In the midst of the losses at Alaska Air Group (NYSE:ALK) that occurred as a result of the in-flight failure of a door plug on a new Boeing (BA) MAX 9 operating by ALK, investors who paid attention to Alaska Airlines (ALK)’s first quarter 2024 earnings presentation noted a key detail: the company was committed to turning around its tradition of losing money in the first quarter of the year. An airline that is based in the Pacific Northwest with a significant presence in Alaska has structural challenges that make it hard for it to make money in the winter but one of the company’s goals has been to change that historic trajectory. The MAX 9 accident not only grounded dozens of aircraft and forced ALK to remove double-digit percentages of capacity from its network but it also set in place a number of other events that could have crippled the company for years. Yet, ALK management has laid out not only a plan to deal with the short-term challenges from the accident and its aftermath but also to continue to address its profitability which is no longer at the top of the industry as it once was.
A Solid Core Business
Alaska Airlines has historically been an investor favorite as a result of having an above-average balance sheet and above average earnings for the airline industry. The latter half of the last decade was challenging for ALK; Delta Air Lines (DAL) decided to build a Pacific Northwest hub at Seattle, ALK’s hometown, as a replacement for its transpacific hub at Tokyo’s Narita airport. Pre-covid, DAL’s hub was just under half of the size of ALK’s Seattle operation but connected most of the top 20 Seattle air travel markets as well as dozens more domestic cities to a half dozen longhaul international markets in Europe and Asia but generating about two-thirds of the total local market revenue that ALK generates at Seattle.
In order to help build its presence on the west coast, ALK acquired relatively young Virgin America Airlines, a premium domestic longhaul focused airline that had strength in California that ALK lacked. The Virgin America acquisition was contested by JetBlue (JBLU) which forced ALK to spend more on the deal than it originally proposed. Amidst intense competition before the pandemic and then the covid crisis, ALK scaled back much of the network it acquired from Virgin America and retreated to its core strength markets in the Pacific Northwest including to/from Alaska and Hawaii. During the past three years, ALK has been focused on rebuilding its network and its financials that were disrupted by the pandemic.
Alaska’s recovery and current performance is generally in line with what other U.S. airlines are experiencing. Global airlines Delta, the most profitable among U.S. airlines, and United (UAL) have led the profit recovery thanks to their strong and growing international networks; U.S. carriers generally fared better than many of their global competitors during the pandemic and are now better positioned in the global market than they have been in decades. In addition, airlines that offer premium products have generally done better than low-cost carriers as more and more U.S. consumers are spending money on experiences and buying higher quality travel experiences than they previously bought. While ALK does not operate longhaul intercontinental flights, it does offer a domestic first-class cabin as well as service to some destinations in Latin America and the Caribbean. ALK reports that its premium travel services are doing well, just as they are for the big 3 global carriers.
A review of ALK’s first quarter financials shows that the company was on track to be profitable if the accident had not happened, indicating that their industry positioning and the strategic initiatives they implemented were on the verge of paying off. However, the accident did occur and set in motion not just the grounding of the MAX which took nearly four weeks to bring to a complete end but also resulted in intense scrutiny on Boeing’s manufacturing and quality control processes – resulting in a reduced production rate for the MAX aircraft which is the only large jet model that ALK has on order. Ironically, it removed the last of its Airbus (OTCPK:EADSY) A320 family aircraft acquired in the Virgin America merger from its fleet just days before the accident. ALK noted that its capacity would have been up a modest 3.5% in the first quarter but was down 2.1% as a result of the 5.5% lost over the course of the quarter as a result of the MAX grounding.
ALK’s network is most heavily concentrated at nearly 50% on mid-con and transcon routes with roughly 20% on the west coast and decreasing percentages to Hawaii, Alaska and Latin America. ALK’s capacity trends show that it is deepening its presence in the middle of the United States, important to help compete with the big 3 carriers in their strength markets. Since Alaska’s continental U.S. hubs are all on the west coast, they carry a significant amount of traffic to and through its west coast hubs that other carriers might carry through hubs in other parts of the country.
ALK’s first quarter revenue and costs were negatively impacted by the sudden removal of so much capacity so quickly as a result of the MAX 9 grounding. Still, ALK says that managed corporate travel has returned to 2019 levels and tech (heavy on the west coast and esp. in the Pacific Northwest) is 85% recovered. It is seeing loyalty and co-brand revenue strength, also in line with what the big 3 global carriers are seeing.
ALK has a potential upside in British Airways decision to develop codesharing relationships with both JBLU and ALK, evidence of British Airways’ dissatisfaction with distribution and corporate sales decisions which have been made by its alliance and joint venture partner, American (AAL). Although AAL is not strong in ALK hubs, any additional business that ALK could get in addition to a stronger position in the oneworld alliance with American, British Airways and other airlines will help ALK’s finances. ALK and JBLU both have extensive code-sharing relationships in which it completes the domestic portions of foreign carrier flights using the foreign carrier’s code and granting them special connecting fares.
Looking ahead, ALK expects to grow its capacity the most in the (current) second quarter with smaller increases later in the year. The company says it needs to retire some of its older aircraft and will likely do so after the peak summer travel season. ALK also says that its peak summer demand has shifted forward in the year as schools start back earlier in the fall or late summer, also a trend that other airlines are seeing, making June its strongest month, and likely resulting in the second quarter earnings as the high mark of its financial schedule.
On the cost side, ALK has historically had a double-digit unit cost advantage compared to the big 3 and that continues. It also has a unit cost advantage compared to Southwest even though ALK uses regional jets with their traditional higher unit costs and lower efficiency compared to mainline aircraft due to ALK’s efficiencies and its laser focus on costs.
