Description

Spirit Airlines (SAVE)

Spirit Airlines (SAVE) is an ultra low cost airline with the lowest costs and best margins in the U.S. airline industry. They provide extremely low priced flights to a combination of vacation destinations, secondary markets and between selected major cities. Despite cramped flights due to more seats per plane and endless complaints about their service their flights are full and the airline is profitable.  I argue that the niche Spirit fills is right for the new normal. Think of them as the dollar store of airlines.

Using 6.5 EV/EBITDAR, which is the valuation of direct peer Allegiant, and my 2012/2013 EBITDAR estimates, I believe Spirit stock offers investors 34% and 60% upside, respectively, over the next two years driven by continued execution and plane deliveries that will increase the size of their fleet by 19% in 2012 and 16% in 2013. Beyond 2013, Spirit’s plane delivery plan will continue to average ~15% growth in planes per year and thus potential upside to the stock price in the out-years should they continue to execute.

Understandably, most analysts, me included, have it ingrained in us to avoid airline stocks, perhaps more so than stocks of any other industry. After all, even Warren Buffett failed when he invested in a legacy airline, U.S. Air, years ago and swore never to do so again. If the Sage himself couldn’t succeed, it’s best to just leave the group alone, right? Yet it’s the same Warren Buffett that today owns NetJets. I argue the maxim really only applies to legacy, traditional airlines like U.S. Air and their peers.

After all, consider how much money was made at various points in time owning stocks of companies such as Southwest, Ryanair, Aligent, and Alaska. I argue these cases provide evidence that it is the traditional, legacy airlines that are the bad bets for long-term investments. However, money can be made in airline business models that work.  Indeed, the ultra low cost airline model is sturdy as both Spirit and Allegiant were solidly profitable in 2008 and 2009.

While this thesis is not dependent on a positive airline industry environment, it is worth noting that at the moment the industry is undergoing one of its occasional periods of rationality driven by consolidation and capacity restraint which is allowing ticket price hikes to hold. It won’t last forever, but while it’s here it is helps.

Spirit Airlines enterprise value breaks down as follows:

Market cap                                         $1,406

Cash                                                   (364)

Debt                                                       0

Capitalized op leases*                            701

Enterprise Value                                 $2,526

*Capitalized operating leases = 6x aircraft rent. CreditSights uses a six multiple.

 As of the end of 2011, the company leased 37 aircraft flying 190 flights daily to over 45 destinations throughout the U.S., Caribbean and Latin America.  Fort Lauderdale, FL, is the company’s headquarters and “hub” as it serves as the connection point from U.S. cities to the large number of destinations they fly to in the Caribbean, Central America and the northern portion of South America. The company’s target market is leisure travelers and those traveling to see friends and relatives.

Follow this link for a visual of the flight routes: http://ir.spirit.com/fleetplan.cfm.

The company has 31 on order to be delivered between Q4’11 and the end of 2015. In November, 2011 they signed an additional agreement with Airbus for an additional 75 aircraft to be delivered from 2016 to 2021.

Link to fleet plan: http://ir.spirit.com/fleetplan.cfm

BUSINESS MODEL

Business travelers and the well-heeled would not enjoy flying SAVE and the company’s CEO Ben Baldanza makes no bones about admitting that their service is not for everyone. Whereas JetBlue fits 150 seats into an Airbus 320, Spirit shoehorns 178 seats. It’s cramped.

The company’s business plan rests on the following three-points (management has more points, but I distill):

• Operate only on routes that are profitable wherever they may be
• Keep costs low
• Remember that their product is their low ticket prices

I highly encourage one to view a recent company presentation from the investor relation section of their website. I think it is important to listen to the audio as management does a great job explaining their strategy. 

DRIVER #1: OPERATE ONLY ON ROUTES THEY CAN MAKE MONEY

Spirit selects routes based on projected profitability regardless of where those routes may be. This includes flights to locations throughout Central America and even Haiti in the Caribbean. The objective is to come in on a route and lower fares at least 25% in order to stimulate and skim marginal demand. If a flight doesn’t make money it’s scrapped and assets are redeployed elsewhere. Management currently sees over 300 market pairs that can meet this hurdle. 

While their overall focus is locations in the Caribbean and Latin America, a region that is generally underserved by low cost carriers, they don’t hesitate to go wherever they believe money can be made. Lately they have added more U.S. locations. 

DRIVER #2: KEEP COSTS LOW

According to a Feb 2^th, 2012 company presentation, SAVE’s breakeven fare per passenger was $62.96. This amount compares to nearly $189 for American Airlines.  Cost per available seat mile (CASM) is much lower, too. See below. 

