UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

 

For the quarterly period ended September 30, 2017  

OR

For the transition period from            to           

Commission File Number: 001-16545

 

Atlas Air Worldwide Holdings, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

(914) 701-8000

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

As of November 1, 2017, there were 25,283,100 shares of the registrant’s Common Stock outstanding.

 

 

 

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TABLE OF CONTENTS

 

 

 

 

 

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Atlas Air Worldwide Holdings, Inc.

Consolidated Balance Sheets

(in thousands, except share data)

(Unaudited)

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements

 

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Atlas Air Worldwide Holdings, Inc.

Consolidated Statements of Operations

(in thousands, except per share data)

(Unaudited)

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements

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Atlas Air Worldwide Holdings, Inc.

Consolidated Statements of Comprehensive Income (Loss)

(in thousands)

(Unaudited)

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements

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Atlas Air Worldwide Holdings, Inc.

Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements

 

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Atlas Air Worldwide Holdings, Inc.

Consolidated Statements of Stockholders’ Equity

(in thousands, except share data)

(Unaudited)

 

 

 

See accompanying Notes to Unaudited Consolidated Financial Statements

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Atlas Air Worldwide Holdings, Inc.

Notes to Unaudited Consolidated Financial Statements

September 30, 2017

1. Basis of Presentation

Our consolidated financial statements include the accounts of the holding company, Atlas Air Worldwide Holdings, Inc. (“AAWW”), and its consolidated subsidiaries.  AAWW is the parent company of Atlas Air, Inc. (“Atlas”) and Southern Air Holdings, Inc. (“Southern Air”).  AAWW is also the parent company of several subsidiaries related to our dry leasing services (collectively referred to as “Titan”).  AAWW has a 51% equity interest and 75% voting interest in Polar Air Cargo Worldwide, Inc. (“Polar”).  We record our share of Polar’s results under the equity method of accounting.

The terms “we,” “us,” “our,” and the “Company” mean AAWW and all entities included in its consolidated financial statements.

We provide outsourced aircraft and aviation operating services throughout the world, serving Africa, Asia, Australia, Europe, the Middle East, North America and South America through: (i) contractual service arrangements, including those through which we provide aircraft to customers and value-added services, including crew, maintenance and insurance (“ACMI”), as well as those through which we provide crew, maintenance and insurance, but not the aircraft (“CMI”); (ii) cargo and passenger charter services (“Charter”); and (iii) dry leasing aircraft and engines (“Dry Leasing” or “Dry Lease”).

The accompanying unaudited consolidated financial statements and related notes (the “Financial Statements”) have been prepared in accordance with the U.S. Securities and Exchange Commission (the “SEC”) requirements for quarterly reports on Form 10-Q, and consequently exclude certain disclosures normally included in audited consolidated financial statements prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”).  Intercompany accounts and transactions have been eliminated.  The Financial Statements should be read in conjunction with the audited consolidated financial statements and the notes included in the AAWW Annual Report on Form 10-K for the year ended December 31, 2016, which includes additional disclosures and a summary of our significant accounting policies.  The December 31, 2016 balance sheet data was derived from that Annual Report.  In our opinion, the Financial Statements contain all adjustments, consisting of normal recurring items, necessary to fairly state the financial position of AAWW and its consolidated subsidiaries as of September 30, 2017, the results of operations for the three and nine months ended September 30, 2017 and 2016, comprehensive income for the three and nine months ended September 30, 2017 and 2016, cash flows for the nine months ended September 30, 2017 and 2016, and shareholders’ equity as of and for the nine months ended September 30, 2017 and 2016.

Our quarterly results are subject to seasonal and other fluctuations, and the operating results for any quarter are therefore not necessarily indicative of results that may be otherwise expected for the entire year.

Except for per share data, all dollar amounts are in thousands unless otherwise noted.

2. Summary of Significant Accounting Policies

Heavy Maintenance

Except for engines used on our 747-8F aircraft, we account for heavy maintenance costs for airframes and engines used in our ACMI and Charter segments using the direct expense method. Under this method, heavy maintenance costs are charged to expense upon induction, based on our best estimate of the costs.

We account for heavy maintenance costs for airframes and engines used in our Dry Leasing segment and engines used on our 747-8F aircraft using the deferral method.  Under this method, we defer the expense recognition of scheduled heavy maintenance events, which are amortized over the estimated period until the next scheduled heavy maintenance event is required.  Amortization of deferred maintenance expense included in Depreciation and amortization was $1.8 million and zero for the three months ended September 30, 2017 and September 30, 2016, respectively, and was $3.7 million and zero for the nine months ended September 30, 2017 and September 30, 2016, respectively.  Deferred maintenance included within Deferred costs and other assets is as follows:

 

 

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Supplemental Cash Flow Information

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the consolidated balance sheets that sum to the total shown in the consolidated statements of cash flows:

 

 

Recent Accounting Pronouncements

In March 2016, the Financial Accounting Standards Board (“FASB”) amended its accounting guidance for share-based compensation.  The amended guidance changes how companies account for certain aspects of share-based payment awards to employees, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows.  We adopted this amended guidance on January 1, 2017 on a prospective basis.  As a result, we recognized $1.8 million of excess tax benefits during the nine months ended September 30, 2017 as a reduction of income tax expense in our consolidated statements of operations.  Excess tax benefits were previously recognized within equity.  Additionally, our consolidated statements of cash flows present such excess tax benefits, which were previously presented as a financing activity, as an operating activity.

In February 2016, the FASB amended its accounting guidance for leases.  The guidance requires a lessee to recognize assets and liabilities on the balance sheet arising from leases with terms greater than twelve months.  While lessor accounting guidance is relatively unchanged, certain amendments were made to conform with changes made to lessee accounting and amended revenue recognition guidance.  The new guidance will continue to classify leases as either finance or operating, with classification affecting the presentation and pattern of expense and income recognition, in the statement of operations.  It also requires additional quantitative and qualitative disclosures about leasing arrangements.  The amended guidance is effective as of the beginning of 2019, with early adoption permitted.  While we are still assessing the impact the amended guidance will have on our financial statements, we expect that recognizing the right-of-use asset and related lease liability will impact our balance sheet materially. We have developed and are implementing a plan for adopting this amended guidance.

In May 2014, the FASB amended its accounting guidance for revenue recognition.  Subsequently, the FASB has issued several clarifications and updates.  The fundamental principles of the new guidance are that companies should recognize revenue in a manner that reflects the timing of the transfer of services to customers and consideration that a company expects to receive for the services provided.  It also requires additional disclosures necessary for the financial statement users to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers.  The two permitted transition methods under the guidance are the full retrospective approach, under which the guidance is applied to all periods presented, or the modified retrospective approach, under which the guidance is applied only to the most current period presented.  While we believe the amended guidance will not have a material effect on our financial statements, we expect that revenue currently recognized based on flight departure will be recognized over time as the services are performed. In addition, we expect that revenue under certain ACMI and CMI contracts, such as revenue related to contracted minimum block hour guarantees, will be recognized in later periods and that some revenue adjustments related to meeting or exceeding on-time performance targets will be recognized in earlier periods. The implementation of our plan to adopt this amended guidance is progressing as expected and we plan to adopt the new guidance on its required effective date of January 1, 2018 using the modified retrospective approach.

