Via SeekingAlpha.com

We think that Mesa Air Group (MESA) could be an opportunity for swing traders looking for short-term gain, but there is too much risk and uncertainty for us to recommend a long-term position.

Mesa is a holding company that operates Mesa Air, a regional airline that provides service to 39 states and 5 countries. Mesa operates a fleet of 145 aircraft, with approximately ~660 daily departures and 3,600 employees. You might be wondering – if this company has services in 78% of states, how have I not heard of them before? The answer is simple – Mesa operates all of their flights under the American Eagle and United Express brands.

The immediate beauty of this business model, which will be described in further detail below, is that Mesa does not have advertising, selling, or marketing costs. Their two large clients, American Airlines. (AAL) and United Airlines (UAL), pay for all of the ticketing and selling costs for them. Mesa’s sole job is to fly passengers on less-popular, regional flights that for a traditional full service carrier, does not make sense to operate themselves. In addition, the company is shielded from having to pay for a majority of the standard operating expenses that come with an airline – fuel, ground operations, gate fees, as United and American handle all of that on behalf of Mesa, paying the suppliers directly. In essence, the largest recurring expenses for Mesa are the employees and the aircraft leasing / upkeep costs.

Business Model and Key Operating Metrics

Mesa operates under capacity purchase agreements with United Airlines and American Airlines, referred to as the “majors”. Under these agreements, Mesa operates regional flights that typically will have lower demand for a fixed fee per number of flights and number of block hours flown. In addition, each aircraft that Mesa operates for the majors has a fixed monthly revenue even if 0 block hours are flown. On top of the revenues per flight, per block hour and per aircraft, the majors also pay for most operational expenses including fuel, landing fees, ticketing, scheduling, ground crew, and insurance. The main costs that Mesa incurs during operations are aircraft purchases/leases, personnel salaries and aircraft maintenance. See below sections for more details on the specifics of the agreements that Mesa has with United and American.

In fiscal 2019, the company operated 456k block hours (11.02% increase from 2018), 247k departures (8.18% increase from 2018), and flew 14.7M passengers (8.17% increase from 2018). The company calculates its operating metrics using available seat miles (ASM) as a proxy for how much capacity they have across their fleet. ASMs are calculated by multiplying the number of seats on the company’s aircraft by the number of miles the seats have flown. Mesa had an ASM number of 10.9B in 2019 which was an increase of 11.84% from 2018. Between fiscal 2018 and fiscal 2019, the amount of contract revenue received by the company went from 639M to 683M (a 6.82% increase). As a result, the amount of contract revenue per ASM (CRASM) went from 6.58 cents to 6.29 cents (a 4.41% decrease) from fiscal 2018 to fiscal 2019. We can interpret this as a drop in utilization of Mesa’s capacity in 2019.

Fast forwarding to the most recent numbers reported for the quarter ending March 31, 2020, Mesa had an ASM of 2.6B and a CRASM of 6.35 cents. This is a 1.6% decline in ASM and a 0.78% decline in CRASM compared to the same quarter in 2019. Overall, these numbers tell us that while Mesa is seeing a reduction in utilization of their fleet, they are also seeing overall decrease in revenue. This means that drops in utilization rates are mainly attributable to a greater decrease in CRASM compared to the decrease in ASM.

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If the company sees an increase in demand for their services in the coming months, this could pay off well as they have relatively higher ASM to meet demands. However, if demand for regional flights remains the same or begins to drop, this could result in lower profit margins as revenue decreases while leasing costs increase / remain stagnant.

American Airlines Capacity Purchase Agreement

Currently, Mesa operates 56 total CRJ-900 aircraft for American Airlines. Per the company’s latest 10-Q, Mesa receives a fixed monthly minimum amount per aircraft under contract, plus additional amounts based on the number of flights and number of “block hours” (time from gate to gate, departure through arrival) that Mesa flies. The largest benefit of this contract is that Mesa does not have to pay for fuel, passenger liability insurance, aircraft property taxes, and other airport related facility and gate fees. However, to protect American from blindly losing money, there are utilization minimums that Mesa must meet before American has the right to “terminate” certain tranches of aircraft between the years 2021 and 2025. This means that if Mesa does not meet pre-established performance and usage metrics, American has the right to withdraw aircraft from Mesa’s fleet. However, the company does not see this as a huge risk. In their most recent 10-K, the company states:

We believe we are in material compliance with the terms of our capacity purchase agreements and enjoy good relationships with our major airline partners.

Even though not meeting their performance and usage metrics is not seen as a risk by the company, this has happened in the past and on various occasions throughout 2020, with American having removed 6 total aircraft from the Mesa fleet.

The contract between American and Mesa is such that termination is only allowed in the following scenarios:

  1. If either company goes bankrupt, the non-bankrupt party can terminate the agreement;

  2. Failure by either company to perform the duties outlined in the Capacity Purchase Agreement;

  3. If the FAA or DOT orders a suspension of operations due to the airworthiness of the classes of aircraft Mesa operates;

  4. If their controllable flight completion metrics fall below certain levels for a sustained period of time; or

  5. A change in Mesa control or ownership occurs without the approval of American Airlines.

In any of these above scenarios, there are a minimum number of days that either side has to provide the other before terminating the contracts. The agreement protects both sides from too much risk, and it gives both sides an out in the case that the other side does something that can be harmful.

