Description

SUMMARY

Recent turbulence in shares of Hawaiian Airlines parent Hawaiian Holdings (HA) is giving investors an opportunity to buy a quality business with a shareholder friendly management at a healthy discount to its peers. HA swooned 10% in one day in early May on news that Southwest Airlines will begin flights between the West Coast and Hawaii, and now trades 30% below year-ago levels. While Southwest has the most ambitious Hawaii plans, other airlines are setting their sights on the Aloha state too. United, which currently has the most flights to Hawaii from the West Coast, with 28 daily, added 11 additional routes to the island in December. Four of these compete directly with Hawaiian.

The fear of increased competition, along with higher oil prices which hit all airlines, has pushed down the stock to the point where it’s cheap by virtually every metric. Hawaiian now trades at 6.4x consensus 2018 earnings, compared to its peer group average of 11x, and well below its own long-term multiple of 9x forward earnings; it looks like a bargain based on EBITDA, EBITDAR and EBITDAR – Capex measures as well.

But look beyond the recent competitive concerns and you will discover a strong operator which has outpaced most of its peers in sales and EBITDA growth over the past three and ten years, and displays an impressive margin profile. 

There are also a number of potential tailwinds to further propel its growth: Hawaii’s tourist economy continues to boom, with the number of visitors surging 9% in the first three months of 2018; its major inter-island competitor, Island Air, went out of business last year, giving Hawaiian a monopoly on those routes; and it recently signed a code-sharing agreement with the dominant Japanese carrier JAL, the first step towards a broader joint venture.

COMPANY DESCRIPTION

Hawaiian Holdings is a holding company whose primary asset is full ownership of the common stock of Hawaiian Airlines. The airline operates approximately 170 daily flights between Hawaii and the mainland US (53% of revenues), Hawaii and international destinations (25% of revenues) and inter-island flights (22% of revenues). Hawaiian has 20% of the market for flights between the West Coast and Hawaii, trailing only behind United and Alaskan Airlines. United leads the group with 25% of the market, followed by Alaskan (24%), American (17%) and Delta (12%). Revenues for 2017 were $2.7 billion, with $755 million of EBITDAR.

THESIS

Hawaiian Airlines is a cheap stock with better performance than its peers

Hawaiian trades at 6.4x consensus 2018 earnings, compared to a peer average of 11x and well below its own 5-year historical average of 9.3x. Legacy peers (DAL, UAL, AAL) trade at an average P/E multiple of 8.4x, while the smaller non-legacy/budget carriers trade at 12.1x earnings. Historically Hawaiian has traded at slightly higher multiples than its legacy peers and at a discount to the budget carriers; now it’s at a significant discount to both groups.

On EV/EBITDAR metrics, Hawaiian also looks inexpensive. It trades for 3.8x FY18 EV/EBITDAR estimates, vs. a peer average of 6.5x. The discount is similarly wide on related metrics:  It trades for 4.9x FY18 EV/EBITDA estimates compared to peers at 7.2x and 10.3x EV/EBITDAR-CAPEX vs. peers at 19x.

Despite the attractive valuation, Hawaiian boasts better operating performance, growth profile and returns on invested capital than most of its peers.

Highest ROIC: Hawaiian has delivered an average of 26% ROIC over the last three years, higher than any other carrier. The stellar ROIC results from a 16% NOPAT margin, the highest of any airline, and 1.8x invested capital turnover, again the highest of the group. Even after capitalizing operating leases, Hawaiian has a ROIC of 22%, tied for first with Southwest, as compared to a peer average of 12%.

Rapid Growth: Hawaiian is growing faster than most other carriers by several measures. Over the past 10 years, sales have grown at 11% CAGR (vs. 8% peers), EBITDA at 27% CAGR (vs. 15% peers) and EBTIDAR at 17% CAGR (vs. 12% peers). Hawaiian has maintained the rapid pace of growth over the past 3 years, with EBITDA growing at 23% (vs 12% peer average) and EBITDAR CAGR at 19% (vs. 9% peers).

Healthy Margins: Current EBITDA and EBITDAR margins at 22% and 27% respectively again top peer averages of 19% EBITDA and 21% EBITDAR.

Strong unit economics: Judged by airline-specific metrics, Hawaiian also stands out. HA has top quartile Revenue Per Available Seat Mile (RASM) and peer average Cost per Available Seat mile (CASM), delivering the highest operating margin (RASM-CASM) in the industry. The company’s focus on unit economics and cost structure over the last few years has paid off.  

