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It's Good to Be a Domestic Airline

By Adam Levine-Weinberg - Jan 26, 2016 at 5:15PM

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Southwest Airlines and Alaska Air Group delivered stellar profit margins in 2015.

Investors have been less than thrilled with legacy carriers' financial results lately, even as they have consistently posted record profits. Carriers like Delta Air Lines (DAL 1.59%) and United Continental continue to face headwinds from the strong dollar, falling fuel surcharges on international routes, and even from the November terrorist attacks in Paris.

Many investors doubt that legacy carriers' earnings growth is sustainable. Image source: The Motley Fool.

By contrast, domestic airlines are more insulated from these issues. Two of the largest domestic-focused airlines -- Southwest Airlines (LUV 1.26%) and Alaska Air (ALK 2.40%) -- reported their Q4 earnings last Thursday. Both companies' results showed that it is a great time to be a domestic airline.

Southwest Airlines' profit soars
Just two years ago, many airline pundits wondered whether Southwest Airlines' best days were behind it. By then, it had been years since the company had met its 15% return on invested capital goal. Labor strife was increasing, and Southwest was being attacked from all sides by resurgent legacy carriers and new ultra-low-cost carriers.

Today, Southwest has put to bed any concerns that it has lost its mojo. The company earned a record adjusted profit of $2.4 billion in 2015 -- up nearly 70% year over year -- on a pre-tax margin of roughly 20%. Moreover, its return on invested capital soared to 32.7%, far above its 15% target.

Lower fuel prices were the primary driver of Southwest's massive profit growth last year. But it was also able to limit its unit revenue decline to 1.5% -- much less than what the legacy carriers experienced -- despite ramping up its capacity growth to 7.2%.

Southwest Airlines outperformed most other airlines in terms of unit revenue. Image source: The Motley Fool.

Southwest expects unit revenue to remain stable again in Q1. Factoring in a modest increase in non-fuel unit costs and lower fuel prices, Southwest should produce another quarter of strong profit growth. Analysts expect adjusted EPS to rise 27% to $0.84. Analysts are also projecting full-year adjusted EPS growth of 21%.

Alaska Air continues leading the industry
Unit revenue pressure has been more intense at Alaska Air, which has faced a growing challenge from Delta Air Lines at its main hub in Seattle. Delta, which had fewer than 40 daily departures in Seattle in early 2013, operated about 100 daily departures on average during 2015 and plans to surpass 140 peak day departures this summer.

Due to this competitive capacity growth, along with its own growth initiatives, Alaska's unit revenue declined 5.7% year over year in 2015. However, Alaska Air has shown a consistent ability to reduce its non-fuel unit costs and improve its fuel efficiency year after year, allowing it to make more money with lower fares.

Indeed, Alaska Air led the airline industry with a 24% pre-tax margin in 2015, up from 17.2% a year earlier. This performance easily surpassed even Southwest Airlines.

Alaska Airlines has the highest profit margin in the airline industry. Image source: The Motley Fool.

At its investor day in December, Alaska announced two new initiatives that should allow it to offset its ongoing unit revenue pressure. First, a revised credit card rewards agreement will boost Alaska's revenue by $60 million (approximately 1% of total revenue) for 2016. Second, Alaska is introducing a full-fledged premium economy section this year. Management expects this to boost annual operating income by at least $85 million by 2018.

As a result of these initiatives, analysts expect another year of double-digit earnings growth from Alaska Air in 2016. Furthermore, Delta Air Lines may slow its growth in Seattle after 2016, which could allow Alaska to return to unit revenue growth in 2017.

Two solid airline stocks
In addition to having strong profit margins, Southwest Airlines and Alaska Air are also the only two airlines that currently have investment-grade credit ratings. This means that they don't have to worry about reducing debt and can return most of their free cash flow to shareholders.

Both airlines announced major capital return plans last week. Alaska hiked its dividend by 38% and also plans to buy back more stock in 2016 than it did in 2015. Meanwhile, Southwest revealed plans to launch a $500 million accelerated share repurchase program soon.

Despite this positive outlook for Southwest and Alaska Air, both stocks are trading for less than 10 times projected 2016 earnings right now. This makes them both solid choices for investors seeking a combination of growth and value in the airline industry.

Adam Levine-Weinberg owns shares of United Continental Holdings, and is long January 2017 $40 calls on Delta Air Lines, 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.

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Stocks Mentioned

Alaska Air Group, Inc. Stock Quote
Alaska Air Group, Inc.
$47.34 (2.40%) $1.11
Southwest Airlines Co. Stock Quote
Southwest Airlines Co.
$39.46 (1.26%) $0.49
Delta Air Lines, Inc. Stock Quote
Delta Air Lines, Inc.
$34.50 (1.59%) $0.54

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