Alaska Air (NYSE:ALK) faced some major challenges in the first half of 2017. The company's recent acquisition of Virgin America has given it a big presence in overcrowded airports such as those in San Francisco and Los Angeles, leading to a decline in on-time performance. Meanwhile, Horizon Air, Alaska's regional affiliate, has been forced to cancel numerous flights because of a pilot shortage.
Nevertheless, Alaska Air was able to give its shareholders two pieces of good news last week. First, the company reported a strong second-quarter profit. Second, management announced that it had been able to accelerate a critical merger integration milestone by about six months.
Reaping the benefits of the Virgin America deal
While many airlines are on pace this year to post weak earnings growth -- or even earnings declines -- Alaska Air's profit growth is being boosted by the addition of Virgin America. Last quarter, Virgin America contributed more than $30 million of profit for Alaska Air, net of interest costs related to financing the deal.
As a result, adjusted earnings per share reached $2.51 in Q2, up from $2.12 a year earlier. On a combined basis -- i.e., including Virgin America's results from Q2 2016 -- revenue per available seat mile increased 3.5% year over year, offsetting a 3.3% increase in non-fuel unit costs and part of a roughly 12% increase in jet fuel prices.
For the third quarter, Alaska expects to face a similar 12% year-over-year increase in jet fuel prices. However, non-fuel unit cost growth should moderate to just 1.5%. With Alaska Air continuing to face less competitive capacity growth than some of its rivals, the company is well positioned to post another strong increase in EPS during Q3.
Merger synergies could come a bit sooner than expected
While Alaska Air is enjoying some incremental profit from owning Virgin America this year, the real value from the merger will come from unlocking revenue and cost synergies. Back in March, management raised its synergy target to $300 million but disclosed that it would take a little longer than originally expected to get there.
The main reason is that Alaska Air and Virgin America need to move to a single reservation system to unlock most of the revenue synergies. The "cutover" was originally scheduled for Q4 2018. However, the company has been able to move that event up to early in the second quarter. If everything goes as planned, this move will boost Alaska's earnings by about $20 million next year.
The move to a single reservation system can be tricky. Five years ago, United Continental (NASDAQ:UAL) botched its reservation system integration, as numerous reservations were "lost," flight delays spiked, and wait times for United's call centers spiraled out of control.
Recalling that incident, some airline analysts questioned Alaska's decision to move up the cutover date. However, management is confident that it can execute a seamless IT transition.
The company is using the lessons learned from United's 2012 meltdown and other airlines' more successful reservation system integrations to guide its planning. It recognizes that combining a massive amount of data from two systems was the weak point in United's process. Instead, Alaska will follow American's example to ensure that all, or nearly all, of its bookings are in the new reservation system at the time of the cutover.
Ramping up growth in a tough environment
Alaska Air will begin one of the first big steps toward capturing its expected revenue synergies next month. Between August and December, it will add a slew of new routes in San Francisco, Virgin America's largest market. By the end of the year, it will offer nonstop flights to most of the places within North America where people want to go from San Francisco.
Alaska Air will be competing with United Continental in all of these markets. United is adding capacity on many of these routes in response. It has also demonstrated that it will vigorously match competitors' prices.
As a result, these new routes may be money-losers at first. However, Alaska Air has a long track record of successful growth -- even in the face of tough competition. This is a point that management likes to repeat again and again. By the time the merger integration process is completed a few years from now, Alaska Air is likely to have a strong market position in San Francisco, notwithstanding the aggressive competition from United.