Friday, September 23, 2011

Alaska Air Group: Soaring Above The Rest

Don't let its industry scare you - Alaska Airlines is the complete package: The most profitable. The most efficient. First in customer satisfaction. Most on-time flights.

Alaska Airlines is owned by holding company Alaska Air Group (ALK), which also owns regional carrier Horizon Air. With Alaska Air Group's P/E less than half of larger players such as Delta (DAL), American Airlines (AMR) and Southwest (LUV), it appears that Alaska's strong performance is not appreciated by investors. The company has mastered the key to succeeding in a difficult industry: By maintaining excellent customer satisfaction, adding capacity and controlling non-fuel operating expenses, Alaska Air Group is able to produce consistent bottom line growth. Competitors surely know that this is the recipe for success, but unlike Alaska, they have not been able to execute.

Alaska Airlines accounts for about 82% of Alaska Air Group's revenues - Horizon Air contributes the rest. Please note that references to "Alaska" will refer to "Alaska Air Group" and not the specific airline, which will be referred to as "Alaska Airlines".

Exceptional Performance

Alaska Air Group has delivered consistent growth and continues to outperform the industry. Management has grown EPS 30.5% annually from 2007 to 2010 due to increased operating efficiency and organic revenue growth. Alaska Airlines continues to add capacity, growing available seats by 18% since 2003, while the industry has remained flat.

The company is not only increasing capacity, but also fills those seats. In August 2011, Alaska Airlines recorded an 88.3% load factor, which has consistently been improving over time in part due to the airlines' strong customer service. Alaska Airlines is #1 in on-time arrivals among domestic airlines and has been ranked highest in customer satisfaction by JD Power for four straight years.

Source: 2010 Annual Report

While fuel costs are certainly a concern to investors, Alaska Air Group has reduced its risk to a potential spike in oil prices by successfully managing costs it can control. Alaska Airlines' non-fuel mainline unit operating costs were 7.85 cents per ASM (available seat mile) in 2010, compared to 8.26c in 2009 and 8.73c back in 2001. 2011 guidance calls for even more improvement, with estimates at 7.60 cents.
Source: 2010 Annual Report. Costs do not include fuel and special items.

Like many other airlines, Alaska engages in fuel hedging as a safeguard against volatile jet fuel prices. The company has positions for 50% of its expected fuel requirements through the end of 2011, with an option to buy at $86/barrel. In 2012, the airline is 40% hedged at $90/barrel. CFO Brandon Pedersen notes that these activities have been successful in the past, saving the company nearly $400 million (although, it has caused some mark-to-market losses this year in Q2). Furthermore, Alaska has been committed to improving fuel efficiency, improving ASM (airline seat mile) per gallon by 16% from 2006 to 2010. In addition, Horizon Air is transitioning to an all-Q400 turboprop fleet that is more fuel efficient, a move that will present short-term costs, but also long-term savings.

Profitability and Efficiency: A Comparison

The powerful combination of capacity growth, cost control and increased load factors has propelled Alaska Air Group to financial success that other airlines should envy. From 2007 to 2010, while Delta, Southwest, United (UAL), American and US Airways (LCC) all saw EPS declines, Alaska came out stronger after the recession.

A look at margin trends can help explain the company's success. In 2010, it posted an industry leading 12.3% operating margin, which has been improving since 2007 (excluding the recession in 2008). Alaska has also been very impressive in how it utilizes its capital compared to the rest of the industry. Alaska's ROIC was 9.91% in 2010. In the trailing 12 month time frame, this figure increases to 11.5%. Management has made it clear that achieving a high ROIC, as well as reducing its debt/capital ratio, are priorities.

Relative Financial Strength

Compared to the airline industry, Alaska sports a healthy balance sheet and is continually reducing its reliance on debt. The company has no new borrowing in 2011, and currently does not lease any aircraft.


Alaska Air Group's P/E is 7.36, compared to the industry average of 12.25. price/sales (0.51 vs. Industry 0.68) and price/book (1.73 vs. 3.13) ratios are also attractive as well.

Future Outlook

During the first half of 2011, we continue to see execution of the same winning formula that produced success in 2010: Revenue increases (+8.1%), along with capacity additions (+9.5%) and non-fuel expense cutting (-4.6%). If not for Horizon Air's fleet transition costs and mark-to-market fuel hedge losses, Alaska Air Group would have posted record earnings. Under GAAP, the company posted first half 2011 EPS of 2.79 in 2011 vs 1.75 last year (+59%).

Analysts estimate 2011 annual EPS at 7.73, representing a 13.1% increase from last year. Assuming an industry P/E of 10 to 11, I target a $77 to $85 price. Management seems optimistic on the prospects for the remainder of the year, despite higher fuel costs. Advance bookings were strong in Q3 and load factors are expected to be in line with last years, if not better. August operational results were promising.

Further capacity growth is expected to fall between 3% to 6% annually, especially with the arrival of new aircraft from late 2012 to 2014. In terms of the threat of rising fuel prices, management is confident that the hedging strategies in place as well as a fuel-efficient fleet will be able to handle these costs.

With continued capacity additions and operational efficiency driving bottom line growth, we can certainly expect Alaska Air Group to deliver superior performance for investors in a timely fashion, just as it does for its passengers.

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