Alaska Air Group, Inc. (ALK) Q4 2011 Earnings Report, Transcript and Summary

Good morning. My name is Steve, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Alaska Air Group Fourth Quarter and Full Year 2011 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.

Thanks, Steve. Good morning, everybody, and thank you for joining us for Alaska Air Group's fourth quarter 2011 earnings call. This morning, Alaska Air Group's CEO, Bill Ayer; Air Group's CFO Brandon Pedersen; and Alaska Airlines' President Brad Tilden will comment on our financial results, our operations and our outlook for 2012. Other 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 some non-GAAP financial measures, such as adjusted earnings or unit costs excluding fuel, so we've provided a reconciliation between the most directly comparable GAAP and non-GAAP measures in our earnings release. This morning, Alaska Air Group reported a fourth quarter GAAP profit of $64 million. Excluding the impact of mark-to-market adjustments related to our fuel hedge portfolio, Air Group reported an adjusted net profit of $37.2 million or $1.02 per diluted share. The result is compared to last year's adjusted net income of $47.4 million or $1.28 per share and the First Call consensus of $1.14 per share. To provide some perspective, the $0.12 miss from consensus is about $4 million due to our low share count. For the full year, Air Group reported a record adjusted net profit of $287 million compared to $263 million in 2010. Earnings per share grew by nearly 10% from $7.14 per share in 2010 to $7.83 per share in 2011 on an adjusted basis. Additional information about our unit cost expectations, capacity plans, future fuel hedge positions, capital expenditures and other items can be found on our investor update included in our Form 8-K issued this morning and available on our website at www.alaskaair.com. I'd like to now turn the call over to Bill.

Thanks, Chris, and good morning, everybody. Well today, we reported the best full year adjusted profit in our history, surpassing the record set last year. The full year result represents our eighth consecutive annual profit and our second consecutive year with return on invested capital above our 10% goal. Although the quarterly profit was down from last year, it was the second best quarter -- second best fourth quarter in our history. Our focus over the past decade on providing great customer service, improving our operations, engaging our employees and generating a return for our shareholders has helped move the company to the top of the industry in many measures. 2011 was a very good year and one that resulted in many accomplishments and new records. For example, we were awarded the J.D. Power Customer Satisfaction Award for traditional network carriers for the fourth straight year. We posted record load factors at both airlines, and for the first time ever, we exceeded 80% for the mainline operation in each month of the year, and we've now had 31 consecutive months of load factor improvement. For the second year in a row, Alaska was named the most on-time airline among major North American carriers by FlightStats. And our people served a record number of passengers and by doing so, increased productivity by nearly 5% and earned $72 million in incentive pay or approximately $4,000 on average per frontline employee. Alaska and Horizon became the first U.S. airlines to operate multiple passenger flights using biofuels, and Alaska won Seattle Business Magazine's 2011 Green Award in our category. We just recently received the 2012 Joseph S. Murphy Industry Service Award from Air Transport World magazine for our numerous environmental and corporate-giving initiatives. And finally, the Wall Street Journal named Alaska Airlines the best-performing carrier in the U.S. in its annual Middle Seat analysis. Horizon is included in much of this recognition, and I would be remiss if I didn't specifically call out the extraordinary improvement in both operational and financial results during 2011. The major changes Horizon has made including the transition to a single fleet of Q400s, and the shift to a 100% capacity purchase model have helped drive this improvement. All of these Air Group accomplishments were because of the hard work and dedication of our people, and I want to thank them for their focus on running a safe and on-time operation and for the excellent customer service they provide. Our results recognize our efforts to ensure that all constituents: customers, communities, employees and investors find value in our company. Long-term success requires this balance of stakeholder benefit, and our industry has a poor history of providing it on a sustained basis. So the challenge now is to maintain our performance and build on this solid foundation. We know that 2011's good results came from the initiatives that we've worked on over the past several years. Success in this business can be fragile, and our continued success will depend on the plans and initiatives that we're working on today. Our future depends much more on what we do than on what happens to the economy, oil prices or our competitors. These factors are important but a clear understanding among all 12,000 employees of what we can control will give us the best chance of sustaining this performance in becoming not just a great airline but a great business. Due to our conviction of controlling what we can control and good execution of initiatives over the past decade, I'm very confident about the future. And with that, I'll turn the call over to Brandon.

