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Alaska Air Group, Inc. (NYSE:ALK)

Q2 2010 Earnings Call

July 22, 2010 11:30 a.m. ET

Executives

Shannon Albert - IR

Bill Ayer - CEO

Brandon Pedersen - CFO

Brad Tilden - President

Glenn Johnson - President, Horizon Air

Joe Sprague - VP, Marketing

Andrew Harrison - VP, Planning and Revenue Management

Jay Schaefer - VP, Finance

Analysts

Bill Greene - Morgan Stanley

Hunter Keay - Stifel Nicolaus

Jamie Baker - JPMorgan

Duane Pfennigwerth - Raymond James

Michael Linenberg - Deutsche Bank

Helane Becker - Dahlman Rose

Dan Mckenzie - Hudson Securities

Jim Higgins - Soleil Securities

Glenn Engel - Bank of America/Merrill Lynch

Kevin Crissey - UBS

Steve O'Hara - Sidoti & Company

Operator

Good morning, my name is Melisa and I'll be your conference operator today. At this time I would like to welcome everyone to the Alaska Air Group Second Quarter 2010 Earnings Conference Call. Today's call is been recorded, and will be accessible for future playback at www.alaskaair.com. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session for analyst and journalist. (Operator Instructions). Thank you. I would now like to turn the call over to Alaska Air Group's Managing Director of Investor Relations, Shannon Albert.

Shannon Albert

Thanks, Melissa. Hello, everyone and thank you for joining us for Alaska Air Group's second quarter 2010 earnings call. Today Alaska Air Group's CEO, Bill Ayer, will provide a company overview; CFO, Brandon Pedersen will talk about Air Group's financial position and the Presidents of our two operating subsidiaries, Brad Tilden and Glenn Johnson will comment on the financial and operational performance, and future initiatives of Alaska and Horizon. Other members of the senior management team are also present to help answer your questions.

Today's call will include forward-looking statements that may differ materially from actual results. Additional information on risk factors that could affect our business can be found in our periodic SEC filings available on our website. Our presentation includes some non-GAAP financial measures and we have provided reconciliation between the most directly comparable GAAP and non-GAAP measures in our earnings release.

This morning, Alaska Air Group reported a second quarter GAAP net profit of $58.6 million. Excluding the impact of mark to market adjustments and connection with our fuel hedge portfolio, and CRJ transition cost at Horizon, Air Group reported an adjusted net profit of $84 million or $2.29 per share. This compares to a first call mean estimate of $2.12 per share and to the last year's adjusted net profit of $26.5 million or $0.72 per share. Again excluding unusual items Air Group reported a year-to-date profit of 97.1 million or $2.65 per share compared to a 1.1 million or $0.03 per share for the first half of 2009.

Additional information about expected capacity changes, unit cost, fuel hedge positions, capital expenditures and fleet count can be found in our investor update included on Form 8-K and available on our website at alaskaair.com.

With that I will turn the call over to Bill Ayer.

Bill Ayer

Thanks Shannon and good morning everyone. Before we get into the quarters results I want to talk about the leadership changes that we recently announced. After eight years at Horizon helm and more than 28 years in various positions at both Alaska and Horizon Jeff Pinneo has retired as Horizon's President and CEO. Glenn Johnson who formerly served as Alaska Air Groups Chief Financial Officer has replaced Jeff as President of Horizon.

That filling Glenn's role is Brandon Pedersen who many of you already know through his roles in finance and investor relations. Jeff took the CEO at Horizon just a few months following 9/11 and help them navigate through some of the industries most challenging years. He led the company as it made substantial improvements and operational performance and customer satisfaction.

And speaking for all of us here let me see how grateful I am for all that Jeff has accomplished and the legacy he has helped build over all these years.

Glenn Johnson has spent 12 of his 28 years at Air Group overseeing finance and then customer service at Horizon. That background combined with his most recent roles running Alaska's operations and finance organizations gives Glenn the experience and perspective to continue the transformation of Horizon.

Glenn will talk about those plans in a moment. And finally Brandon Pedersen CFO replacing Glenn, Brandon joined us in 2003 and is well prepared to take on this expanded role. Like, Glenn and Brad before him, Brandon has committed to the same conservative financial principles that have differentiated us for many years and to achieving an acceptable long term return for investors.

I have the utmost confidence in Glenn and Brandon and the fact that we can make this type of leadership change from within our own ranks is a result of the focus we placed on developing people over the years and it's truly an honor for me to work with so many talented and dedicated leaders at both companies.

This quarter's results represent Alaska Air Group's best adjusted quarterly profit in our history. Our results were driven by higher load factors, improved pricing, bag fee revenues and good cost control partially offset by higher fuel cost.

For the third year on a row J.D. Power and associates ranked Alaska airlines highest and customer satisfaction among traditional network carriers in North America.

Brad will talk more about this in a minute but I want to express my thanks to all employees for consistently providing the kind of customer service that has earned this recognition.

And last week Alaska Airlines was named number one among legacy airlines worldwide in Aviations Week's Annual Top-Performing airline annual study. Their report notes the benefits of been smaller and more nimble and highlight some of the things that we have been working on for sometime such as taking a long term view of the business, focusing on a few key areas and executing well. Aviation Week's recognition is attributed to our entire team including our supervisors, managers and other leaders in Seattle and throughout our system. Our ability to set aggressive goals and make the changes required to achieve them are core to our success and we will continue to build those capabilities.

While we are well aware of the risks in this industry we are optimistic about our future. We're seeing the result of the virtuous cycle among employees, customers and investors that we talked about when we laid out our Alaska 2010 vision back in 2003. We have an engaged hardworking employee group that is providing an outstanding travel experience for our customers. This quarters record financial performance gives us confidence that together we can achieve even more.

And with that I'll turn the call over to Brandon.

