Description

I’m going to keep this one rather short and sweet - I didn’t have a writeup prepared for this, but I think the market is giving us a unique opportunity to purchase shares of Volaris cheaply before the business inflects. I encourage you to read om730’s pitch from 2018 here for more background.

Before I get into the details... Yes, this is an airline. Yes, I know air travel is still down upwards of 60% in most regions. Yes, I know air travel likely won’t return to 2019 levels anytime soon.  However, Mexico seems to be an anomaly here, hence the opportunity. 

Elevator Pitch:

1. Traffic Rebound - Just like all other airlines, Volaris’ traffic numbers in April, May, and June were awful. However, the Mexican market, and Volaris in particular recovered much faster than the rest of the world. July RPMs at Volaris were down only 47% total yoy and only 39% for domestic travel. August RPMs rebounded even further, with total RPMs only down 31% yoy and domestic RPMs down 25%. This rebound is from numbers down between 70-90% from April through June. 

2. Liquidity - Volaris has a net cash balance ex-leases. To my knowledge, it is 1 of only 3 airlines around the globe that can say that. 

3. Declining Competition and Price Wars - Covid has forced a lot of competition out of the Mexican air travel market. Most notably, Interjet has had most of its fleet repossessed. Aeromexico is currently in chapter 11 and likely downsizing its fleet. The domestic air travel market only has 4 players, and 2 of them have just taken a lot of capacity out of the market.  

4. Declining Input Costs - Jet fuel is currently at the lowest level we’ve seen in 5 years.

5. Massive Growth Runway - Ignoring all other factors, Volaris should have a massive runway for growth in a less competitive market moving forward. 

Mexican Market - Declining Competition and Price Wars

The current domestic air travel market in Mexico only has 4 players - Volaris, Viva Aerobus, Aeromexico, and Interjet. Volaris & Viva, the 2 ULCCs, have been steadily taking share from Aeromexico and Interjet for over a decade. In 2015, market share was as follows:

Aeromexico (35%), Interjet (25%), Volaris (24%), Viva Aerobus (11%)

By 2019, market share stood as follows:

Volaris (31%), Aeromexico (24%), Viva Aerobus (20%), Interjet (19%)

At the start of 2017, Interjet - being the most financially levered of the 3 and consistently losing market share - began aggressively discounting fares. This began a price war as all competitors fought to retain their market share. This has led to depressed margins over the past few years for all 4 domestic players, but has also led to share increases for Volaris and Viva. It’s not difficult to understand why - I believe Volaris has the lowest normalized unit costs of any airline (roughly in line with Wizz Air), with a CASM ex-fuel of 4.07 cents in 2019. In fact, Volaris’s RASM is actually lower than either Aeromexico’s or Interjet’s CASM, so neither can effectively compete with Volaris over the long term. 

However, the above is effectively moot. The main point of this thesis is that for the past few years, the Mexican air travel market has had a lot of excess capacity, hence low returns for all players. However, due to covid, a very meaningful amount of capacity has been taken out of the market. 

Interjet has had a vast majority of their fleet repossessed. Pre-covid, their fleet consisted of 66 planes, mixed between Sukhoi Superjets and Airbus A320s. According to different aircraft lessors, all of their Airbus planes have been repossessed. They are left with only 7 operating Sukhoi Superjets. Interjet has actually been attempting to get rid of its Russian-built Sukhois for a while now - they have a fleet of 22 Sukhois, but more than 50% of them haven’t flown since 2018. Apparently, they are a maintenance nightmare and receiving aftermarket support out of Russia is not ideal. With their fleet slashed to a small number of maintenance nightmare Sukhois, Interjet has reduced its numbers of domestic routes by around ~80-90%. 

Aeromexico is currently in chapter 11. They have already been released from leases of 19 aircraft (10 Boeing 737s and 9 Embraer E170s), reducing its fleet from 124 aircraft to 105. They are apparently targeting to have only 80 aircraft by the end of 2020. That is a ~35% reduction in its fleet.

