All value investors should pause for a moment and consider an investment in the airline industry. JetBlue Airways (JBLU) has done an outstanding job of building a niche franchise in a miserable industry. Very few investors seem to understand the unique franchise that JBLU has built. Selling for less than a pretty clean book value, and with a balance sheet that is better than it appears, I believe JBLU is a stock that value investors should own.
After a brief review of my sanity, I will explain some of JBLU's unique characteristics, review its current valuation, and discuss a few miscellaneous topics.
THE WORLD'S WORST INDUSTRY
"It just might be a lunatic you're looking for" - Billy Joel
Let's answer the most important question first. Would any sane person invest in the airline industry?
-the big airlines have lost roughly $55 billion in the last ten years
-all the big airlines (except for Southwest Air (LUV)) have gone through bankruptcy
-Warren Buffett said, "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down." - Warren Buffett, annual letter to Berkshire Hathaway shareholders, February 2008.
As a generalist value analyst for the last 30 years I must admit I seldom wasted a minute looking at this industry. Even though many of the stocks were often statistically very cheap, other than an occasional glance at LUV, I always had better things to do.
What changed? In a desperate search for new ideas, I reviewed the portfolios of professional investors who I have great respect for. One whom I particularly admire is Donald Smith & Co. This firm manages over $3 billion in institutional money using a strict discipline of investing in only the bottom 10% of price/book value stocks. Looking at their portfolio, I think they really understand this unique universe. Smith & Co. has owned JBLU since 2008, and they are now the largest shareholder with just over 10%.
It is also worth noting that the guys at PRIMECAP Management own 8% of JBLU and 11% of LUV. These guys are too growth oriented for me; they own things like Google and Amgen. Even the well respected John Hussman started a small position in the last quarter.
Have these apparently smart investors all gone mad? When I spent some time looking at JBLU, I must admit I was surprised by what I found.
CUSTOMER SERVICE AT AN AIRLINE, IS IT POSSIBLE?
The biggest misconception that most investors have about JBLU is that it is a "discount" or "value priced" airline. In fact, JBLU has such a high degree of customer service that it has the highest customer satisfaction rating in the industry. Whether this high degree of customer satisfaction can be translated into profitability is the great and yet unanswered question.
The following table shows the NPS score for JBLU, other airlines, and a few other consumer businesses. NPS (Net Promoter Score) is based on one simple question, "Would you recommend this product or service to a friend." The approach has been used successfully by Apple Retail, General Electric, and many others.
Table 1
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Using a scale of -100 to 100, JBLU scores at about 65 to 70, while Southwest Airlines is the only one close at about 55. More importantly, JBLU's direct competitors (the large airlines) score, not surprisingly, around 0 to 10. For a reference point, Apple scores slightly higher at about 75. If this measuring tool is anywhere near correct, then JBLU is clearly a differentiated airline.
JBLU earned this reputation in a number of ways. It has always had leather seats with 30+ channel TV's in all of its planes. It does not offer first class, but often outfits its planes to provide slightly more leg room and baggage space. The target has always been the leisure traveler, not the business traveler. Perhaps more importantly, it built a workforce oriented toward customer service. JBLU is a non-union carrier, but not necessarily a low wage carrier, because of a generous profit sharing plan.
JBLU has built a unique niche that I certainly did not understand before I began investigating this company. If industry consolidation eventually leads to more rational pricing, then the benefits could eventually accrue to JBLU. The JBLU investment case rests squarely on the fact that it has built a differentiated product in an often commodity oriented industry.
THE BALANCE SHEET, BETTER THAN IT LOOKS
Given the slew of airline bankruptcy, did you ever think you would see an airline with too much cash? In 2012, JBLU actually pre-paid about $200 million for some future aircraft deliveries. By getting favorable terms from the manufacturer, JBLU decided the prepayment was better than having extra cash.
During the last investor day presentation, JBLU's CFO actually said that he has plenty of free cash flow. Did you ever think you would hear an airline CFO utter these words? The following tables show how JBLU has been able to significantly reduce debt while at the same time growing available seat about 30%. Another key takeaway is that cash from operations has been consistently above $500 million for the past 4 years. Note that the following tables adjust for leased aircraft.
Table 2
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Table 3
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VALUATION
Trying to value airlines is a tricky business. Earnings are so volatile because of variable fuel costs that it is difficult to get a handle of exactly what "normalized" earnings actually might be. My approach to valuing JBLU is to first ask the important question, "what is the least that JBLU might be worth?" This is a number I have great confidence in. I will then try to argue what JBLU might be worth in a "better case" scenario.
