Description

Business Model:

Republic Airways is a leading regional flight operator that offers scheduled passenger service on over 1,300 flights daily to more than 110 cities in the US, Canada, and the Bahamas under pro-rate operations and through fixed-fee code-share agreements with AMR Corp, Delta Airlines and United Airlines. The Company recently divested its branded business subsidiary, Frontier Airlines, in Q3 2013. As a result of the shopping process and ensuing sale, pro-rate operations (3.4% of  2013 revenue) have been reduced by almost 90% over the last two years, and are expected to cease in Q1 2014, leaving only the fixed-fee code-share (94.8% of 2013 expected revenue) and charter (1.7% of 2013 expected revenue) business lines remaining. As of Q4 2013, the Company operated 244 aircraft: 68 smaller, 44-50 seat planes and 176 larger, 69-99 seat planes, making it one of the largest regional jet carriers in the country and one of the two primary players in the space.

The fixed fee business is characterized by reasonably high predictability and stable revenue and margins. The number of aircraft operated and utilization of those aircraft are the most significant drivers of revenue. Under code-share agreements between Republic and each of its airline partners, the Company is compensated on fixed-fee basis on all of its flights, while the partners provide additional services such as reservations, ticket issuance, ground support services and airport facilities. Landing fees, passenger catering, passenger liability insurance and aircraft property tax costs are all passed through to Republic’s partners. Most notably, as of December 31, 2012, all of Republic’s aircraft fuel is provided by each of its partners, who incur the entire cost (and volatility of oil prices). As a result, these fixed-fee agreements limit the Company’s exposure to fluctuations in fuel prices, fare competition, and passenger volumes, reducing the Company’s economic sensitivity and variability of input factors that are typical of the traditional airline industry.

Larger airlines utilize regional operators in order to take advantage of the labor and cost arbitrage opportunities that they provide. Regional operators pay their pilots materially less and have lower overhead costs than the major airlines, allowing regional providers to operate more efficiently in these routes than their major airline counterparts. This cost arbitrage has been demonstrated in the past with United and Continental, as both companies formerly owned in-house regional airlines but divested the businesses and outsourced the routes to regional airlines after deciding it was more efficient.

Management:

Bryan Bedford, Chairman, President and CEO, has more than 24 years of experience in the airline industry. Mr. Bedford joined Republic in July 1999 as president and CEO. During his 14 years leading Republic, the Company has grown from $85 million in revenues and 36 turboprop aircraft to more than $2.8 billion in revenues and an operating fleet of 235 aircraft. Mr. Bedford has done well executing the goals laid out by the Company over time, including successfully restructuring both Frontier Airlines post-acquisition and the Company’s 50-seat platform, Chautauqua Airlines, and more recently, divesting Frontier Airlines to simplify Republic back to its core business. Prior to Republic, he served as President and CEO of Mesaba Holdings, Inc. and Business Express Airlines. Mr. Bedford currently owns 405,341 shares of RJET, equivalent to $3.8 million. In FY 2012, he received $852K in cash compensation, resulting in a 4.5x ownership to salary ratio. 2012 annual incentive pay was based on pre-tax income (40% weight), unit cost (20%), controllable completion factor (10%), on-time departure (5%) and on-time arrival (5%), while share-based compensation was more aligned with investor interest, based on pre-tax margin (50% weight) and achieving corporate strategic objectives (50%).

Valuation:

