em Petroleo.  Erickson paid $23mm for 6 helicopters and a contract with HRT that guarantees one year revenue of $29mm.  This acquisition was previously announced in March for a much higher amount but was scaled back because HRT has found zero oil after drilling 14 wells since 2009 and its equity value has declined from $4.6bln to $125mm.  Erickson management defends the acquisition as “worst case” they receive 6 helicopters and a foothold in the Brazilian market but they already have 50% underutilized aircraft and without a Brazilian partner Erickson will face a politically challenged market for foreign firms.  


    The second headwind is leverage.  Erickson was already levered before they purchased Evergreen but post-acquisition they are very levered.  Their current debt represents 59% of their enterprise value vs the industry average of 25.6%.  Their debt to ebitda ratio is 4.9x vs the industry average of 2.6X.  Erickson’s fire fighting business is fairly stable although it can vary year to year but their defense business faces a much more austere future as the US government attempts to reduce its deficit and placate a war-weary populace.  Their other businesses; oil & gas, timber and infrastructure are all very cyclical and do not fare well in economic downturns.  If Erickson doesn’t quickly transition away from the Afghanistan theatre they run the very dangerous risk of having an economic downturn force their highly levered model into default.


    The final headwind are the primary owners of EAC, the ZM funds.  They originally purchased Erickson in 2007 and are now in their 7th year of ownership, typically the exit period for a private equity investment.  On June 10th, with the stock at $25.50/share ZM funds filed a S-3 registration to register 5.6mm of their 6.9mm EAC shares.  The company also filed a S-3 to register 4mm new shares for resale (with the implicit goal to repay some of their debt).  


    At $21/share, ZM would generate a 50% gross return on their EAC investment (not including their interest payments on debt).  If ZM funds include the gains on their Evergreen investment, the gross returns exceed 70%, certainly a respectable amount given the 07 timeframe of the original investment.  We think it more than likely that both groups are sellers of their shares around $25 and as the average life of ZM’s investment runs longer than 7 years, we think it more than likely that their price target moves lower.  


    We feel the combination of these headwinds along with a defense business that may have peaked in 2012 will ultimately compel the market to award Erickson with a lower multiple than its peers.  At 7X their NTM average adjusted ebitda of $84mm Erickson is worth $12.17/share.  We think this price much more accurately reflects Erickson’s potential value within the next 24 months.


    I do not hold a position of employment, directorship, or consultancy with the issuer.
    Neither I nor others I advise hold a material investment in the issuer's securities.

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