Thanks, Bill, and hello, everybody. As Chris said, Air Group reported an adjusted net profit of $37.2 million this quarter compared to its $47.4 million profit in 2010. The fourth quarter profit brings the full year result to a record adjusted net profit of $287 million compared to 2010's record of $263 million. The 2011 results translate into an 11.7% return on invested capital, eclipsing both the 10.7% mark set in 2010 and our 10% after-tax goal. I want to join Bill in congratulating all Alaska and Horizon employees for these outstanding results and a record year. On a pretax basis, the fourth quarter was $18 million lower than the previous year. The 2011 decline includes a $6 million impairment charge related to an MD-80 leased to another operator. The remaining decline of $12 million resulted from an $83 million or 34% increase in our economic fuel bill and a $23 million increase in our nonfuel operating costs, partially offset by the $86 million improvement in revenue and an $8 million decrease in nonoperating expenses. Again on a pretax basis, full year adjusted earnings improved by $38 million. Operating revenues were up $486 million or nearly 13%, more than enough to overcome a $372 million or 41% increase in economic fuel costs and an $86 million or 3.5% increase in nonfuel costs. Our pretax margin was 10.7%, down slightly from the 11.1% margin in 2010. Consolidated economic fuel price per gallon was $3.18 for the year, 34% higher than in 2010. The impact of higher refining margins was significant, averaging $0.78 per gallon in 2011 versus $0.33 per gallon in 2010. The steep price increase in crude and refining costs, combined with a 6% increase in consumption, drove fuel costs up to a record $1.3 billion for 2011. Although our hedging contracts had a net cost to us in the fourth quarter, the program saved us over $21 million in 2011, bringing our total hedge savings to over $400 million since the program began a decade ago. At our Investor Day last November, I described a modest adjustment to our hedging strategy to one where we would use out-of-the-money options for hedges that we were placing for 2013 and 2014 as a way to reduce our premium expense. To stay with the insurance analogy that we often use, the move was designed to reduce premium costs by assuming a higher deductible, which we are safely able to do because of our very strong balance sheet. With that same objective in mind, we recently modified our 2012 hedge portfolio. For 2012, we are now 50% hedged at an average of $100 per barrel, with a $9 per barrel average premium cost. Prior to the change, we were 50% hedged at $92 a barrel but had an average premium cost of $13. This change allows us to reduce the premium expense that will come through the 2012 P&L by approximately $18 million yet still protects us from significant spikes in oil prices. Turning to incentive pay. As Bill said, Air Group employees will receive $72 million through our Performance-Based Pay or PBP program and the Operational Performance Rewards or OPR program. Under the PBP program, the vast majority of our employees have a target bonus equal to 5% of pay. Like last year, we exceed many of the goal set by our board, including the profitability goal, which represents 70% of the PBP weighting. As a result, the payout for most employees will be more than 6.5% of pay. Alaska employees hit the monthly OPR customer satisfaction and on-time goals 11 out of 12 months, earning another $1,100 each, while Horizon employees hit the OPR targets nearly as often, earning $900 each. We're proud of the fact that incentive pay over the last 3 years totals $240 million. And to give you an example of how that translates to a frontline employee, an Alaska employee making $35,000 per year will have received incentive payouts under the PBP and OPR programs of nearly $12,000 over that 3-year period. We know that $240 million is a lot of money, but we believe that generous, goals-based incentive programs do 3 things: first, they help us hire and retain the best people; second, having goals that improve our operations and financial results aligns the interest of our employees, our customers and ultimately our shareholders; and finally, we're able to share generously with employees when the company is doing well without embedding fixed compensation into our cost structure that becomes a burden in times that our financial results are not as strong. Turning to nonfuel costs. Consolidated CASM x fuel was basically flat for the quarter although slightly higher than even our most recent guidance. Higher-than-expected maintenance costs at Horizon and medical costs and final incentive pay trips at both companies account for the difference. Mainline unit costs increased by 1.8% to $7.89 on the 4.6% increase in Q4 capacity. This was the first quarter-over-quarter increase in 2011 and was partly due to higher wages and benefits, planned and unplanned maintenance costs and increases in other costs combined with slower capacity growth. Although the reasons are explainable, I'm disappointed in our cost performance for the quarter. For the full year, Air Group's consolidated CASM excluding fuel and fleet transition costs declined by 3% on the nearly 7% increase in capacity. Mainline x fuel costs were down over 3% to $7.06 on the 8.5% capacity increase. The mainline result was exactly in line with the full year guidance that we've been giving all year. This was the second year in a row and the ninth time in the last 10 years that we've lowered unit costs. We do have some cost pressures as we head into 2012 such as contractual wage increases, higher maintenance costs, IT investments in both infrastructure and innovation and training costs. We also expect pension expense to be $18 million higher this year because of meager asset returns in 2011 and a reduction in both the discount rate and the expected rate of return on planned assets. In our investor update this morning, we guided to a 1% to 1.5% increase in x fuel costs in the first quarter. This follows a fourth quarter where cost performance wasn't frankly all that great, and we're not happy with the 2-quarter trend. We know we need lower costs in order to offer low fares to our customers, improve our long-term competitive position and continue to meet our return goals. Highly productive employees, better use of technology, keeping tight control over management headcount and maintaining our low overhead mindset while we increase capacity should allow us to bring cost down further. In fact, over the last few months, our divisional leaders have established more than 40 distinct, 3-year cost and productivity metrics that we will be using to track progress against our long-term unit cost reduction goals. For 2012, we expect consolidated x fuel unit costs to be down for the third year in a row by approximately 1.5%, and mainline costs to be down by approximately 1% on expected ASM growth of 6%. Turning to pensions. We're pleased to announce that for the third consecutive year, we contributed an additional $100 million to our defined benefit pension plans in December. This is, of course, over and above the $33 million that we contributed throughout the year under our normal funding policy and brings our total DB contributions in the last 3 years to $427 million. I want to stress that we had no required funding in any of those years, and our contributions underscore our commitment to meeting our pension obligations. As of the end of the year, we are 81% funded on a PBO basis, down from 85% at the end of 2010. We plan to make cash contributions of approximately $35 million in 2012, although again, we'll have no requirement to do so. And as a reminder, we will freeze the DB benefits for our nonunion employees as of January 1, 2014, and all of our plans are closed to new entrants. Looking to the balance sheet, we ended the year with more than $1.1 billion in cash and short-term investments, equal to about 26% of revenues. Because of the strong financial performance, we generated a record $680 million of operating cash flow compared to $554 million last year. Free cash flow was approximately $300 million this year, $70 million less than in 2010 even though our capital spending increased by $200 million. Our strong results over the last 3 years have produced more than $1.5 billion of operating cash flow. With that cash generated, we've been able to do a number of really good things. Let me share some examples. First, we've invested in the business. We've purchased 10 737-800s and 2 Q400 aircraft free and clear that we've used to expand and strengthen the network. Second, we've protected our company from future shocks by lowering our leverage. On balance sheet debt has come down by over $0.5 billion, and the capitalized value of leases has declined by over $300 million. Combined with higher equity from strong earnings, we've been able to reduce our debt-to-cap ratio, including leases to 62%, down 19 points at the end of 2008. Third, we've rewarded our shareholders by repurchasing 3.6 million shares of our common stock for $148 million. And since 2007, we've spent more than $0.25 billion to acquire 8.4 million shares at an average cost of $31 a share. And finally, although it's reflected in the operating cash flow number, it bears mentioning once again that we've contributed $427 million to our pension plan when none was required, and shared $240 million in incentive pay with our employees. And finally, looking at the fleet. We expect to take delivery of 3 737-800s in the first half of the year fitted with the new Boeing Sky Interior. And then in the fourth quarter, we'll be introducing 3 new 737-900ERs into the fleet. This will be a great airplane for us and improve our ability to grow capacity without a commensurate increase in cost. By the end of 2014, we'll have at least 19 737-900ERs in the fleet. With the current firm delivery schedule and planned non-aircraft spending, we expect CapEx to be approximately $425 million in 2012. We'll also have to make a decision this spring on whether or not to exercise options for 3 737s and 2 Q400s that would be delivered in 2013, so our CapEx may go up a bit depending on the direction we choose to go. If the environment remains similar to what we're seeing today, we would once again expect to generate free cash flow in 2012 given that level of CapEx. We plan to deploy that cash in a similarly balanced way. And with that, I'll turn the call over to Brad.

