|Shares Out. (in M):||32||P/E||5.4||4.3|
|Market Cap (in $M):||289||P/FCF||0||0|
|Net Debt (in $M):||786||EBIT||0||0|
|TEV (in $M):||1,075||TEV/EBIT||0||0|
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Mesa Air Group, Inc. (MESA)
Buy MESA equity. MESA is a growing regional airline for American Airlines and United Airlines that IPO’d in August 2018 at $12.00/sh, eight years after filing for bankruptcy. American owns 8% of the Company’s stock that it received in bankruptcy for extending its CPA. The ride has been bumpy for investors as operating underperformance on the American business and contract uncertainty on the United business have weighed on the shares. However, while it took much longer than everyone expected, one uncertainty has been addressed with the recent extension of its United contract. While there’s more work to do to get American operating performance metrics back to acceptable levels, I don’t believe that situation is dire and the issues appear to be fixable.
Given what transpired recently with Republic Airways and how quickly fundamentals can change for the worse in this industry, this is clearly not a buy and hold name but I think its worthy of a trade at current levels. Valuation is undemanding and even more so if the Company is able to meet its EPS guidance of $1.50 – 1.80 and $1.90 – 2.30 for FY20 and FY21, respectively. Skywest, the only other publicly traded comp, trades at a P/E of 9.2x FY21 estimates, roughly twice where MESA is trading (I know, I know…..this was the same pitch for Republic Airways but bear with me for a little bit!). While Skywest has a more diversified book of business and is arguably better managed with a better balance sheet, a 50% multiple discount feels excessive to me. If the Company is successful in stabilizing the American business in the coming quarters, I don’t believe its unreasonable to assume that MESA can trade up to $15.00/sh (~7.0x FY21 EPS) a year from now – still at a healthy discount to Skywest’s multiple.
But I can appreciate the aversion investors have to this industry – the regional airline business today is not as stable as it used to be in the past. Historically, the thesis was that regionals generated stable and predictable income by selling capacity upfront to the majors and avoiding ticket demand and fare uncertainty. However, becoming mere operators also means that the costs of any disruption hit them first. Recently, disruptions caused by the inability to recruit pilots have hit the industry hard and resulted in the bankruptcy of competitor Republic Airways. Similarly, MESA’s shares plunged in August because its earnings were hit by a fueling truck damaging one of its aircraft in Dallas, among several other complications it had very little control over.
MESA is a regional airline providing passenger service to 125 cities in 39 states, D.C., Canada, Mexico and Cuba. All of its flights are operated as either American Eagle or United Express flights pursuant to capacity purchase agreements with American Airlines and United Airlines. For FY19, 44% of its aircraft were operated for American and 56% for United. The Company was the 3rd largest regional airline in the U.S. in 2018 and its flights accounted for approximately 9.0% of all passengers carried on regional airlines. MESA may not be a household name but it is not a small carrier with 145 aircraft currently in service and an additional 20 on the way. Unlike its regional competitors that still fly smaller jets, MESA flies only aircraft with 70+ seats such as Bombardier CRJ-900 for American and the CRJ-700 and Embraer E-175 for United. Generally, the larger the aircraft, the less it cost an airline to fly it, on a per-seat basis.
MESA has a reputation for being a low cost provider in the industry. One significant reason for the low costs is that the Company has been growing consistently over the last ~7 years. Its workforce, compared to other regional airlines, is in fact junior. Many of its employees are ‘1 – 3 year employees’ and because industry wages are dictated based on seniority to a large degree, MESA has a built-in benefit that will be very difficult for other carriers to match.
The Company only flies large regional jets manufactured by Bombardier and Embraer. Below is a summary of their fleet over the next two years:
Currently, MESA operates 62 CRJ-900 aircraft for American under its CPA. Including the two recent spares, MESA owns 48 of these 900s and leases 16. For United, the Company operates 20 CRJ-700 and 60 E-175 aircraft under its CPA.
