Description

Shares are worth at least $30-$35 (60%-85% upside) and potentially much more if they receive the multiple re-rating that they deserve (once investors acknowledge that the Company is currently being valued like an airline, despite a completely different, and vastly superior, risk profile and performance record).  But what is particularly unique and compelling about this opportunity is the substantial margin of safety (discussed in detail below) that creates a truly asymmetric payoff structure for the investor.  Near-term positive catalysts, a 20% FCF yield on 2008 consensus and a best-in-class management team sweeten the deal.

RJET is Not an Airline

Republic is essentially a capital equipment leasing and contract services company that happens to serve the airline industry, but it is NOT a traditional airline.  This distinction is very important and is highlighted by the following attributes:

-RJET bears absolutely NO fuel price risk (yet often trades w/ airlines that trade inversely with skyrocketing oil prices!)

-NO exposure to volatile ticket prices & frequent fare wars

-NO exposure to increased airport landing fees or domestic security fees

-virtually NO sensitivity to passenger load factors

In addition to avoiding all of these primary risks that have historically made airline investments so challenging, RJET also benefits from a number of significant relative structural advantages:

-Long-term contracts of generally 10-12 years provide substantial earnings visibility & downside protection

-Contracts contain fixed price escalators to help offset increases in labor or input costs

-These agreements are not subject to renegotiation (outside of bankruptcy)

Despite these essential fundamental differences, RJET generally trades in-line with the mainline network carriers that are exposed to all of the risks mentioned above and none of the benefits.

Given the security and predictability afforded by RJET’s lucrative long-term contractual arrangements, we believe that the Company should be valued at least at parity with the universe of publicly traded transportation asset lessors.  In fact, given the significant barriers to entry and operational logistics of establishing and maintaining a national network of flight, service and maintenance personnel, we would argue that Republic deserves a premium to a commodity provider of capital.  Nevertheless, the table below illustrates the implied value of Republic at mere parity with its asset lessor peers using Street consensus estimates.  Despite the fact that these financial peers have been dealt a significant blow in recent weeks amid the credit market turmoil, the multiples ascribed to them still imply a value for RJET of roughly $30 (60% upside).

FCF:

RJET generates substantial recurring free cash flows, which are only expected to grow stronger as the net new aircraft added slow as a percentage of the existing fleet (bringing down the high capital expenditures from the recent hyper growth phase).  The latest analyst report (released just yesterday from Merrill Lynch) estimates the following:

Contracts:

RJET’s average contract does not expire until 2016, with the first one not coming up for renegotiation until 2012 and some dated as far out as 2020.  The fixed fee (per departure or block hour) structure, high guaranteed minimums and automatic price escalators provide a level of revenue and earnings visibility and reliability that simply does not exist within the network airline industry.  Given the safety of these arrangements, one can model out the expected earnings of the current fleet (and the contracted backlog) to determine a baseline value for the business.  All additional fleet increases (including many which have already been announced) would be upside to this valuation.

Historical Profitability:

RJET has been profitable for 31 of its 33 year history.  Does that sound anything like a network airline?  Name one!  Southwest (LUV) can claim a similar distinction, but it also trades at 19.8x 2008 consensus earnings – a multiple which would imply a $48 share price (150% upside) for RJET based just on consensus estimates, which we feel are actually too low.

Exaggerated Impact of Airline Bankruptcies:

Bears like to claim that RJET’s revenues are effectively only as stable as their end customers, the network carriers, and they therefore deserve no better multiple.  This argument stems from the fact that any contract can be renegotiated or cancelled in bankruptcy (something that is basically true of any company in any industry).  Not only does this view overlook the numerous structural advantages laid out above, but it also ignores historical precedent.  During the current decade alone, RJET has weathered the bankruptcies and work-outs of America West, American Airlines, TWA, United, US Air and Delta (with a new long-term contract effective upon Delta’s reemergence this past April).  Yet during this same time period, RJET increased revenues 7-fold from just $147m in 2000 to more than $1.1b in 2006 (a CAGR of 41%).  In fact, there is a strong argument to be made that RJET has benefited significantly from these bankruptcies as the network carriers were able to negotiate more lenient scope clauses with their labor unions, thus paving the way for the outsourcing of significantly more business than had historically been allowed.

Customer Diversification:

Another argument made by the bears for network airline multiple parity is that regional airlines are essentially just captive subsidiaries of the mainline carriers, with huge customer concentration risks and limited external growth opportunities.  While this is in fact true of most of the regional airlines, it could not be less true for Republic.  RJET has a significantly more diversified customer composition than any regional flyer (see the table in the next section for a peer comparison) and in fact, just added a 6^th platform this past January through a 13-year agreement with Frontier Airlines to operate 17 Embraer 76-seaters.  Pro forma for this transaction (as well as the recently announced Continental contract for 44 aircraft), no single network carrier would represent more than 25% of Republic’s fleet (vs. an average of 79% for its regional airline peers).

Where is Regional Airline Growth Coming From?

