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Executives

Chris Berry - Managing Director, Investor Relations

Brad Tilden - Chief Executive Officer

Brandon Pedersen - Chief Financial Officer

Analysts

John Godyn - Morgan Stanley

Helane Becker - Dahlman Rose

Hunter Keay - Wolfe Trahan

Jamie Baker - JPMorgan

Glenn Engel - Bank of America

David Fintzen - Barclays

Savi Syth - Raymond James

Mike Linenberg - Deutsche Bank

Duane Pfennigwerth - Evercore Partners

Kevin Crissey - UBS

Steve O’Hara - Sidoti

Alaska Air Group, Inc. (ALK) Q4 2012 Earnings Conference Call January 24, 2013 12:30 PM ET

Operator

Good morning. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the Alaska Air Group Fourth Quarter and Full Year 2012 Earnings Conference Call. Today's call is being recorded and will be accessible for future playback at www.alaskaair.com. (Operator Instructions)

I would now like to turn the call over to Alaska Air Group’s Managing Director of Investor Relations, Chris Berry. Please go ahead sir.

Chris Berry - Managing Director, Investor Relations

Thanks, Michelle. Good morning or afternoon for those of you on the other coast. Thank you for joining us for Alaska Air Group’s fourth quarter 2012 earnings call.

Today, our CEO, Brad Tilden; and our CFO, Brandon Pedersen, will share their thoughts on our financial results, our operations, and our outlook for 2013. Several members of our senior management team are also here to help answer your questions.

As usual, our comments today will include forward-looking statements regarding our future expectations, which may differ significantly from actual results. Information on risk factors that could affect our business can be found in our SEC filings available on our website. We will refer often to certain non-GAAP financial measures, such as adjusted earnings or unit costs, excluding fuel. We have provided a reconciliation between the most directly comparable GAAP and non-GAAP measures in our earnings release.

This morning, Alaska Air Group reported a fourth quarter GAAP net profit of $44 million. Excluding the impact of mark-to-market adjustments related to our fuel hedge portfolio, Air Group reported a record adjusted net profit of $50 million or $0.70 per diluted share. This result is in line with the first call consensus and exceeds last year’s adjusted net income of $37 million or $0.51 per diluted share. For the full year, Air Group reported a record adjusted net profit of $339 million compared to $287 million in 2011. Adjusted earnings per share grew by 21% from $3.92 per share in 2011 to $4.73 per share in 2012.

Additional information about our unit cost expectations, capacity plans, future fuel hedge positions, capital expenditures and other items can be found in our Investor Update included in our Form 8-K issued this morning and available on our website at alaskaair.com.

And now I’ll turn the call over to Brad.

Brad Tilden - Chief Executive Officer

Thanks, Chris and good morning everyone. Chris mentioned our record fourth quarter results, which represented our 15th consecutive quarterly profit. Our pre-tax margin grew to 7.2% for the quarter, which compares to 5.5% in 2011. For this call, I’d like to focus the majority of my comments on our full year 2012 results and on our plans for 2013.

For the full year, we produced our ninth consecutive profit on an adjusted basis and it too was a record result. Here is some additional color on this result. Against a backdrop, where the industry capacity was flat, we grew capacity by 6% and revenues by 8%. 2012 revenues were fueled by our growth into new markets. We added 15 new city pairs net of reductions, including 5 new cities during the year bringing our total new routes over the last five years to 24. This winter, we have 26 flights per day to Hawaii and roughly a 30% share of the West Coast Hawaii market. This region now represents 20% of our network and a second in size only to California.

To ensure that growth was profitable, we continued to focus on increasing productivity keeping overhead in check and lowering our unit cost ex-fuel. Our mainline CASM ex-fuel was down about 1.5% and our consolidated CASM ex-fuel was down about 1%. Productivity was up 3.5% representing our fourth consecutive year of improvement. As a result of the revenue growth and the good cost control, our pre-tax income for 2012 was $552 million compared to $463 million in 2011.

Our pre-tax margin was 11.9% for 2012, up one point from 2011. And as Chris said our adjusted net income for the year was $339 million, which is an 18% improvement over 2011. This record profit translates to $4.73 per share, an increase of 21%. Those of you that have followed us for a long know that we are big believers in understanding our cost of capital and in articulating our goals and our actual results. We earned an ROIC of 13% for 2012, which is a record for us and which reflects returns that are 500 basis points or 600 basis points higher than our cost of capital.

So, 2012 was a good year for Alaska Air Group. None of the success in 2012 or over the past several years would have been possible without the talented and dedicated people we have at Alaska and Horizon. They are the backbone of the company and the rest of the leadership team and I want to thank them for all that they do. I also want to take a moment to offer my sincere thanks to the leaders at Alaska and Horizon, who put in lots of long days and nights to produce these results. They are an extraordinary team of people with expertise in their areas, a focus on performance and a real desire to work together and see each other succeed.

I want to now highlight how our strong performance over the years has affected our financial position. Looking back to just four years ago to the end of 2008, we had a somewhat highly levered typical airline balance sheet, with the debt to cap ratio of 81%. We knew that was unacceptable and focused our attention on improving our profitability and our cash flows, so that we could improve the balance sheet. Specifically, over the last four years, we have generated $2.3 billion of operating cash flow. This has allowed us to make some positive changes and I want to mention a few of these.

First, we have invested $1.4 billion in modernizing and growing our fleet to make it one of the most fuel efficient fleets in the industry. And our success has allowed us to place a new order with Boeing that will allow for fleet replacement and growth over the next decade. Second, we’ve reduced our long-term debt and operating leases by more than $1.1 billion bringing our debt-to-cap ratio down to 54%, a 27 point reduction. Third, we have repurchased over $200 million of our common stock and we are currently executing a $250 million buyback program.

And finally, although it’s included in the operating cash flow numbers, we have demonstrated a real commitment to our people by contributing $535 million to our pension plans and by paying out over $325 million in incentive pay including $88 million for 2012. Every Air Group employee participates in the same incentive plan because we believe in having all of our employees regardless of their role aligned around a common set of goals. This is a powerful incentive and it could – and is consistent with our long-held belief that when the company does well, our employees should do well.

