The airline industry has historically been a by-word for value destruction, combining a capital and energy intensive business with substantial operational and financial leverage. Add in some cyclicality, sticky labor costs, and the possibility for the odd terrorist attack or crash and you have an industry with a long history of sustained operating losses and painful bankruptcies since deregulation in 1978.
Today’s industry is a greatly streamlined vision of its former self and the product of a decade of bankruptcy-driven restructuring and consolidation. The market, however, is justifiably wary of airlines and has paid little heed to the series of significant structural changes that have occurred over the past 10+ years. Competition has become more rational and capacity growth has been restrained even as demand has grown fairly steadily. I believe the industry has the potential to reverse its long-term decline in pricing power and that the potential of such a paradigm shift is not wholly reflected in today's valuations.
I believe jetBlue (JBLU) offers the potential to access the upside benefits of industry consolidation without many of the disadvantages of the mainline carriers, with the added benefit of offering a greatly simplified analytical challenge with fewer moving parts to consider. JBLU profitably operates a small fleet of young, fuel efficient aircraft from its valuable core northeastern hubs and a growing Caribbean and Latin America business and has been one of the more successful of the low-cost carriers (LCCs) in the past decade.
jetBlue is pursuing what is in my mind a less risky strategy than some of its more aggressive mainline and LCC competitors, such as Spirit, by eschewing unbundled fares and focusing on customer service along underserved routes with higher average fares. While fee revenue has allowed mainline carriers to add much needed marginal revenue and help offset their operational disadvantages, it is not yet clear that this is the best path to enhancing profitability for low-cost carriers (LCCs). Although unbundling allows carriers to better align revenues with costs, such as by charging for checked baggage weight, and allows price sensitive buyers to pick and choose their desired level of service, I believe there are limits to the extent this strategy can be pursued.
Although unbundling is likely more efficient at increasing the addressable market through price discrimination, airline revenue management systems already work to maximize load capacity by effectively price discriminating between business and more price-sensitive recreational travelers, so gains are likely to be fairly marginal. Additionally, some customers will prefer the simplicity of a single up-front price, particularly as some competitors like Spirit charge even for the first piece of carry-on baggage. Aggressive unbundling borders on being a tool merely for obfuscating the final cost to the passenger and is unlikely to provide a long-term advantage, particularly as online fare-comparison is easier than ever. JetBlue, in contrast, charges fees for legitimate service benefits such as more leg room or priority access through security lines. While the most price sensitive customers will likely prefer whatever option is cheapest and change their behavior accordingly to 'game' the pricing system, I think the gains won will be marginal and limited to the most price-sensitive leisure passengers.
jetBlue’s service-oriented model has led to 8 consecutive years of being ranked #1 in JD Power & Associates’ customer satisfaction survey. Although jetBlue’s workforce is non-unionized, focusing on customer service is not cheap and is reflected jetBlue’s substantially higher labor expenses as compared to most of its value peers.
Like most airlines, jetBlue has a meaningful amount of debt, and as of 6/30/12, net debt including operating leases was 3.6x 2012 run-rate EBITDAR. This puts jetBlue at the middle of the pack and at the top end as compared to its value peers, with a few offsetting factors worth noting- Spirit has an aggressive order book that will more than triple its capacity over the next 10 years, with a corresponding effect on leverage, while Southwest has a substantially older fleet, which adds operational leverage and suggests further debt will need to be incurred to finance purchases of newer aircraft.
Debt is reasonably termed out and near-term maturities are likely manageable. Debt is about ½ fixed and ½ floating, with the fixed rate debt costing about 6%, and overall cost of debt closer to 4%.
Despite having some attractive operational and strategic characteristics, JBLU trades cheaply in absolute terms and is cheap relative to its peers.
JetBlue currently trades at an EV of 4.7x 2012 run-rate ’12 EBITDAR based on the first six months of 2012. Profitability (as measured by operating cash flow to the firm, ex-net working capital movements [norm. OCFF]) peaked in 2009 as demand recovered in advance of fuel prices, with margins reaching almost 30%. Increasing fuel prices have seen cash operating margins retreat to just under 20% in 2011.
Using normalized free cash flow to the firm (normalized OCFF less capex, excluding capex for new aircraft purchases), which was 810mm in 2011, gives us approximately $5-$7/share based on a 6-7x multiple. If we use a pure EV/EBITDAR approach and assume JBLU derives to trade in line with peers (5-6x EBITDAR, see chart below) on run-rate 2012 EBITDAR of 1bn, we get a value of $5.50-$8.50.
Looking at normalized free cash flow to equity, JBLU earned about $0.89 share in 2011. This gives us $7-$9/share of value on an 8x-10x multiple.
Tangible book value at replacement cost was $8.73. If we apply a 1.7x multiple (corresponding to an 11.5% est. ROIC for 2011 against a WACC of 4.7%) to depreciated tangible book of $5.36, we get a value of $9.02/share. Based on the above metrics, I believe JBLU as-is deserves to trade in the $7-$9 range, corresponding to 40-80% upside. In an environment where competitors raise fares JBLU will be able to benefit from either increased load factors or by boosting fares, which could add incremental upside. I believe this offers sufficient upside to offset the inherent risks of the airline business.