SKYW - SkyWest Navigates Well Its Many Challenges

2023-08-31 12:15:34 ET

Summary

• SkyWest reported better-than-expected Q2 2023 financial results, with EPS of 35 cents and revenue of $725 million.
• Despite being a regional airline, SkyWest has seen a significant increase in stock performance, up 164% YTD.
• SkyWest faces challenges such as a pilot shortage and pressure to retain service to small cities, but has strategies in place to address them.

SkyWest Inc (SKYW) reported its second quarter 2023 financial results on July 27, 2023, noting that it recorded EPS of 35 cents (which beat analyst expectations by 61 cents/share) and revenue of $725 million (which beat estimates by almost $18 million). SKYW stock has fallen 1% over the past month but is still, by far, the best performing U.S. airline stock year to date, chalking up a 164% increase YTD and 127% in the past six months. Those types of stock increases would grab all kinds of headlines for much larger companies but SKYW only has a market cap of $1.76 billion and is, after all, an airline. Long recognized for being classed with the best-run U.S. airlines, SkyWest delivered results that were beyond what many analysts expected. In order to determine if it is worth jumping on this stock, we need to understand SkyWest's business as well as its challenges and strategies in order to determine if there remains upside in the stock. First, we need to understand SkyWest's business model.

SkyWest's Business

Although a U.S. airline, SkyWest operates in a unique position among airlines. SkyWest is a regional airline, operating the Embraer 170/175 and Mitsubishi Regional Jet (formerly Bombardier) 200/700/900, seating from 50-76 passengers. SkyWest's business is operated largely on behalf of the four U.S. major airlines that use contracted regional jets, Alaska (ALK), American (AAL), Delta (DAL), and United (UAL). SkyWest is the largest regional airline in the United States and competes predominantly with Mesa (MESA) and privately held Republic Airways as well as wholly owned regional carriers at AAL, ALK and DAL.

SkyWest's beginnings can be traced to connecting smaller cities using the small aircraft to major airline networks; as the regional jet became commonplace, the majors used regional jets to build hubs including service to medium and larger cities in addition to their historic role of primarily serving small cities. The majority of SKYW's revenue comes from agreements with each of the four major U.S. airlines that buy the capacity that SKYW flies using a combination of aircraft that the major owns as well as aircraft which SKYW owns or leases. Under these agreements, the major airline determines where the SKYW aircraft operate, prices and sells the seats, and controls the service onboard with the major carrier assuming responsibility for significant portions of the costs typically including fuel. SKYW operates under its own government certificates and is compensated on a typically guaranteed basis for the life of the contract. Early in the pandemic as passenger travel was grounded, SKYW benefitted from agreements that provided compensation even though major airlines could not fill the flights and did not want to even spend money on fuel. SkyWest also operates charter flights under its own brand and obtains revenue from managing its own fleet and aircraft assets, some of which are leased to other carriers.

The following charts show the major carriers that SkyWest serves as well as the breakdown of SKYW revenue in 2Q2023.

SkyWest's Second Quarter 2023 Results

SkyWest's $0.35 earnings per share or $15 million was derived from $726 million in revenue, down $73 million or 9%. SKYW deferred $60 million in revenue because of changes in the amount of fixed vs. variable compensation for the present vs. future periods from its major airline partners. Operating expenses were down 2%, driven by lower production. Labor expenses were up 11% but were primarily offset by lower fuel, maintenance, and aircraft rental expenses. Block hours of flying decreased 15.6% while the number of departures decreased 12.9%, highlighting a reduction in the average flight length by 8% to 451 miles.

SkyWest's cash position has decreased by approximately 14% or $140 million YTD while its debt has been reduced by $100 million with the remaining reduction in cash accounted for by aircraft engines and spare parts.

SkyWest's Challenges

Shortly into the pandemic, it became clear that a significant pilot shortage was developing in the United States. Many major airline pilots retired and the pipeline of new pilots was significantly interrupted with fears about how long it would take for air travel demand to return. In historic macroeconomic shocks to the airline industry, there were large-scale employee furloughs or layoffs and there was significant expectation that would occur once again. However, massive U.S. government aid prevented the employment meltdown that could have taken place. As covid restrictions began to quickly fall, demand returned in force and it became clear that there were not near enough pilots to operate all of the aircraft that airlines needed in the skies.

Regional airline pilots were poached by large jet airlines (major and legacy/global carriers) as the large jet airlines tried to ensure they had adequate staffing. Since regional airlines had long been considered a step by many pilots enroute to a much more lucrative carrier at a large jet carrier, the challenge quickly turned to keeping regional jets staffed. A number of the major airlines began offering large incentives to recruit and retain pilots to try to slow the flood of pilots leaving regional airlines but the damage to regional carrier staffing was already set in motion and has still not been fully corrected. One of SKYW's key strategies (discussed further below) has been to retain personnel. It is important to note that there is also a growing shortage of aircraft mechanics and other personnel, including flight attendants who also see a career with a large jet airline as more lucrative and also providing more access to the world than what regional airlines can offer.