Thanks, Brandon, and good morning, everyone. We now have another year behind us, and as Bill and Brandon have said, it was a very good year. We broke a number of records in both Alaska and Horizon. Alaska had its most profitable year ever, reporting $444 million of adjusted pretax profit, and Horizon posted an adjusted pretax profit of $22 million. These equate to pretax margins of 10.3% and 5.7%, respectively. A lot of the profit and schedule reductions and redeployments and by better managing inventory between peak and off-peak days. This is our second consecutive year where we've had an adjusted profit in all 4 quarters. For the quarter, Alaska earned an adjusted pretax profit of $53 million versus $77 million in 2010. Our margin was 5.1% versus 9% in 2010. The 4-point decline in margin is due to revenues which did not increase enough to cover increases in capacity and higher fuel costs, and mainline unit costs x fuel which increased this quarter by 2% versus the decreases we saw in the first 3 quarters of the year. By our calculations, roughly half the margin decline is due to fuel/revenues, and half is due to unit costs other than fuel. Mainline passenger revenue increased by $72 million or 10%. The revenue improvement was driven by a 4.6% increase in capacity and a 5.5% increase in passenger unit revenues. The passenger unit revenue improvement was due to a 3.4% increase in yield and a 1.6-point improvement in load factor to 85.4%. We believe this will be the highest load factor of the top 10 airlines for the second year in a row, and as most of you know, this is a big change from where we were several years ago. Sequentially, we saw mainline PRASM increases of 5%, 6.7% and 4.7% in October, November and December. We are generally pleased with our revenue performance considering our capacity growth and the 2.3% increase in our average stage length. But there is an opportunity to do better as we deal with these very high fuel costs. Some of what we're wrestling with is the shortfall, not in coupon revenue, but in Mileage Plan and the ancillary revenue. Alaska's regional business, which includes revenue from flights flown by Horizon, SkyWest and PenAir, less contractual payments to these carriers, reported a profit of $12.5 million for the quarter versus $6.2 million in 2010. PRASM for this business increased 9.3% on the 2.3% decline in capacity. And the Horizon operation turned in a profit of $5.1 million for the quarter versus a loss of $1.2 million in 2010. Both of these businesses have shown substantial improvement over the last several quarters, and we owe our thanks to the folks involved, particularly at Horizon but also in our marketing, planning and revenue management departments, who together, are engineering a transformation that covers the fleet, cost structure, the brand and the schedule. For the fourth quarter, our mainline CASM x fuel was $7.89, up 1.8% from the prior year. Costs are up due to the reasons Brandon mentioned. We are not happy with the increase, and we are focused on bringing unit cost down. During the quarter, we finalized a 5-year agreement with AMFA which covers our aircraft technicians. Our technicians received a pay increase on the date of signing and increases in the 4 downline years. As part of the discussions, we agreed on significant productivity increases. In fact, we don't plan to increase our technician headcount as we add the next 15 aircraft. This will help us improve our metric for technicians-per-aircraft, which is a good example of one of the 3-year metrics that Brandon referred to. Improvement in this area will enable us to build upon our productivity increases of recent times, which for the mainline business were 9.5% in 2010 and 4.6% in 2011. One area where we have done especially well is operations. Both Alaska and Horizon posted record on-time performances for the year at 88.2% and 86.1%, respectively. Alaska continues to hold the #1 spot among the 10 largest carriers for on-time performance in the last 12 months. This operational record was impacted last week as we dealt with first, the snowstorm and then freezing rain in the Pacific Northwest. We canceled 33% of our flights last Wednesday and Thursday and inconvenienced some 45,000 passengers. Financially, we estimate the impact of the storm was about $3.5 million, with the majority of that being lost revenue. Our people have shown what they're made of, not only for the way they handled this disruption, but also for the way they worked together as a team to produce the great operational results for 2010 and 2011. As we look to 2012, we currently expect to grow mainline and consolidated capacity by about 6%. The growth is mostly coming from annualizing our Hawaii schedule and from routes which have been announced but not started. When the announcements take effect, we'll have 24 daily roundtrips to Hawaii in our winter peaks. In our regional operation, we just announced expanded service in California, connecting San Diego to Santa Rosa, Fresno and Monterey. By quarter, in 2012, we expect consolidated capacity growth of 3.5% in Q1, 6% in Q2, 6% in Q3 and 7.5% in Q4. We are very excited to be moving into our new home in Terminal 6 at LAX in just a couple of months. This will be nicely finished space for our customers, and will help them more easily connect with our alliance partners, and it should streamline the custom and immigration process for our customers coming in from Mexico. We also just announced a reciprocal frequent flyer relationship with Emirates, which will facilitate traffic flows in a high growth part of the world. Emirates is starting nonstop service from Dubai to Seattle on March 1. We're also excited about our alaskaair.com business, which is really starting to grow. Our team launched a completely redesigned website this past April and new mobile applications for the iPhone and Android phones this past fall. Our customers are responding to the changes as our bookings through alaskaair.com increased from 51% of our total in December 2010 to 55% in December 2011. For January, February and March, our consolidated advanced book load factors up 3.5 points, 3 points and 1.5 points, respectively, compared to the same months in 2011. All things considered, passenger demand looks reasonably strong but we're constantly watching this. As I close, I'd like to thank you all for your support of this company over the last several years as we are driving this transformation. And I'd like to also thank our leadership team and our frontline employees. We've got a lot more work to do. The fourth quarter results point to some opportunities, and we will be fully focused on this work. But 2011 was a good year and we want our people to know just how much we appreciate what they're doing. At this point, I'll turn the call back to Bill.

