Description

Thesis:

• The airline industry has structurally improved due to consolidation and ROIC is the new mantra being sung by every CEO.
• JetBlue is the last airline to earnestly embrace shareholder value creation yet signs have emerged their strategy is tilting favorably and management’s LT comp is now linked 50% to ROIC improvement.  Off a depressed base, scope for earnings improvement is very material.
• Valuation is reasonable at 12x their 85c earnings goal for 2014/consensus estimate for 2015, which is considerably below the $1.35 we deem more normal.  On normal EPS, JBLU trades at <8x. 
• As JBLU’s ROIC begins exceeding its WACC over the next twelve months defying analyst expectations, the stock will re-rate to 13x-16x FWD EPS from 12x currently.  13x-16x $1.35 suggests target price of $17-$22, (+60% to 110%) perhaps by 2016. 

Background of idea:

Andrew109’s prescient write-up of Southwest (LUV) during June of 2013 and Biv930’s write-up of United (UAL) during June of 2011 are must reads as background for the structural improvements in the airline industry. 

Given the airline industry’s long history of value destruction, it is our observation that most investors remain hardwired to ignore the structural improvement it has undergone via restructuring and consolidation where the top 4 carriers now control 85% of the domestic marker versus 58% ten years ago.  We include ourselves among the skeptics as it is difficult to avoid anchoring.  For a generation of diversified portfolio managers, ignoring the airline sector has proven to be a winning strategy over the long term, albeit it has lead to sharp pain during intermittent up-cycles for those measured against a benchmark.  The spectacular appreciation of the airline stocks in recent years provides a further excuse to ignore the industry today as it is plausible the improvements are already priced in.  Our qualitative judgment is the industry improvements are permanent, which is not to say it won’t remain cyclical.  Our guess is we are currently in the 6th or 7th inning of the current cycle but as any casual observer knows, the cycle for airlines can get cut short by a long list of negative surprises.

Within this hardwired aversion to investing in airline stocks among generalist investors, there is an additional aversion to investing in JetBlue in particular among dedicated airline investors.  JetBlue is perceived to be the only airline that has not yet found religion with respect to shareholder value creation.  JetBlue is perceived to be been run for customers and employees.  1/3 of JBLU management’s annual compensation is based on brand loyalty as measured by customers’ subjective responses to their flying experience.  This explains why JBLU gives away free DirecTV and SiriusXM, free checked first bags, free and unlimited brand name snacks and beverages, free Fly-Fi internet and the most economy leg room of peers.  What customer wouldn’t want these things for free?  Another 1/3 of JBLU’s management annual compensation is based on cost per available seat mile (CASM) and the last 1/3 is based on margins.  The problem with targeting CASM growth is it directly encourages fleet growth per se (fleet growth lowers unit costs) and at JBLU, fleet growth is being heavily discounted by investors who believe value is being destroyed since ROIC remains below WACC.  In contrast, nearly all competitors are pursuing increased ROIC through disciplined capacity management, increasing ticket prices and unbundling and charging for most of the things JBLU gives away for free.  Unsurprisingly, management of competitors Delta, United and Hawaiian are compensated in part on ROIC and even LUV is moving towards ROIC as an incentive compensation metric.

There are subtle signs of change at JBLU, however.  For the first time, in 2013, the BOD put in place a new LT performance-based comp program predicated 50% on ROIC improvement and 50% on CASM-ex fuel growth relative to peers.  The ROIC target is based on a rolling three year average for the period 2013-2015.  The mid point of the pay out is 7.2%, which is close to their 7% goal for 2014.  Think of their goals as 6% ROIC for 2013, 7% for 2014 and 8% for 2015.  They have intimated they do not intend to stop improving once they reach 8%. 

