2023-07-06 10:37:46 ET
Summary
- Cyclical industrial stock Alaska Air Group offers investors a sound balance sheet, strong franchise, cash earnings, and shareholder-friendly management.
- The airline's stock is cheap based on 2023 projected earnings and cash flow. I believe The Street is overlooking a gem with over a 40 percent upside.
- Despite risks associated with a potential recession, Alaska Air's favorable work/leisure customer breakdown and low debt leverage help the company mitigate financial downside.
- This article provides fundamental and valuation analysis, plus airline peer comparative data.
Introduction
Peter Lynch, one of the all-time investment greats, once remarked, "Sometimes an old friend is your best friend." He referred to the concept of returning to previous stock investments versus always conjuring up some new ticker to own.
For me, Alaska Air Group Inc. (ALK) is just such an investment.
Alaska Air is a dyed-in-the-wool cyclical industrial stock. Such stocks largely ride the waves of the U.S. economy. Therefore, it is not a "buy and forget" security. However, at certain times such cyclicals are fine stocks to own. I contend now is one of those times; right here and right now.
Investment Thesis
My Alaska Air thesis is found below. I've italicized the primary points.
Historically, cyclical industrial stocks tend to perform best as the economy emerges from recession. Since the market is forward-looking, waiting until "the coast is clear" often results in purchasing a stock when much of the upside has passed. Therefore, the time to own ALK stock is before it's a lead pipe cinch. I believe it's impossible to time the market, but patient, long-term investors need only be partly correct, so long as they are not completely wrong. I believe we are closer to the end of the Fed tightening cycle than the beginning.
Airlines in general, and Alaska Air specifically, appear to be enjoying a resurgence in travel demand. My daughter calls it "travel revenge." Sans a deep recession, the beginning of such activity tends to portend multi-year growth.
Alaska possesses the characteristics of a good investment: a sound balance sheet, strong franchise, profits are earned in cash, and the company is well-managed and shareholder-friendly.
Management is optimistic about the company's forward prospects and provides investors with expected metrics to generate a simple earnings model.
The shares appear quite inexpensive.
Fundamental Data Points
I contend good investment due diligence begins with fundamental analysis.
The Balance Sheet Is Sound
One of the first places I look is the balance sheet.
Unlike some peers, during the C19 downturn, Alaska Airlines did not leverage its balance sheet; management bolstered it.
The Big Five commercial airlines include United Airlines ( UAL ), American Airlines ( AAL ), Delta ( DAL ), Southwest ( LUV ), and Alaska Air. Of the lot, Southwest and Alaska Airlines boast the best debt-to-capital ratios; 0.50 and 0.48, respectively.
ALK total debt (including lease liabilities) is $3.73 billion. Net debt (less balance sheet cash) is just $1.30 billion.
Alaska Air Is Efficient
Compared to the other major legacy airlines, Alaska Airline is the low-cost carrier. Of the five majors, 1Q2023 results indicated Alaska's CASMx (cost per average seat mile ex fuel) is the lowest.
Major U.S. Airlines CASMx (cents) - 1Q2023
ALK | UAL | AAL | DAL | LUV | |
CASMxFuel | 9.52 | 12.54 | 13.18 | 13.86 | 11.67 |
Notably, due to the regions in which the carrier primarily operates (U.S. Northwest and Alaska), the first quarter tends to be the weakest.
Alaska recorded the lowest CASMxFuel in 2022, too.
ALK Generates Excellent Cash Flow
Alaska Airlines earns its profits in cash: consistently. The following 5-year table highlights reported net income versus operating cash flow:
Reinforcing the aforementioned, the following FAST Graphs chart illustrates net income versus operating cash flow over the past 20 years:
Management Is Focused and Results-Oriented
Effective April 2021, current CEO Ben Minicucci succeeded the previous CEO Brad Tilden. The transition was orderly. Mr. Minicucci took over during a difficult period, but he and his staff have handled affairs capably. In 2022, the balance sheet was strengthened, the company recorded industry-leading pretax margins, and Alaska Air Group continued its long history of strong customer service and employee commitment .
In response to the COVID-related airline crisis, the cash dividend was eliminated before Minicucci began his tenure. The payout has not been reinstated. However, in 2023 the company initiated a share repurchase program . Approximately 400 thousand shares were retired in 1Q2023. By year-end, Alaska Airlines plans stock buybacks totaling ~$100 million, or about 1.5 percent of the diluted shares outstanding.
Indeed, the Alaska Air Group's franchise remains strong, readily identified, and carries a positive stakeholder connotation.
Alaska Airline Versus Peers
As part of my due diligence, I examine a company alongside its peers. I consider the balance sheet, several operating metrics, forward prospects and my FVEs (Fair Value Estimates).
Here's a brief rundown:
Balance Sheet
Among the Big Five airlines, Southwest Airlines and Alaska Air own the best balance sheets. Delta's balance sheet is weaker, but acceptable. ALK and LUV debt-to-capital ratios (including lease liabilities) are 0.48 and 0.50, respectively.
Alaska Air and Southwest both enjoy much lower net debt relative to peers. In the most recent quarterly earnings report, ALK net debt is down 42% from 1Q2019.
On the other hand, during the C19 airline crisis, United and American weakened their balance sheets. Currently, United holds a BB- / B+ credit rating. American lags the pack with a B- rating. The UAL and AAL debt-to-capital ratios are 0.84 and 1.16, respectively.
