Description

RJET (Long) $5.00 - UPDATED (see below)

I would recommend a long position in RJET (Republic Airways).  RJET is a misunderstood and underfollowed story, with several potential catalysts unfolding which could drive the shares significantly higher over the next 12 months and represents a compelling risk/reward.

RJET, at its core, is a regional airline providing approximately 1,250 flights daily to 109 cities in 35 states as well as Canada, Mexico, and Jamaica for its partners according to its code sharing agreements with American, Continental, Delta, United and US Airways.  RJET operates under long-term fixed fee agreements (10-12 years) with its code share partners which generally have cost escalators to help offset rising labor or other input costs.  RJET is able to use its partners' flight designation codes to tap into its partners' reservation system, it can paint its planes in the style of its partners and use its partners' brand name to market itself as a carrier for its partners.  RJET's regional airline business is not subject to fluctuations in airline ticket prices, fuel, security fees, landing fees, and passenger volumes.  Basically it gets paid to take off and land subject to certain quality control measurements.  In a business where cost is king - RJET is the low cost provider (it operates about 20% below industry averages) in part because: 1) Scale matters.  As one of the largest regional providers it is able to spread fixed costs across all of its partners' plane/routes making its marginal cost of providing service in its markets among the lowest.  2) It posses one of the most desirable fleets largely consisting of Embraer 170 or 175 70+ seat aircraft.  This all combines to give RJET a remarkably stable and profitable business in an industry know for volatility and losses.  It is actually not an airline in any traditional sense but an outsource service provider.  It has been profitable in 31 of 33 years.  It has earned $1.60 every year since 2003.  This core business earned a record $2.42 in eps in 2008 and I think generates around $2.00 in 2009 before any uses of cash and grow from there.  In addition the company should generate around $80-100+ million of FCF from its core operations or around $2.80 a share and has a 13.68/share book value.  RJET has used its strong and stable cash flow to historically buyback shares - buying $140 million in 2007 and $40 million in 2008.  The company is currently trading around $5.00 a share with a market cap of $182 million.

So why is RJET trading at $5.00 a share, what are investors missing?  Why is the downside limited and what will drive it significantly higher making this such a compelling investment?

Risks:

• With a global recession, high fuel prices and weak travel - investors are not rushing into airline stocks and bankruptcy concerns are widespread.
  • RJET, however, is not directly affected by fuel, ticket prices and yield, although there is some sensitivity to capacity coming out of the system as their hours/routes can be trimmed back - the reason why I think 2009 is down a bit from 2008.  But overall, its regional jet business is both relatively stable and profitable.  A corollary to this is that RJET is often underfollowed/ignored by people who cover the sector as it does not have the "juice" of a traditional airline in terms of sensitivity to fuel and travel, which in my view is part of the opportunity.  As explained below - bankruptcy risk at RJET is actually quite remote.
• Concerns about legacy carrier bankruptcies, especially US Air.
  • US air represents about 32% of RJET's fleet and 25% of its revenues.  I won't take the time here to provide a detailed analysis of US Air's financials, but I remain comfortable that they remain solvent absent another big leg down in the economy and point out they just did an equity and convert offering of $234 million in May 2009.
  • Bankruptcies, should they occur, are not new to RJET.  In the past 5 years United, US Air, Delta, Midwest and Frontier, all RJET partners, have all declared bankruptcy...RJET's eps over that time period has been $1.63, $1.66, $1.82, $2.02 and $2.42, respectively.  Simply put, RJET is an important partner for the legacy carriers and is often part of the solution for their problems in terms of lowering their costs.
  • There is a remote possibility of a chapter 7 bankruptcy rather than a chapter 11 - where US Air liquidates.  In this case RJET would need to place its planes with another carrier...or potentially now internally (more on this later).  It is also important to note that RJET maintains an interest in US Air's commuter gates at LaGuardia and Reagan that it will own those gates if US Air fails, making it very likely that if US Air liquidated, RJET would quickly find a home for those planes.
• Concerns about growth given reductions in capacity, potential consolidation and maturing market.
  • Even without growth opportunities, RJET's base business should do something like $2.00 in eps and much more in FCF as cap ex scales down from growth leveling off.  The company has shown a willingness to buyback shares in large quantities - which could drive eps significantly at this valuation.
  • With high fuel prices and capital constrained carriers there remain thousands of older inefficient planes still flying domestic routes at costs much higher than RJET's - representing opportunity.
  • Recent events explained below could add a new platform for growth.
• RJET has lent money to some of its partners, the resolution of which the market has yet to appreciate.
  • The biggest concerns regard money lent to Frontier and Midwest, the resolution of which I explain below.  There is a small loan to Mokulele (Hawaii) that is immaterial and a small term loan to US Air.
• RJET is levered.
  • RJET does carry significant leverage of $2.2 billion.  The debt is all at attractive fixed rates and is all secured by $2.7 billion (book value) of owned aircraft. Its liquidity position is strong, not to mention its free cash flow of $20-25 million a quarter remains robust.  RJET has 123 E170/175 which still have demand in the aftermarket.  They had been selling for $20-25mm per plane. The company has $118 million in cash and minimal working capital needs.  RJET had a small revolver to cover letters of credit that expired unused in May.  They are currently working on a new one.  Generally code share agreements provide that if they are terminated without cause, the planes/leases are putable to the carrier.
• Recently announced deals (described below) have added potential noise to near term results.
  • With Midwest, RJET might close before the restructuring and before the current fleet is returned/put back and replaced with Embraer jets.  This could create noise in near term results.  Also restructuring with Frontier might take a q or 2.  This is opportunity, as RJET will have the ability to remove all of Midwest's current fleet shortly and significantly lower its operating costs.  The best way to look at the company with be on pro forma results assuming the fleet is replaced which is described more fully below.