Well thanks, Brad, and 2011 was an outstanding year and it took all of 12,000 Air Group employees working together to achieve these results. So at this time, we are ready for your questions.

[Operator Instructions] And your first question comes from the line of Bill Greene with Morgan Stanley.

This is John Godyn filling in for Bill. First, just a question on the demand environment. It looks like the advanced book factors that you guys reported in December went up in the most recent disclosure. Can you just give us a sense and elaborate maybe on what you saw in the demand environment sort of between December, and now, it seems like a lot of your peers are reporting strong RASMs, it's not a surprise, but maybe just some color on how the last month or so has evolved would be helpful.

John, this is Andrew. I think probably the most significant change as we look into the first quarter, which is traditionally a weaker one for us, is we had a very significant fare sale with very compelling fares. And we often, in January and February, fly with some empty seats in our airplanes, and we've seen very significant load factor builds in certain regions especially in California. So that would probably be the most significant reason you saw the change in that load factor trend.

Okay. And just a question on your overlap with American. Is there anything that you can tell us about AMR's competitive presence within your markets on the West Coast? And how important would AMR capacity cuts be? I mean, we can calculate the overlap but that doesn't always tell the story. How do you feel when you face them as a competitor?

John, this is Andrew again. Well, a couple of things. As you know, American is a very important codeshare partner with us in the U.S. And secondly, the overlap on a direct basis is about 6%, and probably on an indirect, about 9%. And today, we haven't seen any meaningful change in their capacity where we compete head to head so we just continue to watch that situation and go from there.

Your next question comes from the line of Hunter Keay with Wolfe Trahan.

So, Brandon, let's talk about ROIC for a minute here. As we think about sort of the next leg up on continuing to drive ROIC up, is it a numerator thing or is it a denominator thing? That's the end of my question.

Honestly, I think it's both. I think we need to get better at using the capital that we have. There's always opportunities to do more. Our interest on the numerator is continue to grow this business and do so profitably. On the denominator side, I still think there's some opportunity to even bring that down a tiny bit. So I think the answer to your question is both.

Okay. So maybe using some cash to deploy it and maybe some early debt prepayments in addition to schedule stuff and things of that nature if the opportunity comes up on the denominator side, I guess?

Yes, if I look at just the denominator alone, we're going to have obviously earnings growth that move equity up. But if I think about debt, you mentioned that, we have $200 million of normal debt payments next year so that will take some of the invested capital base down to the extent there's an opportunity to do more than that, that would further that.

Okay, great. And I'd love to hear your thoughts on this, too. Maybe Andrew, on some of this Club 49 promotion that you announced, I guess, it was about 4 months ago. I'm curious to know how much of a revenue bad guy this is going to be for the elimination of bag fees. And I'm wondering if this is potentially an indicator of maybe some concerns that you might have over the long run about some competitive forces up in the Alaska business. JetBlue is now flying to Anchorage. Southwest, I think, has even alluded to some possibility flying up there. Is this sort of a preemptive defensive move because of something like that?

Hunter, this is Joe Sprague. I'll take a shot at that. First off, Club 49 it's not surprising it's been met with a lot of warm acceptance by our Alaskan customers. We are watching the economics of it very closely. The bag fee waiver is the primary benefit for folks in the program up there, and that was about $2 million of forgone revenue in the fourth quarter. That's about where we expected it to be, so no big surprise there. We're doing some weekly fare sales as well up there, which is actually generating a little positive revenue for us. Yes, I mean, we're going to compete very aggressively in our core markets in Alaska, certainly our most core market. And we held our own quite well again some of the other competition that has come up there over the last couple of years. But long term, these are customers that have always been with us, and it was a move to try and recognize their long-term loyalty.

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

Yes. The Club 49, if I was going to Alaska, you'd charge me for the bag, is that right? That's just for your best customers in Alaska?

