Virgin America made its final flight under the Virgin brand last week, finishing out its merger with Alaska Airlines (NYSE:ALK). And while Alaska had a rough 2017 and a turbulent start to the new year, the future could prove a much smoother ride for the airline.

In this week's episode of Industry Focus: Energy, analysts Sarah Priestley and Adam Levine-Weinberg go through the biggest problems and bright spots facing Alaska Airlines today, how the company is working to right its course, and what risk factors investors should watch for in the coming quarters. Also, the hosts touch on what we know so far about the Southwest (NYSE:LUV) investigation and when we can expect to know more about what caused the accident.

A full transcript follows the video.

This video was recorded on April 26, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 26th of April, and today we're going to be talking about Alaska Air Group. I'm your host, Sarah Priestley, and joining me on Skype is senior Motley Fool contributor Adam Levine-Weinberg. Hey, Adam!

Adam Levine-Weinberg: Hi, Sarah, how are you?

Priestley: I'm good, thank you. I was just explaining to you before we started recording about the miserable rain and prolonged winter that we're having here in Washington D.C.

Levine-Weinberg: It's unfortunate. It's much sunnier here in California.

Priestley: [laughs] Yeah, maybe I just need to take a trip to California. For today, we're actually talking about a company that could make that possible. It's an airline, and one that has been in the news for a couple of reasons this past week. One is because they had an unexpected beat on earnings, and the other is because they announced a crackdown on emotional support animals, which, by all accounts, had apparently gotten out of hand. So, there you go. Anyway.

Alaska Air Group is a West Coast airline operator that some of you may not be familiar with. Adam, I've never actually flown with Alaska, but I guess, you being on the West Coast, have you used them before?

Levine-Weinberg: Not very frequently, but yes, I have flown with them a couple of times.

Priestley: How would you rate your in-flight experience with Alaska?

Levine-Weinberg: It's very good. It's nothing fancy, but they are very good at what they do, in terms of getting you to your destination on time, and that's really the most important thing when you're flying an airline.

Priestley: [laughs] Yeah, absolutely, that's pretty much all I care about. For people who aren't familiar with the company, can you give us some of the basics?

Levine-Weinberg: Sure. Alaska Air Group is actually now the fifth-largest airline in the U.S. Their 2017 revenue reached $7.93 billion. That's up 70% from 2012. And about half of that growth was organic, but half came from the acquisition of Virgin America, which was completed in late 2016. 

While Alaska is the fifth-biggest airline in the U.S., it's still quite far behind the top four. The three biggest airlines are the legacy carriers that we all know about -- American Airlines, Delta and United. They all have revenue of about $40 billion, about 5X as much as Alaska. Even Southwest, which is No. 4, has almost 3X as much annual revenue as Alaska. They're well over $20 billion.

Priestley: So, the top four make up 80% of the market.

Levine-Weinberg: Yeah. They really dominate the market, but that also creates a ton of growth opportunities for smaller carriers like Alaska Air Group. That's a big reason why, in 2016, Alaska decided to acquire Virgin America. They paid quite a hefty sum, $2.6 billion of cash. The idea behind the merger was basically to expand Alaska's geographic footprint so that it would have a platform for their growth. If you look back historically a couple of years or longer, Alaska was the dominant airline in the Pacific Northwest. It had its main hub in Seattle, secondary hubs in Portland and Anchorage, and a relatively small presence in California with small, focused city operations in both Los Angeles and San Diego, plus some flights to Hawaii from other cities in California. With the Virgin America acquisition, Alaska is now a major carrier in San Francisco. It's actually the second-largest airline in San Francisco now. And it also has a much bigger footprint in Los Angeles, because Virgin America was pretty strong there, as well.

Priestley: And I know these are all cities that are very sought-after by the airlines, because it can be difficult in a very busy airport to get runway time and to get gate time and things like that. So, obviously, this was a big boon for them. They definitely paid a hefty price for it. They paid $57 per share, is that right?

Levine-Weinberg: That's correct.

Priestley: That was a big premium, an 80% premium on Virgin's trading price at the time. But, it seems to have given them a much bigger footprint, and like you said, a much better foothold in the market in the U.S. In 2017, last year, they were really a stock market darling. The stock was up to almost $100 at one point. Declined 26% over the course of the year because they had this revenue surge after the acquisition of Virgin America, but profitability was declining, and they posted adjusted earnings per share of $6.64, which was down almost 10% for the year. 

So, not a great year for them in 2017. Or, a bit more of a roller coaster, would you say, Adam?

