Mission (Almost) Complete

Although it is premature to declarevictory, Alaska AirGroup isclosing in on the ambitious goals of Alaska 2010, the company’s transformational plan to achieve sustainable commercial and financial success in the notoriously cyclical airline industry.

Conceived seven years ago as airlines confronted the twin lightning bolts of SARS and the Iraq War, at the heart of Alaska 2010 is the notion of a “virtuous cycle” that starts with energized, enthusiastic employees who deliver a superior product to customers (ATW, 1/07, p. 44). So far, it’s working: 2010 marks the third consecutive year that Alaska Airlines has received the J.D. Power and Associates Award for “Highest in customer satisfaction among traditional network carriers.” Those satisfied customers, in turn, enabled the carrier to deliver a superior return for investors, continuing the cycle. Although it is among the smallest of the US major passenger airlines, with just a 3% traffic share, it posted the industry’s second-highest profit last year, earning $121.6 million.

Buoyed by the healthy result, a strong balance sheet and $100 million in stock buybacks, share price more than doubled over the 12 months ended Aug. 10, 2010, to $53 per share from $22.76 a year earlier. Satisfied investors contribute to the virtuous cycle by providing capital for growth, leading to better job stability and more opportunities for employees, thereby renewing the process.

A key goal of Alaska 2010 is generating a 10% return on invested capital, which equates to about a 10% pre-tax margin, according to Chairman and CEO Bill Ayer. AAG has yet to deliver this level of return on an annual basis, but the parent company managed a pre-tax margin of 9.6% in the 2010 second quarter and Alaska Airlines actually had an 11.1% margin (Horizon Air, Alaska’s regional affiliate, had a small pre-tax loss). In fact, the June period was the most profitable quarter in the company’s history after excluding one-time costs and mark-to-market fuel hedging adjustments. Ayer tells ATW, “We may very well hit our ROIC goal” for the full year. He and VP-Finance and CFO Brandon Pedersen also note that the intent is to sustain 10% “over the business cycle,” meaning, Pedersen says, “that in good years we’ll need to generate 12% to 13% returns to offset weaker years.”

Ayer, who oversaw the launch of Alaska 2010 in June 2003, says credit begins “with our wonderful employees; [they] take terrific care of our customers and work really hard.” Significantly, most of them, including pilots and flight attendants, have a direct stake in the company’s financial and operational success through a Performance-Based Pay program that has been introduced as new labor agreements are negotiated. The PBP, which established goals for safety, customer satisfaction, unit costs and net income, paid out the equivalent of about one month’s salary last year for those onboard, Ayer says.

He emphasizes the importance of having everyone in the same program: “It is one formula, the same formula that I have . . . I think it is a real strength and advantage.” At the mainline, clerical, office and passenger service employees are the only workers not participating; the intent is to include them in the new contract being negotiated. In addition to PBP, the company pays monthly bonuses for ontime performance ($50) and customer service ($50).

Airport of the Future Today

Any discussion of AK’s renewal begins at Seattle-Tacoma International, its largest base. Of its 400 daily departures, 121 lift off from Sea-Tac. A visit to the airport during its peak period reveals an anomaly, however: Long lines at other airlines’ check-in counters and seemingly little activity in the space occupied by AK despite the fact that the carrier accounts for around 50% of the passenger movements there.

That’s because as part of its Airport of the Future project first unveiled in Anchorage, AK got rid of its check-in counters a few years ago and replaced them with banks of freestanding kiosks (45 in total) and a separate bag check area. Instead of 52 agent counter positions, it now has three islands with 23 positions and those primarily are for passengers checking bags (a separate area handles customers with problems or special requirements).

The result has been nothing short of astonishing, according to VP-Corporate Real Estate Ed White, who tells this magazine that the airline expected a 40%-50% improvement in productivity and actually achieved a 100% improvement. Before it implemented the Airport of the Future concept at Sea-Tac, average customer check-in time during peak travel periods was 30 min. Today, it takes 3.25 min. for customers to check-in at a kiosk and check a bag, he says. Long backups still occur at security, however, he acknowledges.

