Spirit Airlines profit margin is being buoyed by the historically low cost of fuel and interest rates.
If you own Spirit Airlines, sell the stock. The fundamentals are not favorable to Spirit in the mid to long term. First, fuel costs are the largest or second largest expense in the airline industry and it has been historically low since 2015. In 2016, the Spirit fleet had an average of 86 planes which used 302 million gallons at a cost of $447 million. The average price per gallon in 2016 was $1.48. If you apply the average cost of jet fuel since 2005 of $2.24 to Spirit’s 2016, the fuel costs become $679 million for 2016 which would bring Spirit’s net income down to 32 million dollars.
While the short-term fuel projections are expected to stay low, this is not likely to be sustainable. There is currently over one million barrels per day being produced in excess of demand. There will be a correction because this is not viable for the oil industry in the long term. Also, oil costs are not controlled by Spirit. They have to pay the spot price in order to get the oil they need. Oil prices are highly volatile as prices can go from $155 per barrel to $48 per barrel in the span of one calendar year. This makes cash flows from airlines very unstable as they are highly dependent on volatile oil prices.
Spirit currently has 95 aircraft and this is up from 28 in 2008. Of the 95 aircraft in Spirit’s fleet, they lease 59 of them and their leases will expire by 2029. They have orders for 76 new airplanes to be delivered between 2017 and 2021 which will bring Spirit’s total fleet to 158 aircraft by 2021. They have a good capex plan in place; however, if they have financial issues, they will not be able to reduce their capex without severely reducing their growth prospects. Airlines need to be continually investing in their aircraft or they will be unable to compete with other airlines that have more modern planes that are better maintained. Carl Icahn’s acquisition of TWA proved how difficult it is to compete if you neglect capex in the airline industry.
Spirit lags many of their comps in numerous key metrics. Spirit’s LTM return on equity is 20% which is 10% less than the average of their comps. Spirit’s ineffective use of capital is concerning especially when you consider how they have one of the smaller equity values then their comparables. Spirit also has a negative unlevered and levered free cash flow and is the only company in the comp set to be negative. This by itself is not necessarily bad since Spirit is adding 76 aircraft to their fleet in the next five years, but it is not being represented in their net income. As Spirit has grown, there return on assets has decreased. In 2009, their return on assets was 29% while Spirit’s 2016 return on assets was 9%. While it is not bad, since a 9% ROA is the average for Spirit’s comparables, this is a worrisome trend.
Spirit has a relatively moderate debt ratio of 29%. While this is not currently an issue, it is something to be aware of since this gives them little room if an adverse event occurs. Since we are 8 years into a bull market, it is likely that we will see some form of contraction in the near future. This will be felt by Spirit’s earnings since the airline industry is highly cyclical and will inhibit the company’s ability to borrow in the future.
Spirit has done well over the past five years but the fundamentals are changing and it would be a good time to liquidate the position. The company’s overvalued due to robust demand, low interest rates, and fuel costs. Demand will likely stay strong through the mid-term and we are seeing upward pressure on both interest rates and fuel costs as they are likely to rise significantly in the next four years to six years. A two-stage discounted cash flow analysis using wall street consensus projections as a proxy for market expectations values Spirit at a market capitalization of 3.5 billion dollars. This represents a per share price of 51 dollars which is the current market value. However, this does not factor in a normalization of fuel costs and interest rates. When you take this into account, you get a market capitalization of 2.9 billion dollars for a per share price of 42 dollars.
The problems that I have with Spirit is not bad on an individual basis, added together, all these little problems make Spirit a company that is not worth owning. Spirit has had a good run recently but it is time to get out before the next shock to the industry.