Low leverage: Hawaiian’s leverage ratio of 1.5x Debt/EBITDAR, including capitalized operating leases is the second lowest in the industry behind Southwest (0.8x) and compares favorably with the peer average of 3x.

Competitive fears are overblown.

What the market is expecting….

Last December, United expanded its Hawaii service by adding 11 new routes from U.S to Hawaii. This added a total of 1,700 seats to the Hawaiian market. Based on recent data from the Hawaiian government, total capacity for the first quarter of 2018 increased 14% year on year. Hawaiian Airlines load factor was 85.9% in 2017, and averaged 85.2% in the first quarter of 2018. The higher capacity growth has not had a significant impact on Hawaiian, as only four of United’s new routes directly compete with Hawaiian; a healthy tourist economy has absorbed some of the capacity growth as well.    

The new routes planned by Southwest will add an additional 1,750 seats. However, Southwest is not planning any flights out of San Francisco, Hawaiian’s largest West Coast market. Hawaii’s booming tourist economy should be able to absorb much of the additional capacity; the number of visitors is expected to increase 6% in 2018 and in the low single digits afterwards. Even if we assume a dire scenario - no growth in overall fliers and that all 1,750 seats of Southwest new flights are filled by former Hawaiian passengers –Hawaiian’s load capacity would decline by 2.9 percentage points to 82.3%. That seems to be what the market is assuming as that implies a stock price of $37, about where the stock is trading today.  

While overcapacity is a worry, the strong tourism should be able to absorb much of the new supply. The other lens to analyze the competitive landscape is from a pricing perspective. Thus, the dreaded “Southwest Effect. When Southwest enters a new market, the company tends to underprice existing carriers by approximately 10%, sparking a price war and sometimes driving competitors out of a market all together. Hawaiian currently maintains an 11% Passenger Revenue Per Available Seat Mile (PRASM) premium over competitors on routes from the West Coast to the islands. Hawaiian is able to deliver this premium because its unit economics, customer service, on time performance, and Hawaiian flying experience, creating a competitive advantage that is unmatched by competitors. Using the current stock price, we can back out the price discount that the market is expecting once Southwest enters the market. This discount, unsurprisingly is 10%.  

… and why it won’t happen

Neither of these doomsday scenarios are likely to materialize, and Southwest may not have the planes or regulatory approval it needs until 2019, in any case. Southwest is still awaiting approval from FAA for regulatory requirement to operate between US and Hawaii. Southwest CEO, Gary Kelly has refused to put a date on when flights will commence, as it depends on the regulator’s timeframe. Additionally, Southwest is awaiting the deliveries of 26 Boeing 737-800 which are supposed to be used for Hawaiian routes. None of these planes have been delivered as of yet, making it difficult for Southwest to break into the Hawaiian market in 2018.

The increase in capacity should be offset by a healthy and growing tourism economy. Even if tourism stays flat or decreases, Southwest is unlikely to steal all seats from Hawaiian Airlines. At least some will draw from other carriers, most notably the other lower-cost carrier that flies the same routes – Alaskan Airlines.

Alaskan Airlines has a lower cost structure than Southwest and other competitors, thus the airline best equipped to create the “Southwest Effect” is actually Alaskan. The price war should have already happened.  Instead, even with the increased competition, Hawaiian’s West Coast PRASM premium has grown from 0% in 2014 to 11% today. Hawaiian Airlines has been laser focused on costs and efficiency, and now boasts the second lowest cost structure after Alaskan, making it tough for Southwest to compete and win on price alone. By next year, Hawaiian’s entire West Coast fleet will consist of fuel efficient A321neo, resulting in 15% lower operating costs than Southwest’s larger Boeing 737s. This more efficient fleet should further reduce overall CASM (excluding fuel) for Hawaiian by 3% to 8.9 cents over the next few years.

Further helping Hawaiian maintain its premium pricing is the kind of clientele it serves. Hawaii is a high-end destination, with average daily hotel rates comparable to New York City and San Francisco at around $230 per night. Its visitor mix skews to premium and leisure travel visitors who are willing to pay more for the better quality, customer service and comfort that Hawaiian Airlines provides. The new A321 planes offer a Premium Cabin (9% of total seating) and Extra Comfort (23%) which offer better unit economics and appeal to the typical Hawaiian tourist. Southwest’s planes only offer one standard seating configuration, and can’t offer the same high-quality experience as Hawaiian. Given the demographics and tastes of its passengers, Hawaiian’s premium pricing should not erode as much as the market expects, if at all.

