Description
MAIR Holdings is extremely cheap, with a net cash position exceeding its market capitalization (net cash of $7.38 per fully-diluted share vs. stock price of $6.71), giving it an enterprise value of -$13.8mm. The company is cash flow and earnings positive. While positive developments cannot be counted on with a high degree of certainty, the risk-reward tradeoff is highly attractive. There is minimal downside, but the potential for massive upside.
MAIR Holdings is the holding company for two regional airline operating subsidiaries, Mesaba Aviation and Big Sky Transportation. Northwest Airlines (NWA) owns 28% of MAIR and out-of-the-money warrants that would bring its ownership to 42% if they were exercised.
At the time Big Sky was acquired in December 2002 for $3.5mm, Big Sky entered into the most attractive (for shareholders) contract in the regional industry with its pilots -- wage rates are the lowest in the industry, and the contract is not amendable until December 2009. Because the regional airlines exist to exploit the arbitrage in labor costs and because the most significant cost differential among regional airlines is pilot wages, this contract gives Big Sky the potential to become the lowest cost operator in a rapidly growing industry. Pilot pay for a 50-seat RJ, for instance, is a full 20% lower at Big Sky than at Skywest. For the time being, however, Big Sky’s growth is being stunted by a scope clause in the NWA pilot contract that prevents any air carrier in which NWA has an ownership interest from flying RJs with more than 44 seats without the NW code designator.
MAIR common stock is essentially a very long-dated call option, but with far better terms than a LEAP. This is a very low-cost option, as the net cash position should prevent a significant, permanent drop in the stock price. In effect, the option premium in this context is essentially the amount you can lose. This option does not expire, and yet the “time value” embedded in the option premium is essentially zero or negative in this case. Meanwhile, there are significant catalysts in place (detailed below). Unlike most out-of-the-money calls where the upside potential is huge but you can easily lose your entire premium payment, it is highly unlikely the stock price falls anywhere close to zero. And unlike most calls where the downside is very limited (significantly in-the-money calls) but the upside is also quite limited, the upside in this case is potentially enormous.
Operating margins have dropped precipitously in recent years from between 9.7% - 11.5% during the 4 fiscal years ended March 1997-2000 to 0.2% and 1.9% in FY 2002 and 2003, respectively. Results were down due to numerous factors, but three primary reasons were: (1) a nearly threefold increase in insurance costs post 9/11, (2) reduced aircraft utilization as air traffic contracted, and (3) depreciation significantly in excess of capex (net PPE at 9/30/03 was 27% lower than at 3/31/01). If margins return to historical levels or the industry average, the stock should explode. As an example, if NWA does not terminate the RJ contract, and operating margin were to rise to 10%, and revenue were to drop to $400mm (a 12% drop and a level not seen since 1999, but roughly consistent with the elimination of 5 of the 36 RJs from operations), EBIT would be $40mm. At a 10x EBIT multiple, that would imply a TEV of $400mm, or a stock price of $23.50 after accounting for stock options and warrants per the treasury method. And this is assuming no growth at Big Sky. Even if revenues were to drop 40% to $275mm and normalized operating margin were to be only 5%, that would imply a stock price of over $13, again ignoring the growth potential at Big Sky.
MAIR has been embroiled in contentious negotiations with its Mesaba Aviation pilots union for nearly 2.5 years. However, an end is finally in sight and management has a particularly strong bargaining position. While the union has threatened to strike, MAIR should be able to withstand one without much problem. A majority of MAIR’s costs are variable in the event of a strike (ie. fuel, pilot wages, and even rent expense since NWA would almost certainly call the planes). Even if we assumed that ALL of MAIR’s costs were fixed (a draconian assumption), MAIR has enough cash on hand to withstand a 90-day strike and still come out with over $40mm of cash. The chances of a strike lasting 90 days are very slim, as the last US airline strike to last that long was the one at Eastern that begin in 1989. The landmark Comair strike was less than 90 days, and that was at a point in time when Comair sported plump operating margins in the range of 20-25% (vs. 1.9% for MAIR LTM) and pilots were in short supply, giving them leverage. As a strike goes on, the pool of people voting to authorize it continues to grow, making a positive vote less likely as times passes. By the time a strike hit 90 days, every ALPA pilot in America would be sent a ballot to vote on its authorization (after having been assessed strike fees for the past 3 months). Moreover, while in the past every successive pilot contract in the industry entailed higher wages, Mesa, Atlantic Coast, and American Eagle have all been able to get lower rates than the Comair contract set back in 2001. And in contrast to several years ago when regional pilots were in very short supply, that is no longer the case. Finally, MAIR’s pilots would be foolish to leave for another regional, as they would forfeit all the seniority they had accumulated over the years.