Republic is expected to grow revenue in 2014 by 3.4%, compared to the non-Frontier, core business pro-forma 2013 revenue. This growth takes into account one new Q400 United jet being placed into service in Q1 and 22 E175 American jets coming in throughout the year. Additionally, it accounts for the 27 smaller 50-seat planes that management has stated it will sideline this year. In its Q4 2013 call, management guided to, on average, $93 million of pre-tax earnings. This guidance included a $7 million hit in Q1 due to bad weather, roughly $14 million in increased pilot salary, and roughly $8 million in a one-time pilot bonus. The increase in salary and bonus payment were both contingent on the pilots accepting the new tentative agreement, discussed below. However, on April 4, 2014, the pilots rejected the tentative agreement. Subsequently, on April 7, the Company came out with a new $75 million buyback authorization, effectively saying a near term deal will no longer occur, and noted it will raise its previous guidance in its next quarterly call to account for the no longer occurring salary increase and bonus. Conservatively adding back these costs brings adjusted 2014 pre-tax earnings to $116 million, on a full year margin of 8.4%, resulting in year over year growth of 13.7%. Assuming a 38.5% tax rate and full share dilution by Republic’s remaining convert at yearend (dilutive by 2.5MM shares) results in diluted EPS of $1.33, as net income approaches $72 million. Note that no repurchases of common stock are assumed.

Using the above base case assumptions, Republic trades at a 2014 P/E of 6.3x, well below that of its closest peer, SkyWest, which trades at 18.3x 2014 EPS. Over the last 3 years, SkyWest has traded at a trailing P/E of 8-15x with an average 13.1x. Applying a conservative base case of 10x P/E and 6.0x EV/EBITDA on 2014 expectations implies stock prices of $13.33 and $9.19, respectively. Taking the average of the two results in an implied price per share of $11.26, 34.4% higher than the current price. Downside multiples of 8x P/E and 5.5x EV/EBITDA result in a stock price of $8.07 (-3.7% return), while upside multiples of 14x P/E and 7x EV/EBITDA result in a stock price of $17.65 (110.6% return).

Alternatively, diluted cash EPS is forecast to reach $2.05 in 2014 and $2.36 in 2015. Because of the Company’s significant net operating loss carry-forwards, it has paid no income taxes since 2008. As of the end of 2012, Republic estimated it had $1.4B of NOLs for federal income tax purposes that begin to expire in 2015. As a result, management does not expect to be a cash tax payer for at least the next 5-6 years. Applying a 10x multiple on cash EPS implies a price 145% higher in 12 months.

Investment Thesis:

The Republic story is a two part investment thesis: continued revenue growth combined with multiple re-rating as the market assigns a proper multiple to the new, more stable business profile. The growth story is well underway as Republic has solid growth under contract that began to come online in 2013 and extends into 2015. The Company’s capacity purchase agreement (CPA) with United allows it to operate 32 Q400 planes, 27 of which came into service by the end of 2013, with 1 coming online in Q1 2014 and the last 4 later in the future. More recently, Republic signed a contract with American to operate 47 larger E175 planes. 16 of these planes came online by the end of 2013, with an additional 22 coming in 2014 and the final 9 in H1 of 2015. These additional contracts generate significant additional revenue for Republic and more than offset the potential revenue decline caused by the 27 smaller jet contracts that are being sidelined in 2014 (discussed below). Looking beyond 2014, Republic has the option to receive an additional 47 E175 aircraft from Embraer beginning in 2015 that it hopes to use in a future contract with a large airline. While Republic has identified the potential for 150 future aircraft orders from Delta and American, and possibly additional planes from United, likely to come in 2014 and 2015, it will be difficult for the Company to obtain any new awards without a new pilot CBA given industry-wide pilot shortages.

Also important for revenue growth, the pro-rate passenger service business is essentially completely wound down at this point. Over the last 3 years, the pro-rate passenger service business has declined from $389 million in revenue in 2011 to $46 million in 2013, masking the growth in the fixed-fee business, which has grown from $1.08 billion in 2011 to $1.28 billion in 2013. This headwind will be largely eliminated going forward as 1) the pro-rate business goes to zero in Q1 2014 and 2) pro-rate revenue took most of its hit already in 2013. Similarly, fuel, which was formerly a pass-through expense (and thus accretive to pro-rate revenue), began to be provided directly to Republic by its partners at yearend 2012. The corresponding loss of revenue disguised organic revenue growth in 2012 and 2013, as pass-through fuel expense fell from $303 million in 2011 to $46 million in 2013, but will have minimal impact in 2014.