United Airlines Capacity Purchase Agreement

Mesa operates 20 CRJ-700 aircraft and 60 E-175 aircraft for United, and the terms of the agreement with regards to what is compensated and reimbursed by United is very similar to the American Airlines agreement. An interesting difference is that of the 60 E-175 jets, United owns 42 of them and leases them back out to Mesa at a lower, discounted amount than what Mesa would get on the open market. Additionally, for the remaining 18 E-175s that United does not own, United would be liable for the upkeep and debt associated with those planes in the situation that United withdraws those planes from Mesa’s fleet before the contractual end of the agreement.

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The contract between United and Mesa runs through 2024-2028, depending on the tranche of plane, and is such that termination is only allowed in the following scenarios:

  1. If Mesa fails to meet certain operational performance metrics, United can withdraw from the agreement.

  2. If Mesa fails to meet the duties outlined in the Capacity Purchase Agreement, United can withdraw from the agreement.

  3. If either company goes bankrupt, the non-bankrupt party can terminate the agreement.

  4. A change in Mesa control or ownership occurs without the approval of United Airlines.

Again, in any of the above scenarios, to protect both sides from risk, there is usually a 30 days notice that is needed for a withdrawal from the agreement.

Risks

As with any investment, Mesa comes with risks as well. Since the company is very small (a market cap of $130M) and has a lot of factors that influence its profitability, Mesa especially has a lot of risks.

Competition: Mesa has a lot of competitors in its industry, including subsidiaries of its customers. As stated in their 10-K, competitors include

Air Wisconsin Airlines Corporation; Endeavor Air, Inc. (owned by Delta); Envoy Air, Inc., PSA Airlines, Inc. and Piedmont Airlines, Inc. (Envoy, PSA and Piedmont are owned by American); Horizon Air Industries, Inc. (owned by Alaska Air Group, Inc.); SkyWest Inc., parent of SkyWest Airlines, Inc. and ExpressJet Airlines, Inc.; Republic Airways Holdings Inc.; and Trans States Airlines, Inc.

With so many competitors, a slight slip up by Mesa could cause United and American to switch competitors or convince them to grow and greater utilize their own regional businesses.

Contracts: Mesa only has contracts with United and American and has no other customers. Both of its customers make up roughly half of the company’s business. This means that losing even a portion of 1 customer’s business could be devastating to Mesa. This is a very real risk as both United and American have the right to reduce the number of aircraft under contract given certain notices and conditions. In addition, both contracts have an expiration date (one in 2025 and one in 2028) with no guarantee of renewal.

Coronavirus: As mentioned above, the company’s capacity (measured in ASMs) has grown over the recent year. This means that the company recognizes more expenses for aircraft leases, maintenance and associated depreciation. If these new expenses are not accompanied by increases in revenue, the company’s profit margin could drop, reducing the value of the stock. With the recent coronavirus outbreaks, demand for flights has cratered, causing a lot of distress in the airline industry. As a smaller player operating less frequented flights, Mesa will be especially impacted by the lower demands and has already reported a massive decrease in block hours flown.

Valuation

We applied a traditional DCF valuation to Mesa, and arrived at an intrinsic value of $5.44, which implies a potential gain of 47.39% from the closing price on June 18, 2020. Our assumptions for the various growth rates and formulas are below:

Free Cash Flow:

  1. EBIT Growth: The CAGR of EBIT from 2016 to 2019 was a whopping 130.24%. For our projections, we forecasted a -50% EBIT decline for 2020 due to COVID-19, and from 2021-2024, used a conservative 12-24% EBIT growth rate per year. We are assuming that starting in 2021, demand returns to somewhat normal levels, and increasing air travel causes regional carriers to increase growth again.

  2. Tax Rate: We calculated their average tax rate over the past 4 years to be ~14%, and we applied that rate for the duration of the projections (until 2024).

  3. Perpetual growth rate: 2.5% to be conservative.

  4. Discount rate: 6.5%.

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Source: Excel model

Applying those assumptions to the existing financials from Mesa’s company filings returns a cumulative enterprise value of $938.6 million, plus $73 million in cash, less $843 million in debt, for a total equity value of $168.6 million. Per share outstanding, that equals a forecasted share price of $5.44. Considering that their 52-week high is $11.05, an intrinsic value that is 49% of that high water mark does not seem unreasonable, especially if Mesa and the airline/travel industries do recover as expected, at least to a degree of where they once were.

While Mesa is an undervalued asset based on our assumptions for this particular DCF, keep in mind that this is a highly leveraged company. It has a market cap of ~$130 million and over $800 million in debt. It was able to earn $723 million in revenue this past year, so it is trading at roughly ⅕ sales. Based on that leverage, however, it is very risky for the longer term investor in our eyes.

Conclusion

In conclusion, we feel that Mesa may have days where it moves significantly due to volatility and hopes of a recovery in demand after COVID-19 related lockdowns end, which may provide short term trading opportunities, but our long term outlook on Mesa is not very confident. Mesa operates a very unique business model in which their clients pay for a massive amount of their operational expenses, but at the end of the day, the risk of losing 1 of their 2 clients as furloughs abound presents a danger to Mesa. Given that all airlines are already on shaky ground due to lack of income and continued expenses with COVID-19, future business from United and American may be at risk.

Their balance sheet quality is low, with massive amounts of debt, and we are not confident in their ability to meet all present and future liabilities. Furthermore, there is simply too much power in the hands of their customers for us to feel comfortable making this a long term investment. There are safer, more stable recovery plays in the airline sector to be made.

I am/we are neutral on Mesa.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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