Value Investing

An Analysis Of The Price War Between American And Spirit Airlines

An Analysis Of The Price War Between American And Spirit Airlines by Whitney Tilson

Summary

American Airlines rolled out an aggressive price-matching strategy in June that has impacted Spirit’s pricing and revenues.

This is the major factor that has caused Spirit’s stock to be cut in half this year.

With 62% higher costs, I question how long American can continue this strategy.

I suspect it is more likely to be a warning to Spirit to pursue growth in markets not served by American.

If so, it makes me even more bullish on Spirit’s stock.

In my article earlier this week, Spirit Airlines Is Poised To Be The Next Ryanair, I wrote:

American, perhaps emboldened by low fuel prices, rolled out an aggressive price-matching strategy in June that has impacted Spirit’s pricing…This price war is affecting both Spirit’s revenue and margins…

It would be hard to find a better example of this price war than on the NYC (LaGuardia) – Dallas (DFW) route, which has reached an extreme degree. Because I haven’t flown Spirit in many years and want to experience the airline for myself, I looked for an ultra-cheap flight I could take – and found a round-trip nonstop to Dallas on Dec. 8-9 for $43.09 each way (that’s not a typo; heck, the taxis to and from LaGuardia will cost almost as much as the flights!).

I didn’t check any other airlines because I want to fly Spirit to check it out – but also because I was certain that no other airline would have a price anything close to Spirit’s (the last time I flew to Dallas a year or two ago, I recall it was around $450 round-trip). But I was wrong: if I booked the right American flights (it has a dozen each way every day vs. only one for Spirit), the price was only $79 – and that presumably included an assigned seat and carry-on bag (which Spirit charges extra for)!

(A few hours ago, I checked the same flights again and, sure enough, American underpriced Spirit again: it had three morning flights to Dallas on the 8th and two late afternoon/early evening flights back on the 9th for only $97 vs. $107 for Spirit.)

This Isn’t Sustainable for American

Such low prices aren’t good for Spirit, as its base fares are normally around $80 (they’ve fallen to $68 this year due mainly to the price war with American), but at least its non-ticket revenue has remained steady, as this chart shows:

American Airlines And Spirit Airlines

But such low prices cause American to lose far more money than Spirit for two main reasons: it doesn’t make nearly as much on non-ticket charges and its costs are 62% higher than Spirit’s, as this chart shows:

American Airlines And Spirit Airlines 2

What Is American Thinking?

Obviously American is aware of its massive (and permanent) cost disadvantage vs. Spirit and it knows it can’t possibly drive Spirit out of business (Spirit has $200 million of net cash and just reported its most profitable quarter ever, despite the price war), so what on earth could
American’s management be thinking? Have they lost their minds?

Perhaps not. I think American first considers its cost structure vs. Spirit’s, and then looks at Spirit’s growth plan, which (with firm orders for 106 Airbus A320 planes) looks like this:

American Airlines And Spirit Airlines

Source: Spirit 10K 2014.

Then, I think American’s management team looks at what Ryanair (NASDAQ:RYAAY) has done to the major carriers in Europe over the past decade with this growth:

American Airlines And Spirit Airlines

Source: Ryanair 20-Fs.

I think American’s management, not unreasonably, came to the conclusion that Spirit, while not a major threat today (American’s revenues in Q3 were 19x greater than Spirit’s), is likely to become one, and therefore decided – at a time when low fuel prices have swelled its margins and cash hoard – to engage in a price war to, in part, weaken Spirit, but more importantly send a powerful (and painful) message:

“Take your growth elsewhere! If you bring your new planes onto routes that compete with us, expect us to continue to lash out and hurt you. Even though we’ll lose more money than you, we’re a lot bigger, so we can afford it – and you can’t, as evidenced by our respective stock prices this year.” (American’s stock is down 23% while Spirit’s is down 53%.)

Implications for Spirit

At first glance, American’s “spanking action” might appear to be terrible news for Spirit and make one not want to own the stock. After all, American is so much bigger and, if it chose, could inflict quite a bit of pain on Spirit indefinitely.

But, if my assessment of American’s thinking is correct, it actually makes me more bullish on Spirit’s stock because it means that the price war is likely to end in the reasonable future (I hesitate to put a date on it, but I’d be surprised if it continues much into 2016; in part it depends on Spirit’s actions – I hope management is wise enough to back off a bit against American – as well as on oil prices: if they go up, American is likely to end the price war sooner in order to maintain its own profitability).

Conclusion

Ultimately, however, this is just short-term noise (though this is all that investors and analysts seem to be able to focus on). In the long run, the better business model wins – and I think Spirit has a better one than its competitors (which isn’t to say that there won’t be multiple winners, as I own Delta’s (NYSE:DAL) and JetBlue’s (NASDAQ:JBLU) stocks as well). Americans love a bargain and are willing to put up with various inconveniences and/or minimal service levels to save a lot of money. As a result, well-managed companies with sustainably much lower costs than their competitors tend to do very well over time – just look at Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST) over the past few decades.

More relevantly, consider Southwest (NYSE:LUV) and Ryanair – companies with low-cost models similar to Spirit’s and whose success I think Spirit has a decent chance of replicating. When Southwest and Ryanair were much smaller, the major carriers periodically engaged in price wars that hurt their earnings and stocks – and each time, the stocks proved to be screaming buys.

Here are their price charts going back decades:

Southwest

American Airlines And Spirit Airlines

Ryanair

American Airlines And Spirit Airlines

Note that there were long periods when both stocks performed very poorly, so it’s important to keep two primary lessons in mind: a) the airline industry is cyclical, so size these positions appropriately as even the best companies (and stocks) are going to get hurt during recessions (2008 being the most extreme example, when both stocks got cut in half); and b) it’s very important not to overpay for any stock, but especially airline stocks. Investors who bought Southwest in late 2000 and Ryanair in late 2003, paying more than 30x trailing earnings in each case, didn’t make any money for 13 years and eight years, respectively. They were and are great companies but, at inflated prices, they were lousy stocks.

Ditto for Spirit: investors who bought the stock earlier this year when it was trading at a trailing P/E in excess of 25x have paid a heavy price. But today the opposite is true, as the stock is downright cheap, trading at a mere ~9x trailing, 2015 and 2016 estimated earnings, close to the lowest P/E ratio it’s traded at in years, as this chart shows:

American Airlines And Spirit Airlines

Spirit is also trading at a steep discount to all of its peers, both domestically and internationally, as this table shows:

American Airlines And Spirit Airlines

In summary, there are very few companies I’m aware of that are growing 20%+, with a 25%+ operating margin, 25%+ return on equity, with a net cash position – yet a stock trading at a P/E of ~9x. Hence, I have made it one of my top five positions.

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