Alaska deliberating the best use of cash, plans to grow

"Our results over the last several years give us confidence that our plan is working and we can begin evaluating growth opportunities with the requirement that any growth produces appropriate returns," Chair and CEO Bill Ayer told analysts last week, noting the company's six consecutive years of profitability.

Alaska's transformation over the past few years is more impressive given the fact that it did it through restructuring rather than through bankruptcy. The only other carrier to do that is American and it has not worked out half as well. Ayer has said that bankruptcy would have been much faster but would have ruined the spirit of its employees.

Alaska not stagnant

That is not to say that it has not been growing given its expansion into Hawaii as well as the opportunistic growth in Mexico in the wake of the Mexicana shut down. But, Ayer reminded analysts, when the company rolled out its restructuring plan years ago, he was adamant that growth would never again come at the expense of profitability.

Analysts jumped at the chance to take Ayer's growth statement further but he dodged queries as to whether or not the company is thinking of some sort of strategic asset acquisitions or merger.

Ayer said executives are only now turning their attention to growth in the next decade. "Historically what we've done, and its worked very well, is this incremental approach to building on our strong point of sale presence in the Pacific Northwest," he said. "So the guiding principal here is continue to improve long-term shareholder value and take measured actions. Beyond that, I think it would be premature to say anything. We are talking to the Board on a continuing basis now about looking at the uses-of-cash question.

"We are in a great position," he continued, fetchingly. "We are not going to be rash and rush into anything, but we do think that we are in a position to look at opportunities and, as much as anybody in the industry, we are well positioned to take advantage of some things if they are out there."

Given the speculation surrounding Alaska being a possible target for acquisition, Ayer was pressed further. However, he reverted back to previous statements saying anything the company does has to enhance shareholder value.

"As we talk about plans for the future and the whole universe of things, we believe that the path that we are currently on is the right one," he said. "The development that we have had, the work that we have done over the last seven years to really transform the company [into] a more competitive business model, a lower-cost company, a company that has greater customer value, that flies places people want to go, that has a single, very fuel efficient fleet; these are all things that we have been working on for so long. We think we are starting to see the results in terms of earnings.

"As a public company, if we thought there was a better alternative available for shareholders, we would look at that alternative," he continued. "Where we sit right now, and particularly with this quarter's record results, we're very encouraged that we are on the right path and we are going to keep at it."

2010 expansion

Vice President Planning and Revenue Management Andrew Harrison noted the expansion done this year has basically been on the back of higher aircraft utilisation as well as the delivery of three new aircraft. Ayer had earlier alluded to the addition of three new markets opened in the past 30 days as well as the launch of eight additional markets by the end of the first quarter.

"If you look at the growth, a lot of the Mexico growth is filling in voids in some of our core markets where capacity is going away," said Harrison. "Then we are really growing Hawaii, annualising year over year and again in the Bay area, in the Pacific north-west and in San Diego. That's where the growth and the new revenue is coming from."

Alaska Airlines President Brad Tilden jumped in to assuage fears the carrier is pushing too much capacity but would not take the bait when asked about expanding into Central America.

"Historically, this is the part of the cycle - as people start making money - where people buy airplanes and then they have too many seats and fares go down and airline start losing money," he said. "But you have management teams in place that have been through this cycle a couple of times and people don't want to replay the movie. There is no guarantee that the industry will continue to be disciplined. The consolidation helps discipline. So we are encouraged, we are certainly trying to do our part to be disciplined about everything we do and we are encouraged that the industry will be so as well and we will have a long period of profitability in the industry."

He noted that much of the Alaska capacity put into southern California, the Bay area, Arizona, Nevada and Mexico has matched capacity with demand.

"I think we would all agree that while keeping capacity in check happens industry wide, there might be variances from airline to airline," he continued. "If you look at Alaska's history over 20 years now, our capacity growth has been almost three times the industry average growth rate. I am not signalling that that's where we are headed, but I am signalling that this company has done a good job of finding good profitable places to put airplanes for a long, long time now. And that's what we are talking about as we look at the next five years."