Yes, that's right.

Basically, I just want to clarify your pension. It's still active for current employees, not active for new employees so you're still funding that. And for certain labor groups now, you are terminating it for everybody. Is that what you said?

Yes. Basically to recap -- Ray, this is Brandon. All of the plans are closed to new entrants but there is an active plan for the pilots and the nonunion employees that started before 2003. As I mentioned, we've announced plans to freeze the benefits in that nonunion plan starting January 1, 2014. So for the foreseeable future, we're going to still have service costs, we're going to have a funding obligation. Because of our funded status, we don't, as I said, have any required funding but we just choose to do that.

Okay, great. That clarifies it. And then the other thing is seasonality. Alaska used to be even more seasonable than your other airline, for obvious reasons, since you expanded your network. It sounds like from what you said earlier, there still is a big seasonality factor there in the first quarter. Is that a good assumption to make?

Yes. Ray, this is Andrew. Actually both Q1 and Q4, we still have heavy seasonality with Q2 and 3 being much stronger. And again, every time we come into the quarter, first quarter is getting better and more balanced but we still have work to do there.

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

Just wondered if you could talk about customer willingness acceptance to take higher fares currently. I mean, is there anything that we should read into your, I guess, larger advance book load factors that you're changing something on the revenue management strategy and maybe yields are not as not as strong?

Duane, this is Andrew. I think if I was to answer at a higher level, you have seen over the past couple of years, we've focused heavily on traffic and making sure that we cover our fuel costs and get our return on invested capital. But as has been shared, our load factors are getting at record levels. I will tell you that as we move into the 2012 and into the first quarter, we're going to turn our attention more to the yield side of the business, recognizing that we have good strong traffic and the demand looks solid. And so that's what we're going to be working on to make sure that 2012, we continue to have our revenues exceed fuel increases and also make sure we hit our return on invested capital.

Okay, I appreciate that. And then, I mean is it fair to say with the weather impact in the first quarter that that's going to be difficult to do?

We're still analyzing that but what I can tell you is, is that basically on a load factor side, the ASMs that didn't fly and the passengers that disappeared they about netted out, so it's really in the first quarter will be a little bit challenged just in January but I think over the couple of days, we're going to continue to work through that problem and try to recover.

Okay, so we should not look at your fourth quarter results. I mean, you guys have been growing earnings year-to-year for quite a while now. And there's nothing we should take from your 4Q even if I back out the impairment, earnings were down year-to-year. What, if anything, does that suggest for 2012?

Duane, it's Brad. We don't give guidance particularly on revenues for the future but I think what we're trying to say is we looked at fourth quarter, we had a cost problem. Brandon's given guidance on the first quarter of 2012. We're going to have cost up year-over-year again. We're very unhappy to have cost increases in the fourth quarter of '11 and the first quarter of '12. Our guidance is reductions in unit cost in Qs 2, 3 and 4. On the revenue side, I think I would say that there's -- we feel pretty darn good about how revenues have performed for most of 2012, but right now, we're looking at this saying, "Hey, these fuel costs are really high, and we need to make sure -- we need to make sure we're doing everything we can to recover both like in this fourth quarter." The capacity increase, you've got to make up for the higher capacity, and our objective is to cover all of these higher fuel costs. So that's what we're trying to do. We've got a very good history of doing that over the last several years. The fourth quarter, we slipped a little bit, and the goal is to get back on and produce the same sort of stuff in '12. And I think while we don't give guidance quarter by quarter, we're very confident in the company's ability to do that over time.

I appreciate that response. Is the implication in there, if you can cover fuel, that the capacity plan must change?

Just to continue with it, the commitment is to cover the return on invested capital. So it's fuel, it's CASM. If you look at our 2011 results, getting cost reductions, cost and fuel reductions have been a big part of it. But the commitment is for us to cover our return on invested capital. And going back to Hunter's question, I think if we can do that on the numerator side, at some point, you've got to start looking at the denominator.

Duane, this is Bill. You know our history on being pretty nimble with capacity adjustment, scheduled deployments and so forth and so we're practiced at that and if we need to do more of that, we sure would.

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

A couple of questions here. The 737-900ERs, what's the configuration on that? And then, is that an airplane that you could fly off the West Coast to Hawaii year-round without penalty even in the high wind season?

Mike, it's Brandon, I'll start on that one. So we're going to configure the 900ER with 181 seats. That compares to 157 currently on the 800. So that's a pretty significant addition into the number of seats so that would be really good for cost on per passenger on an ASM basis. In terms of the flying to Hawaii, we could do that. I'm going to maybe ask Ben or Andrew to jump in here in terms of the seasonal restrictions because there are some particularly out of the Pacific Northwest.

Yes. Michael, this is Andrew. We can fly that airplane to Honolulu and to Kona, and we can do it from the Bay Area all year long. There are some seasonal restrictions in the Pacific Northwest during the winter but a good 6, 7-plus months of the year, we can certainly turn that to Hawaii. So our plan right now is to fully equip our 900ERs, ETOPS, make it possible with fly missions to Hawaii, and we will deploy that in the peak times where it makes sense just as we blend that into the rest of our network.

