At a free cash flow yield nearing 25% and a P/E of 8x, we believe SkyWest is presently an excellent value. While the merits of various regional airline operators have been hotly debated over the years on this site (see write-ups on PNCL, RJET, and XJT, and lively discussion threads therein), we were surprised to see that little if any attention has been paid to SKYW, one of the best and most consistent operators of all.
What’s more, while virtually every stock on earth has been beaten down regardless of demonstrated growth this year, we get the additional benefit that the market appears to have completely miscalculated the relative effects on SKYW’s major airline partners of imminent demand destruction (a clear negative) versus plummeting oil (clearly a huge positive). Now, we make no case for major airline investment – the historical value destruction in that group is blindingly evident – but the tendency for regionals to trade at least partially based on sentiment towards the majors adds a significant potential positive catalyst for the regionals as 2009 unfolds, simply because there is good reason to believe sentiment improves towards the majors themselves next year. JP Morgan analyst Jamie Baker recently put out an extensive note (11/14/08) in which he emphasized that at $70 oil (a full 60% above current levels), the only way he could forecast an operating loss for the majors in 2009 would be an industry downturn “several times the magnitude of 9/11.” As an investor, do you think that’s remotely reasonable?
Back to the regionals: if you are not familiar with the regional airline business and how it differs from that of a traditional airline, we encourage you to read gatsby892’s write-up of RJET from 2007. We are not going to argue that the regional airline services business is one of the greatest in the world; it is not the highest ROIC business, and the plight of the major operators clearly affects sentiment towards these stocks (potentially lending itself to sub-market valuations for extended periods).
That said, the word “airline” is entirely a misnomer for many of these companies and history has shown that they are stable and resilient despite myriad setbacks to their major partners. Companies like SKYW and RJET and PNCL, which mostly conduct capacity-purchase operations with the major airlines, bear no fuel price risk and no ticket price (i.e. fare war) risk. While a typical Porter’s Five Forces analysis would absolutely scream “bad idea” given the customer concentration risk to a truly horrendous capital-destructive industry (major airlines), the operators which have focused on capacity operations have actually managed to survive multiple bankruptcies of their only clients and still maintained solid profitability. This is a vitally important distinction to understand if you are to get comfortable with these stories, as the worry over potential major airline bankruptcies during the recession is in large part why many of these regional names currently fetch such ridiculously low multiples.
The regional capacity operators typically get paid on a per-departure or per-block hour basis, plus an allowed markup for them to earn a respectable margin for themselves. Given that they bear no risk from fuel price fluctuations, ticket pricing wars, or passenger load factors, their margins are generally lower than what they could otherwise earn in normal times conducting “at-risk” operations. Any student of investing history, however, knows full well that “normal” times for the traditional airline business seldom last long, as the urge to buy shiny new planes or cut fares given the near-zero marginal cost of transporting an additional passenger ultimately prove irresistible to major airline CEOs. (For insight into what can go wrong when a regional strays from pure capacity operations, browse the XJT write-up and thread from years ago, and then see what’s happened to XJT ever since it made the bizarre subsequent decision to begin independent at-risk flying.) So the historical record to this point shows that accepting the lower normalized margins for the much lower-risk business model has clearly been the better way to go.
SKYW has an extremely stable operating history, as evidenced below (numbers in millions, except Cash Flow from Operations to Net Income ratio):
*SKYW acquired Delta regional subsidiary ASA in 2005
SKYW operates a fleet of 440 aircraft for Delta, United, and Midwest Airlines. For the first 9 months of this year, it used 57% of its capacity for Delta, 40% for United, and the remaining 3% for Midwest. SKYW has been a Delta partner since 1987, and a United partner since 1997. 95% of SKYW’s flying is done via capacity contracts, so its pro-rate/at-risk exposure is minimal.
SKYW acquired Atlantic Southeast Airlines (ASA) from Delta in 2005, making it Delta’s single largest regional partner (should you care, you can check out Atlantic Southeast’s own financials prior to its takeover by Delta in 1999 by looking up the ticker ASAI on Bloomberg). As mentioned above, in its operating agreement with Delta, SKYW is guaranteed at least 80% of all Delta Connection flying out of Atlanta and 30% of all Delta regional flying. As SKYW is currently operating at both those minimums, this ought to mitigate investor fears that Delta could cut SKYW out of the operating loop entirely.
