Description

SkyWest is the largest regional airline in the US and has quietly become something that’s an anomaly in the airline industry: a company with a relatively sustainable competitive advantage, that’s well-run, growing, and profitable. Today, the stock is about $60/share and has a market cap of about $2.5 billion. I think SkyWest could earn about $15 in EPS in 2026 and upwards of $25-30 in EPS in 2028. It should generate $5-6 in EPS in 2024, putting the stock at about 10x P/E.

Regional airlines are strange businesses that evolved from industry strategy shifts and pilot unions. Years ago, major airlines realized that they only made a profit on full-fare paying customers flying between hubs…hence the hub-and-spoke model of major carriers we all know today. Everything else lost money except for the frequent flier credit cards. The problem is that somewhere between 50-70% of airline passengers don’t live near hubs. So, regional airlines were created to ferry people from smaller cities onto the planes flying between hubs, the only profit center. Also, pilot unions at major airlines didn’t want direct competition from lesser-paid regional pilots. Pilot unions wanted to insulate themselves from the low pay that existed from flying smaller planes for smaller airlines, so they forced major carriers to carve out regionals as separate entities and therefore have separate collective bargaining agreements. In the process, various rules were created to ensure that there wouldn’t be too much competitive overlap between regionals and majors, sort of like drug cartels agreeing to stay off each other’s turf.

Today, the US has about a dozen regional airlines flying abound 1,500 airplanes on any given day versus about 3,000 planes flying for majors (United, American, Delta) and about 1,500 for budget airlines (Southwest, JetBlue, Spirit, Alaska, etc). Major airlines enter into contracts with regionals to fly a given route that the major won’t serve, agreeing to pay the regional a fixed hourly rate. The majors also pay for the fuel. It doesn’t matter if the plane is empty or full, the regional gets paid the same regardless of the load factor, though fuller planes are better for business in the long-run. The majors also don’t pay for missed flights and make incentive payments for on-time performance since getting those passengers onto those profitable flights between hubs is what matters. So, operational performance ends up being extremely important for regionals because if they can’t deliver the passengers, what’s the point?

This sounds like it could be a good business (load factor doesn’t matter, someone else buys the gas) but historically the regionals have been no more investible than the majors or budget airlines. Several regionals have gone bankrupt in recent years, some under bizarre circumstances. Sometimes it’s been because of accidents, other times because of pilot availability since the regionals are sort of like the minor leagues for commercial pilots who typically want to move into higher paying and more prestigious jobs with majors. Or, those contracts for hourly rates with majors come up for renegotiation at terrible times when the industry is suffering from a downturn, and the regionals foolishly agree to uneconomic terms because of shortsighted management or an unfavorable competitive position. In the end, the regional airlines are basically trading fuel and demand risk for other risks like pilot staffing.

Covid was highly disruptive for the airline industry which saw demand quickly evaporate then recover. But airlines can’t just shut down for half a year then start back up and be functional again. The main problem was that the industry experienced an historic wave of pilot retirements. Many senior pilots (FAA mandates retirement at 65) permanently retired once everything was grounded in 2020. The airlines were more than happy to see this retirement wave at the time as they were scrambling to cut costs and avoid bankruptcy. The problem was that demand came roaring back and airlines still owned all the planes but had no one to fly them. So, the major airlines quickly found themselves with a massive pilot shortage. The majors began promoting first officers to captains and were then forced to hire as many pilots as they could from regional airlines and charter companies like NetJets for those newly empty first officer positions. Regional pilots couldn’t have been happier to effectively get mass promotions and raises, but it left the regional airlines – the guys at the bottom of the food chain – scrambling to hire pilots and fly planes. The hiring pool for the majors is basically the regionals, while the pilot pool for the regionals is largely new pilots who’ve completed the necessary training and flight hours.

The abrupt hiring needs of regionals was compounded by a relatively recent rule put in place that required regional airline first officers to have an ATP rating (Airline Transportation Pilot) which requires 1,500 flight hours. There used to be no ATP requirement for first officers who previously only needed 250 hours to get hired, but after a crash in 2009 for a Buffalo-bound regional plane, Senator Chuck Schumer strong armed this rule even though flight hours had nothing to do with the crash. (Schumer happened to be at the Buffalo airport when this crash occurred, and he was confronted by people and pressured into Doing Something. Notably, no other country has this 1,500-hour requirement.) So, the regionals needed to hire thousands of pilots (normal attrition rate is ~20%, but it spiked to ~80% in the last couple years) but the pool of pilots who qualified with an ATP rating is only so large at any given time because it takes 5-6 years to build enough flight hours. The regionals got squeezed and started cancelling flights en masse, meaning they weren’t getting paid. There are other details I’m omitting for the sake of brevity, but you basically now understand what happened with SkyWest and other regionals – the pilot shortage caused by covid was felt most acutely by regional airlines who didn’t have enough pilots to fly planes and therefore get paid.

