After buying smaller rival Virgin America in 2016, Alaska Air (NYSE:ALK) was forced to dramatically curtail its share repurchase program. For one thing, the acquisition increased Alaska's net debt by about $2 billion. Furthermore, the company spent much of 2017 and 2018 struggling to integrate the two airlines and return to the level of operational excellence Alaska Airlines was known for prior to 2016.

However, Alaska has made tremendous progress in cleaning up its balance sheet over the past two years, and its profitability is set to rebound this year following a tough 2018. With Alaska Air stock currently trading at an extremely low valuation, the company could surprise investors by buying back a lot of stock over the next two years or so.

Alaska's balance sheet is basically fixed

At its investor day last November, management noted that Alaska Air was on track to reduce the debt on its balance sheet from nearly $3 billion at the end of 2016 to between $1.7 billion and $1.85 billion by the end of 2019. This would allow the company to meet its leverage target by year-end, although it would still carry more debt than it did pre-merger.

So far, Alaska Air seems to be ahead of schedule, as better-than-expected Q4 results enabled the company to end 2018 with $2.1 billion of debt, $100 million better than management's plan.

An Alaska Airlines jet flying above clouds.

Alaska Air has reduced its debt quickly since the end of 2016. Image source: Alaska Air.

In 2019, operating cash flow is set to increase significantly, while capital expenditures will decline to $750 million, compared with roughly $1 billion annually for the past two years. This will allow Alaska Air to generate strong free cash flow in the neighborhood of $650 million, based on analysts' estimates. A little over $500 million will go to dividends and scheduled debt payments (allowing the company to reach its debt reduction target). But there will still likely be some excess cash that could be used for share repurchases or additional debt repayments.

Check out the latest earnings call transcript for Alaska Air.

Profitability is set to surge in 2019

An important consideration for Alaska Air in making capital allocation decisions is its level of profitability. Last year, Alaska's adjusted pre-tax margin fell to just under 9% from around 16% in 2017. With profitability under pressure to that extent, debt reduction became more vital than ever.

By contrast, Alaska Air's profit margin is likely to improve dramatically in 2019. While Alaska had to reduce its Q1 unit revenue forecast earlier this month, it still expects revenue per available seat mile (RASM) to increase 1% to 2% year over year. Furthermore, winter storms, the government shutdown, and the timing of Easter have weighed on RASM this quarter.

Looking ahead, these headwinds will disappear, and the timing of Easter should lift Q2 RASM by at least 1 percentage point. Moreover, Alaska Air expects to capture about $330 million of incremental revenue in 2019 from merger synergies and other revenue initiatives. The pace of the revenue gains will ramp up as the year progresses. This should pave the way for strong RASM growth and margin expansion this year.

At its investor day last fall, Alaska Air introduced a 13% to 15% pre-tax margin target. It could reach the low end of that range in 2019 -- or at least get close -- with further margin upside in 2020 and beyond as the rest of its merger synergies kick in.

Time for a meaningful share repurchase program

Alaska Air's management has hinted that it will be somewhat conservative with regard to capital allocation. But by the end of 2019, the company will already have one of the best balance sheets in the airline industry. Meanwhile, the stock is extremely cheap, trading for less than nine times the 2019 analyst consensus for earnings per share.

As a result, this would be a good time for Alaska Air to restart its share buyback program in earnest.

There will be an even bigger opportunity in 2020. Alaska Air's cash flow is likely to rise again, as its profit-improvement initiatives continue to gain momentum, but capex is projected to stay flat year over year at $750 million. That means the company will likely have well over $500 million of free cash flow after dividend payments, with little or no need to further reduce debt.

Based on Alaska Air's current market cap, $600 million of buybacks over the next two years would be enough to shrink its share count by nearly 9%. If Alaska's profitability rebounds as expected in 2019 and 2020, the company could easily fund this level of share repurchases -- or more.