Levine-Weinberg: One of Alaska's strengths historically was that because it was in this protected Pacific Northwest Market where there wasn't as much competition, particularly true in Alaska, somewhat true in Portland, for many years, it was true in Seattle, although more recently there's been a big increase in competition from Delta Airlines in Seattle. But, you had a pre-tax margin of 24% in 2015, and 24.4% in 2016, which is just really unheard of in the airline industry. So, Alaska was way at the top above its competitors. And now, as it's starting to face some more competition in its markets, both in Seattle but also in its new markets in California, and some other merger headwinds, let's call it, the profit margin really fell quite a bit last year. 

So, a lot of airlines faced some margin pressure in 2017 because of rising fuel costs, but Alaska had this increase in competition both in California and in Seattle from Delta Airlines. So, the result was that its pre-tax margin declined to 16.6% from being 24% or higher in the prior two years. So, that was a pretty steep decline, although it still left Alaska Airlines at an above-average level of profitability compared to other airlines.

The problem is, these profit headwinds have continued into the first half of 2018. So, while the company did post better than expected earnings last quarter, it still saw a pretty dramatic collapse in its profitability, and that trend is going to continue, probably, into the second quarter.

Priestley: Absolutely. And like you said, there seems to be a host of factors. But the relationship with Delta in Seattle is interesting because they had, for years, operated this kind of symbiotic relationship, where Delta had some international flights out of Seattle and then Alaska was operating some regional flights, which worked very well for both carriers. Now, as you said, they're starting to see a lot more competition. And I think they're responding well to that. 

One move that they did make is, obviously, reuniting the Virgin America brand under the Alaska brand. Some have argued that this maybe alienated some Virgin Atlantic loyalists. I don't know how many loyal air travel passengers there are. [laughs] Maybe I'm just speaking from my own experience, but I feel like a lot of people are really going with the cheapest or most convenient option, as opposed to sticking with a carrier, unless they're a credit card follower for the points and the miles and things like that.

Levine-Weinberg: Yeah. I would say, the biggest risk to Alaska from the Virgin America merger is not in losing the volume. The vast majority of people who are flying Virgin America would fly Alaska, or at least would consider flying Alaska. Virgin America was known for having this eight-seat first-class cabin in all of its planes, which was very fancy, basically one flight attendant for just those eight people, humongous seats that were really cushy, all kinds of other perks. And it was a seat where you weren't allowed to get an upgrade just for flying a lot, you had to actually pay for the seat. People liked that because it was exclusive, so there was a certain small class of people who were paying $1,000, $1,500 one way for these seats on routes, and that's obviously very profitable. 

On the other hand, it was only eight seats per plane, so it's still not the majority of Virgin America's revenue by any means. But, it was an important part of that business. Alaska will still have a first-class section. It's actually going to be a little bit bigger. But, the seats themselves won't have as much legroom, and they just won't be as much of a standout, so the revenue premium that it's getting there will probably be smaller. But, you look at the economy cabin, I don't expect to see much pushback from former Virgin America customers at all.

Priestley: Yeah. I think that Virgin America did a fantastic job with a lot of their marketing, but as you said, it's probably not going to hamper Alaska much at all. One of the big things I've seen is, the synergies from the move are taking longer to materialize, which made me think, don't they always? [laughs] Whenever companies present these cost-savings from mergers, it always seems to take longer than they expect to recuperate. 

Their first quarter earnings, you touched on, they were better than what they were expecting, but that's really because, I think, they brought down expectations at the end of last year. Can you can give us a run-through on how they performed?

Levine-Weinberg: As you mentioned, when they provided their guidance back in January, the forecast implied that Alaska might actually lose money in the first quarter of this year. Instead, the adjusted EPS came in at $0.14, but that was still down from $0.99 a year earlier, as Alaska's pre-tax margin fell all the way from 11% to 1.3%. So, just looking at why there was this big margin decline, first, you had unit revenue fall 2.1%, which is still better than the fourth quarter, when there was a 4.1% decrease in unit revenue. This unit revenue pressure is being completely driven by new routes that were introduced over the past year. In fact, Alaska noted on the earnings call this past Monday that there was a 0.5% increase in unit revenue on routes that had been operating a year earlier. So, the decline was because new routes tend to have lower unit revenue to start, and then, if they don't show signs of improvement, they'll usually get cut. But, most routes will improve over the course of anywhere between six months and two years. The other major factor impacting the margin last quarter was a 20% increase in Alaska's average fuel price, and to a lesser extent, a 5.1% increase in non-fuel unit costs.