So, taking all of this into account, our balance sheet is in much better shape today than it was at the end of 2008. As we close the books on another good year, we began 2013 with engaged employees that are working together better than ever before. Excuse me, it’s no secret though that this is a tough business. We are in an environment of high fuel prices, slow economic growth and increasing competition. We are not resting on our past success but working on initiatives that will sustain this performance in the future.

In that vein many of you heard us discuss the company’s five focus areas. Our five-year strategic plan, we are entering the second year of the plan and I want to briefly highlight some of the things we will be focusing on in 2013. First, our highest priority is safety and compliance. It will always be our top goal. In 2013, we are implementing a new safety management system that will help us better track and analyze safety risk factors and take appropriate action.

Our second focus area is our people. We are wrapping a series of workshops with all of our employees, which we are using to communicate our strategic direction, so our people support it. On the labor front, we’ve recently signed a six year extension with our Horizon pilots and our teams continue to work for equitable long-term agreements with flight attendants at both Alaska and Horizon and with pilots at Alaska. We have some momentum getting labor deals done by amendable dates and keeping our people focused on taking care of customers and beating the competition. And we are anxious to see this continue. Of course our new deals need to meet the needs of our employees, our customers, and our owners. Third, our goal is to be the easiest airline to fly and we are working hard to take the hassle out of flying. This includes everything from self-bag tagging, to further leveraging mobile technology to reducing stress in airport security lines. We are striving for our customers to have a seamless transition from the airport curb to their seat on the plane.

And fourth because we want to grow outside of Alaska and the Pacific Northwest, we are taking a look at our brand and how it resonates with potential new customers. Our simple objective is to ensure that people understand our network, our low fares, our award winning customer service and the high quality of our in-flight experience. We are also taking steps to enhance the customer experience. For example, we have added Starbucks coffee and Northwest wines on all of our flights and we introduced the Boeing Sky Interior on all of our aircrafts delivered in 2012. We are also considering other changes to the interiors of our aircraft such as seats, cabin layout, seat power, and enhanced in-flight entertainment.

And fifth our goal is to use our various initiatives to lower our unit cost, so we can keep offering low fares to our customers and keep growing. We have done a lot to make flying affordable with one way fares, reasonably priced first-class tickets and an award winning mileage plan. But we want to become known for low fares and great value. These five focus areas, well executed will be our path to continued success in the years ahead. They will prepare us for the inevitable challenges that come in this industry and they will bring all of us together as we execute the related initiatives. I am optimistic about the future of this company and what we will be able to achieve if we continue working together.

In closing, I want to again thank all of our employees for a record year. As I look back, I am simply humble by the passion, determination, and hard work of the people who make up Alaska and Horizon. It’s been an incredible year and I look forward to working with this great team to raise the bar in 2013.

With that I will turn the call over to Brandon.

Brandon Pedersen - Chief Financial Officer

Thanks Brad and hi everybody. We are very pleased to report that Air Group’s fourth quarter adjusted earnings grew by 35% to $50 million. The fourth quarter profit brings our full year results to the numbers that Brad mentioned. 11.9% pre-tax margin, $339 million of net profit and 13% after tax ROIC. I want to join Brad in congratulating all of the Alaska and Horizon employees for another outstanding year.

Our financial results reflect their efforts along with the structural changes we have made over the last decade such as moving to a single fleet of efficient airplanes of both companies, better matching capacity with demand, reducing our costs, and more efficiently using the capital in our business. Our fourth quarter adjusted pre-tax profit improved by $24 million, a 42% increase. The $88 million or 8% increase in revenues more than off set the $33 million or 10% increase in economic fuel costs and the $42 million or the 7% increase in non-fuel operating expenses. Non-operating expenses were also a $11 million lower this year. About half of the decline is due to lower interest expense. The other half reflects the fact that last year’s results include a $6 million impairment on an MB-80 that we had leased to another operator.

Fourth quarter passenger revenue grew by 9% on a nearly 8% increase in capacity and a 1% increase in consolidated PRASM. Our main line PRASM increased 1.1% compares favorably with the A4A domestic PRASM gain of 1.6% particularly given our 5% increase in stage length. We were very pleased with the unit revenue performance in our core markets. New developmental markets such as Seattle, Filly and San Diego, Orlando brought down aggregate trans-con PRASM a bit, but they are meeting our expectations.

Hawaii PRASM was down in the fourth quarter, pressured by seasonality of travel and the 35% year-over-year increase in our capacity. We have already adjusted our schedule in certain markets to better match capacity and demand and are considering whether additional adjustments should be made. We know that having the right capacity is the best thing we can do to improve unit revenue performance going forward. Bigger picture, I want to quickly remind folks how that market has evolved. In 2008, two carriers that served the West coast of Hawaii ceased operations, with their exit daily seats off the West coast went from 13,700 seats to a low of 11,400 seats. We have been adding capacity every year to take advantage of that unique market opportunity. Today, with our new service and the service added by others, capacity between the West Coast and Hawaii is back to more than 14,000 seats a day, a 3% increase over the 2007 high.

As a result, the double-digit year-over-year capacity growth to Hawaii that we have seen since 2008 will subside considerably. And in fact we don’t anticipate any year-over-year growth in the second half of 2013. In our Investor Update today, we noted advanced book load factors are flat for January and March and up 0.5 point for February on capacity increases of 7% to 8% in each of those of months. Broadly speaking, both business and leisure demand remains stable, although we are mindful that the expiration of the Social Security tax holiday may impact disposable income and concerns about the federal borrowing limits do create an overhang that may impact consumer confidence.

For the quarter, consolidated CASM ex-fuel was down over 1% to $8.72 on the 8% increase in capacity. Three areas drove the flattish unit cost performance. First, maintenance cost increased by 15% largely because of unscheduled engine removals at Horizon. Second, food and beverage costs increased by 24% because of the growth of buy-onboard sales and the investments that we have made to improve the in-flight experience. The response from our customers has been good, but we are working to reduce shrinkage and waste in order to improve margins on these sales, as we seek to get a better handle on what is becoming a very significant retail food and beverage operation. And finally, variable incentive pay was $8 million higher than in the fourth quarter of 2011.

