ALASKA AIR GROUP, INC. quarterly report, Q2 FY2018

Alaska Air Group, Inc. — Q2 2018 Form 10-Q

Reporting period: Three and six months ended June 30, 2018. Amounts are in millions of dollars unless otherwise stated. The company operates Alaska (including Virgin America) and Horizon, with regional flying also provided by third-party carriers.

Financial results

Metric	Q2 2018	Q2 2017	Six months 2018	Six months 2017
Operating revenue	$2,156	$2,102	$3,988	$3,842
Operating income	$271	$487	$300	$644
Net income	$193	$293	$197	$386
Diluted EPS	$1.56	$2.36	$1.59	$3.10
Operating margin	12.6%	23.2%	7.5%	16.8%

Revenue grew 3% in Q2 and 4% for the first half, while operating income and net income fell substantially. Management attributed the Q2 pretax-income decline of $215 million primarily to $131 million higher fuel expense and $139 million higher non-fuel operating expense, partly offset by $54 million higher revenue. Q2 non-GAAP adjusted net income was $206 million, or $1.66 diluted EPS, versus $309 million, or $2.48, a year earlier. First-half adjusted net income was $224 million, or $1.81 diluted EPS, versus $433 million, or $3.48. These are company-defined non-GAAP measures.

Costs and operating metrics: Q2 fuel expense rose 38% to $475 million; economic fuel cost per gallon increased 34.5% to $2.30. Non-fuel expense excluding special items increased 10% to $1,371 million. Consolidated CASM excluding fuel and special items rose 2% to 8.14 cents; first-half CASMex rose 3.5% to 8.46 cents.
Revenue and capacity: Q2 passenger revenue increased 3% as capacity grew 8%, but yield declined 4%, load factor decreased 0.8 percentage points to 86.0%, and RASM fell 4.8%. Management cited competitive fare pressure, particularly on the West Coast, and increased capacity.
Cash flow: First-half operating cash flow was $726 million, versus $1,084 million. Capital expenditures were $423 million; net cash used in investing was $468 million and financing was $347 million. Operating cash flow less reported capital expenditures was approximately $303 million.
Liquidity and debt: At June 30, cash and marketable securities totaled $1,568 million, compared with $1,621 million at year-end 2017. Total debt was $2,312 million, including $314 million current; long-term debt excluding current maturities was $1,998 million, down from $2,262 million. The company made $258 million of debt payments in the first half. Lease-adjusted debt-to-capitalization was 52%. Credit facilities totaled $475 million; the company reported compliance with the $500 million minimum unrestricted cash and marketable securities covenant.
Shareholder returns: First-half dividends paid were $79 million ($0.64 per share); share repurchases were $25 million.

Material changes and business developments

Operating expenses increased 17% in Q2 and 15% in the first half. Wage and benefit costs, fuel, aircraft maintenance, rent and regional carrier expense were among the increases. Employee growth included McGee Air Services insourcing previously contracted ground-service work, as well as network growth and higher labor rates.
Virgin America integration was reported approximately 85% complete. Alaska and Virgin America received a single FAA operating certificate in January and moved to a single passenger service system in April. Merger-related costs were $39 million in Q2 and $45 million in the first half; the company expects such costs to continue through 2019.
Segment results in Q2: Mainline pretax profit was $288 million, down from $478 million; Regional recorded a $20 million pretax loss versus $34 million profit; Horizon earned $10 million versus a $9 million loss.
First-half deferred Mileage Plan revenue was $1,777 million, up from $1,725 million at January 1. The company reported approximately 229 billion outstanding miles. Loyalty-program estimates, including redemption breakage and allocation of contract consideration, involve management judgment.

Outlook, risks and contingencies

Capacity and costs: Management forecast 2018 network capacity growth of approximately 6% and 2019 growth of approximately 2%. Q3 2018 capacity was forecast at 17,095–17,145 million ASMs, about 5.9% above Q3 2017; full-year capacity was forecast at 65,780–65,930 million ASMs, about 6.1% higher. CASMex was forecast at 8.36–8.41 cents for Q3 and 8.50–8.53 cents for full-year 2018.
Management expected higher economic fuel cost per gallon in Q3 2018 than in Q3 2017. Fuel hedges covered about 50% of expected requirements in each of Q3 and Q4 2018, and 25% for full-year 2019, using call options on crude oil.
Management expected full-year wage and benefit, maintenance, aircraft rent, airport fees and regional carrier costs to rise faster than capacity in relevant categories. Targeted capital expenditures were $1.0 billion for 2018 and $750 million for each of 2019 and 2020.
The company planned a “Saver Fare” product and estimated approximately $100 million of annual revenue from it, which management characterized as incremental to merger synergies. It also described other fare and fee initiatives. These are expectations, not reported results.
Material commitments include $2,547 million of aircraft commitments and $2,857 million of operating lease commitments. A Virgin America flight-attendant wage-and-hour class action had a remaining claim scheduled for trial in October 2018. Following a July court ruling partly adverse to the company, management had not determined the range of possible outcomes and stated assessed damages could be material; the company intended to defend and appeal.
Other stated risks include fuel-price volatility, competition, labor matters, operational disruption, integration and synergy execution, economic conditions, concentration in key markets, and regulatory or security events. Management reported no material changes to the 2017 Form 10-K risk factors.

Important facts for investors to verify

Whether fare initiatives and integration milestones improve yields and revenue enough to offset West Coast pricing pressure and capacity growth.
Whether fuel prices, refining margins and hedge outcomes align with the company’s forecasts, and how fuel costs affect reported and adjusted results.
Whether labor, maintenance, airport, aircraft-rent and regional-carrier costs continue to outpace capacity growth, and whether CASMex meets guidance.
How the October 2018 wage-and-hour litigation and subsequent appeals develop, including any potential damages or financial-statement accruals.
Whether planned capital spending, aircraft commitments, debt repayments and shareholder returns preserve liquidity and covenant compliance.
How revenue-recognition estimates for Mileage Plan liabilities and mileage breakage affect future revenue timing.