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Spirit posts 15% operating margin in 55% profit swing on fuel costs

31-Oct-2011

Spirit Airlines experienced a 55.2% decline in profitability in the third quarter when it posted net income of USD27.7 million, despite a 41.8% increase in revenues to USD288.7 million. This revenue increase overwhelmed the 33.7% increase in operating expenses which came in at USD244.1 million. The airline beat consensus estimates for the quarter which expected a US274.9 million profit.

CEO Ben Baldanza pointed out that the company grew capacity by 10.4% in the quarter “while maintaining industry-leading margins on increased operating and net income by over 100%”. Traffic rose 15.6%, outpacing capacity increases. It was able to recapture most of the losses prompted by Hurricane Irene cancellations.

A key focus is lessening seasonality although it is still subject to those headwinds given into concentration in Florida which has prompted a drop in stage length in the third quarter. This is expected to continue into the fourth quarter, which only places more pressure on unit costs. Fourth quarter capacity will be up 5.7% on the network reorientation to smooth out seasonality. Stage length dropped 3.3% to 909 miles in the third quarter and is expected to drop another 7% in the fourth quarter to 885.

Still, in the third quarter 48% of capacity was to/from Florida, down from 54% in 2Q2011. Mr Baldanza noted that its new markets are spooling up faster than expected. He explained new markets are expected to be cash accretive within 60 to 90 days, and, within six months to be fully allocated accretive.

“Maybe it is higher fares from others or perhaps people understand our business model better but we are seeing new markets spooling up better,” he said.

Spirit remains in a high-growth mode expecting 15-20% increase in capacity over the next few years as it increases its fleet from 33 to 68 aircraft by 2015.

Low-cost leader

However, Mr Baldanza pointed to more than 300 markets in the Americas that the airline can potentially serve with a model premised on entering a market which offers fares at least 25% lower than existing fares.

During the call, analysts worried Spirit's inroads into American and Southwest markets might draw fire. Chief marketing officer Barry Biffle indicated competitors are matching, which turns out to be good for Spirit because their match just delays the spill over to Spirit once they sell all their low-priced seats. Spirit also wins because it prompts the market to grow with its stimulative effect.

“We have discipline internally to ensure every airplane makes money and we set high financial hurdles and, if we don’t meet or exceed those hurdles, we are aggressive in reallocating capacity to where we will succeed,” he said. “We do it to address seasonality and in new markets as well. However, we are only adding to stimulate traffic and we put in capacity equal to what we think the amount of stimulated traffic will be. We do it to grow the market, not steal share from others. We don’t affect the traffic level of the big guys at all and we size capacity for the amount of stimulus we are creating and we match that pretty closely.”

In typical fashion, Spirit announced it “liberated” many new cities “besieged” by high air fares, including such strong United, American, Southwest and Delta markets as Chicago-Dallas, Chicago-Boston, Chicago-Detroit and Chicago-LaGuardia as well as expanding in Allegiant’s Las Vegas back yard with flights to Oakland/San Francisco, where many legacy flights have been consolidated in favour of SFO, San Diego and Portland, OR.

Its strategy is particularly important since the ultra-low-cost (ULC) carrier has a significant cost advantage to its low-cost and legacy peers especially when looking at all-in cost per available seat mile (CASM). A Valuentum analysis on Seeking Alpha examined second quarter statistics. In 2008 through 2010, Allegiant enjoyed the lowest all-in, stage-length-adjusted costs, only to be replaced by Spirit in the 1H2011.

Mainline stage-length adjusted CASM for select US carriers: 2008 to 2Q2011

Valuentum noted the cost gap between legacies and traditional low-cost carriers is narrowing, despite the fact United and American remain the least efficient as to costs in the industry. Perhaps the largest progress in closing that gap was made by Alaska Airlines which decided to restructure not only to beat LCCs at their own game but to do it with a 10% return over the course of the business cycle.

