Spirit Airlines (NASDAQ: SAVE ) made a splash a few years ago when it transformed itself into America's first "ultra-low cost carrier." Spirit has very low base fares, but supplements its income with a variety of fees.� Spirit's fees apply to things like checked bags, carry-on bags, advance seat assignment, and even in-flight snacks and beverages. This revolutionary operating model has allowed Spirit to grow revenue by more than 20% per year recently.
Spirit is also profitable, and trades at a very reasonable forward P/E of 10, based on current analyst estimates. Moreover, the company has no debt. Indeed, as my Foolish colleague Sean Williams pointed out last week, both Spirit and fellow niche carrier Allegiant Travel (NASDAQ: ALGT ) , are net cash positive. At first glance, this would appear to make Spirit a great investment candidate.
However, Spirit's balance sheet is not as pristine as it seems at first glance. The company has avoided taking on debt only by committing to expensive, long-term aircraft leases, which are just as much of an encumbrance as debt. This does not necessarily mean that the stock would be a bad investment, but it shows why investors need to look carefully at a company's business model before investing.
Aircraft financing: two models
Airlines operate in a very capital-intensive industry. This is the main reason why airline stocks are considered risky investments. There are two main ways that airlines can fund new aircraft purchases: debt financing, and lease financing. Debt financing gives the airline ownership of the aircraft and tends to be cheaper over the long term, but requires a large upfront payment, which is covered by issuing debt.
By contrast, in a lease financing arrangement, an aircraft leasing company buys the aircraft and leases it to the airline for a period of time, often eight to 12 years. This tends to be costlier because the leasing company accepts the risk of releasing the aircraft at the end of the initial lease term.
Many airlines use a combination of debt financing and lease financing. However, at present, Spirit Airlines does not own any aircraft; all are leased. Spirit's avoidance of debt financing makes the company appear to have a pristine balance sheet, with zero debt.
No debt but lots of bills...
Spirit Airlines may have no long-term debt, but the company still has substantial long-term obligations. Spirit disclosed its future minimum lease commitments in its most recent 10-Q filing, reproduced below (the reported figures are as of Sept. 30, 2012):
Spirit Airlines Future Lease Obligations:
Source: Spirit Airlines 10-Q for Q3 2012
However, that's not all. Spirit is also in the midst of a massive fleet expansion plan. Between 2013 and 2021, the company plans to add roughly 100 planes at a total cost of approximately $4.7 billion. Those may be debt-financed or lease-financed, but either way they will add significantly to Spirit's future spending commitments.
Squaring the circle
Fortunately, it is possible to create an adjusted net debt figure to account for some airlines' higher reliance on lease financing. Indeed, Delta Air Lines (NYSE: DAL ) regularly reports such a figure. Delta adds seven times its annual aircraft rent (i.e. lease) expense to its total debt when reporting adjusted net debt. This is generally considered a good approximation of the "exchange rate" between lease financing and debt financing.
Spirit reported aircraft rent expense of $37.5 million in the most recent reported quarter ($150 million annualized), and this has been rising due to the company's fleet expansion. Furthermore Spirit has 2013 lease obligations of $167 million (which may include some non-aircraft related expenses). Based on an approximate figure of $160 million annual aircraft rent expense, and Spirit's recent cash balance of $399 million, Spirit has adjusted net debt of $721 million.
Bottom of the pack
In order to compare the bang for the buck between various airlines, it is useful to adjust for size by reporting adjusted net debt as a percentage of revenue. Here are the results for Spirit and four key competitors: Allegiant, Delta, United Continental Holdings (NYSE: UAL ) , and Southwest Airlines (NYSE: LUV ) .
| Company | Adjusted Net Debt | TTM Revenue (mainline only) | Debt as % of TTM Revenue |
|---|---|---|---|
| � | � | � | � |
| Allegiant Travel | N/A | $880 million | N/A |
| Spirit Airlines | $721 million | $1.26 billion | 57% |
| Delta Air Lines | $11.7 billion | $30.1 billion | 32% |
| United Continental | $12.4 billion | $30.4 billion | 41% |
| Southwest Airlines | $2.5 billion | $17.1 billion | 15% |
Source: Airline SEC filings
The surprising result is that while Spirit is the only company with no debt on its balance sheet, it has the heaviest adjusted net debt burden in this group, at 57% of revenue. Allegiant is net cash positive (and owns all of its aircraft), while Southwest has kept its debt and lease obligations very manageable. Even the much-maligned legacy carriers Delta and United have significantly more manageable debt burdens.
Why it matters
So what? Bulls might argue that Spirit has routinely posted a high profit margin in spite of heavy aircraft rent expense. Spirit seems to have no trouble paying its bills.
However, high aircraft rent raises Spirit's fixed cost base, reducing the company's flexibility. Competitors with lower aircraft expense can quickly reduce capacity if industry conditions deteriorate. Allegiant and Delta have used this strategy to great effect in recent years. By contrast, because Spirit must pay high aircraft rent costs regardless of whether its planes are flying, it cannot easily cut capacity. Not surprisingly, the company's aircraft utilization rate is the highest in the industry, at 12.8 hours per day.
While industry conditions remain favorable, high aircraft utilization is not a bad thing. The danger for Spirit Airlines investors is that the company could not afford to cut back even if profitability deteriorated due to a fuel price spike or a sudden drop in demand. High fixed costs (i.e. aircraft rent) leave Spirit with much less flexibility than competitors like Delta and Allegiant, which have older, fully depreciated planes that can be mothballed if necessary.
Conclusion
Spirit's high profit margins and low valuation make the company a reasonable investment candidate. However, investors should be aware that the company has one of the heaviest adjusted net debt burdens in the industry, at 57% of TTM revenue, due to high aircraft rent costs. This diminishes Spirit's flexibility, and could prevent the company from cutting capacity to match demand in a future industry downturn.
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