Alaska Air's (NYSE:ALK) dismal earnings trend continued last week, as it posted a sharp drop in profit for the second quarter. So far, the third quarter is shaping up to be just as bad. Alaska Airlines' guidance implies another big profit decline.
The West Coast-focused airline is currently facing three major headwinds. First, rising oil prices have led to enormous cost pressure. Second, fierce competition along the West Coast -- and particularly in California -- has made it hard to raise fares. Third, Alaska Air has been facing some company-specific issues related to completing the integration of Virgin America.
However, with the biggest integration milestones now in the rearview mirror, management has turned its full attention to stabilizing and then improving Alaska Air's profitability. It will be a tough task, but Alaska Air's track record should give investors some confidence in the carrier's turnaround prospects.
Another weak quarter
In the first quarter of 2018, Alaska Air's pre-tax margin fell about 10 percentage points year over year to just 1.3%. As a result, adjusted earnings per share plunged to $0.14 from $0.99 a year earlier.
The second quarter is a seasonally stronger period. Other than that, Alaska Air's profit trajectory didn't change much. On Thursday, the company reported that its adjusted pre-tax margin plunged by 11 percentage points last quarter, falling from 23.8% to 12.8%. Even after the benefit of tax reform, adjusted earnings per share (EPS) declined 33% year over year to $1.66.
The margin decline was driven by the combination of a 4.8% decline in revenue per available seat mile (RASM) and a 34.5% surge in Alaska Airlines' average fuel price, which reached $2.30 per gallon last quarter. By contrast, the carrier managed its other costs well, limiting nonfuel unit cost growth to just 2%.
New markets (which tend to start with lower unit revenue) contributed two percentage points of last quarter's RASM decline. A shift in the timing of Easter drove about 1 percentage point of additional pressure. Finally, Alaska Airlines suffered a self-inflicted 1.5 percentage-point RASM headwind related to allowing too many award redemptions during peak periods.
The third quarter will also be subpar
Looking ahead to the third quarter, Alaska Airlines expects RASM to decline 0% to 3% year over year on 5.9% capacity growth. At the midpoint, this implies a 1.5% decline, driven entirely by the continuing headwind from higher-than-expected award travel. Alaska Airlines has now tightened its inventory management of award seats, which should fix this problem by the fourth quarter.
Meanwhile, costs are still soaring. Alaska expects to pay $2.30 per gallon for jet fuel once again, up from $1.80 per gallon a year earlier, while adjusted nonfuel unit costs are on pace to rise 4.5% to 5.1% this quarter.
Adding together all the elements of Alaska Airlines' guidance, adjusted pre-tax margin could fall by 9 to 10 percentage points in the third quarter compared to the company's Q3 2017 result of 21%.
Management is acting swiftly to return to profit growth
While Alaska Airlines is still posting solid results in the seasonally strong spring and summer quarters compared to many of its peers, the company's current trajectory is unsustainable. Since the beginning of 2018, management has announced a number of moves that should help bolster unit revenue starting in the fourth quarter.
First, Alaska will slow its growth to just 3% in the fourth quarter, as it annualizes a bunch of capacity additions from the fall of 2017 and cuts more underperforming flights. The carrier will slow its expansion rate again next year, having recently cut its 2019 capacity growth forecast from 4% to 2%.
Second, Alaska Airlines expects to unlock roughly $130 million of incremental merger synergy benefits in 2019, having completed most of its major integration work. Third, in April, Alaska announced a series of policy changes and the introduction of a new basic economy "saver" fare that are expected to generate $150 million of incremental annual revenue.
Slower growth in 2019 will also allow Alaska to speed up the reconfiguration of its Airbus fleet to add additional first-class and extra-legroom seats. That could accelerate the company's ability to capture merger synergies.
It's impossible to be sure what will happen to fuel prices or airline industry capacity next year. But there's a good chance that Alaska Airlines will avoid the double-whammy it faced this year of a big step-up in fuel prices combined with a big increase in competition. This could pave the way for a return to strong profit growth in 2019.