|Shares Out. (in M):||16||P/E||11.9||0|
|Market Cap (in $M):||1,935||P/FCF||0||0|
|Net Debt (in $M):||764||EBIT||250||0|
Allegiant Travel Co, ALGT, is an Ultra Low Cost Airline (ULCC). Simply put, ALGT is a very attractive investment due to its unique operating model within the airline industry. It belongs to the small group of publicly traded companies currently trading at reasonable multiples. Most importantly, the company is currently underearning with reason to believe margins will inflect upwards for the next 2-3 years. Even without multiple expansion, I believe this sets it up for a solid return over the next 5 years from both top line and operating margin expansion.
The business model and how it is unique:
I’m going to assume most people at this point are familiar with ULCCs. So what sets ALGT apart from its domestic ULCC competitors – Spirit and Frontier? ALGT operates a low utilization airline, unlike both Spirit and Frontier. This, first and foremost, was what got me interested in ALGT. What exactly is a “low utilization” airline? Utilization is the amount of time per day that the aircraft is in the air (technically, block hours refer to total time from the aircraft door closing at departure gate to the aircraft door opening at arrival gate, but you get the point). From Allegiant’s most recent presentation, you can see that Allegiant’s average daily block hours per aircraft are about 6.5 hrs/day, while Jet blue, Spirit, and Alaska Air are all above 11 hrs/day. The big 4 carriers not listed - United, American, Delta, and Southwest are all greater than 10 hrs/day. To me, this is by far the most important point in this entire writeup. All other carriers go after frequency, trying to push block hours per day up to offset the ownership cost of aircrafts. Because aircrafts are inherently expensive to own, every second you have one sitting on the ground and not flying, you’re losing money. So how is Allegiant able to be successful with low utilization? 2 ways – first, they use planes that have low cost of ownership, generally purchasing older, used aircrafts from other airlines. Second, Allegiant picks and chooses its flight paths, only targeting specific routes, days, and times that have sufficient return. Allegiant is constantly altering the routes they offer depending on season, the demand on certain days, and demand at certain hours in each day. They are allocating capital where the returns are, not just pushing utilization to show top-line revenue or ASM growth. To provide an example of this, you can look at Allegiant’s utilization per month. In 2017, in the peak month of June, Allegiant had utilization of over 7.5 block hours/ per day. Compare this to the off-peak month of September when traffic dies down, Allegiant had utilization of about 4.5 block hours/day. Now, how is this different from ULCC competitors Spirit and Frontier? If you look at the unit economics of ALGT and SAVE, they are actually very similar. But the models are in stark contrast. Spirit and Frontier push for higher utilization to offset their aircraft ownership costs. They need frequency to be profitable. Hence, they can’t allocate aircrafts like Allegiant can. They can’t go into markets that don’t support the frequency they need. However, Allegiant can. This allows Allegiant to go into smaller markets that only support a few flights a week. Between 40-50% of Allegiant’s markets only support 2 flights a week. Only 20-30% of markets support 5 or more flights per week. This translates into another important point – Allegiant has no competition on ~80% of its flight paths because nobody can profitably support flight paths in these small, underserved cities. Said a different way, Allegiant is the only domestic airline that goes after profits at the expense of topline or frequency growth. All other airlines prioritize top line and frequency growth over profits, as it is necessary for them to be successful.
I’m also going to assume for this writeup that the reader is familiar with the unit economics of airlines. If not, there are plenty of other VIC Airline writeups between Spirit, Ryanair, or Wizz where you can familiarize yourself with them. I think it would be reasonable for one to make the assumption that Allegiant would be unable to compete with Spirit, the other US based public traded ULCC in terms of CASM, or cost per available seat mile. It stands to reason that with low utilization, you can’t spread your aircraft ownership costs over as many available seat miles, leading to higher unit costs. This actually isn’t the case. Prior to 2014, Allegiant actually had lower CASM ex-fuel in every year since 2008. Post 2015, ALGT’s unit costs have been bloated due to a fleet transition (which is nearly over, but we will get into later in the writeup). Over the long-run, the CASM ex-fuel between Allegiant and Spirit has worked out to be very similar. In fact, the average CASM ex-fuel between the 2 companies over the past 10 years has been identical. As I mentioned earlier, this is because Allegiant is able to lower their aircraft cost of ownership by purchasing used, older aircraft from other airlines. To summarize, of all the airlines in the US, Allegiant has the lowest unit costs (at least on par with Spirit), and is the ONLY airline capable of allocating their planes only to routes in which the returns are favorable, even if that means the cities in which they operate only make 2 departures per week.
