Description

Note: Written in early April 2021 @ $14 a share. Since crafting this writeup, Volaris has announced the addition of eight new A320NEO aircraft to its fleet this year and reported a solid Q1 earnings. The stock now trades at @ $17 a share, but the long-term thesis remains intact. I still see this as a 2-3x in the next 2-3 years. 

High-Level Napkin Math:

Volaris is the largest Mexican airline by passenger volumes, with 41% domestic market share and 14% international market share as of January 2021, up from 31% and 8% respectively pre-pandemic. In 2019, the Mexican aviation market supported 53M domestic passengers and 47M international passengers. Assuming passenger volumes recover to 2019 levels by 2023, and Volaris maintains its current market share, the company should transport 21M passengers domestically and 6M passengers internationally in 2023 (up from 20M total in 2019). Volaris generated $1.8B in revenue and $550M in EBITDAR in 2019 (a 31% EBITDAR margin). If passenger yields in 2023 are equivalent to 2019, with a 35% increase in passenger volumes, Volaris should generate $2.4B in revenue in 2023. At a 31% EBITDAR margin, that translates to ~$750M in EBITDAR. LCCs tend to trade between 6-9x LTM EBITDAR. At a reasonable 7x, Volaris should trade at a $5.25B EV by year-end 2023. Subtract out ~$2B in net debt (inc. lease liabilities), and that implies a $3.25B market cap, or $28 per share at current shares outstanding. Volaris trades at $14 a share today. That’s a 2x in 3 years (25% IRR). I’ll explain later in the writeup why I believe these napkin-math assumptions are conservative.

Company Background:

Pre-1989, Mexico’s aviation market was government-controlled and dominated by two high-cost carriers, Aeromexico and Mexicana. These two airlines operated entirely on international and Tier 1 domestic routes, ignoring Tier 2 and Tier 3 cities across Mexico. As a result, bus became the primary mode of transportation for the majority of Mexico’s population. However, in the early 1990s, Mexico began privatizing the aviation market to encourage the development of new routes and to stimulate the economy.

In response, a group of influential LatAm investors, including Discovery Americas and Columbia Equity Partners (now DiamondStream Partners), began drafting up a business plan for a low-cost-airline in Mexico. The idea was to offer incredibly low prices on point-to-point domestic routes across Mexico to encourage bus passengers to start flying. After receiving additional funding from Carlos Slim’s Inbursa Bank, Grupo Televisa, and the founders of TACA airlines, Volaris began operations in 2006. Led by CEO Enrique Beltranena, former COO of TACA airlines, Volaris quickly grew scale, transporting 900k passengers domestically during its first year of operations (4% domestic market share). Later on, while its competitors struggled during the Great Recession and H1N1 breakout, Volaris demonstrated incredible resiliency. The company added 5 new aircraft from 2009-2010, grew its international capacity, and expanded its domestic market share to 15% by the end of 2010. Volaris’ success caught the attention of legendary LCC investor Bill Franke, whose PE firm Indigo Partners subsequently bought a 15% stake in the firm in 2010 and currently owns 18% of CSO (Indigo increased their stake by 20% in Dec 2020).

Share Price Performance Since IPO:

In 2013, Volaris completed a dual-listing initial public offering on the Mexican Bolsa Exchange (BMV) and New York Stock Exchange (NYSE). Series A shares were issued in Mexico and CPOs (representing a financial interest in a Series A share) were issued in the form of ADSs in the US. The company IPO’d at a price of $12.00 per ADS on the NYSE, representing a market cap of $1.3B at the time. The subsequent three years were incredibly strong for Volaris, supported by 20%+ YoY passenger growth and low fuel prices (Brent crude was trading in the low $40s per barrel range in early 2016). In FY 2016 as a whole, Volaris generated $1.3B of revenue and $473M of EBITDAR (~38% EBITDAR margin), as well as $1.84 in EPS. The stock traded as high as $22 a share in mid-2016.

