Bob Mcadoo, Prudential Equity Group, LLC
Prior to the airline industry’s deregulation in 1978, independent operators of small propeller aircraft, in business to feed all the larger airlines in the nearest major hub, served hundreds of smaller communities. In the 1980s, as a means of capturing a larger share of these markets, the legacy airlines signed “code-sharing agreements” wherein the small-carrier flights would appear in the consolidated travel agent systems as if they were operated by the large legacy airline. Revenue collected was prorated according to a contractual formula between the large and small airline. Now 37- to 90-seat pure jets, termed “regional jets” (RJs), typically provide the service. RJs are usually flown by separate airlines, although some are wholly owned subsidiaries of major airlines. Virtually all of these arrangements between RJ operators and legacy airlines now provide that the legacy carrier pays the feeder airline a fixed amount per departure and per mile flown, regardless of the passenger load on board. The risk and reward for operating the flight is assumed by the major airline. The schedule and the fares charged are also under the control of the major. This has enabled smaller carriers to finance hundreds of millions of dollars in new RJs with relative ease because, unlike the big airlines, they are able to make money and to service the debt or lease. And the contracts require the major airline also to assume the full fuel-price risk.
This has meant that the RJs are making money today even as their larger partners struggle to stay afloat. Because RJs take none of the risks related to fuel prices, traffic, and fares, they are profitable. Even in today’s difficult air travel market, these airlines are earning 5%-12% operating margins. However, they do face the risks that their legacy partners could go bankrupt and seek contract modifications lowering the RJ’s profit margins or cease service altogether.
We’re Neutral On Prospects For The Regional Jet/Feeder Stocks.
We rate all five of the RJ/ feeder stocks we follow Neutral Weight (Figure 3):
■ We See Upside Potential And Little Risk In MAIR, Rated Neutral Weight With A $13 Price
Target. We view MAIR as an interesting value investment, with $8 per share in cash, no debt, and EPS we estimate at $0.66 this fiscal year (ending March). MAIR Holdings has two subsidiaries: Mesaba Airlines operates prop-jet aircraft and RJs under contracts with Northwest Airlines, and Big Sky Transportation is a small prop-jet operation wherein MAIR takes the risk of fuel, ticket prices, and traffic levels. Big Sky represents less than 3% of MAIR’s total capacity. Unlike most airline stocks (arguably because of its cash per share), MAIR did not fall dramatically during the recent run-up in oil prices but generally traded between $8 and $9, and only recently climbed toward $10 as the price of oil dropped back to the low $40s. Consequently, we see little downside risk in the investment and, given MAIR’s cash and securities per share, possibly substantial upside potential.
■ We Like Mesa Air Group’s Opportunistic Management; We Also Rate This Stock Neutral Weight With A $13 Price Target. MESA flies RJs under contract for United, US Airways, and America West. Its shares have been pressured at times because two of its partners are in bankruptcy. With 57 RJs assigned to bankrupt US Airways, MESA would need to find a new contract for these jets or operate them as an independent if US Airways were to cease operations. MESA management is among the most aggressive and creative in seeking new business opportunities, however, and would likely have alternative uses for the aircraft if US Airways stopped flying. MESA once attempted a takeover of FLYi that was blocked in court; FLYi’s current difficulties may create an opportunity for MESA in the future. Several years ago, MESA profitably participated as an investor in the America West bankruptcy. With $200 million in cash and in light of the industry’s current difficulties, opportunistic creative ventures may be forthcoming.
■ Pinnacle Airlines’s Capacity Growth May Have Peaked—Our Target Price Is $16. Pinnacle’s primary business is the operation of 44- and 50-seat regional jet aircraft under a long-term contract with Northwest Airlines. Between now and fall 2005, Pinnacle’s fleet is expected to grow to a maximum of 139 aircraft, but any future growth would depend on renegotiation of an agreement with Northwest’s pilots. With Northwest assuming all the risks of fuel prices, lack of traffic, and/or inadequate fare levels, Pinnacle generally is paid a rate that targets an operating margin of 10% regardless of fuel price. Even so, PNCL shares were hit earlier this year when oil prices climbed, as investors seemingly lumped all airlines together. As oil prices have fallen back, PNCL has climbed back toward its all-time high. We doubt PNCL will outperform the rest of the airline stocks from here, with no capacity growth in sight.