Priestley: That's driven by those higher labor costs that were agreed to last year, is that correct?

Levine-Weinberg: Yeah, about two-thirds of the non-fuel cost increase was driven by labor costs. There was a new contract signed with the pilots after an arbitration proceeding last fall. Then, just earlier this month, the flight attendants ratified a new agreement, which was retroactive to the beginning of the year, giving them a pay increase.

Priestley: Going from this point, how do you think Alaska Air Group is going to get back on track and improve its reputation, as it were, get back to being that stock market darling that it was in 2017?

Levine-Weinberg: I think that during the second quarter, you'll still have some trouble, because a lot of the headwinds that caused trouble for the past couple of quarters are continuing. There's actually going to be an even bigger headwind from fuel costs. Based on current fuel prices, Alaska now expects a 32% increase in its jet fuel costs, which would be a pretty substantial margin headwind. Also, the timing of Easter this year moved some revenue from the second quarter into the first quarter, because Easter was at the very beginning of April. 

But, looking beyond to the second half of this year and 2019, and then also beyond 2019, there's a lot of reasons to be more hopeful. The first is that Alaska expects to get $300 million of revenue synergies from the Virgin America deal by 2021, and most of those synergies will show up in 2019 and 2020. 

Another thing that's going to help is that the last Virgin America-branded flights operated on this past Tuesday, April 24th. So, going forward, there's going to be just one brand, Alaska Airlines, one tech system. That's good for revenue management, which helps increase unit revenue. It also will create some new revenue opportunities, such as connecting flights between Alaska's international partner airlines like British Airways and the former Virgin America routes. That's particularly important because San Francisco and Los Angeles, which were Virgin America's points of strength, are much bigger international gateway hubs than Seattle, so there's more of these partnering airline flights going into those two cities, where Alaska Airlines can now sell connecting tickets throughout its network.

Another thing that's going to happen is some new revenue initiatives that are not merger-related. The most notable of that was, the company is going to start selling what they call Saver Fares, which are the equivalent of basic economy, and that's going to happen probably in November or December. The idea behind these Saver Fares is, it'll be a ticket that's only for seats in the very back of the plane, and it'll be a little bit cheaper. This is a way to better segment customers, to get the one who are the most price-sensitive on the plane while getting people who are willing to pay a little more to sit further forward or to get an extra legroom seat to pay a few dollars extra. And over the course of a thousand or more flights a day, that can really add up.

Priestley: Absolutely. I noticed they're getting much stricter on their route network, which I think is really sensible, and also leveraging their fleet better. Listening to the call, they were talking about using Boeings for longer haul, Airbuses for shorter haul, and really maximizing their efficiency there. Then, another thing I've actually seen that you commented on, Adam, in an article that you wrote, is how they're cutting their capex, and how management is responding to the current environment by altering their spending quite a lot. 

Levine-Weinberg: Yeah. Alaska has been growing capacity at a high single-digit rate in recent years, and they're really pulling that back to 4% in 2019 and 2020. And it's sensible, because they have a lot to digest with this Virgin America acquisition. There's certain routes that Virgin America ran that weren't profitable, and now Alaska is really taking a tough look at all of that, figuring what routes it needs. By cutting some routes, that leaves more extra capacity to start new routes that are in strategic markets. As a result, they don't need to increase their fleet size as quickly, so that's allowing them to reduce capex to $750 million for 2019 and for 2020, which will allow them to generate free cash flow, pay down debt, also maybe start buying back more stocks than they had been this year and last year.

Priestley: I always think that's a good sign from management, when they're quite responsive in terms of their expansion plans. Pulling them back if necessary shows a bit less hubris than some companies demonstrate.

Adam, I know that you are an Alaska Air shareholder and bullish on the company, and I have to say I'm very impressed by everything I've seen. But, what underlines your thesis?

Levine-Weinberg: I think it's important to realize that Alaska Air has been producing results recently that have been worse than what the market expected and worse than what I expected. But I still think it has a bright future. The key competitive advantage is lower cost structure relative to the legacy carriers. Alaska estimates its unit cost advantage at 18%, and that's really pretty significant. 

Another major point in favor of Alaska Air is that you're going to have merger-related synergies and some of the revenue initiatives that were announced just this week kicking in between 2019 and 2020 for the most part. And that could deliver hundreds of millions of dollars to the bottom line by 2020, all else equal. Obviously, if there's a huge jump in oil prices between now and then, or if you have a big increase in competition in some of its markets, those gains could get eroded. But, assuming all else is equal, I think you're going to see a pretty nice improvement in profitability after 2018. 

