April 04, 2013 - 6:42pm EST by
2013 2014
Price: 1.60 EPS $0.32 $0.00
Shares Out. (in M): 9 P/E 4.9x 0.0x
Market Cap (in $M): 14 P/FCF 2.8x 0.0x
Net Debt (in $M): 23 EBIT 11 0
TEV ($): 38 TEV/EBIT 3.5x 0.0x

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  • Airline
  • Nano Cap


Great Lakes Aviation Ltd. (OTCQB:GLUX)
Current Price: ~$1.60/share (thinly traded, wide bid-ask)
Target Price: $3.50 - 4.00/share (120-150% upside)
Target Price if debt refinanced: $4.00 - 4.50/share (150-180% upside)

Apologies in advance - this idea is far too small for anything but a PA.  However, if you're willing to stomach volatility, illiquidity, and a potentially long holding period, this company is imo dirt cheap.

Great Lakes Aviation (the "Company" or "GLUX") is a regional airline company based in Cheyenne, WY serving 47 airports in 14 states with a fleet of 34 aircraft (all owned).  The company derives 53% of its revenue from code sharing arrangements with United Airlines and Frontier Airlines.  The Company represents the opportunity to purchase:
  • A good business with characteristics of a regulated monopoly
  • Positioned to grow revenues with minimal capital investment
  • Run by an experienced, incentivized management team with proven strategic, operating, and capital allocation skills
  • Trading at ~2.75x normalized equity free cash flow

While most regional airlines are terrible businesses, GLUX is an exception, as evidenced by the Company's relatively strong returns on assets (~8%) and invested capital (!10%) over the last 10 years.  By comparison, GLUX's closest comps (Alaska Air - ALK, Hawaiian - HA, Republic Airways - RJET, and SkyWest - SKYW) have averaged ~3% ROA and ~5% ROIC over the same period. Why is GLUX a better business than those comps?  GLUX has an entirely different business model.

EAS Market
GLUX derives >40% of its revenue from the federal Essential Air Service (“EAS”) program, which provides government subsidies to certified airlines which provide a minimal level of scheduled air service to small communities.  EAS is administered by the Department of Transportation.  EAS RFPs are solicited and awarded for each approved airport every two years.  Unlike most government RFPs, while bid price is a consideration, EAS contracts are not awarded solely based on a low-bid system.  Instead, the RFP process also takes into account service reliability, contractual / marketing arrangements of the EAS carrier with large carriers, and the EAS airport community's views.  EAS airports are definition uneconomic for carriers to service, therefore EAS contracts provide de-facto monopolies to the winning bidder.  As a result, GLUX is the sole carrier for 40 of its 42 non-hub airports.  Moreover, given the high operating leverage of aircraft, it only makes sense for a carrier to fly an EAS route if it can also fly other routes from the same hub.  As a result, all contracts for airports in a particular region are often granted to a single carrier.  GLUX often wins EAS contracts despite not being the low bidder due to its route network and relationships with United and Frontier.  For instance, in 2007 GLUX was awarded contracts for Clovis and Silver City (NM) over Pacific Wings Airlines despite asking for $300,000 more in subsidies thanks to its relationships with major carriers and support from the two community governments.
The number of EAS carriers has declined from 34 in 1987 to 14 in 2012 (7 of these serve over ~85% of the routes).  The Government Accountability Office cites several possible reasons for this consolidation.  First, deteriorating fundamentals caused several carriers to cease operations during the crisis.  Second, low-cost carriers have made it difficult for EAS carriers fly non-EAS routes, decreasing utilization and weeding out additional EAS carriers.  Third, declining subsidies have made it difficult for EAS carriers with larger planes to economically service smaller EAS markets.  
The EAS program currently subsidizes 120 routes, including 46 by 19-seat aircraft.  The 19-seat routes are a national duopoly between GLUX (34 routes) and Silver Airways (12 routes).  GLUX flies all 19-seat routes from Albuquerque, Denver, Los Angeles, Minneapolis, and Phoenix hubs, while Silver flies all 19-seat routes from the Billings and Cleveland hubs.  As a result, GLUX has a formidable position in the Midwest and Southwest small community markets.  