3. Related Parties

DHL Investment and Polar

AAWW has a 51% equity interest and 75% voting interest in Polar.  DHL Network Operations (USA), Inc. (“DHL”), a subsidiary of Deutsche Post AG (“DP”), holds a 49% equity interest and a 25% voting interest in Polar.  Polar is a variable interest entity that we do not consolidate because we are not the primary beneficiary as the risks associated with the direct costs of operation are with DHL.  Under a 20-year blocked space agreement (the “BSA”), Polar provides air cargo capacity to DHL.  Atlas has several agreements with Polar to provide ACMI, CMI, Dry Leasing, administrative, sales and ground support services to one another.  We do not have any financial exposure to fund debt obligations or operating losses of Polar, except for any liquidated damages that we could incur under these agreements.

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The following table summarizes our transactions with Polar:

 

GATS

We hold a 50% interest in GATS GP (BVI) Ltd. (“GATS”), a joint venture with an unrelated third party.  As of September 30, 2017 and December 31, 2016, our investment in GATS was $22.1 million and $22.2 million, respectively.  We had Accounts payable to GATS of $0.3 million as of September 30, 2017 and $2.4 million as of December 31, 2016.

4. Southern Air Acquisition

On April 7, 2016, we completed the acquisition of Southern Air and its subsidiaries, including Southern Air Inc. and Florida West International Airways, Inc. (“Florida West”).  The acquisition of Southern Air provided us with immediate entry into 777 and 737 aircraft operating platforms, with the potential for developing additional business with existing and new customers. We believe this augments our ability to offer the broadest array of aircraft and services for domestic, regional and international operations.  For the three and nine months ended September 30, 2017, we incurred Transaction-related expenses of $1.1 million and $3.4 million, respectively.  For the three and nine months ended September 30, 2016, we incurred Transaction-related expenses of $3.1 million and $17.2 million, respectively.  Transaction-related expenses are primarily related to: compensation costs, including employee termination benefits; professional fees; and integration costs associated with the acquisition.

The unaudited estimated pro forma operating revenue for AAWW, including Southern Air, for the three and nine months ended September 30, 2016 was $448.0 million and $1,337.0 million, respectively, including adjustments to conform with our accounting policies.  The earnings of Southern Air were not material for the three and nine months ended September 30, 2016 and, accordingly, pro forma and actual earnings information have not been presented.  

As part of integrating Southern Air, management decided and committed to pursue a plan to sell Florida West.  As a result, the financial results for Florida West were presented as a discontinued operation and the assets and liabilities of Florida West were classified as held for sale from the date of acquisition through December 31, 2016.  In February 2017, management determined that a sale was no longer likely to occur and committed to a plan to wind-down the Florida West operations.  The wind-down of operations was completed during the first quarter of 2017.

A summary of the employee termination benefit liabilities, which are expected to be paid by the first quarter of 2018, is as follows:

 

 

5. Special Charge

During the first quarter of 2016, we classified four CF6-80 engines as held for sale, recognized an impairment loss of $6.5 million and ceased depreciation on the engines.  All four of those engines were traded in during 2016.  During the fourth quarter of 2016, we classified two CF6-80 engines as held for sale, recognized an impairment loss of $3.5 million and ceased depreciation on the

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engines.  One of those engines was traded in during the first quarter of 2017.  The carrying value of the remaining CF6-80 engine held for sale at September 30, 2017 was $1.4 million, and of the two CF6-80 engines held for sale at December 31, 2016 was $2.8 million, which was included within Prepaid expenses and other current assets in the consolidated balance sheets.  The remaining CF6-80 engine classified as held for sale is expected to be sold during the fourth quarter of 2017.

6. Amazon

In May 2016, we entered into certain agreements with Amazon.com, Inc. and its subsidiary, Amazon Fulfillment Services, Inc., (collectively “Amazon”), which involves, among other things, CMI operation of 20 Boeing 767-300 freighter aircraft for Amazon by Atlas, as well as Dry Leasing by Titan.  The Dry Leases will have a term of ten years from the commencement of each lease, while the CMI operations will be for seven years from the commencement of each agreement (with an option for Amazon to extend the term to a total of ten years).  We placed the first seven aircraft in service between August 2016 and August 2017.  In October 2017, we began flying three additional aircraft and we expect to be operating all 20 by the end of 2018.

In conjunction with these agreements, we granted Amazon a warrant providing the right to acquire up to 20% of our outstanding common shares, after giving effect to the issuance of shares pursuant to the warrants, at an exercise price of $37.50 per share.  A portion of the warrant, representing the right to purchase 3.75 million shares, vested immediately upon issuance of the warrant and the remainder of the warrant, representing the right to purchase 3.75 million shares, will vest in increments of 375,000 as the lease and operation of each of the 11^th through 20^th aircraft commences.  The warrant will be exercisable in accordance with its terms through 2021.  As of September 30, 2017, no warrants have been exercised.

The agreements also provide incentives for future growth of the relationship as Amazon may increase its business with us.  In that regard, we granted Amazon a warrant to acquire up to an additional 10% of our outstanding common shares, after giving effect to the issuance of shares pursuant to the warrants, for an exercise price of $37.50 per share.  This warrant to purchase 3.75 million shares will vest in conjunction with payments by Amazon for additional business with us.  The warrant will be exercisable in accordance with its terms through 2023.

At a special meeting on September 20, 2016, the Company’s shareholders, by a vote of approximately 99.9% of the votes cast, approved the issuance of warrants to acquire up to 30% of our outstanding common shares.  This approval constituted a change in control, as defined under certain of the Company’s benefit plans.  As a result, we recognized $26.2 million in expense, including accelerated compensation expense for restricted and performance share and cash awards, during the three and nine month periods ended September 30, 2016.  The share-based portion of the compensation expense was $11.6 million.

The $92.9 million fair value of the vested portion of the warrant issued to Amazon as of May 4, 2016 was recorded as a warrant liability within Financial instruments and other liabilities (the “Amazon Warrant”).  This initial fair value of the warrant was also recognized as a customer incentive asset within Deferred costs and other assets, net and is being amortized as a reduction of revenue in proportion to the amount of revenue recognized over the terms of the Dry Leases and CMI agreements.  We amortized $1.5 million and $2.9 million of the customer incentive asset for the three and nine months ended September 30, 2017, respectively.  We amortized $0.2 million of the customer incentive asset for the three and nine month periods ended September 30, 2016.  The balance of the customer incentive asset, net of amortization, was $89.5 million as of September 30, 2017 and $92.4 million as of December 31, 2016.

