DAL - A Bumpy Ride With Spirit Airlines Can Offer Value For Money

2023-04-16 07:02:35 ET

Summary

• Spirit is currently trading at a deep discount to the acquisition price that JetBlue has offered.
• The market is implying that the transaction is unlikely to be completed and investors need to analyze the stand-alone entity.
• The stand-alone entity has been struggling with high oil prices, inflation, a big debt load, and a large order book, and operates in an industry that is cyclical.
• However, Spirit is the fastest-growing airline in the US, its low-cost operating model is difficult to compete against and it has a very cheap valuation.

Thesis

Spirit's ( SAVE ) share price is offering investors who are willing to endure some turbulence a good deal. The airline is currently trading at a deep discount to the acquisition price that JetBlue has offered . The market is however implying that the transaction is unlikely to be completed and investors must be comfortable owning the stand-alone entity.

Spirit has been struggling with high oil prices, inflation, and special charges since the pandemic. In addition, the company has a big debt load, a large order book and operates in an industry that is notoriously cyclical. However, these risks and headwinds are intertwined with the business's strong growth and low-cost operating model.

The elephant in the room is the JetBlue acquisition. The Justice Department has sued to block the deal, JetBlue only has a small breakup fee remaining and the offer was made a year ago when the economic outlook was much better. However, if JetBlue stays the course, the likelihood of the courts stopping this merger would be unprecedented, and if the deal is completed, significant upside awaits.

Risks

Higher Oil Prices

Spirit's fuel expense was 34% of total operating expense in 2022 and is the company's largest input cost. The company's modern fleet, with an average age of 7 years, is more fuel efficient than most peers.

Despite this advantage, the risks that higher oil prices hold for airlines became painfully obvious again last year. Fuel costs were up more than 100%, in the latest quarter compared to 2019 on about 20% more volume due to a 69% increase in the average fuel price per gallon.

Going forward the company's fuel efficiency will be helped by the fleet renewal. Spirit has ordered 109 Airbus A320 family aircraft set to be delivered in the next few years. Specifically, the new A321neos will produce 113 ASMs per gallon, while the retiring 319s produced 73 ASMs per gallon, a nearly 40% improvement on a unit basis. Despite this, one thing is certain, higher oil prices are bad for airlines.

Increased Labor Costs

Labor is the second biggest expense for Spirit and the recent tight labor market and pilot attrition has pressured margins. The airline's bargaining position with employees is at a disadvantage compared to other industries with 80% of the workforce being unionized .

In the first quarter, Spirit reached an agreement with the pilots union that boosted their pay by an average of 34% over two years. This added $180 million of wages and expense for 2023 or about 4.5% increase CASM excluding fuel.

There should be some relief as the effects of the pandemic wear off. Spirit has also increased hiring and training of pilots and crew. However, if the labor market remains tight and higher wages are needed to attract workers, Spirit's profits will remain under pressure.

Special Charges

Spirit has endured a number of challenging years since the onset of the pandemic and recorded a number of 'special' charges. In 2022 there was an impairment charge of $334 million due to the fleet renewal. The proceeds from selling the A319ceo's is expected to be $150 million to $200 million, a large discount to book value. In 2021 there was a charge related to the loss on extinguishment of debt of $331 million and in 2020 the company issued shares as it shored up its balance sheet at the onset of the pandemic.

Ultimately, the company needs to become Free Cash Flow positive and return capital to shareholders. That day looks a long way off as the company balances the near term hurdles with its aggressive growth ambitions.

High Leverage

The airline business is capital intensive and, as a result, many airline companies are highly levered. Spirit is one of the most levered US airlines. The company has a B credit rating from S&P, the second lowest of all the airlines, and at risk of higher interest rates and tighter credit conditions.

However, Spirit's credit rating could be artificially low as ratings agencies normally don't consider the cash positions for companies with Spirit's business risk profile. At year-end Spirit had cash and cash equivalents of $1.5b, a large number that would materially improve the credit rating if included in the calculations.

