Investment Thesis: Allegiant's business model is nearing an inflection point as cost inputs are poised to reset higher and its route system is becoming increasingly more complex. Allegiant is subject to significant near-term expense inflation as fuel prices increase (Allegiant maintains no hedges), labor costs escalate (workforce mobilizing to unionize) and airport costs rise (already happening in its most traveled markets of Las Vegas and Orlando). Longer-term Allegiant faces higher maintenance expenses as its planes grow older and it adds a second aircraft type (757s). Allegiant thrives in a low-cost environment where it is capable of flexibly allocating its planes to the routes where it sees the most demand. Allegiant has been able to nimbly direct its aircraft mainly because it has been a relatively small operation with flexible labor, i.e. no pilot and flight attendant unions. Allegiant now faces serious headwinds as growth opportunities are less obvious and its workforce becomes less productive. We note that its flight attendants voted for union representation last month.
Increased business complexity and expense inflation are central to our short thesis. Any slowdown in demand for its leisure travel coupled with higher costs would devastate margins. While there are few signs of weakened travel demand, there is clear evidence that heightened expense trends are here now and we believe this warrants a short position in ALGT shares today.
Background: Allegiant emerged from bankruptcy in 2002 under the direction of Maurice Gallagher, Jr. with its existing business model- flying passengers to leisure destinations in older, cheaper aircraft, specifically MD-80s. After serving as Chief Executive Officer from 2002 until 2010, Gallagher remains the Chairman and continues to be heavily involved in the business strategy.Gallagher has employed a similar business strategy before. Anyone remember ValuJet?
Gallagher was a co-founder of ValuJet. ValuJet's business model was to operate a fleet of cheap, older aircraft (mainly DC-9s) and target customers seeking low fares for leisure travel primarily in the southeastern United States. ValuJet went public in June of 1994 and it immediately commanded a market capitalization of over $400mn. The stock was a star performer for two years after its IPO rising from $12.50 per share at offering to $34.75 at its peak. After posting impressive growth and stock gains, ValuJet crashed- literally- in May of 1996 when a 27-year old ValuJet DC-9 disappeared into the Florida Everglades killing all 110 people on board. A quick look at ValuJet's air safety record shows that it made 19 emergency landings in 1994, 57 in 1995 and 57 in the five months leading up to its crash in 1996. Management's low-cost aircraft acquisition strategy proved to be flawed.
ValuJet Connection at Allegiant:
After taking the helm at Allegiant, Gallagher recruited many of his former ValuJet colleagues. Given the success they had at ValuJet, why not put the band back together and try it again? Andrew Levy, the current CEO, was formerly with ValuJet holding various positions there from 1994-1996. M. Ponder Harrison, who resigned from Allegiant in August of 2009, joined ALGT in 2002 and served as the company's head of marketing and sales- he held the same role at ValuJet. Timothy Flynn is a director at Allegiant and was a co-founder of ValuJet alongside Gallagher. Flynn also is the uncle of Allegiant's current 32 year-old CFO, Scott Sheldon. Additionally, Sean Hopkins, the Head of Contracts & Supply Operations, was formerly with ValuJet. Finally, Robert Priddy, also a co-founder of ValuJet, formerly served on the Allegiant Board and is a managing partner at Comvest Investment Partners which owns close to 8% of ALGT shares outstanding.
Cost Pressures:
Fuel: Like most airlines, fuel is Allegiant's biggest expense item. Allegiant maintains no fuel hedges. Despite utilizing the most fuel-inefficient planes in the sky, ALGT chooses to buy fuel at spot prices. A look at ALGT stock price history shows that it is highly negatively correlated to jet fuel prices. ALGT stock troughed in the summer of 2008 when jet fuel spiked to over $4 per gallon (JETIGCPR INDEX on Bloomberg). In Q2 and Q3 of 2008 ALGT earned $0.13 and $0.24 per share. In Q1 and Q2 of 2009 when jet fuel prices ranged between $1.14 and $1.52 per gallon, ALGT printed money earning $1.37 and $1.17 per share. Jet fuel prices in 2010 averaged $2.07 in Q3 and $2.33 in Q4 and have since risen to $2.72 today. While not near the peak levels of 2008, we view this as a meaningful cost pressure into 2011.
Fuel as a percent of ALGT total expense and total gallons consumed
2007 2008 2009 2010 Q1 2010 Q2 2010 Q3
% of Total Costs 48% 51% 38% 43% 44% 43%
mns of gallons consumed 66 77 94 26 27 28
Source: Morgan Stanley estimates and company filings
Per Morgan Stanley estimates, ALGT consumed 106 million gallons of jet fuel in 2010 paying $2.17, $2.28 and $2.25 in Q1, Q2 and Q3. Assuming they spent an average of $2.45 per gallon in the 4th quarter, Allegiant's total fuel costs are expected to be $242mn for the year. Had ALGT averaged $2.72 (today's price) per gallon throughout 2010, fuel costs would have been $288mn. Given ALGT is expected to earn just over $100mn in EBIT for the year, today's fuel price would have nearly cut ALGT profits in half.
Labor: Salary and Benefits are the second largest cost component at Allegiant. Labor cost per passenger for the first nine months of 2010 were running at roughly $18 per passenger. Relative to low-cost peers, that is significantly lower. JetBlue and Southwest labor cost per passenger are $36 and $41. ALGT has been able to sustain lower costs due to the fact that its workforce is non-union. Notably, on December 22, 2010, ALGT flight attendants elected to unionize choosing the Transport Workers Union (TWU) to represent them. In terms of labor expenses, the two most costly employee groups at any airline include pilots and flight attendants. The latter has chosen union representation, it may only be a matter of time before pilots follow.
