Don't Give Up the Ghost on Spirit Airlines

Irrational markets offer up tremendous values for wise investors.

Spirit Airlines (SAVE) is a case in point. This low cost carrier has a lot of positives going for it:

1. Its fleet of aircraft is 100% Airbus (EADSY) , avoiding all the problems associated with Boeing (BA) .
2. It has no exposure to the Asian, avoiding coronavirus-related cancellations.
3. SAVE is the clear leader in the low-price, bare-bones category, hence their ticker symbol.
4. It has a decent balance sheet (Value Line rates its financial strength at B++).
5. 2019 set an all-time EPS record.
6. 2020 and 2021 are expected to continue that positive profit trend.
7. As of Friday, Spirit was offered for just 7.6-times this year's earnings per share estimate.

That single-digit price-to-earnings P/E is more remarkable than it seems. Since 2011, SAVE's growth has been exciting across all major metrics. Better still, the stock's pullback from near $65 at the end of 2018 now only reflects a fraction of the value built up during those past seven years.

Discrepancies like that are almost always arbitraged away via "catch-up" moves in the underlying shares.

What is Spirit really worth? SAVE's multiple has varied quite a bit over the years, but it averaged about 12.8 since coming public in 2011. A simple reversion-to-the-mean P/E of even 12-times supports a 12-month target price of $64.80. That's a cool 57.7% above Spirit's current quote.

That goal is far from crazy. SAVE topped out north of $83 in late 2014 and early 2015. It exceeded my year-ahead goal price late in 2018 and into January and February of 2019. Sales, cash flow, EPS and book value are all higher now than at any of those previous peaks.

I'm not alone in my positive assessment on Spirit Airlines. Yahoo Finance calls it undervalued and set a 12-month target of $51.47 per share. Reaching that very modest goal, at just 8.4-times this year's estimate, would still deliver a greater than 25% gain.

Independent research house Morningstar is more attuned with my own figures. Morningstar deigns to provide future target prices. It does, however, tell us what they feel is present-day fair value. For SAVE, that number says SAVE is worth $54.50 right now.

Hitting that number implies upside potential of 32.6%. Most of us would gladly settle for that type of return on our entire portfolios each and every year.

Option-savvy traders can do even better, with lower risk, by setting up a conservative buy/write combination. That involves purchase of shares while also shorting a covered call and a naked put on the same underlying shares.

The graphic below shows actual pricing on SAVE's Jan. 21, 2022 expiration date options with the shares at $41.10.

The table below details the actual cash flow of the three related transactions using 100-shares, one Jan. 2022 $45 call and one Jan. 2022 $45 put. It assumes cash payment for the shares purchased less the premiums received from the two option contracts sold.

There are just two possible outcomes if held through expiration day. SAVE will either close at $45 or higher, or below $45.

Closing north of $45 would deliver the best-case scenario detailed below. Any gain of 9.5% or better would make for a cash-on cash return greater than 99% over the next 23-months. That's every bit as good as outright buyers of SAVE at $41.10 would see if the stock rose to $81.83 by the Jan. 21, 2022 expiration day.

There can be no guarantee that SAVE will close above $45 on expiration day. If not, the worst-case scenario shown below would play out. Due to the structure of a buy/write combination, the results are far from scary.

You'd end up with a double-sized share position and more capital would be required. The net average cost per share, though, would drop down to just $33.80, a full 25% below the trade inception price.

Any decline of less than 25% would deliver at least a small gain, or almost as much as the best-case scenario if SAVE close near $45 but not quite above it.

Future stock market action can never be fully predicted. We can know for sure, though, that owning SAVE at the $33.80 break-even point of this buy/write combination would have been a winning position at least 95% of time dating all the way back to late 2013, more than nine years ago.

Note, too, that Spirits' true value has done nothing but go up since 2013, making its low valuation a much bigger bargain than at previous years' nadirs.

SAVE spent most of the past seven years trending between $40 and $63 per share, far above the break-even point on this option combination play.

Buy some SAVE shares, sell some LEAP puts or consider setting up a full combination play.

At the time of publication, Price was long SAVE shares, short SAVE Jan. 2022 options.