There was an important transaction in the airline industry in September 2010 when Southwest Airlines acquired AirTran. Southwest paid about $1.4 billion in cash and stock and assumed roughly $2.0 billion in net debt. Because of complex factors like leases assumed and outstanding hedging obligations, this number is just a "ballpark" guess and not a hard number.
Again using "ballpark" numbers this amounts to about 1.5x book value and over 1x revenue, as the price paid for AirTran. AirTran is similar to JBLU because it was a non-union carrier with a limited geographical set of routes. However, by any important comparison JBLU is a far superior airline to Air Tran:
- Over the period 2006-2011, JBLU's operating margin was more than double AirTran's (very roughly 12.5% to 5.0), and was much more consistent (AirTran had a negative operating margin in 2008, while JBLU was still 9%).
- AirTran was more leveraged and had "near death" experience in 2008, while JBLU has adequate liquidity.
- JBLU has a newer fleet of planes, and significant investments in terminal improvements that AirTran never had.
- Arguing the value of "gate slots" is tricky, but JBLU's East coast gates are probably worth more than AirTran's Atlanta hub.
- JBLU has a much better reputation with its customers.
With JBLU currently selling below book value and at roughly 1x revenue (adjust for net debt), the AirTran transaction gives me great confidence that the downside risk in JBLU is limited.
The upside case is more tenuous, but not unrealistic. One could use the AirTran transaction above to come up with a higher "target price." There have been several articles that have stated that JBLU could be a buyout candidate. They theorize that either American or US Airways would be the logical suitor, if their proposed deal is not allowed. Given the unions have a big voice in the operations of the legacy carriers, I think this is possible, but not likely. There has also been some speculation that the old boss, David Kneeleman, could be interested, but it would be difficult to see how such a deal could be financed. I would not recommend buying JBLU because you think it might get bought.
I would recommend investing in JBLU because earnings could improve to $.80 to $.90 per share over the 2014-5 time period. Estimates had been this high for 2013, until unexpected maintenance costs and high fuel prices raised their ugly heads. The "dog ate my homework" excuse is getting a little tiring, but the $.80-$.90 estimate is not impossible.
What kind of multiple do such earnings deserve? I think Alaska Air and Spirit are the relevant comparisons. There are so many complexities in the earnings of the legacy carriers that I think they are not important comparisons. ALK sells about 11-12x and SAVE at about 16-18x.
JBLU still has enough growth stock characteristics that I think it could sell for 12x (assuming a market multiple of 15). So 12x a mid-point of $.85/share estimate gives me roughly a $10/ share target price.
Without the solid asset value hinted by the AirTran transaction, I think the earnings guess and relative multiple guess is a pretty flimsy valuation method. However, given limited downside, any earning improvement give JBLU an interesting "call option" value.
Is this "upside case" more dependent on macro factors that I would like it to be? Absolutely, to invest in JBLU you must assume that the U.S. economy will not enter a long recession, or that oil prices will not go to $150/barrel and stay there. This is the dirty reality of investing in cyclical stocks. All you can do is to assume the worst, and hope for the best. Can an airline have an asset value that protects the downside? I think JBLU has such a value.
THE LOSS OF THE ENTREPRENEURIAL FOUNDER OF JBLU
Any investment in JBLU is complicated by the board of directors removing the visionary founder, David Neeleman, in 2007. Mr. Neeleman's background, the start up of JetBlue, his removal, and his recent start up of the rapidly growing Azul Brazilian Airways is well chronicled in a half-hour video interview here.
David Neeleman was a college dropout who helped build one of the first discount carriers, Morris Air, which he eventually sold to Southwest Airlines in 1993. Some thought he could be the successor to the legendary Herb Kelleher at Southwest. Kellehar fired Neeleman after 5 months when Neeleman's management style conflicted with longtime Southwest managers.
After sitting out a 5-year non-compete agreement and being a very successful consultant to the Canadian low-cost airline WestJet, Neeleman started to formulate the plan for JBLU. The story is well chronicled in the book, "Flying High…," that can be found here.
JBLU went public is early 2002, and was quite a "high-flyer," despite poor industry conditions caused by the 9/11 attacks only a few months earlier.
Growth was rapid, perhaps too rapid, but in general things were going well until an ice storm in February 2007. JBLU refused to cancel flights, and when the storm worsened, many passengers were caught for hours on the tarmac when there were not enough gates to return to. The fiasco caused an estimated $30 million dollar loss, and a significant loss of customer goodwill. Neeleman was fired by his board of directors a few months later. Was the ice storm the sole cause? No one will ever know for sure. It is quite possible that the board was uncomfortable with Neeleman's rapid growth plans and suspect balance sheet.
