Hawaiian Holdings: Great Value Despite Downgrade

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On Wednesday morning, analyst Glenn Engel at Bank of America/Merrill Lynch downgraded Hawaiian Holdings (NASDAQ: HA), the parent of Hawaiian Airlines, from buy to underperform and cut his price target from $11 to $7.

Engel apparently sees dark days ahead for Hawaiian, with the primary concern being unit revenue weakness. This is compounded by foreign exchange pressure, as Hawaiian has expanded its presence in Japan over the past few years, and the yen's value has fallen more than 10% vs. the dollar over the past few months. 

However, Engel's forecast is too pessimistic, and I believe that lower costs will largely offset any revenue weakness in 2013.  With Hawaiian trading at an extremely low valuation, this is a good stock for long term investors with moderate-to-high risk tolerance to consider.

In Q3, Hawaiian saw unit revenues (RASM) decline by 5.8%.  On the other hand, a mix shift to longer routes (which have lower unit costs) and lower fuel prices combined to reduce unit costs by 6.1%.  Due to these lower costs and a 28% increase in capacity, Hawaiian's adjusted earnings increased by 35% year-over-year in spite of the revenue pressure.  However, last month Hawaiian notified investors that Q4 RASM will be down an even steeper 9%-12%, due in large part to the yen's deterioration.  I expect costs to be down 6%-7% again, but this will not prevent a profit decline (compared to Q411).

Looking forward to next year, Hawaiian will likely see further RASM declines during the first half of the year due to rapid capacity growth and a mix shift away from short-haul flying within Hawaii towards long-haul international routes.  However, this same factor will continue to bring down unit costs (CASM). Costs are approximately 3 times as high on a seat-mile basis for Hawaiian's short-haul flying vs. long haul flying (revenue is correspondingly higher as well). 

Hawaiian's continuing fleet shift from the Boeing 767 to the more efficient Airbus A330 (and eventually A350 and A321 NEO) will also reduce costs.  Over the course of 2013, Hawaiian will retire four Boeing 767 aircraft that are more than 25 years old and thus very expensive to operate.  The A330 is also somewhat more fuel efficient than the 767.  These cost reductions will offset most of the revenue pressure Hawaiian is likely to see in the first half of 2013.

By contrast, I expect strong profit growth from Hawaiian in the second half of 2013.  The pace of new route introductions and capacity increases will finally begin to moderate after the start of service to Taipei in July. (Since November 2010, Hawaiian has inaugurated service to Tokyo, Seoul, Osaka, Fukuoka, New York, Sapporo, and Brisbane, and increased capacity from a variety of other cities). 

There will still be enough growth to keep costs on the decline, and as existing markets mature, strong demand for Hawaii vacation travel should facilitate a return to unit revenue gains. For example, in Seoul, Korea, demand has been growing at a nearly 40% annual rate over the past several years. However, capacity has been growing just as quickly. With industry capacity growth moderating, strong demand should lead to high load factors and better pricing.

As of Thursday's close at $6.48 (down almost 10% since Engel's downgrade), Hawaiian has a trailing P/E of just 4.36.  This puts the company into bargain-basement valuation territory.  Moreover, Hawaiian is unlike most of its competitors in the airline business in that it has more expansion opportunities than it can pursue. 

Sector leaders Delta Air Lines (NYSE: DAL) and United Continental Holdings (NYSE: UAL) have been cutting capacity over the past few years, and are likely to keep capacity flat or down over the next year or two.  Meanwhile, Hawaiian has been able to grow capacity at 20%-30% annually while also growing margins. 

Given how rapidly Hawaiian is growing, it is not all that surprising that the company has encountered some bumps along the road. However, the company has a strong managment team and a strategy that has shown great promise.  Long-term investors should strive to see beyond the short-term trends that Engel uses to justify his "underperform" rating.  Hawaiian Holdings looks like a long-term winner that is already a great value at the current share price.

Adam Levine-Weinberg is long HA and DAL, and has sold March $14 calls in DAL.  Adam Levine-Weinberg is also short UAL.  The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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