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This Airline Could Become a COVID-19 Winner

By Adam Levine-Weinberg - Updated Aug 4, 2020 at 5:02PM

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Two of the top three airlines in Mexico are facing severe financial distress due to the COVID-19 pandemic -- leaving a big opportunity for their largest competitor.

The COVID-19 pandemic has been a disaster for most passenger airlines. Air travel demand has plunged due to travel restrictions, virus fears, and the economic disruption brought on by the pandemic. With substantial fixed costs, most airlines haven't come close to offsetting their revenue losses in 2020.

In the short run, Mexican budget airline Volaris (VLRS 1.88%) hasn't been spared from this industry downturn. That said, Volaris is sustaining far less damage than its competitors, which could help it make permanent market share gains in Mexico.

A surprisingly decent first-half performance

Mexico was slower to shut down than many other countries. As a result, Volaris was able to grow unit revenue and improve its profitability year over year in the first quarter, logging a 3.9% operating margin.

Conditions deteriorated in the second quarter. In late July, Volaris reported that revenue fell more than 80% year over year last quarter on a 76.6% capacity reduction. As a result, the company posted a 2.3 billion peso ($102 million) operating loss. This brought its operating loss for the first six months of the year to 2 billion pesos ($89 million).

Nevertheless, Volaris was able to sharply limit cash burn last quarter by negotiating payment deferrals for various contracts and incentivizing customers to accept travel vouchers in lieu of refunds. It has also reached an agreement with Airbus to defer 20 aircraft deliveries from the next few years to 2027 and 2028, which will save $200 million of predelivery payments between 2020 and 2022. In fact, adjusted free cash flow was close to breakeven in the first half of 2020.

A Volaris plane touching down on a runway

Image source: Volaris.

Demand is already starting to return, particularly in the "visiting friends and relatives" (VFR) and leisure segments that make up the majority of Volaris' business. In August, the airline plans to operate 70% of its originally scheduled capacity: up from 11% in May, 37% in June, and 55% in July.

Competitors are in deep trouble

Volaris' main rivals were much weaker coming into 2020, so they have been hurt far more by the COVID-19 pandemic. Mexican flag carrier Aeromexico filed for bankruptcy on June 30 and is using the Chapter 11 process to shrink. It has already rejected the leases for 19 aircraft, representing about 15% of its fleet. This cements Aeromexico's transition to focus almost exclusively on international travel and domestic business travel.

If anything, Interjet -- until recently the third-largest airline in Mexico -- is in even worse shape. While it hasn't filed for bankruptcy, the vast majority of its fleet has been repossessed by aircraft lessors. This has left Interjet operating a skeleton schedule. And while the company announced a $150 million capital injection last month, that may not be enough to save it. Interjet has a big pile of unpaid bills and now faces a new class action lawsuit from customers accusing it of fraud. Even if Interjet manages to avoid collapse, it will be a shell of its former self.

Prior to the pandemic, Aeromexico and Interjet dominated slot-controlled Mexico City International Airport. With both incumbents shrinking, Volaris is seizing the opportunity to grow in that valuable market. It announced five new domestic routes out of Mexico City in June; three have already started service, with the other two set to begin in October.

Volaris will come out stronger

Volaris ended the second quarter with 10 billion pesos ($436 million) of cash on its balance sheet: nearly double the size of its debt load (excluding lease liabilities). This net cash position will enable Volaris to be aggressive and capitalize on rivals' weaknesses to make long-term market share gains.

That's not to say management will be foolhardy. Volaris is taking a relatively cautious approach to growth in the current market environment. It currently expects to end 2020 with 87 aircraft in its fleet -- up from 82 at the beginning of the year -- and to maintain its fleet at that size until at least 2023. Previously, the budget airline had planned to expand its fleet to 105 aircraft by the end of 2022.

Still, this means that Volaris will be larger over the next few years than it was in 2019, whereas its two main rivals will be significantly smaller (and Interjet could shut down entirely). Moreover, once demand returns in earnest, Volaris should be able to pivot back to aggressive growth quickly.

Last year, Volaris posted a $122 million pre-tax profit, excluding exchange rate fluctuations. With a net cash position and a market cap below $600 million, Volaris stock is primed to fly higher as the pandemic recedes in the years ahead.

Adam Levine-Weinberg owns shares of Volaris. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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