|Shares Out. (in M):||50||P/E||5.0x||4.0x|
|Market Cap (in $M):||300||P/FCF||3x||2.5x|
|Net Debt (in $M):||2,150||EBIT||260||285|
Republic Airways Holdings, Inc. (Ticker: RJET) – We believe Republic’s stock is conservatively worth $24 per share (4x its current price) because Mr. Market is massively underestimating the Company’s profitability and the long-term vision of its industry-leading CEO (Bryan Bedford). We believe Republic can earn discretionary free cash flow of roughly $3 per share (a 50% discretionary free cash flow yield!) and EPS of $2 per share by 2013 as its stellar management team optimizes its branded operation and works on retaining its fixed-fee business over the long-term.
In the meantime, RJET’s stock trades at less than 2/3 of cash per share, 1/2 of book value per share, 5x TTM EPS (excluding non-cash and non-reoccurring restructuring charges), and 3.5x TTM discretionary free cash flow generated by its fixed-fee business alone. Obviously, RJET”s stock is embedding an extremely deep level of pessimism toward both the branded and fixed-fee businesses. We believe RJET’s stock is being valued as if the fixed-fee business is going to zero soon and its branded operation (Frontier) is a massively negative NPV endeavor for RJET. We believe Mr. Market is wrong on both counts. Our confidence is furthered by the fact that RJET’s management team has proven to be the best in the regional industry over its tenure, during which RJET has been profitable for eleven consecutive years while revenue grew 30x.
(Note: we define discretionary free cash flow as cash flow from operations less maintenance capital expenditures less regularly scheduled plane debt principal repayments. Since D&A approximates debt repayments plus maintenance capex and RJET doesn’t pay cash taxes due to tax shields on its aircraft, we use pre-tax profits as a proxy for discretionary free cash flow.)
Why is RJET so cheap?
1) RJET’s GAAP income statement is completely misleading due to non-cash purchase accounting rules and one-time restructuring expenses (most will be gone in 2011)
2) Most investors won’t invest in a company whose name contains the word “airline” (RJET is cheap based upon its contract fixed-fee business alone, however)
3) The few investors who own fixed-fee regional businesses won’t touch RJET because of its branded operations while the few investors that invest in branded airlines (who aren’t day traders) won’t touch RJET because it appears levered relative to other branded airlines (due to the regional side of its business) and Frontier competes directly with Southwest
4) The recent $90 million equity sale surprised investors and subsequent small insider sales sent negative signals to people who haven’t paid attention (management said in late 2009 that they wanted to eventually have a total cash balance over $450 million versus 3Q10’s $390 million)
5) The massive underperformance of RJET’s stock over the past few months makes people believe “somebody knows something” and/or “there are greener pastures elsewhere”
6) RJET lacks a sizeable oil hedge (currently only 5% of 2011’s needs)
7) RJET’s CFO is leaving after eleven years with the company (we wouldn’t read too much into this as the crucial merger work is done and its branded business is profitable)
Trailing Twelve Month Discretionary Free Cash Flow Per Share = $2 (30%+ FCF yield)
It is a big misconception that RJET is in distress. Over the four quarters ended September 31, 2010, RJET generated nearly $2 per share in ex-item pre-tax profits and thus a discretionary FCF yield of over 30% while the bulk of the Frontier/Midwest cost synergies have not annualized. Sell-side analysts and Mr. Market are asleep at the wheel as they fail to adjust RJET’s complicated GAAP accounting to reflect economic reality. Although RJET reports a breakdown of pre-tax profit excluding non-reoccurring charges, management leaves in some phantom GAAP purchase accounting charges that were $15.9 million in 4Q09 and have gradually drifted down to $8.6 million in the latest quarter (see the excerpt from 3Q10 earnings release below):
“Additionally, the Company recorded a total of $8.6 million of non-cash adjustments associated with the purchase accounting for Frontier and Midwest [in 3Q10]: $5.4 million as a reduction of passenger revenues and $3.2 million expense for amortization of intangible assets. This is the last quarter for the non-cash adjustments to revenue and the intangible asset amortization is expected to continue at current levels for the next few quarters.”
