MIAMI — Alaska Airlines reported a record second quarter 2014 profit of $165 million, or $1.19 per diluted share, on Thursday, representing a 58% improvement year-over-year (YOY) on the carrier’s financial results for the second quarter of 2013. Excluding the benefit of mark-to-market fuel hedges, Alaska’s net profit was $157 million.

Total operating revenues jumped 9.4% year-over-year (YOY) to $1.37 billion, led by a 7.9% YOY increase in passenger revenues to $1.17 billion. Mainline passenger revenues rose 8.7% to $974 million, driven by a 4.1% increase in yields to 13.86 cents. Passenger revenue per available seat mile (PRASM) was up 4% to 12.03 cents. Regional passenger revenue, primarily generated by Alaska’a Horizon Air subsidiary, rose 4.1% YOY to $200 million despite a 5.9% drop in yields to 27.55 cents and a PRASM drop of 6.4% to 22.37 cents. Cargo revenue rose 6.7% to $32 million, while other operating revenues, which includes items such as proceeds from the sale of frequent flyer miles via co-branded credit cards, rose 15.2% to $169 million. Alaska’s overall PRASM rose 2.6% YOY to 13.06 cents, despite a 5.2% increase in capacity as measured in available seat miles (ASMs) and an 8% increase in competitive capacity across Alaska’s network (primarily Delta in Seattle).

Alaska’s well publicized initiatives to grow ancillary revenues paid off in the second quarter, and overall ancillary revenue is up $23 million year to date, or 9% YOY per-passenger. Alaska also recorded $8 million in incremental revenues from its new discounted first class fare bucket (dubbed “P fares”). Alaska Airlines is noted for its wide variety of code share partnerships, in particular its two largest ones with American and Delta, which generate nearly $400 million per year in revenues. Total code share revenue for Alaska grew $11 million YOY in the second quarter, but that improvement belied a major shift in the composition of the revenue. As Delta has steadily built up a major presence in Alaska’s largest hub at Seattle, code share revenue has fallen sharply, declining $16 million YOY in the second quarter (more than 30%). Simultaneously, code share and interline revenue from American was up nearly 20% in the quarter, and revenue from international partners also grew.

Operating expenses edged up 2.7% YOY to $1.11 billion. An 8.9% rise in labor costs to $281 million was offset by a 3.3% decline in fuel expenses to $360 million reflecting a $10 million refund of fuel prices, a 2.5% increase in fuel efficiency as measured by ASMs per gallon, and a 2.4% YOY reduction in economic fuel cost to $3.20 per gallon. Maintenance costs fell 14.9% YOY to $57 million, while landing fees and facility rental expense fell 14.7% YOY to $64 million thanks to a $15 million reduction in airport costs at Seattle. Consolidated operating expenses per ASM (CASM) declined 2.3% YOY to 12.37 cents, while CASM excluding fuel fell 0.6% to 8.36 cents.

Alaska Airlines continues to retain its industry leading balance sheet, ending the quarter with $1.51 billion in cash and marketable securities against a total debt load including the future value of operating leases of just $1 billion. Its pension plans are fully funded, and the carrier generated a 16.1% return on invested capital (ROIC) over the trailing twelve months. When combined with the $285 million in free cash flows that Alaska generated over the first half of the year and its 19.1% operating margin. , the ROIC figure speaks to the excellent condition of Alaska’s business today.

But the biggest challenge to Alaska remains Seattle. Despite expansion plans that will see Alaska increase its Seattle departures by 11% by next spring (in addition to all of the flights Delta will add, Alaska has already had to stomach a 9% increase in competitive capacity in Seattle in the year to date. Despite its more international flavor, Delta’s hub at Seattle overlaps with 41% of Alaska’s local ASMs, and Alaska CEO Brad Tilden expects that figure to reach 50% by next summer as Delta adds an additional 30 flights per day. Mr. Tilden admitted that the increased competition in what is Alaska’s highest margin hub is likely to put pressure on Alaska’s PRASM growth (which at 2.6% already lagged network peers in the quarter). Alaska expects its unit revenue growth to “lag the industry” over the remainder of 2014 (two quarters), but plans to leverage its strength in domestic flying in Seattle. Mr. Tilden noted that Alaska flies 55% of domestic seats in Seattle versus just 16% for Delta, and pointed to Alaska’s Fortune 500 corporate contracts in the city as a buffer against Delta.

“Yes. I do think… [that] we’re seeing real strength in Seattle. You mentioned a couple of the big ones. Amazon is growing like crazy. They’ve — I don’t know how many tens of thousands of employees they have, but those are high income jobs and lots, lots of travel. The city is doing well. I think if you were to look at unemployment or real estate prices or what have you, the economy here is quite strong.”

And despite the margin challenges likely to emerge, Alaska is well positioned to withstand Delta’s challenge. Its operating cost advantage over Delta is perhaps a touch overblown, but still meaningful, and Alaska’s non-Seattle operations command healthy margins in their own right which provide a reasonable buffer. The company has a significant cash pile, and can easily convert some of its free cash flow generation or share buyback plans to further investment if that is required. We do not believe that an Alaska – Delta merger is easy to execute at a price that would make sense for Delta, though a further 10-15% decline in Alaska’s share price to around $40 per share would increase the risk. The regulatory pathway for such a merger is also questionable, and thus we believe that Alaska will continue to operate as a stand-alone carrier for the coming year.