Description

Company Overview

With its recent $4.0 billion acquisition of Virgin America, Alaska Airlines (ALK) is now the 5th largest domestic airline in the US with a 6% market share.  Primarily a domestic carrier, Alaska Airlines has differentiated its business model by servicing the Pacific Northwest leisure traveler focused on a “premium value” flight.  Recently, the company began diversifying its passenger mix by marketing to the frequent business traveler. Even with the surge in competition from Delta and Southwest, ALK has been able to maintain its leadership position in the key hubs of Seattle and Portland.  Alaska Airlines acquired Virgin America to enlarge its California footprint, expand its services and fees, and grow its frequent flyer program without negatively impacting the company’s high return on invested capital and operating margins.

Industry

Historically, the airline industry has been a poor investment, due to the constant need for vast amounts of capital in order to keep planes and passengers airborne, the chronically low return on investment, and it being a commoditized industry where ticket prices are the key differentiator.

However, over time, competition and bankruptcies have reduced the number of domestic legacy carriers to just four (American, Southwest, Delta, and United) with a combined market share of over 75%.  Over the past 10+ years, the airline industry may have found religion. No longer focused purely on market share, terms like cost reduction, fuel efficiency, improved margins, and profits have found their way into the industry’s annual reports.  This new-found financial responsibility does not mean the airlines were able to re-engineer the travel industry, they were just able to find a more profitable way to operate. The change began in 2008 when airlines started charging a $15 baggage fee.  Initially, the fee was designed to offset the exorbitant high fuel prices (oil was over $140/barrel at the time). Even as the price of oil fell significantly (the average price over the past four years was around $52/barrel), baggage fees have increased to $25.  To date, Southwest Airlines is the only domestic carrier that does not charge a baggage fee.

Baggage fees are not where the real money and, more importantly, earnings come from.  By following the money, investors quickly learn that most of an airline’s profit comes from selling loyalty.  Airlines have morphed from a transportation business into a frequent flier business. When a passenger takes a flight, he earns frequent flier miles as a thank you gift.  Over time, those miles accumulate and allow a passenger to enjoy a free flight. For the non-business traveler, most frequent flier miles are not earned from flight segments but are generated by using the carrier’s co-branded credit card.  The credit card companies (banks) purchase frequent flier miles directly from the airlines to reward its cardholders. The larger the frequent flier program, the greater the number of co-branded credit cards in circulation, the greater the need and willingness to pay for those frequent flier miles, and the more miles that are purchased by the banks for their credit card programs.

Selling miles to a bank’s co-branded credit card is a very lucrative enterprise for the airlines for many reasons:  1) In 2017, Bloomberg reported that legacy carriers can receive between $0.015 to $0.025 for every mile they sell to a bank for its co-branded credit card.  The cost to the airline is significantly lower, earning them a margin believed to be in the 65% range (airlines do not disclose the metrics around mileage sales).  2) It can take a couple of years until the mileage is redeemed for an airline ticket, giving the airline a very cheap source of cash (the cash received is offset by a deferred revenue liability on the balance sheet).  3) Approximately 20% of industry-wide miles earned via flying or credit card transactions expire unredeemed. 4) Selling miles to credit card companies creates a less cyclical revenue stream for an airline.

Thesis

Alaska Airlines’ recent merger expenses, operation redundancy, and labor adjustment costs have masked the airlines’ true earnings power, creating a significant discrepancy between the company’s recent depressed stock price and its growing intrinsic value.  Alaska expects to not only reduce expenses but increase revenue opportunities through service enhancement reflected in higher fees and new revenue streams. Management intends to increase revenue by $500 million while reducing expenses by $250 million over the next two years.

One of the areas touched upon but not highlighted by management, and a key area of future growth, is the company’s expanding frequent flier Mileage Plan.  Loyalty matters in frequent flier programs and both Alaska Airlines and Virgin America gained that loyalty with great customer service at a reasonable price.  Now that both programs have been consolidated into a single plan, Alaska Airlines will be able to expand and leverage its West Coast footprint to both its frequent flier passenger and its co-branded credit card partners.  Unlike the legacy carriers whose frequent flier members are scattered throughout the US, Alaska Airlines’ customer base is highly concentrated in the Pacific Northwest and has now expanded into California via the purchase of Virgin America.  This West Coast footprint provides a unique opportunity to a credit card company looking to market directly to his specific geographic segment of the US.

Valuation

Since announcing its merger with Virgin America in early April 2016, Alaska Airline’s stock price has declined nearly 20% vs. an average gain of 40% by the four legacy carriers over the same period.  Even with merger expenses negatively impacting short-term earnings, it is important to remember that ALK still maintains a cost structure that is competitive with Southwest Airlines and up to 20% lower than the remaining three.  Alaska Airlines is approximately 80% through its integration which will lower expenses over the next couple of years and improve operational efficiencies. Going forward, the company’s true earnings power and intrinsic value will be revealed.

It is believed that Alaska Airlines has been earning approximately 50% margin on the miles it sells to its co-branded credit card.  Many believe that as their mileage program expands, those margins will improve, both from the operations side, as well as the revenue it earns per mile.  Over the past 5 years, revenue from its frequent flier program has increased over 16% per year, generating $1 billion in 2018. If an investor were to cautiously assume that over the next two years Alaska Airlines’ frequent flier revenue growth slows to only 12.5% a year, with margins remaining at 50%, and apply an 11x multiple, then the Alaska Airline’s Mileage Plan, alone, would conservatively be worth just over $56/share. This provides both a downside valuation and protection for an investor. Adding to that number an increasing intrinsic value from operational efficiencies, increased service fees, along with lower expenses and the value of Alaska Airlines will continue to climb.

Risk

There are a number of risks associated with Alaska Airlines and its industry:  1) 90% of Alaska Airlines employees are represented by 5 labor groups – strikes and renegotiations could negatively impact future earnings.  2) The airline industry is highly cyclical and, in the past, has been well known for destroying value. 3) Ongoing integration with Virgin America could be slowed or not achieve the expense reduction or synergies originally advertised.  4) Continued competition at their key hubs and 5) their business model is highly levered to volatile oil prices.

Summary

Merging two airlines is a herculean task.  In the eyes of the FAA, Alaska Airlines completed its merger with Virgin America in January of 2018.  However, combining two airlines into a single carrier entails a great deal more than repainting the planes or changing signage.  Merging two airlines requires, on average, over 24 months of hard work to blend cultures, integrate front-end and back-end systems, and retrain ground crews, flight staff, and pilots.  All that work translates into upfront costs and expenses which negatively impact short-term earnings. Throughout the process, Alaska Airlines' management has continued to safeguard its culture and its three stakeholders:  Its employees, its customer, and its shareholders – in that order. Management believes that in order to create value for its shareholders, Alaska Airlines must first create value for its employees and, in turn, those employees will create value for its customers through excellent customer service.

Catalyst

1.       Expanding frequent flyer program – members, cardholders and revenues

2.       Operational synergies expanding revenue opportunities

3.       Cost savings – reduced merger expenses and costs savings from the merger