Sun Country Airlines Holdings, LLC Q3 FY2023 Earnings Call

Welcome to the Sun Country Airlines Third Quarter 2023 Earnings Call. My name is Crystal Love, and I will be your operator for today's conference. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I will now turn the call over to Chris Allen, Director of Investor Relations. Mr. Allen, you may begin.

Thank you. I'm joined today by Jude Bricker, Chief Executive Officer; Dave Davis, President and Chief Financial Officer; and a group of others to help answer questions. Before we begin, I would like to remind everyone that during this call, the company may make certain statements that constitute forward-looking statements. Our remarks today may include forward-looking statements which are based upon management's current beliefs, expectations and assumptions and are subject to risks and uncertainties. Actual results may differ materially. We encourage you to review the risk factors and cautionary statements outlined in our earnings release and most recent SEC filings. We assume no obligation to update any forward-looking statements. You can find our third quarter earnings press release under the Investor Relations portion of our website at ir.suncountry.com. With that said, I'd like to turn the call over to Jude.

Thanks, Chris. Thanks for joining us this afternoon, everyone. Our diversified business model is unique in the airline industry. Due to the predictability of our charter and cargo businesses, we are able to deliver the most flexible scheduled service capacity in the industry. The combination of our scheduled flexibility and low fixed cost model allows us to respond to both predictable leisure demand fluctuations and exogenous industry shocks. We believe due to our structural advantages, we will be able to reliably deliver industry-leading profitability throughout all cycles. Today, we're announcing 3Q results, including an adjusted operating margin of over 8% on 18.5% year-on-year departure growth. We know now these results produced the highest trailing 12-month pre-tax margin of any of the 11 public mainline U.S. carriers. The same was true at the end of the second quarter. Demand remained strong across all segments of our business, highlighted by scheduled service TRASM down 5% on 15% ASM growth versus prior year. Since the beginning of the year, every month, scheduled service TRASM has reset to around 35%, higher than pre-COVID comps, with this trend generally continuing into bookings on future travel. Also, our charter block hour production, critical during the fall of scheduled service demand trough, was up over 14% year-on-year. Recall that the third and fourth quarters typically produce margins well below our annual production. We continue to deliver a high-quality product. In the third quarter, our controllable completion factor was 99.4%, while delivering the highest D0 among U.S. mainline carriers. I'm so grateful to all our team members that worked so hard to take care of our customers every day. Unfortunately, the cause of our variance in performance to potential remains crew staffing levels. Due to captain availability, we flew about 3,500 fewer block hours in the third quarter, mostly in July, when the demand environment would have supported our fleet and the fuel price input. We continue to see staffing levels improve, albeit more slowly than we would like. Looking ahead, we recently extended our schedule through the summer of 2024 and announced 10 new Minneapolis markets. I think this is representative of our growth for the next few years as we continue to expand into our Minneapolis opportunity during peak periods, supported by modest off-peak growth in our charter business. As our growth has moderated based on pilot staffing, we've decided to lease out two additional aircraft that were scheduled to enter our fleet in Q4. This will delay the entry into service of two 737-800s planned for the fourth quarter of 2023 until the first quarter of 2025. Aircraft are generally in high demand as much of the aviation industry deals with production delays on new narrow-bodies and service disruptions from GTF. So, we'll make good returns on these aircraft until we're able to fully utilize them. With that, I'll turn it over to you, Dave.