After adjusting for economic reality and using 50 million diluted shares outstanding after the recent equity offering and the outstanding convertible note, we calculate the following pre-tax profits per share for RJET excluding non-reoccurring and non-cash charges:
TTM: FF $1.72 + B $0.26 = $1.98
3Q10: FF $0.45 + B $0.56 = $1.01
2Q10: FF $0.42 + B $0.33 = $0.75
1Q10: FF $0.36 + B -$0.58 = -$0.22
4Q09: FF $0.49 + B -$0.05 = $0.44
You can read the last four earnings releases for yourself below:
How’d RJET Get Here?
We would encourage you to read the other VIC write-ups that do a great job at summarizing RJET’s history as a fast growing fixed-fee regional airline until the regional space ground to a halt in 2008. In late 2009, however, RJET changed its business plan dramatically through its acquisitions of Frontier Airlines out of bankruptcy and Midwest from TPG Capital. Currently, RJET operates approximately 285 aircraft as an unprecedented hybrid enterprise, whose total market capitalization is being valued at only $300 million. Mr. Bedford led this major transition in RJET’s business plan because he saw a turning tide in the fixed-fee business that required aggressive action to reinvigorate RJET’s long-term growth (Disclaimer: we still think PNCL is cheap and has plenty of growth ahead); Mr. Bedford also saw a value investment that was too good to pass up. Here’s a little background on Mr. Bedford’s accomplishments while CEO of RJET:
“Bryan Bedford faced [problems] when he joined Republic Airways Holdings Inc. in 1999. [Bedford said:] ‘You have to be realistic. There’s never a good time to lose money. If that market can’t perform, you have to be honest about your ability to add value to the market, and if you can’t get fair compensation for the service that you’re providing, then you need to exit the market’... Republic started making money in the second quarter of 2000 and hasn’t had a money-losing quarter since [until the first quarter of 2010]... Bedford’s vision has proven successful for the company. He has grown the operation from $85 million in revenue in 1999 to $905 million in 2005 [and revenues may approach $3 billion in 2011].” http://www.sbnonline.com/Local/Article/9102/74/0/Changing_the_flight_plan.aspx
Although most people think Mr. Bedford made a bad move, he knew exactly what he was doing. He knew that starting a branded operation from scratch would not work, as many regionals had tried and failed (including ExpressJet, Independent Air, and Go!). Instead, Mr. Bedford bought the existing nationally recognized brands of Frontier and Midwest at the bottom of the airline cycle in late 2009 for less than their cash on hand and less than their net asset value:
a) After Southwest’s pilot union scuttled Southwest’s higher bid for Frontier from proceeding, RJET purchased Frontier Airlines on October 1, 2009, for $109 million cash plus the assumption of $330 million in debt and $299 million in current liabilities. In its last bankruptcy filing a month prior to the close, Frontier had $234 million in cash (and was profitable) as well as had total tangible assets of $980 million. This means RJET actually netted roughly $125 million in cash by buying Frontier for less than 1/3 of its tangible net asset value of $350 million. (More info is available on page 6 of the Frontier filing linked below as well as page 63 of RJET’s 2009 10-K available at the second link below)
b) In August of 2007, TPG Capital won a bidding war against AirTran to take Midwest private for $450 million in cash. Less than two years later, RJET purchased Midwest on July 31, 2009, from TPG for $6 million in cash, $25 million in a convertible note ($10 per share conversion price), and assumed debt of $72 million. This wasn’t nearly as good a deal as its purchase of Frontier, however, as Midwest was losing money and had a tangible net asset value of -$83 million. Several months later, however, this acquisition allowed RJET to essentially shut down Midwest and grow Frontier by one-third as Frontier replaced all of Midwest’s operations while maintaining its #1 market share in Milwaukee. Mr. Bedford and his team saw that Midwest and Frontier had complementary networks that presented opportunities for growth plus they were targeting $65 million in annual cost synergies by 2011 (2.5% of revenue).