The Amazon Warrant liability is marked-to-market at the end of each reporting period with changes in fair value recorded in Unrealized loss (gain) on financial instruments.  We utilize a Monte Carlo simulation approach to estimate the fair value of the Amazon Warrant which requires inputs such as our common stock price, the warrant strike price, estimated common stock price volatility and risk-free interest rate, among others.  We recognized a net unrealized loss of $44.8 million and $36.2 million on the Amazon Warrant during the three and nine months ended September 30, 2017, respectively.  We recognized a net unrealized loss of $1.5 million and a net unrealized gain of $25.0 million on the Amazon Warrant during the three and nine months ended September 30, 2016, respectively.  The fair value of the Amazon Warrant liability was $132.0 million as of September 30, 2017 and $95.8 million as of December 31, 2016.

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7. Accrued Liabilities

Accrued liabilities consisted of the following as of:

 

 

8. Debt

Term Loans and Capital Lease

We have entered into various term loans during 2017 to finance the purchase and passenger-to-freighter conversion of 767-300 aircraft, and for GEnx engine performance upgrade kits and overhauls.  Each term loan requires payment of principal and interest quarterly in arrears.  Funds available under each term loan are subject to usual and customary fees, and funds drawn typically bear interest at a fixed rate based on LIBOR, plus a margin.  Each facility is guaranteed by us and subject to customary covenants and events of default.

 

The following table summarizes the terms and principal balances for each term loan entered into during 2017 (in millions):

 

 

In March 2017, we amended and extended a lease for a 747-400 freighter aircraft to June 2032 at a lower monthly lease payment.  As a result of the extension, we determined that the lease qualifies as a capital lease.  The present value of the future minimum lease payments was $32.4 million.

Private Placement Facility

 

In September 2017, we entered into a debt facility for up to $146.5 million through a private placement to finance the purchase and passenger-to-freighter conversion of up to six 767-300 freighter aircraft dry leased to Amazon (the “Private Placement Facility”).  The Private Placement Facility consists of six separate loans (the “Private Placement Loans”).  Each Private Placement Loan is comprised of an equipment note and an equipment term loan, both secured by the cash flows from a 767-300 freighter aircraft dry lease and the underlying aircraft.  The equipment notes require payment of principal and interest at a fixed interest rate.  The equipment term loans accrue interest, at a fixed rate, which is added to the principal balance outstanding until each equipment note is paid in full.  Subsequently, the equipment term loans require payment of principal and interest over the remaining term of the loans.  The Private Placement Loans are cross-collateralized, but not cross-defaulted, with each other and, except for certain specified events, are not cross-defaulted with other debt facilities of the Company.

 

In connection with entry into the Private Placement Facility, we have agreed to pay usual and customary commitment and other fees associated with this type of financing.  The Private Placement Facility is guaranteed by us and subject to customary covenants and events of default.  

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In October 2017, we completed the following financings for the first three aircraft under the Private Placement Facility:

Convertible Notes

 

In May 2017, we issued $289.0 million aggregate principal amount of convertible senior notes (the “2017 Convertible Notes”) in an underwritten public offering.  The Convertible Notes are senior unsecured obligations and accrue interest payable semiannually on June 1 and December 1 of each year at a fixed rate of 1.875%.  The 2017 Convertible Notes will mature on June 1, 2024, unless earlier converted or repurchased pursuant to their terms.

We used the majority of the net proceeds in May 2017 to repay $150.0 million then outstanding under our revolving credit facility and to fund the cost of the convertible note hedges described below.

Each $1,000 of principal of the 2017 Convertible Notes will initially be convertible into 16.3713 shares of our common stock, which is equal to an initial conversion price of $61.08 per share. The conversion rate will be subject to adjustment upon the occurrence of certain specified events but will not be adjusted for accrued and unpaid interest, except in certain limited circumstances. Upon the occurrence of a “make-whole fundamental change,” we will, in certain circumstances, increase the conversion rate by a number of additional shares of our common stock for the 2017 Convertible Notes converted in connection with such “make-whole fundamental change”. Additionally, if we undergo a “fundamental change,” a holder will have the option to require us to repurchase all or a portion of its 2017 Convertible Notes for cash at a price equal to 100% of the principal amount of the 2017 Convertible Notes being repurchased plus any accrued and unpaid interest through, but excluding, the fundamental change repurchase date.

In connection with the offering of the 2017 Convertible Notes, we entered into convertible note hedge transactions whereby we have the option to purchase initially (subject to adjustment for certain specified events) a total of 4,731,306 shares of our common stock at a price of $61.08 per share.  The total cost of the convertible note hedge transactions was $70.1 million. In addition, we sold warrants to the option counterparties whereby the holders of the warrants have the option to purchase initially (subject to adjustment for certain specified events) a total of 4,731,306 shares of our common stock at a price of $92.20.  We received $38.1 million in cash proceeds from the sale of these warrants.

Taken together, the purchase of the convertible note hedges and the sale of warrants are intended to offset any economic dilution from the conversion of the 2017 Convertible Notes when the stock price is below $92.20 per share and to effectively increase the overall conversion price from $61.08 to $92.20 per share.  However, for purposes of the computation of diluted earnings per share in accordance with GAAP, dilution typically occurs when the average share price of our common stock for a given period exceeds the conversion price of the 2017 Convertible Notes.  The $32.0 million net cost incurred in connection with the convertible note hedges and warrants was recorded as a reduction to additional paid-in capital, net of tax, in the consolidated balance sheet.

On or after September 1, 2023 until the close of business on the second scheduled trading day immediately preceding the maturity date, a holder may convert all or a portion of its 2017 Convertible Notes.

Upon conversion, the 2017 Convertible Notes will be settled, at our election, in cash, shares of our common stock, or a combination of cash and shares of our common stock.  Our current intent and policy is to settle conversions with a combination of cash and shares of common stock with the principal amount of the 2017 Convertible Notes paid in cash.

Holders may only convert their 2017 Convertible Notes at their option at any time prior to September 1, 2023, under the following circumstances:

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We separately account for the liability and equity components of convertible notes.  The carrying amount of the liability component was determined by measuring the fair value of a similar liability that does not have an associated conversion feature, assuming our nonconvertible unsecured debt borrowing rate.  The carrying value of the equity component, the conversion option, which is recognized as additional paid-in-capital, net of tax, creates a debt discount on the convertible notes.  The debt discount was determined by deducting the relative fair value of the liability component from the proceeds of the convertible notes and is amortized to interest expense using an effective interest rate of 6.14% over the term of the 2017 Convertible Notes.  The equity component will not be remeasured as long as it continues to meet the conditions for equity classification.

