2023-08-21 09:00:00 ET
Summary
- Harbor Diversified trades at only 15% above my conservative estimation of liquidation value.
- The next six months offer three high-likelihood shots on goal to increase Harbor Diversified's intrinsic value.
- The last 6 months have been hard for Harbor Diversified. But early indicators show that the next 6 months should be better.
Thesis
I published my first article on Harbor Diversified ( HRBR ) about half a year ago. My thesis has not changed. The company trades at slightly above my conservative liquidation estimate. It has three shots on goal in the next six months with catalysts that could significantly increase its intrinsic value. So why publish an update? The company has released three financial reports and completed its transition to operating for American Airlines ( AAL ). It is worth updating my estimation of liquidation value and looking out over the next year to see what we can expect. HRBR's stock has also drifted down to a place where I'd consider adding to my position again.
I'll be watching for the answer to these three important questions. What is the outcome of the arbitration with United ( UAL )? What do the economics of the new agreement with AAL look like? Will HRBR act in a shareholder-friendly manner regarding the preferred equity?
Liquidation analysis update
My estimated liquidation value declined from $1.98 a share at the start of 2022 to $1.82 currently. The primary contributing factors here were buying back shares above my estimation of liquidation value and negative operating cash flow for the first 6 months of 2023. For a more detailed explanation of my liquidation calculation see my original article.
Author's work
[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. I assume that the company's planes and spare parts are worth the same amount as the debt financing them. I can do this because the company's debt is secured by some of its planes and spare parts. The debt is non-recourse to HRBR. This approach is likely overly conservative but we can know it is correct.
[2]This line represents the company's municipal bonds they bought back.
[3]This line represents money already paid to HRBR by AAL to help convert its fleet to serve AAL. It is being recognized throughout the contract in accordance with GAAP.
[4]UAL is disputing $52M in payments made to HRBR. I don't know how this will play out so writing to $0 to be conservative.
[5] $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.
Arbitration's increasing importance
Air Wisconsin's dispute with UAL has increased significantly in its importance since my first article. I was wrong in assuming that the full arbitration amount was announced upfront. Instead, the arbitration dispute has grown over time. This has been a drag on HRBR's cash flows since the revenue they claim is being held in accounts receivables rather than converting to cash.
Another thing I was incorrect about was that the arbitration would be resolved in Q3 of this year. The company provided an update in their latest 10-Q that the arbitration won't be resolved until Q4.
My read on the dispute is that UAL was upset by the way HRBR terminated their agreement and decided to play hardball on the contract. My best guess is still that the parties end up settling and HRBR will recover some but not all of the disputed funds. But I feel unsure about this in general.
The amount disputed has grown from $33M to $52M. My conservative liquidation value for the company is $110M, so if HRBR entirely wins in arbitration it would boost my valuation of the company by almost 50%.
Changing airline partners proves rocky
2023 Q1 and Q2 were both negatively impacted by the cutover from flying for UAL to AAL. I expect that there will be a small amount of impact continuing into Q3 and that all impacts will be resolved by Q4. HRBR's block hours and flights both declined during the first two quarters of the year. There are two contributing factors to this the ongoing pilot shortage at regional airlines and changing from flying for UAL to AAL. It is hard to untangle these two things.
Of special concern, is the revenue per flight and block hour has been decreasing. The only real detail we have from regulatory filings on this matter is that the AAL capacity agreement provides higher rates than the UAL capacity purchase agreement.
There is some hope though. Flight radar shows increasing flights starting in June of this year. Please note these don't include Air Wisconsin flights that it runs under its partners' call signs. Also per flight radar in August so far 46 Airplanes owned by Air Wisconsin are regularly completing flights. This is up from 32 Airplanes at the end of June per the company's report .
The pilot shortage is also showing some signs of normalizing. Mainline airlines have begun saying they expect to move from being pilot constrained to aircraft constrained by the end of the year. There is still a shortage of pilots things just don't look quite as dire as they did one year ago.
Overall, we still don't have enough information to confidently say what the economics of Air Wisconsin look like going forward. I expect that HRBR will have positive cash flow from operations in Q3 and Q4. Once Q4 results are announced we should have a much better idea of how to model HRBR going forward.
Preferred resolution
The series C preferred shares should be cleaned up in 2023. Previously, these preferred shares offered a cheap source of funding at a 6% dividend rate. A company like HRBR wouldn't be able to borrow at anything near this rate in the current environment. In 2023, they started getting more expensive.
To simplify slightly, there are 4 million series C shares outstanding. Unless HRBR's stock price falls a lot the first 755 thousand preferred shares are convertible into 16.5 million shares of the common. The remaining 3.2 million preferred shares are considered “Conversion Cap Excess Shares”. Starting in the first quarter of 2023 the conversion cap excess shares begin receiving "Conversion Cap Excess Dividends". The conversion cap excess dividends start at .5% a quarter and increase by .5% each subsequent quarter. This is not an annualized rate and is in addition to the base 6% annualized dividend. By Q4 HRBR will be paying a 14% annualized dividend on the series C preferred shares.
In 2024 the "Ratchet payment" can also start at the election of the preferred equity holders. The ratchet payment increases the annualized dividend of all series C preferred shares by 1% every 6 months. As you can see, things start getting really expensive in 2024. The good news is HRBR can redeem the Conversion Cap Excess Shares at par right now. The preferred equity ought to be taken out before 2024. This is not a matter of financing. HRBR has $140M in marketable securities and taking out the preferred equity should cost the company about $10M. It is a matter of governance. The preferred equity holder is also a member of the board and a large holder of common stock. If HRBR management allows the preferred shares to sit and pay an ever-increasing dividend, it would show a lack of disregard for minority shareholders. If the preferred equity is not cleaned up by the time the company files its 2023 10-K I'll need to deeply re-examine my investment.
Final thoughts
The first two quarters of 2023 were tough for HRBR. This was to be expected with the changeover from UAL to AAL. But it ended up being worse than I was anticipating.
However, the next two quarters are likely to have positive catalysts. Better economics from being fully on the AAL capacity purchase agreement, recovering money in their arbitration with AAL, and cleaning up their preferred shares all provide high likelihood events that should solidify HRBR's value.
Compared to my first article on HRBR. We are farther away from liquidation value but closer to catalysts that should unlock value. I had trimmed my position when HRBR traded around 2.30. I'll look to re-add if the stock trades below $2 and would make the position larger if it traded down to my liquidation estimate.
For further details see:
Harbor Diversified: Waiting For Fair Value To Exceed Liquidation Value