Brandon Pedersen

Thanks Bill and good morning everyone. A pleasure to be speaking with you today and my new capacity. As Shannon said, Air Group reported an adjusted net profit of $84 million for the quarter, compared to a $26.5 million net profit last year, an improvement of more than $55 million after tax and $91 million on a pre-tax basis.

Our results translate to a 13.8% consolidated pre-tax margin and a 12 month return of 8.3% on a $3.5 billion base of invested capital. Depending on how the year shapes out and I'll be quick to see that is not earnings guidance, we may very well hit our goal of a 10% return on invested capital.

We're proud of the progress we have made toward that goal. It's the result of the hard work and commitment of many dedicated employed and we are enthused about the results. At the same time I want to reiterate that Air Group's goal is a 10% return over the business cycle which means that in good years we'll need to generate 12 or 13% returns to offset returns for weaker years in the cycle.

The $91 million improvement in our pre-tax result was mainly due to a $133 million or nearly 16% increase in revenues offset by a $50 million increase in our economic fuel costs. First bag fee revenue which was new in the third quarter of last year accounted for more than $25 million of the revenue improvement.

We originally estimated that the First bag fee would generate $70 million of incremental revenue annually but in the years since it began we have collected $98 million. Ancillary revenue per passenger which includes bag fees and is an important metric for this years PBP incentive payout totals $11.13 per passenger for the first half of the year.

And speaking of incentive pay, we have accrued nearly $40 million year-to-date or half of our expected $80 million annual expense. Last quarter Glen told you that we were tracking to $72 million. So we've seen a bit of an increase that has negatively impacted costs. However because we have six months of financial results in the book and have better visibility to the operational and cost metrics, significant upward adjustments that would impact our cost guidance are not likely at this point unless we're able to reach agreements to add Horizon's pilots and mechanics and Alaska's customer service agents to the PBP program.

The $50 million increase in our economic fuel cost was mainly due to the higher average cost of oil this year. On a raw or un-hedged basis however our fuel costs increased $64 million or 40% which serves as a reminder that the impact the volatile crude oil prices can have and despite the recent price stability, this reinforces our conviction that our hedge strategy of using all caps to hedge 50% of our planned consumption is the right one.

Turning to the Air Group balance sheet, we closed the quarter with cash and short term investments totaling just under $1.3 billion. That puts our cash at 35% of trailing 12 months revenues, which remains among the strongest in the industry. We generated $334 million of operating cash flow during the first half of the year, up from $123 million last year on the higher profit and much stronger advance ticket sales.

Our free cash flow potential for this year is significant, given the improving financial results, $230 million of expected depreciation add back, and the lowest amount of CapEx since 2004. Cash generated from operations was offset by $108 million of capital spending, $27 million in share repurchases, and $131 million of debt repayment including $55 million of prepayments.

We talked before about our desire to bring our cash balance down to 25 to 30% of revenues, and our intent to prepay $200 million of long-term debt by the end of 2011. In light of the potential for more free cash flow than we had anticipated, we're planning to have a conversation with our Board about various alternatives for getting to our target.

During the quarter, we completed the $50 million share repurchase program that was authorized last year, and in June our Board approved a new $50 million repurchase program reinforcing our ongoing commitment to provide a return to investors. We now expect 2010 capital spending to be $210 million slightly higher than the $203 million that we originally planned.

We recently exercised options for two Boeing 737-800 airplanes to be delivered in 2012. With the firm orders currently on the books, we should have 114 737s through 2011, which is one less than we had at the end of 2009 and two fewer than we have today and growth of four units in 2012.

While it's too early to give guidance for 2011, we can say that annualizing our current schedule would result in ASM growth of approximately 3 to 4% at Alaska next year. And the new aircraft in 2012 would represent about an equivalent amount of growth. Glenn's comments today will focus almost exclusively on his vision for Horizon, so I want to take a moment to acknowledge Horizon's results for the quarter.

On an adjusted basis, Horizon posted a profit of $8.2 million, their best second quarter since 2006. Those results exclude a $3.4 million pre-tax charge related to one CRJ that we sub-lease to another carrier. We're planning to dispose of an additional four RJs during the third quarter, and expect to record a charge in the 7 to $9 million range.

As we accelerate our transition to an all Q400 fleet, we will likely incur additional cost in coming quarters including cost-related to CRJ disposal, furloughs and other expenses. We will keep you updated as we know more.

Now over to Brad.

Brad Tilden

Thanks Brandon and good morning everyone. As Bill said this was a great quarter for Alaska Airlines, and we received some important extra recognition for activities that have been underway for six or seven years. We received the JD Power Award for the third year in a row, and margin between us and the number two carrier was the largest it has been in the three years. And the top performing airline award from AviationWeek is great recognition for leaders throughout the company that are working so hard to position us to compete successfully in this new environment.

Those of you that don't follow this award closely, we are honored to have taken over the top spot from Singapore Airlines who ranked highest for the last five years. We cannot be more proud of our people and those at Horizon Air who help us serve our common customers everyday for these accomplishments.

For the quarter, Alaska Airlines reported a record, adjusted pretax profit of $128.1 million, compared to a profit of 44.9 million in 2009. This represent a pretax margin of 14.7% compared to 6% last year. Alaska's mainline passenger revenue increased by just over 100 million this quarter or about 17% due to a passenger unit revenue increased up 11.6% and 4.4% more capacity.

The passenger RASM increase was a function of 4 point improvement in load factor and a 6% improvement in yield and the increase in yield is due to both bag fees and ticket prices.

Looking into the individual months passenger RASM increased by 11% in April, by 13% in May and by 11% in June. And all PRASM increase compares with increases for the domestic industry of 10%, 14% and 18% for those same 3 months.

