Harbor Diversified

Company Description

HRBR is holding company that owns Air Wisconsin.  Air Wisconsin owns and operates 63 regional jets that it flies from small and mid-size airports into the O’Hare and Dulles airports.

The Simple Value Story

During 2023 HRBR switched from flying under the Delta banner to flying under the American Airlines banner.  This change resulted in transition issues, including reductions in revenues, increased costs to support the transition, and a lawsuit from Delta disputing $52m in fees that HRBR is owed by Delta.

The cumulative effect is that the current stock price appears to materially undervalue HRBR as a going concern. At the end of Q3, 2023, HRBR had tangible book value of $209m and just under 60m of fully diluted shares outstanding.  The tangible book value per fully diluted share is $3.48.  The represents a premium of 70% to the current $2.04 share price.

Additionally, there are $52m in disputed funds that HRBR contends it is owed by Delta.  These funds represent an additional potential of $0.87 per diluted share.

In Dec, 2023, HRBR paid off its $52m in long term outstanding notes for $46m.  The difference of $6m represents an additional $0.10 per diluted share. (After repaying all outstanding long term debts in December, 2023, HRBR still has approximately $106m in cash and equivalents.)

The sum of the above three components represent $4.45 in value per diluted share, representing a potential premium of 118% to the current stock price.

HRBR has been active in repurchasing outstanding shares.  It repurchased over 8m shares during 2022.  During the first three quarters of 2023, it repurchased just over 1.7 million shares.  It has a stock repurchase program that provides $1m per month for this purpose.  At the end of Q3, 2023, there remained $8.8 available for repurchases.  As HRBR continues to repurchase shares at below tangible book value, the book value per share for the remaining shares will increase.

Future Earnings

HRBR lost almost $13m during the first three quarters of 2023.  These losses are directly attributable to the transition from Delta to American Airlines.  The transition requires removing planes from circulation, refitting them, putting them back into operation, and commencing operations with American Airlines.

Furthermore, the current contract is only for HRBR to provide 40 planes for service to American (23 of HRBR’s planes have been idled in the meantime).

The primary reason for idling 23 planes is pilot shortage.  HRBR and American have agreed to increase the planes under contract to include an additional 20 planes when HRBR is able to fully staff them.

At the end of Q3, HRBR had successfully transitioned the 40 planes into active operations.

One dificulty in carefully estimating HRBR’s future profitablity is that HRBR hasn’t provided any details about the terms of the new contract with American Airlines, nor has it provided an estimates of future profits.

The Q4 earnings presentation could provide the first clean look at steady state profits under the new contract.  The assumption/hope is that HRBR management wouldn’t have switched to American Airlines unless it was profitable to do so. Furthermore, HRBR’s management wouldn’t have been so agressive about repaying all its debt early, or repurchasing shares, if it didn’t think there were profits on the horizon.

In Q4, 2022, the last clean quarter before exiting the Delta contract, HRBR had net income of $6.5m. Using this as a baseline, adjusting for only flying 40/63 planes, extrapolating to 4 quarters, and assigning a P/E ratio of 12 results in a market value of $200m, which is over twice as high as the current market price.

Additional Items

If HRBR is able to overcome the pilot shortage, then earnings should recover to $6.5m per quarter, or $26m per year. At P/E of 12 this would result in a market cap of $312m, more than 3 times the current level.

If HRBR is not able to overcome the pilot shortages, then it could sell the 23 superflouos planes.  The current market price for these planes is in the range of $1 to $4m per plane.  Assuming a sales price of $1.5m per plane, they could be sold for $34.5m.  These sales would free up additional funds for stock repurchases.  At some point the idled 23 planes will result in either increased earnings or reduced shares outstanding.

In the meantime, there have been a few developments that will affect future earnings.  First, HRBR has signed a new contract with its pilots that extends to 2026.  Presumably the contract increases pilot earnings to address the shortage.  Second, American Airlines has agreed to increase payments to HRBR to help with pilot shortage.  Third, paying off the long-term debt will reduce quarterly interest payments by approximately $1.5m per quarter.

As of the end of 2022, there were two large shareholders that owned 36.5m of the 60m diluted shares.  These shareholders effectively control the company.  To date there has been no indication that these shareholders are conspiring against the minority shareholders.

Management is not particularly enamored with publicly disclosing information.  Prior to 2019 there were fewer than 300 shareholders of record, and no public disclosures.  Since 2019, HRBR has been dutifully filing quarterly and annual reports, and any other legally required filings, but nothing more.  Management does not provide earnings commentaries or earnings calls, there is no investors relations site, and no HRBR website (there is a website for Air Wisconsin).  In the 10K HRBR indicates that if the number of shareholders of record drops below 300 that it will likely halt public disclosures again.  At the end of 2023 there were 391 shareholders of record.

To date I believe that the HRBR management has been doing a good job.  Operations seem to be running smoothly.  It appears that it has successfully made the switch from Delta to American Airlines. It has a fortress for a balance sheet: At the end of Q3 HRBR had over $150m in cash and marketable securities.  During Q4 it paid off all its long-term notes (so presumable cash and securities have dropped to approximately $100m).  Because the stock price is well-below the tangible book value, repurchasing shares makes good economic sense.

This is a very competitive industry, and margins are always going to be tight.  In addition to a few independent operators, the major airlines operate their own regional carriers.  HRBR will never make excess returns on its assets, and it will always be challenged to operate efficiently.  The investment thesis here is that at some point the share price will approach its tangible book value, not that it will be able to grow earnings past a normal return on assets.

The closest similar publicly traded company I found is Mesa Air Group.  Mesa had a very tough couple of years.  In 2022 it lost $182m, and in 2023 it lost $123m.  Mesa is in the process of renegotiating its contract with Delta to increase payments.

Catalysts

There are a few potential catalysts.  First, a return to profitability.  Second, win the $52m dispute with Delta. Third, either move the 23 idled aircraft into active service or sell them, thereby providing earnings or cash. Fourth, the continued repurchase of outstanding shares should eventually start moving the stock price.

Risks

Airlines are very pro-cyclical.  Any significant drop in the U.S. economy will hurt earnings.

We don’t know the details of the American Airlines contract.  We may never know the details.  The contract might not be profitable and HRBR may have a very difficult time returning to profitability.

HRBR could lose the arbitration with Delta.  While none of these funds are currently being reported on the balance sheet, the loss would likely hurt the stock price, at least in the short term.

Conclusion

While there are a few uncertainties surrounding this company’s future earnings, the pros dominate the cons.

  1. The current stock price is $2.04, but there was tangible book value of $3.48 at the end of Q3, 2023.

  2. There is the potential to increase the book-to-market value up to over $4.45 in the near term.

  3. There is no long term debt.

  4. Cash and equivalents are likely over $100m

  5. The firm is actively repurchasing shares.

  6. HRBR has a five year signed agreement with American Airlines and a signed 3 year contract with its pilots.

  7. The airline industry has returned to profitability. Both American and Delta earned stong profits in 2023.

  8. There are two conservative methods to value firms in competitive industries: at net asset value and at present value of steady state earnings. In both cases here it appears that the value of this firm is north of $200m, while the market value is approximately $120m.

  9. I don’t see any credible threat that either the company or the airline industry is under any threat.

In my opinion, this company represents about as good a buy as I can imagine.

Acknowledgements

In addition to performing my own research, I used 3 publicly available research notes produced by other investors.  Value Investors Club has a post and discussions from May 2021 from ‘washwizards’.  Seeking Alpha has posts by Jacob Franklin in Aug 2023, and by ‘PickYourSpots’ in Jan 2023.