Investors weren't too happy about Hawaiian Holdings' (NASDAQ:HA) Q2 earnings report and Q3 guidance.
While the Hawaiian Airlines parent posted record earnings for the quarter and matched analysts' estimates with EPS of $0.61, the analysts had already cut their forecasts after Hawaiian Airlines lowered its guidance earlier in July. The Q3 unit revenue outlook was also fairly bleak, as management expects a 4%-7% year-over-year decline.
So why am I still so bullish about Hawaiian Holdings stock? One big reason trumps all the others: the superior margin potential of its coming A321neo fleet, which will begin arriving in 2017.
Right-sizing the West Coast-Hawaii market
Hawaiian Airlines' profit margin is nothing to complain about right now. The company posted a 10.7% adjusted pre-tax margin in Q2, and with the busy summer season coming up, Hawaiian's full-year adjusted pre-tax margin should be even higher.
However, the airline is somewhat handicapped by its reliance on widebody aircraft for all of its medium- and long-haul flights. Recently, Hawaiian Airlines has made the 294-seat A330-200 widebody its plane of choice for these routes.
A lot of markets can't support a plane of that size. Even in markets that are big enough, Hawaiian Airlines still needs to offer more cheap introductory fares to fill up the plane than would be necessary with a smaller aircraft. This creates a drag on unit revenue, especially on some of the more marginal routes that Hawaiian Airlines serves.
To understand just how much of a handicap Hawaiian's reliance on widebodies is, it's useful to look at one of the company's top rivals in the West Coast-Hawaii market: Alaska Air Group (NYSE:ALK). Alaska posted a record adjusted pre-tax margin of 25.7% last quarter: a full 15 percentage points ahead of Hawaiian's pre-tax margin.
Is Hawaiian Airlines the next Alaska Airlines?
Alaska's use of large narrowbody aircraft is key to its success. Beginning in 2017, Hawaiian Airlines will build out its own fleet of large narrowbodies; it has a firm order for 16 A321neos, which will arrive between 2017 and 2020. The big question for investors is whether this new narrowbody fleet will help Hawaiian Airlines approach Alaska Air in profitability.
To be fair, the current profitability gap is smaller than it appears. Alaska's profit margin on Hawaii routes is probably lower than the company average. Meanwhile, Hawaiian's profit margin is being held back by international routes that are still maturing and have been hurt by the strong dollar. Nevertheless, Alaska almost certainly maintains a big advantage even when focusing on West Coast-Hawaii routes specifically.
One reason for optimism is the right-sizing effect. In recent years, Hawaiian Airlines has added several routes from the West Coast to destinations in Hawaii other than Honolulu. Some of those routes have performed well enough to stick around: others have been dropped.
With the A321neo -- which Hawaiian has said will carry about 190 seats -- many of the domestic routes that didn't work out would become viable, since there won't be as many seats to fill. Even the routes that have stuck would likely be more profitable with an A321neo. The new plane will also open up incremental growth opportunities in smaller markets: many of which have been successful for Alaska Airlines.
Furthermore, the A321neo will be much more fuel-efficient than Hawaiian's current fleet. Last quarter, Hawaiian achieved 76.6 available seat miles (or ASMs) per gallon. To some extent, that is dragged down by short-haul flying within Hawaii. However, those routes only represent 5%-6% of Hawaiian's capacity. Fuel efficiency for the long-haul operations was likely in the range of 80-85 ASMs per gallon.
Hawaiian's long-haul fuel efficiency is thus roughly in line with Alaska's mainline fuel consumption of 81.7 ASMs per gallon.
But the A321neo is a generation ahead of the planes that make up the backbone of Alaska's fleet, and is expected to deliver a roughly 15% reduction in fuel consumption. Additionally, the 737-900 and 737-900ER -- the largest, most fuel-efficient members of the current-generation Boeing 737 family -- make up less than a third of Alaska's fleet.
That means Hawaiian's A321neos could be around 20% more fuel-efficient than Alaska's current fleet average -- and by extension, 20% more fuel-efficient than Hawaiian's widebody fleet.
Valuation looks good, too
The bottom line is that the introduction of the A321neo on West Coast-Hawaii routes should help Hawaiian Airlines bolster its unit revenue by better matching supply with demand. At the same time, it will offer a large improvement in fuel efficiency.
As a result, Hawaiian Airlines should be able to dramatically reduce the margin gap with Alaska Airlines over the next five years as it shifts more flying to the A321neo. (It is unlikely to catch up all the way, as Hawaiian's long-haul widebody flights will likely continue operating at a lower profit margin.)
Of course, the profit growth potential from the A321neo alone wouldn't necessarily make Hawaiian Holdings a good stock to buy. If the stock carried a high valuation, it would imply that investors were already building in big hopes for long-term profit growth.
However, Hawaiian stock currently trades for just 8 times projected 2015 earnings. That's less than half of the S&P 500 earnings multiple, indicating that investors think the company is near an earnings peak. I think that view is mistaken. And that's why Hawaiian Holdings is still my top pick in the airline sector.
Adam Levine-Weinberg owns shares of Hawaiian Holdings, and The Boeing Company. 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.