You may recall that we outperformed the industry by 9 points in the second quarter of 2009. So, we are extremely pleased to have a kept pace as well as we did this quarter, especially given the fact, that we added a lot of low RASM flying and long staged linked markets like Hawaii . In fact, if you compare our passenger unit revenue, the second quarter of 2010 to the second quarter of 2008, we were up 6% whereas the industry was down 2%. So, we outpaced the industry by 8 percentage points over this time period.

The above and beyond efforts of our people on the frontline and operations in customer service positions and the network planning, revenue management and marketing are all reflected in this numbers.

Nearly everyone of our regions posted unit revenue increases and we saw particular strength in the Southern California, Bay Area and Mexico regions, where our schedule pull downs have been most pronounced over the last couple of years.

As we continue to refine our networks, we are launching a number of new markets in the next few months. In the third quarter, we are inaugurating service to St. Louis from Seattle and we are starting service between LAX and San Jose and between Portland and Honolulu.

In the fourth quarter, we started service between San Diego and Maui and we will also add Portland-Kona and San Diego Puerto-Vallarta service. In March of 2011, we will start this service between Lihue on the Island of Hawaii and both Oakland and San Jose. Network changes like these have helped to diversify our revenue base and reduce the seasonality of our business.

Importantly, our fleet and invested capital do not change as a result of this new flying and we expect Alaska's mainline ASM growth to be 7% for the third quarter, 9% for the fourth quarter and 5% for the full year, which is within the range of our previous guidance.

Horizon's full year capacity is expected to be down 1 to 2% which will result in a consolidated capacity increase of 4% for the year. Alaska's total departures will increase by less than 1% for the year and will remain 10% lower than 2008. Alaska's July advance booked load factor is up 3 points, August is up a point and September is up half a point.

Yield trends are positive, and we are continuing to see business demand return as evidenced by an increase in revenues in the middle fare classes and in the first class cabin and effective June 16, we made some small changes to our fee structure which included increasing the first bag fee from 15 to $20, tightening our bag service guarantee from 25 to 20 minutes. We estimate that these will produce about 30 million in incremental annual revenue.

Turning to costs, we ended the quarter with CASM X fuel of $0.000779 down about 5% year-over-year on a capacity increase of 4.4% and in line with our initial second quarter guidance in spite of higher than expected incentive pay accruals. For the rest of 2010, we are still forecasting full year CASM X fuel of between $ 0.000709 and $0.08 which represents a decrease of about 4% from 2009.

We're making very good progress on the productivity and overhead initiatives we talked about over the last couple of quarters. Each of our operating divisions has aggressive targets and our leaders are doing a great job executing against these plans.

At this point I'll turn the call over to Glenn.

Glenn Johnson

Thanks Brad and good morning everyone. I'm pleased to be joining you in my new role as President of Horizon Air. Because our results and guidance are already outlined in this morning's 8-K, I'm going to forgo the usual overview and spend a few minutes talking about my vision for Horizon.

Horizon has many strengths, including our safety record, our reliability and on-time performance, our customer satisfaction loyalty and our outstanding highly committed employees. The one area where Horizon hasn't delivered acceptable results is profitability. Well we're making progress. As this quarter's result indicate, we believe we can and must deliver a 10% return on invested capital at Horizon, matching the goal for Alaska Airlines and Alaska Air Group.

For the 12 months ended June 30th, Horizon's rate was 5.1% and although we have considerable work to do, I'm confident we can achieve the target. To continue closing the gap and to accelerate the pace of the improvements, Horizon's leadership team is evaluating our current business model in determining the changes that will be necessary to make Horizon successfully financial, for the long-term.

Let me just remind you of the number of efforts that we already have underway. First, we're focused on completing the transition to an all Q400 fleet. Our plan calls for us to replace our remaining 13 CRJs, with eight Q400s, which will leave us with a fleet of 48 Q400s. When we finish that transition, we will have reduced our invested capital by approximately $100 million between aircraft and inventory, thus saving about $9 million per year in expense.

As we transition to the single fleet type, we're working closely with Bombardier to improve the Q400s reliability and we're considering the addition of several new line maintenance stations to better support the expanded Q400 line.

Second, we're committed to achieving market level maintenance and pilot costs. We solicited this from a number of U.S. vendors, a heavy maintenance work and confirmed this is a significant savings opportunity. We're now engaged with the IBT which represents our mechanics to determine whether we can realize the same levels of savings within our current framework.

If not, we'll transition this work to a highly-experienced U.S. based vendor, always of course with robust, industry living standards and oversight to ensure the highest level of safety. For many years Alaska Air Group has used vendors to perform most heavy and other specialized maintenance with excellent results.

On the pilot side, we recently announced an agreement in principle with the IBT on a new contract. The Company and the Union are continuing to work together to translate that agreement in principle into a tentative agreement which will then be voted upon by the pilot crew.

Third, we are looking at all areas where Horizon and Alaska have similar functions to identify duplication. We had good success in transitioning several backup as functions into what we call shared services. While remaining two legal entities with two operating certificates, we are actively evaluation which operational areas we can also consolidate.

Finally, we are considering a change in the mix of capacity purchase agreement or CPA versus brand flying that Horizon does. As you know, Horizon has a hybrid model where about 45% of our ASMs are sold to Alaska Airlines in an industry standard CPA deal, and about 55% is brand flying, where we bear the revenue risk and the passengers coming to Alaska, we earn a pro rate of the joint fare. Over the last decade or so, an increase in portion of Horizon's flying has been dedicated to Alaska, and our aircraft have been well suited for complementing or substituting for Alaska on certain routes. That flying coupled with our past and possible future expansion into geographical areas that are not traditional Horizon locals such as California, Arizona and Mexico.

It's causing us to take a fresh look at the cost versus benefits of maintaining the Horizon from an external perspective. We anticipate reviewing our valuation at the Horizon business model with our Board during the third quarter. At this point, I'll turn the call back to Bill.

