Description

Spirit Airlines, Inc. is a merger arb where the reward to risk seems more compelling than ever. While the story has appeared on VIC a few times, for a good overview of the proposed merger I refer you to the writeup by zax382 in May 2022, when SAVE traded at $20.88. Having bounced to nearly $25 in short order, the stock has since tanked to the current price of $15.79.

As a reminder of the timeline, on October 19, 2022, Spirit stockholders voted to approve the Agreement and Plan of Merger. Spirit and JetBlue expect to conclude the regulatory process and close the transaction no later than the first half of 2024. On March 7, 2023, the U.S. Justice Department filed suit to block the merger. The airlines disagree with DOJ’s attempt to block the merger and will defend it in court. The trial date has been set for October 16, 2023.

Spirit shareholders were to receive consideration of $33.50 per share if the merger closes by Jan 2024. That amount includes the $2.50 that was already prepaid as well as the “ticking” fee of $0.10 per share per month that’s being paid since Jan 2023. Outside date is July 24, 2024, with total consideration increasing to $34.15.

SAVE’s stock currently reflects a low probability of the merger going through. However, these concerns around antitrust enforcement seem overblown. The ‘Big Four’ airlines still command a massive market share of around 80%, and other airlines really need some scale to be able to compete effectively. Given that a combined SAVE + JBLU airline would still only reach #5 status, it can be questioned whether antitrust (with hands very full from all the ongoing and expected lawsuits now) really wants to devote its limited resources to fighting this particular one out. The ongoing collapse in margins and stock prices at JBLU and SAVE, even as the Big Four report good margins, only strengthens their arguments before the court. And for what it’s worth, the judge was a Reagan appointee.

Meanwhile, Robin Hayes at JBLU still seems firmly committed to closing this deal. JBLU recently announced a termination of its Northeast Alliance (NEA) with American Airlines. It also announced an agreement with Frontier to divest all of Spirit’s holdings at LaGuardia conditioned upon closing of the JetBlue-Spirit transaction. These ‘burn the bridges’ actions significantly strengthen the case in favor of the merger.

I also refer you to zax382’s analysis of city pairs. It seems a stretch to think the merger would be denied against this backdrop. I think the actual merger probability is close to 70%. As the story drags on and Mr. Market yawns, it ultimately sets up the stock for a hockey-stick move if the merger is approved. More than 15 months have already passed since JBLU made its offer, bringing us that much closer to a conclusion and a potentially high IRR.

If the merger fails to go through and SAVE stock gets punished, it is worth noting that you are left with a low-cost airline that looks quite interesting even as a standalone entity. In that case, JetBlue pays Spirit a reverse break-up fee of $70 million and shareholders of Spirit a reverse break-up fee of $400 million less the amounts prepaid prior to termination. You end up owning SAVE standalone shares for around $15.

Since Covid-19 played absolute havoc with the numbers for all airlines for an extended period, it is worth revisiting profit margins during the pre-Covid period. From 2017 to 2019, Spirit Airline pulled off the following:

                                                            2017                     2018                     2019

Pre-tax margin, non-GAAP            13.7%                   11.9%                   11.9%

(Source : Spirit Airlines February 2020 Investor Presentation)

The new consensus seems to be that the higher margins of low-cost airlines have somehow ended permanently, and that low single digit margins are the new normal. This is overly pessimistic. Since Covid, low-cost carriers have rightly chosen growth instead of profits and captured a disproportionate share of returning passengers. New routes, pilots, cabin crew, ground staff, equipment & training – these are significant expense drags that hit the income statement before the associated revenue starts to flow. In addition, Spirit is getting hammered by issues related to GTF engines, Florida weather, and ATC staffing. While these problems won’t be fixed in a month or two, they shouldn’t be permanent either.

As a mostly domestic airline, Spirit was also hit hard by a shift in passenger preference towards international travel. It is worth mentioning that a very weak Euro, which troughed vs. the US Dollar in the Sept-Nov 2022 timeframe, would have caused travelers to pivot forward bookings towards Europe vs domestic US travel. The Euro has recovered since, and inflation has been running higher there, eroding some of the advantages of Europe as a destination.

In line with most Airbus customers, Spirit is expecting somewhat reduced near-term aircraft deliveries. Despite this, they have a solid orderbook with an attractive delivery schedule that is still “in the money” given the continued tight supply/demand environment for neo aircraft.

As growth slows and some of these issues resolve, margins should trend back to pre-Covid levels. Let’s not forget that revenues for SAVE are on track to approach 2x the pre-Covid period, and that margins expand as routes mature. Margins should also be helped as old A319ceo aircraft are retired in favor of 15% more efficient A320neo, and by the even more efficient 235-seat A321neo planes. If Spirit gets to 10% EBIT margins on 2025 consensus revenue of $7+ bill, that would drive pre-tax earnings to between $4 and $5 per share. The stock isn’t priced for that, setting it up for outperformance at any earnings multiple, even absent a merger.

You can play with the numbers and assign your own probabilities to the merger. Bottom line is, SAVE stock seems compelling here.

Catalyst

Merger