The re-rating of the multiple should occur as investors see the Company’s ability to fill its hiring gap needs and begin to better understand the return profile of the core, fixed-fee business without the impact of Frontier Airlines. Unlike the fixed-fee business, Frontier Airlines was highly sensitive to economic growth and oil prices, and thus had a far more volatile business profile. As a result, Republic has traded at a multiple similar to that of the larger airlines that are exposed to such uncertainties. The divestiture of Frontier changes the quality of revenue and earnings to be far more stable and predictable. As a result, the stock should trade with a valuation more in-line with that of its closest fixed-fee peer, SkyWest. The current discount to SkyWest is despite Republic’s visibility into material revenue and earnings growth over the next 2+ years, while SkyWest’s revenue and earnings are expected to stay flat and decline, respectively, over this same period. Additionally, Republic’s margins far exceed those of SkyWest, as SkyWest does more customer service handling than Republic, and SkyWest is exposed to greater fleet risk going forward as 69% of its fleet consists of small jets, whose use is expected to be cut significantly over time (discussed below), versus just 29% for Republic. Countering these positives is the higher apparent leverage of Republic, lack of a dividend (SkyWest’s dividend yields 1.1%), and fewer pilot count issues at SkyWest.

Divergent View:

As discussed above, the mispricing of Republic’s stock appears to be primarily the result of the market currently improperly assigning an airline multiple to Republic that is not consistent with the stable, predictable, cash generative profile of the business after the sale of Frontier. The financials are noisy given the acquisitions of Midwest and Frontier in 2009 (which altered the margin and revenue profile of the company), subsequent sale of Frontier in Q4 2013, change in pass-through expense of fuel, and wind down of pro-rate flying for Frontier. As a result, historical financials do not provide an accurate picture of the business as it stands now. Rather, by taking a cursory look at GAAP financials and forward estimates, it appears that revenue and earnings are falling materially year over year, despite the strong growth underlying the business. Given the Company’s market cap is small, at sub-$600 million, it has likely been below the radar of many investors (it is only covered by 2 larger sell side firms), prolonging the time period with which the market realizes the fundamental shift in the business.

Additionally, one of the major industry headwinds that the sell side emphasizes is the potential for hub rationalization in the future as a result of major airline consolidation, with the concern being fewer hubs equates to less demand for 50 seat regional jets. In speaking with SkyWest, the company is seeing no signs of hub consolidation and conveyed that even if consolidation ultimately occurs, any potential impact will be minor as the airline industry is continuing to grow both in terms of aircraft and passengers. Furthermore, as discussed below, the gradual reduction in 50 seat flying should largely be offset by increased flying of larger planes as all the major airlines have extended their scope clauses to allow regional providers to fly 76 seat aircraft. The industry-wide pilot shortage has also negatively impacted the stock. While the Company has already announced it will sideline 27 small planes this year, it has been able to fill its remaining hiring needs year to date, reducing the risk of further sidelines.

Lastly, investor concern over Republic’s debt levels has likely been an overhang on the stock. While the Company’s net debt appears significant, at 5.1x TTM EBITDA, actual debt risk is significantly lower. Of Republic’s $2.2 billion in total debt, $50 million is convertible debt and another $100-200 million is in engine and other aircraft part financing. The remainder is aircraft debt, 80% of which is paid by Republic’s partners under its fixed-fee agreements. This ~$1.4 billion can be thought of as largely non-recourse to Republic. As a result, the Company’s net debt to EBITDA, using the debt that is fully recourse to Republic, is closer to 1x. Additionally, over 95% of the total debt is fixed-rate, insulating Republic and its partners from changes in rates.

Investment Risks/Considerations:

ERJ Contract Expiration:  As noted above, 41 of the 70 small regional jets that Republic operates have contracts that expire throughout 2014. While the small jet business is breakeven currently, aircraft obligations under the lease and debt financing for these planes extend anywhere from 2015 to 2018, creating an asset-liability mismatch. As a result, if Republic is unable to re-sign these contracts with durations that cover their financings, or is unable to sell or lease the planes to other parties, the small jet business becomes an earnings detractor. New pilot work regulations (FAR 117) and some uncertainty surrounding the availability of new pilots given the lack of a new pilot CBA has recently put the Company in the position of having to let some of the smaller aircraft stand down in favor of the larger E175 aircraft for American, as the Company announced in February that it would sideline 27 smaller aircraft over the course of 2014, negatively impacting income before taxes by $18-20 million. This risk is well known and regularly documented by the sell side, implying that much of the downside is likely priced in.

