Monday 13 June 2016
Robust finances enable Spirit’s strategy change
Spirit Airlines’ (Spirit) new CEO has announced a new strategy for the Ultra-Low Cost Carrier (ULCC) which will include targeting 500 new domestic routes, cutting capacity by 10% and changing the culture of ‘America’s most hated airline’ in an attempt to improve customer service.
Ishka believes Spirit is sufficiently capitalised to acquire additional aircraft to begin operating new routes and believes a slightly slower growth rate makes sense for Spirit’s new expansion policy and that investment to improve the airline image among customers is necessary to improve the airline’s bottom line in the long-term.
Spirit moves to target new untapped short-haul routes
Spirit appointed a new CEO, Bob Fornaro, after investor jitters last year which wiped 50% off the share price as the carrier reported a 17.5% drop in revenue for its fourth quarter in 2015. The new CEO has identified three key strategic changes for the airline: a push to open 500 new regional domestic routes, a reduction in capacity growth and an improvement in the airlines’ customer service. The airline currently serves 190 routes with 85 aircraft.
Spirit faces increased competition from full service carriers, most notably American Airlines, which are now competing directly with Spirit on fares as a result of lower fuel prices. Spirit occupies a unique position in the US market, straddling primary and peripheral routes. Unlike other ULCCs, such as Frontier and Allegiant, it is mostly in competition with full service carriers like American and low cost carriers like Southwest who account for 50% and 55% of network overlap respectively.
CEO Fornaro plans to exploit market opportunities on routes below 1,000 nautical miles believing that these have become less competitive. Spirit maintains that there are around 500 routes where, on its current cost structure, it could earn an operating margin in the mid-teens or higher. The airline initially plans to move into 125 new markets over the next five years including 20 in 2016.
The move to shorter routes, out of the orbit of the larger carriers will allow Spirit’s to utilize its ultra- low cost structure more effectively. With costs at 5.59 cents per available seat mile (excluding fuel) this remains the carrier’s major competitive advantage. By contrast American’s CASM is currently 8.99 cents. In addition, Fornaro wants to slow down Spirit’s capacity growth by 10% to around 20% this year. However, there are several unknown aspects about the strategy. Spirit has not named which routes it wants to target, making it hard to assess either potential demand or potential competition from other carriers.
America’s most hated airline’ courts customers
Spirit is currently the worst performing US airline both in terms of passenger satisfaction and scheduled reliability. Clearly, the worry is that this may be affecting sales. Low fuel prices have allowed American to fill excess capacity and drive down fares. Scott Kirby, President of American Airlines, explained that 87% of its customers and half of its total revenue comes from infrequent flyers — a key demographic that can no longer be ignored.
In the short term at least, the superior customer service offered on a carrier such as American or Delta is a weakness for Spirit. The approach of Spirit’s previous CEO, Ben Baldanza — famous for publicly mocking customers for their complaint — appears to have run its course.
“Reputation does matter,” Fornaro has stated repeatedly. Fornaro appears to be following Ryanair’s successful pivot towards better customer service which saw profits jump by 32% following the start of its ‘Always Getting Better’ programme and has successfully salvaged the company’s reputation. Ryanair’s customer service push was primarily though a new designed website, allocated seating, and a friendlier customer service at check-in, while booking errors could be changed within 24 hours with no extra charges. These were relatively cheap changes to implement. Spirit is focusing primarily on performance. The carrier is putting more aircraft and staff on standby to reduce delays, which has helped, in part, to improve customer satisfaction by 15% on 2015, albeit from a low base.
Sound fundamentals
The airline’s fundamentals remain strong. Total revenue jumped from $1.93 billion in 2014, to $2.14 billion last year. Spirit also netted $317.2 million in profit last year, up 40% on 2014. And CASK is actually 2.3% lower than last year due to lower aircraft rent and fuel expenditure.
Under Fornaro, Spirit’s first quarter performance for 2016 remains strong. Despite a marginal dip in passenger revenue, total revenue was up by 9.1% mostly on the back of a 20.8% rise in revenue from fees and charges. Load factor, debt and leverage ratios remain stable.
However, net profit did decline in 1Q 2016. One reason for this is higher aircraft depreciation costs as a result of Spirit’s changing fleet composition. Spirit has been buying aircraft as they come off lease, making 15 purchases in the last 12 months including two so far in 2016. Likewise, there has been a rise in special charges from $0.4 million to $16.2 million. This is attributed to lease termination charges as a result of these purchases. Spirit reports that buying a used A320 versus leasing one, equates to an estimated annualised pre-tax benefit of $1m per aircraft.
.PNG)
Fleet and financing
Spirit recently swapped out 10 A321neo orders for A320neos instead. Spirit has also been buying up its A319s as they come off lease. It bought two previously leased aircraft in 1Q 2016. As of March 2016, 71.6% of Spirit’s fleet is currently leased and they currently have 29 active A319s, although in the current fleet plan this will reduce down to 8 over the next five years. The focus on downsizing from A321s to A320s and owning more of its aircraft fits with its new strategy of focussing on smaller markets. Disposal of the A319s, with an average age of 9.9 years, will help Spirit maintain its claim to have America’s youngest fleet.
Spirit has healthy access to both the public and private markets. The airline has $308.5 million of committed debt financing for the eight aircraft it has scheduled for delivery in 2016. In addition, Spirit has secured financing for five aircraft to be leased directly from a third party, also due for delivery in 2016. Last August Spirit signed a $576.6 million EETC to finance three new Airbus A320-200 aircraft and twelve new Airbus A321-200 aircraft. The company does not have financing commitments in place for the remaining 75 Airbus aircraft currently on firm order, which are scheduled for delivery in 2017 through 2021 but liquidity, for first and second tier airlines, remains easily accessible according to banks and lessors.
Scenarios
What if fuel costs rise to above $65 per barrel?
The Ishka View
The net effect of Spirit’s strategy shift could be a ‘new’ airline, much like Ryanair’s renaissance – but based on an expansion of new regional routes to be served by a larger core fleet of A320 aircraft – with improved reliability and customer service. Ishka believes that if Spirit manages to achieve a significantly better perception of its customer service, it would benefit, in the same way as Ryanair has, with improved profitability. Spirit remains poised for greater growth and presents significant opportunities for financiers. Its long term financial indicators are steady and its not significantly leveraged with no perceivable barriers for the carrier to raise additional debt for its incoming deliveries.
Moreover the carrier is slowing its capacity growth from an aggressive annual growth rate of 30%. Ishka anticipates that Spirit will benefit from targeting new routes although there is no clarity yet on the routes Spirit is set to choose. This makes forecasting competitive behaviour and expected profitability difficult. The suggestion on new routes is that the carrier will go for mid market cities, but this begs the next question whether Spirit aims for the markets served by other ULCCs such as Allegiant or Frontier, or the ones served by the majors. Ishka believes Spirit may attempt both, adopting a “suck it and see” approach, to identify where it could make the most headway.
Sign in to post a comment. If you don't have an account register here.