- JetBlue is consistently ranked as one of the best airlines in the US in terms of customer service.
- JetBlue has a lower return on invested capital relative to its peers.
- The company is at a disadvantage in a "price war" scenario due to its higher cost relative to its peers.
Airline stocks have been on a bit of a roll lately with optimism starting to return to the markets. I wanted to do a deep dive and see whether this enthusiasm is warranted. Is there an investment opportunity here or is this a sucker's rally? Today, I am taking a look at JetBlue (NASDAQ:JBLU).
Just a brief background on the company, JetBlue is consistently ranked as one of the best airlines in the US in terms of customer service. In terms of Q1 2020 results, unsurprisingly, revenue was down by 15% due to the impact of the coronavirus pandemic. The full impact of the lockdowns though is not fully captured in these results and will only show for Q2 2020. Like most other airlines, JetBlue took serious steps to mitigate the cash burn from the lack of flights. Cash burn in May was roughly $10 million, down from $18 million in March when the pandemic started.
Like most airlines, JetBlue received a bail-out from the federal government in the form of the CARES Act. The company obtained $936 million with additional possible additional liquidity of $1.14 billion. As payment, the company issued 2.6 million warrants to the government. These warrants will dilute future earnings. According to company management, JetBlue entered the coronavirus pandemic with the "second strongest balance sheet" with a debt to capital ratio of 44%. By May the company had $3.1 billion in Cash which should provide the company with enough of a liquidity cushion.
As mentioned in my previous article, I believe that air travel will gradually return at some point in the future. With the lockdowns easing in different states, domestic travel may be returning soon. However, most international borders remain closed to tourists, including the US, and may remain closed for the foreseeable future. Therefore, I believe most flights in the near-term will be primarily focused on domestic travel. As mentioned by Treasury Secretary Steve Mnuchin "it's a great time to explore America".
Like Southwest (LUV), JetBlue is primarily a domestic carrier and thus gets the majority of its revenue from domestic flights. This means that the company has a chance to be among the first airlines to get their fleet up and running. This is different from the experiences of the majors whose international flights make up a significant portion of their revenue. For example in 2019, international flights made up 28% of Delta's (DAL) revenue ($11.8 billion vs. total revenue of $42.2 billion).
In fact, JetBlue has already announced a plan on how to properly conduct social distancing within flights. The company has an entire program called "Safety from the ground up" which encompasses all touchpoints between crew and customers in the travel journey. It starts from before the flight by ensuring contactless boarding as well as temperature checks. Within the flight, certain seats (either middle or aisle) will be blocked off for customers not traveling together in order to promote proper social distancing. Face coverings are required for both customers and crews.
JetBlue is also committed to properly and frequently disinfecting common surfaces and filtering cabin air using hospital-grade HEPA air filters. These steps should ensure that people feel more comfortable flying, however, also have the unwanted side effect of raising costs (more manpower needed for frequent disinfecting) as well as reduced revenue (due to limited capacity per plane).
JetBlue will survive but is it a good investment
Given that JetBlue is most likely to get out of this pandemic intact, is the company a good investment? Unfortunately, I believe the answer is no. Despite being consistently voted as one of the best airlines in the US, JetBlue has had profitability issues even before the coronavirus pandemic hit.
Using a measurement called Return on Invested Capital ("ROIC") which is a measurement used to evaluate how well the company uses its invested capital, we can evaluate how well JetBlue is run compared to its peers. This measure is appropriate as the airline industry has a lot of capital costs, tying up vast amounts of capital in aircraft, spare parts, and facilities.
Comparing JetBlue with its peers Southwest and Alaska Airlines (ALK) we can see that JetBlue has a much lower return on invested capital. In 2019, JetBlue had a return on invested capital of 9.5% compared to the double digits ROIC of its peers. Looking at the company's operating margins / EBIT margins in comparison to its peers shows the same story as well. JetBlue has had consistently lower operating margins in the last 3 years compared to its peers. This indicates that JetBlue business is more expensive to run than its peers and it has additional costs that are not translating to additional revenue.
Note: I didn't include United Airlines and American Airlines as these companies do not present their ROIC.
Author's calculations using data from Seeking Alpha
JetBlue is well aware of this issue and such that even before the coronavirus pandemic has been making plans in order to increase profitability. Historically, the company's desire to improve the customer experience has been steadily increasing costs without the necessary improvements in top-line growth. Other drivers of costs have been maintenance-related which the company was able to renegotiate with Airbus (OTCPK:EADSF). At the beginning of 2020, the company announced that it was able to trim-off $314 million worth of non-fuel costs. Unfortunately, the company may not see the fruits of its effort due to the coronavirus pandemic completely upheaving the industry.
As detailed in my previous article, I believe the reduced demand and cash burn in the airline industry could lead to a price war among the airlines. Demand has been improving these last few weeks but is still a far cry from "normal times". The headline figures are misleading due to coming off a very low base. Total screenings by the TSA are still down 85% compared to last year. For example, on April 30 the TSA recorded 154,695 passengers screened vs. 119,629 the previous day, a 30% increase. Yet the same day last year the TSA screened 2 million travelers.
Given that airlines are losing millions daily and the commodity nature of the service, airlines could be inclined to lower prices in order to compete for the now limited demand. This sentiment was echoed recently by Southwest's CEO. In a "price war" scenario, the airline with the most efficient operations and cost-structure wins as they have room to lower their prices. As evidenced by the operating margins of the company, JetBlue is at a disadvantage in this situation due to its higher cost relative to its peers.
Even with capacity cuts, the number of available airline seats will still far outnumber customers in the near term, the chief executive officer said in a video message to Southwest employees on Friday. Demand for airline travel is expected to return slowly as the country starts to reopen its businesses.
With a potential price war putting more pressure on already struggling airlines, Southwest is preparing contingency plans in case more radical changes are required for survival, the CEO said
In terms of valuation, I am using the 2019 multiples pre-coronavirus rather than the forward multiples as these would show what the business is like in a stable environment. In 2019, JetBlue had an EPS of $1.91 implying roughly a 7.2x P/E multiple at a stock price of $13.69.
JetBlue always seems to trade at a premium relative to its peers (which have an average of 6.3x). My guess to why that occurs is that JetBlue always tops customer service rankings so the market awards it a premium because of that. While I enjoy flying in JetBlue, that premium is undeserved due to poor financial and operational metrics.
Author's calculations using data from Seeking Alpha
As discussed in my previous article, for the purposes of valuation, I consider the entire airline industry to be "in distress". The airlines are able to operate now but basically needed a bail-out from the federal government to survive. These companies may need to start raising capital if the situation does not improve rapidly.
In situations of distressed asset investing I usually look at the company's book value per share. This is because right now a new entrant can come in and buy all these assets if there is an imminent wave of bankruptcies or downsizing. For JetBlue, I would attach an additional discount of 10-20% due to poor financial and operational metrics. I believe that in times of distress, operational metrics would trump brand recognition. Currently, the book value of JetBlue is $17.02 per share. Applying the discount gives me a share price target of $13.62 - $15.32. At the price of $13.69, JetBlue is already at the lower end of my target range. I would stay away from JetBlue.
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