MIAMI — Ultra low cost carrier Spirit Airlines recorded a net profit of $64.8 million (88 cents per diluted share), for the second quarter of 2014, a 53.9% increase year-over-year from $42.1 during the second quarter of 2013. The controversial company once again led the US airline industry in operating margin and continued its explosive growth.

Total operating revenues rose 22.6% YOY to $499.3 million, led by a 25.5% rise YOY in passenger revenues to $302.5 million. Non-ticket revenue, which is critical to Spirit’s a-la-carte business model, rose 19.4% YOY to $196.9 million. Per-passenger revenue rose 3.7% to $139.90, composed of $84.75 in base revenue (fares – up 9.3% YOY), and $55.15 in non-ticket revenue (ancillary fees – up 3.2% YOY). The growth in ancillary revenue was driven primarily by passengers opting to purchase seat assignments, enabled by a recent software update that allows Spirit to sell seat assignments at kiosks and a more rigorous approach to managing seat inventory.

Average yield rose 2.4% to 14.24 cents, while operating revenue per available seat mile (RASM) rose 4.6% YOY to 12.46 cents on a 17.2% increase in capacity as measured in available seat miles (ASMs). While both metrics benefited from the shift of Easter into April (versus March in 2013), they were also brought down by a 4.4% increase in average stage length, which generated a 2.3 percentage point drag on RASM.

Operating expenses rose 15.7% YOY to $394.2 million, led by a 20.1% increase in labor expense to $77.4 million, a 21.0% YOY increase in landing fee and facilities rental expense to $25.8 million, and a 26.3% increase in maintenance expense to $19.2 million. Labor expense increased in part due to expansion, but was also adversely impacted by higher healthcare costs. The rise in aircraft fuel and aircraft rental expense both lagged ASM growth at 14.5% and 15.0% respectively, both tied in part to higher stage length. Higher average stage lengths allow for more utilization of aircraft (driving down per-ASM leasing costs), while longer stage length flights are also more fuel efficient (Spirit’s fuel efficiency rose 1.3% during the quarter). Furthermore, the extension of the leases for 14 Airbus A319 aircraft drove down aircraft rent per ASM. Operating cost per ASM (CASM) fell 1.3% YOY to 9.83 cents, while CASM excluding fuel fell 0.9% to 5.95 cents. Non-fuel CASM was driven down by Spirit’s improved operational reliability, which reduced unforeseen expenses. Indeed according to FlightStats.com, between May 15 and July 15, Spirit’s on-time percentage was 72%. While that’s not great, it is far better than performance during the same period a year prior (on-time performance hovered in the high 50s and low 60s).

Spirit ended the quarter with $567.2 million in cash and short term investments, up from $530.6 million a year prior and has yet to take on any debt since becoming debt free earlier this decade. For the seven new aircraft Spirit is taking delivery of during the remainder of 2014, three have been earmarked for sale-leaseback financing, while the remaining four deliveries will be financed with debt.

For the quarter, Spirit recorded an operating profit of $106.3 million which translates to an operating margin of 21.3%. Spirit’s free cash flow for the quarter came in at $95.0 million, and its pre-tax return on invested capital (ROIC) was 32.0%, with a post-tax ROIC of 20.1%.

For Spirit, the question is not so much whether the airline will continue to grow, but rather how the airline will grow. One of the revenue opportunities that we are most excited by is the potential for dynamic pricing of ancillary fees. On the carrier’s quarterly earnings call, CEO Ben Baldanza noted that the carrier is a long way from having the technology to price ancillary fees in real time:

“We’re still not to a point where we can dynamically price bag the way tickets are priced but we’ve done a lot in this area. And we’ve been — we’ve implemented some, some higher bag charges for peak summer period times, and based on that, and rolled some of that out to other holiday times and things.”

On the network side, Mr. Baldanza has frequently claimed that there are 500 markets that Spirit could expand into at current margins, and we actually believe that the numbers are stronger than that if you take a five year time horizon. We believe that Spirit probably has 750 markets over the next five years (thanks to rising fares elsewhere) that it could enter at present-day margins, and that around 250 of these will provide superior margins to the present day network. And this assessment takes into account the growth of rival ULCC Frontier Airlines and increased overlap with Allegiant Air.