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Alaska Air Group, Inc. (NYSE:ALK)

Q1 2008 Earnings Call

April 24, 2008 11:30 am ET

Executives

Shannon K. Alberts – Managing Director, Investor Relations & Corporate Assistant Secretary

William S. Ayer - Chairman of the Board, President & Chief Executive Officer

Bradley D. Tilden - Chief Financial Officer & Executive Vice President, Finance & Planning

Jeffrey D. Pinneo – President & Chief Executive Officer, Horizon Air Industries, Inc.

Gregg A. Saretsky - Executive Vice President, Flight & Marketing of Alaska Airlines, Inc.

John F. Schaefer, Jr. – Senior Vice President, Finance & Treasurer

Glenn S. Johnson - Executive Vice President, Airport Services, Maintenance & Engineering, Alaska Airlines

Analysts

Raymond Neidl – Calyon Securities (NYSE:USA), Inc.

Michael Linenberg – Merrill Lynch

Peter Jacobs – Ragen Mackenzie, a Division of Wells Fargo

Frank Boroch – Bear Stearns

Gary Chase – Lehman Brothers

Jamie Baker – J.P. Morgan

Daniel McKenzie – Credit Suisse

Operator

Good morning. My name is Brandy and I will be your conference operator today. At this time I would like to welcome everyone to the Alaska Air Group first quarter 2008 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers’’ remarks there will be a question-and-answer session. (Operator Instructions) I would now like to turn the call over to Shannon Alberts, Managing Director, Investor Relations. Please go ahead, ma’am.

Shannon K. Alberts

Hello everyone and thank you for joining us for Alaska Air Group’s first quarter 2008 conference call. Alaska Air Group Chairman and CEO Bill Ayer; CFO Brad Tilden; and Horizon Air CEO Jeff Pinneo will provide an overview of the quarter after which we’ll be happy to take questions from analysts and then from journalists. Other members of the senior management team are also present to help answer 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. Our presentation includes some non-GAAP financial measures and we provided a reconciliation between the most directly comparable GAAP and non-GAAP measures on pages 8 and 11 through 13 of our earnings release.

As we reported earlier this morning the first quarter 2008 Alaska Air Group lost $35.9 million or $0.97 per share versus a net loss of $10.3 or $0.26 per share last year. Excluding the impact of fuel hedge mark-to-market adjustments in both periods Air Group reported a net loss of $36.3 million or $0.98 per share which compares to our first call mean loss estimate of $0.97 per share and to our 2007 loss of $0.39 per share. One of our fundamental objectives is to achieve an acceptable return on invested capital. According to our calculations Air Group has earned a return on invested capital over the last four quarters of 5.5% well below our goal of 10%. Additional information about expected capacity changes, unit costs, fuel hedge position, capital expenditures and fleet count can be found in our investor update which is included in our Form 8-K and on our Investor website at www.AlaskaAir.com.

Now I’ll turn the call over to Bill Ayer.

William S. Ayer

Good morning everybody. Well the big news today is the Horizon fleet change so after I make a few comments I’ll turn the call over to Jeff to explain the rationale for our decision. Then we’ll hear from Brad for an update on Alaska and the Air Group balance sheet.

With five airlines declaring bankruptcy within a two week period, oil closing at $118 yesterday and growing concerns about the economy to say that the airline industry is facing some of the most difficult challenges in its history is an understatement. Some analysts have likened the headwinds facing the industry today to the aftermath of 911. It remains to be seen to what degree those predictions play out but as I think you have already concluded a significant change is ahead for our industry. Many now believe that $100 plus oil is here for the foreseeable future. That’s also our view and the actions we are taking reflect this outlook.

In addition to the Horizon fleet transition today we are also announcing a number of changes at both carriers in response to the current economic environment. When fully implemented these changes could generate up to $150 million in revenue and cost savings. We plan to devote most of the time this morning to talking about these actions.

Reporting an Air Group adjusted net loss that is more than double lost year’s is disheartening in light of the tremendous efforts and sacrifices our people have made to control costs and to improve our operation. The fact is that the tidal wave of rising fuel costs has outstripped our progress. Our balance sheet and fuel hedge portfolio combined with our progress on costs have put us in a good relative position and they allow us to make considered, rational decisions for the long term. We have been reminded once again that things can change rapidly and we are acting now to ensure that we have a solid position for the future.

Let me take just a minute to talk about some of what we’re doing to improve revenues and reduce expenses in the face of current challenges. Starting with fleet, in addition to today’s announcement regarding Horizon’s fleet we will complete Alaska’s transition to an all 737 fleet with the returning of our last MD80 on September 30th three months ahead of our original plan. The decision to replace our MD80s was 737 800s make good sense at $50 oil and it makes even better sense today. With these changes Alaska and Horizon will each operate single [audio missing] type fleets of the most modern and fuel efficient aircraft in their class. We have attached a couple of slides to our investor update that show how the 737s at Alaska and the Q400s at Horizon compare to other narrow body and regional aircraft in terms of fuel consumption per seat. The bottom line at a time when it matters most we couldn’t have a better fleet to deal with today’s fuel environment.

Through our relationship with Aviation Partners such as Boeing we will soon have wingless on the majority of our 737 900s in addition to our 700s and 800s. Wingless alone are reducing our annual fuel bill by about $20 million at today’s fuel prices. We’ve completed a number of other fuel conservation initiatives and are working on more including a new flight planning system, further reducing the weight carried on aircraft and decreasing the amount of fuel burned while on the ground. We’re also asking the FAA to help us take greater advantage of our flight deck technology for more direct routings and fuel saving approach and departure procedures. Given the potential for significant cost savings and reduced emissions we hope the FAA will implement these improvements on an expedited basis.

