For many investors, airlines are about as toxic an investment as can be imagined. A cost structure that cannot be controlled internally, little room to deal with macroeconomic stress, and balance sheets filled with debt stand out as just some reasons why investors avoid the airline sector. However, Southwest (LUV) has been an exception to this rule. As the only top-tier airline (Delta, United, Southwest, American, and US Airways) to not file for bankruptcy, Southwest is held up on a pedestal by many as a beacon of stability in a volatile industry. And its stock price seems to serve as proof of this notion.
Since going public nearly 25 years ago, Southwest has returned over 13,000%, a solid return for any stock, especially an airline. But, this article is not about Southwest. It is about an airline that we believe is poised to take Southwest's place as the industry's beacon of stability. With operating margins almost two and a half times higher than those of Southwest, a stronger balance sheet, more return of capital, and a low valuation, we believe that this company stands alone in the airline industry. And that company is Alaska Air Group (ALK), parent of Alaska Airlines and Horizon Air. In this article, we will address each of those 4 points, as well as Alaska Air's outstanding labor relations (which are crucial in this industry) and its hedging practices in order to make a case for why we believe that Alaska Air Group is undervalued by the market.
Alaska Air (which is actually based in Seattle), is one of the country's leading Tier 2 airlines (which we define as Alaska, JetBlue, Hawaiian, and Spirit), and operates primarily on the West Coast, with some routes to Hawaii, New York, and Washington. California, Oregon, and Washington are the airline's 3 largest markets, and it is primarily a domestic airline, with service to both Canada and Mexico (to some, those 2 countries fail to qualify as truly international air travel). Alaska Air has never filed for bankruptcy, and over the past decade, it is the best-performing stock in the industry, outperforming both its peers as well as the S&P 500.
We turn now to a brief overview of Alaska's Q3 2012 results, and its views on macroeconomic issues. For the record, unless otherwise noted, management commentary and financial data used in this article will be sourced from one of 3 places: Alaska's Q3 2012 earnings release, its Q3 2012 conference call, or its latest 10-Q filing.
Q3 2012: A Record Quarter, and Clear Economic Skies Ahead
Alaska posted record profits of $2.09 in EPS on revenues of $1.2722 billion. Its EPS beat by a penny, and revenues matched analyst estimates. Revenues grew by 6.2% in the quarter, driven by an 8.3% increase in revenues at Alaska Airlines. Revenue at Horizon Air, Alaska's regional airline, grew by 1%. Freight revenues dropped by 1%, but that is equivalent to a drop of just $300,000. In the quarter, freight revenue comprised just 2.33% of Alaska Air's total revenue. EPS grew by 16.76% from a year ago, as Alaska Air's fuel costs dropped by 19.9%, and the company kept other costs under control. Even an 11.6% jump in maintenance costs, which Alaska Air attributes to engine repairs at Horizon Air, did not put a damper on a good quarter. While Alaska Air did say that maintenance costs would be elevated in Q4 as well, the company is in discussions with Pratt & Whitney (the maker of its Horizon Air engines) about mitigating those costs, as the need for increased maintenance was caused by deficiencies in earlier work by Pratt & Whitney, according to comments made by Glenn Johnson, the President of Horizon Air.
Like all airlines, Alaska was asked on its conference call about how it sees the economy. Conventional wisdom assumes that airlines are an entirely cyclical industry, and that whenever there is macroeconomic stress, they are the first to feel it. However, despite what current headlines suggest, most airlines are not feeling any economic weakness, and we provided an in-depth look into what the 6 largest airlines in the United States, including Alaska Air, had to say about the American economy in our last article here on Seeking Alpha, and we provide Alaska Air's commentary in this article as well. In Q3, Alaska Air did not suffer from any macroeconomic stress. On its conference call, CFO Brandon Pedersen stated that,
"We would once again characterize the demand environment as stable. Both leisure and business traffic seem to be holding up despite continuing concerns at the macro level. As we look to the fourth quarter, advanced booked load factors are up about 2.5 points for October, 1 point for November and December is currently down 0.5 point."
Alaska Air is exposed far more to leisure travel than business, and typically, leisure travel falls at a slower rate than business travel in a downturn. However, with Alaska Air stating that advance booked load factors are down 0.5% for December, analysts seized on that, pressuring Alaska as to whether or not macroeconomic stress is seeping into its results. Andrew Harrison, Alaska Air's Vice President of Planning & Revenue Management denied that this was the case, stating,
"As we look forward and look at -- October is up 2.5 November 1 and December down just a 0.5 point, that feels right to me personally. We have often seen further out, especially when you have a lot of holidays in the December period. The holidays are actually -- both Christmas and Thanksgiving, are all booking up solidly and normal. The one thing to also remember is our trip length is going to be up 4.3% also in the fourth quarter. But overall, other than as I shared earlier, recovering a little bit from, I'll just say, lack of understanding of the seasonality of Hawaii and California, so we're going to bring that in a little bit more. So I think some of these you'll see improve. But overall, we feel pretty solid about the fourth quarter."
