A Low-Cost Airline With Outsized Profit Potential

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March 16, 2016 2:16pm NYSE:JETS

airlinesMarshall Hargrave:  Airlines have not been the booming industry we were promised. Cheap fuel and continued industry consolidation haven’t led to rising margins and steadier cash flow for the major airlines – and certainly not higher stock prices.

The U.S. Global Jets ETF (NYSEARCA:JETS) is up just 2% since it launched in April of last year. The biggest and supposedly best airline stocks, such as American Airlines (NYSE:AAL) and United Continental Holdings (NYSE:UAL), are down more than 14% in the last 12 months.

However, many of the top airlines are still enticingly cheap. But are they basically value traps at this point? If the fall in crude oil from $100 a barrel to below $30 isn’t enough to inject new life into these high fliers, I’m not sure there’s a major catalyst on the horizon to make them investable.

low-cost airline

There’s Still Hope

Although the major airlines are limited with ways they can grow – basically more fees and new routes – the “cheap” airlines still have the opportunity to take market share from the biggest players.

The prime player here is Spirit Airlines (NASDAQ:SAVE), which has seen its shares fall 40% in the last 12 months.

On a valuation basis, it doesn’t appear cheap compared to major airlines. It trades at 10 times earnings. However, it has one of the best balance sheets in the industry, with a debt-to-equity ratio of 50%. United’s ratio is 550% and American’s is 150%. Plus, Spirit is one of the few airlines generating a double-digit return on assets (over 14%).

One of the interesting things that suggests there are still plenty of growth opportunities in the low-cost airline space is that discount carrier Frontier Airlines is looking to go public. It has hired the likes of JPMorgan Chase (NYSE: JPM) to help plan an initial public offering. This would be the first airline IPO since Virgin America (NASDAQ: VA) in 2014.

The major airlines have refused to get into a pricing war, which is good news for Spirit and Frontier, as it makes their low-cost models even more appealing. Meanwhile, Spirit is looking to carve out an even greater niche by targeting more midsize cities that are overlooked and neglected by larger airlines.

Why the Low-Cost Airline Space Is Interesting

Southwest Airlines (NYSE: LUV) is one of the original low-cost airlines. It started flying in the early 1970s and offered low fares. Southwest has grown into the largest U.S. domestic airline. Its stock has crushed the S&P 500 index since its IPO. And over the last five years, shares of Southwest are up 242%, while the S&P 500 is up 55%.

Customers tend to enjoy the super-low fares and are willing to pay ancillary fees for services they need, such as checked baggage and seat selection. Southwest has since moved away from this model, as it’s simply outgrown it.

But the key is that a low-cost model doesn’t mean low margins. Spirit has one of the best profit margins in the business, generating a net profit margin of 15% over the last 12 months. The low fares help Spirit sell more, which boosts volume and increases sales of its higher-margin ancillary services.

Spirit also keeps its planes highly utilized and seating density high. Along those lines, Spirit operates a single fleet type of aircraft, keeping maintenance, parts and workforce costs down. Recall that Southwest also flew only one type of aircraft when it started out, maximizing its aircraft utilization by flying direct point-to-point routes. Southwest has now booked an operating profit for more than 40 straight years.

Spirit is blazing a new path when it comes to low-cost airlines, due to its ultra-low-cost model that affords it impressive returns and margins. The goal is that Spirit can replicate the same success as Southwest and take the torch as the leading low-fare provider. Southwest has grown into a $28 billion company, while Spirit still just has a $3.3 billion market cap, leaving plenty of promise.

This article is brought to you courtesy of Marshall Hargrave from Wyatt Research.

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