|Shares Out. (in M):||73||P/E||15.0x||10.0x|
|Market Cap (in $M):||1,430||P/FCF||15.0x||10.0x|
|Net Debt (in $M):||-400||EBIT||165||240|
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.
|Entry||01/23/2013 06:43 PM|
All good questions. I'll take a quick stab, and come back at me if you want more detail.
* Yes, it's fair to capitalize the leases if you want to compare them apples-to-apples with other airlines that have taken a different approach to financing. The company actually does the conversion math for you, typically in the appendices to their earnings presentations and IR presentations. They capitalize the leases at 7x, and in their early December IR presentation they were reaching an after-tax ROIC of 17%+. In my book, that's solid on an absolute basis, and as airlines go it's excellent. Obviously, if you're treating the leases as debt, then a mid-teens ROIC would lead to a very attractive ROE. The decision about how to treat the leases is obviously up to the investor, however, I would argue that if they're able to exploit favorable financing alternatives to a greater extent than competitors they should get some credit for that. Going forward, I think you may see a shift towards a portion of the fleet being financed through more traditional cap leases. Decisions are made by mgmt on a case-by-case basis based on what makes the most sense from an IRR and ROIC perspective.
* I expect mgmt will hold on to the cash, at least in the medium-term. A few reasons for this. One, as mentioned, they may start doing more traditional financing on the new planes, in which case they'll likely need some of that for deposits. I think their summary view is that returns on expanding the network at this point far exceed other uses for the cash, so they will husband it until they reach more of a steady state. Moreover, 2008 is not that far in the rearview mirror. In 2008, they seriously reduced capacity and went into hunker-down mode. I think they like the balance sheet strength currently, given that we're not that far removed. The CFO has been at the company for less than a year, and is still getting his bearings, so I don't expect him to make any rash movements w/respect to the BS in the near-term.
* I believe that their advantages are quite durable. Their model is no secret. Yet, they've been operating it for several years and have seen little in the way of competition. Other low cost airlines (JetBlue, in particular) have explicitly stated that they have no intention or desire to run cattle cars in the sky. Make no mistake about it, SAVE is not known for it's comfort factor. I saw a report a couple of days ago rating SAVE's service as having the most unfavorable pitch angles of any domestic airline (a very dubious honor). They're selling a low-priced, no frills, service, that few if any competitors have shown an inclination to imitate. In addition to the actual pricing model, I think that management's willingness to admit mistakes quickly and redeploy assets is the exception in this industry. Lastly, they maintain an operational edge that keeps asset turns high; this is not something that can be replicated quickly, a lot of it is cultural.
* With respect to industry capacity...your view is as informed as mine. I happen to be cautiously optimistic, however, view this as free upside. I believe that even if capacity increases, very little of it will be competitive capacity with the price/route combinations that they're targeting.
Hope that helps.
|Subject||RE: RE: RE: RE: Spirit|
|Entry||01/24/2013 07:37 PM|
Oaktree was getting pretty long in the tooth on this investment. They're not so much in the business of carrying long-term stakes in non-distressed publicly traded equities. Their departure doesn't concern me, as they were a purely financial partner. Indigo was the brains behind the strategic shift to ULCC. I would expect them to lighten up at some point, but there hasn't yet been any indication that this will happen in the near-term (to my knowledge).
I think that a lot of industry people, and for sure the majority of consumers, would tell you that the only true competitor on your list is Allegiant. Jetblue and Southwest are "low cost", but this truly is a different segment than "ultra low cost". In my experience, flying coach on either of these two airlines isn't much different than flying coach on any of the majors. This isn't so with Spirit/Allegiant, where you're clearly putting price far above every other comfort/service oriented decision point. They get you there on time, but it ain't exactly a comfortable ride.
I think your concerns on competition and capacity go a long way towards explaning why SAVE trades where it does. Will this time be any different than decades past? Have the majors gotten religion post-2008? I don't definitively know. However, there are some interesting stats out there along the lines of aggregate industry profitability post-2008 exceeding aggregate industry profitabilty for the three or four decades prior to 2008 (something along those lines...don't quote me). In order to get comfortable with this investment, you have to get comfortable that SAVE is truly targeting a different customer. Having sniffed around, I buy into their assertion that they are generating nearly half their demand from customers who otherwise would be priced out of the market. If you don't buy into that, this one probably isn't for you.
|Subject||Labor Costs - Pilots|
|Entry||02/03/2013 12:39 AM|
Thanks for the write up.
