VLRS - Volaris: Engine Recall Opportunity

2023-10-04 11:48:48 ET

Summary

• Volaris shares have dropped 35% since Pratt Whitney increased engine recall.
• Sensitivity analysis suggests that the potential impact has already been priced in.
• Estimate a 9% reduction in capacity and 16% impact to EBITDA in YE24.

Summary

Volaris ( VLRS ) shares are down near 60% from the July peak and coincides with the initial Pratt Whitney engine recall announcement as well as oil price resurgence. The share accelerated the decline in September on the second Pratt Whitney announcement that increased total engine recall from 200 to 700 that can material impact Volaris fleet availability, revenue, and margins.

I ran a "what if" analysis based on the company's aircraft delivery schedule and recalled units to gauge the impact this may have on results and the share price. I found that capacity ((ASM)) could decline 9% and EBITDA 16% in YE24. This would value the shares at 5.4x EV/EBITDA vs my multiple target of 6x and provide a buying opportunity on my YE24 price target of US$10 +55%.

Pratt & Whitney Engine Recall

Volaris is Mexico's largest domestic airline with 40% share. It has an ultra-low-cost business model, focused on the friends and family market i.e. competing with long distance ground based transport such as bus and rail.

Pratt Whitney made two engine recall announcements, the first in July 2023 for 200 of its GTF engines that are predominantly in Airbus 320 NEOs and then September it expanded the recall to 700 engines (350 aircraft) that need between 250 and 350 days for revision and maintenance.

The airline has an all-Airbus fleet, of which 57 units are under the Pratt Whitney engine recall announcement. The timing and schedule of the recall has not been announced. I ran a sensitivity analyst to gauge the impact that this forced fleet reduction could have on Volaris results and valuation.

Capacity Reduction 9%

First, I assume that each airplane will require 9 months to inspect/repair and that Volaris would ground 19 units at a time for the next 36 months to 1Q26. The impact is somewhat offset by scheduled deliveries and extension of leases. This translates into a unit decline of 10% and capacity (available seat miles ASM) decline of 9% in YE24. ASM declines less due to increased utilization (longer stage lengths, more hours flown).

EBITDA Cut By 16%

This reduction in capacity could result in a revenue decline of 9% vs previously estimated for YE24. I did not change estimated load factor nor yields (airline ticket prices). The impact on EBITDA is relevant with a 16% decline vs estimated prior to the engine recall. This assumes lower fuel cost, maintenance and airport fees but maintains other operating costs such as (wages, leases, marketing, and other expenses) The net result is margin contraction to 20% vs 21%.

However, Volaris may look to accelerate the delivery of the new NEO version, lease unaffected older Airbuses or possibly changing engines at the cost of Pratt Whitney.

Until Volaris comes out with a guidance and an action plan, the market is likely to continue to sell the stock. This sensitivity analysis suggests the impact can be short term, hurting growth in YE24 and not the long term viability of the airline.

The second largest domestic airline, Viva, also operates affected Airbus aircraft and may need to also reduce capacity. This could lead to higher ticket prices that may help offset the lower revenue and margin impact.

Valuation

This lower result pushes the stock's current valuation to 5.1x EV/EBITDA for YE24, vs. my target multiple of 6x. This means that the stock may have fully incorporated the engine recall event and now represent a good buy point.

Consensus vs. My Estimates

Consensus has not factored in the engine recall risk nor higher fuel prices. When the analysts begin to run new model inputs, estimates may get downgraded but the price target could continue to point to significant upside.

Conclusion

The recall comes at a very un-opportune time with Mexico airlines ready to increase flight to the US post regulatory approval. However, the capacity impact should not destroy margins but dent growth. The share price seems to have more than incorporated the uncertainty and, in my view, represents a BUY opportunity.

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