On Wednesday afternoon Spirit Airlines (SAVE 0.76%) reported that its adjusted earnings per share surged 52% year over year last quarter, continuing a recent trend of strong earnings growth.
You might think investors would have been pleased with these results. Instead they zeroed in on Spirit's weak forecast for the third quarter, which was well below the market's expectations. As a result, Spirit Airlines stock plummeted nearly 24% on Thursday, ending the day at its lowest level in roughly a year.
Yet while the company's guidance was certainly disappointing, many of the headwinds Spirit is facing are temporary. Profit growth should bounce back in 2020, and Spirit Airlines stock has massive long-term upside.
Strong results in the second quarter
Spirit Airlines continued its steady growth last quarter, expanding capacity 13.2% year over year. Revenue per available seat mile (RASM) rose 5%. Together, these two factors drove an 18.9% increase in revenue to $1.01 billion. (Incidentally, this was Spirit's first-ever $1 billion quarter.)
Adjusted nonfuel unit costs increased 4.6% in the quarter. This was a disappointing but expected result. In its initial guidance for the second quarter, Spirit Airlines had warned that a spike in flight cancellations due to Easter-weekend storms and runway construction in Fort Lauderdale (its largest base) would pressure Q2 nonfuel unit costs by 2.5 percentage points. Lower fuel prices offset some of this cost pressure, though. Spirit paid an average of $2.16 per gallon for jet fuel last quarter, down from $2.32 per gallon in the prior-year period.
The net result was that Spirit Airlines' adjusted pre-tax margin rose to 14.8% from 11.7% in the second quarter of 2019. Adjusted EPS spiked to $1.69 from $1.11 a year earlier. This surpassed the average analyst estimate of $1.65.
The guidance is ugly
Spirit Airlines will expand its capacity by 13% again in the third quarter. But this time it expects unit revenue to be roughly flat year over year (plus or minus 1%). Tougher comparisons are driving the sequential slowdown. RASM plunged 6.8% in the second quarter of 2018, whereas RASM rose 5.5% in last year's third quarter.
The more troubling part of Spirit's guidance -- and the main cause of Spirit Airlines stock's sharp drop -- was management's projection that adjusted nonfuel unit costs will surge 7% to 8% year over year in Q3. A mix shift toward shorter flights (which tend to have higher unit costs) and the ongoing Fort Lauderdale runway construction will drive about 2.5 percentage points of the increase. The impact of weather-related disruptions accounts for much of the rest.
After building slack into its schedule last year in an effort to improve reliability, Spirit Airlines executives thought they had an opportunity to improve efficiency in 2019 by increasing aircraft use. That move backfired. Spirit Airlines has faced more severe weather this year than it did in 2018, which has caused flight cancellations to spike again. Spirit is conservatively forecasting that weather will continue to be a problem for the rest of the year.
Based on that assumption, the company is estimating a 3.5 percentage point headwind to nonfuel unit costs this quarter. Management has already started adjusting schedules for later in the year and 2020 to put more slack in the system and avoid a repeat of its mistakes.
Fuel costs are set to decline again in the third quarter, but it won't be enough to offset the big increase in nonfuel unit costs. As a result, Spirit's adjusted EPS is on track to end up roughly in line with its Q3 2018 result of $1.47, with a modest margin decline offsetting its revenue growth. Analysts had been expecting EPS to jump 27% to $1.87.
Investors are overreacting
While Spirit's Q3 guidance was discouraging, many of the headwinds it is facing are temporary. As a result, the 24% plunge in Spirit Airlines stock doesn't make sense.
The carrier now expects adjusted nonfuel unit costs to rise 4.5% to 5% on a full-year basis, but 2 percentage points of that increase will reverse in 2020. Thus the cost pressure that Spirit Airlines is facing this year doesn't mean much for its long-term cost trajectory. Management reiterated on the company's recent earnings call that Spirit should be able to keep widening its cost advantage relative to the rest of the U.S. airline industry in the years ahead.
Meanwhile, two key projects that should boost unit revenue -- the introduction of inflight Wi-Fi and the launch of an updated loyalty program -- have been delayed modestly. That just means the expected revenue lift will come in 2020 and beyond, not in 2019. Spirit Airlines also faces some short-term unit revenue headwinds from having added six new cities to its route network in the first half of 2019. That pressure should reverse in 2020.
In short, while EPS growth is set to pause in the second half of 2019, Spirit Airlines remains a high-growth company from a long-term perspective. With Spirit Airlines stock now trading for less than 10 times last year's earnings, the recent sell-off seems like a great buying opportunity for long-term investors.