Last month, Hawaiian Holdings (NASDAQ:HA) -- the parent company of Hawaiian Airlines -- reported its second straight disappointing quarter. Hawaiian posted an adjusted loss of $0.29 per share in Q1, compared to a profit of $0.06 per share in the prior year period. Over the past six months, Hawaiian has been challenged by a convergence of two negative factors: the depreciation of the yen relative to the dollar, which has affected revenue and margins on flights between Japan and Hawaii; and heavy competition on routes between the U.S. mainland and Hawaii.
Fortunately, Hawaiian's future prospects appear to be improving. While the yen remains depressed compared to the dollar, Hawaiian has taken actions to mitigate this headwind. More importantly, competition on routes between the U.S. West Coast and Hawaii is on pace to decrease over the next several months. This should improve pricing power for Hawaiian, Alaska Air (NYSE:ALK), and United Continental (NASDAQ:UAL), the three largest competitors in the West Coast-Hawaii market. Furthermore, Hawaiian has been consistently reducing its non-fuel costs, and jet fuel prices have been decreasing recently. The combination of lower costs and stabilizing unit revenue should allow Hawaiian to return to earnings growth by Q3 at the latest. With shares trading for just over six times expected 2013 earnings, this makes Hawaiian a strong investment candidate today.
Course correction in Japan
Hawaiian entered the Japanese market in November 2010 with service between Tokyo and Honolulu, and has rapidly expanded in the ensuing two and a half years. Today, the carrier flies daily from Honolulu to Tokyo, Osaka, and Fukuoka, and three times a week to Sapporo. One of the primary points in favor of expanding in Japan was the strong yen, which made Hawaiian vacations more affordable for Japanese tourists while giving Hawaiian an outsized cost advantage vis-a-vis Japanese airlines. However, in the past year the yen has declined by more than 20% versus the dollar. This sharp change in exchange rates is making it difficult to reliably turn a profit on those routes.
However, the company is taking action to mitigate these headwinds. First, Hawaiian instituted a currency hedging program to create better clarity on exchange rates going forward. Second, beginning next month, the aircraft serving Sapporo will also stop in Sendai to pick up passengers, which will help Hawaiian fill those seats more effectively. Lastly, Hawaiian is improving its distribution in Japan, which is still a relatively new market. This may help stimulate demand while building brand awareness.
While Hawaiian is suffering due to external factors in the Japanese market, its competitors have higher cost structures and are suffering more. On a recent conference call, Delta Air Lines (NYSE:DAL) executives highlighted weak sales from Japan to "beach markets" like Hawaii as a significant headwind, and mentioned that they are considering cutting capacity there. Delta competes directly with Hawaiian on routes from Fukuoka and Osaka to Honolulu, and so any capacity reductions would have a clear benefit for Hawaiian's unit revenues going forward.
Saturation of the U.S. market
Hawaiian is also facing an overcapacity situation on routes between the U.S. and Hawaii, but here the industry has already planned capacity cuts for the next several months. On Hawaiian's recent conference call, CEO Mark Dunkerley observed that industry capacity increased 13% year over year in Q3 and Q4 of 2012, and 11% last quarter. This growth led to excess capacity, making it harder for Hawaiian to fill its planes at reasonable prices. On the other hand, based on published schedules, industry capacity will grow just 5% in the current quarter, before decreasing by 2% in Q3 and by 6% in Q4.
Alaska Airlines and Allegiant Travel (NASDAQ:ALGT), two domestic competitors who recently have expanded rapidly in the Hawaii market, have both admitted that they expanded a bit too much. Alaska's management has stated that they put too much capacity in the California-Hawaii market, which they have now reversed. Meanwhile, Allegiant decided to radically scale back its off-season capacity to Hawaii, operating most routes only during the peak travel season.
Both Alaska and Allegiant have a proven history of reacting quickly when markets are not performing up to their goals. Thus, these capacity cuts are likely to stick as long as the U.S.-Hawaii market is adequately served. With capacity growth reversing in the second half of the year, Hawaiian Airlines should be able to return to unit revenue growth in the U.S.-Hawaii market.
Clear skies ahead?
Hawaiian has missed out on the recent airline stock rally because of concerns about its profitability. However, in Japan the company has taken actions to mitigate the yen's decline, while industry capacity is shrinking in the U.S.-Hawaii market. These factors should improve pricing, allowing Hawaiian to return to profit growth soon. The company has many further growth opportunities as well, but still trades at a rock bottom valuation. These considerations make Hawaiian the most compelling stock in the airline sector today.