Okay, very good. And then just my second question, there's been a lot out there about AMR having a tough time in the L.A. market, lots of different analyses and highlighting maybe the extent of their losses, that they may be need some assistance there. And it was notable that in the last, I guess, set of proposals that they put forth before their pilots, there was a carveout to do a lot more with you guys on the West Coast. And I'm just curious, I know the restrictions there, and some of the stuff is very arcane and maybe even has to do with the history of whether or not it was previously flown by American. But when I think about either one-way codeshares or dual codeshares, and I think about what you do for Delta and what you do for American, how much sort of lesser is the American codeshare or agreement than say what you're doing with Delta? Like is there a lot of potential upside with American on the West Coast if you could have something where the restrictions were unchecked, where there was just a lot more to do with what you do now? I mean, your thoughts on that. I realize there may be some confidentiality elements here but I'm just -- I'm really curious about the potential here on the West Coast with American.

Yes, that's a -- it's a complicated question, I suppose, and we shared a little bit, I think, on the Investor Day. The American agreement, which we will know, has restrictions especially as it relates to scope and that type of thing. And really both Delta and American have a lot of code up and down the West Coast. As far as it goes east to west, that would be something that we really can't do today, and I'm not privy to any other discussions or some of the things that you have seen. But that would be something that would be new facts for us and we would need to explore that.

Okay, okay. If I could just quick -- one quick last one here. You sort of, when I think of Allegiant and I think of you guys, 2 very different models doing 2 very different things, and yet when you look at sort of what they're doing on the West Coast and they started flying out of an L.A. base and they just announced Oakland. And it's interesting because a lot of the markets are more, I'd say, sort of Pacific Northwest-oriented. I think about the Medfords, the Redmonds, Idaho Falls, Montana, it's a lot of markets off the West Coast that if I thought -- if I didn't have a nonstop service on Allegiant, it would be very likely that I would take you guys to some of those markets. So I'm just curious, I mean, again different markets, is there anything out there, or are you starting to see any and maybe this is with respect to Horizon, it's a bigger impact there, or is it just still 2 very different products and they're having no impact?

Yes. What I would say is obviously, their biggest presence is in Bellingham to Las Vegas. And I think that's where they have decent frequencies. The markets that you just mentioned, they're all once and twice a week. And so really at the end of the day, I think they're 2 different business models. And of course, we keep an eye on them and obviously, in the Las Vegas market especially. But we have the mileage plan, the strength of that. We have daily service 3x, 4x, 5x a day sometimes. So where we are today is we watch that but right now, it's not materially impacting our results.

Mike, Brandon here. I just want to reiterate that we watch that very, very closely, and we don't take anything for granted. You have to give kudos to these folks of Allegiant because they have a neat business and they make quite a bit of money. But we are absolutely watching what's going on with those markets.

And I've figured as much. I mean, I think you're movement into the Bellingham, Hawaii market about a year ago was a clear evidence of that.

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

One question is with respect to your interline agreements with some of the international airlines, I know, obviously, you've got the one with Emirates coming up. Is there any way you can say what percent of your traffic actually comes from those agreements, and that they make sense to continue doing? Or is it more publicity kind of...

Yes, Helane, maybe I'll start with the numbers, and get Joe to give some more beef on the background on why we do the international one. I think we have said in the past that our interline business overall is 13%, 14%, 15% kind of in that general area the percentage of our revenues. And I think we've also said that overall the domestic things, if you were to look at the volumes, are the lion's share of the interline agreements. In terms of the international ones are very, very important, Joe. Do you want to talk a little bit about our strategy there and why we do the Emirates deal?

Yes. We continue to feel like our frequent flyer program, the Mileage Plan has utility for our customers that far exceeds our relatively small size. And a big reason is that it alludes to is these international partnerships. The Emirates deal that we announced this past week is an exciting one. That's obviously a very fast-growing airline serving an important part of the world and has a really great product. I believe we will be the first U.S. domestic airline to do any sort of partnership with Emirates, and so we feel really good about that. And that -- they join a long list of other well-respected international airlines, British, Air France, KLM, Iceland Air, et cetera, that we have partnerships with, that really allow a lot of inventory for award redemption for our frequent flyers, for our Mileage Plan members which makes the Alaska program that much more attractive. So we're excited about expanding that network of partner carriers.

Okay. And then I don't know if you said this but can you say at all, give us any color at all on unit revenue growth for January? Or how we should -- or maybe you haven't figured out how last week's storm affects the total business, maybe you already answered that.

Helane, this is Andrew. As you're probably aware, we don't give unit revenue guidance forward-looking. I think we just again reiterate that we're seeing solid demand. We're very happy with our traffic build, given our capacity increases. And our goal, as we focus more on yield over the coming months, is to work to have our revenues exceed our increases in fuel costs.

Helane, it's Brandon. I want to answer your questions specifically on the impact of the storm. We did say in our prepared remarks that the impact was about $3.5 million, with most of that, more than half of that, being a revenue impact and then there was a net cost as well. I just didn't want to make sure that you didn't go away without having that question answered.

Okay, well, that's helpful. And then, can I just ask a balance sheet-related question? I think you said that you finished your share repurchase program in January, and you talked a lot about generating free cash flow and so on. How should we think about re-upping that program? So if you exercise options for additional aircraft for delivery in 2013, would you not re-up the program or does re-upping the program have nothing to do with what you're thinking about in terms of CapEx?

Yes. I think those are 2 independent decisions. So in our investor update, we've provided preliminary CapEx guidance for the year, and I mentioned in the prepared remarks that if we exercise those options, we would have CapEx grow a little bit beyond that. It's probably just off the top of my head, $50 million, $60 million of additional CapEx. But based on what we're seeing today, we would still have the question of, "Is there excess cash to deploy?" And I tried to address that when I said that we have plans to do that in a way that was similarly balanced to what we have been doing in the past. Getting back to Hunter's question, we like the notion of working both the numerator and the denominator to improve returns on invested capital. I can't speak to what our board's going to decide to do but if you look at our history over the course of the last 5 years, we have repurchase programs going in 2007, '08, '09, '10 and '11. So I'll leave you with that.

