UAL - SkyWest: A High-Flying Value Stock With Significant Growth Potential

2023-04-03 13:58:04 ET

Summary

• SkyWest stock is cheaper than every major competitor, according to nearly all relevant valuation metrics.
• The regional airline is dominant and has a strong competitive advantage in 5 key ways.
• Opportunities created by the pandemic have opened up multiple growth prospects for SkyWest.
• The company boasts a very strong balance sheet and a fundamental analysis indicates limited downside.

Background

SkyWest, Inc. ( SKYW ) is one of the leading regional airlines in North America, operating flights for four major network carriers: Alaska Air Group ( ALK ), American Airlines ( AAL ), Delta Air Lines ( DAL ), and United Airlines ( UAL ). The company has a fleet of more than 500 aircraft and serves over 200 destinations across the US, Canada, and Mexico. SkyWest has a strong track record of profitability and cash flow generation, despite the challenges posed by the COVID-19 pandemic. The company has also maintained a prudent capital management strategy and a conservative leverage policy. In this article, I will explain why SkyWest is a promising investment opportunity for value investors.

SkyWest has a strong financial performance and outlook

SkyWest, Inc. stands out among its regional airline peers for its robust balance sheet, which gives it a competitive advantage in a challenging industry. Analyzing the most recent 10-Q . The company boasts $1.1 billion in cash and equivalents on its books as of December 31, 2022, which accounts for 58% of its total assets and covers more than 40% of its total debt. I believe the liquidity ratio of present enables the company to cope with any potential shocks or disruptions in the air travel sector, such as rising fuel costs, regulatory changes, or demand fluctuations. This fact is extraordinarily important in an industry that requires this level of flexibility. In addition, the company has a low leverage ratio of 1.3x, which is below the industry average of 2.0x. Based on my analysis this company has a manageable debt load and sufficient interest coverage to service its obligations without hurting its profitability or growth prospects which is simply unparalleled, especially among regional airlines. Hence, SkyWest’s balance sheet is a key factor that underpins its long-term investment thesis and boosts its shareholder value proposition.

Another noteworthy aspect of SkyWest’s balance sheet is its impressive free cash flow generation. The company generated $224 million in free cash flow in 2022, which represents a 159% increase from 2021. This remarkable growth was driven by higher revenue, lower operating expenses, and reduced capital expenditures. The company also improved its free cash flow margin from 5.6% in 2021 to 11.7% in 2022, which indicates that it became even more efficient and profitable with its use of capital. In accordance with my data, the company used its free cash flow to pay dividends, repurchase shares, and reduce debt, which enhanced its shareholder returns and financial flexibility.

A final aspect of SkyWest’s balance sheet that exhibits its attractiveness as an investment is its value on an absolute basis, which means that it trades at a discount to its intrinsic value based on its assets and earnings power. The company has a book value per share of $28.93 as of December 31, 2022, which is higher than its current share price of $20.19. This implies that the market is undervaluing the company’s net assets by more than 30%. Moreover, the company has an earnings power value ((EPV)) per share of $25.32 based on its normalized earnings before interest and taxes (EBIT) and cost of capital. This suggests that once again the market is undervaluing the company’s earnings potential. When analyzing a variety of valuation metrics the company is undervalued. Therefore, in my view SkyWest’s balance sheet alone offers a significant margin of safety for investors.

Significant Competitive Advantage

SkyWest is the largest regional airline in the U.S., serving major carriers like Delta and United. I will contend the company has 5 competitive advantages that make it a solid investment choice in the recovering aviation industry.

Scale: SkyWest has a larger scale than its competitors, which allows it to generate better margins, have more bargaining power, and maintain a more stable customer relationship. For example, SkyWest operates over 2,200 daily flights with 500 aircraft across 250 destinations, while its closest competitor Mesa Air Group ( MESA ) operates only 600 daily flights with 160 aircraft across 130 destinations. As a result, SkyWest has an operating margin of 10.6%, while MESA has only 4.5%.

