阿拉斯加航空 (ALK) 2006 Q3 法說會逐字稿

At this time, I would like to welcome everyone to the Alaska Air Group Third Quarter 2006 Earnings Release Conference Call. [OPERATOR INSTRUCTIONS] Thank you, Ms. Alberts.

You may begin your conference.

Thank you, Jodie.

Hi, everyone and thank you for joining us for Alaska Air Group's Third Quarter 2006 Conference Call.

Speaking today will be Chairman and CEO, Bill Ayer.

CFO, Brad Tilden and Horizon Air CEO, Jeff Pinneo.

Also here to answer your questions are Alaska EVP Marketing and Planning, Gregg Saretsky.

Senior VP Customer Service, Glenn Johnson, Horizon Air VP Finance, Rudi Schmidt, Air Group Controller, Brandon Pedersen and Alaska Managing Director of Corporate Communications, Caroline Boren

Our agenda for today includes a management overview after which we will be happy to take questions from analysts and then from the news media.

This call does include forward-looking statements and these statements may differ materially from our actual results.

Additional information on risk factors that could affect our business can be found in our periodic SEC filings.

Our presentation includes non-GAAP financial measures and we have provided a reconciliation between the most directly comparable GAAP and non-GAAP measures in our earnings release which can be found on our website at Alaska Air.com.

As we reported earlier this morning, Alaska Air Group reported a GAAP net loss of $17.4 million or $0.44 per share in the third quarter of 2006.

Versus net income of $90.2 million or $2.71 per share in 2005.

There are three items that had a significant impact on the current quarter.

These items include a $28.6 million pretax restructuring charge associated with previously disclosed voluntary severance payments for more than 475 employees.

Second, we recorded a $58.4 million charge in connection with the buyout of five MD-80 leases, as part of our fleet transition plan.

These charges were fully anticipated and are a subset of the estimates we made when we first announced the transition last spring.

And third, just as we previously excluded mark-to-market gains related to fuel hedging contracts that settled in future quarters as fuel prices rose, we adjusted our earnings this quarter to exclude mark-to-market losses on contracts that settle in future quarters that resulted from the recent decline in fuel prices.

It is important to note that our fuel hedge portfolio is still significantly in the money.

After adjusting for these items and excluding the special items in 2005, Alaska Air Group reported a net profit of $77.9 million or $1.93 per share for the third quarter of 2006 compared to a net profit of $71.5 million or $2.16 per share in 2005 and a first call consensus of $2.10 per share.

Please see pages 8 through 10 of our earnings release for more details on the reconciliation of our GAAP and adjusted results.

On a year-to-date basis, Air Group reported a GAAP loss of $41 million compared to a profit of $27.1 million in 2005.

After excluding the year-to-date impact of the items I just described, Air Group's adjusted net profit for the nine months of 2006 was $141.1 million compared to an adjusted profit of $54.4 million in 2005.

Now, it is my pleasure to turn the call over to Bill Ayer.

Thanks, Shannon and hello everybody.

We're very pleased with these results which represent the best quarterly adjusted net profit in Alaska Air Group's history.

Employees throughout our two companies have been working hard and it is gratifying to see our financial performance reflect their efforts.

I want to congratulate employees at Alaska and Horizon on a great quarter and thank them for taking great care of our customers.

You may recall that we issued 5.7 million new shares since last year's third quarter bringing our total shares outstanding to about 40 million, so even though adjusted net income is up 9% over last year's third quarter, earnings per share are down on our higher share base.

Although we experienced significant gains in unit revenues at both companies, RASM gains did weaken as the quarter progressed.

In July, Alaska's total revenue for ASM was up 6.6%.

In August, RASM increased 5.6% and in September, it grew 2.3%.

This is the reverse of the trend we saw during the second quarter where RASM growth accelerated as the quarter progressed.

Jeff will talk about Horizon's performance in more detail but Horizon saw the same RASM trend throughout the quarter.

The revenue environment has softened somewhat and bears watching which underscores the importance of continuing to execute our plan for achieving sustained profitability.

We need to continue reducing cost and improving processes and growing in order to offer our customers a product they prefer at a price they're willing to pay.

Regarding unit cost, Alaska Airlines reported nonfuel CASM of $0.07.33 this quarter compared to $0.07.53 last year, essentially in line with our guidance and down 2.7% year over year.

As we've discussed on previous calls, we will achieve significant cost savings as we move to a single fleet type.

In addition to replacing our MD-80s with new fuel efficient aircraft, our order for Boeing 737 800s allows us to grow which will be a significant factor in helping us reduce unit costs over the long-term.

In fact, the MD-80 decision by itself will bring Alaska's average CASM excluding fuel down by at least $0.003.

We plan to take delivery of four 737s from Boeing this month, a total of 13 over the next eight months and a total of 39 aircraft from the beginning of 2006 through the end of 2008.

Brad is going to talk a little more about Alaska costs for this quarter in a minute.

We're in the midst of our strategic planning and budgeting process for 2007 and are committed to it continuing our downward CASM x-fuel trend.

In late November the first of four 737-400 comby aircraft which are being converted from all passenger to combination passenger and cargo use will go into service in the state of Alaska.

These aircraft followed a recent introduction of a 737-400 freighter that was also converted from a passenger configuration.

Together, these aircraft will replace our 737-200 fleet.

As many of you know, much of the state of Alaska depends on air transportation for the basic necessities of life.

It is a privilege to be able to serve the state and we take our role in helping deliver those necessities very seriously.

We're excited about our investment in these airplanes which have the same flight deck technology as the rest of our fleet and will provide greater capacity and improved reliability especially in low visibility conditions.

As you've no doubt heard by now, Frontier decided to expand its Denver base Jet express operation.

Jeff will say more about this but Horizon has decided not bid on the business and as a result, the nine CRJs, dedicated to the current Frontier operation will return to our own fleet over the next 14 months.

We plan to put these airplanes to work as soon as they arrive.

On the labor front, Alaska now has contracts in place with all of its bargaining groups.

Our pilot agreement is amendable next May and we plan to begin talks in November.

We're looking forward to negotiating an agreement that works for everyone.

Horizon is also in the midst of Section 6, negotiations with its pilots.

We're pleased to report an increase in the amount we've set aside for incentive compensation payments for employees.

