ALK

Business Context and Reporting Period

Company: Alaska Air Group, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2003
Business Overview: The registrant operates through two principal subsidiaries: Alaska Airlines, Inc. and Horizon Air Industries, Inc. The airline industry continues to face adverse impacts from weak economic conditions, U.S. involvement in the Middle East, and the lingering effects of the 2001 terrorist attacks. Management is engaged in extensive cost reduction and revenue enhancement initiatives.

Key Financial Metrics

Revenue and Profit (Three Months Ended June 30, 2003):

• Total Operating Revenues: $609.1 million (up from $575.7 million in 2002).
• Operating Income: $4.0 million (compared to a loss of $5.0 million in 2002).
• Net Income: $45.2 million (compared to a net loss of $2.9 million in 2002).
• Earnings Per Share (Diluted): $1.70 (compared to a loss of $0.11 in 2002).

• Total Operating Revenues: $1,127.8 million (up from $1,075.8 million in 2002).
• Operating Loss: $74.6 million (compared to a loss of $54.6 million in 2002).
• Net Loss: $11.1 million (compared to a net loss of $88.0 million in 2002).
• Loss Per Share (Diluted): $0.42 (compared to a loss of $3.32 in 2002).

• Cash Provided by Operating Activities: $187.0 million.
• Cash Used in Investing Activities: $510.7 million (primarily capital expenditures and marketable securities).
• Cash Provided by Financing Activities: $169.3 million.
• Cash and Cash Equivalents (June 30, 2003): $114.6 million.
• Marketable Securities (June 30, 2003): $606.9 million.
• Total Liquidity (Cash + Marketable Securities): $721.5 million.

• Long-Term Debt and Capital Lease Obligations: $1,016.2 million (up from $856.7 million at year-end 2002).
• Debt-to-Capital Ratio: 61% debt to 39% equity.
• Shareholders' Equity: $643.3 million.

Material Changes vs. Prior Period

Government Compensation: The most significant factor driving the improvement in net income for the quarter and the reduction in net loss for the six-month period was the receipt of $71.4 million in one-time cash grants from the U.S. government under the Emergency Wartime Supplemental Appropriations Act. Without this assistance, the company would have reported a net income of only $0.9 million for the quarter and a net loss of $55.4 million for the six months.

Operating Performance:

• Capacity and Traffic: Available Seat Miles (ASMs) increased 5.7% and Revenue Passenger Miles (RPMs) increased 9.1% for the quarter, driven by new routes (Boston, Denver, Newark, Miami) and increased service in Mexico and the Pacific Northwest.
• Yield: Yield per passenger mile decreased 2.6% due to fewer business fares and weak demand.
• Costs: Operating expenses increased 4.9% for the quarter. Fuel costs rose 7.6% due to higher prices per gallon, though hedging gains mitigated some impact. Wages and benefits increased 10.0% due to higher pension and health insurance costs.

Debt Issuance: In March 2003, the company completed a private placement of $150.0 million in floating-rate senior convertible notes due in 2023. In the second quarter, an additional $65.0 million of debt secured by flight equipment was issued.

Guidance, Outlook, and Risks

Management Commentary and Goals:

• Management is seeking to lower operating cost per available seat mile (excluding fuel) to 7.25 cents by 2005. This is stated as a goal, not a prediction.
• Alaska Airlines met with labor unions in June 2003 to discuss cooperative cost reduction strategies.
• Fuel Hedging: The company has hedges in place for 35% of expected fuel consumption for the remainder of 2003 (crude oil swaps below $22/barrel), 12% for 2004, and 5% for 2005.

Risks and Contingencies:

• Legal Proceedings: The U.S. Attorney's Office closed its criminal investigation into the Flight 261 accident in July 2003. However, one remaining lawsuit regarding Flight 261 is scheduled for a damages-only trial. Management believes the ultimate disposition is not likely to materially affect financial position.
• Market Risks: The company is exposed to jet fuel price volatility and interest rate fluctuations on its variable-rate debt.
• Forward-Looking Statements: Actual results may differ significantly from anticipated results due to economic conditions, fuel prices, and other unpredictable factors.

Investor Verification Checklist

• Government Grant Sustainability: Verify the one-time nature of the $71.4 million government compensation and its impact on the reported profitability.
• Operating Margins Excluding One-Time Items: Review the reconciliation of non-GAAP measures to understand the underlying operating loss of $55.4 million for the six-month period excluding government aid and goodwill write-offs.
• Debt Servicing Capacity: Assess the impact of the new $150 million convertible notes and $65 million secured debt on future interest expenses and liquidity.
• Fuel Hedging Effectiveness: Monitor the effectiveness of fuel hedges given the volatility in crude oil prices and the specific coverage percentages for 2003-2005.
• Flight 261 Litigation: Track the status of the remaining damages-only trial to ensure no unexpected material liabilities arise.
• Cost Reduction Progress: Evaluate progress toward the stated goal of reducing operating costs per ASM (excluding fuel) to 7.25 cents by 2005.