Effective Sunday we’re starting a new schedule called our West Most schedule which features hourly service between Seattle and LAX and every other hour service between Seattle and six other California airports. Over the past several schedule cycles we’ve been reassessing aircraft assignments at both Alaska and Horizon to ensure optimal deployments. As a result we’ve already reduced schedules in some markets. We plan to make additional reductions, exit under performing markets and initiate service to a couple of new destinations that will bring in additional revenue. Our spring and summer schedules reflect these changes and you’ll see more in the fall and winter. We recently completed a comprehensive review of all of our fees and pricing and Brad will provide more specifics on this and on our schedule changes in a few minutes.

In February, Alaska’s on time performance was the second best in the industry. We had a solid performance again in March and April is also going well. Year to date our on time performance is 77% a 3.6 point improvement over last year. Alaska also took the top spot in terms of fewest customer complaints in February and ranked fifth in baggage performance. This performance came during a freight of high loads which makes the improvement even more noteworthy. Horizon posted an 80% on time performance for the quarter which is up 1.8 points over last year.

In times like these it’s important not to lose sight of what’s going well and there are several reasons why we are well positioned to ride out the current storm. Specifically we have a strong fuel hedge portfolio, a young fuel efficient single type fleet at Alaska and the decision to move in that direction at Horizon, a strong network of coach share partners poised to benefit from transpacific growth, a good track record on cost reductions, a conservative balance sheet with good liquidity, better economic conditions in our region of operation and importantly a management team with a proven history of making it through tough times with a commitment to providing shareholder returns.

I often hear from frequent flyers and they tell me that they’ve noticed a significant improvement in our operation and how much they enjoy flying on Alaska and Horizon compared to other options. Our improvement ahs everything to do with the hard work and dedication of our employees and I couldn’t be more proud of the progress our people have made. This progress combined with other aspects of our service create a clear preference for our brands and a long term competitive advantage. My thanks to the folks at both companies and especially to those in our operational divisions.

With that I’ll turn the call over to Jeff.

Jeffrey D. Pinneo

Good day everybody. Well given the announcement we made today regarding our move to an all Q400 fleet I’ll be spending the majority of my time on that but before I get into that I’d like to spend just a minute on our first quarter results.

As reported Horizon posted an adjusted pre-tax loss of $18.1 million compared to a loss of $1.2 million in the same period last year. Our revenues grew 9.7% on 1.8% growth and capacity. System wide RASM was up 7.7% and as in previous quarters mix played a key role in the year-over-year comparison as aircraft that were flying low RASM, low cabin emissions for Frontier last year returned to our native network. If we look at this by line of business brand capacity was up 29% and RASM was down 7.9% due to lower yields and purchase capacity was up 15.8% while RASM was down 1% due to strong load factors which offset lower yields. This year of course the Frontier Flying is gone. As we replace our 37 seat Q200 line with 76 seat Q400s we expect lower RASMs however the [CASM] on the Q400 is much lower than the Q200 it’s replacing so profits should improve. I would like to note that the high ASM growth for both the brand and CPA entities came about due to the rapid return of the Frontier Jet Express aircraft. This capacity growth has affected our revenue performance will be adjusted as part of the move to a single fleet of Q400s.

We have recently announced service between Los Angeles and Flagstaff, Arizona and between Santa Rosa and Las Vegas both of which will be funded from frequency trends in under performing markets. In an effort to recoup some of the cost increases brought on by soaring fuel expenses we’ve enacted a number of fare increases during the quarter. The most significant action occurred in early February when we increased fares between $5 and $20 each way. Even with these recent changes local fares in most markets are still lower than prior to our fare simplification initiative. We remain confident that these higher, more reasonable local fares will improve the mix of revenue on the airplane and still stimulate traffic.

On the expense side of the ledger the $20 million increase in adjusted operating costs represents an 11.7% increase over last year’s first quarter. Predictably it was all about fuel which accounted for the full $29 increase. We reported CASM X fuel and fleet transition costs that were 3.6% below last year and 2.6% below plan which we’re particularly proud of given that we no longer have the low CASM Frontier Flying. The CASM improvement is due to making further strides in employee productivity and getting through the planned maintenance fee that impacted us so much of last year.

Operationally our teams continue to perform near the top of the industry with an on time performance rate of 80.3% for the quarter up 1.8 points from last year. My thanks to all our people for the excellent experiences they continually deliver to our customers.

For the second quarter we’re forecasting a 4% decrease in ASMs with CASM X fuel of $015.5 to $015.6 up 34% from 2007’s second quarter. This expected unit cost increase is the result of replacing last year’s low CASM Frontier Jet Express Flying with higher CASM aids network flying and is offset by lower fleet transition costs, lower maintenance costs and higher gauge aircraft.

With fuel headwinds, other cost increases and a softening economy working against us it has becoming increasingly clear that the route of our challenges is not our product or our ability to take good care of customers but the influx of capacity we’ve introduced into our native network and our costs especially those associated with our current fleet complexity and lack of scale. After careful study we’ve concluded that the costs associated with our multiple fleet type model are simply not aligned with the revenue and fuel cost environment we anticipate going forward. These and other important considerations led to the announcement this morning of our move to an all Q400 fleet. The economics of a single fleet type, the Q400s category leading fuel economy and our experience with the aircraft and its broad customer acceptance make this the right strategy for us.