In an effort to diversify its client base, SKYW attempted to purchase Express Jet (a major partner of Continental) earlier this year for a split-adjusted $35 per share. Given the mess XJT is currently in, one may question SKYW’s sanity in pursuing such a deal. Prior to submitting the merger proposal, though, SKYW had already agreed in principle with Continental on a new capacity purchase agreement. (For those negative on the regional airline business, by the way, note that this was a capacity purchase agreement a major was willing to sign with oil WELL above $100.) Unfortunately for both parties, XJT management viewed this as a hostile bid and went about negotiating its own agreement with Continental in an effort to go it alone, at which time SKYW dropped its bid. XJT was forced to issue several hundred million shares in order to pay down a debt commitment, and its shares currently fetch less than $2. It remains to be seen whether they’ll make it. We certainly think SKYW, on the other hand, ought to be fine.
Part of the concern surrounding SKYW is its exposure to 50-seat regional flying. For those of you who are unfamiliar with the space, the major airlines have been scrambling to reduce flying aircraft of 50 seats or fewer and have announced capacity reductions across the board with those. Delta has been front and center of those reductions, and SKYW is Delta’s biggest regional partner, flying 162 fifty-seaters for Delta (out of its total fleet of 440 aircraft). However, that contract does not expire until 2020 and cannot be cancelled without cause. Thus, short of a material breach by SKYW, the most Delta can really do at present is to reduce utilization of those aircraft. Even on that front, SKYW has minimum utilization language in the contract, and if Delta elects to go under those levels it will be forced to increase its reimbursement to SKYW to compensate the company for its fixed costs. Even still, Delta has to compensate SKYW for its ownership costs on unutilized aircraft. Alternative solutions present themselves as well: SKYW is currently swapping twenty-three turboprop aircraft it operates for United for eighteen 66-seat CRJ 700s to be operated under the same contract.
Year to date, the grand total effect of the nasty conditions in the airline industry has been a year over year decline of 5% in cash flow from operations (from $366mm to $347mm) and 12% decline in EBITDA (from $417mm to a “mere” $366mm). The company is currently carrying the costs of 9 aircraft idled on account of its partner Midwest’s restructuring, but while a clear negative for the time being, the situation is not at all a massive burden. All of this has resulted in a stock which, while off its lows, has still declined nearly 50% over the past year.
Of note: be careful when looking at EBIT margin progression, as almost all their fuel cost flows through both the revenue AND expense lines since it is a reimbursed cost in their capacity operations. Fuel was 40% of expenses in 3Q at nearly $365mm, and only $12mm of that was attributable to the non-reimbursed fuel expense they incur in pro-rate operations (and even that number is significantly lower at current oil prices). Below we present the operating margins as it appears on the surface, and the operating margins adjusted when backing fuel out of the revenue line:
|
Revenue
|
Op Mgn
|
Fuel
|
Rev - Fuel
|
Adj Op Mgn
|
|
2000
|
523
|
17.0%
|
72
|
451
|
19.7%
|
|
2001
|
602
|
9.5%
|
72
|
530
|
10.8%
|
|
2002
|
774
|
15.3%
|
98
|
676
|
17.5%
|
|
2003
|
888
|
12.2%
|
149
|
739
|
14.7%
|
|
2004
|
1,156
|
12.5%
|
253
|
903
|
16.0%
|
|
2005
|
1,964
|
11.2%
|
591
|
1,373
|
16.1%
|
|
2006
|
3,115
|
10.9%
|
1,011
|
2,104
|
16.1%
|
|
2007
|
3,374
|
10.2%
|
1,062
|
2,312
|
14.9%
|
NOTE: This is not a perfect adjustment since a small amount of fuel expense is related to the at-risk portion of the business, and thus is not reimbursed and counted as revenue. As that figure is minor, we have not gone back and factored in the exact amounts each year.
Of note, another positive is that the minor pro-rate operations have turned around. After losing $6mm pre-tax in each of the first two quarters this year, the pro-rate operations turned net income positive and “significantly cash flow positive” in the third quarter.
An interesting minor side note is that the company has begun looking at international opportunities and recently took a 7% interest (for $5mm) in the profitable Brazilian regional airline Trip, with the intent to take that ownership up to 20% with a total outlay of $30mm by March, 2010. SKYW will not run Trip but its stake in the company’s earnings sets it up to capitalize upon a model in Brazil that parallels its operations here in the United States, thus creating an avenue for future growth.
VALUATION
With a market cap of $900mm, SKYW currently trades for 7.5x what it should earn this year (with 9 months in the bag, of course). With an EV of about $2B, its EV/EBITDA ratio is below 4x, and its EBITDA/Interest ratio in the most recent quarter was 5.0 (TTM ratio is marginally lower). SKYW carries a significant amount of off-balance-sheet leases for its aircraft, though, so capitalizing these at 7x rent expense gives an EV/EBITDAR of 5.1x (vs competitor RJET at 6.7x, not as lease-heavy) – still not at all a demanding valuation. SKYW also has a whopping $720mm of cash and marketable securities on hand, providing it ample liquidity.