In terms of what all this means in the real world… essentially Allegiant flies passengers from very small, underserved cities to what they call world-class “leisure” destinations. If you go onto Allegiant’s website, the first thing you will see on their front page are all their flights from Las Vegas. Las Vegas is one of their “leisure” destinations, along with cities like Los Angeles, New Orleans, Fort Lauderdale, Orlando, San Diego, Tampa, Washington DC, etc. You will then see the types of cities they are provided service to, like Belleville, IL, Billings, MT, Bismarck, ND, Bozeman MT, and so on. So, they choose big cities which have a robust travel market, and then give the smaller, underserved cities a route to get there. As mentioned earlier, 80% of these routes have no competition. It is likely that the routes without competition will stay that way, as the majority of these routes only have the market for 2 or 3 flights a week. This wouldn’t be a sustainable market for any airline except for a low-utilization airline. Allegiant is the only low-utilization ULCC in the US, so this likely won’t change anytime soon. At this point, Allegiant flies ~400 routes, connecting ~100 smaller cities to ~20 of their world class “leisure” destinations. In terms of the overall market, I think it’s a bit of a moot point because they operate outside the bounds of the mainstream US airline market. They have, to an extent, created their own market of non-stop flights from smaller cities, that nobody else served, to popular destinations. Management is also confident that there is a large opportunity to expand capacity in this space over the next 5 years. To date, they mostly serve routes from smaller cities to large destinations. On top of there being room left to grow in this space, they think there is an attractive market left mostly untouched serving routes from mid-sized cities to all kinds of destinations.
Onto the customer side. Allegiant offers an unbundled product, meaning the airfare and ancillary products and services are separate. In 2017, the average ticket was ~$67 (which will fluctuate with fuel prices) and the average ancillary revenue per passenger was ~$49 for a total airfare of ~$116. Compare this to the average total airfare of other airlines like Spirit ($109), Southwest ($147), or United ($240). When you look at the numbers, it’s very clear that Spirit and Allegiant are by far the cheapest options available. However, being an ULCC, the experience is not going to be great. Go to any review website and you’ll see customers complaining about seats that don’t recline, no padding on the seats, problems at the check-in counter, having to pay for baggage, etc. With the ULCCs, a ticket only gets a passenger an economy seat with the ability to fit one small personal item underneath the seat in front of them. Getting an in-flight drink, using an overhead bin, checking a bag, booking a seat with more legroom, or even checking in via the ticket counter rather than an automated kiosk all will cost the passenger extra. The experience truly is “no frills.”
Despite all of the above, there remains a robust market for ULCCs and Allegiant in particular. Since 2008, Allegiant’s load factor has averaged 86%, shrinking in recent years due to strains with a fleet upgrade. Even amidst the worst of the fleet upgrade, Allegiant has been able to maintain load factors of roughly 82% at the bottom, with signs of recent improvement. Compare this to the average load factors of the big 4 over the past 10 years, which all hover in the low 80s. In the most recent year, we see Delta at 85%, Southwest at 84%, United at 83%, and American at 83% at the bottom of fuel prices, which is legacy airlines’ time to shine. So regardless of the amount of complaints and bad reviews ULCCs receive, they are still able to fill their planes just as well as legacy airlines which offer much better service. At the same time, the ULCCs have actually been able to take a meaningful amount of market share from the big 4 in the past 10 years. In 2008, total domestic RPMs were 568.3B. Allegiant flew 3.86B RPMs and Spirit flew 6.6B RPMs. So in 2008, the domestic ULCCs had a 1.84% market share, with Allegiant specifically at .6%. Fast forward to 2017, when total domestic RPMs were 683.71B. Allegiant flew 11.1B RPMs and Spirit flew 24.6B RPMs. Hence, in 2017, the domestic ULCCs had a 5.22% market share, with Allegiant specifically at 1.6%. In the past 10 years, ULCCs have almost tripled their market share. It’s very clear that despite the experience, more and more people are opting for a ticket price that is less than half of the legacy carriers. Many people in smaller cities actually have no other options to get to some larger destinations other than to fly Allegiant. This means that in Allegiant’s case, it’s less them taking market share from the legacy carriers, and more them actually making the entire pie larger.
The Fleet Upgrade:
To this point, I’ve discussed what initially got me interested in Allegiant, and why I prefer Allegiant among the low-cost carriers. So the question now becomes – why now? The answer to that is the fleet upgrade Allegiant is currently undergoing, causing them to underearn in 2017 and 2018.
To provide a short summary – at the beginning of 2013, the average Allegiant flight was undertaken in a 23-year-old McDonnell Douglas aircraft. Starting in 2013, they began to update their fleet to newer, larger capacity, more fuel-efficient A320 series Airbus aircraft. By the end of 2018, Allegiant will have retired their last MD-80 aircraft, and be left with a full fleet of A320 series airbus aircraft. In the meantime, this has compressed their margins and stagnated ASM growth as they retire aircraft. In the next 3-5 years, we should see significant margin expansion, ASM/RPM growth, and hence, very predictable double-digit earnings growth.
