Alaska Air Group, Inc. — FY 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. Virgin America was acquired on December 14, 2016; its results are included only from that date, limiting year-over-year comparability. All amounts are U.S. dollars.
Business context
Alaska Air Group operates Alaska Airlines, Virgin America and Horizon Air, with regional capacity also provided by SkyWest and PenAir. The Virgin America acquisition made the company the fifth-largest U.S. airline and expanded its West Coast network. The group carried 34.3 million passengers in 2016.
Financial and operating highlights
| Metric | 2016 | 2015 | Change / context |
|---|---|---|---|
| Operating revenue | $5.931 billion | $5.598 billion | Up 6% |
| Operating income | $1.349 billion | $1.298 billion | Up 4%; operating margin about 22.7% versus 23.2% |
| Net income, GAAP | $814 million | $848 million | Down 4%; diluted EPS $6.54 versus $6.56 |
| Adjusted net income | $911 million | $842 million | Up 8%; adjusted diluted EPS $7.32 versus $6.51 |
| Operating cash flow | $1.386 billion | $1.584 billion | Down $198 million |
| Free cash flow | $708 million | Not stated here | Operating cash flow less $678 million of capital expenditures |
| Cash and marketable securities | $1.580 billion | $1.328 billion | Unrestricted liquidity at year-end |
| Long-term debt, including current portion | $2.964 billion | $683 million | Rose substantially following acquisition financing |
| Long-term debt-to-capital ratio | 59% | 27% | Company measure includes present value of aircraft lease payments |
Reported pretax income was $1.345 billion, up 3%. Adjusted pretax income was $1.4 billion, up 8%, excluding $117 million of merger-related costs and $13 million of mark-to-market fuel-hedge adjustments. The company reported a 24% adjusted pretax margin, in line with 2015. Adjusted measures are non-GAAP.
Passenger revenue increased 4%; other-net revenue rose 17%, largely due to higher Mileage Plan revenue. Consolidated capacity grew 10.6%, while yield fell 5.7% and passenger revenue per available seat mile fell 5.6%. Load factor edged up to 84.3%. Fuel expense declined 13% to $831 million as economic fuel cost per gallon fell 19%, partly offset by higher capacity. Non-fuel expenses increased 10%, including higher wages and acquisition-related costs. Consolidated non-fuel unit costs, excluding special items, declined 0.8%.
Fourth quarter: Revenue was $1.524 billion versus $1.377 billion in Q4 2015; operating income was $241 million versus $255 million; net income was $114 million versus $191 million; and diluted EPS was $0.92 versus $1.51.
Material changes versus the prior year
- Virgin America was acquired for a purchase price of $2.596 billion. The company paid $2.6 billion to equity holders, received $645 million in acquired cash, and obtained approximately $2.0 billion of secured acquisition financing.
- Year-end total assets rose to $9.962 billion from $6.530 billion, and shareholders’ equity increased to $2.931 billion from $2.411 billion.
- Passenger and capacity growth were accompanied by lower unit revenue: consolidated PRASM declined 5.6%, reflecting competitive pressure, capacity growth and lower fares amid reduced fuel prices.
- Fuel costs fell, but higher non-fuel costs, including wages and benefits, and $117 million of merger-related charges contributed to lower GAAP net income and operating cash flow.
Outlook, risks and unusual items
- Management expected 2017 combined system capacity growth of approximately 8.5% versus combined 2016 capacity. It expected continued competitive pressure on unit revenue, while total passenger revenue was expected to increase on a combined-company basis.
- Management expected Virgin America integration costs to continue in 2017 and targeted a single operating certificate in early 2018. Integration, system conversion, workforce alignment and realization of anticipated synergies remain execution risks.
- Management expected first-quarter 2017 economic fuel cost per gallon to be approximately 39% higher year over year; it said full-year fuel costs could not be forecast with certainty. About 42% of expected 2017 fuel requirements were hedged with crude-oil call options.
- Management projected substantial year-over-year increases in several 2017 expense categories, largely due to including Virgin America for a full year. It estimated wages and benefits would rise 30%–35%, maintenance 50%–55%, aircraft rent 140%–145%, and landing fees and other rentals 50%–55% versus 2016.
- Key risks include intense competition and fare discounting, fuel-price volatility, high fixed costs and increased debt, concentrated exposure to Seattle and other West Coast markets, labor negotiations and pilot availability, operational disruption and weather, cybersecurity and technology failures, and acquisition integration. The Delta codeshare agreement was scheduled to end April 30, 2017; management expected an immaterial 2017 financial impact.
- The company recorded $1.9 billion of provisional goodwill from the acquisition, subject to annual impairment testing and possible future impairment charges. Virgin America’s federal and state net operating losses were approximately $773 million and $344 million, respectively, but their use may be limited by tax rules and future taxable income.
- A Virgin America flight-attendant wage-and-hour class action had been certified; in January 2017, the court granted in part and denied in part Virgin America’s summary-judgment motion. The company said it intended to defend the case. Management stated routine litigation was not expected to materially affect results.
Important facts for investors to verify
- How reported and adjusted earnings reconcile, including merger costs, hedge adjustments and tax items, and whether the adjusted results are a useful basis for assessing future performance.
- Acquisition integration progress, realized revenue and cost synergies, integration spending, and the timing of operational and labor-group integration.
- Debt service, aircraft lease and purchase commitments, covenant requirements, and liquidity after the acquisition; the debt-to-capital measure includes lease obligations.
- Trends in yield, PRASM, load factor and competitive capacity, particularly in Seattle and other core West Coast markets.
- Fuel-price exposure and hedge coverage, as well as the effect of higher fuel prices on margins and cash flow.
- Virgin America goodwill valuation and impairment risk, the provisional purchase-price allocation, and the availability of acquired tax-loss carryforwards.
- Control coverage: management and the auditor excluded Virgin America from the 2016 internal-control assessment; it represented about 33% of consolidated assets and 2% of revenue. The auditor issued unqualified opinions on the financial statements and on the assessed internal controls.