The Biggest Growth Opportunity in the Airline Industry Just Arrived

Recently, Spirit Airlines (NASDAQ: SAVE  ) has been one of the most popular airlines among investors. Spirit is an "ultra-low-cost carrier" that aims to use low fares to stimulate demand for air travel among customers who might not otherwise fly. Through low costs and high fees for optional services, Spirit has made this business model exceptionally profitable. Strong demand has allowed it to grow revenue at a nearly 30% annual clip over the last three years.

Spirit Airlines stock has soared in 2013. Photo: Spirit Airlines.

However, an even bigger opportunity in the ultra-low-cost-carrier segment may lie south of the border. Volaris (NYSE: VLRS  ) is a Mexican ultra-low-cost carrier that recently executed an IPO that included U.S.-traded shares. Volaris is already the second-largest airline in Mexico and it has a huge opportunity to grow by stimulating demand for air travel in Mexico. As a result, Volaris looks like a compelling long-term-investing opportunity (albeit a risky one).

Changing the culture
Volaris' growth is powered by two factors. First, the company is not shy about challenging its competitors (most notably Aeromexico). In its prospectus, Volaris highlights its massive cost advantage relative to other major airlines in Latin America. It keeps costs low by using a single aircraft type (the Airbus A320), utilizing its aircraft heavily, and minimizing distribution costs.

As a result, Volaris has a cost per available seat mile, or CASM, of just $0.094. By contrast, CASM averages around $0.14 for its competitors. Aeromexico's CASM is even higher than the regional average, at $0.157. This gives Volaris a massive advantage on the routes where they compete. Volaris uses its cost advantage to offer lower fares and thereby grab market share.

Volaris has quickly grown to become the second-largest airline in Mexico. Photo: Volaris.

The second factor powering Volaris' growth is that air travel is still underutilized in Mexico. The company claims that even after adjusting for the disparity in household income, Americans fly several times more often than Mexicans.

That's not because Mexicans do not travel. Mexico has a thriving long-distance bus industry, which generated nearly 3 billion passenger segments in 2012. This includes an executive and luxury bus industry that accounted for 74.4 million passenger segments. Volaris' management believes that it can reduce airfares to a level that will convince many people to switch from these executive and luxury buses to air travel.

Early returns
Last week, Volaris reported its first quarterly results since going public. Revenue grew 11% due to capacity expansion, offset by lower unit revenue. Despite the unit revenue pressure, adjusted net income jumped 39% year over year to 319 million pesos (roughly $24 million). Net income was boosted by a 4.7% year-over-year reduction in CASM due to both fuel and non-fuel savings.

Recently, Volaris has had to offer even deeper discounts than it has historically due to a combination of slow economic growth in Mexico and more price competition from Aeromexico. While this has had a short-term impact on profitability, it is stimulating even more demand for air travel in Mexico, which is good for Volaris in the long run.

Moreover, Aeromexico cannot keep up its recent fare war. On the recent Volaris conference call, the company's management team pointed out that Aeromexico's domestic operating margin has plummeted from 16.1% in Q3 2011 to just 2.5% in Q3 2013. Clearly, Aeromexico is hurting much more than Volaris from the competitive environment.

Looking ahead
There are a few positive factors that should drive continued earnings growth for Volaris. First, the company has identified plenty of new markets that it can enter over time, and management is planning for a high-teens capacity growth rate.

Second, Volaris recently implemented a new reservations system that will reduce distribution costs by up to 50%. The new system has also enabled Volaris to start charging passengers for carry-on baggage. This practice was pioneered by Spirit in the U.S., and has since become a standard feature of U.S. ultra-low-cost carriers. This move will allow Volaris to make money with even lower base fares, helping it to continue to stimulate demand.

Foolish bottom line
Volaris is in a great position to dominate the Mexican air travel market over the long term. The ultra-low-cost-carrier model is already catching on, and as more Mexicans move into the middle class, demand for low-cost air travel is likely to skyrocket. Volaris already holds 23% of the domestic market, and that market share will continue to grow rapidly.

While I think Spirit Airlines is a great investment opportunity, too, Americans tend to have more disposable income and may be more likely to pay extra for an airline that offers more leg room, free carry-on baggage, etc. Despite all its growth, Spirit represents only 1% of the U.S. airline industry by revenue.

By contrast, Volaris has the opportunity to become a Ryanair of Mexico (or even, more broadly, Latin America). In a few decades, Volaris may be a ubiquitous presence in Latin America, due to its industry-leading, low-cost structure and position as the low-fare leader in a major developing economy. That's why Volaris may be the best airline out there for growth-oriented investors.

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