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

Just on the cost side. I know you're working on it and we're seeing the fourth quarter and the first quarter going up. And you've identified some of the things that should help bring it back down again. How does that work as you go through the year? I was just wondering if it was back-end loaded or how we should think about progression?

Yes. I think that, that is fair to say. This is Brandon, by the way. If we look at what's happening in the first quarter, we have a number of things that are front-end loaded if I look at things on a line item basis, for example. And I just think about what's driving the growth in unit costs year-over-year. If I just looked at what I might have needed maybe to keep my cost flat. Obviously, I've got a big pension headwind coming through wages. That's part of it, although that's pretty stable throughout the year. We've got a big training investment in the first half of the year, that's driving some of it, and then we've got some IT spend that's loaded into the front of the year as well. So that is driving the year-over-year increase in unit costs in the first quarter. That combined, of course, with the fact that it's probably our lowest growth quarter of the year. That's not to say, however, that we're relying on growth to bring down our unit costs.

And so is it the IT spend and things that fall off more in the third and the fourth quarter or...

Yes, I mean, there is some front-end loading that's driving Q1 up a little bit and then things will start to tail off a tiny bit as we get farther out into the year.

Okay, and what generally kind of the ASM variation from kind of trough to peak?

It's mostly -- and I'll start and maybe Andrew can jump in here. It's mostly related to the build of Hawaii throughout the year. And so as we think about the ASM growth numbers that Brad laid out, I think it was just off of the top of my head, 3.5%, 6%, 6%, 7.5%. It's really the growth of Hawaii on a year-over-year basis as we start to get the impact of that as we start to get later in the year. Andrew, you have anything to add to that?

That's right.

And then one last question. On the regional partner side, which is Horizon or with SkyWest -- are there any thoughts on the need to expand that, or do you have the right capacity now and that should be kind of relatively at current levels going to the next few years?

Yes. I think Brandon or Brad mentioned, there are some option considerations that we're going to have to make later on this year. But right now, we're very happy with the deployment and the capacity that we have in our regional markets. And as you heard earlier, the business is performing very well, and we're going to continue to make sure that, that stays that way.

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

A couple of questions. One, if I look at the implied capacity of your regionals in 2012, it looks like it's up 4% to 5% and your fleet is flat so what's driving that?

So yes. Actually what that is really a big credit to Glenn and his team in Horizon, where literally, we're able to free up 2 aircraft with the improved reliability and just getting through the CPA transition and pipeline. So we'll have a couple of extra aircraft to deploy in the back end, which is again no new invested capital, and it's just new revenue coming into the business and the new markets that you've seen recently announced as part of that.

So that extra capacity is back end loaded?

Yes, that's in the middle of the year.

And second question I have is if I look at your RASM relative to the industry, it was about -- it lagged by about 2 points in the spring, 3 points in the summer and looks like about 4 points in the fall. So why do you seem to be underperformed by a growing amount as the year progressed?

So I think the way I would answer that is that, of course, we're not happy with the fourth quarter. And the reality was about 17% of our capacity is in the state of Alaska, and I put too many seats in that market and we had negative unit revenues, which hurt. So we're going to true that up and get that right going forward. Again, as we've said earlier, absent that, our unit revenues and our fares have been enough to cover the cost of fuel and our return on invested capital, and that's our guiding light.

Your next question comes from the line of Dan McKenzie with Rodman & Renshaw.

My first question is just a quick housekeeping item. And I'm trying to try the results this morning to your January 5 filing where you called out a $6 million writedown of an MD-80. And I don't see a mention of it in the earnings release but it looks like it is included in the earnings table so I'm hoping you can clarify if it, in fact, was included.

Dan, it's Brandon. Yes, it was absolutely included. It was in other nonoperating. And we did not, as you pointed out, I'd like to call that out as a "special item" or an adjustment which we consider that part of normal earnings.

Got it. And I guess if I'm not mistaken, I think it was tied to AMR's Chapter 11 filing. And I guess I'm just trying to reconcile here because if we want to strip it out as a one-time, I guess I'm just trying to clarify, if it was tied to AMR's Chapter 11 filing because that's one-time in nature, and if the write-down is one-time in nature. First, I just want to verify if that's correct? And if it is, if we strip it out, it would seem like your earnings for the quarter would really be $2.18. So I just to want to make sure my math is correct.

$2.18? Take it.

Sorry, sorry, $1.18.

No, it is related to one airplane. It's one MD-80 that we had leased to another operator as I'll say. And I guess it was $6 million so just doing some rough math, that's about $0.10. After-tax, yes. By virtue of the fact that we had one MD-80 and it's now impaired, that will be a one-time item.

Very good, I appreciate that. And then Brandon, I guess if I could just come back to your comments a little bit earlier about using free cash flow in a similarly balanced way. If I interpret that literally, it would suggest if you have $300 million in free cash flow again this year, that perhaps $75 million of that would go to share repurchases, if I'm looking at the 4 constituencies that you've targeted your free cash flow for. And I guess my question is, does it make sense to distribute that free cash flow evenly with the stock north of $70? I mean when the stock was at $30 or $50, it seemed like a pretty easy decision. So if I could just give you a little friendly pushback on that area and just get your thoughts?