Our conversations with industry experts (from network airline executives to regional operators to industry consultants) has led us to conclude that there are 3 main avenues for substantial potential growth within the regional airline industry:

1.  Gauge Shift to Larger Regional Aircraft:  Smaller 35 to 50 seat commuter jets have never been particularly attractive for airlines to operate (either internally or outsourced), but they were a necessary component of the nation’s largely hub-and-spoke commercial aviation network.  As fuel costs per flight have risen in recent years, the economics of these smaller aircraft have become even less attractive, prompting the network carriers to explore flying larger commuter jets of 70+ seats (thereby benefiting from greater economies of scale).  Historically, agreements with the airline pilots’ union (ALPA) have restricted network carriers from having the flexibility to outsource the flying of these larger aircraft to lower-cost providers (thereby preserving union jobs).  However, union scope relief achieved largely as a result of the recent round of bankruptcy negotiations is increasingly allowing airlines this flexibility as a compromise for maintaining union wage increases and retirement benefits.  As a result, the regional jet industry is in the early stages of a significant gauge shift from the smaller class aircraft to the more cost-effective, higher margin (and passenger friendly) 70+ seaters.  It is estimated that there are currently fewer than 300 of the larger gauge regional jets versus more than 1,250 aircraft having fewer than 50 seats.  It only stands to reason that the regional airlines with the most to benefit are those with the greatest demonstrated ability to both quickly source and effectively operate aircraft of this size (we argue below that RJET stands virtually alone in this respect – see the table in the next section for a peer comparison).  We believe this is an evolutionary multi-year trend that will lead to wholesale fleet upgrades of existing regional jets as their contracts come up for renegotiation (already happening) and to even greater scope relief for the still troubled network carriers that may eventually lead to the outsourcing of even 90 to 120 seat aircraft in certain markets – a lucrative opportunity for the right regional operator.

2.  Market Share Shift to Lower Cost Quality Providers:  As the network carriers continue to restructure, they are slowly but inevitably exhausting their opportunities for further significant internal cost reductions.  This is increasingly driving them to pressure their outsourced service providers (including the regional flyers) to deliver the lowest-cost product possible within the industry’s fairly high quality and safety standards.  As this pressure continues to increase, we believe that the regional airline industry will experience some consolidation (driving incremental economies of scale and removing excess capacity at the lower aircraft gauges), the primary beneficiaries of which will be those quality operators with the most efficient cost structures.  Not only has Republic consistently been mentioned as one of the industry’s two highest quality operators by everyone we have interviewed, but it also has the regional airline industry’s lowest cost structure (see the table in the next section for a peer comparison).

3.  Point-to-Point Shift Benefits Regional Operators:  Finally, there is an argument to be made that the commercial aviation industry in this country is simply overly saturated as a result of the excess capacity necessitated by the current largely hub-and-spoke network.  After all, how many daily flight options does one need from Columbia, SC to LAX (a recent Orbitz search yielded a dizzying array of 75 alternatives in one 24 hour period on every major network carrier through virtually every national hub imaginable – surely this is overkill)?  Should a fundamental restructuring of the network airline industry ever challenge the logic of the hub model and replace it with the point-to-point model that has been popularized by low-cost carriers like Southwest, we believe that the regional airlines will be significant beneficiaries.  Under such a scenario, the need will dramatically increase for the shorter duration, smaller capacity aircraft that are the staple of the regional operators.

Why is RJET Best Positioned to Benefit from These Trends?

Republic is in the pole position primarily because it:

-Has a cost structure more than 20% below the peer group (7.6 cents per ASM vs. 9.6 cents for the industry)

-Operates the greatest percentage of higher margin 70+ seat aircraft in the industry (44% vs. just 7% for the peer group)

-Owns the greatest percentage of its fleet than any other regional (yielding higher margins & greater flexibility) – 64% ownership vs. just 10% for the peers

-Is the only operator of the increasingly popular high-end Embraer 170s flown in the United States (and has this year become the largest operator of Embraer planes in the world)

-Holds significant options (representing 79 aircraft) to source larger gauge Embraer aircraft through the end of 2008 (a period during which supply is expected to be very tight, increasing RJET’s attractiveness as a prospective regional partner)

-Is universally regarded as one of the two industry leaders in terms of quality and safety metrics (SKYW is the other)

The following table demonstrates what we believe are significant differences between the composition of the regional fleets that will drive very different outcomes for the various players:

Apart from RJET’s superior fleet composition, which we believe will drive the Company’s long-term outperformance, the Street also expects Republic to generate both significantly faster growth and substantially higher profitability than its peers over the next few years:

So, What is RJET Worth?

We use a number of valuation methodologies to arrive at what we believe to be a fair value for Republic:

1.      DCF:  The simplest way to think about the DCF is to look at RJET’s business on a per plane basis.  We constructed a model using the assumptions laid out below to calculate the approximate NPV of a single aircraft, which can then be extrapolated to represent the current fleet as well as to analyze various incremental growth scenarios.  The primary details are as follows:

The bottom line is that our analysis yields an IRR per plane of roughly 23% (consistent with indications we have received from management) and an NPV of roughly 15.5 cents per aircraft.  Because virtually all of Republic’s debt is mortgage debt on the aircraft (the impact of which is included in our NPV calculations), this NPV is essentially equivalent to equity value per share.  Based on management’s guidance of an additional 30 net planes per year and giving RJET zero credit for increased scale or the higher margin contribution from the higher mix of larger aircraft, we still derive an implied value per share under this method of roughly $30 or approximately 60% above the current share price.

2.      P/E Multiple:  Similarly, we looked at the average EPS per aircraft under this same midpoint of guidance scenario and arrived at a current implied per share valuation of approximately $33.50 or 77% above current levels, using the average forward multiple for Republic’s asset lessor peer group.