As the table below shows, the baseline EAS business (reported as "Public Service") allows the conventional "Passenger" business (which would be unprofitable on a standalone basis) to add incremental EBITDA without adding incremental fixed cost (increasing utilization).  
  • If EAS revenue stays constant and Passenger revenue increases, margins expand ('03 - '07)
  • If EAS revenue increases (by adding hubs) and Passenger revenue stays constant, margins contract (‘08)
  • Margin improvement in ‘09 was due to decrease in fuel costs; margin compression in ’10 and ’11 was due to rapid increase in fuel costs
  • Margin improvement in '12 was due primarily to zero rental expense as last two leased planes were purchased.  
  2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Revenue Breakdown                    
Public Service 25.1 20.8 21.9 23.9 24.1 39.3 61.3 60.4 52.4 58.3
Passenger 48.7 54.5 53.3 62.5 73.3 75.7 58.7 63.1 71.0 79.0
Other 2.0 1.0 1.2 1.3 0.7 1.2 1.8 1.9 1.0 0.4
Total Revenue 75.8 76.3 76.4 87.6 98.2 116.2 121.8 125.4 124.4 137.7
Segment as % of Total Rev.                    
Public Service 33.1% 27.2% 28.6% 27.2% 24.6% 33.8% 50.3% 48.2% 42.1% 42.3%
Passenger 64.3% 71.4% 69.8% 71.3% 74.7% 65.2% 48.2% 50.3% 57.1% 57.4%
Other 2.6% 1.4% 1.6% 1.5% 0.7% 1.0% 1.5% 1.5% 0.8% 0.3%
Total Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Gross 30.9% 30.9% 29.8% 33.4% 32.7% 26.6% 31.2% 29.6% 25.7% 27.5%
EBITDA 11.1% 11.5% 12.6% 16.6% 16.5% 10.7% 14.4% 12.7% 9.3% 12.1%
GLUX's management team thus takes advantage of the fact that the EAS business is more defensible on a standalone basis by adding hubs / airports in downturns, while leveraging the fixed cost of operating aircraft in improving / healthy economies.  Though no such disclosure was available in the most recent 10-K, in 2011 management wrote that, "Going forward, we expect EAS revenue… to represent a lower percentage of total revenue. This shift in mix is due to our deliberate efforts to maximize the utilization of our aircraft and other resources…”

Management Team
GLUX management team has significant experience in the regional airline business.  Douglass Voss (Chairman, President) co-founded GLUX in 1979 and served as CEO until 2012.  Charles Howell (CEO) has served since 2002 and was previously the President and CEO of another regional airline.  As discussed above, management has shown a true understanding of the economics of the EAS business.  The team is also cautious; GLUX has declined to submit RFPs for four EAS routes because their Minneapolis hub is still working through infrastructure issues: "…we [can]not add the four EAS markets until… we are certain that the facilities [can] accommodate the size of [our] operations…”

