For many years, Alaska Air (NYSE:ALK) benefited from low competition in the Pacific Northwest, its home market. However, Delta Air Lines (NYSE:DAL) has been growing rapidly in Seattle. Moreover, Alaska's 2016 acquisition of Virgin America gave it huge exposure to the ultra-competitive San Francisco and Los Angeles markets.

In this episode of Industry Focus: Energy, the team takes a look at how these changes in the competitive environment have affected Alaska Air Group's earnings. The company's pre-tax margin plunged by more than 7% in 2017, and it is set to continue falling in 2018.

A full transcript follows the video.

This video was recorded on April 26, 2018.

Adam Levine-Weinberg: 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.

Sarah 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.

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.