AK is using roughly half the number of people previously required to perform check-in but “we didn’t lay off anybody,” White says. Agents now are able to circulate—guiding passengers to kiosks, answering questions and troubleshooting problems. The airline also reduced its real estate footprint. “We’re operating at peak time, during peak season, using two-thirds of the capacity available,” he boasts, adding that AK has enough surplus capacity for at least 10 years.

An added benefit is that passengers place their bags directly onto the belts, requiring no participation by customer service agents. As a result, on-the-job injuries to check-in staff related to bag lifting, the No. 1 cause of staff injuries, have virtually disappeared, White says. Alaska charges $20 per bag for the first three checked bags but is unique in offering a service guarantee: If the bag doesn’t appear on the carousel within 20 min. of arrival, customers receive 2,000 Mileage Plan miles or $20 off a future flight.

Ontime Again

AK’s rise is about more than just speeding check-in times. The whole airline has gotten faster, or at least a lot more punctual. In 2005 it ranked 20th in ontime performance, dead last among US carriers. By 2009 it had captured second place among the 10 largest US airlines and it was in first place through June 2010, when 89% of its flights arrived within 14 min. of schedule. Ayer says, “It is just a remarkable turnaround and is a tribute to our folks who are doing great work,”

To be sure, the dismal performance in 2005 was due largely to the decision that year to outsource ramp handling at Sea-Tac to Menzies Aviation after AK could not reach a satisfactory concessionary agreement with the International Assn. of Machinists-represented work group. “The execution of the outsource initially was not good,” Ayer acknowledges, “and we recognized that early on and we took steps to improve it.”

Since then, however, AK has overhauled its entire focus, and Menzies was a key part of the solution, says MD-Station Operations-Seattle Diana Shaw. “In the fall of 2007 our current COO [and Executive VP-Operations] Ben Minicucci put together a cross-divisional team and the whole thought was we needed to fix Seattle. If we could fix Seattle then we could certainly make a difference across our entire system. We had really been output-oriented: What was our delay performance yesterday? What was our arrival performance? . . . And Ben brought in a philosophy that said, ‘You can do okay by the luck of the draw sometimes, but if you want to make change and sustain it, you have to understand what drives good performance and for that [you have] to look at inputs.’”

So today AK measures inputs. Everyone—pilots, flight attendants, ramp agents, customer service agents, ops agents, cargo agents—works from a standardized timeline of specific actions and activities “that have to be executed at every point in the turn of an aircraft.”

They also work off the same clock, which wasn’t the case previously. To correct this, the airline installed RIDs (Ramp Information Displays) at every gate. As a result, says Shaw, “The ground crew knows when the plane is on, when it is at the gate, and they know how many minutes to departure . . . The ramp lead knows seven minutes before departure he needs to be heading to Ops to take in his load and finalize it. We have the same displays in the jetway that are visible to the ‘A’ flight attendant in the first class galley . . . Everyone knows what time it is. Everyone knows time is getting tight . . . We’re all on the same clock. That was huge.”

Even more basic was solving the mess on the ramp, she says. Often ground crew scrambled to find belt loaders and bag carts scattered about the tarmac as the plane was approaching the gate. Today, painted outlines on the ground mark the locations at each gate for the belt loaders, the bag carts and other equipment.

Cost Pressures  While AK was fixing Sea-Tac, it also was maintaining a close focus on costs. This has been a long, painful process encompassing outsourcing, concessionary contracts and layoffs (the number of fulltime-equivalent employees was down around 3.8% as of June 30 compared to Dec. 31, 2009, and around 11% since the end of 2007). The airline has made efficiency improvements too, such as retiring its gas-guzzling MD-80s and moving to an all-737 fleet, with all aircraft equipped to perform RNP approaches, a technology it pioneered in Alaska in the 1990s.

Cost per ASM excluding fuel dropped from 8.73 cents in 2001 to a low of 7.49 cents in 2008 before spiking to 8.26 cents in 2009, which Pedersen attributes to a combination of factors including less flying (ASMs fell 4.4% last year), higher pension expense owing to the 2008 market crash, the PBP program and a new pilot contract signed in 2009. Prior to this agreement, the pilots had been working under an arbitrated contract that cut wages 26%. Last year’s accord raised pay around 14% in exchange for productivity improvements and changes to the pension and health care programs. “There is great productivity language [in the new contract],” says Alaska Airlines President Brad Tilden. “Once all our pilots are recalled [off furlough] we will have huge flexibility. I think pilots will be able to fly close to 100 hours per month.” AK still has around 100 pilots on furlough.

