An improved economy and low oil prices have done wonders for airline stocks. The value of these stocks has surged in recent years, at times beyond reasonable levels.

I’m especially concerned about the risk of a sharp share price correction for Allegiant Travel Co. (Nasdaq: ALGT), a small passenger airliner with a fleet of 70 aircraft and annual revenue of $1.1 billion.

#-ad_banner-#Allegiant has a sound business model, pursing flight routes in underserved U.S. cities. It also generates a robust income stream from ancillary sources like priority boarding; in-flight food and beverage service; and hotel and ground transport bookings. The company’s growth strategy has led to double-digit revenue gains in nine of the past 10 years. Equally important, the company retains a strong balance sheet.  

Allegiant is clearly an investor favorite, based on the more than 277% gain in its stock over the past three years.

However, shares are now alarmingly overvalued. Allegiant’s price-to-cash flow ratio, for example, has ballooned to more than 12, compared with ratios of about 7-to-10 for rivals like JetBlue Airways Corp. (Nasdaq: JBLU), Delta Air Lines, Inc. (NYSE: DAL) and United Continental Holdings, Inc. (NYSE: UAL). Shares are also exceptionally pricey by several other key valuation metrics.

Simply put, Allegiant is “priced for perfection.” In Wall Street speak, that means things must go perfectly from now on, or the stock could be punished. But Allegiant is bound to stumble at some point in the face of any number of real-world risks.

A key one is the cost of fuel, which has provided welcome tailwinds lately, but could be a particular obstacle for Allegiant once prices head higher, as they will sooner or later.

Unlike most competitors, the firm doesn’t hedge fuel costs with futures contracts. So when jet fuel is cheap, as it is now, Allegiant can realize big savings (fourth-quarter fuel outlays plunged 12%, for example). On the other hand, the company is fully exposed to any price increases.

Another important risk for Allegiant is its aging aircraft fleet — the industry’s oldest, with an average age per aircraft of 22 years. Three-quarters of the fleet is composed of roughly 25-year-old McDonnell Douglas MD-80 passenger jets, which burn fuel much faster than the small number of newer, more-efficient aircraft Allegiant also operates. So fuel costs will be that much higher when oil goes back up.

Regardless of what happens with oil, though, Allegiant may often have to contend with sharply rising maintenance and repair costs for its aging fleet. In 2014, these costs jumped 9% in terms of the amount per available seat miles, or ASMs.

ASM is a key industry measure of an airline’s overall service capacity, obtained by multiplying the total number of seats available for purchase by the number of miles flown. Last year, Allegiant’s ASMs totaled 8.9 billion, while repair and maintenance costs were $0.97 per ASM, up from $0.89 in 2013.

In straight dollar terms, these costs spiked by $14 million, or about 19%, in 2014. Much of the increase was the result of Allegiant operating more aircraft (it added six to the fleet last year). However, a large chunk — nearly $6 million — represented outlays for more frequent maintenance checks required by the FAA under its Aging Aircraft Airworthiness Directives.

Allegiant also has serious labor issues. The firm has been in a contract dispute for several years with its roughly 500 unionized pilots. The pilots are seeking more pay as well as changes in rules related to seniority and scheduling. In a near-unanimous vote, they’ve already authorized a strike and have threatened to initiate one soon.

For Allegiant, a pilot strike would obviously mean widespread flight interruptions and substantial revenue loss. On the other hand, resolving the contract dispute would probably involve giving ground on wages. Either way, Allegiant is probably looking at higher labor-related costs in the near future.

Among the dozen or so analysts following the stock, the average estimate is for profits to soar more than 80% this year. It’s important to remember that falling jet fuel prices, which are fueling those near-term profit gains, will eventually reverse course. As a result, this could represent a peak year of earnings for Allegiant.

Risks To Consider: As an upside risk, Allegiant’s aging fleet could be something of an advantage when fuel costs go up. Typically, the company buys or leases used aircraft at far cheaper prices than new ones, so it’s less concerned than rivals about keeping planes in the air to recover acquisition costs. Thus, if higher fuel prices make operating certain aircraft uneconomical, Allegiant has more flexibility to simply park them in the hangar.  

Action To Take –> Allegiant Travel is a sound, successful company and could meet estimates for 23%-a-year long-term earnings growth. This year, however, the firm is likely to come up short, thanks to certain risks and unreasonable Wall Street expectations. This sets the stage for a sharp pullback in Allegiant’s stock, making the stock an appropriate short candidate.

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