Given the capacity cuts announced to date by the majors and resulting flight plans expected for 2009, the EBITDA and earnings numbers look about flat to slightly down next year, at about $500mm and $2 per share, respectively. Earnings estimates have come down by roughly a third as Delta took its flying down to near contractual-minimum levels. As we mentioned above, though, the safety in SKYW is that once DAL takes utilization below certain thresholds – which management has indicated they have reached – SKYW’s reimbursement steps up, so the company is paid as if it is flying those minimums.
The company earned $205mm in free cash flow (defined as Cash Flow from Operations less Capex) in the prior 12 months, versus a market cap of $905mm, for a FCF yield of nearly 23%. FCF can be expected to decline some next year as the company runs the full year at minimums in the Delta contract and lays out cash to bring in 14 aircraft versus 6 this year. For what it’s worth, the company generated $78mm of FCF in the most recent quarter alone, equating to a $312mm annualized figure or a ~35% FCF yield. While that is not a run-rate, the company is clearly managing through its partners’ difficulties and it is not unreasonable to expect 2009 FCF of anywhere from $150-$180mm, or roughly a 17-20% forward FCF yield in a depressed environment.
Clearly growth plans are shelved for the near future as the majors are cutting capacity across the board. On top of that SKYW is able to use MACRS depreciation on aircraft for tax purposes, thus accelerating the realization of free cash flow over the life of a plane (thus making profitability look a bit higher, see timothy756’s discussion of PNCL for details on MACRS accounting), but in spite of those considerations it is clear to us a company with SKYW’s history of operations deserves a better multiple than 4x current FCF. Not too long ago a 10x FCF multiple would get us interested in a name, and in this environment we’re happy to buy a company of this stability at 40% of that multiple. If 10x becomes our sell target, that’s still a 2.5x on the stock. We re-emphasize that any growth Delta pursues in regional flying necessarily implies growth for SKYW, as it is guaranteed minimum percentages of both Atlanta and overall Delta system regional flying, and is at both minimums now. So we would vehemently disagree with anyone who argues that a no-growth multiple ought to be applied to the business.
Of note, SKYW repurchased 5mm shares at an average price of $25 in 2007, and has repurchased an additional 4.5mm shares at an average price of $20 so far this year. While it held off repurchases in the third quarter given the uncertain industry conditions, the company recently announced it has resumed buying and has 5.5mm shares left in its authorization (10% of shares outstanding).
OTHERS
Why do we like SKYW more than the others? Actually, we own PNCL in larger size and a smaller position in RJET as well. We just felt that PNCL has been adequately addressed in three separate writeups on this site (in which we have participated in the most recent discussion), and RJET was well done by gatsby last year, so we decided to blaze the trail and introduce a new operator to the site’s members who may be unfamiliar with it.
Side note: if you happen to be a fan of Fairfax Financial Holdings and its CEO Prem Watsa (no doubt a controversial figure in investment circles), you may want to take a look at the regional operator Jazz Air up in Canada, whose largest shareholder is Fairfax (north of 10%, they have added to their stake within the past few months). At least that could potentially serve as another comfort factor for you with this business model. Jazz is set up as an Income Trust fund though, and as we have no familiarity with those we have stuck to our simple knitting here; there could be different factors at play with that.
RISKS
Foremost on any investor’s mind at present is figuring out whether a business can survive the potentially epic recession we’ve commenced. We would venture the argument that it was not merely the mild degree of the 2001 recession that enabled a regional like SKYW to survive, but the structure of the business model itself. While a severe recession could indeed bring about temporary pain, we would argue that even one far more severe than the mild downturn of 2001 would still merely dent, but not fatally wound, this business. Once again, try to think back to investor worries about air travel in the aftermath of the unprecedented events of 9/11, and ask yourself whether you would really consider the prospect of severe recession ahead as much worse (if at all) than the sentiment at that period. This business has faced great headwinds before and emerged in acceptable shape.
Given that the plight of major operators at the very least seems to strongly affect investor sentiment towards these stocks, a move in the oil price back to $120 or above would be detrimental to those major operators. In the same Jamie Baker piece we referenced earlier, his estimate is that the major airlines’ capacity cuts had gotten them in sync with a world of $120 oil, but if that level were to be breached again concurrent with the demand destruction we’re likely to see over the next year, we could well see a rash of bankruptcies across the major airline landscape. (That said, Baker is actually projecting record operating profits for major airlines in 2009 in the face of a recession.) We don’t want to focus too much on the relative health of the major operators in the near term, as we’ll note once again that the regionals have survived these bankruptcies in the past, but we acknowledge there is no telling what the stocks will do in the interim as irrational worries about these contracts surface yet again.
