Spirit Airlines, Inc. Should Ignore the Doubters and Keep Growing

Spirit Airlines  (NASDAQ: SAVE  ) has grown rapidly over the past couple of years, and it has even more aggressive growth plans going forward. Between October and the end of 2015, Spirit will increase its fleet by 36% from 58 to 79. (The increase in seat count will be even higher, as Spirit is taking delivery of larger planes.)

One Wall St. analyst team thinks legacy carriers like United Continental might strike back against Spirit Airlines (Photo: The Motley Fool)

One Wall Street analyst team has questioned Spirit's increased growth rate. Evercore Partners downgraded Spirit stock, arguing that the company's rapid growth creates execution risks and could cause a competitive response from larger airlines like United Continental (NYSE: UAL  ) .

However, the short-term risks are minimal, as Spirit's strategy of stimulating demand with ultra-low fares allows it to mature new routes to profitability very quickly. Spirit's growth will also reduce its already industry-leading unit costs. Most importantly, competitors like United Continental have no effective way of responding to Spirit's growth.

Spirit's rapid rise
Spirit Airlines has become one of the darlings of the airline industry in the last 18 months or so. Many airlines have tried to either grow quickly or to expand their profit margins in recent years, but only Spirit has been able to do both.

SAVE Chart

Spirit Airlines Price Chart Jan. 2013-present, data by YCharts

Spirit's rampant growth has been enabled by the rapid rise of U.S. airfares since 2009, which in turn can be attributed to tight capacity discipline by the top four U.S. airlines. The domestic fare environment has continued to strengthen this year. As a result, Spirit has continued to beat expectations.

At the beginning of the year, Spirit projected that its 2014 operating margin would be 16%-18%, roughly flat compared to its 17.1% operating margin last year. However, Spirit posted better than expected revenue and cost results in the first half of 2014. As of last week, Spirit expects a full-year operating margin of 17.5%-18.5%.

A great environment for growth
Spirit's growth rate will approach 30% next year. Normally, it would be hard to grow so quickly without triggering margin pressure. However, the U.S. airline industry is more profitable than it has ever been in the past, making this an ideal environment for smaller carriers to gain share.

Spirit Airlines is planning for rapid growth in the next 18 months (Photo: Spirit Airlines)

Furthermore, even if entering a slew of new markets in a short period of time causes Spirit's unit revenue to fall, the company is starting from a very strong margin position. This means that it can absorb a few points of margin pressure while still growing EPS. Furthermore, these new markets should mature quickly, allowing Spirit's profit margin to bounce back in 2016 or 2017.

Targeting United Continental in Houston: a case study
Spirit's first target for its upcoming expansion is Houston, the second-largest hub market for United Continental. Spirit currently operates seven daily flights to Houston: one each to Chicago, Denver, Detroit, Las Vegas, Los Angeles, Minneapolis/St. Paul, and Orlando.

In the next 6 weeks, Spirit will add daily flights to 5 more cities -- Atlanta, New Orleans, Kansas City, Fort Lauderdale, and San Diego -- boosting its Houston footprint by about 70%. Spirit has a simple strategy for winning customers away from market-leader United: offering really low base fares.

For a Saturday to Saturday roundtrip from Houston to Fort Lauderdale in September, Spirit's cheapest nonstop ticket is currently $152.70. United's cheapest nonstop fare is more than twice as high at $342.70.

This huge gap in the base fares provides a big hint as to why Spirit can afford to expand rapidly. United Continental won't attempt a "competitive response" because any such attempt would be futile. Typically a dominant airline would fight back against an upstart competitor by matching its fares. United can't match Spirit's fares without losing a boatload of money.

Ultra-low cost carriers like Spirit and Frontier get lots of revenue from fees (Photo: The Motley Fool)

After accounting for taxes and fees, Spirit only keeps about $120 of its $152.70 ticket. This equates to a yield of roughly $0.062 per mile. By contrast, United's mainline yield has been more than $0.14 for the past two years -- and it was still barely profitable! Not only can United not afford to match Spirit's base fares, it can't even come close.