The debt issuance costs related to the issuance of the 2017 Convertible Notes were allocated to the liability and equity components based on their relative values, as determined above.  Total debt issuance costs were $7.5 million, of which $5.7 million was allocated to the liability component and $1.8 million was allocated to the equity component. The debt issuance costs allocated to the liability component are amortized to interest expense using the effective interest method over the term of the 2017 Convertible Notes.

In June 2015, we issued $224.5 million aggregate principal amount of convertible senior notes (the “2015 Convertible Notes”) in an underwritten public offering.  The 2015 Convertible Notes are senior unsecured obligations and accrue interest payable semiannually on June 1 and December 1 of each year at a fixed rate of 2.25%.  The 2015 Convertible Notes will mature on June 1, 2022, unless earlier converted or repurchased pursuant to their terms.

As of September 30, 2017, the 2017 Convertible Notes and the 2015 Convertible Notes consisted of the following:

 

 

The following table presents the amount of interest expense recognized related to the 2017 Convertible Notes and the 2015 Convertible Notes:

 

 

Revolving Credit Facility

In December 2016, we entered into a three-year $150.0 million secured revolving credit facility (the “Revolver”) for general corporate purposes, including financing the acquisition and conversion of 767 aircraft prior to obtaining permanent financing for the

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converted aircraft.  There were no amounts outstanding and we had $142.3 million of unused availability under the Revolver, based on the collateral borrowing base, as of September 30, 2017.

9. Commitments

Equipment Purchase Commitments

As of September 30, 2017, our estimated payments remaining for flight equipment purchase commitments are $143.8 million, of which $63.5 million are expected to be made during the remainder of 2017.

10. Income Taxes

Our effective income tax expense rates were 72.7% and 230.8% for the three months ended September 30, 2017 and 2016, respectively.  Our effective income tax expense rates were 59.1% and 60.3% for the nine months ended September 30, 2017 and 2016, respectively.  The effective income tax expense rates for the three and nine months ended September 30, 2017 differed from the U.S. statutory rate primarily due to nondeductible changes in the value of the Amazon Warrant liability (see Note 6 to our Financial Statements).  In addition, the effective income tax expense rate for the nine months ended September 30, 2017 differed from the U.S. statutory rate due to the impact of the 2017 adoption of the amended accounting guidance for share-based compensation which requires that excess tax benefits associated with share-based compensation be recognized within income tax expense in our consolidated statement of operations.  The effective income tax expense rates for the three and nine months ended September 30, 2016 differed from the U.S. federal statutory rate primarily due to nondeductible expenses resulting from a change in control, as defined under certain of the Company’s benefit plans, related to the Amazon transaction (see Note 6 to our Financial Statements). The effective rates for all periods were impacted by our assertion to indefinitely reinvest the net earnings of foreign subsidiaries outside the U.S.  For interim accounting purposes, we recognize income taxes using an estimated annual effective tax rate.

11. Financial Instruments

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). Inputs used to measure fair value are classified in the following hierarchy:

We endeavor to utilize the best available information to measure fair value.

The carrying value of Cash and cash equivalents, Short-term investments and Restricted cash is based on cost, which approximates fair value.

Long-term investments consist of debt securities, maturing within five years, for which we have both the ability and the intent to hold until maturity.  These investments are classified as held-to-maturity and reported at amortized cost.  The fair value of our Long-term investments is based on a discounted cash flow analysis using the contractual cash flows of the investments and a discount rate derived from unadjusted quoted interest rates for debt securities of comparable risk.  Such debt securities represent investments in Pass-Through Trust Certificates (“PTCs”) related to enhanced equipment trust certificates (“EETCs”) issued by Atlas in 1998, 1999 and 2000.

Term loans and notes consist of term loans, notes guaranteed by the Export-Import Bank of the United States (“Ex-Im Bank”), the Revolver and EETCs. The fair values of these debt instruments are based on a discounted cash flow analysis using current borrowing rates for instruments with similar terms.

The fair value of our convertible notes is based on unadjusted quoted market prices for these securities.

The fair value of the Amazon Warrant is based on a Monte Carlo simulation which requires inputs such as our common stock price, the warrant strike price, estimated common stock price volatility, and risk-free interest rate, among others.

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The following table summarizes the carrying value, estimated fair value and classification of our financial instruments as of:

 

 

 

Gross unrealized gains on our long-term investments and accrued interest were $3.2 million at September 30, 2017 and $5.2 million at December 31, 2016.

12. Segment Reporting

Our business is organized into three operating segments based on our service offerings: ACMI, Charter and Dry Leasing.  All segments are directly or indirectly engaged in the business of air transportation services but have different commercial and economic characteristics.  Each operating segment is separately reviewed by our chief operating decision maker to assess operating results and make resource allocation decisions.  We do not aggregate our operating segments and, therefore, our operating segments are our reportable segments.

We use an economic performance metric (“Direct Contribution”) that shows the profitability of each segment after allocation of direct operating and ownership costs.  Direct Contribution represents Income (loss) from continuing operations before income taxes excluding the following: Special charges, Transaction-related expenses, nonrecurring items, Losses (gains) on the disposal of aircraft, Losses on early extinguishment of debt, Unrealized losses (gains) on financial instruments, Gains on investments and Unallocated income and expenses, net.  Direct operating and ownership costs include crew costs, maintenance, fuel, ground operations, sales costs, aircraft rent, interest expense on the portion of debt used for financing aircraft, interest income on debt securities and aircraft depreciation.  Unallocated income and expenses, net include corporate overhead, nonaircraft depreciation, noncash expenses and income, interest expense on the portion of debt used for general corporate purposes, interest income on nondebt securities, capitalized interest, foreign exchange gains and losses, other revenue and other non-operating costs.

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The following table sets forth Operating Revenue and Direct Contribution for our reportable segments reconciled to Operating Income and Income from continuing operations before income taxes:

 

 

 

Given the nature of our business and international flying, geographic information for revenue, long-lived assets and total assets is not presented because it is impracticable to do so.

We are exposed to a concentration of revenue from the U.S. Military Air Mobility Command (the “AMC”), Polar and DHL (see Note 3 for further discussion regarding Polar).  No other customer accounted for more than 10.0% of our Total Operating Revenue.  Revenue from the AMC was $124.9 million for the three months ended September 30, 2017 and $116.2 million for the three months ended September 30, 2016.  Revenue from the AMC was $397.5 million for the nine months ended September 30, 2017 and $346.8 million for the nine months ended September 30, 2016.  Revenue from DHL was $62.1 million for the three months ended September 30, 2017 and $57.4 million for the three months ended September 30, 2016.  Revenue from DHL was $177.6 million for the nine months ended September 30, 2017 and $128.0 million for the nine months ended September 30, 2016.  We have not experienced any credit issues with either of these customers.

