After a multiyear run of stellar profit growth, Spirit Airlines (NASDAQ: SAVE) has faced increasingly severe margin pressure over the past two years. The company's operating margin is on track to sink to 15% or less in 2017, down from a peak of 23.7% in 2015.
Spirit's recent woes have been driven primarily by abrupt pricing strategy shifts by American Airlines and United Continental. Both legacy carriers have started to compete aggressively on price with budget carriers like Spirit, driving down fares in big hub markets like Chicago, Dallas/Fort Worth, and Houston.
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However, Spirit Airlines has ample ability to adapt to the industry conditions it now faces. Most notably, it is shifting its route network to reduce its exposure to the competitive dynamics in any one or two major hub cities.
Competing more with Southwest Airlines
Bulking up in midsize cities is one key aspect of Spirit Airlines' growth strategy. This tends to mean competing more with Southwest Airlines (NYSE: LUV) and other low-fare airlines, rather than going head-to-head with the three big legacy carriers. This is a sensible strategy, as low-fare carriers have shown less inclination to engage in margin-sapping price wars with Spirit Airlines.
Just during the month of November, Spirit Airlines has announced that it will add two more midsize cities to its route map in 2018: Columbus, Ohio, and Richmond, Virginia.
On Wednesday, Spirit Airlines announced 11 more new routes. Several of these fit with the theme of targeting Southwest Airlines' markets for growth. In Baltimore, where Southwest is the dominant carrier, Spirit plans to add nonstop flights to Denver and Montego Bay, Jamaica, in March. From Las Vegas -- another city where Southwest is dominant -- Spirit will add new routes to Tampa and Orlando.
Adding geographical diversity
Another way that Spirit Airlines can protect itself from the fare wars it has experienced recently is by achieving better geographical diversification of its revenue. Right now, a quick glance at Spirit's route network shows that it is heavily weighted to the eastern half of the country.
Spirit Airlines does have significant operations in Las Vegas and Los Angeles, but it hasn't otherwise made much of an effort to grow on (or near) the West Coast. That's also changing with the carrier's latest route announcement.
Next spring, Spirit plans to add four new seasonal routes at Seattle-Tacoma International Airport. (It will fly to Chicago, Dallas/Fort Worth, Fort Lauderdale, and Minneapolis/St. Paul.) That will give it eight peak season routes in the fast-growing Puget Sound region, up from zero at the beginning of 2016.
The other three new routes that Spirit Airlines announced on Wednesday were year-round daily flights between Tampa and Los Angeles and daily seasonal service from Detroit to Portland, Oregon and San Diego. In fact, nearly all of the 11 routes announced will help Spirit build up a bigger footprint in the western U.S.
It will take years for Spirit Airlines to truly diversify its route network. Fortunately, the company's industry-leading cost structure has allowed it to remain solidly profitable even with the constant unit revenue pressure it has faced over the past three years. As a result, Spirit has plenty of time to retool its route network to make it more defensible.
In the long run, carrying out this strategy should enable Spirit Airlines to stabilize its profitability and then return to margin growth. Considering the company's ample revenue growth potential and the stock's modest valuation of about 13 times earnings, its stock could be a big winner for patient investors.
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