Spirit Airlines: America's ULCC pioneer goes public Jul/Aug 2011

Late May saw a notable new addition to the publicly traded US airline ranks: Spirit Airlines, a Fort Lauderdale–based ultra–low cost carrier (ULCC), which completed a modest $190m IPO to pay down debt and fund growth. Famous for its Ryanair–style pricing and unbundling strategies, Spirit has developed a successful niche catering for leisure and VFR travellers to and from Florida, the Caribbean and Latin America. Just about to achieve “major carrier” status with $1bn–plus revenues in 2011, Spirit has been profitable for four years and has promising growth prospects. But, given possible labour and legislative challenges, are 20% annual ASM growth and strong profits sustainable? The IPO was poorly timed. It was one of several offerings in the US in the last week of May that had to be downsized and priced below expected range due to insufficient investor interest. Both broader market volatility and company–specific factors were to blame. In Spirit’s case, investors worried about the high fuel price environment and the possibility that airline ancillary revenues could fall prey to regulatory changes.

Spirit sold 15.6m shares at $12 each (plus 256,513 shares through a partial exercise of underwriters’ over–allotment option), compared to the original expectation of 20m shares at $14–16. The $190m in total proceeds raised was 37–45% less than what had been expected at the $15 mid–point price.

But the shortfall did not really matter.

Spirit floated to the public only about 22% of its stock. Its two deep–pocketed and committed private–equity backers, Oaktree Capital Management and Indigo Partners, retained a controlling combined 71.5% stake by converting their preferred shares to common stock. Some of the proceeds were used to repay notes held by the private equity firms and to redeem stock held by another shareholder.

While Oaktree collected $3m from the sale of the over–allotment shares, Indigo received a $1.8m fee in connection with the termination of its “professional services agreement” with the carrier.

The proceeds boosted Spirit’s unrestricted cash reserves from $62.6m to around $197m (pro–forma, as of March 31) – a very healthy 25% of last year’s revenues. The recapitalisation eliminated all of the carrier’s long–term debt ($281m) and increased its equity from negative $97m to positive $388m.

As one of the major benefits, the stock market listing (on Nasdaq) will enable Spirit to tap the US public capital markets (equity or debt) to fund its fleet expansion in the future. After the disappointing public debut (which included the stock falling initially and then barely lifting above the $12 offer price level for six weeks), Spirit’s shares took off in early July after five analysts initiated coverage of the company with “buy” or “strong buy” recommendations, and by mid–July the stock was trading at the $14 level. Although those five analysts were from financial institutions that were underwriters on the IPO, several other brokerages have also initiated coverage of Spirit with equally bullish reports.

Spirit’s key strengths include its ultra–low cost structure and innovative revenue strategies, including a focus on ancillary revenues. These characteristics may give it an especially resilient business model and customer base, making it even more recession–resistant than mainstream US LCCs.

Spirit has also found a profitable growth niche – the stumbling block for many LCChopefuls in the past. It has developed a substantial network to the Caribbean and Latin America, to supplement its US domestic operations on high–volume routes and in profitable niche markets.

Fort Lauderdale–Hollywood Airport, where Spirit is the largest operator of international flights and where 59% of its daily flights depart or arrive, is the perfect home base for a Caribbean/Latin America–focused LCC. It has a great geographical location,large catchment area population and significant demand for VFR travel from the large ethnic population. It also has relatively low costs and room for growth (it is in the process of being expanded).

A couple of analysts have suggested that, rather than being threatened by American’s Miami hub, Spirit — given its operating efficiency and low fares — may in fact be pulling leisure market share from American and Miami.

Spirit is well–positioned for growth also because of its new Airbus fleet and solid orderbook, its substantial experience of international operations in the Caribbean since 2003, and its financial strength.

On the negative side, Spirit does not have the Southwest/WestJet/JetBlue–style good labour relations and corporate culture.

In June 2010 its flight operations were shut down by a five–day pilot strike. Spirit now faces increasingly unhappy flight attendants, who have had an open contract for four years.

Spirit also faces a potential government crackdown on unbundling and non–ticket revenues, which account for 31% of its total revenues. Among the various threats, proposed legislation would impose federal taxes of up to 7.5% on charges for carry–on and checked baggage.

Spirit’s background

Spirit has gone through an interesting metamorphosis in its 47–year history. Founded in 1964 as Clippert Trucking Company in Detroit, in 1983 the company transformed into a tour operator (Charter One) providing packages to entertainment destinations such as Atlantic City, Las Vegas and the Bahamas. In 1990 the company received an air carrier certificate and launched charter flights. Scheduled services followed in 1992, when the present name was adopted.