13. Labor and Legal Proceedings

Labor

Pilots of Atlas and Southern Air, and flight dispatchers of Atlas and Polar are represented by the International Brotherhood of Teamsters (the “IBT”).  We have a five-year collective bargaining agreement (“CBA”) with our Atlas pilots, which became amendable in September 2016 and a four-year CBA with the Southern Air pilots, which became amendable in November 2016. We also have a five-year CBA with our Atlas and Polar dispatchers, which was extended in April 2017 for an additional four years, making the CBA amendable in November 2021.

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After we completed the acquisition of Southern Air in April 2016, we informed the IBT of our intention to pursue (and we have been pursuing) a complete operational merger of Atlas and Southern Air.  Pursuant to the merger provisions in both the Atlas and Southern Air CBAs, joint negotiations for a single CBA for Atlas and Southern Air should commence promptly.  Further to this process, once a seniority list is presented to us by the unions, it triggers an agreed-upon time frame to negotiate a new joint CBA with any unresolved issues submitted to binding arbitration.  After the merger process began, the IBT filed an application for mediation with the National Mediation Board (“NMB”) on behalf of the Atlas pilots, and subsequently the IBT filed a similar application on behalf of Southern Air pilots.  We have opposed both mediation applications as they are not in accordance with the merger provisions in the parties’ existing CBAs.  The Atlas and Southern Air CBAs have a defined and streamlined process for negotiating a joint CBA when a merger occurs, as in the case with the Atlas and Southern Air merger.  The NMB conducted a pre-mediation investigation on the IBT’s Atlas application in June 2016, which is currently pending (along with the IBT’s Southern Air application).  Due to a lack of meaningful progress in such merger discussions, in February 2017, we filed a lawsuit against the IBT to compel arbitration on the issue of whether the merger provisions in Atlas and Southern Air's CBAs apply to the bargaining process. While this lawsuit is pending in the Southern District Court of New York, the Company and the IBT have reached an interim agreement on a process to proceed with negotiations for a new joint CBA.  These negotiations commenced on July 6, 2017 and the parties have continued to meet regularly since then and bargain for a new joint CBA.

In September 2017, the Company requested the U.S. District Court for the District of Columbia (the “Court”) to issue a preliminary injunction to require the IBT to meet its obligations under the Railway Labor Act and stop the illegal intentional work slowdowns and service interruptions.  In its filing, the Company states that the IBT is engaging in unlawful, concerted work slowdowns to gain leverage in pilot contract negotiations with the Company.  The Company seeks to have the Court compel the IBT to stop the illegal work actions and return to normal operations. The hearing was completed in early November and a ruling on the preliminary injunction is expected during the fourth quarter of 2017.

We are subject to risks of work interruption or stoppage as permitted by the Railway Labor Act and may incur additional administrative expenses associated with union representation of our employees.

Matters Related to Alleged Pricing Practices

The Company and Polar Air Cargo, LLC (“Old Polar”), a consolidated subsidiary, were named defendants, along with a number of other cargo carriers, in several class actions in the U.S. arising from allegations about the pricing practices of Old Polar and a number of air cargo carriers.  These actions were all centralized in the U.S. District Court for the Eastern District of New York.  Polar was later joined as an additional defendant.  The consolidated complaint alleged, among other things, that the defendants, including the Company and Old Polar, manipulated the market price for air cargo services sold domestically and abroad through the use of surcharges, in violation of U.S., state, and European Union antitrust laws.  The suit sought treble damages and attorneys’ fees.

On January 7, 2016, the Company, Old Polar, and Polar entered into a settlement agreement to settle all claims by participating class members against the Company, Old Polar and Polar. The Company, Polar, and Old Polar deny any wrongdoing, and there is no admission of any wrongdoing in the settlement agreement.  Pursuant to the settlement agreement, the Company, Old Polar and Polar have agreed to make installment payments over three years to settle the plaintiffs’ claims, with payments of $35.0 million paid in January 2016 and 2017, and $30.0 million due on or before January 15, 2018.  The U.S. District Court for the Eastern District of New York issued an order granting preliminary approval of the settlement on January 12, 2016.  On October 6, 2016, the final judgment was issued and the settlement was approved.

In the United Kingdom, several groups of named claimants have brought suit against British Airways in connection with the same alleged pricing practices at issue in the proceedings described above and are seeking damages allegedly arising from that conduct.  British Airways has filed claims in the lawsuit against Old Polar and a number of air cargo carriers for contribution should British Airways be found liable to claimants.  Old Polar’s formal statement of defense was filed on March 2, 2015.  On October 14, 2015, the U.K. Court of Appeal released decisions favorable to the defendant and contributory defendants on two matters under appeal.  Permission was sought to appeal the U.K. Court of Appeal's decisions to the U.K. Supreme Court.  Permission was denied.  In December 2015, certain claimants settled with British Airways removing a significant portion of the claim against British Airways and therefore reducing the potential contribution required by the other airlines, including Old Polar.  On December 16, 2015, the European General Court released decisions annulling decisions that the European Commission made against the majority of the air cargo carriers.  The European Commission did not appeal the General Court decision but has, in early 2017, reissued a revised decision to which Old Polar is, again, not an addressee.  On April 13, 2017, Old Polar and claimants represented by Hausfeld & Co. LLP (the “Hausfeld Claimants”) entered into a bilateral settlement agreement in relation to the English proceedings (the “Settlement Agreement”).  The Settlement Agreement contains a mechanism by which the Hausfeld Claimants will release Old Polar and remove from the English proceedings all claims for damages alleged by the Hausfeld Claimants to be attributable to air cargo purchases from Old Polar (and each of Old Polar’s parents, subsidiaries, affiliates, predecessors, successors, agents and assignees).  The amount of the settlement, which is tax deductible and was previously accrued for, was paid during the second quarter of 2017 and did not have a material adverse impact on the Company’s financial condition,

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results of operations or cash flows.  Old Polar remains a contributory defendant in the proceedings and, as such, is subject to certain continuing evidentiary obligations.

In the Netherlands, Stichting Cartel Compensation, successor in interest to claims of various shippers, has filed suit in the district court in Amsterdam against British Airways, KLM, Martinair, Air France, Lufthansa and Singapore Airlines seeking recovery for damages purportedly arising from the same pricing practices at issue in the proceedings described above.  In response, British Airways, KLM, Martinair, Air France and Lufthansa filed third-party indemnification lawsuits against Old Polar and Polar seeking indemnification in the event the defendants are found to be liable in the main proceedings.  Old Polar and Polar entered their initial court appearances on September 30, 2015.  Various procedural issues are undergoing court review.  Like the U.K. proceedings, the Netherlands proceedings are likely to be affected by the European Commission’s revised decision.  We are unable to reasonably predict the outcome of the litigation. If the Company, Old Polar or Polar were to incur an unfavorable outcome in connection with this proceeding, such outcome may have a material adverse impact on our business, financial condition, results of operations or cash flows.  We are unable to reasonably estimate a range of possible loss for this matter at this time.

