Investment Thesis
Spirit Airlines, Inc. (NYSE:SAVE) shares have been hit hard, dropping over 82% since the collapse of their merger with JetBlue Airways Corporation (JBLU) when a Federal Judge in Boston struck down the merger agreement. Since January, investors have built up increasing concern about the airline’s future, especially after the U.S. Department of Justice (DOJ) sued to block the $3.8 billion acquisition on antitrust grounds to prevent less competition and driving up prices. They claim this merger would particularly harm consumers in the low-cost carrier segment that Spirit dominates. Part of the problem with this merger outcome is not that it was rejected, but how it was rejected. The ruling appears to have made it hard for Spirit to pursue another merger (like the one they originally had agreed to with Frontier Airlines).
To be clear, there are no other proposed mergers on the table, but this ruling makes it less likely someone will attempt it.
As a stand-alone airline, my biggest concern for Spirit now is their long-run financial health.
The financial backing from JetBlue via a merger could have supported Spirit to prevent an increased risk of bankruptcy. Now the company is facing a debt load of $3.3 billion and negative profit margins. The biggest issue is that budget airlines have struggled post COVID-19 as bigger airlines have offered lower cost flight options to crowd out the market and grab market share.
Over the last week, I think there has been a slight change in the regulatory landscape that could be asymmetric. The recent DOJ approval of the merger between Alaska Air (ALK) and Hawaiian Airlines (HA) could signal a shift in regulatory attitudes, which might bode well for Spirit in their attempt to maximize shareholder value. The approval of the Hawaiian merger, despite market skepticism, suggests that Spirit could still find a strategic acquirer that can fit the DOJ’s criteria to save them from further financial struggles. The case for an acquirer is strong, with the airline trading at just 0.38x last 12 months book value.
Spirit Airlines continues to hold valuable assets that trade below their tangible value, and the value of their intangible assets at 0 on their balance sheet. While I have been a hold on shares since May, the steep selloff since then (and since the merger was struck down) puts their stock now in an asymmetric high-risk buy, which could attract another buyer (whether they are strategic or a PE firm), especially as consolidation pressures increase in the industry. While considerable risks are present with Spirit shares, the potential rewards for those betting on a recovery or acquisition could be high in this case if one happened.
Why I’m Doing Follow-Up Coverage
Earlier this year, after the merger fell through, I was optimistic about Spirit because of their potential to operate independently and achieve positive operating cash flow. My bullish position was supported by management’s expectations that Spirit would see positive operating cash flow by Q2, based on their Q4 2023 performance that put them on track toward achieving this milestone.
Unfortunately, Q1 performance delivered disappointing results, with the company’s operating cash flow dropping from a positive $140.8 million in Q1 2023 to -$137 million in Q1 this year. After the disappointing results, this led me to review my opinion on Spirit’s ability to fly as a stand-alone airline. The liquidity issues and challenges in converting their capital—mainly aircraft—into cash if necessary has been a big concern to me. This is what led me to downgrading them to a hold.
I think it’s clear that Spirit Airlines’ management has struggled with their turnaround strategy, I think they were really betting on the merger going through. The market’s reaction has been too harsh, with shares dropping as investors assume that the airline’s common stock would be worth nothing in a buyout scenario or a restructuring.
I think the market now has become overly bearish on Spirit Airlines. Despite all the challenges, I think that a private equity firm or another airline could step in to support their operations, and this opportunity is not reflected in the share price. The recent DOJ approval of the Alaska-Hawaiian merger indicates that regulatory resistance to airline consolidation is not absolute, and leaves the door open for Spirit to find a suitable acquirer under the right conditions. In this context, Spirit’s assets could make them an attractive target for a strategic investor or merger partner to pull out the airline from their current financial situation.
