Frontier Group: Growth Fueled By Surge In Passengers And Strategic Promotions (ULCC)

Investment Thesis

Frontier Group Holdings (NASDAQ:ULCC) runs its operations through Frontier Airlines, offering an ultra-low-cost air transportation service. The strong point of this company is its unique business model.

I believe this company has potential for growth in the future due to several reasons. Firstly, Frontier places a strong emphasis on customer experience. They offer family-friendly plans and bonuses for frequent flyers. Recently, they have introduced an option that guarantees an empty middle seat, thereby increasing the space available to the traveler.

Secondly, the company serves over 90 airports in America and is planning to expand its operations.

Lastly, the company’s revenues have seen a significant increase in recent years, paralleled by a notable rise in passenger numbers.

Business Overview

This company’s business model is notably ambitious if we think that companies operating with low costs often deal with extremely thin profit margins. Sometimes, these budget airlines can make a profit just from the sale of extra services, like baggage insurance, or food and drinks provided during the flight. When you look at Frontier’s business model, it’s clear that their goal is to provide a customer experience that merges elements of both exclusivity and budget service, all while keeping their prices very low.

In its latest report, the company outlined various strategies aimed at cost reduction. These include the strategic selection of routes, high aircraft utilization, the use of the latest generation of aircraft, and seat positioning optimization for fuel efficiency. However, these cost-reduction strategies have been implemented by other low-cost companies for years, so I don’t believe that these practices provide a competitive advantage. In fact, I believe that the strength of this company lies precisely in the service and experience it offers to its customers, not merely in its low pricing.

In fact, Frontier’s strategy is focused on enhancing its brand to ensure that customers associate Frontier with an experience that differs from what other low-cost airlines offer. The company cannot enhance its brand by offering expensive services, as it would miss its target customer base. For this reason, Frontier is intelligently working to improve every aspect that can create a pleasant experience for the customer. For instance, they add drawings of animals affected by pollution to the tails of planes to highlight the company’s commitment to ESG values. Another way the company strategically enhances its brand is by introducing appealing packages like “Kids Fly Free” or “GoWild! All-You-Can-Fly Pass”. The aim of these packages is to penetrate the market by attracting customers with a unique experience.

The company offers trips to over 90 airports in the United States and between April and May 2024, the company has planned to expand its operations.

The image provides a visual representation of Frontier’s current route coverage.

As observed in the introduction, the company’s fleet is composed exclusively of A320 and A321. This presents an advantage for the company as these latest-generation aircraft have low fuel consumption and emit fewer emissions. Moreover, having a fleet comprised solely of Airbus aircraft enables the company to organize its flight personnel efficiently.

To get a clearer idea of the composition of the Frontier fleet, we can look at the following pie chart:

Frontier doesn’t own the planes it uses, but leases them. The company has made it clear that once the lease contracts for the A320ceos will expire, they’ll be replaced with A320neos or A321neos. Frontier has written several lease contracts with different end dates, spanning from 2024 to 2028. Given this, we can expect that in the next few years, the company should be able to completely transition its fleet to the A320-21neo family.

The approach of using efficient aircraft and optimizing the distribution of weights and seats has already shown its benefits. This aspect is also factored into the Q4 2023:

The use of the A320neo family aircraft and our seating configuration, weight-saving tactics and baggage process have all contributed to our ability to continue to be the most fuel-efficient of all major U.S. carriers of significant size when measured by ASMs per fuel gallon consumed.

Considering that the Airbus aircraft from the neo family allow for fuel consumption savings of 15 to 20%, if Frontier replaces the Airbus aircraft from the ceos family with Airbus neos over the next four years, it could achieve a significant reduction in travel costs. This is not a factor to be underestimated. In fact, as we will see later, the cost of fuel has a substantial impact on the company’s results.

Key Growth Factors for Future Company Success

Starting from the premise that, as we’ve previously seen, Frontier’s success hinges on meticulous attention to the customer experience. Indeed, the company is making significant efforts in this regard. This begins with their website, which is well-organized and filled with promotional messages for customers, along with options to make flights as flexible as possible. The site’s visual appeal is notable, effectively communicating the company’s values, such as sustainability. This is crucial, as highlighted by the company in its 2023 10-K report, where it was noted that 72% of ticket sales were made via the website.

On March 12, 2024, Frontier introduced a new plan called “UpFront Plus Seating”. This plan, available at an additional cost to the basic ticket, guarantees customers an empty seat, thus providing them with more space. As Frontier has stated, this promotion is not unlimited due to the limited number of free seats. In my opinion, the company introduced this offer to better optimize space on the plane. There might be certain routes that have fewer passengers during specific times of the year. Thanks to this promotion, the company could potentially increase seat yields, as those who opt for this promotion are essentially paying for two seats, albeit not at double the cost.