Spirit had $3.6 billion of total debt and $2.1 billion of net debt, after accounting for the $1.5 billion of cash and equivalents at year-end. The amount of secured debt is $1.9 billion, encumbered against aircraft.

The company's current debt load is relatively isolated from interest rate increases as 96% of the debt is fixed rate. Average interest on the debt is a very reasonable 4.75%. Looking ahead, the company has debt repayments of $0.3 billion and $0.2 billion over the next two years. In 2025 there is a larger payment of $1.3 billion due. The company also has annual lease payments of $0.3 billion as 88 of the companies' 194 aircraft are financed with leases (lease terms expires between 2024 and 2040). In the event of a future recession or tighter credit conditions, these debt and lease payments pose a risk to investors.

Airbus Order

At the start of 2020, just as the Covid pandemic was taking hold, Spirit announced that it had placed a massive 100 aircraft Airbus order.

We're going to double our size by 2025,

Spirit vice president of inflight experience Lania Rittenhouse said at the time.

A couple of months later the pandemic hit and three years later the world and airline industry is still recovering. Yet, those airplanes, although slightly delayed, will be arriving over the next few years and will need to be financed at higher interest rates.

Spirit disclosed in its annual report that is has signed a financing letter of agreement with Airbus which provides backstop senior secured financing for a majority of the aircraft ordered. However, only a very small number of the aircraft have committed financing. In a recession scenario, putting this excess capacity to work could prove difficult, putting further strains on the company's financial position.

Cyclical Business

The huge investments that airlines make in aircraft means operators can suffer severe losses if flying is disrupted. The industry was impacted by 9/11, the Great Recession and Covid. Each time there is a crisis, the airlines are close to the center of the storm. Spirit's largest markets are leisure markets such as Ft. Lauderdale, Orlando and Las Vegas. A recession will impact these markets more than most as consumers cut back on spending.

Spirit's low-cost model should however offer some protection when another recession appears. During the Great Recession, Spirit and Southwest Airlines (LUV) were the only airlines able to remain profitable as people tend to trade down when times are hard.

Outlook

Growing

Spirit has been the fastest growing airline over the last 10 years. Since 2012 their fleet has increased from 41 aircraft to 194 in 2022. The recent large Airbus order is expected to add to this growth in the coming years. The company has often faced questions about its ability to put large amounts of future deliveries to work. But they have always done so successfully, as there always seems to be demand for the cheaper tickets.

Low-Cost Operator and Margins

Spirit's has a cost advantage over its peers because of having higher aircraft utilization, more seats per aircraft, lower fuel and marketing costs.

Spirit's aircraft spends minimal amounts of time on the ground between flights. Point to point flights remove the hub-and-spoke network inefficiencies that legacy carriers deal with, resulting in higher utilization.

Spirit also crams in more seats on each aircraft. The company removes the reclining mechanisms , which enables them the fit as many as 40 seats more on a A320. On average the company has 184 seats per domestic flight, compared to 113 seats for United.

Fleet

The company's cost advantage is also due to the use of a single-family, Airbus A320 fleet. This allows flight crews to operate on any flight and reduces maintenance costs. The Spirit fleet is also one of the youngest fleets in the US and the company's average aircraft age is set to drop by 2 years in the next few years as the fleet renewal program is completed. The younger fleet translates into higher fuel efficiency as shown in the chart below. These savings enable Spirit to operate at lower costs than legacy airlines, offering lower ticket prices whilst still earning some of the best margins in the industry.

Merger

JetBlue had offered $33.50 per share in cash for Spirit, this included prepayment of $2.50 per share that was paid to Spirit stockholders' when the deal was approved in 2022. There is an additional ticking fee of $0.10 per month starting in January 2023. Investors at the moment would not be eligible for the prepayment of $2.50, but they could still earn $31.00 or 80% upside at the time of writing, not including the ticking fee.