How do we get to these conclusions? Let’s begin with the real world first. A fleet transition is very disruptive to an airline, but especially so to an ULCC. ULCCs are predicated on single aircraft fleets, which significantly reduces the amount of staffing and training needed to operate the airline. During a fleet transition, you must retrain your entire staff, and bring on significant amounts of extra staffing to cover the gaps. You can see this in the numbers at allegiant. In 2012, Allegiant had 5.8 pilots per aircraft and 8.4 flight attendants per aircraft. In 2017, those numbers bloated to 10.19 pilots per aircraft and 13.0 flight attendants per aircraft. That is a significant increase in personnel per plane, which was a large source of Allegiant’s cost advantage over other airlines. On top of the increase in personnel, simply paying pilots, flight attendants, and mechanics to be trained rather than for actual work for 5 years is a significant reduction in cost efficiencies. By the end of 2018, the need for extra staffing/training will cease to exist, and this trend should begin to reverse. By 2020, Allegiant expects to be back down to 7.6 pilots per aircraft which seems a very manageable goal. Staffing salary will be the biggest driver in cost savings post-transition. However, there are a few efficiencies to be gained due to the new aircraft type as well. First and foremost is the fuel savings. The MD-80s were incredibly old and fuel inefficient. The old fleet saw ASMs per gallon of fuel of around 60. The new Airbus A320 series planes should see ASMs per gallon of fuel of around 85. For reference, Spirit has a fleet of A320s, and their ASMs per gallon of fuel is ~86. That is an immediate 30% savings in fuel costs. The MD-80s were also a very expensive aircraft to maintain. Pre-2012 (last year of a completely MD-80 fleet), Allegiants maintenance and repair CASM (cost per available seat mile) were routinely at least .90 cents/ASM or higher. Compare this to spirit’s maintenance and repair CASM pre-2012 (who already had a full A320 fleet) of anywhere between .30-.40 cents/ASM. Some of this difference is due to the contrasting operating models, but not enough to cause Allegiants line item to be 3-4x higher than Spirits. However, there is one large, glaring negative from upgrading to an A320 fleet. That is the price/cost of ownership of an A320 aircraft vs an MD-80, and the associated return on capital. Allegiant pays, on average, ~$17mm for a used A320 series aircraft. They used to pay $3-5mm per MD-80. However, there are 2 things that offset this issue. Because of the increased capacity and efficiency per plane, the unit economics per plane are better. And more importantly, the useful life and depreciation of the A320 series is over 15 years, while the MD-80 series was over 3-5 years. So, over the entire useful life of each aircraft, the returns are much more in line. The average EBIT per MD-80 was ~$3mm/aircraft. This means an average cash on cash return of about 75%, and a payback period of less than 2 years. However, with the average useful life being ~4 years, it’s not as good of an investment as it appears at first glance. Management believes with the A320 series, they can generate slightly more than $6mm EBITDA/aircraft. Honestly, I think this forecast is far too ambitious. The load factor/unit revenues to achieve this kind of return seem unreasonable to me. In my model, I find it far more likely that they generate ~$5.3mm EBITDA/aircraft in a base scenario. This means an average cash on cash return of about 31%, with the useful life of this return being 15 years. The numbers for the A320s are worse, but still very attractive.
In terms of the actual fleet, the transition is nearly complete. In January, 2013 the Allegiant fleet consisted of 58 MD-80 series aircraft, and 5 B757 aircraft. That year, they slowly began purchasing used A320 series aircraft from other airlines. By the end of 2017, the fleet consisted of only 37 MD-80s, 0 B757s, and 52 A320 series aircraft. By the end of 2018, the fleet will consist entirely of A320 series aircraft, with management targeting 32 A319s and and 50 A320s for a total of 82 A320 series aircraft.
This brings me to another point that most readers would probably like addressed - the 60 minutes piece run in April, 2018. This journalism gem failed to acknowledge that by the end of 2018, their entire point about Allegiant’s aged, mechanically failing fleet would be rendered obsolete. Yes, Allegiant’s previous fleet was old with the average plane being over 23 years old. Yes, their previous fleet was more prone to mechanical issues. The MD-80 series was introduced into commercial service in 1980 and was certainly outdated in the current market. By the end of 2018, only 8 months after the piece airs, Allegiant will have retired the last of their MD-80s and replaced them with Airbus A320 aircraft. The average age of their A320 fleet is currently ~11 years old. The Airbus A320 aircraft is the most popular aircraft in the world and is much easier to maintain than the aged MD-80 aircrafts. Why 60 minutes would run a piece focused on Allegiant’s mechanical issues with their old fleet that would cease to exist within 8 months and not even mention that fact, I am not quite sure. However, it is important to note that it is possible that the fear instilled by 60 minutes, and the headlines associated with aircraft mechanical issues as whole recently, could be detrimental to Allegiant’s load factor for the foreseeable future. Thankfully, the trends we have seen thus far do not support that argument, with load factors YTD being higher than the previous year.
There are only 3 real variable inputs for allegiant between now and 2020. Allegiant has routes mapped out for flight path expansion, maintenance is a scheduled cost, cost of aircraft ownership is fixed, and Allegiant has negotiated labor rates for its pilots and flight attendants through 2022. This means that the only real factors affecting Allegiant’s performance between now and 2020 are unit revenues, load factors, and fuel prices.