Despite JBLU now speaking the language of ROIC, they missed their goal in 2013 and given the airline’s history, their targets are regarded by investors as lip service only.  An example of this perception is the BofAML analyst’s direct question posed to JBLU’s CFO Mark Powers at their conference in May 2014:

“I think we are glad you have ROIC targets, but it seems like even if the ROIC targets are missed, we haven’t really seen any changes in capacity or behavior.  So what would cause you to review the growth plan or capex plan, in terms of if ROIC doesn’t hit target?” 

This question is one of many that reveal the skepticism investors have for JetBlue’s targets.  Another example is a direct confrontation with the CEO during the Q3’13 earnings call by the Wolfe Research analyst where he ridiculed the company’s plan to spend capex at a level 3x depreciation while ROIC remains below their WACC:

“If you are not going to hit the rolling target of 1% point expansion, why are you ordering aircraft?  I know you are deferring in the near term, but what hurdle rate has been hit to justify another $1.8B of capital committed?”

JBLU is perceived to have the most shareholder unfriendly management team in an industry that is perceived to be value destructive over a cycle.  Why invest in it? 

JetBlue has a management problem, not an unfixable business problem and we believe management is currently changing.

The implementation in 2013 of LT performance-based compensation predicated on ROIC a clue that the BOD is paying closer attention to lagging shareholder returns and building frustration.  There are signs the BOD is preparing for more dramatic change, however.

On May 6, BOD member Ann Rhoades leaked to Bloomberg news that CEO Dave Barger’s employment contact expires in 2015 and they have begun succession planning.  The manner in which this news was leaked seems unusual and more telling is that the CEO was caught off guard as later reported by the WSJ.  http://www.bloomberg.com/news/2014-05-07/jetblue-ceo-weighs-2015-departure-as-contract-expires.html?cmpid=yhoo

Solid waste company Republic Services just hired Robert Maruster as COO.  Mr. Maruster’s former position was COO at JBLU.  Was he fired?  http://finance.yahoo.com/news/republic-services-inc-names-robert-201000488.html

While unconfirmed, the most likely successor to JetBlue’s CEO, Dave Barger, appears to be current President Robin Hayes.  While we are unconvinced Robin will pull all the levers to maximize shareholder value, we are confident he’s a significant improvement over the current CEO and can implement meaningful measures to improve the outcome.  We gain our confidence through recent statements made in both public and private settings.  It is increasingly becoming apparent that Robin and CFO Mark Powers are running the airline today.  Our sense is Robin and Mark are embarrassed by the company’s financial track record as it is openly acknowledged as poor by analysts, investors and competitors alike. 

What are the measures JetBlue can take to improve earnings and valuation?

Let’s start with a review of where we are today and what management’s ROIC goals imply.  Credibility in achieving these goals is a separate debate but current investor perception is there is none given the company has missed its initial targets.  We think credibility will become enhanced once the current CEO steps down. 

2012: They earned a 4.8% ROIC ($0.40), short of their 5% target. 

2013: They earned a 5.3% ROIC ($0.52), short of their 6% target.  Noteworthy is that JBLU’s 2013 ROIC of 5.3% is second lowest in the industry just above United at 4.8%.

Outlook for 2014: Their target for 2014 is 7%, which implies $0.85 of EPS on their proforma balance sheet after the sale of LiveTV and subsequent use of proceeds, which is debt pay down.  The current consensus estimate for 2014 is $0.68, 20% below what their goal implies.  It’s safe to say that investors expect JetBlue to once again fall short of their ROIC improvement goal.  We think consensus is too low given the long list of available earnings levers that can be pulled coupled with favorable industry pricing.

Outlook for 2015-2016: Management’s goal to improve ROIC 1%/year implies 8% ROIC in 2015, which produces EPS of $1.07 and 9% ROIC in 2016, which produces EPS of $1.35. 

9% ROIC for JBLU corresponds to 15% pre-tax ROIC.  It’s worth highlighting that 15% pretax ROIC has been Southwest’s stated target since 2012 and they are now on track to beat it this year, proving previous skeptics wrong.  We think Southwest will continue improving ROIC beyond this year upon achieving their target, raising the bar for JBLU further.

