SAVE - Spirit Airlines: If Merger Fails What's Next?

2023-11-20 14:52:34 ET

Summary

• Spirit Airlines' stock price has fallen to where it may be a value opportunity even without JetBlue merger.
• The stock trades around tangible book of ~$12 per share, versus closest competitor Frontier priced at +60% premium to tangible book.
• Spirit's right-of-use assets for terminal gates and runways at the nation's busiest airports may be even more valuable than its planes.
• ~$2 billion in debt principal payments due 2025 and 2026 the biggest threat to Spirit's existence as a going concern.
• Including merger upside, striving for a margin of safety, Spirit rates a Hold in the $12-$18 range, a strong Buy below $9, and a strong sell above $21.

All eyes right now are on the US Justice Department's suit to block JetBlue ( JBLU ) from acquiring Spirit Airlines ( SAVE ) for $3.8 billion, almost three times Spirit's current market cap. Clearly the market doesn't believe the deal will go through. Spirit's stock price has hovered in the high teens for more than a year as the potential merger hung in the balance, only to crash through the floor in the past couple of weeks, reaching a low of sub-$9 before rebounding swiftly to its price level at the time of writing of ~$12.50 per share.

At $9, Spirit was a great value play with potential embedded upside even if the merger gets blocked, at $12.50, investors are paying a lot more to take on the exact same risk, but it may still be a +EV gamble for those bullish on the airline's trial outcome. Last April, Seeking Alpha's Herman Schroeder published an analysis that covered Spirit's prospects as a standalone entity that rated the airline a Strong Buy. Although Spirit has had a lot of analyst coverage about its status as a takeover target, Mr. Schroeder conducted an excellent deep-dive into Spirit's financial and competitive position to ultimately draw the conclusion that even if no takeover occurs, the stock is still a pretty good, if risky, bet on its own. I found his article to be very useful, as estimates of the company as a standalone entity are necessary for calculating downside risk in the overall expected value equation, even as a takeover play (what do investors stand to lose if the merger fails?). Back then, the stock was $16/share versus $12.50 today, yet not much has changed about the company's fundamental position.

In between then and now, Spirit released a lackluster 3Q earnings report , where the airline lost another $157 million, clocking a 17% drop in TRASM (total revenue per available seat mile) versus an only 7% reduction in CASM (cost per available seat mile), with reports from Pratt & Whitney indicating that Spirit's neo engine problems + associated aircraft groundings will continue until 2025 at least. For a company deep in debt, in a high interest rate environment, that's currently making an operating loss, this is definitely not good news.

Spirit is now trading around its tangible book value of ~$12/share, making it worth a closer look for fans of Benjamin Graham. On the surface, book value seems a good signal to intrinsic value for an asset-intensive business like an airline. Admittedly, Spirit's tangible equity is precarious: it has lost almost a billion dollars of book value since before the pandemic, and tangible equity is dropping by the day as operating losses mount. However, the stock still looks like a bargain relative to its closest competitor in the ultra-low-cost space, Frontier Group ( ULCC ), which is currently priced at a +60% premium to tangible book.

Further, an airline's value lies in more than its planes, as shown by American Airlines ( AAL ) deep negative equity. The fact that JetBlue is willing to pay an enormous premium to Spirit's assets shows this as well. For sure it isn't the Spirit brand, as JetBlue plans to absorb Spirit and eliminate the brand entirely. So what accounts for the difference?

This video by Coby Explanes digs into why JetBlue (and other potential suitors like Frontier) might want Spirit: its gate and runway slots across the country's busiest airports. The New York Times once ran an article ( "Seeking a Place at Airports" ) explaining how difficult it is for even established carriers to secure highly coveted terminal gate and runway slots at desirable airports, citing the issue as a huge hurdle airline startups face. NYT quoted now-CEO of JetBlue Robin Hayes as saying "In some cases, you’ll find carriers hanging on to gates even when they don’t need them just to stop other airlines from coming in." Indeed, Coby Explanes argues that Spirit may be JetBlue's very last chance to acquire the routes it needs to realize its coast-to-coast expansion ambitions to become a true competitor to the Big Four. Direct Flights shows all airports where Spirit maintains a presence, with its main hub at Fort Lauderdale, and significant operations in locations like Orlando, Las Vegas, Baltimore, the Texas Triangle, and Los Angeles.

When combining the value of Spirit's tangible assets (aircraft) and intangible assets (right-of-use for gates and runways at airports in prime destinations), the carrier's value as a package deal seems to be a fair bit above its current market price. Its hard assets alone minus the debt are worth $12 per share, and although Spirit does carry operating lease right-of-use assets on its balance sheet ( see 10-K page 95 ), the vast majority of these are for aircraft and spare engine leases ($3.98 of $4.14 billion, or 96%). Leases with variable provisions are not recorded as assets, and those that are included have an estimated value based only on the sum of lease payments over the lease term, with zero value given to the difficulty in acquiring those leases in the first place. Some things money can't buy, which means Spirit's routes and airport facilities are invisible assets not shown on the balance sheet - assets that at least one competitor (JetBlue) thinks are worth in excess of $2 billion (the buyout offer minus Spirit's tangible equity).