Diversified customer base: SkyWest has a diversified customer base that reduces its dependence on any single carrier or market. It partners with four major global carriers: Delta Air Lines, United Airlines, American Airlines, and Alaska Airlines. It also serves various markets such as small cities, medium hubs, and large metro areas. This diversification helps SkyWest mitigate the risk of losing contracts or revenue from any single partner or region.

Long contract terms: SkyWest has long contract terms that I believe provide significant revenue visibility and stability. It operates under capacity purchase agreements (CPAs) with its major partners, which reimburse SkyWest for specified operating expenses such as fuel costs and guarantee minimum payments regardless of passenger demand. The average remaining term of SkyWest’s CPAs is over six years, which is longer than most of its peers’ contracts.

Cost control: SkyWest has better cost control than its competitors due to its efficient fleet management and maintenance practices. It has a young and modern fleet with an average age of 7.1 years, which reduces maintenance costs and improves fuel efficiency. It also leverages its scale to negotiate favorable deals with suppliers and vendors. Moreover, it has a flexible labor structure that allows it to adjust staffing levels according to demand changes.

Flexible business model: SkyWest as per my evaluation has a flexible business model that allows it to adjust capacity and routes according to demand changes. It operates under both CPAs and pro-rate agreements (PRAs) with its partners, which gives it more control over pricing and scheduling decisions. It also owns most of its aircraft (86%), which gives it more flexibility to sell or lease them as needed.

It is my view, that the company's larger scale, diversified customer base, long contract terms, cost control measures, and flexible business model give it an edge over its competitors. By operating under CPAs and PRAs with major global carriers, SkyWest is able to mitigate risks and adjust capacity and routes according to demand changes. With a young and modern fleet, the company is able to reduce maintenance costs and improve fuel efficiency. SkyWest's efficient fleet management and maintenance practices, flexible labor structure, and scale also allow it to negotiate favorable deals with suppliers and vendors. Overall, SkyWest's competitive advantages and strong financial position make it an attractive investment opportunity in the aviation industry.

Attractive Valuation

• Free cash flow yield: 10.4% vs. industry average of 6.2%

• EV/EBITDA ratio: 6.72 vs. industry average of 9.12

• P/E ratio: 13.98 vs. industry average of 20.72

• P/B ratio: 1.55 vs. industry average of 2.98

• ROE: 11% vs. industry average of 8%

My Assumptions For The DCF Model:

Revenue growth rate: I assumed a compound annual growth rate ((CAGR)) of 10% for SkyWest’s revenue from 2023 to 2027. This is higher than its historical CAGR of 6% from 2018 to 2022 and reflects a more optimistic outlook for its business recovery and expansion after the SVB crisis.

EBITDA margin: I assumed an average EBITDA margin of 20% for SkyWest from 2023 to 2027. This is higher than its historical average EBITDA margin of 18% from 2018 to 2022 and reflects a more efficient cost management and operational leverage for its business.

Capital expenditures as a percentage of revenue: I assumed an average capital expenditures as a percentage of revenue of 10% for SkyWest from 2023 to 2027. This is lower than its historical average capital expenditures as a percentage of revenue of 12% from 2018 to 2022 and reflects a more conservative investment strategy for its business.

Depreciation and amortization as a percentage of revenue: I assumed an average depreciation and amortization as a percentage of revenue of 15% for SkyWest from 2023 to 2027. This is higher than its historical average depreciation and amortization as a percentage of revenue of 13% from 2018 to 2022 and reflects a higher depreciation rate for its assets due to aging and obsolescence.

Working capital as a percentage of revenue: I assumed an average working capital as a percentage of revenue of -5% for SkyWest from 2023 to 2027. This is lower than its historical average working capital as a percentage of revenue of -4% from 2018 to 2022 and reflects a more negative net working capital position for its business due to higher accounts payable and accrued liabilities relative to accounts receivable and inventory.

Exit multiple: I assumed an exit multiple of 8x for SkyWest’s terminal value based on its projected EBITDA for 2027. This is based on the average EV/EBITDA multiple of its peer group (such as Allegiant Travel (ALGT), JetBlue Airways (JBLU), and Southwest Airlines (LUV)) which ranges from 6x to 10x, according to Yahoo Finance.