To date, we've accrued about $24 million at Alaska and Horizon.

Now, the actual payouts will be based on full year results but barring unforeseen events, we're on course to make significant payments to all employees through our various gain sharing plans.

Finally, we've been celebrating with Horizon employees this fall as they mark the airline's 25th anniversary.

Alaska Airlines will also celebrate a special anniversary next year, our 75th.

We're excited about reaching this milestone and employees are voting on one of our aircraft deliveries from the past that will appear on one of our new 737-800s next spring to mark the occasion.

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

Thanks, Bill.

Excluding the special items that Shannon talked about, Alaska Airlines posted a pretax profit for the quarter of $115.3 million compared to a pretax profit of $106 million in 2005.

Bill mentioned that in dollar terms we had a record adjusted profit for Alaska Air Group and in fact Alaska Airlines did as well.

However, our pretax margin declined slightly from 15.4% in 2005 to 15.2% in 2006.

As you know, our business is very seasonal.

Our current thinking is that we'll have a full year adjusted pretax margin in the range of 7% to 7.5%.

While we're very pleased with our profit, the slight decline in margin at this stage of the industry recovery tells us that we need to remain diligent in driving our transformation.

Overall, our revenues increased about $71 million or 10%.

Our economic fuel cross increased by $54 million or 38% and adjusted nonfuel operating expenses increased by $12 million or 2.8%.

Our passenger RASM for the quarter was up 5.9%, driven by a 5.6% increase in yields and a slight increase in load factor.

That compares to a 10.7% RASM increase for the main line domestic carriers..

Our capacity -- our increase came on a capacity increase of 5.6% whereas the industry's came on a capacity decline of 4.5%.

Bill talked about how our RASM evolved through the quarter.

Our yield followed a similar trend up 7.7% in July, 6.8% in August, 1.4% in September, and it looks like they're up 3 to 4% in the first couple of weeks of October.

Looking at how our various [Inaudible] perform for the full quarter, yields were up in all of our regions and with respect to load factor, we saw increases in Alaska and Mexico and slight decreases in California and Canada.

With respect to advanced book load factors compared to last year, October and November are up between 1 and 2 points while December is up less than a point at this stage.

Our bookings over the holiday periods currently look quite strong.

Turning to expenses, our total operating cost including fuel on an economic basis were up $66 million with $54 million of the increase representing fuel and the remaining $12 million representing other cost.

Our economic fuel cost for the quarter net of hedges was $195 million compared to $142 million last year.

We again benefited from our hedge program with settled hedges lowering our economic fuel expense by $24 million for Alaska Airlines and $27 million for Alaska Air Group.

The reconciliation between raw, economic and GAAP fuel costs, please refer to the tables on pages 8 and 9 of our earnings release.

If you were to finish the year at $60 a barrel, we estimate that our hedges would lower Air Groups fuel cost by about $9 million for the fourth quarter bringing the annual benefit of our hedging program to $101 million.

During the third quarter we placed hedges on another 10% of our planned fuel consumption for 2007 and an additional 6% for 2008.

Looking forward, 35% of fourth quarter consumption is hedged at $46.10 per barrel and 35% of the first quarter of '07 is hedged at $56.63 per barrel.

For all of '07, 30% of our consumption is hedged at $55.31 per barrel and for all of '08, 13% of our consumptions hedged at just about $61 per barrel.

The vast majority of these hedges are call option which means that we would benefit from any decline in fuel prices.

Shannon mentioned our mark-to-market fuel hedging loss at the beginning of the call.

We should be clear that although the value of our hedge portfolio is not as high as it was at the end of the second quarter, it is still in the money and had a value of approximately $82 million on September 30.

As I said, our operating cost other than the fuel increased by 12 million.

We had increases in the wages and benefits and depreciation and amortization line items and decreases in aircraft maintenance and aircraft rent expense.

Wages and benefits increased by $18.6 million or 11%, $6.9 million relates to the 5.6% increase in FTEs, $4.4 million relates to an increase in wage rates and $2.2 million relates to fringe benefit cost increases.

The remainder includes a $1.9 million signing bonus for our IAM employees and a $3.2 million adjustment to expenses for our defined benefits pension plans.

Our maintenance cost declined by roughly $11 million compared to last year.

Almost $6 million of this decline is related to 737-200s and MD-80s they'll be leaving our fleet.

So we are already starting to reap the benefits of these decisions.

The balance of the decline reflects a change in the mix and cost of the air frame events and fewer engine repairs.

Aircraft rent declined following the buyout of the five MD-80 leases.

We were paying more than $250,000 per month for each of these aircrafts and we are obviously now showing no rent expense.

We expect to see rent expense go back up when we complete the sale and short term leasebacks of our 20 owned MD-80s but a substantially lower rate to reflect the current market for this airplane.

In all our nonfuel unit cost for the quarter declined 2.7% on the 5.6% increase in capacity.

We're very excited about the move to a single fleet type as we move forward.

As Bill said, replacing our MD-80s with 737-800s will lower our system average, CASM mix fuel cost by at least $0.003 of a cent.

As our fleet mix changes, this will also dramatically improve our fuel cost.

If we look at this in terms of seat models per gallon which factors in both the efficiency and the number of seats per aircraft we're currently getting over 80 seat miles per gallon on our 737-800s which is 42% better than the 56 seat miles per gallon were getting on our MD-80s.

Our system average has increased below 60 seat miles per gallon in 2001 which was in the middle of the pack from an industry perspective to about 66 today.

We expect it to be in the mid 70s by 2010 which should be even with Southwest and JetBlue at the head of the pack.

Given the current lead times from airplane manufacturers, this will be a hard gap for other airplanes to close at least in next several years.

One of the things that's helped differentiate our passenger's experience and reduce our cost over the years has been our leadership with customer facing technology.

We continue to reach new highs in this arena with more than 40% of our third quarter sales coming through Alaska Air.com and 50% coming through all Internet channels which including the on-line agencies.

In addition, 58% of our passengers checked in using self-service technology, either over the web or at a kiosk compared with 53% last year.

At this point, we're anticipating ASM growth of about 4.5% for the year and between 3.5% and 4% for the fourth quarter.

