Ultra-low-cost carrier, or ULCC, Spirit Airlines (NYSE:SAVE) has been hit by a wave of selling pressure this week, after announcing that its largest shareholder -- private equity firm Indigo Partners -- is planning to liquidate its stake in the airline. Spirit Chairman William Franke is the managing partner of Indigo, and he (along with another Indigo partner) will step down from the Spirit board in connection with the stock sale.
Indigo Partners has had a major ownership position in Spirit Airlines since 2006, and has been instrumental in overseeing the company's successful transition to the ULCC business model. However, its exit from Spirit should not be seen as a sign that Spirit has peaked. Indigo appears to be selling its stake in Spirit in order to chase an even bigger opportunity: Republic Airways (NASDAQ: RJET) subsidiary Frontier Airlines.
Republic put Frontier up on the auction block in late 2011, but has delayed the sale process several times in order to make progress with Frontier's restructuring process. Frontier is now a budding ULCC in its own right, albeit one that is much less profitable than Spirit. Indigo's exit from Spirit Airlines is more appropriately viewed as a validation of the ULCC business model than a criticism of Spirit's prospects.
Last week, Republic Airways announced that it had finally agreed on a non-binding term sheet with a prospective buyer for Frontier. I first recommended Republic as a "spin-off value play" back in February due to the impending sale or spin-off of Frontier. Indeed, Republic shares have responded by gaining more than 40% since then.
Due to confidentiality agreements, Republic has been unable to announce the identity of the potential buyer or the terms being discussed. However, based on the timing of Indigo's decision to sell its stake in Spirit and a little bit of investigative reporting by The Wall Street Journal, it is now clear that Indigo is the prospective buyer of Frontier.
The opportunity at Frontier is big. Frontier had revenue of $1.4 billion last year, putting it at roughly the same scale as Spirit. However, whereas Spirit has one of the highest pre-tax margins in the airline industry, Frontier is barely profitable. The main difference is that Frontier has higher non-fuel unit costs than Spirit. Yet if a buyer can find ways to continue cutting costs at Frontier, the company has the potential for substantial margin expansion, creating lots of value for owners.
No real threat
Indigo's interest in Frontier over Spirit suggests that it sees more opportunity to create value there, but that is a testament to Frontier's upside rather than a "warning sign" for other Spirit shareholders. That said, is it possible that Frontier -- under Franke's leadership -- could become a serious threat to Spirit as it completes its transition to the ULCC model? Some analysts have recently expressed concern that Franke could use his knowledge of Spirit's business to make Frontier a formidable competitor.
There are two important reasons to believe that Spirit shareholders should not be concerned about the competitive threat from Frontier. First, as noted above, Spirit still has a significant cost advantage over Frontier. Spirit is continuing to find ways to reduce it costs, such as shifting its fleet mix toward Airbus A320s and A321s rather than A319s. The A320s are more than 20% bigger in terms of seating capacity in Spirit's typical configuration, allowing Spirit to spread its fixed costs over more seats. The A321s are even larger, offering additional cost benefits.
Spirit's cost initiatives create a moving target for Frontier, meaning that it will take Frontier several years to close the cost gap (if it does at all). In the meantime, it would be foolish for Frontier to try to compete directly with Spirit. Indeed, Frontier has been focusing its new route plans on markets without other commercial service, including Wilmington, Del. and Trenton, N.J.
Second, the market opportunity for Spirit and Frontier is very large, meaning that the two should be able to grow for many years without stepping on each others' toes. Earlier this year, Spirit's management team estimated that there were more than 400 potential new route opportunities that could produce an operating margin of at least 14% for the carrier. That easily swamps Spirit's ability to grow for the next five or even 10 years. In other words, Spirit could keep growing 15%-20% a year through the end of the decade even with Frontier as a direct competitor.
Spirit Airlines has been one of the most successful airlines in the U.S. in the last few years, and that's driven its stock price up by more than 100% since its IPO in 2011. This week's pullback presents a good opportunity for investors who have missed out on Spirit's run so far. Spirit's largest shareholder may be selling, but only because it wants to copy Spirit's profitable business model at Frontier Airlines.