MESA owns 18 of the 175s and leases from United the other 42. MESA also owns 18 of the 700s and leases two. On December 3rd, MESA announced it will be adding 20 new 175s to its United fleet – the aircraft will be owned and financed by MESA. Deliveries are scheduled to begin May 2020 and expected to be completed by the end of 2020. In addition to the new aircraft, the contract for 42 existing 175s, which are owned by United, has been extended an additional five years. The 18 MESA-owned 175s are contracted through 2028. As part of the deal, MESA will lease its 20 700s to another United Express carrier.
The average age of the 175s, 900s and 700s is 4, 13 and 16 years, respectively. Because they’re newer, maintenance expenses on the 175s have been low because most of the parts are under warranties and a limited number of heavy airframe checks and engine overhauls have occurred. But as these aircraft age and warranties expire, maintenance costs will increase significantly. On the flip side, because they’re older, the 700s and 900s have been less reliable which has led to the recent underperformance with American.
This would be a good place to discuss the operating issues with American. As mentioned before, this has become a very tough business with far less stability than in the past. The requirements from MESA’s partners continue to move higher and performance levels under contracts signed 10 years ago are now being adjusted. As a result, completion rates of 99% which back in the day were considered a great month but are now categorized as underperformance. In early April, MESA increased the number of spare aircraft it uses to support American from three to five. This was expected to improve its reliability. However, one of its aircraft was subsequently damaged by a ground handler. A second jet suffered ground damage, worsening the spare aircraft shortage. Two others were out of service for major maintenance for an extended period of time due to labor shortages at Bombardier. Effectively, MESA had just two spares available. Even with the two spares, MESA might have been able to achieve the performance targets under ideal conditions, however, severe weather conditions resulted in elevated flight cancellations which then caused the Company to miss out on the performance bonuses it potentially could have earned from American. As a result, management fell short on the American CPA performance targets in the July-to-August measurement period. The failure to meet American’s performance standards has given them the right to remove four jets from the CPA and so far two have been taken out with the possibility of two more even if targets are met going forward. The fact the two removals have been deferred seems to suggest that the relationship with American is cooperative and not punitive. Having said that, it’s clear that trying to run a fleet of 64 older airplanes with two spares, and on many days, zero spares, was very difficult. The additional spares as a result of removals will help performance but management will have to figure out a way to deal with this problem or else risk losing out on the possibility of renewing the CPA.
For the time being, it appears that the Company has its labor contracts situation under control. In July 2017, its pilots ratified a new four-year collective bargaining agreement. Similarly, in October 2017, its flight attendants ratified a new four-year collective bargaining agreement. Prior to this, MESA had fallen far behind other regionals airlines with its pilots being among the lowest paid. This contract puts MESA pilot compensation in line with peers. Captains were able to get a 7.5% percent pay increase whereas first officers got a 27% increase. Good labor relations with pilots are essential for MESA given the high level of turnover. In 2018, 388 pilots left the Company, 304 were first officers and 84 were captains. As a result, MESA is in continuous over-hiring mode, holding training classes every other week. The airline successfully hired more than 400 pilots in 2018 and currently has a strong bench to support further turnover and possibly even growth in the business.
Regional airlines play a key role in the air travel industry as they are ideal for short and medium-haul flights that connect smaller communities with larger cities and act as feeders for domestic and international hubs. In addition, regional aircraft are well suited to serve larger city pairs during off-peak times when load factors on larger jets are low. Regionals operated 41% of all scheduled passenger flights in the U.S. in 2018. Some of the most popular U.S. airports have more than half of their scheduled departures made by regional aircraft, including New York-LaGuardia, Philadelphia, Washington-Dulles, Charlotte, Houston-Bush and Chicago-O'Hare.
The lower trip costs and operating efficiencies of regional aircraft, along with the competitive nature of the CPA bidding process, provide significant value to major airlines. Full-service carriers cut costs by outsourcing low-density routes to regionals, where pilots and crews are paid much less. This is why trade unions impose “scope clauses” to limit the size of the planes they are allowed to fly.
The majors either elect to contract with independent regionals or operate their own captive regionals. Currently, the captive regional airlines include Endeavor (Delta), Envoy (American), PSA (American), Piedmont (American) and Horizon (Alaska). American, which procures approximately 40% of its regional flying from its captive regionals, has expressed a goal of increasing their share to a majority of their regional flying over time. Earlier this summer, Delta Airlines said it would cut ties with two of its five regional carriers it uses, confirming a trend toward fewer regional carriers flying longer distances.
