Alaska Air Group (NYSE:ALK) has steadily raised its profits since the financial crisis of 2009. Even in 2009, when most U.S. airlines posted heavy losses due to the sharp decline in demand for air travel, Alaska posted a healthy profit. In fact, the airline has now posted profits for ten consecutive years. To maintain such solid profit performance in the airline industry, which reeled under losses for most part of the last decade, is quite an achievement. In our view, Alaska’s strong profit performance is driven by its strategy of focusing on a few markets where it controls a significant portion of the overall flying capacity. This dominance in turn provides Alaska with considerable pricing power and healthy margins. The carrier’s few core markets include Los Angeles, Anchorage, Portland, Hawaii, San Diego and most importantly Seattle, which constituted more than 60% of its passengers last year. 
Alaska has an extensive network to fly customers up and down the west coast and from major west coast cities to Hawaii and the state of Alaska. We figure this strategy of focusing on a few markets has worked well for Alaska as it has allowed the carrier to maximize its investments in ground facilities and personnel, as well as gain greater advantage from its marketing efforts in these regions. But in recent months, other airlines—particularly Delta (NYSE:DAL)—have expanded to some of these core markets. In response, Alaska has taken a number of steps, such as reallocating a portion of its capacity to new markets. In our opinion, despite Delta’s expansion, Alaska still holds a dominant position in many of its core markets, which will continue to benefit its results in the coming years. In addition, Alaska’s strong focus on cost reduction will also enable it to compete more aggressively against competitors. And this will enable it to further grow its market share, which is currently around 4% of the total domestic flying capacity in the U.S. 
We currently have a stock price estimate of $95.09 for Alaska Air Group, around 5% below its current market price.
Alaska Is Taking Measures To Retain Its Hold In Seattle
In terms of competitive overlap, Alaska’s principal competitor is Delta Air Lines. The carrier’s other major competitors, based on network overlap, are United (NYSE:UAL), Southwest (NYSE:LUV), American (NASDAQ:AAL) and Hawaiian. Delta, United, Southwest and American are much larger than Alaska and together control over 80% of total seats in the domestic U.S. air travel market. Thus, if any of these carriers decides to expand into Alaska’s core markets, then Alaska will have a significant challenge.
Delta announced such an expansion recently. It wants to establish Seattle, which is Alaska’s most important market, as its international gateway to Asia. (See Delta Is Expanding In Seattle To Target The Fast Growing Asia Air Travel Market) To feed its international passenger traffic from Seattle, Delta in recent months has added domestic flights connecting Seattle to cities such as Anchorage, Fairbanks, Las Vegas, Los Angeles, Portland, San Diego, San Francisco and San Jose. Now, Seattle-Anchorage, Seattle-Los Angeles, Seattle-San Diego, Seattle-Las Vegas and Seattle-San Francisco are the leading revenue generation routes for Alaska. Thus, these new routes from Delta present a major challenge for Alaska. In its first quarter earnings presentation, Alaska said that Delta’s expansion at Seattle has created excess flying capacity. Though Alaska anticipates this excess capacity to be eventually absorbed by the growing demand for flights, we figure in the meantime, this excess capacity will exert pressure on Alaska’s fares and yields. However, to Alaska’s credit, it has a lower cost structure than Delta, so it can drive down its fares more profitably to retain customers.
Additionally, to offset the challenge from Delta’s expansion in Seattle, Alaska is reallocating some of its capacity to new destinations out of Seattle such as Tampa, Detroit, New Orleans, Albuquerque, Baltimore and Cancun. This expansion will likely strengthen Alaska’s position in Seattle as frequent fliers are usually attracted to a carrier that connects to the maximum number of destinations out of a city. Alaska is also reallocating some of its capacity to new markets outside of Seattle to reduce its dependence on the city. This month, Alaska will start flying from Salt Lake City to seven cities in the west. We figure these measures will significantly temper the impact from Delta’s expansion.
Another factor we figure will likely help Alaska retain customers, in light of Delta’s expansion, is its lead over Delta in customer satisfaction scores. According to J.D. Power’s most recent study, which measured customer satisfaction scores for North American airlines, Alaska topped traditional U.S. airlines for a seventh straight year with a score of 737. This score was based on responses from more than 11,300 customers who traveled on major North American airlines during the past year. In this study, Delta was ranked behind Alaska with a customer satisfaction score of 693. 
Alaska Is Lowering Costs To Maintain Its Competitive Advantage Relative To Large Network Carriers
Apart from taking measures to retain the leading position in its core markets, Alaska is also focused on lowering its costs. Last year, the carrier lowered its non-fuel unit costs by 0.1% on a consolidated basis.  This reduction was the eleventh such annual reduction for Alaska in the past twelve years.
In our view, Alaska’s impressive cost performance over the last decade has been driven by many factors. The carrier has subcontracted an increasing number of services to third-party vendors lowering its operating costs and increased the share of alaskaair.com in its total bookings saving distribution costs. Going forward Alaska expects to slash its costs further by improving employee productivity. The carrier will likely also see a more fuel-efficient fleet in the coming years, as it is replacing the older aircraft in its fleet with more fuel-efficient aircraft such as the Boeing 737-900ER. It also has on order the 737 MAX, which is promised by Boeing to be the most fuel efficient aircraft in its class. We figure Alaska’s focus on reducing its non-fuel as well as fuel costs will enhance its ability to profitably drive down its fares. This ability is crucial in the current domestic air travel environment as three of Alaska’s principal competitors – Delta, United and American – have lowered their cost structures through restructurings during bankruptcy.
Overall, these measures around retaining hold in its core markets and reducing costs will likely enable Alaska to continue to grow its profits in the coming years. Higher profits in turn will generate solid cash flows, which Alaska is confident about as it recently announced share buybacks worth $650 million (which is nearly one-tenth the company’s market capitalization) and a dividend hike from 20 cents a share to 25 cents a share. Notes:
- Alaska’s 2013 10-K, February 13 2014, www.alaskaworld.com [↩] [↩]
- Alaska’s Investor Presentation, March 16 2014, www.alaskaworld.com [↩]
- Alaska Airlines and JetBlue Airways Continue to Rank Highest in Their Respective Segments, May 14 2014, www.jdpower.com [↩]
- Alaska Air Group approves $650 million share repurchase program, May 12 2014, www.alaskaworld.com [↩]