Description

The Airline Industry

The airline business has been a very tough business, and nobody knows it better than the insiders:

“People who invest in aviation are the biggest suckers in the world” – David Neeleman, who raised $128 million to found JetBlue

“This industry attracts more capital than it deserves” – Stelios Haji-Ioannou, founder of EasyJet

“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot down Orville Wright...[The airline business] has eaten up capital over the past century like almost no other business” – Warren Buffett

“I’m flying high and couldn’t be more confident about the future” – Freddy Laker, founder of low-cost carrier Laker Airways, 3 days before its collapse on February 3, 1982

In general, the airline industry is represented by:

i)                 High competition, and thus commodity pricing

ii)                Cyclical demand, dependent on the economy

iii)               Large capital requirements, and thus high financial leverage via debt and off-balance sheet liabilities

iv)               High fixed costs, and thus high operating leverage

v)                Volatile input costs, primarily fuel

vi)               Contentious labor unions

vii)             “Black swan” events such as weather, terrorism, and disease

But what if there existed an airline which…

i)                 Was effectively a monopoly, insulated from the effects of competition

ii)                Was susceptible to cyclical demand, but still managed to raise prices most years

iii)               Flew a uniform fleet of low-cost planes, was in a net cash position, and had no operating leases

iv)               Had low fuel costs as a percent of sales

v)                Was able to operate profitably at a low load factor

vi)               Employed long-term incentivized pilots

vii)             Was at lower risk of “black swan” events thanks to its regional position

That airline does exist, can be found in Australia, and goes by the name of Rex – short for Regional Express.

Rex - An Exception

Rex is an Australian regional airline formed in 2002 after the bankruptcy of Ansett Airlines.  A group led by Mr. Lim Kim Hai invested in two subsidiaries of Ansett called Kendell and Hazelton Airlines and merged them to form Rex.  Mr. Lim and his team immediately applied obsessive management and strict operating cost control:

-        Reduced the number of senior managers in the head office from 27 to 4

-        Reduced catering costs per passenger from $6.00 to $1.70 by changing the snacks

-        Reduced fuel spending by refueling at major airports instead of regional ones

-        More recently, limited color printing to save $6,000 per year –a small amount that demonstrates the company’s focus on cost control

Rex became public in 2005 to raise capital, with no existing shareholder selling shares.  Today, the company runs a fleet of nearly 55 planes and flies over 1 million passengers per year to 52 Australian destinations in its core business (this is now increasing due to new tenders).  The fleet is composed of Saab-340 jets, which typically contain 34 seats.  Additionally, the company offers charter flights and also has a highly profitable contract providing ambulance aircraft to the Australian government through 2021.  The past decade has not been a good one for Australian regional airlines, with the following ending up in receivership:

Hazelton Airlines (2004), Great Western Airlines (2005), Aboriginal Air Services (2006), Sunshine Express (2006), Big Sky Express (2006), Transair (2006), O’Connor Airlines (2007), Aero-Tropics Air Services (2008), MacAir Airlines (2009), Regional Pacific Airlines (2010), Tasair (2012), Aeropelican (2013), Brindabella Airlines (2013), Vincent Aviation (2014)

But Rex is different.  The company is focused on routes within Australia that have little or no competition, avoiding routes between major cities that boast a lot of passengers and thus a lot of competition.  On some of its routes, Rex has exclusive government licenses to operate because the government wants to give rural citizens access to the major cities; interestingly, no other airline has applied for them given the limited economics.  On other routes, where the passenger numbers are somewhat larger, Rex is the sole operator without any government license.  Qantas and Virgin know that the entry of a second airline would be extremely unprofitable.  Ultimately, Rex has a monopoly on over 70% of its routes.  Because of this, and because 2/3^rd of its passengers travel for business, the company has consistently raised ticket prices despite a sluggish economy.

