Certainly, Kelly can be forgiven for expecting the eastern landscape to be completely cemented over by development: he is, after all, a native of the Seattle area and more accustomed to living with a view of Mount Rainier, weather permitting. But irony sets in when he speaks of the clouded vision some easterners - specifically Wall Street easterners - have of his home region, and his own airline.
'They don't know the area we serve,' he says, referring to Wall Street analysts. 'If they hear that Southwest [Airlines] is going to do anything even minute, it's magnified in their minds.'
Philip Baggaley, airline industry analyst for rating agency Standard & Poor's, is an example of a dubious observer of Alaska Air. As with most US carriers except for Southwest, S&P does not rate Alaska Air as investment grade. Baggaley notes that a precariously off-balance financial structure, with a debt-to-equity ratio approaching 90 per cent including aircraft leases, is partly to blame.
But what really gives the carrier a negative outlook is a new, dual threat: the entrance of Southwest and United's low-fare 'Shuttle' into the Pacific northwest, which occurred last year while the two carriers waged a price war in California. In last year's fourth quarter and this year's first quarter they helped to lower Alaska Air Group yields by more than 11 per cent, while not spurring the traffic growth that could have compensated for its full-year 1994 yield loss of 15 per cent.
Such concerns are not expressed without reticence, as the company has reinvented itself over the past two years. Remarkably, Alaska Air Group - composed of Alaska Airlines and its regional subsidiary Horizon Air - has lowered unit costs by 24 per cent in that time. Costs of 10.2 cents per available seat mile in 1993's second quarter stood at 7.7 cents per ASM the same period this year, due primarily to productivity gains. The carrier has changed from an ultra-service airline to a high-frequency, low-cost but full-service carrier that focuses on 48 point-to-point markets from Alaska to Mexico. In 1994 it made a $22 million net profit after two years of losses.
Still, there are concerns. 'They are appropriately focusing on some markets where they have natural strength,' he says, adding: 'Unit revenues have fallen substantially, which has wiped out most of the gains from cost cutting. After that, you feel sorry for them.'
Kelly agrees with the location argument: 'We do the West Coast. This is all we do, and we have to be here.' But he disagrees that the cost-cutting has been all for naught. Harry G Lehr, senior vice president of planning and finance, adds that 'yield' and 'cost' are relative terms which should take into account Alaska's service level. 'The decision was not to be the lowest cost carrier, but a low cost carrier.'
Under former president Raymond Vecci, the airline in 1992 decided that the premium product for which it had received numerous 'best service' awards had to go. Southwest's low-cost, low-fare strategy was just becoming the industry mantra, and an airline with the industry's second-highest unit costs, and one that had always been reactive to pricing initiatives, was not going to make it. This was made clear when Alaska Air's 19-year streak of profitability ended in 1992 because of broad economic recession and discount pricing in Alaska markets by MarkAir (then based in Anchorage and under Chapter 11 protection for the first time), and by Southwest in California, where Alaska Air was heavily represented in the intrastate markets. Yields dropped more than 13 per cent, and net losses that year totaled $84 million.
Vecci cut costs dramatically last year by pulling out of the intra-California competition and retrenching to traditional city-pair markets like Seattle-San Francisco and Portland-Los Angeles. Frequencies were dramatically increased to fend off competition. For example, from Seattle and Portland in the last year services have increased from 21 dailies to both the Los Angeles and San Francisco Bay areas to 49 and 55 flights, respectively. But the new capacity also meant that new, productivity-enhanced contracts with Alaska Air's heavily unionised workforce of 6,900 could effectively cut costs. By growing into the new labour agreements (along with laying off 400 people early on), efficiency gains diminished labour expenses by 16 per cent between 1993 and 1994.
A fleet restructuring was also undertaken, reducing the average age of the carrier's 72 aircraft to six years, cutting maintenance costs in 1994 an estimated 26 per cent, and giving the carrier plenty of room to tap the used aircraft market for future growth. Alaska Airlines added six new Boeing 737-400s, one B737-200 and four new MD-83s after converting 20 options on the MD-90.
Aircraft lessor ILFC struck a deal with Alaska Air in late 1994 on 20 B737s, stretching leases from eight to 10 years and requiring the purchase of three B737s. Though capital lease obligations covering the new aircraft increased $57.8 million last year, the new contracts provide the carrier with $6 million in annual savings and the fleet changes increased average seats per aircraft by 2 per cent.
The aircraft refinancing was the final part of the makeover. By the end of 1994, operating revenues had increased 17 per cent to $1.3 billion on a 27 per cent increase in system capacity, while average daily aircraft utilisation increased 26 per cent from 8.2 block hours to 10.3 block hours. If it had not been for the fourth quarter of 1994 and the first quarter of this year, Vecci, whose abrasive personality conflicted enough with the airline's board to cost him his job this year, may have left on a more positive note.