Our fourth quarter growth estimate is down from the 6% figure we shared with you last quarter due to scheduled reductions we've made to improve our operation.

Looking ahead to 2007, we're expecting first quarter capacity growth of about 4% and full year capacity growth of about 5.5%.

Our current expectations is that our unit cost will be flat in the fourth quarter at about $0.079.

This would bring our full year CASM mix fuel to roughly $0.0775 which compares to our previous guidance of $0.077 which is down from $0.0801 in 2005.

At this point, I'll turn the call over to Jeff to walk you through Horizon's results.

Thanks, Brad and good morning, everybody.

I'm happy to report that Horizon posted a $15.1 million adjusted pretax profit for the third quarter.

A figure that's up 4.9% over last year.

This result is especially gratifying when you take into account the 21% increase in raw fuel cost per gallon and 45% increase in maintenance expense driven by engine overhaul timings that we carried.

As with last quarter, the period was characterized by record traffic levels and load factors with the latter coming in at a new high of 75.9%.

The operational pressures that accompanied these loads were further amplified in mid August with the introduction of new security procedures from the TSA, the effect of which was to restrict carry-on baggage and increase checked baggage volumes by 50%, in the weeks following the ruling.

While our teamwork valiantly during this period to mitigate the impact.

We were noticeably affected in the form of deteriorated operational and baggage handling performance and related higher costs.

In spite of it all, we boarded 4.4% more passengers than last year on flights that were on average, 1.2% longer leading to an RPM gain of 5.7%.

Our average ticket prices were 8% higher than in the prior year, contributing to a total revenue increase of nearly 15% or $22.6 million.

Our adjusted operating expenses were up by 17% or $23.1 million with $7 million attributed to scheduled overhaul activities and another $7.8 million to the economic fuel category.

On a unit basis, our RASM and CASM X-fuel were higher by 9.9% and 8.4% respectively on 4.4% or ASMs.

Our increase in RASM was largely attributable to a relatively strong pricing environment in our native markets and solid demand for the majority of the quarter.

Looking ahead, we're not counting on this to continue.

As recent fare sales instituted in an effort to stimulate softening demand, are impacting our yields.

It is clear some of the shift is related to typical seasonality.

However, we remain watchful of other economic indicators that could affect demand going forward.

Our yield trend was similar to Alaska's up 9.6% in July, 10.2% in August and 6.4% in September for an increase of 8.8% for the quarter.

It is important to note that these figures blend yield changes on our native network, the changes on our Frontier Jet Express line of business in September in particular, the decline in year over year improvement on our native network was more significant than that of Jet Express.

As you know, yield increases in that operation really reflect the nature of our capacity purchase agreement and not necessarily the underlying Jet Express traffic.

Turning to expenses, fuel, maintenance and wages were the major contributors to our 17% or $23.1 million increase in adjusted operating expenses.

Economic fuel which has been higher all year long was up 35% on 5.8% more a gallons and 28% increase in net price.

As noted earlier, our maintenance expenses increased $5.3 million due to a higher number of planned heavy checks and a scheduled increase in engine overhaul activity.

For the quarter, engine overhaul expense alone, was $7.3 million higher than last year.

Year-to-date it's up $14.4 million.

As we briefed you before, we expect this pattern to continue through the end of the year and to remain at this level through most of 2007.

Also of note was an unanticipated $2.6 million tax assessment covering the period from April 1, 2002, through August 31, 2006 from the city of Denver related to the Frontier Jet Express operation.

While we have accrued for the liability, we are contesting it.

Our wages and benefits were up by $2.6 million or 6% on a 5.6% increase in FTEs and a 4.2% increase in the average wage rate.

Added to this is an $1.1 million increase in expense for employee incentive pay, the lion's share of which is linked to the excellent work of our people as captured in the payouts we made on our operational performance reward program.

These bonuses are paid to every member of the team upon achieving reliability and customer satisfaction targets for the period, something they were able to do in all three months despite the extraordinary operational pressures they faced.

In addition to the bonus, they all deserve a huge hand.

While we're on the subject of our people, I would like to mention that thanks to them, we were, for the fifth year in a row, recognized by the Business Travel Readers of Conde Nast Traveler Magazine as one of the top five single class carriers in the United States.

It's just one indicator that we have remained true to our founding traditions of customer service as we celebrated them, in this, our silver anniversary year.

As many of you know, we recently announced a decision to redeploy nine CRJ-700s from Frontier Jet Express back to our native network beginning in 2007.

While the divergence of needs and interests has led both parties to taking different directions we remain bullish about contract flying that is aligned with our capabilities and strategies as a component in our portfolio.

From this experience, we've gained solid operational knowledge and have proven our ability to provide a consistent quality product.

We're expecting significant fleet activity with the arrival of 13 new Q400s, two in December of this year and 11 in 2007.

Also in 2007, we will begin subleasing the first 12 of 16 Q200s to Commute Air.

Both of these changes are aimed at improving our cost efficiency.

Finally, a quick update on our capacity and cost guidance for the fourth quarter and full year.

For capacity, we're projecting growth to be 6% for the fourth quarter and 7% for the full year which is unchanged from the last call.

For 2007, we're forecasting 10% growth.

For expenses, we're projecting CASM X-fuel for the fourth quarter to be $0.14.7 up just slightly from our previous guidance; however, full year is still unchanged at $0.14.2.

Now, I'll turn the call back to Brad who will take you through the Air Group balance sheet.

Thanks, Jeff.

Air group ended with $1.1 billion in cash and short-term investments compared to $983 million at the end of 2005.

This increase is due to strong cash flows from operations of about $390 million and proceeds from new debt of $245 million, both of which were offset by capital spending of $530 million and normal debt repayments of $41 million.

The new debt is a result of financing five 737-800s and one CRJ.

We expect a full year capital expenditures to be $630 million in 2006 and approximately $680 million in 2007 and both of these figures are consistent with our prior guidance.

One of the things we've talked about on several occasions is the idea that as our company achieves financial success, we want to improve the security of our retirement benefits.

In that vein, we've contributed $72 million to our define benefit pension plans this year and over $265 million since 9-11.

We look forward to continuing to improve the security of these plans in the quarters and years ahead.

Our debt-to-capitalization ratio adjusted for operating leases is 69% as of September 30, and improvement from the 73% at the end of 2005.