Trump’s election in Nov 2016, however, created major uncertainty around US-Mexico relations. US-Mexico transborder flight activity fell and the Mexican peso collapsed as investment dollars fled the country. The 2016-2018 period was also marked by rising oil prices, with Brent crude rising as high as $85 a barrel in Oct 2018. All these factors combined to crush Volaris’ stock to a low of $5 by the end of 2018.

Despite the macro headwinds, however, Volaris’ fundamentals continued to improve. The company maintained double digit passenger growth and reduced its cost per available seat mile – ex fuel (CASM ex-fuel) by 15% from 2016-2018. Then, in 2019, the company posted 20% passenger growth and a record low CASM of $0.065, the third lowest in the world just behind Budapest-based Wizz Air (another Bill Franke portfolio company) and Malaysia’s AirAsia, and right in line with Ireland-based Ryanair. In 2019, Volaris cemented itself as the largest Mexican airline by domestic passenger volumes (31% market share) and produced a 31% EBITDAR margin, the highest of any publicly traded airline that year. Its share price subsequently recovered to $13 pre-pandemic.

The Effects of COVID-19 on Volaris and its Competitors:

Unlike the United States, the Mexican government did not provide any bailout funding to its airlines during COVID-19. As a result, Mexico’s flagship carrier Aeromexico (24% domestic market share and 16% international market share pre-pandemic) filed for Chapter 11 bankruptcy in June 2020. The company has since received a $1B DIP facility from Apollo, but it came with strict terms. Aeromexico was forced to reduce its fleet from 127 in 2019 to 108 today, and has plans to continue retiring its Embraer narrow body aircraft (used for domestic routes) to focus more on its international operations. Turnaround plan filings indicate it could reduce its fleet down to 80.

Meanwhile, Interjet (20% domestic market share and 10% international market share pre-pandemic) hasn’t flown a plane since December 11^th. Last month, the company finally announced plans to file for Chapter 11 bankruptcy protection in Mexico and the US. Interjet has over $1.5B in unpaid debts related to airport service fees, wages, fuel, taxes, and leases. The company has had 63 of its 66 Airbus aircraft repossessed by lessors, and the Cuban government is reportedly in talks to purchase 20 of its 25 remaining Sukhoi Superjet 100s. Interjet recently stated that they’ve received $1B worth of interest from investors, and have hopes to reopen operations in mid-2021. However, management has tried to fund the restart of operations several times over the past year, and nothing has ever materialized. The risk of an Interjet rebound is extremely low in my opinion.

On the other hand, Vivaaerobus, Volaris’ primary low-cost competitor in Mexico, performed well during the pandemic. The company added 5 planes in 2020, increasing its fleet from 36 to 41. That being said, the private airline is reportedly struggling to raise money (according to a few LatAm investors I spoke to), and its parent company, a large bus operator, took a big hit during COVID-19. Although Viva has grown its domestic market share from 20% pre-pandemic to 26% today, it doesn’t have the same seat capacity or access to capital as Volaris to capture additional leftover market share moving forward.

Similar to 2008-2010, Volaris management navigated this crisis remarkably well. The company entered 2020 with a net cash (exc. lease liabilities) position of $156M and exited 2020 with a net cash position of $240M, achieved through renegotiations with suppliers and a $164M equity raise in Dec 2020. From an operating standpoint, Volaris added 5 new domestic routes and 7 new international routes in 2020, most of which came from Mexico City where passenger yields are historically higher. By December of 2020, Volaris was operating at 102% of 2019 level capacity (as measured by ASMs) and had recovered passenger volumes back to 91%. The company also added 4 new aircraft last year. Volaris has increased its domestic market share from 31% in 2019 to 41% today, and has nearly doubled its international market share from 8% in 2019 to 14% today.

Q4 2020 Performance:

Overall, Q4 2020 (Oct-Dec) was a blowout quarter for Volaris. Despite a 5% decline in YoY capacity (ASMs), The company posted a record 37% EBITDAR margin, the highest quarterly margin since 2016. Volaris also generated $0.37 in EPS on fully diluted shares outstanding at year-end (considering weighted avg shares outstanding., EPS was ~$0.42).

