High level thoughts on airlines, Volaris (VLRS) and pair trades
High level thoughts on airlines, Volaris (VLRS) and pair trades
Over the last few months, I’ve been looking at airlines, underappreciated (for the right reasons) due to a structurally unattractive business model and high economic sensitivity - with oil prices at the current levels, despite sluggish demand forecasts (hence with a potential to rip higher), owning an airline seems ridiculous at best.
The dynamics of the industry tends to encourage overexpansion - the business has an enormous fixed cost base paired with low incremental cost per seat - hence the incentive is to boost utilization to lower unit costs as fixed costs are spread over more flights. Moreover, there exists game-theory dynamics encouraging “land-grab” reckless expansion as revenues tend to increase disproportionately past a critical point - passengers prefer airlines with the most flights to maximize frequent flier benefits. Lastly, demanding unions eating a sizeable portion of margins and a whimsical fuel expense sitting at ~25-35% of OPEX mean that cumulatively, through the cycle, airlines scarcely earn economic profits and thus, are avoided by most.
This is not to say that money cannot be made; examination of price-action over the last decade or 2 demonstrates the opposite- if timed right.
Before going into the actual stock idea, let’s dispel a relevant myth.
Airline stocks do badly in higher oil environments
Stock prices lag operating margins and ROIC; and these two metrics follow industry dynamics a lot more than just Brent prices. The US airline industry earned negative operating margins from 2001 to 2005 despite Brent prices <$60. Post GFC, even with Brent soaring over a whopping >$100, the industry generated a higher, increasingly positive operating margin from 2010 onwards, resulting from improved discipline - post GFC consolidation led to fewer market share battles and less irrational capacity additions.
While lower oil prices do indeed augment operating margins, it also incentivizes irrational capacity growth which creates industry cyclicality - excess profits are annihilated and thus, the relationship between margins and oil is non linear → lower oil prices =/= better earnings.
With that said, if and when the industry becomes irrational, one generally wants to own the lowest cost player because they would be able to survive the fare wars better - either eking out a miniscule profit or taking a minor loss, simple math.
In sum, industry behavior matters the most for generating sector upside and buying the lowest cost operators (and unlevered) generally serve as a downside hedge. Of course, idiosyncratic returns would come from a no. of other variables - starting valuation, capital allocation, margin growth etc.
A few brief examples to justify the points above:
US airlines stock prices from 2011-2014 - SAVE, DAL, AAL were all massive outperformers despite rising Brent due to consolidated, disciplined market as mentioned.
Canadian Market - Air Canada (AC) and WestJet (WJA) were great stocks even amidst sky-high Brent prices. In 2014 (peak of the previous oil cycle), AC controlled ~55% of the domestic market and WJA controlled the other ~36% - a duopolistic domestic market; when capacity management was implemented, ROIC inflected and the respective stocks likewise.
With the myth out of the way, let’s dive into today’s key idea - Volaris (VLRS). VLRS is a predominantly domestic (67% of revenues) Mexican ULCC (ultra low-cost carrier) with the same characteristics as any ULCC globally - point-to-point networks, secondary airports, single-class service, high asset utilization, homogenous and young fleet.
It was quite the hot stock in 2021, but as oil prices surged in 2022 on the backdrop of the Russian invasion of Ukraine (eating margins), accompanied by recessionary fears (hurting sentiment), the stock returned majority of its gains, and is currently sitting below pre-Covid highs.
The general thesis for VLRS can be distilled into 5 points:
Flight penetration remains low in Mexico and poised to grow
Domestic market has consolidated and margins are currently obscured by higher fuel prices
Mismodelling on sell-side
Low starting valuation
Catalysts - Cat 1, lower fuel prices
Flight penetration
The following will be a slew of vanilla data spewed by management incessantly which I find fascinating in helping shape the long term thesis for VLRS.
Lack of apt substitutes
The landscape of Mexico is such that one could fit 25 European countries within and yet, unlike Europe, Mexico doesn’t have a developed passenger rail system.