And speaking of incentive pay, we are proud to report that Air Group employees have earned $88 million through our Performance Based Pay or PBP plan and the Operational Performance Rewards or OPR program, a $16 million increase over last year. Under the PBP program, the vast majority of our employees have a target bonus equal to 5% of pay. Similar to 2011, we exceeded many of the goals set by our board, including the profitability goal which represents 70% of the PBP waiting. As a result, most of our employees will receive a PBP bonus equal to 8.1% of earnings, which is nearly the equivalent of an extra month’s pay. In fact, over the past four years, PBP has averaged over 8% of pay for most employees, and as Brad said, totals over $325 million.

I mentioned earlier, that economic fuel costs were up $33 million or 10% in the fourth quarter on a 6% increase in consumption and the 3% increase in the economic price per gallon. For the year, economic fuel costs were up 12%. The net cost of our fuel hedging program was $24 million for the year or approximately $0.06 per gallon. Those numbers, however, don’t reflect the fact that in 2012, we spent $40 million in cash to buy options that will settle in future years. This is $27 million less than what we spent in 2010, even though our consumption is up by 12%. That decline reflects our move to buy options that are up to 20% out of the money as we elect to take on more risk in exchange for lower premiums that will be expensed in the future.

For the full year, Air Group’s consolidated CASM ex-fuel declined by nearly 1%. Mainline CASM ex-fuel declined by 0.5 point. We have been able now to reduce mainline unit costs 10 out of the last 11 years and much of that improvement has come from productivity gains and keeping a tight lid on overhead. Our play book for 2013 will have more of the same. For example, the self-bag tagging that Brad mentioned reduces the time it takes our customers to drop a bag by about 40%. Another example is shifting a higher percentage of sales directly to alaskaair.com, which improved by the way by 3.5 points from 2011 to 54% of total bookings in 2012. Our goal is to push this to 60% in 2013 saving us distribution costs and getting us close to our customers.

As we look at 2013, we are planning Air Group capacity to increase 7% to 8%. Although with our fleet, we have a great deal of flexibility to adjust that if needed. We expect consolidated non-fuel unit cost to again decline by about 1% and we expect mainline ex-fuel to decline, CASM ex-fuel to decline by about 0.5%.

Let me walk you through some of the larger cost increases. First, we expect consolidated wages and benefits to increase by about 6% to 7% on a 3% to 4% increase in FTEs. Like many companies we’re seeing inflation in employee medical expenses which are going up by 10%. Pension expense will actually be flat year-over-year. Although the P&L impact was less than we initially anticipated, it doesn’t reduce our conviction to keep working out of legacy style benefits such as DB plans. In that vein, we will be freezing the management plan on January 1, 2014, leaving less than a third of our employees actively accruing service credit.

Second, we will again increase our spending on technology. We have budgeted a $20 million increase this year as we continue to strengthen our IT infrastructure to improve speed and reliability replace several legacy systems and invest in new technologies such as mobile that will both improve productivity and our ability to serve customers.

Maintenance expense will grow by 10% much of that relating to lease return costs for 737 aircraft that we intend to return over the next 15 months and an increase in the number of schedule airframe and engine events at Alaska offset by lower maintenance costs at Horizon on a tough 2012 comp. Our guidance reflects those and other volume driven increases offset by lower variable pay. This of course fluctuates through the year depending on how we are tracking vis-à-vis our goals. Our unit cost guidance does not however include any costs associated with new labor contracts.

During the year we’ll take delivery of nine Boeing 737 900ERs brining our total to 13. With 181 seats these larger airplanes are our powerful tool to help us continue to drive unit costs down in 2013 and beyond. They also allow us to sell more seats and grow revenue without increasing the number of departures. For example, we’ve been using the 900ER between Seattle and New York where we own the have two slots. By doing so we’re able to sell up to 24 more seats each way in a high density market with very little incremental cost.

Moving to our balance sheet we ended the year with more than $1.2 billion in cash and short-term investments. Brad covered some of the longer term improvements in our balance sheet and cash flows, but I would like to highlight some of this year’s accomplishments. In 2012 we generated $750 million of operating cash flow compared to $696 million in 2011. And it’s notable that the 2012 figure is net of more than $80 million paid in federal and state income taxes. We expect to pay more than that in cash taxes in 2013 perhaps at a 30% cash effective rate. This is only a very high level estimate at this point but it isn’t important consideration when forecasting operating and free cash flow.

In December we again made a supplemental contribution of $75 million to our pension plans. This is on top of the $35 million that we had contributed earlier in the year and despite the fact that we had no required contribution. This marks our fourth consecutive year of making substantial year end contributions to our DB plans and leaves our DB plans 82% funded on a PBO basis at year end. We plan to make cash contributions of approximately $38 million in 2013 although again we have no requirement to do so. Capital spending in 2012 was $520 million as we took delivery of three Boeing 737 800s, four 737 900ERs and two replacement Q400a resulting in roughly $230 million of free cash flow.

The strong free cash flow allowed us to pay off $275 million of long-term debt. We also repurchased approximately 1.7 million of shares of common stock for $60 million. As Brad said our debt to cap ratio now stands – pardon me at 54% and when adjusting for leases net debt stands at $590 million roughly 60% of just 2012’s EBITDAR of $950 million. Capital spending for 2013 and 2014 is expected to be $460 million and $365 million respectively. We have options that if exercised would increase those amounts, but we would only do so if we felt confident we could meet our return objectives.

And now I’ll turn the call back over to Brad to kickoff the Q&A.

Brad Tilden - Chief Executive Officer

Thanks, Brandon. And at this time, we are ready for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Godyn from Morgan Stanley. Your line is open.

John Godyn - Morgan Stanley

Hey, thanks for taking my question. Brandon, you gave a lot of great detail on demand trends and touched on Hawaii, but I was hoping you or Andrew could elaborate further on what happened with the advanced book factor in January just because it went from up 3 to flat. And also in contrast to some of the risks in Hawaii to what extent are capacity cuts at Virgin America an opportunity?

Brandon Pedersen

Hi, John, good morning, I think I’ll turn that one over to Andrew.