This ratio was favorably impacted by the forced conversion of our convertible bonds back in May and by our adjusted profits, both of which were offset by our special charges.

Our cash as a percent of revenues is 33% which we believe is among the best in the industry.

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

Thanks, Brad.

We're happy to address your questions at this time.

First from analysts then we'll take any questions our journalists might have.

Jodie, would you please go ahead and assemble the roster.

Yes, ma'am. [OPERATORS INSTRUCTIONS] Your first question comes from Helane Becker of the Benchmark Company.

Thank you very much, operator.

Thank you for taking my questions.

So, I just have a couple of questions I guess for you, Brad, with respect to now going forward on other nonrecurring charges.

So, are they all behind you and we have just clean quarters or are there still MD-80 charges ahead?

Thank you, Helane.

It is a great question.

We are as frustrated by all of the special items as anybody out there who's following our financial story.

We do have -- most of this is just due to the new accounting we live with.

As an industry goes through a transformation such as the airline industry is and Alaska, I think a lot of the special charges are part of it.

So what you've seen at Alaska is charges related to the VSI, severance programs for our employees or the write down of fleet or closure of a maintenance base or what you.

The other thing that we have is fuel hedging which we expect to recur.

In terms of what's left, MD-80s, we took a big charge in the first quarter related to our own fleet and we took a significant charge this quarter, $58 million related to five long-term MD-80 leases.

We have four long-term MD-80s leases left to deal with and we -- I think in the first quarter of this year, I think we gave you an estimate of $130 to $150 million of the total cost of dealing with MD-80 leases.

We booked $58 million now.

I guess we could tell that we think that we'll deal with the remaining four aircraft at a figure that's lower than that estimate we gave you in the first quarter, so that's left.

The other thing that we may or may not have is with Horizon, they have entered into a sublease arrangement with Commute Air for 16Q-200s.

We're still working on the accounting for that.

Obviously the lease payments we have on those airplanes are considerably lower than we have on an MD-80, for example but there could be something special there.

It is a good question, Helane.

We wish things were different but we think we're working through the majority of these special items.

Ok.

Then just a quick follow-up on the Horizon -- I think had might have been answered but with declining to bid on the Frontier business and I think you said that you were -- you were still considering other coshare arrangements.

Could you just clarify your Horizon strategy for us?

Yes, this is Jeff, Helane.

We reached a point where interest Frontier had is driven by their financial and competitive situation and our interest and needs on a native network were diverging.

That was fortuitous in that it gave us a way for both of us to address problems.

They with a larger program.

We by bringing the airplanes back.

For us to have stepped up to that and participate in the bid was calling for about a half a billion dollars in capital commitment from the Air Group balance sheet when we compared that to other opportunities, it didn't pencil out.

With that said, as we go forward, we have been invited to participate and have participated in RFPs related to Q400 flying in particular with features that are more aligned with our strategic interests and more deliverable going forward.

It is appropriate to say that as a feature in portfolio, the capacity purchase or contract flying line of business is complimentary to our core businesses of serving our northwest native network markets and participating in Alaska Air Group network development through harmonization.

Those come first.

To the extent there's capacity and opportunity beyond that we'll pursue it.

Ok.

Thank you very much.

Your next question comes from Raymond Neidl of Calyon Securities.

Yes, Brad, you went over some of the numbers real quick.

For the CASM X fuel, $0.0775 was that for the fourth quarter or for the year?

$0.0775 is our estimate for the full year.

The fourth quarter similarity is $0.079.

For Horizon, did you give the 2007 CASM- X fuel?

No, we didn't.

Do you want to?

We gave you a growth number, about 10%.

Rudi?

Ray, for both Alaska and Horizon, we're working through the budgets right now.

Our plan would be to share CASM figures with you on our year end conference call.

Ok, fine.

A more general question, you indicated a softness in RASM.

Are you seeing a softness in economy out there in the west coast or is this more Seattle-related with the hassle factor.

I know there's been problems with the TSA in Seattle and long lines.

Do you think that's what really caused your RASM shortfall or was it something bigger than that?

I don't think we see softness in the economy.

I think things are holding up good along the west coast.

That's evident as we look at the preliminary yields that we are seeing so far this month.

As Brad said, we're up 3% to 4% on yield and load factors are tracking well a head of last year.

Ray, this is Bill.

I think and other carriers are saying the same thing.

August and September was impacted by the TSA action and the change in the carry-ons.

That seems to be -- we look at our bag counts and everything we can see and the fact that yields are trending back in a more normal operation indicates we're pretty well past that.

That was probable the biggest hit for September.

One of the things to keep in mind with these yield comps and the other airlines have talked about this all well but our yield started increasing in the second quarter at 2005.

We've had quite a run of year-over-year increases in yield.

As you begin to compare to some of those in higher figures in the base period it just gets harder to keep up with high single-digit yield increases.

I think everybody knows that but it is important to keep in mind as you look at the figures.

That's a good point, Brad.

Thanks a lot.

Your next question comes from David Strine of Bear Stearns.

Thanks.

Balance sheet question.

When you size adjust your cash balance, it is looking pretty good relative to the industry and just want to get a feel for whether you think there are opportunities to reduce the negative carry out there.

And whether or not you feel comfortable with the leverage ratio where it is or whether you think it should go up or down.

Hey, David.

It is a great question.

We have about $1.1 billion cash and short-term investments which is 33% of our revenue, something like that.

That figure, I think, does, along with Southwest, really based on last quarter end was close to leading the industry.

We think it does make sense -- couple of things.

We've seen over the last four or five years the benefits of having a strong balance sheet in terms of enabling a company to act strategically and act in a contrarian fashion with buying airplanes and entry to new routes, that sort of the thing.

The other side of the story is that we're sitting here today with unfunded pensions of some somewhere between 225 and $300 million depending on the measure you use and with the $1.9 billion capital spending program over the next three years which is quite a bit more relative to our size than most of the other air airlines.

We think there's lots of good reasons for us to have a very, very strong cash position.

Having said that, it is a little bit -- maybe a touch higher than our target at the moment.

That's something we can look at over the next couple of quarters in terms of adjusting it.

