Description

Air Wisconsin – The Undiscovered Airline IPO Trading at Less Than 3x Earnings

Pitch Summary: Air Wisconsin (OTC: HRBR) is a $100m market cap regional carrier trading at less than 1.5x cash and forward FCF with exposure to increased travel volumes and the potential for shareholder-friendly capital allocation. 

Mispricing: This opportunity exists because of the dynamics surrounding how this security became publicly traded and the fact that it is an illiquid micro-cap security trading on OTC markets. Air Wisconsin (AirWis) became Harbor Diversified, Inc. via a merger in 2011 with Harbor Biosciences, a cash-burning pharma business with substantial NOLs and deferred tax assets for the profitable AirWis to take advantage of. HRBR went dark and ceased to publish filings with the SEC, leaving investors unaware of the merger. Nine years later, an investor Travis Martin learned of this merger and filed a lawsuit demanding that HRBR release financials, as they had >300 shareholders. Consequently, HRBR released its 2019 10-K in July 2020, revealing an undiscovered airline IPO that lacked the fanfare and marketing of a traditional IPO process. Over the past few months, we have learned about the company in bits and pieces via quarterly filings, with the 2020 10-K being released on April 1, 2021. Given these facts, AirWis trades at 1.2x 2020 EBITDAR, 0.5x 2020 revenue, 3.3x 2020 earnings, 0.7x year-end 2020 book value, and generates a 61% free cash flow yield. 

Business Overview: Air Wisconsin was founded in 1965 in Appleton, WI. HRBR is a holding company that now consists solely of AirWis and the NOLs of the pharma business ($19.1 million of DTAs); the remainder of the pharma business was liquidated. It owns 64 CRJ-200 aircrafts and flew four million passengers annually pre-pandemic. The company operates under a capacity purchase agreement (CPA) with United Airlines (UAL), in which AirWis serves as a United Express regional carrier. AirWis operates routes to 36 cities across the US, all of which depart from or arrive at two UAL hubs: Chicago O’Hare and Washington Dulles. The company has a market cap of $100 million and generated $185.9 million of revenue in 2020 at a 23.3% EBIT margin and a 41.6% EBITDAR margin. Today, the company has $76.9 million of net cash and trades at 0.5x today’s book value. AirWis generated $1.11 in FCF per share in 2020.

Industry Overview: Regional airlines are critical partners to major airlines (e.g. United, Delta, and American). These airlines exist because they operate out of regional spokes in the commonly used hub-and-spoke model. Simply put, UAL cannot park a Boeing 747 in a tiny regional airport, nor does it want to spend additional capital on acquiring smaller aircrafts. Regional airlines provide aircraft, fleet maintenance, and crew; the larger airlines pay for fuel and aircraft insurance, sell tickets, and plan routes. A typical contract compensates the regional airline on the basis of operating statistics such as number of departures, timeliness, customer satisfaction, and available seat miles (ASM). Pre-pandemic, regional airlines operated 41% of all scheduled flights in the US. They have fared better than major airlines because they are not reliant on international or business travel. Global travel spending fell 76% in 2020, compared to 34% for domestic. Business travel fell 70% in 2020, compared to 27% for leisure. Large air carriers had a ~60% decline in revenues in 2020; regional airlines operating under CPAs had a mere ~30% average decline in comparison. Moreover, regional airlines have fewer fixed costs in their cost structure. As a result, Air Wisconsin produced a net profit margin of 21.5% in 2020.

Industry Outlook: The regional airline industry is more insulated than the broader aviation industry, as it relies primarily on leisure travel. This industry will benefit immensely upon the economy reopening, with pent-up leisure travel demand serving as a tailwind for the latter half of 2021 into early 2022. A former American Airlines consultant and former Airbus employee posited that “larger air carriers are reliant on international and business travel coming back and they won’t see 2019 levels before 2024 or beyond… regional airlines, on the other hand, will see 2019 levels by mid-2022 at the latest, but likely earlier.”

AirWis has strong unit economics because of the UAL contract: On an ASM basis, AirWis earns $90 in EBITDAR per ASM, compared with ~$20 for regional CPA peers Skywest Airlines and Mesa Airlines. Skywest operates under CPAs with Alaska, American, Delta, and United. Mesa operates under CPAs with American, Delta, and United. AirWis, on the other hand, exclusively serves UAL. Pre-pandemic, AirWis was provided monthly payments driven by operating statistics such as ASM and number of departures, in addition to an incentive-based component driven by customer satisfaction. In October 2020, AirWis’s contract with UAL was renegotiated and incentive-based components were suspended, tying the economics of the contract entirely to the operating statistics plus a fixed payment, regardless of flight volumes. The contract provides an extension until February 2023, with two renewal options to 2025 and to 2027. Pre-contract renewal, AirWis earned $35 per ASM, compared to ~$20 for peers. It is clear that AirWis had superior contract economics before the pandemic and obtained even better terms with UAL during the pandemic.

Three other regional airlines – Trans State Airlines, Expressjet, and Compass Airlines – went bankrupt last year. AirWis saw comparable declines in revenue to peers, dropping 29.5% compared to 28.4% for Skywest and 29.8% for Mesa. Despite this, AirWis saw more favorable EBITDAR margins with an astonishing 41.6%, far outpacing Mesa’s 13.1% and Skywest’s 11.2%. AirWis’s contract economics are stronger than peers because of the history between the two companies and the flight route economics. AirWis has been flying as a United Express carrier since the early 1980s and pioneered the concept of codesharing as a regional air carrier. Their relationship with United is far more entrenched than Skywest’s, who started serving UAL in the early 2000s, and Mesa’s, who started serving UAL in the late 1990s. Furthermore, AirWis’s flight routes out of IAD operate at near monopoly status with greater passenger density, given that United is the only airline with a hub at Dulles (comparatively, Mesa and Skywest operate primarily out of more “crowded” hubs, e.g. LAX, where UAL, DAL, and AAL all share a hub). AirWis’s routes out of IAD have shorter distances comparatively, yet still command price premiums given the monopolized status of these routes. Thus, given the long and favorable history of service between UAL and AirWis, and the fact that the routes AirWis serves operate as monopolies with high passenger density, AirWis has been able to achieve superior contract economics than peers.

