1 Way That JetBlue May Be Inflating Its Earnings

JetBlue Airways has engineered a remarkable turnaround in the past few years. As recently as 2014, JetBlue lagged most of its peers in profitability. However, it more than doubled its operating income in 2015. As a result, by last quarter, JetBlue had the best operating margin of any U.S. airline.

JetBlue reported the highest operating margin of any U.S. airline in Q1. Image source: JetBlue Airways.

That said, JetBlue uses fairly aggressive accounting estimates to report its aircraft depreciation expense, compared to rivals using similar airplanes like Spirit Airlines and Virgin America . This means JetBlue may be overestimating its profitability to some extent. Let's take a look at whether this is something that investors should be worried about.

Aircraft costs are a major expense

While labor and fuel costs are usually an airline's biggest expense categories, aircraft costs are another major expense. Airlines have two main options in procuring aircraft: buying or leasing.

When an airline leases an airplane, it's fairly straightforward to calculate the quarterly or annual cost from the monthly rent and any other reimbursement provisions included in the lease.

By contrast, calculating the cost associated with owning aircraft is trickier. First, airlines don't separate the interest expense from debt-financed aircraft purchases from other interest costs. Second -- and more important -- the cost of the airplane is depreciated over its estimated useful life to an estimated residual value.

These two estimates introduce a lot of uncertainty into calculating the cost of owning aircraft. An airline may buy a plane intending to operate it for 25 years, but unforeseen circumstances can make it uneconomical to keep a plane for that long. Estimating what the plane (or its parts) will be worth when it is taken out of service is even more difficult.

JetBlue's aggressive estimates

JetBlue's fleet consists of 60 E190s and more than 150 Airbus A320-family aircraft. It owns the majority of its aircraft, and depreciates them over 25 years, with the residual value estimated at 20% of the initial purchase price.

Spirit Airlines and Virgin America -- which both operate 100% Airbus A320-family fleets -- agree with JetBlue's useful life estimate. Both carriers depreciate their A320-series aircraft over 25 years.

However, Spirit and Virgin America both use more conservative residual value estimates than JetBlue. Virgin America estimates the residual value of its aircraft at 15% of the purchase price. Spirit Airlines puts the residual value at just 10%. Since they are attributing less of the aircraft value to the residual" Spirit and Virgin America report more depreciation expense now than they would using JetBlue's assumptions.

Spirit Airlines uses very conservative aircraft residual value estimates. Image source: Spirit Airlines.

JetBlue's depreciation assumptions for its Airbus planes are aggressive but not implausible. By contrast, its E190 fleet should almost certainly be depreciated at a faster rate.

The E190 is going out of favor as new, more fuel-efficient jets hit the market, reducing E190 resale and residual values. For example, Republic Airways had to record multiple impairment charges on its E190 fleet in the last few years before removing that aircraft type from its fleet, despite estimating the E190's useful life at only 20 years.

What it means for JetBlue

The upshot of all this is that JetBlue's reported depreciation expense may underestimate the rate at which its fleet is depreciating. If JetBlue ultimately takes its E190s out of service before the 25-year mark or its fleet's residual value is lower than expected, the company could be forced to report an impairment charge or accelerated depreciation costs in the future.

Fortunately for investors, JetBlue is quite profitable with or without its aggressive depreciation accounting estimates. Last year, JetBlue reported $345 million of depreciation and amortization expense.

Conservative accounting policies might have increased this cost by 10%-20%, reducing JetBlue's operating income by $35 million to $69 million last year. Given that JetBlue posted operating income of more than $1.2 billion, its profitability is clearly not just a function of aggressive accounting. Still, shareholders should recognize that JetBlue's reported profits could be inflated by as much as 6%.

The article 1 Way That JetBlue May Be Inflating Its Earnings originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of JetBlue Airways and Spirit Airlines and is long January 2017 $17 calls on JetBlue Airways and long June 2016 $30 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines and Virgin America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.