Of the common valuation ratios, P/B is probably the most suitable for estimating a company like Spirit, which is currently unprofitable (making P/E useless) and can juice revenue by flying money-losing routes at low load factors (making P/S useless), so long as investors keep in mind that the B in the ratio becomes smaller the longer the company remains unprofitable. Although Spirit has an attractive P/B relative to peers, the balance sheet also shows the most pressing near-term obligation for the company to navigate: the $1.1 billion in 8% senior secure notes due 2025. This is greater than all of Spirit's fixed rate term loans due through 2039! Another $500 million in convertible notes is due the following year in 2026. Spirit as a whole is also extremely highly leveraged relative to peers, with $3B in long term debt over only $1.3B in equity.

This debt is by far the most significant risk to Spirit as a going concern, and what differentiates it from Frontier, who is much less levered. It is not a guaranteed death sentence however: Spirit has always been highly levered even prior to the pandemic (although to a lesser extent, and the company was profitable back then), it has about $1 billion cash on hand, and dilution is always on the table to survive (Spirit pulled the trigger on this option when COVID first hit, probably too early). Fitch notes other lifelines the carrier can potentially tap: a $500m+ unencumbered asset base, eventual compensation from RTX for the Pratt & Whitney engine issues, and a $300m revolving credit facility (caveat: the revolver matures in 2024, one year before debt armageddon comes due). Should the merger fall apart, this debt is the #1 existential threat shareholders must monitor. Fitch indicates a further rating downgrade should Spirit's cash+revolver cushion fall below $800m, which is highly likely given its current level of $1.2B + anticipated negative FCF in the several hundred million range over the next 12 months.

Of course, the best case scenario for Spirit investors would be the JetBlue deal going through, which makes the debt somebody else's problem. Even if the JetBlue merger gets blocked by the Justice Department, other airlines may make bids, with Frontier likely to return to the negotiating table. In the absence of an acceptable suitor, Spirit may turn the ship around on its own to reach profitability again. Either way, this definitely isn't a binary play with $30 or $0 outcomes. For the bullish, going long with the stock has a much more favorable risk-reward profile (that allows multiple opportunities for upside capture) than going long with options: even if the JetBlue deal materializes, the trial may drag out longer than expected, the acquisition price could be renegotiated, or another black swan event resulting in call options expiring worthless.

Putting it all together

Given its highly complex and fast evolving circumstances, I believe Spirit's value can be better estimated by using book value as a proxy rather than a traditional discounted cash flow model. Unlike the beginning of the pandemic, which was the last time Spirit faced an existential threat, its hard assets have market value reasonably reflective of their carrying amount (back then you could barely give planes away for free). Indeed, Seeking Alpha author and CFA Felipe Brum argues that Spirit's incoming aircraft orders may be worth far more than their purchase price due to industry-wide supply shortage!

So we start at book value of $12/share as a baseline and adjust based on intangibles, modulated by investors' individual risk appetites, in hopes of being "approximately right" in the words of Warren Buffett. On the negative side of the ledger is the massive debt, fast-approaching maturity dates, and high possibility for bankruptcy/restructuring if no buyout occurs. This is amplified by macroeconomic weakness in consumer travel demand, negative free cash flows in the near term, crude oil volatility, soaring interest rates, and the Pratt & Whitney engine problems. On the positive side is a potential acquisition, driven by the value unlock in Spirit's extensive route network, with JetBlue having the current high bid, tempered by a possible ruling in favor of the DOJ on grounds of anti-competitiveness, and the possibility of a reduction in buyout price even if it passes. The macro can also be a tailwind on the supply side, given persistent industry shortages in both aircraft and pilots which could lead to less competition in the short-term and greater pricing power for Spirit.

The original deal had JetBlue paying a combined reverse breakup fee of $470 million to Spirit and its shareholders , less any prepayments, in the event the merger fails for regulatory reasons. This fee has fallen to under $100 million as the result of the upfront cash dividend of $2.50 per share and the ticking fee of $0.10 per month started at the beginning of this year. In the view of this analyst (who is not a legal professional!), Spirit has a greater than 50% chance of winning the antitrust case (the stock soared last week when the DOJ's own witness testified the void left by Spirit would create a "frenzy" of activity from competing ULCCs). Seeking Alpha authors also seem bullish on the trial, with Stone Fox Capital making a cogent argument that Spirit's financial woes are increased incentive for a favorable ruling. After all, Spirit can't contribute to industry competitiveness with discount fares if it goes bankrupt, a JetBlue buyout would be a far preferable outcome for consumers since JetBlue still has lower fares than the Big Four.

Conservatively estimating 25% chance of a $30 buyout (blue sky scenario), 25% chance of a $20 buyout (JetBlue renegotiation or someone else buys), 25% chance of sustaining base-case book value of $12/share as an independent company, and 25% chance of bankruptcy, we arrive at a weighted composite of $15.50. My present rating of Spirit is a Hold in the $12-18 price range, a strong Buy below $9, and a strong sell above $21, adjusting for new developments in the trial as they occur.

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