Spirit Airlines: Rise In Air Travels And Expanding Margins To Warrant Significant Value Creation

| About: Spirit Airlines (SAVE)


Air travels are expected to keep increasing.

Oil prices expected to stay low should allow for further margin expansion.

Attractive business model should allow for continuing increase of market share.

Spirit Airlines (NASDAQ: SAVE), headquartered in Miramar, FL, is an American Ultra Low Costs Carrier (ULCC). The firm operates 385 daily flights to 56 destinations in the US, the Caribbean and Latin America. Spirit Airlines offers low-price travel opportunities as well as various optional services for additional fees. Among its revenues for the year 2015, 45.4% of the company's revenue came from non-ticket sales.

The air travel industry recorded net profit of $33 billion for the year 2015 and is expected to register net profits of around $36 billion for the year 2016, according to the International Air Transport Association. This will be mainly possible thanks to low oil prices that are expected to remain low for the near-future. Indeed, according to the U.S. Energy information Administration, oil prices are forecasted to $35/barrel on average for 2016 and should not exceed the $50/barrel for the year 2017. As a result, many firms are investing heavily on oil at its current prices. Since fuel represents 25% of the airlines cost structure in average, it has provided advantages to consumer incomes that are paying lower prices for the same journey compared to when oil prices were higher. Nowadays, the world economy shows potential growth and the North-America area is expected to lead this economic global acceleration. In addition, both the current increase in consumer confidence and low oil prices will be key drivers of the increasing demand for travels. Indeed, the demand for passenger travel is estimated to increase in 2016 by 7.1%, compared to 2015 to 3.8 billion. Overall, the increasing demand, the decline in oil prices and the efficiency initiatives currently taken by airline companies would help airlines to increase their revenues where the annual compounded revenue growth had increased by 7% over the last decade.

On a year-to-date basis, Spirit Airlines has been the best performing stock among low-cost carriers such as Ryan Air, Delta Air Lines, United Airlines and Alaska Air Group. With an increase of its stock price of 15% since the beginning of the year, Spirit has been followed into the positive territory by only Southwest Airlines. Spirit Airlines has recorded strong financial performance in Q1 2016 which were mostly driven by an increase of $538.14 million in revenue, beating analyst's estimates by $1.96 million (see earnings call). The EPS were announced at $1.01, beating analysts' estimates one more time by $0.05. Total revenues increased by 9.1% for the quarter on a capacity increase of 26.5%. This quarter, total revenue per passenger, which accounts for 54.6% of the firm's revenues declined to $107.88, representing a decrease of around $16 year-over-year, which was mostly driven by a decline of $14 in ticket revenues. Non-ticket revenues, which accounts for the remaining 45.4% of the firm's revenue declined by $2 year-over-year (see earnings call). However, management is confident that non-ticket revenue should not decline further as it remains an inelastic and stable part of the firm's revenue segment, which is exactly what makes this firm a strong competitor in the industry.

On an operation side, the firm has upgraded its pricing systems that will allow management to see things better than the past. In that sense, it will offer the firm a better view of what competitors are selling on the market, allowing management to make more tactical decisions for the future. Furthermore, the firm has developed a new flight dispatch system this quarter which will provide long-term benefit in terms of fuel burn. Management is expected to start benefiting from this system for Q2 of this year (see earnings call). Spirit Airlines increased its fleet to 83 aircrafts this quarter by receiving the delivery of four new aircrafts. As you can see on the firm's fleet plan below, the firm is expected to increase its fleet to 148 aircrafts by 2021. The firm has reached an agreement with Airbus for the deliveries of 11 A321ceo aircraft, net of 2 A321ceo lease expirations for the year 2017.

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(Source: Spirit Airlines)

This increasing fleet is an essential part of the management plan to serve a wider range of the markets which will include mid-size cities.

On the cost side, Spirit Airlines has been able to decrease its cost per available seat mile ,CASM, ex-fuel by 2.3% year-over-year. This decrease in costs is the results of a lower aircraft rent per available seat mile ,ASM, which was driven primarily by a change in the mix of both lease and purchase aircraft in the firm's fleet. However, this decrease of costs could have been higher as it has been offset by both higher depreciation and amortization expenses, and the implementation of the new flight dispatch system, that led to more re-accommodation expenses. Besides, during this first quarter, management has been reaching an agreement with the Association of Flight Attendants CWA for a five year contract that resulted in an increase of labor expenses for a one-time payment of $8.4 million that increased the CASM ex-fuel for the quarter (see earnings call). If we do not count for that extraordinary ratification, we should have seen a decrease in CASM ex-fuel of approximately 4.5% year-over-year. Nevertheless, management is estimating its CASM ex-fuel to decrease by 5% for the Q2 2016, which will be supported by both lower aircraft rentals and other operating expenses linked to ASM. For the rest of the year, management is expecting CASM ex-fuel to remain flat with a slight increase for Q3 and Q4 because of maintenance events. However, this should be offset by the seasonal strength of summer for Q3. The firm forecasted its CASM ex-fuel to continue to decrease, which will allow higher operating margins. Moreover, oil prices have been a real advantage for airlines companies as it has allowed them to decrease their fuel expenses. As you can see on the table below, Spirit Airlines has taken advantage of low oil prices so as to decrease its fuel expenses as a percentage of operating expenses from 38.9% in the year ending 2014, to 28.3% for the year ending 2015, which allows the firm to keep increasing its operating margins.

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(Source: Capital IQ)

If we take a look at more financials, we can see that EBITDA has been growing at a faster pace than revenues, proving the management ability to reduce operating costs, therefore creating value for the company. Indeed, as you can see on the graph below, Spirit Airlines EBITDA Margin has been recorded at 27.15% between 2014 and 2015, whereas revenue growth has been recorded at 10.87% over the same time period.

(Source: Bloomberg)

Another interesting value creation ratio to look at is the ROIC/WACC ratio. As you can see on the summary output of my proforma at the end of the paper, we currently have a ratio of 1.65, which means that the firm is currently creating value. Following all of this news, I decided to conduct a valuation of this stock based on a proforma valuing Spirit Airlines with a discounted cash flow model which focuses on return on invested capital. First, I made the revenue growth converging toward analysts' estimated and revert in the long-term to 2.1%, following GDP growth. Despite its business done primarily in the U.S., I decided to set a market risk premium of 8%, an additional 2% compared to the 6% of the U.S. because of both the oil prices risk and the nature of the business. A weighted average effective tax rate of 38.7% has been used based on the location of the firm's revenues. You can find a one page summary for more details concerning the valuation of this stock. After running a Monte-Carlo simulation with 1000 trials, I calculated an intrinsic value for this stock of $53.02 and a one year target price of $61.08.

Spirit Airlines current business structures allows the firm to have higher profit margins than the industry. Thanks to the current low oil prices, profit margins are expected to increase further to historical records in an industry where demand for passenger travel is expected to keep its growth trends. On the firm side, Spirit is also planning to decrease even more its CASM ex-fuel, increasing its profitability. Management, through its current share buyback program, believes its current stock price is undervalued as well. Indeed, on April 25, the firm decided to buy back 520,000 shares which represents an amount of appreciatively $25 million. I do believe that the stock is currently undervalued and has a lot of potential to grow, which is why I recommend a buy at its current level of $43.63.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SAVE over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.