Lower fuel costs drove roughly 7% of this margin improvement (avg. Brent USD per bbl. of 43 in Q4 2020 versus 61 in Q4 2019), but other factors posed major headwinds. Most notably, the peso depreciated 7% relative to the dollar YoY, contributing to a 2% margin headwind (70% of Volaris’ operating expenses are USD-denominated, while only 40% of revenues are USD-denominated). Volume declines also led to inefficiencies in fixed costs like aircraft rent, maintenance, and labor. Overall, the peso and volume headwinds drove CASM ex-fuel down 5% YoY in the quarter, largely offsetting the fuel tailwind.

So how did the company post a 37% EBITDAR margin during the pandemic? The biggest driver of margin that should give investors confidence moving forward was Volaris’ ancillary revenue execution. While avg. fare revenue per passenger was down 18% YoY in Q4 ’20, avg. ancillary revenue per passenger was up 51% YoY, far better than any sell-side analyst projected. Like many low-cost carriers, Volaris prioritizes ancillary revenues as a crucial component of its business model – unbundle fares to bring base rates down (to compete with buses) and then earn higher margins on add-on products and services. While Volaris has reduced its ticket prices at a 2% rate YoY since 2015 (6% in real terms when adjusting for inflation), ancillary revenue per passenger has increased at a 14% CAGR over the past five years. As of Q4 ’20, ancillaries now make up 48% of total revenues, bringing Volaris closer to Wizz Air (55%), Spirit (55%), and Allegiant (59%). Although some of the health and insurance combos offered during Covid-19 might lose appeal after the crisis, management has consistently shown a creative ability to offer new perks that bring the company closer to its target 50% mark. If Volaris can achieve a Ps. 750 avg. ancillary rev per passenger rate in 2023 (lower than the Ps. 808 achieved in Q4 2020) and an avg. fare revenue per passenger rate of Ps. 1,000 in 2023 (lower than the Ps. 1,017 achieved in Q4 2020), Volaris would still produce higher passenger yields in 2023 than in 2019. Said differently, Volaris’ total revenue per passenger rate was higher in Q4 2020 (in the midst of COVID) than in all of 2019. In reality, Volaris’ newfound competitive positioning should allow it to increase fare prices while also executing on ancillaries. In that scenario, passenger yields could be up double digits from 2019 levels, and Volaris’ 2023 EBITDAR margin could be in the mid-high 30% range (Evercore’s Feb 2021 sell-side report modeled in a 35% margin for 2023). My napkin math assumes passenger yields in 2023 equivalent to 2019, so investors have a pretty significant margin of safety on prices. Further price reductions will only increase passenger demand, so there are multiple ways to win on the top-line.

Expectations Moving Forward:

The current domestic market share breakdown in Mexico as of January 2021 is as follows: Volaris (41%), Aeromexico (31%), Viva (26%), Other (2%), and Interjet (0%). So far, Mexico’s domestic market has recovered to ~65% of 2019 levels as measured by passenger volumes, with a full recovery expected in the 2022-2023 timeframe. Within Mexico, Volaris is by far the best positioned airline to capture the incremental recovery in passenger volumes. From a capacity standpoint, Volaris’ current seat share in the market stands at 42%, but the airline has indicated interest in adding more aircraft. While the company hasn’t publicly announced new additions, a recent sell-side report from Cowen indicated that Volaris has RFPs out for 12 to 14 new aircraft leases which could be incorporated on an as-needed basis. Those leases would be in addition to the 93 aircraft Volaris already expects to operate in 2022 (up from 82 in 2019 and 86 in 2020). Individuals I spoke to in the industry are currently seeing 30-40% discounts on aircraft leases, so I wouldn’t be surprised if Volaris is out hunting for bargains. A few investors in the recent equity raise also mentioned that the company was looking to use the additional capital for new leases. Given the severe capacity reductions of its competitors, new aircraft additions will likely boost Volaris’ seat share in the coming years to 45-50%, and market share tends to mimic seat share in the long run at stable load factors. My napkin math assumes a 41% domestic market share in 2023, so investors have a decent margin of safety on the market share number.