Government support has provided substantial cash: AirWis received a total of $42 million from the US government in 2020 from the CARES Act PSP1 and another $10 million from the PPP loan. Even with an enormous reduction in flight volumes, AirWis posted a 21.4% net income margin in 2020 because of PSP1 being recorded as a contra-expense under US GAAP. This year’s strong earnings, largely driven by government support and reduction of lease expense, enabled AirWis to increase its cash balance from $69 million to $130 million during 2020 without raising any debt aside from the PPP loan. AirWis will receive a further $60.1 million in 2021 from the US government through PSP2 and PSP3, according to the US Treasury. With this government support, AirWis will earn 1.0x its market cap in net income this year. AirWis is extremely unlevered compared to peers, sitting at a net debt/EBITDAR of (1.0x) compared to peers Mesa and Skywest with 5.0x and 8.8x, respectively. As of the announcement of PSP2 and PSP3, AirWis has $72.9 million of net cash (incl. leases). This towering net cash balance will create the opportunity for AirWis management to deliver cash back to shareholders via a special dividend or share repurchases.

AirWis will become profitable on a normalized basis due to lease purchases: In 2021, earnings will be stronger than in 2020, but these numbers are not indicative of AirWis’s future earnings power due to the enormous amount of impending government support. On a normalized basis, using 2019 flight volumes, AirWis will generate $20 million in annual unlevered net income, for a ~8% net income margin. This margin improvement is substantial over pre-pandemic levels, which were razor thin when factoring in one-time add-backs. The improvement is purely driven by the elimination of $40 million in annual rent expense with an incremental step-up in depreciation. This move by management was clearly margin-accretive for the business; normalized earnings will be profitable.

Valuation – Book Value Approach: Year-end 2020, AirWis had $2.12 of book value per share. For today’s book value, we add back current and long-term deferred revenue ($43.2m), which will come in as earnings in 2021. We also add back the $10m PPP loan, which is forgivable. We arrive at an adjusted book value of $3.09 per share. On top of this, AirWis will receive $60.1 million from PSP2 and PSP3 to offset payroll in 2021. Adjusting for PSP2 and PSP3, we arrive at our base case of $4.19 per share.

Furthermore, pre-owned CRJ-200s sell for $1.3 million. Even if HRBR were to liquidate, selling the 64 aircraft at 75% of the market price would generate enough cash to cover the market cap. Adding in the $76.9 million of net cash would yield a share price of $2.51.

For the sake of pointing out the extreme price-value discrepancy, let’s assume that all the operating assets are worthless. If investors only receive net cash of $76.9 million, we obtain a share price of $1.40.

Valuation – Earnings Power Approach: At normalized net income of $20 million, applying a 10x multiple and assuming a dollar-for-dollar conversion of $76.9 million in net cash, we arrive at a $5.84 share price. At 14x, we obtain a $7.30 share price. The discrepancy in price and value for this business is too large to ignore.  

Catalysts: The primary catalyst for a rerating is capital allocation. The majority shareholder in the business is Richard Bartlett, who controls 26% of shares outstanding. Inside ownership is 36%, demonstrating strong alignment of incentives. Management has chosen to stay in the dark for 9 years, but after posting strong financial results and attracting substantial investor interest (daily average volume has increased 5x in the last few months alone), they cannot remain in the shadows. Management has announced a share buyback program, where they will set aside an additional $1 million each month to repurchase shares. ~$13 million, an astounding 20% of market cap, has already been set aside for the program. While shares have yet to be repurchased, management is creating a war chest whose value will soon be unlocked by shareholders. Another capital allocation-related catalyst would be the announcement of a special dividend. With $76.9 million in net cash and a $100 million market cap, simple capital allocation decisions surrounding a dividend or repurchases would prove to be imminent and tangible catalysts, prompting a proper multiple rerating. 

The “call option” catalyst is an uplisting to a major stock exchange from their current OTC existence.

An additional catalyst is the release of the next quarterly filing. The disclosure of $60.1 million of government funding from PSP 2&3 causing net cash balance to explode from $6.8 million year-end 2020 to $76.9 million today will be an eye-opening result to investors.

Risks: The biggest risk is the company receding back into darkness. This is mitigated by the fact that investor awareness is expanding, since daily volume has increased 5x over the last few months. A potential capex cliff poses an additional risk, given AirWis’s fleet age (17 years vs. peer median of 14.5). The fact that UAL makes up 99% of revenues is another point of concern. This risk is mitigated by the operating history of the business; AirWis has won contracts time and time again with United, US Airways, and American Airlines. The last risk is dilution: if the Series C Preferred are exercised, shares outstanding will reach 70.1 million. However, even in the face of dilution, our base case (1) yields a share price of $3.24, and (2) removes the 6% preferred dividend, increasing the portion of earnings that common shareholders have a stake in.

Overall, the asymmetric upside opportunity at play here more than compensates investors for these risks.

Disclaimer: This is not investment advice. The poster may hold a long position in the security discussed.

Catalyst

See above. Share buyback, special dividend.