Thanks, Jude. Q3 was another profitable quarter for Sun Country, with revenue at the high end of our forecast and operating margin in the middle of our expectations, despite fuel prices being 10% higher than anticipated. Total revenue climbed 12.3% year-over-year to $248.9 million, while adjusted earnings before taxes rose to $11.1 million from $9.7 million in Q3 of 2022. The adjusted operating margin was 8.1% for the quarter and 14.7% year-to-date. As Jude pointed out, Sun Country's adjusted pre-tax margin for the trailing 12 months through Q3 was 10.2%, the highest among the 11 mainline U.S. carriers. Our diversified business model continues to show strong results. Revenue in our passenger segment grew in Q3, with combined scheduled service and charter revenue increasing 9.7% year-over-year to $214.4 million. Scheduled service and ancillary sales alone generated $166.9 million, a 9.5% year-over-year increase. Scheduled service TRASM was $0.1172, down 5% from last year, coinciding with a 15.1% increase in scheduled service ASMs. We remain strong in scheduled service TRASM compared to 2019, with Q3 2023 nearly 39% higher than Q3 2019. This represents our sixth consecutive quarter with scheduled service TRASM at least 25% above its comparable quarter in 2019, a trend we expect to continue into Q4. Our total fare per passenger fell 8.7% to $153.11, while we maintained an 86.6% load factor. Charter revenue in Q3 rose 10.6% to $47.4 million with a 14.1% increase in block hours. Part of our charter revenue includes reimbursements from customers for fuel price changes, as we do not bear fuel risk on our charter flights. Fuel prices decreased by over 18.8% year-over-year. Excluding fuel reimbursements from both Q3 2023 and Q3 2022, charter revenue grew 14.6% over the period, aligning with block hour growth and resulting in flat year-over-year charter revenue per block hour. Cargo revenue in the third quarter increased 10% to $26 million with a 6.3% rise in block hours. Last year, we experienced reduced flying due to maintenance events, and our Amazon contract saw annual increases in December 2022. We're growing at a measured and profitable pace, expecting total ASM growth of 8% to 10% in Q4, with a similar rate likely for 2024. Regarding costs, total operating expenses rose 11.4% with a 14.4% increase in block hours in Q3. Adjusted CASM was up 2.6% compared to Q3 2022, down significantly from the over 10% increases noted in the first half of 2023. Maintenance event timing in Q3 contributed significantly to year-over-year cost increases, with airframe check volume doubling from Q3 2022 and material prices rising nearly 9%. Looking ahead to Q4, we anticipate heavy check volume will remain high relative to Q4 2022. In 2024, we expect adjusted CASM to be roughly flat compared to the full year 2023. Turning to the balance sheet, our total liquidity at the end of Q3 was $198 million, a reduction from the end of Q2 due to seasonal booking patterns and the timing of our share repurchases, which concluded towards the end of the quarter. As of November 6, total liquidity was $230 million. By the end of September, we had invested $210.6 million in CapEx, contributing significantly to our planned aircraft growth into 2025. We project our full-year 2023 CapEx to be around $225 million, with our year-ending passenger fleet at 42 aircraft. Growth in 2024 will be modest, with most of the expansion supported by higher utilization. We expect our 2024 capital expenditures to be under half of the 2023 level, with strong free cash flow generation. Our balance sheet remains very strong, with a net debt-to-adjusted EBITDA ratio of 2.4 times at the end of Q3. Given our manageable debt load, we have flexibility in cash deployment. Since Q4 2022, we have spent approximately $80 million on share repurchases, reaching our Board's authorized limit. Recently, our Board approved an additional $25 million for repurchases, which we plan to use strategically. Regarding guidance, we anticipate Q4 total revenue of $242 million to $252 million, reflecting a 7% to 11% increase over Q4 2022, alongside an 11% to 15% increase in block hours. We forecast a fuel price of $3.20 per gallon for the fourth quarter, with an adjusted operating margin between 3% and 5%. The fundamentals of our diversified business remain robust, making our model resilient to macroeconomic shifts, and we continue to focus on profitable growth. Now, I will open the floor for questions.

Thank you. Our first question comes from the line of Duane Pfennigwerth of Evercore ISI. Your line is now open.

Hey, thanks. Just a couple for me. On aircraft, can you just remind us kind of what the ideal vintage or age on the 800s that you're targeting? And how much do you think the market for these assets has changed? I understand you're not in the market. There's a bit of a pause here. But to the extent you own them, how much do you think the value of those assets has changed in this backdrop?

