Wednesday, April 3, 2013

Half-term Report Card - I

Six months in, a quick round up of developments. I am lagging the S&P 500 by 7.5%, the International Small Cap Index by 9.6%, and my own picks by 23.4%.

I’ll start with a review of Hawaiian Holdings.

Hawaiian has reported its 2012 results. The last five years have seen its franchise stress tested: fuel prices have ranged from $1.93 to $4.67 per gallon; the domestic market has fallen into, and has come half-out of, a recession; its major international market, Japan, has suffered a nuclear event causing a calamitous drop in the number of Japanese visitors to Hawaii; the yen has appreciated and depreciated against the dollar, and so on.

And still the franchise remains intact, as it was bound to: it’s a low cost airline with full service amenities; it’s a toll road to a honeymoon, anniversary, and once-in-a-lifetime destination; it’s the transport network for residents who need to hop from island to island to get to meetings, to shop, and to visit relatives; and it’s the network into which all other airlines carrying passengers and cargo venturing beyond O’ahu must feed their traffic.   

The strategic control point of Hawaiian’s franchise is its monopoly position in interisland transportation and significant events are those that threaten that position, including end-runs. In that light, 2012 saw some US carriers increase their direct flights to Maui in an attempt to circumvent that control. Hawaiian responded in an appropriate way, creating a hub in Maui and flooding it with excess capacity. It was, in hindsight, a bit overdone but a sign, nevertheless of competence at work in the executive offices: the integrity of the inter-island monopoly matters, everything else is mere noise.

These are the last five years (you will remember that Hawaiian's fortunes were transformed when Aloha Airlines was liquidated in 2008):

It is a bigger, better diversified, more efficient airline than it was a year ago, and it is still the lowest cost and best performing scheduled passenger service airline in the United States.

There had been some indications that Southwest was considering entering the West Coast-to-Hawaii market. I had thought that unlikely since that market is probably the most brutally competitive market in the United States, a market in which one has to price an available seat mile at 7.5 cents just to break even. Only Hawaiian and Alaska Air Group, both favored with high margin regional monopolies (Alaskan in the Pacific Northwest, Hawaiian in the Islands), could and would compete effectively there. And, in fact, it now seems that Southwest has turned its attention to other, softer markets. 

What, in any case, is Hawaiian worth?

We know the rate at which its net operating assets will grow over the next two years and, since we know that its margins and asset turns are increasing as it grows, applying the past average ROIC to those assets implies a degree of welcome conservatism.

The above implies an expansion of the various market multiples currently accorded to Hawaiian.

At a constant total enterprise multiple (TEV/EBITDAR, where TEV = EV + Capitalized Operating Leases + Pension Liability – Cash – NOLs), Hawaiian’s share price should follow a progression that looks something like this:

When an intrinsic valuation is so much higher than the current market price it doesn’t hurt to do a sanity check by comparing one’s valuation to the market’s valuation of other, “similar” businesses.


The market clearly doesn’t agree with the above rather smug review. It's not that it hates airlines as a group; it just really doesn’t like Hawaiian. 

I’ll be adding to my position as price and cash availability permit.

Dsclosure: I long Hawaiian Holdings


  1. Hello, I'm trying to follow up on your numbers above... How do you come up with the Pretax Operating Income? The nearest I get is by taking the Operating Income from the 10K and adding up D&A, but still don't get your figures... Would really appreciate if you could shed some light as I'm trying to reproduce your valuation model.


    1. Sure, here's a link to a spreadsheet. The 2nd tab has the raw data.

      Operating income = EBIT, so remove all nonoperating and financing costs: lease interest expense, which you can find in the 10-K Form 12; pension liability interest expense; amortization of acquired intangibles like trade names, etc.

      I have chose to include fuel hedging losses as an operating expense.

    2. Thanks a lot for this. I can see you replace Aircraft Rent for Aircraft Rent - Lease Interest. What does this mean?

      Sorry if I'm abusing a bit, please feel free to ignore me :-)

    3. Thanks for the question:

      Companies rent equipment as an alternative to buying it outright. Rental expense consists of two components: the value of the asset (which is depreciated) and the value of the financing charge (which is an implied interest expense).

      The value of the asset can be capitalized -- 7x rent or 8x rent is about right -- and that capitalized amount should be added to the asset side of the balance sheet and subtracted from the liabilities side of the balance sheet. Doing that gives one a much better sense of the underlying economics of the business, the so-called "fundamentals".

      The implied interest charge embedded in the total rent expense is usually included in form 12 of the company's 10-K filing. If it isn't and you want to work it out by hand, Richard Beddard has a very clear explanation here:

    4. Hello,

      Thanks very much for your explanation, really invaluable for someone trying to learn like me.

      So basically what you do is taking the rent paid as "depreciation" from the assets and that's why it is an operating expense, but you substract the interest because that's a financing cost right? Would it make sense not to capitalise and just substract the interest as a cost of doing business (i.e. operating)

      In terms of subtracting from liabilities I guess that what you mean is that you add it as debt, correct, because the company must honour that contract...

      I will read Richard's article. Thanks,


    5. "The value of the asset can be capitalized -- 7x rent or 8x rent is about right -- and that capitalized amount should be added to the asset side of the balance sheet and subtracted from the liabilities side of the balance sheet."

      are you talking about capitalizing an off balance sheet lease? in that case it should be added to the balance sheet as an asset and as a liability.

    6. Thanks for this. That's what I meant -- liabilities are minuses -- and that's what I did.

  2. Any idea if Ranch holds parts of the capital structure not reported in the last DEF 14A (warrants, converts)?

    1. No idea, I'm afraid, and not for the lack of trying to find out.

  3. Could you explain your valuation table a bit?

    just curious how you "know the rate at which its net operating assets will grow over the next two years"

    and then i'm not sure i follow the valuation itself... are you using a residual income model to find "business value?" ie Book value + ((ROE - required return)* Book value)


    i am intrigued by the competitive landscape and need to do my own work here, but wanted to explore your thoughts.


    1. Sorry I didn't get to this earlier -- I'm embarrassed to say that I just saw it.

      Management has laid out the minimum rate of capex for the next few years. It can be found at the IR page in the presentation material.

      As for the valuation approach, i get business value by applying the following formula: (EBIT-tax)/WACC.


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