2023-08-18 18:50:32 ET
Summary
- Harbor Diversified stock has strong support from it's net cash balance and management are buying back shares.
- Details of the American contract are unclear, but likely positive.
- There are risks primarily from arbitration outcomes and maybe capex spending, but risks appear skewed to the upside.
Harbor Diversified ( OTCPK:HRBR ) operates Air Wisconsin, which now flies under American Airlines livery. However, the stock's fairly interesting even before we get to the airline assets. The main risk to the company is an arbitration loss and the need for significant capex as the aircraft fleet ages, but the valuation is supportive such that even with these risks there appears to be upside.
Cash And Arbitration Assets
As of the most recent 10-Q for June 30, HRBR had the following assets. Note that here I am intentionally excluding the aircraft assets and associated revenue. Also, I am taking a relatively punitive interpretation of the United arbitration, in that HRBR could end up paying United funds currently on its balance sheet.
Cash and marketable securities | $157M |
Debt | -$53M |
Potential United arbitration risk (50% probability of $52M loss) - see next section for more detailed discussion | -$26M |
Total net liquid assets on an expected value basis | $78M |
Shares outstanding | 43.7M |
Value per share | $1.79/share |
So we have a relatively conservative valuation of $1.79/share relative to a stock price of $2.10/share. So there's 15% downside, but please remember this is an airline business and we haven't even valued their airline assets yet!
Arbitration - A Risk
This risk is noted in the 10-Q suggesting that HRBR could end up paying funds to United associated with potential wrongful termination of the contract.
"there can be no assurance that the Company will be able to generate sufficient cash flows from operations, or that additional funds will be available, to meet its future liquidity needs, particularly if Air Wisconsin receives an adverse determination in the arbitration with United."
Either way a judgement could come soon.
"Air Wisconsin expects the arbitrators will issue their decision and award in the fourth quarter of 2023."
Lastly, it's notable, perhaps, that United entered into arbitration. Presumably United have the larger legal team and wouldn't enter into arbitration they expected to lose, whereas HRBR did not chose arbitration.
"In October 2022, United initiated arbitration under the agreement."
In summary, there's not much to go on regarding the arbitration, but I've taken a relatively pessimistic assessment above and still the downside is contained, before any discussion of airline assets.
Of course, there's a chance that HRBR wins and receives funds from United and the language of the 10-Q remains optimstic, but given it's better to focus on margin of safety here we start from a more pessimistic assumption.
Airline Assets
Now let's discuss the value of aircraft. The company has a fleet of 64 regional aircraft with an average age of 20.8 years as of June 2023. The book value of the aircraft after depreciation is $25M and the book value of spare engines and rotable parts (things like landing gear) is $61M, for a total of $86M, with some chance the value of spare engines is understated as engines may hold their value for longer than depreciation schedules suggest.
Then in terms of the American contract's value (as another way to assess the value of the airline assets) we don't really know enough to estimate with any precision. However, we know that management chose to enter into the contract freely rather than sell the aircraft assets for cash, so the contract likely has a premium to asset value. Also looking at Mesa Airlines' longer term history (as very similar firm) a 10%-15% net income margin over time appears reasonable (lots of moving parts here, of course). We can also infer that annual revenue may be around $200M. Therefore, the total contract value could be roughly $165M on a discounted cashflow basis over 10 years, but we really don't know.
Scenario Analysis
Given we don't know either the arbitration outcome or the American Airlines contract value, we can look at some sensitivities here, I also add $104M of pre-arbitration net assets to the values below. Equally weighting these scenarios gives a value of around $6/share:
Weak American Contract ($100M) | Base American Contract ($165M) | Strong American Contract ($200M) | |
Good arbitration outcome (+$52M) | $5.90 | $7.40 | $8.20 |
Poor arbitration outcome (-$52M) | $3.50 | $5.00 | $5.81 |
Share Buybacks
It's also great that the company keeps buying back shares in fairly material quantities at above the $2/share level. I think that tells you something. In Q2 2023 the company repurchased almost 1 million shares (~2% of the share count) at an average price of $2.24/share. This is not trivial and if the company keeps using its cash in this way then material reductions in the share count could occur over the coming years, which would make for strong equity returns if operational performance remains on track.
Assessment
HRBR may be fairly cheap on its cash balance alone. There are risks as explained below, but I think the equity is interesting at these levels. Share buybacks are encouraging too as we don't know the full economics of the business, but management presumably does. Very little seems priced in.
If the arbitration were to go well or the American contract showed profits, the stock could rally, and both could occur before by late 2023/early 2024. That said, I am watching out for a ramp in capex spending, which means that the cash on the balance sheet goes on new planes and not share buybacks. I also want to see the American contract utilize more of HRBR's fleet next quarter. A positive arbitration outcome would be icing on the cake, but don't think that's necessary for the stock to work (and there may be a little more risk there than the market currently assumes).
Risks
- The company has an old fleet (almost 21 years old) there's some risk that the company has to invest in new aircraft. The American Airlines agreement explicitly mentions this. The resulting capex cycle could consume a lot of the cash that could otherwise go to equity investors, especially if debt financing is used given the recent spike in interest rates. If the carrot for the American contract to get to full utilization of the HRBR fleet is new aircraft, then that's a big problem.
- The company mentions risk of default due to the technicalities of a credit agreement in their recent 10-Q. Management believes risk to be low here, but it is a concern they have to mention it. It's something to monitor.
- We still have little visibility into the American Airlines contract economics. In Q3 HRBR will only be working with American, and we may get cleaner numbers (as opposed to Q2, which was more of a 50/50 United/American split). However, aircraft utilization may still be ramping up, muddying the picture as is transition time and expenses.
- Even though the American contract has now started and the United contract has ended as of June 30, only half the aircraft in HRBR's fleet are being used by American. This seems likely to change, but if it doesn't it could be a problem for HRBR.
- We'll know the results of arbitration soon, but HRBR could lose and have to pay United a material sum.
For further details see:
Harbor Diversified Remains Attractive Even As Details Of New Contract Remain Opaque