2023-03-06 06:34:55 ET
Summary
- Harbor Diversified trades only slightly above a conservative estimate of liquidation value.
- While Q4 results have not been reported, I expect Harbor to earn 5-10% of its market cap in Q4.
- Harbor's new contract with American Airlines will allow Harbor to continue generating cash for the next two years.
- Significant uncertainty will be removed by the time Harbor reports its Q3 results in the back half of the year.
- Harbor's buyback program will allow them to buy back 2-5% of their shares before the company files its 2022 10-K.
Thesis
Harbor Diversified ( OTCPK:HRBR ) is the holding company of Air Wisconsin. Air Wisconsin is a regional air carrier based primarily out of Chicago. Regional airlines work in concert with major airlines via capacity purchase agreements. These agreements have the regional airline provide flights on behalf of major airlines. In exchange, the major airlines pay a base rate for the number of planes they have contracted and variable payments for the number of flights and hours flown on their behalf.
In the back half of 2022, HRBR announced switching their capacity purchase agreement from United ( UAL ) to American ( AAL ). No economics of the new deal were disclosed. This uncertainty caused an already unpopular and under-followed HRBR to sell off.
HRBR trades slightly above its liquidation value. The stock would be worth $1.96 if liquidated at the end of 2022 Q3. Even if we assume all the planes they own are worthless.
While HRBR has not reported Q4 results flight data is available for Q4. We can use this data to estimate earnings. Flight data indicates HRBR will have earned 5-15% of its market cap during Q4.
HRBR's new contract brings significant uncertainty on how much it will earn moving forward. But if we look at the motivation of the participants involved it should be profitable for HRBR.
The company has shown a willingness to buy back shares when they are cheap. HRBR could have bought back 2-5% of its shares when the 2022 10-K is filed.
I believe all of these factors add up to present an asymmetric opportunity. The downside is muted by liquidation value plus Q4 earnings which will cover the entire market cap. Several positive call options exist that can increase the value of HRBR above the liquidation value. Future positive developments will be amplified by buybacks.
Liquidation Value
HRBR is trading only slightly above a conservative estimate of its liquidation value. See below my adjustments to the Q3 2022 balance sheet to get to liquidation value. I'll explain the adjustments below.
[1] A large part of HRBR's equity is attributable to the airplanes it owns. The 63 CRJ-200s they own are quickly approaching the end of their useful life. Making estimates of their fair value difficult. Luckily HRBR is trading below its liquidation value even if we assume that airplanes are worth nothing. This is because the company's debt is secured by its planes and spare parts. The debt is non-recourse to HRBR. If we assume the planes are worthless we can remove all of the long-term debt from the balance sheet. This a conservative approach but one we can be sure is correct
[2]This line represents the company's municipal bonds they bought back.
[3]UAL is disputing $33M in payments made to HRBR. I don't know how this will play out so writing to $0 to be conservative.
[4] $2.5M of the convertible preferred shares are convertible into 16.5M shares of common. I'm converting these since they are in the money.
As noted already this is a conservative liquidation. The CRJ's could be worth more than the long-term debt or HRBR could win the dispute with UAL. Even under these conservative assumptions, we get a per-share liquidation price of only slightly below the current market price.
Q4 results
Q4 is complete but the 2022 10-K that would cover results for Q4 is not yet filed. We can use 3rd party flight tracking data from Q4 to estimate how much HRBR made in Q4.
Air Wisconsin is compensated along a few metrics. Airplanes under contract, block hours flown, and total flights. These all tie back to how many flights HRBR can schedule. While the correlation is not perfect, I use the number of flights as a proxy for the revenue HRBR earns.
For estimating normalized operating expenses I remove the federal payroll support program since that is nonrecurring. Operating expenses have been between $45M in $61M in the past two years.
Given the revenue estimates of $66M and operating expenses of $53M-$61M, I project HRBR makes $5M-$13M of operating income in Q4. Earnings should be even better than this since the company has an equity portfolio that tracks the broader stock market and the stock market was up between the end of Q3 and Q4.
Adding the operating income to my conservative liquidation value gets us to about today's stock price.
2023 and beyond
Where do we go from here? There is significant uncertainty around the new AAL contract. But remember we are playing with house money at this point. Any additional cash flow is upside since the stock is paid for with the balance sheet and Q4 earnings. I believe HRBR will operate economically for the next two years.
I expect HRBR to operate for at least 2 years. The new contract with AAL is for 5 years. But either side can terminate the agreement after two years. HRBR's favorable debt matures in 2025. HRBR may decide to simply hand the planes back to the bank and walk. The pilot shortage is expected to last for years . So AAL will need HRBR pilots for at least 2 years.
