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Oct 13, 2021
[5 min Read]
Preliminary disclaimer that I'm not a financial advisor and this is not advice. This is some solid arm chair weekend warrior back of the napkin math here though, so tell me why you think I'm wrong...
I will start by saying that I am generally very bullish on most of the airline sector, especially after the recent pullback in their stocks. I've owned stock in Spirit and United since the very bottom of the Covid crash, but I will focus on Spirit in this analysis because it is the airline that I am the most bullish on.
First, I will explain why Spirit is in a better position compared to other airlines. Spirit, being an ultra-low-cost-carrier, generally only caters to leisure travelers, and this is beneficial because business travel has been much slower to recover. Obviously, the larger airlines will try to compete for the leisure travelers, but Spirit has been more successful at capturing these passengers. In 2Q 2021, United's and Delta's revenue was down around 52% and 43% compared to 2Q 2019 respectively, whereas Spirit's revenue was down a mere 15%.
It is worth noting that in the beginning of Aug., Spirit encountered massive operational issues and needed to cancel thousands of flights, stranding passengers, and directly costing them 50M in revenue and 30M in increased expenses, plus more lost revenue due to passenger cancelations that happened afterward. However, I view this as a short-term issue, and the damage to their brand will heal, similarly to how restaurants have recovered from E.Coli outbreaks. On Spirit's next earnings report, I will be looking for management to discuss investments in their infrastructure to ensure this never happens again.
Now, I will discuss the recovery in passenger demand. At the depths of the pandemic crash, passenger throughput declined to as little as 3% of 2019 levels. However, with the invention of the vaccines, airline traffic has (predictably) already made a massive rebound. That being said, there appears to be a pullback in demand the last few weeks, which is likely the cause of the recent decline in airline stocks, but most of this decline is clearly seasonal. The week ended 7/21 had about 14.5 million passengers, but the week ended 9/13 had about 11.5 million, a 21% decline. However, when we compare this to 2019 passenger counts, we see that the week ended 7/21 was around 79% of 2019 levels, but the week ended 9/13 was still about 74%, only a 5% difference. This shows that the recent decline in traffic is mostly seasonal, and when next summer comes along, there will almost certainly be a very strong seasonal rebound in traffic. I expect passenger demand to continue increasing to almost to 2019 levels (only lower due to less business demand). For daily passenger counts, see: https://www.tsa.gov/coronavirus/passenger-throughput?page=0
Next, I will discuss Spirit's fleet. Throughout the pandemic, the larger airlines generally shrunk their fleets to try to reduce cash burn. For example, throughout 2020, Delta retired 227 aircraft. Spirit, however, actually grew their fleet. They generally have a newer fleet so they were not able to retire any aircraft, and were locked into purchase commitments. In 2Q quarter 2019, they had 135 aircraft in their fleet, but grew to 164 aircraft as of 2Q 2021, which is a 21% increase. This perhaps was unfavorable at first, but now that passenger demand has (predictably) returned, Spirit will be able to return to growth much faster, in an environment with slightly less competition due to retired aircraft from other airlines.
Finally, I will discuss Spirit's financials. In 2019, Spirit had 3.8B in revenue, which translated into a profit of 335M. Divided by 68.5M shares, this amounts to EPS of 4.89. Right before the Covid crash, Spirit's stock was $44 a share, which implies a PE ratio of 9. This PE seems very low, but the reason for that is because the airline industry requires much higher debt loads due to large capital expenditures, and even minor disruptions to the airline industry have caused many bankruptcies in the past. However, despite the pandemic which was by far the worst disruption to the airline industry in history, every single US airline has managed to avoid bankruptcy by obtaining massive loans and also aid from the government. This should almost surely allow for larger PE ratios after the pandemic.
When passenger demand recovers, Spirit's revenue performance during the pandemic shows that they should be able to operate at full capacity, and given that their fleet is now 21% larger, it stands to reason that Spirit can easily achieve a 21% increase in revenue (and that is before considering aircraft purchases after 2Q 2021). This amounts to revenue around 4.63B.
I won't discuss operating expenses in great detail, but Spirit gave guidance for 3Q operating expenses to be around 1.01B (before accounting for the expenses associated with their operating issues discussed above). Based on Spirit's guidance for capacity, operating expenses will likely increase slightly beyond the 1.01B. I therefore estimate annual operating expenses in the ballpark of 4.1B (which actually assumes a decrease in operating margin compared to 2019).
Due to increased debt, Spirit's quarterly interest expense of 25M in 2019 increased to 39M. Throughout the pandemic from 4Q 2019 to 2Q 2021, Spirit's debt increased from 2.2B to 3.2B, and their cash position increased from 1B to 1.8B. That means Spirit could easily take their debt load to pre-pandemic levels and still have a large cash position relative to industry pre-pandemic norms. That being said, Spirit will likely keep extra cash in order to fund future aircraft purchases and capital expenditures, but I would still expect major debt repayments down to around 2.6B. This implies interest expense of 30M, and net interest expense of around 26M, which annually is 104M.
I therefore come to net income of around 4.63B - 4.1B - 104M = 426M, multiplied by a tax rate of 25% leaves about 320M. Spirit now has around 110M shares, so this is about $3 EPS. If I use the historical PE of 9, this implies that the share price should be at least $27, already higher from the recent closing prices of around $25. However, as I discussed, I believe the airlines have earned larger PE ratios, so therefore I believe $27 to be the absolute lowest reasonable stock price. Using what I believe to be more reasonable PE ratios of 11 or 12, the shares could easily be around 33-35, and any future growth in Spirit's fleet, improvement in operating margin to 2019 levels, or debt paydown could then push the price into the 40s. The easy (but risky) money has already been made as the airlines have doubled or tripled from the pandemic lows, but I believe the recent selloff in Spirit's stock from $40 to $25 still presents a very attractive opportunity.