In fact, if anyone were to be worried about the Mesaba pilots striking, it should be NWA – not MAIR. NWA can’t afford to lose the $1.1 billion of revenue feed because its fixed costs are so high. Because MAIR’s costs are so much more variable than NWA’s and because the service agreements with NWA provide for such minimal operating margins, the relevant “cost” of a strike to MAIR is not its foregone revenues, but its ongoing fixed costs that must still be covered. Furthermore, NWA is highly dependent on MAIR since its only other significant regional affiliate is its formerly wholly-owned subsidiary, Pinnacle, which only flies 44- and 50-seat CRJs and is in the process of being IPO’d. (NWA has transferred 89% of Pinnacle’s common stock to its pension trust which is planning to sell all of its shares in the IPO according to the latest filing. NWA will sell the remaining 11% of Pinnacle to the public if the greenshoe is exercised). NWA would face significant switching costs in trying to allocate Mesaba’s Saab turboprops to another regional and would not be able to allocate Mesaba’s RJs to a different regional at all. In addition, aside from 8 DC9-10s that are well over 30 years old, NWA would not have any 70-seat replacements for the Avros as Pinnacle only flies 44 and 50 seaters, 70-seat CRJs are in very tight supply, 70-seat ERJs are not yet certified, and NWA’s 159 other DC9s have at least 100 seats and are unlikely to be utilized on former Avro routes since they are NWA’s most profitable aircraft type.
Plus, since the service agreement rates MAIR has in place with NWA are fixed through 2007, currently resulting in such low profitability, and highly restrictive in terms of gaining new business, MAIR should have no incentive to “cave” to pilots demands and thereby lock in negative operating margins through 2007. Instead, MAIR management could rationally push the possibility of a strike to the brink and force NWA to amend the existing service agreements immediately so as to allow MAIR to increase its pilot wages and at the same time produce an operating margin comparable to the rest of the industry.
While MAIR shares have been depressed for a few years, there are now several near-term catalysts in place. On September 5, 2003, NWA CEO Richard Anderson and President Douglas Steenland resigned from the MAIR board. This could give NWA the impetus to sell its 28% stake sooner rather than later (what long-term 28% owner would have no board representation) and enable MAIR to buy out NWA’s stake with fewer fiduciary complications. If the NWA stake is sold, MAIR’s success in shopping for other codeshare business should improve significantly. It could also make MAIR an acquisition target (ie. Skywest or ExpressJet) and give MAIR the option to engage in a massive share buyback without worrying about increasing NWA’s ownership %.
In addition, the deadline for NWA to announce early termination of the RJ agreement with MAIR was just recently extended from October 28, 2003 to December 15, 2003. If NWA decides not to terminate, the stock could pop. If NWA exercises early termination, that should speed up the separation of MAIR from NWA as MAIR could then terminate the turboprop agreement with 365 days notice. At that point, MAIR would have the Big Sky pilot contract, a mountain of cash, and free reign to unleash its full potential.
According to an October 20, 2003 article in Aviation Daily, Mesaba union leader Tom Wychor has stated that the National Mediation Board could offer a proffer of arbitration between Thanksgiving and Christmas. That would mean resolution of the pilot contract in short order, as such a proffer is one of the very last steps in the negotiation process under the Railway Labor Act. Upon receipt of the proffer, either the pilots and management both submit to binding arbitration or the parties are released for a 30-day cooling off period, after which time the pilots would be free to strike. After nearly 2.5 years of negotiations, the endgame may finally be around the corner.
While NWA has shown clear favoritism of late in allocating all CRJs to Pinnacle, once Pinnacle is sold off and the Mesaba contract has been settled, NWA should begin to reverse its treatment of PCL and MAIR. After all, the PCL pilot contract becomes amendable April 30, 2005, while the Mesaba pilot contract will not be amendable until at least several years later. There is room for significant RJ growth in the NWA network. The ratio of NWA RJ ASMs / Mainline ASMs is approximately 5.5% vs. an industry average of 8%, Delta at 17%, and Continental at 11% -- among the majors, only American’s ratio is lower (per UBS research dated 8/26/03). So in keeping with both historical precedent and bargaining tactics, NWA should again “whipsaw” its regional affiliates’ pilots against one another, now allocating new RJs to and otherwise favoring MAIR in order to pressure the PCL pilots as the time draws near to negotiate their contract. Moreover, once the Mesaba contract has been settled, MAIR will no longer need a massive cash horde to signal its ability to withstand a long strike. Instead, it will be in a position to distribute the cash to shareholders or use it in financing new aircraft.
