USF Student Managed Investment Fund Student Managed Investment Fund Student Managed Investment January 22, 2021 BUY Alaska Air Group, Inc. Price as of 1/21/21 close: $54.96 NYSE: ALK 2-Year Price Target: $82 There’s plenty of runway left for this Anton Ashrafyan Eskimo: mix of a recovery trade, [email protected] attractive valuations and long-term Skylar Cantone [email protected] operational and margin expansion Timothy Henning We’re not sure if people have a thing against the [email protected] West Coast, don’t like the cold, or simply don’t Tyler Schulman understand why this airline is unique. Regardless, [email protected] Alaska has been getting treated like the younger sibling when compared to the rest of its peers. Company Overview While it may not stand as tall as its rivals, we do believe it is better looking in many regards. Alaska Air Group, Inc. (“ALK”, “Alaska” or the “Company”) is Alaska boasts a slew of attractive qualities, namely a holding company that its conservative balance sheet, abundant liquidity consists of Alaska Airlines, reserves, domestic route network, unique business Inc. and Horizon Air model, and long-term opportunities for operational Industries, Inc.. ALK operates growth and margin expansion. through three operating Simply put, there’s a lot more than a recovery trade segments: Alaska Mainline, to benefit from here. Alaska checks all the boxes for Alaska Regional, and a long-term holding in the USF SMIF portfolio. Horizon. The Company was founded in 1985 and is 5-Year Price History headquartered in Seattle, Washington. $100 Price Target & Risks Our $82 PT is based on an average of our DCF (9.4% $80 discount rate and 6.0x terminal year EBITDA multiple) and EV/EBITDAR (FY22 estimate and 6.0x $60 multiple) models. Risks to our PT include 1) stagnating recovery in air $40 travel demand 2) loss of competitive advantage in key markets 3) rises in fuel prices $20 4) unfavorable developments in key markets 5) unforeseeable health, safety, terrorism and geopolitical crises. Table of Contents I. Company Overview ......................................................................................................3 II. Investment Thesis ........................................................................................................4 III. Revenue Forecast.......................................................................................................10 IV. Valuation………...........................................................................................................11 V. Risks ..........................................................................................................................13 VI. Management………………..........................................................................................14 VII. Appendix I. Income Statement …........................................................................................15 II. Quarterly Income Statement ............................................................................16 III. Statement of Cash Flows .................................................................................17 IV. Balance Sheet …..............................................................................................18 V. Comparable Company Analysis…………………………………………………….19 VI. Ratios …...........................................................................................................20 1/22/2021 2 Company Overview Mainline Alaska’s Mainline accounts for just over 70% of total operating revenue. This segment includes scheduled air transportation on Alaska’s Boeing and Airbus aircraft for passengers and cargo throughout North America under the Alaska Airlines brand. The airline’s largest concentration of departures is in Seattle, Portland, and the Bay Area. As of 3Q20, the fleet consisted of 166 Next Generation B737s, 41 A320s and 10 A321neos. The graph to the right depicts the breakdown of Alaska’s Mainline operations. It is important to note that over the last few years, a portion of the company's passenger capacity shifted towards Transcon/Midcon operations due to the acquisition of Virgin America. Also, Alaska maintains nearly 40% of the market share in the Northwest market (Washington, Oregon and Alaska). However, the company is shifting into other markets and regions to balance out their network. Regional Alaska’s Regional segment is made up of flights operated by Horizon (70%) and SkyWest (30%). These flights operate under capacity purchase agreements (CPAs) in which Alaska pays the regional carriers a fixed rate in return for their services. In this model, Alaska is responsible for operating and maintenance costs such as fuel and crew costs. Horizon The Horizon segment is made up of capacity purchase agreements (CPAs) sold by ALK’s subsidiary, Horizon Air, to Alaska Airlines. Revenue is generated for ALK through these agreements in which Horizon is not responsible for operating and maintenance costs. 