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Alaska Air Group (NYSE:ALK)

Q3 2012 Earnings Call

October 25, 2012 12:00 pm ET

Executives

Chris Berry - Managing Director of Investor Relations

Bradley D. Tilden - Chief Executive Officer, President, Director, Member of Management Executive Committee, Chief Executive Officer of Horizon Air, Chief Executive Officer of Alaska Airlines and President of Alaska Airlines

Brandon S. Pedersen - Chief Financial Officer, Principal Accounting Officer, Vice President of Finance and Vice President of Finance-Alaska Airlines Inc

Mark Eliasen - Vice President of Finance

Joseph A. Sprague - Vice President of Air Cargo

Andrew Harrison - Vice President of Planning & Revenue Management

George Newman - Managing Director of Accounting and Controller

Glenn S. Johnson - Member of Management Executive Committee, President of Horizone Air Industries Inc, Chief Financial Officer of Alaska Airlines and Executive Vice President of Finance - Alaska Airlines

Analysts

Hunter K. Keay - Wolfe Trahan & Co.

Michael Linenberg - Deutsche Bank AG, Research Division

Helane R. Becker - Dahlman Rose & Company, LLC, Research Division

John D. Godyn - Morgan Stanley, Research Division

Raymond Neidl - Maxim Group LLC, Research Division

Glenn D. Engel - BofA Merrill Lynch, Research Division

Savanthi Syth - Raymond James & Associates, Inc., Research Division

David E. Fintzen - Barclays Capital, Research Division

Stephen O'Hara - Sidoti & Company, LLC

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Kevin Crissey - UBS Investment Bank, Research Division

Operator

Good morning. My name is Jonathan, and I will be your conference operator today. At this time, I would like to welcome everyone to the Alaska Air Group Third Quarter 2012 Earnings Conference Call. Today's call is being recorded and will be accessible for future playback at www.alaskaair.com. [Operator Instructions] I would now like to turn the call over to Alaska Air Group's Managing Director of Investor Relations, Chris Berry.

Chris Berry

Thanks, Jonathan, and good morning, everybody. Thank you so much for joining us for Alaska Air Group's Third Quarter 2012 Earnings Call.

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

Our discussion today will include forward-looking statements regarding future expectations, which may differ significantly from actual results. Information on risk factors that could affect our business can be found in our SEC filings available on our website.

We will refer often to certain non-GAAP financial measures, such as adjusted earnings or unit costs, excluding fuel. We have provided a reconciliation between the most directly comparable GAAP and non-GAAP measures in our earnings release.

This morning, Alaska Air Group reported a third quarter GAAP profit of $163.4 million. Excluding the impact of mark-to-market adjustments related to our fuel hedge portfolio, Air Group reported a record adjusted net income of $150.3 million or $2.09 per share. This result is basically in line with the First Call consensus and exceeds last year's adjusted net income of $131.1 million or $1.79 per share.

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

With that, I'll turn the call over to Brad.

Bradley D. Tilden

Thanks, Chris, and good morning, everyone. As Chris said, Alaska Air Group reported an adjusted net profit of $150.3 million this quarter versus $131.1 million last year. Our revenues increased 6.2% to nearly $1.3 billion on the strength of our low fares and the preference for our product. This is the highest quarterly profit in our history and is the 14th consecutive quarterly profit that we've reported.

Our people are working together better than ever. And to the employees listening today, I want to thank you and your colleagues for everything you did to make these results possible.

Our pretax profit margin was 19.2% this quarter versus 17.7% last year. We believe this margin leads the domestic industry. Seasonally, this is our strongest quarter. Our pretax margin for the last 12 months is 11.5%.

On a year-to-date basis, we produced $289 million of adjusted net income, and for the last 12 months that figure is $327 million. These strong earnings are driving our return on invested capital, which is 12.7% for the last 12 months and they're also enabling us to improve our balance sheet, reward our shareholders and reinvest in our business.

You've probably seen that on September 26, we announced a $250 million share buyback program. The size is roughly 10% of our current market cap and it's significantly larger than anything we have done before. The program comes on the heels of 6 programs since 2007, 5 of which have been fully executed and which together have amounted to $312 million of share repurchases and a net reduction in shares outstanding of 13%. Given what many of you have said about our valuation, we think share repurchases have been and will continue to be an excellent use of capital that will materially benefit our long-term investors.

We also just announced an order for 50 Boeing 737s, including the new 737 MAX. The new order provides for mainline fleet replacement over the next 10 years. With options, we'll have the ability to flex up if economic conditions warrant and if we are achieving our ROIC objectives. Over the last several years, we've seen the material advantage that comes from having modern, fuel-efficient aircraft that are bought at the right prices, and we're extremely pleased that we secured airplanes to continue this pattern well into the future.

The reason we're able to make commitments like the share buyback and the aircraft order is because of our earnings and our strong balance sheet. Looking at the changes in our balance sheet since 2004, which might be viewed as the peak of the post 9/11 industry crisis, our equity has increased from $665 million to $1.4 billion. Our debt and lease obligations have declined from $2.3 billion to $1.7 billion. And we've moved from 78% of our capital structure being represented by debt to 54% today. In those same 8 years, our revenues have increased from $2.7 billion to over $4.5 billion, and we've added 93 737-800s and Q400s to our fleet, 36 of which are owned free and clear.

Turning to our growth. We have several new markets starting in the fourth quarter, including San Diego-Orlando, Bellingham-Maui, Portland-Kauai and Anchorage-Kona. Our growth over the past few years has been successful and has been accretive to earnings. We believe that we can continue to modestly grow our network in a way that is consistent with our return goals and in a way that gives our customers even more choice when flying Alaska.

On the labor front, we recently signed a 6-year agreement with our Alaska ramp service and stores agents. And I'll note that at that point, 6 years was the longest term for a labor deal that we've ever had. This follows agreements reached in the past couple of years with Alaska technicians and Horizon pilots. Each of these contracts provides for pay raises, productivity improvements and continued alignment around financial goals through our incentive plan.

And just yesterday, Horizon reached a tentative agreement to extend our deal with our pilots, again to 6 years. This deal is mutually beneficial to both the company and our pilots, and both sides worked hard to craft an agreement that should be funded through productivity gains. Voting will commence in November and will conclude by mid-December.