The six most powerful value creation levers we see are: 1) first bag fees, 2) increased seat densification, 3) reallocation of A320 aircraft with A321s, 4) pricing in excess of cost inflation, 5) deferring or canceling aircraft orders and 6) implementing a capital return strategy.

While walking through each, keep in mind that the current consensus 2014 EPS estimate is $0.68. 

First bag fee: We estimate a first bag fee of $20-$25 would increase EPS by $0.25 to $0.43, +37%-64% above 2014 earnings.  This is pure profit, after accounting for some behavioral change and minimal incremental costs.  Importantly, for the first time on the Q1’14 call, President Robin Hayes insinuated their ability to add first bag fees upon completion of their IT system Datalex in early 2015:

“…Datalex, our ability to create a retail merchandising capability…will allow us to monetize not just some of the product offerings we have today, but maybe take advantage of things that we don’t today.  We get asked a lot about first bag fee.  Our hesitance in the past has been, we believe that in many of our markets, we get a significant premium because we don’t charge a bag fee and customers certainly take that into account.  But in a world where we can start to give customers bundled offerings and choices, that allows us to protect the fare and maybe go after opportunities like first bag, where we don’t do that today.  I think the investment in Datalex we’re going to start seeing into the early part of next year allows us to do that.  So I’m very excited about what that’s going to drive.  And I anticipate and believe that’s going to allow us to significantly enhance some of our ancillary offerings, particularly around things like first bag, into next year.”

We think this point has been dismissed by the majority of airline investors because management has little credibility and 2015 is too long of a time horizon starting from the spring of 2014 for many airline investors.  One prominent analyst explained to us that Robin’s comment isn’t meaningful: “why own an airline that is destroying value for the next six months when you can buy it in the fall before they actually consider implementing bag fees?” 

We think JetBlue is now serious about this initiative and others, which is in stark contrast to its historic position under CEO Dave Barger, who we think retires in early 2015.  It is worth noting that LUV’s stock has doubled since October of 2013 when their CEO hinted on their Q3’13 call that bag fees could become a reality if the flying public comes to accept the fees that other airlines charge. 

Increased seat densification: We estimate adding 2 rows of seats would increase EPS by $0.24 to $0.30, +35% to 44% above 2014 earnings.  Currently JetBlue has 34 inches of economy leg room versus 31 inches at LUV and 28 inches at SAVE inches.  The extra revenue more than offsets the cost of an extra flight attendant.

Reallocation of A320 aircraft with A321s: We think this adds at least $0.10/year going forward and possibly as high as $0.20/year.  Over three years, this adds at least $0.30, + 44% to 2014 earnings.  JBLU’s order book is exclusively A321s with 9 delivering in 2014, 12 in 2015 and 15 in 2016 and 2017.  The A321 has 10-15% lower unit costs without much unit revenue erosion.  This is because the A321 has 190 seats versus only 150 for the A320.  The reason for this shift now is because JBLU’s network has matured versus 3-5 years and they now have the critical mass to absorb these larger aircraft.  The maturation of the network is one of the chief reasons JBLU’s ROIC has been sub par historically as they have had uncompetitive unit costs.  It’s also a reason why their incremental ROIC should be superior going forward.  We don’t believe the market appreciates that growth at JBLU should actually create value going forward. 

Pricing in excess of cost inflation: We think this adds at least 15c of EPS the next three years, or 5c/year.  This assumes 2.5% unit pricing growth against 2% unit cost growth (includes labor), or 50 bps/year of real price.  Airline fares have declined 39% in real terms since deregulation in 1978.  The average real fare decrease per year since deregulation has been -2%.  Since 2010, however, the average real fare increase has increased 4.2% with an average real fare increase of 2.5% the past three years.  Our .5% real unit price increase seems conservative within this context.