Brazilian Customs Claim

Old Polar was cited for two alleged customs violations in Sao Paulo, Brazil, relating to shipments of goods dating back to 1999 and 2000.  Each claim asserts that goods listed on the flight manifest of two separate Old Polar scheduled service flights were not on board the aircraft upon arrival and therefore were improperly brought into Brazil.  The two claims, which also seek unpaid customs duties, taxes and penalties from the date of the alleged infraction, are approximately $9.6 million in aggregate based on September 30, 2017 exchange rates.

In both cases, we believe that the amounts claimed are substantially overstated due to a calculation error when considering the type and amount of goods allegedly missing, among other things.  Furthermore, we may seek appropriate indemnity from the shipper in each claim as may be feasible.  In the pending claim for one of the cases, we have received an administrative decision dismissing the claim in its entirety, which remains subject to a mandatory appeal by the Brazil customs authorities.  As required to defend such claims, we have made deposits pending resolution of these matters.  The balance was $5.3 million as of September 30, 2017 and December 31, 2016, and is included in Deferred costs and other assets.

We are currently defending these and other Brazilian customs claims and the ultimate disposition of these claims, either individually or in the aggregate, is not expected to materially affect our financial condition, results of operations or cash flows.

Accruals

As of September 30, 2017, the Company had an accrual of $30.0 million related to the U.S. class action settlement that was recognized in 2015.

Other

We have certain other contingencies incident to the ordinary course of business.  Management believes that the ultimate disposition of such other contingencies is not expected to materially affect our financial condition, results of operations or cash flows.

14. Earnings Per Share

Basic earnings per share (“EPS”) represents income (loss) divided by the weighted average number of common shares outstanding during the measurement period.  Diluted EPS represents income (loss) divided by the weighted average number of common shares outstanding during the measurement period while also giving effect to all potentially dilutive common shares that were outstanding during the period using the treasury stock method.  Anti-dilutive shares related to warrants and stock options that were out of the money and excluded were 3.0 million for the three and nine months ended September 30, 2017 and 2016.  Anti-dilutive shares related to restricted share units and warrants that were excluded from the calculation of diluted EPS due to losses incurred were 2.2 million for the three months ended September 30, 2017 and were 0.4 million for the three months ended September 30, 2016.

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The calculations of basic and diluted EPS were as follows:

 

 

The calculation of EPS does not include restricted share units and warrants in which performance or market conditions were not satisfied of 7.6 million for the three and nine months ended September 30, 2017 and 7.5 million for three and nine months ended September 30, 2016.

15. Accumulated Other Comprehensive Income (Loss)

The following table summarizes the components of Accumulated other comprehensive income (loss):

 

 

Interest Rate Derivatives

As of September 30, 2017, there was $6.9 million of unamortized net realized loss before taxes remaining in Accumulated other comprehensive income (loss) related to terminated forward-starting interest rate swaps, which had been designated as cash flow hedges to effectively fix the interest rates on two 747-8F financings in 2011 and three 777-200LRF financings in 2014.  The net loss is amortized and reclassified into Interest expense over the remaining life of the related debt.  Net realized losses reclassified into earnings were $0.4 million for the three months ended September 30, 2017 and 2016, respectively.  Net realized losses reclassified

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into earnings were $1.2 million and $1.3 million for the nine months ended September 30, 2017 and 2016, respectively.  Net realized losses expected to be reclassified into earnings within the next 12 months are $1.5 million as of September 30, 2017.

 

 

 

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with our Financial Statements appearing in this report and our audited consolidated financial statements and related notes included in our 2016 Annual Report on Form 10-K.

Background

Certain Terms - Glossary

The following represents terms and statistics specific to our business and industry. They are used by management to evaluate and measure operations, results, productivity and efficiency.

 

 

Business Overview

We are a leading global provider of outsourced aircraft and aviation operating services.  We operate the world’s largest fleet of 747 freighters and provide customers a broad array of 747, 777, 767, 757 and 737 aircraft for domestic, regional and international cargo and passenger applications.  We provide unique value to our customers by giving them access to highly reliable new production freighters that deliver the lowest unit cost in the marketplace combined with outsourced aircraft operating services that we believe lead the industry in terms of quality and global scale.  Our customers include express delivery providers, e-commerce retailers, airlines, freight forwarders, the U.S. military and charter brokers.  We provide global services with operations in Africa, Asia, Australia, Europe, the Middle East, North America and South America.

Our primary service offerings include the following:

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We look to achieve our growth plans and enhance shareholder value by:

See “Business Overview” and “Business Strategy” in our 2016 Annual Report on Form 10-K for additional information.

Business Developments

Our ACMI results for the first three quarters of 2017, compared with 2016, were impacted by the following events:

During the third quarter of 2017, both ACMI and Charter segment results were negatively impacted by Hurricanes Irma and Harvey and work slowdowns and service interruptions for which the Company is seeking a preliminary injunction (See Note 13 to our Financial Statements).

Charter results for the first three quarters of 2017 also reflected increased commercial cargo demand, increased cargo and passenger demand from the AMC, higher commercial cargo Yields and the temporary redeployment of 747-8F aircraft from the ACMI segment, partially offset by lower cargo and passenger rates from the AMC.

During the third quarter of 2017, we entered into two operating leases for 747-400 freighter aircraft to meet increased customer demand in our ACMI and Charter businesses.  One aircraft entered service in late September and the other is expected to enter service during the fourth quarter of 2017.

In February 2016, we began Dry Leasing one 767-300 converted freighter aircraft to DHL on a long-term basis.  As described above, between August 2016 and August 2017, we began Dry Leasing seven 767-300 converted freighter aircraft to Amazon on a long-term basis.

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Results of Operations

The following discussion should be read in conjunction with our Financial Statements and other financial information appearing and referred to elsewhere in this report.

Three Months Ended September 30, 2017 and 2016

Operating Statistics

The following tables compare our Segment Operating Fleet (average aircraft equivalents during the period) and total Block Hours operated for the three months ended September 30:

 

 

 

 

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Operating Revenue

The following table compares our Operating Revenue for the three months ended September 30 (in thousands):

 

NM represents year-over-year changes that are not meaningful.

ACMI

 

 

ACMI revenue increased $51.8 million, or 25.1%, primarily due to increased flying.  The increase in Block Hours was primarily driven by the startup of 767 flying for Amazon, 747-8F flying for Cathay Pacific Cargo and 747-400 flying for Nippon Cargo Airlines, Asiana Cargo and Suparna Airlines, as well as higher aircraft utilization.  Revenue per Block Hour decreased slightly primarily due to the impact of increased 767 and 747-400 CMI flying.  In addition, ACMI revenue in the third quarter of 2017 was negatively impacted by the aforementioned labor-related operational disruptions.