Between Interjet and Aeromexico, a bit over 30% of the TOTAL capacity of the Mexican aviation market has disappeared. This should prove to be a boon for both Volaris and Viva in terms of pricing as well as market share. 

The only other meaningful domestic player is Viva Aerobus. Viva and Volaris tend to be rational in regards to each other, focusing on different airports. Volaris focuses on Tijuana, Guadalajara, and Mexico City while Viva focuses on Monterrey and Cancun. At the airports Volaris focuses on, Volaris and Viva compete on less than 40% of the routes. Volaris competes more heavily with Interjet and Aeromexico at its main hub.

Traffic Rebound

Traffic in the Mexican air travel market, and at Volaris in particular, has rebounded much quicker than all other airlines around the globe. In August, Volaris’ RPMs were already around 70-80% of its prior year numbers (down 31% total, 25% domestically). Load factors are already around mid-70%. Compare this with August numbers from other ULCCs across the globe (which should rebound much faster than other airlines as regional travel will come back faster):

• Allegiant Air:

• RPMs: down 48% yoy

• Passengers: down 49% yoy

• Load Factor: 44%

• Share Price YTD: Down 24%

• Wizz Air:

• Passengers: down 41% yoy

• Load Factor: 70%

• Share Price YTD: Down 14%

• Ryanair:

• Passengers: down 53% yoy

• Load Factor: 73%

• Share Price YTD: Down 20%

• Volaris

• RPMs: down 31% yoy

• Passengers: down 35%

• Load Factor: 73% 

• Share Price YTD: Down 24%

These ULCCs are the cream of the crop, and Volaris’ numbers are significantly better. Volaris has been able to bring back significantly more capacity than any other airline, and is still able to fill its planes. Despite this (and the fact that Volaris and Wizz are the only 2 here with a net cash balance sheet), Volaris’ share price has been punished more YTD than any other airline on this list. The most ridiculous comparison here is that Allegiant, which carries net debt/FCF of about 4x, has had no material capacity taken out of its market, and has recovered to less than 50% capacity is down the same YTD as a company with net cash, a significant amount of capacity taken out of its market, and has recovered to about 75% capacity. 

Yes, Volaris’ stock price has run quite a bit since the release of their July and August traffic numbers. However, analyst coverage for Volaris still hasn’t even updated capacity for Q3 numbers. Consensus is still about 15-20% below what actual results would suggest. Further, looking out 3-5 years, I believe Volaris is massively undervalued and isn’t getting credit for likely margin rebound and market share gains due to market capacity reductions.   

Liquidity

As stated - to my knowledge, Volaris is 1 of only 3 public airlines with a net cash balance sheet. On top of that, during Q2 (April-June) which was the height of covid, Volaris only burned $23mm vs net cash of about ~$225mm. This was with RPMs down on average 70-90% during these months. With RPMs back upwards of 70%, Volaris should at the very least be cash flow even, and will in all likelihood be cash flow positive.

As an aside on liquidity - Volaris has come to an agreement with Airbus to defer 24 neo deliveries from 2020-2022 into 2027-2028 which postponed $200mm in pre-delivery payments. This provides Volaris with flexibility by currently enhancing liquidity, but giving Volaris the option to pull those deliveries forward if demand recovers quickly. This should prove very useful as Volaris will likely be given the opportunity to take plenty of market share given demand returns to 2019 levels within the next year or 2.  

Declining Input Costs

This one is fairly straightforward, but jet fuel prices are at the lowest point we’ve seen in 5 years. Fuel is the largest line item for just about every ULCC across the globe. Over the past 5 years, fuel has represented about 35% of Volaris’ total expenses. Margins have fluctuated directly in line with the rise and fall in jet fuel. In times of low jet fuel, like 2015-2016, Volaris averages around a 14-15% net margin. In times of high jet fuel, like 2013-214, Volaris averages a 2-3% net margin. 2017-2018 margins are a bit of an anomaly due to the intense price war initiated by Interjet, but we know that has now come to an end. 

