Great Lakes Aviation Is Not Your Typical Airline – GLUX

Great Lakes Aviation is a regional air carrier serving 47 airports and operating 34 aircraft. Though Great Lakes is strongly profitable and produces copious free cash flow, the market values the total company at a mere 2.16 times EBITDA and the equity at just 3.38 times free cash flow.

The market’s dim opinion of Great Lakes is precipitated by the historically abysmal economics of the airline industry and by the company’s recent brush with bankruptcy. However, the actual significance of each of these factors is greatly overblown.

The airline industry is well-known for chronic over-capacity, labor issues, commodity cost shocks and ultimately, bankruptcies. Warren Buffett (himself having lost money on airline investments) is unequivocal in his opinion of airlines, writing:

“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in.”

Despite the poor results of most airlines companies, Great Lakes has an excellent track record. Great Lakes profited in every year since 2002, averaging a 6.40% operating margin and a 11.8% EBITDA margin. Free cash flow was positive in each year, averaging 7 cents on each dollar of revenue.

A chief reason for the company’s relative success is its extensive participation in theĀ Essential Air Service (EAS) program, a government initiative that subsidizes flights to and from remote, rural locations. This program allows Great Lakes to operate flights to places like Devils Lake, North Dakota and Show Low, Arizona. The EAS was enacted in 1978 following airline deregulation to ensure certain rural communities would not lose access to air travel. The EAS has faced criticism as wasteful spending and it very well may be. However, the existence of the EAS has been reauthorized by the US senate and congress through September 30, 2015. The future of EAS is uncertain, but I would bet on rural senators and representatives going to bat for the program after 2015, seeing it as a relatively low-controversy way to “bring something home for constituents.”

At present, Great Lakes derives more than 40% of its revenues from EAS routes, but the company is making efforts to rely more on passenger revenue and less on government subsidy.Here’s a look at the company’s route map as of its last annual report. Since then, the company has added a few new routes and cut a few others.

0001193125-12-138694_G283662G75R25

Despite Great Lakes’ strong operating profits, the company skirted bankruptcy in 2011. In the early part of the 2000s, Great Lakes was massively over-leveraged, at one point owing over $130 million to Raytheon Aircraft Credit Corporation and losing buckets of money. Great Lakes slowly fought its way back to profitability, gradually reducing debt through using its operating cash flow or through structured debt forgiveness agreements. One such agreement on December 31, 2002 resulted in Raytheon Aircraft Credit Corporation owning 36% of Great Lakes’ shares. In the decade that followed, Great Lakes paid down debt and built book value per share from negative $3.12 in 2002 to $2.00 in 2010. This remarkable turnaround lead shares of Great Lakes to rally 900% from the end of 2002 to November, 2010. However, the company still owed millions to Raytheon Aircraft Credit Corporation. Raytheon informed Great Lakes that it had no intention of refinancing the remaining $32.67 million in debt due June 30, 2011, leaving Great Lakes scrambling for alternative financing. After multiple debt maturity extensions, Great Lakes finally found lenders willing to refinance its debt and provide a line of credit. Raytheon accepted a payment of $27 million for full satisfaction of the company’s remaining debt as well as all 5.37 million shares of Great Lakes owned by Raytheon. As a result of the transaction, Great Lakes Aviation’s shares outstanding declined by 37.5%.

Great Lakes Aviation found a savior in its new lenders, GB Merchant Partners and Crystal Capital, but its salvation came at a cost. The four-year, $29.5 million term loan executed with GB Merchant Partners bears interest at LIBOR plus 11% with a minimum of 15.5%. The line of credit provided by Crystal Capital bears interest at LIBOR plus 8% with a minimum of 10.5%. These rates are punitive, but not unheard of for asset-based lenders, which extend loans based on the value of hard assets, not against a company’s potential profits or cash flows. Asset-based lenders lend primarily to distressed companies with few alternatives. The GB Merchant Partners term loan provides for yearly principal reductions funded from the company’s “excess cash flow.” The first of these was made in the amount of $2.1 million in November, 2012. This forced amortization will greatly reduce interest expenses in future years. Still, Great Lakes Aviation would be well-advised to seek traditional financing at more reasonable interest rates at the earliest possible junction. Simply managing to reduce interest rates on the term loan and line of credit to 10.5% and 5.5% would increase earnings per share by 9.7 cents. A refinancing will become easier as the company continues to reduce its debt load and contractual pre-payment penalties on the term loan decrease.

Operating conditions for the Great Lakes have been favorable, and the trailing four quarters saw the company produce its highest ever revenues. EBITDA and operating income rose but remain slightly below highs set in 2009.