Charter

 

 

Charter revenue increased $31.5 million, or 14.9%, primarily due to an increase in Revenue per Block Hour.  The increase in Revenue per Block Hour primarily reflects the impact of Charter capacity purchased from our ACMI customers that had no associated Charter Block Hours, higher fuel prices and higher commercial cargo Yields.  In addition, Charter revenue in the third quarter of 2017 was negatively impacted by Hurricanes Irma and Harvey.  

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Operating Expenses

The following table compares our Operating Expenses for the three months ended September 30 (in thousands):

 

 

Salaries, wages and benefits decreased $11.5 million, or 9.1%, primarily driven by a 2016 change in control, as defined under certain benefit plans, related to the Amazon transaction (see Note 6 to our Financial Statements), partially offset by increased flying. In addition, crewmember costs were negatively impacted by the aforementioned labor-related operational disruptions.

Aircraft fuel increased $8.6 million, or 13.2%, primarily due to an increase in the average fuel cost per gallon.  We do not incur fuel expense in our ACMI or Dry Leasing businesses as the cost of fuel is borne by the customer.  Average fuel cost per gallon and fuel consumption for the three months ended September 30 were:

 

 

Maintenance, materials and repairs increased by $24.7 million, or 49.6%, primarily reflecting $13.3 million of increased Line Maintenance expense due to increased flying and additional repairs performed, and $10.1 million of Heavy Maintenance expense.  The higher Line Maintenance primarily reflected increases of $5.8 million for 767 aircraft, $4.9 million for 747-400 aircraft and $2.7 million for 747-8F aircraft.  Heavy Maintenance expense on 747-400 aircraft increased $4.0 million primarily due to an increase in the number of engine overhauls and additional repairs performed.  Heavy Maintenance expense on 747-8F aircraft increased $3.1 million primarily due to an increase in the number of C Checks.  Heavy Maintenance expense on 767 aircraft increased $2.9 million primarily due to an increase in the number of C Checks. Heavy airframe maintenance checks and engine overhauls impacting Maintenance, materials and repairs for the three months ended September 30 were:

 

 

Depreciation and amortization increased $4.5 million, or 12.1%, primarily due to additional aircraft operating in 2017 and an increase in the amortization of deferred maintenance costs related to 747-8F engine overhauls (see Note 2 to our Financial Statements).

Travel increased $6.3 million, or 19.7%, primarily due to increased flying.

Aircraft rent decreased $1.9 million, or 5.2%, primarily due to the amendment and extension of a lease for a 747-400 freighter aircraft to a lower monthly lease rate (see Note 8 to our Financial Statements) and a reduction in the number of spare engines leased.

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Navigation fees, landing fees and other rent increased $17.8 million, or 114.0%, primarily due to an increase in purchased capacity.

Passenger and ground handling services increased $6.8 million, or 31.5%, primarily due to increased Charter flying.

Transaction-related expenses in 2017 related to the Southern Air acquisition, which primarily included professional fees and integration costs. Transaction-related expenses in 2016 related to the Southern Air acquisition and our transaction with Amazon and primarily included: compensation costs, including employee termination benefits; professional fees; and integration costs (see Notes 4 and 6 to our Financial Statements).

Other increased $8.1 million, or 23.6%, primarily due to increased commission expense on higher revenue from the AMC, the impact of growth initiatives, and higher legal and professional fees related to our request for a preliminary injunction to stop the aforementioned labor-related operational disruptions.

Non-operating Expenses (Income)

The following table compares our Non-operating Expenses (Income) for the three months ended September 30 (in thousands):

 

Interest expense increased $5.2 million, or 24.3%, primarily due to the issuance of the 2017 Convertible Notes and the financing of 767-300 aircraft purchases and conversions.

Capitalized interest increased $0.9 million, or 81.5%, primarily due to an increase in the number of 767-300 aircraft undergoing passenger-to-freighter conversion.

Unrealized loss (gain) on financial instruments represents the change in fair value of the Amazon Warrant (see Note 6 to our Financial Statements) primarily due to changes in our common stock price.

Income taxes.  Our effective income tax expense rates were 72.7% and 230.8% for the three months ended September 30, 2017 and 2016, respectively.  The effective income tax expense rate for the three months ended September 30, 2017 differed from the U.S. statutory rate primarily due to nondeductible changes in the value of the Amazon Warrant liability (see Note 6 to our Financial Statements).  The effective income tax expense rate for the three months ended September 30, 2016 differed from the U.S. federal statutory rate primarily due to nondeductible expenses resulting from a change in control, as defined under certain of the Company’s benefit plans, related to the Amazon transaction.  The effective rates for both periods were impacted by our assertion to indefinitely reinvest the net earnings of foreign subsidiaries outside the U.S.

Segments

The following table compares the Direct Contribution for our reportable segments for the three months ended September 30 (see Note 12 to our Financial Statements for the reconciliation to Operating income) (in thousands):

 

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ACMI Segment

ACMI Direct Contribution was relatively unchanged, as the impact of increased flying was largely offset by higher Heavy and Line Maintenance costs and amortization of deferred maintenance costs.  In addition, ACMI Direct Contribution was negatively impacted by the aforementioned labor-related operational disruptions.

Charter Segment

Charter Direct Contribution increased $1.9 million, or 5.6%, primarily due to higher commercial cargo Yields, partially offset by higher Heavy Maintenance costs and the redeployment of 747-8F aircraft to the ACMI segment.  In addition, Charter Direct Contribution was negatively impacted by Hurricanes Irma and Harvey and the aforementioned labor-related operational disruptions.

Dry Leasing Segment

Dry Leasing Direct Contribution increased $2.8 million, or 38.2%, primarily related to lower interest expense due to the scheduled repayment of debt for Dry Leased 777-200LRF aircraft and the placement of 767-300 converted freighter aircraft.

Unallocated income and expenses, net

Unallocated income and expenses, net decreased $16.4 million, or 20.3%, primarily due to a 2016 change in control, as defined under certain benefit plans, related to the Amazon transaction (see Note 6 to our Financial Statements).  Partially offsetting this item were higher costs in 2017 due to unallocated interest expense, growth initiatives, amortization of the Amazon customer incentive asset, and legal and professional fees related to our request for a preliminary injunction to stop the aforementioned labor-related operational disruptions.

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Nine Months Ended September 30, 2017 and 2016

Operating Statistics

The following tables compare our Segment Operating Fleet (average aircraft equivalents during the period) and total Block Hours operated for the nine months ended September 30:

 

Operating Revenue

The following table compares our Operating Revenue for the nine months ended September 30 (in thousands):

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ACMI

 

ACMI revenue increased $87.2 million, or 14.5%, primarily due to increased flying.  The increase in Block Hours reflects the impact from the Southern Air acquisition, the startup of 767 flying for Amazon, 747-400 flying for Nippon Cargo Airlines, Asiana Cargo and Suparna Airlines, and 747-8F flying for Cathy Pacific Cargo, as well as higher aircraft utilization.  Partially offsetting these items was the temporary redeployment of 747-8F aircraft to the Charter segment during the first quarter of 2017.  Revenue per Block Hour decreased primarily due to the impact of 777-200 and 737-400 CMI flying from the Southern Air acquisition, increased 767 and 747-400 CMI flying and the temporary redeployment of 747-8F aircraft to Charter during the first quarter of 2017.

