Why Wall Street Loves Alaska Airlines

SEATTLE ( TheStreet) -- Wall Street has found a new airline to love.

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"Believe It Or Not, An Airline That Earned Its Cost of Capital; Bravo!," was the title of CRT Capital Group analyst Mike Derchin's report on Alaska ( ALK), after the carrier reported fourth-quarter results, which showed a return on invested capital of 10.7% and also beat estimates. Moreover, Alaska leads the airline industry with an 11.1% pre-tax margin.

Alaska shares are up about 6% this year after rising 62% in 2010.

But it's not just financial metrics that are benefiting perceptions of Alaska. Mergers have been reducing the number of airlines; once the merger between Southwest ( LUV) and AirTran ( AAI) is completed, Alaska will become the seventh biggest U.S. carrier. That brings enhanced visibility so that, essentially, Alaska is getting more notice exactly at the time when its performance has reached a peak.

"We've been the small guy forever," said CEO Bill Ayer, in an interview. "We've had lots of competition (and) done really well against the competition. The future has never been brighter than at this moment. "
Alaska Airlines CEO Bill Ayer

Added CFO Brandon Pedersen, in an interview: "We're a little bit separated from Wall Street, out here in the Pacific Northwest. But Wall Street is starting to recognize our performance." He said that generating a 10% return on invested capital is a longtime goal that the company finally beat in 2010. Historically, "airline shareholders would have been better off investing in a CD," Pedersen said.

The underlying story is that Alaska unveiled a restructuring plan in 2003 and stuck with it. "We've been working on achieving this return on investment capital goal since 2003," Ayer said. "In the plan, we said there are three stakeholders: employees, customers and investors. We set goals for each of them to ensure balance and alignment between them. Since deregulation, investors have been left out of the equation in this industry."

Now, Alaska contends, all three groups are benefiting. The carrier's customer service is routinely rated highly by J.D. Power, while on Feb. 14 its employees will be awarded bonuses totaling $92 million, approximately a month's pay per person.

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Meanwhile, the carrier's cost per available seat mile excluding fuel, the airline industry's principal cost metric, has declined from 8.73 cents in 2001 to 7.85 cents in 2010. The most important component of the effort to attack cost has been the restructuring of the airline's fleet, once a diverse collection of inefficient aircraft and now composed entirely of Boeing 737s. Last week, Alaska said it will convert the fleet at regional subsidiary Horizon entirely to Q400s.

Labor cost reductions have also helped, as have a wide range of other cuts, all made while avoiding bankruptcy. "We recognized we probably would have ended up there," said Pedersen. "But we went the harder route. We focused on the business and we changed all of the things we could change."

Of course, labor cost reductions do not please everybody. "The work group is frustrated," said Kiana Peacock, vice president of District 143 of the International Association of Machinists, which represents about 3,500 agents, ramp and office workers and is the biggest union at the carrier.

Last month, about 2,800 agents and office workers overwhelmingly ratified a new three-year contract. The contract "is not everything we wanted financially," Peacock said, but members approved because it includes a side letter that restricts outsourcing through 2015. "That was our main purpose going into negotiations," she said, noting that in 2005, about 475 Seattle ramp workers lost their jobs under a contract provision that enabled outsourcing if an outside vendor was less expensive, creating worries among remaining IAM members.

Under the new agents and office workers contract, the hourly wage will range from $10.60 to $22. Peacock said the bonus is nice, but "you can't go to the bank and get a bank loan based on a bonus." The contract does, however, put workers near the top of the industry in pay and benefits, the IAM says.

Another feature of the contract is that it will provide up to 80% of Alaska agents with the option to work at home at the same rate of pay as reservations center workers get.

Alaska's success has come despite a route system that is two thirds leisure-oriented. About 15% of capacity is in Hawaii, while 9% is in Mexico. The focus, however, remains the Pacific Northwest, from Alaska to Oregon. Alaska benefits from its dominant position at Seattle-Tacoma International Airport, a key gateway to Asia.

This makes Alaska an attractive alliance partner for Delta ( DAL); Delta has its code on about 100 Alaska routes, while Alaska has its code on about 80 Delta routes. About half of Alaska's departures compete with low-cost carrier flights.

Analysts seem to like everything about the carrier, even its plan to grow at a relatively rapid pace of 8% to 9% during the current year. "While most investors are justifiably wary of airlines growing, Alaska's 2010 performance puts it in rarefied air," raved Stifel Nicolaus analyst Hunter Keay, in a recent report.

"Last year Alaska had the best year in the history of the company -- generating 10.7% ROIC on a weighted average cost of capital of 8% (the airline's calculations), and Alaska's 13% operating margin should be the best among U.S. majors," Keay wrote. "Alaska has consistently outgrown the industry over the past three years yet also consistently delivered superior returns. If this type of performance does not justify modest growth, we don't know what does."

Standard & Poor's analyst Jim Corridore has a buy on Alaska and just raised his 12-month target price to $80 from $75. "Alaska remains the best hedged U.S. airline, in our opinion, a good position to be in, given recently rising oil prices," he wrote.

Soleil Securities analyst Jim Higgins wrote that "Alaska remains our favorite relatively low-risk stock in the (airline) group" and increased his target price to $74 a share. "As far as we can see Alaska's earnings momentum is good and its free cash flow generation and balance sheet remain strong," he said.

Because it has recently been so successful, Alaska has evaded Wall Street's current concern about capacity growth. Recently, it added new routes from San Jose, Calif,. and Sacramento, Calif., to Guadalajara, Mexico, routes that lost service when restructuring Mexicana gave them up.

Whether these new routes represent opportunity or over-expansion is obviously something the airline will evaluate going forward, but it is always wise to remember that Wall Street can turn on a dime.

-- Written by Ted Reed in Charlotte, N.C.

>To contact the writer of this article, click here: Ted Reed