After the coronavirus pandemic triggered the sharpest economic contraction in modern American history, few imagined the stock market returning to all-time highs just months later. While unprecedented fiscal and monetary stimulus certainly played an important role in the rebound, perhaps more important was the reopening of the economy after a period of coronavirus lockdowns. Society owes a debt of gratitude to the medical and scientific communities for improving our understanding of the virus and how to prevent its spread, thus saving hundreds of thousands of lives and enabling much of the economy to reopen.
Today, most industries have seen demand substantially recover and are trading at or near all-time highs. However, a few industries remain severely impacted by the pandemic (e.g., travel and leisure). For some businesses, the market appears to be discounting a very long return to normalcy, a view that is far too pessimistic in our view given that it is likely an effective vaccine will be widely available by mid-2021. While the market appears willing to ascribe ever-increasing multiples of sales to technology businesses with recurring revenue, many businesses with less near-term visibility trade at very low multiples of normalized earnings. It is in these pockets of the market where we believe the best opportunities lie.
During the third quarter we established a 1% position in Allegiant Travel Company. Don’t be fooled by its respectable sounding name, Allegiant Travel Company is more frequently referred to as Allegiant Air. An airline?! Yes, we bought shares of an airline.
We sold the remaining 1% we held in Ametek to fund this purchase, completing our exit from the position. As you might recall, we began selling Ametek during the second quarter due to our view that it would have difficulty sustaining its historical success into the future.
In the annals of business history, there may be no industry with a more terrible track record than passenger airlines. Plagued by high capital intensity, low margins, price sensitive customers, and cyclical demand, dozens of airlines went through bankruptcy over the last few decades, including every major U.S. airline but Southwest. In the inimitable words of Warren Buffett, “If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright.”
And yet, against this backdrop, we believe we found a gem in Allegiant. The company has carved out a very profitable niche for itself by acknowledging the challenges that most airlines face, and consciously choosing a different approach. In the words of Maurice Gallagher, Chairman, CEO, and 17% shareholder: “Different is good. We enjoy being different. We consciously set out to build a different business. Yes, we use aircraft and are categorized as an airline. However, our different approach, a leisure focus, small cities, limited frequencies and inexpensive aircraft have all been developed with the understanding that different was key to our success.”
As an upstart in the early 2000s, Gallagher established Allegiant as an ultra low-cost airline by, among other things, using much older airplanes, requiring direct booking to cut out third party travel agent fees, and eliminating free baggage handling and snack service. As a result of this lower expense base, Allegiant can offer compelling prices that are nearly half the rate of the average U.S. airfare.
In addition, Allegiant primarily targets leisure travelers from small cities where it could further differentiate itself. Traditional carriers employ “hub-and-spoke” networks requiring passengers from small cities to fly to a large city hub, then on to their final destinations. In contrast, Allegiant employs a much simpler “point-to-point” flight network shuttling passengers from their small city directly to common vacation and second home destinations (Florida, Las Vegas, Arizona, Palm Springs, etc.). This combination of a low price and direct flight service is a compelling value for the leisure traveler. In fact, the company found that its offering stimulates passenger demand that didn’t previously exist.
Once established in a market, Allegiant has a lucrative and defensible niche. The incumbent, high cost hub-and-spoke carriers cannot sustainably match Allegiant on price, nor are they compelled to do so because Allegiant is mostly growing the market rather than stealing passengers. Other ultra low-cost carriers that could potentially compete on price choose not to enter Allegiant markets because the opportunity is simply too small to support two such airlines. Further, Allegiant has a reputation for aggressive competitive response when its niche is attacked, quickly slashing prices and copying any new entrant’s flight schedule to bleed it out of the market. Again, in the words of Maurice Gallagher: “ Over the years we have consciously built our system to minimize competition. The key component is to offer service to underserved markets with the amount of capacity the market will bear. We are one of the only service providers whose offerings are based on flights per week versus flights per day. As a result, we are able to look at markets otherwise too small to attract service or a competitive response once we enter the market.”
As a result, an amazing 82% of the company’s routes have no direct competition, and the next best alternative to an Allegiant flight – an expensive indirect flight on a major carrier – is a poor substitute. Allegiant was the most profitable passenger airline in the country over the last ten years with operating margins averaging 18% and returns on equity of 30%. Over that time period, Allegiant has grown from 161 routes to 521 routes, a 14% CAGR.
Despite this superb track record, it has not all been smooth flying for Allegiant. In fact, at quarter end, its stock price was down about 50% from the all-time high it set in 2015 despite about 60% growth in routes over the period. Three headwinds have challenged the business.
• First, the company embarked on an expensive but necessary multi-year transition of its aircraft fleet. The transition was recently completed and KPIs were recovering nicely pre-pandemic.
• Second, the company was in the early stages of launching a destination resort in Florida to capture more value from passengers’ lodging spend. This was perceived by many as a risky distraction from the core business. The plan has recently been mothballed, and potentially abandoned.
• Third, the pandemic devastated demand for air travel. Allegiant passenger traffic is down 40%from last year, and fare pricing is down 14%. The company is burning $1 million of cash per day.
Since the first and second headwinds above are largely resolved (though probably still cast a pall on investor perception), our biggest fundamental concern is recovery from the pandemic. On this front, we have a high degree of confidence that the domestic leisure air travel segment will return to pre-pandemic levels once a vaccine is widely distributed. There is no Zoom call that can replace visiting grandma in person, and no substitute for the magic of taking your young children to Disney. In fact, we think leisure travel could see a surge post-pandemic as people utilize their accumulated vacation time and scratch their travel itch after being confined to home for so long. Pricing recovery will likely lag volume recovery, so if a vaccine is widely distributed by the middle or end of 2021, we expect Allegiant earnings to recover to a more normal run rate by late 2021 or 2022. If we are wrong about the timing of a recovery, Allegiant has the best balance sheet in the industry and the lowest cash burn rate. Allegiant can survive in its current state without going back to the capital markets for at least 18 months providing some margin of safety.
Longer term, we believe there are at least 500, and potentially an additional 1,000 route opportunities meeting Allegiant’s parameters. Further, as a result of financial strain, large airlines are reducing service to many smaller cities creating more opportunity. Potential new low-cost airline entrants, Breeze and Xtra, could compete for these unserved routes, but they have not yet launched and were dealt a setback by the pandemic. Even if they are successful, there should still be plenty of growth opportunities to keep Allegiant busy for five or ten years.
Allegiant fits the profile of what we are looking for in the pandemic driven recession; a very good business suffering a setback, but with its long-term earnings prospects undiminished or even enhanced. Allegiant earned $14 of EPS in 2019, and was on pace to earn $17 in 2020 before the pandemic struck (estimates are now a $12 loss). We paid about 9x 2019 earnings and 7.5x “pre-pandemic” 2020 earnings for our shares. If we are correct in our recovery thesis, and Allegiant also returns to its historic valuation of about 15x earnings and 6.5x EV/EBITDA, the stock could trade around $200 or $250 in 2022, with the potential to compound EPS and share price at a mid- teens clip from there for an extended period of time.