Bill Ayer

Thanks Glenn, and let me just once again congratulate the employees at both airlines on a great second quarter. With that we're ready for questions.

Question-and-Answer Session

Operator

At this time I would like to invite analyst and journalist who would like to ask a question (Operator Instructions) Your first question comes from Bill Greene of Morgan Stanley.

Bill Greene - Morgan Stanley

Yeah. Good morning, so you got some impressive margins and the way I sort of think about this is that margins like that can often attract competition, so how do you think about what you should do going forward? How do you get them even better than almost that peak, and how do you make sure you're not subject to increase in rates from competitors as they look at your margins and say we need some?

Brad Tilden

Hey Bill, this is Brad. It's like a great question. We will tell you we are spending right sometime right now on our -- I think many of the analysts are familiar we have that strategic flying which we called our 2010 plan, and we are working right now on the extension of that strategic plan. And important part of that is competition about our market position, and one of the things that we're thinking about is what do we do over the next two, three, four, five years to ensure that we are positioning ourselves as the airline that offers the best value or really good value on the West Coast of the United States, great value to all of our customers. Now I guess, I might the high level answer to your question is I think that principle is the principle that's going to help ensure that we have an answer to the LLC that maybe attracted to our markets that have this good margins.

Bill Greene - Morgan Stanley

And so what are some of the things that would be considered I'm not sure I quite understand what you would do?

Brad Tilden

To continue to enhance the margin?

Bill Greene - Morgan Stanley

Yeah.

Brad Tilden

I guess I would say and this is just my thinking, but on the revenue side we need to -- we -- I think we're flying at 86% load factor in the month of July, month to date, there is probably some opportunity to continue to push the load factor up a little bit. We do have a mindset about the fare that there's probably our limits to how high this fare, Bill we're still in a position where we can tell our customers that we are offering them great value. So, load factor is an opportunity, fare is maybe some opportunity and then part of the story of Alaska Airlines and Horizon Airlines over the last decade is been every year looking for ways to make our businesses more efficient, so that we can offer these low fares and still provide great returns for our investors.

Bill Greene - Morgan Stanley

Okay.

Bill Ayer

And Bill, this well I might just add that at the end of the day it's really the customer who decides success, margins and all of those things, and so one of the advantages that we've been talking about for sometime is the fact that we are smaller and more nimble, and we've demonstrated that with all other market changes, network changes that we've made and being more in touch with customers.

So we have lots of opportunities and take advantages of those opportunities to talk to our customers, survey them, respond to their needs, and I think we can move a little bit faster than some of the bigger carriers, maybe we can understand a little bit better what customers care about, and as Brad says, really addressing this customer value notion and working to improve, continually improve the value that customers foresee when they fly on Alaska or Horizon.

Bill Greene - Morgan Stanley

Okay, you also -- Brandon you mentioned uses of cash, what sort of -- aside from I guess the obvious, is there anything else that would be on the table, I guess buyback dividends or reinvestment, but you mentioned that you were sort of looking through that. How do you think about that, is there any color you can add?

Brandon Pedersen

Yeah, it's -- I think it's personally it's a high quality problem to have and as I mentioned we'll be talking with our Board about this over the next quarter or so, I think you named the things that would be likely, you've got continuing with repurchase, you've got repayment of long-term debt, you've got investing in other opportunities. There is lots of things out there, and we'll be talking about each of those.

As you know we've talked about our plans to prepay $200 million over the next two years or so, or a year and a half I guess, from this point on that will reduce negative carry, having lower debt is good for shareholders. It's all about thinking about things that we can do with that cash that are good for our shareholders over the long-term.

Bill Greene - Morgan Stanley

All right, thank you for the time.

Operator

Your next question comes from Hunter Keay of Stifel Nicolaus.

Hunter Keay - Stifel Nicolaus

Thanks, good morning.

Bill Ayer

Hi Hunter.

Hunter Keay - Stifel Nicolaus

I'm not sure if you guys saw a while back, you know about a month or two ago, but Hawaiian Airlines actually cut it's PRASM guidance's, is there is a read through here, I mean, I know you guys compete in slightly different markets, but are you causing that weakness for them? Do you think you're taking share from them, or are you actually seeing maybe a little bit of weakness yourself, how did that actually -- how you guys reading that?

Brad Tilden

Hunter this is Brad, I'm not sure we can comment on Hawaiian, but I would say that our Hawaii business has been very, very good. We are ramping up; we are going to be at 108 flights this winter a week, fifteen and half a day or something like that. Our results have been good, certainly the share has -- I don't have the exact figures in front of me, but the share has shifted a lot over the three years in Seattle.

We're going to have six and a half flights a day to Hawaii this winter, so I think that's 60 or 70%, 60%-65% share or something like that. But I don't know that we can comment on Hawaii on Hawaiian's results.

Hunter Keay - Stifel Nicolaus

Yeah, okay that's fine. And I've been sort of reading the cruise liners up in Alaska are getting good pricing, but weak volumes, simply that kind of presents a sort of a worst case scenario for the airline segment of the trip, are you guys feeling pretty optimistic as you move into the cruise season here that you are seeing what you need to see in your Alaska cruise line markets?

Joe Sprague

Hunter this is Joe Sprague from marketing. I -- you know the cruise line has pulled some capacity out of Alaska this summer, and we were aware of that many months ago, there is some new airline capacity up there this summer as well, but I think we've adjusted to that and adjusted to what we knew in advanced was going to be softer demand in Alaska this summer.

On the flipside, we are actually seeing some strengthening in independent tourist, so the folks that are going up to Alaska separate from the cruise lines and seeing that in hotel occupancy and other indicators up there. So I think it's actually turned out as good as we can hope for this summer.