■ Republic Airways Is A Low-Cost Feeder Structured To Stay That Way—Launching With A Neutral Weight Rating And $14 Price Target. Republic Airways Holdings is a holding company comprising Republic Airlines, which operates 70-seat Embraer E170 aircraft, and Chautauqua Airlines, operator of 37- and 50-seat Embraer ERJ aircraft. Republic’s controlling shareholder owns approximately 75% of the outstanding shares. Delta Air Lines owns warrants for approximately 12% of Republic Airways. Republic flies for United, US Airways, and Delta—arguably the three weakest of the legacy carriers. Although it is difficult to compare RJ operators because of variations in contracts, Republic is likely the lowest-cost (or nearly so) operator among the feeder airlines. The shares will likely appreciate as industry conditions improve, but we believe the stock market overreacted to the modestly positive news of recent changes in its contract with Delta.
■ SkyWest Inc. Is The Strongest Feeder For The Weakest Legacies—Rated Neutral Weight With A $20 Target. SkyWest’s primary business is to operate 50- and 70-seat regional jet aircraft as well as 30-seat EMB-120 prop-jet aircraft under long-term contracts with Delta Air Lines and United Airlines. It also operates nine EMB-120 aircraft for Continental Airlines. Under these contracts, SkyWest is relieved of fuel price, fare, and passenger traffic risks, and therefore has been profitable when its partners were not. The company plans to add 20 RJs through mid- 2005, after which it has no specific growth plans. In spite of its earnings, SKYW shares were hurt by Delta bankruptcy fears; when Delta continued to fly, the shares rebounded to nearly their 52-week high. Given the current higher share price and no growth potential, we don’t see SKYW outperforming other airline stocks in our coverage universe.
Prior to the airline industry’s deregulation in 1978, independent operators of small propeller aircraft, in business to feed all the larger airlines in the nearest major hub, served hundreds of smaller communities. In the 1980s, as a means of capturing a larger share of these markets, the legacy airlines signed “code-sharing agreements” wherein the small-carrier flights would appear in the consolidated travel agent systems as if they were operated by the large legacy airline. Revenue collected was prorated according to a contractual formula between the large and small airline. Now 37- to 90-seat pure jets, termed “regional jets” (RJs), typically provide the service. RJs are usually flown by separate airlines, although some are wholly owned subsidiaries of major airlines. Virtually all of these arrangements between RJ operators and legacy airlines now provide that the legacy carrier pays the feeder airline a fixed amount per departure and per mile flown, regardless of the passenger load on board. The risk and reward for operating the flight is assumed by the major airline. The schedule and the fares charged are also under the control of the major. This has enabled smaller carriers to finance hundreds of millions of dollars in new RJs with relative ease because, unlike the big airlines, they are able to make money and to service the debt or lease. And the contracts require the major airline also to assume the full fuel-price risk.
This has meant that the RJs are making money today even as their larger partners struggle to stay afloat. Because RJs take none of the risks related to fuel prices, traffic, and fares, they are profitable. Even in today’s difficult air travel market, these airlines are earning 5%-12% operating margins. However, they do face the risks that their legacy partners could go bankrupt and seek contract modifications lowering the RJ’s profit margins or cease service altogether.
We’re Neutral On Prospects For The Regional Jet/Feeder Stocks.