1/22/2021 3 Investment Thesis Alaska Carriers A Differentiated Value Proposition…. Alaska offers an unmatched blend of premium product and service offerings, akin to legacy carriers, with lower fares that are competitive with budget airlines. Alaska sits by itself in the middle of the airline spectrum between major airlines and no-frills carriers. The Company’s route network employs a traditional hub and spoke model, but is highly concentrated in West Coast markets, principally Seattle, Oregon, California and Alaska. The Company has successfully maintained considerable market share in three of these states (see below). Presence in Key States 66% 48% 37% Notes (1) Source: Diio, Barclays (2) (FY19 % of available schedule capacity) Alaska Washington Oregon Dominance has been maintained by undercutting major airlines on a pricing basis (see below) while still offering comparable amenities such as first-class cabins, airport lounges and a comprehensive frequent flier program. Alaska also boasts an industry leading reputation with the flying public. The Company has consistently received top marks in various industry surveys from best US airline to best frequent flier program. No other domestic airline offers what Alaska has been able to bundle together: low fares, an upscale on and off board experience as well as an impeccable track record with its customer base. Average Fares $205 $208 $200 $152 Notes (1) Source: 3Q19 investor presentation, DOT 1/22/2021 4 Investment Thesis ….Along With Industry Leading Financial Strength Alaska came into the COVID-19 pandemic with one of the industry’s healthiest balance sheets. This has prevented the Company from needing to rush to boost liquidity through copious amounts of high-yielding public debt (as all three major airlines have had to do). Consequently, leverage metrics have remained reasonable as compared to FYE19 (see below). 61% FY19 3Q20 43% 37% 25% Notes (1) Uses lease adj. total debt figure Total Debt / Capitalization Total Debt / Assets Our model assumes that the $1.2 billion between term loans and outstanding credit facility balances, due at the end of 1Q21 and the start of 2Q21, will be paid down. Management indicated they were still deciding on whether to refinance or pay down the debt on the 3Q20 earnings call. Our assumption is derived from the fact that Alaska can easily draw from its marketable securities balance and that operations will already be near cash-break even by 1H21. We are forecasting 2Q21 passenger traffic to be just under the 60% mark of FY19 levels, a threshold management states is necessary for cash break-even. Thereafter, the relatively flat obligation schedule throughout the first half of the decade provides more flexibility for future capital spending and resumption of share repurchase and dividend programs. Our model assumes the Company will restart share buybacks in FY22 at a rate of $115 million per year which roughly completes the remaining balance of the original $1 billion program by the end of our forecast period. 310 Debt Leases 1,201 276 219 166 393 357 265 2021 2022 2023 2024 1/22/2021 5 Investment Thesis Regardless, Alaska still holds $5.5 billion in available liquidity which includes an arsenal of more than $3.7 billion in cash and marketable securities as well as an additional $1.8 billion between credit facilities and available CARES Act loans. Management trimmed cash burn to roughly $4 million at the end of 3Q20 which is not only among the lowest in the industry (see below) but also combines to create, by far, the industry’s longest liquidity runaway (past FY23). As we mentioned before, Alaska came into the pandemic with among the lowest leverage levels in the industry and is consequently projected to maintain that status over the course of the next 24 months (see below). This allows for cheaper and more flexible financing options post COVID-19. Lease Adj. Net Debt / EBITDAR FY19 6.8x FY22E 5.5x 4.1x 4.1x 3.9x 3.8x 2.7x 2.2x 2.4x 1.5x 1.3x .9x 0.5x 0.0x (2) (4) (6) (16) (25) (24) (44) Average Daily Cash Burn Notes (1) FY22 Adj. Net Debt / EBITDAR figures based on Barclays’ estimates. We project this metric at 1.5x, mainly due to our assumption of the paydown in the 2021 obligations. (2) Cash burn figures as of 3Q20 1/22/2021 6 Investment Thesis …. And is Primed to Return to Pre-Merger Operational Efficiency Prior to the 2016 acquisition of Virgin America, Alaska had operated a fleet that consisted entirely of B737s. The deal added several of the A320 series to the fleet. While operations and market share expanded significantly, cost effectiveness