Analyzing Small Cap Stocks: Spirit Airlines
The TDR Three Key Takeaways regarding small cap stocks and Spirit Airlines:
- Spirit Airlines exemplifies the volatility inherent in airline stocks.
- Trading at a discounted price and high level of cash, Spirit Airlines offers an intriguing small-cap opportunity.
- Spirit’s high leverage signals major risks within airline stocks.
Spirit Airlines (NASDAQ: SAVE) (NASDAQ: SAVE), a former darling of the sky, is now a small-cap stock with substantial cash reserves, currently trading at a 95% discount from its peak value. Is this an attractive buying opportunity?
Spirit Airlines’ financial situation and strategic positioning in the challenging airline industry. The company recently decided to lay off 260 pilots as part of its efforts to conserve cash in response to rising inflation. This move highlights the direct impacts of economic trends on corporate strategies.
The investment potential in Spirit Airlines is intriguing. As I researched, theoretically, acquiring Spirit Airlines could be like having cash in the bank. With the share price trading at $4.02 and the company holding $7.00 per share in unrestricted free cash, this introduces the concept of “free caps,” where an investor might leverage the company’s substantial cash reserves against its market value, presenting a unique opportunity in the small-cap stock sector.
The broader economic challenges and attractions of the airline industry. I noted, looking at the overall airline business, it’s very capital intensive, yet many investors find it hard to ignore this industry, including Warren Buffett. In 2007, Warren Buffett wrote in a letter to Berkshire Hathaway investors that “if a far-sighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” This statement provides context for the enduring allure and significant challenges of this sector within the small-cap stock market.
Reflecting on Spirit Airlines’ historical performance, the company has had an impressive history until facing lessons of gross marginal profits and operating leverage. Emphasizing growth, this company is expanding rapidly. They served 44 million passengers last year, compared to 14 million a decade ago—a threefold increase.
However, despite these growth metrics, maintaining profitability remains a challenge. I noticed their gross margin is only 13.9%. This indicates that substantial revenue is needed to turn a profit, highlighting the difficult balance between revenue and profitability in the airline industry.
Despite the initial allure of Spirit’s financial position, several red flags make it a risky investment. The company’s high leverage ratio of 7:1 is alarming. This level of debt is akin to buying a $1 million house with a $7 million mortgage, indicating extreme financial risk. Spirit’s levered free cash flow has been negative, with losses of $800 million in the past year and $265 million the year before, even when seat occupancy rates were slightly better. Additionally, the company’s stock has plummeted, now trading at less than half of its IPO value from 2011 and 95% below its peak.
Moreover, Spirit’s credit rating is a mere 0.4%, signaling a significant risk of bankruptcy within the next two years. The CEO’s recent bleak outlook, blaming external factors like government regulations, further underscores the internal issues within Spirit’s business model. The high operating leverage and the capital-intensive nature of the airline industry leave little room for error. Therefore, despite appearing cheap, Spirit Airlines represents a classic value trap, a seemingly attractive investment likely to lead to significant losses.
A word of caution as an analyst this is the type of business that we would avoid. It’s what’s called a value trap. This advice is crucial for investors navigating the small-cap stock market, where stocks that seem undervalued might carry hidden risks.
This research was aimed to educate viewers on essential financial principles and provide insights to refine investment strategies in the small-cap stock market. Want to keep up to date with all of TDR’s research and news, subscribe to our daily Baked In newsletter.
