A Look At Alaska Airlines’ Business Model And $42.75 Fair Value

Alaska Air Group (NYSE:ALK) has consistently posted growth in top-line and net income since the financial crisis in 2008. Growth has not only been driven by the steadily growing U.S. economy that has resulted in increasing demand for flights but also due to several initiatives undertaken by the carrier. These include the redeployment of aircraft capacity during the winter months from Pacific Northwest region and Alaska to Hawaii to counter the impact of seasonality, subcontracting of several services to third-party vendors to achieve lower cost structures, increasing the proportion of its total bookings through its official website and successful fuel hedging transactions.

In the previous quarter, the carrier also placed an order for 50 Boeing 737s including 37 of the fuel-efficient Boeing 737MAXs. ^[1] As a result, Alaska has positioned itself well for growth and also to weather a potential downturn in the future.

We currently have a stock price estimate of $42.75 for the airline, marginally above its current market price.

See our complete analysis of Alaska here

Redeployment of capacity to offset the impact of seasonality

Alaska’s business is subject to seasonal fluctuations. Its profits are generally the lowest during the first and fourth quarters largely due to lower passenger traffic. Passenger traffic increases in the second quarter and is the highest in the third quarter driven by demand for vacation travel. In the first and fourth quarters, passenger traffic is impacted by inclement weather conditions in the Pacific Northwest region and the state of Alaska. Together these two regions constituted 23% of total passenger traffic for Alaska in 2011. ^[2] Severe weather conditions in these regions increase costs related to aircraft deicing, cancellation of flights, re-accommodation of displaced passengers, and lower overall passenger traffic.

To counter the impact of seasonality, the carrier redeploys a certain portion of its capacity from these regions to routes that connect holiday destinations in Hawaii from its hubs on the west coast. In the past three years, as a percentage of its total capacity, the carrier’s capacity on Hawaii routes increased from 7% in 2009 to 16% in 2011. While the corresponding figures for Alaska routes has declined from 20% to 18% over the same period. ^[2] This strategy of redeploying aircraft from Alaska and Pacific Northwest to Hawaii has significantly reduced the impact of seasonality on the carrier’s business and contributed to growth in top-line and profits.

Subcontracting of services to achieve lower cost structures

In recent years, the carrier has subcontracted a number of its activities to third-party vendors to achieve lower cost structures. It subcontracted its heavy aircraft maintenance, fleet service, facilities maintenance, and ground handling services at certain airports like Seattle-Tacoma International Airport to outside vendors.

Additionally, though subcontracting has lowered the cost structure, it has also increased reliance on outside parties and thereby increased the associated risks.

Achieving a greater proportion of total bookings through the official website

Over the past few years, the carrier has also been able to raise the proportion of its total ticket bookings done through its official website – www.alaskaair.com. Bookings through other channels such as online or traditional travel agencies or reservation call centers are more expensive as travel agencies and third party call centers charge a fee from the airline per booking and in-house call centers have associated maintenance costs.

Alaska raised the proportion of its total bookings done through its official website from 48% in 2010 to 51% in 2011. This channel increases branding and customer-relationship for the carrier. In addition to cost savings, this channel allows the carrier to establish ongoing communication and tailor offers.

Fuel hedging

Alaska also hedges against fuel price volatility through active fuel price hedging. This guards the carrier against sudden rises in prices of crude oil. The carrier engages in hedging primarily through crude oil call options under which it obtains the right but not the obligation to purchase oil at pre-determined prices from another party. However, to achieve these rights, the carrier has to pay certain mandatory premiums.

In the third quarter of 2012, the carrier benefited $21 million from fuel price hedging which lowered its fuel costs 20% y-o-y. However, these transactions can put an additional cost burden in the form of premium in case crude oil prices drop significantly for a sustained period of time. At the end of third quarter of 2012, Alaska had hedged 50% of its total fuel requirements for the fourth quarter and 48% of its total fuel requirements for 2013. ^[3]

Capacity increase to drive future growth

The carrier also placed an order for 50 Boeing 737 airplanes in the third quarter of 2012. ^[1] At the end of 2011, Alaska’s total fleet size was 165 airplanes consisting of 117 Boeing 737s and 48 Bombardier Q400. Including the order placed in the third quarter, the carrier now has firm orders for 75 aircraft with deliveries ranging through 2024. ^[3] These new planes will allow the carrier to add to its capacity and drive growth in its top-line through higher passenger traffic. These new airplanes will also replace older planes in Alaska’s fleet reducing maintenance and fuel costs.

All in all, Alaska’s strategies to reduce its cost structures as well as to position itself for growth bodes well for the shareholders. The airline will continue to post profits unless a slowdown in the U.S. economy or a significant rise in jet fuel prices impact its business.

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1. Alaska Air Group Reports Third Quarter Results, October 25 2012, www.alaskaworld.com [↩] [↩]
2. 2011 10-K, www.alaskaworld.com [↩] [↩]
3. 2012 Q3 10-Q, www.alaskaworld.com [↩] [↩]