For the past couple of years, Spirit Airlines' (SAVE -2.89%) fleet plans have been in limbo as the company tried to finalize a new pilot contract in order to get cost certainty. Fortunately, Spirit's pilots finally ratified a new contract in late February.
Last week, Spirit made one major fleet decision. The company agreed to purchase 14 Airbus (EADSY -2.20%) A319s that it currently leases from AerCap (AER 5.16%). This move is a big bet on the long-term profitability of operating older, smaller jets -- even with higher pilot costs.
A change in philosophy
Under prior CEO Ben Baldanza, Spirit Airlines developed a strong preference for the larger members of Airbus' A320 aircraft family, which have lower unit costs. It also preferred to operate a fleet of young aircraft that were easy to maintain.
However, the company's philosophy has evolved since Bob Fornaro took the helm in early 2016. Fornaro has spearheaded a move to serve smaller markets, in order to mitigate the severe fare wars that have hurt the carrier's profitability in recent years. Spirit Airlines needs to maintain a mix of smaller and larger airplanes to match the growing variety of its markets.
As a result, Spirit Airlines extended the leases on several of its Airbus A319s during 2016 and 2017, and purchased another eight of its previously leased A319s. Even so, at the beginning of 2017, 23 of the carrier's 31 A319s were leased -- with 19 of those leases set to expire between 2020 and 2022.
Small is here to stay
Spirit Airlines' recently ratified pilot deal gave pilots an immediate raise averaging 43%. Thus, it would have been understandable if Spirit now wanted to move toward larger planes in order to spread its pilot costs over more passengers.
Instead, Spirit Airlines has made a long-term commitment to its Airbus A319 fleet. On Monday, the carrier revealed that it recently struck an agreement with aircraft-leasing giant AerCap to buy 14 A319 jets that Spirit currently leases. It will purchase the 14 planes between April and June for a total price of $285 million: an average price of slightly more than $20 million per aircraft.
Spirit will be able to apply maintenance reserves and security deposits currently held by AerCap toward the aircraft purchases. Based on the carrier's previous experience with purchasing leased planes, the maintenance reserves and security deposits may cover 25%-35% of the price.
The remainder of the purchase price can be funded with cash or debt. Given that Spirit Airlines ended 2017 with more than $900 million of cash and short-term investments on its balance sheet, it will almost certainly use cash on hand.
Good for long-term earnings and cash flow
Spirit Airlines is likely to report a substantial special charge in conjunction with the decision to purchase these 14 A319s off lease. That's because it has to mark the aircraft down to their current market values: likely $10 million-$15 million each.
Nevertheless, this looks like a good move for the long run. First, buying these planes will reduce Spirit's aircraft rent expense. There will be some offsetting depreciation, but the net savings should still be substantial, contributing to the carrier's cost containment efforts.
Second, the cash return on this investment will be very attractive. Spirit Airlines will generate some near-term tax savings by purchasing these airplanes, due to provisions of the recent tax reform bill that permit the "expensing" of capital expenditures. Additionally, depreciation is a noncash expense, so all of the aircraft rent savings (after taxes) will become incremental free cash flow.
Finally, Spirit Airlines will be able to avoid lease-return costs -- which are often substantial -- by purchasing these 14 A319s from AerCap. (For example, aircraft lease agreements often specify that maintenance deposits are nonrefundable, even if they exceed the cost of performing all of the work needed to get the aircraft ready for another customer.)
In short, Spirit Airlines is set to reduce its annual aircraft rent expense by tens of millions of dollars, using about $200 million of cash that has been earning very little interest. This is clearly a good move for shareholders.