The Opportunity -

• RJET has recently announced its intention to be the equity sponsor for Frontier out of bankruptcy for $109 million. 
  • Given that RJET had a $40 DIP and was an unsecured creditor of Frontier resulting from a claim of breach of contract from the original filing...RJET is paying net cash ~$56 million. 
  • Frontier has lowered its cost structure in bankruptcy and is now quite profitable even in the current environment.  Bankruptcy filings show it has been nicely profitable for the last 7 months and in May it earned $5.6 million in net income, and an operating profit of $7.6 million.  So RJET is paying a net 10x MONTHLY eps. 
  • Frontier owns mostly very new airbus jets currently on the books for $610 million and against which there is only now $350 million in secured aircraft debt. 
  • Just adding the accretion from the proforma financials filed with the courts - and not taking into account any synergies adds $1.00 to $1.20 to eps.  There is still the possibility of a higher bid coming in bankruptcy which should be resolved shortly.  Should that happen, RJET stands to get its $40 DIP back as well as a higher portion of its $150 million unsecured claim than I have assumed which would still be a big cash inflow for a $180 million market cap company.
• RJET has also announced that it will purchase Midwest Airlines from TPG.  The details here are a bit murkier.  The purchase price was $6 million and a $25 million note convertible into RJET stock at $10/share and TPG has the right to nominate one board member to RJET's board - RJET will not assume any of the Midwest debt.  TPG together with Northwest paid $450 million for Midwest in August of 2007. 
  • RJET will replace all of Midwest's Boeing 717 planes with Embraer 190's...the Boeing planes have expiring leases/are putable. 
  • RJET had already started to do much of the flying for Midwest as Midwest had replaced all of its MD-80's in the last year with RJET service in an effort to deal with higher fuel costs and growing competition from Airtran and Southwest. 
  • Midwest was a money losing operation - losing $25 million in the first three months of 2009.  Midwest will now become an operating subsidiary of RJET and a virtual airline.  The planes will be RJET planes, the back office/admin functions will be folded in with Frontier, leaving only a brand name and flight code. 
  • Without knowing how RJET will secure the new planes - although there seems to be a lot of opportunity for them to pick some up at attractive prices/financing potentially from GE or US Air - or the exact cost structure going forward, it is hard to know how this will impact RJET.  Back of the envelope calculations on the cost of flying a 717 vs a newer regional jet suggests that pro forma Midwest will be close to breakeven.  At some level you need to have confidence in the CEO, Brian Bedford, who has a strong record of building a successful airline by being the low cost provider and partnering with legacy carriers that he is able to do this at least at a break-even rate and potentially at a profitable run rate.
  • The synergies that could be realized with Frontier (both cost and revenue) could be significant.
• With Frontier and Midwest, RJET now has its own brands/flight codes and potentially another leg of growth. 
  • It is important to note that all of this is being orchestrated by Brian Bedford at a bankruptcy remote subsidiary level with little capital commitments - thus minimizing his downside.  Should either or both of these new ventures fail...core RJET should hopefully remain largely intact.
• There are a number of ways the Frontier/Midwest deals could work out.  Trying to pro forma both deals can lead to a wide range of possibilities - the key takeaway I think should be the bull case could lead to significant upside, while the bear case should leave a profitable regional business in tact as discussed later.  The company is largely silent, due in part to needing to complete both and I am sure because they are still working out the best strategy. 
  • There exists the conspiracy theory that United, which is a RJET partner and has been losing significant money at its Denver hub due to Frontier and Southwest (Jet Blue was rumored to be looking at Frontier adding another low cost competitive threat) and is now facing a growing Airtran and Southwest threat in the Midwest (largely out of Milwaukee) could have been instrumental in helping assets/gates fall into its regional partner's hand rather than Jet Blue, Southwest or Airtran.  As such there might be opportunities to work with United as well as other legacy carriers.  How this plays out is hard to know. 
  • There exists a possibility that now with mainline airline of its own - RJET could tap into the star alliance as a code share partner with the legacy carriers.  In other words, there are routes/planes that RJET can not fly as a regional carrier for the legacy carriers due to union rules, but it could fly them under its own flag and code share such that the legacy carriers book 80+% of the fares and RJET flies the routes with its cost structure.  There are thousands of older planes being flown by legacy carriers on domestic routes where it would make sense for the legacy carriers to code share with a Frontier/Midwest (the latter is a virtual airline anyway) because they are not regional jet eligible routes.
  • CEO Brian Bedford has successfully built his business by helping legacy carriers reduce costs and taking over flights where RJET could do it more profitably, splitting the savings.  These new deals would appear to give him another tool with which to do that in an untapped market segment with a much larger opportunity set than in the traditional regional space.

