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Brighter Skies at Spirit Airlines

By Adam Levine-Weinberg - Jan 24, 2016 at 2:30PM

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The budget carrier just dramatically raised its Q4 profit guidance.

Spirit Airlines (SAVE -0.45%) investors came into 2015 with high hopes as fuel prices plummeted and the carrier prepared to ramp up its growth rate. Spirit Airlines stock rose above $80 as its profit outlook for 2015 soared.

Indeed, in early February, Spirit projected that its full-year operating margin would be between 24% and 29.0%, up from the record 19.2% operating margin it produced in 2014. Unfortunately, management had to cut its margin guidance twice in the next six months. This helped drive the stock down by 60% from its highs.

SAVE Chart

Spirit Airlines Stock Performance, 2014-present. Data by YCharts.

However, while 2015 wasn't quite as good a year as Spirit's management originally expected, it also wasn't as bad as management (or investors) have feared in recent months. The company's recent guidance update made that crystal clear -- sending Spirit Airlines stock up 11% on Wednesday and up another 6% on Thursday.

Guidance comes down
Spirit Airlines' original margin guidance for 2015 assumed that domestic airfares would remain fairly stable despite the steep drop in oil prices. Instead, various airlines used their fuel cost savings to lower prices on routes where they compete with Spirit.

American Airlines Group (AAL 1.73%) was most aggressive in this regard. More than half of the carrier's revenue comes from customers who fly American just once a year. Thus, American Airlines decided that it needs to compete on price -- even with budget carriers like Spirit -- to avoid losing customers.

American Airlines has started aggressively matching Spirit's prices. Image source: American Airlines.

This policy may have contributed to American Airlines' mid- to high-single-digit unit revenue declines in recent quarters. But the impact was even greater for Spirit Airlines. In Q3, its total unit revenue fell by a stunning 17.5% year over year.

As this situation developed, Spirit Airlines cut its full-year operating margin guidance range: first to 24% to 27% in April, then to 21.5% to 23.0% in July.

Guidance goes back up
However, since July, Spirit has been able to not just maintain but actually improve its 2015 margin guidance. In July, Spirit forecast that it would produce a 22% to 25% operating margin in Q3. Spirit's adjusted operating margin for the quarter ultimately reached 27.4%, despite the sharp unit revenue decline noted earlier.

As of October, the company still expected a 21.5% to 23% full-year operating margin. As it turns out, this forecast was too conservative. In Spirit's investor update released last week, it raised its Q4 operating margin guidance by 5 percentage points: from 17.5% to 22.5%. Both fuel and non-fuel costs were lower than expected, while revenue came in higher than expected.

Both revenue and costs came in better than expected for Spirit in Q4. Image source: Spirit Airlines.

This updated guidance implies that Spirit's 2015 operating margin was 23.6%. That's better than the updated guidance introduced six months ago, and it isn't far below Spirit's original guidance range for a 24%-29% full-year operating margin.

Plenty of upside left
Looking back at 2015, it's pretty clear that investors overreacted to Spirit Airlines' guidance revisions. The company reached new record highs for revenue, earnings, and operating margin in 2015. And despite facing significant pricing pressure from American Airlines and other rivals, Spirit's operating margin didn't fall very far below management's original bullish guidance.

For 2016, Spirit Airlines plans to boost capacity by 20%, which could lead to another year of double-digit revenue growth. Meanwhile, with jet fuel prices falling to levels not seen in more than a decade, Spirit's profit margin could reach another record this year.

Longer-term, Spirit Airlines' industry-leading cost structure and large market opportunity should allow it to produce many more years of double-digit profit growth. With the stock still trading for just over 10 times Spirit's 2015 earnings per share, long-term investors should stay the course.

Adam Levine-Weinberg owns shares of Spirit Airlines and is long March 2016 $40 calls on Spirit Airlines, long June 2016 $30 calls on Spirit Airlines, and long January 2017 $30 calls on American Airlines Group. The Motley Fool is long January 2017 $35 calls on American Airlines Group. The Motley Fool recommends Spirit Airlines. Try any of our Foolish newsletter services free for 30 days. 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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Stocks Mentioned

Spirit Airlines, Inc. Stock Quote
Spirit Airlines, Inc.
$24.57 (-0.45%) $0.11
American Airlines Group Inc. Stock Quote
American Airlines Group Inc.
$15.25 (1.73%) $0.26

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