Thursday, February 9, 2017

Alliance Aviation Services

I generally avoid cyclical companies: I don't think I can time when cycles turn, so I think there's always a big risk I'll become a bagholder. But there are exceptions. When negative sentiment is so pervasive that prices of even healthy companies fall to extreme levels, I think cyclicals can be great asymmetric opportunities.

Some recent examples where this strategy has worked include FreightCar America, Bracell and Anglo American. (But of course, I can't just look at the ones that worked. I was way early into Hornbeck Offshore, and so that one has not worked out so well so far.)

Alliance Aviation Services (AQZ) is an Australian-based investment along these lines. It is a high fixed-cost business, employing a number of aircraft (financed by debt) and crews, that mostly services hard-to-reach areas that mining companies need to get to. Sound risky enough? This is exactly the kind of company I wouldn't touch with a ten-foot pole under normal conditions.

But thanks to the recent massive commodity slump, right now those risks are all that Mr. Market can think about. AQZ management, on the other hand, has had time to restructure operations, diversify revenue sources, and emerge as a healthy company even as many of its customers are not spending frivolously.

The company announced its half-year results yesterday, with a net profit of $8.5 million over the last 6 months, whereas the market cap is $97 million. The company's second-half results are usually better than its first half's, and management's comments suggest they anticipate that continuing as they appear to expect an even better next set of results. Net tangible assets increased to $134 million, meaning the company trades at an almost 30% discount to tangible book while earning a double-digit return on equity, and at a time when its industry is not doing so hot.

For me, the fixed assets (that are not so specific that they have to be used in mining) give the stock downside protection, while the fact that the company is able to earn a decent return at a bad time suggests there is a lot of upside.

As an added bonus, investors outside of Australia may also benefit from the currency exposure to the Australian dollar. Currencies of nations like Australia that produce commodities have taken a big hit over the last couple of years, but if/when commodity pricing returns, those currencies may stage a comeback.

Here's a link to the company's latest presentation.

Good luck!

Disclosure: Author has a long position in shares of AQZ


Anonymous said...

Any idea what stake management and other insiders have in the company? Do you have a sense for the company's track record vis a vis diluting shareholders?

Thanks for the interesting idea.

juan said...

Good idea, Saj. Thanks for writing it up.

RS said...

Thanks for the interesting idea. It seems that the improvement in first half performance was solely due to the sale of aircraft and parts acquired from the Austrian Airlines transaction in 2015. If I look at the segmented revenue disclosure, A$16.7 million was from aviation services revenue (aircraft and parts sales) with an associated increase in general parts and inventory costs of A$9.0 million (assuming this expense would otherwise be flat y/y), so these parts sales increased net profit before tax by ~$7.7 million. I know they have additional aircraft from the Austrian transaction to sell but these aren't really a recurring profit center for the company, more a one time liquidation of inventory that Alliance doesn't want to keep for internal consumption. Gross margin from contract revenue and charter revenue declined y/y and net income would have been around break-even absent the aircraft sales. So do what extent do you think the H1 2017 results should be taken as reflective of the company's go-forward earning power?

I understand the commodity prices for base metals have improved significantly and that there is likely a lag between the price signal from improved metals prices and increases FI-FO contract revenue for Alliance from mine operators. Still their H1 2017 results don't give me a lot of confidence in the profitability of their contract business and it seems a stretch to say that the business is earning a normalized a double-digit return on equity.

Saj Karsan said...

Hi Anon,

The chairman and managing director own several million shares. The company appears to have been shareholder friendly over the period I've looked back.

Hi RS,

You may be right about that; I don't know. Since they don't break out any segments, I suspect a large part of labour costs is associated with this service business. (While those haven't gone up much, since the rest of the business has shrunk, I suspect a much larger share of labour is now going towards this parts business.)

My reading of the disclosures also led me to believe this segment is probably going to continue to perform, as only a small part of their 2015 purchase was sold/leased this half.

I may be incorrect, however. In that case, you are right that normalized earnings may not look like they do today. But if I/you were to believe that, then we might also think today's book value (to which the company continues to trade at a large discount) is severely understated, since they have a bunch of inventory on the books that appears to be worth much more than historical cost. Thoughts?

RS said...


I think you are almost certainly right with regard to the labour cost allocation. I was initially only estimating the gross margin earned on the services segment as revenue vs. the general parts and inventory costs and completely forgot about the associated expenses that must be flowing through staff related costs. I guess they must have had excess salaried labour last year relative to the amount of work they had as there was only a small y/y increase in salaries and wages expenses to perform the additional work on the services business.

I still think the right way to think about the services segment earnings is as a short-lived project instead of a recurring profit centre on the my possibly incorrect assumption that most of the revenue is coming from the breakdown and sale of the Fokkers acquired from Austrian Airlines. But I also agree with your assertion that the book value of their inventory is then likely understated, especially considering they have only taken delivery of ten of the aircraft for a total cost of US$6.2 million. The magnitude of the understatement is difficult to estimate without knowing how much labour cost was allocated to the segment in the last quarter and the relative value of the aircraft and parts sold vs. the total purchase price. It seems like book value could be as much as $10 to $20 million higher if inventory is adjusted up to market value but I could be way off on that estimate.