Hunter Keay - Stifel Nicolaus

That's good, I think if you just can one more. Help me understand a little bit, this Delta code-share relationship. Is Delta actually free-selling tickets on your medal a good thing? I mean, I know that Delta wants to ramp up it's reliance on fee that you guys are feeding SeaTac, is that P&L accretive, is that a good thing maybe collecting a portion of revenue or maybe a commission, I mean, if they do want to turn that up, would it be better for you guys to have those sell yourself. I mean do they the ability, I know you guys don't want to talk about this specifics of the agreement, but is Delta ramping up it's reliance on you for feeding SeaTac good thing for your P&L?

Andrew Harrison

Hi, Hunter, this is Andrew. The whole the Delta relationship has continued to evolve and as you have seen, we are flying to Atlanta now. I think what we would say is that we found the relationship to be a very positive one, we found that we have been able to work well with them to move out passengers that are in our markets of strength, across the country into their network and vice versa. And also the volume of passengers that they put on us, up and down the West Coast, I think is also helpful. We need to continue to make sure we watch our revenue management and what we sell and what we don't sell and all that complexity. But I think today, we would say that we are very happy with how things are going.

Hunter Keay - Stifel Nicolaus

Okay. I appreciate the colors. Thanks very much and good quarter.

Andrew Harrison

Thanks Hunter.

Operator

Your next question comes from Jamie Baker of JPMorgan.

Jamie Baker - JPMorgan

Hey, good morning everybody.

Bill Ayer

Hey, Jamie.

Jamie Baker - JPMorgan

Question, I guess for Brad on the mainline network. Regrettably and actually, old enough to remember when you didn't fly to Mexico. And the network was much more seasonal, obviously than it is now. And Mexico was obviously a great way to balance, demand year around. Boeing, NextGen's then made Seattle east-west flying a possibility, so we saw some more network shifts there. And obviously, in the last year's so the NextGen's have been improving pretty capable to-and-from Hawaii. So, I guess, my question is what's left from here. There are obviously, a number of larger cities who don't serve in the lower 48. Should investors be thinking longer term about an additional fleet type and international flying at some point? Is that simply the only maturations step that's logically left?

Brad Tilden

And, maybe I can start Jamie on that. I think, there is much more we can do domestically at both companies. And we think that single fleet type is absolutely the way to go in terms of efficiency. We love the 737-800 at Alaska and we think the Q400 is the right airplane for Horizon. So, with that fleet, we think that there is lot we can do.

And the international part of this, I think, is going to be, more domestic itineraries on international, domestic trips on international itineraries connecting to our partners. And we are really pleased to see Delta do the Beijing and Osaka, and who knows what else would happen off the West Coast to Asia, with all our partners that we can connect to. So, there is no limit as we look out there to what we can do and we certainly pleased with the results obviously and we do like this S Curve notion that we've seen happen in Seattle in some degree, and Portland and maybe there is opportunities for more of that, In other words, we are not just flying airplanes between point A and point B but a strategy that focuses on a particular city and builds market share and presence, gives us an advantage. And so longer term, there is obviously more of that we can do.

Jamie Baker - JPMorgan

And would you ever be tempted to explore the current model, off the West Coast to another focus area in the lower 48? Or is the model just too heavily predicted on the West Coast dynamics that are unique unto themselves.

Brad Tilden

I think it depends on the time frame. I think there is probably a logical sequence of things over many, many years, and I think there's just lots we can do and then those are the things we'll be talking about as we, as Brad mentioned in the longer term strategic plan, the next 10 year plan we'll be looking at various opportunities.

Jamie Baker - JPMorgan

All right, terrific. Thanks, thanks very much and congratulations.

Brandon Pedersen

Thanks Jamie.

Operator

Your next question comes from Duane Pfennigwerth of Raymond James.

Duane Pfennigwerth - Raymond James

Hi, good morning.

Bill Ayer

Hi, good morning, Duane.

Duane Pfennigwerth - Raymond James

I wondered if you could share with us total capacity and competing capacity as you define it for the relevant markets for June and the September quarters.

Andrew Harrison

Yes, this is Andrew, Duane. Things are going to be a little bit tough for us going forward. I think in the second quarter, competitive capacity in our markets was down about 4% on the mainline and in Q3 and Q4 we expected to be up about 2%. Big reason for that is many carriers are annualizing their cuts. And also we've seen a lot of; I think 18 to 20% increasing capacity up to the Alaska long haul in the State of Alaska this summer. So it's not huge but here and there, the increased frequencies here and there saw about 2% additional pressure on that network from other airlines.

Duane Pfennigwerth - Raymond James

Thank you for that detail and bearing that in mind, are you seeing that impact in your forward book yields?

Andrew Harrison

We don't, we want to sort of comment on the yields per se but what I think I will say is that as we look forward at our traffic and at loads, what we are seeing is that especially over the last six or eight weeks we continue to see a three to four point increase in traffic booked over our capacity both within the next 120 days and beyond. And also even as I look out into October, we're very happy with what we're seeing as far as helping the buildings. So right now in our unit revenue trends we're not seeing anything that is hugely alarming.

Duane Pfennigwerth - Raymond James

Thanks very much.

Brandon Pedersen

Hey Duane, it's Brad. I might just jump in. Capacity looks like it's up 2% in our markets in the third quarter but we're looking at a reform right now that just shows the competitive frequencies hub by hub. So Seattle, Anchorage, L.A. and Portland and it is as stable as I can remember it being in a long, long time but city by city there's a whole lot of zeros on this report. So it feels like a pretty decent competitive environment we're going to have for the next little bit.

Duane Pfennigwerth - Raymond James

Thank you.

Operator

Your next question comes from Michael Linenberg of Deutsche Bank.