Although international isn’t core to the thesis, it’s important to mention developments on that front. The current international market share breakdown to/from Mexico as of January 2021 is as follows: Non-US/Mexican Airlines (26%), American (16%), Volaris (14%), Aeromexico (13%), Delta (12%), United (11%), Alaska (5%), Viva (3%), Interjet (0%). So far, Mexico’s international market has recovered to 45% of pre-pandemic levels (20% lag to domestic recovery), with a full recovery expected in the 2023-2024 timeframe. US point of sale makes up 50% of Volaris’ international business, and the company is well positioned to continue growing its US-MEX capacity. Volaris added 7 new international routes in 2020 to major hubs like Dallas, Houston, San Jose and Chicago. Bill Franke also helped coordinate a codeshare agreement between Volaris and Frontier (the first of its kind between LCCs) in 2018, which should continue to stimulate transborder flight activity. Volaris is also exploring additional opportunities in South and Central America. Aeromexico and Interjet weren’t the only two victims of COVID-19 in Latin America; major airlines LATAM and Columbia’s Avianca also filed for Chapter 11 protection in 2020. Columbia is a particular market of interest for Volaris, and the company is currently in talks to add four new routes to the country out of Mexico City and Cancun. In 2019, over 1.5M passengers flew between Mexico and Columbia, and Interjet had 40% market share on those routes. Industry folks I spoke to said that the routes were also some of Interjet’s most profitable ones. My napkin math assumes Volaris will keep its international market share steady at 14%, so any additional expansion will provide further upside.

Additional Upside to Napkin Math:

I’ve already mentioned how Volaris could outperform my napkin math through larger domestic and international market shares, as well higher passenger yields brought on by continued ancillary revenue execution. On the cost side, Volaris should also see fuel efficiency improvements from its Airbus NEO transition. NEO aircraft are demonstrated to provide 15-20% more fuel efficiency on a per seat basis, and Volaris’ fleet is expected to be 60% NEO by 2023, up from 35% today. A 25% more NEO fleet bringing 15% more fuel efficiency should translate to a 3.75% total decrease in per-seat fuel costs. This can help mitigate further increases in fuel prices (Brent crude averaged $65 a barrel in 2019, and stands at ~$60 today). Volaris has also historically hedged only 20% of its fuel costs, but that practice could change with additional cash availability. Hedging would provide cushion to further oil price increases.

Volaris should also see some fixed cost leverage on the upside with fleet up-gauging. Its current 86 Airbus fleet comprises of 6 144-seat A319s, 40 179-seat A320s, 24 186-seat A320NEOs, 10 220-seat A321s, and 6 240-seat A321NEOs. In 2021 alone, Volaris plans to return 3 A319s and add 3 A320NEOs and 1 A321NEO, bringing its avg. seat size up from 188 to 190. Further size improvements mean leveraging the same slot fees and labor costs to generate more revenue per flight, and up-gauging could realistically contribute to 100-150bps of margin improvement by 2023.

Additionally, Volaris could see significant upside from a multiple re-rate. Looking at FY 2019 data, it appears that LCCs on average traded between 6-9x LTM EV/EBITDAR pre-pandemic, with businesses like Ryanair trading at 9.5x. On the other hand, at year-end 2019, Volaris only traded at 5.3x LTM EBITDAR. The discount to peers was likely caused by Volaris’ struggles from 2016-2018, as well as the price-war dynamics in Mexico fueled by Interjet’s downfall beginning in 2019. Even today, however, Volaris continues to trade at a discount. As of April 1^st 2021, Ryanair trades at 11.6x 2019 EBITDAR, Allegiant at 9.7x, Frontier at 8.3x, Wizz Air at 8.3x, Spirit at 7.2x, and Volaris at 6.5x. This comes despite the fact that Volaris has the highest EBITDAR margin amongst its peers, the second lowest unit cost positioning, and has recovered passenger volumes faster than any publicly traded airline worldwide (91% in December 2020). I presume that if Volaris begins to consistently post strong earnings results, the stock could re-rate upward pretty significantly. At 8x my 2023 napkin math EBITDAR of $750M, Volaris’ equity would be worth $4B, or $34 a share.