Deep Dive On Hawaiian Merger
The $1.9 billion merger between Hawaiian Airlines and Alaska Airlines was first announced in December. This was one of the largest consolidations in the U.S. airline industry since Alaska’s acquisition of Virgin America in 2016. The main goal of the merger was to strengthen Alaska’s operations on the West Coast and expand their reach into tourist destinations and Asia, markets where Hawaiian Airlines has a notably strong presence for being such a small airline. With both airlines’ complementary networks, the companies believe this tie-up appeals to passengers and Wall Street analysts, especially given the challenges of acquiring new aircraft and gate access in the airline industry.
The merger last week finally cleared a critical hurdle when the DOJ allowed the regulatory review period to expire without challenging the deal. Given the Biden administration’s aggressive stance against airline mergers, as evidenced by blocking the proposed merger between JetBlue and Spirit Airlines, the DOJ’s decision to let the Hawaiian-Alaska merger proceed may reflect evolving DOJ opinion in these situations. Perhaps it views the limited overlap between the two airlines’ routes and their potential to create a stronger competitor against the larger U.S. carriers that dominate the market. These were a lot of the same arguments that JetBlue had with Spirit. They promised to divest routes to win approval. The judge did not think the measures were enough.
The next step for the merger is to secure approval from the Department of Transportation (DOT), which is expected to scrutinize the deal as part of the final regulatory review. Unlike the DOJ, which focuses on antitrust issues, the DOT will most likely look into the merger’s implications for air service, particularly in Hawaii. There are concerns that the combined entity might reduce competition or service levels, especially on interisland routes, where Hawaiian Airlines currently dominates. This could be an issue for their merger plans, but this is an operational nuance that Spirit would not have if they went to secure a merger or a sale with another US airline. None of their routes are ones where they are the only airline that services a destination.
The DOT has the authority to require Alaska Airlines to maintain certain service levels, particularly in less profitable interisland routes, as part of their approval process. While the DOJ did not impose any conditions, the DOT may see the need to protect these routes to ensure that Hawaiian consumers do not face reduced service or higher prices.
In this specific case, it’s also possible that the DOT could require Alaska Airlines to divest certain assets or make other concessions to preserve competition and service quality.
Still, I think this development could pave the way for future mergers under similar circumstances, where the combined entities can argue that the merger would enhance, rather than reduce, competition. For years, the DOJ has been a staunch opponent of mergers that it believed would reduce competition and harm consumers (hence the Sherman Antitrust Act). I believe that the green light given to the Hawaiian-Alaska merger suggests that the DOJ may be reconsidering its position, especially when mergers involve carriers that do not overlap in their routes and market segments.
Many airlines, particularly low-cost carriers, are finding it increasingly difficult to operate profitably with the rise of low-cost ticket options from large carriers like Delta Air Lines (DAL). The collapse of the JetBlue-Spirit merger shows how the failure of merging can bring the risk of these companies going under.
Previously (before the JetBlue-Spirit merger was announced) Frontier Airlines, which operates in a similar low-cost segment as Spirit, offered a deal in 2022 to merge with Spirit. This would have allowed both airlines to consolidate their operations, and achieve greater economies of scale, had it not been for the majority of shareholders that did not support the proposal. Ironically, I was one of them at the time that voted against this merger and voted in favor of the JetBlue option. I now regret that (hindsight is 20/20).
The reason that the Frontier Group (ULCC) (and the Alaska/Hawaiian) mergers were higher-odd events from the start had to do with market segmentation. JetBlue is considered a slighter higher-priced airline and management (in leaked documents) indicated plans for the airline to consolidate Spirit’s fleet into JetBlue planes and raise prices. The DOJ did not like this.
Frontier Airlines, however, offered a merger that would not have removed lost cost options from their routes, which means they would have stood a greater chance of approval. This is where the silver lining is.
Again, to emphasize, there are no public discussions right now of Spirit Airlines merging itself or selling itself to other carriers. The market is implying there is no chance the airline can pursue a merger post DOJ. I think this is misguided and means shares are mispriced. Shares are priced like the only way the company can make money for common stockholders is if they go at it alone and succeed as a stand-alone airline. This does not seem correct. A merger (for their assets) still seems possible. The market should price this in.