As the leading operator of the Q400 we’ve come to know it as an extremely flexible and capable airplane. Its high speed and passenger comfort make it a great match for our current and planned markets and would block our fuel burn rates better than 30% lower than the CRJ-700s despite having nearly 10% greater seating capacity the story becomes even more attractive. Add to this the multi-million dollar savings we expect to realize through simplification and eliminating duplications in parts inventories to training programs to crew [bids] and you quickly see why this strategy is so propelling.

We believe these efficiencies will lead to significantly higher returns on a capital base which is likely to be less than what we have in place. We currently have firm commitments for 15 additional Q400s which will bring our total fleet to 48 and options for another 20 beyond that. In this environment reducing our exposure and maximizing the productivity of our flying are essential so our goal is to use this transition to reduce our total number of aircraft while continuing to serve the vast majority of our current markets with ASM levels that were in place prior to the incorporation of the nine CRJ-700s from Frontier albeit with lower frequency. When we’re finished with the transition Horizon’s fleet will consist of at least 48 Q400 aircraft with the final number dependent upon market conditions and the number of options we exercise.

In addition to simplifying the fleet we’ll also be reducing its size and reducing and re-allocating capacity as appropriate to match current and forecasted demand patterns. Decisions on whether to exercise any of the options we have in place will depend on whether the business case for each incremental airplane meets our ROI seat goal. A key part of this transition will be the successful re-marketing of our 20 CRJ-700s an effort that Alaska Air Group will launch soon. All indications are that worldwide interest in 79 seat regional jets remains strong given the current focus by major airlines on improving the efficiency of their network support by updating their existing 50 seat units. The CRJ-700s have served a great purpose within the Alaska Air Group fleet these past several years by improving performance in markets previously served with Alaska’s larger aircraft. However these markets continue to under perform with no end in sight to the yield pressures and cost increases particularly fuel we believe that moving to an all Q400 fleet is the bests approach for us to generate appropriate returns.

Our targeted timeframe for the completion of the transition is 24 months subject to market conditions and operational planning considerations. We believe this timeline reflects both the urgency of our situation and the need for the transition to be managed in an orderly efficient fashion and while some workforce reductions will be necessary as we transition to a smaller fleet we hope to manage them primarily through attrition and other voluntary means. In addition to this long term initiative the current environment compels us to move aggressively on our range of shorter term profit improvement initiatives that we expect will save us between $4 to $5 million a year. We provided some detail in the press release and plan to communicate more about this with our employees in the days ahead.

There is no question that the path we’ve outlined today will be challenging. It’s bold, it’s ambitious and it’s not without risk and it’s also very clear that in today’s environment taking these actions is essential. Maintaining status quo is clearly the most risky strategy of all.

Now let me turn the call back over to Brad who will provide an update on Alaska.

Bradley D. Tilden

Good morning everyone. With deals stated on an economic basis Alaska Airlines reported a pre-tax loss of $37.7 million for the quarter compared to a loss of $14.3 million in 2006. The increased loss was simply a result of fares not keeping pace with rising fuel costs. Mainline passenger revenue increased 11% this quarter on a 6.8% increase in capacity and a 4.1% increase in passenger [PRASM]. The quarterly PRASM increase was driven by a 3% increase in load factor as our yields were flat. Our PRASM performance lagged the domestic industry by about 2.5 points for the quarter but PRASM for the month of March was slightly better than the industry as our relative performance improved steadily through the quarter. Additionally our yields were diluted by the 6% increase in our average trip length. By themselves our two Portland transcons and three Hawaii routes depressed our system yield by about 3 points and our system RASM by about 2 points so adjusting for these our RASM performance was on par with the industry.

As is the case at all airlines our revenues are simply not high enough given current fuel costs. We’re turning over every rock in our effort to address this problem and today I’d like to talk about three areas that we’re working. Schedule adjustments, fee increases and changes in pricing and yield management practices. Let me spend a minute on each.

First schedule, as Bill said we’ve been actively managing our schedule to improve our profits. Over the last couple of schedules we have completely exited the San Diego-San Francisco and Orange County open markets as well as several Horizon markets. Additionally we’ve reduced frequency in a number of other markets, reviewed the aircraft to add new TransCon from Portland three daily trips to Hawaii and to fortify our Seattle-California schedule which now features 78 flights including hourly service to LAX. With this schedule we’re also making Boise and Reno exclusive Horizon cities. This summer we’re continuing to fine tune the network and we’re adding new service to Maui and Flagstaff, Arizona. As we look forward to the fall we’ll reallocate another 3 to 5% of network capacity and redeploy these aircraft in ways that will bring new revenue to the company. For competitive reasons we’re not ready to announce these changes just yet.

Next fees, effective this summer we’ll be charging for a second bag and effective May 21st we’re increasing the service for tickets sold through our reservation center from $10 to $15. We’re also increasing fees for overweight bags, unaccompanied minors and transporting pets. We’re trying to increase these fees in a way that’s consistent with our simple and customer friendly fare structure and to levels that re in line with the cost of delivering these services. In the aggregate these changes should bring in $30 to $40 million annually.

And finally fares, we’re increasing fares as we can and holding more seats open for our premium customers who book closer to flight departure. In the first quarter we generated $17 million more in first class revenue and at the same time improved the bucket mix in the main cabin. 4% of our sales volume was purchased first class tickets and this figure has grown steadily from a little more than 1% a few years ago. We’re also evaluating changes to our mileage plan to better align with the realities of $118 per barrel oil. We plan to announce these changes later in the second quarter for effect later in the year.

