Everybody is going to want to fly somewhere soon right? You can feel the strong desire; perhaps the greatest ever simultaneous experience of ‘cabin fever’. So, you should be able to buy anything that takes people around on something with wings and have a heyday, right? Unfortunately, this is incorrect. Investing in one of the most bankruptcy-prone and heavily regulated industries in America is difficult, can be counter-intuitive and is subject to economic and regulatory forces that sometimes make incentives hard to understand or predict. Choosing the right airline, if you want to invest in the industry is very important.

Source: Seeking Alpha

The uncertain path of the return of pre-COVID levels of demand on both the leisure and business side makes us think it is wise to stick with the strongest name, financially speaking, and also a name with one of the best prospects for above-industry growth. Alaska sticks out to us. They have a regional and domestic focus. The international focus they do have is primarily in North America to leisure destinations. They have added new leisure routes, have a loyal and affluent customer base, one of the best rates of cash-burn in the industry, an industry-leading product quality and mileage program, and they have pulled off some incredible cost-cutting. Also, in an industry where labor relations matter, ALK managed to not only be amongst the leading companies in terms of cost reductions, but also managed to pay large amounts of incentive pay to employees. The key advantage Alaska had at the beginning of the crisis is that it went into it financially stronger than most.

Source: Alaska Air 2020 Shareholders Meeting Presentation

If you haven’t flown the airline, its product for premium members is a very appealing mix of some of the better old-world airline product features with some of the more innovative products like competitor Jet Blue has. The distinction of first class still holds a certain allure. One of Alaska’s main weaknesses, not belonging to an alliance, was also just rectified when it officially joined the One World Alliance on 3/31/21. This will likely provide ALK with a lot of lucrative traffic and, importantly, significantly adds to the utility and ubiquity of its mileage benefits while exponentially expanding inter-line destinations available to existing customers. Another advantage Alaska has is its strong regional business. Another airline we like, JBLU, had a concentration of routes that made the pandemic harder on it and ALK has consistently had significantly higher load factors. Due to the 2018 merger with Virgin America, which was largely succesful and managed by the new CEO, Ben Minicucci, ALK has been able to rely on strong regional business and the usually thin routes that have now become some of the thickest. The ability of management to pivot traffic better than most resulted in an impressive achievement, especially relative to peers, only an 8.4% decrease in passenger yield with about a 50% drop in revenue passengers at the regional level.  

Source: Company Reports

An Epic “Epicenter” Achievement Caps Off Brad Tilden’s Impressive Tenure as CEO

By now, a lot of folks have heard our narrative for why we like ‘Epicenter’ stocks, or those names that were closest to the social and economic consequences of COVID-19.  We have argued that these companies would use increased operating leverage and meet the torrent of pent-up demand that returned with leaner operating models that we expect will result in EPS above the Street’s consensus.  Alaska Airlines represents the Epicenter narrative in stark fashion.  If you’re looking for an airline you can feel comfortable owning for the long-haul, then ALK would be a good name to consider. It has the key macroeconomic drivers of an Epicenter stock, and of airlines in particular, with a difference investors should like – the strongest balance sheet and some of the lowest borrowing costs in commercial aviation. This means, relative to competitors, it has a lower chance of accumulating negative retained earnings as it struggles to ensure growth stays high enough to service crisis debt. Some airlines, particularly given the still unclear timeline for the return of demand, will likely suffer this fate. We think it’s preferable to own the airline with the lowest chance of this happening.

Source: Company Reports

 The unprecedented nature of the pandemic crisis faced by companies led to a lot of dilutive capital actions, with many airlines offering additional equity and increasing debt-to-capitalization ratios significantly. Alaska managed the impressive feat of maintaining essentially the same net debt from Q42019 to Q4 2020. Even more impressive is the fact that they did this with a 59% drop in revenue for the year. This is all star numbers even for an Epicenter stock. That’s right you heard it correctly Alaska Airlines maintained the same net debt position without changing the share count, with about 60% less revenue to work with. A lot of those savings can be attributed to low energy costs, but the company still cut 22% of it’s non-fuel costs, and is leading the industry in terms of cost-cutting and cash-burn. 

