Niche airline avoids COVID storm clouds

Whilst a large amount of investor focus continues to be channelled into the red hot technology sector, one stock operating in the mining services/aviation sectors, that we believe continues to look interesting, is Alliance Aviation Services (AQZ).

Company overview

Alliance Aviation Services (AQZ) commenced operations in 2002 and listed in December 2011 at $1.60 per share and since then has built up a proven track record of flying workers of the major mining companies to and from work (remote mine sites across Australia), both safely and on time, which are key performance metrics for the company. AQZ currently has a fleet of 42 aircraft, however this will increase to ~56 in the coming months following its recent purchase from US based Azorra Aviation (discussed later). AQZ’s senior leadership team is impressive and has been very stable. Current CEO Scott McMillan held that position at the time of IPO and has now spent 18 years with AQZ. Scott was a founding shareholder, as was current Chairman Steve Padgett.

AQZ has a fantastic track record of retaining clients and contracts (with initial term usually up to 5 years) typically tend to be quite long term, with the average contract life over AQZ’s history being ~12 years.

AQZ has a number of characteristics that we look for in a business, namely:

• Provides an essential service to its customers with a strong value proposition
• Customer base (large cap miners) has solid financial strength given relatively low cost of production, though noting the mining sector is cyclical
• Track record in delivering consistent earnings
• Capable and trustworthy management

AQZ has five revenue streams:

Contract

• AQZ’s main division, where it flies workers to remote mine sites for a range of leading miners

• Where AQZ operates its own aircraft on behalf of other carriers (Virgin and Qantas) with services for Virgin currently suspended

• Regular public transport services to regional Australian airports

• Provision of ad hoc flights servicing tourism, corporate, entertainment, sporting clients
• Currently seeing strong demand from resource sector clients whilst its traditional business has declined materially

• Range of ancillary services such as leasing engines, sale of parts and aircraft

Strong current trading

In late May, AQZ issued a profit update showing the company to be trading at levels well in excess of market expectations, with FY20 pre-tax profit expected to be in excess of $40m (around +35% ahead of consensus). What drove such a massive beat vs market expectations?

• Revised seating plans to accommodate social distancing (ie. less passengers per plane and hence more flights)
• New resource client wins
• Charter revenue grew materially due to social distancing requirements and a lack of availability of scheduled flights by other airlines.

The Corona Virus has not been all good news for AQZ however, with its tourism business being essentially cut to nil for the foreseeable future. In addition, AQZ’s Wet Lease agreement with Virgin has essentially stopped with minimal activity expected in FY21.

Overall, in FY20, the strength in Contract and Charter (ten new resource clients added) more than offset weakness in Wet Lease and RPT divisions.

Capital raising in June

The aviation sector domestically and globally is severely distressed, with AQZ being one of the few aviation players currently profitable. This unusual situation was always likely to be positive for AQZ and to that end in June, the company announced a capital raising for just under $100m. The rationale for the raising was to provide funds for a range of growth initiatives including: opportunistic acquisition of aircraft from distressed aviation participants, providing services to new customers (eg resources, domestic tourism, regional councils), and Wet Lease services to Australian carriers for regional flights.

Acquisition of 14 Embraer aircraft

• Two months later (3^rd of August) AQZ announced the purchase of 14 Embraer aircraft (as well as various inventory and spare parts) for a cost of US$79m from US based Azorra Aviation. The planes can carry up to 114 passengers and will be targeted for regional routes according to AQZ. The earnings contribution will not be immediate however, with first revenue to commence from around February 2021.
• On a per plane basis, the cost worked out at ~A$8m per plane or on an EV/EBITDA basis ~4.0x, which whilst not nearly as cheap as the purchase of 21 aircraft from Austrian Airlines in 2015, was still a relatively attractive price paid, and will be positive for earnings over the next few years.

FY20 result

• AQZ’s FY20 result released on the 5^th of August was predictably solid, with pre-tax profit of $40.7m being in line with previous upgraded guidance, driven by strong results from Contract and Charter activity.
• AQZ did not declare a 2H dividend due to the recent fleet expansion and other growth projects being targeted.
• Over the next 12 months, the company will be focussed on converting recent wins in Charter into contracted revenue and RPT work. Activity in the Wet Lease segment is more uncertain but could provide upside from FY22 onwards. Opportunities domestically could also emerge if the new look Virgin Airlines operates with a reduced fleet.

What are the risks?

The main risk for the business has always been any incident or accident that saw clients lose confidence in AQZ either regarding timeliness/reliability or safety wise. Given AQZ’s track record since 2002 we are confident with their performance on this issue. Other risks include deterioration of the profitability (and activity) of its mining clients however this is mitigated by virtue of the client base being mainly large cap miners in production (not exploration).

Where to from here?

The fund first invested in AQZ in June 2017 at around 90 cents and has been one of our best performers since inception. Clearly AQZ is not nearly as cheap as it has been in recent years, however following what looks to be an accretive and sensible deployment of the proceeds from the recent raising, the stock looks attractively priced on 2-3 year timeframe in what continues to be an uncertain domestic economic environment.