[$SAVE] Spirit - An undervalued airline with an optionality from JBLU merger

[PSA] I have changed the name of the substack. Felt the previous one was bit too cheeky! Figured ‘Unfair Advantage’ is a more fitting name as I want to find companies, situations that gives the investor an unfair advantage.

Summary

All airline stocks have declined post-pandemic due to travel restrictions and are yet to recover. Spirit, in particular, is in potential merger talks with JetBlue, and the merger is currently facing issues with the Department of Justice, leading to further downward pressure on its share price. Currently trading at 2012 prices, it has an EV/2017-19 EBIT average of approximately 9.

JetBlue is offering to buy Spirit at $33 per share, almost 80% above the current market price. Until the deal closes, Spirit shareholders will receive a special dividend of $0.10 per share per month (7% assured yield on the current price), further cushioning the downside. The Spirit share price is suppressed due to general pessimism in the sector and uncertainty around the merger. If the deal goes through, there is an 80% upside, and if the deal does not go through, there is a 20-25% upside by valuing Spirit based on estimated FY23 EPS at 14-15 times earnings. In summary, we see limited risk but higher uncertainty, making this an interesting situation to consider.

Background

Spirit Airlines is an ultra-low-cost carrier that famously 'unbundled' tickets by charging a base fare and extra fees for luggage, priority check-in, snacks, etc. In 2022, Frontier Airlines decided to merge with Spirit in a cash+stock deal that gave Spirit shareholders $22 per share. The stock price rose quickly, but JetBlue countered the offer with an all-cash deal of $33 per share, sparking a bidding war between the three companies. After a rather public fight between the management of the three airlines, Spirit eventually decided to merge with JetBlue in late 2022, while being aware of potential DoJ issues. A lawsuit did follow. With this uncertainty about the future of Spirit, the share price soon began to plummet, dropping 30% from $22 in Nov-Dec 2022 to $17 by April.

The Merger

Over the last few decades, the US airline industry has undergone multiple consolidations, resulting in domination by four large players: American Airlines, Delta, United, and Southwest. Together, these top four companies control close to 80% of the total US airline capacity. In this context, Spirit Airlines sought to merge with Frontier Airlines to become the fifth-largest airline. However, JetBlue made a superior offer, resulting in a public backlash between the management of Spirit, Frontier, and JetBlue. Eventually, Spirit shareholders accepted JetBlue's cash offer of $33 per share, which implied a multiple of approximately 7.5 times the average EPS (17-19) over the past three years.

Thanks to the bidding war, the deal kept getting sweeter. Finally now Spirit shareholders get:

• $0.1 monthly dividend from Jan 2023 to earlier of July 2024 (or) when deal closes

• $ 31.65 in cash if deal does close (post deductions from initial pre-payments etc.)

• $2.50 in dividend when Spirit shareholders approved JetBlue merger (already paid out)

Why is this undervalued?

If the investor is patient, they can earn anywhere between 65% to 27% annualised on this bet. But it requires a lot of patience and stomach to live through the uncertainty.

To reiterate my point, there is tremendous uncertainty but very low risk. However, market frequently confuses the two.

• Spirit shares are currently trading at $17 per share, much lower than both Frontiers’ offer of $22 per share and JetBlue’s offer of $33 per share.

  • JP Morgan downgraded Spirit in mid 2022 because ‘it would take an year before regulatory hurdles are removed’. Forget 3 years, no one wants to wait 1 year

  • In last 12 months, ~$3.5B worth of institutional money was taken out of Spirit airlines (Check appendix for detailed chart)

• Realistically, we can expect Spirit to earn ~$1-1.5 per share, after factoring in additional $180M in wages (post new contract with unions) and ~25% increase in Jet fuel costs.

  • This growth implies ~35% increase in revenue. Spirit management have confirmed ~19-22% increase in available seat miles and we expect rest of growth (~12-16%) from price increases

  • My FY23 Earning estimate implies ~5% operating margin significantly lesser than 2014-2019 margins at 13-20%

• If deal does not go through, Spirit shares could be re-rated by market to ~$20-22 per share (assuming 14-16 times expected FY23 earnings) in addition to assured ~7% annualised dividend without the uncertainty surrounding mergers.

On DoJ lawsuit - Likelihood of upside

In March 2023, Department of Justice blocked the deal stating this would lead to anti-competitive practices including raising air-ticket prices and will not be in best interest of consumer. I am no expert in law but believe there is a higher chance that this deal might close. Here’s why:

• Since 1929, 58 airline mergers have been completed in USA and all of them have been completed under 2 years. There is a high probability that this merger will not take longer than 2 years

• Since 2000s, there have been 4 antitrust lawsuits filed by DoJ against airlines mergers. 1 was completed, 2 ongoing (incl. Spirit JetBlue) and 1 merger did not go through

• Last time DoJ successfully blocked a merger in court was 2017. It’s success rate since then has been 0.

Looking at base-rates here, there is a high likelihood of this deal going through. But nothing is set in stone, so we will have to ride the uncertainty.

Risks

• Spirit while having lowest CASM in industry continues to be impacted by jet fuel costs. Fuel costs were ~22% of revenues in 2015 vs ~38% in 2022. Any further appreciation in Jet Fuel would impact Spirit and entire airline industry

• Pilot attrition & management since start of pandemic has impacted Spirit’s margins considerably. With ~10 new airplanes to join fleet in 2023, every additional headcount could impact margins if they are hired at inflated wages

• DoJ lawsuit could extend beyond July 2024. Which means the uncertainty could last longer leading to lower annualised returns

• Even though JetBlue has secured financing from Goldman Sachs for this deal, it remains to be seen if they would renege on the deal should industry profitability suffer in FY23

Appendix:

For data-nerds like me, adding some interesting details

Complete list of USA airline mergers (Source - link)

List of US airline mergers blocked by DoJ for anti-trust

Jet fuel price - longer term historical chart

Institutional ‘smart’ money flow in Spirit ($SAVE)