Elsewhere our teams are working hard for equitable, long-term agreements with flight attendants at both Alaska and Horizon, and we also recently started early discussions with our pilots at Alaska. I'm optimistic that we can reach deals that follow our guiding principles and that provide long-term assurance for everyone involved.

I can tell you that everyone of us here is focused on running an excellent business that is sustainable and that provides good results for all of its stakeholders over the long run. I don't need to remind any of you that this is the airline industry, and this sort of long-term success and balanced, consistent execution has evaded most airlines. But we believe we have a solid plan and employees who know what is at stake and who are committed to our success.

One of the things we spent a lot of energy on over the past 12 months is a program we call Flight Path that is attended, in small groups, by everyone of our 13,000 employees. In these full-day sessions, the rest of the leadership team and I listen to our employees and talk with them about the industry, the threats, our plan and what we need to do together to keep our company thriving. The response from our people has been good, and I believe we have a strongly aligned team that is ready to take advantage of the opportunities and deal with the challenges that come our way.

I want to end with a thank you to all of the employees at Alaska and Horizon for a record summer performance. They were able to handle more customers than ever before and still managed to run 2 of the most on-time airlines in the country with very high customer satisfaction ratings. And when they weren't at work, our folks were involved in 67 community events, demonstrating our commitment to local areas across our route network. My hat is off to all of them for their incredibly hard work and their -- and for their contribution to the success of this company.

With that, I'll turn the call over to Brandon.

Brandon S. Pedersen

Thanks, Brad, and hello, everyone. Air Group's third quarter adjusted net profit increased by nearly 15%, up from $131 million last year to a record $150 million this year. This represents an after-tax 12.7% return on invested capital for the last 12 months, which was up from 12% at September 30 last year. This will almost certainly mark the third year in a row that we have exceeded our 10% after-tax ROIC goal. With the cost of capital estimated to be between 7% and 8%, the investments we're making to the business are creating significant value for our owners. As recently as 2009, our ROIC was just 6%.

The improvement that we've seen over the last 3 years is not by accident. Our track record of financial performance can be attributed to matching capacity with demand while expanding our network, offering low fares, reducing costs by controlling overhead and improving productivity, having industry-leading operational performance, flying single fleets of fuel-efficient aircraft at both airlines and because our people are working together to deliver an engaging travel experience that keeps our customers coming back. Because of these and other factors, we have improved profit and we've reduced the amount of capital invested in the business.

On a pretax basis, our adjusted profit grew by nearly $33 million to $244 million. The improvement was driven by a $74 million increase in operating revenues and a $14 million improvement in nonoperating expenses. These gains were partially offset by a $33 million increase in adjusted nonfuel operating costs and a $22 million increase in economic fuel costs. Pretax margin expanded by 150 basis points to 19.2%, the second quarter in a row of margin improvement.

We know that others in our industry focus on operating margin, but we believe looking at pretax margin is important because it fully considers the effect of aircraft financing decisions and the amount of leverage in a business. For example, net nonoperating expenses were only $4 million this quarter compared to $17 million in the third quarter of 2009 with much of that improvement coming from lower interest expense because we have much less debt now than we did 3 years ago.

Passenger revenues were higher on a 6.8% increase in capacity with flat unit revenues. Mainline PRASM was up 1.2%, which compares favorably to the A4A domestic average of 0.3% for the quarter. Our industry comps are even more favorable when adjusting for our 4% increase in stage length. As we move into the fourth quarter and for the first half of next year, PRASM will again be affected by longer stage lengths.

We would once again characterize the demand environment as stable. Both leisure and business traffic seem to be holding up despite continuing concerns at the macro level. As we look to the fourth quarter, advanced booked load factors are up about 2.5 points for October, 1 point for November and December is currently down 0.5 point.

Turning to costs. Our adjusted nonfuel operating expenses increased by 5.3% on the 6.8% increase in capacity. This resulted in a 1.5% decline in our consolidated nonfuel CASM, which was consistent with our latest guidance and represents the best unit cost performance we have reported this year.

There are a few notable changes in the P&L that I'd like to mention. First, we saw a 12% increase in maintenance costs, largely due to a high number of engine removals at Horizon. Second, contracted services increased by 9% because of handling costs at the new cities we fly to. Third, food and beverage costs increased by 15% because of the growth of buy-onboard sales as well as investments we're making to improve the cabin experience. And finally, variable incentive pay is up because we're exceeding our PBP plan goals more than we were at this time last year.

Looking to the fourth quarter, we expect consolidated unit costs to decline about 2.5% on a 7.5% increase in capacity, bringing full-year CASM x fuel to between $0.0845 and $0.085, which will represent a 1% decline. Full-year mainline costs are expected to be down slightly as well, to $0.0755 to $0.076.

On the fuel side, economic fuel costs were up 6.5%, basically in line with the 6.3% increase in consumption. Although the economic price per gallon was the same in the third quarter this year and last, the month of September tells a very different story, where the economic price per gallon was higher than the quarterly average by nearly $0.20 at $3.43 a gallon and in line with prices we are seeing today.

Most investors are aware of our simple, proven hedging program designed to protect our balance sheet from spikes in crude oil. We really view it like it is an insurance policy. You might recall that late last year, we began purchasing 10% out of the money options as a means to reduce our premium cost and self-insure a bit more, given the strength of our balance sheet. More recently, we started buying options that are up to 20% out of the money, depending on forward crude prices. We'll see the benefit of this dynamic approach in the form of lower premiums in 2 to 3 years as those hedges mature. There's is a table on our Investor Update that provides current hedge protection levels.

Looking to next year, we're in the middle of the 2013 budget season, and our divisional leaders are working diligently to build budgets that leverage capacity growth and to further unit cost reductions. The higher gauge 900ERs that will begin to enter our fleet next month and customer-facing initiatives, such as self-serve bag-tagging at the kiosks, and our new booking functionality offered on our mobile site, will help us keep costs in check.