The point of this research is to show that Spirit still has residual buyout value to the right acquirer. Under the Biden (or potentially Harris administration) it’s clear the DOJ policy around allowing airlines to merge when their ticket price-points are similar, and their routes do not overlap significantly. Under a potential Trump Administration, we could even see a more lax DOJ. In either case, there is a legal route (and a business case) for the airline. This should be reflected in shares.
Valuation
Spirit Airlines, Inc. is currently trading significantly below their book value, with a TTM price-to-book ratio of just 0.36, compared to the sector median of 2.86. Their deep discount of -87.55% suggests that the market sees Spirit as highly distressed.
What’s interesting about a balance sheet analysis is that Spirit places no value on their brand, with intangible assets recorded at zero dollars. I think this reflects the company’s operational struggles and a desire to be valued from a conservative standpoint to Wall Street. It means that for acquirers, the company’s value (for basically parts) is apparent: it’s the tangible book value.
Given that Spirit shares are trading at roughly 35% of their current book value, there is a possibility that a private equity firm or another airline could see an opportunity to facilitate a turnaround. Even if it were to happen at $0.50 on the dollar for their current tangible book value, this would be a strong value proposition to both a buyer and common stockholders, as it implies roughly 60% upside from current levels.
Keep in mind that if a PE firm (or a non-airline corporate player) bought the airline, the merger would likely not need to get DOJ approval given that they would not be combining with a competitor.
To be specific, Spirit’s tangible book value per share is $7.39, so purchasing the company at $3.70 per share (roughly $0.50 on the dollar) would offer an asymmetric opportunity for value investors or a private equity firm looking for a distressed asset with turnaround potential.
Risks
I want to be clear, the purpose of this research is to say that shares should price in a buyout premium (which I do not think they have right now). The company can (and currently will) try to operate on their own, so all the operational risks that existed before are still there.
In May, Fitch Ratings downgraded the company to “CCC” from “B-” after they noted that the failed merger caused a loss of financial flexibility. S&P Global also gave the same rating, citing the firm’s constrained cash flow generation.
Even with the airline being distressed, I actually still think they could be purchased, even if it was just with the intent to liquidate the company.
Meanwhile, management (despite their previous stumbles) is laser focused on trying to fly alone. As CEO Edward Christie noted on the Q2 earnings call:
…as we move through the period, we must consider every possible avenue available to us to find incremental revenue, cost savings and market opportunities. The chatter in the market about Spirit is notable, but we are not distracted. We are focused on refinancing our debt, improving our overall liquidity position, deploying our new re-imagined product into the market, and growing our loyalty programs.
Refinancing the debt is a big part of the story here. I think the airline is attractive to a buyer today, but a refinanced debt package would significantly improve the story. This, coupled with management noting on the call that major carriers should start pairing back their low-cost options this fall, leads me to think the fundamentals for budget airlines in the US (including Spirit) could improve. It does not take a lot for margins to improve and for a debt refinancing to happen. Once their debt load is in better shape, the capital markets will likely price in higher odds of the airline succeeding, which means investors would have more appetite for common stock.
Don’t get me wrong, shares are under pressure. But I think the market is too bearish. Management is focused on trying to rightsize the ship. The rewards are big if they can get through this crucial period.
Bottom Line
Spirit Airlines is in a tight position, with shares down over 82% following the failed merger. The company faces notable financial challenges, which include potential default on debt that matures. But I think their assets are undervalued, meaning there is a high-risk play for investors who want to stomach a high-risk position that could offer a unique upside.
Contrary to market opinion, I actually still think Spirit could still be a viable acquisition target, whether the buyer intends to liquidate the company’s tangible assets, which are currently undervalued or build out the airline. The DOJ is more flexible to mergers than what is on the surface. The market has yet to price this in. With that, I think shares are a high-risk buy.
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