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 the 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.

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.

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.

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.