VLRS - Volaris: 'V' Is For Valuable And Volatile

2023-07-12 11:31:18 ET

Summary

• Volaris, a Mexico City-based ultra-low-cost carrier, has an ambitious growth plan that includes expanding its fleet and transitioning to a more fuel-efficient fleet, requiring significant capital investment.
• The airline's shares have risen by over 70% this year, but the company remains sensitive to changes in fuel cost and USD exchange rate, with fuel being its biggest expense.
• Despite its growth, Volaris has struggled to translate this into net income, with the company's focus on managing leverage while funding business growth.

I rate Volaris ( VLRS ) shares a Hold at the current time. Volaris benefits from one of the lowest unit costs in the business, not just in Mexico but worldwide, a critical component of its low-cost carrier strategy that allows it to deliver competitive airfares in the marketplace. The airline has an ambitious growth plan over the next few years as it both expands its fleet and upgrades from an A320 CEO Family fleet to an A320neo Family fleet. This ambitious plan requires significant capital expenditures, while the company remains ultra-sensitive to changes in fuel cost and changes in the USD exchange rate.

Company overview

Volaris is a Mexico City-based ultra-low-cost carrier that is the largest Mexican airline by number of passengers carried. It primarily operates domestically within Mexico but its 200+ routes to 70+ airport include destinations in the United States as well as Central and South America. The airline's route map can be found below:

It began operations in 2006 but it embarked on its current high-growth trajectory in 2010, when two of its founders agreed to sell their stakes to a group that included airline investor specialist, Indigo Partners. The airline, similar to other low-cost carriers, aim to "stimulate" traffic by providing low airfare and supplementing these with ancillary revenue sources - everything from seats to food and beverage and more:

A combination of its strategy, nimble operations, and issues with competitors (including the Chapter 11 filing of Aeromexico and failure of Interjet) propelled Volaris into a clear leadership position in Mexico:

Volaris shares are up sharply this year - by over 70%, far outpacing the major averages - but are down about 40% from their post-COVID all-time highs reached in 2021. The recent strength in the Mexican peso will surely help ease the burden of the airline's dollar-based lease and fuel costs, while the airline's strategy of focusing on visiting friends and relatives (VFR) traffic and competing with bus routes - a staggering 46% of its routes only compete with bus traffic - should provide at least some competitive advantage and possibly insulate it from any weakness in the Mexican economy.

Financials and projections

The company's 2023 guidance can be found below:

On the bright side, it shows growth in capacity and revenues while maintaining cost discipline and good EBITDAR margins. However, the thing that stands out most to me is the leverage target, which more than anything is indicative of management's understanding that it needs to keep its debt load manageable in light of its growth trajectory.

Despite this, the big question is whether any of this growth translates into profits - net income, not EBITDAR. In the past this has not been the case; however, the airline has perpetually been in growth mode, so this is at least somewhat excusable. However, this has to change eventually, for shareholder's sake and as validation for the company's strategy.

I would say the same about the above - revenue, EBITDAR and FCF are great, but need to be underpinned by profitability. Whether that arrives remains to be seen.

Strong shareholder alignment

Indigo Partners, an airline-focused private equity firm founded by industry veteran Bill Franke, has created several valuable low cost carriers, including Spirit ( SAVE ) and Wizz Air ( OTCPK:WZZAF ), and has investments in Volaris codeshare partner, Frontier, and JetSMART. It has an economic interest of approximately 18.2% of the company with a market value of $200 million. While it has already taken significant dividends from the airline prior to its IPO, and will eventually look to exit its shares, it should be very motivated to maximize the value of this equity. It has also utilized the group of airlines to increase bargaining power with Airbus to order aircraft at attractive prices. With the stock still trading for around its IPO price from several years ago and only slightly above the share price where the company issued equity in December 2020 , Indigo should likely be committed to retaining its stake until (and if) significantly higher prices are realized.

The Mexican market

The Mexican market is by far the most important to Volaris's success.

Mexico is one of the world's largest countries and economies, with some interesting demographic and economic tailwinds.

Capital allocation

This is definitely a growth story, so capital returns in the near-term are fairly unlikely, as the focus remains on managing leverage while funding growth of the business, including delivery of approximately 145 aircraft that the airline has on order from Airbus. They have financing in place for a significant amount of pre-delivery payments to manage progress payments on these aircraft, and will likely continue to favor lease financing to minimize near-term capital outlays in order to facilitate growth. Their leasing partners have been willing to finance PDPs for them in at least some lease financings, and they've already secured financing for deliveries into 2025. The airline also extended some aircraft leases to opportunistically add capacity. In April, the airline established a share repurchase program , though I'd consider it unlikely to be tapped in any material way at least for the foreseeable future. If anything, it's more likely that they would issue equity (not that this is likely, just that major share repurchases are probably not in the cards anytime soon) and their 2020 equity issuance is further proof of the airline's focus on making prudent investment decisions.

Risk factors

Foreign exchange exposure

The majority of Volaris's revenues are generated in Mexican pesos, while approximately two-thirds of its costs (primarily in the form of fuel and debt/lease servicing) are denominated in dollars. Volaris has traditionally done relatively little to no hedging of this risk. This risk can go both ways, and if it holds, the peso's 14-15% appreciation against the dollar this year should provide a significant tailwind for 2023 results. This should be closely monitored, though, as things in the foreign exchange market can change quickly.

Fuel expense

Fuel is the airline's biggest expense, in particular during 2022 when it comprised almost half of operating expenses. Volaris had hedged fuel at times in the past, but did not enter into any derivative contracts or risk-sharing agreements in 2021-22. They pay for fuel for Mexican flights in MXN, but formula is affected by USD/MXN rate. Their implicit hedge is contained in their re-fleeting program, as the A320 neo aircraft that will comprise essentially all of their fleet by 2027 are roughly 15% or so more fuel efficient than their predecessors. However, this is far from a perfect hedge, and fuel prices should be monitored closely. The airline has multiple levers to pull in an effort to shore up its capital position if need be, and its fare strategy is not really meant to increase prices in response to changes in fuel costs. Perhaps a bit more than legacy carriers, this airline needs fuel prices to be relatively stable.

Category 1 approval

Despite various rumblings suggesting otherwise, Mexico has remained in Category 2 status by the U.S. Federal Aviation Administration. Long story short, this effectively freezes the capacity that Mexican airlines are permitted to operate into the United States. Volaris has publicly stated that it expects an upgrade to Category 1 in the fourth quarter of this year, but that it is prepared to engage in the event that approval comes sooner. This statement is questionable, as it will take some time for Volaris to add the capacity it wants, regardless of when the approval comes.

Conclusion

Volaris is sitting on a potentially significant opportunity to grow its operations and both further differentiate and distance itself from the competition. However, that growth plan will require significant capital investment that is not without risks, including a massive fuel and rental expense that is only partially negated by the airline's plan to transition to a more fuel-efficient fleet. The stock has had a tremendous run in recent months, and profitability is likely to be somewhat constrained by the airline's growth. I prefer to watch from a distance to see how Volaris's pursuit of its objectives materializes, or doesn't.

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