Over the past few years, Hawaiian Holdings (NASDAQ:HA) has achieved stellar EPS growth. Adjusted EPS reached $5.64 in 2017, up from just $1.55 three years earlier.

The Hawaii-based leisure airline produced these EPS gains through a combination of falling fuel prices (in 2015 and 2016) and strong unit revenue growth (in 2016 and 2017). This performance more than offset a steady rise in Hawaiian's non-fuel unit costs, which increased 2% in 2015, 4.8% in 2016, and 6.9% in 2017. The carrier's fuel efficiency has also deteriorated in the past two years.


Hawaiian Airlines' unit costs have risen significantly since 2014. Image source: Hawaiian Airlines.

In light of these unfavorable trends, analysts and investors have mainly focused on Hawaiian Airlines' potential to keep unit revenue growing. As a result, rising competition in the West Coast-Hawaii market has scared many investors away. However, Hawaiian Holdings' recent earnings report and guidance update suggest that its unit cost trajectory is set to improve dramatically.

The genesis of Hawaiian Holdings' cost struggles

To understand Hawaiian's unit cost opportunity, it's important to recognize why unit cost growth has accelerated recently. One major factor is the company's decision to add lie-flat seats -- and an expanded extra-legroom section -- to its Airbus (OTC:EADSY) A330 fleet.

These fleet modifications have played a big part in Hawaiian's unit revenue growth over the past two years. However, reducing the seating capacity of each A330 by 5.4% with little change in operating costs or fuel consumption has put significant upward pressure on unit costs. (By contrast, most airlines have been trying to squeeze more seats onto each airplane in recent years.)

Additionally, Hawaiian Airlines implemented a new pilot contract at the beginning of 2017. The resulting wage increases accounted for 3 percentage points of the company's non-fuel unit cost growth last year.

Headwinds fall away, and a new tailwind arrives

Now that Hawaiian Airlines has gotten its labor rates much closer to industry norms, future wage inflation should be more modest. Furthermore, it will complete the A330 modifications this quarter, so that cost headwind will fade to nothing by early 2019.

A man and a woman resting in lie-flat airplane seats

Hawaiian Airlines is almost done installing lie-flat seats on its A330 fleet. Image source: Hawaiian Airlines.

This is a big reason Hawaiian expects non-fuel unit costs to rise by no more than 2.5% this year. In fact, the company's forecast implies that non-fuel unit costs will be flattish after the first quarter.

Hawaiian Airlines' ongoing fleet transition is also contributing to this improved cost trajectory. The carrier just started operating the first of 18 Airbus A321neos that will join its fleet by early 2020. The A321neos will replace the last of Hawaiian's aging Boeing 767s by the end of this year. Retiring Hawaiian Airlines CEO Mark Dunkerley indicated on the company's recent conference call that the A321neos have significantly lower unit costs than the 767s.

The A321neos will have an even bigger impact on fuel consumption. Engine technology and aircraft weight are the two biggest factors affecting fuel efficiency. The A321neo has a nominal operating empty weight of 51 tons (about 43% less than the 767's empty weight), but it carries only 25% fewer passengers. Meanwhile, the 767 uses 1980s engine technology, compared to the state-of-the-art engines on the Airbus A321neo. As a result, the A321neos will probably be at least 30% more fuel efficient than the 767s.

Hawaiian Airlines expects this fleet transition to improve its fuel efficiency by about 2% this year. However, since most of the 767s won't be retired until after the summer peak season, the biggest fuel efficiency gains will come in 2019.

The longer-term outlook is favorable, too

In addition to receiving most of the benefit of its 767-to-A321neo fleet transition during 2019, Hawaiian Holdings is also positioned to capture other savings next year and beyond. For example, CFO Shannon Okinaka noted during the recent earnings call that the company prepaid $75 million to a maintenance provider in exchange for lower rates beginning in 2019.

Aircraft rent represents another big source of future savings for Hawaiian Holdings. (Last year, the company spent more than 5% of its revenue on aircraft rent.) The leases for its first three Airbus A330s will expire in 2020. These leases are quite expensive, as Hawaiian's financial position was quite weak at the time they were signed.

Hawaiian Holdings will have various good options to address its lease expirations. It could buy those three A330s for cash, reducing its annual ownership costs dramatically. The carrier could also replace them by buying new A330neos or A321neos from Airbus. Doing so would yield less savings in terms of ownership costs but would reduce other expenses like fuel and maintenance.

The net result is that Hawaiian Holdings' unit cost growth is set to stop after the first quarter, excluding the impact of fuel prices, and could decline significantly over the next few years. This is just one more reason the company can weather rising competition in the United States.