As we look to the second quarter we are encouraged by recent fare increases particularly those led by Southwest which should be helpful. Also last year at this time we had a deeply discounted system wide sale but this year the sale fares we have are generally at higher levels. With respect to advanced bookings we’re current down 1 point for April and up 1 point for May and June. Although I used the word encouraged to describe what we’re seeing with revenues, the reality is that Alaska and the entire industry need significant and sustained increases in revenue to make this work. Assuming today’s fuel at $3.60 per gallon which is the number you would get crude at $118 per barrel, refining costs at $0.70 per gallon and assuming no hedge benefit Alaska would need an average fare increase of $10 per passenger to break even about $25 per passenger for us to achieve the kind of margins investors expect. Again this assumes no hedge benefit and we obviously have good hedge protection for 2008.

Despite our hedges Air Group’s economic fuel expense increased by $89 million and that’s after taking $27 million more in hedge benefit this year than last. While crude prices get most of the attention we’re equally concerned about refining margins which at $0.70 now equal what our total fuel cost per gallon was for much of the 90s. Despite the bad news with fuel we were pleased with our non-fuel unit costs which were down 3.4%.

In the second quarter we’re currently forecasting mainline CASM X fuel of $07.5 to $07.6 up 3 to 5% from last year and in line with our plan. The increase is due to maintenance timing, increased depreciation costs and lower ASM growth than we saw in the first quarter. For the full year we still expect CASM X fuel to be about flat at approximately $07.5 per ASM in line with our previous guidance. We seek capacity growth to be flat for the rest of the year which will give us full year capacity growth of about 2%. This figure is down from the 6% figure we planned some time ago. And in 2009 our fleet will either not grow at all or will grow by a single airplane. That will mean that from 2006 through 2009 our fleet will only grow by two or three airplanes.

Our balance sheet remains quite strong and we’re well positioned to weather the current economic environment. At the end of the quarter we had $922 million in cash and short term investments which is up $100 million from the beginning of the quarter. I might note that our portfolio contains no auction rate securities. We have relatively low leverage with adjusted debt to total capitalization of 73%. We had an unused line of credit in the amount of $185 million. We had the second best hedge book in the industry with 50% of this year’s consumption hedged at $76 per barrel and we had a fleet of the most fuel efficient aircraft in the industry. Our $100 million increase in cash was due to positive cash flows from operations of $41 million and proceeds from new debt financings of $292 million. These in flows were offset by capital spending of $139 million, debt repayments of $57 million and common stock repurchases of $41 million. We also took delivery of one leased 737 800 during the quarter.

Year to date we’ve repurchased 2 million shares under our share repurchase program at an average of $23 per share. Given the current industry environment we are going to take a pause with respect to future share repurchases. We may still repurchase stock on the open market from time to time under the current Board authorization but for the time being we’re going to see what happens with fuel prices and the economy. As of today our cash balance is over $1 billion as we’ve made some borrowings since quarter end under our pre-delivery payment facility. As you know we’ve always maintained a conservative balance sheet. This approach has worked well for us and we plan to continue it going forward.

At this point I’ll turn the call back to Shannon.

Shannon K. Alberts

We’re happy to address questions from analysts at this time. Brandy would you please assemble the roster for us?

Question–And-Answer Session

Operator

(Operator Instructions) We ask that you please limit your questions to one and one follow up. We’ll pause for just a moment compile the Q&A roster. Your first question comes from Ray Neidl.

Raymond Neidl – Calyon Securities (USA), Inc.

Could you give us your overall thoughts in an industry that may be consolidating where you’re going to have much bigger airlines out there. I know you have a partnership with a lot of them, but is there a place for a special niche airline like Alaska in a world of giants? What’s your thoughts on that?

William S. Ayer

Absolutely. I think you’re right about consolidation and frankly we think from an industry standpoint that’s a good thing. But we think we have a very significant role to play almost regardless of what happens with the industry and specifically the partnerships that we have with as you know the Switzerland strategy with so many carriers is based on the win-win situation that the relationship works for us and works for them and we think those things will continue. They’ll stay in place as long as there needs to be mutual benefit. So we don’t see anything there. We think Seattle is poised as a place for more agent service for example and looking forward to that. We just think we’re well positioned no matter what happens with consolidation in the industry and the focus is on the things that we’ve talked about here. It’s about fleet and it’s about cost management and customer service and we’re making progress on all those fronts.

Raymond Neidl – Calyon Securities (USA), Inc.

I got on when you were talking about the Q400 which is a great airplane, I’ve ridden on that and it’s very comfortable from the passenger viewpoint. But my question is with Horizon here, I know you have to make major changes there to cut costs and get those guys back to profitability and these high fuel costs, but by going to one fleet type, a fairly big airplane like the Q400, is that going to preclude you from going into a lot of smaller markets or developing newer markets that previously you had developed to turn over to Alaska Air?

Jeffrey D. Pinneo

I’ll start then Brad may want to chime in. I think the answer is that it’s different. That is for as many markets on the fringe, on the very low end for instance and maybe some at the higher end that might not be optimally served by the Q400, we think going forward there are new opportunities as well that more than balance that. I think it’s fair to say that as we go forward there are a few markets that are characterized currently by low frequencies with Q400s and low densities that are going to be a challenge for the Q400 to serve appropriately and so we’re going to work it hard. Our commitment is to work hard to preserve levels of serve whether it’s through us or vis-à-vis Air Group and another third party smaller operator to ensure continuous service into the communities we’ve been a part of for an awful long time. And we see that mainly on the low end.