Michael Linenberg - Deutsche Bank

Oh, yes. Hey, just a couple of questions here. I guess with respect to some of the debt prepayments, Brandon, that you had talked about, I think it was something like 50 million plus, may be in the last quarter or so. What -- are you buying that back at par or are you actually getting a break and maybe even being able to buy it at discount?

Brandon Pedersen

Hey, Mike, it's Brandon. I'm going to let Jay Schaefer, our Treasurer answer that one.

Michael Linenberg - Deutsche Bank

Okay, great.

Jay Schaefer

Hi, Michael. All of this debt that we're prepaying right now is all privately placed debt. So it’s simple mortgage debt and we're essentially prepaying it at par.

Michael Linenberg - Deutsche Bank

Is it relatively high coupon versus where the market would be for that type of debt for you today if you were to issue it?

Jay Schaefer

As you know, base rates were really low but we did a lot of financing deals in 2009 as we became concerned with the weak economy and just the capital markets in general and credit spreads had really gone up. And so those are the deals that we're focusing on right now with this current tranche of prepayments.

Michael Linenberg - Deutsche Bank

Okay, great. Very good and then my second question and this, I think this sort of follows on what Bill Greene brought up about just your margins being so high, and being attractive to competitors particularly in some of the markets, I think are going very well for you, so you don't want to be the dead horse here. But just getting back to Hawaii when I think about some of the capacity that could come into that market off the West Coast that is markets that are going to be targeted by Allegiant and while 757s that are going to bring on, they are going to be pretty large, lot, lots of seats, you know maybe it's north of 200.

My sense is that the markets will look at are markets where they do pretty well and like Bellingham, Washington which is close to you guys. They may do things you need like Long Beach for example. When you think about competing against them, historically you guys have competed against everyone and you've done very well. What -- when you think about a carrier like Allegiant coming into the market, what is your edge? I mean is it the fact that you carry maybe higher price, please your passenger, so you have the business mix, is it the delta code? What can you tell us about your ability to sort of fend them on, number one? Number two, you are competing with them in the Bellingham to Vegas market; I believe you may have even up gauged the airplane in that market. I mean what -- maybe that's the laboratory here, the laboratory experiment, how have you done in that market vis-à-vis them? Can you give us some comfort that as they come in you'll hold them off?

Brad Tilden

Yeah Mike, it's Brad. The first thing I would say to that question is carriers like Allegiant that made the transformation that this company has done, and continues to do is so important. These low cost carriers are coming into our market with obviously, very low cost are a very real threat and that's why we've been doing -- everything we've been doing for the last six or seven years, and that's why we're going to keep on this track going forward.

In terms of how we compete against Allegiant, Alaska Airlines has the lowest fares of the West Coast to the United States to Hawaii, and that's something that we're going to talk more about, and continue to promote. We do fly to Honolulu, but we fly our biggest businesses to Maui and the outer islands. So, I think that's something that's a little bit different for us.

We have 737-800. It's a 157 seat that can fly to almost anywhere in the West Coast to the four islands and so it's a little bit smaller gauge airplane, which make markets like San Diego or San Jose or Sacramento or Seattle or Portland work well, work quite well. So, we really like that asset, and Bill talked about the (inaudible) earlier. We do have a lot of -- in the markets where we are flying, we've got pretty loyal base of frequent travelers. So those are what we have going for us, but I don't think any of us underestimate the threat of folks like Allegiant Air, and so we are prepared to do whatever we have to do to compete against them.

Andrew Harrison

This is Andrew. The only thing I would add there to is that the feeding network that we have to feed our Hawaii flight as well as the strength of our mileage plan, frequent flyer program and our overall frequencies in all of our markets versus the Allegiant model tends to be day or week type–. What we've seen is they do stimulate a lot of traffic, but sometimes that's stimulated and not off of that network. So, to Brad's point, we watched very carefully and it’s something we will be continuing to study in the coming months.

Michael Linenberg - Deutsche Bank

Okay, very good quarter, and if I heard Bill right, Bill, did you say that this was the all time most profitable quarter ever for Alaska? Is that absolute or margin?

Bill Ayer

That's on an absolute basis adjusted for the specials.

Michael Linenberg - Deutsche Bank

Terrific, great job guys, thank you.

Bill Ayer

Thanks Mike.

Operator

Your next question comes from Helane Becker of Dahlman Rose.

Helane Becker - Dahlman Rose

Thanks very much, operator. Hi everybody.

Bill Ayer

Hi Helane.

Helane Becker - Dahlman Rose

Just on in terms of your code-shares on West Coast, could you just talk about how American code works with respect to the Delta code, and kind of what you're seeing there, and have they come to you to talk to you about making more inventory available for their L.A. market?

Andrew Harrison

Hi Helane. This is Andrew. Essentially if you look at -- even if you fly on Delta and you look in their in-flight magazine you'll see a lot of green lines over the West Coast and essentially both the American and Delta are using our West Coast network for their customers and passengers. And in the case on both Delta and American they do a lot of local market code-share up and down the West Coast, so selling LAX, Seattle, Orange County, Portland and all of those. And we find that it works very well for them, and works very well of us, and if anything, helps strengthen the volumes we can put up and down the West Coast. But we have to work with them both, but specifically, as they come to us or whatever, at the moment we just continue to work as we've always worked, and really one of our main focus is at this time is to make sure for our passengers, this is not confusing, it's extremely seamless and I see the benefits of this type of arrangement.

Joe Sprague

Helane, this is Joe. I might just add another benefit of the partnerships with both American and Delta as well as the other partners that we have, is the frequent flier reciprocity, the mileage claim benefits we have with multiple partners is really key for our customer base because of having over twelve different mileage partners, we can offer access to over a 100 countries and something like 706 different city pair. So it's a really powerful part of the whole alliance relationships.

Helane Becker - Dahlman Rose

Okay, great that was actually going to be my follow-up question, so thank you very much.

