Strong Earnings at Hawaiian Airlines: Can the Good Times Continue?

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Last Thursday, Hawaii-based leisure airline Hawaiian Holdings (NASDAQ: HA) reported its third-quarter earnings. The results were stellar once again, with Hawaiian's adjusted pretax margin remaining well above 20%.

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Even though Hawaiian Airlines has been outperforming its peers by a wide margin for the past two years, investors have been nervous about an expected influx of competition from United Continental (NYSE: UAL) and Southwest Airlines (NYSE: LUV). However, these worries are probably overblown.

A huge Q3 profit and a decent Q4 outlook

In the first half of this year, Hawaiian posted a stellar 30% increase in its adjusted earnings per share. However, Hawaiian Airlines has faced increasingly difficult year-over-year comparisons over the course of 2017.

As a result, adjusted EPS was flat last quarter relative to Q3 2016, at $1.92. Revenue per available seat mile (RASM) rose 5.8% year over year, but an 8.2% increase in adjusted nonfuel unit costs and an uptick in fuel prices combined to create some margin pressure. Still, Hawaiian Holdings' third quarter adjusted pretax margin of 22.8% was probably the best in the industry.

Comparisons will get even tougher in the fourth quarter. Hawaiian Airlines expects RASM to be roughly flat on a year-over-year basis (somewhere between down 1% and up 2%). Meanwhile, the company will continue to face a good deal of unit cost inflation, primarily driven by rising fuel costs and a new pilot contract that went into effect earlier this year.

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All in all, the guidance implies that Hawaiian's fourth-quarter pretax margin could decline by 5-6 percentage points relative to the 17.6% year-ago result. Still, that would be a very respectable showing, considering that United Continental just forecast that its pretax margin will plummet to 3%-5% in the upcoming quarter.

Fighting off the competition

Next year, Hawaiian Airlines will face a significant increase in competitive capacity between the West Coast and Hawaii. United Airlines is adding a slew of new flights to Hawaii beginning in late December 2017, and Southwest Airlines plans to start flying to Hawaii sometime in late 2018.

This high capacity growth in the West Coast-Hawaii market will put pressure on Hawaiian's RASM in 2018 -- and perhaps also in 2019. However, Hawaiian Airlines has some important tools to fight back.

First, the company will wrap up its A330 cabin modifications in early 2018. This project entails converting the first class section to lie-flat seating and boosting the number of extra-legroom economy seats from 40 to 68, while reducing overall seating capacity from 294 to 278.

The new premium-heavy seating configuration will boost Hawaiian Airlines' ancillary revenue -- and differentiate it from Southwest Airlines. However, Hawaiian won't get the full revenue benefit of these changes until the project is completed. For now, the carrier operates with a mixed fleet, which means that it can't sell every available seat if it isn't sure far enough in advance about which particular plane will operate a given route on a given day.

Second, Hawaiian Airlines will put its first A321neos into service in early 2018. With 189 seats, these planes will allow the company to enter new markets that can't support widebody service. Hawaiian will also be able to reduce capacity where necessary by switching from a widebody to an A321neo on routes with weaker unit revenue. It will start this process in January, when the Oakland-Maui route will transition to A321neo service.

Third, Hawaiian recently agreed to begin codesharing with Japan Airlines next March. The two carriers plan to expand this partnership to a full joint venture thereafter, subject to regulatory approval. This should give Hawaiian Airlines a boost in the international market to help offset any domestic weakness.

Cost creep will end

Mr. Market may be overestimating the impact on Hawaiian Airlines of new competition from United and Southwest. Nevertheless, the high single-digit RASM growth that Hawaiian has achieved year to date is clearly unsustainable. To remain strongly profitable, the carrier needs to dramatically slow its unit cost growth.

In 2018, the company's preliminary target is for nonfuel unit costs to rise at a low single-digit rate. Hawaiian will lap the implementation of its new pilot contract at the end of this year, after which wages and benefits growth will slow significantly. The addition of brand-new A321neos to the Hawaiian Airlines fleet will also help to hold down nonfuel unit costs. (They will provide huge fuel efficiency gains as well.)

On the other hand, Hawaiian Airlines will face higher rent related to its new maintenance and cargo hangar in Honolulu. Additionally, the A330 retrofits are driving unit cost growth, simply because the program entails reducing each plane's seating capacity by more than 5%. Lastly, the company will incur training costs related to the new A321neos.

2019 represents Hawaiian's real cost-reduction opportunity. By then, the cost headwinds from its A330 retrofit program and the new hangar will have gone away. Furthermore, the carrier will retire its aging 767 fleet by the end of next year, which will reduce aircraft rent and maintenance costs going forward.

Thus, while Hawaiian Airlines will face a tougher competitive environment in the next couple of years, it has plenty of tools to respond. As a result, it is likely to continue churning out strong profits.

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Adam Levine-Weinberg owns shares of Hawaiian Holdings. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.