We are, however, facing significant cost pressures in several areas. First, because of the decline in the discount rates, pension expense will increase, perhaps up to $15 million based on what we were seeing today. Medical costs continue to grow, and we're planning to increase IT spend again this year to fund required infrastructure projects and innovation activities, such as the mobile and self-service investments that I just mentioned. Finally, there is some uncertainty with airport costs, principally at Sea-Tac, as we come up on the expiration of our lease there. Although we're not ready to give preliminary 2013 cost guidance just yet, let me assure you that even with these cost pressures, we are mindful of the need to make our costs more competitive and maintain our track record of unit cost reductions.

Turning to capacity. We expect consolidated capacity to grow about 7% to 8% in 2013. The Alaska fleet will grow by a net of 7 aircraft over the next 15 months as we take delivery of 13 737-900ERs starting next month and retire 6 aircraft in the fourth quarter of 2013.

An advantage we have, that the majority of our airplanes are owned versus leased, giving us a great deal of flexibility to adjust our fleet growth. An example of this flexibility is our recent decision to dispose of 3 additional 737-700 aircraft next year, bringing our planned retirements to the 6 aircraft I just mentioned compared to 3 originally planned.

Moving to our balance sheet. We ended the quarter with $1.2 billion in cash and short-term investments. During the first 9 months of this year, we've generated $635 million of operating cash flow compared to $609 million last year. Capital spending was $340 million, resulting in roughly $295 million of free cash flow. We have paid off $240 million of long-term debt, including $102 million of debt prepayments, improving our debt-to-cap ratio to 54% and taking net balance sheet debt to 0, in fact slightly net cash. We've also purchased approximately 1.5 million shares of our common stock for $52 million so far this year.

Brad mentioned our recent Boeing deal. With this order, our planned capital expenditures for 2012 increased $30 million to $500 million because of the initial predelivery deposits. Firm CapEx in 2013 increased by only $40 million and is now expected to be $420 million, and firm CapEx in 2014 increased by $135 million to $370 million. We have options that, if exercised, would increase those amounts, but we'd only do so if we felt confident we could meet our return objectives.

Our treasury team, which also handles fleet transactions, has been very busy lately, and I want to thank them all. Besides the new repurchase program, the Boeing order and debt prepayments, they recently completed the extension of one of our 2 credit lines out to August, 2015, with lower fees.

We're pleased that the hard work of the last decade is paying off in many ways, including solid financial returns that are exceeding the cost of capital, strong cash flows and material balance sheet improvement. We're often asked why improvements in returns, cash flow and our balance sheet are not better reflected in our multiples. Of course, we don't know the answer to that question. But what I can say is that we're very focused on running the business in a way that benefits our long-term owners by sustaining a level of performance that meets our return goals.

And now, I'll turn the call back over to Brad to kick off the Q&A.

Bradley D. Tilden

Thanks, Brandon. And operator, at this time, we're ready for questions from analysts.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Hunter Keay with Wolfe Trahan.

Hunter K. Keay - Wolfe Trahan & Co.

So I have to ask you about the fuel hedging, I apologize. I asked a similar question to UAL about an hour ago. And I'm only asking because your guys did $3.46 a gallon in the fourth quarter. And Brandon, I appreciate the color and the movement of volume or out-of-the-money hedges. But I mean, the results that you guys have produced over the last couple of years have been unbelievable, and your balance sheet is pristine. You have unencumbered assets. If there is one airline, again, maybe outside of Southwest, that probably has an excuse not to hedge fuel, it is you. And I look at U.S. Airways paying less for fuel than anybody in something like 4 of the last 8 quarters. At what point do you look at that and you say, "You know what, this is not a fluke. This is a real thing." And even if there is a crisis in policy and framing it in the context of you describing the hedge book as insurance, even if there is a crisis, we have the balance sheet and we have the assets to withstand it no matter what happens. So I guess let me ask you a question, at what point did you..

Bradley D. Tilden

Is there a question there or a statement?

Hunter K. Keay - Wolfe Trahan & Co.

Yes. Well, let me ask you a question, the classic self-side rhetoric. When does U.S. Airways no-hedge policy stop being a fluke?

Brandon S. Pedersen

When oil prices run up.

Hunter K. Keay - Wolfe Trahan & Co.

I mean, I hear you, but oil prices just did go up in September, and they paid less for fuel than anybody in the quarter.

Brandon S. Pedersen

Hunter, it's Brandon. I get the question, and I'm going to let Mark Eliasen, our Treasurer, answer it. What I will say is that we have a strategy that we really believe in. It's a long-term strategy. In terms of comparison to other airlines, you do get into apples-to-oranges comparisons because of where people put taxes and into plane fees. But I think what you're really getting at is, does the strategy makes sense? And Mark, maybe you have some comments on that.

Mark Eliasen

Yes. This is Mark Eliasen. I appreciate what you're saying and you make a lot of good points. We're always evaluating our program, as you well know, and we may do some things to change. But for now, our program, it serves us very well. Again, I respect what you're saying. But we really don't know where fuel prices are going, and we're not going to try to figure it out. And our program does protect us against spikes.

Bradley D. Tilden

Hunter knows this, but for others -- I mean, you've gone from basically hedging at the money, combining at the money call-outs just a couple of years ago to 20% out of the money is the practice.

Brandon S. Pedersen

That's right.

Hunter K. Keay - Wolfe Trahan & Co.

Yes, I appreciate the progress, no doubt about it. I think it's trending in the right direction. There's even an argument to be made that if you just actually sold the entire hedge book right now, how much that is actually worth, like Southwest had an opportunity to do back in '08. That's another question. But I guess let me ask you another question relating to bag fees. How do you guys quantify the lower bag fee structure that you have relative to peers? How do you measure the fact that your customers are booking away from other airlines and onto Alaska? How do you know that they remembered that they paid $5 to $8 less per bag a week after they took the trip? How do you measure that?