SKYW has also faced pressure from a number of small cities with which it has developed strong relationships. Although much of its capacity, including where it flies, is controlled by the major airlines that buy the majority of its capacity, SkyWest has long served some cities outside of its major carrier agreements. As the labor shortages have deepened and SkyWest has had to do all it can to staff its operations which are contracted by the major airlines, SKYW has had to cancel some of its own small city service.

SKYW is also being thrust into major aviation policy issues as they have never had to do. Not only is the U.S. considering extending the mandatory airline pilot retirement age from 65 to 67 years but is also considering a request from SKYW to reconfigure some of its smallest regional jets which are less attractive for airline service from their traditional 50 seat configurations to 30 seats. By reconfiguring those aircraft, SKYW wants to be able to operate under a different set of aviation rules that would allow, among other things, to use pilots with lower levels of experience as several small U.S. airlines do. Since pilot training is expensive and there are fewer options to gain flying experience - including in the military - the responsibility for pilot training is increasingly shifting to the regional airlines so that they can staff their own operations.

SkyWest's Strategies

While SkyWest's financial results are commendable given the challenges facing it, the ability for SKYW to grow its revenues and profits and ultimately its stock value will be driven by its ability to address its strategic challenges.

SkyWest's first priority is to gain productivity and efficiency as it uses its assets more efficiently and completes larger and larger portions of the contracted work it does for its major airline partners. SKYW notes that it has the ability to add from 25-35% more flying using its existing fleet primarily through increased utilization of its existing aircraft. Its ability to increase production is dependent on hiring and retaining more staff.

SkyWest's strategies include being an airline of choice for its employees. SkyWest has no unions but has hiked pay significantly in order to attract and retain talent. It added boarding pay for its flight attendants, following partner Delta whose flight attendants are also non-union. While U.S. airlines have traditionally not paid for the time that pilots and flight attendants spend on the ground with the aircraft door open, Delta and SkyWest have added boarding pay not only to ensure their boarding process is smooth and on-time, something that flight attendants facilitate, but also to highlight their ability to deliver benefits to employees that unionized flight attendants have not yet been able to obtain. SkyWest also has career development paths for many of its employee groups. SkyWest notes that it is reducing its attrition rate including among pilots and esp. first officers who often want to reach the minimum necessary hours and then move on to a large jet carrier.

One of SkyWest's greatest challenges is to retain its historic position as a provider of air transportation to small cities throughout the U.S. By being able to serve many small cities, SkyWest ensures its future. Major airlines are increasingly shifting flights to many medium sized cities to mainline jets such as the Airbus 220 and 319 and Boeing 717 and 737 but the sheer size of many small cities makes it difficult to serve those cities using small mainline jets; retaining service to small cities is a key strategy for ensuring SkyWest's future.

As noted above, SKYW is petitioning the FAA to operate its charter division under a set of rules that would give it greater flexibility than is allowed under part 121, the rules that currently govern SkyWest and all large jet U.S. airline operations. SkyWest says it intends to hire pilots that meet Part 121 requirements including a minimum of 1500 flight hours (or 1000 if trained in an FAA approved university flight training degree). Still, SKYW is pushing for SkyWest Charter to be able to operate under the relaxed rules in order to increase its service to small cities. Given that more than 70 U.S. cities have lost air service over the past three years, it is critical that the U.S. figures out how to find a solution not to just to the pilot shortage - which doesn't exist in other countries - but also to the ability to serve small cities.

SkyWest Charter is opposed by two of the largest U.S. airline unions, the Airline Pilots Association and the Association of Flight Attendants, both units of the AFL-CIO. It is not a surprise that both unions have come out strongly against SkyWest's proposal and guised their objections in the name of safety even though other airlines use the same rules. On the other side of the fence, public comments in favor of SkyWest's proposal come almost entirely from small cities.

A recent draft from the FAA indicates that the government is ready to side with unions over small town interests. This draft of a proposed rulemaking which would solicit public comments says:

The FAA is considering issuing a notice of proposed rulemaking that will seek comment on removing the exceptions for part 380 public charter operators from the definitions in 14 CFR 110.2 and delink FAA's safety regulations from DOT's economic regulations. If the FAA were to remove the exceptions, operators would then conduct public charter flights under the operating part applicable to their operation based on the same criteria that apply to all other non-part 380 operators, including the size and complexity of aircraft they operate and the frequency of flights. Were FAA to amend its regulatory framework, some operators conducting public charter operations would need to transition from operating under part 135 to part 121.