A growing shortage of pilots and maintenance technicians represents a concerning trend for the industry. More and more young pilots are entering the workforce through regional airlines, however, a larger negative shift is occurring in the 60-plus range that suggests new airmen are not being created at an equal pace to those reaching mandatory retirement age. With passenger demand continuing to climb, and despite more pilots entering the workforce, the industry is not keeping pace with retirements, let alone predicted growth. In addition, every regional has faced considerable turnover of employees. Regional airline pilots, flight attendants and maintenance technicians often leave to work for larger airlines, which generally offer higher salaries and better benefit programs than regional airlines are financially able to offer. To address this, regional airlines have had to significantly increase pilot compensation. The only fix to this shortage problem is a dramatic expansion of the population of students pursuing aviation careers.
Capacity Purchase Agreements
MESA’s two CPAs with American and United provide guaranteed monthly revenue for each aircraft under contract, a fixed fee for each block hour and flight actually flown, and reimbursement of certain direct operating expenses. As a result, MESA is not exposed to fuel, occupancy or fare volatility. American and United control route selection, pricing, seat inventories, marketing and scheduling, and provides ground support services, airport landing slots and gate access.
The American CPA will terminate with respect to different tranches of aircraft between 2021 and 2025. The CPA requires minimum levels of flight operations. In the past, MESA’s operations have been negatively impacted by its inability to hire pilots at a rate sufficient to support required utilization levels, and credits had to be issued to American. In July, American exercised its right to permanently withdraw two aircraft due to the Company's failure to meet certain performance metrics. The aircraft were removed on November 2nd. On November 25th, the Company further amended the CPA as the Company did not meet certain performance metrics during the most recent measurement period, which allows American to remove two additional aircraft. American has agreed to defer the right to remove these two aircraft but has elected to remove one of two previously deferred aircraft, effective January 2020.
On November 26th, the United CPA was amended and restated to extend its term and to add 20 new E-175s to the scope of the agreement. These new aircraft will be financed and owned by MESA and operated for a period of 12 years from the in-service date. Deliveries are scheduled to begin in May 2020 and be completed by December 2020. Five years after the in-service date, United has the right to remove the 175s from service by giving notice including the payment of certain wind-down expenses plus, if removed prior to the ten-year anniversary of the in-service date, certain accelerated margin payments. The United CPA does not require United to schedule any specified minimum level of flight operations for the aircraft. In addition to adding the 20 new 175s, the term of the 42 175s aircraft leased from United were extended for an additional 5 years, which now expire between 2024 and 2028. If United elects to terminate the CPA in its entirety or permanently remove select aircraft from service, MESA can return any of the affected 175s leased from United at no cost. In addition, if United removes any of the 18 owned 175s from service, United would remain obligated to assume the aircraft ownership and associated debt through the end of the term of the agreement. Furthermore, MESA agreed to lease the 20 700s to another United Express service provider for a term of seven years. MESA will continue to operate these planes until they are transitioned over the period between May and December 2020. United has a right to purchase the 700st at FMV. Finally, the term of 18 175s that the Company owns will expire in 2028.
Managing Tail Risk and Balance Sheet Mismatch
One of the key risks to be aware of when investing in a regional airline is the potential balance sheet mismatch that arises from long-term obligations that exceed the contracted cash flows from the CPAs. The Company has significant long-term aircraft-related lease and financing obligations, however, I believe it has done a pretty good job in minimizing the tail risk potential of the assets not being able to cover the corresponding liabilities. As of the most recent quarter, MESA had 17 aircraft with leases extending past the term of their corresponding CPAs with an aggregate exposure of $32mm. Additionally, the Company has no financing arrangements on aircraft with projected negative equity. MESA has $1.3bn of PP&E type assets, net of accumulated depreciation, of which, $1.1bn relates to owned aircraft. This compares favorably with total debt of $858mm.