Joseph A. Sprague

Hunter, this is Joe Sprague from Marketing. So it's a good question and definitely something that we pay a lot of attention to. We actually are doing more customers research right now, I think, than we probably ever done in our history, and customer perceptions and behavior around bag fees is definitely something we look at within that research. So that's partly how we know. And I guess just to elaborate a little further on that. I mean, our bag fees on a per-passenger basis are down this year. I think we're seeing sort of an ongoing change in customer behavior, just generally, when it comes to checking bags. But we do feel good about where our bag fees are today. It's not to say we would not ever consider making some adjustments. But right now, there's a lot to be said for the simplicity, where we have each of the first 3 bags set at $20. And we do talk about that with customers. We make sure that they're aware that that's what the fees are and that there is that simplicity. We still have the industry's only baggage service guarantees. So we promote the fact that customers are getting something of direct value in exchange for their bag fees. And it's interesting that the new DOT customer or passenger protection regulations that came out with respect to bag fees, we're not sure that they're accomplishing exactly what they were intended. But it has brought a lot of visibility to bag fees, that consumers are probably paying more attention to the actual fees maybe than they have in the past. We believe that customers are looking at this. And in our case, we have a lot of leisure travelers, as you know, a lot of families traveling with small kids and whatnot. And in those cases -- I mean, just a basic example. A family of 4 traveling together, what they would pay for checking 2 bags each with Alaska Airlines versus any of the other bag -- airlines charging bag fees could be $80 to $100 or more per family traveling. And we think that they do realize that, and that's a meaningful number for them.

Hunter K. Keay - Wolfe Trahan & Co.

Yes. If they check 3 bags, they'd pay more on Southwest than they would on Alaska, by the way. Shame on anyone for checking 3 bags.

Bradley D. Tilden

Hunter, this is Brad. I might just want to acknowledge that this is a good question. I think Joe outlined our current thinking. There's a -- we think the customers notice, and we -- as you look at J.D. Power results and all that, we do think fees do affect their preference for airlines. The flip side is we get that we -- and I think Alaska has been a leader in sort of this notion to provide the appropriate returns to investors. We get that it's an important source of revenue that's helped the industry. So I think we've articulated our thinking about this today. But I -- we acknowledge it's a good question, and I guess it's something that you wrestle with every quarter and you think about all the time. Anyway, just wanted to acknowledge that it's a good question for us to think about.

Operator

Your next question comes from the line of Michael Linenberg with Deutsche Bank.

Michael Linenberg - Deutsche Bank AG, Research Division

I just have 2 questions. My first on some of the competitive capacity. I was going to ask you how your Bellingham-Maui is booking up and then knowing that there's another competitor starting service in that market? And then I was also wondering how Bellingham to Honolulu is doing since you have another competitor starting up in that market? And then that's the -- those are sort of maybe potential negative markets. Then in some of the positives are some of the capacity cutbacks that we're seeing from competition in your markets. If you can just talk about that?

Andrew Harrison

Michael, this is Andrew. Just on the Bellingham -- and I might touch on Hawaii, in general, because I'm pretty sure I'm going to get the question. But the Bellingham-Maui is sort of seasonal, and it's booking up within our expectations and the same with the Honolulu. Competitive-wise, you're right. I think many of the airlines have been very disciplined, especially as we move into the first quarter of 2013. People are getting more surgical with discipline, which has been great. One of the things -- I think Mark Dunkerley did an excellent job a little bit describing the environment of Hawaii this summer and the seat capacity, and he shared that the Bay Area was up 25% and Southern California were up 15%. Both Alaska and Hawaiian added seats to those markets. We added over 100% capacity to the Bay Area. San Jose-Oakland to be all 4 markets. People talk about the fiscal cliff. I learned the hard way about the Hawaii-California cliff in September. But jokes aside, we're learning and we're adjusting. And what I can assure you is, is that going forward, as we learn Hawaii better, we will be making adjustments and refinements. Overall, capacity to Hawaii will continue to grow at about 40% next quarter, in the fourth quarter. But what I will say is that we've essentially seen all the capacity come back from Aloha and ATA. We've talked internally about pushing the envelope for Hawaii by still maintaining a good, strong business. I think we're at the corner of the envelope, looking down at the stamp right now, but -- that's to say we will do a little bit more. But I think you'll see the growth subside and us get smarter about our revenue management and capacity discipline, especially for the seasonality going forward.

Michael Linenberg - Deutsche Bank AG, Research Division

Okay, good. And them some of the other markets like some of the moves by Virgin and Southwest in your markets?

Andrew Harrison

Yes. So as is probably obvious to some folks, basically our San Francisco network, for lack of a better word, is completely covered now by Virgin. They have launched on top of us in every market. So we're seeing some challenges there, same with Portland to the Bay Area. And San Francisco is up 40% in seats. They're abating going forward, but those are pretty much some of the hotspots that we're seeing. But on the plus side, we're seeing some rationalization of capacity in the Pacific Northwest, especially in some of our feeder markets. And so overall, net-net, we see competition somewhat -- the capacity, again, somewhat neutral going into the fourth and the first quarter.

Michael Linenberg - Deutsche Bank AG, Research Division

Okay, good. And then just my next question to -- I guess to Brandon. You talked about higher pension expense. With some of the legislation, I think it was the transportation bill back in July, there was a modification to the discount rate. And I'm not sure if you guys benefit from that or not, because you're -- I believe you're also a beneficiary of the Pension Protection Act of '06, and one may supersede the other. So is there anything in that bill that would benefit you from a pension expense or even a contribution basis?

Brandon S. Pedersen

Mike, it's Brandon. I want to apologize, I will not be able to come up with nearly as humorous of analogy as Andrew has been able to put forth on this one. The -- I think you're confusing funding with GAAP expense. From a GAAP-expense perspective, we don't get any relief, if you will, from any sort of bill that's floating around Congress. That's a funding thing. On the GAAP side, what I was talking about is movement in the discount rate down to what GAAP says you're supposed to use which, as I said, would put our pension expense up, maybe up to $15 million next year. Now having said that, on the funding side, we actually have no required funding this year or next. And so it really doesn't help us in that regard. We choose to fund, but we have no required funding.

Operator

Your next question comes from the line of Helane Becker with Dahlman Rose.

Helane R. Becker - Dahlman Rose & Company, LLC, Research Division

Just on a couple of things. One is with respect to your maintenance costs. I was kind of surprised that they were up 12% in the quarter. I don't think we were thinking it would be that high. Is there something in there?

George Newman

Actually, the maintenance costs are split between our 2 divisions. Alaska is up probably about $1 million, and original operation is just the one that's contributing to it. Most of it is attributable to engine repairs. And I will let Glenn expand further on it.

