Southwest Airlines' (NYSE:LUV) late-2017 decision to enter the Hawaii market -- along with growth on West Coast-Hawaii routes by other airlines -- has subjected Hawaiian Holdings (NASDAQ:HA) to extreme pressure over the past two years, and particularly in 2019. As a result, Hawaiian Airlines' adjusted pre-tax margin fell to 9.2% in the first half of 2019, down from 12.4% in the prior-year period and 16.2% in the first half of 2017.

However, Hawaiian Airlines is stepping up its game to handle the new competition. Its third-quarter results and plans for the next year suggest that the carrier has a good chance to stabilize its profitability during 2020 despite continued growth in Hawaii by Southwest Airlines.

A solid quarter

Entering the third quarter, Hawaiian Airlines projected that revenue per available seat mile (RASM) would decline 1.5% to 4.5% during the quarter, in line with its 3.4% RASM decline for the first half of the year. Making matters worse, Hawaiian's management said that adjusted nonfuel unit costs would spike 3.5% to 6.5% year over year because of the timing of expenses, leading to severe margin pressure.

Fortunately, demand surpassed the company's expectations in August and September. That led the company to boost its guidance earlier this month, saying that RASM came in roughly flat for the quarter.

On Tuesday afternoon, Hawaiian Airlines reported that RASM dipped just 0.1% last quarter, on a 0.4% capacity decrease. Solid unit revenue growth in international markets offset declines on interisland routes and mainland-Hawaii routes. This caused total revenue to tick down to $755 million from $759 million a year earlier. Adjusted nonfuel unit costs rose 4.9%, near the midpoint of the guidance range. Meanwhile, Hawaiian's economic fuel cost per gallon fell to $2.04 per gallon from $2.15 per gallon a year earlier.

A Hawaiian Airlines plane flying over the ocean, with mountains in the background

Hawaiian Airlines' unit revenue trajectory improved last quarter. Image source: Hawaiian Airlines.

The net result was that Hawaiian's adjusted pre-tax margin receded modestly to 14.6% -- still a very strong result -- from 15.9% in Q3 2018. Adjusted pre-tax income fell 8.7% to $110.4 million, while adjusted EPS declined 10% to $1.72, with a reduced share count mostly offsetting the impact of a higher effective tax rate.

Competition will keep rising

Southwest Airlines introduced a slew of Hawaii routes between March and May, but it has held steady since then, because of fleet constraints related to the Boeing 737 MAX grounding. However, Southwest is set to resume its expansion in just a few weeks, with the launch of flights between Sacramento and Honolulu and between Honolulu and Lihue.

Hawaiian currently has a monopoly on both of those routes. As a result, Southwest's entry into those markets will drive additional unit revenue pressure. This is probably part of the reason Hawaiian Airlines expects its unit revenue trend to deteriorate modestly this quarter, with RASM falling 0.5% to 3.5%.

Looking into 2020, new Southwest routes from Oakland and San Jose to Lihue and Kona, from Sacramento to Kahului, from Kahului to Kona, and from Honolulu to Hilo will keep the pressure on. (Hawaiian Airlines doesn't serve all of those routes, though.) The low-fare carrier is likely to launch service from San Diego to Hawaii in the first half of 2020 as well. That means Hawaiian Airlines needs to find ways to reduce its unit costs and generate incremental revenue to offset the headwind from Southwest's growth.

Hawaiian has the tools to compete

The good news for investors is that both of these goals are achievable. Hawaiian Airlines launched sales of its Main Cabin Basic fare type in a few select markets last month and has now rolled it out on nearly all North America-Hawaii routes. Main Cabin Basic is expected to provide $15 million to $25 million of incremental annual revenue next year.

In addition, over the next few months, Hawaiian will put its last few Airbus A321neos into service. That will allow it to grow in markets where it does not compete with Southwest, while substituting the smaller A321neo for larger A330s in markets where Southwest Airlines is a threat. The A330s will be redeployed to boost Hawaiian's presence in Japan, a market that has been performing extremely well recently.

On the cost side, the company is in the midst of a major structural cost reduction program, which will start to deliver significant savings next year. Recent lease renewals for three A330 aircraft will result in lower aircraft rent expense, too. Finally, Hawaiian's growth rate will accelerate -- the timing of A321neo deliveries delayed some growth from 2019 into 2020 -- which should help reduce unit costs.

There will undoubtedly be more volatility in Hawaiian's future as Southwest continues its expansion in Hawaii and the market establishes a new supply demand balance. Nevertheless, the company's solid Q3 results should give investors additional confidence that Hawaiian Holdings can weather the storm.