A Low-Cost Carrier with High-Flying Growth

Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. –Warren Buffett on airlines

Like most investors, my reflexive avoidance of commercial airline stocks stems from what seems to be their near-constant flirtation with bankruptcy. And these days, airlines must not only manage both high labor and capital costs, they also face commodity risk from volatile jet fuel prices.

So when an airline kept popping up on a screen I routinely run to find firms with high-quality management teams, I simply ignored it. But ultimately, curiosity got the better of me, and I decided to see what analysts were projecting for future earnings. And that’s when I underwent an attitude adjustment.

Low-cost airline Allegiant Travel Co (NSDQ: ALGT) specializes in scheduled flights from small cities to prime leisure destinations ranging from Las Vegas to Orlando. And similar to other airlines that have adapted their services to compete with online travel agency sites such as Travelocity, the company enables vacationers to save even more by bundling hotel reservations and car rentals with their flight booking.

Although the small-cap stock has a market cap of just $1.4 billion, it’s tracked by 16 different Wall Street analysts, with nine rating the stock a “buy,” six a “hold,” and one a “sell.” Their consensus estimate for year-over-year revenue growth is 10 percent for 2013 and 20 percent for 2014, while earnings are expected to jump almost 30 percent this year and nearly 20 percent the next.

But before I saw those figures, Allegiant caught my eye because it has significant inside ownership and high returns on invested capital–two characteristics that suggest management’s interests are aligned with shareholders and executives are skillfully allocating capital. Insiders own almost 21 percent of shares outstanding, with Chairman and CEO Maurice Gallagher, Jr. holding just over 20 percent of shares outstanding.

Gallagher became majority owner in 2001 after a career as a serial entrepreneur and investor in both the airline and telecommunications industries. Gallagher’s performance as an owner/manager is decidedly checkered.

Checkered Past

As one of the founders of the former WestAir, he helped build the company into one of the nation’s largest regional air carriers during the mid- to-late 1980s. But due to overexpansion, the airline industry suffered greatly during the early ‘90s recession, and WestAir was forced to pursue aggressive cost-cutting measures to stave off bankruptcy. Unfortunately, the company continued to lose money and it was just days away from bankruptcy court when Mesa Airlines acquired the company in May 1992.

Gallagher then went on to co-found ValuJet in 1993, serving as vice chairman of its board of directors. The low-cost carrier soon became the fastest-growing and most profitable company in the industry. But one of the components of its financial success ultimately led to tragedy. The company attempted to save money by buying an aging fleet of DC-9s, which at an average age of 25 years gave it the second-oldest fleet in the industry. It also outsourced repairs and maintenance to 21 different companies.

One of its contractors improperly labeled a box of old oxygen generators and loaded it onto a ValuJet plane. That sparked the fire on flight 592 that caused it to crash into the Florida Everglades, killing everyone on board. The troubled firm then merged with a smaller regional carrier and did business for a number of years under the AirTran brand.

Thereafter, Gallagher founded Mpower Communications Corp. He served as acting CEO of the Las Vegas competitive local exchange carrier (CLEC) from 1997 to 1999, as well as chairman of the board from the company’s inception until its Chapter 11 bankruptcy filing in 2002. Similar to what happened to the airline industry in the prior decade, telecom firms went on a debt-fueled expansion during the late-‘90s bubble and were ill-prepared to endure the ensuing recession.

More recently, Gallagher served as chairman of CommPartners Holding Corp, until its 2010 chapter 11 filing. The telecom wholesaler’s business was rocked by the 2008-09 global recession, and its fortunes waned further once large carriers were able to connect with each other directly rather than use the company as a middleman for such services. It was subsequently acquired in 2011 by Momentum Telecom.

The common thread among these stories is that Gallagher does an outstanding job when a young company is in growth mode during an economic upswing, but does a poor job guiding a company through industry and economic turmoil.

However, Allegiant offers an interesting twist on Gallagher’s usual scenario. This time around, Gallagher played the role of deep-pocketed suitor to a troubled company. In 2001, the airline was in bankruptcy court, and Gallagher was the company’s largest creditor. He acquired the company out of bankruptcy, becoming its CEO in 2003 and chairman of the board in 2006.

Since the company’s initial public offering in late 2006, the stock is up almost 211 percent versus the S&P 500’s return of almost 21 percent. Although Allegiant does not pay a regular dividend, this return includes the reinvestment of two special dividends over the years, including a $2 payout this past December.

Even more impressive, the stock gained over 51 percent in 2008 at the height of the bear market, when the S&P lost 37 percent and airline industry stocks dropped almost 44 percent.

This latter detail is especially noteworthy given the fact that Gallagher’s previous ventures tend to falter once the economy tanks. In fact, upon reporting its fourth-quarter earnings results, the company celebrated its 40th profitable quarter, despite record fuel costs.

