Spirit: The Ticket to the Airline Industry
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JetBlue’s (NASDAQ: JBLU) introduction in early 1999 presented a huge industry shift when compared to the legacy operators like Delta Air Lines (NYSE: DAL) and United (NYSE: UAL). The airline’s low-cost approach was a natural progression from the “value” added strategy used by existing operators at the time (we paid for those meals, but did we really enjoy them?). At the same time, JBLU’s relatively stripped-down operations were still high quality – its customer satisfaction levels were, and still are, unmatched – and it was able to offer free additional goodies like seat-back television sets.
As if the JBLU strategy was not efficient enough, Spirit Airlines (NASDAQ: SAVE) is an even further progression into the no-frills airline approach. In fact, if any individual airline is going to be a viable entity in the long run, and more importantly, if it is going to present an attractive investment opportunity, it will evolve along the same lines as SAVE.
True Low Cost, No Frills
Founded more than 30 years go, but only recently entering the capital market, SAVE operates its 35 aircraft fleet and 49 route operations from its Fort Lauderdale, Fla., hub. Like more regionally-focused airlines including Alaska Air (NYSE: ALK), SAVE has always geared operations toward local economies of scale maximization. Although the airline only accounts for around 1% of the nation’s daily air traffic, it maintains a significant control on its specific markets (i.e. niche routes like Ft. Lauderdale to primary Colombian cities, small islands in the Caribbean, etc.).
The systematic seeking out and attacking of the fullest, most efficient regional routes has proven to be among the most profitable of airline strategies, especially when compared head-to-head with larger airlines’ large focus on international flights. Such smaller scale players – SAVE, Allegiant (NASDAQ: ALGT), and ALK – have historically enjoyed higher operating margins as a result.
Note: The EBITDAR margins for 2007, 2008, 2009, 2010, and the first three quarters of 2011 were averaged
Operating efficiency not only stems from SAVE’s local market penetration and dominance, but can also be attributed to its extremely favorable cost structure. First, the corporation answers to no debt burden, so it is not prone to the negative leverage effect for which the industry is known. Being at the mercy of rising fuel costs, potential labor relations issues, and inclement weather, debt servicing obligations are usually the proverbial straws that break airline’s backs.
How does SAVE operate so inexpensively? The corporation’s favorable operating structure actually fuels a unique cost-saving cycle:
- Small size, local penetration, and no debt allows SAVE to charge significantly less than other competitors for identical routes
- The corporation charges passengers for nearly all add-ons: carry-on bag, each additional checked bag, overweight/oversized baggage, seat request, boarding ticket printing (if not done online), traveling pets, and snacks, etc.
- Customers are willing to pay the additional fees for add-ons because the base flight price is considerably less expensive than competing airlines. Likewise, having to pay for additional baggage and overweight/oversized luggage, passengers are less likely to bring excess belongings on their vacation. This is further assisted by the characteristics of many of its destinations – many of Ft. Lauderdale-based routes go to beach areas, which inherently require less luggage (is a T-shirt and swim trunks ever too little?)
- Less baggage/etc. requires less infrastructure in the way of pre- and post-flight luggage storage and fewer baggage handlers, as well as less fuel due to less plane weight.
Of course, all of these cost savings are very minimal on a per passenger basis. However, when applied to nearly 200 passengers per flight over the thousands of flights per year, these savings add up to create a true competitive advantage. The add-on, no-frills flying experience is obviously not for all passengers, so SAVE specifically targets those routes where the strategy will play out best. Those passengers looking for extra services can, and will, pay for those services at airlines that offer them.
SAVE, as a result, enjoys the lowest cost per available seat mile and average breakeven fare price among other major competitors in the airline industry.
Percentages represent increase over SAVE (base) level
Percentages represent increase over SAVE (base) value
SAVE currently operates around 50 routes, but is continually examining additional growth opportunities. The airline actively seeks out and targets routes in which competitors’ prices can be undercut by 25% or more and stimulate the demand from 200+ passengers each way on a daily basis. Other competitors always have the opportunity to compete on price to maintain consumer demand, but much like a Wal-Mart/mom-and-pop retailer situation, price matching by the higher cost operator usually leads to unprofitability and exit from the market. The slow growth strategy (the company is 30 years old and is still relatively small) will maintain profitability as the highest-returning routes are identified and dominated.
Aside from low-cost operations, SAVE also stands out due to its pairing with complimentary product/servicing offerings. Hotel and vacation package offerings, for instance, are subject to less intense price elasticity and seasonality than the airline’s base fares. SAVE generates almost $43 per customer in ancillary revenues, which, as a percentage of its base fares, is the highest in the industry.
As SAVE management highlights, nearly 70% of the carrier’s passengers are destined to stay in and pay for hotel accommodations anyway – helping customers book these reservations only acts to give the airline a piece of the pie. Likewise, by delivering value on their flights from the onset through bare minimum services and extremely low base fares, SAVE’s strategy actually incentivizes customers to spend more on the additional services. Because they aren’t spending much to begin with (when compared to an identical flight from a competing carrier), many aren’t opposed to spending more.
The corporation currently derives around 35% of its total revenues from ancillary revenue streams, with plans of hitting 40% in the near future. By examining the operations of amusement parks, cruise liners, and hotels – all of which generate 50% – 60% of their revenues from non-ticket add-ons – SAVE management is continually generating innovative ideas to hedge the natural volatility of their ticket-based revenues.
A newer, rather simple idea posts in-flight ads from outside corporate advertisers. Although customers obviously are not responsible for the payment of the ads, the ads do act to cover overhead costs and subsequently offer a further average price decrease on base fares.
Like all airlines, SAVE is not 100% immune to the operating issues that often plague other airlines. Although the corporation is less unionized than most other competitors, it has had its share of strike issues.
Ever-increasing jet fuel prices are also of concern, although with relatively attractive operating margins (13.3% in first three quarters 2011), the airline can sustain further increases without being forced into the red. This is likely to be the single largest risk over the mid term, and the success of an investment in SAVE is influenced to a certain degree on the long-term play in jet fuel price. February 2012 fuel prices are up more than 10% from the corresponding month last year, and the aviation fuel index (presented by Platts) has increased 3.5x since 2000.
Lastly, although SAVE’s attractive operating strategy is a refreshingly efficient take on the airline industry’s traditional structure, the corporation does not necessarily stand out as an extreme bargain (although it does not appear to be extremely overpriced, relatively, either).
As is well appreciated (hopefully), the risk of paying too much should be of highest concern over the short, mid, and long term. SAVE is definitely worth a closer look
SAVE’s profitability, efficiency, and growth prospects undoubtedly deserve a premium over other competitors in the industry, but investors should determine the amount they are willing to pay for growth, if anything. Up over 25% since early January, the margin of safety is swiftly narrowing!
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