Bradley D. Tilden

The toughest thing is going to be those markets that are closer in with a smaller number of frequencies today. I think a lot of Horizon’s capacity today is represented in the marketplace. Seattle those markets that are closer in with a smaller number of frequencies today. I think a lot of Horizon’s capacity today is represented in markets like Seattle-Spokane and Seattle-Portland. Seattle-Portland is 30 plus frequency so you have an opportunity to up-gauge and still have really frequent service passengers.

Jeffrey D. Pinneo

We’re learning as we go forward when we talked about frequency trends, Ray. In most of our markets one or two flights off of what was a six flight pattern is a really healthy thing to do. We’re not losing traffic, it’s still a very convenient pattern, more for local passengers in the network and the lower unit costs in the Q400 make it a much better proposition. All in all we’re pleased with how that progresses and as we learn, we can also take a look at other things that we’re not doing today that in years in the future might pencil out profitably too.

Raymond Neidl – Calyon Securities (USA), Inc.

Would you consider contracting out to a third party for smaller aircraft?

William S. Ayer

Yeah, Ray, we may well do that. We don’t have a huge need for that. It may be something like three our four airplanes for particularly small cities that feed Seattle and Portland. It may be that our need for that is so small that we have trouble attracting someone but that is actually part of our thinking, to look at someone’s Delta, serve some of the particularly thin city fares that feed Seattle and Portland.

Jeffrey D. Pinneo

That’s not unlike what Alaska does today in the state of Alaska.

William S. Ayer

Sure.

Operator

Your next question comes from Mike Linenberg with Merrill Lynch.

Michael Linenberg – Merrill Lynch

Couple questions here, maybe as a starting point with the new competition coming into the LA and San Francisco to Seattle market at the same time that you guys are going to hourly service, I’m not sure if you’ve actually started the hourly service, what are you seeing with bookings and how are loads holding up and of course should we expect that pricing in that market will be depressed given the competition and the additional seats?

William S. Ayer

Maybe I’ll start and maybe we can get Gregg to offer some color on this as well, candidly this is one part of our network that there is going to be a little bit of pressure with respect to capacity. We’re going at 13 flights into LAX last summer and we’re going to 15 this summer and I think San Francisco we had seven and we’re going to eight. We’re increasing gauge a little bit in these Virgin American markets specifically and responsive air service which is four and three. I think it’s important to keep in mind that in the bigger scheme of things we have 500 flights a day and a lot of our markets’ capacity is flat or down but there is a fight going on up and down the West Coast from Seattle LAX and Seattle to San Francisco and we don’t intend to give anything in that fight. Those margins are extremely important to us and we will defend them to the end.

Michael Linenberg – Merrill Lynch

I don’t know if Gregg is there.

Gregg A. Saretsky

Maybe another thing I’d say is that it’s a bit too early to tell the impact of Virgin on our service. They only started in the month of March in one city pair and we saw no impact. In fact our Bay area PRASM in the month of March exceeded our system PRASM improvement. There is [missing audio 00:03:13] we had Eastern moved into it and we netted from that. As we look forward in both LA and San Francisco in the next quarter we’re seeing demand in SoCal roughly flat, identical load factor roughly flat year-over-year and in the Bay area a little bit of softness but nothing that’s very concerning and I think as we say that I stated in the last quarter’s conference call we’re in this fight to win and we know how history has played out elsewhere in the country and we don’t intend for that to happen here.

Michael Linenberg – Merrill Lynch

My second question, and this is either to Jeff or Brad, I think Jeff you had commented about Horizon as you think about each airplane coming in there are these return on investment [inaudible] I see hurdles. Can you share with us what those hurdles are or even just give us a rough range as an investor or as one who follows the company when you look at historically the returns generated by the Horizon business? And I realize there could be some transfer costs, call it inefficiencies between the two models, but historically it has appeared from the outside that you have been in violation or not in – I was going to say violation or not able to meet those return prerequisites. Based on what it’s been historically, it seems like you would take no additional 70 seaters. I know it’s kind of a philosophical question but it does sound like you are on to the right track going to a single aircraft type. That does seem to be what will make that model work.

Jeffrey D. Pinneo

It’s a great question, Mike, and I think it’s not only philosophical, I think it’s very pragmatic relative to getting smarter about our business, the deployment of capital within Alaska Air Group and what’s standards any investment decision needs to make. I know you’ve heard us talk increasingly with detail about [inaudible] and over the last few years and I think the standard that I referred to is the one that old Alaska and Horizon with the guidance of our Board are applying to any investment decision going forward. So with that said, as you look at opportunity out there, it’s a difficult challenge. You’re looking at trying to forecast the returns on a 17 year commitment to an asset in a volatile environment. There is certainty to that. I can say is that we’ve gotten an awful lot smarter about how we calculate the prospects, the range and what the downside risks are. What you can take I think a lot of confidence in is that the analysis and it’s much more refined, sharper the standards are high. We understand there’s risk. In this business getting out of bed in the morning has risk to it, so that goes with the turf. But we’re being wise about it and we’re being conservative and it’s been a great collaborative effort. You guys want to add anything that?

Bradley D. Tilden

Mike, I guess we would agree with the premise of that question, that returns on capital at Horizon today are not what they need to be. I think they’re about 2% in terms of the way we would calculate that. I’m not sure that we want to actually share our own model in terms of what this does for us because candidly it just may not be as precise as it should be to share with you. What we look at takes a tremendous distance towards getting towards appropriate returns on capital with the fleet move by itself. The other important thing in your question, while there is some capital investment involved in getting to more Q400s, I actually think the invested capital base at Horizon will stay flat or go down as the capital associated with the Q200s and CRJs comes out of the base.

