Allegiant: Waiting For A Better Entry Point

| About: Allegiant Travel (ALGT)

Summary

Allegiant continues to enjoy peak margins as cost inflation and competitive pressure might reverse record margins.

While the valuation is cheap on current multiples, also given the great track record, there are headwinds as well.

If we factor in a long term reversal in margins and huge capital spending needs in the coming years, it is understandable why shares trade at low current multiples.

It should be said that a 40% pullback has increased the appeal of the shares, as I will be a buyer on further significant dips.

Allegiant Travel Company (ALGT) is an interesting airline which does not act as your "typical" airline business. As the wider airline industry has benefited from consolidation and lower fuel prices in recent years, Allegiant has been performing well for a long period of time.

The structural outperformance of the business is interesting to observe, as momentum for airline stocks has cooled down significantly in recent months.

While the only millionaire investor in the sector is the person who started out with a billion, given the competitive nature of the industry and its poor track record, I think that shares are worth a consideration.

Allegiant Travel's Business

Allegiant serves 342 routes with 85 aircraft as of this moment. These flights take place between roughly 90 small and medium sized cities and nearly 20 leisure destinations. While most airlines focus on hub to hub models and serve major cities, Allegiant deliberately targets these underserved markets. As a result, Allegiant does not face direct competition on roughly 80% of all its routes.

While this strong positioning gives the company pricing power, Allegiant has chosen to employ a low price model as it aims to boost margins by having great capacity utilization. It only flies 2 times a week to many of its destinations, and is able to show solid load factors on relative large planes as a result.

Continued growth requires a lot of capital as Allegiant is in the process of accelerating the retirement of its again MD-80 fleet. While it previously hoped to take these planes out of business in 2020/2021, it now hopes to take the large plane out of the fleet in 2019. This move should improve reliability, service levels and reduce operating costs.

The replacement of these planes as well as continued growth means that Allegiant has to accelerate the purchase of other planes. Allegiant has moved all of its pillar on the Airbus A319 and A320. These planes have better fuel efficiency and lower operating costs. While the company continues to buy used Airbus planes, Allegiant has a long way to go as still half of its fleet is comprised out of the MD-80 series at the current moment.

Incredible Growth

Allegiant has grown from a revenue base of just $250 million in 2006 to $1.3 billion on a trailing basis, even as lower fuel surcharges had a big dampening impact on reported sales growth in recent times. The company has been profitable in each year over the past decade, even during the economic crisis. Operating margins have swung violently, as they came in anywhere between 10 and 30% of sales.

Despite this impressive topline sales growth and related capital expenditures, Allegiant has maintained a flat outstanding share base as the balance sheet is strong as well.

Shares traded in a $15-$50 range for the period 2007 until 2012. From this moment in time, shares embarked on a huge momentum run which lasted several years. Shares hit the $100 mark in 2013 and peaked at nearly $240 in 2015.

Ever since, shares have been nearly cut in half to $130, as worries about competition and margins have hurt the overall sector. This is highlighted on the recent conference call, on which executives acknowledged that Spirit has expressed its desire to enter some of Allegiant's non-competitive routes as well.

The Business Model

Allegiant's business model is different from the normal as it focuses on small and medium sized underserved cities. Unlike most airlines it focuses on leisure travel over business travel, as the low-frequency flight schedule allows for great utilization numbers, even for larger planes. The company typically flies out and returns to a destination the same day, providing some comfort for its operating staff which can return to home at night.

All of this combined with a no frills and low-cost business approach made that the company is very distinguished versus most of its competitors. The no frills approach has some disadvantages as well. The company acquires planes with a minimum age of 10 years and refrains from buying new planes. As a result, it is likely that maintenance charges increase over time as Allegiant is more closely supervised by the FAA as well.

With prices being very low and fuel being pretty much a "fixed" costs versus competition, fuel swings have the potential to result in greater margin swings versus competition. Fuel costs fell from an average of roughly $50 per passenger in 2013 to just $20 in the recent quarter. This tailwind, although in part offset by pricing pressure, has resulted in the fact that operating margins currently come in at peak levels of 30%.

With 10-year average margins coming in at around 15%, investors should realize that current margins are not likely to be sustainable going forwards.

The Recent Quarter

Allegiant reported decent second quarter results last week. Sales for the first six months were up by 6.5% to $693 million, as margins improved further to exceed 32% of sales, as operating profits came in at $225 million. Net earnings came in at $133 million, equivalent to little over $8 per share.