New Pilot CBA: Coming to a new CBA with pilots is highly important in order for Republic to maintain its growth profile beyond 2014. Unfortunately, as mentioned above, the pilots recently voted down the tentative agreement that the Company had come to with the pilot union. In speaking with the national union (which had advised the pilots to accept the agreement), it realizes the deal is going to get no better and any potential agreement now is likely well into the future as the government must re-engage in negotiations. As a result of the lack of a new agreement, the primary risk to the Company is the potential sidelining of additional smaller jets should it not be able to recruit the necessary number of new pilots. Thus far year to date, Republic has not had issues hiring the number of pilots it needs.

Furthermore, until a new agreement is finalized and the Company has greater clarity on long-term labor costs and its overall cost structure, it will be harder for Republic to compete effectively for new business. Additionally, there is more risk working with Republic right now from the perspective of the major airlines, which are hesitant to take on risk associated with an uncertain pilot agreement in new contracts when they have other alternatives. That said, SkyWest noted that the major airlines consider SkyWest and Republic top-tier carriers, and it doesn’t see a big opportunity to take market share from Republic.

Decline of Small Plane Usage: Airline consolidation, along with higher fuel prices, has limited the economic use of smaller regional jets and led to reduced capacity. Today, management estimates that there are roughly 1,100 50 seat regional jets that operate domestically in CPA-type agreements nationally. Over the next 4-5 years, it believes that regional airlines will shed roughly 600 of these jets. However, the recent changes by all the major airlines in their mainline pilot scope provisions enable regional airlines to fly larger jets up to 76 seats, opening new opportunities, which should help offset the decrease in small jet flying. Management expects that roughly 300 additional large jets will replace the 600 outgoing smaller jets. All of Republic’s partners have expressed interest in upgrading 50 seat jets to larger capacity aircraft, and the Company is positioning itself to be highly effective and competitive in the 69 to 80 seat space while it manages the runoff liability of the 50 seat jets. While Republic currently operates 70 small regional jets that it needs to keep competitive in the shrinking pool, the Company is well-positioned for growth opportunities with multiple partnerships, a strong relationship with Embraer, and a focus on growing its larger regional aircraft fleet.

Technicals:

RJET is currently in a downward sloping channel. The stock began its initial descent in August 2013 upon rumors of Indigo buying Frontier from Republic. The stock fell 11% on October 1, 2013, when the formal agreement to sell Frontier to Indigo was confirmed.

Catalyst

Catalysts:

As investors more fully appreciate Republic’s more stable profile and refocus on the core business, its undervaluation relative to peers should correct. Q3 2013 was the first quarter in which Republic’s financials broke out the pure go-forward core business and Q1 2014 will be the first quarter without reporting a significant discontinued operation, such that GAAP earnings closely resembles those of continuing operations. As investors digest the earnings profile in forward quarters this discount should close.

In addition, a new CBA (discussed below) would serve as a significant catalyst going forward, as it opens Republic to more easily signing new business. While discussions have been on and off for well over a year, negotiations with the assistance of a private mediator resumed for a two week period in mid-November and a four day period in December and the two parties came to an agreement in February after final discussions in January. The Republic pilots submitted final votes on April 4, 2014, rejecting the deal, which likely pushes any potential deal far into the future. However, the Company will guide in the upcoming Q1 call to higher earnings that result from the cost savings of no new deal, which should provide an added catalyst.

Extension of any of the 41 small jet contracts that expire in 2014 will also serve as a positive catalyst, as will new contracts with airlines for the larger planes that Republic expects to receive beginning in 2015 and comments by management that it is hiring sufficient pilots to cover its existing contracts.