Why Is Alaska Air Ahead Of Its Peers? – Part 1

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Alaska Air

Alaska Air Group (NYSE:ALK), which almost doubled its profits in the second quarter due to significant fuel cost savings, reached a new 52-week high of $81.75 per share recently. While most of the airline stocks have been soaring over the last one year on the back of plummeting crude oil prices, Alaska Air has outperformed all its peers (except JetBlue) by growing more than 67% since last July and by more than 36% since the beginning of the year. Interestingly, the airline’s out-performance is not solely driven by the depressed oil prices. There are multiple quantitative as well as qualitative factors, apart from the sluggish oil prices, that have enabled the Seattle-based airline to deliver industry leading operating margins over the last 10-12 quarters and remain resilient even when the rest of the airline stocks were knocked down by investors due to fear of an overcapacity in the market.

P-1

Source: Google Finance

In this series of articles, we will discuss each of these factors in detail and how they drive the airline’s stellar performance. However, in this note (Part 1 of the series), we will analyze only the quantitative factors, such as diverse revenue base, focus on operational excellence, and a low cost structure, that influence Alaska Air’s performance. Look out for Part 2 of the series to read about the qualitative factors that are driving the airline’s current market price.

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We have a price estimate of $81 per share for Alaska Air, which is 6% ahead of its current market price.

See Our Complete Analysis For Alaska Air Group Here

Diversifying Revenue Base

Alaska Air does not believe in putting all its eggs in one basket. The airline considers itself a growth company and thus, it has been diversifying its operations over the years in markets which have a strong demand, and is exiting the ones which are not economically sustainable in the long term. The chart below depicts how Alaska Air has ventured into Hawaii and Transcontinental markets over the last decade, while optimizing its operations in other markets.

ALK_Capacity

Source: Bank of America Merrill Lynch 2015 Transportation Conference

Over the last one year, the airline has launched services in 18 new markets, and has exited five existing markets that were not commercially viable. Of these new markets, at least 13 markets have become profitable in their first year of operation and at least 9 of them would be sustainable even if the fuel prices rise back to $3 per gallon((Alaska Air Group 2Q15 Conference Call Transcript, 23rd July 2015, Seeking Alpha)). In addition, the airline has plans to re-launch 18 new markets in the second half of this year. This proactive approach of the airline to diversify its operations has enabled it to double its revenues from $2.7 billion in 2004, to $5.4 billion in 2014 in the last 10 years, growing at a CAGR of 7.2% annually((Bank of America Merrill Lynch 2015 Transportation Conference)).

ALK_new routes

Source: Second Quarter 2015 Results, Alaska Air

Apart from diversifying its operations, Alaska Air has introduced a number of new revenue streams, the latest one being the preferred seating program. While the customer satisfaction is likely to go up due to the additional legroom and complimentary drinks offered under this program, the airline is expected to generate additional revenue of $15 million annually((Investor Presentation, 6th April 2015, www.alaskaair.com)). While this might appear to be a meager figure on a standalone basis, but when we combine this with the revenues coming from the various other initiatives undertaken by the airline during 2014 and 2015, this is expected to add more than $100 million in the airline’s overall revenue in 2015 and beyond. Thus, the airline’s strategy to diversify its revenue base will allow the airline to offset a  weakness in its passenger yields and augment its top line growth in the coming quarters.

ALK_rev

Source: Investor Presentation, 6th April 2015, Alaska Air

Focus On Operational Excellence                                                                                                  

A happy customer is the backbone of a successful business. The management of Alaska Air truly understands this and has strongly etched this strategy into the airline’s business model. It has been diligently working over the years to consistently improve and maintain high standards for customer service through an exceptional operational performance. As a result, the airline has been recognized as the “highest in customer satisfaction among traditional carriers” by J.D. Power for eight consecutive years. The satisfaction of Alaska Air’s customers is clearly evident from the upsurge in the cash generated from the airline’s loyalty program. Despite winning this award, the airline recently launched a new “Beyond Service” workshop which is aimed at training over 8,000 employees, including senior executives, on how to further enhance their customer service.