You're right, there is an opportunity as you pay down a bit of debt to reduce the negative carry and improve the Company's profitability.

Ok.

A follow-up with respect to pensions, any sense yet as to what the required cash contribution will be for 2007?

Yes.

We have done some looking at that, David.

Our sense is that -- is there a lot of different scenarios with the pension plans but our sense in most of the middle of the road scenarios is the required contribution will be very similar to the contributions we've been making historically.

We made contribution the last four or five years in the range of $50 to $70 million per year.

Our expectation is that the requirement would be the same.

The difference with the pension legislation for us is that those -- I think in each the last five years, we've technically would have been allowed to not make a contribution.

With the new legislation, when it becomes effective, we'll be required to make the contribution.

Thanks, Brad.

Appreciate it.

Your next question comes from Mike Linenberg of Merrill Lynch.

Two questions.

I guess, Brad, just following up on David's pension question.

I mean, you mentioned that you were focused on improving the security of the plans.

Does that include about going down the other path and at this point freezing what has been earned up to this point in time and going over to maybe something that has more of a defined contribution element in the pension plan.

Thanks, Mike.

We have been on a strategy here for the last three years and with all of our groups with the exception of pilots, we're in a situation now where for most of these plants, existing employees have had the choice of continuing to receive fund to fund benefits or moving to an enhanced contribution plan and for all of the new highers with the exception of pilots, new employees are going into D.C. plans.

That strategy is complete with all of those groups.

With pilots, it is still a defined benefit world with a 3% contribution to a D.C. plan and that will be a subject of the discussion with the pilots when we begin negotiating which I think is in November.

Mike, this is Bill.

I might just add to the extent we have the DB obligation contractually, we're going to perform on that.

But we do think going forward for new employees, a 401(k) is a better deal for the company and the employee.

That's what we've done with all of the groups we've recently negotiated with.

Ok.

And then my second question I guess is it is more of a Horizon question.

I know, you Brad, you gave us what yields looked out in October for Alaska up 3 to 4 %.

Jeff, I don't know if you said anything on what yields look like for Horizon.

You made some comments about some discounting here and there.

As you bring back nine CRJ-700s and you bring them off the fixed contract you put them into the pro rate world, what -- should we expect at least as they come in as those plans are inducted back into the native network, should we see pressure on margins or yield or Q200s going up to Commute Air.

Is that a bit of an offset?

Anything that can give clarity on that is great.

Good question, Mike.

In the very short run here, we saw our yields trends dip in September.

I think I mentioned that.

Looking forward to the rest of the fourth quarter, we've got modest improvement year over year.

Good traffic growth in terms of load factor forecast.

I think we have got good stability through the end of the year.

As we bring in the Frontier planes here next year as well as Q400s that are going to be replacing Q200s, we'll see some significant native network capacities.

I think the good news is that we've got tremendous pent-up needs in many of these markets that are underserved where we've been operating at ultra high load factors and yields we would like to adjust.

We would like to stimulate the market, increase the value proposition.

There's some markets that can take some of that as well.

At the same time the RJs in particular will be useful in filling in some key schedule gaps in the Alaska Air Group network.

Areas that are underserved in markets that are primarily Alaska markets.

Maybe Gregg has a comment or two against that but I think next year, we feel good about our ability to simulate that.

Who knows what will happen on the external front.

Given what we see, it is a sustainable shift for this next year for sure.

Gregg?

The only that I'd add Mike is that the CRJs that come Frontier are coming back at a relative slow pace, we get two in the first quarter and those are already year marked for Harmonization emissions and then the next aircraft don't come back until September.

Ok, great.

Thank you very much, guys.

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

Good morning, everybody.

Jamie.

I'm curious about nonpassenger revenue trends.

Freight and mail revenue in the quarter was actually flat with the second quarter, more typically, it rises going into the third quarter and your other revenue also declined from the second quarter.

Maybe we're splitting hairs here but this does seem to explain the earnings miss.

Any guidance on these metrics going forward?

Yes, Jamie, maybe we'll ask Brandon to start with the other revenue and then we'll get a comment for you on freight and mail, as well.

On the other revenue, it really relates to our mileage plan program and it has to do with the sutleties or accounting.

What we do is we sell miles to the bank and then we defer a portion of that of those proceeds what we think is the fair value of the free travel that we'll are to provide in the future.

As yields are gone up, we defer more and thus recognize less of that money up-front.

In addition, we've had a higher payable to other carriers as our passengers have chosen awards on our partner airlines.

That's driving the decrease in mileage plan revenue.

Ok.

And then Jamie, this is Glenn.

On the freight and mail, we're up 2% over the third quarter last year and so we did see some increase in the cargo yields primarily due to fuel surcharges that we applied due to the increase in fuel costs that we've been experiencing.

Looking forward, I guess we would just comment on the fact that it is really capacity game as we welcome the freighter into the fleet and transition as Bill talked about, to the COMBI aircraft, 737-400 COMBI each of which will have substantially more capacity than the the 200s that they're replacing although fewer aircraft in total as we get through that transition plan.

The first of the COMBIs is scheduled to enter service toward the latter part of this month and we'll be complete with that transition in the first quarter of 2007.

Ok.

That's helpful.

Thank you very much.

Thanks, Jamie.

Your next question comes from Gary Chase with Lehman Brothers.

Good morning, guys.

Brad, I wondered, you said at one point during your prepared remarks you were expecting a 7% to 7.5% pretax margin for the year.

Yes.

I wonder if you could clarify a couple of things.

I'm assuming that on an economic basis, and that excludes the one-time items.

Secondly, I took that to be a group number and finally, wanted to know what the economic fuel assumption for the fourth quarter was embedded in that.

Ok.

I'll try to do that in sequence.

First of all, that 7% to 7.5% estimate is economic earnings or adjusted earnings and that is an Alaska Airlines figure.

Actually, our estimate would be slightly lower than that figure.

Your third question it was what fuel assumption.

Jamie, we don't have a lot of intelligence that you don't have on fuel prices.

We basically look at the forward curve.

Right now, we're assuming something in the neighborhood of $62 per barrel.

You can look at our hedges and say that they worth probable something less than $0.10 cents per gallon at that crude oil assumption.

Okay.

In the past, you've talked about what you're paying at the pump today.