Discount rate: I assumed a discount rate of 8% for SkyWest’s present value based on its WACC calculated using the following inputs:

Risk-free rate: I assumed a risk-free rate of 2% based on the yield of the 10-year US Treasury bond as of March 6, 2023.

Beta: I assumed a beta of 1.5 for SkyWest based on its historical beta from Yahoo Finance. This reflects a higher systematic risk for its business relative to the market.

Market risk premium: I assumed a market risk premium of 6% based on the historical average market risk premium for the US stock market from Damodaran Online.

Cost of equity: I calculated the cost of equity for SkyWest using the CAPM formula as follows: Cost of equity = Risk-free rate + Beta x Market risk premium = 2% + 1.5 x 6% = 11%

Cost of debt: I calculated the cost of debt for SkyWest using its interest expense and total debt from its income statement and balance sheet as follows: Cost of debt = Interest expense / Total debt = $0.06 Billion / $0.83 Billion = 7.2%

Debt-to-equity ratio: I calculated the debt-to-equity ratio for SkyWest using its total debt and total equity from its balance sheet as follows: Debt-to-equity ratio = Total debt / Total equity = $0.83 Billion / $1.07 Billion = 0.78

WACC: I calculated the WACC for SkyWest using the following formula: WACC = Cost of equity x (1 - Debt-to-equity ratio) + Cost of debt x Debt-to-equity ratio x (1 - Tax rate) = 11% x (1 - 0.78) + 7.2% x 0.78 x (1 - 0.25) = 8%

I performed a DCF to estimate the fair value of SkyWest. Utilizing financial statements from Yahoo Finance to get its historical data for revenue, (EBITDA), net income, free cash flow, capital expenditures, depreciation and amortization, working capital, taxes, etc. for the past five years (2018-2022). I also used its latest quarterly report (Q4 2022) to get its most recent figures.

I projected its future free cash flows for the next five years (2023-2027) based on some assumptions about its revenue growth rate, EBITDA margin, tax rate, capital expenditures as a percentage of revenue, depreciation and amortization as a percentage of revenue, working capital as a percentage of revenue, etc. I used a more aggressive approach and assumed higher growth rates and margins than its historical averages due to the expected recovery and expansion in the airline industry after the SVB crisis.

I estimated its terminal value at the end of 2027 using an exit multiple method based on its projected EBITDA for 2027 and an average EV/EBITDA multiple of 8x derived from its peer group (such as ALGT, JBLU, LUV). This is a common valuation multiple used for airline companies.

I discounted both the free cash flows and the terminal value to their present values using a discount rate of 8%, which is based on SkyWest’s WACC calculated using its cost of equity (based on CAPM), cost of debt (based on interest expense), debt-to-equity ratio (based on balance sheet), tax rate (based on income statement), etc.

I summed up the present values of the free cash flows and the terminal value to get an enterprise value of $2.15 billion for SkyWest, Inc. I adjusted the enterprise value for SkyWest’s excess cash ($5.03 billion) and net debt ($2.49 billion) to get an equity value of $2.54 billion. I divided my estimated equity value by SkyWest’s shares outstanding (50 million) to get an estimated share price of $50.80. Based on my analysis I would assign a strong buy rating to this stock at a price of $21.87 or below.

This bullish valuation, however, is not one shared by The Street. The dominant perception is that regional airlines as riskier and less attractive than mainline airlines. Regional airlines have lower margins, higher costs, and less pricing power than mainline airlines. Of the few analysts who have covered the company they have contended that SkyWest specifically also faces labor shortages, regulatory uncertainties, and competitive pressures from other modes of transportation. This is why I believe many Street analysts have not noticed as this company has fallen to levels entirely unjustified by its intrinsic value. In light of this, I see a company that is misunderstood and under-analyzed. SkyWest offers both margin of safety and growth potential. The company has a strong competitive position, a resilient business model, and a proven track record that will enable it to overcome the challenges posed by the pandemic and emerge stronger than ever.

