"If capitalists had been present at Kitty Hawk when the Wright brothers' plane first took off, they should have shot it down." - Warren Buffett
Airlines --- the favorite punching bag of the market!
What other industry in America can claim 100 bankruptcies since 1978? What other industry that has managed to survive for over a century can claim to have never turned a net profit? What other industry has been so thoroughly propped up by the government, but still manages to fail every decade or so?
I would definitely not call myself a fan of the airline industry when it comes to investing. Most of the time, I’d rather be on the short side of airlines, but this isn’t one of those times. Airlines have been beaten down very thoroughly as oil prices have been rising over the past few months. This does not mean that I am in love with the industry by any stretch of the imagination. Nor does it mean that I would suggest buying airlines indiscriminately on a technical basis. However, I do believe a few air carriers could offer attractive value propositions at the current price levels. This might be especially attractive to those with bullish positions on oil, as this could give you a decent hedge on those positions.
On that note, let’s examine the case for mid-cap air carrier Jet Blue (JBLU) as a long candidate.
Jet Blue is the youngest of the major airlines, commencing service in 2000. It prides itself as a “value airline” with great customer services. The company also frequently harps on some of the minor luxuries available on their flights (e.g. free television, unlimited snacks). The basic business strategy seems to be cheap flights and good (but not costly) entertainment.
In its latest 10-K filing, Jet Blue claims to be the “most fuel efficient” of the airlines and serves 52 different markets in 19 states, Puerto Rico, Mexico, and a handful of Latin American and Caribbean nations. The majority of their operations have originated in New York City and they are the largest airline by number of passengers flying out of JFK International Airport. Jet Blue is also the largest carrier in Boston in terms of destinations served.
Jet Blue believes it has the lowest operating costs of all major airlines, calculating their “cost per available seat mile” at 5.94 cents. It only uses two types of aircraft: the Airbus A320 and the EMBRAER 190 and has an average aircraft age of 3-4 years. The frequent pitch is that Jet Blue is one of the best airlines from an investor perspective because its young fleet gives it greater fuel efficiency. Of course, this begs the question, what happens as JBLU’s fleet ages? I’ll leave you to determine the answer to that one. All the same, there still could be some value here.
With that, let’s move on to the financial aspects of JBLU that potentially make it attractive.
The Balance Sheet and Earnings
Comparatively speaking, Jet Blue has one of the strongest balance sheets amongst the major airlines. Only Southwest (LUV) seems to be in similar shape. The following chart lays out the Net Tangible Assets (NTA) of the major airlines and shows the ratio of Liabilities-over-NTA:
As you can see, most of the major airlines have a lot of leverage. Jet Blue and Southwest don’t appear to have anywhere near as much debt as the other carriers, which is a significant long-term advantage. Jet Blue also has a current ratio of 0.97, which compares favorably with many of their competitors.
As with most air carriers, earnings seem to shift back and forth for Jet Blue. Due to high depreciation and amortization charges, I would not peg “Net Income” as the most appropriate measure for a DCF valuation. The following chart lays out five different earnings-related measures over the past five years:
Please note that I translated all items to a per share basis based on 273 million shares outstanding (which assumes some slight dilution). For this reason, EPS figures are not necessarily going to match the figures on JBLU’s financial statements, but I do this more to create a steady state, while still speaking in per share terms.
The next chart lays out the 3-, 6-, and 9-year averages based on the above chart.
I also decided to chart out JBLU’s first Quarter ’09 figures:
If you need a quick guide to my abbreviations, here ya go:
CFOs = Cash Flows from Operations
FCFs = Free Cash Flows
NI (DEPS) = Net Income (Diluted Earnings Per Share)
NI + DA = Net Income plus Depreciation and Amortization
INCR in SE = Increase in Shareholders’ Equity
Overall, it would appear that JetBlue has been ever-so-slightly profitable over the long run --- which stands as a pretty big feat in the airline industry. Net Income Plus Depreciation & Amortization (NI + DA) would seem to be the most useful metric to use for my valuation since I calculate asset values separately. However, I could see the merits behind using Net Income, as well.
My biggest concern from the above charts is Jet Blue’s highly negative free cash flows. That can be explained to some extent by the fact that they are a newer and growing airline. All the same, CapEx has dramatically exceeded Cash Flows from Operations in many years. In their most recent earnings call, CEO David Bargar stated that Jet Blue has taken steps to reduce capital expenditures in 2010 and wants to generate positive free cash flow.