Domestic flight underpenetration
Pre-Covid domestic trips per capita for Mexico, sits at ~0.55 whilst other developing nations e.g. Chile (~1.12), Malaysia (~2.0) feature higher trips per capita. For Mexico to achieve the same penetration as Malaysia, domestic passenger count would have to 3.6x. Since the introduction of Southwest Airlines, US penetration rate has tripled from slightly less than 1x in 1971 to ~3x today, providing a precedent for the latent potential in Mexico.
Bus Switching
This is the key point which underpins the big picture thesis - 3 billion people travel by bus in Mexico and a mere 1% conversion to air travel would double Mexico’s domestic air market. Moreover, for certain routes, the average bus fare exceeds VLRS’ air fares despite the long dreary travelling hours. I personally believe that the relative underpenetration that still persists is due to a lack of awareness of the stark differences in price/service, validated by the fact that >60% of first-timers (given a free-ticket) prefer air travel subsequently.
Last year, bus travelling benefited from federal subsidies on diesel prices, which has halved ever since and so the bus switching trend should continue from hereon.
Rationalized Market
Pre-Covid, the market was dominated by four players (by order of market share) - Aeromexico, VLRS, Interjet and VivaAerobus.
Prior to its bankruptcy, Interjet facing financial troubles and desperate to win market share, engaged in a fare war, pricing its hybrid service at low-cost carrier (LCC) prices, depressing margins across the industry.
The demise of Interjet could be attributed to two simple factors - 1) an acquisition mistake of Russian Sukhoi aircrafts, 2) operating a hybrid model.
In 2012, Interjet, seduced by discounts, ordered 22 Sukhoi SSJ100 Russian aircrafts in lieu of industry standard Bombardier and Embraer aircrafts ; a series of unfortunate events - a lack of spare parts and a fatal SSJ100 crash in Moscow led to a cumulative grounding of 18 Sukhoi aircrafts by end 2019 - approximately 20% of its total fleet.
A hybrid model sits between a premium service and LCC service which typically caters to different passenger types. In other words, Interjet was “stretched thin” in no man’s land and had to resort to desperate pricing measures to stay relevant.
resulting in VLRS and Viva snapping up Interjet’s capacity.
As a result of the pandemic, Interjet finally collapsed and filed for bankruptcy with VLRS and Viva, quickly snapping up the spare capacity. Not only was Interjet a victim but Aeromexico was similarly bankruptcy-restructured and emerged a smaller airline, doubling down on its differentiated premium service.
Post the flurry of catastrophic events, the domestic market is now dominated by 3 players - VLRS (42%), Viva (30%), Aero (27%).
To make money on the stock, one has to believe that the fare wars of yesteryears are a thing of history and that aggregate industry margins are poised to be higher, at least over the next couple of years.
Reasons to believe this might be so:
Each player will stick to their own niches
As mentioned, Aero offers a premium service catered for corporate travel. Viva on the other hand mainly serves beach destinations. A key factoid that is unique to the Mexican domestic air market is that 46% of VLRS’ routes have zero air competition, except with buses. In other words, 54% of VLRS’ routes compete with the other 3 players, a huge improvement from ~80% pre-Covid. Uncompeted routes allow VLRS’ to implement flexible pricing - maximizing yield and load factors simultaneously. It is worth noting that this distinct lack of overlap is not enjoyed by the other players.
Fare-wars make no fiscal sense
VLRS has a strong balance sheet (no debt) and low cost structure (see note) - e.g. VLRS’ RASMs are lower than Aero’s CASM - it is virtually impossible for Aero to compete on fares without P&L bleeding. Aero also has debt with maturities due 2024/25 and so having strong operations is necessary for favorable refinancing.
(Note: VLRS has one of the lowest CASM ex fuel in the world, only surpassed by Wizz Air)
What would margins look like in a rational market? Treading back to 2018, the industry suffered a capacity glut - fare wars induced by Interjet, political instability tilting supply in excess of demand. The quagmire of excess eventually eased due to the unfortunate grounding of the Boeing 737 and the repossession of Interjet’s Sukhoi fleet. Margins leapt more than 10 pts (with stable fuel prices allowing direct like-for-like comparisons), spurred by augmented RASMs (diminished fare wars) and cost reductions.