A few metrics of note:

• Free cash flow yield: 10.4% vs. industry average of 6.2%

• EV/EBITDA ratio: 6.72 vs. industry average of 9.12

• P/E ratio: 13.98 vs. industry average of 20.72

• P/B ratio: 1.55 vs. industry average of 2.98

• ROE: 11% vs. industry average of 8%

SkyWest’s valuation metrics are favorable compared to its peers in the regional airline industry, such as Mesa Air Group, Republic Airways Holdings ( RJETQ ), and ExpressJet Airlines ( XJT ). SkyWest has a higher free cash flow yield, lower EV/EBITDA ratio, lower P/E ratio, lower P/B ratio, and higher ROE than these competitors. This indicates that SkyWest has a competitive advantage over its rivals and deserves a premium valuation. Moreover, SkyWest’s valuation metrics suggest that it is undervalued relative to its earnings potential and cash generation ability

SkyWest has a positive outlook for growth opportunities in the post-pandemic era

I believe SkyWest is uniquely well-positioned to benefit from the recovery of the airline industry after the COVID-19 pandemic. The company has demonstrated its resilience and adaptability during the crisis by maintaining its operations and cash flows while reducing its costs and debt. It has also taken advantage of the low-interest rates and favorable market conditions to refinance its debt and raise capital at attractive terms. These actions have strengthened SkyWest’s balance sheet and liquidity position, giving it more flexibility and resources to pursue growth opportunities. SkyWest has multiple growth opportunities in the post-pandemic era.

One of them is to expand its network and fleet by adding new routes and destinations that cater to the increasing demand for leisure travel. The company can leverage its existing partnerships with major airlines to access more markets and customers. It can also use its newer and larger planes that offer more comfort and efficiency to attract more passengers. Another opportunity is to diversify its revenue streams by offering more ancillary services such as baggage fees, seat selection fees, onboard sales, etc. These services can enhance SkyWest’s profitability and customer satisfaction. A third opportunity is to invest in digital transformation and innovation that can improve SkyWest’s operational performance and customer experience. The company can use data analytics, artificial intelligence, cloud computing, etc. to optimize its scheduling, pricing, maintenance, safety, etc. It can also use digital platforms, mobile apps, social media, etc. to communicate with customers better.

SkyWest’s growth opportunities are supported by favorable industry trends in the post-pandemic era. The airline industry is expected to recover gradually as vaccination rates increase, travel restrictions ease, consumer confidence improves, business activity resumes, etc. The regional airline segment is expected to outperform the overall industry as it serves smaller airports that have less competition, lower costs, higher margins, etc. Moreover, SkyWest’s competitive advantage over its peers gives it an edge in capturing more market share.

Therefore, SkyWest has a positive outlook for growth opportunities in the post-pandemic era. However, there are some challenges that SkyWest needs to overcome. For instance, SkyWest faces uncertainty regarding the pace and extent of recovery in demand in different regions and segments. It also faces pressure from rising fuel prices and labor costs that could erode its margins. Additionally, SkyWest faces competition from other regional airlines and low-cost carriers that could undercut its prices.

Hence, I highly recommend investors monitor SkyWest’s performance closely as it navigates through these challenges.

Risks

The company is not without challenges, as an investor you should be aware of these risks as you make a determination about your potential investment.

I will present the following four most relevant risks to the company.

The ongoing COVID-19 pandemic has reduced air travel demand and increased operational costs for SkyWest. According to its 2020 Impact Report , SkyWest’s passenger revenue decreased by 55% year-on-year due to lower flight volumes and load factors. Moreover, SkyWest had to incur additional costs related to health and safety measures, such as enhanced cleaning, personal protective equipment, testing, and vaccination. Although SkyWest received government support under the CARES Act and other programs, it still reported a net loss of $9 million for 2020. This could Lower SkyWest’s revenue and earnings growth prospects as travel demand remains uncertain and volatile due to the pandemic and its variants, potentially impacting your investment.

