Republic Airways' (RJET) are up a jaw-dropping 78% year-to-date, with shares recently topping $6, capping an impressive rebound from their 52-week low at $2.47 in October. While the airline sector as a whole has had a strong start to the year, with the Guggenheim Airline ETF (FAA) rising 24% year-to-date, most of Republic's strong performance is attributable to news that the company is looking to spin off its troubled subsidiary, Frontier.
Republic is in talks with various financial advisers to separate the branded subsidiary from Republic's heritage business. During this period, Republic is creating an independent management team for Frontier to prepare it for when it eventually leaves its parent company, led by former US Airways CEO David Siegel.
Investors have been interpreting this as very good news. However, for this to work out well for Republic's investors, two things need to occur. One: Frontier needs to be sold off at a reasonably good price, or if it is not sold off, its spinoff needs to receive a warm welcome from the market. And two: Republic's heritage business of flying airlines for code-sharing partners such as American (AAMRQ.PK) needs to be reasonably profitable. I have concerns about both of these propositions.
In my previous article about Republic published July last year, I argued that the stock offered a high-risk high-reward situation with the stock trading around $4.50/share, and it essentially was a call option on finding a buyer for Frontier and/or lower oil prices. Neither of these has played out as I anticipated.
Last July, Republic had made some signs that Frontier was potentially on the block, but Republic's intentions for the company were not clear. Over the past 6 months, however, Republic has become increasingly bent on selling Frontier. On November 8th of last year, the company made it official, saying it would be divesting Frontier.
However, while Republic's commitment to selling Frontier has increased, it has still failed to line up a buyer. At this point, Republic is starting to look a bit like a desperate seller. They are becoming more and more committed to unloading Frontier in the near term, and yet it is not easy to see many scenarios under which Republic gets a good price for Frontier in the current market environment.
An ideal solution would be selling Frontier whole to another US airline. However, this seems quite unlikely, as many airlines are looking to cut capacity and retrench, rather than expand. Frontier's operating culture seems to distinct to make it a natural fit with other small operators such as Spirit (SAVE) or Jetblue (JBLU), and Southwest (LUV) seems to be an unlikely buyer due to a significant clash in the fleet types of the companies' planes.
If Frontier is not sold off to another airline, other options include a private equity takeover, and a spinoff. Republic's CEO Bryan Bedford made a statement in November last year that supports the idea that private equity may be a buyer, saying that Frontier
is going to be attractive either to private equity or our shareholders or possibly to strategic investors.
I am skeptical that Frontier is a good fit with private equity. Frontier has already engaged in aggressive cost-cutting, reducing expenses by $120 million last year. The standard private equity approach of levering up debt, firing employees, and slashing expenses seems to be a poor fit for Frontier's needs. What can private equity do to create value that Republic cannot?
Finally, Frontier can be spun-off. This could work, but it has pitfalls. For one, Frontier will need access to a lot of capital by 2016 to pay for the 80 new Airbus planes that will be joining the fleet in the latter half of that year. At this point, Frontier has a marginal presence in the airline industry and is struggling for survival. It would need to seem to grow larger or get bigger partners, rather than downsize itself further by cutting ties with Republic.
Furthermore, it is hard to see the appeal of Frontier as a standalone entity in the current market environment. Oil prices have surged back to the crucial $100/barrel level. Frontier has not been able to turn a consistent profit for quite a few years now; it fell into bankruptcy in 2008 because of high fuel prices. Since Republic took over Frontier, according to the Wall Street Journal, Frontier has produced a pre-tax loss of $235 million, and most of the period since then was with an oil price generally lower than the current one.
Frontier still has the potential to carve out a successful niche in Denver, particularly if the company can become an ultra-low cost carrier as management envisions. But it seems quite risky to throw Frontier, on its own, out to a fickle market that will be hesitant to support an airline that was in bankruptcy just a couple years ago and that has generated large losses since then.
There is a second part to Republic's valuation equation. Republic is worth whatever it gets from selling off/spinning off Frontier plus the residual value of its code-sharing airline business. After converting again to a regional airline, Republic will fully reposition itself within the more dependable but low-margin regional airline business.
This sector has done alright over the past couple of years, but it has inherently less upside than a branded airline operation. The operating margins for branded operations of well-run airlines including Jetblue, Southwest, and Spirit are several multiples greater than regional airlines, with the branded operations getting 6 to 13% margins vs. 3% for large regional carrier Skywest (SKYW).
It is also worth noting that since Republic acquired Frontier, its shares have risen nearly 50% (it was trading just north of $4 at the time of the deal). By comparison, Skywest has risen only 30%, despite the fact that Skywest has been consistently profitable and kicked out a dividend during this time. At the same time, Republic was taking on large losses from the newly-integrated Frontier. It is hard to justify Republic's superior share performance, in comparison with Skywest's, over this time period given that Skywest has produced much better operating results.
And with high fuel prices again clouding over the airline industry's profits, it is unclear how profitable Republic will be able to be even after shedding Frontier. Republic's CEO believes that in the wake of American Airline's bankruptcy the company will be able to get more business for its regional airline as legacy carriers look to shift more flights from their own expensive cost structures over to lower-cost regional carriers. This is a reasonable expectation. However, analysts have doubts. For example, Ray Neidl, an aerospace analyst for Maxim, recently said that:
we only expect a few [regional carriers] to survive. In an era of what we believe will be permanently higher fuel costs, the sector should be much smaller.
There are just too many question marks around Republic to make it a good buy at this point for investors. While Frontier could be sold at a nice valuation or spun off successfully, success is not guaranteed. Particularly if oil prices remain high, it is not hard to envision a scenario in which Frontier is spun off and soon ends up bankrupt, leaving Republic shareholders with no gain from the whole Frontier experiment.
And while Republic may be able to make headway in the regional air space, it is hard to get excited about paying $6 a share for Republic now when it was a $4 stock when it was a regional airline before it acquired Frontier in 2009. Investors purchasing stock in Republic need a variety of things to go right for their investment to pay off. It is not a gamble that I personally would take.