ALK

Business Context and Reporting Period

Company: Alaska Air Group, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2004
Outstanding Shares: 29,555,270 common shares as of June 30, 2004.

The Company operates primarily through its subsidiaries, Alaska Airlines, Inc., and Horizon Air Industries, Inc. The reporting period covers the three and six months ended June 30, 2004. The Company revised its 2003 financial statements to reclassify certain fuel hedge gains from operating expenses to nonoperating income, though this had no impact on net income or EPS.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Operating revenues increased 14.4% for the three months and 14.9% for the six months compared to the same periods in 2003, driven by higher passenger traffic and yields.
• Profitability Decline: The Company reported a net loss of $1.7 million for the quarter and $44.4 million for the six months, compared to net income of $45.2 million and a net loss of $11.1 million, respectively, in 2003. The 2003 results included a one-time $71.4 million government compensation payment which was not present in 2004.
• Impairment Charges: A significant non-cash impairment charge of $37.2 million (quarter) and $39.6 million (six months) was recorded, primarily due to the accelerated retirement of the Boeing 737-200C fleet.
• Fuel Costs: Aircraft fuel expenses increased 53.9% for the quarter and 36.1% for the six months year-over-year due to higher market prices, partially offset by hedging gains.
• Accounting Change: The Company lost "hedge accounting" status for fuel derivatives due to reduced correlation between crude oil and jet fuel prices. Consequently, $22.3 million in mark-to-market hedging gains were recorded in nonoperating income for the quarter.

Outlook, Risks, and Management Commentary

• Capacity Outlook: Alaska Airlines expects a 6.5% capacity increase for 2004, while Horizon Air expects a 20% increase, driven by new aircraft and contract flying for Frontier Airlines.
• Fleet Strategy: The Company plans to replace retiring 737-200C aircraft by modifying existing 737-400s and acquiring new 737-800s in 2005 and 2006.
• Liquidity: Cash and marketable securities totaled $865.2 million at June 30, 2004. The Company expects to meet capital commitments through internally generated funds and existing cash reserves.
• Risks: Key risks include volatile fuel prices, the competitive environment, potential labor disputes, and the impact of the loss of hedge accounting on earnings volatility. The Company also faces significant indebtedness and potential credit rating downgrades.
• Non-GAAP Measures: Management highlights adjusted earnings excluding impairment, government compensation, and mark-to-market hedging gains to demonstrate underlying operational performance. On this basis, the Company would have reported net income of $8.2 million for the quarter.

Investor Verification Checklist

• Impairment Validity: Verify the fair market value assumptions used for the $36.8 million write-down of the 737-200C fleet.
• Fuel Hedging Exposure: Assess the impact of the loss of hedge accounting on future earnings volatility and the effectiveness of the remaining hedge portfolio (covering 45% of 2004, 48% of 2005, and 15% of 2006 fuel needs).
• Debt Covenants: Review the covenants in Alaska Airlines' $150 million credit facility expiring in December 2004 and the ability to distribute dividends to the parent company.
• Contract Flying Economics: Evaluate the profitability and long-term sustainability of the Frontier JetExpress contract, which significantly impacts Horizon's yield and cost metrics.
• Capital Expenditures: Confirm funding sources for the $266.9 million in firm aircraft orders and future fleet expansion plans.