Description

Company Overview

Spirit Airlines is an ultra-low-cost carrier (ULCC) operating 420 daily, point-to-point flights to 61 destinations throughout the United States, Caribbean, and Latin America.  With its focus on the price conscious traveler, Spirit is often described as a bus with wings.  Its business model is based on providing rock-bottom, unbundled airfares by curbing operating expense while charging for amenities that air travelers have come to expect as part of their ticket price.

Industry Overview

For a full service US domestic airline, airfare represents 85% of their total revenue while ancillary revenue (sale of frequent flier miles, baggage fees, on-board retail and services) accounts for 12.5%.  On most long-haul flights, Business and First Class represent less than 30% of total aircraft seats but nearly 70% of the revenue.  However, when it comes to profitability, sale of frequent flier miles and baggage fees together make up nearly 75% of profits.  To compete, the ultra low cost carrier has had to learn how to be profitable without the lure of  Business or First Class service or relying on the sale of frequent flier miles.

The ULCC business model was pioneered in Europe by Ryanair over 32 years ago.  The idea was to challenge the duopoly that British Airways and Aer Lingus had on the daily flights from London to Ireland.  Because their original plane could only seat 15 people and the flight was less than an hour and a half long, Ryanair did away with amenities like food and drinks.  In addition, by flying from regional airports like London's Gatewick into Waterford, Ireland instead of Heathrow to Dublin, Ryanair was able to further slash its airfare to one third the price British Airways and Aer Lingus charged for a ticket.  Soon more planes and routes were added.

ULCC travel is well established and embraced in Europe, representing 24% of airline travel.  Ryanair controls over 50% of the ULCC market and has grown into one of largest European airlines.  Even though Spirit Airlines began operations around the same time as Ryanair, it only has a three percent market share, representing just over 50% of the ULCC portion of the US domestic market.  Over the next 5 years, the budget carrier market is expected to grow to be 8 - 10% of the US domestic market.

Business Model

The price of a Spirit Airline ticket gets a passenger with a small “personal item” that fits underneath the seat from the point of origin to the destination.  If a traveler would like to check a bag, use an overhead bin, have more legroom, choose where to sit or have a drink on the flight (including water), it costs extra.  In fact, passengers using a ticket counter agent instead of a kiosk during check-in will be charged a $10 fee for printing a boarding pass.  It may seem unimaginable that an airline would behave in such a draconian manner and still have passengers willing to fly on its planes; it would also have been inconceivable that an airline would forcibly remove one of its passengers because he would not “voluntarily” give up his seat for an airline crew member had a video not been posted.

Even with the lack of on-board service and conveniences, Spirit Airlines has maintained a load factor (how many seats are occupied per trip) of nearly 84.7% which compares to United at 83.5%, Delta at 85% and Southwest at 82.5%.  However, when it comes to profitability, Spirit leads the group with 11.5% margins while United, Delta, and Southwest have historically been in the mid to low single digits.  It costs Spirit roughly $65 (not including the cost of fuel) to fly a passenger, a cost that has remained consistent over the past 7 years.  The company’s non-ticket revenue over the same period has covered all but $11 of that cost.  With its airfare priced as a fixed spread over fuel costs, Spirit creates a steady and predictable operating profit per passenger between $0.017 and $0.025 cents/passenger/mile - 2.5x what the domestic carriers are generating.

Over the past four years, Spirit has doubled the number of planes in service, but ticket revenues and profits for the past two years have come under pressure as domestic carriers are taking advantage of lower oil prices (low fuel costs) to compete with the ULCC.  Air travel is a commodity and during times of low oil prices, domestic carriers will discount airfares in order to improve their load factor and compete with other airlines on specific routes, but that does not mean they will be able to sustain profits in the long-run.  When oil prices begin to rise and the spread between full service carriers and Spirit’s airfare widens, Spirit will be able to recapture some of its passengers while also benefiting from higher revenues and improved margins.

