Alaska Air (ALK 1.16%) has experienced severe margin compression over the past several quarters, due to a combination of rising fuel costs, stiff competition, and merger pains following its 2016 acquisition of Virgin America. However, management is laser-focused on rebuilding the company's profitability. Toward that end, Alaska Airlines is set to reduce its growth rate until it starts hitting its margin and return on invested capital goals.
Last quarter, Alaska Airlines began taking concrete steps to align its fleet plan with its new target of 4% annual growth and $750 million of annual capital expenditures for 2019 and 2020. The carrier restructured its orders with Boeing (BA 0.39%), Airbus (EADSY 1.15%), and Embraer (ERJ 1.72%) to better fit its projected needs.
Pausing regional growth
In 2017 and 2018, Alaska Airlines has dramatically expanded its regional jet fleet in a bid to capture lucrative opportunities in lower-traffic markets. It has been using Embraer E175s to add new routes from Portland, San Francisco, and Seattle to the Midwest, as well as on a handful of West Coast routes and on its routes from Dallas to New York and Washington, D.C.
At the end of 2016, Alaska Airlines had 68 planes in its regional fleet. That rose to 83 at the end of 2017 and is set to reach 95 by the end of this year. However, while it has had success on some routes, others haven't met Alaska's financial targets. As a result, the carrier has recently culled a number of routes from California and Portland. The routes from Dallas to New York and Washington D.C. will be cut later this year.
Alaska Airlines has rapidly expanded its regional fleet recently. Image source: Alaska Airlines.
Alaska's management seems to realize that it may have expanded the carrier's regional network too quickly. The company recently deferred six Embraer E175 deliveries from the 2018-2019 period to after 2020. Partially offsetting these deferrals, Alaska will extend the lives of three Q400 turboprops that it had planned to retire in 2019. The net result is that Alaska's regional fleet is now set to shrink from 95 aircraft at the end of 2018 to 92 aircraft by the end of 2019.
Pulling back on mainline deliveries, too
Alaska Airlines made even more significant changes to its mainline order book during the first quarter. It converted all of its Boeing 737 MAX 8 orders to the larger 737 MAX 9 variant in order to grow in a more capital-efficient way. Meanwhile, it deferred six Boeing 737 deliveries from 2019 to the early 2020s.
These changes to the Boeing and Embraer order books reduced Alaska's 2019 aircraft-related capital commitments by more than $250 million, from $816 million to $560 million.
This 2019 spending (and some previously planned 2018 spending) has been pushed into the 2020 to 2022 period. Nevertheless, Alaska's aircraft capex is on track to remain below $600 million in each of those years. This should allow the company to achieve its goal of limiting annual capex to $750 million until profitability recovers.
Building in future fleet flexibility
The final change that Alaska Airlines made to its order book last quarter was the deferral of its Airbus orders by a year. The company inherited an order for 30 A320neos as part of its Virgin America acquisition. Those planes were originally scheduled to arrive between 2020 and 2022; now they will come between 2021 and 2023.
Alaska still hasn't decided whether or not it actually wants these planes. Management estimates that returning to an all-Boeing fleet could save the company up to $25 million annually due to staffing and maintenance efficiencies. (That said, there may be offsetting benefits to maintaining a mixed fleet.) Alaska Air would only have to forfeit about $15 million of pre-delivery payments to Airbus if it chooses to cancel the order.
Management had originally planned to make a long-term fleet decision by the end of 2017. However, the company's slumping profitability and the upheaval of its merger integration made it more prudent to wait.
Deferring the Airbus deliveries by a year should enable Alaska Airlines to wait until late 2018 to make a firm commitment one way or the other. Considering how important this decision is, Alaska's management should take all the time it needs to ensure that it makes the right move.
