Last month, I made the case that profit margins in the airline sector will improve over the next several years, due to shifts in the supply / demand balance. This could potentially make airlines attractive investments. However, there are still very significant concerns about financial risk, operating risk, and valuation for the airlines. My goal in this series is to analyze seven major US carriers to see which ones are worthwhile as investments. In this article, we'll examine JetBlue (JBLU).
The Case for JBLU
JetBlue is one of the most interesting airlines in our group of seven carriers. With consolidation taking place amongst the legacy carriers, as well as Southwest's (LUV) merger with Airtran, JetBlue would appear to be in a sweet spot. The legacy carriers and Southwest can grow revenues through improved pricing, higher load factors, and acquisitions, but they will have a difficult time expanding their networks at this point, given their market saturation.
JetBlue doesn't face this limitation, as there are still significant chunks of the US where JetBlue does not fly. Additionally, JetBlue still has room to expand in a lot of their markets. For this reason, JetBlue does seem more interesting than most of the other carriers.
JetBlue is also one of the best-run airlines in the US. It was started under the "Southwest business model," but the firm offered a unique value proposition in being a discount airline, while also providing some significant luxuries to passengers, such as in-flight TV. It was actually a very smart business plan, because most of the "luxuries" that JetBlue offers don't really cost that much to provide, especially when you spread the cost out over thousands of flights.
While the discount flight space will always be competitive, JetBlue has stood strong against its larger rivals, such as the legacy carriers and Southwest, while also holding its ground against other up-and-comers, such as Spirit (SAVE), as detailed excellently by Brent Snyder of the Cranky Flyer blog.
The other thing that makes JetBlue attractive is reasonable risk metrics, a rarity in the airline sector. In my last article, I showed financial risks of seven major carriers and we saw that JetBlue was actually one of the safer airlines in this realm, with no long-term defined benefit pension liabilities (which weigh down Delta (DAL), United Continental (UAL), and US Airways (LCC)), and also a moderate debt load.
(click to enlarge)
From a valuation risk perspective, JetBlue appears a bit safer as well, as it's one of the few major airlines selling below its net tangible assets.
JetBlue also has some of the best operating margins in the industry, a key metric showing its superior performance.
From all of this, we can see good reasons why JetBlue might be one of the better choices in the airline industry. Yet, there are also many reasons why we might keep away from JBLU.
Let's start with an ugly chart. The airline sector has been pretty good at destroying value for shareholders over the past few decades, and JetBlue hasn't always had a stellar record, either. In my view, the best measure of long-term value creation for the airlines is book value or net tangible assets per share. The latter measure is superior, but for JBLU, the difference is negligible, so here's ugly chart #1:
As you can see, from 2002 to the end of 2011, JBLU created absolutely zero value for shareholders. Mind you, this is book value per share and not a stock price chart, so it's not nearly as influenced by market sentiment. We really should see a reasonably straight-forward upward path here. While it's true that the airline sector in general has struggled a lot, we can also see in the below chart that Southwest has done a reasonable job where JetBlue has failed.
Still, it's not as bad as it looks. The two charts below show the same data for JBLU and LUV, with 1-year, 3-year, 5-year, and 8-year annualized returns. As you can see, JBLU actually fares rather well in all those timeframes, with the exception of the longer 8-year window.
So even with some negatives here, we can also see positives. My other concern with JBLU was showed in my previous article, where my "mindless quick valuation" showed some ugly math for JBLU. While that should concern us a bit, that quick valuation also ignores a lot of driving factors behind JBLU that make it look more attractive. For that very reason, we'll now dive deeper into the company.
Revenue Growth and Operating Margins
First, let's take a look at JetBlue's revenue growth. The compounded average growth rates are below.
This is one of the most impressive things for JBLU and much of its growth has been organic. Perhaps more impressively, over the past five years, the total number of common shares outstanding has only grown about 3.6%, from 272 million to 282 million shares. This is important primarily because a lot of the carriers have seen revenue growth that comes at the expense of dilutive offerings and acquisitions, whereas JBLU has been able to grow without additional capital infusions.
As I mentioned in my prior article, JBLU also has some of the most impressive operating margins in the industry.
That's definitely something that intrigues me about JBLU and shows that the company is healthier than a lot of its competition.
In order to better understand valuation, let's run a few scenarios. First off, the "mindless valuation" in my previous article assumed average growth of about 3% and no margin improvement, which is why we came up with such dismal numbers. In fact, using those figures, I came up with a value of zero for the stock.
Fortunately, as we've seen above, JBLU's revenue growth has been solid and their prospects for future growth seem reasonable. Moreover, my entire thesis revolves around margin improvement, and I think JBLU can be one of the biggest beneficiaries.