Given these weak balance sheets, I find neither United nor American stock compelling on a relative basis; other metrics none withstanding. In a cyclical industry with limited competitors, I focus upon best-of-breed.
Operating Performance
Among major peers, Alaska Air is the low-cost carrier. Full-year 2022 CASMxFuel was 10.41 cents. That's more than a penny per seat mile better than the second-best carrier. ALK top CASM performance continued into 1Q2023.
In 2022, Alaska recorded the industry-best pre-tax margin .
For FY 2022, Alaska Air and Southwest both reported record operating revenues, surpassing previous top line records set in 2019.
Stock Valuation
I believe the market has undervalued Alaska Airlines stock significantly. Meanwhile, I contend Delta and Southwest stock currently have materially lower upside potential.
In the next section of this article, we will review some valuation specifics.
Forward Prospects
I am bullish on the forward prospects for the airline industry. All the major carriers are likely to enjoy improving revenue, net income, and cash flow. Arguably, Alaska Airlines and Delta may be the best positioned.
In 2023, Delta management expects 15% to 20% top line revenue growth, and 10% to 12% operating margins; these margins would be ~double FY2022 results. The 2023 EPS forecast is $5.00 to $6.00 a share. At midpoint, that's a 71% YoY improvement.
For 2023, Alaska Airlines management promises 8% to 10% revenue growth. Pre-tax margins are projected to range between 9% and 12%. 2023 EPS is expected to range from $5.50 to $7.50. That's a 50% improvement versus 2022 actuals.
Note: for reference, in 2022, Alaska Airlines reported a 7.6% adjusted pre-tax margin. Delta reported a 5.9% adjusted pre-tax margin.
Peer Summary
This is how I handicap the five major airline carriers:
Alaska Airlines : sound balance sheet, well-run, good forward prospects, stock has significant valuation upside.
Delta Airlines : acceptable balance sheet, well-run, excellent forward prospects, but the stock has run up and may lack the factor-of-safety upside found in ALK common shares.
Southwest : very good balance sheet, excellent forward prospects, well-run, but similar to Delta the stock appears to offer a less compelling value proposition than ALK.
United Airlines and American Airlines : poor balance sheets, poor credit ratings; therefore, these carriers cannot be considered among best-of-breed. UAL and AAL business models are neither low-cost nor best / differentiated service. In addition, over the next year or two, UAL faces relatively high capex demands.
ALK Valuation
Let's take a deeper look at Alaska Air stock valuation.
We will begin by looking at forward earnings.
In 2022, Alaska Airlines generated $9.65 billion total revenue. Management is guiding to an 8% to 10% revenue increase. Using the midpoint, we may expect the 2023 top line to be ~$10.5 billion. Applying a 10.5% pre-tax margin (management 2023 pre-tax midpoint guidance), we may expect about $1.1 billion pre-tax profit. Management forecast a 25% ETR. Therefore, net income should come in around $825 million, or $6.55 per share, presuming a 2% diluted share count reduction from last year. The reduction is based upon management's stock repurchase guidance.
Next, let's use FAST Graphs to look at historical operating PE ratios. The following graph illustrates stock and valuation performance between 2011 and 2019. I selected this time frame to capture the average PE from post-Great Recession through pre-COVID. The average multiple is about 12x.
Utilizing these data points, our first ALK valuation benchmark is $6.55 EPS times a 12x PE or ~$78 per share.
Applying the same process to 2023 projected operating cash flow, we find current Street estimates expect $12.76 cash flow, and the 2011 to 2019 average P/OCF multiple was 5.8x. This suggests the FVE to be about $74 a share.
Today, Alaska Airline common stock trades at $53. A $76 stock price indicates over 40 percent upside.
For comparison, using the same basic methodology, my FVEs for Southwest and Delta are $43 and $60, respectively. These Fair Values represent potential upsides of 18% and 26%, including dividends.
Indeed, Southwest or Delta appear to be good airline stock picks. However, Alaska Airlines has a balance sheet nearly as strong as Southwest and better than Delta, excellent relative fundamentals, is a well-managed company, and shares appear offer greater potential upside value; meaning there is a greater investment factor-of-safety.
Risks
Historically, airline stocks are volatile and therefore risky investments. A deep recession will crush shares of all the major carriers. Airlines may also face long-term headwinds if business travel fails to return to its previous peak due to permanent remote work / electronic communication arrangements. Alaska Air is no exception. However, the carrier's favorable work / leisure customer breakdown is likely to mitigate financial downside in the event of a mild recession or longer-than-expected period of inflation / monetary uncertainty.
Summary
I contend cyclical industrials like the Airlines are poised for an inevitable U.S. economic up cycle. These up cycles tend to last for several years. Alaska Airlines stock possesses best-of-breed attributes: a sound balance sheet, a strong franchise, earns its profits in cash, and the company is well-managed and shareholder-friendly.
The current $53 stock price suggests a compelling upside. A dip below $50 a share on general market weakness would be an outstanding opportunity to accumulate shares.
Southwest Airlines and Delta also look to be good airline equity investments, though these stocks may not offer Alaska Air shares' factor-of-safety.
Please do your own careful due diligence before making any investment decision. The article is not a recommendation to buy or sell any stock. Good luck with all your 2023 investments.
For further details see:
Alaska Airlines Flying Under The Radar: Best-Of-Breed Bargain