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Spirit Airlines Inc. Investors Had No Need to Worry

By Adam Levine-Weinberg – Feb 20, 2014 at 2:00PM

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Spirit Airlines Inc. surprised investors last fall by projecting that unit costs would increase in Q4. As it turned out, there was no need to worry.

After Spirit Airlines, (SAVE -0.28%) reported Q3 earnings back in late October, investors briefly panicked. The stock dropped as much as 8% after the earnings report came out, dipping under $40 before recovering.

To any longtime airline industry follower, it was clear that the sell-off was overdone. While Spirit Airlines is pricier than most airline stocks, it earns industry-leading margins and has huge growth potential. Spirit's recent Q4 earnings report proved that this is a solid business built to deliver big returns for long-term investors.

Unfounded fears of cost creep
One of the main reasons why investors were unhappy with Spirit's Q4 earnings report was that the company projected a 4%-5% jump in nonfuel unit costs. Spirit's business model is built around having the lowest costs of any airline, so it is somewhat understandable why this guidance was worrisome.

Spirit Airlines relies on having the lowest unit costs of any airline. Photo: Spirit Airlines

That said, the main cause of this increase was an unusual engine blowout that occurred in October. Later that month, Spirit estimated the repair expenses at $10 million. This seemed like an overly conservative cost estimate at the time.

Sure enough, the company revised that guidance last month to $8 million in repair expenses. Spirit also found additional cost savings during the quarter, allowing it to further reduce its unit cost growth. Finally, on Wednesday the company announced that it believes all of its costs will be covered by insurance, other than a $750,000 deductible. The result: Spirit's nonfuel unit costs actually declined by 2.5% last quarter!

Looking good for 2014 and beyond
Keeping unit costs low is the key to Spirit's business model. By doing so, it can earn very high margins even while charging significantly less than rivals. Due to its consistent price leadership, Spirit rarely has to worry about filling its planes.

Thus, with unit costs declining yet again, Spirit had no trouble generating rapid earnings growth -- EPS more than doubled year over year. For the full year, Spirit's revenue soared 25.5% while its adjusted pretax margin expanded from 12.7% to 17.1%, boosting earnings by more than 60%.

Spirit isn't likely to post such rapid profit growth in 2014. Due to the timing of Spirit's aircraft deliveries, capacity is expected to grow at a more modest 16.7% pace this year. Nonfuel unit costs are expected to rise slightly due to higher maintenance expenses and the impact of new federal regulations for pilot rest periods. This will keep Spirit's operating margin in a 16%-18% range -- roughly flat year over year.

But growth will accelerate toward the end of the year and into 2015. Spirit now expects capacity to rise 29% in 2015. This will lead to faster revenue growth, and it should also allow Spirit to reduce its unit costs by better leveraging fixed costs. As a result, Spirit's profit growth should accelerate again next year.

Foolish bottom line
Spirit Airlines investors got a brief scare last October, but contrary to the company's initial expectations, unit costs continued to fall last quarter. Spirit's continued cost discipline and long growth trajectory both bode well for long-term investors. If you're looking to buy and hold one airline stock forever, Spirit Airlines is still definitely one you should consider.

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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