One year ago, eight years after filing for bankruptcy, Mesa Air Group (MESA 3.61%) returned to the public markets, completing an IPO at $12 per share. The regional airline has taken investors on a bumpy ride since then, with the shares losing nearly half of their value.
The latest turbulence struck near the end of last week. The company reported disappointing results for the third quarter of its 2019 fiscal year and its guidance raised the possibility that things could get even worse. Let's take a look at why Mesa Air Group stock plunged 32% on Friday and what the company would need to do to bounce back.
The raw numbers
At first glance, Mesa Air Group's Q3 earnings report might not look too bad. Revenue increased 4.9% year over year to $180 million. Adjusted pre-tax income reached $13.4 million, up 15.9% from $11.6 million a year earlier. While adjusted earning per share fell to $0.30 from $0.37 in the prior-year period, that was just a consequence of the company's IPO, which increased its share count.
However, a look under the surface shows more cause for concern. Adjusted pre-tax income was $21 million in the second quarter of fiscal 2019 and $25 million in the first quarter.
Generally speaking, the spring season ought to be one of the most profitable times of the year, as that's when airlines tend to increase their aircraft utilization due to high travel demand. That wasn't the case for Mesa. The airline's two sequential declines in pre-tax income -- which have nearly cut its profit margin in half since the beginning of the fiscal year -- should be a big red flag for investors. Indeed, analysts had been expecting adjusted EPS to reach $0.55 last quarter.
Operations fall apart
Poor operational performance was the main driver of Mesa Air Group's sharp profit decline last quarter. Earlier this year, the company agreed to new contract terms with American Airlines (AAL 3.46%) that would have enabled Mesa to earn incentive compensation for meeting specified operational targets. Unfortunately, the carrier fell well short last quarter.
In early April, Mesa increased the number of spare aircraft it uses to support its regional flight operations for American Airlines from three to five. This was expected to improve its reliability. However, one of its aircraft was subsequently damaged by a ground handler. Two others were out of service for major maintenance for an extended period of time due to labor shortages at Bombardier. Effectively, Mesa had just two spares available for much of the quarter.
Even with two spares, Mesa might have been able to achieve the performance targets in its American Airlines contract under ideal conditions. However, the airline had to deal with lots of severe weather last quarter, leading to an elevated number of flight cancellations. This caused Mesa to miss out on the performance bonuses it potentially could have earned.
The outlook for Q4 isn't good, either. A second Mesa jet suffered ground damage on July 31, worsening the spare aircraft shortage. As a result, management expects to fall short of the American Airlines contract's performance targets in the July-to-August measurement period.
Plenty of upside -- but also massive risks
By the end of this month, Mesa expects to have all five spares available to get its operations for American Airlines running smoothly. Meanwhile, it has posted much better performance metrics for the flights it operates on behalf of United Airlines. Better operational performance could potentially drive a rebound in profitability in fiscal 2020. With Mesa Air Group stock currently trading for less than four times trailing earnings, this would make the stock look like a great turnaround play.
However, due to the company's poor operational performance, American Airlines has exercised an option to remove two CRJ-900s from its capacity purchase agreement with Mesa as of early November. It may exercise a second option to remove two more aircraft from service in early 2020. If Mesa can't redeploy those planes profitably, they will essentially be dead weight for the regional airline, weighing on its earnings for the foreseeable future.
Furthermore, Mesa has dozens of jets operating for United under capacity purchase agreements that will expire within the next year -- some as soon as the end of August. For many months, management has been telling investors that extensions will be signed soon, but nothing has been finalized yet. The American Airlines capacity purchase agreements start to expire in 2021, so that represents another potential challenge looming on the horizon.
Even if Mesa manages to get all of these contracts extended, it may have to offer concessions on pricing to seal the deals. That could cause its profitability to erode further. Thus, while Mesa Air Group may ultimately turn things around, there are a lot of things that could potentially go wrong. Investors should be able to find better opportunities elsewhere.