Monday, June 14, 2010

JetBlue Airways (NASDAQ:JBLU): Gaining high-yield traffic traction; Upgrade JBLU to Buy - Merril Lynch/BAC

Merrill Lynch/BAC is upgrading JetBlue Airways (NASDAQ:JBLU) to Buy from Neutral with a $11 price target (prev. $6.50).

JBLU’s unit revenue gains have lagged the industry as a result of the carrier’s relatively lower exposure to the surge in high-yield business traffic and its push into new markets. Merrill believes that JBLU’s schedule strength in JFK will lead to continued improvement in New York business mix and that JBLU’s rising market share in Boston offers another opportunity to improve its high yield mix. First half headwinds (cutover to a new reservation system and JFK runway construction) are now behind the carrier, and JBLU’s cost pressures also ease in the second half.

They believe year-over-year earnings decline will cross over to increases in the second quarter, and they are doubling their second quarter estimate to $0.08 (partially due to better than expected May traffic results) as compared to $0.06 consensus and a year ago profit of $0.05. For the full year, Merrill is raising their 2010 estimate to $0.35 ($0.32 consensus) from $0.19 and their 2011 estimate to $0.60 ($0.52 consensus) from $0.37.

JBLU increasing penetration in top 25 markets
In their industry report released today, Merrill looked at the top 25 markets of each airline over the past decade to gauge whether an airline is becoming more or less relevant to its customer base over time. JetBlue had the top ranking in 13 of its top 25 markets as early as 2003, a remarkable feat for a start-up carrier. Moreover, JBLU’s share has steadily climbed throughout the decade owing to its schedule dominance in JFK and its superior service product. In 2009, JBLU had a leading share in 21 of its top 25 markets, in line with most legacy airlines, and its market share in its top 25 markets averaged 56%, up 10 pts over 5 years (by far the best performance in the sector). Similarly, average revenues in JBLU’s top 25 markets gained 27% from 2003 to 2009 (also the best performance in the sector).

In firm's view, JBLU’s dominant share has lifted its business mix despite JFK’s less attractive location. From 2003 to 2009, JBLU’s top 25 yields increased 22% as compared to an industry decline of 16%. Currently, JBLU’s share of Boston traffic is beginning to escalate as well. The combination of AMR’s and LCC’s cutbacks and JBLU’s 33% expansion will vault JBLU into a leading share of domestic traffic by year end. Given that JBLU operates out of the most conveniently located Boston airport, yields may respond more quickly than in New York

Broader base reduces risk
JBLU has broadened its revenue base even as it increases its existing market penetration. In 2003, JBLU derived 85% of the company’s revenues from its top 25 markets, making the airline highly vulnerable to competitive attack. Revenues from JBLU’s top 25 markets equaled 42% of revenues in 2009 and they expect concentration to drop below 40% in 2010. Low fare carriers are increasingly penetrating larger markets, and JetBlue’s top 25 markets gained 27% from 2003 to 2009, the best performance in the sector.

Valuation becomes more attractive normalizing for fleet
Multiples typically compress as airline progress through the cycle, but more so for legacy airlines than low fare carriers. Merrill's $11 price objective is consistent with past mid-cycle low fare multiples of 10X-12X pretax earnings. JBLU appears expensive on sales multiples, but not after adjusting for its 4.3 average fleet age. They estimate that JBLU will generate $0.40 per share of free cash flow in 2010 and $0.60 in 2011 despite growing capacity 6%-7%. Deferral of fleet modernization is boosting many airlines’ free cash flow, but JBLU’s free cash multiples look well below the industry average using sustainable levels of capital spending. They derive their $11 price objective by applying the following mid-cycle multiples to their 2011 estimates: 1.15X EV/Sales, 11X pretax earnings, 6X EV/EBITDA, 6.5X EV/EBITDAR, 10X FCF, and 15X Normalized FCF.

Emphasis on growth
JBLU management has historically emphasized growth even as returns deteriorated. After cutting capacity in 2008, investors became concerned in April when management announced the addition of 7 leased A320s this fall on top of the existing plan to buy 9 planes a year. While Merrill notes they would prefer management would err on the side of caution, they note that the retreat of legacy carriers in Boston does create a vacuum that could be quickly filled by other low fare airlines. In addition, JBLU can currently internally fund its capital spending and JBLU’s EBITDAR margins are amongst the industry leaders.

Notablecalls: I like this call:

- This is a new Street high target for JBLU, surpassing the former $10/share target by $1.

- The chart looks OK & the stock is looking to break new 52-week highs in the n-t.

- Note that Deutsche is out with a group initiation call on Airlines, initiating JBLU with a Buy rating and $8 target. After a relatively strong 2009 earnings performance was overshadowed by a Mar Q 2010 loss (driven by several one-off events), they think JetBlue's shares are ready for take-off as an improving fundamental backdrop should drive earnings growth and margin expansion particularly as we move into 2H 2010.

All in all, I think this call warrants attention today. Should trade up by at least 5%, putting $6.80 levels in play. Could go higher if resistance gets broken.

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