NWA’s contract with its pilots became amendable in September. The existing contract’s scope clause is by far the most restrictive in the industry. United, USAir, and American all have recently had their scope clauses relaxed significantly. Given these precedents and to maintain competitiveness, NWA’s scope clause should be relaxed in its new contract, further propelling RJ growth in the NWA network.
The airline industry is notoriously cyclical. While MAIR’s current results are depressed, there is good reason for optimism. For example, unlike other regional airlines whose partners absorb the price volatility, MAIR is totally exposed to fluctuations in insurance costs. This has been particularly painful post 9/11, as insurance and taxes nearly tripled from $5.3mm in FY 2001 to $15.1mm in FY 2003. However, insurance costs have begun to fall. ExpressJet said on its conference call that insurance costs were lower than expected, as they fell 71% for the 9 months ended 9/30/03 vs. the prior year period. Likewise, Pinnacle’s insurance costs were down 40% year-over-year for the 6 months ended 6/30/03, even as its fleet and ASMs grew. A $9.8mm reversal of MAIR’s insurance costs back to their FY 2001 level would translate into $98mm, or nearly $5 per share of incremental value at a 10x EBIT multiple. In addition, while MAIR’s margins have suffered in the past 2 years due to decreased aircraft utilization, the general rebound in air traffic ought to lead to increased utilization and higher margins as fixed costs are leveraged. Finally, while in prior years a pilot shortage and the resulting high turnover led to outsized training costs, there is presently a surplus of pilots which should allow training costs to remain under control.
Valuation
MAIR is trading at a slight discount to net cash and at just 74% of tangible book. All of the relevant Enterprise Value multiples are not meaningful since TEV is negative. Capitalizing the operating leases gives an EBITDAR multiple of 5.1x, substantially lower than the comps, but that would seem to be an incorrect way of looking at MAIR since the planes are puttable to NWA – unlike store leases that remain in place even after a retailer shuts a store, MAIR should only be paying rent on planes that are producing revenue. MAIR stock reached $28.75 in July 1998 when revenues were 2/3 of what they are today, further proof that the stock could explode if operating margins return to normal or growth resumes. Even NWA’s November 2000 offer to buy out all other shareholders at $13 per share, which was viewed as a “lowball” figure at the time is double the current share price (and would correspond to nearly $16 per share applying the same implied enterprise value since net cash today is nearly $57mm higher). Even if you subtract interest income and give MAIR no credit for its cash horde, the stock trades at 9.5x average net income over the past 7 fiscal years, and 7.4x average net income if you exclude the last 2 fiscal years post 9/11 (over FY 1997-2001). Finally, NWA has implied the enterprise value of Pinnacle is $544mm, while Pinnacle flies fewer ASMs than MAIR.
Risks
-MAIR management fails to recognize the strength of its bargaining position vis-à-vis NWA and does not pressure NWA during the MAIR pilot negotiations; instead, management “caves” to pilot demands and thereby locks in negative operating margins through 2007
-Big Sky mechanics contract became amendable May 2, 2003
-NWA pilots negotiate a new contract without significant scope clause relief so MAIR does not get NWA codeshare growth
-NWA doesn’t terminate RJ service agreement, so MAIR doesn’t terminate turboprop agreement, NWA holds onto its 28% stake, and NWA scope clause restricting Big Sky is not relaxed so Big Sky’s growth remains stunted
-MAIR is responsible for insurance, employee, and maintenance costs and they rise significantly
-Repricing of stock options may be indicative of management entrenchment and unwillingness to make maximization of shareholder value the key directive
-Strike at NWA – though unlikely given the number of pilots on furlough and the industry’s present financial difficulties
-NWA bankruptcy enables NWA to reject service agreements – minimal risk as evidenced by recent airlines in bankruptcy that have significantly increased their use of regional aircraft; plus, MAIR profit margins already miniscule
Catalyst
-Recent resignation of NWA CEO Anderson and President Steenland from MAIR board
-December 15, 2003 deadline for NWA to decide whether to exercise early termination of RJ agreement
-Renegotiation of service agreements with NWA to provide enhanced margin
-NMB proffer / resolution of Mesaba pilots’ contract negotiations
-Sale of NWA’s ownership stake
-Relaxation of NWA scope clause in its current negotiations with its pilots
-Falling insurance costs
-Increased aircraft utilization as traffic rebounds
-Growth at Big Sky