Famous investor Warren Buffett recently reversed his old rule never to invest in airlines by purchasing stakes in four large-cap US airlines. According to Buffett, the US airline industry has become more rational in its pricing, and consequently is providing an attractive investment. Our small-cap universe includes several airlines. Spirit Airlines is one. Spirit is the largest low-cost carrier in the US, measured by total seat capacity. Its low-cost model is similar to that of Ryanair and Wizz Air in Europe. Spirit has been a holding in the Kempen (Lux) Global Small-cap Fund since spring 2016.
Spirit Airlines is an ultra-low-cost carrier. Although the original low-cost model was introduced by Southwest Airlines in the 80s, Spirit improved on this by stripping out all the extras in its ticket price when the company introduced the concept of the bare fare in the US. When you buy a ticket from Spirit, you purchase a seat and pay separately for everything else, from on-board snacks to checked luggage. In this respect, Spirit’s business model is similar to Wizz Air or Ryanair in Europe.
Three cost advantages
Our own research, based on the annual reports from all US airlines, shows that Spirit is ableto offer lower prices than its competitors because it has the leanest cost base in the US aviation industry in 2016,. No other airline can fly as cheaply in the US as Spirit. There are three reasons for this.
First, Spirit only has one type of aircraft in its fleet: the Airbus A320 series. As a result, Spirit needs to carry only one type of replacement and maintenance parts, and its pilots are trained to fly on all the planes in Spirit’s fleet.
Second, Spirit has a high-utilisation model. On any given day, Spirit aircraft spend more time in the air than their counterparts at other competitors. It can therefore squeeze more out of its fleet than other airlines.
Finally, Spirit has the youngest fleet in the United States, with an average age of approximately five years. This significantly reduces maintenance and operating costs and improves reliability. The first Airbus A320s with the ‘new engine option’ were recently delivered. This engine is more fuel-efficient than older ones. All this leads to significant cost savings compared to its peers.
Stimulate new demand
Spirit has substantial pipeline for future growth. Whereas low-cost carriers in Europe already have a significant market share, the US is still underpenetrated from a low-cost perspective. In fact, the US market is dominated by the big four legacy carriers (Delta Air Lines, Southwest Airlines, United Continental and American Airlines). In the investor relations presentation of March 2017 Spirit estimates that there are at least 500 markets (city-to-city route pairs) where they can effectively compete against the legacy carriers. On these routes, Spirit can undercut the incumbents on pricing, whilst still achieving attractive profitability levels. In the same presentation Spirit states that they aim to add 125 of these markets to its current base of 220 in the coming five years. In addition to taking over market share from the incumbents, there is a Spirit entry effect: when Spirit enters a specific market, it tends to stimulate new demand. By offering fares significantly below the rates of legacy carriers, Spirit attracts customers who previously could not afford to fly.
In the near term, a potential factor weighing on Spirit’s share price is the ongoing negotiations with pilots over a new pilot contract. As a low-cost carrier, Spirit’s pilots typically earn less than what is common at legacy carriers. Spirit’s pilot labour contract became amendable, and the company is currently in the process of negotiating with the ALPA (Air Line Pilots Association). The stock market seems to anticipate a significant step-up in hourly wages. Although we at the Kempen Global Small-cap Fund agree that a sizeable increase in pilot pay is likely, we do note that under the current contract Spirit’s pilots enjoy better-than-industry-average working conditions. For example, they have more days off than is usual at a low-cost carrier. We expect, after our analysis and talks with the management, that Spirit will try to trade higher pay for less good conditions. This should partly offset the higher costs due to higher hourly pilot wages by improving pilot productivity.
Spirit in our portfolio
We were first introduced to Spirit at the Raymond James Institutional Investors conference in March 2016. We liked Spirit’s business model and decided to build an initial position. In the summer of 2016, concerns about overcapacity in the US air industry pushed down Spirit’s share price in accordance with the market. As Spirit’s long-term prospects had not changed, we decided to take advantage of this weakness to add to our position.
Though the stock has since recovered, we still believe that Spirit is uniquely positioned to gain market share in the US and firmly believe in its business model. In our view, the market continues to underappreciate the potential of the ultra-low cost model in the US and gives little credit for Spirit’s very sizeable growth potential. In our view, Spirit’s valuation is attractive.
Valuation: Enterprise Value/EBITDA
The table below shows a comparative valuation analysis of four low-cost airlines. It shows the Enterprise Value of the company versus its expected earnings before interest, taxes, depreciation and amortisation for the current fiscal year, according to analyst expectations. It demonstrates that Spirit is the cheapest stock among these four low-cost carriers. All in all, we believe Spirit Airlines to be an attractive long-term investment.
Comparative valuation 4 low-cost US airlines
Date: 18 april 2017
This document is prepared by the fund managers of Kempen (Lux) Global Small-cap Fund (‘the Fund’), managed by Kempen Capital Management N.V. (‘KCM’). The Fund currently holds shares in the subject company. The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments. The information in this document is solely for your information. This document should not be considered to constitute an investment recommendation and it is not intended as an offer or a solicitation to buy or sell any financial instrument mentioned in this document. This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of KCM.