While Spirit may now be in the driver’s seat on deciding fare and yield levels on its competitive markets, the rising cost pressures from distribution (it has to date recovered those costs) and maintenance as well as fuel, will ultimately narrow the gap it and Allegiant have with LCCs. Still, as air fares at LCCs and legacies rise, its ultra-low-fare model will likely continue to attract those who have been shut out by higher fares.

Indeed, United said during its call that it has virtually eliminated low-yield fares given the strong demand the industry is enjoying, which works to the benefit of Spirit and Allegiant.

“Our product is our price,” Mr Baldanza explained, “and we offer passengers the opportunity to save money with low fares.”

He doubted there would be a scenario similar to Delta's move to combat JetBlue with its creation of low-cost carrier, Song. “We did not build an airline to attract business clientele,” he added. “We take a different view where we have the lowest price point possible and the customers queue up for that based on their propensity to care about price for their trip. As we enter business markets, we are not attacking the revenue base that would be threatening to the big carriers.”

Mr Biffle added that the same tactic would not work against Spirit since it has less concentration of its network into a handful of routes.

“In order to do something that is the magnitude of a Song against JetBlue, you’d have to have a lot more capacity when we only have one to two flights a day into these markets,” he said.

Washington angst expressed

While his counterparts railed against increasing government taxes and fees during their earnings calls, Mr Baldanza took the opportunity to discuss its appeal, with Allegiant and Southwest, of the new Department of Transportation (DoT) rule requiring airlines to use fares, inclusive of government taxes and fees, in advertising. The three airlines lost the first round of the battle but are still appealing. In the meantime, Spirit is also bringing resources to bear that ensures compliance by the Jan-2012 deadline.

Mr Baldanza indicated the increased costs caused by the rule far outweighed the consumer benefit that is fleeting at best since the rule does not raise fares – it merely causes the perception of raised fares. And for an airline reliant on price sensitive travellers, this could be both good and bad news, according to Mr Baldanza. On the one hand, he suggested, consumers might stop shopping but, on the other, the perception of high fares at other carriers has always boded well for Spirit since it offers lower fares, with or without including government taxes and fees.

The DoT rule is ostensibly an effort to achieve more price transparency but actually does the opposite because it hides the exorbitant taxes and fees. The rule could increase fares between USD20 and USD100 dollars on a Spirit ticket depending on whether it is domestic or international. It then shifts the blame for the perceived fare increase on the airlines instead of tax policies in Washington.

Southwest said during its briefing that it has diverted precious resources in order to ensure compliance. Those resources would otherwise go toward building its long-overdue new reservation system. Instead it is tweaking the old one to be able to accommodate its merger with AirTran, codesharing and ancillary products. One of the reasons Southwest does not charge bag fees is because its reservation system could not accommodate that change, which drew analyst’s criticism since there was an estimated USD500 million in revenues being left on the table.

While this no-bag fee policy has turned into a silver lining bringing significant share shifts from those who do charge such fees, delaying the reservation system change has also delayed entering international markets.

Following Allegiant mode

Part of Spirit’s strategy is to capture a larger share of the consumer travel spend. To that end, Spirit launched its complete vacation package offering on its web site following Allegiant and WestJet in the practice.

While airlines have always offered combined air fare-car-hotel packages, it has become a new and important revenue source after Allegiant pioneered the practice as part of its ancillary revenue model. While only rolled out in the past few months, Mr Baldanza reported good progress with the initial rollout.

“If we look at total RASM, we like idea growing ancillary revenue because we use it to lower base fares, stimulate more traffic and grow markets even faster,” said Mr Baldanza. “Even if ancillaries don’t grow that only means base fares won’t drop as rapidly. We manage revenues with ancillaries within that.”

Revenues

The company said EBITDAR for the quarter was USD77.4 million resulting in an EBITDAR margin of 26.8%, ex unrealised fuel hedge losses and special items. Its GAAP operating income was USD44.6 million, resulting in a 15.4% operating margin. The results were impacted by the fact that the company experienced a huge tax break in 3Q2010.