We rate all five of the RJ/ feeder stocks we follow Neutral Weight (Figure 3):
■ We See Upside Potential And Little Risk In MAIR, Rated Neutral Weight With A $13 Price
Target. We view MAIR as an interesting value investment, with $8 per share in cash, no debt, and EPS we estimate at $0.66 this fiscal year (ending March). MAIR Holdings has two subsidiaries: Mesaba Airlines operates prop-jet aircraft and RJs under contracts with Northwest Airlines, and Big Sky Transportation is a small prop-jet operation wherein MAIR takes the risk of fuel, ticket prices, and traffic levels. Big Sky represents less than 3% of MAIR’s total capacity. Unlike most airline stocks (arguably because of its cash per share), MAIR did not fall dramatically during the recent run-up in oil prices but generally traded between $8 and $9, and only recently climbed toward $10 as the price of oil dropped back to the low $40s. Consequently, we see little downside risk in the investment and, given MAIR’s cash and securities per share, possibly substantial upside potential.
■ We Like Mesa Air Group’s Opportunistic Management; We Also Rate This Stock Neutral Weight With A $13 Price Target. MESA flies RJs under contract for United, US Airways, and America West. Its shares have been pressured at times because two of its partners are in bankruptcy. With 57 RJs assigned to bankrupt US Airways, MESA would need to find a new contract for these jets or operate them as an independent if US Airways were to cease operations. MESA management is among the most aggressive and creative in seeking new business opportunities, however, and would likely have alternative uses for the aircraft if US Airways stopped flying. MESA once attempted a takeover of FLYi that was blocked in court; FLYi’s current difficulties may create an opportunity for MESA in the future. Several years ago, MESA profitably participated as an investor in the America West bankruptcy. With $200 million in cash and in light of the industry’s current difficulties, opportunistic creative ventures may be forthcoming.
■ Pinnacle Airlines’s Capacity Growth May Have Peaked—Our Target Price Is $16. Pinnacle’s primary business is the operation of 44- and 50-seat regional jet aircraft under a long-term contract with Northwest Airlines. Between now and fall 2005, Pinnacle’s fleet is expected to grow to a maximum of 139 aircraft, but any future growth would depend on renegotiation of an agreement with Northwest’s pilots. With Northwest assuming all the risks of fuel prices, lack of traffic, and/or inadequate fare levels, Pinnacle generally is paid a rate that targets an operating margin of 10% regardless of fuel price. Even so, PNCL shares were hit earlier this year when oil prices climbed, as investors seemingly lumped all airlines together. As oil prices have fallen back, PNCL has climbed back toward its all-time high. We doubt PNCL will outperform the rest of the airline stocks from here, with no capacity growth in sight.
■ Republic Airways Is A Low-Cost Feeder Structured To Stay That Way—Launching With A Neutral Weight Rating And $14 Price Target. Republic Airways Holdings is a holding company comprising Republic Airlines, which operates 70-seat Embraer E170 aircraft, and Chautauqua Airlines, operator of 37- and 50-seat Embraer ERJ aircraft. Republic’s controlling shareholder owns approximately 75% of the outstanding shares. Delta Air Lines owns warrants for approximately 12% of Republic Airways. Republic flies for United, US Airways, and Delta—arguably the three weakest of the legacy carriers. Although it is difficult to compare RJ operators because of variations in contracts, Republic is likely the lowest-cost (or nearly so) operator among the feeder airlines. The shares will likely appreciate as industry conditions improve, but we believe the stock market overreacted to the modestly positive news of recent changes in its contract with Delta.
■ SkyWest Inc. Is The Strongest Feeder For The Weakest Legacies—Rated Neutral Weight With A $20 Target. SkyWest’s primary business is to operate 50- and 70-seat regional jet aircraft as well as 30-seat EMB-120 prop-jet aircraft under long-term contracts with Delta Air Lines and United Airlines. It also operates nine EMB-120 aircraft for Continental Airlines. Under these contracts, SkyWest is relieved of fuel price, fare, and passenger traffic risks, and therefore has been profitable when its partners were not. The company plans to add 20 RJs through mid- 2005, after which it has no specific growth plans. In spite of its earnings, SKYW shares were hurt by Delta bankruptcy fears; when Delta continued to fly, the shares rebounded to nearly their 52-week high. Given the current higher share price and no growth potential, we don’t see SKYW outperforming other airline stocks in our coverage universe.