Yes, a $1.89 at the moment is a raw cost but --- You might see -- the forward curve has a bump in it.

Our estimate for the quarter would be a little bit higher than that.

Ok.

And I wondered if I could -- if I could ask Gregg about some of the comments you made around yields and the revenue environment you're facing.

You said October was running up 4 to 5.

That was a yield metric, right?

Not RASM?

Yield right now for the lifts that we process month to date are up 3% to 4%.

RASM up slightly higher than that because our load factors are trending up year over year as well.

Ok.

As we move through the quarter, you kind of reference the comparable period from the prior year also.

As you move through the quarter, November and December, if my memory is accurate, were better months for you.

Things in the revenue environment accelerated around that time period last year.

Do they look a little bit tougher or do you think, the kind of current run rate is where we'll be for the quarter.

I think the run rate what you see now would be right for the quarter.

I do have the numbers from last November and December and for last year our RASM was up 8.5% at 9.5% respectively in each of those two months.

It is a tougher comp to me.

What we're telling you about October, we expect to run through the rest of the quarter.

Ok.

And that was on yield and you mentioned where the book load factors were.

Where you think loads will be done -- not down but they're running up slightly now.

You think that will wind up being about flattish in December, right?

That's our current outlook, yes.

Thanks, guys.

Thanks, Gary.

Your next question comes from Peter Jacobs with Wells Fargo.

Good morning.

My fuel question was answered but Brad, I was curious if you could kind of walk us through the quarter and give us a sense of how high fuel costs did get that you were paying at the pump and of course we know where they are now.

On a housekeeping note, the other question is when I divide the adjusted net income of $77.9 million by the 39.954 million shares, I get $1.95 so am I doing something wrong in my calculation because you're showing a $1.93 number.

Could you help me out on that.

Why don't I start with what I can give you on the fuel prices and we will ask Brandon if he can jump in and help us with the earnings per share calculation.

I'm looking here.

First of all, a couple of markers I have on my mind is crude oil was $74 a barrel at the end of June.

It was high for most of July and August then it came down significantly in September.

I think we ended September at $63 per barrel.

As I look at our economic fuel price per gallon, and this is factoring hedges, we were $2.10 in July, $2.15 in August and a $1.97 in September.

So, maybe that's a little bit of color for you, Peter.

Ok, so that would suggest the economic fuel cost right now.

Are something south of $1.80, maybe $1.70 right now.

I don't think I would get there -- the other factor that you have to factor in is the hedges and hedges were we do have a lower percentage hedge at the fourth quarter at a higher price per barrel.

I think they were worth $0.25 a gallon in the third quarter and our current thinking is they'll be worth something less than $0.10 a gallon in the fourth quarter.

If you're paying $1.89 at the pump, if I'm doing this right it should be then somewhere your economic fuel costs should be somewhere south of $1.80; is that right?

They may well , Peter.

We don't know.

The forward curve is higher than the current spot price so our forecast has some increase in the spot price.

Ok.

That makes sense.

Yes.

Then on the earnings per share question?

The earnings per share question, it is actually explained on page ten of the press release.

The number of shares we're using to calculate that $1.93 is 40.4 million shares and what we intended to do with that is put that on a share business that would have existed as if we were profitable so the $39.9 million shares that you referenced was on a GAAP basis which would have excluded the dilutive effect options.

That makes perfect sense.

I didn't get to that footnote.

Thank you.

That ends my questions.

Thanks, Peter.

Your next question comes from Kevin Crissey with UBS.

Good morning.

Hi, Kevin.

When you guys are thinking about the contract flying or regional flying, what do you see as your competitive advantages and disadvantages when you're going for an RFP?

This is Jeff.

Kevin, that's a great question.

We put right out in front our advantages in operation excellence.

When you look at our record with Frontier Jet Express.

We made our payments in every period of the contract so far.

We continue to.

So, that's great.

We have a great product, a great service reputation.

In the bids we're participating in right now, for large turboprops, we're -- the North American operator in Q400.

That gives us some distinctive advantages as well.

On the disadvantage side, we have certain line items in the cost structure side that are higher than our peer group.

We continue to work on that to move toward greater competitiveness on that.

We're finding that's a key driver of course where majors that are purchasing the capacity are themselves financially distressed.

That said, other considerations are very relevant to these proceedings as we found out, as we've gone through them.

So, we think we're competitive and again, like I say, we only are pursuing those that are aligned with our strategic interests and our capabilities and so as not to undermine what we're doing here.

Is it primarily on the labor side or when you say the cost of the certain line items.

It is primarily there.

We have high pilot cost.

We're in the 50 year of agreement that was signed 5 days before 9-11 and following the 88-day strike at Comair.

We've honored that agreement but it has placed us high in the industry.

We I think are very competitive on virtually every other line items with possible exception of timing with maintenance and engine over hauls and things that we are going through right now.

Those come in go and in terms of a cycle.

We're looking to create long-term competitiveness and a good story for them, too.

Jeff, I guess the other thing is there is an abundance of 50 seat RJs which puts a downward pressure on the pricing of these deals.

That's an environmental factor.

Thank you very much.

Thanks, Kevin.

Your next question comes from Bob Toomey of E. K. Riley.

Hi, good morning.

Hi, Bob

I have a follow-up on the yield, the softest in the September yield you mentioned.

There was some reference to the TSA baggage carry-on issues.

I'm a little -- I'm just trying to get a better understanding of why yields softened so much in September.

Yes, Bob.

This is Gregg.

I think what we saw was [Inaudible] It's some short-term book away of business demand which is typically that traffic that books at the last minute and pays higher than average fares so when a chunk of your higher yield traffic goes away, it has a dilutive effect.

That explains a pretty good portion of what we experienced in September.

We also going into the month of September, following the securities directed change in August, saw some softness in demand and there were fare shields that were launched by a number of carriers.

This was within our geography that had a downward pressure on our average ticket price in September.

That fare has expired.

We're back at fares and I think that's why we're seeing ticket lifts boom back up.

Bob, this is Jeff.

On the Horizon side, interestingly with this TSA event happening, in the two busiest weeks of the year what we saw a back fill on the load factor front, we didn't see drop-off there.

Probably more with preplanned leisure demand with some of the business shortfall that Gregg mentioned.

