ALASKA AIR GROUP, INC. quarterly report, Q3 FY2014

Business context and reporting period

Alaska Air Group, Inc. (Alaska Airlines and Horizon Air) filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2014. All dollar amounts below are in millions unless otherwise noted. Airline results are seasonal and fuel costs are volatile; interim results are not necessarily indicative of full-year performance.

Financial performance and position

Metric	Q3 2014	Q3 2013	Nine months 2014	Nine months 2013
Operating revenue	$1,465	$1,557	$4,062	$3,946
Operating income	$316	$470	$720	$708
Net income	$198	$289	$457	$430
Diluted EPS	$1.45	$2.04	$3.31	$3.02
Operating cash flow	Not separately reported	Not separately reported	$892	$822

Q3 reported revenue fell 6% and net income fell 31%, mainly reflecting the absence of a $192 million noncash Mileage Plan accounting gain recorded in Q3 2013. Excluding that prior-year item, revenue increased approximately $100 million, supported by traffic growth.
On the company’s non-GAAP basis excluding fuel-hedge mark-to-market adjustments and the special Mileage Plan item, Q3 net income was $200 million ($1.47 diluted EPS), versus $157 million ($1.11) a year earlier. Nine-month adjusted net income was $446 million ($3.24 diluted EPS), versus $306 million ($2.15).
For the first nine months, passenger revenue rose 7%; total revenue rose 3%. Operating expenses rose 3%, including a 5% increase in non-fuel expense. Q3 passenger revenue rose 7%, while fuel expense increased 9% and non-fuel expenses rose 4%.
Non-fuel cost per available seat mile (CASM) decreased 3.6% in Q3 to 7.87 cents and decreased 1.0% year to date to 8.28 cents. Q3 traffic grew 7.5% and capacity 8.1%; load factor declined 0.5 percentage point to 86.0%.
Nine-month net cash from operations of $892 million was offset by $618 million used in investing and $320 million used in financing. Capital expenditures were $559 million. Cash and cash equivalents declined to $34 million from $80 million at year-end, while cash plus marketable securities totaled $1,343 million, up from $1,330 million.
At September 30, 2014, long-term debt was $710 million, plus $115 million current debt. Shareholders’ equity was $2,229 million. Long-term debt-to-capital, including the present value of aircraft operating leases, was 31:69, compared with 35:65 at year-end 2013. The company reported $200 million of unused credit facilities and compliance with the $500 million minimum unrestricted cash-and-securities covenant.

Material changes and unusual items

The $192 million Q3 2013 Mileage Plan revenue item was a one-time, noncash adjustment related primarily to the modified co-branded credit-card agreement and revaluation of deferred miles revenue; it materially distorts reported year-over-year comparisons.
Q3 2014 included $4 million of fuel-hedge mark-to-market losses, versus $20 million of gains in Q3 2013. Nine-month periods included net gains of $17 million in 2014 and $7 million in 2013.
Fuel hedging changed: the company discontinued refining-margin swaps in July 2014 and held crude-oil call options covering 236 million gallons through March 2016. It reported lower economic fuel cost per gallon year to date.
Share repurchases totaled $242 million and dividends $51 million in the first nine months. The $250 million repurchase authorization was completed in July; the company then began a $650 million program. Shares outstanding were 132.6 million at October 31.
Aircraft investment and commitments are substantial: nine 737-900ER aircraft were purchased during the period; firm aircraft purchase commitments totaled $2.623 billion. In October, the company exercised options for 10 additional 737-900ER aircraft.

Outlook, commentary, and risks

Management forecast Q4 capacity growth of approximately 10% and full-year 2014 growth of approximately 7%. It targeted CASM excluding fuel and special items down approximately 2.5% in Q4 and 1.0% for the full year.
Management expected competitive capacity in its markets to rise approximately 9% in Q4, pressuring yields and load factors. It cited network changes, operating performance, service, customer loyalty, and cost structure as competitive strengths.
Management expected lower economic fuel cost per gallon in Q4 and for full-year 2014 versus 2013, while warning that actual fuel prices and hedge effects can be volatile. Full-year incentive pay was expected to be approximately $115 million, versus $88 million in 2013.
In October, the company reached a five-year agreement in concept with Alaska flight attendants, subject to the applicable process. It expected at least $400 million of 2014 capital returns through dividends and repurchases.
Key risks include competitive pressure, fuel-price volatility, operating disruptions, labor matters, dependence on concentrated markets, economic conditions, system and regulatory risks, and contagious illness or fear of contagion (a newly added risk factor). Credit-card agreements could require reserves if specified credit-rating or liquidity thresholds are breached. Routine litigation was not expected by management to materially affect results.
Contractual obligations totaled $4.639 billion, including aircraft purchases, debt, operating leases, interest, and other obligations. The company also disclosed a significant deferred tax liability and potential future cash-tax increases as accelerated tax depreciation reverses.

Important facts for investors to verify

Compare reported results with the company’s adjusted non-GAAP figures, particularly the prior-year $192 million noncash Mileage Plan item and fuel-hedge accounting effects.
Track Q4 yields and load factors against the forecast increase in company and competitor capacity, and assess whether cost-reduction targets are achieved.
Monitor fuel prices, hedge coverage and premiums, and the effect of ending refining-margin swaps on fuel costs and cash flows.
Assess liquidity against aircraft purchase commitments, capital spending, shareholder returns, credit-card reserve triggers, and the $500 million facility covenant.
Verify the timing and funding of aircraft deliveries, exercised options, labor-agreement implementation, and expected future tax payments.