Massive Growth Runway

Volaris faces a massive growth runway mostly because of the state of the Mexican air travel market. The Mexican market is experiencing accelerating secular growth, which is likely to continue. Over the past 12 years, air travel passengers have increased at a CAGR of about 9.7% which is astoundingly high. However, if you look at the base and where the market is today, the market still has plenty of room to grow. 

Consider the following -  Mexico’s intercity bus market is still multitudes larger than its domestic air travel market. In Mexico, there are about 3 billion intercity bus passengers annually. This is compared to the domestic air travel market with 53 million passengers in 2019. The size of the market for buses carrying passengers from city to city is over 50x larger than its domestic air travel market! Interestingly enough, Volaris’ management claims that on 40% of their routes, their only competition comes in the form of buses. All this despite the fact that Volaris’ flights are actually the cheaper option more often than not, and take a small fraction of the time. I think this alone will provide Volaris with a multi-decade long tailwind.

Also consider the average Mexican only flies by air around .4 times per year (up from about .2 times per year in 2006) compared to the average American which flies almost 3 times per year. Even if it takes Mexico 40 years to catch up to America’s numbers, that passenger growth would still provide the Mexican air travel market with about double GDP growth.

Just to give a brief history of Volaris’ growth from 2012-2019:

ASM CAGR - 17.6%

RPM CAGR - 18.3%

Load Factor has increased slowly but steadily from ~82% to ~86%

CASM ex- fuel (USD) has decreased from 5.5 cents to 3.98 cents

Valuation

Valuation of any airline right now is not very transparent. However, looking out 5 years I believe we can make a few assumptions to give us an idea of an array of outcomes. 2020 and 2021 may be lost years, but covid should be a non-factor by 2025. I believe estimating TRASM, and hence fuel prices, to be a lost cause. No one has a crystal ball for that sort of thing, so instead I will make assumptions about Volaris’ “average through the cycle” unit margin based upon historical data. Looking back through all of Volaris’ public data, they have averaged about .5 cents/ASM total or .6 cents/ASM if we exclude the Interjet price war years. This is fairly low for an ULCC with a cost base like Volaris. I would expect that yield to rise as competition becomes less fierce.

I value Volaris at 6x EPS (bear), 8x EPS (base), and 10x EPS (bull). ULCC peers - Allegiant, Spirit, Ryanair, and Wizz - typically trade in the range of 10-15x EPS. However, I think when looking at the potential outcomes 5 years from now, worrying about a multiple doesn’t make much sense. If Volaris is currently trading at $8 per share, and I think it can make $4 EPS 5 years from now, this idea is going to do well regardless of the multiple the market puts on it. 

Bear Case: 

Second shutdown. Volaris defers additional deliveries which delays its ability to capitalize on share gains. Cash burn for additional 2Q before demand begins to return, after which Volaris is cash flow positive. I still believe in this case that extra liquidity will not be needed, but a capital raise is possible. It is unlikely considering in this scenario, they are playing defense and not growing their fleet. Given the reduction of capacity, a return to its average margin of .5 cents/ASM over the past decade by 2025 seems very conservative. This implies load factors in the low 80s and average jet fuel prices.  

FYE 2019 ASM - 24,499 (in millions)

FYE 2025 ASM - 34,000

2025 Net Income - $170mm

Current P/E Ratio on 2025 EPS - 4.7x

Share Price at 6x EPS - $10.10

Base Case: 

Mexican Market maintains its opening trajectory. Return to 2019 capacity levels by 2021. Volaris doesn’t fill the gap in capacity from Aeromexico & Interjet, but continues on its capacity expansion at pre-covid levels. Average seats per plane and unit costs continue to improve as the fleet becomes more and more diluted by new Airbus A320/321 neos. (These are roughly ~10% cheaper in terms of unit costs). Average margin increases slightly to .6 cents/ASM which would have been their average over the past decade taking out the years affected by the Interjet price war. I think this yield increase is rational considering the cost efficiency of the new planes, the lack of competition, and 

