Spirit Airlines Inc. ("Spirit" or the "Company") trades at just 10x forward earnings.  Net of its cash, it trades at just 7x forward EPS.  This despite 40%+ after-tax returns on its invested capital (high teens returns if all operating leases are treated as capital leases), double digit operating margins, and tremendous free cash generation.  The Company has a huge growth runway ahead with an aircraft order book that implies a more than tripling of its fleet over the coming decade.  Strong management and a defensible competitive niche should drive strong upside going forward irrespective of the competitive environment, with additional upside optionality to the extent that current industry-wide capacity and pricing displine is maintained.

Spirit is a low-cost airline that operates a fleet of 45 Airbus A320 aircraft.  Its aircraft serve roughly 50 destinations with over 200 daily flights.  Spirit categorizes itself as an ultra low-cost airline ("ULCC"), a segment that targets an even more price sensitive consumer than other low-cost airlines such as JetBlue and Southwest.  As the pioneer in the U.S.-based ULCC segment, Spirit focuses not only on no-frills service, but has also been the most aggressive U.S. carrier with respect to unbundling the pricing associated with various optional elements of its air travel service (baggage, advance seat selection, food, etc.).  This aggressive unbundling permits consumers to pay for only those services that they actually use, and gives Spirit the ability to charge extremely low base fares.  Spirit's average system-wide base fare is currently around $80 per flight, with occasional promotional fares offered below $10 per flight.

Spirit's predecessor entity, Clippert Trucking Company, was founded in 1964.  Over the subsequent decades the business expanded into both ground-based charter tour operations and air charter operations.  In 1992, the business was renamed Spirit Airlines, at which time it began offering regularly scheduled air passenger service to a range of destinations.  Throughout the 1990s and early 2000s, Spirit struggled along with much of the rest of the airline industry to offer a profitable, differentiated service.  During 2004 and 2005 distressed debt specialist Oaktree Capital Management ("Oaktree") made a series of investments in Spirit, eventually gaining control of the business.  This led to a recapitalization of the Company in 2006, at which point Oaktree brought in private equity firm Indigo Partners LLC ("Indigo") as majority owner.  Indigo, which had prior experience successfully rolling out the ULCC model in multiple markets worldwide, spearheaded Spirit's transformation to the U.S.'s first ULCC model by 2007.  Spirit went public in mid-2011.

The ULCC model is not without its critics.  Numerous anecdotes exist (for all airlines, not just Spirit) of consumers arriving at airports and being hit at check-in with "hidden" bag fees.  As a pioneer in unbundling incremental services, Spirit often bears the early brunt of negative press associated with these fees.  For instance, there was a fair amount of outcry recently when Spirit began charging incremental fees for carry-on bags.  Despite the occasional backlash, though, unbundling is a trend that is unlikely to reverse.  The unbundled pricing model has withstood legal scrutiny and, of equal importance, continues to gain increasing acceptance from consumers.  Virtually all U.S. airlines unbundled meal service pricing many years ago on domestic flights, and most have now at least partially unbundled baggage service.  The ULCC unbundled pricing model has proven wildly successful in much of the rest of the world for many years, and is likely to continue gaining traction in the U.S. going forward.

The key to Spirit's economic model is a combination of high asset utilization and low operating costs.  Spirit has 178 seats on each of its A320 aircraft, 19% more than competitor JetBlue puts on the same Airbus model.  Moreover, it manages to use each of its aircraft for an average of 12.7 hours/day, 7% and 21% more than competitors JetBlue and Southwest, respectively.  On the cost side of the ledger, Spirit has unit costs that are 19% below JetBlue and 8% below Southwest.  This combination of higher asset utilization and lower costs than its competitors yields a breakeven fare per passenger of just $58, versus $133 for JetBlue and $103 for Southwest.  This drastic difference in breakeven level gives Spirit tremendous pricing flexibility, thereby allowing it to stimulate significant low-end demand in its markets that otherwise would not be served.  The Company estimates that 40-45% of its customers would be priced out of the market were it not for Spirit's presence.  If true, this implies that almost half of Spirit's business is not subject to typical competitive pricing dynamics, and with only one or two aircraft in any given market the Company should be able to continue flying under the proverbial competitive radar for quite some time.  Spirit management's confidence in the sustainability of its competitive advantage is evidenced by its current aircraft order book.  Spirit is scheduled to take delivery of over 100 new aircraft over the next eight years, which would represent more than a tripling of its current fleet.  This fleet will be deployed on some subset of the roughly 400 routes that Spirit believes currently meet its economic return hurdles.

