|Shares Out. (in M):||35||P/E||4.1x||1.9x|
|Market Cap (in $M):||230||P/FCF||4.0x||1.8x|
|Net Debt (in $M):||2||EBIT||0||0|
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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?
The Opportunity -
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.
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.
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.
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