Glenn S. Johnson

Thanks, George. Helane, this is Glenn. So we are actually in a heavy point in engine maintenance cycle. So this year, we had 14 engine events in the quarter versus 7 last year. What I would also say is that we had some issues with the engine work that was done by Pratt, where the life of some previous repair work that they had done did not meet the expectations that we had. And so that affected 5 of that increase of 7 year-over-year. And we're expecting to see that same kind of trend through the fourth quarter of this year, and we're also working with Pratt to determine what we can do in terms of mitigating the costs that we were not expecting due to that deficiency in the earlier work.

Helane R. Becker - Dahlman Rose & Company, LLC, Research Division

Oh, okay. So the same level of increase for the fourth quarter?

Glenn S. Johnson

I'm expecting to see an increase in the volume of again in the fourth quarter.

Helane R. Becker - Dahlman Rose & Company, LLC, Research Division

Got you, okay. And then my other question is just with respect to some of the new service like Portland, Washington, Seattle, San Antonio that you talked about in the press release comments, did you say how those have booked up, and how the success have been -- sorry, has been on those?

Andrew Harrison

Helane, this is Andrew. I was just reflecting on this morning. I think we've started 17 new markets in the 12 months ended September. And so what I would say, although we don't state specifics, is that many of these markets are booking up certainly on the volume side is where we would like to see them. Right now, they're healthy with sale fares and promotional fares going into the fall season. So we are going to be watching those closely. In general, normally markets take 1 to 2 years. What I will tell you is that there is nothing that we have seen that gives us cause for major concern on these new markets. So overall, we feel pretty good, but we'll be working them hard with Joe and his marketing team to promote those markets going forward.

Helane R. Becker - Dahlman Rose & Company, LLC, Research Division

Okay. And then just my last question. Did you say that you were going to slow the number of new cities that you are opening now going forward? I thought I heard you say something about growth for next year, and I kind of missed that, sorry.

Andrew Harrison

Okay. That's okay. I was probably referring to Hawaii growth and how that is going to become much slower. What I will tell you is, Helane, that I think given the aircraft deliveries, we're looking about 7% to 8% growth next year. In the next 3 weeks, we will be announcing 3 new markets for 2013 for the mainline business, and from where I sit today, that will be it for new market in 2013.

Brandon S. Pedersen

Helane, this is Brandon just some more color on that. You might have been referring to the comments I made about slowing down the fleet growth. We've made the decision recently to get rid of 3 additional 737-700s late in the year next year. Just because we want to be prudent with the fleet.

Operator

Your next question comes from the line of John Godyn with Morgan Stanley.

John D. Godyn - Morgan Stanley, Research Division

I just wanted first to ask a question about your thoughts behind the fleet order that you placed. We've seen a number of airlines sort of be very opportunistic about taking advantage of what seems to be kind of almost rock-bottom pricing for some older used aircraft. Relative to those types of opportunities, what made timing of a new aircraft order so attractive?

Brandon S. Pedersen

John, I'll start and then maybe Mark can jump in here a little bit. Brad made the comment in his section that we have really benefited in a material way from having a fleet of really efficient aircraft, larger-size aircraft, and for us, that's kind of the mindset that we have. We know that there's great deals out there on used airplanes, but that has not really been successful for us. We prefer to go the other direction. As we looked at the timing of the fleet order, it's important to know and to keep in mind that of the 75 firms now that we have on the books, about 2/3 of that book are largely -- are replacements, and the other 1/3 allow a really modest amount of growth over the next 10 years or so. And then the final thing that we were really thinking about was getting in line for the MAX. The MAX is going to be an awesome airplane. It's going to have 13% better fuel efficiency. And what we didn't want to do is put ourselves in a competitive disadvantaged position by not being appropriately timed on that. Mark, do you want to add to that?

Mark Eliasen

I was just going to add that our partnership with Boeing is very strong, and we're happy then pleased that they gave us early slots in the MAX, so we can get both the Dash 8 and the Dash 9 early in the cycle. And like Brandon said, we're really impressed with the fuel savings that, that will bring us.

Bradley D. Tilden

Yes. And you might just join -- you don't -- from the way we look at the economics, it's not like you have to pay something to have new airplanes. As we look at a 15- or 20-year-old airplane, and look at those airplanes on a cost per block hour or cost per seat basis, they're normally very, very pricy for both maintenance costs and fuel costs. So we look at these -- the analyses that our teams run, we look -- the new planes make sense. They pay for themselves. And as Brandon said, you have the chance to up-gauge as well and bigger airplanes are working for us.

Brandon S. Pedersen

Yes for sure,especially if you think about the 900ERs that come in the next 5 years or so. The NPV on that decision is great because what you do is you take that -- you take an airplane that has a 181 seats, low maintenance costs, great fuel efficiency and you use it to take out a 400 that has high maintenance costs, bad fuel efficiency or a 700 that, frankly, is the airplane -- an airplane that's just too small for what we want to do with it.

John D. Godyn - Morgan Stanley, Research Division

Okay, that's helpful. And is it fair to say that just given the size of the order, we're unlikely to see any sort of another order for a number of years? Are we sort of taken care of for a while now?

Brandon S. Pedersen

I guess the way I would answer that is when we were thinking about the way to structure this order, what we really wanted to do was position the Alaska book to allow for replacement and a potential -- and potential growth to the extent we saw market opportunities. This is a very, very dynamic business. Lots of changes. What I will say is that we're really happy with how we positioned the order now. But I can't say over the long term whether or we would not need more airplanes if there were some big change in the industry that caused us to want to do more than we're doing. But just to reiterate, for now, and based on what we see, our order book positions Alaska and -- for exactly what we want to do over the long term.

John D. Godyn - Morgan Stanley, Research Division

Okay, that's helpful. And can I just ask a question about the advance book factors that are out there? And I know that, that is not the only moving part, and you guys have put a very good PRASM numbers even when we've seen some volatility in advance book factor. But I couldn't help but notice how much it was revised down and then the fact that it's negative in December, which kind of caught my eye. Can you just kind of talk to maybe what's going on there, and in particular, to the extent you have any visibility, how are the holidays booking up?

