Alaska Air Group: Rough Winds Ahead (NYSE:ALK)

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Alaska Air Group (NYSE:ALK) was able to weather the effects of the COVID-19 crisis and remain somewhat stable. However, the economic strain on the airline industry during the pandemic was great and the recovery is not over. The effect of the crisis, combined with debt load and a possible impending recession, will create significant financial stress on all airline companies, including ALK. Although I believe ALK has made appropriate strategic decisions in response to the crisis, the combination of multiple headwinds will affect growth in the near future. I consider the current valuation to be overpriced and recommend a hold on the stock.

A Bright but Delayed Future

ALK is collaborating with Microsoft (MSFT) in support of a clean fuel project. SAF (sustainable aviation fuel) will bring innovation and efficiency to the airline industry. ALK and MSFT have signed a Memorandum of Understanding in support of a fossil-free chemical company, Twelve’s SAF project. The integration of SAF fuel will bring economic benefit and eco-friendly production to airlines. Airlines will receive a tax credit for using SAF, which will increase revenue for the company.

SAF might also present initial challenges. Challenges could include limited federal policies regarding SAF use and time-consuming documentation to record the environmental impact. This might require positions needed to properly document and track policies, which would incur a cost to the company. Production can also be affected by incorporation of SAF due to an additional processing step. SAF includes a processing step to blend SAF fuel with conventional fuel. The blended fuel also has to meet certain requirements in order to be approved for use. After verification, the composition of the fuel needs to be determined for processing purposes and emissions documentation.

ALK has a goal of reaching net-zero carbon emissions by 2040, and has signed an agreement with Aemetis (AMTX) to purchase 13 million gallons of SAF over a seven-year term agreement. Although SAF will ultimately boost production and decrease expense, it does not come without any expenses. Allowances will have to be made in order to regulate this fuel, which will incur costs.

ALK has been making progress toward simplifying to an all-Boeing single fleet. This simplification will support a low-cost/high-productivity business model. However, in order to make this adjustment, old planes must be retired and new planes purchased. According to ALK’s 10-Q, aircraft rent expense has increased by 18% in Q2 2022. The 10-Q also highlights additional aircraft purchases incurring expense. A total of 80 orders for aircrafts are set for 2022-26, as depicted by the chart below. With current debt obligations, order for new aircrafts, and a possible impending recession, growth might continue at a slower-than-desired pace. Taking into consideration debt load and impending expenses, I consider ALK’s trading price to be overvalued.

Valuation

I price current intrinsic value for ALK at $95 per share. However, while utilizing a discounted cash flow rate, debt is not adequately captured. In 2020, ALK took out a $267 million loan to cover for employee salaries during the crisis. In addition, the conversion to a single fleet will increase debt obligations.

Free cash flow has been steady, but not adequate to offset current debt obligations. Year-ended 2020 free cash flow was in the negative. It has gained momentum and positive flow into 2021 and 2022. Considering airlines are a consumer-based and cyclical industry, we could see a drop in sales in an economic downturn and therefore a further drop in free cash flow in the coming year.

I calculate ALK’s cash ratio at 0.69, indicating an inability to cover the debt load sufficiently. My main concern in evaluating any company is if they have enough cash to cover their debt, especially in an economic downturn or crisis. ALK is currently out of balance, with debt being too high and cash flow being too low. I would recommend a hold for fair price.

Taking into consideration the debt load acquired, in addition to a possible impending recession, I place fair valuation on ALK 60%-70% away from the current intrinsic value. When valuing a company, I will adjust 50% away from the intrinsic value to allow a margin of safety. However, in this case, I have adjusted further due to the debt load. This will put my buy price and fair valuation at around $28-$38 per share.

Risks

ALK encompasses more than 120 destinations, most of them located within the U.S. Although airline flights are expected to rise over the next few years, the U.S. is projected to have the smallest increase according to the International Air Transport Association. We also need to take into account the possible impending recession. Consumers might choose to fly less often, which would impact production.

According to the 10-Q (linked above), raw fuel expense has increased by 141% when compared to FY21. Airlines have been able to offset inflation costs with rising flight prices. However, if overall capacity drops in the near future, as ALK has projected in its Q2 report, growth will continue at a slower pace. Airlines have also faced significant staffing issues since the COVID-19 crisis. ALK has had to cancel flights and reduce its schedule due to a staffing shortage. This shortage could continue to affect production and revenue for the rest of the year.

Summary

ALK has made strategic efforts to combat economic loss from the COVID-19 pandemic. However, the effect of the crisis – along with a possible recession – will undoubtedly affect this company and its degree of growth. The company’s zero-emissions goal, SAF integration, and single fleet transition all allow for healthy future growth. My main concern would be the rate of that growth due to the current debt load. I would recommend a hold and wait for better buying opportunity in the fair price range of $28-$38 per share.