Hi all, I was running some screens on small cap companies with...

Hi all,

I was running some screens on small cap companies with revenue growth >5% p.a., low leverage and insider ownership and came across Rex. It caught my attention given it's performance consistency, clean financials (i.e. no restating historical figures, one-off costs, etc.) and remarkable dividend yield. I believe the latter is a massive plus in the current low-rate environment, especially if sustainable. Consequently, I did some more work and came up with the below. Let me know what you think...(for a bit background on why I do these write-ups check out my first write-up and commentary on the CCV thread: https://hotcopper.com.au/threads/back-to-fundamentals.4919758/)


Regional ExpressHoldings Ltd (ASX: REX)

Business Summary

REX possesses 3 income streams:

1.Regularpublic transport (FY19: $278.4m revenue, ~88%); commercial airline transporting passengers and freight throughout Australia

2.Charter(FY19: $28.5m revenue, ~10%); operates under the Pel-Air brand, which engages in air freight, aeromedical and charter activities

3.AustralianAirline Pilot Academy(FY19: $4.6mrevenue, ~2%); pilot training facility based in Wagga Wagga, NSW

SummaryFinancials

1		Mkt cap ($m)	6m	3yr Avg. TTM NPAT multiple	14.6x
2	Net debt ($m)	$8.1m	FY19 NPAT multiple	8.3x
3	EV ($m)	$132.5m	FY19 Dividend yield	8.9%
4	Revenue (4yr CAGR)	5.5% p.a.	FY20E* NPAT multiple	11.3x
5	NPAT (4yr CAGR)	27.3% p.a.	FY20E* Net dividend yield	7.4%

* See valuation section for assumptions

Thesis:

Conservativelypositioned and primarily operating in monopolisedroutes, Rex’s current valuation presents a compelling opportunity to purchase a cash-generative airline paying sustainabledividends yielding ~10% p.a. afterfranking.

Sustainability and airlines rarely go hand in hand, and Virgin’s recent decision to cut 750 jobs and review all routes after six consecutive years of losses is case in point. In 1988 Warren Buffet noted that:

“a durable competitive advantage in the airline industry has provenelusive ever since the days of the Wright Brothers. Indeed, if a farsightedcapitalist had been present at Kitty Hawk, he would have done his successors ahuge favour by shooting Orville down. The airline industry’s demand for capitalever since that first flight has been insatiable. Investors have poured moneyinto a bottomless pit.”

Arguably, it is this investorcaution towards the historically volatile airline industry that provides an opportunity to invest in Rex at current valuations. Its monopolistic characteristics are shifting its risk profile to resemble something more akin to a regulated utility, and thus it deserves to trade at a premium to its peers.

1.Rex is a monopolyoperator in ~84% (54/64) of its routes. Of these 53 routes, ~53% are State regulated. This improves earningsquality by making ticket pricing and demand more predictable, which leads to greater earnings visibility and stability

a.In the ~16% (10/64) of routes where Rex does compete with either Qantas or Virgin, Rex is highly competitive. It offers the cheapest fare across 6 of these routes at an average discount of ~16% to the nearest competitor, and this is before applying their “Community Fare” scheme (available on select routes)

b.Management have also shown remarkable discipline by swiftly exiting loss-making routes and demonstrating a clear awareness of their core competencies. Rex has only recorded one statutory loss sincelisting in 2005, outperforming both Qantas and Virgin

2.Rex is conservatively leveraged at ~4% D/E and can capitalise on further industryconsolidation

a.Since 2002, 20+regional carriers have collapsed and there are suggestions that AirNorth (operating in NT, the only state where Rex is not present) and Skippers (operating in north WA) may also collapse in the near-medium term. Rex is well-positioned to expand its network into any gaps left by these carriers or routes that may be abandoned by Virgin following its operational review

b.More generally, despite domestic passenger growth (FY14-9 CAGR ~1.2% vs ~3% FY08-13) slowing, declining ASKs (available seat kms), demonstrating industry consolidation, have translated into higher load factors (averaged ~80.3% in FY19 vs ~78.8% in FY09) for incumbents. Since FY15, Rex’s load factor has increased by 880bps to ~63.1% and this trend is expected to continue, increasing profitability

