Is Alaska Air Group, Inc. Due for a Pullback?

As last year drew to a close, I reviewed the stock of Alaska Air Group, (NYSE: ALK  ) , and determined that it had room to climb in 2014. So far, so good; through the first quarter of this year, the stock has gained roughly 29%. Is the Seattle-based airline, one of the most efficient U.S. major carriers, getting ahead of itself?

The short answer to this question would appear to be no. While 29% is a precocious gain for just a handful of months, and though I'd love to take credit for a brilliant stock pick, the Dow Jones U.S. Airlines Index, which posted a brute gain of 86% last year, is up another 28% year to date. It's entirely possible that Alaska Airlines is getting bid up in the larger demand for airline stocks. Let's peel the aviation onion back a bit to get a closer read on Alaska's prospects for the rest of this year.

Earnings and valuation continue to look attractive
Alaska Airlines continues to impress investors with each earnings report. In its most recent filing for Q4 2013, the company reported record earnings of $78 million, a 68% increase over the prior year's quarter. The positive earnings were driven primarily by a 7% increase in revenue. When a company can increase earnings so significantly, it can offset a rise in the stock in terms of relative valuation, and we see this phenomenon at work with Alaska Airlines. When we reviewed the company's stock in November, ALK traded at 11.3 times trailing 12-month earnings. Since then, even after its price appreciation of more than one-fourth of its value, the airline's P/E ratio has remained in the same ballpark, at 13.0. This compares favorably to the peer group we previously compared ALK to. Currently, Southwest Airlines (NYSE: LUV  ) trades at 22.5 trailing 12-month earnings, and the P/E ratios of the rest of the group are as follows: Spirit Airlines -- 25.3, Republic Airways Holdings -- 19.1, and JetBlue Airways (NASDAQ: JBLU  ) -- 17.6. Thus, relative to its competitors, Alaska still looks cheap.

Finishing strong on two important objectives
One of management's most important achievements during the last 10 years has been its generation of strong operational cash flows. As we discussed in November, Alaska Airlines now holds a zero "net debt" position (i.e. cash less long-term debt) and, as of the last quarter, cash and marketable securities on hand have grown to $1.3 billion, or 1.5 times the $871 million of long-term debt on the balance sheet.

During the same time period that Alaska has been reducing its debt, it has sought to decrease the unfunded status of its pension plan. As of the end of 2013, the company's pension plan is now fully funded. In addition to bringing its unfunded liability to zero, Alaska has modified its retirement plans over the years while increasing contributions, the net effect of which will result in about $40 million less pension expense in 2014.

Continued progress in non-financial focus areas
The best-run companies pay almost more attention to non-financial metrics than pure profit and loss objectives, and this seems to be the case with Alaska Airlines. We know that the company is obsessive about on-time performance: Its 87% on-time arrival record placed it first among major North American carriers for the third year in a row, as ranked by FlightStats.

On a similar note, if you're looking for a key metric that can give you a quick read on the company's relative health each quarter, look for the amount that Alaska pays out in "Performance-Based-Pay," or PBP. Coming off a strong fourth quarter, the company's incentive payment to employees increased more than 20% in 2014 versus the prior year, equivalent to four-and-a-half weeks of pay for employees -- yet another company record.

Salmon livery on an Alaska 737, image courtesy Frank Kovalcheck under Creative Commons License

An update on the slugfest with Delta in Seattle
Likely the biggest question surrounding Alaska's performance is the effect of longtime codeshare partner Delta Airlines (NYSE: DAL  ) flexing  its competitive muscle in the airline's home base of Seattle. In 2013, Delta's desire to compete with its earnest affiliate changed the relationship between the two airlines fundamentally. In ALK's 201310-K annual report filing, management mentioned Delta by name as a threat:

Our biggest concern going forward is increased competition in our markets, from both traditional and low-cost competitors. Specifically, Delta Air Lines is significantly increasing its international and domestic departures in Seattle. We plan to vigorously defend our markets through Mileage Plan promotions, schedule changes, community events, and similar responses. We also continue to focus on lowering unit costs in the long-term so that we can compete more effectively, and increasing fuel efficiency by replacing older 737-400 and 737-700 aircraft with larger 737-900ER aircraft.

Sometimes, when a muscular ally begins to seem less than cordial, it can help to make friends with other big kids on the block. To this effect, Alaska Airlines is seeking to increase its ties with American Airlines (NASDAQ: AAL  ) . Alaska's marketing alliance with Delta contributes 3.8% of total company revenue, but American is not far behind at 2.6%. Strategically, the company may be looking to flip the two airlines' relative importance in order to make AAL its biggest codeshare partner, which was the case five years ago when American contributed 3.4% of total revenue, to Delta's 1.9%. One would think that diminishing revenue from Delta will be a significant priority for Alaska's management this year, as it's much easier to fend off a competitive challenge from a company when you're not also partially beholden to its income. Interestingly, when questioned on the company's Q4 2013 earnings call, Vice President of Planning and Revenue Management Andrew Harrison disclosed that ALK is indeed exploring revenue options with American's management team.

Of the tactics management mentioned in the quote above, schedule changes may be one of the more effective weapons to parry Delta's incursion. Recently, Alaska has closed a number of less-profitable routes, nixing city pairs such as Los Angeles -- San Jose, and Portland -- Long Beach. In turn, since December, it's opened up five routes out of Seattle, with only one (Albuquerque) in traditional western U.S. territory (the others are Detroit, Tampa, Baltimore, and New Orleans). This is a clear signal that management intends to not only maintain, but increase its market share on its home turf, while bulking up its presence eastward. 

So, is it still OK to invest?
So far, Alaska Airlines seems to have neutralized the revenue challenge from Delta. The risk for those wanting to take a new position is associated more immediately with the airline industry itself, which has enjoyed a huge run-up since the beginning of 2013. Otherwise, the company has much that an investor could wish for: revenue expansion, a well-optimized balance sheet, and an incentivized workforce, among other attractive characteristics. If you're in for a decent holding period, say at least one to three years, you can open a position now with relative comfort. This stock still has room to climb.

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