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Alaska Air Group Plots Its Path to Higher Profits

By Adam Levine-Weinberg – Nov 28, 2018 at 8:55PM

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By capturing merger synergies and rolling out a variety of other revenue growth initiatives, Alaska Airlines hopes to quickly bounce back from a steep drop in its earnings power over the past two years.

Alaska Air Group (ALK 0.20%) has fallen hard since buying smaller rival Virgin America two years ago. The carrier's adjusted pre-tax margin peaked at 24% in 2015 and 2016, but it is set to fall into single-digit territory in 2018. Surging fuel prices have caused much of the decline, but the company also made some missteps as management focused on driving a speedy merger integration process.

However, Alaska Airlines is finally getting back on track, as efforts to shore up unit revenue have started to bear fruit. At the company's investor day on Tuesday, management provided more detail on how Alaska plans to rebuild its profitability over the next year or two.

Alaska Air announces a margin target

Alaska Air's profitability has been so volatile in recent years that investors have been unsure what to expect going forward. It's clear that the airline's 2015-2016 margin performance is not a realistic long-term goal. On the other hand, Alaska can certainly do better than the single-digit pre-tax margin it will post for 2018.

In the investor day presentation, management laid out a margin target for Alaska Airlines for the first time. The company aims to generate a pre-tax margin between 13% and 15% going forward.

A rendering of an Alaska Airlines plane flying over clouds

Alaska Airlines has set a pre-tax margin target of 13% to 15%. Image source: Alaska Airlines.

That's well below Alaska Airlines' peak level of profitability, but it would still represent a huge improvement relative to the status quo. Indeed, based on the carrier's projected 2019 revenue of $8.8 billion, even a 13% pre-tax margin would result in earnings per share of roughly $7. That wouldn't be far behind the record annual EPS of $7.32 that Alaska achieved in 2016.

Much of the improvement will happen in 2019

A 13% pre-tax margin isn't out of reach for next year. As management has previously disclosed, Alaska Airlines is set to capture the biggest chunk of the synergies from the Virgin America merger in 2019: an incremental $130 million compared to 2018.

Additionally, over the course of 2018, Alaska Airlines has set a number of revenue-enhancing initiatives into motion. It is implementing an increase in its baggage fees next week, and it has been rolling out a number of fee and policy changes -- most notably, the introduction of "Saver" fares, which will go on sale before year-end. The Saver fares will allow Alaska to improve its revenue segmentation by keeping fares low for price-sensitive travelers while encouraging less price-sensitive customers to buy more expensive tickets.

Alaska Airlines estimates that these changes will produce $200 million of incremental annual revenue. A stepped-up effort to win corporate travel contracts should add another $40 million. Management indicated that it expects to capture the vast majority of this total opportunity of $240 million in 2019.

Meanwhile, Alaska Airlines has identified $160 million of cost efficiencies that it can wring out over the next few years. This will limit nonfuel unit cost inflation over that period.

Momentum is already building

Alaska Airlines' unit revenue performance is already improving quickly. After declining 3.6% in the first half of 2018, revenue per available seat mile (RASM) was roughly flat in the third quarter. The carrier's initial guidance called for a 1.5% to 3.5% increase in the fourth quarter.

However, Alaska significantly increased its fourth-quarter unit revenue guidance on Tuesday. It now expects to post a strong 3% to 5% RASM increase this quarter. Most of this unit revenue growth is being driven by Alaska Airlines' efforts to better match supply with demand, including dropping underperforming routes -- not the revenue initiatives described above.

Like its peers, Alaska Airlines is also poised to benefit from lower fuel costs next year, as oil prices have retreated rapidly since early October. If fuel prices remain low, even the high end of Alaska's 13%-15% pre-tax margin target range could be within reach next year.

Looking ahead, Alaska will have more than $100 million of incremental merger synergies left to capture in 2020 and 2021. That additional firepower gives it a good chance of continuing to expand its profit margin beyond 2019. This bright outlook could keep Alaska Air stock moving higher over the coming year.

Adam Levine-Weinberg owns shares of Alaska Air Group. The Motley Fool recommends Alaska Air Group. The Motley Fool has a disclosure policy.

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