SkyWest (NASDAQ:SKYW) is a regional airline based out of St. George, Utah, operating regionally through its subsidiaries. Investors should conduct a thorough examination of SkyWest because it has recently begun taking aggressive measures to reduce its cost structure and has protected itself against fuel price fluctuations through code-share agreements with Alaska Air Group (NYSE:ALK), American Airlines (AAMRQ.PK), Delta Air Lines (NYSE:DAL), and US Airways (LCC). The fuel used in these code-share agreements is fully reimbursed by SkyWest's major partners, thus hedging SkyWest's exposure to rising fuel costs. Given the recent rise in oil prices, management's decision to launch the code-share agreements was a shrewd one.
Along with the code-share agreements, SkyWest announced that it was awarded 34 additional dual-class aircraft [pdf] and that 66 CRJ200 aircraft are being removed with Delta Air Lines [pdf]. Furthermore, SkyWest has signed an agreement with American Airlines to operate 23 CRJ 200 jets [pdf] as American Eagle. SkyWest's strategy of replacing its old, high-maintenance fleet should not only cut operation costs but also reduce incident rates.
SkyWest airlines declared its 71st consecutive dividend [pdf] on March 6, 2013. For those of you counting at home that is nearly 18 consecutive years of dividends. SkyWest's dividend yield of 1.1% was second best among its peer group. Bearing in mind that SkyWest had a negative net profit margin in 2011; the fact that it rewarded shareholders and maintained the dividend streak is encouraging.
Market trends in the airline industry have been favorable as of late as air traffic statistics showed an increase in demand and revenues in 2012. Moreover, recent economic improvements such as an increase in GDP and an increase in jobs bode well for investor's sentiments about airline stocks. Barring an unforeseen catastrophe, there is no reason to believe this trend will not continue in the latter part of 2013. Recent escalations in oil prices are definitely a cause for concern. That being said, as previously mentioned, SkyWest has hedged its exposure to rising fuel costs through its code-share agreements and the rising oil prices should not have a significant impact on SkyWest unless the large airlines terminate their code-share agreements with SkyWest. Furthermore, because of the discretionary nature of airline travel, the airline industry is more susceptible to substantial losses and bankruptcies during periods of economic recession. I see that being an extremely unlikely for SkyWest given the airline's recent turnaround and improving economic conditions.
SkyWest's financial restructuring initiatives were effective in 2012 as SkyWest posted return on assets of 1.2%, return on equity of 3.76%, net profit margin of 1.45%, and a reduction in its long-term debt to assets ratio of 2.96%. I believe these improvements in profitability are the direct result of SkyWest's profit improvement plan. While SkyWest's returns may look dismal, you must consider that SkyWest posted an overall net loss last year and made some bold, strategic moves to transform the financial strength of the company. I believe management's decision to enter the code-share agreements along with cutting operation costs is the primary reason why SkyWest did not post another net loss in 2012. Moreover, the profit improvement plan had a substantial impact on SkyWest's fourth-quarter results. SkyWest reduced total operating and interest expenses [pdf] for the last quarter of 2012. SkyWest reduced its total airline expenses by 4.6% after excluding fuel costs that were directly subsidized by major partners. Expense reduction was the result of a decrease in non-pass through maintenance costs and a reduction in both CRJ200 engine overhaul and customer service labor costs.
Given the improvement of SkyWest's financial structure, I believe investors can buy SkyWest's stock for half of what it is worth. After discounting the free cash flow [(Net Income+Depreciation+Amortization)-(Change in Net Working Capital-Capital Expenditures)] over the next 10 years, I have the stock valued at $31.19 assuming a 10.1% growth rate and a 10% discount rate. Given the closing price of $15.25, May 7, it is trading at about a 51% discount. This would provide a significant margin of safety for those thinking of buying a stake in SkyWest airlines.
I am a value investor at heart and because of this I prefer to follow small value stocks like SkyWest that are temporarily out of favor and offer a bigger upside for capital appreciation. University of Stanford accounting Professor Joseph Piotroski recently developed a nine point value scale called an "F-Score" that is used to find companies with improving profitability, liquidity, and operating efficiency that may have recently been considered financially distressed. Piotroski's F-Score aims to separate the winners from the losers among a universe of low price-to-book stocks. Piotroski starts by scoring two points if the current year's net income and operating cash flow are positive. He then scores one if the current year's return on assets is greater than the previous year. He scores one point if the OCF is greater than net income and one if the long-term debt-to-assets ratio is decreasing. He tallies one if the current ratio is greater than last year's and awards a point if shares outstanding are staying the same or (even better) if the company is buying its shares back. Finally, he marks two if the current year's gross margin is greater than the year prior and if total sales growth is greater than total assets growth. A passing score is considered to be eight or nine. Below is an examination of SkyWest to see if it passes Piotroski's screen.
As you can see from the chart, SkyWest passes Piotroski's screen. The American Association of Individual Investors has used Piotroski's "F-Score" criteria to pick stocks in its model portfolios and the results have been profound. The Piotroski F-Score screen has averaged a 25.8% return since 1998 while the S&P 500 has averaged 2.6% over the same time period. I must emphasize that it is wise to properly diversify and that the number of stocks passing Piotroski's screen will vary significantly depending on market conditions. For instance, there were a bevy of "F-Score stocks" after the bursting of the housing bubble in 2008. Including SkyWest, there are currently nine stocks passing Piotroski's F-Score screen. I will write about these other securities in future articles.
SkyWest's cost reduction strategy of replacing its old aircraft and entering code-share agreements, when coupled with an improving economy, bodes well for the future prospects of the airline. Potential investors would be wise to give this company a second look because SkyWest's profit improvement plan has proven effective for SkyWest and should catapult the airline to sustainable profitability levels for the foreseeable future. I believe the stock will be trading in the low $20 range by the middle of 2014. Moreover, SkyWest's efforts to increase its asset base, cut costs, and leverage its scale advantages have provided the airline with a sustainable competitive advantage - one which I believe will send the stock sailing high in the value skies for years to come.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.