Andrew Harrison

Thank you, Brandon. So, John, it’s a couple of things. Yeah, I think in the mid-December guidance, we had January up three points or so at that snapshot in time. There is a few things moving around, but the big picture, number one is the first half of January we had very strong load factor build, Christmas moving out into the Tuesday, we had a strong demand coming in, in January. And the other thing is we still had grown Hawaii 34% in January and those booking start a lot further out. So, overall we expected to see some decline in the advanced book load factor and we are feeling pretty good about where it stands today. As far as Virgin goes, they have launched some new markets mainly Portland to the Bay and Southern California, but overall outside of that, they have just been humming along with a standard capacity with some good winter trims. And then as I understand it, they have slowed their growth in the future. So, it will be interesting to see what they do going forward.

John Godyn - Morgan Stanley

Okay, great. And just changing topics and maybe back to Brandon, you have emerged as a leader in the industry in terms of returning capital to shareholders and recently up the volume there, I think that’s always major stock a bit more investable than some of your less fortunate competitors. But now as other legacy airlines kind of closed in on distributing cash to shareholders, how important is it to maintain leadership in the amount of cash you are returning relative to the peer group?

Brandon Pedersen

Well, John maybe I’ll start and then Brad can cleanup my mess. I don’t view this as a race, I think your point about us being a leader in that regard is true with something we are proud of, it goes all the back to the 2010 plan on how we wanted to make sure that things were good for all three important constituents, customers, shareholders and investors. And for us what it really comes down to is a balanced approach to deploying capital. And if that makes us the “leader to the pack” that’s great, but I am not necessarily concerned with watching and keeping up with the Jones as if you will. We have a really good track record. And I think it makes a good case for investors to like Air Group stock.

Brad Tilden

Brandon, there is no mess to clean up. I think that’s an excellent answer. John, our basic focus has been to run a good business and then do the right thing in terms of capital allocation. We are proud of what we have done for investors. The important recent change was we went from $50 million share repurchases to a $250 million share repurchase. So, and that’s something we are working on now. So, but it’s a good question of something we look at all the time.

John Godyn - Morgan Stanley

Got it, thanks.

Operator

Your next question comes from Helane Becker from Dahlman Rose. Your line is open.

Helane Becker - Dahlman Rose

Thank you so much. Hi everybody.

Brad Tilden

Hi Helane.

Helane Becker - Dahlman Rose

This is my question. You guys did a really great job last year and it looks like this year it could be more of the same. And then I forwarded this to Chris earlier today, there is this e-mail going around from some of your contractors at Seattle-Tacoma Airport about how you guys are doing well and they are not. And can you just like address that issue I mean they are contracted employee? So, on the one hand, you really don’t have control over them. So, how do you make them understand that and how do you keep them from not delivering a great product to your customers?

Brad Tilden

Hey, Helane, it’s a good question, and we want to do the right thing at Sea-Tac and be a good corporate citizen. Keith Loveless is our General Counsel and he is in the room, he doesn’t always get a lot of questions, but this might be a good opportunity for Keith to speak, because this group is called Working Washington and Keith is leading our internal effort to address these issues.

Keith Loveless

Yeah, I guess Helane I might start by saying that, that we are just super proud of what we have been able to do for our employees through this bonus program. It’s been consistently paying out and we feel like the 13,000 employees are – it’s important that we all be aligned around this. In terms of the working Washington group that issued this press release that to be blunt about it that is a group that is largely organized by SEIU and so we see that as a larger effort by SEIU to organize the contract workers have at the Port of Seattle, not just the ones that work on Alaska airplanes, but also the ones that support the other carriers that Sea-Tac. And as you say we really don’t have a lot of control over that. We do have a lot of control over who we contract with out there and we try to pick good quality vendors that treat their employees right and that have good labor standards as well as safety standards and that have good customer service. And it is unfortunate that they have focused on this but our first obligation is to our own employees.

Helane Becker - Dahlman Rose

Yeah.

Brad Tilden

And Helane you won’t be surprised of this , but we I mean we do understand what our economy needs more than anything right thing now was more jobs and more good jobs. Our philosophy is the best way to do that, the best way to provide more jobs its run a successful business. And so that’s what the 2010 plan was all about, that’s what these five focus areas are all out. That’s why we try to do when we go to work everyday. And we believe that us running this business successfully is the best more good way to provide more good sustainable long-term jobs. So, there is – there is issues we are working with but I think run good path here.

Helane Becker - Dahlman Rose

Okay, that’s great. Thank you.

Brandon Pedersen

Thanks, Helane.

Operator

Your next question comes from Hunter Keay from Wolfe Trahan. Your line is open.

Hunter Keay - Wolfe Trahan

Thanks. Good morning everybody.

Brad Tilden

Hi Hunrer.

Hunter Keay - Wolfe Trahan

Hey, so the Saber agreement you guys singed last summer I believe was full content agreement. So, I’m curious to know how you think you’re going to able to drive traffic to your website. Wondering if it sort of involves like higher ad spend to get people to go there or you are just sort of banking on participating and sort of a broader consumer shift that’s going out of that area?

Joe Sprague

Hi, Hunter, this is Joe from marketing. Yeah, it is a couple of different things and to be clear, we absolutely have a goal of boosting our direct share of bookings at alaskaair.com. And it sorts of with having number one good platform. Over the last two or three years we’ve completely redesigned alaskaair.com. It went from being about the slowest just as one major performance of the site at today being the first or second classes. We measure things on this side much more carefully than we’ve done before. I think we have the most robust testing program, where we are testing how to optimize the selling activities on our site and drive more conversion. I would argue better than any other airline out there right now.

You mentioned sort of page search, we do our share of that and obviously we’re trying to optimize that as much as we can. Personalization is key we’re trying to do some things that appropriately personal experience for customers coming through alaskaair.com, which great helps greatly in terms of repeat business folks coming back to alaskaair.com. We advertise this side generally, so we expand network into new areas folks that’s the best source for them to come for lower fares. And then mobile as been big factor and this as well having our new mobile site to complement our mobile apps and introducing bookings on the mobile apps is helping us to take advantage of this explosion of mobile commerce and of course step is all coming through us direct. So 2012, I think it was mentioned we had our best share of alaskaair.com bookings ever at 54%. And we look forward to boosting that several points higher as been moving forward into 2013.