Alaska has traditionally paid more for jet fuel than other carriers as a result of higher fuel costs on the west coast; as west coast traditional refineries have been converted for other uses, price has increased even more and the refining crack spread or margin has increased. ALK notes that the jet fuel refining margin was increased for the past two years but is beginning to return to lower historic levels and in line with Gulf Coast refineries which will help its fuel costs. In addition, ALK expects to begin buying jet fuel in other parts of the world and ship it to its hubs even further offsetting the higher west coast fuel costs, a practice which ALK says is common in the industry.
One final cost area that ALK has to address is its open flight attendant contract. Airline contracts are governed by the Railway Labor Act; under the RLA, labor contracts do not expire but become amendable. There is a lengthy process unions have to meet to be able to strike which gives companies a strong incentive not to settle labor contracts quickly. Alaska’s flight attendant contract became amendable and the union representing its flight attendants says they are becoming increasingly frustrated with the pace of negotiations.
Airline labor costs have rapidly grown post covid and many airlines are struggling to pay the higher labor costs. Currently, non-union Delta and SkyWest have provided updated pay scales to its flight attendants and other personnel while unionized Southwest has now closed the renegotiation process for its labor groups including its flight attendants. Unionized American and United have yet to settle new agreements with its flight attendants even though nearly all other labor groups at both airlines have received new contracts. Alaska is in a similar position as AAL and UAL.
Delta led the industry post-covid in settling both with its unionized pilots as well as with the remainder of its workforce, the majority of which are non-union. DAL is generating the revenues to support significantly higher labor costs while many other airlines are not. As ALK attempts to increase its profitability, including on a year-round basis, managing its labor costs will be a challenge. Because the AAL and UAL FA contracts should be settled before ALK’s based on the amendable dates, ALK will have time to prepare for the higher rates that come with the settlement of contracts at those two larger airlines.
Counting on the Merger
While Alaska continues to build its own operation to be more profitable, it is optimistic that its merger with Hawaiian Airlines (HA) will be approved. The DOJ is currently in the phase where it can notify ALK whether it will challenge the merger but has not done that yet. Many people are fearful of the DOJ’s decision given its rejection of two deals involving JBLU but both involved factors which were not only different than the ALK-HA merger but also different from other airline mergers that the DOJ has approved in the past, even if under different administrations.
The Alaska-Hawaiian merger should be a fairly straight forward end-on-end merger of two legacy airlines; both ALK and HA provided interstate transportation before 1978, classifying them as legacy carriers. ALK’s presence is on the west coast extending to the Midwest and Eastern U.S. as well as to Alaska, Hawaii, and Latin America while HA connects cities on the U.S. mainland, predominantly in the western U.S., to Hawaii where it operates an interisland service. HA also has service to a number of destinations in the Asia/Pacific region. ALK and HA combined would have almost 40% of mainland to Hawaii capacity and do overlap on several routes, raising the specter of some limitations from the DOJ. However, the mainland-Hawaii market is highly competitive and ALK and HA have competitors even in markets where those two overlap.
Hawaiian’s business was significantly impacted by the covid pandemic which required it to take on proportionately more debt than mainland airlines because of Hawaii’s greater entry requirements and slower reopening even though some of HA’s Asia/Pacific destinations such as Australia and Japan remained closed for travel even longer. Post-covid, the Japanese Yen has been weak which has depressed travel from Japan to Hawaii.
In addition, Southwest Airlines began service from the mainland to Hawaii pre-covid and also added several interisland routes. Although LUV has wanted to use smaller MAX 7 aircraft, it has been forced to use larger MAX 8 aircraft since Boeing has not certified the MAX 7. The combination has put even more seats into the intrastate market, depressing fares and making it difficult to fill all of the seats.
Despite the depressed international travel market to Hawaii, HA just took delivery of its first Boeing 787-9 aircraft which will, for now, supplement its fleet of A330-200 aircraft which are capable of serving all of the Pacific Rim and the Eastern U.S. from Hawaii.
The ALK-HA merger provides the opportunity for the combined entity to better coordinate schedules across the U.S. which will help AS and HA’s service from the mainland to Hawaii even as some duplicated capacity is expected to be removed. In addition, AS could increase feed to HA’s international flights from Hawaii to Pacific Rim destinations but it is also possible that ALK could redeploy some of those widebodies for service from the mainland to Asia or Europe, something ALK does not now do although ALK would face a very competitive international marketplace. Although AS has just simplified its mainline fleet back to just the Boeing 737 family, ALK has a complex fleet with aircraft from a total of four Airbus and Boeing aircraft families none of which are the 737 family which ALK operates. ALK eliminated its Airbus aircraft in order to increase efficiency and reduce costs but its operation will become significantly more complex and costly. HA is losing money currently which means that ALK will have to work quickly to stem the losses.
A Turnaround Story in the Making
Alaska stock has underperformed other airlines during the past year but was on the verge of addressing many of the reasons for its underperformance at the time of the January MAX accident. Even on a standalone basis, ALK should begin to see improvements in its finances.
Indications that the DOJ will allow the ALK-HA merger could come in days and would allow ALK and HA to accelerate their integration plans. A merger would require a significant amount of focus from ALK management but will open a new chapter of growth for ALK which could include longhaul international service.
ALK is very likely to see near-term improvements in its financial performance which will boost its stock price and should soon begin a new chapter of expansion and, thus, is worthy of a BUY rating.
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