Shares of Alaska Air (NYSE:ALK) rallied after the company made plans to acquire smaller rival Virgin America in 2016. The stock briefly surpassed the $100 mark in early 2017, a few months after the merger closed.
However, it didn't last. While the technical process of merging the two airlines went smoothly, it was more difficult to win over Virgin America loyalists to the Alaska Airlines brand. At the same time, the carrier faced rising fuel prices and stiffer competition in many of its markets. Alaska Air stock finally bottomed out earlier this year at just $53.39.
Since then, shares of the West Coast-focused airline have started to recover as Alaska Airlines' earnings growth has accelerated. If the company can hit its margin target while returning to a faster growth rate over the next two years, Alaska Air stock could soar more than 50% to surpass $100 again by 2021.
The earnings recovery has begun in earnest
In the first half of 2019, Alaska Air's adjusted earnings per share soared 29% year over year to $2.34, driven by a strong 3.9% increase in revenue per available seat mile (RASM), solid nonfuel cost performance, and a slight decline in fuel prices.
Management expects a similar level of unit revenue growth in the third quarter, with its current guidance calling for a 3% to 5% RASM increase. It faces more pressure on nonfuel unit costs, largely due to new labor contracts ratified this quarter, offset by a bigger year-over-year drop in fuel prices. Analysts currently expect EPS of $2.22 this quarter, up 16% year over year.
The outlook for the fourth quarter is even brighter. Whereas nonfuel unit costs are on track to rise about 5% in the third quarter, Alaska Airlines' Q4 outlook calls for a 1.2% decline in nonfuel unit costs. And with oil prices already moderating -- after surging on Monday following drone attacks that temporarily knocked out about half of Saudi Arabia's production -- Alaska is likely to pay significantly less for jet fuel next quarter than the $2.35 per gallon average price it paid in the fourth quarter of 2018.
This sets the stage for Alaska's earnings growth to accelerate further in Q4. Indeed, analysts are calling for EPS to skyrocket 79% year over year to $1.34 next quarter, putting Alaska Air's full-year adjusted EPS at $5.90, up 32% from $4.46 last year.
Strong earnings growth is likely to continue beyond 2019
Alaska Air is on track to report an adjusted pre-tax margin between 11% and 12% this year. While that would represent a big improvement over 2018, it would still fall short of the long-term pre-tax margin target of 13% to 15%. Fortunately, the company is likely to continue expanding its profit margin over the next couple of years.
First, Alaska Airlines has estimated that it will capture the final $105 million of synergies from the Virgin America acquisition in 2020 and 2021. Capturing those synergies will boost its pre-tax margin by more than 1 percentage point.
Second, a substantial proportion of the $160 million in annual cost savings opportunities that Alaska Airlines identified at its investor day last year will hit the bottom line in 2020 and 2021. This could enable the carrier to keep nonfuel unit costs roughly flat over the next two years, which would in turn cause RASM gains to drop straight to the bottom line (assuming steady fuel prices).
Third, Alaska Airlines will continue to fine-tune its route network over the next several months. It is dropping about 18 noncore routes -- either permanently or seasonally -- while adding capacity in higher-demand markets and launching new routes connecting California to the Pacific Northwest. These moves should keep unit revenue rising next year.
Alaska Air stock is primed to soar
Barring a huge jump in oil prices or a recession, these revenue and cost catalysts should boost Alaska Air's pre-tax margin into the company's target range next year, with more potential upside in 2021. Meanwhile, Alaska Air's revenue is on track to rise to nearly $10 billion by 2021.
Assuming a pre-tax margin of 14% and no change to the company's share count, Alaska Air's EPS would surpass $8 by 2021. A pre-tax margin of 15% and an increase in share repurchase activity -- enabled by the company's debt reduction over the past few years -- would boost EPS to $9.50 or more.
Alaska Air stock currently trades for 11 times the company's projected 2019 earnings. Two years from now, the company will have a stronger balance sheet, a higher profit margin, and plenty of growth opportunities, which would justify a valuation at that level or higher. With Alaska on track to grow EPS to more than $8 (and possibly more than $9) over the next two years, airline investors could see a $100 stock price by 2021.