Alaska Air Group: Medium-Term Headwinds; Still A Good Investment Choice (NYSE:ALK)

Investment Thesis

Alaska Air Group (NYSE:ALK) is a domestic airline company. The company has successfully weathered the COVID-19 crisis and has managed to maintain a strong financial position. Although the market was disappointed with Alaska Air Group’s Q3 earnings due to weakening pricing power and high fuel prices, we believe that the margin pressure is temporary as the company works through competitive issues, while the airline remains well positioned overall. There’s also a fundamental driver for lower fuel prices, which will provide serious margin support.

Airfares Pressure & Revenue Outlook

The financial results for 3Q 2023 signaled some challenges in the airline industry. Oil prices rose again and carriers were unable to pass the costs on to the consumer quickly enough. According to the IATA’s analysis for August, domestic airline capacity is 12.1% above 2019 levels, while total demand is only 9.2% higher.

In 3Q, Alaska Air Group’s average passenger yield reached ₵16.66 (-9.9% y/y), down from our forecast of ₵17.22. Notably, other carriers (for example, United Airlines and American Airlines) did not have such significant fare reductions: UAL’s domestic fares declined by only 1.7% y/y and AAL’s fell by 4.4% y/y, even though ALK’s average transportation costs are significantly lower compared with its competition.

As fuel is expensive, the assumption remains that tickets will continue to be expensive in 2024, but Alaska’s management has mentioned concerns about competition (which makes sense given the increased fleet capacity), so it will closely monitor consumer reaction to pricing in 1Q 2024. The company intends to hold on to its market share on the main routes, so it is willing to sacrifice margins over the short term.

As such, we are lowering the forecast for the average passenger yield from ₵16.91 (-1.5% y/y) to ₵16.54 (-3.6% y/y) for 2023, and from ₵18.07 (+6.9% y/y) to ₵17.43 (+5.4% y/y) for 2024.

We have also cut the forecast for Alaska Air Group’s capacity and traffic on account of the following reasons:

• Wildfires in Maui (Hawaii) brought down the demand for flights to that destination. The number of scheduled flights and the load factor are poised to decline here, but we assume that bookings will recover by the second half of the year. The management has also said there’s no reason why the destination shouldn’t regain its popularity in 2024.
• The company canceled deliveries of Boeing 737-10 MAX planes in 2024. Prior plans called for deliveries of 6 planes by the end of 2024. The company now doesn’t plan to resume purchases of 10-MAX planes until 2025.

In connection with the lower forecast for airfares and the revised schedule of plane deliveries in 2023, we are cutting the revenue forecast from $10656 mln (+10% y/y) to $10429 mln (+8% y/y), and from $12182 mln (+14% y/y) to $11333 mln (+9% y/y) for 2024.

Oil Market Update & EBITDA Forecast

Anyway, we saw some significant updates related to the oil market. We have adjusted the forecast for OPEC oil production: We take into account that Saudi Arabia will gradually increase volumes by 0.3 mbs per month from January 2024 (from 9 to 10.5 mbs) in order to avoid a large surplus in the oil market (we expect the market to be in surplus from the beginning of 2024). Previously, we believed that Saudi Arabia would immediately increase oil production by 1 mmb/d starting in January 2024, canceling the voluntary production cut. We also raised our production forecast for Iran (as Iran revised its forecast from 2.85 mb/d in July to 3.1 mb/d in October in light of the easing of US sanctions).

We have taken into account that Venezuela will gradually increase oil production by 0.2 mbps, from 0.7 mbps in October 2023 to 0.9 mbps by the end of 2024, in the context of easing US sanctions. However, we do not expect this to have a significant impact on the oil market, as the United States plans to buy oil for the strategic reserve in 2024 (purchases in January will amount to 0.2 mb/d), probably at the expense of oil from Venezuela.

We have raised our production forecast for non-OPEC countries as their production in October was higher than we expected (production rose from 58.0 mb/d in September to 58.7 mb/d in October). At the same time, we have lowered the forecast for oil demand in China and the EU and raised the forecast for US demand for November-December 2023 – 1H 2024, taking into account a stronger seasonal decline in demand in January followed by a more significant recovery in February (as part of the forecast improvement).

We changed our forecast for the oil market balance in November 2023 from a deficit to a surplus due to an increase in the production forecast and a decrease in the oil demand forecast. We still expect oil to remain in deficit in December 2023. We have also revised our January balance forecast to a surplus from a deficit (we expect a surplus of 1 MBS on the back of increased production in non-OPEC countries, reduced production in North Arabia, and a seasonal slowdown in demand).

Due to the change in the forecast for the oil market balance from a deficit to a surplus in November 2023 and January 2024, we have raised our forecast for the Brent price in 4Q. 2023 from $92.8/bbl to $88.2/bbl and for 1H 2024 from $96.1/bbl to $86.8/bbl.

We no longer expect oil prices to rise to $100/bbl at the beginning of 2024, but we are waiting for $90/bbl, on average, in December 2023 and we predict a decline in prices in January 2024 against the backdrop of a surplus. In Q4 2023 – Q1 2024, we expect an average oil price of $88.2-89.6/bbl, and in Q2 2024 – Brent prices will fall to $90/bbl. 2024 – Brent price falls to $83.9/barrel.

Though crack-spreads remain elevated, the reduction in forecast of oil price led us to lower the forecast for jet fuel price from an average of $3.02/gallon to $2.98/gallon in 2023 and from $3.21/gallon to $2.78/gallon in 2024.

Therefore, we are lowering the EBITDA forecast from $1397 mln (+57% y/y) to $1363 mln (+32% y/y) for 2023 and increasing from $1909 mln (+12% y/y) to $2006 mln (+44% y/y) for 2024.

Valuation

We are evaluating Alaska Air Group’s target price based on FTM EV/EBITDA multiple.

We are lowering the target price of the shares from $67 to $56 due to:

• EBITDA forecast reduction for 2023 and its increase for 2024;
• the shift of the FTM valuation period (we earlier included the period from 3Q 2023 through 2Q 2024 into the forward 12 months EBITDA forecast, while now the forecast period runs from 4Q 2023 to 3Q 2024).

Based on the new assumptions, we are maintaining the rating for the shares at buy

Downside Risks

While we are generally optimistic about Alaska Air Group’s future performance, there are several risk factors that should to consider:

• The company has high operating leverage, meaning that even small fluctuations in fuel prices and/or passenger yields will have a significant impact on its margin profile. According to Alaska Air Group management and other public airlines’ post-Q3 earnings commentary, the industry will try to maintain high yields, but increasing competition due to the expansion of the US fleet capacity may create an additional momentum for airfares to decline, which will negatively impact revenues and margins.
• Jet fuel price remains the largest expense item, and financial performance is highly sensitive to oil prices and crack spreads. Stock performance also shows a significant correlation with the oil market, as airlines tend to be out of the market’s favor when it’s an oil bull cycle. However, after analysis, we believe that we will see a decline in oil prices in the medium term, which will support ALK’s performance.
• Alaska was one of the first airlines to reach an agreement with the labor union. Although the deal includes significant pilot wage rises, this employment category represents only about 14% of the company’s FTEs, so the expense item won’t seriously impact the margin profile.

Conclusion

Alaska Air Group is our favorite in the airline sector due to its exposure to the domestic market, low debt burden, and clear business growth plan. Although the near term will be a bit challenging for the company due to increasing competition, we believe that ALK’s pricing policy and the decline in the oil market will soon become a tailwind for the company.

To manage the position, we suggest keeping an eye on ALK and its peers’ financials and industry research (e.g., IATA and FAA).