ALASKA AIR GROUP, INC. quarterly report, Q3 FY2017

Alaska Air Group, Inc. — Q3 2017 Form 10-Q

Reporting period: Three and nine months ended September 30, 2017. Unless otherwise noted, amounts are in U.S. dollars. Virgin America was acquired on December 14, 2016, so reported 2017 results include it while reported 2016 comparisons do not; management also provides combined-comparative data for selected operating measures.

Financial results and liquidity

Metric	Q3 2017	Q3 2016	Nine months 2017	Nine months 2016
Operating revenue	$2.120bn	$1.566bn	$5.971bn	$4.407bn
Operating income	$439m	$400m	$1.098bn	$1.108bn
Net income	$266m	$256m	$661m	$700m
Diluted EPS	$2.14	$2.07	$5.31	$5.63

Reported GAAP operating margin was approximately 20.7% in Q3 (25.5% in Q3 2016) and 18.4% for the first nine months (25.1% in 2016); net margin was approximately 12.5% and 11.1%, respectively (16.3% and 15.9% in the comparative periods). These unadjusted comparisons are affected by Virgin America’s inclusion only in 2017.

Comparable performance: On a combined-comparative basis, Q3 revenue rose 5.4% to $2.120bn, while operating expenses rose 10.4% to $1.681bn. Nine-month comparable revenue increased 5.9% and expenses 12.3%. Adjusted net income was $278m in Q3 versus $272m, and $721m for nine months versus $717m.
Operating metrics: Q3 combined capacity (ASMs) increased 7.2% year over year; load factor was 85.4%, PRASM declined 1.2% on a combined-comparative basis, and CASM excluding fuel and special items increased 1.0% on that basis. Reported consolidated CASM excluding fuel and special items was 7.98 cents, down 2.7% from the uncombined prior-year figure.
Cash flow: Nine-month operating cash flow was $1.357bn; investing cash outflow was $1.142bn and financing cash outflow was $399m. Capital expenditures were $841m, implying approximate operating cash flow less capital expenditures of $516m. Cash and cash equivalents fell $184m to $144m; cash plus marketable securities increased from $1.580bn at year-end 2016 to $1.740bn.
Debt and liquidity: Total debt was $2.701bn, including $334m current; long-term debt net of current portion was $2.367bn, down from $2.645bn at December 31, 2016. Shareholders’ equity was $3.491bn. The company reported $475m of total credit facilities and compliance with their $500m minimum unrestricted cash and marketable securities covenant. Management’s liquidity discussion cites $400m of unused lines of credit.
Shareholder returns: Dividends declared were $0.30 per share in Q3 and $0.90 per share for nine months. Nine-month repurchases were $50m; the company also repurchased 369,182 shares for $25m after quarter end.

Material changes and management commentary

Q3 GAAP pretax income increased $25m to $427m. Management attributed the increase to $554m higher revenue, partly offset by $372m higher non-fuel expense and $143m higher fuel expense. On a combined-comparative basis, Q3 adjusted mainline pretax profit fell $48m; higher fuel and non-fuel costs outweighed revenue growth.
Fuel expense rose 20% on a combined-comparative basis in Q3; economic fuel cost per gallon increased to $1.80 from $1.58. Nine-month combined-comparative fuel expense rose 28%, reflecting higher fuel prices and consumption. Fuel prices and refining margins remain a significant earnings risk.
Horizon pilot shortages led to approximately 1,300 cancellations, reduced scheduled service into Q4 and early 2018, and estimated lost Air Group revenue of $25m–$30m in Q3. Management said schedule changes and hiring efforts should bring these operational headwinds behind the company by year-end. Q3 on-time performance was 85.0% for Alaska, 73.3% for Virgin America and 78.6% for Horizon; air-traffic-control issues and runway construction also affected performance.
The October 30 pilot arbitration award, effective November 1, set higher wage rates and retirement contributions for Alaska and Virgin America pilots. Management estimates incremental costs versus the prior status quo of approximately $24m for the remainder of 2017, $150m in 2018 and $180m in 2019.
Virgin America integration remains a major priority. Management targeted a single operating certificate in early 2018 and a single reservations system in Q2 2018, expected to bring approximately $20m of revenue synergies forward into 2018. Merger-related costs were $24m in Q3 and $88m for nine months; further costs were expected through 2019.

Outlook, commitments and risks

Management forecast Q4 2017 capacity of 15,950–16,000 million ASMs, CASM excluding fuel and special items of 8.50–8.55 cents, and economic fuel cost of $1.95 per gallon. Full-year 2017 capacity growth was forecast at approximately 7.2%, with CASM excluding fuel and special items of 8.19–8.21 cents.
Management expected approximately 8% capacity growth in 2018 and higher unit costs, citing pilot wage increases, a new engine-services agreement, a growing regional mix and integration costs. The filing also reports a subsequent nine-year parts-management and maintenance agreement with approximately $459m of minimum obligations, not included in the disclosed contractual-obligations table.
Capital expenditure expectations were $1.050bn in 2017, $1.195bn in 2018 and $1.010bn in 2019, excluding capitalized interest. Disclosed contractual obligations totaled $11.577bn, including debt, leases, aircraft purchases and other commitments; these are scheduled obligations, not current-period expenses.
Other risks include competition and pricing pressure, concentrated West Coast markets, volatile fuel costs, labor and staffing constraints, operational disruption, and the ability to integrate Virgin America and realize anticipated synergies. A certified class action by Virgin America flight attendants alleges wage-and-hour violations; the company disputes the claims and intends to defend the case. Management did not expect routine litigation to materially affect results.
Topic 606 revenue accounting was expected to increase Mileage Plan deferred revenue by approximately $340m–$380m at adoption and increase the opening-retained-earnings impact by an estimated $160m–$190m, with full retrospective application. Management expected lower annual revenue recognition under the new Mileage Plan accounting and a change in classification of certain ancillary revenues.

Important facts for investors to verify

Track comparable revenue, unit revenue and non-fuel unit costs separately from reported growth, which is materially affected by the Virgin America acquisition.
Monitor pilot-award implementation and the estimated labor-cost increases, alongside integration spending and delivery of the reservations-system and other synergy milestones.
Assess the persistence of fuel-price and refining-margin increases, Horizon staffing and flight reliability, and the effect of disruptions on revenue and costs.
Review funding capacity against aircraft commitments, lease obligations and the additional maintenance-agreement minimums; confirm covenant headroom and liquidity as cash balances fluctuate.
Confirm the final purchase-accounting values for Virgin America and the eventual adoption effects of Topic 606; the acquisition accounting remained preliminary at September 30, 2017.