Labor tensions have been a recurring problem at ultra-low-cost carrier Spirit Airlines (SAVE -1.80%) in recent years. In 2010, pilots walked off the job for several days. That's the only strike experienced by the entire U.S. airline industry in the past decade.
More recently, Spirit Airlines pilots have become vocal in criticizing the company's management, as contract talks dragged on for years with little progress being made. These frustrations boiled over last May, with most of its pilots refusing to pick up overtime work. This forced Spirit Airlines to cancel hundreds of flights, angering many of its customers.
However, a tentative agreement has finally been reached with its pilot union for a five-year contract. Let's take a look at how this will affect the company going forward.
Pilots are set to get big raises
Under the recently completed tentative agreement, Spirit Airlines has offered its pilots an immediate wage increase averaging 43%, according to the pilot union. It will also make double-digit direct contributions to pilots' retirement plans. (Previously, there was a 100% match for pilots' contributions up to 9% of their annual pay.) Spirit also agreed to pay a ratification bonus of $75 million that will be divided among its roughly 1,800 pilots.
The tentative agreement still needs to be ratified by the union's membership. The voting will run from Feb. 7 to Feb. 28, so the contract won't be official for nearly a month (assuming it passes, which isn't guaranteed).
Estimating the cost of the new contract
Thus far, Spirit Airlines hasn't commented on the tentative agreement with its pilots. However, last May, management released some information about the company's initial contract proposal. This provides a baseline for evaluating the potential financial impact of the tentative agreement.
Spirit Airlines' proposal as of last May included, "among other benefits, a 30% increase in pay on the date of signing of the amended agreement," according to COO John Bendoraitis. Spirit estimated that this would have increased the company's costs by more than $440 million over five years.
As noted above, the tentative agreement incorporates significantly larger raises, along with higher retirement contributions. This could make the incremental cost over five years closer to $700 million. That probably wouldn't be split evenly over five years, as most airline labor contracts call for modest annual wage increases during the term of the contract. A reasonable estimate for the first-year cost might be $120 million.
What it would mean for unit costs
An immediate $120 million annualized cost increase would certainly be significant for Spirit Airlines. That works out to roughly 4.5% of Spirit's 2017 annual revenue and 3.7% of the company's estimated 2018 revenue.
In its first year, the new contract may create a roughly 6-percentage-point headwind to Spirit's nonfuel unit costs. (This excludes the impact of the $75 million one-time ratification bonus.) However, Spirit Airlines previously estimated that nonfuel unit costs would decrease 3%-5% year over year in 2018, excluding the impact of any pilot deal, in line with the 4% decrease it expects to report for the final quarter of 2017.
In other words, Spirit Airlines should be able to offset the vast majority of this increase in pilot compensation through other savings during 2018. The net result is likely to be low single-digit nonfuel unit cost growth. This is a small price to pay for achieving better labor relations.
Spirit Airlines can handle its cost increases
While Spirit Airlines' unit revenue likely fell by about 2% last quarter, that would be much better than its original forecast. It's also a big improvement over the 6.3% decline Spirit reported for the third quarter.
For 2018, Spirit Airlines would need mid-high single-digit unit revenue growth to keep its pre-tax margin flat in the face of rising fuel costs. That will be difficult to achieve, but it's not impossible. A relatively small (less than $10 one-way) increase in Spirit's average fare would do the trick. Airlines across the industry should be motivated to avoid fare wars this year, given the steep fuel cost increases they face.
Furthermore, Spirit's effective tax rate will drop from 37% to 24% this year, due to tax reform. That should enable Spirit Airlines to grow its earnings per share in 2018, despite absorbing big increases in its fuel and labor costs.