After rallying in 2012 and early 2013, Republic Airways Holdings (NASDAQ: RJET ) stock has gone into a big slump. The stock recently hit a new 52-week low more than 40% below its mid-2013 high.
Republic Airways and other regional airlines, such as SkyWest (NASDAQ: SKYW ) , have faced more than their share of problems recently. Legacy carriers have become less interested in using the 50-seat jets that are so plentiful at regional airlines. Meanwhile, a combination of low pay and new regulations has created a shortage of regional airline pilots. Lastly, bad weather caused airlines to cancel tens of thousands of regional flights this winter.
Nevertheless, Republic Airways looks extremely undervalued today. The company's inability to agree on a new contract with its pilots will force it to shrink in the next few years, but it will also reduce costs and free up cash that can be returned to shareholders.
Pilots fight back
Regional airline pilots have become increasingly militant as the pilot shortage has given them newfound bargaining leverage. Pilots at SkyWest subsidiary ExpressJet and American Airlines (NASDAQ: AAL ) subsidiary American Eagle recently rejected contract proposals that entailed concessions on the pilots' part.
Earlier this month, Republic's pilots rejected a new contract offer, even though it included raises and a signing bonus. Clearly, the Republic pilots believed that the raises and work-rule changes were not good enough.
The contract rejection means that Republic will continue to have trouble recruiting pilots. (Since Republic's pilots are unionized, the company cannot unilaterally offer higher pay to attract new pilots.) This means that Republic will park more 50-seat jets in the next two years or so, a process it began earlier this year.
The benefits of the contract rejection
But there are compensating benefits for Republic Airways. The company had been budgeting for significant pilot raises and a signing bonus in 2014. The cost of implementing the new contract was the biggest reason why CFO Tim Dooley originally projected that EPS would probably decline year over year to a range of $0.90-$1.20.
Now that pilots have rejected the contract, Republic will not be on the hook for the raises or the signing bonus. The company has not quantified the impact of these changes yet, but they are likely to be significant.
Additionally, without a new pilot contract in place, Republic Airways cannot consider growth initiatives. As a result, it does not need to keep extra capital around to invest in future growth. Instead, the company plans to return $75 million to shareholders through a combination of share repurchases and early retirement of convertible debt. This could shrink the diluted share count by about 15%, providing a corresponding boost to EPS.
Between the lower labor costs and lower share count, Republic is now on track to post significantly higher EPS than originally expected, both for 2014 and the next few years. The average analyst estimate for 2014 has already risen from $1.04 to $1.09 in the last week, and it is likely to rise further when Republic updates its guidance later this month.
As I have noted in previous articles, among regional airlines, Republic Airways is relatively well positioned because it has fairly low exposure to small regional jets. While competitors like SkyWest are still flying hundreds of these inefficient planes, Republic is down to several dozen, compared to its nearly 200 larger regional aircraft.
It's not all smooth sailing ahead for Republic. It will continue to face a drag from the scarcity of pilots, which has forced it to ground some of its small regional jets prematurely.
But Republic Airways is arguably the strongest player in the regional airline sector. Moreover, the company trades for around seven times earnings and well below book value -- making it an attractive value investing opportunity. As a result, I increased my investment in Republic Airways last week.
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