GLUX Income

Fuel costs are the biggest reason for the lagging EBITDA and operating income. In 2009, aircraft fuel costs accounted for 21.9% of revenue. In the twelve trailing months these costs rose to 30.2% of revenue. The future course of fuel prices is unpredictable and Great Lakes does not hedge its exposure to fuel costs. Fortunately, Great Lakes remained profitable even as fuel costs rose to record highs in 2008.

Great Lakes Aviation’s balance sheet is the strongest it has been at any point in the last decade. The company’s net debt of $20.84 million is 1.20 times trailing EBITDA, compared to net debt to trailing EBITDA of 3.91 in 2007. The Q3 2012 cash and debt figures are adjusted for the November 2012 $2.1 million principal payment.

Balance sheet

Great Lakes produced 55 cents in free cash flow in the trailing twelve months. With a share price of $1.86, this free cash flow is being capitalized at a whopping 29.6%. A more reasonable capitalization rate of 12-15% would indicate a share price of $3.67 to $4.58, well above current levels. A large part of this cash flow is earmarked for debt reduction, but shareholders will benefit greatly from the deleveraging process. Each dollar devoted to reducing principal on the company’s term loan increases after-tax income by slightly more than 10 cents and increases equity’s claim on the total enterprise value by the full dollar.

Being conservative, let’s imagine that Great Lakes can maintain constant EBITDA of $15 million and free cash flow of $4 million per year. Each of these figures is a material decrease from actual trailing results. If the company uses all of its free cash flow to pay down debt for the next three years, shares would have to appreciate by 40% just to maintain today’s EV/EBITDA ratio of 2.16. But that’s ridiculous. A 2.16 EV/EBITDA ratio for the company that is not either massively over-leveraged or experiencing precipitous declines in revenues and EBITDA is in no way justifiable. What if we look at the same scenario but assume that the company trades up to a more reasonable 4.5 EV/EBITDA over three years? In that case, shares would appreciate by 249% or 51.6% annually.

Despite Great Lakes Aviation’s potential, risk is high. Fuel costs could roar higher and pressure the company’s margins. GB Merchant Partners could refuse to refinance the company’s term loan in four years (though hopefully the company will find alternative financing by then). CEO Douglas Voss controls nearly half of shares outstanding and effectively controls the company. Investors must trust him to make good capital allocation and business decisions. Perhaps most worryingly, cuts to the EAS program could destroy the profitability of many of the routes Great Lakes flies.

Despite these risks, Great Lakes looks attractive on a risk-adjusted basis. If Great Lakes can navigate these operational risks and continue to improve its capital structure, shareholders could be looking at a much more valuable company in just a few years.

Disclosure: no position.

20 Comments

  1. Thanks for the article.

    Assuming $4.5M FCF, Market Cap (as of 2/6/2013) of $15M and net debt of $21M, the EV($36M)/FCF($4.5M) ratio comes to 8.

    In light of all the risks you mentioned (reliance on EAS, fuel price volatility, adverse refinancing possibilities, management holding majority stake), is this investment still considered undervalued?

    I’m a newbie at valuation, so feel free to correct me if I’m wrong.

    • Well, you’re not wrong. Valuation is always a matter of opinion and there is never a crystal clear correct answer. However, you are overlooking a few things.

      EV/FCF is actually not a useful ratio because it compares the value of the entire capital structure to post-interest expense cash flows. However, if you own the entire firm, you are entitled to receive those interest payments as well!

      A much better comparison is EV/(Free Cash Flow + Interest Expense – Tax Shield From Interest Payments).

      Total debt is $29.23 million with a blended interest rate of around 14%. Annual interest payments are $4.09 million or so, less tax savings of 35%, or $1.43 million for a net interest expense of $2.65 million. If we add this figure to the free cash flow we get $7.15 million.

      Enterprise value of $36 million divided by $7.15 million free cash flow to the firm is a ratio of 5.03. Much better! That is nearly a 20% free cash flow yield for anyone who buys the entire debt and equity of the company.

      The rule to remember is to compare like to like. Compare free cash flow to equity with equity market capitalization and compare total enterprise value to free cash flow to the firm.

    • I like the strategy in the long run, though short-term results might suffer. The company releases monthly passenger reports and the recent months have been lackluster to say the least.

      Is the 15.5% debt destroying value? Absolutely! I cannot for the life of me figure out why the company is not being more aggressive in refinancing this debt, pre-payment penalty or not. The only consolation is the company is required to pay down this debt from excess cash flow, which will reduce the interest burden over time.

  2. I appreciate your analysis, did some of my own, and have taken a long position in the company.

    That said, there are still some issues that make me uncomfortable. Among them:

    1) Were the borrowing deals they reached in 2011 really the best available? Man those rates are just SO punitive – looking at it from where they stood around the time the deals were reached, it seems they weren’t in bad enough shape to merit such harsh deals.