Can you speak to what will happen to labor over time. My understanding with some of the older legacy carriers is that a major thorn is the pecking order in pay which the union structure demands for pilots as they move up in the system. Is SAVE's lower cost base sustainable - as it's pilots gain more tenure, will they look to move on or for pay comparable to pilots with similar experience at the larger competitors? It could be the pilots are being paid market rate on a relative basis (relative to their experience) and the savings are on variable items (i.e. food, extra bags) which SAVE either charges for or does not cover allowing for lower overall expenses per passenger. But if labor costs, pilots in particular are a key driver here, I would be curious to learn about sustainability of that advantage.
Thanks in advance for any color in this regard.
|Entry||02/04/2013 07:15 AM|
Thanks, hadn't seen that post. Some positives and negatives from an opportunity and competition standpoint. Overall, I think a primary takeaway is that management moves aggressively to redeploy assets that don't meet hurdle returns; a very different midset than the traditional majors' approach of market share at all costs. Time will tell whether the number of routes they think are available to them are sufficient to absorb the capacity they'll be bringing online.
|Subject||RE: Labor Costs - Pilots|
|Entry||02/04/2013 08:35 AM|
SAVE pilots are represented by the ALPA with a contract that becomes amendable in mid-2015. The way the contracts usually run, the beginning of the amendability period gets the clock ticking on a renegotiation process that can potentially last for years. So, from a practical standpoint, I don't see the potential for upward pressure on labor costs becoming an issue for a number of years and, as such, this isn't high on my list of worries.
The ALPA is the largest pilots union in the world, and represents pilots from a large mix of carriers including many majors. You can check out the list here http://en.wikipedia.org/wiki/Air_Line_Pilots_Association,_International. So, even when the renegotiation period starts, I don't see material event risk driven by aggressive promises from a competing, more powerful union.
From a supply/demand standpoint there are definitely some headwinds. New FAA requirements are substantially increasing the number of flight hours required for commercial pilots, and there is a large wave of current pilots that are running hard up against the mandatory 65-year retirement age. This will likely favor pilots' ability to demand higher wages over time, but this will impact all carriers equally, with some minor variations based on the terms of the various airlines' labor agreements.
If SAVE can continue its current growth trajectory, they will have a lot of leeway on pilot labor costs. While comp is important to the pilots, the ability to advance up the food chain is very important as well, and a growing carrier offers far more opportunity in this regard than a static or shrinking carrier. All of these guys want to move into the captain's seat, as it gives them huge additional leeway in terms of scheduling, which is often a major unadvertised perk of the job. If you dig in on the current negotiations for the merging of the Continental and United pilots unions, it will provide some decent color in this regard, with the United pilots representative of the sclerotic old guard and the Continental pilots representative of a much younger, more motivated group given far more responsibility at a younger age, and looking for a different mix of comp/scheduling/work-life balance.
I realize that these comments are more qualitative than you're probably looking for, but hope they help a bit.
|Entry||02/08/2013 03:11 PM|
I don't have a firm opinion for you on max fee revenue/ticket. I believe that ultimately, no matter how retarded you think the US consumer is, you can't "fool" them indefinitely. As such, an investment in SAVE has to be premised on a belief that the long-term value proposition offered by SAVE is to get you from point A to point B cheaper than the competitors on an all-in basis (base ticket cost + fee revenue). Whether the revenue comes from base ticket fare, or fee revenue, is at some level irrelevant over the long-term. Ridiculously cheap base fares may hook some new adopters for a flight or two, but if the all-in cost isn't superior those travelers won't come back. From an economist's point of view, unbundling service elements (and charging separately for them) is actually the fair thing to do as it gets rid of the free rider problem. Moreover, I have bought into management's assertion that the aggressive unbundling is actually an important contributor to the economic model, as it helps reduce aircraft weight (and fuel consumption), and gate turnaround time, by putting an economic price on those things which negatively impact those metrics (i.e. checked luggage and carry-on luggage). Finally, Spirit has also used the aggressive unbundling strategy to its advantage from a marketing standpoint (i.e. advertising ultra-low base fares).
