spirit final report

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1.0 Executive Summary

The purpose of this report is to provide a comprehensive analysis of Spirit Airlines

(SAVE) through qualitative and quantitative examinations of its financial data and business

model. We intend for our findings to contain useful and beneficial information for potential

investors in the company as well other interested parties. None of the authors of this

report hold positions in the stocks discussed nor have any connections whatsoever to the

corporation.

Spirit Airlines represents an intriguing outcome of an airline industry undergoing

major changes. The rise in lower-‐income flyers, uncertainty over global oil prices, and

demographic shifts towards urbanization have all contributed to the creation of a two-‐

tiered industry in which ultra low-‐cost carriers like Spirit have thrived. The airline’s

unconventional and often controversial marketing techniques have also given it unique

recognition in the aviation business.

The information in this report is presented in two main parts. The first section

provides an evaluation of Spirit Airlines from a qualitative standpoint. The corporation’s

management, competitive environment, and industry-‐specific challenges are among topics

discussed in this section. The second part of the report encompasses detailed analysis of

quantitative data derived from the airline’s Form 10-‐K filing with the SEC. This section

includes extensive use of financial ratios and common-‐sized data to conduct a thorough

appraisal of the corporation’s financial and economic position. Much of our analysis

involves data comparisons with the carrier’s main competitor Southwest Airlines. We

conclude our findings with an overall assessment of the airline as well as advice for

potential investors. The appendix contains all financial statements – for both airlines – and

data analyzed in this report.

The combination of qualitative and quantitative analyses included in our evaluation

intends to give a multi-‐faceted and complete perspective of Spirit Airlines. We hope that

this report serves as a valuable source of information for anyone looking to invest in the

airline or learn more about why the corporation is such a fascinating player in the industry.

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2.0 Company, Industry, and Environment

2.1 Description of Corporation and Management

Spirit Airlines is an ultra low-‐cost carrier (ULCC) headquartered in Miramar, Florida.

Founded in 1964, the airline struggled for decades as a mid-‐tier operator with limited

destinations on the east coast until drastically transforming itself with the arrival of new

majority shareholders Oaktree Capital and Indigo Partners in 2005.1 The new ownership

hired maverick CEO Ben Baldanza to spearhead the rebranding process.2 After weathering

a rough transition that included a massive pilots strike in 2006, Baldanza succeeded in

implementing a new business plan focused solely on providing the lowest ticket prices to a

narrow segment of the air travel market.3 While its larger competitor Southwest Airlines

had previously championed flying on a budget, Spirit pioneered a marketing strategy with

its entire emphasis on the unrivaled based fares offered by the carrier.

In January of 2016, Spirit hired Robert Fornaro to replace Baldanza as CEO after a

prolonged period of low stock prices and slipping revenues. Despite describing the change

as necessary for the airline’s future, the management has publicly stated that Baldanza’s

“no frills” business model has been key to the company’s success and that they have no

intention of changing it.4 “Our ultra low-‐cost structure is the foundation of our competitive

advantage,” said CFO Ted Christy in February.5 Industry analyst Seth Kaplan of Airline

Weekly in Fort Lauderdale agreed that “Spirit made a good choice in Baldanza's

replacement. Sometimes one CEO is the right person to grow a company to a certain point,

and then someone else is the right person for the next phase.”6

1 http://commons.erau.edu/cgi/viewcontent.cgi?article=1602&context=jaaer 2 http://www.seatmaestro.com/airlines-‐seating-‐maps/spirit-‐airlines/history/ 3 http://commons.erau.edu/cgi/viewcontent.cgi?article=1602&context=jaaer 4 http://atwonline.com/blog/bob-‐fornaro-‐s-‐plan-‐spirit-‐airlines 5 Ibid 6 http://www.sun-‐sentinel.com/business/tourism/fl-‐spirit-‐airlines-‐new-‐ceo-‐20160105-‐story.html

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2.1.1 Pricing Philosophy

Spirit Airlines’ pricing philosophy follows the belief that passengers should only pay

for the services they use and should not subsidize the services used by other passengers.7

Spirit accordingly sells tickets at low, unbundled base fares that remove components

traditionally included in the price of a flight.8 These “bare-‐bones” fares only cover the price

of the seats themselves and allow each passenger to bring on one small carry-‐on. All other

services – checking one’s bags, getting a can of soda, or even getting one’s boarding pass

printed at the gate – are provided at additional fees.9 By allowing customers to save by

paying only for the options they choose, the company claims to bring in a level of

transparency unlike many other competitors.10 Former CEO Baldanza describes Spirit’s

characterization as so: "We're selling low prices, and compete for customers on the basis of

price and price alone. In the retail world, we would be the dollar store."11

Spirit’s unconventional pricing model has come at the cost of its public image, with

the airline consistently ranked among the ten most hated companies in the United States

each year.12 Consumer dissatisfaction ranges from outrage over the airline’s hefty add-‐on

fees, no-‐exceptions policy, and crammed seating, to disgust over the company’s bizarre

advertising regime. Spirit’s management has been largely unapologetic about these issues,

claiming that these characteristics are simply reflective of the low fares passengers pay.13

Former CEO Baldanza has dismissed the majority of complaints as “irrelevant” and cited a

particular Yelp customer’s review as his reason why: "I travel on Spirit all the time. I know

they suck! But, for a cheap ticket, I will endure anything".14

7 http://marketrealist.com/2015/11/understanding-‐spirit-‐airlines-‐low-‐cost-‐business-‐model/ 8 http://www.reuters.com/finance/stocks/companyProfile?symbol=SAVE.O 9 http://www.reuters.com/finance/stocks/companyProfile?symbol=SAVE.O 10 http://marketrealist.com/2015/11/understanding-‐spirit-‐airlines-‐low-‐cost-‐business-‐model/ 11 http://articles.sun-‐sentinel.com/2013-‐03-‐24/business/fl-‐spirit-‐airlines-‐ceo-‐q-‐and-‐a-‐ 20130321_1_spirit-‐ ceo-‐ben-‐baldanza-‐low-‐cost-‐carrier-‐spirit-‐airlines 12 http://finance.yahoo.com/news/america-‐most-‐hated-‐companies-‐145925561.html 13 http://www.cnbc.com/2016/02/18/spirit-‐airlines-‐triggered-‐the-‐most-‐complaints.html 14 http://abcnews.go.com/Travel/spirit-‐airlines-‐crazy-‐airline-‐taking-‐world/story?id=16921444

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2.1.2 Non-‐ticket Revenue

Unbundled pricing is just one part of Spirit’s multifaceted ancillary revenue strategy.