Island Air’s bankruptcy delivers a near monopoly in inter-island travel

While investors are focused on flights to and from the continental US, Hawaiian generates 22% of its revenues from inter-island travel. Its primary competitor on these routes, Island Air, filed for bankruptcy and ceased operations in November 2017, giving Hawaiian a near monopoly in inter-island travel. While there is one other regional airline, Mokulele, it only operates a handful of routes that do not directly compete with Hawaiian. Other smaller regional airlines can’t seem to compete in this market. Aloha Air, much like Island Air, went bankrupt and shut down in 2008. Even ferries have had limited success because of regulatory and environmental challenges. Air is the quickest and cheapest method to fly between the islands and Hawaiian has optimized a fleet for these routes.

While Southwest has mentioned entering the intra-island market, it will be hard to match the efficiency of Hawaiian’s fleet of re-configured Boeing 717 planes. These small twin-engine jets are perfect for short flights between the islands which can be as short as 40 minutes. Southwest would rely on its signature Boeing 737 between islands, with much higher operational costs.  Additionally, given Hawaiian’s effective monopoly – 90% of the market and growing – it has a high number of HawaiianMiles members within the state, which will pose yet another headwind for Southwest should it enter this market.

In the near term, Hawaiian should see a boost in market share by absorbing Island Air’s customers, and can potentially even increase its prices slightly.

Code-sharing agreement with JAL will drive increased international traffic

Japan is Hawaii’s biggest international market, representing 60% of all non-US arrivals. Japan Airlines (JAL) leads the market for Hawaii-Japan routes with 28% of all seats. But Hawaiian is close behind, with 23%, reflecting the success of its strategic decision to penetrate this market a few years back.  Now the two are in the early stages of joining forces. Earlier this year, Hawaiian and JAL signed a code-sharing agreement, a move which should drive increased traffic for both airlines. Guests can now book through either company and connect at destinations served by both. On all codeshare fights, Hawaiian and JAL passengers can choose to earn either HawaiianMiles or JAL Miles, reinforcing loyalty for both airlines. The agreement also gives Hawaiian Airlines access to a new distribution channel, JALPAK, which specializes in package tours for Japanese travelers to key destinations, particularly Hawaii.

The code-sharing agreement is the first step towards broader cooperation. In June, Hawaiian and JAL applied for antitrust immunity (ATI) to create a joint venture with the US Department of Transportation and Japan’s Ministry of Land, Infrastructure, Transport and Tourism. The JV, if approved, will allow Hawaiian and JAL to coordinate flights and schedules, expanding the range and timing of flights across the day and appealing to a wider set of customers.

Strong management team has created enormous shareholder value   

Hawaiian emerged from bankruptcy in 2005 and has increased its market capitalization from $180 million that year to $1.9 billion today, even after factoring in the recent sell-off. It has boosted pre-tax margins to 18.7%, up five-fold since 2013, while delevering from 4.9x debt/EBITDAR in 2013 to 1.5x currently. Management recently initiated a quarterly dividend of $0.12, first paid in November 2017, and authorized a $100 million buyback program that will last until 2019.

Peter Ingram replaced retiring Mark Dunkerle as CEO in March of this year, but is not a newcomer to the story. He has helped guide the transformation of the company from bankruptcy since joining in 2005 as CFO. As such, Ingram is well suited to navigate the changing competitive dynamics and continue to drive value for shareholders going forward.

KEY RISKS

Cyclicality of airline industry. The airline industry is highly cyclical, so a downtown in the US or global economy would hit the profitability of the industry.

Rejection of ATI. Antitrust immunity application could be rejected given that Hawaiian and JAL together would control slightly more than 50% of the market.

Increased costs. Hawaiian negotiated a labor agreement with the Air Line Pilots Association (ALPA) on April 2017, driving up wages and salaries by around 9%. The next amendable agreement is July 2021 which could increase labor costs again. Oil prices could also continue to rise.

Natural disaster impact. With the recent eruptions, history of tsuanmis, etc., this has always been a factor. 

VALUATION

I assume a 9x P/E multiple on 2020 EPS of $6.02 and a 4.5x multiple on FY20 EBITDAR of $730 million implying a price target of $54, which represents a 50% upside and an 18% IRR over the next 2.5 years.  

Catalyst

Consistent performance

M&A

Pricing