Vice President Finance and CFO Brandon Pederson also noted that much of the restructuring has been designed to reduce seasonality. "The idea behind all of the restructuring is to get out of the habit of creating a loss in the fourth quarter versus having this huge profit in the third," he said. "We are really spreading operations over the course of year so we can generate profit in all four quarters."

Horizon restructuring

The executives discussed the dramatic changes at Horizon. Ayer called it one of the most important components of Alaska's plan to move to an all Q400 fleet. He said that will be accomplished next year, and help Horizon to capture the efficiencies similar to those at Alaska when it shed its MD80s.

The goal, said Pederson, is to have market costs and market revenues between the two companies. The restructuring, which has been ongoing for the past nine months, will probably be completed by this time next year, according to Ayer.

Read more: Alaska Air restructuring Horizon Air subsidiary, dropping its branded business

Shedding its branded service, Alaska is optimising Horizon's route system to benefit Alaska Air Group.

Ayer reported a tentative agreement with Horizon pilots for a new contract, saying it is expected to be ratified in the fourth quarter. It also outsourced maintenance just as the mainline carrier has. He indicated, however, the maintenance oversight function will be robust given the experience at Alaska in which aircraft were returned unready which for service. The company organised a maintenance team to work with the MRO to ensure aircraft are ready for service.

Alaska is also working with Bombardier to improve the schedule reliability of the Q400 in addition to streamlining any remaining redundant functions between Alaska and Horizon.

Horizon posted an adjusted pre-tax profit of USD18.8 million for the third quarter on total operating revenues of USD180.9 million, up 1.5%, according to Pederson. However, the results excludes nearly USD7 million in charges related to four CRJ aircraft that left the fleet during the period and USD3 million in restructuring charges related to outsourcing the last of the heavy maintenance function.

"As part of our plan to accelerate the Horizon fleet transition we are working on a deal that would allow us to move another eight RJs to a third-party carrier in the first half of 2011," he said. "If we are able to get this done, we will accelerate delivery of eight Q400 aircraft from 2012 and 2013 into 2011 to replace those RJs on a one for one basis. This will result in higher capital spending then originally planned over the next six to nine months. Because we don't yet know the final structure of the deal for the eight RJs, it's possible that we may incur more fleet transition costs. We expect those charges, if any, to come in the first half of 2011 when those aircraft are likely to leave the fleet. Assuming we do bring the Q400 deliveries forward air group CapEx would increase to USD211 million in 2010 and USD312 million in 2011."

The company was questioned as to whether it would not be better to sell Horizon off as AMR is doing with American Eagle. Indeed, analysts have long advocated this. However, Ayer said that is not part of the company's plan for Horizon.

"We are going through a lot of work at Horizon because we think it's a great part of Air Group and can become even more significant and more profitable and contribute in a bigger way," he said. "Our intent is to continue to keep it as a wholly owned subsidiary and create more value with the actions we are taking."

The restructuring of the regional, according to Horizon President Glenn Johnson, is to bring its operations, costs and fees in line with other regional programs. "We are really focusing Horizon on producing safe, reliable, low-cost ASMs on behalf of the group," he said, adding Horizon will be about 11% of ASMs.

"There are three pieces of it," said Johnson, adding it is about saving cost, tighter integration with mainline and to replace Horizon's brand flying with mainline service. "It is absolutely about finding synergies between Alaska and Horizon. It's also about improving the efficiency of Horizon particularly through the fleet transitioning getting to the all-Q400 fleet. So, I think there is a broad range of benefit that will come out of this business transformation plan. The goal is to get Horizon to the same level of return on invested capital as Alaska is now enjoying."

Third quarter results

Alaska Air Group reported a third quarter net profit of USD122.4 million, excluding special items such as market-to-market adjustments in connection with the fuel hedge portfolio as well as fleet transition and USD6.1 million in restructuring costs at Horizon. Net profit in the third quarter 2009 was USD87.6 million.