Spirit is the world’s leader in airline non-‐ticket revenue production with approximately 40%

of revenue being derived from non-‐ticket sources.15 This non-‐ticket revenue comes from

the following additional travel-‐related options: (a) $9 Fare Club, (b) hotels and rental cars,

(c) GDS exchange, (d) Big Front Seat, and (e) travel insurance, and Other: (a) on-‐board

advertising, (b) online advertising, and (c) a co-‐branded credit card.16 Spirit Airlines’

exceptional ability to manage costs through techniques such as high craft utilization, a

high-‐seat-‐density configuration, and efficient flight scheduling also help the company to get

more revenue out of each aircraft than any other airline.17

2.1.3 Advertising Campaign

Spirit aggressively promotes its low fares and unbundled pricing with unapologetic

and often bizarre advertisements. These include the infamous M.I.L.F. (Many Islands Low

Fares) promotions using the slogan “hotter and cheaper than ever”, as well as a TV

commercial that features a model undressing herself to promote the “Bare Fare”.18 The

carrier has even become known for launching provocative advertisements that blatantly

reference controversial events, such as the BP oil spill in 2010 (“Check out the oil on our

b*ches”) and the celebrity naked photos scandal in 2014 (“Our Bare Fare was hacked!”).19

While the airline’s tasteless and irreverent marketing techniques have drawn formal

complaints from customers, employees, and even groups like the Association of Flight

Attendants, Spirit maintains the belief that consumers ultimately care only about their

wallets. Former CEO Baldanza once defended the advertisements by saying: “The only

thing that’s obscene is the fares that most of our competitors charge.”20

15 http://docs.lib.purdue.edu/cgi/viewcontent.cgi?article=1018&context=atgrads 16 http://docs.lib.purdue.edu/cgi/viewcontent.cgi?article=1018&context=atgrads 17 http://marketrealist.com/2015/11/understanding-‐spirit-‐airlines-‐low-‐cost-‐business-‐model/ 18 http://viewfromthewing.boardingarea.com/2014/09/04/spirit-‐airlines-‐promoting-‐naked-‐photos/ 19 http://www.npr.org/2013/09/03/218625844/spirit-‐airlines-‐sees-‐business-‐take-‐off-‐with-‐raunchy-‐ads 20 http://www.forbes.com/sites/grantmartin/2014/07/09/spirit-‐airlines-‐tries-‐to-‐improve-‐image-‐by-‐ giving-‐away-‐free-‐miles/#41fae1cd1c52

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2.2 Industry Analysis and Competitive Environment

2.2.1 Industry Overview

The U.S. airline and aviation industry comprises a significant portion of the national

economy, contributing over one million domestic jobs and five cents of every dollar of U.S.

gross domestic product (GDP).21 The market recorded an all-‐time high of $18.92 billion in

net income in 2015, which saw growth of over 122 percent from 2014. The preceding year

had recorded $8.5 billion in net income, with 71 percent of revenues generated through

inland (domestic) flights.22 After a rapid decline in 2008 associated with the stock market

crash, the amount of passengers carried by airlines steadily increased, reaching an all-‐time

high of 696 million passengers in 2015.23

Figure I: Domestic market share of leading U.S. airlines between February 2015 and January 201624

Source: Bureau of Transportation Statistics

21 http://airlines.org/industry/#economic 22 Based on own calculations -‐ See Appendix 1 23 Based on own calculations -‐ See Appendix 2 24 Market share based on Revenue Passenger Miles; February 2015 – January 2016

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The four biggest airlines – Southwest, Delta, American, and United – currently have

a total market share of 63.6 percent based on operating revenue and provide 80 percent of

total air passenger traffic. This industrial oligarchy emerged from the consolidation of ten

major airlines into four dominant mega-‐carriers due to a series of bankruptcies and

mergers over the past 12 years.25 Acquisitions have continued into the present, with the

most recent example being Alaska Air Group’s share purchase of Virgin America for $2.6

billion in early April of 2016.26 The deal allowed Alaska Airlines, owned by Alaska Air Group

along with its sister carrier Horizon Air, to leapfrog JetBlue and become the fifth-‐largest

U.S. carrier in terms of traffic.27 While these consolidations have hit consumers with

increased ticket prices, the airline industry as a whole has consistently achieved net profit

margins above 15 percent in the last decade. The decline of energy (especially oil) prices

has aided this development, as well as improvements in matching capacity to consumer

demand.28

Market entry barriers are considered at this time to be prohibitively high, as the

industry is capital-‐intensive and involves both enormous fixed and variable costs. Aircraft

are expensive to acquire and maintain, while airlines spend an average of nearly 35 percent

of their revenue-‐per-‐plane on fuel.29 Price-‐matching between carriers has also greatly

affected the industry, with many larger airlines willing to suffer financially in order to gain a

greater market share on their competitors.30 The increased prevalence of price-‐matching

emerged as a direct response to the rising status of ultra low-‐cost carriers. With its ability

to offer the lowest fares threatened by bigger airlines that operate at far greater volumes,

Spirit suffered a dramatic reduction in revenue growth in 2015. The resulting plunge in the

company’s share price (shares went from $74 in January to $40 at year-‐end) spelled the

end of Ben Baldanza’s tenure as CEO.31

25 http://money.cnn.com/infographic/news/companies/airline-‐merger/ 26 https://www.virginamerica.com/cms/news/virgin-‐america-‐merger-‐with-‐alaska-‐airlines 27 http://www.fool.com/investing/general/2016/04/11/why-‐alaska-‐air-‐bought-‐virgin-‐america.aspx 28 Oliver Wyman -‐ Airline Economic Analysis S 2015-‐16 29 http://www.wsj.com/articles/SB10001424052702303296604577450581396602106 30 S&P 500 Capital IQ Spirit Airlines 31 http://www.fool.com/investing/general/2015/12/22/1-‐piece-‐of-‐great-‐news-‐for-‐spirit-‐airlines-‐ incorpor.aspx

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2.2.2 Opposing Business Models

The U.S. domestic airline industry is a competitive and volatile environment with a

high sensitivity to outside elements. Factors that influence the performance of carriers

include airport capacities, route structures, governmental regulations, technological

deployment, aircraft inventory management, weather, urban economic development, and

consumer spending on airline transport services.32 The industry is currently split into two

tiers: the legacy carriers and low-‐cost carriers. Their opposing business models differ not

only in terms of cost structure, but other components such as the services they offer to

customers (an unbundled fare with an $8 bag of chips as opposed to a traditional ticket

including a “free” can of soda) and their route network configurations (determining which

and how many destinations they service).33

The legacy carriers comprise of American, Delta, and United Airlines. These carriers

employ a product-‐differentiation approach to achieve a competitive advantage by

providing to their customers greater benefits and comfort in their flying experience.34

Legacy carriers are also able to maximize their degree of connectivity through a complex

“hub-‐and-‐spoke” network model. This allows them to consolidate their passengers at a hub

airport and then fly them to their final destinations in smaller aircraft. As a result, legacy

carriers are able to increase load factors and decrease fares, while also flying to more

destinations.35 Disadvantages include higher operating costs required to maintain the

complex transport infrastructure, longer travel durations, and flight delays due to travelers

having to transit through the hub.36

32 http://www.investopedia.com/features/industryhandbook/airline.asp 33 http://upcommons.upc.edu/bitstream/handle/2099/16292/1191-‐6795-‐2-‐PB.pdf 34 http://scholarworks.wmich.edu/cgi/viewcontent.cgi?article=3635&context=honors_theses 35 The Low Cost Carrier Revolution Continues: Evidence From The US Airline Industry, Bogdan Daraban, Shenandoah University, USA 36 http://www.investopedia.com/articles/investing/022916/economic-‐analysis-‐lowcost-‐airline-‐industry-‐ luvdal.asp

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Low-‐cost carriers (LCCs) include Southwest and JetBlue, as well as the ultra low-‐cost

carriers (ULCCs) Spirit, Frontier, and Allegiant Air. These airlines appeal to price-‐sensitive

travelers by applying a discount-‐leadership approach to the market. British transport policy

expert Kenneth J. Button describes describes the low-‐cost model as being designed to

“attract traffic from competitors in the short term, while generating new traffic to cover

their immediate costs, with the hope of forcing traditional carriers from the market”.37 The

utilization of a “point-‐to-‐point” network model connects each origin and destination via

non-‐stop flights. By eliminating intermediate stops, LCCs achieve substantial cost savings in

comparison to “hub-‐and-‐spoke” airlines.38 The savings come at the disadvantage of limited

destinations, since there are only a finite number of economically reasonable city-‐to-‐city

flight routes.

