Fitch Publishes Rating on Spirit Airlines at 'BB '; Outlook Stable
KEY RATING DRIVERS
The rating is supported by Spirit's industry-leading operating margins, healthy liquidity, low cost structure, and modest leverage. Fitch believes that Spirit's cost advantage over its peers gives the company significant cushion to operate through potential future economic downturns while maintaining adequate financial health. The ratings are also supported by Spirit's track record of successful growth achieved in the years since the previous recession, which partly offsets our concerns about the company's plans for future growth. Spirit has doubled its total capacity since 2010 while improving both its yield and average load factor. Fitch notes that Spirit's profitability has been a standout in the airline industry. The company's 30%+ EBITDAR margins put have put it among the most profitable airlines worldwide for the past four years.
Fitch's primary concerns center on the company's aggressive plans for growth. Spirit expects to increase its capacity as measured by available seat miles (ASMs) by 15%-20% annually for the foreseeable future, including 30%+ growth in 2015. Correspondingly, its order book for new aircraft is large, consisting of 101 A320 family aircraft as of March 31, 2015. Heavy upcoming deliveries will require significant capital investment, and as a result Fitch expects free cash flow (FCF) to remain negative for the next several years. Capacity expansion may also pressure unit revenues. As seen in the first half of this year, heavy growth has contributed to Spirit's declining RASM numbers. Unit revenue may continue to feel some pressure as Spirit enters new markets and increasingly competes with larger carriers.
Additionally, if Spirit is unable to successfully manage its growth, it has the possibility of being left with too many aircraft and not enough profitable routes on which to operate them. This risk is partially mitigated by Spirit's track record over the past five years and by the relatively low penetration of ultra-low cost carriers (ULCCs) in the U.S. compared to other markets around the globe.
Other concerns are typical of the airline industry and include Spirit's unionized workforce, high degree of operating leverage, exposure to fluctuating fuel prices, and exogenous shocks that could cause demand for travel to drop quickly. Spirit also operates in a highly competitive industry, which includes stronger legacy carriers than in the past, and growing low-cost competitors such as Allegiant and Frontier. Start-up competition is also a longer term possibility, particularly given the high profits that the ULCC business model generated in recent years.
Low Cost Structure: Fitch considers Spirit's ultra-low cost structure to be a key competitive advantage and supporting credit factor for the airline. For full-year 2014, Spirit reported a cost per ASM excluding fuel of 5.61 cents, which is well below any of its larger competitors. Low costs are driven by high aircraft utilization rates, operating a single fleet type, high-density seating configurations, outsourcing certain labor functions, and maintaining a simple point-to-point route network. Spirit has no pension obligations, a key cost differentiator between some competing airlines. Importantly, Fitch expects unit costs to decline in the mid-single digits this year and to hold roughly flat in the intermediate term, whereas many other airlines in the U.S. are expected to experience at least moderately rising unit costs, meaning that Spirit's cost advantage should widen.
Fitch also believes that Spirit's low cost structure and corresponding low ticket prices, should help it to perform in future economic downturns. Spirit's low unit costs and high operating margins mean that it can maintain its low ticket prices and potentially attract traffic away from the legacy carriers in a downturn as travel budgets tighten. Alternatively, Spirit has the flexibility to drop fares to stimulate traffic while still generating an adequate return. Fitch also notes that Spirit performed well compared to its peers during the 2008/2009 recession, generating a modest net profit in both years despite high fuel prices and a severe economic downturn. Spirit's business model has evolved since that time, and its margins and financial flexibility are better, supporting Fitch's view that the company could operate through a downturn without a material impact to its credit profile.
Focus on Ancillary Revenue: Non-ticket revenues are a key component of Spirit's business model. Spirit has become the market leader in this area, with a full 40% of its revenue coming from non-ticket items. This strategy is important because it allows Spirit to keep its base fares low, which tends to attract the leisure travelers that make up its target market. Its low fares also cause Spirit's flights to show up at the top of search results on the on-line travel agency websites. Non-ticket charges also help to keep Spirit's cost structure low. For instance, carry-on bag fees discourage passengers from packing heavily, helping to keep planes lighter and more fuel efficient. Fewer carry-on bags also lead to faster turnaround times. Charging to print boarding passes at the airport and making calls to Spirit's call center help to keep labor costs low.
