26-Feb-2014 9:20 PM

Allegiant Air faces bumps ahead in 2014 as costs grow and unit revenues soften in 1Q

Analysis

Allegiant Air's strong top-line financial performance in FY2013 was belied by cost creep that is continuing into 2014 driven by maintenance expense and investments in yet-to-be revealed non-airline initiatives.

With Allegiant's guidance of unit cost increases for FY2014, no US airline is escaping some level of cost escalation during the year. Similar to sentiments expressed by other carriers, Allegiant concludes it is making the necessary investments now to ensure a profitable future.

Even as Allegiant's core business model - transporting cost-conscious travellers from small US markets to large leisure destinations - has essentially remained intact during the past couple of years, the carrier has also undertaken initiatives that are creating challenges in its cost performance in FY2014. While the company's financial fundamentals still remain strong, wildcards in its cost structure remain, including negotiating labour deals amid increasing tension between management and employees.

Summary

Allegiant Air's strong financial performance in FY2013 was overshadowed by cost creep, driven by maintenance expenses and investments in non-airline initiatives.
Allegiant's unit costs, excluding fuel, remain the lowest among US carriers, but it experienced a 5% rise in unit costs in FY2013.
Maintenance and repair expenses are expected to increase in FY2014, with a larger number of heavy C checks on its MD-80 fleet.
Allegiant is investing in non-airline ventures, with start-up costs expected in 2014 and benefits in 2015 and beyond.
The carrier predicts sluggish unit revenue performance in 1Q2014, with flat to down 2% in passenger unit revenues and a fall of 2% to 4% in total unit revenues.
Allegiant faces labour strife in 2014, with unionised pilots, flight attendants, and dispatchers, and slow contract negotiations.

Maintenance and non-airline business ventures help to lift Allegiant's costs

Allegiant's 17% increase in FY2013 net income to USD92 million year-on-year was overshadowed by a 5% rise in unit costs at the ultra low-cost carrier. Despite the increase, its USD5.60 unit costs excluding fuel remains the lowest among US carriers.

Allegiant Air unit cost performance: 4Q2013 vs 4Q2012 and FY2013 vs FY2012

Some of Allegiant's cost pressure in FY2013 is attributable to factors beyond the airline's control. A US government shutdown that shuttered the FAA resulted in delays by Allegiant in placing Airbus A320s into service, which created temporary increases in crew costs.

During FY2014 the largest driver in Allegiant's projected unit cost rise of 13% to 15% in 1Q2014 and 4% to 7% for FY2014 is a return to what the carrier explains as more normalised maintenance spend.

Allegiant estimates maintenance and repair expenses of USD100,000 to USD110,000 per aircraft per month during FY2014, and expects to perform a larger number of heavy C checks on its MD-80 fleet than in 2013 when maintenance costs increased just 1.5%. Recently company executives explained that maintenance expense in FY2013 was particularly low, and "a little bit outside the kind of longer term trend". They believe the aircraft maintenance cost per month is more similar to maintenance spend five or six years ago. During FY2012 Allegiant's top-line maintenance expense grew 9%.

The cost spike Allegiant expects during 1Q2014 results from maintenance expense and the lingering effects of delays to adding the A320 narrowbodies to its operating certificate, and start-up expense in two non-airline initiatives the company has attempted to remain tight-lipped about. A recent article in the Las Vegas Review Journal stated the company reportedly signed a deal with rental car company Enterprise to sell vehicles from the car company's fleet.

Allegiant publicly has characterised the new ventures as small start-ups, and cautioned that investors would not likely see any material impact in the overall results from the initiatives. For now it seems Allegiant is incurring the start-up cost in 2014, with the benefits from the secret businesses not occurring until 2015 and beyond.

Allegiant predicts sluggish unit revenue performance in 1Q2014

As it braces for cost pressure Allegiant also estimates capacity growth of 10% to 14% in 1Q2014 and 8% to 12% in 2Q2014 as its passenger unit revenues are expected to be flat to down 2% in 1Q2014 and total unit revenues are expected to fall 2% to 4%. Usually capacity growth can ease cost inflation given costs are spread out over more ASMs, but supply growth is not denting Allegiant's maintenance cost pressure or the uptick in spend on new non-airline business ventures.

