No China Exposure
I have been looking for stocks with no China exposure, and Alaska Airlines (ALK) fits the bill. The airline industry is benefiting from lower energy costs, but oil is now a risk if it bounces back. Capacity additions have increased competition, and fares have begun to come down since mid-2Q. I chose Alaska because many of their routes don't compete head-to-head with ultra-low-cost-carrier (ULLC's). I decided to hedge Alaska against a pop in the price of oil by adding a long WTI future hedge.
Less Competitive Routes
Alaska is adding capacity, just like most other airlines. Alaska also eliminated 5 routes recently. They freed up assets to serve new, less-competitive routes. Many new routes, shown here, do not currently have a non-stop flight or has only one carrier providing a non-stop flight.
The cost of fuel is a big issue to deal with when looking at an airline investment. Since oil has been elevator down for the past year, airline stocks have had a strong tailwind from margin expansion. But today with WTI trading with a $38 handle, I feel like the easy money has been made on the short side of the oil trade. So I decided to add a long WTI future hedge to Alaska in order to hedge the position to a snap back in oil. I calculated a bunch of different hedge ratios based on OLS and volatility ratios. The hedge ratio is somewhere in the neighborhood of 20%-50%. I prefer to err on the side of hedging too much WTI rather than too little, so I am going to lean toward the 40%-50% area. Using a 50% hedge ratio, buy 1 WTI future for every 2,000 shares of Alaska.
Alaska is an exceptionally well run airline with a shareholder friendly management team. They have proven themselves to be prudent managers of capital. I trust management will continue to maximize the FCF of the business.
I expect Alaska will generate over $500M in FCF in 2016. With an enterprise value of just below $10B, the multiple to FCF around 18x. I expect the 2016 EBITDA to be over $1.7B which puts the EV / EBITDA at 5.5x.
One could argue the airlines are experiencing peak earnings and cash flow right now, and a valuation should be done on a normalized profitability level. This is certainly a risk to any airline stock, and something to be monitored. The airline industry has been adding capacity, and ticket prices have recently exhibited downward pressure. I don't want to see this competition get out of hand, and I'll monitor this situation closely.
Michael Grove, CFA