We adjust our pricing based on the age of the aircraft, so there isn't a specific preference since we incorporate that into the valuation. Our most successful point has been with approximately 12-year-old airplanes, which historically aligns the value with both the transferred maintenance value and the residual value of the components. For aircraft younger than that, we have to pay more for the newness, and for older aircraft, we usually don't receive as much compensation for the age. This age range seems to be the sweet spot in the market, coinciding with typical large maintenance events occurring on those aircraft types. We evaluate the aircraft by considering the transferred maintenance value, which has increased in importance due to OEM price escalations and bids. We also add a premium to that value. The last aircraft we arranged about six or seven months ago had no premium due to discounts during COVID, whereas previously, premiums were around $1 million to $2 million. The situation remains consistent, but there is significant demand for short-term leases and engine leases, with people extending their leases temporarily. This is largely influenced by the production challenges faced in the industry.

Okay. Great. Are you booked through 2025? What is your growth number for next year? I don't know if you mentioned it on the call. Sorry if I missed it.

Yes. So, we are largely booked through 2025. If you recall, we did this deal with the 737-900ERs that are on lease to Oman Air. Those start to come off lease and redelivered to us in November of '24. So that's incremental aircraft in '25. Jude also mentioned an additional lease deal that we are near completion on for two more aircraft we were going to take; those will now come in the first quarter of '25. So that's seven incremental. And we may or may not be in the market for one or two more. I mean, the good news here is between improved utilization, the aircraft that we already have in the pipeline, the CapEx for those has largely been incurred already. So, we think we're in a great position from a fleet perspective.

Great. And if I could just sneak one last one in. Just your thoughts on when you think we'll be able to fully capture these peak demand periods. Would spring break be a reasonable guess on that? I thought it was interesting FedEx suggesting that they're overstaffed on pilots by about 700. Some of the press reports indicate that at least one peer is canceling higher bids or offers that it made. So, it feels like this pilot shortage is effectively over. Given that, when do you think you're in a position to fully capture peak demand?

Yeah. So recall, for a year now, at least for us, the issue has not been hiring pilots, and the issue has not been pilot attrition. So that's not a concern. The issue has been on the upgrade front. And there's myriad reasons for that, which we've talked about in the past. We are seeing positive trends based on some of the actions we've taken over the last six months. We're seeing positive trends in the captain upgrade world. I think we're all around the table anticipating a very strong Q1 and a strong ability to capture peak demand in March, which is part of the company's best quarter. But the trends are moving in the right direction. We don't see a shortage of pilot availability at this point. It's an internal issue for us that we are making progress and working through.

Okay. Thank you.

Thank you. Please standby for our next question. Our next question comes from the line of Catherine O'Brien with Goldman Sachs. Your line is now open.

Thank you, gentlemen. Thanks for the time.

Hi, Catherine.

Hey. Maybe just one follow-up on the captain upgrade issue. I know you said in your prepared remarks, it's getting better but a little slower than hoped. I guess how has your capacity and unit cost outlook changed over the last couple of months, if at all, as we head into 2024? And how sensitive is that guidance to maybe seeing that captain upgrade issue going better than expected next year? Just trying to get a sense of sensitivities there. Thanks.

I believe our planning for the growth numbers in 2024, which I mentioned as high single digits to low double digits, is very achievable. The roughly flat CASM numbers relate to that. If we continue to see positive trends in upgrades, we can accelerate the growth of the airline without needing additional aircraft due to the existing utilization opportunities. Any extra growth will positively influence CASM. Our outlook has probably not changed significantly in the past few months, though we may have adopted a slightly more conservative stance regarding growth, but there hasn't been anything drastic.

What might surprise everyone is that as we increase utilization and direct that extra capacity to peak periods, we are likely to see a rise in unit revenue as well, since the lost flying primarily occurs during times of high demand. Pilot constraints are measured in monthly block hours. In a very fluctuating demand environment, which we are set up to handle, those peak times also lead to higher than average unit revenues from missed flying. As we enhance utilization, we will see significant progress. This will happen more rapidly as we lease out some aircraft. Improvement will be gradual rather than sudden; I believe it will continue to get better in the coming months.