To make up for revenue lost in discounted ticket prices, LCCs (and especially ULCCs

like Spirit) catch up to their legacy carrier rivals through non-‐ticket revenue. This income is

generated by charging customers for any extras services beyond being guaranteed a seat

on the plane. While all LCCs and ULCCs have unique pricing models, common services that

come at an extra charge include priority boarding, extra baggage, and the offering of food

and beverages. Despite the negative publicity and poor customer feedback that typically

accompany the “no-‐frills” business model, LCCs have succeeded in establishing a profitable

market niche by carving out shares from the large legacy carriers.39

37 Button, K. (2014). Low-‐cost airlines: A failed business model? Transportation Journal, 51(2), 197–219. http://doi.org/10.1353/tnp.2012.0017 38 http://www.investopedia.com/articles/investing/022916/economic-‐analysis-‐lowcost-‐airline-‐industry-‐ luvdal.asp 39 http://www.lek.com/sites/default/files/Volume_VI_Issue_2.pdf, http://centreforaviation.com/analysis/us-‐major-‐airlines-‐recognise-‐the-‐ulcc-‐threat-‐marketplace-‐ dynamics-‐will-‐change-‐but-‐beware-‐cost-‐creep-‐250994

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2.3 Economic Climate and Market Outlook

2.3.1 Global Economy

Although Spirit Airlines still has limited international operations, global economic

events play a role in future expectations. China’s sluggish economy and financial instability

have threatened a global economic slowdown.40 Commodity-‐rich Brazil, a massive

producer of raw materials needed for industry, has seen a sharp decline in the value of its

exports in the last two years.41 The European Union is struggling with both a massive

migrant crisis and concerns over sovereign debts of member states, while Russia has been

steeped in a recession since 2008.42

A heated rivalry between China and the United States, with the largest and second

largest economies measured by purchasing power parity (PPP) in the world, respectively,

has been a major fixture in the global economy.43 Political posturing between the two

nations threatens to have long term effects on business interests around the world.

However, global GDP is still expected to grow at 2.5 percent in 2016, while the U.S.

economy continues to experience steady growth despite a downturn in the stock market at

the beginning of the year.44

2.3.2 Latin-‐American Economy

Spirit currently offers flights to several destinations in the Caribbean and Central

America, as well as in Peru and Colombia.45 Therefore, economic conditions in that region

do have an impact on the airline’s bottom line. Approximately 10 percent of the carrier’s

flight revenue is generated by flights to and from Latin America.46

40 http://www.bloombergview.com/articles/2016-‐02-‐23/two-‐wrong-‐ways-‐to-‐think-‐about-‐china-‐s-‐ slowdown 41 http://www.ft.com/intl/cms/s/0/699def92-‐dbb3-‐11e5-‐9ba8-‐3abc1e7247e4.html#axzz47HmoYg1m 42 https://www.conference-‐board.org/data/globaloutlook/ 43 http://www.theatlantic.com/international/archive/2016/01/global-‐economy-‐2016/422475/ 44 https://www.conference-‐board.org/data/globaloutlook/ 45 https://www.spirit.com/routemaps.aspx 46 http://www.transtats.bts.gov/Data_Elements_Financial.aspx?Data=7

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Economic growth in Latin America has slowed in recent years amid the global

economic downturn.47 Mexico in particular has seen its manufacturing sector and oil

exports decline sharply.48 However, the country’s unemployment rate stands at 3.7 percent

and shows better economic health than most other Latin American nations. Another

success story in the region is Colombia, which has experienced a historic economic boom

since the early 2000s.49 The nation’s growth has been fueled by a burgeoning middle class

accompanied by its strength in petroleum and manufacturing exports.50 As of now, Spirit

serves four different destinations in Colombia, more than in any other country.51

2.3.3 U.S. Economy

The activities and monetary policies of the Federal Reserve have a significant impact

on the health of the U.S. economy. In early 2016, the Fed indicated through its “dot plot”

of future expectations, that four interest rate hikes were planned for this year. However,

the Federal Reserve’s Open Market Committee (FOMC) declared on April 27 that U.S.

interest rates (currently at 0.5 percent) would remain unchanged at least until June.52 The

Fed has stated its intent to eventually raise the rates in the near future, citing the

strengthening U.S. economy as justification.53

At 5 percent, the U.S. unemployment rate is at its lowest point since 2008.54

However, participation in the labor force is remarkably low, with only 62.7 percent of

Americans working or actively seeking employment.55 Due to the quality of jobs available,

as well as the diversity in the labor force, neither of these statistics accurately reflect the

prosperity of the economy.56

47 http://money.cnn.com/2016/04/29/news/economy/mexico-‐brazil-‐latin-‐america-‐economy-‐ gdp/index.html 48 Ibid 49 http://www.heritage.org/index/country/colombia 50 https://www.eia.gov/dnav/pet/PET_MOVE_EXPC_DC_NUS-‐NCO_MBBL_M.htm 51 https://www.spirit.com/routemaps.aspx 52 http://www.theguardian.com/business/2016/apr/27/janet-‐yellen-‐federal-‐reserve-‐interest-‐rate-‐hike 53 http://www.theguardian.com/business/2016/apr/27/janet-‐yellen-‐federal-‐reserve-‐interest-‐rate-‐hike 54 http://data.bls.gov/timeseries/LNS14000000 55 http://money.cnn.com/2016/02/06/news/economy/obama-‐us-‐jobs/ 56 Ibid

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Corporate spending in the United States has declined heading into the second

quarter of 2016. Deutsche Bank analyst Michael Linenberg states: "We have observed a

slowdown in U.S. corporate profits, which is a concern given that they are a leading

indicator of economic activity, and therefore, could lead to reduced demand for corporate

travel."57 Nonetheless, he believes that consumer spending and the demand for leisure

travel remain at a healthy level.58 As an ultra low-‐cost carrier that exclusively targets

consumers looking for cheap leisure travel, Spirit Airlines has not suffered financially from

the decline in corporate travel.59 The airline therefore currently has an edge over its larger

counterparts that are invested in business traveling.

2.3.4 Oil Market

A large factor influencing volatility in the airline industry comes from the cost to

operate per seat (CASM), because this measurement reflects changing fuel costs. For Spirit,

fuel efficient technology and strategic management have led to the airline having one of

the best CASM ratios in the market.60 Low oil prices in 2015 and 2016 have also benefitted

the carrier, which does not hedge its oil prices (essentially protecting themselves against

major price increases). 61 Bigger airlines that do this common industry practice have been

unable to benefit from the lowest oil prices since 2002.62 Because airlines sell tickets

months in advance, daily changes in oil prices make it difficult for airlines to keep their

revenue margins consistent. Since prices began to drastically drop in 2014, Spirit has been

able to secure industry-‐high profit margins of nearly 20 percent.63

57 https://www.etrade.wallst.com/v1/stocks/news/search_results.asp?newsType=headlines 58 https://www.etrade.wallst.com/v1/stocks/news/search_results.asp?newsType=headlines 59 Ibid 60 http://airwaysnews.com/blog/2015/02/16/analysis-‐spirit-‐airlines-‐bends-‐the-‐cost-‐curve/ 61 http://www.fool.com/investing/general/2015/12/08/3-‐airlines-‐that-‐could-‐soar-‐with-‐lower-‐oil-‐ prices.aspx 62 http://www.macrotrends.net/1369/crude-‐oil-‐price-‐history-‐chart 63 http://www.fool.com/investing/general/2015/12/08/3-‐airlines-‐that-‐could-‐soar-‐with-‐lower-‐oil-‐ prices.aspx

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Oil prices are creeping upward again, and stand at around $50 per barrel at the

time of writing.64 However, predicting the oil market is both difficult and contentious.

