Alaska Air Group Could Be a Buffett-Munger Stock

Holding company offers investors performance at a reasonable price

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Feb 16, 2017
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2016 was quite a year for Alaska Air Group Inc. (ALK, Financial). Not only did it have strong operating and financial results, but it also completed a $4 billion acquisition of Virgin America (VA), increased its dividend by 9%, bought back 1.5% of its shares and paid $100 million in bonuses to its employees. Is this really an airline?

Investors looking for capital gains would be at least relieved and perhaps pleased. During 2016, the stock fell from $81.44 on Jan.1 to $55.66 on June 27, then turned around and rallied to close out the year at $88.73.

Because of that latter-half rally and gains in the first six weeks of this year, it’s not a bargain stock or a value stock. However, it did make it into the Buffett-Munger screener at GuruFocus. To make it onto that list, companies must meet four criteria:

  • They consistently grow their revenues and earnings.
  • They have competitive advantages, a moat, that provides them with pricing power.
  • They take on little debt while growing the company.
  • They are fair valued or undervalued.

Warren Buffett, by the way, has had a change of heart about airlines. He once called them "death traps for investors" but now has sizable stakes in Southwest Airlines Co. (LUV, Financial), American Airlines Group Inc. (AAL, Financial), Delta Air Lines Inc. (DAL, Financial) and United Continental Holdings Inc. (UAL, Financial).

History

In the darkest days of the Great Depression, in 1932, Linious "Mac" McGee started McGee Airways and began flying out of Anchorage to other destinations in Alaska. Twelve years later the company adopted the name Alaska Airlines. The following half century saw numerous changes, but there appear to have been a few constants: financial strains and management changes along with acquisitions and mergers.

The airline’s big opportunity came with deregulation of the industry in 1979; at the time, it had just 10 aircraft and, except for Seattle, was stuck within Alaska’s borders. Deregulation allowed it to expand to the lower 48, first down the west coast and into Mexico, and then across the country.

The mid-1980s saw the formation of Alaska Air Group (a holding company for Alaska Airlines), and the acquisitions of Horizon Air and Jet America Airlines. Since then, the company has continued to grow, both organically and through acquisitions. Its most recent, and its biggest buy, was Virgin America in December 2016. That makes it the fifth-largest airline in the U.S.

History based on information at the company website and at Wikipedia.org.

The business of Alaska Air

Alaska Air Group is a holding company that has, for several decades, operated Alaska Airlines and Horizon Air. Then, of course, there was the addition of Virgin America late last year. A press release announcing the closing noted the company would not make a quick decision about how Virgin would fit in: “Alaska plans to continue to operate the Virgin America fleet with its current name and product for a period of time while it conducts extensive customer research to understand what fliers value the most.”

According to its 10-K for 2015 (unless otherwise noted, information in this article comes from the 10-K), Alaska Air distinguishes itself from other airlines through what it calls its Five Focus Areas:

  • Safety and compliance.
  • People.
  • Hassle-free customer experience.
  • Energetic and compelling brand.
  • Low fares, low costs and network growth.

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Image from Alaska Air Group’s 2016 Investor Presentation.

The acquisition of Virgin America adds to its scope and opportunities. It adds 14 gates in California, one in Dallas and 60 gates in the Northeast. The latter is particularly important, as Alaska Airlines and Horizon have focused in the West Coast region, where they have the largest market share.

It is also expanding upmarket, with the introduction of Premium Class last month; that provides extra legroom, early boarding, snacks, and complimentary drinks.

Alaska Air also offers perks through a mileage plan and its own VISA Signature card. The company reports that mileage plan revenues accounted for 11% of its revenue in fiscal 2015.

Fuel continues to have dramatic impacts on the profitability of airlines. Alaska Air reports in its 10-K that fuel expense ranged from 22% to 35% of operating expenses in the five fiscal years ending with 2015. Each additional $1 per barrel change in the price of oil means approximately $12 million of fuel cost. It notes that West Coast jet fuel prices tend to be higher and more volatile than in other regions, making fuel price a competitive issue, because of its base and major markets on the West Coast.

To deal with fuel prices, the company makes fleet refinements where it can and pursues efficiency initiatives to minimize fuel consumption.

Employees: All companies speak in glowing terms of their employees, but few walk the walk like Alaska Air. Do a search for the word "employee" in most companies’ 10-Ks and a few references turn up, often just producing a head count. In Alaska Air’s 10-K for 2015, a search for "employee" brings up 48 references.

What’s more, earlier this month the company announced $100 million in employee bonuses for fiscal 2016. On average, that works out to 8% of a year’s pay for most employees, or the equivalent of an extra month’s wage.

Revenue

The preliminary revenue estimate for fiscal 2016 is $5.931 billion.

Revenue growth is shown in this 10-year GuruFocus chart:

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The company says its growth has helped it broaden its revenue base; this slide from the Investor Presentation shows that broadening over the past 11 years:

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According to the 10-K, nonpassenger sources (including freight) accounted for 15% of revenues in fiscal 2015.

Competition

Alaska Air calls the airline industry highly competitive and characterized by low profit margins.

In the Investor Presentation, the company describes its segment of the market as Low Fare Premium Product Carriers and lists its direct competition as Virgin America (now owned by Alaska Air), Hawaiian Airlines (Hawaiian Holdings Inc. [HA]) and JetBlue Airways Corp. (JBLU, Financial).

Hoover’s lists its three main competitors as Delta Air Lines, Southwest Airlines and United Continental Holdings. To that list can be added American Airlines Group.