Jeffrey D. Pinneo

When we have substantially improved returns.

Bradley D. Tilden

Right.

Bradley D. Tilden

We think we’ve a line of sight to how we get there in terms of the goal we talked about.

William S. Ayer

Importantly we have a discipline about this that several years ago we didn’t have and I think a lot of carriers are probably in that same boat. As we look at from the Board’s perspective allocating scarce capital to the two entities with a standard and we’re getting better at our forecasting of returns and we have a very strong discipline about this going forward and I think that’s really important.

Operator

Your next question comes from Peter Jacobs with Ragen Mackenzie.

Peter Jacobs – Ragen Mackenzie, a Division of Wells Fargo

First question I guess for Brad, could you expand a little bit on your comments regarding the $10 in extra average fare that you’d need for break even and then the $25 per share to make he acceptable returns that you want. Is that relative to the first quarter or is that how you look at it over the entire year? I’m just trying to understand how that maps into the seasonality of the business, so on and so forth.

Bradley D. Tilden

Candidly, what we did with that quick and dirty analysis was we assumed the revenue performance for the last three quarters of the year was similar to the first quarter and we assumed the capacity growth and the cost guidance that we’ve given you and then we took fuel out at whatever crude assumption you have and you know our hedge positions, but we basically took fuel out and we took the 350 million gallons that we think we’ll burn and multiplied that by $3.60 a gallon which is that’s the fuel cost at $118 a barrel crude, $0.70 crack and zero hedges. And if you do that and have the same passenger count that’s in our forecast, you needed to get $10 a passenger to bring the P&L of Alaska Airlines to zero and you needed $25 or $26 a passenger to bring the P&L to a 10% margin.

Peter Jacobs – Ragen Mackenzie, a Division of Wells Fargo

I’m glad they have transcripts of these calls because that’s how we’re going to have to follow that. Second question is the $0.70 refining margin that you talked about for the crack spread, now that’s not including the taxes and fess you pay, is it? Or should I think about another $0.14 on top of that?

Bradley D. Tilden

No, the $0.70 does not include taxes and into plane and that’s about $0.13 a gallon.

Peter Jacobs – Ragen Mackenzie, a Division of Wells Fargo

That’s how then you get to this $3.63?

Bradley D. Tilden

Right.

Peter Jacobs – Ragen Mackenzie, a Division of Wells Fargo

Okay, because I couldn’t get the math to work.

William S. Ayer

Peter, we said in the notes that that’s a figure that people should just be really, really reacting to. Over my time at Alaska the crack spread has been in the range of $0.07 to $0.15 and so to see it go to this level today is very, very difficult for folks like us that depend on this commodity to try to make things work. It’s difficult to understand why it is where it is.

Peter Jacobs – Ragen Mackenzie, a Division of Wells Fargo

Also, could you talk a little bit more just about some of the competition and how you’re holding up in other parts of your system, maybe TransCon, Mexico and areas like that and what kind of competitive reaction you’re getting with your flights to Hawaii?

Gregg A. Saretsky

I would say our advanced book load factor is trending up year-over-year in each of the next couple of months and apart from some softness as mentioned you mentioned earlier in the Bay area the rest are all trending ahead. We’re delighted with the response we’ve seen in the blind markets. I think on a go forward basis perhaps it will be helped a little bit by the reduction in capacity to the Islands generally from the West Coast. Our advanced bookings are very strong. Clearly in that market as in others we need to get a little bit more ticket price to make our return targets. Mexico is strengthening, that largely a function of reductions in competitor capacity there and the TransCons look to be strong again for the summer.

Peter Jacobs – Ragen Mackenzie, a Division of Wells Fargo

One last short one please and that is what kind of sense do you have in terms of when we’ll see some of these fare or revenue initiatives start to take hold? Is that something that we should look at as being maybe material in the third or fourth quarter this year or should we be a little bit more muted in our expectations?

Bradley D. Tilden

The figure we provided was $30 to $40 million annually which would be roughly 1% of the company's revenue. I guess if I was thinking about that I would say you should begin to see that roll in in the third quarter in terms of having any real significant impact. We’re thinking a little bit towards the latter part of the second quarter.

Operator

Your next [audio cuts off 00:01:54]

Frank Boroch – Bear Stearns

Bill, I was wondering if maybe if you could share have you had opportunity to communicate the slower growth plans with labor? Or maybe Jeff? You could both comment on this and how does that impact their expectations and maybe the peace of negotiations?

William S. Ayer

At Alaska, Frank, I think it’s been an evolving story and as we said a while back this year was planned to be upwards of 6% capacity growth and that’s now scaled back to 2% and we’re through the biggest part of that with this quarter and we go back to some very slow growth rates for the balance of the year. We do make a habit of keeping all the employees informed about what’s going on and I think this is pretty visible. People have friends at other carriers, they know what’s going on, they know the risks in the industry and people are very concerned and I think by and large from what I’m hearing are appreciative of the actions that we’re taking to maintain a relatively good position here for the company. And what I’ve noticed frankly is people working together more, decisions are easier to get to in this kind of environment frankly and we’re finding better everything about our company. The differentiation here is customer service and we’re seeing lots of indications that that’s getting even better. I think the on time performance is a further indicator of that, the improvement there. I think we’ve communicated well and we do that as an ongoing thing and that Jeff has the additional piece of the Q400s and he’s already been working that communication with his folks.