So Spirit is probably the only independent survivor from the early 1990s crop of LCC start–ups in the US (now that Frontier is in the Republic camp and AirTran has been acquired by Southwest). In the 1990s Spirit operated typical LCCstyle north–south low–fare services, utilising DC–9s and MD–80s (the last DC–9 left the fleet in 2003) and achieving high load factors. It had only two unprofitable quarters in that decade.

However, those were frustrating years as the legacy carriers fought tooth and nail to keep LCCs out of their hubs. Spirit never succeeded in acquiring or sub–leasing its own gates at Northwest’s Detroit hub. It achieved fame in early 2000 by taking on Northwest in a lawsuit that accused the legacy of predatory pricing and of trying to prevent it from competing in Detroit.

In 1999 Spirit moved its headquarters from Detroit to Fort Lauderdale, where it had already built a substantial presence, and began calling itself “South Florida’s hometown airline”. The move also reflected interest in Latin America routes, though international operations did not begin until late 2003.

Spirit was hit hard by 9/11. It had to cut 40% of its schedule and lay off one third of its workers, and it took 18 months to return to the former flight and staffing levels. As further major setbacks, an equity deal that had been in the works (with Raymond James) fell through because of 9/11, and Spirit was also turned down by the government’s loan guarantee programme.

Nevertheless, in the 1999–2003 period Spirit doubled its annual revenues and made significant investments in its systems, technology, product and brand. The investments included a new class of service, “Spirit Plus” business class, which featured leather seats and complimentary drinks and snacks and was sold at a $40-$100 mark–up. In other words, Spirit essentially transformed itself to a more up–market LCC – probably encouraged by JetBlue’s huge immediate success in 2000.

As a major milestone, in February 2004 Spirit received a $125m equity investment from Los Angeles–based Oaktree Capital Management. The investment gave Oaktree a controlling 51% stake and reduced Spirit chairman/CEO Jacob Schorr’s stake from reportedly 75% to 37%.(Schorr had originally invested $2.25m for a 21% stake when he joined the company as CIO in 1997, and within three years he had acquired a 51% stake and taken over at the helm.) Oaktree’s investment facilitated a much needed fleet renewal programme and a new growth phase for the airline. Spirit immediately placed orders for up to 95 A320–family aircraft (35 firm and 60 options, some from Airbus and some from lessors), to replace its 32 ageing MD–80s and provide for growth. In July 2005 Spirit received another $100m in new funding from Oaktree and Goldman Sachs Credit Partners for the purpose of accelerating its fleet renewal. As a result, the transition to an all–Airbus fleet was completed in 2006, two years earlier than planned.

Having launched its first international route in December 2003 (to Cancun, Mexico), after the Oaktree investment Spirit formally positioned itself as an LCC with a special focus on the Caribbean and Latin America. It filed applications to serve some 10 countries in the region. As the Airbus deliveries began in November 2004, Spirit launched its second international route, to Santo Domingo in the Dominican Republic.

In 2004 Spirit also made many changes to its domestic network, terminating unprofitable routes and announcing expansion in major new markets. Significantly, it gained access to Washington National that year via a special granting of slots by the DoT. With the change in ownership, Spirit also began to reconstitute its management team. In January 2005 Ben Baldanza was brought in from US Airways as president/COO, and in May 2006 he was named CEO, enabling Schorr to retire to chairman’s position (he subsequently passed that role to Indigo’s managing partner Bill Franke). Before his role as SVP marketing and planning at US Airways, Baldanza was Grupo Taca’s managing director/COO.

In July 2006 Spirit was again recapitalised when Indigo Partners, a Phoenix–based private equity fund, acquired a majority stake and control from Oaktree, which also injected more funds and remained the second largest investor. Indigo focuses mainly on investing in airlines and currently has stakes in five other LCCs or ULCCs – Singapore’s Tiger Airways, Hungary’s WizzAir, Mexico’s Volaris, Russia’s Avianova and Indonesia’s Mandala Airlines.

The new investment was aimed at providing Spirit the resources to accelerate growth and “consolidate the company’s position as the leading LCC to the Caribbean”. Oaktree also wanted to bring in Indigo’s significant airline expertise. Bill Franke was previously America West’s chairman/CEO and, in addition to his LCC interests around the world, he manages a private equity fund focused on investments in Latin America.

Following Indigo’s involvement, Spirit was “redefined” as a ULCC in 2006. It began a rapid transformation from a mainstream LCC to the ultra–low cost business model.

In September 2010 Spirit’s shareholders agreed on a new recapitalisation plan that would take the airline public in 2011. Among other things, the plan stipulated that all debt will be repaid or redeemed and all preferred stock exchanged for common stock in the IPO.

Financial turnaround

The new fleet, the network realignment and the switch to the ULCC business model had an immediate dramatic impact on Spirit’s financial performance. After three years of operating and net losses totalling $172m and $236m, respectively, the airline turned modestly profitable in 2007, despite a 46% surge in capacity.

