I have just pitched one of my favorite long positions, Spirit Airlines (SAVE, Financial). Normally, an airline business could be thought of as a combination of high fixed operating costs and high capital expenditures for airline purchases and leasing. Those business characteristics result in high debt level and low return on equity. However, Spirit Airlines has proved the opposite. In the past three years, Spirits Airlines has generated high double-digit returns on both equity and assets. Trailing 12 months, its return on equity reached nearly 28.5%, while its return on assets was nearly 16%. How can Spirit Airlines generate such a high return? Let’s take a deeper look.
Low cost leadership strategy
First, let’s start with the business model. Spirit Airlines is an ultra low cost carrier (ULCC), meaning that it finds all the ways to reduce its operating costs, thus, providing customers with much lower airfares than other normal airlines. Normal airlines often target business travellers, with special treatment for premium customers and multiple class cabin and multiple fleet types. The ultra low cost structure targets travellers who pay for their own ticket, it treats all customers the same, offering only one class cabin and single fleet type.
In the company’s 10-K filing, the company believed that low unit operating costs was attributable to several factors including:
- High aircraft utilization.
- High-density seating configurations on aircraft.
- No hub-and-spoke-inefficiencies, meaning only direct flights.
- Opportunistic outsourcing of operating functions.
- Direct-to-consumer marketing, thus reducing marketing and sales costs.
Spirit Airlines could offer extremely low fares by having unbundled fares, meaning that it charges extra for nearly everything besides basic airfares such as more bags, drinks, food, seat assignments, etc. Indeed, Spirit Airlines has found different innovative ways to generate more non-ticket revenue. For example, it charges for both checked and carry-on baggage, for premium seats and advance seat selection. It also generated subscription revenue from its $9 Fare Club ultra low-fare subscription service. Moreover, it offers third party travel products including hotel rooms, transportation and other ticket for attractions. As a result, the company has managed to grow average non-ticket revenue per passenger flight segment by 10 times, from around $5 in 2006 to $55 in 2014. The total non-ticket revenue has jumped from $243.3 million in 2010 to more than $786 million in 2014.
Extremely low operating expense items
Spirit Airlines has proved to have the lowest unit operating costs, even among ULCC companies such as Southwest Airlines (LUV, Financial) and JetBlue (JBLU, Financial). In the company’s presentation, the adjusted cost per available seat miles (CASM) of Spirit Airlines was only 9.65 cents in 2014, while the CASM of Southwest Airlines’ and JetBlue’s were much higher. Let’s look at the breakdown of cost of the three low cost airlines:
| Operating expenses 2014 (cents per ASM) | SAVE | LUV | JBLU |
| Fuel & oil | 3.75 | 4.04 | 4.25 |
| Salaries & wages | 1.92 | 4.14 | 2.88 |
| Aircraft rent | 1.20 | 0.22 | 0.28 |
| Landing fees and other rents | 0.64 | 0.85 | 0.71 |
| Marketing, distribution & Integration costs | 0.46 | 0.1 | 0.51 |
| Maintenance & repair | 0.45 | 0.75 | 0.93 |
| Depreciation & amortization | 0.29 | 0.72 | 0.71 |
| Other operating | 0.95 | 1.68 | 1.52 |
| Total cost per ASM | 9.65 | 12.50 | 11.78 |
What I find fascinating is the very low salaries, wages and benefits costs. Spirit Airlines has the lowest salaries and wages cost of only 1.92 cents per ASM, while those of Southwest Airlines and JetBlue are much higher at 4.14 cents and 2.88 cents per ASM. Salaries and wages of Southwest Airlines and JetBlue accounted for more than 33% and 24.4% of the total operating expenses, while those of Spirit Airlines are only 16.3% of the total expenses. Moreover, Spirit Airlines also manages to have lower cost of fuel and landing fees and maintenance and repair compared to the other two airlines.
Certainly, the lowest operating expense of Spirit Airlines has translated into higher operating margin as well as higher return on equity than other low cost competitors. Spirit Airlines showed that its total revenue per passengers is even below most of its peers’ breakeven cost. Its pre-tax operating margin was 21.2%, much higher than that of Southwest Airlines at 16% and JetBlue at 12.2%.
Conclusions
As most of the airline operating expense items are fuel and oil, and salaries and wages, in order to improve profitability, airlines should focus on reducing these two expenses. The culture of Spirit Airlines and the way it operates has enabled this airline to have low costs, especially salaries and wages. I personally think that Spirit Airlines could further improve its profitability by keeping these costs low and find more innovative ways to generate more revenues.
