Shares of Spirit Airlines Incorporated (NASDAQ: SAVE ) tumbled on Tuesday following its Q1 earnings report. While Spirit's adjusted EPS of $0.52 came in ahead of the average analyst estimate, some investors were disappointed by the company's guidance. The stock was down more than 6% at one point but eventually recovered half of its loss.
Spirit Airlines stock has had a few other minor setbacks in the last year, but each time, patient investors have been rewarded. The same is likely to be true this time. Spirit Airlines will begin a new period of massive growth later this year. As Spirit gradually continues reducing its unit costs and wooing new customers with extremely low fares, the stock can fly much higher.
The biggest winner in the airline industry
Most major airlines have seen huge improvements in their profitability in the last couple of years due to a combination of stable fuel prices and industry capacity discipline. For example, Delta Air Lines (NYSE: DAL ) -- the most successful legacy carrier today -- increased its pre-tax profit by more than $1 billion last year, and has a good shot at repeating this feat in 2014.
However, in one sense, Spirit Airlines is the real winner. Spirit has a much lower cost structure than legacy carriers like Delta. In fact, Spirit believes Delta's unit costs are more than 50% higher than its own. Delta therefore needs high fares to earn big profits.
This high-fare environment allows Spirit to offer substantially lower prices while still earning an even higher profit margin than Delta (or any other major airline). Spirit's low prices stimulate demand and should allow it to grow its capacity 15%-20% annually for at least another decade while maintaining its high profit margin.
Profit growth ahead
Spirit's solid 2014 guidance is a testament to the strength of its business model. For the full year, Spirit expects an operating margin of 16.5%-18.0%, which is essentially in line with its 2013 operating margin of just over 17.0%.
This is an impressive result because Spirit is facing significant cost headwinds this year from the new rules governing pilot rest and from investments to support faster growth next year. By contrast, Spirit's unit costs are likely to decline significantly in 2015 due to the faster growth rate, a mix shift toward larger planes with lower unit costs, and the use of more cost-effective financing.
Obviously, Spirit's 2015 profit margin will depend to a large extent on whether it is able to stimulate enough demand to fill all of the new capacity it is putting in the market. However, the company has a strong track record in this regard. As long as legacy carriers like Delta maintain their pricing discipline, Spirit should have plenty of room to win business with its rock-bottom airfares.
Foolish final thoughts
If Spirit is able to keep its profit margin steady in 2014 despite some cost headwinds, then it has a good chance to widen its profit margin in 2015, given that unit costs should be falling. Even without significant margin growth, though, Spirit should be able to meet the average analyst estimate for EPS of $3.69 -- up more than 50% from last year's level.
Spirit has plenty of long-term growth potential, too. The company has repeatedly pointed out that even after growing at a 15%-20% clip through the end of this decade, it will still represent less than 5% of total U.S. airline industry capacity. There will surely be more blips in the years to come, but Spirit's proven model and huge runway for growth ensure that any dips in its stock price will be short-lived.
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