2008 again saw modest profits, but in 2009 – when the rest of the industry suffered the worst effects of the recession – Spirit achieved record earnings: operating and net profits of $111.4m and $83.7m, respectively.

The 15.9% operating margin was among the highest in the US airline industry. The stellar 2009 results reflected success in reducing ex–fuel unit costs while maintaining relatively stable total unit revenues.

Between 2006 and 2009, Spirit’s ex–fuel CASM fell by a stunning 21%, from 6.89 to 5.45 cents, while RASM was unchanged (9.37 and 9.35 cents).

After the sharp growth spurt in 2007, Spirit responded to the fuel and economic challenges by trimming its capacity by 2.4% in 2008 and 9.4% in 2009. It terminated at least seven A319 leases. As a result, in the2006–2009 period capacity was up by 29%, which was largely achieved through a stunning 43% increase in average daily aircraft utilisation from 9.1 to 13 hours.

Spirit’s 2010 earnings (operating and net profits of $68.9m and $72.5m, about 9% of revenues) were adversely affected by higher fuel prices and the June pilot strike. But in this year’s first quarter the airline was back at double–digit operating margins (11.5%), despite higher fuel prices and the acceleration of ASM growth to 20.9%.

Spirit’s labour costs are among the lowest in the US industry. The airline is also fortunate in that the June 2010 pilot strike left no obvious lasting negative impact. The pilots ratified a new five–year agreement in August 2010, which is expected to increase pilot labour costs by around 11% in 2011, compared to the cost of the previous agreement.

The airline believes that the deal will enable it to retain competitive pilot labour costs. Spirit will need to pull the same trick with its two other unions. Its flight attendants’ contract has been open since August 2007, and the dispatchers’ contract becomes amendable in July 2012.

Unique niche and ULCC strategy

Spirit is probably the only example of a Ryanair–style operation in the Americas, where a more upmarket approach has become the norm among successful LCCs.

The only airline that has a similar pricing and revenue strategy is Allegiant, but the Las Vegas–based carrier is truly a niche operator and has unusual features such as old MD–80s, low aircraft utilisation, etc. (see Aviation Strategy briefing, January/February 2007).

In the IPO prospectus Spirit argued that the diminished legacy–LCC cost differential in the US, which has resulted from the legacy restructurings, has provided an opportunity for the introduction of the ULCC business model “as a subset of the more mature group of low–cost carriers”. Having studied the other ULCCs, particularly Ryanair, Spirit had concluded that “the ULCC model focused on routes from the US to the Caribbean and Latin America could be successfully deployed”.

In other words, this is a niche strategy – albeit involving a very large and promising growth niche. The Caribbean/Latin American markets seem tailor–made for the ULCC model. VFR traffic, which Spirit specifically targets because it is an important contributor to non–ticket revenue production (higher baggage volumes, etc.), accounts for as much as 35% of Caribbean–originating travel to the US, while the large populations of Caribbean and Latin American descent in New York and South Florida – Spirit’s traditional strongholds – generate much VFR travel. Many of the markets have historically been under–served by LCCs. Furthermore, South America, where air travel by the emerging middle classes is set to soar, is obviously a major future growth market for leisure/VFR travel to the US.

The ULCC business model is built on extremely low costs. There seems to be a consensus that Spirit has achieved one of the lowest cost structures among airlines in the Americas. According to Citigroup, its stage length adjusted CASM is 24% below JetBlue’s and 6% below Southwest’s.

Like ULCCs typically, Spirit achieves its low cost structure through high aircraft utilisation, a single–type fleet, high–density seating, short turnaround times, high labour productivity, a low–cost base of operations, use of outsourced services and extensive use of low–cost distribution methods (web–based sales, direct–to–consumer marketing).

The low costs enable Spirit to offer very low base fares, which are combined with a range of optional services for additional fees. The low fares stimulate demand, and the resulting higher passenger volumes and load factors lead to increased sales of ancillary products and services. This, in turn, enables Spirit to “reduce the base fare even further, stimulating additional demand”.

Since adopting the unbundling strategy in 2007, Spirit has lowered its base fares by up to 40%. Its average base fare was $77 in 2010 and $82 in first–quarter 2011, though it regularly offers promotional fares of $9 or less.

The key difference between Spirit’s and other US airlines’ unbundling strategies is that other airlines look at ancillary revenues as additional revenue streams, but Spirit wants them so that it can reduce fares. Spirit typically lowers its base fares whenever it adds a new fee. This has understandably caused some angst among analysts, but the strategy seems to be paying off.