Forbes columnist Bill Gilmer explains: “The process took me through a number of current

oil price forecasts from banks, investment houses, and consultants, and the differences in

opinion are wide and discouraging.”65 The oligopoly of oil-‐producing nations known as

Organization of the Petroleum Exporting Countries (OPEC) heavily influences prices by

controlling the level of output. Despite oversaturation of the market driving down prices

since 2014, OPEC has refused to cut production thus far.66

The most historically accurate indicator of oil prices is the oil futures market, which

is becoming more widely used but is still susceptible to volatility.67 Based on the current

state of the market, Spirit may continue to benefit from avoiding oil hedging at least in the

short term.

64 http://www.oil-‐price.net/ 65 http://www.forbes.com/sites/uhenergy/2016/01/19/why-‐are-‐oil-‐prices-‐so-‐hard-‐to-‐ forecast/#7dd9fcc6563e 66 http://money.cnn.com/2015/06/05/investing/opec-‐decision-‐oil-‐prices/ 67 http://www.forbes.com/sites/uhenergy/2016/01/19/why-‐are-‐oil-‐prices-‐so-‐hard-‐to-‐ forecast/#7dd9fcc6563e

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2.4 Other Factors

2.4.1 Introduction of New Aircraft

In 2013, Spirit ordered seven new Airbus A319s and ninety-‐eight A320s, including

forty-‐five A320neos (new engine option). The airline also opted to replace ten old

A320ceos (current engine option) with thirty aircraft in the larger A321 class. The A320neo,

which is fitted with a new style of winglets (named “sharklets” by Airbus) for better

aerodynamics, burns 16 percent less fuel than its predecessor (A320ceo) and costs nearly

15 percent less to maintain annually.68 The plane also seats 185 passengers in a single-‐class

layout while offering substantially increased storage inside the cabin.69 The A321 is the

largest plane in the fleet, seating 220 passengers. Spirit offers fewer seats with extra

legroom on this model, allowing for a tighter seating map.70

The newest additions to Spirit’s fleet have been used to accommodate the airline’s

increasing traffic fueled by added destinations in the Caribbean and Latin America.71 Traffic

(measured in revenue passenger miles) increased nearly 30 percent between 2014 and

2015.72 The new aircraft, in particular the A320neos and A321s, carry more passengers at a

lower operating cost, while also offering an improved travel experience with greater

amenities. This has allowed the airline to lower its fares at times when most of its

competitors have raised prices. Airbus Chief Operating Officer John Leahy commented the

following after Spirit’s order for brand new planes in the A320 class: “Spirit’s priority has

always been to save its passengers money, while transporting them as comfortably as

possible. That is exactly what the A320 allows the airline to achieve. These are eco-‐efficient

machines with wonderful comfort.”73

68 http://aviationnews.eu/news/2011/02/tam-‐becomes-‐first-‐a320neo-‐customer-‐in-‐latin-‐america/ 69 http://www.airbus.com/presscentre/pressreleases/press-‐release-‐detail/detail/spirit-‐airlines-‐to-‐grow-‐ fleet-‐with-‐largest-‐airbus-‐single-‐aisle-‐model/ 70 http://traveltips.usatoday.com/type-‐planes-‐spirit-‐airlines-‐use-‐62835.html 71 https://www.flightglobal.com/news/articles/in-‐focus-‐how-‐to-‐power-‐a320neo-‐is-‐tough-‐choice-‐for-‐ airlines-‐383733/ 72 http://ir.spirit.com/releasedetail.cfm?ReleaseID=916968 73 Ibid

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2.4.2 Government Regulation

Since the Airline Deregulation Act of 1978, the U.S. Department of Transportation

no longer controls ticket prices or services.74 The deregulation of the industry led to a

boom in air traffic, as flights became affordable for more Americans during the 1980s. The

rise of competitive pricing also meant that airlines could no longer survive without

innovative management and robust cost controls.75 While larger carriers have since

consolidated or gone bankrupt, low-‐cost carriers have emerged as big winners by taking

advantage of the influx of new lower-‐income flyers. In 2015, Southwest Airlines was (and

continues to be) the largest U.S. carrier in terms of domestic passenger traffic – an

impossibility without a deregulated airline industry.76

Government regulation of the airline industry today is mostly limited to ensuring

flight and passenger safety. However, despite having the freedom to choose their own

fares and services, airlines are subject to numerous special fees and taxes in addition to

income and payroll taxes.77 These expenses are incurred in each and every jurisdiction,

either domestic or abroad, that an airline operates in. The stated purposes of taxes paid by

airlines typically involve national security, environmental protection, agriculture inspection,

infrastructure enhancement, airport operation and maintenance, as well as agency

financing (U.S. Department of Transportation subsidiaries associated with air travel include

the Federal Aviation Administration, the Transportation Security Administration, and the

Immigration and Customs Enforcement).78 Among the most common ticket taxes are the

Domestic Passenger Ticket Tax (7.5 percent of the ticket price, collected for the FAA), the

September 11th Security Fee (collected for the TSA), and the Passenger Facility Charge

(collected for airports).79

74 http://www.investopedia.com/ask/answers/041315/how-‐does-‐government-‐regulation-‐impact-‐ aerospace-‐sector.asp 75 http://aviationweek.com/blog/law-‐changed-‐airline-‐industry-‐beyond-‐recognition-‐1978 76 Ibid 77 http://airlines.org/data/government-‐imposed-‐taxes-‐on-‐air-‐transportation/ 78 Ibid 79 http://www.usatoday.com/story/travel/columnist/mcgee/2015/07/01/airline-‐fees-‐taxes/29518427/

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New fees and taxes imposed by the government directly raise ticket prices, as

airlines typically pass the full cost onto their passengers. For this reason, airlines are held to

the “full fare” rule, making it mandatory for them advertise their fares with government

fees and taxes included.80 The FAA also protects consumers by requiring airlines to provide

basic services to passengers in case of lengthy tarmac delays, as well as offer compensation

to flyers who are bumped from their flights or whose bags are lost by the carrier.81

2.4.3 Environmental Regulation

The global aviation industry produces 12 percent of carbon dioxide emissions from

all transportation sources.82 While this number pales in comparison to the 74 percent

contributed from road transport, regulatory agencies like the EPA have recently

accelerated efforts to curb aviation emissions. Over the past five years, the International

Civil Aviation Organization (ICAO), a U.N. agency, has been working to develop global

aircraft emissions standards for the first time.83 The standards largely focus on developing

better technology for aviation while phasing out impaired and inadequate equipment.84

Given concerns over the economic ramifications of new regulations imposed on the

industry, EPA officials claim they are not likely to adopt the proposed ICAO standards until

