Take a company that has grown revenue at rates greater than 10% for the last five years and has projected five-year growth of 16% annually. The company has roughly the same amount as cash and debt on the balance sheet, and has been using that cash productively to reduce debt and buy back shares. How much would you be willing to pay for such a company?
Upon reflection, you might consider this business to be fairly priced at a P/E of 15 and a bargain in the low teens. Now, suppose that this company's P/E isn't even in the double digits but is rather an insanely cheap six. In other words, you can potentially buy this business at an earnings yield of approximately 18%.
The company? ExpressJetHoldings
The business
ExpressJet is the largest regional airline in the world, running 1,175 daily flights on behalf of Continental Airlines
The company focuses exclusively on operating flights efficiently and reliably. Continental handles the rest of the business, including marketing the brand, scheduling flights, and selling tickets. Continental then pays ExpressJet according to a formula that covers ExpressJet's expenses, plus a 10% operating margin.
ExpressJet has been quite successful with this model, growing seat miles at a 25% annual rate over the last five years. Its revenues are more than $1.5 billion a year, while its net income last year was $122 million. Its debt and cash are both about $200 million.
The valuation
So what's a company like this worth? Suppose you take analysts' estimates at face value and assume that the company grows cash flows 16% annually for five years and then at a 3% rate in perpetuity. Using a conservative discount rate of 15%, the company is worth about $25 a share, meaning that at the current price of about $10, it is trading at 40% of intrinsic value.
Even if you cut back on these rates, and assume that ExpressJet doesn't achieve that 16% growth, but only matches inflation, the stock is still worth $15. And that's assuming that the five analysts who came up with the 16% estimate are completely wrong in their projections for this company.
Industry risks
How can the company be so cheap? I think the market is pricing in a huge degree of risk. The airline industry sells a commodity product with high fixed costs and marginal costs of nearly zero -- it costs the airlines a lot to fly a given route, but once they're flying it, it costs almost nothing to fill an empty seat with another passenger. Thus, there's significant motivation to keep planes full. As a result, the market has intense price competition and frequent bankruptcies. The terrorist attacks of Sept. 11, 2001, exacerbated these issues, and most of the major carriers have suffered years of losses.
Plus, the business is changing. Discount airlines such as Southwest Airlines
Add to this mix collective bargaining issues, pension plan shortfalls, and soaring fuel prices, and it's easy to understand why Warren Buffett describes the business as "ungodly tough."
Company risks
On top of industry risks, ExpressJet faces some corporate risks as well. The company is joined at the hip to Continental -- most of its planes and facilities are leased from Continental, and ExpressJet even buys fuel at a discounted rate from its partner. This can be a competitive advantage, as it's unlikely that Continental would suddenly switch to a different regional operator and ExpressJet can focus on efficiency and reliability while leaving other aspects of the business to Continental.
But these close ties are also a disadvantage. If Continental suffers, then so will ExpressJet, and it has no other customers to ease the pain. Continental can cancel its purchase agreement with 12 months' notice. Plus, while the deal between ExpressJet and Continental currently gives ExpressJet operating margins of 10%, this rate is negotiated annually. If Continental needs to cut costs, it may reexamine this deal. In fact, it has already done so. Between 2001 and 2004, ExpressJet's margins were around 10%, capped at 11.5%. In 2005, the cap fell to 10%, resulting in a hit to ExpressJet's income.
The partnership could also hinder the company's ability to grow and do business with Continental's competitors. For example, it's unlikely that ExpressJet would ever be acquired. Under its agreement with Continental, any unauthorized change in control will result in ExpressJet's margins falling to zero.
Thus, ExpressJet shareholders need to stay aware of Continental's position in the industry. Continental has experienced many of the problems that have troubled the industry, including net losses in the all but one of the last five years. Unlike Delta and Northwest Airlines, Continental has avoided bankruptcy, though at one point it did warn that it could face liquidity issues should it fail to lower costs sufficiently.
Things are looking up recently. In October, Continental did a secondary offering of 20.7 million shares. That's an unfortunate 31% dilution for Continental's shareholders, but a positive for ExpressJet shareholders, who would like Continental's balance sheet to be as strong as possible. Plus, this month, Continental announced a deal with the flight attendants' union, following up a February agreement with mechanics and pilots, so labor disruptions are unlikely over the next few years. In addition, Continental's operating performance is improving along with the rest of the industry. Recent load factors have been up over 1% year over year.
Even on a good day, the airline industry is unlikely to ever be a friendly place for investors. And should terrorists strike, any recovery for Continental could quickly turn into a catastrophe, particularly considering the company's $6 billion debt. But for the moment, things look a bit less tenuous than in the recent past.
The upshot
Make no mistake -- ExpressJet is a risky company. But it's also pricing in a lot of that risk. Even if the company's growth only matches inflation, it's undervalued, and if it hits the estimates, it's insanely cheap. Whether it's cheap enough to buy depends on your tolerance for risk and your outlook for Continental and the airline industry.
ExpressJet is trading at price we love at Inside Value, but if you consider its competitive position, it's a business we'd rather avoid. Though not all Inside Value recommendations are as cheap as ExpressJet, they all have strong competitive positions. So, if you consider the risks as well as the potential reward, Inside Value's picks offer better odds.
If you're interested in our perspective on the top values in the market today -- including a company trading at a similar discount to intrinsic value, but with impressive competitive advantages -- we offer a free 30-day trial. You'll have access to our top recommendations, all our past picks, dedicated discussion boards, and tools like our discounted cash flow calculator.
Richard Gibbons , a member of the Inside Value team, wonders why people keep starting new airlines when they know the industry is dreadful. He does not have a position in any securities mentioned in this article. JetBlue and Priceline are Stock Advisor recommendations. The Motley Fool has adisclosure policy.
