Description

Interested in a profitable airline with a sustainable capital stucture trading at 2.2x EBITDA, a P/E of 5.3x, and a 22% free cash flow yield?

World Airways is a storied company that has been around since 1947. Founded by Benjamin Pepper, the airline was bought by flamboyant Ed Daly in 1950, who focused the airline on its core business of non-scheduled passenger and cargo service, primarily for the United States military. The company entered the public mind largely on the back of its troop transport flights to Vietnam, and subsequently, its refugee airlifts out of South Vietnam.

After the Vietnam War, the company tried to parlay its success into scheduled passenger service, but union problems and deregulation led the company into financial distress. The latest iteration of the company is back to its roots – approximately 75% of its revenues are derived from military passenger and cargo traffic, with the balance from ACMI (Aircraft, Crew, Maintenance, and Insurance – otherwise known as “wet” lease) contracts to commercial carriers. (It is important to note that ACMI leases do not include fuel, which allows the fuel to be a pass through cost to customers. Military revenue also generally allows for fuel cost pass-through.)

Unlike its historic mistakes, however, the company is much better positioned to make sustainable profits in what is a fundamentally cyclical business. Rather than owning aircraft outright, it now leases all of its planes with relatively short duration terms. It also avails itself of the “power by the hour” market in which the company leases planes on “as-needed” basis. As would be expected, capacity utilization is a key driver of profitability in this business, and this leasing policy allows the company to maintain higher utilization rates.

Key Issues:

Two key issues facing investors in this company are the structure of the current plane leases, and the contracts with the airline employees. The company currently has 16 planes under lease, of which four are up for renewal or renegotiation this year at lower rates. While the exact duration of the balance of the leases is not public, the company has stated that a majority of the remaining leases have less than a five year term. This is important, as many of the current leases were signed in the 1998-2000 period where lease rates were substantially higher than today.

Labor relations are also critically important to the company. Recently, the company put out a press release announcing that the pilot’s union had voted down a contract extension to January 1, 2007. This was surprising, as the negotiating committee of the union had tentatively agreed to the contract and recommended approval to the broader union. After speaking with the company, it appears that both sides were caught off-guard and are currently talking to the rank and file pilots to understand the vote. However, it should be noted that the contract extension was primarily about work-rule changes that were cost-neutral, and company continues to feel that a contract that is cost-neutral can be achieved. The company renegotiated the flight attendants contract in 2003, and that contract is currently set until 2006. The last key employee group is the mechanics, who are not unionized.

Capitalization:

Before turning the financial results, it is important to spend a little time on the capital structure, which is not easy to decipher. The company had a significantly out-of-the-money convertible bond due in August of 2004, which was exchanged for a new convertible bond and cash in December of 2003. In addition, the company replaced an onerous bank facility with what is arguably an equally onerous ATSB guaranteed (Airline Transportation Stabilization Board) facility that was granted with significant warrants. In addition, the company has a sizable amount of in-the-money options and warrants. Offsetting this, the company has a significant amount of cash which is not required for use in the business. Assuming conversion of the in-the-money instruments, the effective capitalization of the company is as follows:

Capitalization
ATSB Tranche A Loan due 12/18/08 (Commercial Paper + 50bp) $27.0MM
ATSB Tranche B Loan due 12/18/08 (LIBOR + 1%) 3.0MM
Accrued Rents (effectively permanent financing from Boeing & ILFC)9.5MM
Total Debt $39.5MM

11.398MM Current Shares Outstanding @ $3.60 $41.0MM
6.949MM Shares Outstanding from Warrants & Options @ $3.60 $25.0MM
7.580MM Shares Outstanding from New Convertible Issuance @ $3.60 $27.3MM
Total Equity Capitalization $93.3MM

Cash on balance sheet ex redemption of old convert $38.5MM
Cash generated from issuance of Warrants & Options $13.0MM

Net Cash $12.0MM
Enterprise Value $81.3MM


It should be noted that this capital structure is highly sustainable, without any near-term maturities.

Valuation:

The only guidance officially issued by the company is for first quarter revenue of $110 to $120MM, and EBIT of $7.5MM to $8.5MM. Combining this guidance with last year’s results (ex the first quarter positive revenue impact of the US troop mobilization), the company should earn approximately $32MM in EBIT, and assuming a similar level of D&A, approximately $37MM in EBITDA, resulting in a EV/EBIT multiple of 2.5x and EV/EBITDA multiple of 2.2x. If one was to capitalize the lease expenses at a 7x multiple, which is arguably conservative in this low-plane cost environment, EBITDAR is $122.5MM against an EV of $679.8MM (assuming $85.5MM of airplane lease expense). This resulting EV/EBITDAR multiple is 5.5x.

On a net income and free cash flow basis, the multiples are even more compelling. Excluding interest on the convertible issuance, the effective interest rate of the debt is approximately 6.5%, resulting in annual interest expense of $2.6MM. The company will be a full-boat tax payer, so a 40% tax rate will yield approximately $17.6MM in net income after tax, or EPS of $0.68 per fully diluted share. At the current share price, this implies a P/E of 5.3x. If one was to exclude the $0.46 of net cash per share from this calculation, the P/E drops to 4.6x.

Since the company leases its fleet, capital expenditures are relatively minimal, approximating $5MM per year. Hence, the company is earning approximately $17.6MM in free cash flow as well, yielding the same multiples as P/E, or an effective yield per share (ex cash) of 21.8%.

Sustainability:

Clearly, these valuation numbers are incredibly cheap, and yet the stock has languished in the $3.00 - $5.00 range for the last six months, amidst a small-cap bull market. The primary explanation is likely that the market views the military-related nature of the company’s post-Iraq revenues as unsustainable, and that these numbers should be discounted as “peak” earnings. Currently, the U.S. military plan calls for 100,000 U.S. troops to remain in Iraq until at least 2006, and the military is building 14 permanent bases in the country to house these troops. This should sustain these levels of military revenue for at least two years, provided the military maintains its current policy of providing two weeks leave to troops on extended tours of duty. (This was the policy of the military during the Vietnam War.) While military revenues will decline post Iraq, several factors will mitigate the negative turn in revenues.

First, with the company’s lease structure, the company will be able to return planes as military revenues fall away, keeping its costs in line with what may be a shrinking top-line. Essentially, the U.S. withdrawal from Iraq will likely (and hopefully) not be a sudden and rapid one, which will give the company time to “right-size” its fleet.

Secondly, the company has demonstrated success in increasing the non-military component of its business. The company recently announced the wet-lease of one of its three MD-11 cargo carriers to EVA Air for a one-year cargo contract, which essentially will result in full utilization of this airplane.

Finally, the military business for World Airways is not a binary contract – as troop transport needs for the military decrease, the company will likely increase its “market share” vis-à-vis the government, as non-traditional military carriers (such as regularly scheduled U.S. carrier such as American and United) drop back from Civil Air Reserve utilization to focus on their core business.

Catalyst

WLDA should move towards fair value with several events. First, the ATSB facility will likely be fully paid by the end of the year, which should simplify the company’s capital structure and highlight the significant cash build. In addition, the company has now been profitable for two consecutive years, and hopefully will start to attract the attention of some analysts, particularly since the liquidity risk of a near-term debt maturity has been taken off the table. The company is allegedly talking to analysts and may have coverage soon. Finally, and while less likely but certainly possible, the company may attract interest from a financial acquirer, given its strong free cash generation.