Breakeven Fare, $                                           CASM (cents)

American                             189                                                                         16.14

Delta                                     166                                                                         14.89

JetBlue                                 133                                                                         12.13

Southwest                          97                                                                          10.43

Spirit                                      63                                                                          9.73

 SAVE deploys a number of strategies to maintain these low costs, including:

 Fitting planes with a high density seating configuration. Spirit configures their A320 with 178 seats compared with 150 seats over at JBLU.

1. Flying more fuel efficient airplanes, specifically the A319 and A320. 
2. 3.       Maintaining high average daily aircraft utilization. Spirit average utilization is 12.8 hrs/day compared to 11.7 at JBLU and 10.9 at LUV. Thus, they turn aircraft faster. 

DRIVER #3: THE PRODUCT IS LOW PRICE

The only reason to fly Spirit is because you either need a really low priced ticket or you really want a low priced ticked. As it turns out there are a lot of people in these two categories. Spirit flights are cramped, no frills and they nickel and dime their customer to death. As they are quick to point out no one is required to fly their airline. 

To keep the base cost low, customers are charged for everything including seat selection, to check bags and more even for bringing on an overhead bag (a bag that fits under your seat is still free). Customers are also accosted by on board advertising of every sort and fees for all onboard items. 

Spirit is adamant that breaking down the cost of everything and charging for it allows flyers to decide what they want to pay for. The charge for stowing a bag in the overhead is worth some review as it is the one that pisses off everyone the most. The press and politicians went nuts. Cries were even made for a law to force airlines, Spirit in particular, to allow free overhead bags. Of course, this is ridiculous. All those customers lining up to buy tickets and fly Spirit can just march down the terminal and pay a higher price to fly any of the other airlines that don’t levy a specific charge for an overhead bag. 

 Yet, consider Spirits view on this. The stowing of overhead bags takes time. We’ve all been there stuck in the isle trying to board as one passenger and then another takes the time to stow their overhead bag. Then finally we hold up the line to stow our own bags. Less time wasted means higher aircraft utilization.  Higher utilization means lower costs. Less bags means less weight. Less weight means less fuel burned. Less fuel burned means lower costs. Lower costs mean lower ticket prices. The cost can be isolated and customers can be charged and decide for themselves whether to pay it. If one prefers to fly an airline were flyers collectively assume this cost, then so be it. 

Think about it. Say you’re a poor immigrant who would like to go visit your family back in Port au Prince, Haiti (recall they fly to Haiti) and you can stuff a change of clothes or two and a toothbrush in an under the seat bag on and save a few bucks. Those saved dollars might be the difference between going or not. It all makes sense. The same goes for that fraternity brother making it to that all important spring break trip. Every dime is another PBR. 

Search airline complaint boards and one quickly finds it full of complaints about SAVE’s service (ranging from lack of leg room, to ability to be on-time, to extra fees for taking too much luggage, the staff, etc, etc, etc), but I believe these complaints should be taken in context. This is the airline industry. Click over to the boards about other airlines and one quickly finds that fliers have pretty much nothing good to say about all airlines. All airlines are pretty miserable. With that said my qualitative review of complaints suggests the venom is worst for SAVE (followed by Allegiant). 

Given the cattle car nature of the service provided by SAVE and ALGT, it makes sense that they get the most complaints. However, the complaints that ALGT has received have not stopped the stock price from going up. SAVE’s stock may not go up, but I doubt it will be because they get the most complaints in the industry. In fact, I would not be surprised to find that many of these complainers will indeed fly SAVE again. Let me explain by way of anecdote.

A money manager friend of mine flew Spirit over the holidays. He and his wife went to see their daughter who recently graduated from college. He said the experience was horrendous and he would never fly them again. I called him back and noted that while I assume he would not fly Spirit again, I wondered if his daughter was coming to visit him and if he was paying for the plane ticket would he have any problem having her fly Spirit. He responded that while he feels her pain for having to deal with the terrible Spirit flying conditions he would indeed buy her a Spirit ticket assuming it is cheapest. Oh, and upon further thought he conceded that I should not assume he would not fly it again as he admits he is a pretty cheap spender and Spirit has cheap flights.  This makes me think that no small number of those posting garden variety SAVE complaints may very well fly Spirit again.

Finally, in making the case for Spirit filling a niche I add my own experience with an ultra low cost airline. After b-school my soon to be wife and I tramped around Europe for a couple months. Money was tight and we got from city to city on an ultra-cheap airline that charged 99 euros for each flight. I specifically recall not enjoying the experience, but it fit our budget. It was either fly the ULCC or stay home. I’m not eager to relive that or to fly Spirit, but under the right conditions, I too, would get on board an ULCC airline again.

