Description

Note

The headline numbers include capitalized leases of $12.4 billion in the EV calculation.

Thesis

Volaris (VLRS: $6.44) is a well capitalized, well managed  Mexican ultra low cost carrier (ULCC) whose earnings and stock have collapsed due to a combination of: a deceleration in market growth, excess capacity,  an aggressive price war, a weak Peso, and rising oil prices. I believe that the current situation is unsustainable for the entire industry and, therefore, temporary. In the next two years, I believe that VLRS’ profitability will recover to historical levels.  When this happens, I believe that VLRS stock will recover to the low to high teens ($8.50 to $18 per share), generating a total return of 30 to 180% from current levels ($6.28/share). While the market to market risk is high if the situation persists, I think the risk of a permanent loss of capital is very low. On the downside,  I believe the stock could conceivably trade down 40% which is equivalent to 80% of book value if the current situation deteriorates. However, the company should be able to ride out the downturn without an impairment to equity. The company has a capable and well incented management team. It has, along with smaller rival Viva, by far the lowest operating costs in the industry. And, it has the strongest balance sheet, with $399 million of gross cash and $212 million of net cash as of 1Q18.

Background and Company Description

Volaris (VLRS) is an ultralow cost carrier (ULCC) with point to point operations serving Mexico, the United States, and Central America. The company was founded in 2005 with an initial $100 million investment led by Roberto Kriete and family (Taca Airlines), Emilio Azcarraga (Televisa), Carlos Slim (Inbursa), and Discovery America’s Fund (Harry Krensky). In 2010, Emilio Azcarraga and Carlos Slim sold their combined stake (25% at the time) to Bill Franke, managing partner of Indigo Partners LLC (Frontier Airlines, Wizz Air Holdings of Eastern Europe, Jetsmart of Chile). In 2013, the company went public in the US and Mexico and raised $346 million at a price of $12/ADR.   Today the “control group” retains a 33% economic interest: Indigo Partners (Bill Franke), Blue Sky Investments (Roberto Kriete) 13%, Discovery Americas (Harry Krensky) 4%.

Volaris began operations  in February 2006 which coincided with the re-privatization of Aeromexico and Mexicana and the entry of multiple low cost airlines: Azteca, Avolar, ALMA de Mexico, Interjet, VivaAerobus, and Volaris. This led to an intense period of passenger growth and  to a period of fierce competition which culminated with the bankruptcy of Mexicana in 2014. Presently, the domestic market has been reduced to four players: Aeromexico ( 31% domestic market share), Volaris (28%), Interjet (24%), Viva Aerobus (17%).

Volaris’ business strategy is to rely on its  ultra low cost model in order to offer very low fares and stimulate demand. In the most recent quarter, the average fare was $50/passenger and the average  ancillary revenue generated was $21/passenger. Volaris’ cost per available seat mile (CASM) stood at 4.8 cents in the most recent quarter. This compares favorably with the local competitors: Aeromexico 7.7 cents, Interjet 6.6 cents, Viva Aerobus 4.8 cents. This also compares favorably with other low cost operators in different geographies: Ryannair 4.7 cents, Alegiant 6.4 cents, Spirit 6.4 cents, Gol 6.3 cents, JetBlue 8.6 cents. Southwest 8.9 cents. Volaris’ management believes that the Mexican market, which has grown  passenger traffic at a 9.6% cagr this past decade, is still very underserved and has further room to grow. Mexicans travel by air .37 times a year. This compares to .44 for Brazilians and 2.62x for Americans. Given Mexico’s geography, management sees the potential to double the number of routes served domestically and to more than double the number of routes served internationally.

Currently Volaris operates  seventy A320 family aircraft with an average age of 3.8 years all of which are leased. In the most recent quarter, Volaris flew 4.3 million passengers, 5 billion in available seat miles, of which 31% were international. Overall load factor in the most recent quarter was 82.2%: 84.2% for domestic flights  and 77.9% for international flights. Volumes grew 11.2% year over year.

