Just two years ago, Mexican budget airline Volaris (NYSE:VLRS) seemed destined to become a reliable profit machine, just like many of its U.S. peers. However, the carrier's earnings plunged beginning in late 2016 due to a combination of overcapacity, rising fuel prices, and a weak Mexican peso.
This week, Volaris reported that profitability remained under pressure last quarter. The first quarter isn't shaping up to be any better. Management is working on a number of initiatives to drive costs lower while boosting unit revenue, but investors probably shouldn't expect to see meaningful improvement until the second half of 2018 and beyond.
Another subpar quarter
Volaris posted earnings per share of $0.28 for the fourth quarter, beating the average analyst estimate of $0.20. However, most of the company's income came from foreign exchange effects, rather than its operating results.
By contrast, its quarterly operating income plunged 75% year over year to just $6 million. Revenue per available seat mile slipped 6% year over year, whereas unit costs were roughly flat, causing severe margin compression. (Volaris had a meager operating margin of 1.8% last quarter, down from 7.3% a year earlier.)
On an absolute basis, Volaris' fourth-quarter performance was nothing to write home about. That said, operating margin had plunged 13.8% year over year in the first nine months of 2017, so at least it appears that the carrier is starting to stabilize its profitability.
For the first quarter, management actually expects a modest year-over-year operating margin increase. However, that's not a very ambitious goal: Volaris posted a negative 13.7% operating margin in the year-ago period. Additionally, it will benefit from favorable seasonality related to the timing of Easter in the first quarter of 2018.
How management is responding
Right now, unit revenue pressure is Volaris' main problem. U.S. carriers have added lots of capacity in beach markets and Mexico City since the U.S. and Mexico lifted limits on flights between the two countries in August 2016. Domestic industry capacity within Mexico is rising rapidly as well. This is driving fares down dramatically during nonpeak periods.
Volaris is doing its best to shore up unit revenue in this tough environment. As always, it is working to grow nonticket revenue so that it can afford to reduce fares. However, it's also rolling out some new initiatives. For example, it signed a codeshare agreement with Frontier Airlines last month.
This will have two benefits. First, Frontier will supply connecting traffic, allowing Volaris to serve passengers from markets like Minneapolis and Salt Lake City that couldn't support nonstop flights. Second, using Frontier Airlines as a sales channel for tickets on Volaris will allow the latter to capitalize on Frontier's greater name recognition in the U.S. Management thinks that the Frontier partnership could ultimately supply 2%-3% of the traffic on Volaris' transborder routes. It may not sound like much, but that's enough to have a big impact on profitability.
Moreover, Volaris plans to further diversify its route network as well. It launched a subsidiary in Central America in late 2016, and its Costa Rican subsidiary recently received approval to fly to the U.S. Volaris Costa Rica will start four U.S.-Central America routes this spring, tapping into a high-fare market that could be very profitable.
Volaris is also trying to push its unit costs even lower. CEO Enrique Beltranena mentioned on the company's conference call that management is working on more than 100 initiatives to reduce unit costs. The biggest opportunity by far relates to Volaris' fleet.
The carrier's fleet plan calls for retiring 13 of its older Airbus (NASDAQOTH:EADSY) A319s and A320s by the end of 2020 while taking delivery of 26 A320neos and six A321neos. The new models offer significantly lower fuel and maintenance costs. On top of that, most of the aircraft that Volaris will receive come from its own order book with Airbus, which generally means that pricing is better relative to planes that were ordered directly by aircraft leasing companies.
Furthermore, Volaris teamed up with three other affiliates of investment firm Indigo Partners to order 430 A320neo-series aircraft from Airbus in late 2017. (80 of those planes are for Volaris.) This will allow it to upgrade half of its fleet by 2026. The record-setting order also enabled Volaris to secure bigger discounts than it has received on its previous aircraft orders.
This turnaround will take a while
While there are some things that Volaris can do in the short term to bolster its profitability, the biggest opportunities will take longer to play out. For example, flying from Central America to the U.S. could be very lucrative in the long run, but even highly promising new routes can take months to turn profitable.
Meanwhile, the Frontier Airlines codeshare agreement won't go into effect until this summer. Thus, two of Volaris' most important revenue initiatives aren't likely to kick in until the second half of 2018 -- or even 2019.
Fleet renewal, the biggest cost opportunity, will have most of its impact years from now. Volaris has a lot of levers it can pull to reach its full potential over the long haul, but there's no quick fix to the rampant overcapacity in its current markets. Investors simply need to be patient.