MANAGEMENT HAS WHAT I WOULD TERM “UNIQUE” PROMOTIONAL STRATEGIES.

Management is not afraid to promote their DDs, MILFs and to encourage MUFF diving in order to entice new flyers; that is to say their Deep Discounts; More Islands, Low Fares; and diving into their More Unbelievably Fantastic Fares.

And then, of course, there is the stripper mobile:

http://www.jaunted.com/story/2011/6/10/84844/4411/travel/Spirit%20Airlines%27%20Sleaziest%20Ads%20Yet%20Bring%20Out%20the%20Strippermobile

OK, everybody simmer down, I’m just the messenger.

It goes without saying that this kind of sophomoric advertising draws slings and arrows from all sorts of consumer groups, political interest groups and politicians. However, I’m with Spirit’s CEO and private equity backers on this one (Oaktree Capital and Indigo Miramar). The tactic works like a dream.  The various consumer groups, interest groups and politicians that boil over with scorn and incredulity at Spirit’s nerve issue press releases and in the process generate even more advertising for Spirit as the news outlets pick up the story. This is clearly the plan here and I think the CEO and the private equity team are crazy like foxes on this one.

If Spirit uses risqué advertising to drum up free advertising, then their latest spat with the FAA shows how they use controversy to do the same. Last week a new FAA rule went into effect that requires airlines to advertise the entire cost of a ticket including all the government taxes. SAVE along with a number of other airlines including Jet Blue and Southwest are protesting this change. However, unlike the other airlines which are quietly filing a protest to try and overturn the ruling, Spirit is publicly attacking the government for requiring airlines to “hide” the cost of government taxes in their tickets and thus trying to mask to flyers how much the government is jacking up the cost of their flight. Yep, politicians are furious (in particular, Senator Barbara Boxer) and, yep, Spirit is getting even more advertising out it.

The same goes for the “negative” press they get at times for some of the new fees they generate. It seems bad at first, but then you realize that it keeps bringing more free advertising. One harrumphs over the gall Spirit has to charge for X or Y or Z, but it only further gets the word out Spirit is the place for a cheap flight.

PRIVATE EQUITY OVERHANG DISAPPATING

Spirit IPO’ed in May of 2011 at $12/share. Post the IPO, the airline was 68.5% owned by its private equity backers, Oaktree Capital (26.8M shares, 37.3% holding) and Indigo Miramar LLC (22.4M shares, 31.2% holding). Late in January 2012 a secondary of 11M shares was completed at $14.50 somewhat reducing the overhang. Post close of the secondary the stock shot right back up so thus far the market is able to soak up the supply.

LABOR ISSUES

Spirit had a pilot strike in 2010 that hurt bookings, but was quickly settled. They’re currently in dispute with their flight attendants. If the stock was hit because of a strike I believe it would be an excellent buying opportunity as I suspect it will be settled in reasonably good speed.

FINANCIALS

Spirit’s top line is driven by their plane delivery schedule which has them taking delivery of roughly 15% new planes per year through 2015. In 2012 and 2013 the deliveries will increase their planes by 19% and 16% respectively.

I’m assuming ~2% growth in yield (revenue per revenue passenger mile) for 2012 over and above the Q4 2011 exit rate (about 6% YOY). Fuel costs are assumed to rise 7% from year-end 2011 exit rate (roughly current fuel increase YTD). Should oil rise then Spirit should have additional pricing power as legacy carriers should increase prices, too. My 2013 numbers assume all these factors remain roughly the same, but they simply add more planes. These factors drive a 15.1% operating margin. This compares to a peak operating margin in 2009 of 15.9%. EBITDAR and earnings for 2012 and 2013 come to $357M and $421M and $1.77 and $2.11, respectively.

Upside exists should oil remain stable and the industry remain rational. Further consolidation and restrained capacity additions should allow for further price hikes and better margins for Spirit. In fact, Street estimates for 2012/2013 are well above mine and I believe if a couple things break the company's way then Street numbers are unattainable. It only takes a few ticks in the right direction by oil or fares or both and you get to their numbers. I’m merely being conservative.

For valuation purposes Allegiant (ALGT) serves as a good comparison for Spirit as it is in the U.S and is a ULCC very much in the vein of Spirit. During periods when business was good and the economy was stable/up ALGT traded between 6 and 12x EV/EBITDAR. Today it trades at 6.7x EV/EBITDA. I’m using 6.5x for Spirit.

Based on 6.5x EV/EBITDAR (see below) I believe Spirit stock is worth $25.75 based on 2012 numbers and $30.75 on 2013 numbers. My model has earnings of $1.77 in 2012 and $2.11 in 2013 putting P/E at fair value at 14.5.

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