by Whitney Tilson

Summary

The selloff in Spirit Airlines’ (SAVE) stock, down 51% this year, is hugely overdone.

The company has amazing economic characteristics and the long growth runway, yet the stock trades at less than 9x earnings.

Over the next decade, I believe that Spirit – both the company and the stock – will do what Ryanair (RYAAY) has done over the past decade in Europe.

On Monday afternoon I presented Spirit Airlines as my favorite long idea at the Robin Hood Investors Conference. Since then, I’ve updated my slides and posted them here.

My investment thesis can be summarized in one sentence: there are very few companies I’m aware of that are growing 20%+, with 25%+ operating margins, 25%+ returns on equity, with net cash positions, whose stocks are trading at a P/E of less than 9x.

After soaring from $10 to $85 from 2011 through 2014, the stock has been crushed this year for a variety of reasons that I’ll discuss below, tumbling 51%, far worse than any other airline, as these two charts show:

I think this selloff is massively overdone. Despite its significant customer service problems and current price war with American Airlines, Spirit is – and will remain – an excellent business and has tremendous room to grow over the next decade.

Background

Spirit has 76 aircraft operating more than 350 daily flights to 56 destinations in the U.S., Latin America and the Caribbean. It is an ultra-low-cost carrier (ULCC), which is not to be confused with low-cost carriers like Southwest, JetBlue and Virgin America. ULCCs include Allegiant and Frontier in the U.S. and Ryanair in Europe.

Growth

Spirit has been growing like a weed, tripling its revenue and more than quadrupling its operating income since the 2009 low, as this chart shows:

More importantly, Spirit has an enormous growth runway in front of it. It serves fewer than 200 markets currently, but believes that more than 500 markets meet its threshold for growth. I don’t doubt this and think that Spirit will continue to grow at a rapid clip for at least another decade, just as Ryanair has done in Europe over the past decade, as shown in this chart (courtesy of Kellogg MBAs Justin Hess, Alexander Hunstad and David van der Keyl):

If I’m right, then I expect Spirit’s stock will perform along the same lines as Ryanair’s. Here’s a chart showing how well Ryanair’s stock (ADR) has done over the past 14 years:

Spirit’s Cost Advantage

The key to Spirit’s success is its ultra-low costs, which translate into almost absurdly low prices (one personal example: yesterday I booked a round-trip nonstop flight on Dec. 8-9 from NYC (LaGuardia) to Dallas (DFW), for $43.09 each way). Here’s a chart from Spirit’s investor presentation showing its cost advantage vs. its major competitors:

(Note in particular the 62% cost advantage vs. American, which has started a price war against Spirit – discussed below. Hmmm, I wonder who’s going to win that one???)

In fact, Spirit’s costs are so low that its total average price (including extras and the company’s very high profit margin) is lower than its competitors’ costs, as this chart shows:

Spirit’s extremely low costs are driven by many factors:

• One type of plane and one class of service
• Cramming the maximum number of seats (~20% more) onto every plane by reducing legroom and having seats that don’t recline
• No seat-back pockets, wifi or entertainment systems
• All direct flights (no hub-and-spoke)
• A limited frequent flyer program
• Personnel who do multiple jobs (e.g., flight attendants who also clean the plane and act as gate agents)
• Turning aircraft quickly and flying at all hours, thereby maximizing daily flight time (12.7 hours/day for Spirit; 11.8 for JetBlue; 10.9 for Southwest)
• Rapid growth means lots of new airplanes, which reduces maintenance expense

Every one of these factors, other than the last one, strikes me as sustainable – as Ryanair has proved.

Spirit’s Price Advantage

Spirit charges extremely low base fares ($66.96 in Q3) and then charges extra for nearly everything such as a seat assignment, any bag beyond a small carry-on item, all drinks and food, etc. These extras averaged $53.39 for Spirit last quarter, resulting in total revenue per passenger flight segment of $120.35. While these extras cause some travelers to feel nickeled-and-dimed, almost all travelers on Spirit pay less in total than they would on any other airline (even if one adds Spirit’s charge for seat selection and one bag), as this chart shows:

Spirit Stimulates Demand

Spirit’s prices are so low, in fact, that its entry into a market stimulates demand, as these two charts show:

This demand stimulation is really important because if Spirit is filling its planes in new markets with new travelers (rather than stealing them from another airline), there’s less likely to be a fierce competitive response.