Recent Unit Revenue Weakness: Spirit's reduced revenue and profit expectations for 2015 are not a credit concern at this time as the company is still poised to generate record results this year. Fitch's forecast for 2015 anticipates an EBIT margin of 22% for the year, up 340 basis points from 2014. Because this year's revenue decline has been at least partially caused by one-time events including the dramatic drop-off in crude oil and expanded competition in Dallas, Fitch does not expect the magnitude of revenue weakness to persist over the longer term. Spirit's RASM declined by 9.9% through the first quarter of the year. The company issued revised guidance in July, lowering its forecasted operating margin for the year to 21.5%-23% compared to guidance at the beginning of the year of 24%-29%.
Mixed Credit Metrics: Spirit currently operates with little debt on its balance sheet. Fitch calculates Spirit's total adjusted debt/EBITDAR, which accounts for operating leases, at 3.3x as of March 31, 2015, which is at the low end of most its North American peers. Fitch expects total adjusted leverage to remain roughly flat over the intermediate term as debt incurred to finance aircraft should be partially or wholly offset by growing EBITDA. Funds from operations (FFO) adjusted leverage is high for the rating at 4.1x.
While Spirit's leverage is moderate, its coverage metrics are weak compared to some peers because of the company's heavy use of operating leases. FFO/Fixed charge coverage as of March 31, 2015 was 2.1x, which is weak for the recommended rating. Fitch expects coverage metrics to improve over the next several years due to the benefits of owning some aircraft versus having 100% operating leases. Spirit is also able to negotiate lower aircraft lease rates as it grows in size and as its credit profile improves.
Solid Financial Flexibility: As of March 31, 2015, Spirit had a cash and equivalents balance of \\$742 million, equal to 37.3% of LTM revenue, which is higher than most of its North American peers. The company also maintains two lines of credit totaling \\$56.6 million. The credit lines consist of an \\$18.6 million line related to corporate credit cards, and a \\$38 million line available for both physical fuel delivery and jet fuel derivatives. As of March 31, 2015, the company had drawn \\$5.5 million on the former and \\$8.9 million on the latter. Spirit's financial flexibility is supported by the absence of near-term debt maturities, and the fact that it has no pension obligations.
FCF to Be Pressured: Fitch expects Spirit's FCF to remain negative for the intermediate term as the company increasingly finances aircraft with debt. Fitch's forecast incorporates negative FCF in the range of \\$200 million-\\$300 million annually. The company currently leases the majority of its planes and the corresponding increase in capital spending is expected to push FCF negative for the foreseeable future. Although negative FCF is a concern, the company's decision to purchase some aircraft is likely a better long-term strategic decision, given that the cost of funding for those aircraft should be cheaper than leasing. Accelerated depreciation offered by purchasing the aircraft will also have cash tax benefits, which are expected to boost cash flow from operations going forward.
Unlike many other U.S. Airlines, Spirit does not intend to return a material amount of cash to shareholders in the foreseeable future. The company is focused on growth, and intends to invest heavily in the business going forward. Spirit initiated a \\$100 million repurchase program in 2014, but intends to use it opportunistically when it feels that the stock price is low and not as a means of returning significant cash to shareholders. Competitors including Southwest, Delta, Alaska, American and United have all begun returning cash to shareholders as their profits have improved.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Spirit include:
--Capacity growth of around 30% in 2015 and roughly 20% annually thereafter;
--Healthy industry competition and growing capacity leading to moderate unit revenue declines in 2015 and 2016;
--An all-in fuel price of around \\$2.10/gallon in 2015 rising to the \\$2.30 range thereafter;
--Negative FCF in the range of \\$200 million to \\$300 million annually driven mainly by aircraft purchases.
RATING SENSITIVITIES
Factors that could individually or collectively cause Fitch to take a positive rating action include:
--Total adjusted debt/equity credit falling below 3x on a sustained basis (Debt/EBITDAR as of March 31, 2015: 3.3x);
--FCF trending towards positive;
--FFO fixed-charge coverage ratio increasing toward 3x.
Factors that could individually or collectively cause Fitch to take a negative rating action include:
--Total adjusted debt/EBITDAR rising toward 4x on a sustained basis;
--Liquidity as a percentage of LTM revenue falling below 20% on a sustained basis (as of March 31, 2015: 37%);
--Material weakness in revenue or a sharp uptick in costs resulting in EBIT margins sustained below 12% (as of March 31, 2015: 20.6%);
--Difficulties managing planned capacity growth which cause Fitch to make material negative revisions to its financial projections.
Fitch has published the following ratings;
Spirit Airlines, Inc.
--IDR at 'BB+'.
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