As part of the deal JetBlue has offered to divest assets at airports where the combined presence would meet objections from regulators or otherwise interfere with its North East Alliance. The breakup fee of $70 million and $400 million less any amounts paid to the Spirit shareholders, which will be roughly $400 million in nine months' time, leaves a small remaining breakup fee of approximately $70 million.

There are multiple reasons why this merger should be expected to go through.

The airlines are small. The combination of the seventh and sixth largest airlines in the United States to become the fifth largest airline does not appear to be anti-competitive.

The Justice Department's argument also relies on segregating 'low-cost' airlines from others. However, despite Spirit's low costs, they charge almost as much as American when all the extras are added on per an analysis from WSJ .

JetBlue has offered to address any overlap issue and appears to go to any length to have the merger approved. JetBlue's so-called ' 'remedy package" would divest all of Spirit's assets in New York and Boston as well as gates and other assets in Fort Lauderdale.

There have been a number of previous mergers in the industry.

• In 2016, the DOJ provided clearance to the Virgin America-Alaska Air deal. Interestingly, after the merger Alaska Air became the fifth largest airline.

• In 2013, US Airways and American Airlines merged

• In 2011 Southwest acquired AirTran. This was the first major acquisition in the low-cost-carrier industry.

Finally, if a JetBlue offer falls through there is always Frontier. The low cost operator offered $25.69 per share for Spirit. The merger is more likely to be approved as most of the objection to the merger is aimed at JetBlue conversion of Spirit planes to having more leg room and fewer seats, an argument that goes away if Spirit merges with Frontier.

However:

The DOJ has sued to block the deal despite the agency having lost a number of cases recently. Their objection to the deal could make the transaction drag on and result in it becoming a big distraction for both parties.

One of the biggest critics of the deal was the CEO of Spirit Ted Christie. He preferred the merger of equals with Frontier that allowed Spirit to participate in the upside as the post pandemic recovery took shape.

He argued that the deal with JetBlue would face tougher regulatory hurdles because:

1. The current administration's frequent challenge of mergers and their potential negative reaction to JetBlue's plan to remove seats and increase legroom/quality of service.

2. The merger would further strengthen JetBlue's network, this would be on top of the Northeast Alliance with American, which is currently being litigated.

In a weird twist, Spirit was actually one of the airlines that was a vocal opponent of the Northeast Alliance, saying that it was anti-competitive.

JetBlue could also walk away from the deal. The remaining breakup fee of $70 million to be paid by JetBlue is relatively small. They made their initial bid in March 2022 when interest rates were lower and the economic outlook much better. JetBlue's ability to take on the added balance sheet and order book of Spirit could prove too risky and in effect JetBlue could choose not to exercise the option to buy Spirit.

Ultimately, if the merger is called off the stock is expected to make a deep dive. However, airlines should continue to do better post Covid and a bid from Frontier could be around the corner, especially if a more business friendly administration gets into power.

Valuation

If the company returned to pre-Covid profit levels of 1.67 cents per ASM and reached the expected future capacity of $63.5 billion, it would generate roughly $1 billion operating profit. Giving a back of the envelope valuation of EV/EBIT of 4x.

A more detailed forecast was provided by the Spirit board of directors as part of the merger fairness opinion, shown below.

If we assume these assumptions are correct, it would also imply that Spirit is extremely cheap, trading at a Fwd. P/E multiple of 3.4x based on 2024 expected earnings and EV / FCF multiple of 4.2x.

Conclusion

If the JetBlue deal is completed, investors will get an 80% return on their investment. If not, they will own an airline that is extremely cheap, growing fast, offering the cheapest tickets out there.

They will also own a company with $2 billion of net debt, an order book that is going to increase the fleet by 50% over the next few years and an airline that is flying close to the sun, that could end up in trouble if another deep recession or pandemic arrives.

I would recommend you make sure your tray tables are stowed and your arm rests are down, this might be a bumpy ride. A value for money journey could however await those willing to buy a ticket.

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