SkyWest: This Unique Airline Stock Has Room to Grow (NASDAQ:SKYW)

Introduction

I first wrote my initial investment thesis on SkyWest, Inc. (NASDAQ:SKYW) in June 2024. Back then, I felt SkyWest was a strong US regional airline experiencing asset improvement. usage, which led to growth on both the top and bottom. As a testament to its resilience as a regional airline emerging from the COVID-19 crisis, we believed the company deserved its premium multiple compared to peers. With the flight deals driving revenue growth in the company’s latest Q2’24 results, I maintain my ‘buy’ rating on the company. Additionally, as the stock has sold off 11% from recent highs, I have personally initiated a position in the company, noting that a large portion of its aircraft will be fully owned and paid for by 2026.

Company overview

SkyWest is a regional airline and it happens to be the largest regional airline operation in the United States. Under the holding company SkyWest Inc, the company owns both SkyWest Airlines and SkyWest Leasing. Through SkyWest Airlines, the company operates approx 500 aircraft connecting 240 destinations across North America, allowing passengers to access a wide network of endpoints. Having carried more than 38 million passengers last year, the company has partnerships with major airlines such as United Airlines (UAL), Delta Air Lines (DAL), American Airlines (AAL), and Alaska Air Group (ALK).

The way the company’s business model works is that through these major airlines, SkyWest operates regional jets in their network systems. The major airlines handle all marketing, flight schedules, passenger fares, ticket sales and reservations. Through their agreements, SkyWest operates the flights under their banner, often adhering to certain operating procedures and standards (which might look slightly different from one airline to another).

This is what makes the SkyWest business model so unique and less risky. Due to the nature of their agreements, SkyWest’s margins tend to be better and more sustainable, especially when you consider that partner airlines pay fixed fees and arrange and pay for the fuel used on capacity purchase flights. These capacity purchase contracts (CPA) represented 94% of the company’s fleet last year.

The remaining 6% are part of proportional arrangements, where SkyWest operates flights using the ticketing and reservation systems of the main partner airlines. Unlike CPA, under proportional agreements, major airline partners are responsible for collecting passenger fares for the routes operated, which may involve adjustments when passengers connect to major airline partner flights. SkyWest has greater flexibility in setting flight schedules and passenger fares under proportional arrangements and is responsible for arranging and paying for the fuel used for these flights.

Results and outlook Q2’24

In the second quarter of SkyWest’s fiscal year, the company reported revenue of $867 million, which was a 19.5% increase over last year’s Q2’23 revenue of $726 million. Compared to sales estimates, that represented a higher 5% for about $41 million above what The Street expected.

On the net income side, SkyWest posted net income of $75.6 million during the quarter for about $1.82 in EPS, beating estimates by 9 cents. Compared to just 35 cents in earnings per share in the same quarter last year, it would appear that SkyWest had an excellent quarter on both the top and bottom lines.

At the end of the quarter, the company had a fleet of 248 E175, 49 CRJ900, 167 CRJ700, 144 CRJ200. It brought the total fleet to 608 aircraft, and the company anticipates that will continue to grow as they are on track to add a new E175 aircraft with Delta sometime in Q3’24 or Q4’24, along with 28 new E175 aircraft with United, and a new E175 aircraft with Alaska Airlines sometime next year. These capital spending plans indicate that the company is growing nicely and building on its ability to fund its growth by partnering with major airlines, especially as travel picks up. This will also help improve profitability as older aircraft, which have high maintenance capital expenditure, can be replaced with newer, less expensive models.

At the end of the quarter, approximately 44% of aircraft in regular service or under contract were operated for United, 28% were operated for Delta, 19% were operated for American Airlines and 8.8% were operated for Alaska Airlines. The table below represents SkyWest’s current fleet with each of its partners.

So what drove this quarter’s results? More aircraft in the fleet with longer block hours were the main factors. As travel demand increases and SkyWest continues to grow its fleet, the number of aircraft in scheduled service fell from 492 in Q2’23 to 475 this quarter. In addition, block hours increased 12.3% year over year as scheduled daily utilization of SkyWest aircraft continued to increase.