Got it. As you have the ability to manage those peaks, is the first priority to maximize the scheduled service as utilization increases? I know you also mention the possibility of adding ad hoc charters, or maybe the approach varies depending on the season. Any insights on this would be appreciated.

Yeah, both is the answer. I mean, keep in mind, the way we integrate charters and scheduled service is unique in the industry. So we'll build aircraft routing that incorporates both of those lines of business depending on the season. And so the predominance of incremental growth will be in scheduled service, but we intend to grow charters next year as well.

Got it. If I can sneak one last one in? I just want to make sure I'm not mixing apples and oranges as we think about the go-forward on scheduled service RASM. You both kind of made comments that you'd expect that versus 2019 trend, which has been 30%-plus higher over the last couple of quarters, you weren't expecting any major change. I don't know what your forecast on scheduled service ASM is, so that would be helpful. But I guess like if I just plug in plus up 30% something scheduled service RASM in the fourth quarter, I think that implies up year-over-year, and some admittedly very quick math, is that what you're expecting? Or help me figure out what...

No. The point I'm making is that since the beginning of the year, we've seen a reset to pre-COVID levels. I'm using 2019 as a comparison, and it has been very stable between 35% and 40% on a scheduled service TRASM basis month by month. Importantly, we experienced a strong and rapid domestic recovery in the summer of '22. This recovery then extended to near-international markets like Mexico and the Caribbean last winter, and now it's transatlantic. I believe it will likely expand into the Pacific. The key point is that it appears to be resetting on a more permanent basis to similar peak and off-peak trends we saw pre-COVID, but at a higher level. One comparison I would highlight is December. December had the best calendar setup in December of '19, so it will be slightly tougher in terms of comparison. However, it will still perform much better in 2023, though it won't reach that 35% level. Therefore, how we perform in the fourth quarter will depend significantly on December's results.

Yeah. And just maybe I didn't say it clearly enough, but the number I quoted was six consecutive quarters of 25%-up plus, and we expect that trend to continue.

Very clear. Thank you for the time.

Thank you. Please standby for our next question. Our next question comes from the line of Helane Becker of TD Cowen. Your line is now open.

Thanks, operator. Hi, team. Thank you for the time here. Just two questions. One is the scheduled service revenue in the third quarter looked like a sequential decline that was bigger than what we've seen in prior quarters, notwithstanding Dave's comment about being up 25%. And we saw a smaller increase in ancillaries. I'm just wondering if there's anything going on there.

Hey, Helane. Dave is looking at some numbers. But I just want to caution you on sequential for us because we're just really, really seasonal. So, the year-over-year change in the second quarter versus in the third quarter certainly settled down. That was a function of two things. One, we're growing a lot faster. But also, the comps in '22 were really challenging. And they lasted well into the fall season, which is something that's pretty rare for us. And that was focused on big city connectivity into Minneapolis, like I call out Boston, Seattle, big markets like that, that were really strong in the third quarter. Those have since settled down into a more permanent increase versus pre-COVID levels, but flat on the year-over-four basis.

Got it. That's helpful. My follow-up question is about the announcement you made regarding the ads, which wasn’t today. These ads are coming out of Minneapolis for next winter and summer. Have you noticed any pushback from Delta? Do you see them thinking that if they are doing well in this market, they should also be involved?

Helane, let me share a few insights, and I'll bring Grant in to elaborate. Firstly, we have a robust brand presence in the Minneapolis market. We may be seen as a spill carrier for some of our services outside of Minneapolis, but in that region, we focus on cultivating our brand. We actively engage with the community and have a dynamic loyalty program. Therefore, I don't consider us a spill carrier in the Minneapolis area at all. This approach reflects in how we specifically plan our schedule according to reliable demand patterns. We recently announced 10 new markets, many of which align with our MLS partnership for scheduled service, and I believe this will be a recurring strategy for us. We intend to maintain connections from Minneapolis to both domestic and international markets, targeting VFR traffic during the summer months from Memorial Day to Labor Day. In the winter, we will introduce some new markets, but primarily focus on growth within existing routes as we leverage peak opportunities with fleet expansion and pilot development. This strategy contrasts sharply with our operations in the Mexican and Caribbean markets from Texas during the summer. In the past, we have serviced Hawaiian routes from the West Coast, which certainly fits the spill carrier model. However, we are very deliberate regarding capacity deployment to achieve high unit revenues. Do you have anything else to add?

