Why I Doubled Down on Spirit Airlines Stock

2015 has been a great year for airlines, most of which are earning record profits thanks to the impact of lower fuel prices. However, it hasn't been a very good year for airline stocks. That's especially true for ultra-low cost carrier (or ULCC) Spirit Airlines . Spirit Airlines stock has declined about 40% since hitting an all-time high above $85 last December.

Spirit Airlines 1-Year Stock Performance, data by YCharts

To some extent, Spirit's weak stock performance can be explained by falling unit revenue and the company's reduced margin guidance for 2015 -- but the sell-off has still gone way too far. As a result, I doubled down on Spirit Airlines stock earlier this week.

Margin guidance heads lowerAs recently as February, Spirit expected to produce a pre-tax margin of 24%-29% for the full year. Due to a weaker-than-expected fare environment, Spirit had to reduce that guidance to 24%-27% in April.

The fare environment worsened in June, while unusually severe weather in that month affected Spirit's pre-tax profit by about $20 million. As a result, the company had to slash its margin guidance again last month. Spirit now expects a full-year pre-tax margin of 21.5%-23.0%.

Not surprisingly, these two guidance cuts played a central role in the Spirit Airlines stock crash. Before the first cut, the stock traded around $78 -- after the second cut, the share price had fallen to $60.

The stock can't catch a breakIn the past few months, most of Spirit's major competitors have announced plans to scale back their capacity growth in response to the weakening fare environment. That should allow industry pricing to stabilize or even improve somewhat in 2016.

In another positive development, oil prices (and thus, jet fuel prices) have cratered again in the past few months. Based on today's "forward curve" -- which represents the market's expectations for oil prices in the future -- Spirit's average fuel cost per gallon could decline by more than 10% next year. Nevertheless, Spirit Airlines stock has continued to move lower.

Frontier Airlines recently joined Spirit as an ultra-low cost carrier. Photo: The Motley Fool

One potential reason for Spirit's ongoing slide -- aside from the broader market's tumble -- was a piece in The Wall Street Journal this week highlighting Frontier Airlines.

Frontier has shifted to a ULCC business model in the past few years. It is now headed by two veterans of Spirit Airlines who helped develop and perfect the ULCC model there. The WSJ piece also noted that Frontier plans to more than double its fleet to 114 planes by 2022. The long-term threat from Frontier is thus investors' latest worry about Spirit Airlines stock.

Profit will continue growingIn spite of investors' worries, Spirit Airlines is on track to grow its earnings this year, next year, and beyond. Even after cutting its margin guidance twice, Spirit will still easily exceed its adjusted pre-tax margin of 19.2% from 2014 while also posting double-digit revenue growth.

Analysts expect revenue growth to accelerate to more than 20% next year, as Spirit's rapid capacity expansion continues and unit revenue stabilizes. However, analysts expect EPS to rise by "only" 18% to $4.92, implying modest margin contraction.

This may be too pessimistic, though. As noted above, the recent drop in oil prices means that Spirit's fuel cost per gallon could decline significantly again in 2016. Non-fuel unit costs and fuel efficiency will also be helped by the addition of 15 larger A321 planes with 228 seats over the next 6 quarters. As a result, Spirit may be able to improve its profit margin further next year.

Spirit Airlines is well-positioned for further margin expansion in 2016. Photo: Spirit Airlines

Longer-term, Spirit Airlines' strong financial position and industry-leading cost structure will allow it to fend off the threat from Frontier Airlines and any other competitors that may show up. Additionally, the ULCC market segment in the U.S. is a fraction of its size in Europe: implying that there is plenty of room for two or three airlines to grow and thrive in this space.

Valuation is downright absurdSpirit Airlines stock is actually pricier than most other airline stocks, despite trading for less than 13 times the average analyst estimate for 2015 EPS. Yet considering that Spirit is likely to grow revenue and EPS at a double-digit rate for the foreseeable future, this valuation is far too low.

Most stocks with growth prospects as bright as Spirit Airlines would be trading for 20-30 times earnings. I expect Spirit to demonstrate over the next year or two that its recent stumbles have not compromised its long-term revenue and EPS growth potential -- and that could be enough to send Spirit Airlines stock soaring to new heights.

The article Why I Doubled Down on Spirit Airlines Stock originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of Spirit Airlines and is long March 2016 $40 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines. 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.

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