Shares of budget carrier Spirit Airlines (NYSE:SAVE) got slammed on Tuesday morning as investors reacted poorly to an investor update released late on Monday. As of 11:30 ET, Spirit Airlines shares were down nearly 7%.
Yet while Spirit's revenue fell short of expectations during the second quarter, this revenue weakness was fully offset by lower costs. Furthermore, Spirit Airlines still has a clear path to significantly improve its revenue performance in the second half of 2016.
Unit revenue disappoints
The main reason for Spirit's share price slide was the revelation that total revenue per available seat mile (TRASM) fell 14.3% during Q2. This was a somewhat larger decline than the company had projected.
However, it wasn't really that big a miss, nor was it a big surprise. On Spirit's Q1 earnings call, CFO Ted Christie stated that TRASM would likely decline at a pace similar to Q1, when TRASM was down 13.8% year over year.
Furthermore, other domestic-focused carriers like Southwest Airlines (NYSE:LUV) had already confirmed that the revenue environment remained weak during Q2. At its investor day last month, Southwest stated that unit revenue would rise less than 1% year over year in Q2 -- far better than Spirit's performance but worse than what most analysts had expected.
Low costs get lower
While unit revenue remained weak at Spirit Airlines last quarter, unit costs came in better than expected. Spirit had originally projected that its non-fuel cost per available seat mile (CASM) would decline 5% year over year in Q2, but non-fuel CASM instead fell about 8%.
Spirit Airlines stated that the larger-than-expected unit cost reduction was primarily driven by the timing of maintenance expenses. That might suggest that these costs will simply show up in the second half of the year. Yet Spirit has a track record of routinely beating its cost guidance. Even if maintenance expenses increase later this year, the company may find other savings.
Furthermore, aircraft rent and depreciation and amortization expense both came in significantly lower in Q2 than Spirit had expected. This produced $4.3 million of cost savings relative to the original guidance. This may mean that Spirit was able to extend or buy out numerous aircraft leases during the quarter, which would reduce its aircraft costs going forward.
In any case, Spirit Airlines now expects its adjusted operating margin to reach 22% in Q2. That's at the high end of the original guidance range of 20.5% to 22%. This puts Spirit in position to meet or beat the average analyst EPS estimate of $1.05 when it reports earnings later this month.
Revenue should start to turn soon
While Spirit Airlines' Q2 TRASM was a little worse than expected, unit revenue could rebound surprisingly quickly in the next few quarters.
Most importantly, industry capacity growth is set to slow dramatically in the next few months. For example, in August, Southwest Airlines will lap the final round of its growth in Dallas. This should mitigate the year-over-year unit revenue pressure that Spirit has been experiencing in Dallas since late 2014 as Southwest has aggressively expanded there.
Spirit is also slowing its own growth. It plans to grow its fleet by just one aircraft in Q3. Meanwhile, after starting 14 new routes in March and April, Spirit doesn't have any more routes scheduled to begin until November. As Spirit's newer routes mature, they will start to produce stronger revenue results.
As capacity growth moderates both at Spirit and across the industry, pricing should firm up. This will address concerns that Spirit's profitability is bound to collapse -- helping Spirit Airlines stock finally gain traction once again.
Adam Levine-Weinberg owns shares of Spirit Airlines and is long December 2016 $30 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines. 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.