Spirit Airlines: Lower Occupancy Can Be A Huge Problem

Summary

• In my view, Spirit Airlines presents a mixed bag of pros and cons. Today, I add one important item to the latter.
• While per seat economics have benefited from an environment of high occupancy, margins should suffer from much emptier planes.
• The combination of high operating and financial leverage likely leading to intense stock price volatility pushes me away from the company.
• Looking for a helping hand in the market? Members of Storm-Resistant Growth get exclusive ideas and guidance to navigate any climate. Get started today »

I have recently written about Spirit Airlines (NYSE:SAVE), after completing a sector-wide study in which I picked likely winners and losers in the space. In my article, I rated the ultra-low cost carrier stock a "Hold" due to an apparent mixed bag of pros and cons.

On the bullish side of the fence, the bare-bones approach to cost management could help the airline during times of distress, and so could the company's lower exposure to international travel while cross-border traffic is likely to be limited. On the bearish end of the spectrum, Spirit seems too leveraged, just when balance sheet robustness becomes a crucial item to consider in assessing an investment opportunity in the airline space.

Today, I present a more subtle reason not to bet on SAVE during turbulent times: the relatively larger impact of lower occupancy rates.

(Image Credit: Airbus)

Let's revisit the fundamentals

I will start the discussion by briefly addressing the basic economics of air travel. Operating an airline is costly, and many of the expenses are fixed (or very close to it) on a per flight basis. Think about it: to fly even a fairly empty segment, an air carrier still needs to fill up the tank, compensate the flight crew (US law mandates one flight attendant for every 50 commercial passengers), perform maintenance and pay the airport fees.

Safely carrying as many passengers as possible at once is, in part, what has made the airline industry much more profitable after the mass reorganization wave of large US airlines in the early 2000s. When occupancy rises (i.e., more passengers carried per number of seats available), fixed costs can be better spread across each revenue-generating unit - a friendly synonym for "people on board". Profit maximization, by the way, is largely the reason why we now have what feels like two inches of leg room when flying economy class.

When good becomes bad news

The problem is that the math also works in reverse. While higher occupancy is good for the bottom line, lower occupancy is not. Softness in demand for air travel or distancing needed between passengers inside the aircraft, which could become the new norm in a post-coronavirus world, can cause per seat economics to fall apart.

The graph below depicts the simple average of the quarterly load factors (the official name for occupancy rates) of all major US airlines in 2019. Notice that Spirit has produced the top metric among low-cost carriers, and one of the best across the entire industry. While this has been good news for the company during favorable economic times, Spirit could lose its competitive edge amid a "sink all boats" recessionary environment in which far fewer people are traveling.

(Source: D.M. Martins Research, using data from multiple company reports)

High occupancy levels are, in part, what have allowed Spirit to run a profitable business. The following graph depicts the company's highly competitive per-unit margin (passenger revenue over operating costs per unit, see orange bars), even though it commands the lowest per-unit sales in the sector by a long stretch.

Should occupancy rates drop across the entire sector for an extended period of time, as will likely be the case, Spirit's cost efficiency could become a less crucial factor in the company's financial performance. Air fares are unlikely to fill the gap and provide any uplift to per-unit margins, assuming consumer spending suffers from a deep recession ahead that seems all but inevitable.

All things considered, Spirit may end up suffering more than its peers from decreased margins, which, in turn, could hurt the airline's bottom line and stock price significantly.

(Source: D.M. Martins Research, using data from multiple company reports)

Yet another reason to stay away

Airlines have not been designed to thrive in an environment of low occupancy rates. Companies that rely heavily on higher load factors to better distribute the operating costs may be the most vulnerable to the expected deterioration in per seat economics that lies ahead.

Therefore, I maintain my extremely cautious stance towards SAVE. The combination of high operating and financial leverage leading to intense stock price volatility is precisely what I would like to avoid the most, given an already very risky airline space.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.