Investing is extremely difficult if you are focusing on large-cap companies and their short-term performance. Even the smartest investors can’t produce any meaningful alpha by following this approach. On the other hand, investing is easy if you are focusing on small-cap companies and their long-term performance. In this article we will share an idea that is likely to beat the market by a large margin. We will revisit this idea in 6 months and publish a follow-up article. Eiad Asbahi of Prescience Investment Group initially pointed out this opportunity but he probably got his clue from activist investor Zac Hirzel.
Zac Hirzel of Hirzel Capital Management has been acquiring a stake in Hawaiian Holdings, Inc. (NASDAQ:HA) since the beginning of 2013 and is now its largest shareholder with a 10.8% stake. In addition, he was recently appointed to be a member of the company’s board of directors. Other hedge fund managers recently buying the shares include Brad Gerstner of Altimeter Capital Management and Geoffrey Raynor of Q Investments. Gratia Capital, Nokomis Capital, and Castlerock Asset Management are among HA shareholders too. We pay attention to hedge fund activity in small cap stocks because our research has shown that the most popular small-cap stocks among hedge funds historically outperformed the market by an average of 18 percentage points per year (read the details here). It’s not a typo; 18 percentage points is a large margin and Hawaiian Holdings, Inc. (NASDAQ:HA) is one of those stocks that fit the bill.
Hawaiian Holdings, Inc. (NASDAQ:HA) is a $600 million market cap holding company for Hawaiian Airlines, the 11th largest domestic airline that has consistently ranked highest for on-time departures and arrivals in the U.S., based on the Department of Transportation. It operates non-stop flights between Hawaii and 11 major cities in the U.S. mainland, Japan, South Korea, Taiwan, Australia, New Zealand, American Samoa and Tahiti. New non-stop service between Honolulu and Beijing is expected to begin in April 2014.
Since 2010, Hawaiian Holdings, Inc. (NASDAQ:HA) has been investing heavily in its business to grow its international routes in Asia, which has hurt profitability and cash flow. However, it is now at an inflection point in terms of growth, as its fleet size stabilizes at 50 aircraft through 2015 (vs. 47 in 2013 and 37 in 2011). Consequently, management expects capital expenditures to decline through 2016 from a peak of $525M in 2013, which should result in improving free cash flow generation that turns positive in 2015 and 2016 (vs. negative cash flows of $305M in 2013). Combined with maturing routes that will require less investment (and, hence, generate more cash flow) and reduced hedging costs for jet fuel from new risk management programs, it should not be a stretch for Hawaiian Holdings, Inc. (NASDAQ:HA) to improve its profitability going forward. Some investors believe that, starting in 2016, the airline could begin to return some cash to shareholders. Given the heavy investment the company made in recent years, even the possibility of such an event would have a huge positive impact on investor sentiment, in our view.
There has been renewed interest in airline stocks following the recent consolidation wave, with the big three – American Airlines Group Inc (OTCMKTS:AAMRQ), Delta Air Lines, Inc. (NYSE:DAL) and United Continental Holdings Inc (NYSE:UAL) – receiving the most investor attention, at the expense of smaller carriers like HA. The stock trades at discount to peers on both a forward P/E (9.7X vs. 12.5X for peers) and EV/EBITDA (3.8X vs. 4.8X for peers) basis, reflecting HA’s current below-average profitability metrics. However, as growth moderates and the carrier harvests its previous investments, we believe margins, returns and cash flows should all rise from a cyclically low base, leading to multiples expanding toward levels in-line with the industry. Simply applying peer multiples to current estimates yields a stock price between $14.50 and $15.50, or 28-37% upside from today’s price.
At this point, it is unclear what actions Zac Hirzel will take as a new board member. However, as the largest owner of the stock, the activist hedge fund manager’s interests are clearly aligned with other investors so his appointment should be viewed as very shareholder-friendly.
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