In 2017, a Reuters poll showed that U.S flyers preferred cheap tickets over perks and comfort when traveling. Spirit Airlines is a small, but steadily growing ultra-low-cost airline that capitalized early on this trend by introducing “bare fares” and “no frill” flights, offering relatively cheap base rates for tickets, but charging extra for almost everything else, from choosing seats to bottles of water, essentially unbundling the services that a traditional airline would have included in the price of a normal ticket. Today, we are going to analyze the airline industry, as well as Spirit’s operating efficiency, growth, risks, and valuation to ultimately decide whether or not it makes sense to be a shareholder of the underdog airline. Unless stated otherwise, all numbers and statistics presented below are as of August 7th, 2019.
The airline industry
Until recently, airlines were notoriously unprofitable businesses. Fierce competition led to aggressive price cutting, with many airlines losing money on each flight, resulting in massive losses industry-wide. Between 1977 to 2009, the sector suffered combined losses of over $52 billion. However, recent bankruptcies and mergers consolidated the industry, leading to increases in capacity, operating efficiency and overall profitability. In fact, Warren Buffett, who had once called airlines “a death trap for investors”, now owns a stake in all of the big four U.S airlines: American, United, Delta and Southwest. The big four currently dominate the U.S domestic airline industry, with almost 70% combined market share.
In spite of its history, 2018 marked the 10th consecutive year of profitability for U.S airline industry. Capacity has grown at an average rate of 2.5% each year since 2009, and major U.S airlines carry over 17% more passengers than they did 10 years ago. The industry is expected to continue growing, with the U.S Federal Aviation Administration forecasting a 1.9% average annual growth in passengers over the next two decades.
Operating efficiency is key in the airline business. Airlines run at relatively low margins, so modest increases in unit revenues or decreases in unit costs can tremendously affect overall profitability. For example, the expenses of scheduled flights do not vary significantly with the number of passengers carried. Whether a flight is at full capacity or half capacity, the airline will incur similar labor, fuel and other costs. Therefore, on the revenue side, a slight increase in load factor (the percentage of aircraft seats actually occupied on a flight) may significantly improve the overall profitability of a flight. Similarly, on the cost side, a slight percentage increase in fuel costs could have a materially negative effect on an airline’s operating profits.
Labor and fuel costs disproportionately represent overall airline expenses. In 2018, labor and fuel represented approximately 24% and 32% of Spirit’s operating expenses respectively. Therefore, an airline’s operating efficiency depends highly on its ability to bargain effectively with its labor unions, as well as the pricing and availability of aircraft fuel. Some airlines manage fuel price volatility risk through derivative contracts. Others choose to pay market rates over long periods of time as a form of natural hedging, letting the occasional high price average out the occasional low price.
As one would expect, Spirit has relatively low unit revenues, given their cheap ticket prices. However, Spirit also has the lowest unit costs in the United States, and therefore has the advantage of being able to maintain profitability at low prices where its competitors cannot.
Spirit maintains another competitive advantage by operating a single-fleet type of Airbus A320-family aircraft that is one of the youngest and most fuel efficient in the United States operated by common flight crews. By operating a single aircraft type, Spirit is able to avoid the costs of training crews across multiple types while also making flight crews interchangeable across all aircraft. Additionally, the average age of an aircraft in Spirit’s fleet is only 5.4 years, allowing for comparatively low maintenance costs. However, it is expected that these costs will increase as the fleet ages.
In terms of performance, Spirit has been steadily improving. In 2015, Spirit ranked last among all U.S airlines in on-time arrivals. However, following a management change the following year, Spirit climbed its way to first place in on-time performance in 2018, while continuing to maintain its low costs. Additionally, Spirit’s cancellation rate improved from 6% in May 2017 to only 0.56% in the same month the following year.
Although Spirit has been around since the 1960s, it only transitioned into its current business model of ultra-low-cost-carrier in 2007. As a pioneer in the ultra-low-cost-carrier space, Spirit’s brand reputation has taken a beating over the years for being perceived as excessively stingy (customers were surprised about having to pay for a bottle of water), as well as their poor on-time performance and cancellation rates. However, Spirit’s brand has seen steady improvement over recent years as customers became more understanding of their business model, and as late/cancellation rates declined due to operating efficiency improvements. As a result, Spirit has more than doubled its share of the U.S domestic market to 4% in the past six years. It has grown its revenues by 72% over the past five years, and plans to continue growing its capacity in the mid-teens over the next several years. Spirit’s ability to grow its earnings will depend mostly on whether or not it can execute on its capacity growth plans and minimize cancellations, while continuing to manage and reduce costs. Over the next few decades, they may see gains from macroeconomic tailwinds, as the air travel market is expected to grow steadily. Additionally, low-cost-carriers have been consistently growing their share of the total air travel market, and if this trend continues, Spirit would be well-positioned to benefit.
Spirit is susceptible to many of the same risks as other airlines, including disruptions or cancellations from unexpected weather problems and other factors beyond Spirit’s control, rising oil prices and other variable costs, as well as other macroeconomic issues such as economic downturns. However, most of these issues are short-term in nature, and don’t pose existential threats to the business. The greatest threat to Spirit’s business is increased competition from traditional carriers. Beginning 2015, domestic carriers with far more resources than Spirit began to match lower cost airline pricing in order to compete with Spirit and other low-cost airlines. So far, Spirit has been able to hold its ground, continuing to grow its revenues and market share. However, it is uncertain whether or not Spirit can maintain its rate of growth in such a competitive environment.
Additionally, Spirit’s assets are almost 70% funded by debt, due to the large upfront costs of purchasing aircrafts. This could put Spirit in a bad position in the event of an economic downturn. However, this is somewhat offset by Spirit’s strong cash position of $1.22 billion compared to its current liabilities of $1.21 billion, resulting in a cash-ratio of 1.01, which is relatively high compared to other airlines. Over the past several years, Spirit has continued to maintain a strong cash position relative to short-term debt, demonstrating their intention to be prepared in the event of an economic downturn.
The following discounted future earnings model makes the following assumptions: Spirit’s earnings will grow at 5% year over year for five years starting July 2019; it will have a price/earnings ratio of 11 at the end of this period; and the investor demands an 11% annualized return during this period. Discounting future earnings under these assumptions, Spirit’s present value is approximately $3 billion. Its current market capitalization is about $2.8 billion, meaning that the stock is currently undervalued under these assumptions. However, any model is only as good as its inputs, and even a small change in expected earnings growth, terminal price/earnings ratio or discount rate could have a significant impact on the present value. Whether or not you should to invest in Spirit at these prices will depend on your own expected future value and required rate of return.
Despite being an underdog in the U.S domestic airline market, Spirit is a company with relatively strong fundamentals and solid growth potential. However, Wall Street does not seem to agree with this sentiment. Spirit’s price/earnings ratio of 8 and price/book value of 1.36 seems to imply very low expectations of growth, despite a history of consistent, moderate growth. If Spirit is able to effectively execute on its growth plans, it may prove to be a very profitable investment at today’s prices.
Disclaimer: Consult your financial professional before making any investment decision.