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Spirit Airlines Incorporated's Cost Guidance Is Incredible

By Adam Levine-Weinberg – Apr 11, 2018 at 9:25AM

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Spirit Airlines expects to reduce its nonfuel unit costs significantly this year, despite handing out huge raises to its pilots.

Last fall, Spirit Airlines (SAVE -0.99%) forecast that its adjusted nonfuel unit costs would decline 3%-5% year over year in 2018. This reflected the ultra-low-cost carrier's dreadful cost performance during the second quarter of 2017, when a pilot dispute forced Spirit to cancel hundreds of flights. Adjusted nonfuel unit costs surged 10% year over year in that quarter.

However, investors viewed this 2018 cost guidance as a placeholder, as Spirit Airlines entered the year on the verge of signing a new pilot contract. Sure enough, in February, the pilots ratified a deal that gave them immediate raises averaging 43%, plus other benefit enhancements.

Yet while Spirit Airlines did increase its unit cost outlook after the new pilot contract was ratified, the impact on its cost structure wasn't as bad as investors may have feared. And in an investor update released on Tuesday, Spirit moved its 2018 cost guidance lower again -- putting it almost exactly back where it was at the beginning of the year.

Cost guidance gets worse -- and then gets better again

On March 1, Spirit Airlines updated its cost guidance in light of the new pilot contract. At the time, it projected that unit costs would be down about 3% in the first quarter and down 0%-1% for the full year.

In other words, over the course of the full year, the additional costs from the new pilot contract will essentially cancel out the tailwind from facing an easy year-over-year cost comparison in Q2. Considering the size of the pilots' raises, the cost impact was relatively modest. This may indicate that Spirit achieved substantial productivity improvements in the new contract.

A yellow Spirit Airlines plane parked at an airport gate

Spirit Airlines' new pilot contract isn't hurting profitability as much as expected. Image source: Spirit Airlines.

On Tuesday, Spirit revealed that unit costs came in comfortably better than its projections last quarter. It now expects to report a roughly 5% nonfuel unit cost decline for Q1. Even more remarkably, the carrier revised its full-year cost outlook down by 3 full percentage points. Spirit Airlines' new forecast that adjusted nonfuel unit costs will decline 3%-4% in 2018 is virtually identical to the initial guidance that the carrier provided late last year.

Reliability improvements and an aircraft deal bolster the cost outlook

Spirit Airlines attributed most of its Q1 cost beat to completing more of its scheduled flights. Indeed, after overcoming the disruption from last year's pilot dispute, Spirit has started making big strides in terms of boosting its reliability. On-time performance and completion factor have both improved significantly in the past several months.

If Spirit Airlines can continue to improve its reliability, it will help the company reduce its unit costs even further. It could also lead to unit revenue improvements a little further down the road, by helping the carrier improve its reputation.

Turning to the full-year outlook, Spirit Airlines will achieve substantial cost savings due to its recent decision to buy 14 previously leased A319s. Aircraft rent represents one of Spirit's largest expenses. Indeed, the company spent nearly 8% of its revenue on aircraft rent last year: $206 million.

In the past, Spirit has noted that it can save about $1 million annually per aircraft by buying rather than leasing planes. The savings may be even greater here, because the carrier is acquiring cheap used aircraft.

Good news for earnings

In its recent investor update, Spirit Airlines acknowledged that unit revenue fell 2.4% year over year in the first quarter. This was near the low end of its guidance for a 1%-2.5% decrease in unit revenue, due to a combination of tough competition and a higher completion factor.

However, with the improvement in its unit cost forecast, Spirit Airlines should be able to surpass the average analyst EPS estimate for the first quarter of $0.37.

Unit revenue is likely to decline again in the second quarter, due to the timing of Easter, price matching by rivals, a tough year-over-year comparison, and Spirit Airlines' rapid growth. That said, Spirit is steadily refining its route strategy -- cutting underperforming routes and increasing the number of seasonal routes it operates -- which could help limit the pressure on unit revenue.

Meanwhile, nonfuel unit costs will decline at a high single-digit rate this quarter, or perhaps even a low double-digit rate. This should more than offset the sharp increase in fuel costs that Spirit will face. As a result, EPS could soar past the average analyst estimate of $0.98.

Spirit Airlines stock may continue to struggle until the company offers firmer evidence that it can get unit revenue growing again. But with the stock trading for around 10 times earnings -- and plenty of room for future revenue and earnings growth -- Spirit Airlines stock looks like a tremendous bargain right now.

Adam Levine-Weinberg owns shares of Spirit Airlines. The Motley Fool owns shares of and recommends Spirit Airlines. The Motley Fool has a disclosure policy.

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