Jet fuel is the single largest expense for ultra-low-cost carrier Spirit Airlines (NASDAQ: SAVE) , accounting for more than a quarter of its cost structure. Thus, it would be natural to assume that the recent rise in oil prices — which is pushing jet fuel prices higher — would be very bad news for Spirit Airlines shareholders.
Indeed, higher fuel costs could drive up Spirit’s unit costs in 2018. Yet other airlines will face just as much pressure from rising jet fuel prices, including Spirit Airlines nemesis United Continental (NYSE: UAL) . This cost pressure could force airlines like United to cut back on discounting this year, allowing Spirit Airlines to increase its unit revenue significantly.
Airlines face a new cost headwind
For the past few years, employee wages have been the main cost headwind for most airlines. However, fuel prices started to creep up again during 2017. Those increases have accelerated in the last few months.
As recently as June, the market price of Gulf Coast jet fuel averaged $1.30 per gallon. Even in October, jet fuel prices averaged $1.66 per gallon. By contrast, the cost of jet fuel popped above $1.90 per gallon early last week. At that level, most airlines would face “all-in” jet fuel prices (including taxes and transportation costs) of about $2.10 per gallon.
Spirit Airlines will face higher jet fuel prices this year. Image source: Spirit Airlines.
For comparison, Spirit Airlines’ average fuel cost was $1.73 per gallon in the first nine months of 2017. United Continental’s average fuel cost was $1.68 per gallon during the same period.
Time to pull back on discounts?
Price competition has had a huge impact on Spirit Airlines in the past few years, driving steep unit revenue declines. Unit revenue started to recover in early 2017, but then United’s aggressive price-matching activity triggered a damaging fare war during the summer.
United Continental already has one of the lowest pre-tax margins in the industry, at roughly 8%. Based on the recent price of jet fuel, it would need 4%-5% unit revenue growth just to maintain that margin performance next year. However, United expects unit revenue to decline as much as 2% for the recently ended fourth quarter.
In other words, United needs to boost its fares just as badly as Spirit does. This will probably cause it to take a more cautious approach to price matching in 2018.
It wouldn’t take much to turn things around at Spirit
There are already some signs that the revenue environment is improving. Several airlines raised their Q4 unit revenue forecasts last month. Spirit Airlines wasn’t one of them, but it typically waits until mid-January to update its fourth-quarter guidance. Thus, investors will have to wait a little while to learn if the carrier has participated in this revenue recovery.
If larger airlines like United put more emphasis on pricing discipline in 2018, Spirit Airlines might benefit from an opening to push its fares higher. Its average fare won’t need to rise very much to have a meaningful impact on unit revenue. For the past two years, Spirit’s average fare has been about $56. That’s down from an average of $65 in 2015 and $80 in 2014.
A mere $10 increase in the average fare — along with continued growth in non-ticket revenue — would drive a roughly 10% unit revenue gain. Not only would that fully offset rising fuel costs, but it would also probably cover the cost of boosting Spirit Airlines’ pilot pay to market rates.
A return to strong profit growth?
Spirit Airlines has maintained a high capacity-growth rate in recent years, averaging about 20%. Unfortunately, due to its persistent unit revenue declines, its revenue growth has averaged just 11% for the past three years.
In 2018, Spirit expects to boost flying by 22% to 25%, after its capacity was artificially depressed in 2017 due to pilot availability issues and engine problems on its A320neos. If its unit revenue starts growing again — due to other airlines reducing discounting in response to higher fuel prices — Spirit’s revenue could surge by 30% or so. This would allow it to post a big increase in profit as long as its pre-tax margin stays roughly flat. (Spirit Airlines will also get a big profit boost from the reduced corporate tax rate.)
Of course, if Spirit Airlines’ unit revenue continues declining this year, its earnings will plunge due to the uptick in fuel prices. However, the more likely outcome is that higher fuel prices will lead to less price competition, paving the way for a resurgence in 2018.
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Adam Levine-Weinberg owns shares of Spirit Airlines. The Motley Fool owns shares of and recommends Spirit Airlines. The Motley Fool has a disclosure policy .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.