From my perspective, I get comfort that Spirit's all-in cost advantage (and, therefore, its value proposition to customers) is sustainable from a couple of different angles. First, Spirit's operating cost structure is clearly superior to its competitors. The numbers are the numbers, and they don't lie. If the cost structure weren't demonstratively superior, I would be more concerned that Spirit was simply divvying the base price vs. fee revenue pie up differently than its competitors, and "fooling" customers in an unscrupulous manner to generate above market profit in the short-term. Secondly, Spirit has been flogging its model for long enough in numerous markets (with great success in most cases) to get me comfortable that they're doing something differently, and better, than competitors. I do believe that management's focus on return on capital, asset turns, and other metrics that would be considered commonplace in many industries is unique enough in the airline business to provide them with a discernible advantage. They approach their business from a mentality which is somewhat unusual in the airline industry.
So I guess in summary, I'm saying that I don't worry too much about maximum fee revenue/customer, as I don't believe that will necessarily be the long-term driver of SAVE's success. Instead, I believe that their all-in cost to the consumer vs. the competition will be the driver of long-term success, and I feel comfortable that they can sustain this.
All that said, there are additional levers for them to pull on the fee side. If you look at ULCC models elsewhere in the world, some have been very successful in generating additional fee revenue through ancillary services unrelated to the flight itself as narrowly defined. For instance, SAVE is heavily represented in Carribean vacation markets. As such, their customers clearly need other services, the most obvious of which is lodging. SAVE can partner with providers and act as a marketing conduit for lodging and other vacation services, with virtually no additional capital outlays. The hit rate doesn't have to be very impressive to tweak that $125 of fee revenue up materially.
|Entry||02/08/2013 08:54 PM|
An excellent write-up, zzz.
My biggest concern is that Spirit’s maintenance costs are understated by 25-40%.
I did a lot of work on JetBlue when they were starting out and went public (and the stock was flying high), and while I loved the company, I fortunately avoided the stock after an old industry veteran CEO warned me that a major reason for the high margins and returns on capital that JetBlue was showing were because it was a small, rapidly growing company.
Maintenance is a HUGE expense and every plane in the world is on a maintenance schedule that calls for certain (very expensive) things after a certain number of flight hours and/or takeoffs and landings: an engine "tune-up" after 500 hours, and engine overhaul after 2,500 hours, replace the tires after every 100 landings, etc. (I'm making up the numbers, but you get the idea).
For a small carrier that is getting deliveries of new planes every month, you can see how maintenance expense as a percentage of revenues will be very small -- I recall for JetBlue it was something like 1/3 the amount of mature carriers (2% of revenues vs. 6%) -- because when you buy a brand new plane, there's ZERO maintenance cost for a while, and then it ramps up over the first few years. But over time, as the airlines grows and new planes as a percentage of the carrier's fleet shrink, this advantage goes away and the upstart ends up with the SAME maintenance costs as everyone else (roughly speaking; carriers that have shorter segments and therefore more takeoffs and landings will have higher maintenance costs, all else being equal; carriers that fly only one type of plane (like Spirit) will have lower costs).
This is an important point: NOBODY can have a meaningful cost advantage when it comes to maintenance. The maintenance schedule is mandated by the FAA (thank goodness) and, whether it’s outsourced or not, every carrier pays pretty much the same amount, adjusted for average stage length and commonality of aircraft (I even visited a maintenance facility in Canada that JetBlue uses -- very interesting to see stripped down aircraft).
I confronted JetBlue's investors relations person with this info and asked her what JetBlue's financial statements would look like if the company, rather than expensing maintenance costs as incurred, instead signed a 10-year per-flight-hour maintenance agreement for its entire fleet, such that the maintenance expense would be the same for EVERY ONE of JetBlue's planes, no matter how old it was. She hated this line of questioning and refused to answer. I'm glad I ran away, as the stock collapsed by 80%...
I recall reading somewhere (in your write-up or one of the comments/questions) that SAVE has precisely this type of evenly-spread maintenance agreement, but can't find it now – and the financial statements indicate otherwise.
I looked up maintenance expense divided by total flight hours (I think that’s the right way to do an apples-to-apples comparison) for Southwest, JetBlue, and Spirit (I couldn’t find the data for Delta and Alaska) for Q1-Q3 ’12, and here’s what I came up with:
Spirit is 40% lower than the other two.
Another way to look at it is maintenance costs per available seat mile. It’s not as good of a metric because Spirit packs more seats on each plane, but at least I was able to get info for two more carriers:
Delta: 0.91 cents per ASM
Spirit is 47% lower than the average of the other four.