Let’s begin with the cost side of the equation. The fleet transition has affected Allegiant’s numbers in a very significant, noticeable way. I will let the numbers speak for themselves:
2012 CASM Ex-Fuel (cents):
Salary and Benefits - 1.78
Station Operations - 1.05
Maintenance and Repairs - .99
Sales and Marketing - .26
Aircraft Lease Rentals - 0
D&A - .77
Other - .47
Special Charge - 0
Total CASM Ex-Fuel - 5.32
2017 CASM Ex-Fuel:
Salary and Benefits - 2.73
Station Operations - 1.05
Maintenance and Repairs - .83
Sales and Marketing - .39
Aircraft Lease Rentals - .02
D&A - .89
Other - .68
Special Charge - .26
Total CASM Ex-Fuel - 6.86
As you can see, CASM ex-fuel has increased almost 30% since 2012. The change is mainly due to the salary and benefits line. This line increased a full cent, or 53%, from 1.78 to 2.73. As mentioned earlier, this is mainly due to the increased staffing and training costs from the fleet transition, and should be begin to subside post-2018. I have modeled out my own assumptions through 2022, and management has also released through own CASM guidance through 2020. The main assumptions are as follows: staffing returns to normal with the negotiated salary increases through 2022, depreciation and amortization reflects the change to all A320 fleet, and maintenance and repair reflects change to A320 fleet with heavy maintenance now being capitalized which should reduce lumpiness in these costs. Using my numbers, I get to roughly 6.0 cents per available seat mile ex-fuel by 2020. Management guides to 5.99 CASM ex-fuel by 2020. The reason for the significant increase in CASM from 2012 versus our prediction is mostly due to the increased cost of ownership of A320s and the negotiated salary increase for pilots and flight attendants. Minus any extraordinary items, this is a very predictable side of the equation.
Lets move to the capacity side of the equation. Once again, this is fairly formulaic but will vary slightly depending on fuel prices. There are 2 major factors causing large capacity (ASM) growth by 2020. Both are associated with the fleet upgrade. The first is the simple increase in number of aircraft, and the associated seat-per-aircraft increase with the new fleet. The second is the aircraft utilization increase we will see with the new fleet. As I detailed earlier, Allegiant was able to run a low-utilization airline due to the ultra-low cost of ownership the enjoyed with their fleet. Cost of ownership increases a bit with the A320s, so Allegiant will need to increase their utilization to offset this. Block hours pre-transition were 5-6 hrs per day. With the A320, management is targeting 7 hrs per day, which is still significantly lower than all other domestic airlines. Management has also laid out their target fleet by 2020, which includes 110 A320s. This combination will grow ASMs by double digits through 2020 in a rather mechanical fashion. Below details the numbers for 2017, as well as the assumptions for 2020:
Aircraft - 89
Average Seats Per Aircraft - 168.2
Utilization - 6.7 hrs/day
ASMs - 13.6B
Aircraft - 110
Average Seats Per Aircraft - 173.8
Utilization - 7.0 hrs/day
ASMs - 18.1B
I would like to mention that there is some flexibility here. Basically, when there are low fuel prices, Allegiant will expand into more and more off-peak flying as it will hit their profitability hurdle rates during this time. When fuel prices rise, Allegiant will cut some of their off-peak flying as they will no longer be able to hit their margins on these flights. Obviously this isn’t something that anyone can estimate with any amount of certainty, so I’m not going to waste my time with trying.
The hardest part here is the customer/revenue side. There is a stark difference in the way unit revenues work at Allegiant versus other domestic airlines. This is due to the competitive landscape. If you look at Spirit, they compete heavily with the legacy airlines. Just take a look back over the past few years, when American started fighting back in a price war against Spirit. Even with fairly stable costs, Spirits unit revenue yield has dropped nearly 12% in the past 2 years. This has dropped their operating margin from an industry best around 24%, all the way down to single digits. In the most recent quarter, their operating margin has hit 7%, less than a third of what it was just over 2 years ago. Compare this with Allegiant, which has also had a rough few years due to the fleet transition. Unit costs have ballooned over 20% in the past 2 years at Allegiant, yet they’ve been able to maintain a 17% operating margin for 2017. This is despite Allegiant having costs of 6.86 per ASM versus Spirit’s 5.51 per ASM in 2017. Spirit and Allegiant offer the same no-frills, uncomfortable ULCC experience, and despite unit costs being much higher at Allegiant over the past 2 years, they’ve been more than able to make up for it with their pricing power. In 2017, Allegiant collected a yield of 11.05 cents/ASM versus Spirits 8.95 cents/ASM resulting in current operating margins for Allegiant being double what they are at Spirit. I would think the reason for this pricing power would be readily apparent from the rest of the write-up, but we’ll cover it nonetheless. As detailed earlier, Allegiant has no competition on 80% of it’s routes. It flies from small cities like Moline, Illinois or Billings, Montana to larger leisure destinations like Las Vegas or Orlando. These routes have no competition because of the sparse frequency these routes support. Most of these routes will only support 1 or 2 flights per week, which no other airline could support profitably. Allegiant is the only airline able to support these routes because of their extremely low annual cost of ownership per airplane. This means that they are able to let their airplanes sit much longer per day, and still be profitable. They don’t have to push for frequency; they are able to allocate their airplanes to the attractive routes focusing on profitability rather than pushing for ASM growth. The closest domestic competitor they have in terms of annual cost of ownership per plane is Spirit. Spirit’s cost of ownership is much higher than Allegiant’s as they typically either lease or own outright new Airbus A320 series aircraft. Allegiant purchases used aircraft from other airlines, which significantly drives down their costs. Without Spirit undertaking a massive change in operations and fleet, they will not be able to compete with Allegiant’s routes. As of this write-up, there are no other known competitors trying to get into the low-frequency airline business in the US. If you take a look back at the past 5 or 10 years at yields, unit costs, load factors, etc. for Allegiant, Spirit, and the legacy airlines, it becomes very apparent that Allegiant has serious pricing power that no other airline can match. The cherry on top is that this model isn’t cannibalizing any of the legacy airlines’ business, so price wars are less significant at Allegiant unlike at Spirit.