The team also has also been a smart steward of capital.  As shown below, the company has used ~70% of its operating cash flow to pay down $57mm of debt.  When the company has made growth capital expenditures, they have been accretive (added hubs in '08, aircraft in '10 - '12).  For example, in 2012, the Company saved $0.5mm of annual rent expense by purchasing its last two leased planes for $1.7mm.
  2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
CFO 9.2 9.7 5.5 6.9 8.1 7.5 8.3 10.6 8.0 9.0
CFI (0.5) (1.8) (0.8) (0.6) (0.7) (2.0) (1.3) (2.8) (3.9) (6.5)
CFO - CFI 8.7 7.9 4.7 6.3 7.4 5.5 7.0 7.8 4.1 2.5
Debt Paydown 5.5 10.5 3.9 5.5 6.0 6.1 6.1 6.4 3.7 3.3
Cumulative 5.5 16.0 19.9 25.4 31.4 37.5 43.6 50.0 53.7 57.0
% of CFO - CFI to Debt Paydown 63.1% 132.1% 82.2% 87.9% 81.3% 111.1% 86.8% 82.0% 89.9% 132.0%
% of CFO to Debt Paydown 59.7% 107.7% 70.3% 80.2% 74.0% 81.4% 73.3% 60.3% 46.3% 36.7%
Total Debt 115.3 98.6 78.9 75.5 67.2 59.4 51.8 44.0 29.5 26.2
% Reduction   14.5% 20.0% 4.3% 11.0% 11.6% 12.8% 15.0% 33.0% 11.1%
Finally, management is incentivized - Mr. Voss owns 46.4% of the outstanding shares.
There are several ways to look at valuing this business.
Given the following assumptions, GLUX should be worth $3.50 - 4.00/share (120-150% upside to current price):
  • $130mm of normalized revenue
  • ~12% normalized EBITDA margin
  • $1.5mm of normalized maintenance capital expenditures
  • 40% tax rate
  • Share valued at 6.0x - 7.0x resulting normalized equity free cash flow of $5.2mm
GLUX's closest (though far from perfect) comps trade at 
  • Alaska Air (ALK): 4.6x EBITDA, 6.6x EBIT, 13.1x earnings, 2.9x TBV
  • Hawaiian (HA): 2.6x EBITDA, 4.5x EBIT, 5.2x earnings, 2.0x TBV
  • Republic Airways (RJET): 5.4x EBITDA, 10.1x EBIT, 9.4x earnings, 1.0x TBV
  • SkyWest (SKYW): 4.1x EBITDA, 10.8x EBIT, 14.1x earnings, 0.5x TBV
By comparison, GLUX trades at 2.2x EBITDA, 3.5x EBIT, 4.9x earnings, and 0.3x TBV.  Though GLUX undoubtedly has lower quality planes, it certainly has a much superior business.  GLUX should arguably trade at least 4x EBITDA, which would imply a per share value well above $3.50.
Finally, GLUX has significant downside protection from its assets.  Taking significant haircuts to receivables and to inventory, the Company has $15-20mm worth of current assets.  Additionally, significant broker checks and transaction comps suggest that each of its 32 planes is worth somewhere between $850k and $1.5mm.  Valuing the planes at $1mm a pop gets you a total asset value of $45-50mm against total liabilities of $45mm.  However, given that there are at a minimum three years of the EAS program remaining (discussed below in risks section) and management is likely to allocate its estimated ~$15mm of equity free cash flow over that period to debt paydowns, the Company's market cap is likely covered by liquidation value when the EAS program is set to expire (though it will most likely be renewed - discussed below).  
Capital Structure
Worth discussing (though not central to the thesis), is the Company's heavy capital structure.  In November 2011, the Company refinanced its existing debt with a $10 million revolver (“RC”) and a $24 million term loan (“TL”) both from GB Merchant Partners and Crystal Financial.  The two facilities are extremely expensive, with strict covenants:
  • RC Interest Rate: L + 800, 250 floor
  • TL Interest Rate: L + 1100, 450 floor, 100 unused line fee
  • 50% Excess Cash Flow sweep to TL
  • Strict leverage covenants, dropping to 2.25x EBITDA near maturity
The November 2011 issuance was likely expensive because the EAS program was set to expire in 2011 ("The uncertainty surrounding the future of the EAS Program has impeded our ability to obtain financing on commercially reasonable terms").  The two lenders (Gordon Brothers and Crystal Financial) are asset based lenders / liquidators who clearly don't want to underwrite to the business' robust cash flow generating potential.  As the case study on the Crystal Financial website states, “the firm’s revenues rely in part upon subsidies from the EAS and the business is subject to the fluctuations in fuel prices, [so] the Company’s historical financial performance varies from year to year,” which is why Crystal lent based on “the collateral value of the company’s current assets as well as owned airplanes."  However, given that the Company's (EBITDA - Maint. Capex) / Interest Expense ratio has not dropped below 3.0x in the last 10 years, GLUX should be able to get a cheaper loan based on its cash flow generating ability.  Rather than a blended ~14% rate, the Company should be able to achieve an estimated 8-9% cost of debt, which should contribute another $0.8mm to equity free cash flow.  At a 6-7x multiple, this would be worth another ~$0.50/share.  

Worth noting is that at a 10% ROIC, ~14% debt is destroying value for shareholders.  Put another way, shareholder capital is subsidizing the lenders' return.  Since equity investors get to create the stock at 0.3x TBV, the equity still has an incredibly attractive cash return (~35%), but the true best case scenario here is for the Company to get a PIPE that takes out the existing debt (callable at 103 through November 2013).  Though the implied cost of equity capital on a PIPE would likely be higher than the 14%, a PIPE should still be accretive because an unlevered capital structure would allow the Company to de-risk by taking money off the table (read: dividends) prior to the renewal/expiration of the EAS program in September 2015.  