Another positive aspect is the growth in the number of passengers in recent years:

In 2021, Frontier served 20.7 million passengers, and this number rose to a total of 30.2 million people in 2023, leading to a CAGR of 13.42%. I believe this is a significant trend. If Frontier offers an experience that stands out from other low-cost airlines, customers will take notice and spread the word. Moreover, the 2026 Football World Cup will be held in the USA, an event that will undoubtedly necessitate the movement of a large number of people. Frontier could exploit this opportunity to attract new customers and further accelerate this growth trend.

Another important variable is the cost of fuel. In fact, it represents a large cost for Frontier. In 2023, jet fuel represented 31% of total costs, which shows that the company’s economic performance is closely linked to fuel price trends.

If we examine the historical trend of jet fuel prices, we can observe that there was a significant increase in 2022. This has impacted the company and its valuation in recent years.

A report from BMI suggests that the global average jet fuel prices are expected to stabilize at around $105-106 per barrel in the upcoming years, a slight decrease from the $110 per barrel seen in 2023.

Additionally, as previously mentioned, the increasing use of Airbus aircraft from the neo family should gradually reduce the company’s fuel costs in the next years.

Financial Analysis

From a financial point of view, Frontier seems to be improving in recent years, after the negative period of 2020. As we can see, revenues are increasing at a good pace.

From 2020 onwards, there’s been a consistent upward trend in revenues, escalating from 1.2 billion to a robust 3.5 billion, boasting a CAGR of 30.58%.

When we turn our attention to net income, it’s clear that there’s been a positive shift, although the company has yet to cross into the realm of positive net income. In 2023, the financial records showed a net income of -$11 million.

The financial outcome was heavily influenced by operating expenses. In 2023, these expenses amounted to $3.592 billion. A significant portion of these operating costs was fuel, which alone cost the company $1.130 billion in 2023.

When we take a closer look at Frontier’s balance sheet, it’s noticeable that there’s been a decrease in liquid assets, including cash and cash equivalents, over the past few years. This trend does raise a small question mark over the company’s short-term solvency

From the analysis of the solvency ratios, we see that both the quick ratio and the current ratio took a hit in 2023. The main concern stems from the company’s consistent pattern of negative cash flows in recent years, which has had a significant effect on the company’s liquid assets.

In the graph, one can observe the evolution of Frontier’s stock price in comparison with the S&P and the NYSE Arca Airline index. As can be seen, the stock has underperformed both indices in recent years. Furthermore, it’s noteworthy that Frontier’s stock tends to be significantly influenced by sector dynamics. In fact, over the last six months, it has increased by approximately 55%, following the sector trend.

Valuation

Should the patterns of revenue growth and enhancements in net income continue into 2024, the company could potentially achieve a positive cash flow from its operating activities. This hasn’t happened in the past few years, and it’s crucial to bear in mind that for a company of this nature, cash flows can exhibit high volatility due to substantial CapEx, considering the high value of the assets. For instance, in 2023, there was a loss of $224 million caused by the net change in operating assets, which significantly impacted cash flows.

To estimate future cash flows, we can observe the average level of cash flows generated by operating activities prior to Covid. The average was $198 million. For the next few years, it might be overly optimistic to assume that the company can return to those levels of cash flows. However, by observing the listed growth factors, we can assume that the company could manage to get a level of cash flows of $35 million next year, which is equivalent to the average of the last ten years. Then, assuming an expected growth rate of 5% and a WACC of 7% through the discounted cash flows model, we obtain a stock price of $9.58.

Downside risks

A substantial portion of the company’s target market is not individuals who need to travel, but rather families or groups of people who travel for holidays or to visit places of interest. When families reduce their financial resources due to a crisis or recession, they tend to spend less on holiday trips. Therefore, Frontier’s revenues and ticket sales are strongly tied to the economic cycle, while other companies that offer more essential services are not affected by this issue to the same extent. If people need to travel by plane, they will likely choose the airline that offers the lowest price, not the one that guarantees an alternative onboard experience. Especially in this historical period characterized by significant uncertainty, a contraction in demand could have a substantial impact on the price of Frontier’s stock.

Another critical issue that I highlighted during the financial analysis is that the company is gradually exhausting its liquid resources. If it fails to generate a positive net income in the upcoming years, its solvency could further deteriorate. It’s also worth noting that the company has a Debt to Equity ratio of around six. This implies that the company finances nearly all of its assets with debt. Consequently, a decrease in liquidity heightens the company’s risk.

Conclusions

In summary, Frontier is an intriguing company that offers a service that defies market logic: it provides an ultra-low-cost service while simultaneously offering an experience that customers may perceive as exclusive. Recently, it has demonstrated its ability to attract new travelers and expand its service.

With the notable efforts in brand promotion, a strong emphasis on environmental sustainability and ESG principles, and the data showing a substantial uptick in travelers opting for Frontier for their journeys, we can expect this trend to persist in the years to come. Given the company’s potential to yield positive cash flows down the line, the stock, presently priced at $6.25, might present a worthwhile opportunity, in my view. Consequently, my recommendation would be to consider a BUY with a long-term perspective.