The deal will be economic for HRBR. AAL appears to have stolen HRBR from UAL. Leaving UAL with Mesa Airlines( MESA ). AAL was reportedly unhappy with MESA and moved first to change its regional partner. Why would HRBR jump at AAL's offer unless it was favorable? The pilot shortage will have given HRBR some leverage in negotiations. Major airlines have been willing to cover the cost of rising pilot wages for regional airlines in multiple cases in the past year. Including AAL recently giving HRBR a bulk payment to retain pilots . Management has shown to be shrewd financial players in the past. I don't think they would operate under a contract that loses them money.
Assuming HRBR can find pilots to fly, I don't see why they are not making money for the next two years. How much money is a harder question? But once again this is all upside.
After the next two years, the future is even murkier. I have my doubts about how much longer HRBR's current planes will be viable and the industry is moving away from CRJ-200s.
I see several possibilities past two years:
-
HRBR could squeeze a few more years out of their current planes.
-
HRBR could buy or lease some other cheap end-of-life planes.
-
HRBR could conduct a wind-down.
-
HRBR could be bought out by one of the major airlines to secure pilots.
In a real upside scenario, HRBR could continue to earn the same operating income in 2023 and 2024 as it did in 2022. I don't expect this, but the company would re-earn its market cap again in the next two years.
Attractive Buybacks
What gives this story juice is HRBR buying back shares when the shares have been cheap. Over the first 9 months of the year. HRBR bought in over 20% of its shares. This slowed at the end of Q3 as the company's share price rose and it burned through its cash.
The share price has come down since the end of Q3. Cash flow had been muted compared to their earnings because UAL was paying HRBR in notes. In the Q3 report, HRBR disclosed UAL had pre-paid $50M of non-contested notes during Q4.
By the time the company reports in March, the company will have $10M authorized under its repurchase plan. With more than enough liquidity to use all $10M. The volume of the stock is the limiting factor. I still expect them to have bought in 2-5% of the shares outstanding depending on how aggressive management is.
Risk - New contract is non-economic but HRBR continues to operate anyways
HRBR loses money on the new contract but continues to operate anyways. Management teams do not always act rationally from an economic perspective. Current insiders don't communicate much with investors, due to high insider ownership minority investors would be left with no recourse.
I don’t see this as likely. Management has a strong ownership interest. Executive pay is not excessive. The management appears to be good stewards of their capital given previous actions: buying back shares at low prices, using NOL to shield earnings, and turning a consistent profit in a hard industry.
Risks - Insiders unfriendly to minority shareholders
Management could do something against the interest of minorities. Management was forced into being a public company. They have not yet proved they are friendly to minority interests. While the company appears to be significantly undervalued insiders could keep this value for themselves.
A particular risk is that management may try a take-private bid at some price lower than the price we enter before the story has fully played out.
The buyback is one sign that they expect to include minorities. Why buy in shares if they don’t intend to let those shares share in the economics of the company? A negative action towards minorities would likely result in a lawsuit. Management already stands to gain a lot by running this company for all stakeholders.
A note on liquidity and pink sheets
Illiquid stocks and underfollowed stocks can offer a chance for smaller stock pickers like me to gain an edge. They also come with an increased risk of fraud.
Limited liquidity comes with its own set of challenges. Be sure to use limit orders if buying/selling. The liquidity can cause the stock to move around somewhat violently. If you are trying to establish a 7 figure position this stock is probably not for you.
Valuation
I'll paint a reasonable upside and downside scenario for HRBR. I assign no value to any cash earned beyond the next two years. This valuation does not account for share buybacks which could enhance the upside scenario.
Downside Scenario
HRBR earned $5M in Q4. HRBR can’t find enough pilots for the new contract or for other reasons the new contract is not viable. HRBR chooses to wind down.
Liquidation value plus $5 Million earned in Q4 gives us $2.04 per share.
Upside Scenario
HRBR earned $10M in Q4. Air Wisconsin wins pay dispute with UAL. HRBR continues to operate earning $40M in operating income per year in 2023 and 2024.
Liquidation Value plus $10M plus $33M plus $40M earned per year for the next two years discounted back at 10%. Gives us $3.75 per share.
Final thoughts
I like HRBR as an asymmetric bet. The downside is limited. We don't know how much the upside is worth but there are multiple paths to win. HRBR's aircraft could be worth more than its debt. HRBR could recover some money from its dispute with UAL. The new contract with AAL could prove to be more economic than I expect. HRBR could figure out how to survive for more than the next two years.
I also like that the next 9 months should provide catalysts. Earnings reports over the next 9 months should tell us how profitable the new contract is. The UAL dispute could also be settled in the next 9 months. This new information should cause the stock to recognize more value.
For further details see:
Harbor Diversified: Downside Already Covered, Catalysts On The Horizon