Pedersen says the company sees further opportunities for savings but points out that “we will probably need some growth to get down to where we were before.” Company guidance for 2010 is for CASM in the 7.9-8.0-cent range.

When it comes to managing fuel costs, AAG takes a conservative approach, using caps rather than riskier forward purchases and swaps. Currently, 50% of the fuel requirement for the rest of 2010 is hedged at $78 a barrel. “It’s like an insurance contract,” Pedersen explains. “If fuel is lower then you participate in the upside but you never have a collateral obligation. You never have a call if the price goes below your collar, for example. That’s where everybody else got burned [in 2008].” But caps cost a lot of money—AAG spends around $50 million a year on them.

The good news is that it is literally rolling in the green stuff; it ended the second quarter with around $1.3 billion in unrestricted cash and short-term investments. In fact, Pedersen figures that AAG has about $300 million more than it requires, so it is paying cash for aircraft, retiring debt and buying back stock. The problem won’t necessarily go away because its capex in 2010 is just $210 million and it’s even lower in 2011.

Flat Fleet Growth

AK added four 737-800s this year but three 737-400s and two -700s have or will depart, giving it 114 737s (including 84 NGs) at Dec. 31, down a unit versus 2009. The same thing happens in 2011 when it adds three -800s and removes three -400s. The fleet will not grow in absolute numbers until 2012, when four -800s come on line with no retirements planned. Despite the stable fleet growth, the airline is not sitting still. Mainline ASMs are expected to rise 5% this year on the bigger -800s and longer flying (departures should be pretty flat). Amazingly, with virtually no net increase in aircraft AK has opened 24 new markets since June 2008 including 18 between January 2009 and July 2010, with nine more scheduled to launch by the first quarter of 2011. It currently serves 62 cities.

Primarily this has been achieved by reducing frequencies in underperforming markets such as Mexico, says VP-Marketing Joe Sprague. Taking advantage of the demise of ATA Airlines and Aloha Airlines in 2008, most of that capacity has been redeployed on services from the mainland to Hawaii. “Fifteen percent of our route network this fall and winter is to and from Hawaii, up from nothing three years ago,” he notes.

Using 180-min. ETOPS-certified 737-800s, AK is largely bypassing the primary markets. “We do Honolulu service from Anchorage and Seattle and soon from Portland, but the main focus has been Maui, Kona and Kahului nonstop from the West Coast, not taking people through on a connection,” Ayer says. Typical of this are the carrier’s Sacramento-Maui, Seattle-Lihue and Oakland-Maui routes. The Hawaii service works well given AK’s estimated 70/30 leisure/business mix, but the carrier still has some opportunities in the mid-continent, officials say, and it is adding a daily Seattle-St. Louis service this month. Its bilateral partnerships with 15 airlines, led by American and Delta, give its customers access to more than 700 markets around the world.

When it comes to IFE, the carrier is sticking with its digEplayer portable movie players, invented by a former Alaska Airlines employee. Passengers can rent the players for $6 or $12 depending on flight length (they are complimentary in first class) and they are pre-loaded with movies, television shows, cartoons and other entertainment features.

“Will that be our IFE solution forever? Hard to say,” Sprague states. “It most likely will be our IFE solution for the next year or so and it still has good customer acceptance.” The airline has chosen Aircell’s Gogo solution for inflight connectively. At press time around 60% of the fleet was equipped and the goal is to have the entire fleet done by year end.

By then, the company may be ready to announce a successor to Alaska 2010, although Ayer is keeping his cards close to his vest. He says AAG probably deserves a B+ on how well it met the program’s goals; “And we are tough graders,” he jokes. But there is more to do. “We’ve greatly increased our understanding of the [success] levers. We’ve set solid goals which we continue to raise as we achieve them. The net result is there is sustainability to this. This isn’t just a one quarter or a one year deal. We’ve got some stuff in place here that we think is going to hold us in good stead for a long time into the future.”