ALK_Award

Source: Bank of America Merrill Lynch 2015 Transportation Conference

On the operational front, the airline has been leading its peers on a majority of the performance metrics. For instance, so far in 2015, Alaska Air has an on-time arrival rate of 86.6%, one of the highest in the industry, compared to its closest competitor Delta Air Lines with 84.2%((Bureau of Transportation Statistics)). The carrier has also managed to curb its cancellation rates to under 0.5% as opposed to American Airlines and JetBlue who reported a cancellation rate of 2.5% for the first half of 2015. This remarkable performance, built by the determination and persistence of the management over the years, differentiates the airline from its competitors. Consequently, the airline has become a preferred choice of its customers.

ALK_scorecard

Source: Bank of America Merrill Lynch 2015 Transportation Conference

A Low-cost Structure

Alaska Air is neither a full-blown legacy carrier such as United, nor a low-cost carrier (LCC) like JetBlue. Thus, it is well placed to take advantage of the benefits offered by both the worlds. To leverage this, the airline has been taking initiatives over the years to improve its efficiency and productivity and bring down its unit costs (excluding fuel costs) to resemble the cost structure of the LCCs. In 2014, Alaska Air reduced its non-fuel costs by 1.3% on a consolidated basis((Alaska Air 2014 Form 10Q, 11th February 2015, www.alaskaair.com)), which marked the fifth consecutive year of unit cost reduction. The airline targets to further lower its unit costs by 0.5% in 2015 by replacing its older, smaller 737-400 airplanes with 737-900 and 737-MAX airplanes to gain efficiency from flying larger and more-fuel efficient aircraft. In addition, the airline is adding split-scimitar winglets to some of its aircraft, which can bolster the fuel efficiency by 1.5% per aircraft. Currently, Alaska Air has a fuel efficiency of 77 available seats per mile per gallon (ASM/gallon), which is remarkably high compared to the legacy carriers. Since the phasing out of these smaller planes will take another two years, the airline’s fuel efficiency is likely to reach new heights by 2017.

ALK_efficiency

Source: Bank of America Merrill Lynch 2015 Transportation Conference

Further, the airline has long-term labor contracts which link the incentives of the employees to their performance. These techniques reduce employee turnover and ensure better productivity from the employees. Alaska Air has been able to enhance its overall productivity by more than 3.5% annually over the last 7 years. According to the airline’s latest presentation, 1% improvement in productivity is equivalent to savings of approximately $11 million annually. So to do a quick back of the envelope calculation, Alaska Air has saved, or rather earned, over $270 million (without considering the time value of money) due to productivity enhancement in the last 7 years.

ALK_Productivity

Source: Bank of America Merrill Lynch 2015 Transportation Conference

Clearly, the airline is not just relying on weak crude oil prices to boost its profits, but is rather working towards reducing its unit costs on a sustainable basis. In fact, the airline has been successful in bridging the gap between its own cost structure and that of the LCCs. This implies that the airline still has a potential to expand its operations without worrying much about straining its pricing power.

ALK_CASM

Source: Bank of America Merrill Lynch 2015 Transportation Conference

Driven by its low cost structure and extraordinary operational performance, Alaska Air has been delivering industry leading operating margins over the last few years. In the June 2015 quarter, the airline generated an operating margin of approximately 26%, which is almost 7% higher compared to the same quarter in 2014. One may be tempted to argue that the spike in the airline’s operating margin is primarily driven by the fuel cost savings. While we agree that the weak oil price scenario is playing a major role in the earnings of the Seattle-based airline, it is worth noting that it is a global phenomenon. However, only Alaska Air has managed to create a mark by growing its margins more than 7% higher than the industry average through its well-managed cost structure.

In addition to this, the airline delivered a return on invested capital (for the trailing twelve months) of 22% in the June 2015 quarter, compared to 16% in the 12-month period ending June 2014. This return is more than double of the cost of the capital of the airline, which means that the airline is generating sufficient returns for its shareholders as well as to plow back into its business. Thus, from an investor’s perspective, Alaska Air is a lucrative bet.

Operating Margins – Comparison

ALK_Margins

Source: Company Filings

We conclude this note by saying that Alaska Air’s focus on operational excellence, along with a low-cost structure and diverse operations, has distinguished the airline from its counterparts and will enable it to growth and outperform its peers even in the future.

Stay tuned for “Why Is Alaska Air Ahead Of Its Peers? – Part 2” to understand more about the qualitative factors influencing Alaska Air’s extraordinary performance.

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Source: Google Finance

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