Description

Situation Overview:  VLRS is the largest ultra-low-cost carrier in Mexico and is amongst the lowest-cost operators (by CASM) in the world. A key shareholder of VLRS is Indigo Partners - who are known for owning other low-cost airlines like Frontier Airlines, Wizz Air, and JetSmart. VLRS, benefitting from Indigo Partners’ economies of scale, enjoys favorable negotiated aircraft pricing with Airbus. This competitive advantage in addition to other operational advantages discussed in past write-ups, enables the company to fly routes profitably that other carriers are not able to. 

The prior VIC write-up (by droppe, AIFL, and om730) does a great job of laying out the background, business model, opportunity, and why VLRS should trade at a higher multiple. The key thesis is still intact - Mexico now has a more rational airline passenger market (mostly due to the demise of Interjet). 

The business model and profit profile have not changed.  However, since the last write-up, over two years ago, a slew of events/news have transpired - mostly temporary or non-material. Meanwhile, the stock price has been nearly cut in half since mid-2023.  Below are the significant events in 2023:

• Cat 1 safety designation by the  US FAA was only regained in the fall of 2023, after over 2 years of trying to regain it.

• RTX Pratt & Whitney GTF engine recall mid-2023 – large portion of Volaris fleet

• 2022 high jet fuel prices (somewhat bleeding into 2023)

Cat 1 Designation: Cat1 designation was regained in mid-September 2023; Volaris has rapidly expanded service cross-border with international passenger/ASM/RPM growth in the high-teens/low-twenties for Oct/Nov/Dec (even considering the below engine recall).  For Mexico not having Cat 1 status to fly into the US limits what Mexican airlines could do (e.g. could not add new routes, etc.). The last time Mexico lost Cat1 status was around 2010 and it took about 6 months to regain compliance. This time it took well over 2 years. Hence, Volaris (and Viva / AeroMexico) could not expand service in the most lucrative market (for Volaris US cross-border service generates considerably better economics than domestic) at an opportune time (all American airlines have expanded/done well in the cross-border market since 2021).

Pratt & Whitney GTF Engine Recall: P&W engine recall is the most material issue currently plaguing VLRS (recalling ~3,000 engines affecting airlines worldwide including VLRS and its main competitor Viva). It affects 52 aircraft of VLRS's fleet, out of 129 as of 12/31/23. Engines will be out ~250-300 days for maintenance over the next couple of years. For VLRS that translates to about 16-20 aircraft out at any point in time, reducing the fleet by ~15% (they had 16 aircraft grounded as of earnings call) - the recall will probably be more weighted towards 2024 vs 2025. However, there are multiple mitigating factors:

• Volaris has new aircraft orders being delivered, 4 already post 3Q23, 11 in 2024 and 13 in 2025

• Extending leases on 18 current aircraft that were supposed to be redelivered over 2024-2025

• RASM demand/supply effects: with reduced capacity RASM will improve. Management mentioned that culling ~10% of the lowest generating routes will increase RASM by 5-7%

• Additional improved RASM from a focus on US/MX passengers.

• Viva is in the same predicament with a similar percentage of its fleet affected by the recall. This implies more capacity will be taken out of the market.

• AeroMexico is now impacted by the Boeing issues.

High Jet Fuel Prices: The high jet fuel prices can be hedged separately so I won’t spend time on it. 

Near-Term Expectation / Outlook: Given the P&W recall, we expect ASM and Revenue to be temporarily down.  Management’s 2024 guidance helped inform the magnitude of the decline - guidance was for 2024 ASM to be down ~17%; which will translate to revenue decreasing. However, the EBITDAR margin should expand nicely to ~32% in 2024 (vs ~26% in 2023). 

In the meantime, VLRS continues to add net new planes and extend leases which should offset the ASM drop in the second half of the year due to the recall. In addition, VIVA (~33% market share) is currently behind on the recall - they will likely need to catch up in 2024 by sending more planes to the recall. Aeromexico is also likely going to be impacted by the recent Boeing grounding.  Overall, this should help RASM for VLRS and Mexico in 2H 2024 as well as 2025. We are already seeing evidence of this in the TRASM (at ~8.6 cents) guidance which is expected to grow ~12% y/y in 1Q24. For these reasons, we expect both RASM/Revenue to be above expectations in the second half of 2024. 

As we lap the recall, we expect future TRASM and Revenue to grow nicely (double digits) in 2025; plus conservatively assuming some EBITDAR contraction (depending on fuel price), we estimate ~$1B of EBITDAR in 2025. In addition, Volaris is getting compensated by P&W/RTX for each engine recalled - it seems fixed costs will be covered implying ~$3-4mm per aircraft for the period they're grounded. This estimate is in line with management's 5-year target. 

The company had published its mid-term (5-yr) target of doubling Revenue (to ~$3.6B), EBITDAR (~$1.1B), and FCF (~$0.8B) by 2025.  This P&W engine recall certainly impacts the short-term performance and might delay these targets by ~1 year but we do not see any reason why VLRS should not achieve these targets in 2025/26. We think it's a timing issue as we go through the recall. Below is a slide from the company’s investor deck.   

Source: December 2023 IR deck

Longer Term: VLRS should be able to continue to enjoy a long runway for profitable growth driven by Mexico’s growing middle class, benefits of nearshoring, taking market share from the bus routes, as well as expanding into other South American markets and their visiting friends and relative passengers. 

Valuations / Expected Returns: Building on management’s FY2024 guidance and 2025 target, we think VLRS should be at a run-rate of ~$3B in revenue with ~31% EBITDAR margins = ~$1B EBITDAR in 2024/2025, subject to fuel price.  This implies that VLRS shares are currently trading at sub 4x EBITDAR multiple or ~12.5x EBIT.  We think this is an attractive entry point as most of the recent challenges are temporary and will be reimbursed by P&W. 

It’s a cyclical business, in Mexico, election year, going through a disruptive recall issue, so a conservative ~5x EBITDAR multiple should be a reasonable starting point. Over time, we think there is a path to higher multiples (6x-7x-8x) as we exit the recall process and VLRS operates under normal conditions. Why?  The company has a strong balance sheet (net Cash ~$0.2B), and is one of the lowest cost operators in the world, expanding in a market with a growing middle-income class supported by nearshoring, stealing market share from the bus routes, and generating healthy FCF. Overall,  one can argue that a higher multiple is deserved, but we’ll be conservative at 5x for now. 

At 5x VLRS’ ~$1B EBITDAR in 2024/2025, this should translate to ~$20 per ADS share - more than 2x the current price of $8.5 per share. As the company executes, we can expect some multiple expansions as well as continued EBITDAR growth over the next few years. 

Risks to Consider:

• Jet fuel price
• The P&W recall takes much longer than expected
• Mexico election year 
• New entrants possibly disrupt the rational pricing

Catalyst

• Multiple expansions as management executes out of the P&W recall
• Continued expansion into the US as well as other South American markets over time
• Special dividend or less likely aggressive share repurchase.  Not likely to buy back shares in 2024 or 2025 (Mexico rules regarding buybacks).