The good news in the quarter is that the company signed a new 5 year contract with its pilots, resolving any potential labour issues. While the final details were not released, a new contract will likely place some pressure on the future profitability as will be discussed below. The company furthermore announced the purchase of another 12 A320s, destined to be delivered in the coming years.

These orders result in capital expenditures of an estimated $360 million this year. With depreciation and amortization charges still running at only $100 million this year, net investments of $260 million will "eat" pretty much all of the anticipated earnings.

Fortunately the balance sheet remains relatively strong as the company holds $434 million in cash, with debt standing at $630 million. This net debt load is equivalent to just $200 million.

Estimating The Potential

The real questions is what future margins can look like. Given that the new pilot agreement went into effect as of August 1, we can seen an immediate impact of the deal. Ex-fuel Costs per Available Seats Mile are expected to increase by 4-6% on an annual basis in the coming third quarter, driven by the new agreement.

Note that CASM came in at $8.58 cents in the third quarter of 2015, comprised out of $2.63 cents in fuel expenses and operating CASM of $5.95 cents per mile. A 4-6% increase for a 2 month period suggests that these costs will increase by 6-9% on an annual basis. I believe that this is equivalent to $11-$15 million in additional operating costs per quarter, or roughly $40-$60 million per year.

That could have an after-tax impact of roughly $25-$40 million which is significant at $1.50-$2.50 per share per year. That suggests a 4-5% headwind in terms of operating margins for the year to come.

This cost inflation and potential recovery in crude prices, alongside with competition could easily trigger a retreat from peak margins in the future. If we believe that the 10 year average margin of 15% is a sustainable number to work with, operating profits come in at just $225 million for a $1.5 billion business.

This exactly matches the operating profits being reported for the first half of this year, suggesting that profits of roughly $8 per share are sustainable in such a scenario. With shares trading at $130, even after having fallen $100 from the highs, shares would trade at 16 times "sustainable" earnings, not being a terribly cheap multiple for an airline.

What About CAPEX?

By the end of 2016, Allegiant anticipates to operate a combined 33 A319 and A320s. This is up by 7 compared to the Airbus fleet reported as of February of this year, with capital spending seen at $360 million this year. This math suggests that the average price of the used Airbus planes comes in at roughly $50 million per plane.

In order to expand from a fleet of 33 at the moment to 85 by 2019, cumulative capital spending needs would come in at roughly $2.5 billion in the coming three years.

This number might be exaggerated a bit as well however. Since Allegiant introduced the Airbus in 2013, cumulative capital spending totaled little over $1 billion, allowing it to reach its current fleet of 33. That suggests that a price of $30 million per plane might be more realistic. To add another 50 planes in the period 2017-2019, Allegiant might need to spend some $1.5 billion in the coming three years.

In either way, Allegiant has indicated that if capital spending needs become too large in the nearby future, it might resort to leasing alternatives as well in order to alleviate pressure on the balance sheet.

Final Thoughts

With Allegiant on track to earn roughly $15 per share in 2016, a price-earnings ratio of 8-9 seems like a no-brainer at the moment. This is certainly the case given the strong growth and healthy balance sheet. The reality learns that the situation is a bit more complicated than that.

Current earnings multiples do not reflect growth, but more importantly they are based on operating margins of around 30%, while margins roughly half of that seem more sustainable in my eyes. That leaves a price-earnings multiple of 16, which is still not very high for a business with such a great growth track record.

The issue is that growth will cost the business a lot as MD-80s will be retired in a relatively short time window. Estimating capital spending at $2 billion for the period 2017-2019, these charges are only offset by perhaps $500 million in depreciation charges and cumulative profits of $600-$700 million in this time period, assuming peak margins continue. in either case, net debt will continue to increase despite growth and record high profits as the proceeds for the sold MD-80s are not anticipated to be very material.

The rapid pace at which the company is moving to the A319/A320s thereby place lot of strain on the balance sheet, although Allegiant should be able to finance such growth, certainly if some planes will be leased. That said, the cash flow picture looks dire for the coming years, something which has to be taken into account in the valuation. If we assume 15% operating margins to be the standard, and factor in growth, earnings per share of $10 are sustainable. Given that cash flows are particularly poor in the coming years, and the company continues to operate in the volatile airline industry, I require a discount. A 10 times multiple on such earnings results in a targeted entry point of $100 per share, levels at which appeal becomes evident in my eyes.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.