Frank Boroch – Bear Stearns

Lastly, as you see the need to make the fleet changes, what’s the bigger driver? Is this going to help you or this is going to hurt the 2010 CASM X fuel goals but you should see a larger benefit on the unit revenue side? How do you foresee getting some of the fixed costs out that previously you hadn’t thought about?

Male Executive

Are you asking more about Alaska or Horizon?

Frank Boroch – Bear Stearns

I guess I was speaking about both, given that the growth trajectories are now changing but the 20/10 plan as being more about the Alaska and the 7.25 CASM figure.

William S. Ayer

We’re probably not in a position to provide a lot of update on that, Frank. Obviously new capacity is some of the lowest CASM capacity you have because we’re bringing on new big airplanes with lots of seats and a lot of them have been flying in longer haul missions so that helps. It looks like in an environment like this you have to do everything you can possibly to hold your business together and so there may be more diligence and more attention with respect to the other side of the business. I think net-net our guidance for this year is still 7.5 and we are quite comfortable with that guidance when we’re in a position to provide some guidance, some views towards 2009 we’ll do that.

Operator

Your next question comes from Gary Chase with Lehman Brothers.

Gary Chase – Lehman Brothers

I apologize, I’ve been trying to listen to some of this consolidation hearing so if you said some of this, I do apologize but I was curious, one of the things that everybody wants to do in an environment like this, fuel has moved $30, or jet fuel has, in such a short period of time, everybody is now moving to adapt to this environment and I think to a lesser extent than others, you’ve got to act but to a lesser extent than others given the hedge position you have and the balance you’ve got. I guess I’m just a little surprised to hear that what you want to do now is despite this rapidly changing environment which you acknowledge is true to invest a lot of additional capital in the business. Can you talk to what the incremental investment is to do this fleet transition and how you think about this concept of maybe at a time like this it might make sense to disinvest in the business a little bit which is what I think some of the competition is trying to do and/or at least keep some powder dry to see what shakes out relative to consolidation in other things. Is this constraining in any way?

Bradley D. Tilden

Gary, we might ask Jay Schaefer, our Treasurer, to comment on this. He’s been real involved on this project.

John

One important I think point to make in particular with Horizon is while there are 15 firm Q400s coming in as they move to a single fleet as the Q200s and the CRJs leave that their invested capital will be either flat or likely down from where it is today. For Alaska we are getting through our single fleet transition to all 737s so like last year this year we have a heavy capital expenditure amount but that’s going to start to decline as we get through the single fleet transition. So as we look into 2009 and 2010 cap ex begins to fall pretty dramatically and I think that’s appropriate given where fuel is today but after we’re done with both fleet transitions as Bill said in his opening remarks, we’ll have the two most fuel efficient airplanes in their class and given where fuel is that’s probably a pretty appropriate place to be for an airline.

Gary Chase – Lehman Brothers

Just a couple follow ups to that, invested capital will be down, that means you expect proceeds from aircraft dispositions to offset the incremental cost of buying the Q400s?

John

Horizon fleet will shrink from roughly 65 airplanes down to between 48 to 53ish and so that’s part of it.

Gary Chase – Lehman Brothers

Presumably this is you think a superior alternative to just downsizing the Horizon fleet and waiting to see what plays out? I guess the follow on question is what fuel price would you not contemplate?

William S. Ayer

Maybe just to be clear, Gary, there is actually no change on Alaska Air Group’s capital spending as a result of this announcement. Prior to this decision we had a firm order for 15 Q400s. Those 15 Q400s will come in and we will have 48 Q400s on the property. The real announcement today is we’re basically saying that plus or minus a couple of airplanes is the fleet that we see at the moment. And then we retire the Q200s and we retire the CRJs and they come out of the capital base. In terms of what fuel price or what might change our thinking about this, I think the proviso that is important is the re-marketability of the CRJ-700s. The economics of this decision are based on us having certain success getting out of that fleet type and I’m not sure at a point that we can talk about exactly where the threshold is but we do need to find a market for those 20 airplanes for this strategy to work.

Gregg A. Saretsky

We stay close to that Gary, you don’t know until you actually get out and put a sign on these things but all indications are that worldwide the market for the 70 seat bus aircraft is still very robust. You get to the place that they just described, flat or reduced invested capital, incremental capital announcements made here and fleet size that’s going down from 67 to somewhere around 50. That’s the story.

Operator

Your next question comes from Jamie Baker with J.P. Morgan.

Jamie Baker – J.P. Morgan

I saw you did have handful of MD80 cancellations recently. Just curious as to your level of confidence that you’re in complete compliance with the recent ADs on 737 rudders and fatigue issues.

Glenn S. Johnson

We’re getting into Phase II of the FAA Special Audit as you know. I think we have a high level of confidence in the work but given the experiences that have occurred across the industry I guess we’re also prepared to work with the FAA in their inspections which go through June 30th and help them through evaluating our paperwork and our airplanes.

Jamie Baker – J.P. Morgan

Second, you’ve historically shown a little more breadth of revenue acceleration from the first quarter to the second and most airlines in the business in an obvious reflection of where you fly, I realize there’s some extra noise this year, but is there any reason that we shouldn’t really assume a fairly typical level of seasonal acceleration? You’ve identified Southwest fare increases and a little bit of pressure in the Northwest corridor, but above and beyond that any reason they shouldn’t be in line with history?