Investment Thesis

Even though Shares of Spirit Airline (SAVE) have appreciated about 50% over the past year, I still believe there is meaningful upside opportunity over the next 3-5 years.  Spirit Airlines future profitability will come from levering its existing business model.  Over the next five years, Spirit has announced that it will add up to 60 new planes to its fleet.  Assuming that the budget airline will maintain similar margins as it has over the past seven years, Spirit will continue to generate a steady $0.02 / Available Seat Mile (ASM) of operating profit.  By the end of 2021, the airline could comfortably be generating twice its current EPS, especially if oil prices increase from the low levels we have seen over the past two years.

Competitive Edge

Spirit’s competitive edge starts with its fleet of 100 Airbus A320s, which is the youngest fleet of any US carrier and configured to hold 20% more passengers than its domestic counterparts.  The seats themselves are lighter, smaller, and do not recline.  Since all the planes are the same, Spirit saves money by training its pilots and maintenance crew on one type of aircraft.  Having the newest planes also translates into fuel efficiency, and when operating 12.5 hours/day, gives Spirit the lowest cost per available seat mile (CASM) of any domestic US carrier.  These cost savings are used to keep its ticket prices low.

Operating in this niche segment of the airline industry is also an advantage for Spirit.  Even though the large domestic carriers have lowered prices to compete with Spirit as oil prices declined over the past two years, none of them have the cost structure to maintain the pressure for the long-run.  When oil prices begin to increase, the price spread between Spirit’s airfare and that of the large domestic carriers will widen.

Growth Catalyst

Spirit will be adding three variations of the Airbus A320 to its fleet over the next five years bringing its total fleet to 160 planes.  At fiscal year-end 2016, Spirit was averaging 295.7 million ASM / plane or 25.5 billion miles in total for the year; this equates to an average of 172 seats per plane.  Based on management’s guidance provided in March of 2017, by the fiscal year-end of 2017, the company expects to have 110 planes in service with an average of 182 seats per plane.  This would improve the average ASM to 312.2 million / plane or 34.3 billion total ASM.  Based on the projected delivery schedule released in the company’s annual report, by fiscal year-end 2021, Spirit will have 158 aircraft in service with an average seat capacity of 186, bringing the average ASM / plane to 319 million or a total of 50 billion ASM, doubling its ASM in 5 years.

Over the past five years, Spirit Airlines has had an average load factor of 85.5% compared with current levels of 84.7% and an industry average of 83.5%.  As fuel prices move higher, expectations are that the cost spread between domestic airfares and Spirit will widen, allowing for improved load factors and profitability.

Valuation

Since there are a number of variables that impact the airline industry (fuel prices, economic growth, competition), the best way to value Spirit is by getting comfortable with the downside (bear case) and then determining what a reasonable base and bull case valuation would be.

Bear Case

• If the economy slows down or moves into a recession, there will be a small to meaningful decline in air travel.  Even with its expanding fleet, Spirit’s ASM / plane will likely fall as daily departures decline.  My assumption is that Spirit’s average operating profit of $0.02 cents/passenger/mile decreases to $0.0165 cents/passenger/mile - levels seen in 2009 and 2011.  In addition, the ASM / plane hits 265 million, reflecting levels in the 2009 - 2011 time period.  In the short-run (2017 - 2018) when using both EV/EBITDAR and EPS metrics, Spirit value falls to the mid $40’s (multiples:  EV/EBITDAR=5.5x & EPS = 10.5x).  By 2021, even by keeping the ASM and operating profits the same, valuation recovers taking the stock to $68 - $70/share.  

Base Case

• The base case returns the operating profits to $0.02 cents/passenger/mile but keeps the ASM steady at very conservative 300 million / plane reflecting an economy that continues to grow at subpar levels while oil prices remain steady.  Using an EV/EBITDAR multiple of 6.5x & EPS multiple of 12.5x, by 2021 Spirit is valued at slightly over $100/share.

Bull Case

• The Bull case assumes that the average ASM increase to 315 million per plane, generating operating profits of $.0225 cents/passenger/mile.  Imbedded in the rise in operating profit is the gradual rise in oil prices.  Using elevated multiples of 7.5x & 15x for EV/EBITDA and EPS, respectively, reflects the growth in both the company and the ULCC segment.  This values Spirit Airline around $150/share by 2021.

My valuations are linear.  I am not giving any credit to growth in ASM or operating earnings between 2017 and 2021.