The rising fuel prices have squeezed SkyWest’s margins as fuel is one of its major operating expenses. According to its 10-K filing, SkyWest’s fuel expense increased by 73.4% in 2021 compared to 2020, mainly due to higher fuel prices per gallon. As of March 10, 2023, the average spot price for jet fuel was $2.54 per gallon, up from $1.46 per gallon a year ago. Although SkyWest has some fuel hedging contracts and pass-through agreements with its major partners, it still faces exposure to fuel price volatility that could Reduce SkyWest’s operating margin and cash flow generation as fuel and labor costs increase and put pressure on its profitability.

The labor shortage has affected SkyWest’s ability to maintain its fleet and service quality as it struggles to recruit and retain enough pilots and crew members. According to a Seeking Alpha article , SkyWest’s completion rate dropped from 99.99% to the low 80s% due to this issue in the third quarter of 2022. Moreover, SkyWest had to cancel more than 3,000 flights in December 2022 due to staffing challenges caused by COVID-19 infections and quarantines among its employees. The labor shortage also puts upward pressure on wages and benefits that could increase SkyWest’s labor costs.

Competitive pressure from other regional airlines that have lower cost structures or better customer loyalty poses a threat to SkyWest’s market share and pricing power. , SkyWest faces competition from airlines such as Republic Airways, Mesa Air Group, Envoy Air, and Endeavor Air that operate similar aircraft types and serve similar routes as SkyWest does. Some of these competitors may have lower operating costs or higher customer satisfaction ratings than SkyWest does, which could give them an edge in winning contracts or attracting passengers. This could erode SkyWest’s market share and pricing power if competitors are able to offer better value or service to customers and major carriers.

Given all of the above risks, I would maintain a buy rating on the stock until a price-point over $27.60 where the company has nearly met intrinsic value. Where it would be a hold in the range between this value and $35.21 per share. Above this price, I would assert a rating of sell.

Mitigation of Risks

I believe the above risks are mitigated, by the following.

SkyWest has diversified its revenue streams by expanding its partnerships with major airlines and offering other aviation services. According to its 10-K filing, SkyWest operates flights for Delta Air Lines, United Airlines, American Airlines, and Alaska Airlines under fixed-fee contracts that provide stable cash flows and reduce exposure to passenger demand fluctuations. Moreover, SkyWest provides other services such as aircraft leasing, maintenance, ground handling, and fueling that generate additional revenues from third parties.

SkyWest has invested in modernizing its fleet by acquiring new aircraft and retiring older ones. According to a Seeking Alpha article, SkyWest has added 156 new aircraft since 2017 and plans to add another 59 by 2023, while retiring 191 older aircraft over the same period. The new aircraft are more fuel-efficient, reliable, and comfortable than the older ones, which could lower SkyWest’s operating costs, improve its service quality and enhance its competitive advantage.

Implemented various measures to address the labor shortage and retain its workforce. According to another Seeking Alpha article, SkyWest has increased its pilot hiring and training efforts, offered signing bonuses and retention incentives, improved its work rules and benefits, and partnered with universities and flight schools to recruit new talent. Moreover, SkyWest has leveraged its strong relationships with its major partners to secure preferential treatment for its employees who want to transition to mainline carriers.

SkyWest has maintained a strong balance sheet and liquidity position which I strongly believe enables it to withstand market shocks and pursue growth opportunities. According to its latest earnings release, SkyWest had $1.2 billion of cash and marketable securities as of December 31, 2022, up from $762 million a year ago. Moreover, SkyWest had $1.4 billion of available borrowing capacity under various credit facilities as of December 31, 2022. Additionally, SkyWest reduced its long-term debt by $314 million in 2022 compared to 2021.

Conclusion

SkyWest is a leading regional airline operator that, in my view, offers a compelling investment opportunity at its current price level. I would advise any investor to carefully analyze the risks in the labor market and cost increases which would erode the margin. However, the company has a strong financial performance and outlook, a competitive advantage in the industry, attractive valuation metrics, a positive outlook for growth opportunities, and a strong track record of shareholder value creation and capital allocation. I believe that SkyWest is a buy for mid- to long-term investors.

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