Fuel costs as a % of sales are lower compared to other airlines, but labor costs have consistently increased as a % of sales.  Historically, when the labor market was tight, Rex’s pilots would jump ship (plane) to join larger airlines offering them higher salaries and Rex had to follow suit.  Since then, Rex has built its own flight school and ties a pilot’s tuition loans to a long-term commitment (seven years) with the airline – if the pilot leaves prior, s/he is left with compounding tuition debts (often reaching A$100k); as a result, pilot resignations last year were at a 12-year low but since have begun to creep up (presumably due to fuel decline tailwinds at major competitors which have increased ability to pay employees).

But that does not mean the company has not been immune to labor cost increases - in fact, wage increases have been the biggest issue for Rex over time, rising 4% per annum since 2009 while revenues have remained flat.  While this has accounted for the majority of the decline in margins over the past 5 years (see table below), this is about to change.  The company has recently reached three, three-year bargaining agreements covering the majority of employees (engineers, flight attendants, and airport services personnel; pilot negotiation is ongoing) which will limit wage increases to CPI.  In the past, this figure had been set on an absolute basis (e.g., 3.5% per annum) – such compounding of costs was destructive during a time when revenues were flat.

Rex operates a uniform fleet of Saab-340 jets, giving it efficiencies in maintenance labor and spare part procurement.  Note that most costs have declined as a % of sales, mostly due to increased efficiency.  The depreciation of the AUD has obscured these efficiencies, causing the maintenance operating expenses (along with fuel, typically paid in USD) line to increase as a percent of sales.  A larger amount of owned planes has resulted in lower lease expense but higher depreciation (which I argue below exceeds maintenance capex).  Overall, Rex is able to operate at a break-even load factor of 50%, compared to 70-75% on a typical global airline (which is a ballpark, given that industry consolidation and fuel prices cause variations this figure).

The following is a summary comparison of Rex to a global airline:

Prior to the financial crisis, Rex boasted passenger figures of 1.5 million per year.  But with the economic weakness in Australia, and a decline in the mining fly-in-fly-out operations, the passenger figures have declined to just over 1 million passengers per year, a level similar to that in 2005.  Given that most of its travelers are flying for business, Rex has managed to raise prices to keep revenues stable.  As an example, average fare in 2008 was $141 with 1.4 million passengers; it is now $192 with 1.1 million passengers.

A lot of the passenger reduction was companies reducing discretionary travel, for example using conference calls instead of flying to meetings.  There was also a significant reduction in mining fly-in, fly-out operations (FIFO), which would transport miners to and from the mines.  Passenger counts have stabilized since last year as the less important travel has disappeared.  The majority of business travel and medical travel which comprises Rex’s business from the rural cities to the big cities will likely not be affected.

With these figures, Rex generates nearly 210 million in the passenger business.  Add charter and other revenues and total revenues are nearly 250 million.  For a breakout of revenue and cost per ASK, please see Rex’s investor presentations.  Operating cash flow margins (before capex) have ranged between 9-13%.  Rex depreciates its planes between 15k – 60k hours (with the core fleet at 60k hours); at current rates of depreciation, the fleet has an implied 10 year remaining life (the planes fly 1.7-1.8k hours per year).  This is conservative, as the planes can easily be flown another 15 years (to 90k hours) with maintenance capex of 5-7.5 million per year, or 2-3% of sales (the higher end of the range is a result of the declining AUD vs. USD).  All that is required is a signature from Saab, which has also agreed to continue supporting the fleet for another 20 years given that it won some military tenders for the same plane.  Hence depreciation exceeds true maintenance expense and results in lower income statement profitability for Rex.  Furthermore, keep in mind that nearly all major capex (buying the last of the planes) has been done, and aside from a few small projects, the company should be spending only maintenance capex going forward.  Thus sustainable FCF margins are between 6-11%, or between 15 – 27.5 million.  While this is clearly a wide range, the passenger airline business is volatile – and thus the key in any investment is a massive margin of safety.  The important thing is to 1) understand why Rex is a structurally cash generating business and 2) to pay as little as possible for it.

