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 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.
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.
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.
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.
Adam Levine-Weinberg is short shares of United Continental Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.