The strategy certainly helped Spirit weather the recession (during which air fares faced downward pressure anyway). Between 2006 and 2010, Spirit’s non–ticket revenues grew from $23.8m to $243.3m, to account for 31% of its total revenues. On a per–passenger- flight–segment basis, non–ticket revenues increased from $4.80 to $35, which more than offset the decline in average ticket revenue from $104.56 to $77.39 (see table, left).

Spirit stipulates that the base air fare should provide “everything necessary for a complete and safe flight”. The airline has firmly ruled out some of the more extreme ideas floated by Ryanair CEO Michael O’Leary, such as charging for bathroom use. US travellers have become used to paying fees in the past 2–3 years as most of the carriers have begun charging for checked baggage, food/drink, change, call–centre bookings and suchlike. But many people felt that Spirit crossed the line when it began charging for carry–on bags in August 2010. The move received much negative media and government attention, with one New York Senator even calling for legislation to define carry–on bags as a “reasonable necessity” for air travel.

The brouhaha died down because no other airline was interested in introducing such fees. One year on, Spirit and its customers seem happy with the policy. Spirit reduced its fares by $40 (the amount of the bag charge if purchased at the airport).

Its customers can avoid the fee if they pack so lightly that their bag fits under their seat. And the boarding and disembarking processes are now faster and less stressful.

As another first, Spirit recently began imposing a $5 fee for boarding passes printed by check–in agents. The airline passes through all distribution–related expenses. Its optional offerings include advance seat selection, “Jump the Line” priority boarding and upgrades to “Big Front Seat”.

In addition, Spirit has developed non–flight related ancillary revenue streams, including a “$9 Fare Club” (an annual subscription service giving access to the lowest fares and discounted baggage fees), a “Free Spirit” affinity credit card programme, sale of online and on board advertising, sale of hotel bookings, car rentals and airport parking through its website, and sale of vacation packages.

In its own words, Spirit has a “low–cost, viral marketing strategy incorporating provocative, edgy content”. The Miami Herald recently aptly described it as having“gained notoriety by poking fun at the indiscretions and criminal misdeeds of politicians, actors and sports figures”.

However, it should be noted that the CEO has the opposite image. Baldanza gives the appearance of being a gentle and low–profile figure – also contrasting with the brash, controversial and publicity–seeking CEO of Ryanair.

Spirit faced some unique challenges when it began switching to the new business model after being a mainstream LCC. There was a surge in customer complaints lodged with the DOT, as the former customer base was not necessarily impressed by the higher seating density and the new fees. So Spirit has had to make special efforts to offer transparent pricing and communicate better with customers. Its website allows customers to see all available options and their prices prior to ticket purchase.

Much like Ryanair, Spirit now has a loyal customer base. Its customers know that they are being nickel–and–dimed, but they are used to it and like the low fares.

The biggest threat to this strategy is the potential government crackdown in the form of taxes on non–ticket revenues and restrictions on unbundling. Congress is investigating the industry practice of unbundling. Proposed legislation in the Senate, if enacted, would impose federal taxes of up to 7.5% on charges for carry–on and checked baggage. It seems certain that US airlines’ ability to generate lucrative non–ticket revenues will be reduced. And Spirit, with its heavy reliance on non–ticket revenues, is likely to be among the worst affected carriers.

Growth plans and prospects

Spirit’s principal target growth markets are the Caribbean and Latin America, a region where it already serves an impressive 25 destinations. The airline is also looking to selectively expand in large US domestic markets that either feed traffic to and through the South Florida base or are under–served by LCCs and make it possible to develop a significant share of local traffic.

The current fleet plan is to grow from 35 aircraft (as of March 31) to 68 at the end of 2015. The 33 firm orders include 20 for A320s and 13 for A319s (which may be converted to A320s) – giving the carrier useful flexibility. Spirit is currently assessing its fleet needs in 2016 and beyond. All of the current fleet is leased, and at least the next seven A320 deliveries from Airbus will be taken through sale–leasebacks.

Analysts are generally very bullish on Spirit’s earnings growth in the next couple of years. Avondale Partners (which was not an underwriter on the IPO) suggested in a mid–July report that the airline can deliver revenue and income growth above 20% for several years.

Spirit does not really have direct competition. Its fee and fare structure and lack of frequencies make it very clear that it caters for a different market and is not after business traffic. As the Avondale report observed, “traditional carriers may well view the Spirit customers as not worth pursuing”.

Nevertheless, the likes of JetBlue and American may in the future challenge Spirit, especially when it becomes a major force in the Caribbean/Latin America. JetBlue also operates through Fort Lauderdale and has been growing rapidly in the Caribbean.

American has just announced plans to grow its departures from Fort Lauderdale by 30% next winter, with new services to Los Angeles, Chicago and Dallas.

Many analysts have made the point that the most important thing that Spirit must do is hold down non–fuel costs – something that the additional A320s and continued ASM growth should help it accomplish.