Hunter Keay - Wolfe Trahan

Okay, thanks.

Brandon Pedersen

Hey, Hunter, it’s Brandon. One more comment on that some of these enhancements don’t necessarily manifest themselves through higher advertising spend, but are really what’s driving some of the increase in IT investment as well we really want to make our mobile site great and takes IT dollars.

Hunter Keay - Wolfe Trahan

Yeah. Thanks Brandon and I will do more on this cash deployment stuff. Just to follow-up from some of the stuff that John was saying. I think investors obviously noticed the buyback, so it’s great. And it’s very differentiated and putting aside competitive concerns from what other guys are doing, let’s just forget that for a second. If you guys look at your free cash flow yield and you look at what you can do on the dividend side, I mean the math is pretty compelling. If you really payout a 25% of your earnings you’re looking at 3% free cash flow yield already factoring in self-funding to CapEx, already factoring in paying off debt maturities. I think one of the reasons Southwest gets a better multiple than everybody else is because they have this very small dividend that passes investor screens. Is there something being said I mean you guys, we talk about all the time, I mean you want to open up your stock to new investors, how do you feel just about the basic concept of opening yourself up to a screen just like being a very, very modest dividend that would still allow you to do all the other stuff you wanted to do?

Brandon Pedersen

Yeah, it’s Brandon. I understand that and I think we get that. What I can assure you is that we talk with our board frequently about capital allocation and we are really proud of what we have been able to achieve. Having said that, there are merits to the argument that you are presenting and it’s not lost on us and that’s something that we think about.

Brad Tilden

Yeah, I agree with what Brandon is saying for a long time there was kind of – if you had cash to return to shareholders, it was kind of a question of do you use that cash to repurchase stock or to pay a dividend. We felt like the returns were better – it’s between those two, the returns were better for investors by us repurchasing stock. I think with the stock price appreciation, that math is getting closer. And I think you are asking a good question that it’s a good issue for the board to wrestle with.

Hunter Keay - Wolfe Trahan

Okay, I appreciate that. Thank you.

Brandon Pedersen

Thanks.

Operator

Your next question comes from Jamie Baker from JPMorgan. Your line is open.

Jamie Baker - JPMorgan

Hi, everybody and hello to Hunter, you beat me on the dividend question. The current pilot contract at American affords very, very liberal domestic code-sharing significantly beyond what the other, your other legacy partners can do. However, the MOU between U.S. Airways and the APA and USAPA meaningfully tightens up the allowance for code-sharing and though I recognize current flying is grandfathered in. I know you don’t want to comment on how much revenue American currently feeds the Alaska franchise, but I am curious when do scope issues like these even impact your business plan, is it a stretch to declare that a standalone American would be a better outcome for Alaska than a potential merger?

Andrew Harrison

Hey, Jamie, this is Andrew. I suppose a couple of big picture, I mean industry consolidation in one way as you look at it has I think helped the industry with capacity discipline and a lot of good things coming from that. So, that might be one part of the question whether there is a standalone or a merger. On the other hand to your point, we have been very restricted with the American code-share agreement historically. And personally, there is opportunity and some things that may come here soon that will be sharing public when it’s ready to help broaden some of this. I think the way I would characterize it is, is that like everything Delta and American are important cogs in the wheel, but they are not the only cog and then not the most important cog, they are actually very much important through the whole thing. So for us personally, there has been a number of areas in our network that I think from a partnership perspective can get better for both careers with its expanded scope in the code-share namely East West stuff and doing a little bit more through their hubs and one of them in particular. So, we are looking forward to that and then we will just take it as we go.

Jamie Baker - JPMorgan

Okay, good. I appreciate that. I wasn’t asking the question, because I thought it would materially derail your profitability, but at the margin it’s something that’s on my mind. So, I appreciate the feedback.

Brandon Pedersen

Yeah.

Operator

The next question comes from Glenn Engel from Bank of America. Your line is open.

Glenn Engel - Bank of America

Few questions. First, your capacity growth is fastest in the first quarter yet you are assuming that the unit cost comparisons get better as the year progresses, what’s going to drive that?

Brandon Pedersen

Hi Glenn, it’s Brandon. There is a couple of things. One is that you are right, well it’s actually the capacity is about flat year-over-year. And in terms of how that affects the unit cost performance, I think you see a lot of that maintenance cost increase that I talked about landing in the first half of the year, and then particularly the first quarter of the year. I think looking out at just off the top of my head I think the maintenance expense number will increase probably around $10 million in the first quarter alone. So, that’s driving that.

Glenn Engel - Bank of America

On the revenue side in the fourth quarter, it looked like December PRASM was down after being up in October-November, why did your numbers get worse in December, it didn’t seem like the industries did?

Andrew Harrison

I think, this is Andrew December PRASM is down marginally mainly driven a little bit by load factor in December, which was down. And the way I would characterize that would be essentially and as Brandon has alluded to, we are still working to finalize our Hawaii seasonality with capacity. And I will tell you most of our regions did very well, but on the load factor front, the new markets in the trans-con that we have just got going in specifically California, Hawaii booked down their load factors. So, overall though we feel very good with the December performance both from a profitability standpoint and then also our trip plan was up significantly. So, no real major aberration there at all, but it was down marginally for the December.

Glenn Engel - Bank of America

Your fuel price, your first quarter guidance and your fourth quarter is running about $0.25 to $0.30 higher than we’ll say U.S. Airways has un-hedged. Why is the gap so wide, it seems even larger than what the hedge premium would suggest?

Mark Eliasen

Yeah, hey Glenn, this is Mark Eliasen. Just a couple of comments on fuel, to answer your question specifically, hedging cost just about $0.10 and the other thing that we have been wrestling with out here on the West Coast is the jet crack spreads or the refining margins have been about $0.09 to $0.10 higher than the rest of the country. So, that’s been another headwind related to that. I guess, more importantly for us fuel is a real important thing for us all the way around, but what we really focus on is how much profit the business produces from the fuel we do use. And I think if you look at The Wall Street Journal, I would say that we are number one among major U.S. airlines in fuel economy. So, we are really focused on that. And I think both airlines about conserving fuel of both to save money and to protect the environment I think in particular I’d give a shout out to our pilots who have done a lot to conserve fuel at both airlines.

