ALASKA AIR GROUP, INC. quarterly report, Q3 FY2012

Alaska Air Group, Inc. — Q3 2012 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2012. The filing was signed November 7, 2012. Alaska Airlines and Horizon Air are the company’s principal operating subsidiaries. Financial statements are unaudited.

Financial performance

Metric	Q3 2012	Q3 2011	Nine months 2012	Nine months 2011
Operating revenue	$1,272.2 million	$1,198.1 million	$3,524.7 million	$3,273.5 million
Operating income	$269.5 million	$143.2 million	$457.7 million	$334.8 million
Net income	$163.4 million	$77.5 million	$271.7 million	$180.5 million
Diluted EPS	$2.27	$1.06	$3.77	$2.46
Operating margin	21.2%	12.0%	13.0%	10.2%
Net cash from operating activities	Not separately stated for quarter	Not separately stated for quarter	$637.3 million	$608.8 million

• Q3 operating revenue rose 6.2%; passenger revenue increased 6.9%. Nine-month revenue rose 7.7%.
• Q3 operating expenses fell 4.9% to $1,002.7 million, primarily because reported aircraft fuel expense declined 19.9%. Nine-month expenses rose 4.4% to $3,067.0 million, mainly reflecting higher fuel costs.
• Q3 reported fuel expense included a $21.2 million mark-to-market hedge gain, compared with an $84.3 million loss in Q3 2011. Excluding hedge mark-to-market timing and 2011 fleet-transition costs, adjusted Q3 net income was $150.3 million, or $2.09 per diluted share, versus $131.1 million, or $1.79. Adjusted nine-month net income was $289.4 million, or $4.02 per diluted share, versus $250.2 million, or $3.41. These are non-GAAP measures.
• Q3 consolidated load factor was 86.9%, up 0.4 percentage points; traffic rose 7.2% and capacity 6.8%. Q3 passenger revenue per available seat mile (PRASM) increased 0.1%, while yield decreased 0.3%.

Liquidity, debt and capital

• At September 30, cash and marketable securities totaled $1,185.6 million, up 3.9% from December 31, 2011; cash and cash equivalents alone were $27.5 million. Management said liquidity, operating cash flow and available sources were expected to fund operations for the foreseeable future.
• Total debt was $1,066.1 million, including $167.2 million current; long-term debt net of current portion was $898.9 million, down from $1,099.0 million at year-end 2011. Nine-month debt payments included $137.4 million scheduled payments and $102.5 million of aircraft debt prepayments.
• Operating cash flow of $637.3 million was offset by $513.5 million used in investing and $198.5 million used in financing. Investing included $339.7 million of property and equipment additions. Financing included $51.7 million of share repurchases and $49.3 million sale-leaseback proceeds.
• The company had two undrawn $100 million credit facilities and reported compliance with their $500 million minimum unrestricted cash and marketable securities covenant. It also reported 42 unencumbered aircraft available as a potential financing source.
• Shareholders’ equity was $1,439.2 million, compared with $1,173.2 million at year-end 2011. The company completed a $50 million repurchase program and authorized a new $250 million program, expected to be completed by December 31, 2014.

Material changes and management commentary

• Q3 pretax income increased $140.3 million year over year. Management attributed the improvement chiefly to $74.1 million higher revenue and $83.5 million lower reported fuel expense, partly offset by $31.3 million higher other operating expenses and influenced by fuel-hedge mark-to-market timing.
• Mainline Q3 passenger revenue increased 8.3%, supported by 7.0% capacity growth and 1.2% PRASM growth. Regional passenger revenue increased 1.0%, as 5.3% capacity growth was partly offset by a 4.1% PRASM decline; management cited competition and new markets.
• Non-fuel CASM, excluding fleet-transition costs, fell 1.5% in Q3 to 8.05 cents, and 0.6% for the nine-month period to 8.40 cents. Nine-month economic fuel cost per gallon increased 7.0% to $3.35.
• The company reclassified ancillary items such as bag and change fees from passenger revenue to “Other—net” for all periods to improve peer comparability; total revenue was unchanged.
• Horizon’s transition to an all-Q400 fleet was completed in 2011. No fleet-transition expense was recorded in 2012; 2011 included $38.9 million for the first nine months.
• On October 10, 2012, the company agreed to acquire 50 additional Boeing 737 aircraft. It reported commitments for 75 aircraft, including 38 737-900ERs and 37 737 MAX aircraft, with deliveries through 2022, plus options for 69 additional 737s. The filing estimates approximately $3.0 billion of minimum fixed aircraft payments from 2012 through 2024, including Q400 commitments.

Outlook, risks and contingencies

• Management forecast Q4 2012 consolidated capacity growth of about 7% and CASM excluding fuel and special items of 8.60–8.65 cents, down about 2.5% year over year. Full-year forecasts were capacity growth of about 6% and CASM of 8.45–8.50 cents, down about 1%. No earnings forecast is provided in the filing.
• October load factor was up 2.5 points year over year; advance bookings indicated flat load factors for November and December. Management described demand as stable. It preliminarily expected 2013 capacity growth of 7%–8%.
• Management expected Q4 economic fuel price per gallon to be about 4% higher year over year, citing increased West Coast refining margins. Fuel price volatility and hedge outcomes remain important risks; hedges covered about half of estimated Q4 2012 fuel requirements for crude oil, with refining-margin swaps also in place.
• The Sea-Tac terminal lease expired December 31, 2012, and negotiations with the Port of Seattle had not succeeded. A rate-resolution process would not interrupt tenancy, but the outcome and any challenge were uncertain. The company believed the process should reduce its rates.
• Other identified risks include competition, economic conditions, operational disruptions, labor negotiations, significant indebtedness, revenue concentration in key markets, and reliance on automated systems. Negotiations with Alaska’s and Horizon’s flight-attendant unions were ongoing; Alaska pilot discussions were at an early stage. A tentative Horizon pilot contract extension was subject to a vote and could result in an approximately $1.0 million signing-bonus charge.
• The filing disclosed credit-card agreement provisions that could require reserves if specified credit-rating or liquidity triggers are met; no reserve was required at filing. Deferred tax liabilities from differences in tax and book depreciation could lead to future cash tax payments, with timing not estimable. Management expected 2012 cash taxes of $70–$90 million.
• Routine litigation was not expected by management to materially affect results. Disclosure controls were assessed as effective, and no material change in internal control was reported.

Important facts for investors to verify

• How much of the earnings improvement reflects underlying operations versus the unusually favorable Q3 fuel-hedge mark-to-market comparison; review both GAAP and adjusted results.
• Whether the Q4 and full-year unit-cost targets were achieved, and how actual fuel prices, refining margins and hedge settlements affected results.
• Progress on the Sea-Tac lease rate process and its eventual effect on airport costs.
• Funding plans and returns for the expanded aircraft order, including the potential use of cash, debt or leases and the exercise of aircraft options.
• Labor-contract outcomes, pension costs and contributions, and whether any credit-card reserve triggers or other liquidity covenants become relevant.