Not too long ago, Alaska Air (NYSE: ALK) was a model airline, at least from an investor's perspective. In both 2015 and 2016, the company produced outstanding 24% pre-tax margins (excluding special items), outpacing rivals. However, rising costs, growing competition in Seattle, and unit revenue weakness at its Virgin America subsidiary are combining to undermine its profitability. In the current quarter, Alaska will be lucky to break even.
Alaska Air's management expects results to improve dramatically over the next year or two, as the company begins to unlock merger synergies and the competitive environment hopefully improves. Upgrading to Boeing's (NYSE: BA) newest jet -- the 737 MAX 10 -- could drive further margin improvements for the company.
A refleeting opportunity awaits
When Alaska Air acquired Virgin America in late 2016, it inherited a fleet of more than 60 Airbus A320-family aircraft. This Airbus fleet is set to grow to 72 planes by the end of 2018. By contrast, Alaska Airlines had previously operated an all-Boeing 737 mainline fleet.
Alaska Airlines' mainline fleet currently consists of Boeing 737 jets. Image source: Alaska Airlines.
Alaska Air has been considering whether to maintain a mixed fleet going forward or to return to an all-Boeing mainline fleet. It had initially planned to make a final decision by the end of 2017, but that timeline appears to have been delayed by the company's recent financial difficulties.
Returning to an all-Boeing fleet would be relatively straightforward. 53 of Virgin America's A319s and A320s are leased, with expiration dates between 2019 and 2025 (and heavily concentrated in 2022 and 2023). That would leave only 10 owned A320s that would need to be sold -- potentially requiring writedowns -- and about nine leased A321neos, which should be easy to unload, thanks to the massive demand for that model.
In other words, if Alaska Airlines wants to return to an all-Boeing fleet, it should be feasible to do so between now and 2025.
The advantage of going big
Alaska Air's management estimates the annual savings from operating a single fleet type at a fairly modest $20 million-$25 million. However, there would be additional benefits from undertaking a fleet transition.
Most significantly, the Virgin America fleet has a high concentration of smaller narrow-bodies, with 10 A319s and 53 A320s. After Alaska Airlines retrofits these planes to add more seats, the A319s will seat 126 and the A320s will seat 150. By contrast, the most common aircraft in Alaska Airlines' fleet is the 737-900ER, which holds 178 seats.
Virgin America primarily operates A320s with about 150 seats. Image source: Virgin America.
It may have made sense for Virgin America to use smaller aircraft since it was a relatively young (and small) airline that was still building its customer base. By contrast, Alaska Airlines has found that the lower unit costs of larger planes more than offset the negative unit revenue impact of "upgauging." As a result, more than half of Alaska's Boeing fleet consists of the largest 737 models (the 737-900 and 737-900ER).
With the combined carrier having even more heft on the West Coast, there's an even greater rationale to move toward the largest aircraft. Furthermore, Boeing's new 737 MAX 10 has space for two extra rows compared to the 737-900ER. This would give it a capacity of 190 seats in Alaska Airlines' configuration.
Between the inherent efficiency of larger planes within an aircraft family and the fuel savings from the 737 MAX's state-of-the-art engines, Alaska Air's trip costs for a 737 MAX 10 wouldn't be much more than what it is paying for the much smaller A320 today. Thus, an A320-to-737 MAX 10 fleet transition could potentially deliver a massive unit cost reduction.
Plenty of room for the 737 MAX 10 in Alaska's route network
The biggest problem for airlines trying to upgauge their fleets is finding suitable markets for the new, larger planes. Fortunately, Alaska Airlines shouldn't have any trouble putting the 737 MAX 10 to work profitably.
Flights to Hawaii are an obvious use case for the 737 MAX 10, as leisure travel demand remains robust. Busy hub-to-hub corridors like Seattle-Anchorage, Seattle-San Francisco, and Seattle-Los Angeles could also thrive with a larger aircraft. Lastly, the 737 MAX 10 could be useful for adding seats on transcontinental routes to the capacity-constrained New York-area airports.
To be fair, Alaska Airlines could achieve the same benefits of upgauging and upgrading to new engine technology by ordering more A321neos. However, if it is going to make the massive investment of replacing its fleet of A319s and A320s, it might as well also get the $20 million-$25 million annual savings from operating a single fleet type. That's why the 737 MAX 10 could be Alaska Airlines' airplane of the future.
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Adam Levine-Weinberg owns shares of Alaska Air Group. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.