After several years as one of the highest-flying airline stocks, Spirit Airlines (SAVE 0.25%) stock has struggled in 2015. Investors got another dose of bad news on Monday afternoon, as Spirit cut its margin guidance for Q2 and the rest of 2015.
As a result, Spirit Airlines stock dropped 10% on Tuesday morning before trimming some of its losses. Still, after peaking above $85 late last year, the shares have lost more than 30% of their value.
Spirit Airlines Stock Performance, data by YCharts.
After enduring yet another disappointment, should Spirit Airlines investors throw in the towel? Or could this be a good buying opportunity?
Another guidance cut
Early this year, Spirit Airlines projected that it would earn a full-year operating margin of 24% to 29%. While Spirit has routinely been among the most profitable airlines in the U.S., this level of profitability is virtually unheard of in the airline industry. But thanks to the big drop in oil prices between mid-2014 and early 2015, Spirit's management thought this margin level was achievable.
However, lower fuel prices -- combined with accelerating industry capacity growth in a few markets -- have led to sharper price competition than the airline industry had experienced in the past few years. At first, this discounting mainly affected off-peak periods, but it is increasingly spilling into peak travel days.
As a result, in April, Spirit Airlines reduced the high end of its guidance range, calling for a 24% to 27% full-year operating margin.
This week, Spirit Airlines cut its guidance in a much more significant way. The airline now expects a full-year operating margin of 21.5%-23.0%. Spirit also estimated that it produced a Q2 operating margin of 21%-21.5%, far below its April estimate of 24.5%-26.5%. Most of the shortfall was caused by unusually bad weather in June.
Keep an eye on the big picture
Investors are understandably upset that Spirit Airlines has had to cut its guidance twice in 2015, especially given its track record of outperformance during the last few years. That said, it is important to keep these developments in perspective.
In 2014, Spirit Airlines achieved a record adjusted operating margin of 19.2%. Even at the low end of its new guidance range, Spirit is projecting significant margin expansion this year. Meanwhile, thanks to its 30% projected capacity growth in 2015, Spirit Airlines will produce double-digit revenue growth again this year, despite the ongoing unit revenue pressure it faces.
Spirit Airlines is still on pace for double-digit revenue growth and margin expansion in 2015. Image source: Spirit Airlines
Most companies would kill for double-digit revenue growth combined with margin expansion. Yet Spirit Airlines trades for about 14 times projected 2015 earnings (based on the midpoint of its new guidance). That puts it at a significant discount to the broader market.
Furthermore, Spirit Airlines has plenty of potential to keep growing while expanding its profit margin. It is early in the process of shifting most of its fleet financing from leases to lower-cost debt. And Spirit is just beginning a multiyear fleet transition that will see it phase out most of its Airbus A319 planes while dramatically increasing its usage of the vastly more cost-efficient A321.
It's all about cost
In the past year or so, Spirit Airlines' management has repeatedly noted in investor presentations that the ultra-low-cost carrier airline market segment has tons of growth potential in the U.S. Ultra-low-cost carriers represent nearly 20% of the airline industry in Europe, compared to less than 5% in the U.S.
More recently, Spirit's management has been going out of its way to direct investors' attention away from unit revenue and fuel prices, two highly watched metrics at most airlines. Instead, the company believes the most important metrics to watch are unit costs and earnings.
This might seem self-serving, but it's a sound approach given Spirit Airlines' business model. By keeping unit costs on a steadily declining trajectory, Spirit can reduce its fares. This allows it to stimulate travel demand among its core market of working-class and middle-class consumers. (To a lesser extent, it can also steal business from higher-cost competitors.)
For most airlines, fare reductions are seen as a sign of weakness. That's why many Wall Street analysts think that Spirit should slow its growth in order to prop up pricing. But as long as profit is growing, why should Spirit (and its shareholders) care about growing unit revenue?
Indeed, Spirit's most important cost-reduction initiative -- adding dozens of A321s to its fleet -- is specifically predicated on growth. In the long run, Spirit will be better off continuing to grow while steadily driving down its unit costs, even at the expense of unit revenue growth, rather than slowing its growth in order to bolster unit revenue at the expense of unit cost reductions.
Only by maintaining its cost advantage will Spirit be able to sustain high profitability in the long run. Despite cutting its 2015 guidance yet again, Spirit still seems to be on the right track.
