Hawaiian Holdings: One Airline For The Long Run

Oct.19.11 | About: Hawaiian Holdings, (HA)

Airlines in the US are notoriously low return investments. However, in the past 2-3 years, several airlines have merged - cutting capacity, ramping up utilization and bringing in a new dawn in airline efficiency. As fuel prices have risen and budget constrained consumers have bought down margins, efficiency has became paramount to survival in the US airline business.

Five airline-related companies are worth looking into a good bit as their earnings have stabilized and they continue to target positive returns on invested capital. They are United Continental (NYSE:UAL), US Airways (LCC), Alaska Air (NYSE:ALK), Air Transport Services Group (NASDAQ:ATSG), and finally but not least, Hawaiian Holdings (NASDAQ:HA). All have positive outlooks at this time for a lot of what I've mentioned above and they've been better at competing (at least on price) with the higher service airlines such as JetBlue (NASDAQ:JBLU) and Southwest (NYSE:LUV).

That is all great news, but the one airline company that I believe has the best risk/reward ratio out of the group is none other than Hawaiian Airlines. It has had some trouble this year, writing off some lease contracts and disruptions to the customer market in Japan... however all that is waning off and the earnings power is slowly coming back. If I add back the lease termination charges alone, we are looking at normalized earnings of about $40million in 2011.

Hawaiian Airlines owns about 87% of the inter-island market in Hawaii and that is a major competitive advantage in keeping earnings afloat. In the past 3 years the normalized earnings have been about $50-$60 million. In fact if I normalize 2Q in 2011 for Japan, the income for 2011 would again most likely hit $50 million, but I'll stick to the $40 million to be conservative.

This is a higher beta company, but the #'s are still very nice, even given the Japan situation (quake/tsunami/nuclear problems), looking at some enterprise value (EV) ratios using an estimating $40 mil in normalized earnings for 2011 at $5/share we have the following ratios:

9.0x EV to normalized (conservative) net income
1.5x EV to book value
1.0x Market cap to book value ratio
3.3x EV to operating cash flows
7.3x EV to free cash flows (assuming half of capex is maintenance)

The cash flow returns on invested capital (ROIC) are just above 8%. This is weak but considering it is a high beta company and had a difficult spring/summer, this can be easily one of the best ROIC airlines in the US. IT has capex for about $120 mil. If I assume the other half is for growth and earns 8%, in 5 years it can hit about $75 million in cash flows and be worth $10.

Now if the economy in the California/Hawaii/Japan gateways resume to normalcy, and I think that can happen sooner rather than later since airlines are operationally leveraged (high fixed capital costs), I'm expecting a minimum price of $7.50 and a valuation of $10+ in a positive market. That would make its current enterprise value about $500 million and equate to 10x current free cash flow of $50 million.

Remember, the airline has a lock on Hawaii - its the only kind of monopolistic airline in the US. In reality it probably deserves a premium of 20% to both my valuations. It will never be merged with a larger airline for concerns of a monopoly in Hawaii. A private equity fund can buy it, but will probably have to re-capitalize it and put it back on the market or to another fund.

Current Value: $5
Fair Market Value: $7.50, 50%+ projected gain
Strategy #1: Buy shares outright
Strategy #2: Sell Novemeber 2011 puts strike of 5 for 35 cents, yielding 7% in one month (this may have changed since I wrote the article)!

Disclosure: I am long HA, ATSG.