In sum, for $5.00 a share I think you get a stable core regional business with strong fcf flow for around 2.5-3.0x eps and 2x the fcf of the regional jet business with a free option on the Frontier and Midwest deals.  In fact at around $5.25 a share RJET itself is trading close to option value, even though the bankruptcy risk at the RJET parent is remote for the reasons described above and would require bankruptcies and liquidations at the legacy carriers.  I think the long term risks associated with the Frontier/Midwest deal are minimized by the deal structure (purchased in bankruptcy remote subsidiary holding companies with minimal equity from the parent) while the potential rewards are large.  Should Frontier/Midwest fail, the core regional jet business could still earn $1.50-$2.00+ eps over the cycle, so the downside from $5.00 seems limited.  If you just layer Frontier's recent results and assume Midwest is close to break even, you can get around $2.80-3.00 in eps (assuming pro forma financials for Midwest fully restructured - I should note the Midwest deal might close before all the restructuring takes place which might lead to short term bumpiness in RJET financials).  If you add synergies, any economic rebound and potential share buybacks from RJET's strong pro forma FCF, the bull case can lead to in excess of $4.00 of eps potential in a year or two.  Using a conservative 7x-9x multiple on $4.00 of eps gives me an upside case of $28-36 a share within a year to year and ½ from closing both deals.  From the IPO until 2q 2008 when oil spiked and forced Frontier into bankruptcy creating uncertainty, RJET generally traded with a multiple between 7x and 12x.  My reasonable downside case is that both deals ultimately fail and are liquidated/sold and the core business in a continuing weak travel environment generates $1.40 of eps which at 4x-5x is still $5.60-7.00 within a year...which is still up potentially significantly from here.  The biggest risk would be that the economy and travel continue to weaken while oil spikes.  In that case the Frontier/Midwest segments where they bear fuel risk could fail and while the regional jet business is not subject to fuel risk - if such an environment lead to more legacy bankruptcies/liquidations than the regional jet business could face additional pressure as well.  Trading at $5.00, significant long term downside would seem to assume real bankruptcy risk at RJET, which for reasons above seems miscalculated while it assigns almost no value for the Frontier/Midwest potential.

UPDATE

Well, in the last couple of weeks Southwest Air stepped in with a higher bid for Frontier - $170 million (although it also had more contingencies like putting more planes back in bankruptcy so increasing the unsecured pool).  It made some sense for Southwest to bid as analysts think it lost around $30 million out of Denver in the last quarter, while Frontier continues to generate strong earnings - $8 million just last month.  Ultimately the southwest bid was hampered by the pilot unions not agreeing and RJET essentially increased its offer by waiving its unsecured claim (about $14 mil).  So now RJET has closed on Midwest and will soon close on Frontier.  Adding Frontier should be at least $1.00 accretive.  The next couple of quarters can be noisy as: 1) Midwest is still losing money.  Its unclear how much they are currently losing, but if you look forward - the company is being completely restructured.  All of its planes are being returned to be replaced by regional jets, all of its operating employees are being let go, and its back offices will now be folded in and run by Frontier.  Frontier can now extensively code share with Midwest and they can exchange routes.  Worst case seems to be Midwest breaks even restructured.  Best case is that there are both large cost and revenue synergies by combining it with Frontier which could add $20-40+ of operating earnings.   2) Mokulee Air (Hawaii) continues to lose money...almost $7 mil last quarter.  Management thinks that the airline is just ramping up - first getting on internet distribution sites and the like.  But this is not likely to be a sustainable situation.  Management will most likely shut it down or sell it by early next year so that 2010 comps without the losses.  So pro forma, RJET should have between $3-4 of earning power even without a significant rebound in travel.  There are still a lot of moving pieces, and there are a number of ways that this can play out.  RJET sits in a very interesting seat with the ability to work out a number of value adding deals with its mainline partners.  It should also begin reporting its earnings now by segment - regional and mainline operations.  If you apply a mainline comp multiple (JBLU, LUV, AAI) to the Frontier/Midwest business (assuming Mokulee is shut) you get the regional business for a negative value.  Say the mainline business does $110-140 of EBITDA pro forma which I think is conservative.  At 6x that is $750 of enterprise value.  Less Frontier debt of $300 (assumed adj for less restricted cash needed out of BK) and the $25 of convert TPG took for Midwest (converts at $10) would leave you with an equity value of $425 or $12 a share for just the mainline businesses they took out of bankruptcy.  Say the regional business is worth 10x a $1.90 or so they might do this year and you get $31.  Numbers are still unclear as management has yet to come out and really explain synergies and restructuring plans and you can use different multiples - but at $6.00 there is a lot of upside potential without what would seem to be a lot of downside risk.

Catalyst

Closing on both Frontier and Midwest.  Restructuring Midwest and selling or closing Mokulee.  All of whcih should lead the market to understand a much stronger earnings potential than it is currently assuming.