Alaska Air has a penchant for conservatism, and while we will look to November and December operational results (released in early December and January) for more color on Alaska Air's revenue performance, we do not believe that Alaska Air is facing a weak economy in its core markets. And even if Alaska were to face a weakening economy, its hedging practices will help cushion its bottom line.
Fuel Hedging With Calls: When Paying More Pays Off
Every airline has different hedging policies, which suit the unique needs of that airline. Delta (DAL), for example, utilizes swaps, thereby locking in fuel costs within a pre-defined range. Delta's trade-off is that in exchange for lower hedging costs (because of its use of swaps), it has a floor in how low its fuel costs can go. For Delta, that is what works best, as it is able to deploy the extra cash from using swaps to meet its healthy obsession with paying down its debt. US Airways (LCC), on the other hand, doesn't hedge at all. The company's management team has been consistent in arguing that hedging isn't worth the time or money it costs. And as jet fuel costs have fallen over the last several quarters, the full decline flows right through to US Airways' bottom line. Alaska Air, on the other hand, utilizes call options to hedge its fuel costs, and it is able to do so because of a pristine balance sheet.
Hedging fuel costs with call options is the most expensive hedging strategy, for there is no opposing trade to offset its cost. But, an airline that hedges with call options is able to benefit if and when fuel prices fall, as there is no floor to how far they can go. And for a leisure-focused airline like Alaska Air, this provides a double benefit. As Merrill Lynch notes, leisure travel typically falls less than oil in a recessionary economic environment, thereby providing airlines like Alaska Air with a cushion to guard against a fall in demand. As we have stated in our prior articles on both Hawaiian (HA) and Delta, investors should not base their investment decisions in this sector on hedging practices alone. Each airline utilizes the hedging strategy that best fits its needs. And for Alaska Air, call options allow it to participate in the benefits from falling fuel prices, while still protecting itself from spikes in fuel costs.
Margins and Valuations: Alaska Deserves More Respect (And a Higher Multiple)
Alaska's margins are almost two and a half times higher than that of Southwest, and yet its P/E ratio is half of Southwest's. We present trailing 12-month results for both Alaska Air Group and Southwest below, as well as their valuations (financial figures are in millions of dollars)
Alaska Air Group Trailing-12 Month Results
|Q4 2011||Q1 2012||Q2 2012||Q3 2012||Total|
|Operating Income (GAAP)||$114.1||$72.4||$115.8||$269.5||$571.8|
|Operating Income (Non-GAAP)||$87.3||$59.9||$159.1||$256||$562.3|
|Net Income (GAAP)||$64||$40.8||$67.5||$163.4||$335.7|
|Net Income (Non-GAAP)||$37.2||$28.3||$110.8||$150.3||$326.6|
As the table above shows, Alaska Air's operating margin for the past 12 months comes in at 12.31% on a non-GAAP basis, and 12.51% on a GAAP basis. And what about Southwest?
Southwest Airlines Trailing 12-Month Results
|Q4 2012||Q1 2012||Q2 2012||Q3 2012||Total|
|Operating Income (GAAP)||$147||$22||$460||$51||$680|
|Operating Income (Non-GAAP)||$167||$10||$485||$208||$870|
|Net Income (GAAP)||$152||$98||$228||$16||$494|
|Net Income (Non-GAAP)||$66||$-18||$273||$97||$418|
Based on the data above, Southwest's non-GAAP operating margin for the past 12 months is just 5.25%, and it is 4.11% on a GAAP basis. And yet, Southwest still commands a higher valuation. Based on their November 9 closing prices, Alaska and Southwest trade at respective P/E ratios of 9x and 16.18x trailing 12-month non-GAAP earnings. In our view, there is no reason for Alaska Air to be trading at such a discount to what most investors see as the industry bellwether. Alaska's operating margins are almost three times higher than Southwest's, and yet its P/E ratio is over 44% lower. When 5-year growth rates are taken into account, the oddity of this valuation discrepancy is also maintained.
Based on consensus 2012 and 2013 earnings estimates, Alaska Air's pro forma EPS for these 5 years is growing at a CAGR of 34.19%. Earnings are set to grow by 20.41% in fiscal 2012 and 13.34% in fiscal 2013. By comparison, Southwest's earnings for fiscal 2012 are set to grow by 30.23%. Fiscal 2013 earnings are set to grow 62.5%. And based on these estimates, Southwest's earnings are growing at a CAGR of 36.79%
Shouldn't this justify Southwest's valuation premium to the industry? While we certainly believe that Southwest is one of the leaders of the airline industry, we see no reason why Alaska should be valued at just 8.62x estimated 2012 earnings, or 7.61x estimated 2013 earnings. And in our view, Alaska Air's balance sheet and its capital deployment plans further underscore the fact that it is undervalued.