YE2019 ASM - 24,499

YE2025 ASM - 46,000

2025 Net Income - $253mm

Current P/E Ratio on 2025 EPS - 3.2x

Share Price at 8x EPS - $20.04

Bull Case: 

Demand returns quicker than expected. Volaris uses its flexibility to increase its fleet for opportunistic growth. Above-mentioned increase in seats per plane and unit costs are more drastic, as the fleet transition to A320/321 neos is quicker. The drop in capacity in the Mexican market from 2019 to 2020 represents roughly 35,000 (in millions) RPMs. That is nearly double Volaris’ entire RPMs in 2019. My bull case will assume Volaris can capture half of that (which I think is rational as they are the leading player in Mexico, have the strongest balance sheet in Mexico, and the only other real contender is Viva), while the market continues to grow at its secular average. This implies a fleet about double the size it is currently, or about 170 aircraft, within 5 years. This may seem like a stretch, but if demand continues to bounce back as it has, I believe the market could absolutely support this capacity growth. I believe a higher margin of .7 cents/ASM is rational in this scenario, as it accounts for more operational efficiency, less competition, and still leaves Volaris well behind peer’s margins like Wizz, Ryanair, Allegiant, and even Spirit.   

FYE 2019 ASM - 24,499

FYE 2025 ASM - 56,000

2025 Net Income - $392mm

Current P/E Ratio on 2025 EPS - 2.0x

Share Price at 10x EPS - $38.81

All said and done, I believe this to be an idea with an incredibly favorable risk/reward ratio. Volaris has the healthiest balance sheet among Mexican airlines, which both minimizes liquidity risks due to covid while also providing the most upside due to potential fleet expansion to soak up capacity reductions. 

Risks & Mitigants

1. It’s an airline. 

1. Yes, but multiple ULCCs have proven that it is possible to create enormous value as an airline. 

2. But it’s an airline during covid! 

1. Volaris has a net cash balance sheet, enough cash to ride out multiple years of low-capacity, cash-burning environments, an incredibly low cost base, and flexibility in terms of its fleet. Being an airline during covid may actually wind up benefiting Volaris, as it is the most well positioned to take advantage of capacity reductions.

3. The lower level of air travel worldwide is the “new normal.”

1. 3 responses to this. First, Volaris is already at 75% RPMs yoy just 6 months after covid hit, and demand started coming back only 1-2 months after shutdowns ended. Demand is accelerating rapidly and any kind of “new normal” is getting closer and closer to the “old normal.” Second, Volaris caters mostly to the “visiting friends and relatives” and leisure travel segments, which should recover more quickly than other travel. Third, Volaris’ main competitor is inter-city bus traffic, which exposes people to closer quarters for a significantly longer period of time.

4. Potential Capital Raise.

1. I find this to be the most likely risk. Volaris has announced a summons for an extraordinary shareholder meeting on September 18th, with intent to raise up to 3.5 billion pesos ($165mm USD). Any equity raise at this price would be very dilutive to shareholders. However, this can also be viewed as a positive. From Volaris’ press release - “While the domestic market capacity is shrinking by around a third due to restructuring processes at other Mexican carriers, the Volaris ultra-low-cost business model has allowed the company to ramp-up more quickly and strengthen its competitive position. As a result of recent changes in the marketplace, Volaris expects the additional capital from such a capital raise will allow it to take advantage of potential opportunities to grow its network and expand its fleet.” This capital raise will most likely be used to take advantage of potential share gains by being more aggressive with its fleet plans. I would hope that any capital raise at this point would be debt, but I can take comfort in the fact that an equity raise of $165mm is relatively small and would only dilute shareholders about 22%. 

Catalyst

- Traffic numbers continue accelerating

- Market share gains post Mexican market capacity reductions