Description

ExpressJet Holdings (“XJT”), a regional jet operator, is currently trading at roughly 4.5x normalized sustainable EPS ex year-end cash, with a clean balance sheet and multiple potential catalysts in the coming 12 months. The stock has fallen due to recent adverse news, however, the decline is overdone, and the result is a compelling buying opportunity.

ExpressJet is the major regional affiliate for Continental Airlines (“CAL”). It is paid to operate jets and fly passengers under the Continental Express name, flying in and out of CAL’s major hubs in Houston, Cleveland and Newark. XJT was established by CAL in the mid-1990s, and spun-off in 2002 as part of CAL’s effort to raise liquidity. The current contract with CAL states that XJT will be reimbursed for all costs plus a 10% operating margin. Regardless of fuel costs, regardless of whether the planes are full or empty, XJT is paid the fully allocated cost to fly plus 10%. This contract can be canceled on 12 months notice by either party without cause.

The purpose of the relationship between XJT and CAL is simple: cost savings. Similar to most other regional airlines, XJT affords CAL significant cost savings by providing it with a mechanism to pay pilots and other employees significantly less than it would have to pay them if they flew as CAL employees, and were therefore covered by CAL’s own collective bargaining agreements. For example, a first year pilot for CAL is guaranteed approximately $40K per year, while XJT pilots start at $18K per year. Approximately 30% of CAL’s revenues are derived from XJT or XJT-delivered clients. Should CAL have to fly these aircraft themselves, they would have to bring salaries on a material portion of their routes up to the level of the mainline employees, thereby making the operation uneconomical.

Currently, XJT is flying approximately 266 aircraft, and for the remainder of 2006, will accept delivery of 8 more. XJT flies Embraer 50 seat regional jets. XJT flies four variations, but all are relatively similar. All the aircraft are owned or leased by CAL, and subleased at cost to XJT. In the 10 years that XJT has been flying they have performed very well, leading the pack in on-time performance and efficiency. Secondly, they have managed to lower their per-unit cost every quarter that since 2001. This solidifies XJT as a solid operation that is not easily replaced.

In December 2005, CAL gave notice to XJT that it would remove 25% of XJT’s fleet and request RFPs from other potential regional operators for these routes. The rationale behind the withdrawal of the aircraft was that CAL felt that XJT’s rates were above market. Reportedly, Continental asked XJT to lower their rates by $120mm, XJT counter offered $60mm, and a stalemate resulted. CAL subsequently decided to take back the 69 aircraft from XJT and attempt to find an alternate operator. Assuming that a new operator emerges, CAL will begin to remove the first of the 69 aircraft in January 2007, with the remainder coming out of XJT’s fleet over the next 6 months. XJT, as part of the original agreement, has the right to either retain these aircraft (and use them as they wish, as long as they don’t fly them for an alternate operator into a CAL hub) or return them to CAL. XJT has until September 30, 2006 to make this choice. The 69 aircraft is the maximum that CAL can remove in a rolling 3 year period, giving comfort that a similar announcement will not happen again until 2009.

From the standpoint of XJT this has several implications. Assuming that XJT does not ultimately win the RFP and continue flying the jets for CAL, XJT will be faced with a choice of whether to retain these jets for an alternate use or to return them to CAL. The XJT/CAL contract states that if XJT ultimately retains the jets, the lease‘s implicit interest (i.e. what XJT pays to CAL to sublease the jets) will rise by 200bps. As CAL was the first buyer of this type of jet from Embraer, and by far the largest customer, the initial rate offered by Embraer was extremely attractive. As such, the 200bps increase will still leave XJT with a competitive lease rate. If XJT retain these planes, there are number of options that they can pursue. First, XJT partially owns two subsidiaries, ExpressJet Europe, and Wing Aviation. The former is a start-up operation based in Ireland which is looking to begin operating as a regional feeder carrier similar to XJT, providing a potential use for these jets. The latter, Wing Aviation, is a small charter and fractional ownership operation. The 69 aircraft could be retro fitted for charter or corporate flying making this a viable option; however, we would not be fans of such a strategy due to the high inherent risks of operating an airline (as opposed to operating a regional feeder with a cost-plus structure). Other options include XJT flying the jets as a regional operator for another major, or themselves subleasing the jets to another operator and keeping the spread. As an aside, there are rumors that Virgin America is currently exploring regional feeder alternatives for its pending operation.

For CAL, the removal of the aircraft presents an interesting situation. CAL is on the hook for the 69 planes assuming that XJT does not retain them. Should CAL go ahead with its announced intention to replace part of the XJT capacity, it would need to accept two bids; one from an operator for the XJT Embraer planes, and one for an operator flying a new type of aircraft. Given that an operator would need to secure replacement aircraft on 3 month notice (i.e. the period between the Sep 30th 2006 deadline for XJT’s decision and the Jan 2007 start date), and given the lead time to acquire these jets, XJT’s ability to put the planes back to CAL places both CAL and the bidders in a rather precarious position. There are some interesting game theory implications for the current situation. Clearly, XJT has every incentive to push its decision as close to the Sep 30th deadline as possible, as that will limit CAL’s options.

Secondly, ramping up operations for 69 planes in 6 months is extremely difficult. The largest regional operator in the world, Skywest, flies 370 aircraft. If Skywest becomes the new operator, they would have to grow by 20% in a 6 month period. This growth would require the hiring and training of flight crews. Indeed, XJT (the second largest regional operator in the US) at its peak was accepting only 4 new jets per month. We believe that the growth profile is unrealistic, daunting, and may not result in a smooth transition.

