How America's Most Profitable Airline Will Keep Flying in 2017

By Markets Fool.com

In the past few years, Alaska Air (NYSE: ALK) has become the most profitable airline in the U.S. It's keeping up the momentum in 2016 despite a massive surge in competition in its markets. Over the past 12 months, Alaska Air has generated a stellar 24.8% pre-tax margin.

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Looking ahead, Alaska Air plans to dramatically expand its presence in California by buying smaller rival Virgin America (NASDAQ: VA). It hopes to close that acquisition by the end of 2016, but must first resolve an ongoing antitrust review by federal regulators as well as a separate antitrust lawsuit brought by private citizens.

Alaska Air hopes to finalize its merger with Virgin America soon. Image source: Alaska Airlines.

Whether or not Alaska manages to close the Virgin America merger in the next few months, the company is on track to continue posting strong results in 2017 and beyond. Let's take a look at how it will do so.

Continuous fuel-efficiency gains

After two years of benefiting from sharp fuel price declines, airlines (including Alaska Airlines) are starting to face year-over-year fuel price increases. However, offsetting this, Alaska has been improving its fuel efficiency by about 2% annually by replacing its oldest planes with modern Boeing (NYSE: BA) 737s.

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In total, Alaska improved its fuel efficiency by 25% between 2004 and 2015. In 2017, Alaska will complete the process of replacing all of its previous-generation 737-400s with new Boeing 737-900ERs. (Alaska Air CFO Brandon Pedersen quipped last week that the 737-900ER is like a Prius with wings; it uses less fuel than a 737-400 despite having 25% more seats!)

The other benefit of retiring the last 16 737-400s is that it will simplify Alaska's maintenance operations. That will offer an additional cost reduction opportunity.

Alaska Airlines' fuel-efficiency gains will slow down after 2017, but they won't stop. Beginning in early 2018, Alaska will add Boeing's 737 MAX 8 and 737 MAX 9 to its fleet. According to Boeing, those models will offer double-digit fuel efficiency improvements relative to the 737-800 and 737-900ER.

Alaska Airlines will add the new Boeing 737 MAX 8 to its fleet in early 2018. Image source: Boeing.

Growing ancillary revenue

Boosting non-ticket revenue has been a key focus for most airlines, and Alaska is no exception. Earlier this year, it revised its co-branded credit card agreement in order to provide more benefits for cardholders and bring in more revenue. The company expects credit card-related revenue to continue growing in the years ahead.

Additionally, Alaska Airlines has started to retrofit its fleet with a new section of extra-legroom seats, dubbed "Premium Class." Tickets for the new seats will go on sale next month for flights starting in early January. Alaska plans to finish the retrofit program by the end of 2017.

Alaska Air executives have forecast that this initiative will add $50 million of incremental operating profit in 2017. By 2018, the annualized impact will be more than $85 million.

Competitors are finally easing up

For the past several years, competitors have been growing rapidly in Alaska Airlines' markets. Indeed, since early 2015, Alaska has consistently reported double-digit increases in competitive capacity. Not surprisingly, this growing competition has driven fares lower. Alaska's ability to maintain its stellar profitability during this period has been remarkable.

In 2017, Alaska Airlines may finally get a respite from this competitive capacity growth. Based on currently published schedules, Alaska is set to face a 9% uptick in competitive capacity in Q1 2017 but a modest 1% increase by Q2. (For comparison, competitive capacity surged 13% year over year last quarter.)

If competitive capacity growth really does sink to low single-digit levels by Q2 2017, it will set the stage for a return to solid unit revenue growth at Alaska Airlines.

Virgin America would provide even more upside

The combination of steadily improving fuel efficiency, rising ancillary revenue, and a tamer competitive environment should help Alaska Air offset much of the headwind from rising oil prices in 2017 and beyond.

Completing the Virgin America merger would be the icing on the cake. When the merger was first announced, Alaska estimated that the Virgin America acquisition would add $100 million in pre-tax income immediately. By 2020, when all the merger synergies would be realized, the Virgin America acquisition should add $325 million to Alaska's pre-tax income.

Thus, it's obvious why Alaska Air is eager to address any antitrust issues and complete the merger. However, the nice thing for investors is that the company has plenty of room for long-term profit growth even without the benefits of the merger.

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Adam Levine-Weinberg owns shares of Alaska Air Group and Boeing. 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.