Deferring or canceling aircraft orders: The effect would be multiple expansion from stepped up FCF and ROIC.  From 2011-2014, the cumulative ratio of capex/depreciation is 2.8x.  In 2014, capx of $950m represents 3x depreciation of $315m.  Investors believe this growth is destroying value and on the surface, reported ROIC of 5.3% last year and 4.8% the year before supports this notion.  We think prospects for ROIC improvement are promising and willing to give them the benefit of the doubt that growth capital can earn a return.  Still, a slowdown in growth would be welcome.  With the youngest fleet in the industry at 7 years old (for perspective, DAL’s fleet is 17 years old), JBLU in theory could run the business for cash and produce FCF of $1.40 in 2014 and $2.00 on a more normalized basis without eroding the business since just earnings accretion from bag fees and extra rows would more than offset any increase in maintenance expense.

Implementing a capital return program: A large share buyback at this early stage of transformation could be extremely powerful.  We have no reason to believe one is likely in the near term, however. 

Incorporating these earnings drivers, starting with the 2014 consensus estimate of $0.68, which we believe is too low, we derive $1.62 in EPS by 2017 at the low end and $2.00+ using the higher end of estimates. 

Earnings Power and Valuation:

Though we quantify several specific earnings drivers above, we are inclined the value the stock based on a more normalized level of earnings.  The concept of normal earnings for an airline may cause you to chuckle.  Our framework for JBLU earning a 9% after-tax ROIC is triangulated between three things: 1) JBLU’s inherent ability to earn this amount just from implementing bag fees and adding 2 rows of seats as discussed above—as early as 2015 should they choose to, 2) Southwest’s stated pre-tax ROIC target of 15% as the governor for growth capex, 3) The average ROIC of five US based low cost carriers today is 11% and 4) Precedence of legacy airlines earning 15% pretax ROIC (which equates to 9% after-tax ROIC for JBLU) throughout the last uninterrupted airline cycle during the 1990’s. 

9% ROIC for JetBlue implies EPS of $1.35. 

JetBlue currently trades at 12x 2015 consensus EPS estimate of $0.86.  Just rolling this P/E forward, JBLU has the potential to be a $16 stock if earning $1.35 by 2016.

We think multiple expansion is likely, however, as investor’s begin capitalizing growth as value-creating rather than value-destroying once JetBlue’s ROIC begins exceeding its WACC over the next twelve months.  The average FWD P/E (fully taxed) of a group of five US based low cost carriers today is 14.5x with ALGT and SAVE at 17x, LUV at 15x and ALK and JBLU at 12x.  JBLU’s TTM ROIC of 5.3% compares to this group’s average ROIC of 11%.

At a FWD P/E ranging from 13x-16x, JBLU has the potential to be a $17-$22 stock by 2016.

Catalysts:

• CEO change will provide analysts a new reason to consider JBLU.  This could happen as early as November’s analyst day or at the latest by early 2015.  (Multiple expansion)
• First bag fees announced.  (Earnings accretion of $0.25-$0.43)
• Slower fleet growth via order deferral or cancelation of the lease roll off of money losing 190s.  (Multiple expansion)
• Reallocation of A320s and E190s with lower cost A321s with delivery of 9 in 2014, 12 in 2015 and 15 in 2016 and 2017).  (Earnings accretion of at least $0.10/year)
• Pricing in excess of costs. (Earnings accretion of at least 5c of EPS/year)
• Adding two rows of seats.  (Earnings accretion of $0.24-$0.30)
• Share repurchase program.  (Earnings accretion and multiple expansion)
• An activist investor gets involved and accelerates the implementation of these measures.  The analogy here is Canadian Pacific is to Canadian National as JetBlue is to Southwest.

Risks:

• The BOD renews the current CEO’s contract.
• The company continues to fall short of their ROIC targets by not implementing bag fees and charging for all of the current giveaways after Datalex is implemented in early 2015 and continuing to grow too fast. 
• All risks that normally apply to airlines including in particular exogenous economic shocks and less disciplined capacity restraint than the industry has shown in recent years.

Catalyst