One key point that should be highlighted is that a key driver of ALGT business strategy is their ability to be nimble with their flight plans. A labor union only complicates flight planning. The fact that ALGT flight attendants elected union representation removes the flexibility management has over flight scheduling. It is difficult to quantify the ultimate cost impact, but one would expect it to be meaningful. Also, there will likely be an indirect negative impact on revenue as flights may not be able to be diverted as easily pre-union.
Airport (Station) costs:
Station costs are the third largest expense component at Allegiant. Station costs per available seat mile was a deflationary item for ALGT in 2009 and 2010. We expect that trend to reverse in 2011.
Las Vegas McCarron International (LAS) is the most important destination for Allegiant. At the end of Q3 2010, 40 out of a total of 145 routes connected to LAS. The company is headquartered in Las Vegas and much of its workforce, including mechanics are based in Las Vegas. Allegiant's initial routes were connecting small cities to Las Vegas. A material portion of its ancillary revenue is generated through 3rd party fees (Las Vegas hotel and event bookings) on Allegiant's website. Notably, LAS costs per departure are rising, up 12% year over year. Management recently admitted that airport driven expenses are up over 21% in Las Vegas.
Orlando is arguably the second most important leisure hub for ALGT. Per management's most recent presentation slides costs per departure in Orlando are up 39% year over year. At the end of Q3 2010, 29 out of 145 routes were destined to or from Orlando. Allegiant flies roughly half of its routes through Orlando International (MCO) and half out of Orlando Sanford (SFB). Per its October 26th, 2010 press release, Allegiant is consolidating all of its flight to SFB. Management stated that costs drove the decision.
Given the cost pressures at LAS and Orlando, Allegiant's other major leisure destinations are likely seeing similar trends.
Maintenance: Given the age of Allegiant's planes maintenance costs are difficult to forecast. Maintenance has averaged about $100k per month per plane, or $1.2mn per aircraft annually. We estimate that an incremental $10k in average monthly maintenance would equate to a $0.05 hit to earnings per quarter. Allegiant's fleet is nearly 20 years old and the MD-80 is no longer in production. Notably, on January 10th, 2011 Allegiant reported its December 2010 traffic report which included a subtle mention of higher than expected maintenance costs. The press release contained the following excerpt:
Guidance subject to revision
The company's cost per passenger guidance is slightly higher than previously
projected due to having carried fewer passengers than expected as a result of
irregular operations caused by the severe weather in late December in addition
to unscheduled engine maintenance expenses.
Allegiant has had several scary incidents operating its older planes. On October 8, 2010 an Allegiant plane caught fire on a runway in Orlando forcing the evacuation of the 147 people on board. On March 29, 2007 an Allegiant plane landed in Orlando with its nose landing gear retracted causing substantial damage to the plane- there is some footage on YouTube at the following link.
A quick Google search of "Allegiant emergency landing" turns up several stories of other Allegiant emergency landings. Sound eerily similar to ValuJet's track record?
At some point ALGT will have to upgrade its fleet of planes. MD-80s have historically cost ALGT roughly $4mn per plane. Management has stated that the 737 would be the most likely replacement- used 737s currently cost between $10 and $30mn per aircraft.
Other Key Points and Potential Catalysts:
Capital Expenditures: CAPEX is trending higher.
(millions) 2006 2007 2008 2009 2010E 2011E
Capex $28 $42 $54 $32 $110 $80
Allegiant announced that it will be spending $18mn to increase seating in its MD80 planes from 150 seats to 166 seats. This is an attempt to insulate margins in our opinion as this should drive increased revenue per flight. Yet, we question how its customers will react to less legroom. Also, ALGT acquired 4 older 757 aircraft in recent months and is committed to buying 3 more for $32mn in 2011. The company had high hopes to initiate routes to Hawaii. However, ALGT was unable to obtain its ETOPS certification (required to fly over large bodies of water). It hopes to receive its ETOPS certification in the next year. Yet, in the interim it has leased 2 757s out and plans to use the others on its existing route network.
Free Cash Flow Metrics Deteriorating: After showing several years of positive cash flow metrics the last two quarters have turned negative. In Q3 2010, ALGT prepaid for $25mn in hotel room inventory in Las Vegas and capital expenditures have been racing higher. Bulls have focused on Allegiant's balance sheet and cash flow generation; it will be interesting to see if negative cash flow trends in Q2 and Q3 were temporary or a more permanent situation.
Insider Selling: Both Gallagher and Levy have been selling aggressively in the October through December 2010 time period. Levy offloaded 1/3 of his stock position in December.
Valuation Considerations:
ALGT is expected to earn $3.38 2010 and at trades 14x earnings or 12x ex net cash. Given ALGT risk profile, we feel the premium multiple relative to its peers is not justified. See table below.
P/E 2010E P/E 2011E EV/EBITDAR 2011E
ALGT 14x 12x 5.4x
ALK 9x 8x 4x
AMR NA NA 6x
DAL 7x 6x 5x
HA 10x 8x 4x
JBLU 17x 12x 6x
LCC 5x 4x 5x
LUV 16x 14x 5x
UAL 6x 5x 4x
Average 11x (ex AMR) 9x (ex AMR) 5x
Conclusion:
Allegiant's industry leading profitability is unsustainable and 2011 is likely to prove difficult to navigate. Fuel, labor, airport and maintenance costs are all set to rise meaningfully in 2011 and beyond. We view shares at today's level as an attractive short candidate.
Risks:
Fuel prices plummet
Leisure demand proves to be very robust