Alaska Air Shrugs off the Competition

Alaska Air (NYSE: ALK  ) has earned very high profit margins in recent years due to its good cost structure and strong position in most of the markets it serves. It holds a near-monopoly on flying within the state of Alaska, and a dominant market share for flights between Alaska and the rest of the U.S. It is also the leading carrier in the Pacific Northwest, operating hubs in Seattle and Portland.

Alaska Airlines is the leading carrier in Alaska and the Pacific Northwest (Photo: Alaska Air Group)

This year, other carriers are starting to intrude onto Alaska's territory: particularly Delta Air Lines (NYSE: DAL  ) , and to a lesser extent, JetBlue Airways (NASDAQ: JBLU  ) and Virgin America. Not surprisingly, this has put downward pressure on fares.

However, Alaska has done an admirable job of maintaining its earnings power in 2013, despite the uptick in competition. This should give investors confidence that Alaska can manage future increases in competitors' capacity as well.

Competitive incursions
While Delta is Alaska's most important code-share partner, Delta's expansion in Seattle has been a mixed blessing. On the one hand, Delta's new international routes in Seattle rely upon passenger "feed" from Alaska, boosting demand for Alaska's domestic flights from Seattle. On the other hand, Delta has also started adding capacity in Seattle on routes that Alaska already serves.

This summer, the biggest effect was on the busy Seattle-Anchorage route. Alaska dominates that market, but Delta began new seasonal service this summer. The competition will heat up even more next year, as Delta is starting service from Seattle to San Francisco and adding more flights from Seattle to Los Angeles and Las Vegas (all routes that Alaska serves today).

Moreover, Delta is not the only airline increasing service in Alaska's core markets. JetBlue also introduced seasonal service between Seattle and Anchorage this year. JetBlue's new service operated from May until earlier this month. Whereas Delta had a clear strategic reason for serving that route -- it is building an international gateway in Seattle -- JetBlue is not a major player in either market. Presumably, that means JetBlue saw the high fares on the Seattle-Anchorage route as a growth opportunity.

Virgin America has also been growing in some of Alaska's West Coast markets. This summer, Virgin America added two flights a day between Alaska's Portland hub and San Francisco, although it simultaneously stopped flying the more competitive Portland-Los Angeles route. Virgin America also began flying between San Jose and Los Angeles this spring, competing with Alaska and several other major carriers.

Overcoming adversity
These increases in competitive capacity have had a clear impact on Alaska's results this year. In the spring, the company experienced a 10% decline in yield (a measure of the average airfare) on long-haul flights to the state of Alaska. This was one of the most important factors contributing to a 3.8% decline in Alaska's Q2 unit revenue. However, through good cost management, Alaska was able to limit its year-over-year profit decline to 5%.

If anything, these pressures increased in Q3, as most of the capacity increases began midway in the second quarter. In fact, Alaska reported last week that yields on the long-haul routes to Alaska declined 15% during the quarter. The company also faced pressure on many of its north-south routes along the West Coast.

However, this was offset by strong performance elsewhere in Alaska's network. Unit revenue improved significantly on flights to Hawaii, as Alaska and some of its competitors cut back on capacity. (For comparison, Hawaiian Holdings (NASDAQ: HA  ) reported a 10% increase in unit revenue on flights between Hawaii and the mainland U.S. for Q3.) As a result, Alaska's passenger unit revenue declined just 1.2% in Q3. Nevertheless, Alaska grew adjusted profit by $7 million year over year.

Looking ahead
Despite all of the competitive pressures it has faced this year, Alaska Air has actually grown the bottom line by $21 million year to date, while restarting its dividend and continuing to shrink its share count through share buybacks.

Therefore while Alaska faces continued capacity pressure in many of its core markets, investors shouldn't worry too much. Indeed, Alaska is implementing a variety of revenue and cost initiatives over the next year, such as adding a row of seats to most of its planes, increasing its bag fees and change fees, and renegotiating its lease at Sea-Tac Airport. These should allow it to offset any negative impact from Delta's continued growth in Seattle.

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