Cargojet: Despite The Massive Rally, It Is Trading At Fair Value (OTCMKTS:CGJTF)

Thesis

Cargojet Inc. (OTC:CGJTF) is poised to continue seeing exceptional growth in the years ahead due to its dominant position and the industries’ high barriers to entry. Despite its aggressive investments in CAPEX and the explosive run up in share price, the company is actually well priced. Furthermore, e-commerce tailwinds will act as an additional catalyst as users continue to expect faster shipping times.

Business overview

Cargojet is an overnight air cargo service provider based in Canada that operates domestically and internationally, carrying over 1,800,000 pounds of cargo each business night. Cargojet is Canada’s top cargo airline by representing over 90% of the domestic overnight air cargo lift available in Canada and being the only national overnight air cargo consolidator. It offers aircraft, crew, maintenance, and insurance (ACMI) services to customers across several continents. Cargojet also runs scheduled routes for cargo customers between the United States and Bermuda; between Canada and Germany; and between Canada and Mexico.

In addition, it offers specialty charter services. For those that don’t know, air cargo charter services allow individuals/businesses to rent an entire plane/fleet for a specific period of time, to use at their own discretion. It offers these services for a wide variety of products that range from livestock, to military equipment, personal protective equipment, and large shipments across multiple locations. Lastly, the company operates in the ground handling and ground service equipment business.

Only national overnight air cargo consolidator:

Being the only business in a specific niche is clearly an advantage. Freight consolidation allows products from multiple shippers to be put into one shipment. If a business has a small shipment to make, it wouldn’t make sense to use a full truckload/plane/shipping container for their shipment as they would be paying for more shipping space than they actually need. Freight consolidators help businesses save money by consolidating them into one shipment; this is especially beneficial to online businesses.

Catalysts for growth:

This is an industry with high barriers to entry because it is capital intensive. For this reason, there is a relatively low amount of domestic competition for Cargojet compared to other easy-to-enter industries.

Given that the company is spending heavily on growth capital expenditures, this will allow them to capture a large portion of future demand in this growing industry as they won’t have to worry too much about competition. In fact, during Q2, they actually turned down a lot of international business. In their most recent conference call, CEO Ajay Virmani stated that if they had 20 more planes, almost double what they currently have, they could have flown those.

This extra demand came from new customers, which shows Cargojet’s influence around the world. Ultimately, Cargojet is focused on serving its Canadian customers first, and they did not turn down any business from them. We like this approach because it increases the odds that these domestic companies will keep doing business with them, which is important as 75% of their revenue is domestic.

Cargojet has long-term contracts with minimum volume guarantees, variable surcharges for uncontrollable cost changes, and CPI-based automatic annual price increases for all their customers, making their revenue stream stable.

In addition, e-commerce as a percentage of retail has lots of room to grow, especially in Canada, and there is no reason to believe that this uptrend won’t continue in the long term. With the recent conclusion of USMCA, the online shopping de-minimis has been increased from $20 to $150. This means that Canadians don’t have to pay duties on any product from the USA or Mexico with a value of $150 or less. This should allow for an increase in volume for cross border e-commerce purchases. Cargojet claims that they are well-positioned to benefit from this trend in both their B2B and B2C business.

Source: investor presentation

How COVID-19 has boosted Cargojet’s business:

Revenue, adjusted EBITDA, cash from operations, and other metrics for the most recent quarter all saw explosive growth compared to last year. This was a result of explosive e-commerce growth during the lockdown earlier this year, increased demand for personal protective equipment, and reduced passenger flights.

Passenger planes carry cargo in their bellies, but the reduced use of passenger planes led to an increased demand for Cargojet’s services, “Reduced passenger flights led to strong…growth in international markets that we believe will continue for the short and medium-term,” said Cargojet CEO Ajay Virmani.

The COVID-19 effect has certainly waned, but the fact is that the virus itself is not gone, cases are still on the rise, and no one knows how long it will last. Even if a vaccine is discovered soon, Cargojet can still benefit from it by transporting vaccines. Here is what the CEO had to say about transporting vaccines: “There’s 100 million vaccines, right? So they will not equate to the volume that the PPE was there. But it would certainly be an increased activity from that standpoint.” Vaccines won’t bring them as much business as personal protective equipment did in Q2 when COVID-19 was at its peak, but nonetheless, they would see a boost from vaccines.

CEO Ajay Virmani also stated that B2B volume was almost non-existent in Q2, but he expects B2B to pick up again going forward while the B2C surge drops off a bit. When combining these 2 factors, he believes that Cargojet will still see a “great net increase from where things were prior to COVID-19”.

E-commerce activity is likely to stay elevated for a long time, and it may never drop down to pre-COVID-19 levels as people are realizing how convenient it can be to shop online. “Although Q2 results are unlikely to be replicated in future quarters, demand for charter services and e-commerce remains above the pre-COVID-19 levels, and is likely to persist for some time,” said Mona Nazir, an analyst at Laurentian Bank.

Past performance:

Operating cash flow has been consistently growing in the past 5 fiscal years and in 2020 so far.

Cargojet reported cash from operations of $206.4m for TTM ending June 30, 2020 on its cash flow statement. Below, is their past 5 years of cash from operations.

Cargojet cash from operations past 5 years.

Source: Finbox

The same can be said about its revenue, which has seen growth that is just as impressive at a 5-year CAGR of 20.4%, not including this years’ boost from COVID-19.

Cargojet has appreciated almost 900% in value in the past 5 years, and much more if you go back even further.

Cargojet share price performance past 5 years.Source: stockcharts.com. Cargojet in red, S&P 500 in blue, TSX in green.

