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Analysts Are Underestimating Hawaiian Airlines' Unit Revenue Potential

By Adam Levine-Weinberg - Dec 26, 2017 at 8:20AM

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Hawaiian Airlines will face higher competition in the mainland-Hawaii air travel market next year, but that doesn't mean its unit revenue will decline.

Like most of its peers in the airline industry, Hawaiian Holdings (HA -5.61%) would need to post strong unit revenue growth in 2018 to keep its pre-tax earnings stable. Rising costs -- particularly for fuel -- will create a pre-tax margin headwind of 4 to 5 percentage points.

However, while analysts expect most airlines to fully offset their cost headwinds next year, they aren't nearly as confident about the outlook for Hawaiian Airlines. On average, Wall Street analysts expect revenue to rise just 5% next year at Hawaiian -- slightly slower than its planned capacity growth rate -- and EPS to tumble from $5.64 to $4.48.

A Hawaiian Airlines A321neo parked on the tarmac

Most analysts expect that Hawaiian Holdings' EPS will tumble in 2018. Image source: Hawaiian Airlines.

This implies that Hawaiian's revenue per available seat mile (RASM) will be flat or even down year over year in 2018, causing sharp margin contraction. But while the carrier will face higher competition on West Coast-Hawaii routes, these predictions seem far too pessimistic.

Three major regions -- only one faces big challenges

Hawaiian Airlines serves three major geographical regions. In round numbers, about half of its revenue comes from flights between Hawaii and the U.S. mainland, a quarter comes from flights within the state of Hawaii, and a quarter comes from international routes.

The 2018 outlook for the interisland and international regions is quite strong. During 2017, Hawaiian Airlines has faced stiff unit revenue pressure within Hawaii due to the growth of its main competitor, Island Air. In Q3, Hawaiian posted a high single-digit RASM decline for its interisland routes. However, Island Air shut down for good last month, leaving Hawaiian with a virtual monopoly in its home market. This should enable it to achieve high single-digit or even double-digit RASM growth within Hawaii during 2018.

Meanwhile, Hawaiian's momentum is accelerating in the international market. International RASM increased more than 12% last quarter, nearly double the increase just two quarters earlier.

Obviously, Hawaiian Airlines will face tough year-over-year comparisons in 2018, which will put a damper on its RASM growth in the international market. On the other hand, beginning next spring, Hawaiian will benefit from the first phase of its new partnership with Japan Airlines, which will give it broader distribution in Japan and access to connecting traffic. This should keep RASM growing, albeit at a slower rate.

A Hawaiian Airlines plane flying over the ocean, with mountains in the background

Hawaiian Airlines is gaining momentum in its international markets. Image source: Hawaiian Airlines.

The net result is that for these two regions combined, Hawaiian Airlines is likely to post mid-high single-digit RASM growth next year.

How dangerous is rising competition in the West Coast-Hawaii market?

In the mainland-Hawaii market, conditions will be more challenging, due to a big uptick in industry capacity. This may cause Hawaiian Airlines' RASM to decline in this market, but it shouldn't be as damaging as many analysts seem to expect.

First, most of the capacity growth will be in Hawaii's secondary markets, while about two-thirds of Hawaiian Airlines' mainland-Hawaii capacity goes through Honolulu. There could still be an indirect impact on Hawaiian's Honolulu routes from travelers taking nonstop flights to the other islands rather than connecting through Honolulu. Nevertheless, it's helpful that only a small fraction of Hawaiian's capacity will face higher direct competition.

Second, Hawaiian Airlines' A330 retrofit program will wrap up soon. This will dramatically increase its inventory of lie-flat first class seats and extra-legroom economy seats in the West Coast-Hawaii market. The incremental revenue from this premium seating will make up for at least some of the impact of increased competition.

Third, the addition of the A321neo to Hawaiian's fleet will give the carrier the flexibility to cut capacity by 25% or more on any underperforming routes, without reducing flight frequencies. This will be a powerful tool to combat the potential revenue headwind from competitors' growth in the West Coast-Hawaii market.

These three factors may not fully offset the impact of higher competition on pricing. But any unit revenue decline on mainland-Hawaii routes is likely to be modest. If the other half of Hawaiian's network posts strong RASM growth as expected, that should be enough to ensure that unit revenue rises on a companywide basis as well.

EPS will soar past analysts' expectations

Analysts' earnings estimates for Hawaiian Holdings imply that its adjusted pre-tax margin will fall from 18% in 2016 and 2017 to around 13% next year. Some margin contraction is likely due to the combination of higher fuel prices and increased competition on West Coast-Hawaii routes, but these estimates seem far too pessimistic.

Furthermore, the current analyst consensus doesn't factor in the impact of tax reform. Hawaiian's effective tax rate will drop dramatically next year, creating a 20%-25% tailwind to EPS.

Thus, even if Hawaiian's adjusted pre-tax margin falls to 15% next year, EPS will soar past $6. With the stock still trading for around $41, Hawaiian Holdings remains one of my top picks for 2018.

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