In the last year, earnings performance at regional airline SkyWest (NASDAQ:SKYW) has deteriorated rapidly as many of the threats it faced came to fruition. While the stock market as a whole has gradually moved higher, SkyWest shares have dropped, reaching a new 52-week low late last month.

SKYW Chart

SkyWest vs. S&P 500 data. Source: YCharts.

Investors have had plenty of reasons to stay away from SkyWest stock. While SkyWest looks very cheap by some typical valuation metrics, it is on track for a big drop in earnings this year, primarily due to a combination of bad weather and bad regional flying contracts.

As a value investor, I find SkyWest enticing because the company's market cap is currently less than half of its book value and the stock trades for a little more than three times free cash flow. However, I still plan to stay away until it shows that it can stabilize and then rebuild its profit margin.

Hitting rock bottom
Last week, SkyWest reported an ugly $0.44/share loss for Q1. SkyWest was forced to cancel about 21,000 flights due to severe weather at many of its hubs this winter, which had a negative pretax impact of $30.3 million.

Most regional airline contracts call for some level of reimbursement from the mainline carrier for weather-related cancellations, as the mainline carrier controls scheduling (and canceling) flights. However, SkyWest has one large contract with United Continental (NYSE:UAL) that does not include any compensation for weather-related cancellations.

SkyWest's regional flights for United Continental have become a money pit. Photo: The Motley Fool

These weather issues piled on top of the main problem that has been causing fits for SkyWest recently: the unprofitability of its ExpressJet business unit. As SkyWest President Brad Rich stated on the company's recent conference call, ExpressJet would have been unprofitable last quarter even if the weather had cooperated.

ExpressJet primarily flies 50-seat regional jets as United Express, although it also does some regional flying for Delta Air Lines (NYSE: DAL). The 50-seat jet business is going downhill quickly, and ExpressJet's contract with United Continental is particularly unfavorable. SkyWest executives recognize that they need to end this money-losing flying, but doing so will be a long, drawn-out process.

Fixing the mess
SkyWest's primary tool for boosting its profit margin is allowing unprofitable contracts to expire. However, while SkyWest has 50-seat jet flying contracts coming up for renewal every year, the jets covered by its problematic United Express contract still had an average of 4.3 years left under contract as of December 31. The contract terminates in 2020.

As individual aircraft come up for renewal, SkyWest may offer to keep them in service under terms that would allow it to be reliably profitable. If SkyWest cannot come to an agreement with United (or its other legacy carrier partners), it will walk away from the business. At that point, it would only be responsible for relatively modest lease return costs.

SkyWest plans to ground hundreds of small regional jets like this one in the next few years. Photo: The Motley Fool

In addition, SkyWest is growing its large regional jet operations. Starting later this month, the company will operate 76-seat jets for United Express, which will be much more profitable than the 50-seat jet flying it is replacing. Ultimately, SkyWest is scheduled to add 40 76-seat jets by the end of next year, and it may have other opportunities to grow its large regional jet business.

Bargain valuation?
While SkyWest shares trade for just above 10 times the company's 2013 earnings, analysts expect EPS to be cut in half this year. At more than 20 times 2014 earnings estimates, SkyWest looks very expensive for a struggling company.

However, there's more than meets the eye. First, SkyWest is currently valued at less than half of its $1.4 billion book value. Second, SkyWest's earnings could bounce back next year -- weather permitting! -- as the company removes unprofitable 50-seat jets from its fleet and adds more lucrative 76-seat jets.

Third, and most importantly, SkyWest's cash flow vastly outstrips its earnings. SkyWest has nearly $250 million in annual depreciation expense, due to earlier capital spending on its nearly 200 owned aircraft (most of SkyWest's planes are leased, though).

The resulting cash flow is more than what is needed to pay off SkyWest's debt -- an average of about $180 million matures each year for the next several years. The difference could potentially be returned to investors through dividends or share repurchases, and SkyWest has been pretty good about returning cash to shareholders in the past.

Foolish bottom line
SkyWest's extremely low price-to-book valuation, its strong cash flow, and the possibility of a rapid rebound in earnings make it an interesting opportunity for value investors. On the flip side, the company's ExpressJet unit has been a persistent loss maker, in part due to its below-market contract with United Continental.

SkyWest has not clearly articulated how quickly investors can expect ExpressJet to return to profitability -- or at least break even. If half of SkyWest's business continues to lose money for years to come, the company could turn out to be a value trap. I'm putting SkyWest on my watchlist, but I won't invest until I see more tangible evidence of a turnaround.

Adam Levine-Weinberg is short shares of United Continental 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.