Glenn Engel - Bank of America

And finally when I looked at the fleet plan, it looked like you are not going to grow your fleet at all now in 2014, I thought previously you are planning on growing that fleet some, so what changed?

Brad Tilden

In 2014, the plan right now is to have 10 in and I don’t have the investor update in front of me, probably a whole bunch going out. I think the answer to your question is that there is a lot of things moving around in 2014. We have a lot of flexibility. One of the uncertainties right now is what we do with the Combi fleet there is actually five of those airplanes that we want to retire here as sometime in the next two years. The other thing that we have is a whole lot of flexibility with options. And so to say firmly that we are not going to grow the fleet in 2014, I don’t think its right, I don’t think we have decided. I think the bias is to grow as long as we can do so and meet our return goals, but there is a lot of moving parts between now.

Glenn Engel - Bank of America

Actually, the update shows you we are going to shrink the fleet by three in 2014?

Brad Tilden

Yeah, and that reflects the Combi is going out in 2014, there is five of those. We have tentatively packed those to go out in the fourth quarter, but again that’s still moving around.

Glenn Engel - Bank of America

Thank you very much.

Brad Tilden

Well, thanks Glenn.

Operator

Your next question comes from David Fintzen from Barclays. Your line is open.

David Fintzen - Barclays

Hey, good morning everyone.

Brad Tilden

Hi, David.

David Fintzen - Barclays

Maybe a question for Andrew just I think in some past quarters you’ve talked about sort of getting the State of Alaska capacity right, I mean, if we look at some of the DOT data, it looks like you definitely achieved that in the second quarter. And it sounds like the core RASM has been holding up pretty well. I am just curious like kind of how you think about that capacity going forward and are you at a point where you can get back to some growth in State of Alaska ASMs or is that an ongoing sort of need to cut?

Andrew Harrison

So, the State of Alaska is interesting only because the summer is obviously very different than the rest of the year. We are still watching how that carry us load or make decisions about the summer in the State of Alaska. One of the things that I will say core Alaska outside of summer seasonality is not really growing, it’s very static it’s in all of that. Our biggest challenge quite honestly, which may not be a significant to your world is that we have peaks and troughs. And even this Christmas we were too tight and I heard about it. And so we need to add some more flights during certain peak periods of the time. Overall, I would say that we are very comfortable with the State of Alaska capacity. And again there’s just tweaking going on there, but I don’t see any major changes in that as we see here today.

David Fintzen - Barclays

Okay, okay, thanks. But maybe just to follow-up on maintenance maybe for Brandon, you mentioned maintenance is sort of front-end loaded, I mean, if I look back over the last number of years on an ASM basis maintenance, that is down, I mean I think it’s down sort of the team, sort of over the last four to five years. Are we going to – is maintenance cost pressure going be an ongoing theme over the next few years or is there will you get past the first of this year and beginning of this year and that sort of the worst of it for the foreseeable future?

Brad Tilden

David, I think this is the peak, it’s been (in any future) here talking. Yeah, I think this year is a peak with some heavy maintenance visits on our Classics 737s. In terms of going forward, we do plan to level load this thing with power by our contracts on our majority of our Dash 7 engines. So, our goal is to make sure these maintenance costs stay within a tight range.

Brandon Pedersen

Dave, this is Brandon just a follow up as I said in my prepared comments a lot of the increase is lease return provision or lease return expense coming through. We had started accruing for those lease return costs about year out. And so as we look at the number of leased aircraft that are going back in the fourth quarter of this year and then the first half of next year, lost of that expense will hit in 2013. So, it’s really the combination of that, the combination of what Ben has talk with – Ben just talked about offset by some maintenance declines at Horizon. I think it’s also important reiterate what you said in your leading which was maintenance expense has comedown and that really reflects the modernization of the fleet and the great works that our maintenance folks have done to improve their processes and just get much better.

David Fintzen - Barclays

Okay. But it’s not like over the next couple of years, you’re at a point where you start hitting a lot of heavy maintenance on sort of the beginning of that fleet modernization and that becomes a big pressure point?

Brandon Pedersen

Its Brandon again, I’m trying to convince Ben to get rid of those classics…

Brad Tilden

I was just going to say that we get - we started getting more expense on those classics and then ultimately we will get to a point where we have the initial wave of 800s that came in, start to need engine overhauls. But as Ben said we’re looking to various – we are looking into a power by the hour deal to try to spread that cost out.

Brandon Pedersen

You’ve got these figures, but just as a reminder for everybody on the call about 124 737s, 30 are classics, so it’s a quarter of the airplanes that are kind of subject to the tail end of the maintenance cost curve.

David Fintzen - Barclays

Okay, great. That’s very helpful. I appreciate all the color.

Brad Tilden

Thanks David.

Operator

Your next question comes from Savi Syth from Raymond James. Your line is open.

Savi Syth - Raymond James

Hi, good morning everyone.

Brad Tilden

Hi, Savi.

Savi Syth - Raymond James

Just on the Boston market I was wondering if you could comment on some of the new markets that you’ve opened up within the last year and how those are progressing. And also I know this is extremely late stage, so maybe you don’t have any color, but I thought the Boston-San Diego route was interesting and just maybe how that’s looking?

Andrew Harrison

Hi, Savi, it’s Andrew. I think as you might have heard earlier even over 2012 we’ve had 20 new markets, 11 mainline, and nine regional. As it relates specifically to some of the San Diego, I think is what you might be a alluding to. But we’ve had some growth in San Diego, we have had some regional growth in there, while using Horizon Monterey, Santa Rosa and Fresno, we serve Mexico out of there, we serve Hawaii out of there. We’ve been growing that on San Diego-Boston again as in keeping we are there in Portland and Seattle. And really that’s a market where there is no Jet Blue has service there but very much point of sale to the East Coast folks that has no direct service at all to folks living in San Diego. And so we’ve started that. And as you’ve seen Orlando and this is all part of our strategy of balancing you’ve seen us start Philadelphia, you’ve seen us start Salt Lake City, we’ll be starting Salt Lake City markets out of Seattle and also some extra markets out of California. But there all doing as we’ve expected and I will take time to develop.

