Why I Bought Into Republic Airways

For years, investors lamented Republic Airways' (NASDAQ: RJET) decision to diversify beyond the regional airline business. The Frontier airlines low-cost-carrier operation was seen as a money-wasting distraction. Thus, it's surprising that investors haven't looked too kindly on the company's decision to get out of this secondary business.

Republic Airways YTD price chart, data by YCharts.

The regional airline business is tough, but Republic Airways is in a better position to meet those challenges than it has been for years. The company has a significant amount of growth already locked in for the next two years, with further growth opportunities beyond that. With the stock trading for more than eight times projected 2013 earnings, the potential rewards seem to outweigh the risks for Republic Airways.

Simplifying the business
One of the biggest advantages of the regional airline business -- compared to the rest of the airline industry -- is that most revenue is locked in under "fixed-fee contracts" with the major airlines. Republic is thereby insulated from swings in passenger demand. Republic's partners even pay for the company's jet fuel, removing another source of volatility.

By contrast, the Frontier Airlines segment had neither of these advantages. It was at the mercy of passenger demand and fuel prices. While the decision to sell off Frontier will hurt EPS in the short run, it eliminates a significant source of uncertainty.

Republic also offloaded some of its debt as part of the sale, and it will receive approximately $77 million of cash proceeds. This can go toward reducing the company's still significant debt load. That will help mitigate another one of Republic's key business risks. The sale of Frontier should therefore justify a higher earnings multiple for Republic: something that has not materialized yet.

Good earnings prospects
Stripping away the Frontier Airlines segment, Republic Airways has generated strong earnings growth this year. Adjusted EPS totaled $0.75 last year, but the company has already posted adjusted EPS of $0.84 for the first nine months of 2013, and management expects EPS of $0.30-$0.40 in Q4.

Profit improvements have been driven by the restructuring of Chautauqua Airlines, the business unit responsible for flying small regional jets, along with growth in Republic's large regional jet and turboprop flying. At the end of Q4, Republic Airways expects to have 249 aircraft in fixed-fee service, up from 222 at the end of Q1.

Republic's primary near-term-growth driver is a recently implemented contract to fly 76-seat regional jets for AMR's (NASDAQOTH: AAMRQ) American Airlines subsidiary. Last quarter, Republic began flying the first four jets under this contract, and it will top out at 47 jets in early 2015. The 76-seat jets also provide a much better profit margin than the 50-seat jets that Republic is gradually phasing out.

A cheap stock with growth prospects
Right now, I think investors are underrating Republic's long-term prospects. After the stock's recent slide below $10, it trades for just eight times current-year earnings, even though the American Airlines contract just started ramping up and creates a strong likelihood of earnings growth in the next two years. I believe this bargain price is more than adequate compensation for the risks inherent in Republic's business.