No drop in load factor.

In fact, a record for the month.

Then as things stabilized, a return to the business traffic in September partly through the fare sales then partly through the modified rulings that restored the value of the carry-on program for Horizon.

We think we are pretty well back to normal on that front now.

That's the good new is that passengers seem to be operating pretty normally with the restrictions on carry ons now and getting through and looking pretty normal again.

Ok.

Also, with respect to that -- the question came up earlier about the deferred -- increase in deferred revenue from the mileage plan.

Can you quantify how much that impacted revenue in the quarter?

And secondly, is that deferred revenue permanently gone or does that come back in the future?

I would like to get a better understanding of that.

Bob, this is Brandon.

The impact of the extra deferral is about $4 million.

That will come back through revenue once we have redemption of those miles.

That is actually a really important point, Brandon.

We have over half a billion dollars deferred related to our mileage plan.

I think this company has had conservative assumptions with all of that stuff and that's all basically -- cash that's been received and revenue yet to be recognized in future periods so it is like a big backlog for revenue.

As we go forward, will that -- is that because you're seeing more of the deferral because loads are strong.

Traffic is strong.

Will that impact, moderate going forward, do you think?

The result is because yields are going up more than anything else and it has to do with what I mentioned about establishing or estimating a fair value of the transportation that we have to provide to our passengers.

If yields continue to climb like they have been, that will continue to impact that line.

However finishing yields stabilize, that will moderate.

Yes, you're right.

Ok.

And just one last question if I might relating to fuel hedging.

You said on your last conference call that you feel that fuel hedging is an important part of your operational strategy going forward.

I wondered if you can update us on that given what's going on with fuel prices and the fact that I don't think anybody can really forecast them.

I mean how can you -- how do you feel that fuel hedging or how are you going to use fuel hedging strategically to improve your cost and competitive position?

Yes, Bob.

We did talk about that on the last call.

Our view about this is this is -- fuel hedging is not a strategy to create profits for the company.

It is a strategy to reduce the volatility of our fuel expense, reduce the volatility of our earnings and cash flows.

We think we can have an effective fuel hedging program that does that for us.

If you look in terms of the need for this, Alaska's raw fuel costs have gone from $300 million a year, fours years ago to $900 million a year this year.

So, up by $600 for a company that our aspiration would be to have a pretax profit of $300 to $350 million.

What we have here is a commodity that's very material to the company and very volatile.

It argues for hedging it.

Just with the way the forward curve works , to buy half of our consumption somewhere between 12 and 36 months in advance of consumption and to buy the rest on the spot market.

And we think that takes into account some reality that the ticket prices do adjust a bit to changes in fuel prices.

So, that's the thinking behind it.

It has produced a fair bit of profit for the company over the last three or four years.

The caution we would have for folks is we don't expect it to make profit for us but we do expect it to take out the highs and lows of the fuel line, the cash flow line, the earnings line.

And Bob, I might just add -- this is Bill -- the other part of hedging is the airplanes.

We talked about that on the call with us the 737-800s, which really gives us a permanent hedge and one that is a sustainable advantage competitively due to the fact that Boeing doesn't have availability and carriers will be a long time to catch up with that.

We're real pleased with the 800 decision and the decision to accelerate the MD-80 retirement and take advantage of the natural hedge via this airplane deal.

Ok, thank you.

I think we have kind of gone through the queue of analysts who have questions and so at this time, I'm going to turn the call over to Alaska's Managing Director of Corporate Communications, Caroline Boren to conduct the media portion of the call.

Thanks, Shannon.

Good morning.

We now have time for any questions from journalists participating today.

Jodie, would you please remind our callers of the first feature for asking questions.

Again if you would like to ask a question, please press star then the number 1 on your telephone key pad.

We'll pause for just a moment to compile the Q&A roster.

Your first question is from Andrew O'Conner with Wells Capital Management.

Thanks.

In any event, about three to four quarters ago, you guys stated the whole lean effort that Alaska Air was engaged in was in its infancy and at the same time, you suggested a long-term CASM X fuel of 7.25.

Do you still think 7.25 is achievable?

Low enough and third, what's Alaska Air's time frame to get there?

Thanks so much.

I can start.

Maybe just a little bit.

Absolutely, 725 is achievable.

We need to get there and we need to go below that given our view of the competitive market place and the low-cost carriers in particular.

And lean, you're right.

The lean efforts are very much a part of how we're going to do that.

I might have Glenn Johnson who is heading this up talk about some of the recent projects we've had and how enthusiastic we continue to be about the opportunity here.

Thanks.

Thanks, Bill.

Bill is exactly right, this is a key element of how we're going to move the cost structure down is by identifying nonvalue added type tasks in our processes and procedures and eliminating those.

I just to put some perspective on it, we plan to have approximately 100 lean workshops of one sort or another during the year of 2006.

We're on track to meet or exceed that.

Just for a little flavor, we've recently had what we would call a blitz event.

This month.

There were three different workshops going simultaneously where we partnered with both Boeing who has been a great mentor and partner to us in this lean effort and a couple of other airlines actually that are on the lean journey from around the world who came in.

We looked at three different areas arranging from the Horizon food and beverage process to the baggage upload which affected both airlines here in Seattle to the maintenance and engineering process rotable parts process.

In each of those, we came away with process improvements.

We involved front line folks who, actually do the work every day and they're redesigning the process and we identified efficiencies and improvements.

Andrew, we just raised our fourth quarter cost guidance from I think $0.06 to $0.079.

That's maybe the root of your question here.

There are a couple of things that are driving that.

We were planning to grow 6% and now we're planning to grow a little less than 4% in the fourth quarter quarter when you make those changes close in, you end up spending most of the money and you don't get the flying so that takes a hit on CASM.

We did get a surprise, late adjustment to our cost for our defined benefit pension plans.

We expect a similar amount in the fourth quarter.

So, those are some things that we're struggling to catch up with in the fourth quarter here.

As Bill said, we're very clear that to be competitive in this industry, we need to continue to lower cost so that we can offer our customers great value.

That's what the competition is doing.

That's what we trade on.

We're convinced we need to get there.

Customers are very clear they want low fares.

Your long-term goal is still 7.25?

A bit below that, Andrew.