2017. This still gives airlines limited time to position themselves favorably under stricter

rules, especially large carriers like Delta that have aging fleets.85 With an average fleet life

of only 5.3 years, Spirit Airlines is at the forefront of modernization stemming from the

new environmental initiatives. According to environmental aviation watchdog group Green

80 http://ideas.time.com/2013/12/16/spirit-‐airlines-‐president-‐the-‐government-‐is-‐hiding-‐taxes-‐in-‐your-‐ airfares/ 81 https://www.transportation.gov/briefing-‐room/us-‐department-‐transportation-‐expands-‐airline-‐ passenger-‐protections 82 http://www.atag.org/facts-‐and-‐figures.html 83 http://www.icao.int/Newsroom/Pages/New-‐ICAO-‐Aircraft-‐CO2-‐Standard-‐One-‐Step-‐Closer-‐To-‐Final-‐ Adoption.aspx 84 http://www.icao.int/Newsroom/Pages/New-‐ICAO-‐Aircraft-‐CO2-‐Standard-‐One-‐Step-‐Closer-‐To-‐Final-‐ Adoption.aspx 85 http://www.airfleets.net/ageflotte/Delta%20Air%20Lines.htm

16

Air, Spirit has “chosen the efficiency route by deploying new, efficient fleets and

technologies as well as more efficient operational practices.”86

Southwest Airlines, despite an older average fleet life of 12.4 years, has also begun

to prepare for new regulations.87 The carrier directly acknowledges the future liability of

compliance costs in its 10-‐k: “On July 1, 2015, the Environmental Protection issued a

proposed endangerment finding for greenhouse gas emissions from aircraft...published an

advance notice of proposed rulemaking summarizing international efforts to regulate

aviation emissions. Regardless of the method of regulation, policy changes with regards to

climate change are possible, which could significantly increase operating costs in the airline

industry and, as a result, adversely affect operations.88 While inconsequential at present,

environmental regulation will become increasingly relevant for airlines in the future.

2.4.4 Passenger Usage Fee Controversy

Spirit has been subject to numerous legal troubles as a result of its unforgiving

pricing model. A controversial lawsuit in 2014 alleged that the carrier “concealed the

existence and purpose of the Passenger Usage Fee and that the airline used the mails and

wire to defraud consumers into thinking they owed less money for their tickets.”89

Although the airline claimed that the fee was issued to provide website and phone service

to customers, in reality it “offered no service or advantage to the flyer”, and served

primarily to be another hidden source of income disguised as a government-‐required ticket

fee.90 Despite being habitually cited and fined by the Department of Transportation (DOT)

for deceptive advertising, Spirit has continued to charge its passengers the Passenger

Usage Fee to this day.91 Since 2008, the scheme has profited the airline to the tune of $40

million, far outweighing the periodic fines paid to the DOT.92

86 http://www.greenaironline.com/news.php?viewStory=1853 87 http://www.airfleets.net/ageflotte/Southwest%20Airlines.htm 88 http://www.sec.gov/Archives/edgar/data/92380/000009238016000175/luv-‐12312015x10k.htm 89 http://www.condonlaw.com/2014/10/michael-‐holland-‐2/ 90 http://www.classaction.org/spirit-‐airlines 91 http://www.huffingtonpost.com/2012/08/07/spirit-‐airlines-‐slapped-‐with-‐lawsuit_n_1752955.html 92 Ibid

17

3.0 Statement of Cash Flows

The statement of cash flows allows analysts and investors to understand how a

company funds its operations and where it obtains cash. Unlike the income statement and

balance sheet, this financial statement measures changes in cash flows during the year

while discounting accrued figures or sales made on credit. For this reason, the change in a

company’s cash account rarely equals its net income. The following section highlights

important components of Spirit’s cash flows as compared to those of Southwest Airlines.

3.1 Cash Flow from Operations (CFO)

Cash flow from operations reflects the cash that is used and received by the

revenue-‐generating activities in a business. This portion of the statement of cash flows

serves as an effective barometer of a company’s efficiency in managing its receivables,

inventory, and short-‐term cash obligations. Investors want to see positive cash flow from

normal and recurring operations in a business – a negative CFO can indicate severe liquidity

and debt problems. For the most comprehensive analysis, it is always important for

investors to cross-‐reference accounts in the statement of cash flows with corresponding

figures in the income statement.

3.1.1 Growth in CFO

93 http://www.marketwatch.com/investing/Stock/LUV/financials/cash-‐flow

Growth rates in CFO from 2011-‐201593

2014-‐15 2013-‐14 2012-‐13 2011-‐12

Spirit 81.6% 33.3% 71.9% 33.6%

Southwest 11.7% 16.9% 20.4% 48.2%

18

Spirit has shown tremendous growth in its CFO since 2011, roughly corresponding

to increasing net income figures in the same time period. The overall growth can be largely

explained by the airline’s expansionary activity in the last five years. Spirit has expanded its

operations to new domestic and international destinations while also offering more flights

between major cities (the airline added 24 non-‐stop routes in 2014 alone).94 The expanding

network has given the carrier a significant boost in sales. As mentioned earlier in this

report, Spirit has also benefitted massively from the steep decline in oil prices since early

2014. Cheaper fuel’s positive effect on the carrier’s operating costs is reflected by the 81.6

percent growth in CFO between 2014 and 2015.

3.1.2 Cash Flow Margin

The cash flow margin expresses how much a company generates from its core

operations per dollar of sales. A high margin can indicate a company’s strong ability to

convert sales into cash, and may also suggest high earnings quality. The operating cash

flow can be found on the company's statement of cash flows, and the revenue can be

found on the income statement.

𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑚𝑎𝑟𝑔𝑖𝑛 =𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠

Spirit’s cash flow margin grew significantly in 2015. This is explained by both the

airline’s extensive expansion (driving up both cash flow from operating activities and net

sales) as well as lower fuel costs reducing the airline’s operating expenses. Due to its

practice of oil price hedging, Southwest did not experience a similar jump in cash flow

94 http://www.sun-‐sentinel.com/business/tourism/fl-‐spirit-‐airlines-‐expansion-‐update-‐20150313-‐story.html 95 http://csimarket.com/stocks/at_glance.php

Cash Flow Margin 2015 2014 2013 2012 2011

Spirit 22.1% 13.5% 11.8% 8.8% 16.0% Southwest 16.3% 15.6% 14.0% 12.1% 8.9%

Industry Average 10.3%95

19

margin in 2015. However, both airlines’ margins exceed the industry average,

demonstrating strong earnings quality and relative efficiency in converting sales into cash.

3.1.3 Fixed Charge Coverage Ratio

𝐹𝑖𝑥𝑒𝑑 𝑐ℎ𝑎𝑟𝑔𝑒 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜

=𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥𝑒𝑠 + 𝐿𝑒𝑎𝑠𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝐿𝑒𝑎𝑠𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

Fixed Charge Coverage Ratio

2015 2014 2013

Spirit 3.2 times 2.8 times 2.7 times

Southwest 10.6 times 4.7 times 3.1 times

Spirit’s expansion in 2014 and 2015 saw the airline invest in hundreds of new aircraft,

many of them leased. For this reason, the airline has considerable lease expenses each year.

The fixed charge coverage indicates a company’s ability to cover interest and lease expenses.

Both Spirit and Southwest show strong ratios, with the discrepancy between them widening

in 2015 due to the former’s increase in debt and lease obligations. Lower fuel prices and

higher efficiency have resulted in greater earnings before interest and taxes.