Mr Baldanza attributed its revenue increase to the distressing economic news during the quarter, when passengers increasingly sought air fare savings. However, legacies and low-cost carriers also reported huge jumps in revenues citing the strong demand and fare environment thanks in large measure to highly constrained capacity. Even so, most observers assume that the high demand is raising all boats as those more price-sensitive customers, who are missing from the legacy loads, trade down to LCC and ULC carriers such as Spirit.

Mr Baldanza also echoed peers, citing higher passenger volumes, a strong pricing environment and non-ticket revenues for its rising operating revenues. In addition, it also cited the increased capacity and the growing acceptance of its ULC business model.

Total revenue per available seat mile (RASM) climbed 28.4% to USD 11.92 cents year-on-year, driven primarily by higher yields. Spirit does not include yield or PRASM in its statistical metrics. Load factor jumped 3.8 points to 87%. Passenger revenues grew by 35% to USD186.7 million.

It used one of its own metrics to illustrate its success, saying total revenue per passenger flight segment (PFS) jumped 18.5% to USD126.37 year-on-year while average ticket revenue per PFS increased 12.9% to USD81.71. Non-ticket revenue jumped 56% to USD102 million in the quarter.

Average non-ticket revenue per PFS increased 30.4% to USD44.66 year-on-year, primarily driven by the introduction of its carry-on bag fee in Aug-2010. When it imposed the unique fee, it dropped fares by a corresponding amount. It also yielded more revenue from already adopted non-ticket revenues.

Spirit does not give revenue guidance but did say capacity will be up 5.6% in the fourth quarter, the smallest jump in the entire year. It cited two factors for the slowing growth: annualising the growth of previous capacity hikes and higher fuel.

Expenses

Fuel was the main culprit behind the 33.7% jump in operating expenses in the quarter when fuel jumped 40% in the cost per gallon, compounded by a 10.4% capacity increase to 2.4 billion. Fuel accounted for 50% of the cost increases.

Fourth quarter ex fuel CASM will be up 5.7% year-on-year and for the full year it is expected to be flat. Indeed, the 7% decline in stage length is responsible for some of that increase, but senior VP and chief financial officer David Lancelot indicated without that costs would be flat to up 1% if adjusted for the stage length it flew in 4Q2010.

Cost per available seat mile (CASM) rose 21% to USD 10.08 cents while CASM ex fuel and special items rose 5.8% to USD 5.74 cents, the second-lowest in the US industry of airlines reporting metrics, on a 3.3% decline in average stage length, contributing a 1.8-point increase in CASM ex fuel. Spirit's stage length is dropping despite the industry dramatically dropping short-haul routes impacted by the increasing hassle factor that has seen passengers retreat to their cars. 

The company also cited increased distribution costs and maintenance, a trend that impacted every carrier both this quarter and last. Distribution costs rose 30% in the quarter, or 18% on a per available-seat-mile (ASM) basis, driven by an increase in credit card fees that correlated to revenues.

Unlike its legacy peers that are trying to shift bookings to their own web sites away from online and other third party vendors, Spirit followed JetBlue and other LCCs in broadening distribution channels to third-party agents, more expensive than its Spirit.com site. The shift did not materially impact operating income because revenues exceeded the increased distribution costs.

Maintenance increased 38.9% or 23.7% per ASM owing to shorter stage lengths and unscheduled maintenance. And, as with its low-cost and legacy peers, maintenance is expected to increase, although the increase is expected to be offset on a unit-cost basis as it brings in new Airbus aircraft increasing its now 35-aircraft fleet with the 33 it has on order, with delivery slated between Nov-2011 and 2015.

Spirit ended the quarter with USD351 million in total cash and cash equivalents. During the quarter, its credit-card holdback restricted cash was eliminated meaning it now has restricted cash and, on top of that, no debt.


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