Alaska Air Group, Inc. Is Flying into Headwinds

Last week, Alaska Air Group, (NYSE: ALK  ) reported record full-year adjusted earnings of $383 million, or $5.40 per share. Alaska has been one of the most successful companies in the airline industry in the last five years, rebounding from a net loss in 2008 and a meager profit of $122 million in 2009 to post double-digit pre-tax margins in three of the last four years.

Alaska Air Group will be flying into headwinds this year.

However, 2014 could be a very challenging year for Alaska Air. Beginning this past spring, it has faced significant competitive capacity increases on many of its core routes. This heightened competition will continue to put pressure on fares throughout 2014 and especially in the second half of the year.

Competition reaches a fever pitch
In 2013, Alaska Air's biggest competitive headache was an increase in other airlines' seasonal long-haul service to Alaska. The company's dominance of the Alaska air travel market is one of its biggest competitive advantages. However, the state saw a big increase in low-cost-carrier service last spring and summer, with flights on JetBlue Airways (NASDAQ: JBLU  ) to Seattle and on Virgin America to San Francisco.

There was also new competition on some of its California routes. For example, in February, both Delta Air Lines (NYSE: DAL  ) and Virgin America announced that they would begin flying on the crowded Los Angeles-San Jose route. On the flip side, industry capacity on routes between the West Coast and Hawaii -- about 20% of Alaska's business -- declined in the second half of 2013, offsetting some of the pressure elsewhere.

As bad as 2013 was on the capacity front, 2014 could be worse. Delta is significantly boosting its short- and medium-haul capacity out of Seattle (Alaska's main hub) this year. This includes new or increased service on numerous routes that Alaska currently dominates. Most notably, during the summer peak, Delta will operate five daily nonstops from Seattle to Alaska, up from just one last summer.

Delta's growth in Seattle could be a major thorn in Alaska's side.

Meanwhile, Southwest Airlines (NYSE: LUV  ) is expanding in San Diego and Portland. It is starting new service on several routes from both cities, most of which will compete with Alaska Airlines flights.

Alaska's dilemma
Alaska Air Group is a very well-run airline, but in the next few years it may become the victim of its own success. It already has very high margins by airline industry standards. This is due in part to its relatively good cost structure. However, part of its success can also be attributed to the limited competition it has faced recently.

With airline industry margins improving, many airlines are looking for low-risk/high-reward expansion opportunities. Previously, Alaska has been left alone in cities like Seattle and Portland, but now other airlines see these cities as growth markets due to the limited competition there. With Alaska making so much money there, other airlines want a share of the pie.

Foolish bottom line
Alaska Air Group has a lot of things going for it: a dominant position in Alaska, a very good reputation in the Pacific Northwest, and a competitive cost structure. However, while the rest of the airline industry should see another year of strong profit growth in 2014, Alaska may have already peaked.

By the second half of this year, Alaska will have trouble avoiding unit revenue declines as the significant uptick in competition from Delta and Southwest will outweigh positive economic factors.

Moreover, this rising competition will probably extend well beyond 2014 as many of Alaska's markets will remain underserved. (For example, Seattle is the largest U.S. metro area without significant ultra-low-cost carrier service today, a situation that won't last for long.) As other airlines gravitate toward these opportunities, Alaska may eventually have to settle for lower margins.

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