20

3.2 Cash Flow from Investing Activities

Cash flow from investing activities reports the change in cash that results from

investment gains and losses as well as from any sales or purchases of fixed assets. This

section of the statement of cash flows is important for capital-‐intensive firms like airlines.

Spirit’s Investing Activities 2015 2014 2013

Pre-‐delivery deposits for flight equipment,

net

(142,323) (115,802) (70,288)

Capitalized interest (10,159) -‐ -‐ Purchase of property

and equipment (548,800) (186,569) (19,812)

Net cash used in investing activities

(701,282) (302,371) (90,100)

3.2.1 Capital Expenditures

Purchase of Property and Equipment ( % of outflows)

2015 2014 2013 2012 2011

Spirit 64% 59% 22% 37% 16%

Southwest 36% 26% 26% 28% 13.88%

Spirit’s expansionary activities in 2014 and 2015 are evident from the airline’s

significant increase in capital expenditures. This can be seen in the increase in property and

equipment in the balance sheet, as well as the large cash outflow in the airline’s investing

activities for purchase of property and equipment. Spirit’s investing outflow from purchasing

new aircraft jumped from 22 percent in 2013 to 59 percent in 2014, rising further to 64

percent in 2015. In contrast, Southwest only shows a minor increase in cash outflow for

property and equipment, as the airline replaces older aircraft in its fleet (which is significantly

older than Spirit’s).

21

3.3 Cash Flow from Financing Activities

Cash flow from financing activities accounts for changes in cash resulting from debt

or equity financing, dividend payments, and repurchasing of existing stock.

Spirit’s cash flow from financing activities has increased significantly since the

airline’s initial public offering (IPO) in 2011, with cash proceeds of $171.0 million. While

2012 and 2013 saw no major change in capital structure, Spirit began to repurchase

common stock and heavily leverage with long-‐term debt between 2014 and 2015. The

massive increase in debt was used to finance the acquisition of new aircraft and the

expansion of the carrier’s route network. Spirit has never paid dividends and does not

intend to ever do so, according to the company’s management.

Southwest demonstrates clearly different behavior with its negative cash flow from

financing activities. In 2015, the company’s board of directors authorized a repurchase of

up to $1.5 billion of common stock in addition to an increase in dividend payments.96 The

carrier’s high amount of long-‐term debt indicates that it is still paying for heavy investment

and expansion in the past. Southwest no longer has to borrow cash, but will be in the

process of repaying long-‐term debt and capital lease obligations for the foreseeable future.

For this reason, Southwest’s cash flow has remained negative for the past five years.

96 http://www.sec.gov/Archives/edgar/data/92380/000009238016000175/luv-‐12312015x10k.htm

Cash Flow From Financing Activities (in millions of dollars)

2015 2014 2013 2012 2011

Spirit 399.15 144.01 8.54 -‐12.82 156.65

Southwest -‐1,024 -‐1,248 -‐851 -‐766 -‐149

22

3.3.1 Repurchase of common stock and dividend policy

In early 2015, Spirit repurchased approximately 1.5 million common shares for

approximately $99 million under an initial share repurchase program. The company

authorized another $100 million share repurchase program in October of 2015. Prior to

these events, Spirit had only repurchased common shares issued by employees having

restricted stock grants. Due to good results in cash flow from operations (82 percent year-‐

to-‐year growth), Spirit was able to buy back its shares without losing money.

Spirit does not currently pay dividends on its common stock and does not plan to in

the foreseeable future. This is unsurprising considering the airline’s expansion strategy of

reinvesting earnings to boost future growth rather than to reward shareholders. The

potential outcome in case of an adverse operating development remains uncertain. The

lack of dividend payments may make the carrier’s stock unattractive to many investors,

possibly limiting Spirit’s ability to finance operations through equity.

Southwest has issued small-‐percentage repurchases of common stock each year. In

2011, the airline repurchased shares for an all time high of $1.2 billion, making up 20.6

percent of its total outflows. In November of 2015, Southwest declared its 157th

consecutive quarterly dividend of $180 million, intended to show a long-‐lasting history of

profitability and growth.

Spirit could benefit from stock repurchase programs that would decrease the

amount of outstanding shares on the stock market. By reducing the dilution effect, both

earnings-‐per-‐share and the market price could be impacted favorably.

Repurchase of Common Stock

2015 2014 2013 2012 2011

Spirit 13.1 0.2 0.1 0.1 0.1

Southwest 20.6 16.6 9.4 7.0 3.9

23

3.4 Summary Analysis

Spirit Airlines Cash Inflows 2015

Spirit’s cash flow from operations has significantly grown (CAGR of 28.8 percent)

over the past five years, contributing more than 46 percent of total cash inflows in 2015.

The airline is not only profitable (profit margin of 14.8 percent in the same year), but also

shows strong capability in generating cash from operations. In 2015, Spirit entered long-‐

term debt arrangements providing $536.8 million in cash to cover capital expenditures for

new aircraft. The debt proceeds covered the investment amount by over 97 percent,

accounting for 52 percent of total inflows. While the company has increased its debt load

significantly, there are currently no clear indications that it may struggle to cover its short-‐

term and long-‐term obligations.

46.10%

52.32%

1.58%

Operations (CFFO)

Issuance of long-‐term debt

Others

64.18%3.08%

13.13%

16.64%2.96% Capital expenditures

Payments on debt and capital lease obligationsRepurchase of common stockPre-‐delivery deposits for flight equipment

24

4.0 Income Statement

The income statement measures the operating performance of a business. It

presents a company’s revenues, expenses, net income, and earnings per share for the

stated period. The following section analyzes Spirit’s income statement in comparison to

Southwest’s over the past five years.

4.1 Net Sales

Benefitting from its unconventional pricing model, Spirit Airlines leads the industry

in revenue from ancillary (non-‐ticket) revenue. The ULCC generates 45 percent of its sales

revenue from non-‐ticket sales and the remaining 55 percent from traditional passenger

sales. Competitor Southwest Airlines uses a traditional pricing model and therefore relies

heavily on passenger sales making up 92 percent of its revenue. Spirit’s non-‐ticket sales

remained constant at 40 percent every year from 2012 to 2014. A horizontal analysis shows

that, in 2015, a 23 percent increase in non-‐ticket sales boosted the margin of non-‐ticket

sales revenue to 45 percent of total revenue. The growth in Spirit’s ancillary revenue

reflects the unprecedented success of the company’s unbundling strategy. The airline’s

policy of charging extra for services has ensured that its non-‐ticket revenue continues to

grow while still attracting price-‐sensitive travelers with low base fares.97

97 http://marketrealist.com/2015/11/spirit-‐airlines-‐assessing-‐benefits-‐unbundled-‐services/

25

4.1.1 Growth in Net Sales

Net Sales Growth

2015 % 2014 % 2013 % 2012 % 2011 %

Spirit 2,141,463 10.9% 1,931,580 16.8% 1,654,385 25.5% 1,318,388 23.1% 1,071,186 N/A

Southwest 19,820,000 6.5% 18,605,000 5.1% 17,699,000 3.6% 17,088,000 9.1% 15,658,000 N/A

Spirit’s net sales in dollars have grown steadily over the past five years. However,

sales growth has slowed down since its peak of 25.5 percent in 2013. However, Spirit’s net

sales growth rate of 10.9 percent in 2015 is well above Southwest’s 6.5 percent. The

consecutive decline in net sales growth in 2014 and 2015 may concern some investors and

shareholders. Spirit is younger than most of its competitors, meaning the airline had more

room to grow within its target market. An initial public offering in 2011 allowed the

company to raise significant cash for marketing and fleet expansion, resulting in the high

growth until 2015. Unfortunately for Spirit, its successful pricing strategy is being

increasingly mimicked by other airlines that are competing for frugal flyers. Price-‐matching

by competitors has eaten into the ULCC’s market share, slowing the growth rate of sales.