So how does Allegiant look at unit revenues when they don’t face much competition? They essentially have a hurdle rate/range of margin they look at for each route. If margins are too high, they have to worry about poaching from competition. If margins are too low, the route no longer makes sense in that environment and will be axed. Overall, they are looking for a 20% operating margin from their routes. Since going public in 2007, Allegiant has managed a cumulative operating margin of 18%. Operating margin is unlikely to stay above or below this number (as long as no new competitors enter the market) for any meaningful amount of time. If Allegiant is able to hit this number in the middle of a fleet transition when their costs are very bloated, during a time when their ULCC competitors are significantly undercutting them in terms of average fare and unit revenues - I see no better way to reinforce the presence of their pricing power.
That brings us to the bottom line. What will Allegiant look like in 2020? While I don’t claim to have any sort of crystal ball, I think we can be reasonably sure that their ASM’s will have grown by double digit percentages and their unit costs (especially their Salary/Benefits) will be significantly lower. Combine that with their pricing power and lack of competition within their niche, and I think that alone is grounds for an attractive investment. Once again, Allegiant’s costs ex fuel and route mapping (or ASM growth) over the next 3 years are largely already planned out. The only questions are fuel prices and unit revenues/load factors. Using fairly conservative assumptions in my model, I see Allegiant making ~$5.3mm EBITDA/plane in 2020. Management guides to ~$6.1mm EBITDA/plane, which I obviously think is unlikely but possible given operational improvements with the new fleet. This gets us to roughly $590mm in EBITDA by 2020, up from ~$380mm in 2017.
Using today’s enterprise value, that gets us a multiple of roughly 7.9 EV/EBITDA. While this may seem like a slightly elevated multiple for airlines, especially in comparison to the legacy airlines and spirit, I believe Allegiant’s superior operating model deserves a premium. However, when you compare the multiple with overseas ULCCs like Ryanair or Wizz, the multiple seems more in line. Ryanair currently trades at over 10x EV to EBITDA and Wizz Air trades over 8x EV to EBITDA. We can value out 3 scenarios for Allegiant by 2020, accounting for differences in fuel prices, unit revenues, etc. Each accounts for cash inflows by 2020, and outflows for planned A320 purchases.
-The economy slows down, leading to air travel decline. Unit revenues, margins, and ASMs come down. Operating margin hits the mid teens, levels Allegiant hasn’t seen since 2008. EBITDA/plane falls to $3.5mm. 2020 EBITDA sits at $390, roughly in line with the current annual EBITDA. Assuming the EV to EBITDA multiple drops down to 6.5, Allegiant has an enterprise value of $2.5B. Allegiant is valued at $100 per share.
-This is the case laid out above. Profit/ASM is 20% margin from yield. EBITDA/plane comes in around $5.3mm. Gradual increase in oil price. 2020 EBITDA comes to ~$590mm. Assuming a steady 7.9x EV to EBITDA multiple, Allegiant has an enterprise value of $4.6B. This gets us to a share price of $250 by 2020. This represents an IRR of over 40%.
-If we believe management's guidance, Allegiant will be earning $6.1mm EBITDA/plane in 2020. In order to get to these assumptions, they are likely modelling more ASM growth than I am (a better fuel environment) in off-peak flying. Operating margin is likely still 20% of yield. 2020 EBITDA comes to ~$670mm. Using an 8.5x multiple more in line with successful ULCCs Ryanair and Wizz, Allegiant has an enterprise value of $5.7B. Allegiant is valued at $320 per share. This represents an IRR of over 60%.
I find the bear case highly, highly unlikely. Imaging a scenario where they come through the fleet transition, eliminate costs of training and over-staffing, and then somehow manage worse margins than the bottom of the transition seems absurd to me. However, it must be said that if they see competition among their routes, these numbers are possible. Like I said earlier, no low-frequency airline competition is currently known of or in the works in the US. I find the most probable situation to be something between my base case and managements case. I used fairly conservative assumptions in my case for the fuel environment and ASM growth.
I don’t view the other risks as major risks to the thesis. The economy and fuel prices are cyclical in nature, and thus transitory. Competition in the low-frequency space is a scary risk, but there is currently nothing in the pipeline. If there were, it would not be difficult to see it coming and make and education decision at that time.
