Hawaiian Holdings

Opportunity

Hawaiian Airlines is an interesting small-cap equity that is relatively uncovered and widely misunderstood. While there is no doubt that Hawaiian faces some challenges (most obvious being the entry of Mesa into the Hawaiian interisland market), investors have overlooked many of the positive fundamentals make Hawaiian one of the most compelling investments in the airline industry today. With the acquisition of 4 ex-Delta 767’s, declining fuel prices, improving yields, and the potential for consolidation, there are numerous catalysts that could make this a 2-3x investment. Based on the current TEV of $220MM (not including the $71MM in restricted cash from credit card holdbacks) and 2007E EBITDA of ~$95MM, Hawaiian is trading at just over 2.3x 2007 EBITDA, with a 38% levered FCF Yield.

Bankruptcy 2003-2005

Hawaiian Airlines (operating subsidiary of Hawaiian Holdings), was operating under Chapter 11 bankruptcy protection from April 2003 until June 2005. Like many other airlines, Hawaiian struggled post 9-11 as tourism slowed, fares declined, and costs increased. In addition, Hawaiian had gone through a refleeting program, which had increased their fixed costs right before the downturn. It was an interesting saga, as the old Chairman, John Adams, initiated a tender offer to repurchase the company’s common stock in June 2002, shortly after Hawaiian and Aloha terminated their merger agreement. Mr. Adams basically used $25MM of the company’s cash to primarily tender for his own shares – you can imagine the outrage by creditors when the company’s financials quickly deteriorated and forced the company into bankruptcy in early 2003. A few of the large creditors (primarily lessors) influenced the Bankruptcy Court Judge to dismiss Mr. Adams and appoint a trustee, who guided the company through the bankruptcy process.

Mark Dunkerley was hired as the COO just before they filed, and was named President and CEO shortly upon emergence. Mark has a strong industry background including 10 years at British Air and a turnaround assignment at Sabena Air.  The company’s performance markedly improved during bankruptcy, driven by a rebound in traffic and fares, and the airline actually generated record levels of profitability in 2004. An investor group led by Larry Herschfield’s Ranch Capital and several hedge funds funded a plan of reorganization, and Hawaiian emerged in June 2005 (the company’s stock was never cancelled). The stock has been fairly volatile, which has been driven by fears of higher oil prices, Mesa’s announced entry into the interisland business (started 6/1/06), and complicated non-cash purchase accounting adjustments, which have skewed the GAAP profitability and masked the underlying performance.

Brief Business Overview / Entrance of Mesa

For a brief background, Hawaiian operates a fleet of 11 B-717 (interisland) and 18 B-767’s. While Hawaiian’s origins were providing transportation in the interisland market, the airline has been growing its long-haul business to/from Honolulu and Maui. HA’s current route structure is focused on the West Coast (Portland, Seattle, LA, SFO, San Jose, Sacramento, Las Vegas, Phoenix, San Diego), as well as a few routes to Asia-Pacific markets. Hawaiian is consistently rated at the top for customer satisfaction, on-time, fewest lost bags, etc. While I won’t argue that Hawaiian can generate a “fare premium” to other carriers, I do think it is obvious that flyers prefer Hawaiian if the fares are competitive with the alternate carriers – this is why Hawaiian’s load factors have led the industry in the 85-90% range for the last three years.

Approximately 70-75% of Hawaiian’s revenues are generated from long-haul routes, with the remaining coming from the interisland business. Hawaiian also recently purchased 4 ex-Delta 767’s to increase frequencies to its existing west coast markets, where load factors have consistently exceeded 90%. This is an extremely accretive transaction, as Hawaiian has the demand to add additional capacity without materially affecting yields.  They should also be able to leverage their existing infrastructure and reduce CASM ex-fuel going forward. Hawaiian believes they have other opportunities to expand to new markets (in Asia and the US), and this is where the growth will come from in the future.

The interisland market has been shrinking the last several years for several reasons:

1. More flights directly from US mainland cities to the outer islands (as opposed to long-haul flights being funneled through Honolulu and carriers like Hawaiian picking up the connecting traffic)
2. Commercial development in the outer islands make local travel less necessary (i.e. if there is a large shopping mall in Kauai, less of a need for locals to travel to the larger islands)
3. Aloha and Hawaiian raised fares after 9-11 and both carriers went though restructurings – there is some demand elasticity

Mesa Airlines announced in September 2005 that they would start a new interisland carrier in Hawaii called Go!. Go! launched on June 1, 2006 and is currently flying 4 CRJ-200’s (small, 50 seat regional jets), which has increased capacity in the interisland market, and brought down the yields. Mesa is currently being sued by Hawaiian and Aloha for using confidential information Mesa received while evaluating these carriers in bankruptcy for use in its own business plan – while I haven’t attempted to quantify this, I do believe Hawaiian has a very legitimate claim, and there are “smoking gun” emails and press quotes from Mesa’s management team that support Hawaiian’s lawsuit.

I have no idea what Mesa is trying to accomplish (other than potentially pushing Aloha out of business). They are losing money, flying a very inefficient, high-cost aircraft not meant for 100-mile segments, they are only flying with 30 passengers on a plane, and their own investors aren’t supporting their efforts. While Mesa and their $39 fares have garnered a lot of headline attention and affected Hawaiian’s stock price – the impact from Mesa isn’t that significant and is creating a huge opportunity for investors. In Q3 (the 1^st full quarter of Mesa competition), Hawaiian’s transpac yields were up 9.8%, while the interisland yields were down 15%. But since about 90% of Hawaiian’s ASMs are related to the long-haul segment, consolidated yield was still up 5.5%.

Outlook

Hawaiian’s capacity should be up approximately 12-13% in Q4 2006 and FY 2007, driven by the additional routes from the ex-Delta 767’s that started service in October and November.  The additional capacity should drive ex-fuel unit costs down by 2%, as the airline leverages their fixed costs and airport station expenses. I’ve assumed a 60bp decrease in load factors and a 2% increase in yield, resulting in a RASM improvement of 1.5%. I think I’ve also been conservative in modeling the fuel costs at $2.00/gallon for 2007 vs a spot price of $1.75-$1.80. Hawaiian will use about 128MM gallons next year, so a 1c change in jet fuel equates to a $1.3MM change in EBITDA (assuming no pass through).  Another factor supporting strong tourist demand is that starting in January 2007, US tourists must have passports when flying to Mexico and the Caribbean. While it’s hard to quantify, it would seem to be at the very least a modest positive for Hawaii as a destination.

Hawaiian currently has 46.5MM common shares O/S plus about 1MM dilutive shares using the treasury method (see options/warrant schedule below). Using my projections below, Hawaiian is currently trading at 2.3x 2007E EBITDA and 4.7x EBITDAR (capitalizing aircraft rent at 7x), which is a very big discount to the comps. In addition, the company currently has $71MM tied up in restricted cash, as they have a 100% holdback on all credit card transactions – the company is currently in discussions to loosen those restrictions, which could be used to reduce their debt load (although interest rates are fairly favorable at approx 9%). The company should also generate tremendous FCF next year (2006 was abnormally high due to the 4 aircraft purchases). Maintenance capex is about 20MM/yr, so at $96MM of EBITDA, the company has minimal net interest expense, is not a cash taxpayer, and generates $10MM of working capital (advance ticket liabilities).  My estimate of $84MM of free cash flow is a 38% free cash flow yield!

EBITDA                $96

Interest                   (2)

WC                         $10

Taxes                      $0

Capex                      ($20)

FCF                        $84