Maybe, just maybe, all this will reverse…

SkyWest was founded in St. George, Utah, in 1972 by Ralph Atkin. The company grew steadily, though its performance was somewhat unremarkable for no other reason than the airline industry was still coming out of deregulation and competition was extremely tough. In 1991, Ralph’s brother Jerry Atkin took over as CEO. With Jerry in charge, SkyWest became the main acquirer of other regional airlines, often in shrewd deals. They bought American Southeast Airlines (170 planes) from Delta while Delta was in bankruptcy in 2005, and required the cash in order to exit bankruptcy. They bought ExpressJet from Continental Airlines in 2010 while Continental and United were trying to merge and were basically forced to divest their regional airline in order to get the merger approved. Combined, these were transformative deals that made SkyWest the largest regional in the country. It was after these deals and SkyWest pulling far away from the other regional airlines that their financial performance began to be noticeably better. Other regionals were mostly floundering. A lot of SkyWest’s success can be traced back to the Atkin family, and the fact that they ran SkyWest out of a tiny city in southwest Utah and they ran it like a private company. As Jerry grew the company, he was able to leverage their size to negotiate better hourly rates with majors, and himself and the rest of management simply had a different culture where they wouldn’t enter into bad deals.

Today, SkyWest is by far the largest regional airline in the US with about 600 planes, which also makes it the fourth largest airline in the US measured by fleet size. And yet hardly anyone knows it exists. The reason is because SkyWest isn’t really an airline, it’s a staffing company that happens to fly airplanes. Think I’m exaggerating? Check out SkyWest’s website…you can’t book a flight, check schedules, cash in your Sky Miles or whatever, or any of that usual stuff. Look what’s on there instead, it’s almost entirely a giant career page.

About half of SkyWest’s fleet are nice Embraer 175’s, which are the most desirable planes for regionals and command the highest hourly rates. The other half is comprised of older Mitsubishi CRJ’s. Some of these Mitsubishi’s are relatively new planes and command good hourly rates, but some are older and are going to be retired soon. Mitsubishi stopped making planes a few years ago, leaving Embraer as the only OEM making regional jets for the US market. SkyWest’s fleet is overall solid, but more importantly they’ve always employed more crews per airline vs competitors. This has meant that SkyWest is the rare example of size being an actual sustainable competitive advantage. With larger size comes more crews, and SkyWest has 50% more crews per airplane vs every other regional airline. More crews mean more flight availability and better on-time performance and more incentive payments. SkyWest can fly more routes and make more money and offer better pay and better home bases for pilots. This is not just speculation, it’s observable in the history of SkyWest, which has left every other regional behind.

If size is a real advantage, can other regionals grow or merge to match SkyWest’s size? Probably not. We know they can’t grow organically since there are only so many qualifying planes being built by Embraer each year, and realistically the E175 is now the only viable option in the US market. Also, the majority of the global E175 fleet already operates in the US, so it’s unlikely that a regional could buy a bunch of E175’s from Europe or Asia. So, this is a pretty strange market here that is very supply constrained. Could other regionals merge their way into competing better? Unlikely. The combined number of planes owned by all other independent regionals is just 280. American has by far the largest owned fleet of regionals (four separate companies: Republic, Piedmont, PSA, and Envoy) making up a combined 535 planes, but another peculiarity of regional airline contracts limits the number of regional jets a major can fly, and American is just about at that limit now. United doesn’t own a regional carrier, and Delta only owns Endeavor Air which has 140 planes; neither seem to care.

Could a regional airline fly a Boeing 737, or one of those new Airbus 220’s? Nope. In another strange quirk for this industry, regionals are contractually unable to fly planes above a certain gross weight (86,000 pounds) or with more than 75 seats, and they’re not allowed to have a flight travel beyond a certain distance. Why? Pilot unions. Embraer makes this awesome new plane, an E195. The plane is fantastic and everyone loves it. Embraer has sold exactly zero of them in the US. Why? Because it weighs 115,000 pounds and seats 114 people. So, no regional can fly it, and it makes no sense for any major when they could instead use a Boeing 737 that holds over 170 passengers. I told you this was a strange business.

The reason to care about SkyWest right now is that everything that’s held SkyWest back since 2019 has finally stopped. Actually, it’s all reversing, and historically bad conditions in pilot staffing are now flipping to historically good conditions. This isn’t speculation, we can see evidence of this unfolding in real-time amongst both major airlines and pilots.