Sunseeker, on the other hand, is a legitimate risk. This thesis is based around efficient capital/aircraft allocation. Allegiant is attractive because of the way management runs the business, not because of the industry in which it operates. So when management takes a 90 degree turn and decides it wants to branch off into a $600mm condo development project, that signals a red flag to investors. And rightfully so. Why move away from your core competency where you see attractive returns on capital in a market with plenty of room for growth? Management would counter with the synergies they’ll see with their airline (wanting more money from their customers wallets..), and how de-risked the project is. The total risk on the project is limited to $125mm non-recourse debt, with the rest being de-risked through using sales deposits for construction costs, and completing the project in multiple phases, allowing for building as demand warrants. To be honest, I wince every time I see a sunseeker resort presentation because of the extremely promotional nature they’ve decided they need to represent it with. It’s almost as if they have a chip on their shoulder. They feel like they need to prove how great of an investment it is, since the investment community has reacted to Sunseeker with extreme skepticism. This is the most worrying part to me.
At the end of the day, this all boils down to management and how well you trust them to shephard your capital. I trust Maury Gallagher, and the decisions he has made to this point. He built Allegiant from a bankrupt airline serving less than 10 cities in 2000 into what it is today. Most importantly, he thinks and acts like an owner. He still owns 20% of the company, and has imprinted a frugal operation into Allegiant. I still don’t like Sunseeker. They have a well-worn, proven path of creating value for shareholders. I don't think straying is smart. But if Maury is comfortable exposing shareholders to Sunseeker considering his nature and the fact that he owns 20% of Allegiant, I can get comfortable as well.
Honestly, a lot of the numbers and details here are fairly superfluous. This is my favorite type of investment - it can be explained in a few sentences, and doesn’t require a multiple rerating to be successful. All it needs is proper execution from management.
Allegiant is a good business, operating in a lousy industry. It has high returns on capital unlike its competitors, very limited competition (in fact, zero when sticking to its niche), and is trading at a very reasonable multiple which is hard to find in this environment. It is currently underearning due to a fleet transition, and even if the fleet transition doesn’t help unit economic of the business, several operating costs will vanish within the next year. This will cause earnings to inflect upwards, providing a currently attractive investment opportunity.
Competition in the US low-frequency ULCC space
Economy Slows Down
Higher Fuel Prices
Earnings inflect upwards after fleet transition
Fleet expansion from 77 planes at YE2018 to 110 planes at YE2020
|Entry||10/14/2018 08:22 PM|
Thanks for the write-up.
1) How do you quantify the downside scenario for Sunseeker? I ask because ALGT has been moving the goalposts on how they are proceeding with Sunseeker, and this worries me. At first they said they would fund construction with deposits - not happening. Then they said they will "ringfence" the airline by using non-recourse project level debt - not happening. So I worry that Maury is going "all-in" on Sunseeker and is willing to write a blank check. So, if Sunseeker fails, what is the downside? 600mm project liquidated at 50 cents on the dollar? Call is $20 of downside to stock?
2) PAR Capital just showed up as a 10% holder. The PAR guys are very well repsected airline investors and successfully went "activist" on UAL. Do you know what PAR's angle here is? Are they trying to kill / sell Sunseeker behind the scenes?
3) ALGT has had some high profile management departures over the last several years (eg. Jude Bricker, Lukas Johnson). Any views on this? I get the sense that its driven by "Maury's" mentality that its his way or the highway.
|Subject||Re: Few questions|
|Entry||10/14/2018 11:25 PM|
1) As you alluded to, my information is a little bit outdated here. I will try to get a better answer once I have access to my computer, but I’m currently traveling so I’ll do what I can from my tablet.
The expectations Allegiant set regarding the real estate funding have turned out to be completely false. However, they finally came out with their intermediate term plans in a recent investor presentation. They plan to fund the project for the near future from cash from operations. Here’s the details:
- Currently ~$350mm cash on the balance sheet. Should be ~$500mm by the end of q3.
- they are finally done with fleet transition which was a huge cash drag. By the end of 2018, they will have picked up 77 A320s for an average of $17mm so that’s about $1.3B cash outflow over the past 5 years. Now, they’re only planning on adding 10 A320s per year, so that gets reduced to $170mm a year in growth capex.
- EBITDA this year should be around $400mm, and likely upwards of $600mm within 3 years. That means that even after growth capex, starting now Allegiant should be pulling in around $150-200mm annually in FCF which had been negative in recent years due to the huge capex of the fleet transition.
- Allegiant now says the budget is $420mm, excluding cash already spent. They have a liquidity target of $300mm. They say they can fund the project with cash flow, and then longer term pursue financing during or after construction.
- Looking at these numbers, they can absolutely afford to start the project with cash from operations barring any extreme events in fuel prices or the economy. To me, I think it makes sense to look at the cash inflows and outflows by 2020 to find the downside value. Assume they fund the resort entirely from cash flow, and that the investment is worth 0. Also have to assume that we’re adding 20 A320s to the enterprise value. That’s $420mm plus $340mm of cash outflows, in total about $47 per share. We’re also likely seeing at least $500mm of FCF by the end of 2020, or $31 per share. That’s in total a $260mm cash outflow we can add to the EV by 2020.
- is it ideal to fund it from cash from operations? Hell no, obviously a combination of non-recourse debt and deposits from future owners would have been ideal. But I think it says something about Allegiant as an airline that they’re even able to fund a project like this from operations while maintaining upwards of 10% growth rates in their total fleet count.