Note that Spirit should be HIGHER than all but Southwest given the short average stage length (though offsetting this is flying only one type of aircraft, an advantage Southwest also has in part). Here’s the data for average stage length:
Here’s what Spirit’s Q3 12 10Q says (here’s the key line: “Maintenance expense is expected to increase significantly as our fleet continues to age”):
“Maintenance costs for the third quarter of 2012 increased by $3.2 million, or 29.1%, compared to the prior year period and 6.7% on a per-ASM basis. The increase in maintenance costs is primarily due to the seat maintenance program introduced in the first quarter of 2012, which contributed $2.3 million in maintenance costs in the third quarter of 2012, bringing its total cost incurred related to this program to $5.4 million. We believe total expenses related to this program will be approximately $7 million with the remaining balance incurred in the fourth quarter of 2012. We do not expect the ongoing expense of our seat maintenance program to have a material impact on our overall future maintenance cost outlook. The average age of our fleet increased to 4.9 years as of September 30, 2012 from 4.5 years as of September 30, 2011. Maintenance expense is expected to increase significantly as our fleet continues to age, resulting in the need for additional repairs over time.”
“We account for heavy maintenance under the deferral method. Under the deferral method, the cost of heavy maintenance is capitalized and amortized as a component of depreciation and amortization expense in the statement of operations until the next heavy maintenance event. The amortization of heavy maintenance costs was $2.3 million and $0.8 million for the third quarters of 2012 and 2011, respectively. If heavy maintenance events were amortized within maintenance, materials, and repairs expense in the statement of operations, our maintenance, materials, and repairs expense would have been $16.5 million and $12.3 million for the third quarters of 2012 and 2011, respectively.”
So, roughly speaking, I’d estimate that fully loaded maintenance for Spirit would be 50-75% higher than current levels.
What impact would this have on earnings? In Q3, maintenance was $14.2 million. An extra 50-75% would be $7.1-$10.7 million extra. Operating income was $49.7 million, so this would have reduced it by 14-22%.
For the first three quarters, maintenance was $37.3 million and operating income was $106.4 million, so the reduction would have been 18-26%.
In short, over time, all other things being equal, this will reduce EPS by 15-20% -- not crushing, but something investors need to consider.
I welcome any comments.
|Entry||02/11/2013 08:53 AM|
Your point is a good one, and your attempts to put some hard and fast numbers around the inevitable headwinds are reasonable. If you speak with SAVE management, they freely admit that increasing maintenance expenditures will be a headwind going forward, but they have not given hard guidance regarding specific numbers.
Here are some general thoughts.
Maintenance expenses fall broadly into two buckets: 1) heavy maintenance and 2) routine maintenance.
Heavy maintenance includes big ticket, recurring items like engine overhauls. These typically kick in a few years after an aircraft first goes into service, and then recur on a regular schedule. The older aircraft in the SAVE fleet have begun their initial heavy maintenance services. SAVE's operating leases require them to fund these expenditures ahead of time through the establishment of a reserve, which shows up as the "Prepaid aircraft maintenance to lessors" item on the balance sheet. Thus, from a cash flow perspective, the heavy maintenance is already in the numbers, but from a P&L perspective there will be a headwind as D&A gets debited and this reserve gets credited over time.
Routine maintenace includes ongoing wear and tear items like busted tires, busted windshields, landing gear wear and tear, etc. These are expense as incurred, and to some extent are already reflected in the P&L, however, as aircraft age the need for these items will creep up over time as well.
SAVE should get some minor economies of scale given their reliance on a single aircraft model. I don't expect this to be material, as the same argument can be made for JBLU and (as your numbers show) the maintenance expenses aren't a material advantage for them.
I do expect that 3Q and 4Q 2012 margins for SAVE are somewhat depressed given issues mentioned previously, so actually get to a smaller hit going forward than the 14-22% you are positing since I calculate the hit off a lower "normalized" operating expense base as a % of revenues. I am in the mid-high single digits (i.e. around 7%) in terms of an expected hit to run-rate operating profit assuming a more normalized (i.e. JBLU-like) cost per ASM.
|Subject||RE: RE: Author Exit Recommendation|
|Entry||07/09/2013 04:18 PM|
Andrew, no, just price. Trying to be disciplined on exit. Shares are getting close to my estimate of fair value which, admittedly, implicitly assumes lower growth in the fleet than SAVE's order book would indicate. However, seems that there should be better risk-reward out there elsewhere.