But the impact of all these efforts began to diminish last year when aggressive pricing hit Alaska Airlines from Southwest and Shuttle by United from the south, and from MarkAir, once again in bankruptcy, from the north. Suddenly, in bread-and-butter markets like Seattle-San Francisco fares slumped from $539 for a full coach round-trip to $139, and stayed there. On the Alaska routes, MarkAir's longstanding 'permanent fund' discount, which provided four round-trip coupons in exchange for a $980 cheque given to Alaska residents each year, was bumped to five coupons. Alaska Airlines' response, to offer four coupons instead of three, diminished yields in its namesake region.
Even worse, however, was a load-factor drop of close to four points in 1995's first quarter, when loads bottomed out at 56.4 per cent. With a 25 per cent increase in capacity over 1994's first quarter in effect, the breakeven load factor was 64 per cent. Alaska's net losses hit $6.3 million, but Kelly argues that losses were endemic to the industry.
Still, he says, 'the markets tend to adjust.' This has apparently happened, with a second-quarter turnaround fully in place - the operating numbers improved each month and the group reported net income of $7 million on revenues of $24.5 million. With what one analyst terms 'peace breaking out' between Southwest and Shuttle by United, meaning a more stable fare environment has taken hold, even yields have climbed back up for Alaska Air: though the second-quarter revenue per passenger mile of 11.9 cents was 8.1 per cent lower than in the second quarter of 1994, it was 6.3 per cent higher than in the first quarter of 1995.
With unit costs down and a fleet restructuring taken care of, it is now the balance sheet that Alaska Air officials are attempting to repair, with an eye towards achieving a rarity in the US airline industry: an investment grade rating. To that end, in July they called for the redemption of a 7.25 per cent liquid yield option note issue (Lyon) due in 2006 and was convertible to common stock at $38 per share. Thinking that the issue would be called next year, Kelly and Lehr substituted that debt with a more favourable package of convertible senior debentures.
The subsequent offer was originally set at $100 million but was increased and overalloted to a level of $132 million, all of which retires the Lyons. 'The chance it [the Lyon] was going to convert was small,' says Lehr. 'By taking it out and substituting 6.5 per cent debt that is convertible in three years at $21.50 [per share], we can see that conversion now happening and $130 million in debt converted into equity. In one fell swoop it will do a substantial job of cleaning up the balance sheet.' However, there is still the concern over competition, though Kelly believes this threat is overstated. The Shuttle by United has not had a large direct impact on Alaska Air. And Alaska Air now only competes with Southwest in nine nonstop markets and in 11 markets that are one-stops for the Dallas-based competitor. Horizon's service competes with Southwest in four markets. By comparison, Alaska Air Group offers nonstop service in 145 city pairs.
But though the city-pair numbers may be small, the markets in which Alaska and Southwest compete are Alaska's largest. Included on the list are Seattle-San Jose, Portland-Las Vegas and Seattle-San Francisco. In fact, there is little doubt that Southwest's expansion into the Pacific northwest has taken passengers away from Alaska Airlines, as evidenced by traffic figures from Sea-Tac International Airport, Alaska Air's home.
In June 1995, Southwest's traffic through Sea-Tac reached 143,900 passengers, up nearly 80 per cent from the 80,600 passengers in June last year. With 552,800 Alaska Air passengers using the airport, Southwest's Seattle passenger base has risen from 17 to 26 per cent of Alaska's. Certainly, Southwest took traffic from other carriers, like Reno Air. But Southwest, with a 44 per cent growth rate over June 1994 allowing for the combination with Morris Air, has become the fastest growing airline at Seattle. Alaska Airlines' 16 per cent traffic growth in the same period included major gains from MarkAir's withdrawal.
It is this limited potential for growth that concerns some observers. Southwest's decision to enter Florida in 1995 may see a diminished focus on the West Coast, and MarkAir's pullout from service to and within the state of Alaska - which comprises 25 per cent of Alaska Air's system - will give Alaska Air $30-60 million in added revenue, Lehr estimates. But there are limits to growth for Alaska Airlines. 'Other than some of the Alaska markets, they don't dominate a hub and they don't have an international system to fall back on,' Baggaley states, adding that even though MarkAir is gone, 'it has been replaced by the new guys.'
The new guys, Kelly responds, don't have Alaska Air's service levels. The point of the restructuring has always been to differentiate the airline from the low-cost competition through such amenities as nonstop services, high frequencies, meals, advanced seating and a global frequent flyer plan. The marketing, he says, will produce the growth: 'We've transformed ourselves into a low-cost competitor with a service edge. We've always sold the differentiation between us and the competition, but it's never been greater than today. By every measure, we offer more.'
Wherever the marketing efforts go, Alaska Air is still looking for new markets to exploit, with Vancouver the next target. Though Alaska Air did not receive any rights to serve Canada under the new, phased-in open-skies agreement between the US and Canada, it fully expects to be a winner when Vancouver is opened up in 1996. 'The West is always going to be the prime focus,' Kelly says. 'But we happen to have this city of over a million people magically appearing on our route structure. I'm not concerned about the ability to grow in our region.'
Anywhere but East, even in Canada. Three years ago, Alaska Airlines tried a Los Angeles-Toronto service, but gave up after eight months. The reason? In points East, Kelly says, Alaska Air 'is a hard story to sell.'
Source: Airline Business