Like Gallagher’s earlier low-cost airline ventures, Allegiant has a fleet that’s far older than both the major carriers and many of its low-cost peers. As of late November, the average age of the airline’s 66 active planes was 22.8 years, while the fleets of its three main low-cost competitors averaged 7.2 years in 2011.

And based on the usual valuation metrics, shares of Allegiant appear to trade at a premium relative to the other four North American low-cost carriers. Indeed, JetBlue Airways Corp (NSDQ: JBLU) appears to offer the best value among these firms as measured by its forward price-to-earnings ratio (P/E) of 8–its trailing 12-month P/E is 14.5. By comparison, Allegiant’s current P/E is 18.4, while its forward P/E is 11.6

But Allegiant has a lower short interest ratio than JetBlue–nine days’ worth of its trading volume is held short versus almost 12 days for JetBlue.

Labor Pains

After JetBlue, Southwest Airlines Co (NYSE: LUV) has the next best forward P/E among the low-cost carriers: 9.4. But its workforce has the highest percentage of unionized employees among these five companies. Roughly 82 percent of Southwest’s employees belong to a union, while neither Allegiant nor JetBlue currently have employees under union contract.

That can lead to a big difference as far as operating costs go. While employee compensation and benefits account for 29.2 percent of Southwest’s costs, they’re just 22.6 percent of JetBlue’s costs and a paltry 17.3 percent of Allegiant’s costs.

And given this candid observation in 2011, Gallagher is no fan of unions:

“In this industry and others that are heavily unionized, you ultimately end up with bankruptcy as the primary driver.”

Later, he added, “Unionization is one of those things that clogs the arteries and makes you less quick and not as nimble as you need to be on top of your game.”

But it’s only a matter of time until Allegiant becomes unionized. In fact, a majority of the company’s flight attendants signed union cards back in 2010, and more than two years later the negotiations for their first contract are still underway. Meanwhile, the company’s pilots voted for union representation in August of last year.

Once these two groups finally have contracts in place, that will mean about half of the company’s employees work under a union contract. While that will certainly increase the company’s labor costs, it may not push them as high as they are at Southwest. For example, about 52 percent of Spirit Airlines’ (NSDQ: SAVE) employees are unionized, but the company’s compensation and benefits account for a comparatively lean 19.6 percent of operating costs.

Competitive Edge

Allegiant’s primary edge over its low-cost peers is that it offers direct flights from underserved markets where it has little to no competition. Indeed, it faces competition on just 17 routes among the 198 it offers between small cities and 13 leisure destinations. That leaves the firm with a monopoly on almost 86 percent of its routes.

Its focus on small cities could eventually pose a challenge to the airline’s efforts to expand to international markets such as Mexico and Canada. Many of the small airports Allegiant serves don’t have customs clearance, which means return flights from international destinations would require layovers at gateway airports.

For now, ancillary fees offer major growth opportunities. And the firm’s bundled vacations are a deal for both passenger and carrier alike. As a wholesaler of bookings for hotels, car rentals and even shows, the company has no inventory risk and enjoys high margins–these deals accounted for 29 percent of the firm’s pre-tax income over the past 12 months.

As evidenced by the company’s name, its long-term strategy is to become a travel agent that happens to offer air service. But that can’t truly start happening until its brand recognition increases.

In the meantime, that gets us to Allegiant’s other fee-related edge–its willingness to push products and services that generate ancillary fees. And though these hardly earn goodwill from passengers, many consumers have now been conditioned to accept such charges when flying.

These fees also serve to cushion against drops in other sources of revenue. While Allegiant’s average fare dropped 3.3 percent year over year in the fourth quarter, its ancillary air-related charges jumped 26.6 percent, accounting for nearly 30 percent of its average income from each customer.

That may sound high already, but relative to competitors such as Spirit, the company may have room to grow. In the third quarter of 2012, for instance, Spirit earned $49.81 per customer from such fees, compared to $37.05 for Allegiant.

Finally, Allegiant boasts a strong balance sheet. At year-end, it had $352.7 million in cash and just $150.9 million in debt.

Even with unionization looming as a headwind, it looks like Gallagher has learned numerous lessons from his earlier stints in the airline industry. He’s also astute at managing analyst expectations. The company has surprised on earnings for eight consecutive quarters. 

But given the nature of the industry itself, it’s difficult to see Allegiant as a long-term holding. When even legendary investors such as Warren Buffett have almost been burned by airline investments, caution is most definitely warranted. In 1989, Buffett was enticed by US Air’s high revenue growth and invested $358 million in the airline’s preferred stock. At the time, he also had high praise for the airline’s management team. For a lengthy period, this was a losing bet, though it ultimately worked out in the end:

As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

Given all these caveats, I can’t see Allegiant as anything more than a short- to medium-term play for aggressive small-cap investors. Its shares currently trade near $74.30, down about 5.8 percent from its 52-week high. Analysts’ target price for the stock over the next 12 months is $82.64.

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