The only thing I would add is that, yes, being the leisure carrier of choice in this region, we added 15 new markets this year. They are all performing well and returning positively. We have extended and added these new markets. Delta is a strong competitor with a solid hub here. We do not anticipate having uncontested non-stop routes. However, we feel confident about our potential for success, supported by previous examples that reinforce our approach.

One more thing on Delta. We want Delta to be successful in the market because it serves business customers, and we want a vibrant business community here in the Twin Cities. So I think we serve completely different segments of the market. And we launched these 10 new markets, and they did change their schedule in a few of the markets to add some non-stop opportunities. Most of it's on regional connectivity. I think that's consistent with everything we've seen with them since the Sun Country transition began in 2018 or so.

Got it. Okay, that's really helpful. Thanks, team.

Thank you. Please standby for our next question. Our next question comes from the line of Michael Linenberg of Deutsche Bank. Your line is now open.

Hey, good afternoon, guys. Dave, you had called out...

Hey, Michael.

You mentioned in the fourth quarter about a significant number of heavy checks related to maintenance. What impact might that have on margins? What other factors might be affecting margins? If I consider margins declining year-over-year, fuel seems to be okay. Is labor a factor? Is it maintenance? Any insights on this would be appreciated.

The number of heavy checks in the fourth quarter is about three times higher than in the fourth quarter of 2022. This serves as a significant factor, primarily due to the timing of these checks. It likely translates to a $4 million to $5 million impact for us in Q4, which is notable. This is the main issue that stands out to me. However, this is part of our schedule with airframe heavy checks, and there's not much we can do about it.

Okay. Good. And then just my second question, it was interesting, one of your fellow low-fare competitors was talking about refocusing on different markets and maybe allocating more of their flying to underserved markets versus overserved. And Minneapolis came up at least, I think, twice on that call. And I think you guys know Minneapolis better than anyone, Jude, you and Grant. Your thinking on that? Is it an underserved market? Is there gate availability? Should we be concerned that we're going to see more low-fare competition in that market? I know you've dealt with low-fare competitors in the past. Any thoughts on that comment? Thank you.

I think it's interesting how the U.S. market has set itself apart. The success of U.S. carriers last quarter has largely depended on how they manage off-peak demand, and they do this in three main ways. First, network carriers focus on business customers and have benefited from a longer Atlantic season this year. The ultra-low-cost carriers discount their fares to stimulate demand in that environment. Then there's us, and we simply eliminate those flights. I believe our approach is the most effective. This positions us well to serve markets like Minneapolis and others as we navigate a volatile demand profile. Out of 98 markets from Minneapolis, only five are year-round, and the local consumers have varied travel preferences depending on the time of year, which we're prepared to accommodate. I'm not overly concerned; I expect some overlap in traditional leisure destinations like Cancun, Orlando, and Vegas, as well as in Detroit and Denver since those carriers operate there frequently. However, this doesn't change my outlook at all. Grant, do you have anything to add?

I would like to mention that we have expanded our services to many new markets. This expansion allows leisure customers to travel non-stop from these places. Additionally, it's important to recognize that Minneapolis has a high sales volume. The efforts of our team to build the brand and increase our market share have been significant. As travelers seek destinations, they often visit both delta.com and suncountry.com. It’s not simply a matter of introducing new flights and expecting them to succeed; substantial work has gone into establishing what we have developed over the past few years.