The success of Spirit's ULCC business model is evidenced by the Company's financial performance.  Double-digit operating margins and returns on invested capital in excess of 25% are not only attractive on an absolute basis, but are either at or near the top of the Company's airline peer group.  Spirit's ongoing healthy free cash flow generation, in combination with proceeds from its IPO, have contributed to the Company's current net cash balance of $400mm.  This cash, which represents nearly 30% of Spirit's current market capitalization, is a major strategic asset for the Company in an industry that is typically characterized by high levels of debt.  The cash will not only support Spirit's aggressive expansion plans over the next several years, but gives the Company the ability to weather virtually any adverse operating environment that might come its way.

The airline industry is certainly not without risks.  In fact, given its history of consistent destruction of shareholder value, many investors consider it uninvestable.  Notwithstanding this track record, there are reasons to be cautiously optimistic about the industry.  Despite repeated cycles of bankruptcy and restructuring throughout the industry's history, until 2008 senior management at virtually all the major airlines clung to an operating paradigm that dictated that a larger route network was necessarily better.  This mentality, in turn, assured overcapacity in an industry characterized by high fixed costs, virtually ensuring unhealthy price competition and abysmal economic returns.  In 2008, however, the twin headwinds of recession-driven demand destruction and persistently high fuel prices seem to have finally caused a sea change in thinking.  Subsequent to 2008, the majors have shown remarkable discipline in either restraining or reducing capacity, thereby supporting load factors, rates, and most importantly, consistent profitability.

To the extent this operating discipline is sustained, it will be a competitive positive for Spirit.  Unwillingness by larger competitors to subsidize low volume, marginally profitable (or even unprofitable) routes creates a more benign pricing environment, and additional high return growth opportunities for Spirit's ULCC operating model.  Even in a more competitive environment, however, Spirit should be capable of thriving.  Despite the airline industry's abysmal overall lack of historic profitability, there have always been smaller, more nimble operators that have proven capable of generating sustained profitability and attractive economic returns.  Typically, these operators have done so by offering a more favorable value proposition than the majors, and doing so on a more limited scale.  Both of these characteristics play to Spirit's strengths.  In addition, Spirit management has proven itself willing to aggressively redeploy assets to the extent their initial assessment of a new route's profitability proves misplaced.  Spirit maintains an institutional bias towards admitting mistakes quickly, and moving to rectify them.  If Spirit's move into a new market does not spur the necessary demand to generate minimum required financial returns, or if the competitive response is more aggressive than expected, Spirit quickly reassigns the aircraft to a new route or market where the required return hurdles can be met.

Several one-time factors in the back half of 2012 combined to temporarily depress Spirit's operating margins.  Not the least of these was Hurricane Sandy, which not only scored a direct hit on Atlantic City (an important operational base for Spirit), but drove widespread demand destruction among discretionary travel customers across the entire key mid-Atlantic market.  Although Spirit shares initially sold off with the equity market's typical uncompromising approach to airline stocks, they have since rebounded in-line with overall market tailwinds.  Despite the rebound, they still remain exceedingly attractive.  Today, net of the Company's roughly $5.50 per share in net cash, Spirit trades at 7x expected 2013 EPS.  With Spirit's aircraft fleet slated to triple in size over the coming years, the market is implicitly assuming a permanent, material reduction in Spirit's ability to continue generating attractive returns on both existing capital, and capital to-be-deployed over the coming years.  Spirit's unique niche in the ULCC segment, strong operational focus, and impressive track record give me confidence that this is highly unlikely.  As successful execution leads to a return of market confidence, I expect significant upside over time in Spirit's share price as it moves to more accurately reflect intrinsic value.