Given that SKYW proposes to exceed the FAA minimums for part 380, it isn't clear how the removal of exceptions would affect them but it is clear that they were planning to use them as part of their strategies to rebuild service to small cities.

Another key industry issue which would impact the airline industry and SkyWest is the proposal to allow commercial airline pilots to fly beyond the current mandatory age of 65 until 67 on domestic flights. The mandatory retirement age was 60 as recently as 20 years ago and created significant stagnation in pilot career progression. This time, the intent would be to keep more pilots in the air and to help alleviate the pilot shortage. Since regional airlines and low cost carriers are being most negatively impacted by the strong growth at the big 3 global carriers - each of which is hiring 1500-2000 pilots/year - increasing the pilot age might "buy" the industry a couple years for the supply of new pilots to catch up to the demands of global air travel and the pause of training during the covid era. Of course, the primary factor in advancing the pilot retirement age must be safety and there are concerns that while some pilots are certainly capable of flying longer, a higher percentage of the pilot workforce might end up on disability. Maintaining the most stringent pilot medical certification is difficult and it isn't clear that all current pilots are in the best health, particularly concerning mental health issues and veterans benefits according to a recent Washington Post article.

Since recent reports could cloud or delay efforts to raise the retirement age, it isn't clear how soon SKYW or other regional airlines could benefit but it is certain that, if the retirement age is changed, SKYW will disproportionately benefit with its staffing challenges.

SkyWest is being thrust into a number of major policy issues, each of which could benefit the company or make achievement of its goals more difficult. Given that there are multiple moving parts, it is difficult to assess the outcome until more can be definitively known. SkyWest has a long history of adapting well to changing environments and it is certain to do the same regardless of the outcome. More significantly, SKYW history and its positioning in the current regional airline industry make it likely that SKYW will benefit more than its competitors when all is considered.

SKYW Stock Assessment

Knowing SkyWest's financial performance, its challenges and strategies, and a general review of the industry, it is necessary to begin to draw some conclusions about the potential for SKYW stock.

Several stock charts comparing SKYW to various groupings of airlines provides particular insight. When compared to major airlines, SKYW over a 5 year horizon doesn't look like it is performing as well as larger airlines, most of which are dependent on the regional airline industry to execute the larger airlines' strategies. SKYW stock remained depressed until the last year when the entire airline industry began to recover financially post-covid. SKYW has grown faster than the large jet airline industry as a whole even compared to the big 3 global carriers which have seen the strongest revenue growth as international markets have reopened.

A comparison with low cost and ultra low cost carriers paints a very different picture. SKYW has performed much better than the low cost/ultra low cost carrier segments as those carriers have struggled under much higher costs, driven in part by the expensive labor agreements that the big 3 global carriers can afford and are necessary to attract workers in the tight labor environment. The airline industry right now is shifting toward more premium travel experiences, something low cost carriers cannot deliver. SKYW has performed very well compared to those carriers.

A comparison to MESA, one of the few other publicly traded regional carriers, makes SKYW look even more favorable. Mesa operates about one-third of the number of regional jets that SkyWest operates and has had to shift large portions of its operations from serving American to United as the former became increasingly dissatisfied with Mesa's service and value. United is providing significant financial support to Mesa but Mesa is operating much closer to the "survival" mode rather than to thriving with an eye to the future. Most of the rest of the U.S. regional airline sector is either privately held or operated as wholly owned subsidiaries of larger airlines so the contrast between MESA and SKYW highlights the difference in how well SKYW is run compared to its peers. It is still very possible that there will be strategic changes in the structure of the regional airline industry and SKYW is well positioned to be a player. SkyWest is well-positioned to be the last man standing in an industry that has a cloudy outlook for some players.

It is also clear that the big 3 - which are driving many of the changes in the industry right now - want a viable regional airline industry to remain. All 3 plus ALK see value in using regional airlines not just to serve small communities but to use regional jets to increase flight frequency to build their hubs. In short, the 4 airlines that use regional jets want the regional airline industry to come along and to ensure that they and their regional airline partners are able to survive and thrive in the current challenging environment.

Specific to SKYW stock, it does not currently pay a dividend but did pre-covid. DAL and LUV have both reinstated their dividends and it is likely that SKYW will once the regional jet industry is more stabilized.

SkyWest has clearly been able to navigate any number of the many strategic challenges that have been thrown at it over the past five years. However, the list of challenges is longer than ever and the resolution of some of them may take a couple of years.

As Seeking Alpha analysts, we don't get to create recommendations by time horizon but, if I had that option for SKYW, I would recommend a short term hold based on its recent runup and a medium to long-term buy.

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