Risks

There are a number of risks facing Spirit and the airline industry:

• Competition from other carriers:  There is nothing stopping another carrier, including the large domestic airlines, from invading the ULCC space.  This was actually the trend over 14 years ago when Delta, US Airways, American Airlines and United all created budget airlines under different brands (Song, MetroJet American Eagle & Ted).  They have all since shut down or operated by a third party, as the domestic airlines were unable to wring out the necessary costs to make those flights profitable, let alone break even.

• Union Strikes:  Approximately 73% of Spirits employees are represented by 4 labor unions.  Spirit pilots have been negotiating with the company for a new contract for the past 2 years and are becoming more vocal about their disappointment.  The same sentiment is being expressed by pilots from Frontier Airlines, Jet Blue, and Alaska Airlines; no airline is safe from union negotiations.

• Fuel Prices:  Fuel costs make up a significant portion of Spirits operating expenses.  From time to time, Spirit Airlines has used fuel derivatives to hedge their fuel costs.  As of the end of March 2017, the company did not have any derivative hedges outstanding.  With its airfare priced as a fixed cost over fuel prices, Spirit’s business model is designed to be flexible and react quickly react to changes in its cost structure.  However, as one industry insider pointed out, the longer the Spirit pilots contract negotiation remain unresolved, it is very likely their fuel costs will trend higher.  Pilots have significant control over the fuel efficiency of a plane and will often reflect their displeasure through higher fuel costs.

• Economy:  Airlines are highly correlated to the economy and Spirit is no different.  If the economy were to go into another recession, Spirit's routes, load factor and revenues would be negatively impacted.  This would also put a burden on its business model and balance sheet as the company is in the process of purchasing up to 60 new planes over the next five years.

Summary

Historically, the airline industry has been a very poor investment.  Airlines require vast amounts of capital in order to keep their planes and passengers airborne.  The return on investment has been chronically low, as air travel is a commodity and it is much easier to lower airfares than raise them.  With the fall-off in oil prices and lowered airfares over the past two years, full service airlines have witnessed an increase in traffic and profitability.  However, most of those profits are from non-ticket revenue such as mileage sales and baggage fees.  Spirit’s business model has demonstrated, over the last two years, that it can operate profitably when fuel prices are low and maintain a return on invested capital that consistently ranks in the upper teens and above.

The FAA anticipates that demand for domestic air travel will double over the next 20 years, with domestic ULCC market growing to 15-20% of the market by 2035.  Doubling air travel will put a strain on the major city airports, most of which have limited opportunity to expand.  This will lead to regional airports picking up some of the slack as infrastructure and investment money finds its way into renovation and development projects.  Regional airport expansion plays to the strength of Spirit’s business model, because takeoff, landing fees and gate fees are significantly discounted when compared to the major city airports.  Of course, all of this air travel growth assumes that the economy continues to grow at a steady pace.

If the economy were to fall into a recession, airlines would suffer in much the same way they did in 2008-2011.  A continued slow economic growth coupled with rising oil prices would reflect the airline industry of 2011 - 2015.  Spirit Airlines has demonstrated that its business model has built-in flexibility to continuously price its airfare as a fixed spread over fuel costs, as well as quickly switch its routes to maintain and maximize its revenues.

All of my valuation assumptions are linear, meaning that I do not attribute any growth or decline in ASM or operating profit between 2017 and 2021.  Although this does not reflect the world in which we live, I believe that it helps in focusing on the downside valuation.  My belief is that if you can get comfortable with the “Bear” case over the next five years, the upside will take care of itself.

Catalyst

• The addition of 60 new Airbus A320 planes over the next five years which will increase the average seats per plane from 172 to 186 by 2021. This will improve Spirit's ASM per plane and lower its CASM.
• Rising oil prices will help widen the spread between Spirits airfare and a full-service carrier's "budget" ticket - elevating Spirit's load factor back its 85.5% level

Over the past five years, Spirit Airlines has had an average load factor of 85.5% compared with current levels of 84.7% and an industry average of 83.5%.  As fuel prices move higher, expectations are that the cost spread between domestic airfares and Spirit will widen, allowing for improved load factors and profitability.