This excerpt from an Investor Presentation slide maps how Alaska Air sees the competitive marketplace:

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Moat

Morningstar gives Alaska Air a Narrow moat rating.

Vuru.com is more generous, with a Medium moat, saying, “Alaska Air Group has maintained substantial gross margins, suggesting that they have been able to set prices without consideration of the cost of goods sold. This potentially leaves flexibility in inflationary environments to raise prices on consumers and maintain profitability.”

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The following operating margin factoids from GuruFocus underline that strength in operating margins:

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Growth

The company points out in its Investor Presentation that it has grown by an average 8.4% per year since 1995, far faster than the industry as a whole, which has averaged 1% per year over the same period. It points out that both its network and revenue have grown more than 2.5 times over those 21 years.

In the 10-K for 2015, it says, “With the cash generated by the continued success we have had in the past decade, we are able to continue to invest in our business for profitable growth and to enhance the customer experience.”

The company also says in the 10-K it expects to stay on the same growth path, using its cash flow and other competitive advantages to open new markets and expand existing markets. At the same time, it must watch industry capacity, which could push down prices.

The acquisition of Virgin America opens new opportunities (especially in California, one of its priority targets) as noted in the Investor Presentation:

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Other

Alaska Air Group is incorporated in Delaware and headquartered in Seattle.

Fiscal years end on Dec. 31.

As of Dec. 31, 2015 it employed 15,143 full- and part-time staff (11,614 at Alaska and 3,529 at Horizon); 83% of Alaska’s and 44% of Horizon’s employees are represented by unions. Labor costs accounted for 41% of total nonfuel costs in fiscal 2015 and 2014.

Chairman, president and CEO: Bradley Tilden, age 55; he is also CEO of Horizon Air Industries. He joined Alaska Airlines in 1991, became controller of Alaska Air Group and Alaska Airlines in 1994.

Executive vice president - finance, chief financial officer: Brandon Pedersen, age 49; he joined Alaska Airlines in 2003 as staff vice president/finance and controller of Alaska Air Group and Alaska Airlines and was elected vice president/finance and controller for both entities in 2006. Officer information from Reuters.com.

Ownership

As this GuruFocus table shows, more than 99% of the company is owned by institutional investors (including mutual, pension and hedge funds):

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GuruFocus also reports that 13 of the investing gurus it follows have Alaska Air holdings. PRIMECAP Management (Trades, Portfolio) is the biggest, with 6,100,300 shares (on Jan. 31), good for 0.56% share of total ownership. Jim Simons (Trades, Portfolio) and Ken Heebner (Trades, Portfolio) are the second- and third-largest holders.

This chart shows that holdings by short sellers are roughly in the middle of the range established since 2009:

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As of Jan. 5 Tilden owned 121,698 shares while Pedersen owned 16,000 (as of Dec. 12, 2016).

By the numbers

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Financial strength

Alaska Air Group receives middling marks for financial strength and strong marks for profitability and growth:

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As this chart shows, debt is up, and up significantly, with Alaska assuming $1.4 billion in Virgin debt and lease commitments:

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However, Alaska Air says it still leads the pack when it comes to leverage:

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It also notes in an acquisition presentation that one-time deal costs will be in the $300 million to $350 million range, while annual synergies are expected to amount to $225 million. The company also expects the deal to be accretive in the first year.

Since 2009, EBITDA (earnings before interest, taxes, depreciation and amortization) has grown steadily:

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EPS (earnings per share) are expected to grow in fiscal 2017, after plateauing in 2016, and free cash flow has also grown:

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Alaska Air’s WACC (weighted average cost of capital) is 7.04%, and its ROIC (return on invested capital) is 36.94%.

Valuations

Alaska Air Group receives a 4-Star (out of 5) rating for predictability; that is consistency of earnings over the previous five years. Such earnings growth should pull up the share price, and that’s mostly what has happened in the past decade.

Among the valuations at GuruFocus, only the Peter Lynch chart shows it being fairly valued or undervalued:

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The analysts followed by Nasdaq.com have a 12-month consensus price of $108.00, about 11% above its close on Feb. 15, and they’re moderately bullish on the stock:

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The price-earnings (P/E) ratio is 14.81, which is relatively high in the context of its range over the past five years:

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The PEG ratio (price/earnings divided by average annual earnings growth over five years) is low at 0.59; a ratio of less than 1 suggests the stock is undervalued, a ratio between 1 and 2 suggests fair valuation, and a ratio of 2 or more suggests an overvalued stock.

A premium price might be expected of Alaska Air’s stock, at least when compared to the industry. As this table from Morningstar shows, the company has consistently – and persuasively – outperformed its peers in total returns:

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A look at the price in the context of its 200-day simple moving average shows the stock jumping well above its moving average:

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Conclusion

Yes, Alaska Air Group does have what it takes to be a Buffett-Munger stock.

It has grown and continues to grow both its revenue and its earnings. The acquisition of Virgin America should help it maintain its momentum in the future, especially if the earnings are accretive in 2017.

That performance is underlined by a return on equity near 30%, and it’s worth noting this airline company continued to grow even when oil and gas prices reached peak levels a few years ago. Perhaps it will have difficulties if fuel prices rise again, but based on its record, that should not take away too much from its earnings.

The share price is currently just below its 52-week high and may well pass it any day now. Still, with its strong earnings potential, a verdict of over-priced is not reasonable either.

It is not a value stock, nor is the dividend big enough to consider it an income stock. It is worth the consideration of investors looking for a quality stock at a reasonable price.

Disclosure: I do not own shares in any of the companies listed in this article, and I do not expect to buy any in the next 72 hours.

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