One year ago, investors were very optimistic about Alaska Air's (ALK -1.85%) prospects. The company was finally poised to benefit from slower growth by competitors in its markets, after several years of Delta Air Lines (DAL -1.64%) expanding rapidly in Seattle. Additionally, management had indicated that Alaska Air's acquisition of Virgin America would yield meaningful synergies very quickly.
As a result, Alaska Air stock reached an all-time high around $100 in early March. However, it's been all downhill from there, as various challenges have led to severe margin pressure for the carrier. Following Alaska Air's earnings report on Thursday, the stock price even dipped below $60 briefly.
Alaska Air stock performance, data by YCharts.
During Alaska Air's recent earnings call, management essentially urged shareholders to be patient. Given the company's strong track record up until 2016, investors should probably heed this advice.
The past year hasn't gone as planned
Alaska Air's earnings per share didn't decline all that much in 2017. Alaska ended the year with adjusted EPS of $6.64, down from $7.32 a year earlier. However, it should have seen a big benefit from having Virgin America in the fold. Full-year revenue increased 34% -- largely because of the acquisition -- but this was more than offset by the company's lower profit margin.
A few things have gone wrong. First, Alaska Air has encountered significant cost pressure from rising fuel prices, wage increases, and integration-related expenses. Second, Delta Air Lines didn't slow its growth in Seattle for very long. Third, unit revenue has been under pressure in California. Some of this weakness has come from Alaska Air's rapid growth there, but it's also likely that the carrier alienated Virgin America enthusiasts with its plans to phase out that brand.
Additionally, within a few months of completing the Virgin America acquisition, Alaska Air's management realized that merger synergies wouldn't materialize nearly as quickly as originally expected. This removed a potential offsetting factor that could have protected the company's profit margin last year.
Alaska Air is facing severe margin pressure. Image source: Alaska Airlines.
2018 will be another transition year
Thus far, the outlook for 2018 is even bleaker. Fuel prices are still rising rapidly. Furthermore, management expects nonfuel unit costs to increase about 2.5% year over year, largely due to a new pilot contract that went into effect a few months ago.
Most notably, unit revenue trends remain quite weak. For the first quarter, unit revenue is on track to decline 3.5%-4.5% year over year. (For comparison, Delta Air Lines expects to post a 2.5%-4.5% unit revenue gain this quarter.) Alaska will face competitive capacity growth of 6% in Q1 and 8% in Q2 based on current schedules, as Delta plans to boost peak-day seats out of Seattle by more than 10% by the time summer rolls around.
In fact, Alaska Air's guidance implies that it won't do much better than breakeven this quarter. That's far worse than what analysts had been expecting. Of course, the first quarter is always the weakest part of the year, but Alaska still needs dramatic improvement in its unit revenue trends as the year progresses to produce acceptable results.
Management is making the right moves
During the earnings call, Alaska Air's management highlighted several reasons why investors shouldn't give up on the company. First, the initial set of meaningful merger synergies will kick in after the company unites all of its operations under the Alaska Airlines brand in late April.
For example, Alaska Airlines has more international airline partners than Virgin America. Once it is flying all of its San Francisco and Los Angeles routes under the Alaska Airlines banner, it will be able to supply a lot more connecting traffic to those partners.
Alaska Air will also start to optimize the aircraft types used in each market in late April, though most of these changes won't happen until late 2018 or even early 2019. This will mainly entail using the company's larger Boeing planes on more transcontinental routes while shifting most of its Airbus fleet to short-haul routes along the West Coast.
Alaska Air will start to redeploy the former Virgin America fleet in late April. Image source: Alaska Air.
Other efforts to drive revenue and cost synergies will also unfold later in 2018. As a result, management expects to realize $200 million of synergies during 2019, up from just $65 million this year. Alaska Air is also evaluating whether to introduce a "basic economy" option (or something similar) to improve its revenue segmentation capabilities.
Finally, Alaska Air has significantly reduced its capex plans for the next three years. This will support free cash flow during this period. Furthermore, it is an important signal that management isn't out to build an empire -- it will cut back on investments if the projected returns aren't high enough.
Obviously, there's no guarantee that Alaska Air will return to its winning ways soon. But there are a lot of ways that the company may be able to improve its profit trajectory over the next year or two. That's why I'm planning to patiently hold my Alaska Air stock. Investors with a long time horizon should consider doing likewise.
