Like other regional airlines, Republic Airways Holdings (NASDAQOTH:RJETQ) has been hard hit by the growing U.S. pilot shortage. However, while rivals such as SkyWest (NASDAQ:SKYW) are struggling to stay in the black in this challenging environment, Republic's focus on more-profitable large regional jets is allowing it to boost earnings.
In fact, Republic Airways just reported first-quarter earnings per share of $0.26, which represents 18% growth in pretax income from continuing operations. Furthermore, Republic raised its full-year EPS guidance from $0.90-$1.20 to $1.20-$1.40. Based on this solid outlook, Republic still looks extremely undervalued.
A tough quarter
Numerous airlines reported that severe winter weather impacted their results in the last quarter. No one was affected more than the regional airline industry. Regional airlines fly small planes, and the legacy carriers usually control their flight schedules. When severe weather forces flight cuts, regional airline flights are the first to go, since these cancellations affect the fewest people.
Republic Airways canceled more than 12,400 flights in the first quarter, representing a 145% year-over-year increase in cancellations. Meanwhile, SkyWest had to cancel about 21,000 flights due to the severe weather.
However, Republic's superior contractual terms meant there was a night and day difference in the two companies' performances. SkyWest recently estimated the impact of cancellations at $30 million (compared to $7 million at Republic), which will cause it to report an ugly first-quarter loss.
Navigating the pilot crunch
Regional airlines constantly need to recruit new pilots just to replace the steady stream who resign in order to take jobs at major carriers that provide more upward mobility. And if a regional airline wants to grow, it needs to hire even more pilots!
Pilot recruitment has become a huge problem for regional airlines due to low starting wages and new rules that require 1,500 hours of flight time for co-pilots. In February, Republic Airways removed 27 small regional jets from service this year to free up pilot labor for 25 new 76-seat jets that it will fly for American Airlines (NASDAQ:AAL).
Republic can barely find enough pilots to offset attrition, making fleet growth impossible. Since the large regional jet service for American Airlines will be more profitable than flying small regional jets, Republic decided that the best course of action was grounding the small regional jets.
Republic Airways has also tried to attract more pilot candidates by proposing a new contract for those employees. The terms would have raised wages to near the top of the regional airline industry. However, Republic's pilots soundly rejected the contract proposal, instead holding out for bigger raises.
Many other regional airlines have had similar problems. Pilots at American Eagle (a regional subsidiary of American Airlines) recently rejected a long-term-contract proposal, as did pilots at SkyWest's ExpressJet unit.
Capital return over growth
After its pilots rejected the tentative contract agreement, Republic Airways management realized that it would be impractical to grow in the future. Instead, the company now appears focused on returning excess capital (which it had previously hoped to invest in various growth initiatives) to shareholders.
Last month, Republic's board of directors approved a $75 million capital return program. This authorized management to repurchase a combination of stock and convertible debt totaling $75 million within the next 12 months. On the same day, the company paid $22.3 million in cash to redeem a convertible note, which will reduce its diluted share count by 2.2 million shares.
While Republic had hoped to grow its fleet of large regional jets, its new plan to keep the fleet count flat should also work out well for shareholders. In the last six months or so, Republic's market cap has fallen below its book value again. While the stock has bounced by 20% since hitting a 52-week low last month, it still sits about 15% below book value of more than $11 per share.
As long as Republic stock remains below book value, its share repurchases will increase book value per share. Republic's low price-to-book ratio provides a considerable margin of safety for investors.
Republic's new focus on capital returns rather than growth could pay off for investors. The last few aircraft for its new American Airlines contract will arrive in early 2015. After that, the company will generate significant free cash flow until it starts taking delivery of CSeries jets for its proposed low-cost carrier venture (something that may never happen).
This free cash flow will allow Republic to pay down aircraft debt (reducing interest expense) and repurchase more shares. Either of these would produce EPS growth even in the absence of revenue growth.
In short, Republic Airways shares remain significantly undervalued. They currently trade for less than eight times the bottom of management's EPS guidance range and for less than book value. This gives Republic Airways stock as much as 50% upside in the next one to two years.
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Adam Levine-Weinberg owns shares of Republic Airways Holdings and is long November 2014 $7.5 calls on Republic Airways Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.