I can't emphasize enough the unpredictability of our schedule. Some days we might operate 150 flights, while other days we may have only three during the third quarter. This variability is what allows us to consistently generate these unit revenues.

If you had the right amount of pilot time to take advantage of peak periods during the September quarter, how much margin do you think you missed out on due to not being at the optimal staffing level, considering that the additional flying tends to be very high margin?

Our variable contribution in July is around 40%. However, incremental flying during that period would be slightly lower since we face capacity constraints on monthly block hours, leading us to consolidate flights on the busiest days. We would be increasing flights on Wednesdays and Saturdays, for instance, but they would still be in the 30% to 25% range. This demand period extended into early August, so the 3,500 foregone block hours could result in approximately $7 million to $10 million in operating earnings for the quarter.

Okay. Very good. Thank you. Thanks everyone for answering my questions.

Thanks, Mike.

Thank you. Please standby for our next question. Our next question comes from the line of Scott Group of Wolfe. Your line is now open.

Hey, thanks. Afternoon. I know we talked about the fourth quarter RASM assumptions, but maybe just help us with some of the other pieces in the fourth quarter revenue guide, scheduled service capacity and then maybe expectations on charter and cargo revenue.

I'll start with the easy one. Cargo is fairly flat, which we would expect every quarter to be from kind of looking forward. Dave, anything else?

We discussed our expectations for revenue growth and block hour growth for the fourth quarter. I anticipate that unit revenues will decrease slightly in the fourth quarter, largely due to maintenance costs being the primary factor driving costs per available seat mile in Q4. These are the key trends to note.

Okay. I understand that there is significant seasonality in your model each quarter, and there isn't much pre-pandemic data to reference. I'm looking for clarity on the operating margins: Q1 was at 20%, Q2 at 15%, Q3 at 8%, and now this quarter is down to 4%. Based on your current insights, what do you anticipate the margin run rate will be as we move into 2024? Is it likely to be in the mid single digits, high single digits, or back to double digits? It's challenging to gauge given the heavy seasonality and limited historical data.

Our pre-tax trailing 12-month margin is 10.2%. And so you were talking about operating margins, so that put operating margin probably in the 14% range. I mean, I think that's something we should be able to continually replicate.

I think that 14% number is replicable in the near future, and the potential for the business is greater than that. I mean, Jude mentioned the number. Once we get sort of the full advantage of the peak opportunities, particularly in the summer months, we should be able to do better than that sort of mid-teens operating margin number.

And you feel like you've got visibility to that low-teens op margin next year?

Yeah. I mean, we're selling through Labor Day. So we have pretty good visibility into sales. I don't know if you watch our schedule that much, but we're adding January. Other commentary you're seeing around the industry is people cutting back in January as being a trough period. We're seeing the need for more capacity and also responding to improved pilot staffing situation. Yeah, I think it looks kind of pretty good in the first quarter.

Yeah. So I mean, we're not giving full-year 2024 guidance at this point. But based on where we're at now in terms of getting our plan together for next year, we think we have some very achievable revenue and cost goals, and they put our op margin in that range that we were just talking about.

Okay. And then maybe just lastly, just some of the puts and takes around free cash flow for next year. It sounds like CapEx coming down a bunch. But how do you think about free cash flow next year?

Yeah. So free cash flow is going to be significantly higher. First of all, again, not to give too much '24 guidance, but we expect a material improvement in results next year and a drastic reduction in CapEx. So I think we're going to be a very strong free cash flow generator, which is one of the reasons we felt comfortable allocating another $25 million to share repurchases. We will continue on this track. Our aircraft are largely purchased. Operating results look strong. Based on what we've seen so far, we'll continue to make the best use of our cash as we generate it.

Okay. Thank you for the time guys. Appreciate it.

Thanks, Scott.

Thank you. At this time, this does conclude our question-and-answer session. I would now like to turn the call back over to Jude Bricker for closing remarks.

Thanks for your time and attention, everybody. We'll talk to you again at the end of the year. Thanks.

Thank you. This does conclude today's conference. You may now disconnect.