“This time is different” – ahh, the famous last words of finance. Perhaps they ring true for regionals, and the operating model is dead. On the Delta-Northwest merger call, management there commented that in Compass in Mesaba (the two owned regional subsidiaries), they had the “very best operators in cost structure,” and that their goal will be to bring regional margins down to better reflect those of the overall industry’s. If that is indeed true, then Delta cannot unilaterally negotiate changes in the contracts outside of bankruptcy. Say we reach that point, and then in bankruptcy Delta determines that its best interest is to tear up the contract and just allow SKYW to stake a massive unsecured claim. While a problem, we note that Delta would have tremendous difficulty reassigning all the aircraft from its single largest regional partner overnight. To wit, Delta was not even able to internally reassign the seven CRJ-900s it took back from MESA this fall, and awarded those aircraft to Pinnacle on an interim basis. Are we to believe that Delta would suddenly be able to reassign 162 50-seaters (not to mention an additional 69 aircraft of 70+ seats)? Odds are the parties would find some sort of amicable resolution, as any regional markets Delta shunned by dropping SKYW would be none too thrilled in welcoming them back (assuming there are other competitors in said markets). Further, SKYW still flies well over 100 aircraft for United, which has no internal regional subsidiary, so the likelihood SKYW completely loses that flying also seems remote.
Further, given that SKYW’s ownership costs are reimbursed by Delta, anything the latter does to impair SKYW’s credit profile – such as lowering margins to unacceptable levels – will only increase Delta’s cost in the contract by increasing SKYW’s ability to obtain credit.
We have seen no proof from any party that shows that a major is able to conduct regional operations more profitably than the outsourced operators, though. The historical record to this point is fairly clear that the majors have not been able to maintain the same cost structure with wholly-owned regionals as well as the independent regionals. These regionals benefit from lower labor costs (a big part of it, to be sure, though one whose gap is shrinking somewhat), and lower costs to manage a less-diverse fleet (which, for instance, minimizes transition/re-training costs for pilots moving up the ladder upon a single pilot’s retirement). The argument that the majors are more cost competitive now and thus have little use for regionals is not a new one, either. We can go back as far as the 1st quarter 2003 SKYW earnings call (as far back as we can get transcripts on Bloomberg) to see the following question: “There has [sic] been some people out there claiming that with the new rates that the mainline airlines have now, the new cheaper pilot rates, that they won’t need RJs [regional jets] so much in the future…[will you] address that?” Management responded as is typical, that the record shows companies like SKYW can provide lowest-cost service. So this was a concern five and a half years ago, prior to multiple industry bankruptcies and union negotiations since then, and yet see how those fears turned out by reviewing the operating statistics we posted above. We are not saying it is zero risk, just that some perspective is warranted.
Reduced utilization – this is already happening, but there are stated minimums in the contracts below which SKYW’s reimbursement levels increase.
Financing risk – SKYW actually has obtained full credit commitments for incoming aircraft from export credit agencies such as Export Development Canada. Currently the leveraged lease market is dead, as management indicated on the most recent earnings call, so SKYW is being forced to use a bit more debt financing than it would prefer. It is likely, though, that one day credit market conditions will return to normal and capital will be flowing again, enabling SKYW to more freely use leases and their accordant tax benefits.
SKYW was forced to file a lawsuit vs DAL this year over what’s now about $33mm of irregular operating expenses that SKYW had to pay passengers for certain situations. SKYW felt it should be reimbursed this under the contract agreement, and DAL disagreed. This could add tension to the relationship (but again, DAL is already operating at the contractual minimums for flying).
Of the two subsidiaries, SkyWest Airlines and ASA, only the latter (about 1/3rd of the total SKYW employment base) is unionized. The former’s pilots actually voted against unionization in 2007. We suppose if Democratic efforts toward Card Check are passed, this could result in a move toward unionization here. However, we are not sure that will have a dramatically negative effect on the company, as the 2007 pilot vote seems to indicate that those employees by and large don’t really have a problem with the way management treats them.
Performance risk – shoddy performance by SKYW or ASA could result in termination of contracts. We believe we are being extremely well compensated for this risk.
CATALYSTS
Continued cash flow generation through the recession proves the company’s strength as it showed in prior recessions and after 9/11.
Recently announced resumption of buybacks at clearly undervalued levels will increase per-share value.
Massive windfall to the majors of $100 drop in crude more offsets the decreasing demand brought about by recession, leading to healthier major airline operations in 2009 and improved sentiment towards regionals.
Catalyst
Continued cash flow generation through the recession proves the company’s strength as it showed in prior recessions and after 9/11.
Recently announced resumption of buybacks at clearly undervalued levels will increase per-share value.
Massive windfall to the majors of $100 drop in crude more offsets the decreasing demand brought about by recession, leading to healthier major airline operations in 2009 and improved sentiment towards regionals.