ALASKA AIR GROUP, INC. quarterly report, Q3 FY2018

Alaska Air Group, Inc. — Q3 2018 Form 10-Q

Reporting period: Three and nine months ended September 30, 2018. Figures are in U.S. dollars; financial statement amounts are in millions unless otherwise indicated. The filing covers Alaska Air Group and its airline subsidiaries, including Virgin America, which legally merged into Alaska Airlines on July 20, 2018.

Financial performance

Metric	Q3 2018	Q3 2017	Nine months 2018	Nine months 2017
Operating revenue	$2,212	$2,110	$6,200	$5,952
Operating income	$297	$427	$597	$1,071
Net income	$217	$259	$414	$645
Diluted EPS	$1.75	$2.09	$3.34	$5.19
Operating margin	13.4%	20.2%	9.6%	18.0%

Operating revenue rose 5% in Q3 and 4% for the first nine months, while operating expenses increased 14% and 15%, respectively. Q3 pretax income fell $133 million, primarily due to fuel expense increasing $145 million and non-fuel operating expenses rising $87 million, partly offset by $102 million of additional revenue. Q3 adjusted net income, excluding merger costs and fuel-hedge mark-to-market adjustments, was $237 million ($1.91 diluted EPS), versus $270 million ($2.18) a year earlier. Nine-month adjusted net income was $461 million ($3.72 diluted EPS), versus $703 million ($5.66); 2018 adjustments also exclude a $25 million employee tax-reform bonus.

Revenue and operations: Q3 passenger revenue increased 4% as capacity grew 5%; load factor declined 0.5 percentage points to 84.9%. For nine months, capacity grew 6.7%, while yield declined 1.6% and load factor fell 0.8 points. Consolidated RASM was nearly flat in Q3 and down 2.3% for nine months.
Costs and margins: Q3 fuel expense increased 39% to $513 million; economic fuel cost per gallon rose 29.4% to $2.33. Non-fuel operating expenses excluding special items rose 7%. Consolidated CASM excluding fuel and special items increased 1.9% in Q3 and 3.0% for nine months.
Cash flow: Nine-month operating cash flow was $986 million, down from $1.357 billion. Capital expenditures were $554 million; operating cash flow less capital expenditures was approximately $432 million. Investing activities used $333 million and financing activities used $666 million. Cash, cash equivalents and restricted cash ended at $184 million; balance-sheet cash and cash equivalents were $174 million.
Debt and liquidity: Total debt was $2.029 billion, including $345 million current, versus $2.569 billion at year-end 2017. Cash and marketable securities totaled $1.397 billion, down 14% from $1.621 billion. Lease-adjusted debt-to-capitalization was 49%, versus 53% at year-end. The company reported $400 million of unused credit lines in its liquidity discussion and compliance with the $500 million minimum unrestricted cash and securities covenant.
Shareholder returns: The company paid $118 million in dividends and repurchased $37 million of shares during the first nine months; Q3 dividend was $0.32 per share.

Material changes and business developments

Virgin America integration was approximately 90% complete. Alaska had obtained a single FAA operating certificate and moved to a single passenger service system; Airbus fleet reconfiguration and crew-system integration remained underway.
Q3 on-time performance was 80.9% for Mainline and 81.2% for Regional. The regional segment recorded an $13 million pretax loss in Q3, compared with $25 million pretax profit a year earlier; nine-month regional results shifted from $57 million profit to $82 million loss.
The company reported a Q400 aircraft loss following an unauthorized flight from Sea-Tac on August 10. It stated the loss was fully insured with no deductibles; the claim process was pending completion of the FBI investigation.
Accounting changes adopted in 2018 affected revenue recognition and presentation. Management used retrospective presentation for the comparative periods; revenue adoption increased opening retained earnings by $171 million as of January 1, 2016. Early adoption of the tax-effects standard increased 2018 retained earnings by approximately $62 million.

Outlook, risks and contingencies

Management forecast 2018 capacity growth of approximately 5.3% and 2019 growth of approximately 2%. Q4 2018 capacity guidance was 16,120–16,170 million ASMs; full-year guidance was 65,375–65,425 million ASMs.
Forecast CASM excluding fuel and special items was 8.97–9.01 cents for Q4 2018 and 8.50–8.52 cents for full-year 2018, implying increases of approximately 3.6% and 3.2%, respectively, versus 2017.
Management expected Q4 economic fuel cost per gallon to be approximately 18.5% higher year over year. Fuel-price volatility, West Coast competitive pricing and capacity growth, labor costs, and continued merger-integration execution were key operating pressures.
Management estimated the new Saver Fare could generate approximately $100 million in incremental annual revenue and higher checked-bag fees approximately $50 million. These are estimates, not earnings guidance. The company also planned to lease 12 LaGuardia and eight Reagan National slots to another carrier from October 2018 through 2028.
Merger-related costs were $67 million for the first nine months; management expected additional costs through the remainder of 2018 and into 2019. Aircraft purchase, lease and capacity-purchase commitments are substantial; the filing lists total contractual obligations of $9.719 billion.
A Virgin America flight-attendant wage-and-hour class action had an adverse partial summary-judgment ruling. Plaintiffs valued damages and penalties at $85 million and sought judgment in that amount; final judgment was expected in March 2019, with the company intending to appeal. The company stated routine litigation was not expected to materially affect results.
The company said risk factors had not materially changed from its 2017 Form 10-K. Other cited risks include competition, fuel-price volatility, labor matters, operational disruptions, market concentration, integration and regulatory risks. Management reported disclosure controls were effective and no material change in internal control over financial reporting.

Important facts for investors to verify

Whether fuel prices, competitive pressure and lower yields continue to outpace revenue growth, and whether the stated capacity and unit-cost outlook is achieved.
Progress and remaining cost, timing and revenue-synergy effects of Virgin America integration.
Cash generation and liquidity after planned capital expenditures, aircraft commitments, debt service and shareholder returns; also monitor credit-line and credit-card reserve covenants.
Outcome and potential financial exposure of the flight-attendant class action, including the appeal and any judgment.
Realization of management’s estimated incremental revenue from Saver Fare and bag-fee initiatives, and the impact of the leased airport slots.