- That being said, I actually live on the west coast of Florida. I do agree with Allegiant that for the destination it is, it is pretty underpenetrated in terms of this type of real estate unlike other areas of Florida. What’s the appropriate percentage to discount the project in a downside scenario? I have no idea, but it’s definitely not zero. Even with it being 0, the return by 2020 still looks attractive to me. Just take my base case $250 - $47 + $31 = $234. That’s still a 95% return by the end of 2020.
2) As far as I’m aware, PAR is a passive stake. Even with it being a 10% stake in Allegiant, it’s less than a 2% position from them and not in their top 10 holdings. I’ll let you know if I find out more.
3) Lukas Johnson is a very interesting one. He left algt to become the ceo of a startup ulcc in Canada. Canada has a significantly underpenetrated ulcc market, especially for small, underserved cities. The business plan mimicked that of ALGT. I think Lukas saw what Maury did with Allegiant, and as a young guy, he saw an opportunity to copy that growth. Then this happened: https://globenewswire.com/news-release/2018/09/11/1569126/0/en/Jetlines-Welcomes-Proven-Ultra-Low-Cost-Airline-Executive-as-New-CEO.html
I don’t know this for sure, but I find it likely that Lukas legimately left because he thought he saw an opportunity in Canada. I mean he even funded a significant portion of the startup with his own capital.
Jude Bricker also got tapped for a ceo role at Sun Country. His explanation for leaving was that he saw an opportunity with a future as bright as when he first joined Allegiant. Who knows if that’s the case, but he was appointed a week after the previous ceo resigned so that seems to support that case.
What I do know is that both executives got tapped for ceo roles at smaller ulccs. You could make a case that Maury is hard to work with. I think it’s actually more likely that Maury has cultivated talent at algt with their impressive track record, and other companies aware of that. Both guys spent a long time at algt. Neither had prior management experience in airlines, or any other company for that matter. The culture at Allegiant is clearly cultivating something. If you’re in transition as or starting up an ulcc airline, Allegiant seems to be the top company to poach executives from.
|Entry||12/04/2018 12:29 PM|
Good questions. I’ll answer the most important question first -
1. Do you think the fundamental decision to convert the fleet to A320s was the correct one?
I think there’s a few angles to the question. From a unit economic standpoint, it looks OK. Each incremental mile flown by an A320 should be at least as profitable compared to an md-80. Total CASM post fleet transition should be pretty similar to what is was before the transition. The issue is with how this aircraft is most efficiently used when compared to an md-80 and how that affects their business model. Like I mentioned in the writeup, low utilization is critical to their business model. Now obviously, the A320 has a higher cost of ownership and lower fuel costs than an md-80. This means you’re gonna wanna keep the A320 in the air more than the md-80. This means higher utilization, but they’re really only stepping it up from around 5-6 hrs/day to 7. I’m not concerned with that as it shows they still don’t have to push capacity to try to be profitable.
Whats more concerning to me is the strain this is going to put on their niche. They plan to have 110 A320s by 2020. That’s more planes, with more seats, flying more flights than their previous business model. This niche is only so big, and they’re already nearing a cap with their tiny cities. Now they’re having to move up to more mid-sized cities to grow, which means more competition. While they may not have to push capacity with the new planes, this new model certainly does require more capacity than the old model, and that’s unfortunate. It just puts them closer to the cap on their niche faster, which isn’t ideal and is likely one of the reasons sunseeker exists.... more on that later.
I think the big positive come from a more intangible effect - the A320 is a nicer plane. They’re on average 10 years old versus 20+ for the md-80s. From what I can tell, the md-80s were a maintenance nightmare. Constant maintenance cancellations and mid-air breakdowns really dented Allegiants reputation with a lot of the public. The 60 minutes piece didn’t help. So the A320 will definitely provide a better overall experience for customers. That can’t hurt, but whether or not this really matters is debatable... everyone always knew Allegiant was a shitty experience but they havent had any difficulty filling planes regardless.
So was it the right decision? I don’t know. Maybe there were better options, but this seems like an OK one. Either way, I think the fleet transition is misunderstood, and margins/earnings power seem underestimated from sellside going forward. I think the big risk from the transition is them getting closer to outgrowing their niche rather than any risks stemming from the economics of the plane.
2. D&A vs. CapEx
Couple moving parts here. First off, accounting for maintenance has changed during the fleet transition. Allegiant expensed heavy maintenance on the md-80s whereas they are capitalizing heavy maintenance on the A320s. As a side note, heavy maintenance is a check airlines must go through based on guidelines from the FAA and manufacturers. For the A320, they must go through this check every 6 years where they essentially tear apart the entire plane. So this is inherently a very lumpy expense which comes through every few years, which is why it’s capitalized on the A320. Now I don’t know what it actually costs to perform a heavy maintenance check on an A320. Manufacturers don’t release it because they don’t want you to be able to compare their profitability to competitors. From what I can guess, it takes 20-30k manhours, and most of cost breakdown is 3/4 man hours, 1/4 parts. This likely puts the check in the range of $1-1.5mm per plane every 6 years. Or somewhere around $200k per year amortized over 6 years. From the writeup, you’ll know Allegiant on average pays $17mm per plane over a 15 period useful life. So in total, that puts us around $1.35mm annually per plane vs managements guide of $115k - $120k per plane per month, or $1.38mm - $1.44mm per year. This ignores that “other capex” line, which I don’t know how that’s being amortized. But you’re a bit low in your annual D&A assumption, and I think the numbers are much more in line than you think.