It is important to understand that Frontier wasn’t a broken airline. Although Frontier had posted small losses in the few years leading up to its bankruptcy filing in April 2008, Frontier was actually making money in Denver while Southwest was losing money there:
“Barclays Capital airline analyst Gary Chase says its analysis ‘suggests that Southwest is losing a significant amount of money in Denver, while Frontier has been profitable year-to-date [in 2009]. Frontier has made substantial progress during its bankruptcy proceedings and currently enjoys a significant revenue advantage over Southwest in Denver markets’."
Frontier filed for bankruptcy because of oil’s spike to $130 and the ensuing 100% charge holdback enacted by its credit card processor. Since Frontier only had $121 million in cash on hand in early 2008, the company was forced to file for bankruptcy protection (RJET now has roughly $500 million in cash plus $80+ million a year in pre-tax profits from its fixed-fee business). Thus, RJET bought a low-cost airline that had already proven it could profitably compete with Southwest at a point in time where it could pick and choose what contracts and assets to retain during bankruptcy. Since the acquisition, Frontier has been reporting record load factors and Southwest has purchased AirTran (to shut down the brand), which is the only competitor that has a lower cost structure than Frontier:
Mainline Stage Length Adjusted CASM Ex-Fuel, Ex-Items (3Q09)
AirTran: 5.74¢ (being phased out by Southwest)
(Page 13 of Dec 9, 2009 RJET presentation; for more information, please read the two presentations on Republics website: http://www.shuttleamerica.com/investorrelations.html(Go to “Events” and then “Past Events”))
A Recap: What $6 Will Buy You
1) Approximately $10 per share in cash and $12 per share in book value
2) Republic Airways: 1/3 of revenue; 2/3 of fleet
a. The lowest cost provider of regional contract flying in the U.S. (3rd largest based upon planes and revenue behind PNCL and SKYW)
b. Grew fixed-fee contract revenues by 10x over the past decade, including being profitable in 31 consecutive quarters (this quarterly streak ended in 1Q10)
c. Republic currently generates annual revenues and pre-tax profits of nearly $1 billion and $85 million ($1.70 per share), respectively, and flies for five legacy carriers under contracts with an average remaining term of seven years. While three contracts have an early termination clause, Republic would not be on the hook for the airplanes
d. Republic is consistently in the top three regional airlines in all operating metrics
3) Frontier Airlines (includes the former Midwest): 2/3 of revenue; 1/3 of fleet
a. Frontier serves 80 destinations in the U.S., Mexico, and Costa Rica from major hubs in Denver (#2 in market share), Milwaukee (#1 in market share), and Kansas City (#3 market share)
e. It generates annual revenues of $1.8 billion with nearly 3 million frequent flyers
f. Frontier offers DirecTV or WiFi, STRETCH seating, and pre-assigned seating
g. Operates planes of all sizes, from 30 seats to 160 seats, for better market optimization and more point-to-point opportunities than their chief competitor, Southwest
h. Frontier and Midwest maintained a revenue premium over Southwest and AirTran in Denver and Milwaukee, respectively
i. Frontier has a lower cost per available seat mile (CASM) excluding fuel than Southwest Airlines, especially when adjusted for stage length
4) 22% of go!Mokulele, the #2 inter-island carrier in Hawaii behind Hawaiian Airlines
Buffett’s 1-800-Don-tbuy: We called, no one answered
We have never invested in a U.S. branded airline before, nor are we ever likely invest in one again. We understand the well-known fact that branded airlines are typically a terrible long-term business and the industry as a whole hasn't earned a profit let alone its cost of capital because of unions, volatile fuel prices, high capital intensity, and competitive pricing. This is a well-known fact, however, which is one of many factors creating RJET’s extremely cheap stock price.
One thing is clear about the branded airline industry: branded airlines are a commodity business with only slight loyalty due to frequent flyer programs. However, amidst the obvious trash one can sometimes find a diamond that Mr. Market has passed over. In this case, RJET's Frontier is becoming one of the U.S.'s lowest-cost national branded airlines – apparently to nearly everyone's surprise based upon the Company's absurdly low stock price. We gain extra comfort in our investment from the fact that RJET's contractual flying generates $80+ million in annual discretionary FCF by itself, entirely justifying the Company's current stock price with a 25% discretionary free cash flow yield even if Frontier did not earn a single dollar.