Andrew Harrison

John, this is Andrew. As we look forward and look at -- October is up 2.5 November 1 and December down just a 0.5 point, that feels right to me personally. We have often seen further out, especially when you have a lot of holidays in the December period. The holidays are actually -- both Christmas and Thanksgiving, are all booking up solidly and normal. The one thing to also remember is our trip length is going to be up 4.3% also in the fourth quarter. But overall, other than as I shared earlier, recovering a little bit from, I'll just say, lack of understanding of the seasonality of Hawaii and California, so we're going to bring that in a little bit more. So I think some of these you'll see improve. But overall, we feel pretty solid about the fourth quarter.

Brandon S. Pedersen

John, it's Brandon. I want to come back and just add one more thing about the fleet. What I was really focused on was the mainline fleet and how our order with Boeing positioned us for the future. The other thing that we're thinking about, and we've talked about this internally with our employees, is we're looking at whether or not it make sense to have Q400s up in the State of Alaska at some point. This is really, really early in the planning stage. But to the extent that we did something like that, we may see a need for more Q400s.

Operator

Your next question comes from the line of Ray Neidl with Maxim Group.

Raymond Neidl - Maxim Group LLC, Research Division

With your big cash reserves and strong profitability, have you ever thought about buying another airline and shown on how to do it right? Are we getting...

Bradley D. Tilden

Yes, you guys are doing great.

Raymond Neidl - Maxim Group LLC, Research Division

It might be worthwhile, but if you just read up. Now I just wanted to just clarify a couple of things about what's happening, the great direction in your ROIC and debt-to-capitalization ratios. Do you have any new target levels that you're shooting for now in those 2 areas as use of your cash?

Brandon S. Pedersen

In terms of targets, no, we don't really have target levels necessarily. I'll take each one of those individually. ROIC, we have long said that our goal is to generate a 10% return on invested capital over the business cycle. We have had a couple of really strong years. We're at a 12.7% ROIC number on a rolling 12 basis now. And we will certainly finish the -- this year, 2012, with a really strong number. But we're sticking by our long-held goal on ROIC. In terms of debt-to-cap, we are really, really proud of what we've been able to do with the balance sheet over the last couple of years, 3, 4 maybe and bring debt-to-cap down to 54%. I noted in my remarks that we had prepayments of roughly $100 million so far this year. We would likely not prepay any more debt. We're feeling good about our capital structure. Just if you look at normal maturities next year, we have $160 million-ish of current maturities, and then you take that and you assume there's going to be some increase in equity if we have profitability again next year, which all signs are pointing to us having, that would bring our debt-to-total cap down into something that started with a 4. People would say, "Is that too low?" And I don't know that there's ever an amount that's too low in this industry. I think the history of this industry has been that there's been way too much debt. We don't necessarily have a target. But boy, I'll tell you, as we realistically look at our capital structure, I just do not see it getting down into the 30s. We would probably want to do something a little bit different, tweak our strategy a tiny bit. But I don't see anything, any issues with having a capital structure that has a debt weighting in the 40%-something range.

Raymond Neidl - Maxim Group LLC, Research Division

Okay, that's interesting. Also talking about the Q400 that you were mentioning a little while ago. Maybe bringing them up to Alaska, whatever. That leads to my question with Horizon. I guess at this point you've got it pretty well-fixed that way that you wanted, maybe there is a little bit more work to do there. Now are you looking at other tasks for maybe Horizon? Other parts of the country? You've mentioned Alaska. I assume that Horizon, if you were going to use the Q400 up there, it would be Horizon flying it. Are there any other opportunities separate from Alaska Airlines where you can move that type of model or that product?

Bradley D. Tilden

Ray, it's Brad. The first thing -- and I'm going to ask Glenn to really answer the question, but the first thing I want to say, to Glenn and to the Horizon employees, is they have done a fantastic job of improving that company's performance. If you look at the cost structure and the move to the single fleet, lots of back-office overhead they pulled out. The branding stuff, which I think is really -- their Alaska-branded airplanes or Alaska with a small Horizon. I think the operation is really, really cleaned up. And if you look at the returns that company is producing, they've come a long way in a couple of years. And so I think a huge compliment goes to Glenn and his leadership team and all the folks at Horizon. And then Glenn, you could talk more about that and talk about further opportunities for Horizon.

Glenn S. Johnson

Sure. Thanks, Brad. Ray, this is Glenn. The first thing I would say is like Brad, I want to extend my thanks and compliments to the whole Horizon team. They're the ones that got this thing turned around. At the same time, I'd like to say that we're never done. We've got cost pressures still on, in particular, our maintenance costs that we're working very hard internally and with Bombardier. So those things are still in our sights in terms of improvement. In terms of future opportunities, as Brandon said, we are starting a very preliminary look at how the Q400 might be a good fit in the state of Alaska. Beyond that, we're kind of a typical CPA carrier now, so we look to our friends at Alaska to determine what opportunities they can best use the Q400s to feed these -- the growing fleet size as well as the growing gauge at Alaska. And I'm personally very enthusiastic about those opportunities, both in the Pacific Northwest network as Alaska gets bigger airplanes that Brandon was talking about and then potentially more in the state of California. I guess I would say you've seen us do some things intra-California and I personally believe the Q400 is a great airplane for that kind of stage length, just like it will be in the state of Alaska.

Operator

Your next question comes from the line of Glenn Engel with Bank of America Merrill Lynch.

Glenn D. Engel - BofA Merrill Lynch, Research Division

A question on the regional operation. If I look at the regional, the RASM there was down about 4%. So why is the regional lagging the mainline so much?

Andrew Harrison

Yes. Firstly, we have very tough comps. Our unit revenues were up 15% last year in Q3 as we shrunk ISMs and restructured the fleet. But just bluntly, the major region for the reduction in unit revenue was competitive capacity in the summer. Southern California had some big increases. California to Portland, we have 10 flights a day. And as I said, seats were up 60% between Portland and San Francisco. We see those competitive pressures abating a little bit going forward, but that's the main reason for those negative unit revenues.

Glenn D. Engel - BofA Merrill Lynch, Research Division

And can you talk about the transcon opportunities? I guess when you're looking at the 7% growth, what region of the country now starts looking most attractive, if Hawaii is starting to fill out, and how is that opportunity doing?

