Last week, Virgin America (NASDAQ:VA) posted another quarter of strong profit growth, demonstrating the growing success of its high-tech, service-focused business model.
Adjusted net income soared more than 70% year over year to a record of $73.0 million. Virgin America's adjusted operating margin of 18.2% during Q3 was right in the middle of the pack in the U.S. airline industry. This is a huge accomplishment considering that Virgin America only turned profitable in 2013.
Virgin America's record profitability puts it in a good position to begin growing again after nearly three years of holding capacity roughly flat. Here's how the company plans to resume its growth while maintaining its newfound profitability.
Entering growth mode again
After a two-and-a-half-year period with essentially no growth, Virgin America received a new A320 in July, the first of 10 arriving in the span of one year. In total, these aircraft additions will increase Virgin America's capacity by nearly 20%.
Initially, Virgin America has used the new capacity coming on line to restore flights that it had cut a year earlier to free up capacity for a new focus city operation in Dallas. However, this week it launched a new destination with its first flight to Honolulu, Hawaii. Next month, it will supplement its daily San Francisco-Honolulu flight with daily San Francisco-Maui flights.
In 2016, Virgin America expects to continue focusing its growth in San Francisco. This will likely include increased frequencies on some short-haul West Coast markets, but Virgin America could also consider entering one or two additional new markets.
After 2016, Virgin America doesn't have any aircraft deliveries scheduled until 2020. However, the company plans to continue growing in the interim if market conditions remain favorable.
For this growth, the company would likely look to the leasing market. As Virgin America CFO Peter Hunt told me in a recent interview, aircraft lessors have ordered roughly 1,000 A320neo family aircraft, many of which are scheduled for delivery in the 2017-2019 time frame. Due to its growing profitability, Virgin America has become a preferred partner for aircraft leasing firms, so it should be able to get as many planes as it needs at competitive prices.
Squeezing out more profit on existing routes
Introducing fuel-efficient A320neos to the fleet and restarting growth should have a positive impact on Virgin America's bottom line. The company is focused on improving profitability throughout its route network, though.
To some extent, Virgin America will simply benefit from lower competitive capacity in the near future. During the past year, Virgin America's unit revenue has been dragged down by overcapacity on its routes at JFK Airport in New York and at Love Field in Dallas. By Q1, capacity is expected to decline 8% year over year on Virgin America's routes out of JFK and 5% year over year for its Love Field routes. That should support higher pricing.
Virgin America is also working to increase its ancillary revenue. CEO David Cush says that Virgin America has had a per-passenger deficit of $6-$7 relative to the legacy carriers for ancillary revenue. He attributes this primarily to technology limitations that prevented Virgin America from using variable pricing to maximize ancillary revenue.
However, Virgin America has recently implemented new tools from Sabre that support variable pricing and also allow it to sell ancillary products through online travel agencies and the global distribution systems used by many corporate clients. These new capabilities should allow Virgin America to catch up to peers in terms of ancillary revenue in the next few years.
Primed for more profit growth
Analysts are currently divided over whether Virgin America will be able to grow its earnings next year. Some appear to think that the company's return to growth will diminish its earnings, at least in the short run.
It's true that new routes can sometimes take a couple of years to turn profitable. However, the easing competitive capacity situation in Dallas and New York and Virgin America's ancillary revenue push will provide offsetting revenue tailwinds. Meanwhile, Virgin America's unit costs are on pace to decline again in 2016 due to incremental fuel cost savings and the youth and scale benefits of faster growth.
Finally, Virgin America will continue to benefit from its strong position and loyal following in the prosperous San Francisco market. That represents a foundation for years -- and possibly even decades -- of steady growth. All of these positives make Virgin America stock look very reasonably priced at just under eight times pre-tax earnings.
Adam Levine-Weinberg owns shares of Virgin America. The Motley Fool recommends Virgin America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.