Southwest’s CEO Gary Kelley believes that Spirit will struggle to keep a competitive edge in

the future despite its lower cost structure.98

98 https://skift.com/2015/12/11/southwest-‐ceo-‐on-‐how-‐a-‐maturing-‐airline-‐can-‐keep-‐its-‐competitive-‐mojo/

23.1% 25.5%

16.8%10.9%

9.1%

3.6% 5.1%6.5%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

2011-‐2012 2012-‐2013 2013-‐2014 2014-‐2015

Net Sale Growth Rate

Spirit Airlines Southwest Airlines

26

4.2 Operating Expenses

Total Operating Expenses

2015 % 2014 % 2013 % 2012 % 2011 % Spirit 1,632,341 76.2% 1,576,317 81.6% 1,372,093 82.9% 1,144,398 86.8% 926,804 86.5%

Southwest 15,704,000 79.2% 16,380,000 88.0% 16,421,000 92.8% 1,646,5000 96.4% 14,965,000 95.6%

In the airline industry, operating expenses can be considered to constitute the cost

of sales. Spirit has managed to increase its profit margins by decreasing operating expenses

each year since 2012. The airline has demonstrated its ability to operate within its

economies of scale by expanding sales revenue while simultaneously lowering its cost

structure. However, Spirit’s edge over Southwest is decreasing regarding its lower

operating expenses. This is due to the airline’s expansion into less profitable flight routes,

and may indicate that it has grown too rapidly.

4.2.1 Labor and Fuel Costs

Labor and fuel costs are the two major operating expenses for airlines. Both Spirit

and Southwest have seen a slight rise in labor expenses over the past five years as a result

of wage increases and new hires. Spirit facilitates a labor-‐intensive strategy that promotes

the employee’s overall efficiency and reduces the department’s redundancy for routine

tasks like trash disposal. This strategy may explain the lower satisfaction among Spirit

employees compared to Southwest employees, according to Glassdoor.99 Companies must

recognize that excessive cost cutting may deteriorate the overall quality of the business.

Salaries, Wages, and Benefits

2015 % 2014 % 2013 % 2012 % 2011 %

Spirit 378,210 17.7% 313,988 16.3% 262,150 15.8% 218,919 16.6% 181,742 17.0%

Southwest 6,383,000 32.2% 5,434,000 29.2% 5,035,000 28.4% 4,749,000 27.8% 4,371,000 27.9%

99 https://www.glassdoor.com/Reviews/Spirit-‐Airlines-‐Reviews-‐E13683.htm

27

Aircraft Fuel Costs

2015 % 2014 % 2013 % 2012 % 2011 % Spirit 461,447 21.5% 612,909 31.7% 551,746 33.4% 471,763 35.8% 388,046 36.2%

Southwest

3,616,000 18.2% 5,293,000 28.4% 5,763,000 32.6% 6,120,000 35.8% 5,644,000 36.0%

Airlines face considerable uncertainty regarding their operating costs due to

frequent fluctuations in the price of oil. Before 2014, Spirit’s fuel costs remained steady at

around 35 percent of total net sales. As oil prices dramatically declined in 2014, certain

airline companies (in particular, airlines that do not substantially participate in oil price

hedging) were able to immediately reap the benefit of lower fuel costs. Spirit reduced its

fuel costs by 24.7 percent from $613 million in 2014 to $461.4 million in 2015, when it

equaled only 21.5 percent of net sales. Southwest participated in oil price hedging, and

consequently will have had to pay $1.8 billion in additional fees by 2018.100 Interestingly,

Southwest’s income statement shows that the airline still benefitted from a 10.2 percent

decrease in fuel costs in 2015 – the exact same as Spirit. Spirit maintains the lowest cost to

operate per seat (CASM) in the market. This is achieved through maximizing the number of

seats in each plane which absorbs the already minimized operating cost.

4.2.2 Operating Profit Margin

The operating profit margin measures profit generated after subtracting operating

expenses, and is calculated as follows:

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒

𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠

100 http://www.usatoday.com/story/money/cars/2016/01/25/airlines-‐fuel-‐price-‐bets-‐not-‐always-‐paying-‐ off/79288102/

28

Operating Profit Margin

2015 % 2014 % 2013 % 2012 % 2011 %

Spirit 509,122 23.8% 355,263 18.4% 282,292 17.1% 173,990 13.2% 144,382 13.5%

Southwest 4,116,000 20.8% 2,225,000 12.0% 1,278,000 7.2% 623,000 3.6% 693,000 4.4%

American 18.0%

JetBlue 20.0%

Industry 13.0%

To varying degrees, most airlines have benefitted from increased operating profit

margins due to the decline in oil prices. According to the International Air Transport

Association, fuel use has increased industry-‐wide while overall expenditures have

decreased.101 Spirit recorded an operating margin of 23.8 percent in 2015, the highest

among its peers. For the same period, Southwest reported an operating margin of 20.8

percent, followed by JetBlue at 20 percent and American Airlines at 18 percent. The

industry benchmark lagged far behind at 13 percent. A major reason for Spirit’s consistent

growth in operating profit margin over the past five years is its ability to reduce operating

expenses via the strategy of high daily aircraft utilization, high-‐seat-‐density configuration,

and efficient flight scheduling. The airline maintains the lowest cost to operate per seat

(CASM) in the industry, achieved through maximizing the number of seats in each plane

(Spirit has even explored the possibility of stacking seats on top of each other).102

4.2.3 Return on Total Assets

Returned on total assets (ROA) measures firm’s efficiency in managing its total

investment in assets, and is calculated as follows:

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 =𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

101 http://www.iata.org/whatwedo/Documents/economics/IATA-‐Economic-‐Performance-‐of-‐the-‐Industry-‐end-‐year-‐2014-‐report.pdf 102 https://usattravel.wordpress.com/2015/10/06/airbus-‐reveals-‐idea-‐to-‐make-‐airplane-‐seating-‐even-‐worse-‐stack-‐fliers-‐on-‐top-‐of-‐each-‐other/

29

Spirit’s successfully maintained a double digit return on assets (ROA) over the past

five years. Its ROA is also the highest among its peers. Spirit’s ROA ratio in 2015 shows a

little bit of decline compared to previous years ROA ratios. This subtle decline is driven by

Spirit’s investment in more total assets such as more aircrafts and equipment. Spirit’s

balance sheet shows that Flight equipment has increased by a magnitude much higher than

the rate of net income; therefore, this drives down the ROA ratio. Analyst should not be

concerned about this, as investing in PP&E with excess cash generated by CFFO to expand

the company can benefit the company in long term.