Operator

Your next question comes from Dan Mckenzie at Hudson Securities.

Dan Mckenzie - Hudson Securities

Hey, good morning guys, thanks. Given the I guess kind of the questions on competitive capacity, I wanted to circle back to them one more time because my analysis is a little bit different than yours, Andrews. I'm not quiet sure how you define it, but I'm looking at direct and indirect competition and are indirect through alternative airports. I'm seeing Virgin cut 18,000 seats or cut 15% of its capacity in the third quarter, and cut again in the forth quarter, and on Southwest I'm seeing them cut, I'm seeing Southwest cut 38,000 seats in the third quarter or 58,000 in the fourth quarter.

So their capacity cuts actually accelerate and I guess my question is, what percent of the revenues are we talking about here? Is this perhaps 30% of the revenues, 40% of the revenues are impacted by this competitive capacity cuts and how material is that to -- just in terms of revenue improvement year-over-year?

Bill Ayer

Hey Dan, a couple of things firstly. The modeling we use is -- maybe it's overly complicated, but basically we look at where we fly and depending on who or which competitor we're looking at, and how significant that route is to our network, we sort of weight it across that network, so if we have a single frequency in a market and someone has big increase, it doesn't really affect our overall network that much.

But that said you know a couple of things, we are seeing some stabilization or increase frequency in some of our markets from Southern California, but at the end of the day, we are seeing some up gauging in things go on there, but nothing huge, I'm just trying to think off the top of my head. There is some increased capacity out of that will be going into Mexico from Virgin of the West Coast.

We've seen JetBlue increase there gauging capacity out of Long Beach up to Seattle and the Pacific Northwest, we've seen United and American coming to Los Angeles Reno, those types of things, but -- so I don't know. I think we are seeing modest sort of strengthening but nothing significant. But, I am not saying it's hugely go down. As far as our network, obviously Southwest is across our network in a pretty big while I think about a third of our network, we go head-to-head with Southwest somewhere.

Brandon Peterson

If it changed a bit, Dan, you have follow this for a long-long time. It used to be that Nevada, Arizona, Southern California and Bay area where 50-60% of the network, but with the growth of transcon and mid-con and Hawaii, Mexico, State of Alaska, which always has, those are less. I think you are into wishing 30-40-50% is probably a pretty close to our exposure to those folks.

Dan Mckenzie - Hudson Securities

Okay. Great, thanks. That will do for me.

Operator

Your next question comes from Jim Higgins of Soleil Securities.

Jim Higgins - Soleil Securities

Good morning everyone. Most of my questions have been answered but did you receive a refund of aviation security infrastructure fees in the second quarter?

Brandon Peterson

No, it's Brandon. We did not participate in that law suit and so we didn't have any share of the refund that came.

Jim Higgins - Soleil Securities

Okay, great. Thank you very much.

Bill Ayer

Thank you Jim.

Operator

Your next question comes from Glenn Engel of Bank of America/Merrill Lynch.

Glenn Engel - Bank of America/Merrill Lynch

Good morning, two questions please. First one, you touched on a little bit, but can you talk about how much capacity is up in Alaska to 48 state market versus last year and how that compares with two years ago.

Andrew Harrison

Hi, Glenn, this is Andrew. We're going to be coming up into, firstly in the quarter just done. Our capacity was down about 5% and we are going to see about that number in the third quarter as well. At the top of my head, I think we're going to be about flat with 2008 capacity. But other competitors have increased. Basically a lot of the competitors came back in. They got out in '09 and they came back in 2010.

Bill Ayer

The long history and this is I recall was that every summer, if that what we were saying we had about what we are seeing today. And we had a little bit of a holiday from that last summer and this is kind of backwards always been. So, no big deal on Alaska.

Glenn Engel - Bank of America/Merrill Lynch

So, how much on a year-over-year basis, that was the Alaska capacity up for including, you and the competitors?

Andrew Harrison

I am not sure we have that. I don't have that off the hand, I am sorry.

Glenn Engel - Bank of America/Merrill Lynch

Second question I have is one the flying the transcon pipeline, one, how is that performance relative to the system? I guess, just how many frequencies do you tend to have in the market and what would you expect to have right down the road? What would your ideal be for having frequencies in the east-west type markets?

Brad Tilden

Hey Glenn, it's Brad. We don't comment specifically on regions, but I think you can gauge from the way that we have grown transcon over the years, we have been happy with the results there. Typically, we're one or two frequencies. So, our market share in those markets is 15-20% if you had to averages it. And we do see that as not a near-term opportunity but maybe two or three, four years down the road, if the economy comes back as a place that we see further opportunity to grow.

Glenn Engel - Bank of America/Merrill Lynch

And what would be, you know, 5-10 years down the road? Where would you hope to be in terms of frequencies in these markets?

Brad Tilden

It's really hard question to answer, but I guess, you can look at something like our presence. Seattle, Southern California is an example. We have gone over 20 years from almost nothing there to having 50% of the share between the Northwest and Southern California. So, our thinking about it, it would be kind of the incremental. Put some capacity in, get the capacity to work, make a little bit of money, and then build on that, and do more the same.

Brandon Pedersen

Hey Glenn, it's Brandon. There's lots of benefits that come from adding frequencies if the market traffic can support it. We offer more utility to our customers. It gives us an opportunity to improve productivity on each end of the flight. It's something that we're seriously looking at but we would only do that over the next years as Brad said if the traffic can support it.

Brad Tilden

And I might add that you know, we're sensitive about capacity increases as anybody out there but given our small fleet size, one additional round trip to the east coast is essentially one airplane and that's almost 1%. So overtime, as we start looking at doing these things you can quickly see how 3, 4, 5% growth a year really isn't very much given the fleet size that we have here.

