It took me quite some time to warm up to Allegiant Travel (NASDAQ:ALGT) (43.71, $874mm market cap), the Las Vegas-based airline operator and provider of other travel services. After all, I practically preach that the consumer of tomorrow won't be spending anything like the consumer of the past. Leisure travel is one of those areas that will likely struggle in the scenario I envision. Nevertheless, I see ALGT as poised to do very well whether the consumer retrenches or returns.
Another reason I was slow to embrace the story is that it operates an airline. While I have had a long-term respect and appreciation for Southwest Airlines (NYSE:LUV), I view the airline industry as perhaps even worse than the auto industry. For me to buy into an airline story, it has to be unique. Having read public filings and other company information, listened to conference calls and crunched a few numbers, I find that this is not your typical airline.
Before their recent report, I started a position and then added to it following the report on modest weakness. I also added it to my Top 20 Model Portfolio. The stock certainly isn't for everyone. An investor should consider it only if they appreciate the following characteristics:
- Net cash on the balance sheet
- Positive FCF generation
- Terrific management alignment with shareholder interest
- Business model built upon profitable growth
- Underserved markets with limited competition
- Strong unit demand growth
- Adjacent market expansion
- Low valuation
- High short-interest
What is Allegiant Travel?
A look at this company must start with the people behind it. CEO and Chairman Maurice Gallagher, who owns 21% of the company, is a serial entrepreneur who ran WestAir in the 80s (Mesa acquired) and was a founder of ValuJet (AirTran predecessor) before forming the CLEC MPower in the late 90s. He was a lender to the original Allegiant Air, which, after bankruptcy, emerged in its current form with Gallagher as a major equity holder.
He has surrounded himself on his Board of Directors and his senior management team with people from his prior companies, so the team is more cohesive than one might normally expect for a relatively new company. Gallagher earns no salary and receives a cash bonus , like other senior managers, only if operating income exceeds 5% of sales. He has taken total cash compensation of $100K per year for the past two years.
The company owns and leases a fleet of MD80s that serve to fly leisure travelers from small cities to leisure destinations such as Las Vegas, Phoenix, Florida and, more recently, Southern California. Their service is non-stop and not frequent, allowing them to have very high capacity on these big planes. Every sale they make is direct to the consumer. Beyond air fares, which are extremely low, the company generates ancillary revenue from both add-ons (insurance, baggage, assigned seats and in-flight products) as well as hotel, rental car and attraction bookings. This ancillary service revenue is about 1/4 of overall non-charter sales.
This is not your typical airline. Note several factors that serve to differentiate, including limited service, exclusive focus on the leisure traveler in small cities, low prices, and ancillary revenues that come from the philosophy of selling the entire leisure experience rather than just the transportation element. When one thinks about the business model, it is very much focused on efficiency, similar to cruise lines but with much lower capital investment. They price the planes to fill.
Their major expense is fuel (see below), but there are other expenses that are highly variable. Unlike other airlines, since they own very inexpensive planes and have so much variable cost, they can take advantage of flexibility to balance fares, input costs and route capacity. In seasons of lower leisure travel, they charter their planes to the military, always focusing on getting the highest EPS per plane possible. One has to appreciate the very limited competition that they face directly. The real competition is the willingness of the leisure traveler to drive to a different city and/or to endure multiple stops.
What makes the investment work?
When one looks at ALGT, it has successfully navigated an extreme spike in its largest input cost, fuel. Sales have grown 17% over the past year despite significant erosion in fares as well as some recent challenges to its ancillary revenues. EPS have grown at a 32% rate over the past 5 years.
The growth has been driven by the addition of new markets, increased penetration of existing markets, its ancillary revenue stream and improvement in its cost structure (ex-fuel) as it achieves scale. The company has more origination cities as well as potential destinations to add to its network. In a continued soft economic environment, the high value offering to consumers as well as a potentially increasing role the company plays to the downstream or "on-the-ground" service providers (car, hotel, attractions) bodes well for unit demand and the potential for robust ancillary revenue capture.
The company's financials are very strong, with equity (mainly its fleet investment) of $257mm (as of 3/31 - waiting for 10-Q this week). Total debt is $61mm, with cash of $228mm ($133mm net of future travel liability). Again, not one's typical airline expectations! The company generates FCF. Total Capex this year is expected to be $35mm, down sharply from the past two years but in line with D&A. The company uses its capital very wisely, recently buying some planes as cadavers for their parts. As of Q2, it has also repurchased $17.6mm of stock at an average cost of 37.79.
So, what makes the investment work is that the market begins to appreciate better both the operating model as well as the capital allocation decisions that management makes (not surprisingly given the huge amount of skin in the game). I think that the company can continue to succeed in both a challenging economy as well as in one that improves. In the weak economy, their value appeal as well as their continued share gains works, while an improved fare environment in a recovering economy would be beneficial.
What are the risks?
The stock has a massive short-interest, reported as of 7/15 at 6mm shares (15 days of trading volume and 30% of all shares), which is down from 9mm in April but still quite high given that insiders own almost 25% of the company and 5 institutions own another 50% (as of 3/31).