The most recent quarter reflects this to a degree as operating cash flows were $124 million compared to CapEx of $149 million (which includes $58 million in flight equipment sales). That suggests that JBLU could be headed on the track towards positive FCFs.
Also from that earnings call (see call transcript), CEO David Bargar suggests that Jet Blue remains dedicated to not “nickel-and-dime... customers. While this might harm the bottom line in the short run, I believe this is more prudent for a long-term approach." One of the main reasons I like Jet Blue from an investment perspective is that they seem to have a more long-term view than their competitors.
One other area of interest is business travel. Jet Blue has not historically been the airline of corporate travelers, but as companies across the board look to lower their costs in the current environment, it stands to reason that JBLU may be a beneficiary due to their low-cost model.
Taking into account the financials and potential growth factors, let’s take a look at potential valuations for Jet Blue.
I decided to run four quick DCF valuation scenarios. Jet Blue’s net tangible assets are worth roughly $4.80 per share. I decided to discount that to $4.50 in my first three scenarios for no particular reason, other than to be a little more on the safe side. Since JBLU is still growing and has significant CapEx that distorts its free cash flows, I’ve decided that Net Income Plus Depreciation/Amortization (NI + DA) is the best measure of “added value” for my valuation. However, this number is a bit more aggressive than Net Income/Earnings Per Share (EPS), so some of these scenarios veer closer to EPS.
For all of these scenarios, I used an 11% cost of capital. That might be a bit high given the stated interest rates I found for JBLU, but since I consider all airlines high-risk, I don’t think it’s a bad idea to play things on the conservative side.
For each scenario, I state an initial year “added value” figure (which represents a long-term average) and assume a 3% growth rate. Here’s a chart laying out the scenarios:
Based on my valuation scenarios and all the data I have, I would value Jet Blue at $8. That would put my valuation closest between Scenarios #1 and #2 above. 35 cents per share in yearly “added value” seems to be a bit on the conservative side when compared to historical NI+DA figures that average closer to 50 – 60 cents per share on a yearly basis. However, given the risks involved with airlines, I believe it’s best to stay on the conservative side (without going overboard) and as I stated earlier, I can see legitimate reasons to believe that Net Income is a more accurate measure of real earnings.
My downside probable valuation is $6, which is a slight discount to Scenario #1. It would assume that Net Income is a better measure of added value and that GAAP earnings will drop a slight bit. My upside probable valuation is $11.
For downside risk --- I always warn people to assume it’s $0; but given JBLU’s assets and position, $2 might be more realistic. That figure implies that JBLU becomes slightly unprofitable over the long-term and that their net tangible assets are slightly overstated.
For upside potential, I’d suggest $13. I base this on their steady growth pattern (particularly in the NI + DA) figures.
While I like Jet Blue better than all the other major airlines (save perhaps Southwest), I wouldn’t go so far as to recommend it as a long-term investment (which I define as 2-10 years). I join Warren Buffett and other airline skeptics in that regard. Under $5, I think of it more as a medium-term value buy (6 months to 2 years). If I bought in at $4.60 and the stock hit $7 within the next 5 months, I would probably go ahead and sell it; especially considering the volatility of the airline stocks.
One reason I believe this might be a good buy right now is that the fundamentals don’t support oil at $60+/barrel at the current time. Inventory levels are too high, so if oil retreats a bit, the airlines will probably move upwards. But even if they don’t, I believe you have some margin of safety with JBLU based on their net tangible assets, fuel hedges, and past history of minor profitability. If you’re not completely convinced (don’t worry, I’m not either), it might be useful to think of it more as a potential hedge for bullish oil-related securities.
For my simulated $10 million portfolio, I have initiated a 0.9% position in JBLU at an average cost of $4.47 per share. I’ve also initiated a 0.7% position in Southwest (LUV) at $6.80 per share. As I suggested, this is more of a hedge play on my oil stocks (e.g. USO, USL, HERO, ATW), while giving me some potential to nab up some bargains. I will probably not consider adding this to my actual portfolio unless I see JBLU drop below $4 --- but it’s definitely worth keeping an eye on.
Disclosure: No position in JBLU or any airlines