In my view, these are excellent signals and give me confidence in SkyWest’s business, even after the stock is up 45% year to date. But it’s not just revenue growth that should get investors excited about the name; expense growth is also moderate, leading to fairly significant margin expansion.

For example, during the quarter, the company’s operating costs rose just 7.7% year-over-year. Against earnings growth in the teens, this allowed margins to expand to 13.8% from 4.4% last year. The major component was wages, which increased by 10.1%. In my opinion, this is something we should expect given the correlation with higher volumes and lock-in hours.

Importantly, however, the increase in jet fuel is a very small part of the company’s total operating expenses. As such, with most of the increase in expenses being in wages and salaries, margins at these levels appear sustainable. Furthermore, with the second largest contributor to total operating expenses being aircraft maintenance and repair (up 12.8%), I feel confident in securing lower growth here going forward as the fleet be completed with new fleet.

On the outlook, I am bullish on the near-term outlook for the company. Why? It’s not just the results of the last quarter. On the earnings call, the company took the opportunity to revise upward guidance, with expectations now reflecting an improvement for this year’s block of hours to be 9% to 11% from last year. That range is up from previous guidance of 7% to 9% a quarter ago when we last reviewed the company

So, as a result of this, along with expected GAAP EPS guidance in the high $6 range, the outlook has improved for the company. Why this matters is that it helps improve the company’s balance sheet and allows the company to buy back shares at reasonable levels.

From a balance sheet perspective, SkyWest now sits in a cash position of $834 million, a cash pile sufficient to give it the flexibility to buy back a third of its market capitalization or pay a third of the debt. With strong free cash flow generation, the company has been active in its share buyback program, buying back 177,000 at an average price of $75.23, pretty close to where the stock is currently trading.

Additionally, debt reduction was also a focus as the company paid down $115 million in debt during the quarter and plans to repay a total of $400 million in fiscal 2024. In my view, this this highlights SkyWest’s disciplined financial strategy and commitment to enhancing shareholder value while maintaining a strong balance sheet. By properly managing cash reserves, buying back shares and reducing debt, management is demonstrating that it is taking the right steps to allocate capital to position the company well for the future.

Conclusion

The sell-side remains cautious on management guidance, with 2024 EPS estimated at $6.78. From a valuation perspective, based on 2024 and 2025 consensus estimates, SkyWest trades for just 11.0x 2024 EPS and 9.7x 2025 EPS (source: S&P Capital IQ).

This is despite the company continuing to “beat and lift” on a regular basis, often beating sales estimates and even its own guidance on occasion. In my view, it is clear that there is lingering skepticism among analysts, despite the majority ‘buy’ ratings on the stock. Despite a track record of beating expectations, the sell-side appears to be mindful of potential risks or uncertainties that may not be fully apparent in the company’s historical performance.

Some of these risks include continued industry uncertainty regarding the lack of qualified pilots, economic weakness and the threat of pandemics, terrorism and war, as previously mentioned. While many of these factors are outside the company’s control (and should still be monitored by investors with equal scrutiny), the company has made excellent progress in attracting new pilots. On the earnings call, management noted that it expects to be at more than 5,000 pilots by the end of the year, which is about a 25% increase from 2023. That alone should help improve block hours, in -an industry where pilots are few.

So, in conclusion, I think SkyWest’s business model is above average for an airline and its strong financial performance last quarter doesn’t seem to be properly reflected in its current valuation. In my view, margins appear stable with room for improvement as the company ramps up its pilot workforce and fleet expansion, which will position it well to effectively meet any challenges. As the stock has recently experienced a pullback, the current valuation presents an attractive entry point for investors, reinforcing my confidence in the company’s long-term prospects. Overall, SkyWest remains a compelling investment opportunity, which is why I maintain my ‘buy’ rating.