Description

Spirit Airlines (SAVE) has become an interesting special situation / risk arb opportunity with limited downside at today's price given available hedges. 

The quick summary is that SAVE now trades below its unaffected price from when its deal with Frontier (ULCC) was announced, and slightly below the implied value of the Frontier offer. There is an all-cash offer almost 60% above the current trading price from Jetblue, and a few ways JBLU could still win this deal. 

Background:

As this is a risk arb situation I will not waste time with the details of the businesses, other than to say that ULCC and SAVE are "ultra low cost" domestic airlines - the two largest in this category - whereas JBLU is generally thought of as a "low cost" airline akin to Southwest. SAVE has more seats per plane, worse services, charges you for every bag, etc. JBLU is a little more service oriented but still puts price pressure on the big guys.

On February 7th, ULCC and SAVE announced a merger, where ULCC would be acquiring SAVE in cash and stock. The ratio for the deal is 1.9126 shares of ULCC and $2.13/share in cash for each share of SAVE. 

SAVE stock jumped 17% on the deal and even went higher the next few days, and ULCC's stock also traded well. The spread traded as narrow as 5% on day 1, although the premium wasn't substantial -- The unaffected price of SAVE was $21.78 and the deal implied $25.83, or a 19% premium.

Soon the spread settled in the 7-8% range, but the sector sold off, with SAVE, ULCC and JETS all falling 22-25%. 

By April 5, JETS had recovered all of its losses, but ULCC continued to underperfom by about 11%. This could have been arb flow pressuring the shares, or more fundamental skepticism around the deal. As you might expect SAVE correlated very well with ULCC given the arb dynamics.

On April 5, JBLU offered $33 in cash for SPR, a 50% premium to where the stock was trading and about that vs SAVE's unaffected price. The rationale for the deal was that JBLU+SAVE would finally give the airline enough heft and diversity to compete with the four major national carriers, there would be significant synergies, service levels at SAVE would improve, more opportunities for SAVE employees, etc. The fundamental idea was that JBLU, which has demonstrated a downward pressure on prices vs the main carriers when it enters a market, would be able to propagate this effect across a broader set of flights. Implied was that SAVE, with its low service quality and mediocre offering, doesn't really compete with the big 4 today.

SAVE's stock rallied on this deal and then faded, most notably on May 2nd when they reiterated their support for the Frontier merger and rejected the JBLU deal.

This is where things get interesting. The letter that SAVE made public appeared almost exactly in conjunction with a revised offer from JBLU. The revised offer committed to substantial divestitures including in any Northeast market and Ft Lauderdale, and said any divestitures which did not qualify as a MAC -- a pretty sizeable concession. In addition they committed to a break fee of $1.84/share to SAVE (almost 10% of the current market cap). 

SAVE's letter was strange. Clearly it was written in rebuttal to a private and improved offer from JBLU, but looked hastily constructed to respond to this better deal. In fact, in one paragraph it mentions how they wanted a break fee, and then in the last paragraph they contradict themselves and say that a break fee is not enough. A strange situation.

JBLU put out a public presentation about its new deal and why they thought it would more easily pass anti-trust scrutiny than the ULCC deal.

Today (May 5), SAVE put out a revised presentation directly addressing the JBLU deal, with the main argument being that it would not survive DOJ scrutiny due to conflicts in the NEA. This is despite JBLU agreeing to divest any legs within the NEA, which to me seems to entirely solve this issue. 

Risk/Reward and Trade Setup

The trade here is fairly simple. If the status quo persists and JBLU fails to win support for its deal, then a properly hedged long in SAVE will likely lose very little money. One could hedge with ULCC on the deal terms - or as I prefer - hedge with the more liquid and less shorted JETS. JETS has a 90% correlation with SAVE over a multi-year (including covid) timeframe and even 90% recently outside of deal announcement days. 

This way, you can hang around until the deal vote, owning SAVE at below its unaffected price. If the market starts to believe that the ULCC deal also can't get done (which I think is reasonable and will address below), then you still don't have a ton of downside as we're below the unaffected price and you are really just taking more generic airline risk where you can be hedged. There is likely a 5-10% "arb freakout" risk if the ULCC deal unexpectedly breaks but that probably won't happen for a while anyway. If you hedge solely via ULCC I could see a situation where ULCC goes up 8-10% and SAVE doesn't move much as a deal spread materializes, so I think less risk with JETS but either probably works well. 

BUT in the event SAVE is forced to go with the bid from JBLU, you can make 35%+ on the day they agree, even assuming a very wide deal spread emerges. 

JBLU's Opportunity:

JBLU has made its bid public, including its sweetened offer, and did so AFTER they knew that SAVE would reject their new proposal. They seem highly committed to this deal, and have clearly thought through the implications of going public. All of their moves to date strike me as being aggressive.

There are three distinct ways JBLU can win this deal, in my perspective:

1) The easiest is that they choose to abandon the NEA, which is SAVE's essentially only argument against the JBLU deal today. More on this below, but it is well within JBLU's ability to just walk from this, or they could perceive that they will lose the upcoming NEA case with the DOJ and so walk anyway given lack of downside in doing so. I think this is definitely still on the table.