Savi Syth - Raymond James

How do they compare versus markets in the Pacific Northwest in the sense of, is it greater leisure mix and just profitability in general?

Andrew Harrison

On the Orlando that’s very much leisure mix market and we see that all day long just like Fort Lauderdale from Seattle. On the San Diego-Boston to be determined obvious as we haven’t really we haven’t started that, but we do expect to see some mix of business traffic which is certainly in the Boston marketplaces as well as good leisure traffic.

Savi Syth - Raymond James

Alright.

Andrew Harrison

It’s booking up quite well just to be honest with you.

Savi Syth - Raymond James

Great, thank you.

Brad Tilden

And Savi, it’s Brad. Just to be really clear I would call that a San Diego strategy not a Boston strategy.

Savi Syth - Raymond James

Thanks Brad.

Brad Tilden

Yeah.

Savi Syth - Raymond James

Alright. Thanks guys.

Brad Tilden

Yeah. Thank you.

Operator

Your next question comes from Mike Linenberg from Deutsche Bank. Your line is open.

Mike Linenberg - Deutsche Bank

Hey guys, just two questions here. One, Brandon, when you look at your numbers and whether you look at leverage or coverage ratios, right now Alaska is performing probably the best that it’s performed. And then if you go back 20, 30 years and even profitability etcetera and yet when we go back and we look at how the rating agencies looked at you as a company back in early 90s, in early 90s, you were an investment grade credit on a senior unsecured basis. And you look at a lot of the metrics today and they are a bit higher than what they were back then and yet if I look at just on Bloomberg here, it looks like you are a double B minus on a senior unsecured basis from S&P. What do they tell you now like what do you need to do, you need to get to like a 23% operating margin, I mean, what gets to an investment grade, I just because you are well above what you were back then, what’s changed?

Brandon Pedersen

It’s an absolute mystery frankly and you are absolutely right, maybe I’ll ask Mark Eliasen to chime in on that.

Mark Eliasen

Hey Mike, this is Mark. I will just say that we have a great relationship with S&P and we talk to them frequently. We respect what they have done and they will say right away that their standards have changed over time. They changed over time as a result of issues that happen in 2008, but they have I think respect and admiration for what we have done for the business, our leverage going down, they appreciate. We kept them posted before we did our stock buyback we consulted with them. And I think we have a good dialogue there. One thing that they do point out is that we are a smaller airline and that’s the challenge for us. But I think that they respect our numbers and they put us on a positive outlook. So, we are looking for good things coming forward.

Mike Linenberg - Deutsche Bank

Okay. And I didn’t mean to just take on S&P, I would say Fitch and Moody’s, they sort of all take the same view on the industry, which I don’t know arguably it just it feels like it’s a better industry today than what it was in the early 1990s, but I guess it’s an opinion that they are not on the same page as of yet. My, go ahead…

Brandon Pedersen

Our creditors look at us and they do look at the S&P rating, but they actually put us in a higher category than S&P does and that’s what really counts is the people who lend us money.

Mike Linenberg - Deutsche Bank

Okay, good. And then just my second question I go back, I think it was about a couple of months back, there was a five or six-page press release out between it was from both you and Delta and it talked about a lot of good things going on in Seattle and it talked about the growth of the code share. And it’s obviously been very positive for both of you. And then not too long after that, we see Delta flying from Seattle to Los Angeles, which is obviously important market for you guys. So, I am curious what’s behind that, I don’t know maybe it was just in response to you guys announcing the Seattle Salt Lake service maybe it’s just some funds borrowing between partners what gives there?

Brad Tilden

Mike, it’s Brad. What I would say is that we have extraordinarily good relationship with both Delta and America and there are two domestic alliances or biggest alliances. And I think the partnerships work really, really well. We have kind of a network where we grow, where we fly a lot up and down the West Coast and out of the West Coast. And Delta in particular has all kinds of wide bodies they fly out of Seattle. I think 8 wide bodies a day between Amsterdam and Charles de Gaulle and Narita and Haneda, they are adding and Beijing and Shanghai, so a big picture. It’s an extraordinarily good relationship and we get that what we do in this relationship is we help them fill those wide bodies flying out of Seattle. And then that feed is really important to Alaska, because it helps us justify more 737s flying in places like Seattle-Salt Lake and Seattle-LA and Seattle-New York and so forth. There is once a while in relationships like this, there are little things and you have mentioned a couple of them. And I think there are little things that happened along the edges, but I don’t think we should let them distract any of us from what overall is an exceptionally good relationship.

Mike Linenberg - Deutsche Bank

Okay, fair enough. Thank you. Thanks everyone.

Operator

Your next question comes from Dave Pfennigwerth from Evercore Partners. Your line is open.

Duane Pfennigwerth - Evercore Partners

Still Duane, good morning guys. Dave does sound cooler though I will admit. Just a couple of quick ones for Andrew, historically how much does an earlier Easter help March PRASM?

Andrew Harrison

So, yeah this year, it’s moving to the Sunday on the March 31. For us Duane, it’s not a huge change basically the schools in the Pacific Northwest are sort of staying put there vacation time, its California that moves. So us personally with this week earlier, we don’t believe it’s going to be a major impact on our first quarter results, that’s out there.

Duane Pfennigwerth - Evercore Partners

Okay thanks. And then just you may have touched on this, but just in terms of sort of system competing capacity trends in the March quarter versus what you saw on 4Q, and maybe you could comment on the State of Alaska and Hawaii specifically?

Andrew Harrison

So, looking forward, I look forward to a couple of months – excuse me a couple of quarters as you know industry capacity changes for the summer going forward. But looking forward, we see certain pressure in some of the Pacific Northwest to the Bay and Southern California. We see a little bit of pressure in the Bay area to Mexico, but overall on a weighted average, competitive capacity in our markets is marginally down over the next few quarters. So, we see that fairly stable there. I think you mentioned the State of Alaska, I think we have our summer schedule out there right now. We are going to be up just a little bit, but again overall no major changes there.

Duane Pfennigwerth - Evercore Partners

Okay, thanks very much.

Brad Tilden

Thanks Dave.

Operator

Your next question comes from Kevin Crissey from UBS. Your line is open.