    2) Along those lines, why was their previous lender willing to take a significant haircut on its loan, and sell back shares so cheaply?

    3) I assume GLUX management shopped around, and got the best deal they could. That suggests that multiple parties (previous lender, new lenders, and others the deal was shopped to), thought GLUX merited very harsh loan terms.

    4) I, too, have looked at the recent passenger data (through January, 2013), and it is not great. The whole dependence on EAS is also not terribly reassuring over the medium to long term.

    So, I’m presenting a bit of a bear case, yet I’m long.

    Hmm…

    Well, at least the valuation SEEMS cheap…

    • As Phil and OTCadventures said, I think there’s a lot wrong with this company. However, the company is dirt cheap – “a cigarette bud with one last puff.” The airline industry is volatile. Even the best providers like JetBlue have had volatile revenue and earnings. Thus even a slight increase in revenue or earnings will provide a good boost to share price. Especially when there is less than 50% of shares is held by outsiders.

      Also another positive would be that insider holdings is huge. It would be almost impossible for Douglas and Gayle to sell their shares in the OTC market each day, their positions are so large that it would depress share price significantly. The two of them have a lot to lose if GLUX goes under (NCAV is essentially 0).

      • Hi Phil, I share your concerns with GLUX’s financing. I remain skeptical that the current capital structure is the best available. Surely a commercial lender would be willing to lend against the fleet at 10-12%. Aircraft are valuable and surprisingly liquid assets. Comparables for their values are readily available.

        The fact that Raytheon was willing to take a haircut on the deal doesn’t concern me a lot. I suspect Raytheon, being a gigantic company, simply wished to be free of the hassle of dealing with small headaches like Great Lakes.

        Despite these issues, Great Lakes has been strongly profitable recently and had been for a number of years before the issues with the debt rollover. I picked up more shares today at $1.65. This stock is so illiquid that the smallest orders can send the price shooting up or down. It pays to be patient and submit orders around the bid.

  3. How much longer can the company use its current fleet (average age 18 years)? Or, put another way, are you comfortable that the reported depreciation accurately reflects the economics of the business? If the company will have to start replacing aircraft soon, it likely will have serious problems. If depreciation accurately reflects the useful life of the aircraft, then the company should be ok.

    I’m not suggesting that reported depreciation doesn’t match economic reality, I just don’t know one way or the other. To me, that issue and EAS funding in the medium- to long-term are the biggest issues with the business.

  4. I did a quick research of this company about 28 monthes ago and ended up not buying any shares.. I talked to the president then, who struck me as very honest and conservative (quite typical of folks with aviation back grounds) and he scared me when he said it was very speculative if they could refinance the debt and also whether the EAS would be cancelled or not…. Even though they were successeful in refinancing, it was nice the honest risk assements the CEO gave… My gut feeling was quality people …
    The aircraft should always be maintained to a high standard ..since that is a requirement for aviation safety.. my concern now is with the EAS and refinancing…

    As a side note, The asset lender holding the 16% 29 million loan may have made a very lucrative contract here, I am assuming they are probably using 50% leverage in providing the loan (and guessing their Cost of capital around 6%) would give them an estimated return around 29% on their funds…

  5. Any update? Obviously traffic tanked in the last 11 months, any feeling for how permanent/temporary the weakness is? They seem to have adjusted capacity to suit lower demand in the third quarter and improved RASM and Load factor, which probbs helped bring up margins from the very low levels of the previous three quarters. But, by my math they are still in danger of busting their leverage ratio covenant. Average weekly borrowings need to be at or below 2.50x EBITDA by september 30, by my math (based on q3 traffic) they did somewhere in the ballpark of 4.2m in the quarter which would put TTM at 8.34m. Say they collected 4m in CFO (cash generation is typically high in q3 from seasonal changes in working capital) and did 500m in capx, for 3.5m fcf and used it all to pay down debt. Average borrowings would have been at least 24m which would be almost 2.9x.

    If my numbers are too conservative or if they managed to eek out enough cash from asset sales to keep debt down during the quarter there is still risk of breeching in q4 when traffic is seasonally week and the max leverage ratio steps down to 2.25x.

    SO, if they breech how likely is it that they get a waiver? I mean logically I would expect them to just use the opportunity to extract more fees, they are already getting a great deal and are cushioned by asset value lavishly in excess of the debt. But I haven’t done diligence on these guys and how patient they might be, what are your thoughts?

    Thanks!

    • The transition away from EAS supported routes has been going quite poorly. I know some value investors have started to step in at these levels, but I am extremely worried about the debt covenants. Once the covenants are breached, I expect the lender will extract restructuring fees and apply a penalty rate, which will make it even more difficult for Great Lakes to get out of the hole it finds itself in.

      At some point, GLUX’s share price could get cheap enough to be a nice call option on a miracle, but I am staying out here.