Also, max pax isn’t maintenance capex, that’s a project to increase seats in some of their planes which is obviously non-recurring growth capex.
3. Regarding the EBITDA forecast
I don’t really have issues with management’s cost forecasts. When I modeled out the unit economics of an A320 to 2020, my costs were largely inline with the managements. Where we diverged then must have been unit revenues, so management thinks this new model is going to have higher margins than the past. I assumed they’d pass along much of the cost savings to the customer to stick within their ideal operating margin - however, when I talked to management about this, it sounded like they were planning on capturing it themselves. We’ll see what happens, but I think the margin assumptions for $6mm EBITDA/plane are just too high.
In terms of what will be done by YE2018 - the entire fleet transition will be finished, but obviously FY2018 still has the md-80s in it. So FY2019 will be the first full year to appreciate the benefits of the fleet transition. Fuel benefits will be fully in effect for 2019. The biggest benefit we’ll see in cost reduction by 2020 will come from the extra salary and staffing needed through the transition. We will not see that fully by YE2018, and that will likely be a somewhat linear effect over the next few years. You can see the timeline of effect for 186 seat modification from their capex guide above. The credit card program is obviously an ongoing thing. The e-commerce initiatives they say will be done by 2019, so won’t fully show up until 2020. That’s a huge number though, and me saying I’m skeptical is an understatement.
Likely where I diverge from management is in what we know is going to happen and what is unknown. The changes in the fleet are known. Fuel will come down. Salary will come down. More seats in the same plane will yield better unit economics. So those line items - fuel per asm benefit, CASM ex fuel benefit, 186 seat modification, and fleet productivity are rather set in stone. The rest are unknowns. Management obviously knows that part of the business better than I, so whether or not you take their word for it is up to you. But I don’t think you even need those “unknown” benefits for the investment to work. This is probably where managements guide to $6mm EBITDA/plane differs from my own.
4. Should we be concerned with the really big goals the Company has?
Yes, and I think this is the major risk to the thesis.
When people typically look at airlines, they see a cyclical industry with a history of being too capital intensive and competitive for anyone to ever make any money. I don’t see those as being large risks to Allegiant. Yes, fuel prices will fluctuate, but Allegiant is the best operator in the industry and has little competition. I have confidence that looking out 5 or 10 years, regardless of what fuel prices do, the airline will keep compounding earnings. On top of that, the current fleet transition seems to be misunderstood, and earnings will likely inflect upwards soon. That’s why I own this company.
Unfortunately, it comes with this large side bet that (contrary to early indications) is 100% risked to shareholders. I think what is likely happening is that Maury sees growth in their niche coming to an end sometime in the next decade or so, so he’s trying to find replacement growth in something synergistic. I get it, but that doesn’t mean I agree with it. And your prediction about hotel management doesn’t sound far fetched to me if sunseeker goes well. The one positive thing I can say about sunseeker is that he seems to be replicating what he did with Allegiant, just in a different industry. When he took over Allegiant, he didn’t try to compete with anyone else. He didn’t move into the legacy carrier’s markets or even the other LCC’s markets. He created his own niche. While he may not be doing exactly that with sunseeker, he’s moving into a nice but uncompetitive market in Florida that sees a lot of traffic from his airline. It’s not like he’s trying to build a hotel in Vegas or Miami. Either way, it muddies the waters of the overall business and pulls a lot of cash away from a high ROIC business that it knows it’s competent in.
As far as management goes, I’m less concerned with that. I think management’s priority is still, and will continue to be, the airline. He brought extra management onboard for Sunseeker who’s only job is to focus on Sunseeker. The legacy airline guys will continue to be solely airline.
Thanks for the questions. I enjoy feedback or getting pushback on my ideas, so feel free to keep em coming.
|Entry||12/04/2018 01:09 PM|
One thing I forgot to mention - the reason why you see so much heavy maintenance capex in the next few years is because of the fast ramp up of A320s. Off the top of my head, I think they’re going from something like 30 a320s last year to 76 currently to upwards of 100 by 2020. The average age of their a320s is 11 right now - most are bought around the age of 10 to 11. Most likely, other airlines with a320s commonly sell them before their second heavy maintenance check at 12 years where you have to pull the entire thing apart and incur a large cash outflow. So Allegiant is performing a lot of heavy maintenance checks in their first 1 or 2 years they own the planes, then won’t perform another for 6 years. So as long as they’re scaling their fleet up quickly, that capex will be bloated. Once that slows down, you’ll see a lot more FCF start flowing through. But until then, I think the earnings do project the correct earnings power.
|Subject||Re: Re: Questoins|
|Entry||12/04/2018 10:00 PM|
After taking a step back, it’s clear that the number I threw out for heavy maintenance is too low. Let me see if I can get a better number for that...