Last week, Alaska Air Group, (NYSE:ALK) continued its long streak of industry-leading profitability. Whereas most airlines aspire to earn double-digit pretax margins during the peak spring and summer seasons, Alaska managed to post an adjusted pretax margin of 11.8% in Q1, the weakest quarter of the year.
Despite Alaska Air Group's continuing momentum, I am staying far away from the stock. The reason is simple: Delta Air Lines (NYSE:DAL) is in the midst of a major expansion in Seattle, Alaska Air Group's hometown and main hub. Rising competition from Delta is bound to put pressure on Alaska's earnings, and there's no way to know how far Delta's expansion will go in the long run.
Delta's rapid growth in Seattle
Seattle is a strategically important market for Delta. Its positioning in the northwestern corner of the continental U.S. makes it a great connection point for flights to Asia (and even Europe!). As a result, Delta is building Seattle into a major international gateway to challenge United's competing transpacific hub in San Francisco.
Delta has added new international flights from Seattle to Tokyo's Haneda Airport, Shanghai, and London just in the last year. In June, it will begin flying from Seattle to Seoul and Hong Kong as well. In the first stage of this growth, Delta relied heavily on Alaska Air Group's extensive domestic network in Seattle to provide connecting traffic.
However, Delta has now made it abundantly clear that it would prefer to generate most of its own connecting traffic. Since last October, it has announced new flights from Seattle to more than a dozen destinations in the U.S. and Canada.
All told, Delta will grow from just 35 peak-day departures in Seattle last month to 79 peak-day departures in Seattle by the summer, with additional flights scheduled to begin later in the year. Delta's capacity growth in Seattle will become a significant headwind for Alaska as 2014 progresses.
Alaska Air Group investors shouldn't take too much comfort from the company's strong Q1 results because hardly any of the new flights from Delta had begun during the quarter. Most of Delta's new capacity is coming online during the spring, with a few more flights beginning in the fall.
This additional competition could start to have an impact on Alaska's results in the current quarter. That said, Alaska CEO Brad Tilden stated on the company's recent conference call that "business conditions actually look pretty good to us going into the spring and summer."
However, it is easiest to absorb capacity increases during the peak season, as carriers can stimulate extra demand with relatively small fare cuts. The biggest effects will not be felt until after Labor Day, when it is harder for airlines to fill seats. It's too early for Alaska to measure demand for this post-Labor Day period, based on typical booking patterns.
Alaska Air Group's management seems to be at least somewhat concerned. Alaska executives noted several times on the recent earnings call that there was too much capacity in Seattle. However, the Alaska management team also seems to expect that Delta will quickly retreat if domestic fares start falling in Seattle.
While Delta's management team is also very focused on earning high returns, I think Delta is in "investment mode" in Seattle today. In other words, Delta would be willing to absorb losses in order to scale up a Seattle hub, as long as it is comfortable with its long-run profitability there. So far, Delta seems very happy with its performance in Seattle.
Delta has plenty of opportunities to add international flights in Seattle to destinations such as Taipei, Guangzhou, Singapore, or Rome. These would create connecting traffic for its domestic flights in Seattle, and support even more domestic flights in the future. Thus, Delta's competitive overlap with Alaska in Seattle is more likely to grow than to shrink in the next few years.
Foolish final thoughts
Alaska Air Group has a talented management team that has consistently created value for shareholders in recent years. It is thus in good hands to weather the challenges that lie ahead. However, I still think investors would be better off avoiding the stock.
Delta's growth in Seattle will put pressure on Alaska's unit revenue as 2014 progresses. Most importantly, it's hard to predict where Delta's growth in Seattle might end. As it adds long-haul international routes, it will be able to support more and more domestic flights in Seattle. In the long run, it could challenge Alaska's dominance in its home market. That's too much risk to contemplate investing in Alaska Air Group.