Stable Revenue from Extras

While charging for everything beyond a seat and a small carry-on bag may irritate some customers, it provides Spirit with a very stable and profitable source of revenue. As one can see from this chart, Spirit’s average ticket price has dropped significantly (by 15%) this year, yet total revenue is down only 10% because of stable non-ticket revenue.

Why Has the Stock Been Cut in Half this Year?

The stock’s halving this year is due to a variety of factors, the most important of which is that American, perhaps emboldened by low fuel prices, rolled out an aggressive price-matching strategy in June that has impacted Spirit’s pricing, causing Spirit to report in Q3:

“Total revenue per passenger flight segment (“PFS”) for the third quarter 2015 decreased 13.1 percent year over year to $120.35, primarily driven by a 20.8 percent decrease in ticket revenue per PFS. The decline in ticket revenue per PFS was driven by lower fare levels as a result of increased competitive pressures [60% of impact] as well as a higher percentage of Spirit’s markets being under development compared to the same period last year [40% of impact].”

In addition, Spirit’s load factor in Q3 fell from 87.6% to 85.2% YOY and Q4 guidance is for unit revenue to decline even more than Q3.

This price war is affecting both Spirit’s revenue and margins, which has led analysts to project that earnings per share will be roughly flat in 2016. The growth investors who owned this stock above $80 hate no growth, even for a year, so they’ve fled – and no self-respecting value investor would ever own an airline stock, right?

There’s also concern that Spirit is growing too fast (available seat miles rose 34% in Q3), though this will likely be the peak as capacity growth is projected to be only ~20% in 2016.

In summary, the near-term outlook for Spirit is cloudy, leading analysts and investors to fear the worst (more revenue and earnings reductions), so most of them don’t want to own the stock until there’s more clarity. Here is the typical analyst view today (from Credit Suisse): “We see few catalysts near-term to bring investors back. Q4 needs a revenue beat & guidance that shows unit revenue declines have bottomed – this won’t be known until February.”

Why I Think the Analysts Are Wrong

Analysts are, I think, making the classic mistake of projecting the immediate past indefinitely into the future. This chart shows Spirit’s total revenue per flight segment, with 2016-2018 numbers based on current analyst estimates:

I think this is overly pessimistic. Analysts are not just projecting a continuation of the depressed 2015 number – they’re forecasting that the decline from 2014 doubles, resulting in total revenue per flight segment of barely over $100, and staying that way for years. This is ridiculous.

First, with 62% higher costs, American is surely incurring significant losses trying to match Spirit’s pricing, which is clearly unsustainable. My understanding is that this may be a temporary strategy to push Spirit out of a few key markets.

And it may succeed. Spirit has demonstrated a willingness to avoid share battles and move aircraft to more attractive markets, which is likely what will happen if the price war persists. As Spirit noted in its latest investor presentation, it has “no emotional attachment to any particular route – if a route is underperforming expectations and we no longer believe it will be able to achieve its target threshold, it is cut from the schedule.”

In summary, as this chart (again, courtesy of the three Kellogg MBAs) shows, the major drivers of Spirit’s revenue decline in 2015 are very likely to at least stabilize and even reverse in 2016 (and thereafter):

Spirit’s Mouth-Watering Economic Characteristics

Spirit has astonishingly good economic characteristics. It was one of the only airlines to make a profit in both 2008 and 2009, and has consistently high margins that are the envy of the industry. This chart shows Spirit’s net income margin every quarter since Q1 ’09:

Now here’s the same chart showing Spirit’s margin compared to every other U.S. airline – note that while Spirit isn’t the highest every quarter, it’s consistently one of the best:

Lastly, this chart shows Spirit’s high and rising returns on assets and equity:

Spirit’s Ridiculously Cheap Stock

So what would you pay for the stock of a company with an enormous (and likely permanent) cost advantage, growing 20%+ annually, with 25%+ operating margins, 25%+ returns on equity, and a net cash position? 15x earnings? 20x? In fact, Ryanair today trades at 23x 2015 earnings and Southwest in its early years (when it was the size of Spirit today) also traded at similar multiples.

