At an investor meeting in late 2018, Alaska Air (NYSE:ALK) executives laid out a long-term margin target for the first time. Just two years earlier, the airline's adjusted pre-tax margin had reached 24%, thanks to low fuel prices and a favorable competitive environment. By contrast, at the time of the November 2018 presentation, Alaska was on track to report a full-year adjusted pre-tax margin below 9%, because of higher fuel prices and increased competitive pressure in certain markets.

Management's goal was to boost Alaska Air's adjusted pre-tax margin to a range of 13% to 15%. Last week, Alaska confirmed that it made significant progress toward this target in 2019, as its adjusted pre-tax margin expanded by 3.1 percentage points to 12%. Furthermore, Alaska Airlines has plenty of opportunities to continue its margin expansion in 2020 and over the next few years.

A strong end to a strong year

In the fourth quarter, Alaska Airlines' revenue per available seat mile (RASM) rose 4.2% on a 3.5% capacity increase, exceeding the high end of management's initial guidance for the quarter. That drove a 7.9% increase in revenue to $2.23 billion. Meanwhile, adjusted nonfuel unit costs ticked up 0.7% year over year, while Alaska's average fuel cost fell to $2.21 per gallon from $2.35 per gallon a year earlier.

The combination of strong RASM growth, flattish nonfuel unit costs, and lower fuel prices was a recipe for significant margin expansion. Alaska's adjusted pre-tax margin reached 10.9%, up from 6.2% in the prior-year period. That caused adjusted earnings per share to nearly double from $0.75 to $1.46.

An Alaska Airlines plane flying over clouds

Alaska Air's adjusted EPS nearly doubled year over year last quarter. Image source: Alaska Airlines.

RASM also rose 4.2% for 2019 as a whole. Adjusted nonfuel unit costs rose 2.3%, partially offset by a 3.9% decline in Alaska Airlines' average fuel price, from $2.28 per gallon to $2.19 per gallon. The net result was that full-year adjusted EPS soared 44% to $6.42.

The outlook is solid, if not spectacular

Looking ahead, management expects Alaska Airlines' unit revenue growth to slow. The Q1 forecast calls for unit revenue to rise 0.5% to 3.5%. To be fair, the company initially projected that RASM would increase 1% to 4% last quarter, so the guidance may just be conservative. That said, Alaska Airlines is now starting to lap the implementation of "Saver" fares -- its version of basic economy pricing -- which boosted its unit revenue growth throughout 2019.

Adjusted nonfuel unit costs are on track to increase by about 3% this quarter. Lastly, Alaska's guidance calls for economic fuel costs to rise to $2.21 per gallon from $2.13 per gallon a year ago. Based on the midpoint of its guidance range, adjusted EPS would end up roughly in line with the company's Q1 2019 result of $0.17.

However, fuel prices have plummeted over the past few weeks. As a result, Alaska's average fuel price for the first quarter could ultimately end up similar to or slightly below the $2.13 per gallon it paid in Q1 2019. That would enable about 1 percentage point of margin expansion. If Alaska were to achieve the high end of its unit revenue guidance range as well, EPS could conceivably rise to approximately $0.45 to $0.50.

Alaska Airlines hasn't provided formal guidance for the full year, other than to estimate that adjusted nonfuel unit costs will increase 2%. However, management did say that it expects full-year profit growth. The elimination of various underperforming routes and redeployment of that capacity into Alaska's core intra-West Coast markets should help the carrier achieve this goal.

Plenty of earnings upside after 2020

Following its strong 2019 performance, Alaska Airlines is already close to achieving its 13% to 15% pre-tax margin target. Alaska should be able to make further progress in 2020, although it may not be able to move past the low end of the target range.

Fortunately, the West Coast airline should be able to continue expanding its profit margin after 2020. First, it expects to capture the last $45 million of merger synergies from its Virgin America acquisition in 2021. Second, Alaska has a significant medium-term margin opportunity from replacing the Airbus A319s and A320s it inherited from Virgin America.

Alaska Airlines plans to place an order with either Boeing or Airbus in the second half of 2020 to replace its 61 remaining A319s and A320s with 737 MAX 9s, 737 MAX 10s, or A321neos. All three options would offer between 178 and 190 seats, but would likely have trip costs similar to Alaska's 150-seat A320s and only slightly higher than its 123-seat A319s.

This could boost Alaska Air's pre-tax margin by up to 3 percentage points, when the replacement campaign is completed in the mid-to-late 2020s. That could allow it to eventually reach or exceed the high end of its long-term margin target range. With Alaska Air stock currently trading for around 10 times its 2019 adjusted EPS, this margin expansion potential means there's a ton of upside for long-term investors.