William S. Ayer

I think that’s right, Jamie. If we talk about April by itself, the Easter thing was significant. The other thing that maybe affects us a little bit more than the others is April has 30 days and we ended up with five Tuesdays and Wednesdays which we have a little bit more exposure to the leisure market so that maybe hits us a little bit more than the other airlines. I think that maybe something you’re seeing in terms of why the April advances are different than May and June. In terms of the yield side, I think the industry is moving to get fares up and we’re following that trend and I just take my hat off to our folks down in the revenue management area. I think that good stuff is happening down. I guess the bigger issues is that is it enough with fuel where it is? I think it’s going to be good compared to last year. I think the seasonal trends will probably continue. It’s not going to be nearly enough for fuel is $118 a barrel. We’ll still work it as hard as we can.

Operator

Your next question comes from Daniel McKenzie with Credit Suisse.

Daniel McKenzie – Credit Suisse

I had to hop off the call for a few minutes. I apologize if my questions have been asked, I wonder if you could talk about Alaska’s willingness to be a bidder for any assets that might come up?

William S. Ayer

Our focus is 150% on what we’re doing here at both Alaska and Horizon and certainly we’re going to pay attention as to what happens to the industry and if there are opportunities. Being relatively better positioned as we are gives us a chance to maybe look at some of those opportunities. But that’s such a broad question. We’re going to pay attention and continue to position the company for the best long term benefit.

Daniel McKenzie – Credit Suisse

Separately, let me just go back to Horizon at this risk of kicking the dead horse, a number of legacy carriers are dumping significant numbers of RJs, so RF flying is presumably getting cheaper. I’m just wondering if you have a sense for whether the new fleet swap for Horizon will result in economics that perhaps are less than where RJ economics are already going today?

Bradley D. Tilden

Dan, can you repeat the question? We just want to make sure we answer exactly what you’re asking.

Daniel McKenzie – Credit Suisse

What I’m trying to get at it here is in terms of the economics of the Q400s and given where RJ economics are going, Express Jet is renegotiating its contract with Continental, there’s RJs that appear to be getting dumped on the market. The cost of RJ flying seems to be going down and I’m just wondering is your sense that the new Q400 flying going to be even more cost competitive than were RJ economics appear to be going now?

William S. Ayer

If it were all done by a third party, for example?

Daniel McKenzie – Credit Suisse

Exactly.

William S. Ayer

That’s your question?

Daniel McKenzie – Credit Suisse

Yes.

William S. Ayer

Maybe I’ll jump in here, Jeff and you could follow on or something. There is a chance that if you have a little bit of a [inaudible] view and said what is the lowest cost bid here, there is a chance that you can get this flying done for a lower cost, then this Q400 solution is going to work out. Our company is not always positioned to sell the lowest cost, lowest service end of the spectrum. I think this is going to be much, much more competitive from a cost perspective and it’s going to enable us to keep our brand together, keep the position we have for providing good customer service. We do believe that in terms of the long run business model and our ability to have revenues that exceed our costs and provide returns, it’s the best answer for us. I guess we can see that if you were just looking for the lowest CASM solution there probably is one out there that’s not this Q400 idea.

Jeffrey D. Pinneo

I know that the distinction when you mention RJ coming back and the distinction between the type of capacity that’s cutting back in the 50 seat versus the type that’s still in demand, the 70 to 90 seat and with as much as is coming back onto the market it’s not clear that any pricing that’s associated with putting those things back to work is going to be directly reflective of the cost either. A number of operators being put in a very tough situation of being handed back airplanes and such. Our view is we look at the Q400 and it’s competitive and virtually all those spaces particularly when we the benefits of single fleet and efficiencies that we’re moving toward there and then you add into that the synergies that we have within the brand the way that they’re a seamless product and everything else on the revenue side we think it’s a very competitive alternative to that.

John

I must might add the AK we had some charts that included fuel efficiency by regional aircraft and if you look at the fuel efficiency of the Q400 versus a CRJ-700 and in particular the 50 seat RJs that maybe the regional carriers are flying, this is a very, very, very competitive airplane given today’s fuel environment.

Jeffrey D. Pinneo

It’s about 22% better than the class of 50 seat RJs and even the [MBROW]170 that you referred to, it’s even better than that. Compared to our own CRJ-700 it’s about 18% better on a per passenger basis.

Daniel McKenzie – Credit Suisse

If I could just throw one last really quick one your way, if I could just flip that question around, is there any demand since it is a specialized plane, is there any demand from other legacy carriers that could perhaps be an opportunity under the CPA arrangement for the Q400?

John

We believe that’s a strong possibility. We’ve had conversations. I think on a going forward basis the new efficiencies will have with this strategy cost possibly will make it an even more competitive alternative as other major partners are more interested in fuel efficient network support solutions. We’ll certainly keep those channels of conversation open.

Shannon K. Alberts

I’m going to have the call move on now to the media portion and I’m turning the call over t our Managing Director of Corporate Communications, Caroline Boren who will conduct that portion of the call. Brandy, I’m going to go ahead and ask you to remind our media callers of the procedure for asking questions and then we’ll proceed

Operator

(Operator Instructions)

William S. Ayer

It sounds like there maybe aren’t any.

Operator

Please hold while we continue to queue the roster. There are no media questions at this time.

William S. Ayer

Thanks everybody for your participation and we’ll talk to you next quarter.

Operator

This concludes today’s Alaska Air Group first quarter 2008 earnings release conference call. You may now disconnect.

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Source: Alaska Air Q1 2008 Earnings Call Transcript

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