In the past two years or so, Alaska Air (NYSE:ALK) has faced rapidly increasing competition in its hometown of Seattle from Delta Air Lines (NYSE:DAL). This represented a significant threat to Alaska's profitability because most of its flights either depart from or arrive in Seattle.
Yet through a series of revenue-enhancing moves, terrific cost control, and a little luck in the form of lower fuel prices, Alaska has continued to deliver strong earnings growth. It may confront an ever bigger threat in the next few years, though. That's because ultralow-cost carrier Spirit Airlines (NYSE:SAVE) announced last week that Seattle will be its next new market.
Alaska has weathered the threat from Delta
Delta decided in 2013 to build a hub in Seattle in order to provide convenient connections for travel between the western U.S. and Asia. This led to Delta entering a slew of nonstop markets from Seattle where Alaska Airlines was its main competition. By the summer of 2015, Delta was operating 128 peak day departures in Seattle, up from around 40 two years earlier.
Delta's rapid growth in Seattle has caused Alaska Airlines' unit revenue to underperform the airline sector for the past few years. Revenue per available seat mile (RASM) slipped 0.5% in 2013 before growing 0.9% in 2014. Year to date in 2015, RASM has dropped 5.4%.
Nevertheless, Alaska has posted steady profit growth. Adjusted pre-tax profit has increased from $552 million in 2012 to $616 million in 2013 to $922 million in 2014. Through the first three quarters of 2015, Alaska has already earned $1.05 billion in adjusted pre-tax profit -- more than in all of 2014. Share buybacks have caused Alaska's EPS to rise even more quickly.
Enter Spirit Airlines
While Alaska Airlines has thrived despite growing competition from Delta, it now faces a much different kind of threat. Spirit Airlines plans to enter the Seattle market next spring. On March 24, it will begin flying twice a day to Los Angeles, and on April 14 it will add two daily flights to Las Vegas.
Spirit Airlines can afford to offer much lower fares than other airlines both because it has high ancillary revenue (averaging more than $50/passenger) and rock-bottom unit costs. While Alaska is quite efficient, its mainline nonfuel unit costs came in at $0.0745 per available seat mile in 2014, compared to $0.0588 at Spirit.
By contrast, Delta has higher costs than Alaska Airlines. Delta's main competitive advantage in Seattle is the breadth of its global route network. Spirit Airlines competes solely on price, though. Its arrival in Seattle is more likely to spark a damaging fare war as it starts to peel away price-sensitive travelers.
Why it could be a big deal
Spirit's entry into the Seattle market is especially significant because Alaska Airlines has faced relatively little competition from ultralow-cost carriers in its home market up until now. Frontier Airlines currently offers up to two daily flights from Seattle to Denver -- and that's essentially it.
Seattle-Los Angeles and Seattle Las-Vegas are more important routes for Alaska Airlines than Seattle-Denver. They are both high-traffic routes on which Alaska holds more than 50% market share. Spirit's entry could push prices down significantly, particularly if other carriers match Spirit -- something that has been increasingly common.
That said, even a sharp drop in fares on two important routes wouldn't have that much impact on companywide profitability for Alaska Air. The problem is that Spirit is likely to add many more flights in Seattle as it plans to grow 15%-20% annually for the foreseeable future. It could, therefore, exert pricing pressure on more and more of Alaska's routes over time.
Additionally, Alaska is running out of low-hanging fruit in terms of "self-help" initiatives to increase revenue and reduce costs. As a result, it probably has less flexibility to offset potential revenue pressure caused by Spirit's growth with cost savings or incremental nonticket revenue.
I have no doubt Alaska Air will remain a highly profitable company even if Spirit Airlines quickly ramps up its presence in Seattle in the next few years. However, the stellar profit growth it has posted in recent years may prove to be unsustainable.
Adam Levine-Weinberg owns shares of Spirit Airlines and is long January 2017 $40 calls on Delta Air Lines,, long March 2016 $40 calls on Spirit Airlines, and long June 2016 $30 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines. 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.