By Jim Corridore
JetBlue Airways (JBLU ), a highly profitable and fast-growing discount airline, carries S&P's highest investment ranking of 5 STARS, or buy. This bullish stance reflects our opinion that JetBlue will be able to continue its rapid revenue and earnings growth, and that despite a valuation in excess of the S&P 500-stock index, much of this growth isn't priced into the stock.
JetBlue operates a low-fare, low-cost airline that flies point-to-point routes. It differentiates itself by flying new aircraft, by offering low fares, leather seats, free satellite TV at every seat, and preassigned seating, and by trying to provide high customer service and reliable performance. This strategy has been well received. Witness the 87.4% load factor (the percentage of available seats that are full) JetBlue reported in the second quarter of 2003, which we expect will be the best among U.S. airlines. This load factor was achieved despite a 70% increase in capacity over the second quarter of 2002.
JetBlue began flying on February 11, 2000, with two planes out of John F. Kennedy Airport in New York City. As of July 24, it was flying 45 Airbus A320 planes in 22 markets. It plans to add eight more A320s by yearend and 13 in 2004. JetBlue also recently announced firm purchase orders for 100 Embraer 190 aircraft, with delivery starting in 2005 and options for an additional 100.
Part of JetBlue's strategy is to find underserved niche markets where current offerings are limited and fares are high, enabling it to move in with lower fares to stimulate demand. The new Embraer planes will fit nicely into this strategy, in our view, allowing breakeven levels with as few as 60 passengers on a plane in some markets. That means JetBlue can move into smaller cities than is possible with the A320s.
JetBlue feels it'll be able to stimulate demand with the Embraer 190s at low fares, and once it drives a certain level of demand in those markets, it can move a larger A320 into that market, helping JetBlue to make more money on that route. We feel this strategy will allow it to maintain a high capacity rate and revenue growth without adding significantly to unit costs.
JetBlue reported second-quarter 2003 results on July 24, posting earnings per share of 55 cents, vs. 22 cents in the year-earlier period. Excluding a one-time receipt of $22.8 million from the U.S. government related to the Emergency War Time Supplemental Appropriations Act (representing a refund of previously paid government security taxes), JetBlue reported EPS of 38 cents, beating our 26 cents target as well as the Street estimate of 28 cents.
Revenue in the second quarter rose 64%, on a 70% increase in capacity along with a 5% decline in yield. Unit costs decreased 2.9%, to 6.07 cents per available seat-mile, by far the best in the U.S. airline industry. This was accomplished despite a 91% rise in fuel prices.
The higher revenues and lower unit costs led to net income growth of 81% (again excluding the impact of the government security fee reimbursement). JetBlue achieved this growth amid the winding up of the war in Iraq, a period of at least Orange Alert, and generally weak traffic statistics when compared to historical travel levels.
We believe JetBlue has the correct strategy in place to generate continued revenue and earnings growth, especially now that signs point to improved travel demand. Along with many of its competitors, JetBlue has been reporting that summer travel seems to be strengthening, with advanced bookings in July and August coming in very strong so far.
We believe JetBlue is the fastest-growing and lowest-cost airline in the U.S. and is best positioned to benefit from a strengthening revenue environment, as it will be adding about 60% to capacity in 2003 and will likely maintain a high level of growth through at least 2010, given the orders in place with Airbus and Embraer.
At the same time, JetBlue has one of the industry's healthiest balance sheets, with a debt-to-total-capitalization level of about 61% as of the end of the first quarter of 2003. Recent debt and equity offerings have increased cash levels to over $500 million, which we see as more than adequate given the carriers's size.
We believe JetBlue has the financial flexibility to allow it to continue to finance its growth plans, as well as to engage in fuel hedges to keep its fuel cost levels stable. It has 83% of its estimated fuel requirements in the third quarter of 2003 hedged and 78% of fourth-quarter requirements. This is a level many of its peers can't match due to financial restraints. By Jim Corridore
We expect revenues in 2003 to grow about 53%, as JetBlue adds about 60% to capacity and as pricing pressures and lower fares in new markets lead to some yield erosion. We estimate that expenses will rise about 50%, as increased utilization and fixed-cost leverage creates economies of scale. After lower interest and depreciation expense as a percentage of revenues, we expect EPS to rise about 47% in 2003, to $1.25, from 85 cents in 2002. In 2004, we see 40% revenue growth and 36% EPS growth to $1.70. We also forecast a five-year compound annual growth rate (CAGR) for earnings of 35%.
On a Standard & Poor's Core Earnings basis, we see EPS of $1.17 in 2003, a difference of only 6.4% from our operating earnings target, reflecting the fact that JetBlue has no defined-benefit pension plan and our estimation that expensing options would cost it about $5.5 million in 2003. To us, the low divergence between operating and S&P Core Earnings estimates indicates a high quality of earnings.
We think that a combination of increased revenue growth while keeping costs in control will allow JetBlue to meet our target of 35% CAGR for EPS over the next five years. The stock was recently trading at 26 times our 2004 EPS target of $1.70 (excluding earnings attributed to the government security fee refund), which we raised from $1.53 after JetBlue reported second-quarter results. While this valuation is above the S&P 500, on a p-e-to-growth rate (PEG) basis, using our 35% CAGR projection for EPS, JetBlue's PEG is only 0.74, much lower than the broader market.
We arrived at our 12-month target price of $60 by valuing JetBlue's shares at 35 times our 2004 EPS target, which applies a PEG of 1.0 to the stock. This is still lower than the S&P 500, and equates the stock's price to its future EPS growth. At the same time, on a p-e basis, this level is only in the middle of JetBlue's historical p-e range. (However, since it went public only in 2002, it doesn't have a lot of historical data.)
When constructing a peer universe for JetBlue stock, we find it constructive to only use other discount airlines. Of these, we cover only Southwest Airlines (LUV ) and AirTran Holdings (AAI ). On a p-e basis, JetBlue is trading at a substantial premium to both of these stocks. However, again, we feel it's appropriate for comparisons to be based on PEG. And since we expect JetBlue to increase earnings at a substantially faster rate than these two rivals, our projected PEG of 1 for JetBlue, based on our $60 target price, would still be a sharp discount to Southwest's 1.7 and only a slight premium to AirTran's 0.93.
Additionally, we expect all three of these profitable airlines to see some p-e and PEG expansion over the next 12 months since, in our view, they're the three best-positioned airlines to benefit from an improving industry environment. (We have accumulate recommendations on both Southwest and AirTran.)
FASTEN SEAT BELTS.
Our target price of $60 implies a potential price appreciation of about 33% over the next 12 months for JetBlue's stock, which we feel will materially outperform the S&P 500 over the same period.
Investors should be cautioned that airline stocks are highly cyclical and volatile, and that JetBlue's strategies have their own specific execution risks. The carrier will need to maintain high growth rates in order to meet our expectations for future earnings growth. In addition, as a new airline, its operating cost structure is likely to go only up as maintenance and compensation costs rise.
That said, we think JetBlue has the correct strategy in place to tackle these issues, and feel its future growth in revenues will outpace cost increases.
Analyst Corridore follows airline stocks for Standard & Poor's