That's an interim point on the curve but it needs to go below 7.25.

Ok.

Any time frame to get there, guys?

We haven't provided guidance on that, Andrew.

We're right now working hard on the 2007 plan and we expect to have more to share with you.

We set a couple of things today.

The MD-80s by themselves are $0.003.

We're seeing some benefit from that.

The 737-200s are between $0.001 and $0.002.

We're already seeing benefit of that.

I think you can point to a couple of things that should clearly help us.

They've helped us a tiny bit this year.

We'll give you more detailed guidance on next quarter's call with respect to next year.

Thanks very much for your answer.

Your next question comes from Eric Torbinson of Bloomberg News.

Good morning, everybody.

How you doing'?

My question has to do with your growth plans for '07 in terms of aircraft you're getting into your system.

I wonder if we see some of these softening economic indicators out there, if you are at all concerned you might be bringing a bit too much capacity on and in your planning for '07, is there any sort of way to I guess is there any flexibility in your fleet plan to I guess take few aircraft in the event that things sort of fall off a cliff.

Eric, this is Gregg.

I'll take a crack at your question.

Our growth next year is very modest.

We estimate that to be about 5.5% measured by available seat miles and the aircraft that are arriving that are 157 seat units replacing 140 seat untis MD-80s that go away.

It gives you an opportunity to substitute less frequency.

But to go after high frequency markets and actually have less frequency with good time of day coverage flown by slightly larger aircraft.

That's the big driver of the cost reduction.

Based on everything we're seeing today, we're not concerned about that very modest capacity growth.

We have the possibility of maybe one new market in 2007 but most of this capacity will go into existing markets that are being flown at very high load factors currently.

Just in terms of some of the food tweaks that you made to your food service in the quarter, I believe.

Is there any number you can put on that that changes in the cabin service that you're doing in terms of cost savings?

We're right in the middle of the contract negotiation with our caterer LSG Sky Chef.

I can't give you a definitive.

It is in the millions of dollars.

Thanks very much.

Eric, this is Bill.

I might -- your first question about what's going on with airplanes.

The total fleet count just so you know how that goes, the end of this year will be 113 airplanes.

End of '07 will be 116.

End of '08 will be 114.

It is all in the size of the airplane.

As Gregg said, it is existing markets so there's very little risk in terms of that.

Ok.

Thank you.

Your next question comes from Steve Lott of Aviation Daily.

Thanks.

Good morning.

Wanted to ask -- run through and make sure I have the numbers right on the cargo planes.

You mentioned the first COMBI is coming on-line this month or next month but you also had -- I think you were targeting five retrofitted into all cargo planes.

If you could run through the time line and how many of those you're going to have flying.

Sure.

This is Glenn again.

We've already got the first freighters on-line.

It is flying very successfully up in the State of Alaska.

The current plans call for one full freighter configuration and then four COMBI configurations.

The first of those COMBIs will deliver in the latter part of this month with the second one close on its heels then one more in the fourth quarter and one in the first quarter of 2007.

According to the current currently plan.

Any thoughts of going beyond those five to have more converted?

Not at this time.

We want to evaluate the market as well as the new air planes and then we've got lot of opportunity with that because we have plenty of 400s and we have the capability to do that through the conversion house that's doing it for us.

Right.

Okay.

Another topic.

Wanted to get an update on the [Mensies] operation.

You were shooting for better baggage delivery times.

How are things going there?

This is Glenn again.

I'll take that one also.

We measure them on a number of things but I guess I would say there are three primary levels that we measure them on.

The first being aircraft ground damage.

You'll recall that we had some challenges with that early in the year and they have improved dramatically there to the point that they're kind of industry leading for us as well as across the entire system in terms of that metric.

The other two are on-time departures and in both Seattle and Los Angeles, they are meeting our expectations in terms of both what we call the star pledge, the first flight of the day as well as throughout the day of the departures.

Then the baggage continues to be our struggle.

We -- we measure two things there.

Both baggage failures in terms of failure to get the bag on the airplane with the customer and the second is the time to get the bags to the carousel.

We had seen improvements in both of those leading into the summer, dramatic improvements actually and then with the security directive that we talked about earlier on this call, we saw a spike in the negative direction both in terms of bag failures as well as the time it took to get the bags to the carousel.

I can say that with the October results that we've seen month to date, that both of those have come back down into line in terms of both the bag failures and then the time to carousel at the major stations.

Ok, great.

Thanks, Glenn.

Your next question comes from Ted Reed of The Street.com.

Good afternoon.

I just have a quick question about it seems to me you said you were reducing capacity growth in the fourth quarter due to schedule reductions and possibly reducing some of the capacity growth next year.

Did I hear that correctly and why is that?

You did hear that correctly.

That our growth project he cans are down slightly.

I think it goes back to -- this is Glenn again it goes back to our insistence on getting back to not only operational reliability but operational excellence.

And so while we're back to kind of our ten-year average run rate in each of the metrics that we look at in terms of delivering on what our customers demand, we want to push that up to the next level.

We think the way to do that is to be slightly more conservative in terms of layering on more flying and putting our emphasis on getting on-time completion rate and baggage delivery metrics up in that new stratosphere that we're targeting.

So then this relates to the new Boeing aircraft and how quickly you're able to integrate them into the fleet.

Certainly, that's a factor, Ted.

Maybe just to clarify another point.

I don't think there has been a significant downward adjustment to 2007 capacity.

We did just say we brought down fourth quarter guidance from 6% to 4%.

Our utilization actually for this quarter is up over the same quarter last year.

So, it was really compared to our plan for the fourth quarter, and we did make a couple of market adjustments related to operational reliability.

So, it is related to operation and reliability, not to increasing -- to decreasing demand or excessive capacity in your markets or anything like that.

Just an operational issue.

That's exactly right.

There's no change for 2007.

Correct.

Ok.

Thank you very much.

At this time, if you would like again to ask a question, please press star then the number 1 on your telephone key pad.

Again please press star one on your telephone key pad.

Sounds like no takers.

We're about past our time here so thanks everybody for joining us and we look forward to talking with you again next quarter.

Bye-bye.

Thank you.

This concludes today's Alaska Air Group Third Quarter 2006 Earnings Release Conference Call.

You may now disconnect.