Description

This is not a traditional airline. This is a contracted operator with recurring revenues, trading for only 2.2x core segment cash EPS, and the non-core business is free. Over the next several months, a divestiture, inflection point in earnings, and cash return to shareholders should yield a stock worth $12-$16 per share.

Historically, Republic was a fixed-fee operator of regional jets for the national carriers in the U.S. with no exposure to the price of fuel. After the busted acquisition of Frontier Airlines and a dilutive equity offering, shareholders lost patience with the company and headed for the exits. However, investors have disregarded the remarkable transformation that has occurred ever since. In the last 18 months, management has restructured both Frontier and Republic, and has announced it is in the process of divesting Frontier. Successful execution of the restructurings and the eventual split of the company have created a near-term inflection point in earnings and capital allocation. At today’s stock price, RJET is trading for just 3.5x 2013 Republic segment EPS and you get Frontier and a large NOL balance for free. Or, said another way, the stock is trading for just 2.2x Republic 2013 cash EPS of $2.00 (Republic is not a cash taxpayer) and Frontier is free. We believe there are near term catalysts that will yield a stock worth $12.00-$16.00 per share for RJET shareholders.

Business Summary

The core of RJET is its fixed fee business, Republic, which has proven to be a consistent performer in a volatile industry. Republic flies its own jets (under the brand names of conventional carriers like Delta and United) and is paid a fee contractually, regardless of how many passengers are on the flight. Additionally, the price of fuel is a pass-through to the brand carrier, removing a significant amount of the risk inherent in operating an airline. Through 36 years of service and despite the periodic struggles of customers like Delta, United/Continental and US Airways, Republic has never lost a customer through consolidation or bankruptcy. And since its public offering in 2004, this business has yet to lose money in any single quarter.

Unlike Republic, Denver-based Frontier has been anything but steady. The purchase of this traditional airline in 2009 exposed RJET to unpredictable jet fuel prices and sucked capital away from the stable Republic segment. High energy prices led to volatile results at Frontier, which masked the solid operations of the contracted business. The quarterly consolidated numbers were muddled, sell-side analysts were distracted, and the market placed negative value on Frontier.

Strategic Alternatives

“We expect resolution on the Frontier separation program to complete sometime in early 2013.” – CEO Bryan Bedford

Management then decided it would restructure Frontier and hired Barclays to monetize it. By renegotiating jet leases with creditors and agreements with labor unions, management created a profitable Frontier which will be marketed to strategic and financial buyers from a position of strength as an ultra low cost carrier (“ULCC”). After dragging down RJET earnings for 3 years, Frontier will earn ~$0.30 per share in 2012. We have found CEO Bryan Bedford and CFO Tim Dooley to be very focused on shareholder value and non-sentimental toward Frontier Airlines. Therefore, we believe RJET could announce a divestiture in the next several months, allowing the market to focus on the fair value of the core business.

Strengthening the Core

“I'm pleased to say that we've reached agreements, which… should provide approximately $45 million of annual cash flow improvement...” – CEO Bryan Bedford

After completing the restructuring of Frontier, management set out to restructure Chautauqua Airlines – a subsidiary of Republic. Chautauqua operates small jets (37-50 seats) which are not cost efficient and have been a drag on Republic profits. This unprofitable small-jets business was basically being funded by the steady income of the larger jets (70-110 seats). Management has renegotiated Chautauqua leases, found work for 25 jets it had expected to park, and secured $45m ($0.60 per share after-tax) in annual profit improvement, with potential for another $15m.

We estimate Republic after-tax earnings of $0.71 per share in 2012 will ramp up to $1.28 per share in 2013, driven by the benefits of the restructuring. As soon as RJET separates from Frontier, analysts and investors will shift their focus back on the stable Republic business. We believe that business is worth a P/E multiple of 6x-8x earnings, or $7.70-$10.27 per share. Adding on Republic’s gross NOL with an NPV of $2.45 per share, we approximate total segment value is $10.00-$13.00 per share. Likewise, given the fact that Republic is not a cash taxpayer (RJET books accelerated depreciation on jets, shielding cash taxes), one could simply value the business at 6x 2013 cash EPS of $2.00, or $12.00 per share.

It is also worth highlighting that Republic finds itself in an attractive position while the industry endures plenty of change. The combination of recent consolidation and bankruptcy filings in the fixed fee industry has shrunk the competition down to only a few companies. The supply / demand fundamentals appear to be favorable, providing opportunities for growth in the future.

Capital Allocation

“… everybody is going to have to get a fair return on invested capital. Or we're just not going to invest the cash; we'll give it back to our shareholders.” – CEO Bryan Bedford

From a balance sheet perspective, RJET can be fairly misleading. The consolidated balance sheet appears to be highly leveraged with $2.2b in total debt against a market cap of $218m. However, the vast majority of the debt is collateralized by jets and principal payments are funded by the branded carriers. Additionally, “puts” and “make-wholes” protect Republic in the case of early termination of a long term agreement by a branded carrier. The truth is that the company actually has over $4.00 per share of unrestricted cash at the corporate level and that will grow as Republic free cash flow generation ramps up. Frontier will no longer be tying up capital so we expect RJET will begin returning cash to shareholders in 2013

Valuation

We believe the core Republic business alone is worth $10.00-$13.00 per share (on an after-tax EPS basis including the NOL or on a pre-tax basis). Over the next 6 months, as RJET separates from Frontier and reaches an inflection point in Republic profits, the shares will likely reflect the earnings power of the core business. We also estimate that in a transaction, Frontier will trade for 4x-6x 2013 EPS, or $2.00-$3.00 per share (below the 8x multiple given to Spirit Airlines - “SAVE”). Adding up the pieces gets us to a valuation range of $12.00-$16.00 per share for RJET stock. With a fresh set of eyes and the mindset that past performance is not indicative of future results, it becomes apparent that the core Republic business is strong and well-positioned for life after Frontier. Management is focused on creating value and will likely allocate a significant portion of the accelerating free cash flow generation to shareholders.

Catalyst

• sale of Frontier in late 2012/early 2013
• earnings ramp at Republic in 2013
• dividends and/or buybacks in 2013