For the past few years, Spirit Airlines (NYSE:SAVE) and its pilot union have been embroiled in an acrimonious contract negotiation process, as the pilots aimed to catch up to their peers at larger airlines in terms of wage rates. This fight culminated in an alleged work slowdown last spring, causing a spike in flight cancellations that alienated customers.
However, the two sides reached a tentative contract agreement in late January, and the pilots have now ratified this contract proposal. This agreement will increase costs for Spirit Airlines, putting pressure on its 2018 profitability. But it will also give the company much more stabilit, enabling it to solidify its long-term growth plans.
The new contract is now official
The contract the pilot union ratified in February provides immediate raises averaging 43%, plus a big increase in retirement benefits. The pilots will also share a $75 million ratification bonus.
Despite the bad blood between the pilots and management from 2017, the tentative agreement won broad support among union members and was ratified by a 70%-30% margin. Ninety-eight percent of the pilots eligible to cast a ballot participated in the ratification process. The new contract goes into effect immediately, and it will become amendable in five years.
Thus far, management hasn't spelled out the impact of the new contract on costs. However, based on some estimates provided in the course of last year's labor dispute, it appears that the first-year cost increase from the new contract could translate to roughly 4% of annual revenue. While this increase will put upward pressure on Spirit's non-fuel unit costs this year, the carrier should be able to offset much of it through higher productivity and cost savings in other areas.
Time to finalize future growth plans
In 2018, Spirit Airlines is set to increase its capacity by more than 20%. Most of this growth is being driven by new Airbus (NASDAQOTH:EADSY) A320-family aircraft deliveries in late 2017 and 2018. In addition, capacity was artificially depressed last year because of flight cancellations related to the pilot dispute and major hurricanes, as well as the grounding of part of Spirit's A320neo fleet because of reliability issues.
However, beyond this year, Spirit's order book is only sufficient for about 10% annual growth through 2021. Furthermore, Spirit doesn't have any orders with Airbus beyond 2021.
While Spirit Airlines expects to moderate its growth rate over time, that's not the primary rationale for this conservative plan. Instead, management wanted to get the cost certainty of a new pilot contract before committing to more aircraft. With a pilot deal now in hand, Spirit Airlines is likely to place a significant aircraft order sometime this year.
What will Spirit Airlines buy?
Not long ago, it seemed like a foregone conclusion that Spirit Airlines would stick to the Airbus A320 family, including the A320neo, as its exclusive aircraft type. However, Airbus' move to take a controlling stake in the smaller CSeries aircraft program could change that equation.
Spirit Airlines will end 2018 with 122 aircraft. The 182-seat A320/A320neo will account for half of the year-end fleet, with the other half split almost evenly between the 145-seat A319 and the 228-seat A321. Looking ahead, I expect the A320/A320neo to remain the backbone of Spirit's fleet. Spirit is also likely to order A321neos to serve its highest-demand markets, as that model has extremely low unit costs.
However, Airbus currently has a production backlog of more than 6,000 A320-family aircraft. As a result, it could be difficult to secure additional delivery slots before 2021 or 2022. While Spirit Airlines could turn to the lease market instead, that would probably lead to higher aircraft costs compared to a direct purchase.
In addition, the A319 and its successor, the A319neo, aren't very efficient. Spirit Airlines needs a better option if it wants to continue expanding in small and midsize markets.
The CS300 model looks very appealing from this perspective. It is roughly equivalent in size to the A319, but it has significantly lower fuel and maintenance costs. (Pilot costs may also be slightly lower because it is a smaller aircraft type than the A320 family.) Indeed, its unit costs are roughly on par with the larger A320neo. And with the CSeries program joining the Airbus family, Airbus will no longer have an incentive to undercut CS300 pricing.
Unlike Airbus' A320-family aircraft, the CS300 appears to have open delivery slots as early as 2020. That would allow Spirit to resume a slightly faster pace of capacity growth, perhaps in the range of 12%-15% annually. In addition, Spirit has leases expiring for 19 A319s between 2020 and 2022. Replacing the A319s with CS300s would drive substantial cost savings.
There are certainly valid reasons for Spirit Airlines to stick with a uniform fleet of A320-family aircraft. However, the likelihood it will supplement the Airbus fleet with CS300s has increased substantially over the past couple of years.