Many competitors are in significantly more dire financial straights than ALK. This, is of course understandable for an industry prone to bankruptcy. In fact, the industry is so prone to bankruptcy that every single US airline that operated prior to the de-regulation of 1978 has declared bankruptcy at one time or another. All except one that is: Alaska Airlines. This isn’t just a badge of pride. The conservative balance sheet management and prioritization of shareholder interests has meant that ALK came into the crisis stronger, and so is poised to go into the re-opening stronger. The firm’s materially above-industry balance sheet-quality translates into lower borrowing costs and default risk.

Source: Bloomberg

Positive Cashflow On The Horizon, New Alliance, New Management

Airlines are one of the most heavily regulated industries in existence. Some truly strange incentives arise under such circumstances. For example, the reason the services airlines provided prior to 1978 were so posh (filet and lobster served on fine china was an expected first class service) was because it was literally one of the only areas where airlines could legally compete. Yes, the ‘golden age’ of aviation was partly a product of unintended regulatory consequences. Another interesting feature is the presence of anti-trust exemptions in the industry. Normally, it is illegal for competitors to expressly coordinate on pricing; however, in the case of sub-fares on an inter-line trip (a multi-leg trip using one or more carriers) when two companies operate with only one shared profit margin they typically both receive more than they would independent of coordination. The consumer usually gets a lower fare in the process. This phenomenon is called ‘the removal of double marginalization’ and is one of the key reasons why Airline Alliances, particularly for a coastal airline like Alaska, are incredibly powerful tools that can benefit an airline and its customers.

Source: Company Reports

Investing in this industry requires shareholders to be ultra-conscious of a risk that is more remote in many other industries; bankruptcy. Alaska’s historical conservative balance sheet management is more impressive when you consider the scale of it’s growth over the past thirty years. It went from being a tiny regional airline to the fifth largest airline in the United States. It regularly goes toe-to-toe with the big guys on routes, and wins. It unquestionably provides a higher quality and more refined product that consumers value above what the large legacy carriers can offer.

Source: 2020 Shareholders Presentation

It has the wherewithal and the will to pivot more toward its warm-weather leisure destinations and it also has added major value to one of the leading edges of its competitive advantage by finally joining a major Airline Alliance. Effective on 3/31, Alaska Airlines officially became part of the OneWorld Alliance. Even though the full return of business travel may still be far off, this development should allow Alaska to expand its mileage program at the expense of the larger carriers, and perhaps at the expense of even a less traditional competitor, Jet Blue. While Alaska doesn’t have the same level of product differentiation as Jet Blue, it is very close. The addition of the benefits associated with joining One World should enhance what is already one of the best (or the best, by some measures) mileage reward programs in the industry. Overall, Alaska has managed this crisis better on an apples-to-apples basis than its competitors. We think this will put it in a strong position versus the competition in the coming years to deliver returns to shareholders.

Risks And Where We Could Be Wrong

The airline industry is fiercely competitive. Delta is directly competing on ALK’s turf with its relatively new hub in Seattle. The Low-Cost-Carrier model that ALK is a part of despite its legacy status can be subject to competitive pressure on less established routes. The new routes established by Alaska could prove unprofitable, which would be a setback in the firm’s pivot toward leisure. However, we’re encouraged by Alaska Air’s close coordination with the state government of Hawaii and think it shows their head is in the game on the leisure issue. However, there could be less than stellar returns from the Alliance as well. If business travel takes too long to return, the ultimate benefits could also be delayed.

A perpetual source of risk for the airline industry is its direct exposure to the price of fuel. In Alaska’s case every $1 increase in the price of a barrel of oil equates to about $11 million in additional fuel costs. So, if the price of oil spikes significantly due to geo-political events or any other reasons, airline stocks and free-cash flow may take a hit. This is a standard risk of the airline business though, and we imagine that the many reductions in fixed and variable costs Alaska made during the height of the COVID crisis should pay off when pre-COVID levels of volume return. The main risk for any airline is that they don’t have a strong enough financial position to await the return of demand levels that restore profitability. Alaska Airlines has the industry’s strongest balance sheet, in our view. It will likely report positive cashflow for Q1 2021.

Prior “Signals”