Kevin Crissey - UBS

Hi, thank you for taking the question. So, maybe through Andrew/Joe here, I am not sure, but if I think if a flight is not booking up well, it seems that the industry responses to start lowering fares, but that doesn’t necessarily have to be the issue where you could just not be getting enough attention to your website to sell your product, it wasn’t the price that was the sticking point, it was the overall traffic to your selling source. Kind of when I think about it what an OTA does, they might buy more, get more attention on Google or however they want to do it. How should we think as you grow your web direct, how should we think about how your website and that strategy fits in maybe with your revenue management process? Thank you.

Joe Sprague

It’s a good question Kevin, this is Joe. And I would say Andrew’s team and the marketing team were closely together in a number of different areas and this is a particularly key one. I mentioned earlier that our share of bookings at alaskaair.com has grown substantially over the last couple of years. And one of the fun things to track is how much it spikes up whenever Andrew’s revenue management team does do a fair sale and then we get out and really promote that sale. It has a very direct impact obviously on our alaskaair.com bookings. We try and help that process along. And especially as we are sort of going into some new markets whether it be Hawaii or some of the other California new markets, the nice thing about sort of online bookings is that we are able to target our advertising very, very directly. So we can deal target whether its online advertising or the actual search results that would produce a direction for a consumer to come to alaskaair.com.

And so we are spending a bit more on page search, but we are also targeting it pretty aggressively more so than we have done in the past. Then the other thing just sort of general advertising and promotion we are doing a lot more to raise awareness in new markets, both of our new service, but also of alaskaair.com in particular being a great source for those low fares for that new service. So, as we go our customer base, we get people sort of joining the mileage plan. We had big increases in mileage plan membership the last year that allows us to also communicate directly with those customers. We do a lot of e-mail marketing to customers that we have in the database and then also as sort of a channel to shift people directly to alaskaair.com.

Kevin Crissey - UBS

Perfect. Thank you for that.

Operator

Your next question comes from Steve O’Hara from Sidoti. Your line is open.

Steve O’Hara - Sidoti

Hi, good afternoon or good morning.

Brad Tilden

Hi Steve.

Steve O’Hara - Sidoti

I was curious just about the, I guess restructuring of the Horizon business and making it a branded regional. And I am just wondering in terms of maybe the benefits and the costs of having it in in-house regional versus a partner like SkyWest. I mean, what do you gain by having the in-house regional? What do you lose by having it? And then do you ever look at the possibility of either selling that business or spending it all?

Brad Tilden

Yes, Steve I think maybe just first pause and backup a couple of steps. Horizon has gone through a lot of changes in the last five or six years, but a lot in last couple of years. And you know about the branding stuff, there have been efforts to get some of their costs down to lower levels. A lot of the back office stuff that isn’t completely visible to people outside the company, but back office functions have been hugely streamlined. So there is one team working on all of these functions instead of two. And on other calls we’ve talked about the tremendous job that Glenn Johnson and his leadership team have done. And I look at it and I just I see a lot less effort happening for the two companies and I see regional business its producing $100 million a year of pretax profit. So, it looks really good, your specific question about spinning off Horizon or having someone else do that for us. I think where we look at that is we’ve got something that if we can do it ourselves and make it work well that’s what we wanted to do.

And we feel that it is working well, Horizon has the Q400, there is not a lot of those flying and flown in the United States. It’s a tremendous airplane for the markets what we’re using it kind of shorter stage lengths from Seattle and Portland and so forth, it’s a tremendous airplane. And Horizon has a lot of know-how with that airplane and also a great – our long tradition of providing great customer service. So, it’s profitable, it’s producing good returns on capital, it’s meeting our objectives and we like – we like the current setup.

Chris Berry

I am sure we have time for maybe one more question here. Okay, Steven, so you got another follow up there.

Steve O’Hara - Sidoti

And almost done. Thanks.

Chris Berry

Thank you.

Operator

Our final question in queue is from Hunter Keay from Wolfe Trahan. Your line is open.

Hunter Keay - Wolfe Trahan

Hey, Thanks a lot for the follow up, do you guys disclose what variable incentive pay would be at baseline target this year?

Brandon Pedersen

At target baseline and incentive pay for PBP and OPR is right around $60 million.

Hunter Keay - Wolfe Trahan

Again, okay cool, thanks. And one for Andrew, Andrew as you talked about some adjusting some of the schedule in certain Hawaiian markets. Obviously you can’t down gauge, I don’t think you are going to be taking dots off on the map any time soon. Have you even thought to maybe sort of moving departures around a complement Allegiant in markets where you guys compete? So, they take them out there, you’re taking back or something like that given the fact that some of the markets are very, very low frequency markets?

Andrew Harrison

Sure. So, a couple – to you point Hunter a couple things on Hawaii is, yeah, with legend coming in and doing two or three a week that we get them bring back or whatever. Big picture here is Hawaii is extremely sensitive to the time of the day of the departure and of the West Coast its 9, 8, 9, 10, 11 in morning. Really what we’ve done is looking at the outer islands like (indiscernible) and you are going to see already in the public booking system there that we are going to split Oakland and San Diego, (indiscernible) to go three to four times a week each of those cities and so. That’s what where we are doing half of ou8r capacity is in the Pacific Northwest, the other roughly is in California. And so what are showing is there is not taking dots off the map to your point. But we are going really match supply with demand because Hawaii is extremely seasonal especially in California. And we are just going to be more focused on that going forward and perhaps we have been.

Hunter Keay - Wolfe Trahan

Okay, thank you again.

Andrew Harrison

Thanks, Hunter.

Operator

I have no further questions in the queue. I’ll turn the call back over to Mr. Brad Tilden.

Brad Tilden - Chief Executive Officer

Alright, thanks everybody for joining us today. We look forward to talking with you again next quarter. We’ll see you.

Operator

Thank you for participating in today’s conference call. This call will be available for replay beginning at 4 o’clock Eastern Standard Time today through 11:59 PM Eastern Standard Time on February 24, 2013. The conference ID number for the replay is 37716850. The number to dial for the replay is 1 (800) 585-8367 or 1 (404) 537-3406. Also, the call will be accessible for future playback at www.alaskaair.com. Thank you. This concludes today’s conference call. You may now disconnect.

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