It has heavily outperformed the S&P 500 and the TSX, which can be expected from a high growth stock. The question is, how much higher does it go from here? Our valuation below can give you a good idea of what the stock is currently worth.

Valuation

At a first glance, Cargojet seems ridiculously overvalued. However, if the company stopped investing so heavily on growth, the story starts to change quite a bit. If the company wanted to shift its focus solely to cash flow generation, it would actually be just under fair value.

Using a single-stage DCF model, if we assumed that Cargojet would stop growing, spend only enough on CAPEX to maintain operations, and rollover their debt instead of aggressively paying it down, the company would be worth $3.310 Billion. This translates to a per share price of $212.22 CAD, or $160.06 USD using a 1.33 USD/CAD exchange rate.

Cargojet stock valuation Source: Author

Key Inputs:

  • Discount rate 7.5%
  • Perpetual growth rate 2% (CPI-based automatic annual price increases)
  • Single stage growth model: 182.1 / (0.075-0.02) = 3310.8
  • Q3 and Q4 consensus estimates for revenues
  • Estimated CFFO margins for Q3 and Q4 to incorporate a reduced boost from COVID-19
  • Maintenance capex from management guidance
  • CFFO figures are net of interest payments

Technical Analysis

We’ll keep this part short and sweet. Below is a daily time frame chart of Cargojet. It has clearly been on a tear recently, and just a few days ago it broke through its multi-month resistance at $195. Although this can keep trending higher in the next few days, a smart buying point has usually been on pull backs near the 50-day simple moving average, shown by the blue line. Therefore, long-term investors should benefit from buying Cargojet on a dip if that happens the near future.

CJT.TO technical analysisSource: stockcharts.com, (CJT:TSX)

Insider ownership:

Cargojet’s CEO and founder, Ajay Virmani, owns 5.71% of the company, or roughly $175m worth. We like this because it not only shows that he is confident in the company, but we can assume that he will act in the best interest of shareholders. Mr. Virmani was also named the top strategist of the year and one of Canada’s top CEO’s by the Globe & Mail.

In terms of insider activity, there has not been any insider buying within the last 12 months. There has only been a small amount of insider selling.

Risk factors – The good, the bad, and the neutral:

The good:

Beneish M-Score:

The Beneish M-Score uses financial ratios to determine whether or not a company has manipulated their earnings. A score of less than -2.22 means that a company is most likely not an earnings manipulator, and vice versa for scores above -2.22.

Cargojet’s Beneish M-Score of -2.83 suggests that the company is not likely to be an earnings manipulator.

Beneish M-Score CargojetSource: Finbox

Probability of default:

Cargojet’s interest coverage ratio for the last 12 months is 2.7x. However, this is because of the surge in demand in their most recent quarter due to COVID-19. Their average interest coverage ratio for fiscal years ending December 2015 to 2019 averaged 1.6x. The COVID-19 boost in earnings is expected to subside as there is not as much of an emergency state as there was in previous months, however, management still expects to see net gains as things go back to normal. Therefore, we are going to assume a forward interest coverage ratio of about 2-2.5x.

This interest coverage ratio implies that their bond rating is B2/B. The weighted long-term average default rate for stocks with B rated debt is 3.33%.

The bad:

Heavily reliant on top 10 customers:

Cargojet’s 10 largest customers accounted for approximately 81.3% of 2019 revenues of the company, and their top three customers each accounted for over 10% of the company’s 2019 revenues. A loss of even one of their main customers can materially impact their operations. Most of Cargojet’s contracts are 3 to 10 years in length, with the option for customers to terminate these contracts upon 6-18 months if targets are not met. There is no guarantee that customers will renew contracts, as competition can potentially come in and offer better services in the future.

High fixed costs:

Cargojet has high operating leverage since it has high fixed costs for each flight route. The expenses for the flights do not change depending on the amount of cargo they transport. Therefore, a decrease in revenue could result in a significantly higher decrease in earnings as the expenses would still remain high.

Fuel prices:

Cargojet is exposed to fuel prices as they use significant amounts of fuel for their fleet. Fuel costs represented 25-30% of the company’s direct operating costs, historically. They can mitigate this by implementing surcharges, however, competition could have cheaper alternatives that may prevent Cargojet from implementing surcharges.

The neutral:

Balance Sheet:

Cargojet has a high amount of debt of about $406.2m compared to their equity of $222.4m. This doesn’t include lease liabilities, which are $184m. Their debt load had been growing steadily up until 2019, where it peaked at $508.1m. Since then, management has been paying it off, and they plan on being debt free within 5 years or less.

Cargojet has no material amount of cash on hand, thus, it is marked as a dash on their balance sheet.

Their short-term assets of $104.4m do not cover their short-term liabilities of $152.8m, but their total assets of $1,146.5b, cover their total liabilities of $924.1m. We are not concerned about their current ratio because we expect them to produce free cash flow going forward as they did last quarter. Further, they also have a revolving credit facility of $600m, of which about $388m is available to use if they ever need short-term liquidity.

Overall, their balance sheet is mediocre, but not concerning.

Final Thoughts

Cargojet operates a rapidly growing business in an industry with high barriers to entry. Their aggressive approach to expanding their operational capabilities along with their desire to quickly pay down debt means that the Cargojet appears ridiculously priced. However, upon further review, we determined that the company is structurally capable of generating enough cash flow to justify its current valuation if it decided to simply maintain its current capabilities. With over 90% of the domestic market belonging to them, its aggressive spending puts it in a strong position to continue capturing most of the growth generated by industry tailwinds.

Please note: All numbers are in Canadian dollars, unless otherwise stated.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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