Republic Airlines RJET - Posted on Sum Zero 2/8/2010

Sometimes, in the rubble of hated industries lie companies at valuations where holding your nose and pulling the trigger can be handsomely rewarded. We can all agree that the airline industry has been a destroyer of capital, has a propensity for irrational competition, and has a major input, fuel, which is highly volatile. Within the airline industry, Republic Airlines is a “special situation” that has done a poor job communicating their “story”. Before we get into the details, here are a couple of tidbits. The shares now trade at $4.85 per share which is less than 1/3 of book value, the company has no major debt maturities in 2010 and $9 per share in cash (a little over $4 per share is restricted for credit card holdbacks).

THE BUSINESS - Republic Airways (RJET) offers scheduled passenger service on approximately 1,600 flights daily to 121 cities in 44 states, Canada, Costa Rica, and Mexico under branded operations at Frontier, Midwest, and through fixed-fee airline services agreements with five major U.S. airlines. The fixed-fee flights are operated under an airline partner brand, such as American Connection, Continental Express, Delta Connection, United Express, and US Airways Express. The airlines currently employ approximately 11,000 aviation professionals and operate 288 aircraft.


Republic Airlines has been profitable for 31 straight quarters and 33 of 35 years of operation. Until 2009 Republic’s history as a public company was primarily that of a successful and profitable regional airline operating flights on behalf of the “major” airlines on a fixed fee basis. Like other regional airlines, Republic has a better cost structure than the major airlines and is able to arbitrage the cost difference, and allow the majors to keep the plane lease liabilities off of their balance sheets. On the fixed fee business, Republic gets paid a set fee for operating the flight, plus the cost of fuel, regardless of how many seats are sold on the flights. The result is that a fixed fee airline is a much lower risk airline without the volatility of fuel prices, changes in consumer demand, and fare wars. In the past five years, one of the biggest risks for Republic Airlines as a fixed fee operator of flights on behalf of the majors has been the financial viability of Republic’s partners. The fixed fee business is a stable and attractive business, until a partner goes into bankruptcy voiding the contract and Republic is left with expensive idle planes and no simple way to redeploy them. As a result, regional airlines such as Republic and Pinnacle Airlines have been diversifying and adding “Branded” operations. For these flights, Republic operates like a conventional airline taking responsible for the booking of the reservations and assumes both demand risk (they have to sell the seats) as well as responsibility for all fuel related expenses. The branded operations are higher risk, but also provide an outlet to redeploy aircraft in the event that a fixed fee customer such as United goes into bankruptcy.


FRONTIER SOLID ACQUISITION NOT RELECTED - In the second half of 2009, Republic acquired two “branded” operations, Frontier and Midwest. The two situations were quite different. Frontier was a profitable airline. Frontier was forced into bankruptcy through a combination of $140 oil and their credit card processor with very little warning instituting a 100% holdback on all credit card sales until after the completion of travel. Frontier used the bankruptcy process to restructure and based on their monthly filings during bankruptcy became quite profitable. During a horrible consumer recession, in the first nine months of 2009, Frontier generated $80M in pretax earnings (excluding bankruptcy and one time charges). Through Sept 2009 Frontier had 10% pre-tax operating margins.


The Frontier acquisition closed on October 1st and none of the operating results are included in Republics results YTD. However, the Frontier acquisition on a normalized basis could have a substantial impact on Republics earnings. A little back of the envelope math, Frontier will do $1.3B in revenue in 2010, let’s assume that in 2009 even though there was a consumer recession, the 10% operating margins were peak because of lower fuel prices and perhaps the company delayed maintenance (there is not a consensus on this point) – and that margins should be 6%. At 6% margins and a 37% tax rate – Frontier would generate $1.40 per share in earnings. At 3% margins it would generate $.70 (remember this is a $5 stock and the core fixed fee business generates in excess of $1 per share). At 10% operating margins Frontier would generate over $2.30 in earnings. As a point of reference South West had operating margins below 3% in 2009 and average operating margins of 7.5% from 2005 through 2008. In the short term results will be depressed because there are restructuring charges related to moving Frontier front office operations from Denver to Indianapolis. On the back end, there are tax breaks that should enhance profitability.


MIDEWEST AIRLINES - The second branded acquisition that Republic made is not as attractive as Frontier. Republic purchased Midwest Airlines for $31M plus the assumption of $72M in debt. Unlike Frontier, Midwest was losing money and is a turnaround situation. Midwest has historically had a strong presence in Milwaukee, high customer satisfaction (rated #1 domestic carrier by Zagat survey), and commands a pricing premium. Unfortunately, Midwest has traditionally had a poor cost structure so despite getting more revenue per mile, they had substantially higher costs per mile - and no economies of scale. This has been a formula for losses. Republic is creating a “virtual airline”, keeping the Midwest name but stripping out the high cost structure. They have replaced all Midwest pilots with Republic pilots and mechanics at a 40% savings. They also intend to consolidate back offices and eliminate duplicate staffing at common airports They are attempting to layer in their lower cost structure while retaining the brand and the price premium. Unfortunately Republic/Midwest is attempting this strategy in the face of fierce competition in Midwest’s primary market of Milwaukee. Southwest has entered the market and increased capacity by 30%. Republic has indicated that Midwest will lose money in 2010 along with other carriers operating out of Milwaukee. Over the summer, before any of the cost savings measures or Southwest arrival, Midwest was losing approximately $8M per month.