RJET's Frontier now has a cost advantage over Southwest (who also happens to be buying and phasing out Frontier's most formidable competitor, AirTran). In fact, Frontier has lower labor costs, lower maintenance cost, and will soon have lower fuel costs once the Bombardier C-Series are received in a few years. Since 48 of 51 of Frontier’s Airbus aircraft are either owned or on leases that expire from 2013 to 2017, Frontier can replace its entire fleet in the next few years with fuel efficient and cheaper Bombardier C-Series aircraft. Frontier will then possess the newest and most fuel-efficient fleet in the country, giving RJET a further cost advantage over Southwest and all its other competitors.
You can read more about the C-Series decision by RJET here: http://crankyflier.com/2010/03/01/republic-orders-new-bombardier-airplane-that-will-compete-with-boeing-and-airbus-if-it-works/
Frontier also has several product offering advantages over Southwest: multiple airframes which allows for fleet optimization (especially servicing small markets point-to-point), STRETCH seating with extra leg room, pre-assigned seating, inflight DirectTV or WiFi, and those freshly baked Midwest chocolate chip cookies (sounds trivial, we know, but is enormously popular in Midwest's markets). Frontier's low-cost moat is fortified against spikes in oil prices and competitors’ attempts at predatory pricing by RJET's $80+ million in annual fixed-fee discretionary FCF and roughly $500 million in cash (after the recent offering).
Although many people point to the fact that RJET’s branded business now competes directly with its fixed-fee clients as a reason that RJET might not win new fixed-fee business in the future, we believe the situation is a bit more complex: Southwest probably would have bought Frontier had RJET not hurried the process; thus, RJET prevented Southwest from getting nearly 50% market share in Denver, surely a big benefit to United and RJET’s other fixed-fee clientele. Similarly, AirTran attempted to buy Midwest two years ago to get majority market share in Milwaukee; instead, TPG Capital (with Northwest’s backing) outbid AirTran and took Midwest private for $450 million in cash. Thus, Frontier’s markets may have been more competitive and difficult for RJET’s fixed-fee clients if Southwest and/or AirTran got their hands on Frontier/Midwest. Ultimately, we think RJET’s fixed-fee business should be relatively stable over time from its current base due to its best-in-class operations and lowest-in-class cost structure (excluding fuel).
Future Earnings Power
We believe our 2013 targets of $3 and $2 per share in discretionary FCF and EPS, respectively, will prove to be extremely conservative. RJET simply needs to have a stable contract service business while Frontier needs to generate a 4% annual pre-tax profit margin (a threshold Frontier exceeded in the seasonally strong 3Q10):
+4% pre-tax margin on $2 billion in Frontier revenue = $80 million pre-tax profits
+8% pre-tax margin on $1 billion in fixed-fee flying = $80 million pre-tax profits
=Combined pre-tax profits of $160 m
+ $220 m D&A
= $380 m in CFO
-Maintenance capex of $30 m
-Regularly scheduled plane debt principal payments of $200 m
=Discretionary FCF of $150 million or $3 per share compared to the $6 share price
- Oil price spike to all-time highs
- Predatory pricing by Southwest
- Fixed-fee business doesn’t win new business because Frontier competes directly with RJET’s fixed-fee clients
- Frontier plane crash
- Difficulties with RJET’s pilot unions
Catalysts Are Plentiful Over the Next Year
1)The purchase accounting adjustments clouding earnings are mostly done after 4Q10
2)The final steps of the Frontier/Midwest merger will be completed by YE 2011, if not sooner
3)Closing of Southwest’s purchase of AirTran is due in mid-2011, thereby eliminating one of RJET’s most formidable competitors and returning some rational capacity and pricing to the Milwaukee market
4) RJET’s recent equity offering may lead to a lowering of the credit card holdbacks, freeing up some of RJET’s $191 million - about two-thirds of its market cap - in restricted cash (unrestricted cash is roughly $300 million or $6 per share after the equity raise)
5) Profits and FCF should be very robust in the seasonally strong 2Q and 3Q