Ultra-low-cost carriers like Spirit can keep fares so low because they have much lower costs than legacy carriers like United and because they get lots of revenue from ancillary fees. (Fee revenue represents more than 40% of the total at Spirit.)

United Continental's core customers would not appreciate the ULCC model of charging for everything from soft drinks to assigned seats. Thus, United cannot simply copy Spirit's fee structure. But that also means it needs to advertise even higher fares to break even.

Foolish final thoughts
There's no guarantee that Spirit's planned rapid expansion will go smoothly, although there's no reason to believe it will face major bumps given its extraordinary run of success. However, even if there are some growing pains, Spirit has an opportunity to scale its highly profitable business model by an order of magnitude. Its management team is thus wise to push the growth pace.

Spirit investors can take comfort in the fact that no established airline in the U.S. can rival its low fares. There are plenty of open questions about how much the growth of Spirit and other ultra-low cost carriers will impact legacy carriers like United. However, what is clear is that even if Spirit represents a threat to these airlines, there's not much they can do to fight back.

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  • Report this Comment On July 24, 2014, at 11:49 AM, Subsound90 wrote:

    Spirit airlines is certainly the lowest cost, but they are going to have some real issues if they refuse to cleanup their service (http://www.consumeraffairs.com/travel/spirit.html). It doesn't matter if one saves a bit on the flight if it is delayed half a day or more, or if it doesn't get there at all. Frontier and even United are not that much more and they actually depart and arrive somewhere around when they are supposed to.

    People and companies remember this crap when it ruins vacations and business trips. They don't like having their time wasted.

    My personal experience is that I have been booked on Spirit a few times...but I have never actually taken a flight. Contracting for a bit the company that managed it would book on Spirit to save money. However, the flights were delayed so long (or outright cancelled) that I had to grab another flight as they fought with their client services...till Spirit was dropped.

    My wife also booked a vacation on Spirit. I didn't realize, and it would have cost to cancel, so I went hoping for the best and expecting the worst since it had been a few years. The flight was delayed for over 20 hours because they stated the plane was not safe to fly according to the FAA. On top of previous bumping of the flight by 8 hours. By the time we would have arrived for our short vacation we could have slept and would have hopped onto the return flight without seeing more than the hotel.

    When we complained their response was to go away and call the service line. The service line, after hanging up on me a few times, just stated that it was tough luck and maybe we could have a $50 voucher for a flight if they had any left at the desk. We refunded and left...and received a text the flight was later cancelled entirely.

    It's not to go into personal stories, but these really add up over time the more people a company pisses off. As people and friends have terrible stories it doesn't matter how much you save them. This isn't like an internet service provider where choices are limited...travel has a lot of competition and thin margins.

  • Report this Comment On July 24, 2014, at 4:26 PM, TMFGemHunter wrote:

    @Subsound90: Thanks for the comment. It sounds like you had especially bad luck! Yesterday, for example, Spirit had 2 canceled flights out of 284. About a third of its flights arrived at least 15 min. late, but that was still better than a lot of airlines, including American, United, Southwest, and JetBlue.

    Spirit's business model is built around leisure travelers, although there certainly are some people who do business travel on Spirit to save money. If you're on a tight schedule, Spirit isn't the right airline for you. Most of its routes are once a day, and it doesn't keep much in the way of spare aircraft (because doing so is expensive). So if something happens, you can expect long delays... and if a flight is canceled it could be a couple of days before Spirit can get you to your destination.

    That said, the numbers don't lie. More and more people are flocking to Spirit.

    Adam

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10/1/2014 3:59 PM
SAVE $66.82 Down -2.32 -3.36%
Spirit Airlines CAPS Rating: ***
UAL $45.47 Down -1.32 -2.82%
United Continental… CAPS Rating: *

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