Is Volaris Beginning to Pull Out of a Dive?

Financial results at Mexican ultra-low cost carrier Volaris (NYSE: VLRS  ) have fallen sharply since the company made its stock market debut last fall. As a result, Volaris' stock price has plummeted by about 50% since its IPO day, leaving early investors on the runway.

VLRS Chart

Volaris Stock Chart, data by YCharts.

Volaris' recent troubles have been caused primarily by overcapacity in the Mexican air travel market. With several Mexican airlines trying to grow rapidly, weak economic growth has forced carriers to slash ticket prices. However, burgeoning demand should bring supply and demand back into balance in the near future. Volaris' industry-leading cost structure will help it prosper when that happens.

Weak fare environment may be improving
Excess capacity -- caused by a combination of rapid capacity growth and a slowdown in the Mexican economy -- began weighing down Volaris' results starting last fall. Total unit revenue fell by nearly 17% in Q4 2013, and then fell by 18% last quarter. This caused the company's net loss to swell from around $5 million in Q1 2013 to $28 million in Q1 2014.

On the company's recent conference call, CEO Enrique Beltranena stated that overcapacity has been particularly concentrated on some routes from Tijuana and Guadalajara. Volaris is reacting by scaling back its capacity on those routes. In its place, Volaris is adding flights from the U.S., where demand is stronger, while opening a new base in Monterrey.

As a result of these actions, unit revenue has started to improve. Volaris currently expects to post a double-digit sequential improvement in unit revenue in Q2, although unit revenue will still probably be down year over year.

Based on current trends, Volaris should be able to at least break even in Q2. Source: Volaris.

Meanwhile, unit costs should continue to decrease due to capacity growth and a mix shift to more efficient A320 aircraft instead of the smaller A319. This should be enough to bring Volaris from a -13.3% profit margin in Q1 to breakeven or a little better in Q2.

Capacity headwinds should moderate
While it's impossible to be sure about how Mexican airlines will manage capacity going forward, current trends seem favorable. Top Mexican carrier Aeromexico's fleet plan calls for modest growth in the next few years, and Aeromexico has the flexibility to reduce its fleet if necessary by not renewing leases for some aircraft.

For its part, Volaris plans to more than double capacity by 2020, but most of this growth will happen in the latter part of the decade. The current fleet plan calls for fairly modest growth from 44 planes at the end of 2013 to 54 at the end of 2016.

Among the other low-cost carriers, Interjet's growth is targeted in smaller markets that it will serve with the new 93-seat Sukhoi Superjet. This is a big threat for Aeromexico, but it should not impact Volaris very much. Lastly, VivaAerobus ordered 52 new A320-family aircraft last fall, charting a course for growth. However, for the next few years, these deliveries will replace older planes due to be retired, limiting capacity growth.

All in all, capacity growth in the Mexican market is on pace to moderate for the next two to three years. Meanwhile, economic growth and the continuing shift of luxury bus passengers to air travel should help bring supply and demand back into balance.

Unit costs will continue declining
While Volaris should benefit from improved pricing as demand catches up to capacity growth in the next year or two, it will also continue reducing its costs. Going forward, there are a few key initiatives that will push costs down. First, Volaris will add five seats to its A320 aircraft, which will reduce unit costs for that fleet type by about 2.7%.

Second, Volaris is replacing smaller A319s with the larger A320 and A321 models, which offer lower unit costs. This will increase the average gauge of its fleet from 160 seats in 2013 to 178 seats by 2018.

Third, fuel is by far Volaris' biggest cost, representing roughly 40% of all operating expenses. In 2012, Volaris ordered 30 A320neo aircraft from Airbus. New engine technology in these planes will provide a double-digit improvement in fuel efficiency. Earlier this year, Volaris signed an agreement to lease 16 more new engine aircraft. The introduction of these planes starting in 2016 will help Volaris reduce its unit costs significantly.

Foolish bottom line
As a Volaris shareholder, I am not too worried about the company's recent problems. The Mexican air travel market has huge long-term growth potential, so supply and demand are virtually guaranteed to come back into balance, whether it's later this year, in 2015, or in 2016. That said, Volaris is a fast-growing company in an unsettled market, so it is only an appropriate investment candidate for patient, risk-tolerant investors.

In the next five years or so, I believe Volaris can become as successful in Mexico as Spirit Airlines is in the U.S. That's a very enticing prospect for Volaris shareholders, as Spirit Airlines' market cap is six times higher than that of Volaris. It will take many years for Volaris to reach that point, but that's OK -- the potential gains would be well worth it.

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