We are good airline operators. We're good at managing costs. We're good at managing operations. We're actually good at managing revenues, but we have been a little bit focused on the merger. And the sooner we get to the place where the merger is done and we're running the airline, which means whatever, getting close to our people, budgets, all of that stuff, the better. --Alaska Air Group CEO Brad Tilden

The quote above, from Alaska Air Group's (NYSE:ALK) third-quarter 2017 earnings call yesterday, neatly juxtaposes two narratives that accurately describe the Seattle-based carrier. One is that of a well-run, disciplined network airline that tends to lead the industry in any given quarter in several categories, including safety, customer satisfaction, and on-time performance.

The other, more current narrative describes an organization struggling to integrate an acquired competitor. Through three quarters of 2017, nine months after its December 2016 acquisition of Virgin America, Alaska has seen its typical operating margin shrink from costs both directly and indirectly associated with integration. More worrisome for shareholders is management's acknowledgment that the hard work of integration has pulled the airline's attention away from its basic business model. 

That model is to maintain low costs, offer low fares (but not ultra-low fares), and grow the top line through revenue management and capacity expansion. The expansion part hasn't been the issue -- as CEO Tilden pointed out during the call, Alaska has added capacity at an annual rate of 7% to 8% for the last 20 years. And since inking the deal with Virgin, the combined company has entered 37 new markets -- Alaska's largest network expansion in its history.

Alaska Airlines with updated blue and white livery on tarmac.

Boeing 737 in new Alaska Airline colors. Image source: Alaska Air Group.

But revenue and cost management have proven tricky this year. In the third quarter of 2017, revenue per available seat mile (RASM) declined 4.3%. Management attributed roughly 1.5 percentage points of this decline to a pared-back flight schedule in its regional Horizon Air subsidiary, due to a pilot shortage (now being remedied), and increased pilot training for new Embraer 175 aircraft added to the Horizon fleet.

RASM was also pressured from unexpected challenges by competing airlines in California, a market in which Alaska has ramped up its presence considerably, via the merger and subsequent introduction of additional flights. During the earnings call, management discussed competitors' recent steep discounting of close-in tickets (i.e. tickets bought very near to flight dates) on both intra-California and California transcontinental routes, which between them now make up roughly a quarter of Alaska's network.

In these routes, Alaska is seeing its peers slice close-in fares anywhere from 20% to 50% despite strong passenger demand and no significant change in airlines' capacity. This likely represents simply a near-term headache for the company as legacy and ultra-low-cost carriers (ULCCs) push back against Alaska's more muscular approach to the California market -- a consequence of the merger. But over the long term, basic economics have a way of convincing airlines to act rationally, so this rate pressure shouldn't be taken by investors as a permanent headwind.

Returning to traditional discipline

More pertinently over a longer horizon, Alaska should resume its typical focus on low costs, which provides the economics for both competitive fares and revenue growth. In the first nine months of this year, the carrier's operating margin has slipped to 18.3%, versus 25.1% during the same period in 2016.

Out of this difference, Alaska's fuel cost per gallon is running 20% higher than last year, equaling four percentage points of operating income decline which the company has little control over outside of its fuel hedges. The remaining three percentage points of cost creep are mostly, if not entirely, merger-related. These can be neutralized, but it may be late 2018 before we see a resumption of true ongoing cost efficiency. According to Tilden, Alaska has "another six or eight months to run hard" to complete integration with Virgin America. 

Though a return to normal operations by next summer isn't a terribly long time, investors didn't manifest much patience yesterday, swiftly administering a 13% single-session haircut on Alaska's share price. If you believe in the wisdom of crowd-sourced pricing, investors simply brought Alaska's valuation in line with both fellow network carriers and ULCCs, ratcheting down its forward price-to-earnings (P/E) ratio of near 12 to just over 10:

ALK PE Ratio (Forward) Chart

ALK PE Ratio (Forward) data by YCharts

Thus, the market isn't expressing skepticism on Alaska Air Group so much as it's resetting the company's valuation to an industry baseline. As a consequence, investors are likely to wait until the carrier resumes its characteristic operational efficiency before placing a new premium on "ALK" shares.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.