Spirit Airlines (SAVE) is a no-frills, low-cost airline operating in the United States. The company has its roots in the southeastern U.S. with a large number of flights between Florida and popular holiday destinations in the Caribbean. In recent years, the company has seen rapid expansion into the Northeast and is more recently pushing into western U.S. markets.
I believe this company has continued strong growth prospects, a competitive advantage over traditional carriers, and an excellent balance sheet. Using my 10-point system, I have rated the company an 8, or a "buy." Below I have outlined my thesis.
(Note: I won't go into detail here, but for more information on my investing philosophy please check out my profile or website linked above. The two most important criteria for me are the magic formula and my circle of competence for the business/industry. Each of these has a maximum score of 2 points, whereas the other criteria a maximum of 1 point each. Maximum possible score is 10 points.)
The first item to check in my system is whether the company is a magic formula stock or not. Spirit Airlines is currently on the 50 over $50 million magic formula screen. For those who are not aware of what the "magic formula" is, this is a stock ranking system created by value investor Joel Greenblatt and was first described in his The Little Book that Beats the Market. Details about his methodology, including the screens, can be found on his website. I won't go into detail here on the methods described in his book, but the basic premise is to find companies with a high earnings yield (measured by EBIT/EV) relative to the return on invested capital (ROIC) that they produce. So you are screening for "good" companies at "bargain" prices. If you check out the website above, you can sign up (for free) and view the current top 50 stocks over $50 million in market cap using this methodology, and you can also change the market cap to whatever number >$50 million you want. Following my philosophy, I check the 50 over $50 million and the 50 over $1 billion screens as a starting point for stocks to analyze, as I strongly believe in the logic of this screening methodology as a sound value investing strategy.
Given that Spirit is currently in the 50 over $50 million screen, I score this criteria with 2 points.
Score: 2 points
(Note: In my evaluation system I consider buying companies that score in total 8 points or higher, out of a possible 10 points. If a company is not a magic formula stock and therefore receives a score of 0 on this criteria, then the only way I'd consider buying it is if it scores 100% on all other criteria, which would imply I really understand the company very well -- a score of 2 in circle of competence.)
Circle of Competence
I consider the airline industry to be largely within my circle of competence, based on the fact that I have done a lot flying as a consumer over the past decade on a variety of major U.S., European, and Asian airlines. This also includes several very low-cost airlines such as Spirit. Also, I have several years of work experience in the industry -- although this was in IT-related functions, I did experience first hand some of the challenges that the legacy carriers have in terms of cost reductions and complex mergers. I have never flown on Spirit itself, and for this I will deduct half a point.
Score: 1.5 points
The prospects for the low-cost airline industry remain bright. Spirit has a business model that I feel sparks a love/hate relationship with a lot of consumers. People will tell you that they love having the chance to find very cheap fares to take them to their favorite destinations. However, they do not like being what they consider deceived on "hidden" fees. This article gives an example of negative press on the customer service and fees of Spirit.
Despite some consumer negativity on this business model, the idea of charging for extras on flights (even a soda can be $3 or more) seems to do very well for the profit margins of Spirit and several of its competitors. Spirit posted a quarterly profit margin of approximately 10% in its most recent quarter ($34.59 million net profit on sales of $346 million). Details can be found in the July 10-Q. This compares very favorably to the legacy airline carriers as well as other low cost companies, the majority of which have margins between zero and 5%. In this article from Reuters, you can see that the company has gross, operating, and net margins significantly higher than the industry averages.
In my experience and opinion, the hype over the fees is largely overblown, and over time consumers are getting more used to this structure. In fact, the legacy carriers are trying to play catch up on this structure, recognizing that the model is more profitable. This article published recently describes how customers had better get used to it as "baggage fees are here to stay," which is a policy that virtually all of the legacy carriers have instituted.
In terms of business growth, this continues to be strong for Spirit. There are still a lot of untapped routes, particularly in the western U.S. The company stated on its recent conference call that it expected strong growth at or near the current rate over the next five to seven years. I therefore see strong near-term prospects for the company, and give it a full score in this category.
Score: 1 point
Spirit has only been a public company since May 2011. As such, I find it personally difficult to judge fully how shareholder-friendly the company is. The company does not pay a dividend. This is not surprising, due to the current expansion rate and capital-intensive nature of the business. The company also does not have a share repurchase plan currently in place. I do, however, feel the company communicates well with shareholders and there remains high levels of insider ownership. I therefore give this criteria a half a point.
Score: 0.5 point
In my experience, I have observed that the legacy carriers continue to struggle with cost cutting and huge labor and pension costs. An example of this can be read in this article, where American Airlines (AAMRQ.PK) is in difficult negotiations with its pilots union. These kinds of difficulties for legacy carries have made it very difficult to adapt quickly to the changing market. Low-cost carriers like Spirit have a competitive advantage as they have no outstanding labor issues and they are growing and profitable. Being a capital-intensive industry, there are some natural barriers to entry that mean there will not likely be a huge amount of new discount carriers popping up that quickly.
There is, however, fierce competition among the existing carriers in some markets, and some level of brand loyalty will always steer some travelers away from the "cheap" companies like Spirit. There is also a fair amount of complaints about customer service quality (see my previously referenced article for an example). Overall, I find the competitive moat as partially existing but not compelling, as clearly there exists an advantage over the larger legacy carriers that cannot adapt so quickly to compete better with Spirit. But at the same time there are several low-cost carriers that can compete quite well. I therefore score this criteria with a 0.5.
Score: 0.5 point
Spirit has a clean balance sheet with zero debt and a very strong cash position. This criteria I can therefore safely score with a full 1 point in my system.
Score: 1 point
Spirit has been profitable for five consecutive years. Earnings have been increasing at a good clip the past few years. You can view the 10-year overview at MSN Money for the complete picture. From 2010 to 2011, earnings saw a huge 40% rise, as sales also increased from $780 million to over $1 billion for the first time. However, earnings decreased more than 15% from 2009 to 2010. The trendline shows a definite upward direction, but clearly there is an element of cyclical behavior to earnings in the airline industry, and profits can fluctuate significantly as fuel prices (and therefore net profit) can be impacted greatly if oil prices change quickly. Therefore I give this a 0.5 for the overall positive trend, but the cyclical nature of the business means there is always some shorter-term risk of greater earnings fluctuation that can at times provide more negative surprise to the stock price.
Score: 0.5 point
Margin of Safety
To calculate whether the current price constitutes a sufficient margin of safety, I have performed a simple DCF. I believe that the value of a company should always be thought of in terms of how much the company can earn in profit now and in the future for its shareholders. In the case of Spirit I have taken the following inputs:
- Current Earnings: $1.43/share
- 10-year Growth of Earnings: 7%
- Growth After 10 years: 0%
- Discount Rate: 6%
- How confident am I in these earnings estimates? I am 75% confident.
In my model I have chosen 7% growth over 10 years because I am very confident that the rate will be much higher in the upcoming few years (10%-15% range), and after four years I expect it to gradually drop, with an average of 7% over the entire 10-year period. I believe this is a pretty conservative assumption. I also take a further margin of safety of 25% by indicating I am only 75% confident in these estimates.
This DCF model gives an intrinsic value of approximately $31/share. At the time of writing, the share price of Spirit is $17.36, which would imply that the upside from the current price is 78%. Since I generally look for an upside of 50% or greater, I can feel confident about the margin of safety here.
Score: 1 point
Total Score: 8 points
Conclusion: Spirit Airlines is a "Buy."
Disclosure: I am long SAVE.