The market cap of 99 million compares favorably to the reported tangible book value of 187 million (53% of TBV).  With the appropriate adjustments, the true tangible book value is closer to 250 million (40%).  The company has some land in Sydney that is booked at cost but has increased in value over time, has many planes written down to 0 (where the engines alone can be sold for 500k USD), and also has a large spare parts pile (500,000 line items) that it purchased last year from the bankruptcy of Pinnacle Airlines at cents on the dollar (they paid 5m AUD for ~40m of value).  These parts will be used both to reduce the company’s own maintenance expense as well as to sell parts to other airlines.  I don’t anticipate that the airplane fleet will be liquidated or that there is a readily available buyer for these airplanes, but it is important to have an idea of asset values.  It is also interesting to mention that Rex has allocation of 15-20% of the slots at Sydney airport during peak times – an asset without apparent value on the balance sheet.I have excluded the $15 million of debt on Rex’s books that is backed by the Australian government for the Ambulance Victoria contract.  This is a 10 year contract that yields 3 million per year in pre-tax profit and debt was borrowed to finance the planes – for which the government is liable, not Rex.  I have also not reduced the cash to factor for the deferred revenue which passengers pay up front when buying tickets as I believe the deferred revenue levels are sustainable and there is also low incremental cost to add passengers to an existing flight.

I focus on absolute valuations, but it is interesting to look at the relative valuation of Rex to Qantas, the major Australian airline.  While Rex sells for .5 of tangible equity with gross debt/equity of 0.08 and assets/equity of 1.45x, Qantas sells for 3x tangible equity with gross debt/equity (including capitalized operating leases) of 3.5x and assets/equity of 8x.  Nobody cares about the little guy!

Sustainable earnings of ~20 million on a 99 million, unlevered market cap results in a 20% earnings yield.  This does not account for the current expansion in Queensland or Western Australia or continuing cost reduction initiatives.

Earnings are of no use, however, if they are allocated improperly.  Fortunately at Rex, the capital allocation is very strong.  On the operating side, the company has made a great use of cash to buy the remaining planes that it did not own – paying less than 2 million per plane for a 15 year life ($130k/year) whereas per annum lease costs are 300k.

On the capital side, the capex is done outside of any growth opportunity that comes up.  New planes (if necessary) are inexpensive (1-2 million) and the yearly maintenance requirements are minimal.  New planes will only be purchased if they generate an appropriate return on capital for new routes.

The Chairman Mr. Lim owns 17% of the company, and his friends and family control nearly 2/3^rd of the business.  He does not believe in a “dividend policy,” instead believing that capital should be spent on its highest use – which may or may not be a dividend at different points in time.  When the share price is cheap, he also likes to repurchase shares – something the company has done historically.  Some of these shares are granted to employees - partial owners in the business that can elect to have 2% of their salaries paid in shares.

Given the low capital requirement of the business, and in addition to the buybacks (perhaps constrained only by the lack of meaningful liquidity), Rex has announced “meaningful dividends” in the near future.  In the event that Australian regional travel continues to remain lethargic, such malaise would be to the long-term benefit of efficient operators such as Rex as weaker competitors fail.

Also worthy to note is that Mr. Lim does not pay himself a salary, instead viewing himself as a business owner.  “Why is Rex so resilient?” asks Mr. Lim.  “It is inbuilt in our DNA that we can only rely on ourselves and so we must save for a rainy day.  From the very first day of our existence 12 years ago, we have consciously eschewed borrowings, choosing to grow at a pace that is in harmony with our cash flow.  Just as we see in the story of Joseph in the Bible, we made use of the good years for shoring up our defenses against the bad years.”

Ultimately, there are many risks to investing in Rex, and especially in investing in any airline.  These risks include:

-        Australian economy weakness (mining, real estate, etc.)

-        Australian currency weakness

-        Revenues in Australian dollars, fuel purchases and some opex/capex (33m USD) in USD

-        Irrational competition

-        Increased input costs, such as labor and fuel

-        Airplane crash

At the end of the day, Rex is a superior airline, but an airline nevertheless.  I conclude with another quotation from Mr. Lim: “The [airline industry] risk/reward ratio is wrong – a huge capital investment for low returns, with huge fluctuations of risk.  I’ve made money, but I wouldn’t invest in any other airline.”

Catalyst

Re-initiation of dividend

FCF building up on balance sheet