Yet Spirit today trades at less than 9x trailing, 2015 and 2016 estimated earnings, at close to the lowest P/E ratio it’s traded at in years, as this chart shows:

Spirit is also trading at a steep discount to all of its peers, both domestically and internationally, as this table shows:

Lastly, despite growing both its revenue and profits faster than its most similar peer, Allegiant, Spirit’s stock trades at a huge discount to Allegiant’s on every metric, as this chart shows:

But What About Travelers Hating Spirit?

A quick Google search reveals endless stories that are summarized in this blurb in AirlineReporter.com:

It’s true, people vehemently despise Spirit Airlines. Just the mention of the company elicits emotion-filled horror stories. Indeed they have a solid 1 out of 5 star rating on TripAdvisor, and they are frequently found at, or near, the top of various “worst airline” rankings.

Heck, even my wife cringed when I told her I bought the stock, and when I disclosed this purchase to my investors, I felt compelled to write: “I know, I know, it’s really horrible airline – but at least read my slides with an open mind.”

So let’s look at the facts. Spirit’s customer service problems fall into two areas: reality and perception. Regarding the former, according to the Department of Transportation, Spirit consistently is among the worst airlines in terms of on-time arrivals, though its cancellation rate it about average (in the first nine months of 2015, Spirit’s percentage of flights cancelled was better than the industry in four months and worse in five, with the average slightly worse: 1.94% vs. 1.73%).

On the plus side, the rate of mishandled bags is 18% better than average (2.73 vs. 3.33 reports/1,000 passengers), and the rate of “bumping” passengers is half the average.

So, overall, Spirit does indeed have a genuine service problem, but its perception problem might be worse. Many of Spirit’s customers (especially first-time ones) aren’t used to being charged for so many extras, so clearly Spirit needs to do a better job of setting expectations (which it’s trying to do).

Add up both the reality and perception problems and Spirit’s complaint rate in the first nine months of this year was 6x higher than average (11.93 complaints/100,000 enplanements vs. 1.97). (While terrible, it’s still only one complaint for every 8,400 passengers.) Perhaps the best that can be said about Spirit’s customer service is that there’s a lot of room for improvement!

Surely so many customers hating Spirit will eventually cripple the business, right? This was my concern when I first looked at this stock three years ago – and was the main reason I didn’t buy it (causing me to miss the run from $20 to over $80 – arrrrh!).

I now realize that this was a serious mistake, mainly because I was thinking about this business from my perspective – but I’m not the customer Spirit is targeting! I am willing/able to pay an extra $50-$100 for a flight with better service, a few extra inches of legroom, a seat that reclines, etc., but many (most?) Americans don’t have this luxury.

An article in AirReporter.com has a good summary:

Ultra-low-cost carriers can be a great option. They can provide you fast and safe transportation, the cheapest way possible. If you only care about getting your body from one place to another, without frills or high expectation of service, you cannot beat an ultra-low-cost carrier. It is about being an informed customer and doing the math to make sure you are choosing the right airline.

I don’t walk into McDonald’s expecting a delicious meal. I expect to get a cheap meal and mediocre service. Why would a passenger pay for an ultra-low-cost airline and expect MGM Grand Air level of service?

In direct contrast to these [low] ratings and frequent “I’ll never fly Spirit again” claims, the airline continues to grow and increase market share.

Price Target

Most companies with Spirit’s characteristics – growing 20%+ annually with a long runway, 25%+ operating margins and returns on equity, and a net cash position – trade above 20x earnings. Indeed, Ryanair and Southwest consistently traded at 15-20x forward earnings in the early stages of their growth cycles.

Applying a 15 multiple to 2016 estimates of $4.03 results in a stock price of $60.45, 64% above today’s price. That sounds about right to me for a one-year target – and I think the upside is much higher over many years, which is how long I hope to own this stock.