First off, let's take a look at JBLU's income statement, margins, and cash flows for 2010 and 2011.
I'm focusing largely on "Operating Income minus Estimated Taxes" to derive a value for JBLU's operating assets. I use that value to adjust JetBlue's equity, and determine a valuation.
It's important to note the degree of financial leverage inherent in JBLU's cash flows to shareholders. While it's less than you see at DAL, UAL, and LCC, it's still moderately high, as tends to be the norm in this industry (with Spirit being the exception).
As you can see, OI - Estimated Taxes is around 90 cents per share, but EPS is only around 30 cents per share for JBLU. This means that debt holders are receiving 2/3 of all profits right now. However, with a 30 cent per share improvement (after taxes), that share suddenly falls to half, and common shareholders receive all the benefits. Which leads me to my basic point here: it doesn't take much of an improvement in operating margins and revenues for JBLU's valuation to jump upwards significantly.
Let's run two quick scenarios to hammer home this point. Remember that in the 2011 income statement, JBLU achieved operating margins of only 7.1%. Let's see what happens if that improves to 10% for the long-haul. In this scenario, we'll also use 10% revenue growth for 3 years, before reverting to a long-term average growth rate of 3%.
Note that OI - Taxes jumps up to $1.54 per share, while EPS jumps to 83 cents by the end of 2015. So basically, profit distribution to common shareholders almost doubles immediately (in the first year) and then jumps up almost 160% by 2015.
Yet, even with this significant improvement, we still only come up with a value of $6.68 per share. This is using a 12% hypothetical discount rate. By the way, I reject this rate, and I'll explain towards the end of the article, but I'll try to keep within the confines of traditional finance for now.
Let's take a look at another scenario to see how small shifts can dramatically change things. In this scenario, we'll use 8% operating margins instead of 10%. We'll also use a lower revenue growth rate of 8% for the first three years, before settling into an average long-term growth rate of 3%.
You can see how dramatically things change. By the end of 2015, we only end up with EPS of 57 cents in this scenario, compared to 83 cents in the last scenario. My equity valuation plunges down to $3.67 as well.
Operating Margins are Everything!
Just to show how important operating margins are in this analysis, let's take a look at two different valuations where the only difference is the operating margin. In both scenarios, we'll use 8% revenue growth, but for one, we'll have an operating margin of 7% and for the other, we'll use 11%. Of course, these are probably not realistic valuations. After all, if JBLU has shrinking margins, its revenue is probably declining from 8% growth, and if it has rising margins, its revenue is probably rising more rapidly. Let's ignore that - the point is that valuations here are incredibly sensitive to operating margins.
Now, here's the same scenario, except with 11% operating margins.
In the first scenario with the lower 7% operating margins, we come up with a valuation of $2.26. In the second scenario with 11% margins, we come up with a valuation of $7.91. Essentially, 4 percentage points of difference results in a valuation 250% higher. This is why the airline sector is so interesting right now; the operating and financial leverage inherent in most of the airline's business models offers significant rewards with only a minor increase in operating and profit margins.
The Trouble with Traditional Finance
I'm not a fan of traditional finance's methodology for valuation, because it uses a silly hypothetical, supposedly objective measure for risk with beta and WACC. I prefer to set my own subjective required rate of return based on my own (also subjective) perceived level of risk. Why? Because it's silly to pretend that we can accurately measure risk based on past history. Yet, that's exactly what most valuations rely on.
The financial history of the airlines over the past few decades is not a pleasant one. It's been one of the riskiest sectors to invest in, and very difficult for long-term investors to profit off of. For this reason, I don't see a 12% discount rate as adequate. Rather, I want to see a minimal return of 14% for JetBlue, which is a moderately leveraged company in the airline industry. I will have higher required rates of returns for other airlines, such as US Airways, Delta, and United Continental, all of which I view as having higher risks than JetBlue.
The reason I chose a 14% required return for JetBlue is that I'm seeing other opportunities where I believe I can make 10% - 12% returns with lower risk. 14% seems reasonable to me, and I'd be even more tempted if I could earn a 20%+ potential return. Therefore, I base my own valuation on this figure.
Based on a 14% required rate of return, and my own estimates for revenue growth (12% for three years) and operating margins (9.5%), I come up with a valuation of $6.78 for JetBlue. JBLU is currently valued in the high 4's, so I think it's a reasonably attractive investment; maybe 20% - 30% undervalued.
I owned a significant stake in it in 2011 and this year, but eliminated it as the price rose close to $6.00 in July. For now, I chose not to invest in JBLU, because I am more intrigued by other opportunities, including a few other airlines. But if it were to dip back below $4.50, I might decide to jump in again. At $4.89, it at least sits very high on my watchlist, and it's a reasonably attractive investment.