Mismodelling of sell-side
Last week, VLRS sold off ~10% post Q1 23 due to underperforming estimates and a negative EPS, despite reaffirming guidance. Unfortunately, I could not get this piece out on time and the stock has retraced a good portion of the sell-off, perhaps a result of buyside firms digesting the results and updating their models properly.
To put it simply, results were far from a disappointment. Notably,
VLRS locked in a record Q1 TRASM of 7.7c
A negative EPS is normal for Q1 so nothing to worry about
EBIT losses were lower than Q1 22 and EBITDAR margins came in at a similar ~17%, despite fuel cost/gallon 12% higher and appreciation of the Peso which was a headwind to dollar denominated fixed costs - labor and G&A.
EBITDAR margins for Q1 23 were 3 pts higher than Q1 18 (peak of irrational competitive dynamics as mentioned), despite 57% higher fuel costs per gallon - indicating an obscured structural margin step-up.
The street is conservatively adopting management’s midpoint guidance of $3.3b sales for 2023 but modelling EBITDAR margins at ~850m (25%) despite management guiding to a midpoint 30% margin - 990m.
I find this appalling.
VLRS has upgraded approximately half of its entire fleet into the fuel efficient A321neo Airbus aircrafts which sits more pax per aircraft and consumes lower gallons/ASM.
With the assumption of
Additional seats factored into ASM growth
CASM-X of 4.7c (per management’s guidance)
D&A and rents as a % of revenues in line with historical %
the street seems to have mismodelled either
the improved fuel efficiency; gallons/ASM - I assume to decline from 9.64 in 2022 to 9.4 in 2023
fuel costs - which currently sits at $2.274 (VLRS is fully unhedged). Management guides to an additional ~40c to triangulate economic fuel costs which is ~$2.70 at present.
Stress-testing the figures and modelling a wildly higher fuel cost of $3.30 (higher than management’s estimates), still gets to $930m of EBITDAR (28% margin) - $80m in excess of the street’s estimates.
A caveat regarding management’s estimates is the assumption that CAT 1 will be commercially operative by Q4 which seems to be baked into their revenue guidance. However, just toying with the figures, even assuming lower revenues but higher margins would triangulate an EBITDAR in excess of the street’s $850m.
Valuation
At $11.76 (last closing price), VLRS trades at ~4x EBITDAR (my estimate - which bakes in fuel costs at $3.30 as mentioned). This is on the low end of the LCC multiple range and does not even account for further margin expansion; management has indicated that $80 WTI should yield margins in the 30s.
Notably, when Indigo first acquired its 50% stake in VLRS in 2010, they paid 8.3x EBITDAR.
Catalysts
Cat 1
When Mexico scuttled the cabotage flight reforms, VLRS surged ~10% in a day. I expect a similar price action when Category 1 status is reinstated. Cat 1 is essential for transborder expansion and VLRS stands to benefit from its code-sharing agreement with Frontier, facilitating connecting itineraries.
Mexico is currently trapped in Category 2 and the last time this happened, Cat 1 was reinstated in less than 6 months (2010), so this has gone on for longer than expected (~ 2 years); management has constantly over-optimistically projected Cat 1 reinstatement and perhaps the market is unsure of the validity of management’s current projection for reinstatement in H2.
However, it is worth noting that Grupo Aeroportuario del Pacífico (PAC) in their Q1 23 call reaffirmed this guidance.
Fuel
Not to belabor the same points but jet fuel prices are sitting way below both the street and management’s estimates. Even if jet fuel prices were to jump 10-20% from current levels, it’s not hard to triangulate street-beating EBITDAR figures.
Management will be updating fuel price guidance in Q2; should they aggressively lower the figures, I expect estimates to be revised across the board, and the stock to respond accordingly.
Final thoughts and risks
It is helpful to think about what the market is expecting at a given stock price.
At current prices, the market is capitalizing earnings at low multiples which implies that the market believes
higher margins are unattainable
financial distress
Point 2 is easily refuted given VLRS’ net cash balance sheet. Point 1 is where the debate is held and the only way the market will be willing to capitalize earnings at a higher multiple would be for margins to stay elevated for many quarters (show), or the players in the market can demonstrate that they are willing to be disciplined (tell).
