Southwest Airlines and Alaska Air Earnings: A Tale of 2 Californias

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In the past few years, Southwest Airlines (NYSE: LUV) and Alaska Air (NYSE: ALK) have been arguably the two most successful U.S. airlines. Southwest and Alaska have achieved enviable margins through a combination of low fares and an unrelenting focus on efficiency.

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However, the two carriers' fates diverged in the third quarter. Southwest Airlines posted another strong quarterly profit. Meanwhile, Alaska Air stumbled, reporting a significant year-over-year decline in its profitability. The discrepancy can be traced back largely to how these two airlines performed in California.

Southwest Airlines stays strong

Last quarter, Southwest Airlines was hit hard by Hurricane Harvey and Hurricane Irma. In total, the storms reduced the company's revenue by about $100 million. Nevertheless, revenue per available seat mile (RASM) declined just 0.5% year over year.

Meanwhile, unit costs increased by a modest 2.5%, excluding special items. As a result, Southwest was still able to report a solid operating profit of $871 million last quarter (again excluding special items). That was down from $972 million a year earlier.

Southwest Airlines' strong results were notable for two reasons. First, it incurred lots of storm-related disruption -- unlike Alaska Air, which has a minimal presence in Houston and Florida. Second, Southwest has major operations in several of United Continental's (NYSE: UAL) hub cities, many of which were plagued by fare wars last quarter.

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Most other carriers with a broad national footprint reported steep profit declines in the third quarter. For example, United's adjusted operating income plunged more than 30% year over year. Compared to that baseline, Southwest's results were quite commendable.

Alaska Air didn't fare so well

Alaska Air posted a 2% year-over-year increase in its adjusted earnings per share last quarter. However, the company acquired Virgin America last December, boosting its revenue by roughly a third, so it ought to be posting much stronger earnings growth this year.

Alaska's cost performance was fairly good last quarter. Non-fuel unit costs crept up by a mere 1%. However, RASM declined 1.6% year over year. (Both of these statistics include Virgin America's Q3 2016 results as part of the comparison.) That's why adjusted pre-tax income declined 13% year over year on a combined basis for Alaska Airlines and Virgin America.

Considering that Alaska's largest base of operations is in the Pacific Northwest -- far from the epicenter of the recent fare wars -- and the company didn't face a big hurricane-related headwind, this profit decline was disappointing. The weakness can be traced to one region: California.

It's all about California

On Alaska's third-quarter earnings call last week, management indicated that the company faced severe pricing pressure in California. The weakness affected both transcontinental flights from California to the East Coast and short-haul flying within California. As a result, while RASM was roughly flat in "legacy" Alaska Air markets last quarter, RASM fell by about 8% on routes acquired in the Virgin America deal.

During the earnings call, some analysts questioned whether the weak results mean former Virgin America customers are defecting to other airlines. Alaska's management doesn't think so, noting huge growth in the number of loyalty program members and co-brand credit card holders.

Some of the weakness may stem from United Continental having hubs in San Francisco and Los Angeles, Virgin America's two main bases. As a result, the former Virgin America network is exposed to the industry fare wars.

Additionally, Alaska's growth in California is provoking competitive responses by other carriers, including Southwest Airlines. Southwest has added flights in California several times in the past year in order to protect its market-leading position there. The combination of more flights (in some cases) and more competitive pricing in California is surely adding to the pressure on Alaska Air.

Interestingly enough, Southwest Airlines said its RASM in California was only slightly worse than the system average last quarter. This reflects the loyalty of its customer base -- but also its geographical diversity. Southwest is an important player at virtually every major airport in California, unlike Virgin America, which was heavily concentrated in San Francisco and Los Angeles.

Alaska Air executives aren't satisfied with the company's performance in California right now. They will likely cut the carrier's capacity in some underperforming markets in the near future. In the long run, Alaska Air is still well-positioned to succeed in its new California markets, but it looks like the current turbulence will continue into 2018.

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