A Winning Airline Stock

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Warren Buffet once said of airlines:

"How do you become a millionaire? Make a billion dollars and then buy an airline."

The airline industry is known for all too common bankruptcies. It seems like every major airline has gone through bankruptcy at one point or another. American Airlines filed for bankruptcy in 2011, Delta Air Lines (NYSE: DAL) filed in 2005, US Airways (NYSE: LCC) filed in both 2002 and 2004, United Airlines (NYSE: UAL) (now United Continental) filed in 2002 - the list goes on and on.

What's worse, the airline industry is perhaps the least liked of all industries. It seems like everyone has at least one horror story of being stuck on the tarmac for 3 hours, or of their flight being overbooked, or of having their luggage lost, or of never-ending delays. Some people refuse to fly on certain airlines because of past incidents.

This makes investing in the airline industry difficult. Finding an airline which is consistently profitable and provides a high level of customer satisfaction is not an easy task. There are only a few which fit this description, but my favorite is Alaska Air Group (NYSE: ALK).

Overview

Alaska Air Group is the parent company of both Alaska Airlines and Horizon Air. They fly mainly to and from destinations in the US west coast, Alaska, Canada, Hawaii, and Mexico.

<img src="/media/images/user_13886/alk-map_large.png" />

Alaska Air is routinely ranked highly on surveys of customer satisfaction, with J.D Power and Associates naming the company the #1 traditional airline in terms of customer satisfaction.

Alaska Air recorded $4.3 billion in revenue in 2011, making it one of the smallest traditional airlines in the country. For comparison, Delta recorded $36 billion in revenue and United Continental recorded $37 billion in revenue.

Investor presentation here

Balance Sheet

Data from Morningstar

Alaska Air has been aggressively reducing their net debt over the past few years. At the end of 2008 the company had a net debt position (including pension obligations) of $1.72 billion. By the end of the third quarter of 2012 this had been reduced to just $328 million, a reduction of over 80%. This includes a cash position of $1.19 billion and very little short-term debt, leaving ample liquidity for the company. On a per-share basis this net debt comes to $4.55 per share. Overall, the balance sheet looks extremely strong.

Profitability

After suffering a negative net income in 2008, the company has posted positive numbers since then. Net income grew from $122 million in 2009 to $245 million in 2011, with TTM net income through the third quarter of 2012 of $336 million, or $4.64 per share. This puts the TTM P/E ratio at 10.08 based on a stock price of $46.79.

On a pre-tax basis, Alaska Air maintains a higher ROIC than almost all other airlines.

<img src="/media/images/user_13886/alk-roic_large.png" />

ROIC is a measure of how well the company deploys its capital. For every dollar which Alaska Air reinvested into the company they realized a pre-tax return of 20.5%. The next-best traditional airline is Delta with 18.7%, with US Airways substantially lower at 13.2% and United Continental even lower at 11.2%. The budget airlines do even worse, with a pre-tax ROIC less than half that of Alaska Air.

A high ROIC means that Alaska Air only engages in expansion which will create significant value for shareholders. The company is not engaged in a blind pursuit of higher revenue or greater market share. This is a big plus for investors.

Valuing Alaska Air is a bit tricky. The company is growing fairly quickly, with revenue growth of 12.7% in 2011. Furthermore, the company plans to spend quite a bit of money on new aircraft over the next few years, as you can see from the chart below.

<img src="/media/images/user_13886/alk-cap_large.png" />

This increased spending will probably put a squeeze on the free cash flow, which sat at $309 million in 2011. This makes a discounted cash flow calculation difficult, since free cash flow probably won't be growing due to the increased capital expenditures.

Valuation

What I'll do instead is this: calculate the value of the company today assuming that it doesn't grow at all - meaning that the only new plane purchases are replacements. The total TTM capex is $433 million, but some of this is "growth" capex with the rest being "maintenance" capex. A reasonable estimate of the maintenance capex is the depreciation charge of $258 million. I'll calculate the TTM owner earnings using this maintenance capex. My result is $388 million, or $5.39 per share.

Using this value, I'll do a discounted cash flow calculation assuming that growth is 3%, or roughly the rate of inflation. For a discount rate I'll use both 12% and 15% and use these values to define a fair value range. Using these parameters and subtracting out the net debt I arrive at a fair value range of $41.62 - $57.05.

So based on only the current earnings Alaska Air is on the low end of my fair value range. With expected EPS of $4.74 in 2012 and $5.47 in 2013, representing 15% growth, the true value of Alaska Air, assuming that the company doesn't make terrible decisions regarding expansion, is most likely higher.

One thing we can do is fast forward a year and do the same no-growth calculation assuming that EPS indeed grew to $5.47 per share. This would put owner earnings around $6.19 per share (including tax-adjusted interest and some non-cash items). Doing the same calculation as above the fair value range at the end of 2013 will be $48.49 - $66.20. This puts the current stock price below next year's fair value range.

The bottom line

The increased capital expenditures over the next few years makes a traditional discounted cash flow analysis difficult. However, at the current market price Alaska Air is attractively priced based on my no-growth calculation. The airline industry is one which involves high levels of spending to simply maintain the current fleet, let alone grow, but Alaska Air has been able to achieve a return on invested capital far better than most of the competition. In a tough industry, Alaska Air looks like one of the best bets.


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