Examining the ownership structure of the relevant players, Apollo owns ~20% of Aero and for Viva, insiders are planning to offload a slice onto the public markets in the near future (IPO) → it is neither in Apollo’s interest to decimate profits via irrational fare-wars, nor is it in Viva’s interest to public list with anemic margins.
Other relevant points
VLRS is 15% owned by Indigo Partners, founded by Bill Franke, a successful pure low cost carrier private equity firm. Indigo orders a large volume of aircrafts solely from Airbus and thus 1) obtains a discount or orders, providing a cost benefit to portfolio companies (including VLRS), 2) obviates excess/spare aircraft risk as the planes are fungible between companies under the Indigo umbrella. 1) is an especial benefit at present as manufacturers and lessors are seeing increased costs, either in the form of raw input inflation and higher cost of funding respectively.
Given VLRS’ low CASM, it will be difficult for US carriers to compete directly with them. Southwest tried and left in 2019.
Base fare is unlikely to grow by much in coming years as VLRS aims to earn more TRASM from discretionary ancillary revenues (baggage fees, food and beverages, advanced seat selection etc.); a lower base fare also precludes competition and prevents regulatory scrutiny. Ancillary revenues have grown from ~$20 in 2017 to $38 in 2022 - 41% of revenue per passenger with European counterparts in the ~50% range, signaling further room for growth.
There is upside expansion (didn’t cover in this piece) in Central America markets as there is no ULCC player.
VLRS is unable to conduct share repurchases or dividends at the moment as capital return is capped at the level of retained earnings and current retained earnings are negative.
Risks
Irrational price competition or capacity overbuild. It is worth noting that as per last June, demand was 8% higher than 2019 whilst the number of industry aircrafts were the same as Dec 2019 - ~350 aircrafts. VLRS is guiding to ~10% ASM growth dependent on real-time demand trends so nothing too excessive. Capacity expansion may also be difficult in the near term as manufacturers and lessors have indicated supply chain constraints, delaying aircraft delivery.
New entrants. Apart from a government funded airline to facilitate connectivity in underserved routes (stated intention thus far), a private-backed airline entrant is unlikely given the costs to compete with Indigo - it would be much smarter to own a stake in a cheap VLRS outright.
Volatile/higher oil. Sudden spikes in oil could be detrimental to VLRS as the airline caters to VFR (visiting friends and relatives)/leisure travelers - whilst lower economic sensitivity (not subject to corporate budgets), will still see margins hurt as tickets are usually purchased in advance and so there might be a mismatch in yields/revenues and actual operating fuel costs at time of flight.
Moreover, the current oil crisis, unlike previous ones, is predicated on supply shortages which means there is no “strong economy” to offset the higher costs.
High speed rail (This is a little random but related to a piece of non-investing research I’ve been doing). There are two proposed plans, in infancy, for HSRs in Mexico. Numerous studies have exhibited that introduction of HSRs lead to air travel reduction in subsequent years e.g. Eurostar vs flights from London to Paris. In any case, this risk won’t be happening anytime soon.
Pair Trading
For the US market, airline revenues typically range around 0.98% of US nominal GDP with an 85% correlation to nominal GDP growth. Airline and hotel revenues are also ~90% correlated. Current demand remains robust but that could turn.
One could hedge out oil price risk and demand downturn via say a short on AAL which is an unhedged airline (same as VLRS) with a large corporate client base; with cost reductions across industries, at some point, corporate travel gets a big spanking. Moreover, AAL has not generated an ounce of FCF even pre-pandemic (equate ROU acquisitions through operating leases as CAPEX), is net debt and trades at 6x 23 consensus EBITDAR.
Another way to think of this is, the market is pricing AAL and say UAL at higher EVs than pre-Covid despite a potential looming recession and higher oil prices. Compare this then with LUV - an LCC carrier trading at ~4x 23 consensus EBITDAR due to operational hiccups of late, sporting an EV lower than pre-Covid; LUV is also net cash and generated FCF pre-COVID. Say LUV could spit out $4-$5 of EPS again in a few years time, the stock could easily be worth north of $40.
In any case, these are some brief thoughts I’ve been having and I wanted to keep this piece snappy. Would be happy to hear alternate views on this “anathema” industry.
Disclosure: Long VLRS, short AAL