A Well-Timed Energy Play (Hint: It’s Not an Energy Stock)

New job growth, falling energy prices, rising home prices — the litany of encouraging economic news is creating a “wealth effect” that enhances the confidence of consumers and puts them in a mood to spend. And one item they’re hankering for is airline tickets.

Global recovery is a huge tailwind for the airline industry, which could use all the help it can get. Airlines struggle with onerous overhead, thin profit margins, quarrelsome labor unions, high fuel and maintenance costs, and the fickleness of passenger demand.

However, quickening recovery is generating record prosperity for the airline sector and one operator in particular: regional player Alaska Air Group (NYSE: ALK). I’ve covered aviation for more than 30 years, as an analyst as well as a pilot, and ALK is far and away my favorite airline stock. This passenger carrier is the best managed among its peers and faces clear skies ahead.

And if you’re looking for a great play on falling energy prices, this airline fits the bill. For an airline, the price of jet fuel can make the difference between being in the black or in the red.

West Texas Intermediate crude now trades at about $49 per barrel while Brent North Sea crude trades at about $52/bbl. Oil prices recovered in the latter part of 2016 but they’re on a downward trajectory again, as inventory levels remain stubbornly high and negative investor sentiment punishes the energy sector.

Oil prices are more than 50% off their mid-summer 2014 highs, providing a huge windfall for operators such as Alaska Air Group. At the same time, a rising middle class in emerging markets is demanding “the good life” that it sees in America — and part of this conspicuous consumption includes tourism. Mexico’s surging economy, for example, compelled ALK to launch a new route this year to Mexico City via San Diego.

Booming travel demand should continue regardless of any hiccups among U.S. economic indicators. Let’s examine the prosperous flight path of my airline pick.

Steady profits from hazardous flying…

The strongest regional airline by far is Alaska Air Group, based in Seattle. Alaska Airlines, a subsidiary of Alaska Air Group, serves roughly 100 cities through Alaska, the Lower 48, Hawaii, Canada and Mexico.

Alaska Airlines is the fifth-largest U.S. airline in terms of passenger traffic and it carries more passengers between Alaska and the contiguous U.S. than any other airline.

Alaska Airlines contributes about 80% of the parent company’s total revenues and its sister “feeder” airline, Horizon Air Industries, accounts for the remaining 20%.

Flying in Alaska can be treacherous, due to inclement weather and rugged topography. Founded in 1932, Alaska Airlines claims decades of hard-won flying experience in the area that no potential rival can match. The company has become a local institution.

Alaska Airlines also is the only commercial carrier with in-state routes, making the airline the sole travel option for the state’s crucial oil and gas industry. The airline’s safety record is rock solid, despite challenging flying conditions, and its name is a trusted brand among the state’s hardy residents.

Alaska Airlines serves as de facto “mass transit” for Alaskans, which in turn amounts to a high barrier to entry for any potential competitors. But Alaska Airlines hasn’t been resting on its northern laurels.

The carrier is continually adding routes, such as new service between San Diego and Lihue, Hawaii, between Portland and Fairbanks, and to Mexico City. The strategy is to tap under-served travel niches and then win traveler loyalty through operations that boast reliable safety and on-time records.

Picking a Virgin for marriage…

ALK’s $2.6 billion acquisition of Virgin America closed in December 2016, a bold move that should propel earnings and revenue growth even if the overall economy sputters.

The addition of the hip and stylish Virgin brand gives Alaska Air Group greater cachet, as well as valuable slots at major California airports and high-margin transcontinental routes.

Unlike most of its rivals in the airline industry, Alaska Air Group enjoys strong labor relations, which helps keep turmoil and costs down among the ranks. A labor strike can paralyze an airline and wreak havoc with its bottom line; Alaska Air Group’s far-sighted management has taken steps to prevent the sort of worker dissatisfaction that’s common in the industry.

Alaska Air Group has proven that labor peace, combined with economic recovery and low fuel costs, equals big profits.

Alaska Air Group reported second-quarter fiscal 2017 earnings of $296 million or earnings per share (EPS) of $2.38, compared to earnings of $260 million, or EPS of $2.10, in the same period a year ago.

The company in the second quarter generated $1.1 billion of operating cash flow, of which it pumped $512 million into capital expenditures. In the quarter, the company also launched nine new routes and announced 10 new routes.

ALK shares have risen nearly 28% over the past 12 months, compared to a gain of about 10% for the S&P 500. The stock should generate further market-beating upside, as the company’s earnings momentum continues.

The average analyst expectation is that ALK’s year-over-year earnings growth should reach 15.5% in the current quarter, 13.5% next quarter, 7.5% in the current year, and 8.5% next year. My calculations show that five-year earnings growth should reach nearly 10% over the next five years on an annualized basis.

And yet, this often-ignored stock is a superb value play. ALK’s forward price-to-earnings ratio (P/E) is 11, roughly in line with its peers but considerably lower than the overpriced S&P’s forward P/E of 20.4.

As oil prices continue to trade near $50/bbl, ALK will enjoy a massive tailwind in addition to its other inherent strengths. For investors keen to leverage the resurgence of the airline sector, this company offers a first-class seat for growth.

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