Finally, a note on Volaris’ enterprise value. As of Q4 ’20, Volaris has roughly $1.9B in net debt (including lease liabilities) and $1.6B of equity value (at $14 a share), combining to $3.5B of EV. Of the $1.9B in net debt, $240M is net cash and ~$2.2B is lease liabilities. Although it’s hard to pinpoint the exact lease liability of each aircraft, we can calculate an average. Volaris currently operates 86 aircraft and has $2.2B of lease liabilities, which translates to $26M per aircraft worth of lease liabilities. Using average historical load factors and ASM per aircraft numbers, I’ve determined that Volaris would need around 25 more aircraft to support my napkin math 2023 passenger volumes, meaning an additional $650M in lease liabilities. In reality, however, any new aircraft leases that Volaris signs in the coming 12-24 months should come at a discount to pre-pandemic levels. Volaris also generated $315M of free cash flow in 2019 (op. cash flow less capex) and should reasonably generate $500M+ of cash over the next three years. Depending on how the thesis plays out, net debt shouldn’t change much from the current $1.9B by 2023 (I assume $2B in the napkin math), and any additional reductions would accrue directly to equity.

Biggest Risks:

1)      Delay in passenger volume recovery: Recovery in passenger volumes could be further delayed by an increase in COVID cases, threat of new variants, and a slower vaccine rollout. Certain aspects of travel could also be permanently impaired by changes in consumer behavior, virtual communication technologies, etc. Luckily for Volaris, 100% of its network is domestic or short-haul international, so its customer base is less sensitive to changes in business travel. It also operates almost entirely in the VFR and leisure segments, which have shown resiliency during COVID-19 and should recover well with a return to normalcy.

2)      Peso devaluation: Since 2010, the Peso (MXN) has depreciated relative to the USD at an average yearly rate of ~4%, a result of higher inflation rates in Mexico and a slower GDP growth rate relative to the U.S. over the past few years. Given the 30% delta between VLRS’s % of USD operating expenses and % of USD revenues, a 4% devaluation generally creates a 1.2% operating margin headwind. Consensus expectations for MXN/USD through 2023 are hovering around the 20-21 range (up from 19.3 in 2019), implying at most a 2% margin headwind from 2019 levels. Volaris has taken steps to mitigate this FX risk by matching its receipts and local payments to their respective currencies as much as possible, and converting its excess cash to USD. However, currency risk still remains. As I don’t have an expertise on the state of the Mexican economy and global currencies in the long run, I’ve structured this pitch as a 2–3-year recovery play. As long as nothing drastic occurs from a macro standpoint in the short term, the thesis should pan out as expected. Interested investors can structure their own hedges accordingly.

3)      Fuel Prices: As previously mentioned, Volaris has historically hedged only 20% of its expected fuel costs, making it susceptible to changes in oil prices. Given fuel is Volaris’ largest operating expense (38% of total OpEx in 2019), a 2-3% change in the USD per gallon rate can impact Volaris’ EBIT and EBITDAR margin by 1%. A fuel price headwind can be further compounded by peso devaluation, since Volaris buys its fuel in USD. Similar to peso risk, I don’t have an expertise on the future of oil prices, and forward curves have changed quite dramatically over the past few months. If Brent crude continues to sit below its 2019 average of ~$65 a barrel, fuel shouldn’t be an issue. Even at $70-75 a barrel, Volaris’ NEO fleet transition should provide some cushion against margin headwind. Any drastic changes beyond that, however, and the airline industry as a whole will struggle. Even then, Volaris will benefit from its relative cost advantage. Interested investors can hedge accordingly.

Catalyst

-strong Q2-Q4 2021 traffic results from a rebound in US-MEX and MEX domestic travel

-additional aircraft announcements

-earnings consistency and scaled margins (35%+ EBITDAR margins) in 2022 and 2023