For this year, it certainly is a lot less higher than what we've done in the past. We are going to be bringing on about 1% more headcount. So what we'll call it somewhere around 1,000 or 2,000 more heads this year, but a big reduction from where we were last year. And it's just a sign of where we're at with efficiencies as well. We probably hired ahead a little bit in 2023. But -- this year, we're looking to grow the airline mid-single digits and head count is going to grow by about 1%. – Devon May, CFO of American Airlines, 1/24/2024

We have planned for stability in the regionals after 2.5 years of really instability where we didn't know how many hours we had really 3 to 4 months ahead of time. And what we've seen is that there is a lot more stability. What we haven't accounted for is the full utilization of our fleet. So we still have 50 to 100 airplanes and less of utilization than we are -- than we have on the ground in our fleet. So should that lower hiring at the Mainline translate into more availability in the back half of the year, that would be potential upside to our P&L. – Glen Hauenstein, President of Delta Airlines, 1/12/2024

It's pretty much this sentiment repeated across the board – the majors are done hiring. They don’t want or need more pilots. What are pilots saying? Mostly, they’re now lamenting how quickly and drastically the hiring market has flipped.

Meanwhile, the bottom-end of the funnel keeps rapidly filling up, with FAA issuance of ATP ratings reaching a new record in 2023, after a record 2022. So not only is SkyWest going to stop losing pilots to majors and budget airlines, but the hiring pool is getting larger by the day. It’s rare for a new ATP-rated pilot to get hired by a major or budget airline in general, and those places have hit the brakes on hiring anyway. All of these young pilots are knocking on SkyWest’s door.

The Air Line Pilots Association, Int’l (ALPA) today released updated data from the Federal Aviation Administration (FAA) showing that the agency issued 11,225 airline pilot certificates (ATP-MELs) during the 2023 calendar year, exceeding analyst forecasts and airline demand for new aviators. This is the second year in a row that pilot production numbers are breaking records. In addition to the impressive pilot production number, the number of certified flight instructors totaled 93,567, a nearly 20 percent increase over 2019, further demonstrating that the airline pilot pipeline remains strong and robust—and there is no need to make unstudied, arbitrary changes to U.S. aviation safety regulations.

Put it all together and the next few years look like they couldn’t get much better for SkyWest. The majors have hired everyone they need and then some, which means the regionals are going to stop losing pilots. Budget airlines like Spirit and Southwest have run into serious financial trouble and none of them are hiring away from regionals for the foreseeable future. The hiring frenzy is over. Meanwhile, the FAA continues to issue a record number of new ATP licenses, meaning the hiring pool for the regionals – the starting point for almost every new pilot – just keeps growing. A boom is turning into a bust. I estimate that SkyWest is short 1,000 pilots that they can fill in the next 24 months, which will just keep leading to upwards earnings revisions for a while.

Can SkyWest return their operating margins to pre-covid levels around 15-17%? Sure, why not. The conditions are favorable enough that this isn’t unreasonable. Last time conditions improved drastically the company went from earning about $1 in EPS to over $8 in EPS. How much money would SkyWest make? It depends because there’s another underappreciated thing about SkyWest: they have a great stock repurchase program. In 2023, with their stock bottoming at $20/share, SkyWest repurchased about 20% of the shares outstanding. Also, SkyWest is able to take advantage of accelerated depreciation, so as long as they’re buying new planes, cash taxes are immaterial.

Who knows exactly what the financial statements are going to look like…the airline business is always full of surprises. But SkyWest will get more planes, have those planes fly more, and have nice hourly rates. Meanwhile, it doesn’t look like expenses (most of which are fixed) should grow much. The company can keep buying about $300-600 million worth of stock per year, which would reduce shares outstanding (and increase EPS) by 7-14% annually.

Operating margins peaked at 18% in 2019 and hovered in the low-to-mid teens in the stable years before that. I don’t think it’s crazy that SkyWest could return to those highs or possibly even exceed them for a few years. Even achieving low-teens margins would generate $12-14 in EPS in a couple years. Historically, the stock has traded between 10-15x P/E, and I think it’s reasonable to expect its multiple to expand back to 15x if earnings keep growing – I’m an unapologetic optimist. So, SkyWest’s stock would still trade as high as $180/share even with those low-teens margins. And maybe by 2028, they’re flying their planes at 2017-209 utilization levels and margins are more like 18-20%. It’s not crazy that SkyWest would earning close to $30 in EPS and the stock is worth $300-450/share. I know this all sounds ambitious, but it’s just predicated on operations returning to normal/favorable conditions that they saw before covid and are clearly on a trajectory to return to. The leverage is there. I don’t think anyone would be disappointed if the stock merely doubled from here.

Keep in mind the airline business has a funny way of running into problems every decade or so, whether because of terrorism, infectious diseases, fuel, faulty engines, etc. So, even if I’m right about this, I’m sure there will be some negative developments along the way, and as always, I’ll just have to evaluate them as they come along. But for now, SkyWest’s shares look deeply undervalued and highly asymmetric. 

Catalyst

https://www.youtube.com/watch?v=pEp_IAfyldo