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In a Tough Quarter, Spirit Airline's Low-Cost Advantage Shines Through

As expected, Spirit Airlines' (NASDAQ: SAVE) third quarter was hit hard by hurricane season. The airline canceled a total of 1,650 flights due to the storms, which cost the company an estimated $40 million in lost Q3 revenue. On top of the pilot work stoppage that took place in May, this is shaping up to be a very challenging year for Spirit. For full-year 2017, analysts are now expecting 13% revenue growth, along with an EPS decline of roughly 27%.

However, taking the longer view, the airline's future still looks bright. In fact, stripping out the severe effects of this year's hurricanes, Spirit posted what looks to me like a pretty decent quarter. As the low-cost operator in the markets it serves, Spirit continues to operate from a position of strength. But this year's disruptions turned out to be quite costly -- and it's going to take a while before earnings growth resumes.

Image source: Spirit Airlines. 

A few encouraging signs in an ugly report

In the third quarter, while Spirit's revenue grew by 10.6% to $687.2 million, adjusted EPS declined by 24.2% to $0.94. Unit revenue slid 6.3%, driven by lower fares due to aggressive pricing from other airlines. And adjusted operating margin fell 660 basis points to 16.4%, with 450 basis points of the decline due to the hurricanes.

Metric 

Q3 2017

Q4 2017

Year-Over-Year Change

Revenue

$687.2 million

$621.3 million

10.6%

Unit revenue

8.95 cents

9.55 cents

(6.3%)

Adjusted EPS

$0.94

$1.24

(24.2%)

Adjusted operating margin

16.4%

23%

(6.6 percentage points)

Data source: Spirit earnings.

Although ticket revenue per passenger decreased 3.2% for the quarter, Spirit's non-ticket revenue per passenger actually rose 2.6%. This ancillary revenue -- which comes from things like charging for food, checked bags, or printing boarding passes -- made up nearly 50% of the airline's total revenue per passenger. That's encouraging because non-ticket revenue tends to stay stable regardless of what's happening to fare prices, providing a buffer during times like right now, when unit revenue is suffering.

Unit costs continued to trend in the right direction, too, as Spirit's adjusted CASM ex-fuel (cost per available seat mile, excluding special items and fuel) decreased 1.1% compared to last year. As Spirit continues to expand its capacity (available seat miles) each year, it expects this number to continue to decrease over time, helping solidify its long-term competitive advantage.

Additionally, the company says it is on target to achieve operating margin of 14% to 14.5% for full-year 2017, which is just below the company's long-term "mid-teens" target. According to Spirit, without the effects of the pilot disruptions and the hurricanes, operating margin would be headed toward a 17% finish for 2017. That would be a very solid result in light of the fare pressures Spirit has experienced in the second and third quarters.

Looking ahead

While low fares from rivals will continue to hurt Spirit's unit revenue for now, it appears that pressure may be beginning to ease a bit. On the conference call, Chief Commercial Officer Matt Klein said:

Since our last update -- if we go back to early September, when we did our last update, we'd say that we've seen the pricing environment largely stabilize. ... We also recognize that the environment may be around for a little while, but that's OK. Our cost structure allows us to thrive this way and grow in a low-fare environment. Having said that, we have seen some evidence of fares firming up around the holiday periods, and I would characterize the overall environment as improving relative to a couple of months ago. 

Spirit's Q4 guidance looks at least a little better than this quarter. The company expects a unit revenue decline of 4% to 6%, which it expects to be partially offset by a 3% to 4% decline in its adjusted CASM ex-fuel costs.

And for 2018, Spirit is estimating a larger capacity increase of 22% to 25% as it adds 10 new aircraft to its fleet. It also expects its adjusted CASM ex-fuel costs will decline 3% to 5% for the year, helping put more distance between Spirit and its rivals. However, the company notes that that figure doesn't factor in any CASM hit that would result from a new, more expensive contract with Spirit's pilots.

Growth in 2019 may begin to look a little different, as Spirit is only committing to growing capacity by 10% to 12% for now. But CFO Ted Christie said on the call that Spirit's unit costs will continue to decline regardless of the company's growth rate.

While growth is beneficial to cost [reduction], it is not the only thing that we focus on. So optimal deployment of the existing assets is as beneficial as the growth. ... But the truth of the matter is that our objective is to always manage to a stable declining cost structure. And growth at 12%, 15%, 10%, 18%, we come up with ways to make it work. And so I'm still in the same camp as I was before this call or before you guys learned that we might be at 10% for 2019. I still feel the same way.

One bad year doesn't invalidate Spirit's model

To the degree that you believe the hurricanes and pilot-related cancellations of 2017 are events not likely to be repeated, Spirit's core strengths continue to shine through. The company's low-cost advantage over its peers is set to widen, making the likelihood of a protracted fare war seem relatively low. Non-ticket revenue continues to grow, helping offset lost revenue from the ticket side of the equation. And Spirit's planned double-digit capacity increases in the years ahead should continue to fuel solid gains in revenue and earnings. While investors are hoping for a much less dramatic 2018, even during a year when nearly everything went wrong, Spirit seems to be doing just fine.

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Andy Gould owns shares of Spirit Airlines. The Motley Fool owns shares of and recommends Spirit Airlines. The Motley Fool has a disclosure policy.