Business context and reporting period
United Continental Holdings, Inc. (UAL) and wholly owned United Air Lines, Inc. filed a combined, unaudited Form 10-Q for the quarter and nine months ended September 30, 2010. The statements reflect United’s pre-merger business; Continental was not consolidated because the merger closed on October 1, 2010. United operates mainline and regional airline services.
Financial results and liquidity
Amounts are in millions of dollars except per-share data. UAL and United reported similar results; figures below are UAL unless noted.
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Operating revenue | $5,394 | $4,433 | $14,796 | $12,142 |
| Operating income (loss) | $535 | $88 | $1,038 | ($87) |
| Net income (loss) | $387 | ($57) | $578 | ($411) |
| Basic EPS | $2.30 | ($0.39) | $3.44 | ($2.83) |
| Diluted EPS | $1.75 | ($0.39) | $2.78 | ($2.83) |
| Operating margin | 9.9% | 2.0% | 7.0% | (0.7)% |
- Q3 revenue rose 21.7%; nine-month revenue rose 21.9%. Management attributed improvement chiefly to stronger yields and demand, business and premium-cabin travel, and prior capacity reductions.
- For the first nine months, operating cash flow was $1,801 versus $878 in 2009; investing cash outflow was $152 versus $52; financing provided $247 versus using $340. Cash and cash equivalents increased to $4,938 from $3,042 at year-end; restricted cash was $220, for total cash of $5,158.
- At September 30, current assets were $7,070 and current liabilities $8,256. Long-term debt was $6,025, with $1,449 due within one year; capital lease obligations totaled $1,367, including $461 current. Debt plus capital lease obligations were approximately $8.8 billion, with about $1.9 billion due within 12 months. Approximately $8.5 billion of assets were pledged; unencumbered asset fair value was approximately $400 million.
- Interest expense was $171 in Q3 and $520 for nine months, increasing from $146 and $415, respectively. The company said higher debt, borrowing rates and financing-cost amortization drove the increase.
- Operating costs increased 11.8% in Q3 and 12.5% for nine months. Mainline fuel expense was $1,242 in Q3 and $3,398 for nine months; the nine-month increase was 34.4%. Reported fuel expense and comparisons reflect hedge accounting and hedge settlements.
Material changes versus prior periods
- UAL moved from losses to profits in both the quarter and nine-month period as revenue growth exceeded operating-cost growth. Q3 operating income increased to $535 from $88; nine-month operating income improved to $1,038 from a loss of $87.
- Passenger revenue benefited from a prospective frequent-flyer breakage estimate and accounting-method change: approximately $65 in Q3 and $205 for nine months. The company estimated a further $50 revenue increase in Q4; nine-month profit-sharing expense also rose by about $30 from the change. Reported EPS included estimated benefits of $0.39 basic/$0.28 diluted in Q3 and $1.22 basic/$0.89 diluted for nine months.
- Fuel prices and costs increased, while 2009 comparisons included substantial fuel-hedge gains and losses. Nine-month cash fuel-hedge losses were $89 in 2010 versus $491 in 2009; non-cash hedge results also differed materially.
- Q3 merger-related costs were $44; nine-month merger-related costs were $72. Total impairments, merger-related costs and special items were $63 in Q3 and $187 for nine months, versus $43 and $250 in 2009.
Outlook, risks and unusual items
- Management expected $1.0–$1.2 billion of annual net merger synergies on a run-rate basis by 2013, including $800–$900 million of incremental annual revenue and $200–$300 million of net cost synergies. The airlines were to continue operating separately until integration; realization and timing were uncertain.
- UAL estimated Q4 2010 merger-related costs of at least $380 million; United separately estimated at least $240 million. The UAL estimate includes Continental costs. Management cautioned that near-term merger expenses could exceed expected benefits.
- The company said near-term cash and operating cash flows were expected to cover expenses, leases and debt service, but liquidity remains exposed to fuel prices, demand, operating costs, hedge collateral, refinancing access and covenant compliance. It was compliant with credit-facility covenants at quarter-end; the required fixed-charge coverage ratio was 1.5 to 1.0. Credit ratings were below investment grade.
- Capital commitments totaled $7.7 billion, primarily for aircraft and related investments, with $7.2 billion payable after 2014. Orders included 25 Boeing 787s and 25 Airbus A350s, expected for delivery in 2016–2019. Financing commitments were conditional and not assured on acceptable terms.
- Fuel hedges covered about 78% of expected fuel consumption for Q4 2010 and 37% for the first nine months of 2011; these estimates did not reflect merger-related changes. Management highlighted fuel-price volatility and potential hedge ineffectiveness.
- Key contingencies included ongoing labor negotiations (about 82% of United employees represented), a European Commission air-cargo surcharge investigation for which no reserve was recorded, and a pending appeal of an antitrust challenge to the merger. The company estimated a possible $40 million trans-Atlantic joint-venture revenue-sharing liability if the contemplated formula applied retroactively. A technology-services dispute could involve costs exceeding $100 million.
- UAL disputed the PBGC’s position that the merger triggered a right to redeem $597 million of notes. The company said such redemption could trigger prepayment of approximately $2.2 billion of other debt, though it believed it could arrange replacement financing. A standstill agreement ran through January 31, 2011.
- The merger was believed to have caused a Section 382 ownership change for Continental; whether UAL also experienced one was unresolved. This could limit use of tax-loss carryforwards. Other stated risks included integration execution, labor disruption, environmental regulation, asset impairments, and debt-covenant or refinancing difficulties.
Important facts for investors to verify
- How much reported profit and revenue growth depended on the frequent-flyer accounting estimate change, and whether the expected Q4 benefit was realized.
- Actual merger integration costs and progress toward the stated 2013 synergy targets, including whether costs exceed benefits.
- Post-merger liquidity, debt maturities, covenant headroom, access to financing and the funding of the $7.7 billion capital commitments.
- Fuel prices, hedge coverage and hedge-accounting effects, including the impact of merger-related changes to fuel consumption and hedges.
- Resolution of the PBGC notes dispute, Section 382 tax limitations, labor negotiations, the surcharge investigation, and the technology-services contingency.