Frontier Group Holdings (NASDAQ:ULCC) went public in an offering which has not been a great success. For investors in the airline sector, it is a balancing act between dismal current operating conditions and potential for booming earnings in the near term, that is after the much anticipated reopening takes place. That said, it feels as if investors in the entire sector have priced in quite some good news already, perhaps a bit too much to my taste.
Low Fares
Frontier Group is a so-called ultra low-cost carrier which has a strategy called ''low fares done right''. The company focuses heavily on the US and near international destinations which it serves with 104 narrow-body Airbus 320 planes, with a real roadmap to expand the fleet in the coming decade.
The company was acquired by Indigo Partners back in 2013, which reshaped the company following a number of key replacements resulting in a rather dramatic improvement in the operating performance. That is of course until February 2020 when the arrival of Covid-19 hit the airline sector almost like no other segment of the economy.
The company has three main bases in Denver, Orlando and Las Vegas, drawing significant numbers of leisure travelers (up to 90% of the clientele) as it serves routes to more than 110 airports from these bases. While the company has been hit hard by the pandemic, like the rest of the industry, the airline expects to benefit in a big manner from the anticipated recovery.
The company has incurred relatively little debt during these times and the company believes that leisure will rebound in a big way. Management, furthermore, believes that new working patterns and a mixture of working life and regular life results in more frequent and shorter trips, benefiting the domestic low-cost airline carriers.
Valuation & IPO Thoughts
Management and underwriters sold 30 million shares at the lower end of the preliminary price range of $19-$21 per share. Exactly half of the shares were sold by the company, generating $285 million in gross proceeds.
These proceeds come on top of the existing net cash holdings of $30 million, which results in a net cash position of around $280 million, according to my estimates. With a total share count of 215 million shares valued at the offer price, the company is awarded a $4.08 billion equity valuation. If we adjust for the net cash position, the business is valued at around $3.8 billion.
The company has seen solid operating performance ahead of the pandemic. Frontier generated $2.16 billion in sales in 2018 on which a $92 million operating profit was reported. Revenue rose 16% to $2.51 billion in 2019 as operating earnings rose sharply to $309 million that year.
Of course, the pandemic hit the company hard as sales were cut in half to $1.25 billion as this resulted in an operating loss of $365 million, despite $193 million CARES credits received by the company. The company has been hit hard with a big fixed cost component including aircraft rent. I, furthermore, notice that the number of departures fell only 37% as revenue fell amidst a dramatic decrease in the load factor at 67% (down 19 points compared to the year before).
If we look at the pandemic trends, it is obvious that the company is a long way from becoming profitable again. First quarter sales of $544 million were essentially equal to the first quarter of 2019. Sales collapsed to $194 million in the second quarter which typically is a stronger quarter for the airline given the leisure trends. Revenue recovered on a sequential basis to $245 million in the second quarter and $267 million in the third quarter, as the company continued to lose quite a bit of money during those quarters. Operating losses came in around $100 million a quarter, or just over a million a day!
With shares essentially trading flat on their first day of trading, the valuation discussions above remain intact. With a $3.8 billion operating asset valuation, the company is valued at around 1.5 times sales in 2019 and around 13 times operating earnings, while having a clean balance sheet.
Potential Risk
The biggest near term risk for the company is of course Covid-19, albeit said that existing net cash holdings give the company enough liquidity to continue to operate with a net cash position throughout 2021, even if the pandemic continues to strangle society during the entire year.
Other risks include the obvious factors such as rising environmental consciousness, a very competitive field from national carriers and other low-cost carriers, economic sensitivity and other exogenous factors such as volatile fuel prices, impact of extreme weather and, in the past of course, terrorism.
Peer Comparisons
The best way to compare Frontier is to see how it fared during normal times, as I take 2019 as a base case for that. If we look at the performance vs. Allegiant (ALGT) and Spirit (SAVE) the following picture emerges.
Allegiant currently supports a $5 billion enterprise valuation. With just over $1.8 billion in sales in 2019 the company is valued at 2.7 times sales, a much higher multiple than Frontier. Part of that premium is explained by the fact that its operations are vastly more profitable, as Allegiant reported an operating profit number of $364 million in 2019, for operating margins equal to 18% of sales!
As Frontier's margins were limited to 12% in 2019, Allegiant trades at a rather similar 13-14 times operating profit number for 2019. The optimism among investors, which allowed Frontier to go public, is evident within Allegiant's share price. In fact, shares of Allegiant trade at an all-time high and have risen approximately 30% above the pre-Covid-19 levels.
Spirit has seen a big recovery in the share price as well, but has not entirely recovered to pre-Covid-19 levels, in part because of significant dilution incurred during the pandemic. Of all these ultra low-cost carriers, the company is the biggest with $3.8 billion in sales in 2019 when it reported an operating profit of $501 million. Based on its performance the company trades around 1.5 times sales based on an enterprise basis and 11 times operating earnings as investors do not like the dilution incurred and net debt apparent on its balance sheet, placing the company at a disadvantage vs. its competitors.
Conclusion
After having drawn the conclusion that Frontier trades at largely similar valuation multiples as it two peers, I see no compelling reason to favor Frontier over its peers. In fact, the optimism reflected in the share price of all these players makes me a bit cautious. Given this dynamic, I do not think that shares look rather compelling here as they look fairly valued vs. peers, yet I fail to see great appeal for the sector at large here.
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