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Spirit Airlines' Nemesis Crashes and Burns: Good News or Bad News?

Over the past year, legacy carrier United Continental (NYSE: UAL) has become a giant thorn in Spirit Airlines' (NASDAQ: SAVE) side. Under the leadership of its new president, Scott Kirby, United has set out to regain share in its hub markets. Among other things, this strategy has involved an aggressive campaign to match the fares of ultra-low-cost carriers like Spirit Airlines and Frontier Airlines.

So far, this strategy has been a giant failure. United Continental reported a steep unit revenue decline for the third quarter, and management expects unit revenue to fall again in Q4. As a result, United's profitability is plunging. Depending on how United responds, this could either be very good news for Spirit Airlines -- or it could point to even more misery ahead.

Spirit's profit margin is crashing

During its first five years as a public company, Spirit Airlines developed a reputation for posting consistently strong profit margins. Even after Spirit's profitability started to go into reverse last year, the company remained well above its target of mid-teens operating margins.

Spirit Airlines has historically had very strong profit margins. Image source: Spirit Airlines.

However, Spirit is on track to break that streak in 2017. In the seasonally weak first quarter, it posted an 11% adjusted operating margin. Spirit was on track to rebound with a stellar second-quarter performance until a dispute with its pilots spiraled out of control, leading to mass flight cancellations. Even so, the company posted an adjusted operating margin of 19.1%. During the summer, the carrier's fare war with United escalated. Based on Spirit's most recent guidance, its adjusted operating margin likely declined from 23% in Q3 2016 to just under 15% last quarter.

The fourth quarter could be even more painful. Spirit will face a tougher year-over-year revenue comparison this quarter, and its adjusted operating margin was just 16.2% in Q4 2016. This means that its operating margin will probably fall into single-digit territory for the fourth quarter.

Trading blame

Executives at Spirit Airlines and United Continental have been pointing the finger at each other for the recent price war. On the Spirit Airlines earnings call in July, management claimed that United was not just matching Spirit fares but actively undercutting them. This forced the budget carrier to suspend its efforts to push fares higher.

United's management doesn't agree with that characterization. On the recent United Continental third-quarter earnings call, CEO Oscar Munoz blamed the company's weak revenue performance in part on Spirit Airlines offering last-minute fares as low as $10.

The truth lies somewhere between these two extremes. United Continental appears to have made the first move, becoming more aggressive about pricing sometime around June. However, this prompted Spirit to implement steep fare cuts in late July in order to remain competitive.

Doubling down

United Continental executives realize that the company's recent results aren't acceptable. But for now, they aren't backing down from the ongoing fare war with Spirit Airlines (and Frontier Airlines). Instead, they hope to soften the blow to unit revenue by making smaller adjustments to United's pricing and segmentation strategy.

Since United began making these adjustments, Spirit's revenue outlook has improved modestly. Between early September and the end of Q3, Spirit Airlines increased its unit revenue outlook by more than 1 percentage point. Nevertheless, the year-over-year trend remains sharply negative. Clearly, small tactical adjustments by United won't help Spirit Airlines all that much.

This strategy isn't sustainable

On the bright side -- at least for Spirit -- United Continental's price-matching strategy doesn't seem sustainable. Unit revenue declined by 3.7% last quarter and is projected to slip 1%-3% in the fourth quarter, while unit costs continue to creep higher. United expects to produce a meager pre-tax margin of 3%-5% this quarter. Unless its revenue performance improves dramatically, it could even post a loss in the first quarter of 2018.

United Airlines is at risk of posting a loss in Q1 2018. Image source: United Airlines.

It seems clear that United's competitive strategy is having a big impact on its profitability. This is occurring even though only 17% of the carrier's domestic revenue currently comes from markets served by ultra-low-cost carriers. As Spirit and Frontier continue to grow -- and various long-haul budget carriers add flights to the U.S. -- a blanket price-matching strategy could become increasingly self-destructive for United Continental.

As a result, in the long run, United's woes may help Spirit Airlines rebuild its profit margin. Sooner or later, United Continental shareholders are going to demand tangible results from management. When that happens, United will have little choice but to pull back from its price-matching strategy, giving Spirit Airlines some much-needed breathing room. This could allow Spirit to return to steady unit revenue growth at long last.

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Adam Levine-Weinberg owns shares of Spirit Airlines. The Motley Fool recommends Spirit Airlines. The Motley Fool has a disclosure policy.