In the first few years after its mid-2011 IPO, Spirit Airlines (NYSE:SAVE) became a market darling, posting a string of big earnings beats and huge share-price gains. Yet while Spirit continues to earn a very high margin, the stock has performed poorly since the beginning of 2015, because of a multiyear slide in its unit revenue.
Despite Spirit's recent woes, its fellow ultra-low-cost carrier Frontier Airlines plans to go ahead with an IPO in the next few months. Frontier hopes to drum up interest by marketing itself as a better version of Spirit Airlines.
Frontier has become hugely profitable
Last year, Frontier Airlines earned a record $200 million in profit. That was a pretty remarkable feat, considering Frontier was purchased for less than that amount by its current private-equity owners in late 2013.
Radical cost cuts have been the key to Frontier's success. The company has outsourced numerous jobs, packed more seats onto its planes, and gotten rid of various amenities. (Most notably, it did away with its toll-free customer-service number in 2015.)
Thanks to these efforts, Frontier Airlines was able to reduce its adjusted non-fuel cost per available seat mile (CASM) from 7.89 cents in 2013 to 5.43 cents in 2016. That was slightly better than Spirit's adjusted non-fuel CASM of 5.45 cents. As a result, Frontier's pre-tax margin was 18.4% last year, or 21.7% excluding special items.
Even better than Spirit?
In the registration statement it filed with the SEC last week, Frontier Airlines pointed out that it outperformed Spirit Airlines on several key business metrics last year. Compared with Spirit, Frontier had higher unit revenue and slightly lower non-fuel unit costs in 2016. As a result, its adjusted pre-tax margin was almost 2 percentage points higher than Spirit's.
That said, this outperformance may not be sustainable. In the past two years, price matching by the legacy carriers -- particularly Delta Air Lines and American Airlines -- has led to severe unit revenue erosion at Spirit Airlines. Many of these price-matching campaigns specifically targeted Spirit, which had been growing rapidly in big hub markets. Meanwhile, Frontier Airlines flew beneath the radar by focusing on midsize markets.
However, price matching is becoming a blanket strategy for the legacy carriers, rather than a tactic reserved for a few markets. In addition, United Continental (NASDAQ:UAL) is getting more aggressive about price matching, joining its legacy carrier peers. (United has poached some top executives from American Airlines recently, precipitating this strategy shift.)
A more aggressive United Continental would be bad for Frontier, which still has a huge amount of route overlap with United. (Both carriers have hubs in Denver.) Some of the price-matching dynamics that hurt Spirit in 2015 and 2016 could hit Frontier in 2017 and 2018.
Meanwhile, on the cost side, Frontier Airlines has unusually low labor costs because of its frequent brushes with bankruptcy. For example, its top-of-scale pilot wage rate is about 10% below that of Spirit Airlines, which itself is below the industry standard. Now that Frontier has become strongly profitable, it will need to start paying employees more.
Worth a look at the right price
Spirit Airlines has proved the durability of its business model over the course of many years. Frontier Airlines seems to be in equally good position. It has already done the hard work of reducing its costs to industry-leading levels while growing its ancillary revenue. That said, Frontier still needs to show that it can cope with rising competition from United Airlines and the other legacy carriers while also raising wages for its employees.
With this in mind, Frontier Airlines could be a good IPO stock to consider if it sells for a lower earnings multiple than Spirit Airlines stock. However, if the two carriers' valuations are equal, investors should probably stick with the proven winner: Spirit Airlines.