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Allegiant’s Growth Model in Question

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Allegiant’s Growth Model in Question

Allegiant’s Growth Model in Question
February 03
09:02 2015

MIAMI — The parent company to U.S. ultra-low cost carrier (ULCC) Allegiant Air reported a $4.8 million net profit for the fourth quarter of 2014 last week, hit hard by a write down on its fleet of Boeing 757 aircraft. Excluding the impact of the 757 fleet, Allegiant’s net profit for the quarter was $32 million. For calendar year 2014, Allegiant recorded a net profit of $86.7 million ($113.3 excluding special items), down 6.1 percent year-over-year (YOY) and up 22.8 percent YOY excluding specials. The 757 write down manifested as a $43.3 million non-cash impairment charge.

The first thing to recognize is that Allegiant is still an incredibly profitable company growing at a rapid rate. This rapid growth is of course personified by the bevy of route additions and accompanying press releases, but also by the fact that Allegiant’s capacity growth, as measured in available seat miles (ASMs), rose 9.8 percent YOY for all of 2014 and 10.6 percent YOY for Q4.

Demand growth (measured in revenue passenger miles or RPMs) outpaced ASM growth in Q4 at 12.1 percent and matched it for the full year. 2014 operating profit (excluding the 757 charge) rose to $200.4 million, creating an operating margin of 17.2 percent (up from 15.5 percent) a year prior. Unit revenues grew on a stage length adjusted basis, and even the worrying trend in third-party revenues that I’ve been warning about for several quarters reversed itself, with hotel room night and rental car day production improving substantially once adjusted for network composition effects. But the adverse impact of the 757 fleet on headline profit numbers obfuscated this otherwise stellar quarter for all but the most careful observers.

With regards to the 757 charge, let me start by recapping the concept of a write-down. A write-down occurs when a company reduces the book value (value recorded on its balance sheet) of an asset because that asset is overvalued compared to the market value. For reasons of accounting, this change is recorded on income statements (a more famous example being the write-downs Delta took on its portfolio of fuel hedges, which count as assets, in Q4) and instead of being spread across the remaining time horizon of the asset (i.e. splitting the value of the write down across four quarters for an asset that is going to expire at the end of one year), the entire write down must be incurred in the quarter when the value of the asset changes materially.

As far as the reason for the reduction in the 757’s value, it primarily has to do with Allegiant’s decision to retire the fleet before the heavy S4C maintenance checks instead of flying them after those checks. Aircraft that require heavy maintenance are less attractive than ones that already have heavy maintenance completed because these checks are expensive (running roughly $1.5 million per aircraft, or $9 million across the fleet).

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(Credits: Eddie Maloney)

Demand for these 757s (one retired this year, two at the end of 2016, and three at the end of 2017) will be lower than Allegiant was planning for when it was going to do the heavy check and keep flying the airplanes, and accordingly, their value is lower as well. In fact, on the basis of a roughly five times cash flow valuation, the excess cash outlays for these aircraft of $9 million almost perfectly matches with a $43.3 million reduction in value. And commensurately for Allegiant, while its headline profit figures are harmed in the near term, the savings of a $9 million cash outlay for a fleet that is unprofitable anyway is an extremely positive long term financial outcome.

Beyond the 757, here were some other highlights from Allegiant’s quarterly earnings call:

  • Growth coming from increased utilization (frequency in existing markets) as opposed to new routes;
  • Q1 growth constrained by lack of pilot availability;
  • Reduction in fuel prices makes MD-80 economics more attractive, to the point that Allegiant is considering boosting utilization by 10 percent or even 13-14 percent (approaching six hours per day) with profitable flights on the margins;
  • Pilot productivity was down sharply in Q4;
  • TRASM growth affected by 9/11 security tax increase (from $2.50 to $5.60 per ticket), and increase in the convenience fee ($10-$13 per segment);
  • Expecting $1.80 per gallon gas prices in 2015 and more than $185 million in savings as a result;
  • Worried about labor groups and labor-related projects versus airline competitors;
  • Growth on East Coast (now up to 50 percent of scheduled service) is driving up rental car days;
  • Predominance of growth in 2015 will occur on East Coast;
  • Hotel days increased as a result of resolved contract issue. But hotel days most profitable in Vegas and Vegas is declining as a percentage of the network;
  • Michael Linenberg suggested a stock split to improve liquidity; and
  • Allegiant thinks demand in ND oil markets will shift when production declines, and as to date, that hasn’t happened yet.

There’s plenty of interesting color in there, but perhaps the most interesting comments are related to Allegiant’s plan for incremental growth in 2015, with lower fuel prices. Allegiant is talking a lot more recently about adding capacity/frequency in its existing markets, which distinguishes it sharply from ULCC peers Spirit Airlines and Frontier Airlines, which both are pursuing aggressive growth plans through adding new destinations.

Now clearly Allegiant has not saturated every possible market in the U.S. that can handle its business model, but it is certainly closer to saturation than it is to zero markets entered. And I don’t really see where this changes in the long run. International opportunities are not meaningful in terms of critical mass, and the Hawaiian gambit (even as Allegiant pledges to stay in the market) has proven to be a strategic mistake.

Even if the Airbus A319s and A320s that Allegiant will inevitably add to its fleet as the A320neo and 737 MAX hit the market en-masse can serve more markets efficiently than the MD-80s they will replace, they will not (as a whole) increase the number of markets viable to Allegiant by the 20 or 30 percent necessary to maintain current growth rates. The prospect of the Allegiant growth model really slowing down is still probably three-four years away, but it is food for thought.

 

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About Author

Vinay Bhaskara

Vinay Bhaskara

Senior Business Analyst, Big Airline Enthusiast, Avid Airport Connoisseur, Frequent Flyer, Globetrotter. I Miss Northwest Airlines Every Day. vinay@airwaysmag.com @TheABVinay

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