2) JBLU seems to be openly recruiting an activist. And the activist case here seems amazing -- an all cash bid up 60% for a deal that I think has a better chance of getting approved than the ULCC bid (but also you don't even have to take that risk, just get the deal agreed and move on), and very limited downside as you're buying SAVE below its unaffected price and you have hedging options that dramatically reduce risk of capital loss. Given the combo of smallish market cap (2.2bn) and a ton of trading volume (115m a day), an activist could build a large position here quickly. And, great mechanism for action in the upcoming shareholder vote. 

3) The ULCC deal requires a shareholder vote, which should happen in June. JBLU has many mechanisms to disrupt this vote including a "best and final" offer as it approaches, or discussions with proxy advisors like ISS. The cash upside should be very appealing to shareholders. 

SAVE's Objection

An important question here is - what is SAVE doing? There are a few theories:

1) SAVE has been a huge opponent to JBLU's Northeast Alliance with American Airlines. They have consistently argued it is anti-competitive, written briefs in support of the DOJ's case, etc. They are kind of locked in from a public perspective to be anti-JBLU while the NEA still exists. Also you kind of get the sense they hate JBLU. But it would be very difficult to turn tail on the NEA, then go back to the DOJ to approve the JBLU deal and be like, yes, JBLU is great. In some ways they may NEED an active shareholder to push them in the right direction here. And look, to their credit, they may just honestly believe that because of the NEA the DOJ hates JBLU and so nothing involved with JBLU is going to work. But importantly -- JBLU agreed in its latest offer to divest any legs in the NEA. To me this really destroys SAVE's best argument - and they basically say "well, sure, but its still not good enough."

2) SAVE may see the big reopening opportunities that are coming in 2Q/3Q and want equity upside and worry about the truncated opportunity with just $33 share price. This obviously looks silly right now but management teams often think about only the most optimistic scenarios when evaluating this type of thing.

3) They anchored on "no" before JBLU improved their deal and they are stuck there. This is what their rejection letter reads like. 

Anti-Trust Concerns:

So, the key question is -- can JBLU get this deal done? Obviously can't say with certainty, but in evaluating this pro-forma for the divestitures they had mentioned, I have been pleasantly surprised with how much easier this deal has gotten. I think it has a much better chance than the ULCC-SAVE deal when viewed objectively.

First, strategically for the consumer it makes a lot of sense. Creating a 5th powerful national airline with low cost DNA is going to benefit more consumers across the country than simply merging the only two ultra low cost players. Imagine if a second Southwest popped up -- its a nightmare for UAL/AAL/DAL. But that is effectively what JBLU is trying to create here. Whereas with ULCC-SAVE, you aren't going to change much other than making the ultra low cost portion of the market even less competitive. Net benefit to consumers seems significantly less on its face to me. 

Second, when you get down the brass tacks and look at overlap, the JBLU deal also makes sense. The total number of legs overlapped by the two companies is 48, whereas the overlap with ULCC-SAVE is 76. So hard to see how JBLU is worse. More importantly, however, the divestiture proposal put forward by JBLU includes any leg that interacts with the NEA (most of northeast) and Ft Lauderdale. When you then look at overlapping legs and airports, it gets stark:

As you can see, JBLU has effectively committed to divest 14 of the worst 15 overlapping legs between the airlines. The only remaining suspect flight is Orlando to San Juan -- not a giant issue. 

When you look at overlapping airports by market share, similar dynamic: 

This leaves only two modest problem airports -- Orlando where they will have a combined 25% share (LUV has a 23% share there now) and San Juan, not a giant market. JBLU seems to want to move heaven and earth to get this deal done and this is a very effective divestment commitment. 

Timeline and Risks

This looks like such an obvious activist target to me with so much upside I have to imagine that someone (or even multiple parties) will show up to try to make the case to shareholders that the JBLU deal is superior. The actionable window for this is today until the record date, which likely will be set in 6 weeks or so. As such, I could see a fairly quick resolution here. JBLU may also choose to improve its bid further or generally begin taking its case to shareholders. 

The key risks:

1) You need to hedge airline exposure via either the deal stock (ULCC) or a basket (JETS). As I mentioned, the historical correlation here is fantastic but, of course, correlations do break down. I could imagine a situation where one is hedged JETS and ULCC underperforms or vice versa. That said, I still believe total risk will be fairly small compared with the JBLU deal upside.

2) If the entire airline space rips higher on better re-opening results and the JBLU $33/deal stops looking as attractive, the impetus to go with JBLU will be less. Long way to go though. 

3) Look, maybe no one shows up or JBLU just walks. In that case perhaps those like me hoping for more sell the stock, although we're already below the unaffected price here even adjusting for macro moves and so there isn't really a "deal break" scenario that sounds super scary. But arbs could freakout and hit the stock modestly.  

Disclaimer

This document is for informational purposes only. All content in this report represents the author's opinion. The author obtained all information herein from sources believed to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind — whether express or implied. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any information contained herein. This report is not a recommendation to purchase the shares of any company. The information included in this document reflects prevailing conditions and the author’s views as of the date submitted, all of which are accordingly subject to change. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity. Any or all forward-looking statements, assumptions, expectations, projections, intentions or beliefs about future events included in this document may turn out to be incorrect. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment prior to making any investment decision.

Catalyst

• Activist shows up to pressure SAVE to re-evaluate deal
• JBLU takes case to shareholders / ISS
• Deal vote in June