There are no convertible securities that would offset this massive bet. Why are these folks so concerned? FUEL PRICE RISK. There may be a few other reasons, such as a macro bet against Las Vegas and concerns about the aged fleet and the potential for higher maintenance costs down the road or additional capex to upgrade, but judging from the questions on the last call, many are wondering why the company doesn't hedge.
CFO Levy reminded that the company historically has hedged and may again in the future. While I think I get it, it appears that many others don't understand or agree with the company's position that it has a natural hedge in fare pricing. In a stronger economy, while fuel prices may edge up, fares should too. In a protracted weaker economy, pressure will stay on fares (but they are already extremely low), but fuel prices should fall.
Additionally, the company can control its risk by cutting flights. Unlike more traditional airlines, they don't have to fly at a loss. Funny, though, all these other airlines started hedging when fuel prices were quite high for the most part. There doesn't seem to be an example of a profitable airline over the long haul (except LUV), so I question the traditional thinking of hedging.
I looked into jet fuel prices. After all, if they are really "low", it would seem foolish to not lock in. What I found are that they aren't low and that locking in is quite expensive from what I can gather. First, here is a chart (click to enlarge) of Jet Fuel prices (courtesy of IATA - www.iata.org):
Note that prices have increased by about 33% over the past six months. This index, by the way, begins in 2000 and 100 is equivalent to 0.87 per gallon. For a longer-term perspective in comparison to oil (click to enlarge):
It appears that the prices, not surprisingly, track oil fairly closely. From what I understand, there are no jet fuel futures. To hedge, one would buy forward oil prices or perhaps heating oil from what I have learned. The problem now is that both of these markets are in massive contango - the future prices far exceed today's price. I have a chart (click to enlarge) that demonstrates the relationship traditionally as being a discount, which makes sense unless the spot price is temporarily depressed:
As you can see, for both crude oil and the refined product, the current price for the near-term future and one-year out requires the buyer to pay a 10% premium, while the typical relationship has been a discount. The company didn't discuss this dynamic, but I would expect that part of why they aren't hedging is that the expense is astronomical. No one knows how the dynamic between fares and fuel costs will play out, but I believe that this "risk" could prove to be an opportunity. The chart below (click to enlarge) shows the possible outcomes for fares and fuel prices:
While clearly rising jet fuel prices and flat or falling air fares is potentially problematic, the company wins in the opposite scenario as well as in avoiding hedging costs in flat fuel price environments. In a continued weak economy, it could be that fares don't fall much further as capacity in general comes out due to bankruptcies or consolidations, while fuel prices might be under pressure. Traditionally, airlines have been able to revive themselves after bankruptcy, but today's credit crunch has changed that dynamic. Also, it is more difficult for new entrants to come into the market these days. In a stronger economy, while fuel prices might rise (and might not), it would seem that air fares could go up. This is an industry that won't forever fly people at a loss!
I believe that the company is essentially internally hedged and shouldn't hedge unless fuel prices get "low" relative to the fare structure. I suggest that those who fear this risk consider hedging it themselves by purchasing an E&P company leveraged to oil or oil itself.
What's it worth?
What's appealing about high growth and low PE stocks like ALGT is that there are two ways to win. On one hand, the PE can expand as investors become more appreciative of the business model and risks. On the other hand, continued earnings can grow the stock even if the multiple doesn't expand.
I think both can happen here. Analysts project that earnings will more than double this year, but they don't have great expectations for 2010 or 2011. I believe that they are missing the strong unit growth despite unfavorable fares as well as other challenges and have a more optimistic view of the out years. Clearly, they don't expect margins to stay this high. Rather than argue that point, I propose that multiple expansion potential alone justifies investment, with higher EPS a potential kicker that gets a much higher return. In the chart below, it is clear that the company trades at a low valuation: 10.5 PE and <5X trailing EV/EBITDA (7X adjusting for advanced purchases). I believe that the market fails to take into account the growth potential and the strong balance sheet and treats this company like a more typical airline.
I have a 65 target for a year from now (up about 50%) due to primarily multiple expansion from 10.5X to a more appropriate 15X (using consensus estimates, though they might prove to be too low). Note that the median PE since the IPO has been closer to 17X. I also arrive at a similar target based upon a sales metric. I expect that sales will grow at least in line with current forecasts of 19%. That would yield June 2010 trailing sales of $631mm. Assuming an EV/Sales ratio of 1.7X(just above the median) and adding back net cash of $200mm a year from now, the enterprise value would be $1.07 billion implying an equity value of $1.27 billion ($64 per share).
Of course, this would be an all-time high for the relatively young stock and a double off of the recent March low. Not too much of a stretch from panic evaluations for a company that has superior growth characteristics and a strong balance sheet. As you can see in the chart below (click to enlarge), the stock has acted a bit out of sync with the market lately, but it has been a relatively strong performer despite the recent pullback.
The way I look at it is that investors hung with this one as fuel prices escalated in 2008 (it was a market performer), and then breathed a sigh of collective relief when the madness stopped. Net-net, it has survived that major challenge as well as an absolutely terrible overall consumer spending environment, generating strong growth and beating the market soundly. I expect that 40 should hold as support and look forward to seeing the shorts potentially reconsidering their large bet against this company.
By the way, yes I see the potential "Head & Shoulders" formation and will be watching closely for a break of 40.
Disclosure: Long in an account I manage as well as in my Top 20 Model Portfolio