Please ensure Javascript is enabled for purposes of website accessibility

Here's More Proof of Airline Investors' Irrationality

By Adam Levine-Weinberg – Feb 28, 2016 at 10:15AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Too many investors are overly focused on airlines' unit revenue trends rather than their profit growth.

The behavior of airline stocks over the past year has been puzzling for investors. Airline profits have soared to record highs thanks to low fuel prices. However, most airline stocks have struggled, as investors have become worried about unit revenue declines.

Many airline stocks have fallen in the past year despite strong profit growth. Photo: Spirit Airlines.

This reaction neglects the significant interplay between fuel prices and fares. When fuel prices decline, it encourages airlines to grow faster by adding flights that might not be profitable with higher fuel prices. Yet if fuel prices were to rebound in the next few years, airlines could bolster their unit revenue (and profitability) by cutting these same flights.

Nothing better showcases airline investors' irrational obsession with unit revenue than a comparison of ultra-low cost carriers (ULCCs) Spirit Airlines (SAVE -3.07%) and Volaris (VLRS -0.12%). Let's take a look.

Spirit plummets; Volaris rises
Spirit Airlines was one of the worst-performing airline stocks of 2015. Shares of the largest U.S. ULCC have lost 40% of their value in the past year. By contrast, shares of Mexican ULCC Volaris have more than doubled in the past year, leading the industry.

VLRS Chart

Spirit Airlines vs. Volaris Stock Performance; data by YCharts.

The two airlines share very similar business models, built around minimizing unit costs, filling planes with low base fares, and making money on a variety of fees for optional add-ons.

To some extent, the vast divergence in stock performance between Spirit and Volaris last year was just correcting big moves in the opposite direction during 2014. That said, as of Thursday, Volaris shares traded for 13.6 times trailing operating income: a substantial premium to Spirit Airlines at 6.7 times trailing operating income. Clearly, investors are a lot more positive about Volaris than Spirit Airlines right now.

The stocks are driven by unit revenue performance
It's not too hard to figure out why investors have been dumping Spirit Airlines while snapping up shares of Volaris. Spirit Airlines posted sharp unit revenue declines during 2015, whereas Volaris delivered consistent unit revenue growth.

For the full year, Spirit Airlines' total unit revenue declined 14.7% year over year. In Q4, its unit revenue declined 16.0%. Meanwhile, Volaris reported a 9% total unit revenue increase for the full year, with a smaller 2.8% gain in Q4 2015.

What unit revenue gains?
The ironic thing is that from the prospective of a U.S.-based investor, Volaris hasn't actually been growing unit revenue lately. As a Mexico-based company, Volaris reports its results in pesos, but the Mexican peso has declined drastically against the dollar in the past year and a half.

In dollar terms, Volaris' unit revenue is declining. Photo: The Motley Fool.

The weak peso means that Mexican airlines haven't faced the same amount of (local currency) pricing pressure as U.S. airlines. Fuel costs haven't fallen as much when measured in pesos, while other dollar-denominated expenses such as aircraft rent and maintenance costs have increased sharply.

On a dollar basis, Volaris' total unit revenue declined roughly 7% for the full year, from $0.081 to $0.075. For Q4 specifically, on a dollar basis, total unit revenue fell approximately 12% year over year, from $0.089 to $0.078.

Thus, measured in dollars, Volaris' unit revenue is falling. Nevertheless, Spirit and Volaris have both posted profit growth by reducing their dollar-denominated costs, helped by lower fuel prices. The biggest difference between the two is that Volaris' profit growth is showing up on the unit revenue line in its financial statements because of the weak peso.

Use the irrationality to your advantage
There's no rational reason for the massive divergence between Spirit Airlines' and Volaris' stock performance: It's all driven by perception. Volaris seems to be doing better from a revenue perspective, so its stock is outperforming.

The key takeaway is that many of the airlines that have reported big unit revenue declines -- not just Spirit Airlines -- are irrationally undervalued right now. Patient investors should consider buying these stocks while they're extremely cheap and waiting for Mr. Market to come to his senses.

Adam Levine-Weinberg owns shares of Volaris and Spirit Airlines. Adam Levine-Weinberg is long June 2016 $12.5 calls on Volaris, short June 2016 $20 calls on Volaris, and long June 2016 $30 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines. 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.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Spirit Airlines Stock Quote
Spirit Airlines
$19.55 (-3.07%) $0.62
Controladora Vuela Compañia de Aviación Stock Quote
Controladora Vuela Compañia de Aviación
$8.12 (-0.12%) $0.01

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 10/05/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.