Andrew Harrison

So I mean, as I mentioned earlier essentially we've got all the new markets going into 2013. We're going to announce 3 more here shortly, which I can't comment on right now. But you're going to see very few new markets going into 2013 outside of the new ones that we have already done recently.

Glenn D. Engel - BofA Merrill Lynch, Research Division

Finally, I have noticed that you've been cutting Alaskan capacity quite a bit. What's driving that?

Andrew Harrison

I believe we were flat in the third quarter. But we -- historically, we had too many seats in the market, to be quite honest. And we've been shoring that. We look at Alaska week by week by week. So we're just getting the seats right in that market.

Operator

Your next question comes from the line of Savi Syth with Raymond James.

Savanthi Syth - Raymond James & Associates, Inc., Research Division

Just one additional question on Hawaii. How is the ancillary revenue trends in Hawaii?

Joseph A. Sprague

Savi, this is Joe. Ancillary overall is about flat in absolute dollars year-over-year, down a little bit on a per-passenger basis. Big contributor there, as we've already talked about, was the bag fees. But maybe specific to your question, Hawaii does a couple of things that are really nice for us from an ancillary standpoint. One area where we have had really strong performance for the last several months is with our buy-onboard food and beverage program. We do especially well with that on our flights to Hawaii. We try and plus up the product a little bit there to make it -- for a great customer experience, but we get some additional revenue benefit as well. And then over time, we're trying to build up more of our car and hotel business. It's not where we want it today, but over time, we think we can grow that a lot higher. And Hawaii will be a key part of that. And in fact, as it pertains to our current hotel business, Hawaii actually is up nicely year-over-year.

Savanthi Syth - Raymond James & Associates, Inc., Research Division

What is the gating factor in building up the hotel and car business?

Joseph A. Sprague

I'm sorry Savi. One more time?

Savanthi Syth - Raymond James & Associates, Inc., Research Division

What is the gating factor or what will you need to see for that component to start increasing?

Bradley D. Tilden

Savi, it's Brad. I think, I mean, the first thing I think I would say is I think there is enormous opportunity in places like Hawaii for us to sell cars and hotels over alaskaair.com. I think it's customer preference and awareness in kind of getting critical mass and the right relationships with the hotels. So I think it's all of that stuff. And I think we're -- I don't know, with a lot of these things, that if you maybe contrast it with other technology moves, you see little moves to get from 0 to 1% to 2% to 3% to 4%, then you start moving bigger. And I don't know if we can say right here what the gating factors, but I would just say that I think over time, there is enormous potential there because I think customers trust us. They like the Alaska Airlines experience and I think alaskaair.com is a trusted place to buy airline tickets, and it will also be a good place for cars and hotels.

Savanthi Syth - Raymond James & Associates, Inc., Research Division

Understood, great. Just one quick last follow-up question on the booking trends. I think in the past, you have mentioned just because the selling patterns that you should see book load factors narrow as you get closer to the date. Is that still the case, or has something changed there?

Andrew Harrison

Savi, this is Andrew. I don't see any major changes in our booking patterns except as I shared earlier. We've got some work to do on how we've been selling Hawaii, especially California, and you're going to see us make some adjustments there and maybe sell more a little earlier and sort of build our way up there. But other than that, nothing significant.

Operator

Your next question comes from the line of David Fintzen with Barclays.

David E. Fintzen - Barclays Capital, Research Division

Just a couple of quick ones, maybe one for Andrew. You talked about sort of being a little more tactical in Hawaii, and I think you mentioned California in terms of seasonal capacity. Are there good counter-seasonal markets to shift into? Or should we be thinking in terms of a bit less aircraft utilization?

Andrew Harrison

I think, overall, between the summer in California and the winter in the Pacific Northwest, we have opportunities to offset each other. We have opportunities to leverage our fleet network in the Pacific Northwest to help out California. So I think what you're finding is sort of just a tweaking of our Hawaii network on some of the weakest days, nothing majorly material.

David E. Fintzen - Barclays Capital, Research Division

Okay. Okay, that helps. Then on the 7% to 8% ASM growth that I think Brandon mentioned for next year. How much of that is up-gauging? Is that, what, 2, 3 points or is that less?

Brandon S. Pedersen

David, it's Brandon. I don't have that handy. Andrew, do you know off the top of your head?

Andrew Harrison

Smaller portion of the...

Brandon S. Pedersen

Yes, I don't know the answer to that off the top of my head. What I do know is that we've got 15 900ERs coming in, 6 going out -- excuse me, 13 coming in, 6 going out. So that's basically 7 net aircraft. They are bigger and our stage length is going to continue to grow as well. But I don't know the split.

Operator

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

Stephen O'Hara - Sidoti & Company, LLC

Just going to the buyback. I mean, in terms of the amount, looking at the consensus estimates that are out there, I mean, it looks like you guys are going to generate -- you should generate, based on the estimates at least, a lot of free cash flow based on the CapEx guidance you have so far. Your debt repayments are going down, I think, in the next 2 years. So I mean it seems like the -- maybe the $250 million seems a little small or maybe the time frame seems a little long? But can just talk about that a little bit?

Brandon S. Pedersen

Sure. This is Brandon. I obviously can't and won't comment about the first call and guidance and our -- your assertion that the cash flow is going to be big. What I can tell you is that generating free cash flow is certainly a goal of this company. And in terms of the $250 million being small, I guess I would push back a tiny bit and say it is 10% of our market cap. And if you look at the history of what we've done, we've done a series of $50 million authorizations for, I think, there's 4 of them in a row. And what we really wanted to do with a $250 million authorization, that's again, 10% of our market cap, is demonstrate our confidence in our plan and our cash flow. So I don't know that I have a whole lot more to add other than that.

Stephen O'Hara - Sidoti & Company, LLC

Okay. I guess I mean, just in terms of what you guys have done to the balance sheet over the last couple of years, it seems like you could easily do a lot more.

Bradley D. Tilden

Steve, it's Brad. I mean, think another thing we might say about it is, is it is something you continually look at. And Brandon, I can't remember, but we -- in our grid, we increased our repurchase rate by 71% a few months ago. I can't remember the month when we did that at current stock prices. But it's something that -- we've just announced this $250 million. Now we get into 2013, see how things are looking at. You just -- you continue to evaluate it as you go.