Thirdly, because of union rules, XJT would need to lay off the youngest members of its workforce to meet its reduced labor needs. Assuming that XJT is only able to lower its overall labor costs by 5% (given the comp spread between junior and senior employees) and the rest of the costs by 25%, overall per unit costs for XJT would actually rise by 6%. Given the cost plus nature of the XJT/CAL contract, this rise in per unit costs would imply that a new operator would have to lower their rates by 20% over XJT’s current rates just for CAL to break even on its regional jet operations in aggregate (versus the current 100%-XJT operated setup). In order to save the $120mm that CAL has asked XJT to reduce its costs by, the savings offered by an alternate operator would, in our opinion, be impossible to achieve.

Finally, due to the hit the share price took, the two largest share holders saw substantial capital losses. In this case, the two largest shareholders are CAL and the CAL retirement plan. These four scenarios suggest that CAL has no intention of replacing XJT, and is using its leverage as a negotiating tactic to force XJT to lower its rates to help save CAL save $120mm annually.

In terms of earnings power, XJT should be able to generate roughly $170mm in EBIT with the full 274 jet fleet at the current 10% margin rate. Clearly, this margin rate will not persist for long. When XJT offered $60mm in savings, it stated that it was doing so “in the best interests of shareholders.” Management indicated that this number would not necessarily fall completely to the bottom line as the company could cut some internal expenses as a partial offset. If we assume that XJT ultimately offers $90mm in savings to CAL (the midpoint of the $120mm bid and $60mm offer) and offsets this with $15mm in internal cost savings, then the company should be capable of generating $95mm in EBIT, $1.00/shr in EPS, and $1.10/shr in FCF (the company runs a favorable D&A/capex spread, and has a negative working capital position).

A second scenario would be for XJT to continue offering the $60mm in savings, but on a reduced fleet size minus the 69 jets. Using the smaller base of aircraft and providing the $60mm in savings in the form of EBIT margin rate reduction ($60mm on 274 aircraft results in $45mm in savings net), XJT should generate $90mm in EBIT, $1.00/shr in EPS, and $1.10/shr in FCF (assuming that costs increase as XJT lays off employees). With the decline in the fleet size, cost savings as described above would be unlikely.

Under either scenario, XJT will likely continue operating the full fleet of aircraft in 2006 at the current rates. The $60mm rate reduction implies a 7% EBIT margin, assuming no aircraft are returned. For 2006, assuming this 7% margin kicks in mid year, XJT will generate roughly $2 per share in FCF. This would result in XJT having approximately $3.00 in net cash per shr by the end of 2006. The net result is that XJT trades at roughly 4.5x normalized sustainable earnings ex cash. In addition, on a downside case scenario, with XJT giving back $120mm to CAL through a rate reduction, XJT should generate roughly $0.66/shr in EPS, resulting in a downside valuation of 7x earnings ex cash (assuming the $15mm in costs savings are achieved).

While the above scenarios are likely, there is another potential risk that needs to be addressed. As mentioned, the contract for XJT is cancelable on 12 months notice. Secondly, XJT’s only customer is one of the two remaining network airlines that have not filed for bankruptcy. Given the size of the operation that XJT is providing, it is unlikely that CAL would terminate the entire agreement. This is due to the put option that would ensue with XJT returning all or none of the aircraft under lease. However, in Chapter 11, CAL could simply reject the leases on the aircraft that are leased to XJT (i.e. put them back to the lessor, Embraer) and not have to worry about the prospects of being stuck with several hundred unused 50 seat jets. Northwest Airlines recently faced a similar predicament. Its regional carrier, Mesaba, was flying aircraft that were uneconomical. Because leases were held by Northwest, it had to wait until the Chapter 11 filing before actually rejecting the aircraft and the contracts. The result is that Mesaba will be left with no planes to fly. A Chapter 11 filing by CAL is a similar risk for XJT. This is partially mitigated by the relatively strong balance sheet at CAL. CAL has done a good job of avoiding Chapter 11, and should its liquidity begin to become an issue, the signs should be apparent long before the event takes place.

Finally, XJT management realizes that their dependence on a single customer is not helping the share price. They have begun initiatives to diversify outside of regional flying. While the results are currently immaterial, there are several initiatives underway. Mentioned previously, the company owns part of a European regional jet start-up, and a charter operation. In addition, the size of the current fleet makes XJT the largest user of Embraer jets in the world. They have a significant training and maintenance base, and have recently begun work for third parties in these areas. Management has commented time and again that they view these initiatives as a means for diversifying away from CAL. While not included in the potential for earnings, this presents incremental opportunities.

To conclude, XJT’s shares have fallen due to the numerous perceived risks of having CAL as its only customer. This risk was compounded by CAL threatening to remove 25% of the XJT fleet. While the headline associated with this is not pretty, once all the scenarios play out, XJT will still be providing CAL with services, with its shares trading at about 4.5x sustainable earnings ex-cash. Given the kind of multiples in question, XJT should be worth in excess of $13/shr. This represents a 10 times multiple, plus the cash per share mentioned above.

DISCLOSURE: We and our affiliates own shares of XJT, and may buy additional shares or sell some or all of our shares, at any time without notice. We undertake no obligation to update the information provided above or to inform you of any changes in our views of XJT. This is not a recommendation to buy or sell shares.

Catalyst

Retaining 69 jets, continue to fly them for CAL
Announcement of other value-enhancing uses for the 69 aircraft (release, fly for other major)