NON CASH AND NON RECURRING CHARGES IMPACTING GUIDANCE - On Thursday the company provided an update to guidance at the Raymond James conference. The midpoint of the guidance was $.66 per share in 2010 EPS. This is still not a normalized earnings number. There are two moving parts for investors to be aware of, and thus creates the opportunity. Embedded in this number is $35M ($1/share) in purchase accounting costs related to the writeoff of goodwill from the Midwest acquisition. There are also restructuring charges related to integrating thinfs such as integrating IT systems and moving HQ to Indianapolis. So there is one dollar in non cash charges related to a purchase and non recurring restructuring costs. It takes little imagination to see $2/share in normalized cash flow for a company with $5 per share in unrestricted cash per share and $10 per share in total cash - with less than $3 per share in non asset backed debt.



RISKS: The bear case for Republic is almost exclusively focused on the branded business. There are four primary concerns.


1)Branded Business Kills the Fixed Fee Business - The branded business will hurt Republic’s chances of getting new business on the fixed fee side because they are becoming a direct competitor of their customers (Counterpoint – Republic still enjoys a significant cost advantage over the major carriers and no contract renews before 2013)


2)Branded Business Perpetually Underperforms - The branded business will perpetually lose money and offset the continued profits of the fixed fee business. (Counterpoint – Frontier was actually very profitable going into Republic and December traffic figures that were released were actual up y/y making a complete implosion unlikely. The fixed business has historically earned in excess of $1.40 per share. The company has guided to -2% to -2% Pre tax margins in 2010 with restructuring costs and integration costs in the front half and some savings realized in the back half. )


3)Execution - The skill set of running a branded business (scheduling, pricing, equipment deployment, and marketing) are not native to Republic since they were not required for the Fixed Fee business because the partners handle this roll. In addition, the senior leader of this initiative, Sean Menke, just left the company (Counterpoint – Sean Menke went from CEO of Frontier to running a portion of Republic and staying with the company would have required moving from Denver to Indianapolis. Clearly his departure is a negative and this is a legitimate risk but there is other talent within the company and the industry.)


4)Fuel Price Fluctuations – The company is partially hedged on the branded side of the business, but as a consumer of over 200M gallons of fuel/yr, the airline is clearly vulnerable to large swings in the cost of fuel. The company is15% hedged for 2010. Each $1 move in oil prices translates into $5.5M in additional costs (34.4M shares outstanding).


Catalysts –
•RENEGOTIATION OF CREDIT CARD HOLDBACK – The company currently has more than $6 per share in restricted cash which is being held back by their credit card processor. The company is in the process of renegotiating its processing agreement. Reducing the holdback to 50% would increase the non restricted cash per share to almost $6 per share (in excess of the current share price). The company does have $2.7B in debt, however all but $85M of the debt is asset backed aircraft debt.


•IMPROVED GUIDANCE – The company has several moving parts right now as it transitions from a fixed fee business to a blended business. Their guidance has been very imprecise as they have admitted they are still grappling with purchase accounting, the scope of the restructuring, and the impact of Midwest Airlines. The net effect is that in the absence of clear guidance, people have assumed the worst. For example, the Avondale analyst has modeled that Midwest will lose $100M (on rev of $400M – which is a slight acceleration of losses – pre any restructuring). In addition, he has modeled Frontier only being break even in 2010, even though it was profitable coming into Republic.


• STOCK BUYBACK/CAPITAL STRUCTURE - The company has indicated that it would like additional cash on its balance sheet making a large purchase of stock difficult. However, the company is selling at less than 35% of book value and has engines and other spare parts that it can consider selling to free up capital for share repurchases. Clearly at this valuation, repurchasing shares is one of the best uses of capital - as a company they repurchased over $100M in shares in 2007.

Variant View
My basic belief is that management is overwhelmed by the acquisition, the accounting, and the number of moving parts. I believe that they have given conservative EPS guidance that buries in non cash charges, one-time restructuring expenses, and back loads the cost saving/synergy so that investors have a poor picture of how the pieces fit together and what cash flow or normalized earnings will look like. Assuming management continues to behave rationally and does not let MidWest destroy profitability for years to come, Republic on a normalized basis in 2011 should earn in excess of $2/share and have a 50% reduction in the credit card holdback which would give them $7 per share in cash. Putting a six multiple on normalized earnings gets you a $12 stock (with $7 in cash).


The analyst from Avondale put out a report indicating that losses from Midwest would accelerate even though the cost structure will be completely revamped (Crews make 40% less under Republic). He has a company with a market capitalization of $170M losing a $100M on Midwest which only has $400M in revenue and the company indicated it would cost $30M to idle the planes. Perhaps he is correct and management will drive the company over a cliff, but RJET is trading at a significant discount to book, has a core fixed fee business which remains profitable, has numerous operating levers to pull, and a cost advantage over competitors. Management has been profitable for 31 quarters and 33 of 35 years if management can execute patience will be rewarded in this sub $5 stock.