Sure. Thanks for the friendly pushback. I don't think there's any suggestion there that we need to distribute that number, $300 million, to use your example ratably among the constituents. We've done -- I'll start with the pension funding. We've done quite a bit of that, as I've said, in my comments. And we're in an ultra-low interest rate environment and based on what happens, we'll see what happens the funding levels. But we don't have any commitment to fund that by another $100 million next year. Our plan funding is $33 million for 2012. In terms of debt repayment, we have $200 million of planned maturities of long-term debt. Whether we do more than that is yet to be seen. And then on the repurchase side, I think I'll go back to what I said to Helane, which is the company, has had an active share repurchase program in place since 2007. I'm not promising that there's going to be one in 2012 because that is, of course, the board's decision. But we have a ton of confidence in this company, and it's not just what is the price today, $71, $72 a share. It's what do we think we can do over the next few years, and I think that's more the way we think about whether or not it's a "good deal" to repurchase shares.

Understood. And do you have a sense for the timing on when you would make these your decisions on the usage of cash?

I think it's just fair to say that we'll make those decisions throughout the year based on what we see in the environment and what we do with the options and what happens in the competitive environment. There's so many things that go into those decisions. I think that's a dynamic process that runs really the course over the year.

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

Just 2 quick questions. I think you'd noted some weakness in the ancillary, and I guess if you could just talk about it, if it has anything to do with -- if it's different than the Club 49 promotion, could you expand on that and what your plans are kind of move that higher or maybe in line with industry if that's the problem. And then second with the return on invested capital was for Horizon, if you have that.

Steve, this is Joe, I'll take a shot at the ancillary first. Yes, I think overall, ancillary was a bit less than what we would've hoped. A big driver there was bag fees, less related to Club 49 and more just in general, I think we're seeing a behavioral change with customers with respect to bag fees. In the second half of the year where we have a very good clean comparison to 2010 when we have that higher first bag fee in place, we actually had a 6% decline in checked bags. So that's something that we're concerned with and wrestling with and looking at what we can do about that. Beyond bag fees though, I would note that some other important areas of ancillary did perform pretty well for us on a year-over-year basis in 2011. Notably buying board revenue from our northern bikes, meals for purchase program performed exceptionally well last year. And on a year-over-year basis, our hotel and vacation sales were also up nicely.

And I'm sorry, ROIC, I apologize, Steve. We don't -- we've really changed the focus internally, where we're really thinking about ROIC on an Air Group level because it really is Air Group capital that is -- that's way we think about it. In terms of Horizon level results, what we're really trying to do is trying to drive the specific companies to focus on pretax margin. We talk a lot internally about the goal to have a 10% pretax margin, in fact, the need to have a 10% pretax margin. We talk to our employees about this notion of keeping $0.10 for every dollar that we've collected. Alaska is in pretty good shape on that front, and Horizon is moving in the right direction. If you look at Horizon standalone results and remember, this is CPA revenues from Alaska minus actual costs that are typically borne by a CPA provider. Horizon's margin for the quarter was 5.7%. So Horizon is still on the journey up to the 10% goal. But as I said, we're really focused more on pretax margin at the subsidiary level and ROIC at the consolidated level.

Okay. And then if I could just jump back to the ancillary real quick. I think you guys did have the 20, 20, 20 in place. I'm just wondering if there's any thoughts of changing that? And do you think that would help? And maybe you can comment on whether you think you'd get any revenue premium based on your lower ancillary?

Steve, it's Brad. I don't know what we would comment or what we would in the future. What I would tell you that we're wrestling with this issue, we do want to get our revenues -- we want to get revenues to a point where we're recovering these high level of fuel costs, as well as our growth. And we need to push things a little bit to get to that point. Bag fees are tough because we know that the increase to bag fees, the revenue goes up. And we know that, as Joe just hinted at, that there's -- customers don't love bag fees and their behavior changes. So we're going to look at the overall problem without a focus on any one particular area and quite confident that we'll get this thing -- it will make a little bit of adjustment here as we move forward.

Your last question comes from the line of Hunter Keay with Wolfe Trahan.

I'll be quick. Did you guys mention anything about variable pay targets for 2012?

No.

Hunter, it's Brandon again obviously. We didn't give guidance on variable pay targets for 2012. Our mindset around variable pay is that it should be aligned with the business plan, and we've just wrapped that up so we'll be announcing the targets internally. And what I will tell you is that at target, variable pay is right around $60 million on a consolidated basis, and that's roughly -- and get some notes here, that's roughly $50 million in the PBP plan and roughly $10 million in the OPR plan.

Great, that's helpful. And in terms of gross interest expense on the year-over-year basis has been trending down, fair to think that the fourth quarter gross interest expense is a reasonable run rate going through the next year?

Yes, we'll give some guidance in our next investor update on what we think non-op will be, and I can add some color on gross interest expense in another forum. But Q4 is -- the non-op in Q4 is kind of murky because there's the impairment charge related to the MD-80 and there's some capitalized interest true-ups that were in there and stuff. So I'll provide more guidance at another time. But your point is right on and it's fair to say that interest expense has come down nicely as a result of all the debt that we've paid off over the last couple of years.

Okay, we're going to have to wrap it up here in the interest of time. So thanks everybody for joining us today, and we look forward to talking with you again next quarter. Take care.

Thank you for participating in today's conference call. This call will be available for replay beginning at 11:30 p.m. Eastern Standard Time today through 11:59 p.m. Eastern Standard Time on February 24, 2012. The conference ID number for the replay is 37712522. The number to dial in for the replay is 1 (800) 642-1687 or 1 (706) 645-9291. Also, the call will be accessible for future playback at www.alaskaair.com. You may now disconnect.