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Skywest Airlines – 18 plane strategic alliance agreed with Virgin Blue. Increase in target price from 35p to 40p. Buy at 28p.

On 10th January Skywest announced that it had entered into an exclusive 10 year strategic alliance with Virgin Blue Group to service regional Australia, operating up to 18 new Virgin Blue branded turbo jet aircraft to a number of existing and new destinations around Australia. The agreement also includes the ability for Skywest to code-share on Virgin Blue’s domestic network.

It is expected that the first aircraft will arrive mid 2011 with four Virgin Blue branded aircraft in operation by the end of the year. The company hosted a conference call to further inform the market, and we summarise the key points below.

• The arrangement will be relatively low risk for Skywest and more akin to its current charter agreements than its scheduled services. Under a ‘wet’ lease Skywest will provide everything Virgin Blue requires (crew, planes, maintenance etc) and Skywest will charge Virgin Blue on a ‘cost plus’ basis meaning that downside from periods of low demand is insulated. However the additional codeshare arrangement means that Skywest can generate additional revenues by selling Virgin Blue tickets through its existing distribution channels.

• Skywest expects to continue growing organically by improving operating performance on its existing routes.

• The new planes will be twin prop aircraft with between 50 and 100 seats, giving Skywest the capacity to effectively double its fleet.

• The new routes will bring the Eastern side of Australia into play for Skywest enabling the company to better service its charter customers in the resources sector. With the growing demand for labour in the Western Australian natural resources sector, Skywest will now be able to help its customers to fly in workers from other regions across the Island continent.

• Skywest expects to roll out six to eight new aircraft by the end of the 2012 financial year. The pace of expansion thereafter remains to be seen.

• Skywest will use its increased bargaining power to gradually upgrade its existing fleet for more economical and fuel efficient aircraft.

We have now introduced 2012 forecasts which show a 25% increase in revenues based on continuing growth in the charter business and the commencement of the alliance with Virgin Blue. We have increased our target price by 14% to 40p which is just over 8 times 2012 earnings. The shares offer an attractive 2.9% yield for 2011 rising to 3.6% in 2012. As further visibility emerges regarding the roll out of the Virgin Blue alliance, we anticipate being able to raise our target price. Should everything go to plan earnings per share of more than 8p is not unreasonable for 2014. The stance is buy.

Forecast table