2023-11-16 15:05:08 ET
Summary
- I reiterate my buy rating as I expect improvements in supply conditions, driving revenue and operating earnings growth.
- In 3Q23, pilot shortages have limited the company's growth potential, causing them to forego high-margin revenue opportunities.
- Management's efforts in pilot hiring and plans for increased capacity in 4Q23 and FY24 are positive indicators for future growth.
Overview
My recommendation for Sun Country Airlines ( SNCY ) is a buy rating, as I expect the supply situation to continue getting better, which will drive growth in revenue and operating earnings. Note that I previousl y gave a buy rating for SNCY in August b ecause I saw the drop in share price as a buying opportunity. My belief back then was that once SNCY hires enough pilots, growth should accelerate back to normalized rates.
Recent results & updates
R eported on November 7th, 3Q23 rev enue growth of 12.3% exceeded management's 8% to 13% guidance, with RASM from scheduled service units declining by 5% year over year but still up by 39% compared to 2019. As the most significant bottleneck, pilots, is gradually being alleviated, I believe the revenue growth environment still remains favorable to SNCY. In 3Q23, SNCY was unable to increase utilization during peak periods to meet demand levels due to a lack of pilot staffing. I note here that this is huge for SNCY, as these periods typically carry the highest margin revenue opportunity. Specifically, management noted that peak demand periods in the quarter saw 3,500 fewer block hours flown than what the company should have been able to due to pilot shortages. If SNCY had had enough pilots working at these times, it might have made an extra $7 million to $10 million in profits from the extra flights, which translates to a 35% to 50% increase in operating profits. These indicate that the supply side is still the limiting factor, and on the bright side, management has reaffirmed that the company has not had any trouble hiring or retaining pilots over the previous 12 months. Management noted that captain upgrades were trending upward throughout the call, and the business anticipates a stronger capture of peak demand in March.
With that outlook, management has set a target increase in capacity of 8% to 10% for 4Q23 and expects capacity growth in FY24 to mirror the 2023 exit rate. In other words, FY24 will have a much larger capacity to capture growth. Management has stated that the present growth plan may have upside in FY24 if captain upgrade trends improve above projections, which would lead to increased utilization within the current fleet. There are two key angles here. One, upside growth potential is less dependent on adding new aircraft or fleet. Two, any incremental growth next year would drive CASM ex-fuel costs lower, which means high incremental margins. This quarter, fleet management stood out as a strong example of management's resource allocation abilities. Given that management expects to be able to lift the pilot limits and that expansion in FY24 will not be contingent on new aircraft, the company plans to lease out two planes that were set to join the fleet in 4Q23. If the lease is fulfilled, these two planes would rejoin Sun Country's fleet and start operating in 1Q25. If this new lease agreement goes through, it will raise Sun Country's total number of leased aircraft to seven. This is a pretty smart strategy, in my opinion, as it reduces the cost of maintaining the planes and also allows SNCY to rake in cash flow in the meantime.
One final thing to note regarding revenue is that while management anticipates a small year-over-year decline in RASM for 4Q23, unit revenue for SNCY has rebased considerably higher compared to pre-pandemic levels. The last six quarters have all shown growth of at least 25% compared to 2019, and 4Q23 is expected to continue this trend, according to management.
All in all, my thesis remains unchanged. Because of pilot staffing limits, utilization levels are capped during peak demand periods, causing SNCY to forego flying some of its highest margin revenue opportunity, limiting the company's growth potential. I expect growth and operating profit margin to continue rising given that capacity will likely increase by high single to low double digits annually in 2024 while unit prices should remain roughly unchanged. Better pilot availability means the SNCY can increase capacity growth through greater utilization, which improves both unit expenses and unit revenue.
Valuation and risk
According to my model, SNCY is valued at ~$20 in FY25, representing a 39% increase. This target price is based on my growth forecast of 10% over the next two years. My rationale for using the same assumption is that I now have higher confidence that revenue will be able to grow at normalized levels (using peers as a benchmark) given that supply constraints (pilots) are gradually being elevated. A major update to the model is that I have revised my FY23 EBITDA margin assumption by 200bps to reflect weaker than expected 3Q23 margin performance, which was due to the missed high margin revenue opportunities. My downward revision is also reflected through FY24 and FY25. With better visibility into the supply situation and FY24 growth outlook, I have increased my valuation assumption to 5.5x forward EBITDA, which is where the stock is trading today.
The risk here is that SNCY might not be able to resolve the supply-constrained situation as well as they would have imagined. Given that supply is the key piece to the puzzle, any mis-execution in lifting the pilot supply constraint would impact growth and earnings.
Summary
My recommendation for SNCY remains a buy as I anticipate improved supply conditions to drive revenue and operating earnings growth. Management's efforts in pilot hiring and optimism about increased capacity for 4Q23 and FY24 are very positive, and with increased pilot availability, the business should see higher utilization accordingly.
For further details see:
Sun Country Airlines Q3: Supply Situation Improving