The Downturn

Volaris stock peaked at $20 per share in April 2016. The peak, not surprisingly,  coincided with a peak margins and consensus estimates. At the time,consensus estimates for 2017 GAAP EPS  stood at $1.66 and operating margins for the trailing twelve months stood at 15% versus -1% today. Then, fundamentals began to deteriorate.  Volaris has a mismatch between dollar denominated revenues and expenses. In 2014 the Mexican Peso (MXN) began to devalue in excess of inflation differentials versus the USD. The devaluation accelerated in 2015 (14%) and 2016 (17%).  Dollar revenues represent roughly one third of total revenues and dollar expenses represent roughly two thirds of total expenses. Volaris was unwilling and unable to pass on cost increases which led to a decline in yields in USD and put pressure on margins. Jet fuel prices added to the impact of the devaluation.  Jet fuel bottomed around USD 90 cents a gallon in the 1Q16 and proceeded to more than double to the current $2.08. Volaris hedges up to 50% of consumption 18 months forward. As the hedges began to roll off, combined with a weaker Peso, higher fuel prices began to impact margins. Viva and Volaris both were increasing capacity in excess of market demand and taking share from Aeromexico and Interjet in the domestic market. Volaris and Viva had been expanding domestic and international available seat miles (ASM) in excess of 20% in 2015 and 2016. Interjet, which is the most financially levered competitor and has had operational issues embarked on an aggressive pricing campaign at the end of 2016: (https://skift.com/2018/01/12/troubled-mexican-airline-interjet-grounds-some-of-its-aircraft/). The election of Donald Trump brought tremendous uncertainty to legal immigrants and tourists  which delayed travel plans. Their actions resulted in an abrupt deceleration in north south traffic at the beginning of 2017. This deceleration coincided  with Volaris aggressively opening of new routes and new frequencies to the United States. The situation seemed to be stabilizing at the end of 2017. However, the price war, which had been started by Interjet, intensified as all carriers began to fight to retain  market share. This led to a much worse than expected 1Q18 for Volaris and yet another leg down in the stock. The situation was worsened by fears of the election of a left wing president, Andres Manuel Lopez Obrador (AMLO) who ultimately won the July 1 election. The subsequent rally, I believe, has been driven to a large extent due to overly negative position in Mexican assets going into the election.

Envisioning a Potential Recovery

Currently, sentiment is the mirror image of what it was in 2016 with analysts seeing, “ no light at the end of the tunnel given uncertainty over market recovery.” However, there are some “green shoots” starting to appear.In the last quarter, all four airlines lost money and cash levels are getting low. Cash levels of the two main competitors, Aeromexico and Interjet are getting low at 13% and 6% of trailing twelve month operating revenues. This compares to 29% for Volaris.  Aeromexico, which is controlled by Delta since 2016, has been acting rationally and has been reducing domestic capacity. Interjet, which is the most levered (7.2x EV/E) appears to be curtailing its expansion.Volaris has slowed down ASM growth by half to roughly 10% in the past few quarters which is more in line with market growth. Viva Aerobus, which was hoping to IPO, has shelved those plans, putting pressure on its ability to fund its aggressive growth plans.Volaris announced a modest price increase in May,  $5/ticket for the international market and MXN 50/ ticket for the domestic market, signaling its intentions to competitors. The worst possible election outcome occurred and the Mexican Peso appears to have stabilized.By all measures, the MXN appears very undervalued at current levels. From a technical standpoint, short interest has risen to 5.6 million shares. I consider this to be a dangerously high level (for the shorts, who have been right thus far) given that the stock trades 550,000 shares a day on average.

Valuation Target

Volaris’ current book value per share is $4.88. This is a very hard book value composed mainly of cash, guarantee deposits on future engine maintenance, predelivery deposits, and net PPE. I think the downside is a slight discount to book value. To calculate the upside, I look at consensus revenue estimates for 2020 ($1.73 billion) and apply anywhere from a 7 to a 15% operating margin which translates into $.84 to $1.80 of EPS.  I then apply a 10x multiple to my estimates yielding a target of anywhere from $8.40 to $18/share. I think that these revenue assumptions are reasonable if not conservative given how depressed yields are in USD and given that volumes continue to grow at roughly 10% for the entire market. The margins I am envisioning, I think are reasonable given Volaris’ historical margins and industry comparables. Due to the high operating leverage embedded in these types of companies, margins tend to overshoot from one extreme to another. Ryanair, for example, has gone from a 3% operating margin in 2009 to a current operating margin of 23%.

Risks

This is an airline. Airlines are difficult businesses with low barriers to entry, high operating leverage. They require near perfect execution. I think VLRS is the best operator with the lowest costs and the best balance sheet.

Earnings are volatile. I think a well run ULCC can create value over time and generate very high returns on capital, but returns can be very volatile.

New accounting rules will bring operating leases on balance sheet. I think investors are aware of this, but I could be wrong.

A recession in the US. Mexico’s exports are heavily weighted to the US.

An abrupt increase in oil prices. This would hurt in the near term, but would ultimately get passed on by the entire industry. Medium term it would help the Mexican economy.

Catalyst

A recovery in earnings driven by a more rational pricing environment. 

Market consolidation, such a potential merger between Viva Aerobus and Volaris