The risk most worth discussing is a closure of the EAS program.  As already discussed, if the EAS program lasts only until it's scheduled expiration in September 2015, there's still little chance of long-term capital impairment given current asset value and the value of the Company's 34 planes.  In November 2015, the Company should have at $10-15mm of debt, ~30 planes worth at least $20-25mm, and positive net working capital.  At the current $14.3mm market cap, this implies at worst 25% downside.  That said, a more complete analysis of the EAS program expiration follows.
In the last two years, Congress has already passed several restrictions on the EAS program:
  • EAS cannot provide subsidies >$1,000 per passenger (requirement waived on aircraft with >15 seats, so all GLUX aircraft exempted)
  • DOT cannot add new EAS routes
  • EAS routes must maintain an average of 10 enplanements per day in order to receive subsidies (requirement waived for communities >175 miles away from nearest major or small hub)
Significant risk of more reductions in the program do exist given the current budgetary environment.  However, there are several reasons why the program is likely to be extended:
  • Costs only ~$200m per year, a “drop in the bucket” of the federal budget
  • Program has been extended repeatedly in past, often by overwhelmingly majorities
  • Likely significant pressure on Senators and Congressmen from smaller, more rural states (e.g. North Dakota) to extend the program for the benefit of its citizen
A history of the EAS program gives strong credence to the theory that the program will puff along for a very long time.  Over it's 34 year existence, the EAS program has been renewed 22 times.  From a structural standpoint, too many Senators and Representatives have a large enough rural constituent population to make axing a ~$200mm program worth the headache.  Most recently, in June 2012, Rep. Tom McClintock (R-CA) proposed an amendment to a House spending bill to eliminate the EAS program, but the amendment was soundly defeated 238-164 in a Republican / Tea Party controlled House.  

If further budget cuts are made to the EAS program, the cuts are more likely to pare the program than to completely eliminate it.  The two most prevalent arguments against the EAS program are that 1) EAS airports are close to major hubs (<175 miles away) and that 2) EAS routes service too few passengers per day (<10 daily enplanements).  Given these lines of attack, not all EAS carriers are built equal.  GLUX is particular suited to defending against these two arguments, since only 5 of GLUX's 35 routes are both <200 miles from a hub and have <15 enplanements per day.  These subsidies encompass only $7.5mm in subsidies (see below).

        Avg. Daily   Dist. to L/M   Threat   Subsidy  
Airport   Hub   Passengers   Hub (miles)   to Route?   Under Threat  
Clovis   ABQ   6.8   216          
Silver City/Hurley/Deming   ABQ   6.6   213          
Alamosa   DEN   17   201          
Alliance   DEN   4.9   256          
Chadron   DEN   4.9   301          
Cortez   DEN   25.8   258          
Dickinson   DEN   16.4   528          
Dodge City   DEN   12.5   249          
Great Bend   DEN   2.5   261          
Hays   DEN   24.9   277          
Kearney   DEN   21.1   181          
Laramie   DEN   27.1   144          
Liberal/Guymon   DEN   13.9   255          
McCook   DEN   6.3   271          
Moab   DEN   3.1   240          
North Platte   DEN   24.7   277          
Pueblo   DEN   4.9   125   YES   1,592,276  
Scottsbluff   DEN   28.5   212          
Vernal   DEN   4.6   174   YES   1,299,194  
Worland   DEN   6.1   398          
Ely   LAS   6.9   237          
Merced   LAX   27.5   114          
Visalia   LAX   4.2   N / A   YES   1,697,929  
Prescott   LAX/DEN   20.3   102          
Devils Lake   MSP   7.2   405          
Fort Dodge   MSP   26.8   156          
Huron   MSP   4.6   279          
Ironwood/Ashland   MSP   10.4   218          
Jamestown   MSP   9.9   332          
Mason City   MSP   43.6   132          
Thief River Falls   MSP   15.2   302          
Watertown   MSP   31.1   207          
Kingman   PHX   6.5   103   YES   1,168,390  
Page   PHX   14.6   280          
Show Low   PHX   8.7   168   YES   1,719,058  
TOTAL       500.0           7,476,847  

The other major risk worth addressing is fuel prices, which have been on the rise.  The Company discloses that a 1 cent increase in fuel prices would impact the Company's profitability by $113k, so this risk is significant.  However, with fuel prices at an all time high, the Company has potential optionality to mean reversion.

  2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Aircraft Fuel Cost 12.0 14.0 16.9 19.5 24.9 38.6 26.6 31.4 39.0 41.9
% of Revenue 15.8% 18.3% 22.2% 22.3% 25.4% 33.2% 21.9% 25.0% 31.3% 30.4%

All in all, while not without hair, I see the opportunity to buy a consistently profitable, moated company with an excellent management team at a 35% EFCF yield / 2.75x equity free cash flow as an asymmetric risk-reward proposition.  Based on a granular analysis of the EAS program, I believe the program unlikely to go away.  If cut, GLUX would likely be minimally affected.  Even if the program is completely slashed, I'm comfortable that the cash flow generating potential of the business will de-risk the investment at current prices within the next three years.  All in all, at an estimated 25% downside and 120-180% upside, this is a heads I lose very little, tails I win a lot proposition.  
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.


Potential capital structure changes, including a refinancing or PIPE
Continued debt paydown / delevering
Renewal of the EAS program (longer term)
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