Allegiant Air unit revenue and cost guidance: Jan-2014 and 1Q2014 and 1Q2014 and FY2014

Some of the softness in passenger unit revenue in 1Q2014 is due to the shift of the Easter holiday from Mar-2013 to Apr-2014. Absent the introduction of any new ancillary products such as carry-on bag fees, Allegiant believes that in the near future passenger unit revenues should grow at a faster clip that total unit revenues.

Allegiant breaks out its ancillary revenue in third party products and ancillary air revenue. During 4Q2012 the company eliminated offering airfare discounts that were tied to hotel sales as a means to increase overall profitability. For FY2013 its ancillary revenue per passenger derived from third party products declined nearly 5% as hotel nights fell almost 14% year-on-year.

Allegiant Air third party ancillary revenue performance: 4Q2013 vs 4Q2012 and FY2013 vs FY2012

The carrier explained that excluding the air discount, hotel room occupancy actually increased 25% year-on-year during FY2013. Going forward the company has developed new technology that allows for selling one-way hotel packages and land-only travel packages, which over time Allegiant believes will drive its hotel volume higher.

Allegiant believes benefits from technology spend should emerge in 2014

Allegiant during the past couple of years has opted to increase its technological spend, including on its maintenance technology. Carrier CEO Maurice Gallagher remarked in that area Allegiant has not discovered any third party product that matches the technological maintenance programme it has created on its own.

The company has also had a cash outlay during the last 18 to 24 months to upgrade other internal systems, that Mr Gallagher believes should "roll out nicely in 2014". He predicts excellent returns on those investments and other spend on automation as the development phase of those projects comes to an end.

It is easy for any company to promise solid returns after expending ample cash to upgrade systems in order to remain competitive or be on the cutting edge in the future. For the moment there is little reason to doubt Allegiant's conclusion that its investments will pay off as the company continues to deliver top-line profits, double digit operating margins and delivers dividends to shareholders.

Allegiant Air select financial results: 4Q013 vs 4Q2012 and FY2013 vs FY2012

Allegiant takes aim at Mexico while labour relations continue to sour

Allegiant follows a still tenuous foray into Hawaii in 2012 with a new fleet of Boeing 757s with an aim to launch service to Mexico in 2014 while it still absorbs adding Airbus aircraft to its fleet of existing MD-80 jets. The stakes are higher for Allegiant to successfully execute its business model in the transborder Mexican market after its less than successful experiment with trans-Pacific flights to Hawaii requires a win or two to inspire new confidence.

See related report: Allegiant takes a conservative approach to Mexico as it still works to learn nuances of Hawaii

Those initiatives alone are a lot to absorb but Allegiant also faces continued labour strife in 2014. Its pilots, flight attendants and dispatchers are now all unionised, and pilots have filed suit against the carrier alleging work rule violations. Contract negotiations with both pilots and flight attendants are progressing slowly, and it seems overall labour relations at Allegiant are becoming more tense.

Allegiant and other US airlines pledge of returns while cost continue to rise

Underneath Allegiant's continued favourable financial results are cracks in areas where it has historically had an absolute advantage - namely costs. It is hard to do an apples-to-apples comparison of Allegiant against other US carriers since its business model is totally niche (low frequency service from small markets to large leisure destinations).

Allegiant's explanation that maintenance is reaching more normalised levels is a concern given its fleet is still largely comprised of older MD-80s that will continue to rotate in and out of heavy maintenance during the years to come.

Allegiant Air fleet projections: YE2014 and YE2015

Behind the scenes Allegiant is obviously working to get its cost inflation back to historical levels, but in the near term it seems the company is stuck in a certain type of limbo that other US carriers find themselves in - waiting for returns to kick in on certain investments as costs continue to rise.