There's also lots of long-term growth opportunities in California. As Alaska has noted, the market size there is 3-4X bigger than its historical market in the Pacific Northwest, but it's still actually smaller in California than it is in the Pacific Northwest. So there's really quite a lot of room to grow in places like San Francisco and LA. 

And then, the last one is, in the longer-term, especially after 2020, there should be some pretty significant cost savings opportunities by updating Alaska's fleet, particularly the former Virgin America Airbus fleet, which doesn't have as good a unit cost profile as some of the larger planes that are available and will be available with new engines in the next few years.

Priestley: Yeah, they're just getting increasingly more and more efficient. It's fascinating to watch. I think also, you've definitely touched on this before when we've talked about airlines, it's such a cyclical industry, it's so representative of the health of the economy that it's tied to. With Alaska, that would be the U.S. economy. If you're bullish on the near-term and long-term future of the U.S. economy, then it's definitely worth looking at. I know a lot of investors were spooked by the volatility that we experienced earlier this year, but air travel is certainly only going to increase. And especially as Seattle, its major hub, becomes more and more tech-focused and it expands its reach further down the West Coast, too, and across the country, it's definitely going to become more crucial.

Levine-Weinberg: Yes, I certainly agree.

Priestley: Thank you very much for that overview on the Alaska Air Group, Adam. Really appreciated that. One last thing that I wanted to ask you about before you go. Obviously, we had the incredibly tragic incident on the Southwest Airlines flight recently, and I was just wondering if you could talk any Southwest investors through what the process looks like on the safety side in the investigation for this?

Levine-Weinberg: Sure. The National Transportation Safety Board is now investigating the fatal accident on last week's Southwest Airlines flight from New York to Dallas. That's standard for any major incident involving an aircraft, especially if there's a fatality. To give some background on the incident, an engine part broke during flight, a piece of the fan inside of the engine broke off and caused pieces to go flying everywhere. One of those pieces broke a window, and the result was that you have the cabin of the airplane, which is pressurized, very rapidly depressurizing. All of that air is getting sucked out of the window, and the result was that the passenger who was sitting next to the window got pulled very quickly toward the window and sustained fatal injuries.

Now, the NTSB has already offered some initial information about the accident. They said there were some signs of fatigue on this fan blade that broke off. And it is, in fact, standard procedure for them to offer daily updates to the media in the first few days. But, the NTSB says that during that time, it only releases confirmed factual information. They don't speculate about the underlying causes of any accident until they've released the final report. 

Looking forward now, you're likely going to have a preliminary report coming out within the next few weeks. But, during this time, the NTSB will still be gathering a lot of information. They will almost certainly try to locate all of the missing pieces of this engine and then bring it to a test facility, reassemble it to try to get more of an understanding about why there was this this fatigue in the engine part and what went wrong.

Then, at some point, you'll get a final report specifying the causes, but that's probably not going to be issued for at least a year, and in some cases, it's taken several years for a final report to come out, because they really do try to make sure that they get it right, rather than getting it out fast. That said, time doesn't stand still. The FAA has already ordered emergency inspections of several hundred engines which they think might be vulnerable that are similar to the one that had this failure last week, and those are supposed to happen within 20 days. 

Part of the problem and the reason why this accident happened was because you couldn't actually see the defect in the engine with the naked eye. They need to do ultrasound examinations of each engine. So, that's what they're going to be doing during this testing process over the next couple of weeks.

Priestley: That's great. I've definitely been on the other side of these investigations, and yes, it can take an incredibly period of time. That's a lot of paperwork to chase down, and often it is literal paper. It's a very scary time, I'm sure, for a lot of people involved in this, and an awful accident to happen. We'll be watching that to see what happens. Thank you very much for that rundown, Adam, I appreciate it!

Levine-Weinberg: You're welcome!

Priestley: That's it from us today. If you would like to get in touch, please feel free to email us at industryfocus@fool.com, or tweet us on Twitter @MFIndustryFocus. As always, people on the show may own companies discussed, so don't buy or sell anything based solely on what you hear. Thank you to Austin Morgan for mixing the show today. For Adam, I'm Sarah Priestley, thanks for listening and Fool on! 

Adam Levine-Weinberg owns shares of Alaska Air Group and Delta Air Lines. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.