Brandon S. Pedersen

Yes. The other thing I would add is that a balanced approach has worked well for us. As I said, we probably won't do anymore prepayments necessarily, but we have had a cash balance of roughly $1.1 billion to $1.2 billion for quite a while now, and we have always found good uses for that cash that are investor-friendly.

Stephen O'Hara - Sidoti & Company, LLC

Okay. And then second, I guess, just going to Delta's buy of the trainer facility, I guess, just curious about your opinion of that as maybe an option for Alaska on a smaller scale? I mean, is this something that the industry could do on a JV or kind of a coop basis to help save on fuel costs?

Mark Eliasen

Steve, this is Mark Eliasen. I would just say that we understand why Delta did that, we're all frustrated with fuel costs. As far as our immediate plans, those are creative ideas that you threw out there, but we really don't have anything in the works right now other than to continue to watch fuel and do our best through our hedging program to protect ourselves from spikes in that fuel cost.

Stephen O'Hara - Sidoti & Company, LLC

Okay. And then lastly, I guess, what's your ancillary revenue per passenger? And then I think Allegiant's done a pretty good job cutting their credit card fees by moving to debit cards. Is this something you could do for in cabin? Would that help at all or is that something that you guys have at your radar?

Brandon S. Pedersen

Yes. In terms of ancillaries, our ancillary fee per passenger right now is about $11.80 on a year-to-date basis. In terms of opportunities, I think Joe spent a few minutes earlier talking about the ancillary opportunities that we have. Turning to the debit card thing, we have seen a significant -- excuse me, decline in credit card costs because of the Durbin Amendment and how that has brought credit card costs down. In terms of moving to debit cards in the cabin, we do accept both debit and credit. Joe do you want to add to that or...

Joseph A. Sprague

No. Just that we're -- we think we have some opportunities with our overall credit card agreement. It's an important financial vehicle for us and we think we can enhance on that even further.

Andrew Harrison

This is Andrew. I might pile on here real quick. We talked a lot about ancillary, but one thing folks should be aware of is we're doing a lot of work to get more revenue onto our aircraft. For instance, we only have 1 fare. Say Seattle-San Francisco, we only have 1 fare. We only have 1 class to sell in the first class of the deepest -- of the lowest to the highest of the highest, peak-peak season. We're going to add more booking classes. We have a leg-based revenue management system. We're hoping by 2014 to have an O&D system that will significantly improve our revenue performance. We sell upgrades at the gate. We need to get that electronic and more variable. So we have a bunch of things in the works, to Brandon's IT comments, that we think are going to bring more revenue in as we continue to grow the airline.

Operator

Your next question comes from the line of Duane Pfennigwerth with Evercore Partners.

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Just a couple of little items most of the stuff has been well hashed here. On the CapEx guidance through 2015, I appreciate that's a long-term plan. You got some footnotes around incremental deposits, around options. How should we be thinking about how you think about whether or not you are going to exercise those options and timing? So like for next year, what do you need to see to decide if you're going to pull the trigger on that incremental $100 million of CapEx?

Brandon S. Pedersen

Duane, it's Brandon. What we need to see is a plan that gives us confidence that those incremental airplanes are going to be able to meet our return targets.

Duane Pfennigwerth - Evercore Partners Inc., Research Division

So I guess when would you know that? Is it middle of next year, and you say, "Yes, we're going to hit a 12% ROIC again, so let's do it." Or how do you think about that?

Brandon S. Pedersen

Yes. It's really more where these airplanes are going to go and what we think the NPV looks like. One of the difficulties in this business is you have to put down deposits on airplanes a fairly long period before you actually get the asset and then it's a 20-year asset that you have to use profitably. And so there is a great deal of uncertainty, obviously. But as we talk about it internally, as we look at the fleet plan, as we look at our list of market opportunities, as we look at the direction we're going on our cost structure, again, it would all come down to whether or not we have a high degree of confidence that we can deploy those aircraft in a way that meets our return targets.

Duane Pfennigwerth - Evercore Partners Inc., Research Division

Okay. Consistent, good answer. What is the value of your unencumbered assets as they stand today? And along those lines, if you had to raise something against them, what you think you could raise?

Mark Eliasen

Duane, this is Mark. I would say that we're got, as we have mentioned, 40 unencumbered aircraft. It's a little bit speculative to say how much we could raise. We talk to banks and creditors all the time and they would be anxious to lend against especially our 737-800s. So it's in the several-hundred-million-dollar range if we needed to. But right now, we don't see that need.

Operator

Your next question comes from the line of Kevin Crissey with UBS.

Kevin Crissey - UBS Investment Bank, Research Division

You got it covered by this point.

Operator

And your final question comes from the line of Hunter Keay with Wolfe Trahan.

Hunter K. Keay - Wolfe Trahan & Co.

Andrew, I just want to sort of hear your opinion on one particular market, that is San Diego-Orlando. I believe that it is historically kind of a lower-yield market on an O&D basis. I'm curious to know, A, why you think that specific market can work? And, B, more broadly, just tell me what you think about when you decide to open up a market like that, that doesn't touch Seattle?

Andrew Harrison

Yes. In short, number one, you are very -- you are spot on as it relates to a lower-yielding market. What I would is that, firstly we look for is we still have a good presence in Southern California. And San Diego-Orlando, we have experience with Orlando. It's one of the largest demanded markets that is -- that has not got direct service today, largest O&Ds out of San Diego. So there is no head-to-head competition, it has very high demand and our airplane that we are using there is around utilization. We're actually getting some utilization play there. But to your point, it's a test market. I mean it's outside of our core and we'll be working that hard with the marketing group. But that's a little bit how we think about it.

Operator

There are no further questions at this time. I'll turn the call over back to Mr. Tilden.

Bradley D. Tilden

All right. Well thanks, everybody, for joining us today. We are looking forward to chatting with you again next quarter. Thanks.

Operator

Thank you for participating in today's conference call. This call will be available for replay beginning at 12 p.m. Eastern Standard Time today, through 11:59 p.m. Eastern Standard Time on November 25, 2012. The conference ID number for the replay is 94985179. The number to dial for the replay is 1 (800) 585-8367 or 1 (404) 537-3406. Also, the call will be accessible for future playback at www.alaskaair.com. Thank you. You may now disconnect.

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