      • Thanks for the response. How do you know they are transitioning away from subsidized routs? I know the total EAS communities served went from 35 to 32 yoy last quarter but the subsidy per departure/per ASM actually went up slightly suggesting that the subsidized flights as % of total went up. I have not done full work on this biz (only looked at it for a day and decided to put on hold until I got more color around the debt issues) so I appreciate your clarifications.

        Also on the debt, at what point does another creditor come in willing to offer GLUX money on more competitive terms? I mean it seems like gb/crystal is already getting too good of a deal, if they extract further fees doesn’t it become too good to continue at one point?

        Thanks again

        • Somewhat embarrassingly, I can’t locate the source that originally lead me to believe the company was choosing to pursue more conventional routes. You are correct that the average subsidy has gone up. I may have to reconsider my thoughts on that if I can’t locate the original comment from management or find it in a filing.

          The fact that no other lender has stepped in is one of the primary reasons I am not invested in Great Lakes. Even prior to the bankruptcy, Great Lakes had tried for years to obtain a loan in order to repay Raytheon, its previous lender. Great Lakes never found a willing lender and had to go with the asset-based lender at punitive rates. If this company really were capable of earning its cost of capital in the long run, one would think a traditional lender would step in.

          Honestly, I wish some creative hedge fund would step up and offer $25 million in five year financing. They could attach a coupon of 8% and receive warrants at the current share price equal to 10% ownership and everyone, including current shareholders, would probably be a lot better off. Right now the only one benefiting from the awful financing deal is GB Merchant Partners.

          The fact that this hasn’t happened makes me think that people smarter than me see a lot more risk here than I do. Alternatively, perhaps management is not up to snuff.

  6. Yea it does seem unusual how good of a deal the creditors are getting, from what I understand part of it is that the deal was made in 11′ and there was uncertainty around the whole EAS program.

    I think it should be worth a very substantial premium to a strategic (or even financial buyer looking to ultimately exit through a strategic). I mean current EV is likely in the low 30ms, replacement cost is probbs around 50m; based on historical resilience (at least relative to other airlines) of cash flows and returns on invested capital this business does not seem to destroy value and seems like it should be worth replacementcost. Also because of their small size they seem to have unusual costs (higher fuel, having to pay big airlines for bookings) so a strategic would likely be able to operate this business much more profitably (not to mention scale on sg&a) and it seems like the 58 year old chairman who owns 46% of the equity would have an incentive to sell the company at one point.

    Even if normalized EBITDA-MCX is only 8m it deserves at least 5 times multiple on that. No matter how I slice it, seems unlikely that you are paying too much at the current implied EV, providing they stay out of bankruptcy. Other than a very small (sub 50bps) R&D position, I am not involved in a meaningful way yet. I think it is likely a good opportunity but I kind of want to wait and see how the creditor issues play out and I can’t imagine the stock rips up next quarter if they breech, so there is no reason to believe the opportunity will be gone by the time we get more color.

    Thoughts?

    • Definitely some strong upside here if the business stabilizes or is taken over. Probably looking at gains of 300%+. So you have that on one hand, and a total wipeout on the other. Handicapping the probabilities determines if the weighted expected return is acceptable. I am not confident in my ability to assign those probabilities, so I am staying out of this one.

  7. Anyone involved here should pay some attention to Pinnacle Airline. Monish Pabrai actually owned Pinnacle at one point. I believe the thesis was that Pinnacle had a “niche” and “contracts” in place that protects it. I got involved when Pinnacle was very distressed. In essence, it was a 10x if they avoid bankruptcy and a zero or a some recovery if they file for bankruptcy. Luckily, I was smart enough to size it as a 1% position. They indeed did file. Their contract partner screwed them big time in bankruptcy! Delta was the only DIP lender willing to lend to Pinnacle. But Delta also stipulated that the contracts be restructured and essentially wiping all economic viability of Pinnacle going forward. I sat in that bankruptcy court listening to smart hedge fund managers argue that the only DIP loan available was too punitive and they need to find another DIP lender. Their argument was that the existing contract has value that will lead to recovery for the shareholders. The equity is not insolvent, etc. The judge appreciated the arguments but coldly asked the parties if there is anyone else willing to write a $35mm check to cover payroll and operating needs “today”, no lender or smart HF money stepped forward. In one stroke, Delta in essence “stole” or “took” all of the economic interest of Pinnacle. Here’s my warning to all “For airlines, do not base your valuation on some sort of replacement cost. Such concept is fairy tale.” I have also found that Murphy’s law tend to apply very well in airlines “Anything that can go wrong, will go wrong”

    • Thanks for your input. I remember looking at Pinnacle Airlines briefly. That story is a good reminder that anything can happen in bankruptcy court and what appears to be an asset now can be illusory in the end.

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