Allegiant Enters the Big Time

Allegiant Travel (NASDAQ: ALGT  ) has become one of the most successful airlines in the U.S. (albeit not a very well-known one) by attacking a distinct niche: leisure travelers going from small cities to warm weather destinations. Focusing on markets where it does not face any competition has helped Allegiant generate margin performance near the top of the airline industry for the last several years.

Allegiant has also benefited from maintaining a very low cost structure. The company buys used, older-model airplanes that other airlines are replacing, which are often available at bargain prices. This allows Allegiant to concentrate its flying on days of the week and in months with the highest demand. Allegiant's strategy of flying its routes less than daily works because leisure travelers tend to be more flexible in their scheduling than business travelers.

Earlier this month, Allegiant announced a new route that marks a significant shift in the company's philosophy. Beginning in late October, Allegiant will serve the busy Los Angeles-Honolulu route twice a week. This route is already served by all three major network carriers, as well as Hawaiian Airlines (NASDAQ: HA  ) , with each carrier offering multiple daily flights. What is Allegiant up to? More importantly, will it work?

Rethinking the market
A few years ago, Allegiant purchased Boeing 757 aircraft, which are larger and have a longer range than the MD-80s that are the mainstay of Allegiant's fleet. The primary reason for buying the 757s was that they would enable Allegiant to begin flying to Hawaii, a market that fits with Allegiant's overall leisure-oriented strategy.

Allegiant finally entered the Hawaii market in mid-2012, and the company expanded its flight schedule later in the year and then again in early 2013. However, Allegiant has discovered that Hawaii demand is more seasonal than it expected, and some of its markets cannot profitably support even one or two weekly flights during the off-season. As a result, Allegiant is seasonally cutting service on most of its mainland-Hawaii routes in mid-August. It's unclear whether all of those routes will be restarted during the 2014 peak season.

However, this move left Allegiant with a lot of extra 757 capacity. While the company has some ability to use those planes on other routes, the additional capacity cannot be absorbed in many of Allegiant's markets. (The 757s contain nearly 35% more seats than Allegiant's MD-80s.) Entering a busy market like Los Angeles-Honolulu could make sense insofar as there are enough travelers to keep planes full outside of the peak travel season.

Searching for bargain hunters
The real question for Allegiant is whether it can make a name for itself on a highly competitive route. The company's strategy seems quite simple: dramatically undercut competitors on price. Allegiant is offering $99 one-way tickets on the route (in limited quantities). By contrast, the cheapest tickets on market leader Hawaiian Airlines for travel in November are $273.50 each way. Even with Allegiant's additional fees, its cheapest tickets are half the price of tickets on Hawaiian.

Allegiant thus hopes to stimulate new travel demand in the LA-Hawaii market. By offering base round-trip airfares that are hundreds of dollars lower than competitors' prices, Allegiant will make a Hawaii vacation affordable for many travelers who could not pay today's market price. Given the size of the Los Angeles market, it seems quite plausible that Allegiant's lower fares will stimulate enough demand to fill its two weekly round-trips to Honolulu without having a major effect on competitors like Hawaiian.

Foolish bottom line
In some ways, Allegiant's new service between Los Angeles and Honolulu represents a big change. For the first time, it will be serving a route with many direct competitors. That said, the route still fits into the company's broader strategy of stimulating demand for leisure travel to warm weather markets with low fares and infrequent service. Allegiant's lower cost structure and ancillary revenue opportunities give it a good chance to succeed in this new market.

Allegiant stock has dropped by more than 10% this week, based on a relatively minor earnings miss. This could be a good time for bargain-hunting investors to buy stock in a company that has consistently posted strong margins and free cash flow growth over the last 10 years. If Allegiant can succeed in the Los Angeles-Honolulu market, it could create numerous future expansion opportunities in similar markets.

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