Fast-growing niche airline Hawaiian Holdings (NASDAQ:HA) hit a speed bump in the past year, as overcapacity in many of its markets, along with the yen's devaluation, led to lower ticket prices. In Q4 of 2012, the company reported breakeven results on an adjusted basis, after having produced adjusted EPS of $0.31 in the prior-year quarter. Similarly, Hawaiian's adjusted loss of $0.29 per share in Q1 2013 represented a big decline from a profit in Q1 2012.
Fortunately, Hawaiian's performance has probably bottomed out already. When Hawaiian reports Q2 results on Tuesday, analysts expect to see a smaller profit decline (EPS of $0.12 versus EPS of $0.22 in Q2 2012), followed by a return to profit growth in Q3 or Q4. Capacity cuts by Hawaiian Airlines and competitors like Alaska Air (NYSE:ALK) in underperforming markets will lead to better pricing power in the second half of 2013 and beyond, boosting earnings.
As Hawaiian returns to a more moderate capacity growth rate for the next several years, margins are likely to rebound, leading to significant increases in profit. This should lead to strong returns for investors over that period of time.
Hawaiian's recent underperformance can best be described as due to growing pains. The company has been expanding rapidly, with capacity growing at a 20% clip on average for the past three years. It is very difficult to grow that quickly without eventually running into execution problems (and companies that manage to avoid these growing pains are particularly impressive).
In Hawaiian's case, the expansion plan seemed to be working very well until the West Coast-Hawaii travel market (still Hawaiian's largest) became flooded with too many seats. Alaska Airlines had been rapidly expanding its service to Hawaii for the past several years, filling in gaps created by the 2008 bankruptcies of Aloha Airlines and ATA Airlines. However, it overshot the market's potential last year, hurting its own profitability.
Allegiant Travel (NASDAQ:ALGT) also entered the market last year, and probably expanded too quickly. Lastly, Hawaiian Airlines was expanding its presence on the West Coast last year, particularly with the opening of a second hub in Maui.
At the same time that the West Coast capacity situation was at its worst point (late 2012 and Q1 2013), Hawaiian had to deal with the rapid devaluation of the yen. Japan is the company's largest international market, and the rapid swing in the exchange rate from 80 yen per dollar last November to 100 yen per dollar today hurt profitability by making travel to Hawaii more expensive for Japanese tourists.
Given that Hawaiian has faced substantial pressure in its biggest domestic and international markets simultaneously in the past year, it's not very surprising that profitability suffered. However, by reallocating capacity to better-performing markets and further diversifying its sources of revenue, Hawaiian should be able to recover quickly.
Will Hawaiian bounce back?
The weak yen will continue to weigh on Hawaiian's performance for the foreseeable future. However, the overcapacity in the West Coast-Hawaii market has now been reversed. Most major U.S. carriers serving the Hawaii market are cutting capacity for the second half of 2013. For example, Alaska Airlines has cut its capacity between the Bay Area and Hawaii by more than 35% for the fall. Allegiant is also seasonally cutting most of its Hawaii routes beginning next month.
With lower capacity on these routes, Hawaiian Airlines and its competitors should not have to resort to the discounting behavior that led to weak earnings results over the past several quarters. Hawaiian is also seasonally redeploying some capacity from North America to international markets in the fall, taking advantage of higher demand abroad at that time of year.
A number of factors caused Hawaiian's expansion plans to go awry in the past year, but the tide looks to be turning. The company is expected to report its Q2 earnings on Tuesday afternoon, and management will likely provide an update on the demand environment for Q3 and beyond. In all likelihood we will learn that the outlook for Hawaiian Airlines is brightening.
Fool contributor Adam Levine-Weinberg owns shares of Hawaiian Holdings and is long October 2013 $6 calls on Hawaiian Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.