Cargojet Stopped Growing And Only Trades At 6.9x TTM P/E

Cargojet (OTCPK:CGJTF)(TSX:CJT:CA) has become a Canadian success story in the growing on demand global delivery market over the past couple decades. The company thrived during COVID as competitor passenger carrier traffic, and its associated underbelly cargo room being sold to customers, dropped from the supply-side in the transport industry. Consumers still were at home with a lot of online shopping to do, so traffic for Cargojet held up nicely. These tailwinds helped drive Cargojet's stock price above $240 near the end of 2020. That market enthusiasm has faded, and the stock is now down around 33% from 52-week highs, bringing the company back to pre-COVID levels amid shrinking revenues YoY.

Quick Intro to the Company

Since being founded in 2001, Cargojet has become Canada's leading provider of time sensitive domestic network air cargo services. The company operates its business across North America transporting time sensitive air cargo each business night utilizing its fleet of all-cargo aircraft. The company’s co-load network strategy consolidates cargo received from various customers and transports such cargo to the appropriate destination in a timely and safe manner. The company prides itself on its customer relationships and ability to efficiently co-load planes with various customer orders in a regular route network.

The company’s revenues are generated from its domestic network air cargo service between 16 major Canadian cities each business night. In addition to their Canadian roots, the company operates an international route between Newark, New Jersey, USA and Hamilton, Bermuda. This provides a five-day per week air cargo service for multiple customers and is patterned after the domestic business that Cargojet has built in Canada. Customer contracts contain variable surcharges for uncontrollable costs (including ability to pass through increases in fuel costs) guaranteed volume minimums and CPI-based annual price increases.

Latest Results

Cargojet's latest results show the company continuing to have a tough time with diluted EPS of $1.68 down a whopping 82% compared to Q2 2022 and YTD diluted EPS of $3.35 down 43% (all financial values are in Canadian Dollars, unless stated otherwise). Revenues of $209.7 million in Q2 2023 were down 15% compared to $246.6 million in Q2 2022 causing year-to-date revenues of $441.6 million to now be down 8% compared to the prior year.

The decrease in total revenue was due primarily to a $7.2 million decrease in domestic network revenues, a $1.1 million decrease in all-in charter revenues and a $25.2 million decrease in fuel surcharge. The decrease in domestic network revenues was due primarily to a decrease in e-commerce and B2B volumes during the period, partially offset by contractual customers’ consumer price index increases.

Gross profits show an exaggeration of the decline, down 30% to $42.5 million for the quarter and 31% to $88.0 million for the year-to-date period. On the expense side, selling, general, and administration expenses for the six month YTD period went in the opposite direction, growing 15% to $33.3 million. All of this led to operating profits for the quarter and six-month period that were down 48% and 45% to $26.9 million and $53.7 million, respectively. The rise in interest rates and continued issuance of debt caused interest expenses to reach $13.5 million for the quarter, up 125% and 82% for the quarter and YTD period respectively.

Profitability & Growth at Cargojet

Cargojet's place in the airline cargo industry leave the company open to the same highly competitive and low-barrier to entry market of airlines in general. As can be seen below, Cargojet has only been able to achieve a return on equity of 5.4% and return on invested capital of 9.1% over the past five years. This level of profitability is below my rule of thumb of 15% ROE and 9% ROIC, giving me doubt if, in my opinion, the company will be able to maintain its intrinsic value over the next business cycle.

The lower ROE is driven by the 2020 negative earnings of $87.8 million due to a $157.1 million loss on derivatives during the irrational oil market early in COVID. It is normal operations for airlines to hedge their fuel costs and while COVID was an odd time for the industry, Cargojet also benefited from revenue upside in these hedges in 2021 and 2022 of $64.9 million and $85.6 million respectively. So including both the bad and goods years in the average profitability seems appropriate.

Cargojet had been growing revenues steadily prior to the past year at a CAGR of 17.5% since 2018, but they have also been issuing shares, as we will touch on more later. On a per share basis since 2018, revenue CAGR has been a more modest 6.9% as seen in the graph below along with cash flow from operations and capital expenditures over the past 5 years. While the mid-term growth rates look appealing, the peak in revenues over the past years makes me hesitant. Fortunately, at 6.9x TTM P/E investors are not really paying for that growth.

How About The Capital Structure?

Cargojet has added around $326 million (+80%) of debt in recent years while also issuing more share in the capital structure, as can be seen below. The interest coverage (including lease payments) of 2.03x the financial leverage is starting to look a little shaky for a cyclical company with low profitability. This 2.03x coverage leaves little room for any mid-term revenue weakness and further or prolonged higher interest rates.

Also notable from the above graph is that Cargojet has been continually issuing shares every year, with the share count increasing a whopping 53% since 2018. The per share growth figures mentioned earlier still point to growth considering this dilution, I would like to see a company that is more profitable, or less aggressive, and able to finance their expansion internally.

To counter the high leverage, some might be quick to point to the client list and minimum volume contracts mentioned by management, where most customers pre-purchase a guaranteed space and weight allocation on the Company’s network and a corresponding guaranteed daily revenue amount is paid to Cargojet. While the company does benefit from some minimum level in these contracts, is still volatility in bad economic times and these contracts do rollover and are open to competitive pressure. The volatility of revenue is best-described from the company's own MD&A as seen below.

Although a significant portion of domestic network revenues are fixed due to guaranteed customer allocations, Cargojet’s revenues will generally rise and fall with the overall level of customer volume typically expressed in pounds. - Q2 2023 MD&A

Helping the liquidity situation, Cargojet also has a sizable amount of hybrid debt outstanding that is convertible to equity at a 5% discount at the option of the company. In a worse case economic environment scenario for Cargojet, the conversion of this debt to equity could be utilized to maintain liquidity, but would seriously dilute shareholders in the process.

Takeaway For Investors

Cargojet's profitability metrics like ROE and ROIC are below my desired levels at 5.4% and 9.1% respectively, and its capital structure has seen increased debt and share issuance. The company operates in the highly competitive airline market with low barriers to entry and is also subject to economic cycles. The competitive pressures and economic cycles seem to be showing up now, with the peak in revenue over the past year at a time when the company has expanded quickly. Investors are not paying for growth at only 6.9x TTM P/E but should take caution of the financial and operating leverage of the company with a low cash flow profile.

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