16.5%

11.8%

15.0% 14.2%12.5%

1.0%2.3%

3.9%5.8%

10.2%

0.0%

5.0%

10.0%

15.0%

20.0%

2011 2012 2013 2014 2015

Return on Total Asset

Spirit Airlines Southwest Airlines

30

5.0 Balance Sheet

The balance sheet, also known as the statement of financial position, depicts assets

a company’s assets, liabilities, and stockholder’s equity at a particular point in time. Long-‐

term comparative analysis provides a comprehensive insight into the performance of a

firm. This section will evaluate the balance sheets of Spirit Airlines and competitor

Southwest Airlines over the last five years using horizontal, vertical, and ratio analysis. Due

to the size difference between the two airlines, we use the common-‐sized balance sheets

for a more accurate comparison.

5.1 Assets

5.1.1 Cash and Cash Equivalents

Cash and Cash Equivalents Growth

2014 – 2015 2013 – 2014 2012 – 2013 2011 -‐ 2012

Spirit 27% 19.25% 27.31% 21.4%

Southwest 23.48% (5.39%) 21.74% 34.26%

Spirit Airlines has maintained relatively consistent growth in cash and cash

equivalents, albeit a slight decline in growth between 2013 and 2014 due to a $1.4 million

payment towards a $7 million settlement noted in the company’s 10-‐K. The stable growth

rate is especially notable considering the decrease in cash and cash equivalents as a

percentage of total assets throughout the years, a result of heavy investment in capital

equipment.

Southwest Airlines experienced greater volatility, with growth shrinking 5.39

percent between 2013 and 2014. However, Southwest’s cash and cash equivalents only

make up about 7 percent of its total assets, meaning volatility has little impact (in contrast,

Spirit maintain a cash account between 30 to 50 percent of total assets).

31

5.1.2 Flight Equipment

Flight Equipment (% of total assets)

2015 2014 2013 2012 2011

Spirit 32.7% 12.8% 1.1% .3% .6%

Southwest 91.3% 93.7% 87.6% 88% 86%

Spirit’s massive investment in new aircraft in recent years resulted in flight

equipment growing to 32.7 percent of total assets in 2015. The expansionary behavior

explains the company’s decreasing growth in cash and cash equivalents. Spirit’s 10-‐K

discloses its orders of nearly 200 new aircraft in 2014 and 2015 that account for the

immense increase in flight equipment.

However, Spirit’s investment in flight equipment remains considerably smaller than

that of competitor Southwest, which has a considerably larger fleet and route network.

Southwest is not in the expansionary stage like Spirit, and consequently has a stable fixed

assets. Another explanation for the discrepancy is that Spirit leases a considerable portion

of its aircraft – these aircraft are not reflected in the flight equipment account.

5.1.3 Current and Quick Ratios

The current and quick ratios are both indicators of a company’s short-‐term

solvency. Since Spirit does not have inventory, its quick ratio equals its current ratio.

Southwest includes parts and supplies at cost in its inventories. For this reason, the quick

ratio gives a more accurate analysis of each company’s ability to meet its short-‐term

obligations with liquid assets.

𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

32

Quick Ratio

2015 2014 2013 2012 2011

Spirit 2.20 1.97 1.93 1.98 1.95

Southwest 0.50 0.61 0.70 0.81 0.87

Industry Avg 0.38

Both airlines exceed the industry average, but Spirit exhibits a greater ability to

meet its short-‐term obligations. A look at each company’s common-‐sized balance sheet

reveals that Spirit’s current assets total 40.6 percent of total assets, while its current

liabilities only total 18.4 percent. On the other hand, Southwest’s current assets make up

only 18 percent of total assets, with current liabilities totaling 35 percent. Spirit’s high cash

and cash equivalents, as well as its comparatively lower amount of fixed assets, explain the

airline’s considerably better liquidity over its competitor.

5.2 Liabilities

5.2.1 Long-‐term Debt Less Current Maturities

Long-‐term Debt (common size %)

2015 2014 2013 2012 2011

Spirit 23.6% 8.5% 0% 0% 0%

Southwest 3.0% 1.3% 3.3% 1.5% 3.6%

Spirit began to take on long-‐term debt in 2014 and 2015 to fund its purchase of

aircraft and other expansionary activity. The airline’s 10-‐K reveals that eleven new aircraft

were funded with long-‐term debt instruments. Spirit’s major debt financing will test the

company’s ability to generate enough cash through operations. The airline will need to

maintain its strong growth in cash to keep up with debt repayment. Southwest has not

engaged in major investment over the last five years, and consequently maintains a far

lower percentage of long-‐term debt.

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5.3 Stockholders’ Equity

5.3.1 Debt-‐to-‐Equity Ratio

The debt-‐to-‐equity ratio measure a company's financial leverage by comparing the

airline’s total liabilities to its stockholders’ equity. Companies with high debt-‐to-‐equity may

be risky to investors because they may struggle to satisfy their debt obligations. In the

event of bankruptcy, creditors are satisfied before investors.

Debt − to − Equity Ratio =𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟V𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

Debt-‐to-‐Equity Ratios

2015 2014 2013 2012 2011

Spirit 1.07 0.59 0.54 0.58 0.60

Southwest 1.90 1.91 1.64 1.66 1.27

Industry Avg 0.88

Spirit’s debt-‐to-‐equity remained relatively stable until 2015, when it increased

dramatically and surpassed the industry average. As discussed previously, the major

increase in the airline’s debt is due to the investment in flight equipment. Southwest’s

significantly higher debt-‐to-‐equity makes the company a riskier investment since the airline

heavily on debt financing. Considering that Southwest can be viewed similarly to Spirit in a

mature stage of development, the high debt-‐to-‐equity may be cause for concern to a

potential investor in Spirit. The next few years will be pivotal, as the company will need to

properly manage its debt load during its ambitious expansion.

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6.0 Analysts’ Opinion

Having achieved unprecedented success in the last decade as an upstart ultra low-‐

cost carrier, Spirit Airlines has entered a crucial new stage in its development. The airline’s

low cost structure combined with low oil prices have allowed it to enjoy profit margins far

exceeding the industry average. By offering low unbundled fares and charging for extra

services, the carrier has attained a significant share of the market while being the industry

leader in ancillary revenue. However, Spirit has transitioned into a highly leveraged

expansionary phase. The airline has invested heavily in pursuit of a broader market share,

and cautious investors should be critical of whether the company has grown too quickly.

As a result of its expansionary behavior, Spirit has mostly financed the purchase of

new aircraft with long-‐term debt. While leveraged financing is a common way to facilitate

capital expenditures, the airline will need to show that it can maintain a steady cash inflow

from operations in order to repay its debt obligations. Spirit has shown impressive figures

over the past five years in terms of liquidity, efficiency, and profitability, but there have

been worrying signs of slowing growth. The carrier’s expansion into less profitable flying

routes may impede earnings if passenger traffic does not increase as expected. Other

airlines have also moved to hinder Spirit’s pursuit of a higher market share by offering to

match its prices even at a loss. A prolonged war of attrition with a bigger and more

established airline could prove disastrous for the carrier.

All things considered, we believe Spirit to be an interesting company to watch for

potential investors. The airline is in a critical transition stage, and could be a risky

investment if future conditions are unfavorable. However, the carrier’s savvy management

and impressive track record for growth suggest that Spirit may one day rival Southwest

Airlines for having the largest passenger base in the nation. Despite a rocky start to 2015,

the ultra low-‐cost carrier has shown an undeniable ability to adapt to the changing market.

We advise that investors consider all risks involved before investing in the company, and to

closely follow new developments that may impact Spirit’s future success.

-‐Compiled by Y.C., E.H., P.L., S.L., M.R., and D.W.