Alaska Air Group, Inc.: At Last, Some Hopeful Signs

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Since the beginning of 2017, profitability has spiraled lower at Alaska Air (NYSE: ALK). Revenue surged 34% last year, largely due to the company's late-2016 acquisition of Virgin America, but adjusted earnings per share still declined 9.3% for the full year (from $7.32 to $6.64).

Alaska Air entered 2018 on track for further sharp earnings declines. Its initial guidance for the first quarter implied that the company would only break even.

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However, Alaska's guidance has improved in multiple respects over the past few months. Most importantly, the company raised its revenue per available seat mile (RASM) forecast last Friday. This offers shareholders some hope that Alaska Air is finally getting back on the right track.

Competition becomes a headwind

For many years, Alaska Airlines benefited from its dominant position in Seattle -- its hometown and main hub -- as well as in Portland, Oregon and Alaska. The company's low cost structure, the lack of serious competition, and the growth of the Seattle tech industry provided ample opportunities for high-margin growth.

In the past few years, the competitive landscape has changed. Delta Air Lines has quickly built up a competing hub in Seattle, putting pressure on fares there. It also caused a shortage of gates at Seattle-Tacoma International Airport, constraining Alaska Airlines' ability to keep growing in its hometown. This helped encourage Alaska Air to buy Virgin America (which had focus cities in Los Angeles and San Francisco) as a platform for growth in California.

California is a far bigger market than the Pacific Northwest. It also has far more competition, with virtually every big airline fighting for a significant piece of the pie. These competitors are eager to preserve their market share in this key market. For example, Southwest Airlines launched a massive promotional campaign last fall touting its position as the No. 1 airline in California. Southwest also announced a slew of new routes in California -- including the upcoming launch of flights to Hawaii.

As a result, Alaska Air struggled in California during 2017. In the third quarter, RASM fell 8% year over year on former Virgin America routes. For the whole company, RASM declined 6.1% in that quarter and 7.6% in the fourth quarter. The combination of plunging unit revenue and rising fuel prices has severely pinched Alaska Air's once-lofty profit margin.

Guidance is getting better

In January, Alaska Air's management forecast that RASM would decline 3.5% to 4.5% in the first quarter. While that would have represented a sequential improvement from the second half of 2017, it still implied that the carrier's adjusted pre-tax margin would plummet to around zero, from double-digit territory a year earlier.

Alaska confirmed this revenue forecast in March. However, last Friday, the company raised its guidance significantly. It now estimates that RASM slipped just 2.1% to 2.3% year over year last quarter. This improving trend allowed investors to breathe a sigh of relief, particularly because Southwest Airlines had cut its own first-quarter revenue forecast just a few weeks earlier.

Alaska Air's cost outlook has also improved. The recent guidance update indicates that fuel efficiency came in much better than expected last quarter. Alaska also beat its initial non-fuel unit cost guidance, despite facing $9 million of additional costs related to agreeing on a new contract for its flight attendants.

There's still plenty of work ahead

While Alaska Air seems to be moving in the right direction, the company can't be satisfied with smaller unit revenue declines. Without consistent RASM increases, it won't be able to offset the impact of rising fuel and labor costs.

In the past few months, Alaska has made some tough decisions about its route network, reducing capacity on underperforming routes. Revenue synergies should also start to kick in soon, particularly after the Virgin America brand is retired later this month.

As a result, Alaska Air is likely to return to solid RASM growth in the second half of 2018. This could help the stock recover some of its recent losses. However, investors should keep a close eye on Alaska's progress. If the company gets knocked off course again, Alaska Air stock could plumb new lows.

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