Airlines are tricky investments in the best of times, as the industry has an uncanny knack for shooting itself in the foot over and over again with irresponsible capacity, pricing, and service quality decisions. Add in the volatility that comes with operating in emerging economies, and it only gets more challenging for operators like Azul (AZUL), Copa (CPA), and Volaris (NYSE:VLRS).
Volaris certainly isn’t going to be a suitable idea for everyone, and the near-term outlook is most definitely challenged between engine-related aircraft groundings, aircraft delivery delays, and a weakening macroeconomic backdrop. Still, trading at less than 3.4x forward EBITDAR, it seems like a lot of bad news is already priced into the shares of this Mexican ultra-low-cost carrier.
Cost Control Drives A Beat As Capacity Remains Significantly Constrained
Volaris reported a 7% decline in revenue in the second quarter, driven by a 17% decline in available seat miles (capacity, in other words). Yield (total revenue per available seat mile, or TRASM) improved 12%, but revenue still missed by about 3%.
On the cost side, total costs per available seat mile (or CASM) rose 9% to $0.081, while CASM ex-fuel rose 11% to $0.053. This was better than expected, with the company under-spending in areas like marketing and maintenance (no need to market for grounded flights, and likewise lower maintenance costs for those planes), and it drove EBITDAR growth of 23% and a 5% to 8% beat (5% as per Bloomberg’s “consensus” number and 8% by Visible Alpha’s number). EBITDAR margin improved 880bp yoy to 35.9%. While EBIT is largely ignored by airline analysts, this line item did grow 29% in the quarter.
Volaris Continues To Operate Around A Major Fleet Availability Issue
With Volaris flying a fleet made up mostly of A320s and A321s, the company has been hit by the issue of defective metal components in the new Pratt & Whitney GTF engines (Pratt & Whitney is part of RTX Corporation (RTX)). The double-digit decline in available capacity in the quarter was not a byproduct of weak demand, but rather the need to ground planes to have the engines repaired, with the company seeing 31 planes grounded in the quarter (versus 29 in the prior quarter and a total fleet of 136).
There’s little that management can do about this situation beyond mitigating the damage. The company has been working with Pratt & Whitney to improve turnaround times and revised its capacity a little higher (a 14% decline for ’24 versus prior guidance of 16%-18%), but the airline is still looking at a peak grounding of 34-35 in the current quarter (Q3’24). While wet leasing is an option, it’s an expensive option and management has been focusing on reallocating aircraft across its most profitable routes and altering schedules to maximize load factors and maintain service levels as much as possible – not a trivial concern, as about half of its domestic routes compete only with busses.
The engine issue is the main driver of Volaris’ capacity challenges, but it’s not the only issue in play. Airbus (OTCPK:EADSY) recently cut its 2024 delivery target (again), and while the magnitude of the cut was not that large (a 30-unit cut), it continues a trend of the major OEMs struggling to deliver on their sizable narrowbody order books.
Macro Issues Are Worth Watching, But Likely Not That Material
As if all of that wasn’t enough, Volaris is also looking at a slowing Mexican economy that is expected to grow at around 2% in 2024 and again in 2025 (and the estimates have been coming down since the start of the year). With the U.S. economy also slowing and considerably uncertainty about the outcome of the U.S. elections in November, the overall macroeconomic outlook for Mexico is not the best at the moment.
As a ULCC, Volaris largely targets more economically-sensitive consumer travel, and less than 20% of the company’s business has historically been categorized as business travel. Not only does leisure and “visiting friends and relatives” travel tend to be more economically-sensitive, it also competes with bus routes, and a significant part of the growth thesis at Volaris has been based on converting more “high-end” bus traffic (an estimated 800M trips per year) to air travel and growing ancillary revenue (fee-based services, including baggage).
Looking at the airport operators, there is some evidence that travelers are getting more cautious; Grupo Aeroportuario del Sureste (ASR) saw traffic to its Cancun airport decline 8% in the second quarter, and domestic travel has been weakening for all of the airport operators in recent months.
If there’s a bright side to this pressure it’s that it’s coinciding with the aircraft groundings and by the time management expects to be back to 2023 levels of capacity, most of these issues should have worked themselves out. Over the longer term, Volaris remains leveraged to a growing Mexican middle class with more disposable income that can afford to take more trips and/or upgrade from traveling by bus to traveling by air.
The Outlook
I’m expecting mid-single-digit revenue contraction this year, followed by a modest recovery in FY’25 (up 5%) and a much stronger recovery (high-teens) in FY’26. While I’m looking for a five-year revenue growth rate of 7% from ’23 to ’28, that growth rate moves to 10% if you use ’24 as the starting point, and over the longer term I expect growth in the mid-to-high single digits (around 7%).
Turning to the margin side, Volaris is doing a good job of managing profitability during this capacity challenge, but I do expect EBITDAR margins to be relatively flat over the next few years. In the near term, management will continue to try to maximize its more profitable routes and as capacity returns, I expect the company to “reinvest” in growing the business through expanded marketing spending.
On the subject of costs, I think it’s worth noting that a CASM ex-fuel in the $0.05’s is quite good – Copa gets close, but most other comparable operators are in the $0.07’s.
Free cash flow generation is going to be impacted significantly over the next few years as the company takes delivery of new Airbus neo jets, but over the longer term, I believe the company can generate high single-digit to low double-digit FCF margins.
Discounted cash flow is less useful than I’d like, given the uncertainties on the timing of the recovery of the engine groundings and future aircraft deliveries. What I can say, though, is that the stock is pricing in some combination of low future revenue growth, low margins, and a high discount rate. Using a double-digit discount rate and a 7% long-term revenue growth rate, FCF margins have to average out in the low single digits to drive today’s price and that seems like a very low expectation.
A multiples-based approach likewise suggests not much enthusiasm for the shares. The stock is trading at around 3.4x my 12-month EBITDAR estimate, well below the longer-term average of around 4x (I say “around 4x”, as adjusting for the pandemic period is inexact, not to mention the impact of higher rates relative to the historical comp period). While I do think that’s too low, I have to note that Copa is trading at about the same multiple, and I’d argue that Copa is probably the better company of the two.
The Bottom Line
A 4x multiple on 12-month EBITDAR would drive a $12 fair value, and even a 3.5x multiple would support close to 20% upside from here. It’s hardly an ideal operating environment for Volaris, but I don’t think it’s as bad as what the market seems to be pricing now. With that, I think this is a name with some contrarian appeal today.
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