"This quarter's results represent Alaska Air Group's best adjusted quarterly profit in our history displacing last quarter's record," said Pederson. "Our financial performance was driven by increased traffic, stable yields and good cost management through improved productivity and lower overhead. These results translate to a record 17.9% adjusted pre-tax margin for Air Group which brings our trailing 12 months return on invested capital to 9.2%."

He expressed optimism that Air Group will reach its 10% return-on-invested capital goal or "get darn close to it". He cited a USD100 million increase in revenues for the USD55 million improvement in adjusted pre-tax result.

Consolidated passenger unit revenues increased 3.7% on a 6.1% increase in capacity. However, that was tempered by a USD31 million increase in economic fuel cost and a USD13 million increase in non-fuel operating expenses. Absolute non-fuel costs increased just 2% on a 6% increasing capacity resulting in a 4% decline in consolidated CASM ex-fuel.

"We are quite pleased with our cost performance this year," said Pederson. "Our challenge for 2011 is to not let 2010's solid profit distract us from our focus on driving unit cost down by improving productivity and keeping overhead in check."

Alaska closed the quarter with cash and short-term investments totaling just more than USD1.3 billion. Cash is at 35% of revenues, one of the strongest - if not the strongest - in the industry, according to Pederson. About USD500 million of operating cash flow was generated during the first nine months of the year, a first, up from just over USD300 million last year.

Pederson reported that cash generated from operations was offset by about USD150 million of capital spending bringing free cash flow for the nine months to approximately USD350 million or about 12% of year-to-date revenues. However, he added that the company plans to focus more on the free cash flow metrics.

"To that end, we continue to execute on our USD200 million debt prepayment plan bringing aggregate prepayments at September 30 to USD115 million and to USD169 million if you count October activity," he said. "We ended the quarter with a debt-to-cap ratio of 68%, the lowest leverage since 2000. Our plan was to spread the programme over most of 2011 but we've stepped up the rate of prepayment and now expect to finish during the first quarter of next year. Besides reducing our leverage more quickly it will reduce our negative carry resulting in a slight EPS benefit."

Alaska Airlines President Brad Tilden reported an adjusted pre-tax profit of USD173 million compared with a profit of USD118.7 million in the third quarter of 2009. He also said, year-to-date adjusted pre-tax profit was USD328 million, a margin of 12.8% and a 140% improvement over last year. He predicted the airline would hit its 10% ROIC goal if it produces a 1.5-2% margin in the fourth quarter.

Alaska's mainline passenger revenue increased by USD90 million or 11.6% for the quarter. The increase was driven by a 7.3% increase in capacity and 11.2% increase in traffic. However, yield per passenger mile was flat. "We're very pleased with the absolute unit revenues we are seeing," he said. "Nearly every one one of our regions posted unit revenue increases."

Outlook

Alaska's mainline ASMs are expected to grow 9% in the 4Q2010, bringing full-year ASM growth to 5.5%. Tilden indicated October advanced growth factor is up about 4 points and 2.5 points in November. However, December is below last year by 1.5 points.

"We have seen our year-over-year load factor comps increase as we get closer to travel dates and we would not be surprised this is the case again in the fourth quarter," said Tilden.

Turning to costs, we ended the quarter with CASM ex-fuel of 7.52 cents down 4.7% on a 7.3% increase in capacity. Productivity increased by more than 10% to 174 passengers per FTE for the quarter. In the first nine months, overhead spending is down USD8.6 million or 4.4% from 2009.

Alaska Airlines is forecasting 2010 full year CASM ex fuel of between 7.9 and 7.95 cents, lower than the 7.9- to 8.0-cent range it was expecting for the year. Mainline ASMs will grow 8-9% in 2011 with a 6% increase in departures. Tilden pointed out that nearly all of the added capacity represents the annualisation of flying initiated or announced in 2010. It is working on extending three leases for 737-500 aircraft into 2012 which would result in a net increase of three aircraft next year.

While it continues to work on its 2011 budget, it expects CASM ex-fuel will be down at least 3% versus 2010.

Transcript courtesy of Seeking Alpha