JBLU - Despite Weak Trading Spirit JetBlue Merger Could Still Close

2023-11-01 10:23:53 ET

Summary

• Options market data suggests a ~25% likelihood of the JetBlue-Spirit merger closing.
• Weak Q3 numbers raise concerns about Spirit's standalone viability unless costs can be cut.
• Still, Spirit and JetBlue may still prevail in court as the facts have changed since the primary antitrust arguments were written.
• Secondly, Spirit's pre-pandemic history is encouraging; if it can return to that as a standalone airline (if the deal breaks), then the future would be bright.
• Overall, Spirit appears an interesting, if risky, proposition with limited correlation to the broader market.

The markets don't think the JetBlue ( JBLU ) Spirit ( SAVE ) merger is likely to close. Latest option data for July 19, 2024 contracts, which is the outside date for the merger appears to imply, broadly, a 24%-27% of Spirit reaching the deal price by that date.

There's also concern, based on weak Q3 numbers with falling revenues and rising costs that Spirit may not be a going concern if it can't merge with JetBlue. Lastly, the $400M break-fee is net of funds already paid to Spirit shareholders, who have received almost that amount already, so there's no real silver lining to any deal break.

However, despite all this, Spirit may still be an attractive, if risky, bet at these levels. That's in part due to maybe a greater chance of winning the antitrust case than the market believes and also because Spirit has delivered impressive operating results historically if they do remain independent and can focus on their business rather than legal arguments and potential merger preparations.

The Antitrust Case

In recent years, government antitrust efforts has pushed aggressively to resist many large mergers. This is based on thinking about consumer harm that may be justified, but does not appear firmly rooted in recent legal precedent. Therefore the government have ended up losing a number of high-profile cases recently. Airline mergers require less novel antitrust thinking, but even here the government's case may have flaws:

• JetBlue has historically tended to lower prices for market it competes in, which is good for consumers.
• The government's case is based on part in JetBlue's code-sharing alliance with American, which ended in July 2023 so is arguably no longer relevant.
• JetBlue and Spirit are divesting many airport slots to low-cost competitors where their market share is high.

This is not to say that the government won't win the case. Even though JetBlue are a cheap airline, Spirit are definitely cheaper with an unbundled product and maybe incremental consolidation and the loss of Spirit's business model is bad for consumers, particularly leisure travelers looking for the absolute cheapest flights.

If JetBlue and Spirit prevail, it will likely be that actions have already been taken that mitigate many antitrust concerns. Still it's hard to handicap, I'll put the chances at 50/50 currently as it really seems the case could go either way.

Spirit With Or Without A Merger

From here, less amounts already paid, Spirit shareholders should receive $27-$28/share depending on when the merger closes due to a $0.1/month ticking fee prepayment. That obviously assumes that Spirit and JetBlue prevail in the antitrust case and that JetBlue doesn't somehow walk away or renegotiate (both would be contractually hard to do).

If the merger fails, then after recent Q3 numbers, whether Spirit remains a going concern is an open question.

That said, with $5B of revenue, if Spirit can deliver pre-covid operating margins of 10%-20% as it did consistently for 2015-2019, then its stock price would likely be worth somewhere in the range of $16-$62/share at 10x operating earnings less $3.3B of debt. However, on recent numbers Spirit is bleeding cash losing $263M of net income for the first 9 months of 2023 and seeing an operating cash outflow of $64M. Not good.

Potential Outcomes

Next, based on the above we can map out what an expected value for Spirit might look like. This is less as a definitive way to quantify value, but more as a way to determine the drivers of risk and return and broadly size any potential opportunity.

So in this relatively simplified scenario above you have an expected value of $23.63/share for Spirit . More than double today's price. This is also a medium/long term expectation, it's of course highly likely the price declines on any deal break in the short term.

Risks

• Spirit's operating performance pre-covid was so much better than we've seen in recent years. Maybe they will be unable to return to anything like that in the event of a deal break. Still, it also seems wrong to totally ignore 5 years of relatively recent operating history. If you disagree with the chance of Spirit regaining reasonable operating performance, then you may want to consider owning options rather than the stock.
• I haven't included a chance that JetBlue walk from the deal. The CEO does appear extremely committed to the transaction, but it's unclear if the board shares that view especially in light of weaker airline stock prices.
• the options market sees a ~25% chance of JetBlue/Spirit winning in court, I'm at 50%. Also, buying options might have a better risk/reward than owning the stock.
• Even though I can see upside here, there's a material chance of total wipeout if Spirit is unable to remain a going concern based on recent results. As such, this is definitely not the perfect setup and involves material risk.
• If the deal breaks you'd likely want to buy shares after that happens rather than owning them beforehand even if medium-term expected value were on your side.

Conclusion

Spirit is overall an interesting setup here for two reasons. Firstly, their chance of winning the antitrust case may be higher than the market is giving them credit for currently, especially in light of material actions taken since the Department of Justice wrote their primary arguments.

Secondly, prior to the pandemic, Spirit's operating performance was robust. Of course, that's hard to remember now, and clearly results in 2023 have been dire so far, but if Spirit does see the deal break and can really double down on operating performance, there may be upside there, though some favorable tailwinds on wages and airline fares would be needed.

That said, there is also material chance the deal breaks and Spirit cannot survive. They are losing cash currently as ticket prices appear to be softening and costs, especially employee costs, are rising, for now.

Overall though, Spirit seems an interesting, if risky, setup here and with limited correlation to the broader market.

Key Catalysts To Watch

• Trial outcome or settlement - Nov 2023-Jan 2024 (if JetBlue and Spirit win that is extremely favorable)
• JetBlue's commitment to the deal - ongoing - any jitters here are a major concern, especially if the trial goes well, a firing of the CEO would be a major negative for Spirit as any replacement would likely be far less committed to the merger
• Spirit Q4 earnings - Feb 2024 (if still publicly traded) - if the deal breaks, want to see some positive momentum in operating results and improvement in cashflow, or bankruptcy becomes a potential risk

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