Glenn Engel - Bank of America/Merrill Lynch

Thank you.

Brandon Pedersen

Thanks Glenn.

Operator

Your next question comes from Kevin Crissey of UBS.

Kevin Crissey - UBS

Hi guys.

Bill Ayer

Hi Kevin.

Kevin Crissey - UBS

Can you talk about Google's acquisition of ITA, what might mean for you?

Joe Sprague

Yeah Kevin, this is Joe. We do have a partnership with ITA. They provide the shopping engine for the alaskaair.com website and it's been a positive relationship and so there's of course this Google acquisition is fairly recent news and we're studying that closely to see what it might mean.

I think there is some intrigue that might even further strengthen ITA in terms of some of their research and development activities that could benefit us. And so like the rest of the industry we're going to be watching that closely over the next few months to see if that gets approved and how that moves forward.

Kevin Crissey - UBS

So do you have an official stance because you have opportunity to comment right on that with the Department of Justice? Is that something you've formalized yet?

Joe Sprague

We have not and you're absolute right. There will be a lot of industry comment with respect to that acquisition but we've not formalized what our formal position would be on that yet.

Kevin Crissey - UBS

Okay. Can you talk about; Allegiant going into Hawaii is about hotels. They may make some money on cars but it's about hotels and I mean they certainly they make some money on the fair as well but I think it's also about hotels and car rental. How do you do in that or how do you think your opportunity is there, I guess?

Joe Sprague

This is Joe again, Kevin. Actually that's an area of big opportunity for us especially on the ancillary side as we look ahead to what other opportunities we might have in that category. We an initiative this year to improve the shopping functionality for cars and hotel on our website and we'll be continuing that effort aggressively here over the next few months and we have an existing infrastructure that reaches out and builds relationships with hotels in some of our key leisure destinations. And so we've been working that very hard over the last three years. We're excited about the partnerships that we have with hotel properties in Hawaii already and as we sort of combine those partnerships with a better shopping functionality we think we have a lot of opportunity in this area.

Kevin Crissey - UBS

Those partnerships -- I'm sorry, just a follow-up. Those partnerships are direct relationships with the hotels or you have an intermediary?

Joe Sprague

Actually both. We have an intermediary to help with some of the sourcing of hotels for our website and then through our Alaska Airline Vacations efforts which is sort of our in-house tour wholesaler. We have our own direct relationships as well.

Kevin Crissey - UBS

That's right, thank you.

Operator

Your next question comes from Steve O'Hara of Sidoti & Company.

Steve O'Hara - Sidoti & Company

Hi good afternoon. Most of my questions have been answered. I just had a question about the cost and maybe you addressed this. I think you guys guided for slightly higher cost on the 16th of June or the 15th of June. I'm just wondering what the difference was the end of the quarter?

Brandon Pedersen

So, hey Steve, it's Brandon.

Steve O'Hara - Sidoti & Company

Hi.

Brandon Pedersen

You're right, on the mainline we guided to 785 to 795 which should move up just a tick from our initial guidance during the quarter and then it came down. As you know we ended up at 0.000779. We had some favorable adjustments to our workers comp cost that actually helped us out late in the quarter there and then just generally good cost performance by all of our operating divisions in the month of June.

Steve O'Hara - Sidoti & Company

Okay, and then secondly in terms of the bag fee, you noticed any discernable change in terms of the markets maybe operates versus Southwest or JetBlue in customer behavior? I mean did you lose any revenue premium that maybe you got before based on your bag fee?

Andrew Harrison

Steve, this is Andrew. I suppose from the network and our own perspective I have seen no huge downside from this at all.

Steve O'Hara - Sidoti & Company

Okay. Thank you very much.

Operator

Your next question is a follow-up from Hunter Keay of Stifel Nicolaus.

Hunter Keay - Stifel Nicolaus

Hey thanks for taking my follow-up. I appreciate it. Bill, my question for you is, pull your chairman out for a second here, when we're talking about this cash deployment, first of all let me just frame this with the $50 million share buyback you guys have authorized, I think it's incredibly differentiated. I think it's really valuable for the shareholders, and I really applaud it. But if you're thinking about the context of deploying more cash as you're going to build more cash may be affected. Is there any reason why that maybe it shouldn't be $100 million, and I hate to get greedy on this but -- I know all right, it sounds as if it's a good problem to have, but if you're thinking about driving our ROIC, that's your probably highest cost of capital on your invested base and has a two pronged effect like supporting the stock, driving earnings etcetera. Do you guys, do you think I don't want you to speak for the board obviously, but you as chairman do you think your stock that is still currently undervalued and could you maybe see some upside in buying back some more shares?

Bill Ayer

I'm probably I got to take that bait. I think that as Brandon said this is something we're teeing up for a full board discussion because it's a high quality problem, and there is lots of alternatives, lots of opinions. The guiding principle obviously is we are going to do what's best for shareholders over the long-term. That's our business model. We are going to -- shareholder understand that they deserve a return, and it's been missing in this industry for ever, and we're going to keep doing things to benefit our shareholders, and our customers and employees along the way.

Brandon Pedersen

Hey Hunter, it's Brandon. There is no reason that you can't get to 100 million by having $250 million offerings. Our Board have a history of reauthorizing as we work through the authorization their on the table. Our Board has a history of renewing those if the economic circumstances won't.

Hunter Keay - Stifel Nicolaus

Yeah point well taken. I appreciate that. Just thought I'd throw it out there. So thank you so much again.

Brandon Pedersen

Thank you.

Operator

Okay. I think that's it.

Bill Ayer

Okay. So thanks for joining us today, and we look forward to talking with you again next quarter. Take care everybody.

Operator

Thank you for participating in today's conference call. You may now disconnect.

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Source: Alaska Air Group, Inc. Q2 2010 Earnings Call Transcript
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