As long as MESA continues to align the aircraft leases and financing obligations with the terms of its CPAs, investors can have confidence that the reported pre-tax income is an accurate reflection of the profitability of the business. Having said that, any unexpected increases in costs, such as higher maintenance expenses or higher pilot compensation, will increase the tail risk potential for the business as the CPAs will then generate a lower NPV on the contracts. Approximately $37.2mm, or 5.8%, of MESA’s operating costs under its CPAs were pass-through costs, excluding fuel which is paid directly by its major airline partners. As a result, any increase in labor, aircraft maintenance and overhead costs over and above the budgeted amounts under the revenue-guarantee arrangements will hit the profitability of the Company. This is exactly what led to the bankruptcy of Republic Airways when it couldn’t recoup the higher costs of a new pilot contract from its airline partners.
MESA has a market cap of $289mm and an enterprise value of $1.1bn. The balance sheet is levered with $858.1mm in total long-term debt including $8.5mm of capital lease obligations. All of this debt is secured and was incurred in connection with the acquisition of aircraft and aircraft engines. The collateral backing this debt has a book value of $1.2bn, providing a solid cushion for the lenders. Liquidity is healthy with $73mm of cash on the balance sheet and an untapped $35mm credit facility.
The weighted average interest rate on the aircraft and engine debt is ~5.25% and matures as per the following schedule:
The cap table below is pro forma for the $550mm in aircraft and engine debt that MESA will take on over the next 24 months. It also assumes $305mm in cash build that I estimate over the next two years.
The Company will not be a taxpayer for the foreseeable future given federal and state NOLs of $478mm and $228mm, which expire in fiscal years 2027-2037 and 2020-2039, respectively.
MESA has grown its business considerably during the last five years. Revenues and EBITDA have compounded at ~10% and ~15%, respectively, over this period. During FY19, the business posted significant improvement in virtually every area. Contract revenue was up 7%, pre-tax income was up 78%, and adjusted EBITDA was up 27%. Block hours were up 12% on essentially the same fleet by increasing the utilization of the aircraft.
Below are some operating metrics that shows the strong year over year growth trajectory of the business:
The Company’s operations generate significant cash flow but much of it is invested back into the business to fund growth initiatives. While maintenance capex is only 1.5 – 2.5% of revenues, MESA has been spending a lot of money acquiring aircraft and engines. In FY19, it incurred capex of $125mm primarily related to the purchase of ten CRJ-700s, which were previously leased, and eight spare engines. In FY20 and FY21, the Company will incur significant additional capex to purchase the 20 new E-175s for United. The cost will be $420 – 470mm, split between FY20 and FY21. MESA plans to finance the entire purchase price. Additionally, the Company will purchase 20 – 25 engines to support the leased 700s and the 900s fleet at American. The cost for this will be ~$100mm, split between FY20 and FY21. Again, MESA will finance the entire purchase price.
Management believes it has good visibility into the business and felt comfortable guiding profitability for the next two years. For FY20, management expects EPS within a range of $1.50 –1.80. This assumes that block hours will be about the same as in FY19 even though the Company will be utilizing 3 fewer aircraft. For FY21, management is guiding EPS to a range of $1.90 – 2.30. Much of the expected benefit in FY21 comes simply from lapping the higher maintenance program in FY20 and from the higher profitability of the newer aircraft that come with warranty coverage for the first four years.
MESA equity is attractively priced on several metrics. It trades below book value and at very low multiples. Having said that, given the business risks already discussed, its prudent to underwrite this investment conservatively. I’ve assumed that in FY21, the business will generate $240 – 260mm in EBITDA, up from the current run rate of ~$215mm. This assumes no additional growth in the business from new contracts. An EBITDA multiple range of 5.0 – 6.0x seems reasonable to me but I recognize that even this could be aggressive if the American problems worsen or if the pilot situation changes. Additionally, I’ve placed a value of $50 – 80mm on the NOLs, a discount to what they theoretically would be worth given the pre-tax income MESA generates. This gets me to a wide valuation range of $6.50 – 19.00/sh for the Company in 12 to 18 months. Note that this analysis includes the $550mm of incremental debt that will be incurred from aircraft and engine purchases over the next 24 months.
* Stabilize the American performance targets
* Win additional contracts from American and United and increase guidance
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