3.~67%insider ownership,including ~23% by the Chairman Kim Hai Lim indicates an alignment of incentives between management and shareholders and a strong likelihood that the Board will deliver on the commitment to support a “healthydividend payout ratio” of ~75%

a.Some indicators of management competence include:

i.Cost control à Lin Kim Hai appears to be very cost aware with costs ex. fuel/ASK growing by only ~1.9% p.a. since FY15

ii.Fleet management à Rex is committed to remaining a single modeloperator, owning a combination of 58 (2 leased) SAAB340 B and B+’s that are renowned for their economy

iii.Political/regulatory engagement à Management closely follow regulatory developments and arenot afraid to lobby Governments and Councils, evidenced by their numerous submissions to State and Federal inquiries

iv.On-time departure and cancellation performance à Consistent industry leader, maintaining the lowestcancellation rates of any regional airline

Valuation:

Assumes Rex does not pick up any new routes, passenger growth is stagnant for FY20 and reverts to ~1% p.a. through to FY23, below the 5yr industry CAGR of ~1.2%. Fare growth is forecast at ~1.1% (average annual fare growth since 2002), costs ex. fuel growth at ~2.5% and fuel at ~5.6c/ASK for FY20, ~5.3c/ASK for FY21 and then reverting to ~5c/ASK for FY22-3, which implies a Brent Crude Oil price of ~$85/AUD per bbl. Consequently, load factors creep from ~63% in FY20 to ~65% in FY23. Charter revenue growth slows to ~2-3% through the period and training revenue growth slows by increments of ~5% during the forecast period yielding ~$5.5m of revenue in FY20 and ~$7.5m in FY23. Finally, CAPEX is kept at historical levels of ~$20m p.a.

These conservative estimates place Rex on ~11.3x NTM NPAT (discounted @ ~12% WACC), while comparables trade at a median of ~12.7x NTM NPAT. On peer multiples, Rex is worth ~$1.68 (+~25%), and if valued at a 10% premium to peers, which is arguably deserved after accounting for the monopolisticfeatures and industry-leading dividend yield, Rex could be worth ~$1.84 per share (+~38%).

New routes are not forecasted given the difficulty of estimating corresponding passenger growth and capacity utilisation without route specific information. However, route expansion could represent meaningful upside to the above valuation.

Risks:

·While the opportunity to pick-up new routes amid industry consolidation could be beneficial, Rex may bite off more than it can chew. Expansion would require purchasing/leasing new planes (additional CAPEX à higher depreciation costs), finding additional pilots and possibly taking on more debt. If these additional costs coincide with a broader market downturn or poorly selected routes that culminate in lower load factors, Rex’s profitability is likely to take a substantial hit

·Fleet upgrade requiring substantial CAPEX spend, since the average fleet age is at least ~20-25 years. Arguably, this is unlikely given research by both SAAB and independents suggesting that the SAAB340B/B+’s could remain in service for another ~15+ years (https://www.mro-network.com/maintenance-repair-overhaul/why-turboprop-mro-and-will-remain-brisk)

·Fuel costs could rise on further weakening of the AUD/USD, or an increase in Brent Crude Oil prices

·Rex loses competitive tenders to regulated routes in WA and Qld, or peers decide to compete in routes where Rex is the sole operator

oWA:

§Perth-Albany-Esperance expires 27 February 2021

§Perth-Monkey Mia-Carnarvon expires 30 June 2023

oQLD:

§Western and Northern 1 and 2, and Gulf routes expire in 2022

·Route deregulation

·Increasing airport charges

·Contract terms with State Governments that may require Rex to provide a frequent service without the ability to reduce capacity despite declining passenger numbers?...contracting terms with the Qld State Govt. are not publicly available, while the WA State Govt. only provide brief factsheets (https://www.transport.wa.gov.au/aviation/air-services-in-western-australia.asp)

Summary Financials