Balance Sheet and Capital Deployment: Airlines Really Can Return Cash to Shareholders
For the most part, airlines do not send cash to their investors. Buybacks are a rarity in the industry, and dividends even rare. Southwest pays its shareholders a token dividend of a penny per quarter, which results in a yield of 0.44%. While Alaska Air pays no dividend, it has been buying back stock regularly, and its newly announced buyback underscores its industry-leading financial position, as well as the company's confidence in its future.
Alaska Air announced a $250 million stock buyback at the end of September, which, based on its current market capitalization, is equivalent to 8.74% of its outstanding shares. No airline, not even Southwest, is returning capital to investors at such a rate. And analysts on Alaska Air's Q3 call were unimpressed by even this. Sidoti asked Alaska Air's management,
"Just going to the buyback. I [Sidoti analyst Stephen O'Hara] mean, in terms of the amount, looking at the consensus estimates that are out there, I mean, it looks like you guys are going to generate -- you should generate, based on the estimates at least, a lot of free cash flow based on the CapEx guidance you have so far. Your debt repayments are going down, I think, in the next 2 years. So I mean it seems like the -- maybe the $250 million seems a little small or maybe the time frame seems a little long?"
Given Alaska Air's financial position, this buyback would seem to be small. But, in our view, it should be applauded. Airlines, for the most part, do not return capital to shareholders, and for Alaska Air to be buying back almost 10% of its stock is a strong message that the company believes in its long-term success. And should the company continue to generate cash at these levels, the buyback can be expanded.
Alaska Air's balance sheet is one of the strongest in the industry. The company ended Q3 2012 with $1.1856 billion in cash and investments, and debt of $1.0661 billion, giving the company a net cash position of $119.5 million. By comparison, Southwest has $9 million in net cash and investments on its balance sheet. Alaska Air's balance sheet is solid, and even with its buyback, it will continue to be at the top of the airline industry. S&P placed Alaska Air on review for an upgrade (Alaska Air is currently rated BB- by S&P) in July, citing the company's strong cash flow generation and reduced leverage. And S&P has stated that Alaska Air's planned buyback will not affect its credit rating or positive ratings outlook. An airline that is willing to send cash out the door on buybacks in these amounts is, in our view, an airline that is confident in both its financial strength and its future success.
Labor Relations: Alaska Air Understands Its Importance
One of the things that has made Southwest a leader in the airline industry is its labor relations. From the very beginning, Southwest understood the need to treat its employees properly, no matter if they were unionized or not. Happy employees are productive employees, and Southwest recognized the importance of this early on, and the airline is still one of the industry's leaders when it comes to labor relations.
Alaska Air operates the same way. Its management team understands that an airline needs to have a cordial and productive relationship with its employees, and that contention benefits no one. For the record, 83% of the employees at Alaska Airlines are unionized, while 47% of Horizon Air employees are unionized. Alaska Air's strong labor relations are exemplified by its contract negotiations and pension funding policies. On November 2, Alaska Air and its Horizon pilots renewed their contract a full 3 years ahead of schedule, extending its expiration from 2015 to 2018. Alaska Air understands that it is far better to work with pilots than against them, and this contract extension is a reflection of that philosophy. The company's pension funding practices also serve to highlight its dedication to positive labor relations. ON the company's Q3 call, CFO Brandon Pederson stated that,
"On the [pension] funding side, we actually have no required funding this year or next. And so it really doesn't help us in that regard. We choose to fund, but we have no required funding."
Many airlines in the United States jettisoned their pension plans through bankruptcy. United Continental's (UAL) pilots have still not fully forgiven the company for jettisoning its pension plans in bankruptcy, and labor relations at United Continental are strained. Alaska Air is doing all that it can to avoid that, and is going as far as to fund its pension plans even when it has no obligation to do so. Alaska Air understands that if it does right by its employees, they will do right by Alaska Air.
Alaska Air Group is, in our view, the next Southwest Airlines. It has a solid balance sheet, good hedging practices, an unassuming valuation, and operating margins that are the envy of the industry. The company is buying back almost 9% of its stock, and is committed to a productive relationship with its employees. Over the past 25 years, Southwest Airlines has shown that it is possible for investors to make profits in this sector. And from what we have seen, Alaska Air Group also serves as proof of this. The company has outperformed Southwest and the entire airline industry, as well as the S&P 500 over the past decade, and we fully expect this outperformance to continue. In our view, Alaska Air Group is the new Southwest of the industry, and it has the financials and operational results to prove it. In our view, Alaska Air Group is undervalued, and within the airline industry, it is in a class of its own. We believe that this airline's best days are ahead of it, and that investors who add to or initiate positions in the company will be rewarded for bucking the conventional wisdom that airlines are an uninvestable sector.