Shareholders of Mexican budget airline Volaris (VLRS 1.47%) have endured a wild ride over the past few years. Extreme volatility in the company's profitability has led to equally extreme volatility in its stock price.
Indeed, after a much-hyped IPO back in 2013, the stock quickly lost half of its value. Volaris stock subsequently tripled between late 2014 and early 2016, but it has now given back nearly all of those gains, returning to single-digit territory.
That said, 2018 could be a bounce-back year for Volaris. Furthermore, the company's efforts to improve its cost structure, diversify its revenue base, and reduce its exposure to fuel price and currency volatility could lead to more stable profitability in the future.
Sabotaged by external events
Volaris' profitability has plunged over the past year or so. For the first nine months of 2017, the company's operating margin was -0.5%, compared to 13.3% in the same period of 2016. Overcapacity and rising fuel prices played a role in this margin collapse. However, two other unusual factors caused most of the damage.
First, in early 2017, the Trump administration's immigration crackdown and its aggressive rhetoric toward Mexico caused a sharp drop in travel demand for many of Volaris' transborder routes. To make matters worse, the peso's value plunged against the dollar after President Trump was elected, due to his plan to crack down on imports from Mexico. A weak peso drives up Volaris' dollar-denominated expenses, including jet fuel, aircraft rent, and maintenance costs.
Second, natural disasters undermined a budding recovery during the third quarter. Within the span of a month, several of Volaris' key international markets were hit by major hurricanes, and a large earthquake rocked Mexico City. These natural disasters delayed Volaris' revenue recovery.
Conditions are improving
Fortunately, industry conditions are already improving. Earlier this month, Volaris increased its fourth-quarter guidance. The company now expects its Q4 adjusted earnings before interest, taxes, depreciation, amortization, and rent (EBITDAR) to be between 27% and 29% of revenue. That's 1 to 2 percentage points ahead of Volaris' previous outlook, but still down from its 34.1% EBITDAR margin a year earlier.
Looking ahead to 2018, fare levels could improve significantly, as year-over-year comparisons will be extremely easy (especially in the first half of the year). Meanwhile, recent changes to Mexico's bag fee regulations should enable solid nonticket revenue growth.
On the cost side, Volaris is on pace to benefit from a significantly stronger peso in Q1. As for the rest of the year, exchange rates are likely to remain volatile, due to ongoing negotiations about the future of NAFTA.
At a more fundamental level, Volaris is revamping its fleet to reduce its fuel consumption -- and to a lesser extent, nonfuel unit costs. By the end of 2018, it will have 18 planes (23% of its fleet) with next-generation engine technology, up from just two as of last September. It is also retiring its least efficient planes (A319s) at a steady pace.
Building a more stable (and profitable) future
As Volaris revamps its fleet to become more fuel-efficient, it will gradually become less exposed to fuel price swings. The carrier has also taken other steps to reduce its earnings volatility.
For example, Volaris is adding new routes to the U.S. at a steady pace. In addition to providing geographical diversification, this increases Volaris' dollar-denominated revenue. (All of its tickets for flights to/from the U.S. are priced in dollars.) That in turn limits the impact of currency fluctuations on the company's profitability. Volaris recently signed a codeshare agreement with Frontier Airlines, which could enable further growth in the U.S.-Mexico market.
Furthermore, Volaris has created a subsidiary based in Costa Rica to serve routes in Central America -- and from Central America to Mexico and the U.S. There is much less competition in many of these markets than there is in Mexico. Last month, Volaris Costa Rica finally won approval to fly to the U.S. The first routes will launch this spring. This will further Volaris' goals of diversifying its route network and increasing its dollar-denominated revenue.
Volaris certainly faces its share of challenges. However, the improving revenue environment, new baggage fees, and the company's cost-reduction efforts could enable a turnaround in 2018. Looking beyond this year, Volaris' efforts to diversify geographically and increase its dollar-denominated revenue could make that turnaround sustainable.