Alaska Air Group, Inc. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. Financial statements are unaudited; amounts below are in millions of dollars unless otherwise noted.
Business context and financial results
Alaska Air Group operates Alaska Airlines and Horizon Air. The quarter featured continued capacity growth and lower fuel costs, alongside pressure on passenger unit revenue and higher non-fuel expenses. The company was also preparing for its proposed acquisition of Virgin America.
| Metric | Q3 2016 | Q3 2015 | First 9 months 2016 | First 9 months 2015 |
|---|---|---|---|---|
| Operating revenue | $1,566 | $1,515 | $4,407 | $4,221 |
| Operating income | $400 | $433 | $1,108 | $1,043 |
| Net income | $256 | $274 | $700 | $657 |
| Diluted EPS | $2.07 | $2.14 | $5.63 | $5.05 |
| Operating margin | 25.5% | 28.6% | 25.1% | 24.7% |
Q3 operating expenses rose 8% to $1,166, as non-fuel expenses increased 10% and merger-related costs were $22. Fuel expense fell 8% to $225. For the first nine months, operating expenses rose 4% to $3,299, while fuel expense fell 20% and non-fuel expenses rose 10%. Reported nine-month results included $36 of merger costs. Excluding merger costs and mark-to-market fuel hedge adjustments, management reported adjusted diluted EPS of $2.20 for Q3 and $5.77 for the nine-month period; these are non-GAAP measures.
Cash flow, liquidity and debt
- Nine-month operating cash flow was $1,206, compared with $1,229 in 2015. Capital expenditures were $509, producing free cash flow of approximately $697, versus approximately $561 in 2015 (calculated as operating cash flow less property and equipment additions).
- Cash and marketable securities totaled $3,226 at September 30, 2016, including approximately $1.5 billion of debt proceeds intended to fund the Virgin America acquisition. Management identified approximately $1.7 billion excluding that financing as existing liquidity, in addition to operating cash flow and $252 of undrawn credit facilities.
- Total debt was $2,136, up from $683 at December 31, 2015; long-term debt, net of current portion, was $1,861. The increase largely reflects approximately $1.5 billion of secured borrowing for the proposed acquisition. Debt-to-capital including the present value of aircraft operating leases rose to 45% from 27%.
- The company reported $102 of dividends paid and $193 of share repurchases in the first nine months; repurchases were paused in Q2 while preparing for the acquisition. It reported compliance with the $500 minimum unrestricted cash and marketable securities covenant on its credit facilities.
Material changes and operating trends
- Q3 revenue increased 3%, but pretax income fell $35 to $402, primarily because non-fuel expenses increased $104, partly offset by higher revenue and $20 lower fuel expense.
- Q3 consolidated capacity (ASMs) increased 8.1%, while passenger revenue per ASM declined 5.8%; load factor was unchanged at 85.6%. Management attributed weaker unit revenue to competitive capacity, fare activity, and lower fuel prices affecting ticket prices.
- Q3 CASM excluding fuel and special items rose 1.6% to 8.20 cents. For the first nine months it declined 1.0% to 8.16 cents.
- Other revenue increased 13% in Q3 and 16% for the first nine months, primarily from Mileage Plan revenue, including higher partner and affinity credit-card revenues.
- Q3 pretax profit declined at Alaska Regional ($35 versus $45) and Horizon ($9 versus $10); Alaska Mainline pretax profit was $383 versus $386.
Outlook, risks and unusual items
- For 2016, excluding the proposed Virgin America acquisition, management forecast system-wide capacity growth of approximately 8.5% and CASM excluding fuel and special items down approximately 0.5%. Q4 capacity was forecast to grow approximately 3%, with that CASM measure up approximately 0.5% year over year.
- Management expected full-year economic fuel cost per gallon to be below 2015 levels, but higher in Q4 2016 than Q4 2015. It also expected full-year increases in wages and benefits, maintenance, landing fees, contracted services, and depreciation.
- The proposed Virgin America purchase was for $57 per share, approximately $2.6 billion in cash, with assumed debt and lease obligations subject to stated exclusions. The transaction remained subject to regulatory approval and DOJ review. A private antitrust case sought to block the merger; the court required at least seven days’ notice before closing and noted that consummation would be subject to divestiture. The company said it considered the allegations without merit.
- As of September 30, the company had obtained approximately $1.5 billion of secured financing; it obtained a further $100 million after quarter-end. Contractual obligations totaled $7,908, including $3,177 of aircraft purchase commitments and $1,193 of operating lease commitments, as presented in the filing.
- Effective October 1, the company prospectively changed the estimated useful life of certain aircraft and related parts from 20 to 25 years; it expected no material effect on Q4 or full-year 2016 results. The filing also identifies fuel-price volatility, competition, operational disruptions, labor, and acquisition approval as risks.
Important facts for investors to verify
- Whether regulatory and court proceedings permit the Virgin America acquisition to close, and the ultimate financing, debt assumption, and integration costs.
- Whether passenger unit revenue stabilizes amid competitive capacity growth, and whether planned capacity growth supports profitability.
- Whether non-fuel cost growth, including labor, medical claims, maintenance, and fleet-related depreciation, tracks management’s outlook.
- How much of reported cash and securities is available for general operations after excluding acquisition-related financing and considering debt, capital spending, and other commitments.
- The eventual balance-sheet and revenue effects of the Mileage Plan accounting standard expected to take effect in 2018.