The board put David Barger in charge, and he remains there today. Barger was the "operating guy," that the "vision guy," Neeleman, brought in to start JBLU. He is not nearly as flamboyant, or dynamic, as Neeleman, but he might very well be a better manager.
Neeleman has gone on to found a very successful airline, Azul Brazilian Airways, in his native country. The company could well go public in the near future.
The airline industry is widely covered by the mainstream media. It is full of well publicized characters and scoundrels. Value investors are used to dull and musty companies that almost no one cares about. JBLU is a different animal.
Any company that is only 15 years old, and has not had its visionary founder at the helm for the last 5 years is bound to experience some problems. I believe these issues are well known, and reflected in the current stock price. Not that many industry experts believe that JBLU can succeed without Neeleman. Given the "odds" reflected in the current valuation, I believe it is a good time to once again bet against the experts.
WHAT CAN GET BETTER
- Macro - Airlines still must be viewed as consumer cyclicals. The considerable improvements JBLU has made in the last 5 years were accomplished during a period of stubbornly high unemployment. If economic conditions improve, then JBLU's improvements might become more obvious.
- Industry - Airline industry fundamentals almost have to improve over the next 10 years, because it is hard to imagine them getting any worse. Going from 7-8 major carriers down to 3-4 should reduce excess capacity and allow fares to slowly rise. This will not occur overnight, but the next 10 years will be better than the last 10.
- Company specific - Even if you do not think the economy will ever improve, or if you believe industry fundamentals will remain miserable, there are enough good things happening at JBLU to justify an investment.
- Transcon - JBLU has significant room for improvement in its transcontinental flights. In the previous table that showed customer satisfaction, JBLU's performance on its transcontinental flights (New York and Boston to Long Beach's Airport, primarily at non-peak times) is well below its Florida traffic. JBLU is taking steps to improve this business. The biggest improvement is access to high speed Internet through the entire flight.
- Relationships - JBLU is steadily increasing its relationships with non-domestic airlines. This has not always been a part of the JBLU business model. The latest of these deals was with British Airways. It was interesting that during the last conference call, the CEO expressed disappointment that the analysts did not ask any questions about the new relationships.
- The Next Boston - JBLU deserves enormous credit for what it has accomplished at Boston's Logan Airport over the last 5 years. The following slide shows JBLU's accomplishments, both in terms of market share and margin. It should be noted that no industry expert thought this was possible.
Table 4
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Similar transformations are already well underway at Ft. Lauderdale and San Juan, Puerto Rico. The real question is, what is next? I have no idea, but when that next growth step is announced, it has the chance to be a significant positive that is not in any analyst's estimate.
JBLU's ability to grow during a difficult environment has been somewhat "off the radar."
WHAT HAS BEEN GOING WRONG
- Costs - Analysts are disappointed in JBLU because they have missed their earnings numbers for the past 3 quarters. So despite JBLU's improving fundamentals, the analysts are not recommending the stock. The earnings misses have been caused by high fuel costs and unexpected maintenance expenses. When fuel costs are rising, the analysts always think you should have hedged more, when prices fall they think you should hedge less. Volatile jet fuel prices and the high cost of hedging make JBLU's earnings almost a "random number generator." To me, this means the best time to invest is after several misses.
- Spirit Airlines - Perhaps the most troubling longer-term issue that JBLU faces is the success of Spirit Airlines (SAVE) over the past several years. SAVE is not a direct competitor because of its no-frill approach, but they have nipped away at the bottom end of the Florida market. SAVE is a Wall Street favorite, with 10 Buy recommendations, and only 1 hold recommendation. Hopefully SAVE will not be too aggressive on price as it competes with JBLU. This is an issue that should be watched carefully.
CONCLUSION
The easy way out is to say, "I never look at airlines, I hate the industry, I'll pass." I challenge all value investors to take the more difficult path and give JBLU a look. JBLU has some unique characteristics that make it an interesting investment. I believe that downside risk is limited, and the upside potential is substantial. One of the very best low price/book investors (Donald Smith & Co.) is the largest shareholder with a 10% position. Go ahead, give that creativity muscle a workout.
Additional disclosure: Business relationship disclosure: Investing 501 is a pair of analysts with over 60 years of professional investment experience. This article was written by Gregg Jahnke, one of our
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