Charter

 

Charter revenue increased $126.5 million, or 20.5%, primarily due to increased flying.  The increase in Charter Block Hours was primarily driven by increased commercial cargo demand, increased cargo and passenger demand from the AMC and the temporary redeployment of 747-8F aircraft from the ACMI segment during the first quarter of 2017.  Revenue per Block Hour increased primarily due to higher Yields for commercial cargo, higher fuel prices and the impact of Charter capacity purchased from our ACMI customers that had no associated Charter Block Hours, partially offset by lower cargo and passenger rates from the AMC.  

Operating Expenses

The following table compares our Operating Expenses for the nine months ended September 30 (in thousands):

 

 

Salaries, wages and benefits increased $8.7 million, or 2.7%, primarily driven by the impact of the Southern Air acquisition, growth initiatives and increased flying.  Partially offsetting these items were a 2016 change in control, as defined under certain benefit plans, related to the Amazon transaction (see Note 6 to our Financial Statements) and lower costs related to crew training.  In addition, crewmember costs were negatively impacted by the aforementioned labor-related operational disruptions.

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Aircraft fuel increased $50.0 million, or 26.3%, primarily due to increased fuel consumption reflecting the increase in Charter Block Hours operated and an increase in the average fuel cost per gallon.  We do not incur fuel expense in our ACMI or Dry Leasing businesses as the cost of fuel is borne by the customer.  Average fuel cost per gallon and fuel consumption for the nine months ended September 30 were:

 

Maintenance, materials and repairs increased by $49.8 million, or 30.7%, primarily reflecting $31.0 million of higher Line Maintenance expense due to increased flying and additional repairs performed, the Southern Air acquisition, and $21.1 million of Heavy Maintenance expense, partially offset by a $3.0 million decrease in Non-heavy Maintenance expense on 747-400 aircraft.  The higher Line Maintenance primarily reflected increases of $11.9 million for 767 aircraft, $9.9 million for 747-400 aircraft and $6.1 million for 747-8F aircraft.  Heavy Maintenance expense on 747-400 aircraft increased $19.1 million primarily due to an increase in the number of D Checks, engine overhauls and additional repairs performed, partially offset by a decrease in the number of C Checks. Heavy Maintenance expense on 767 aircraft increased $4.2 million primarily due to an increase in the number of C Checks.  Heavy Maintenance expense on 747-8F aircraft decreased $3.4 million primarily due to a decrease in unscheduled engine repairs, partially offset by an increase in the number of C Checks.  Non-heavy Maintenance on 747-400 aircraft decreased $3.0 million as a result of fewer events.  Heavy airframe maintenance checks and engine overhauls impacting Maintenance, materials and repairs for the nine months ended September 30 were:

 

 

Depreciation and amortization increased $11.2 million, or 10.2%, primarily due to additional aircraft operating in 2017 and an increase in the amortization of deferred maintenance costs related to 747-8F engine overhauls (see Note 2 to our Financial Statements).

Travel increased $11.2 million, or 11.9%, primarily due to the impact of the Southern Air acquisition and increased flying, partially offset by lower rates for crewmember travel.

Aircraft rent decreased $5.8 million, or 5.3%, primarily due to the amendment and extension of a lease for a 747-400 freighter aircraft to a lower monthly lease rate (see Note 8 to our Financial Statements) and a reduction in the number of spare engines leased.

Navigation fees, landing fees and other rent increased $20.9 million, or 37.0%, primarily due to an increase in purchased capacity and increased flying.

Passenger and ground handling services increased $12.6 million, or 19.5%, primarily due to increased Charter flying.

Special charge in 2016 primarily represented a $6.5 million loss on engines held for sale (see Note 5 to our Financial Statements).  We may sell additional flight equipment, which could result in additional charges in future periods.  

Transaction-related expenses in 2017 related to the Southern Air acquisition, which primarily included professional fees and integration costs.  Transaction-related expenses in 2016 related to the Southern Air acquisition and our transaction with Amazon and primarily included: compensation costs, including employee termination benefits; professional fees; and integration costs (see Notes 4 and 6 to our Financial Statements).

Other increased $16.2 million, or 15.2%, primarily due to increased commission expense on higher revenue from the AMC, the impact of the Southern Air acquisition and other growth initiatives, and higher legal and professional fees related to our request for a preliminary injunction to stop the aforementioned labor-related operational disruptions.  Partially offsetting these items was an accrual for legal matters in 2016 (see Note 13 to our Financial Statements).

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Non-operating Expenses (Income)

The following table compares our Non-operating Expenses (Income) for the nine months ended September 30 (in thousands):

 

Interest expense increased $9.2 million, or 14.4%, primarily due to the issuance of the 2017 Convertible Notes and the financing of 767-300 aircraft purchases and conversions.

 

Capitalized interest increased $3.5 million, primarily due to an increase in the number of 767-300 aircraft undergoing passenger-to-freighter conversion.

Unrealized loss (gain) on financial instruments represents the change in fair value of the Amazon Warrant (see Note 6 to our Financial Statements) primarily due to changes in our common stock price.

Income taxes.  Our effective income tax expense rates were 59.1% and 60.3% for the nine months ended September 30, 2017 and 2016, respectively.  The effective income tax expense rate for the nine months ended September 30, 2017 differed from the U.S. statutory rate primarily due to nondeductible changes in the value of the Amazon Warrant liability (see Note 6 to our Financial Statements) and by the impact of the 2017 adoption of the amended accounting guidance for share-based compensation which requires that excess tax benefits associated with share-based compensation be recognized within income tax expense in our consolidated statement of operations.  The effective income tax expense rate for the nine months ended September 30, 2016 differed from the U.S. federal statutory rate primarily due to nondeductible expenses resulting from a change in control, as defined under certain of the Company’s benefit plans, related to the Amazon transaction.  The effective rates for both periods were impacted by our assertion to indefinitely reinvest the net earnings of foreign subsidiaries outside the U.S.

Segments

The following table compares the Direct Contribution for our reportable segments for the nine months ended September 30 (see Note 12 to our Financial Statements for the reconciliation to Operating income) (in thousands):

 

ACMI Segment

ACMI Direct Contribution increased $19.3 million, or 15.8%, primarily due to the Southern Air acquisition, increased flying and lower costs related to crew training.  Partially offsetting these items were higher Heavy and Line Maintenance costs, the amortization of deferred maintenance costs and the temporary redeployment of 747-8F aircraft to the Charter segment during the first quarter of 2017.

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Charter Segment

Charter Direct Contribution increased $10.3 million, or 13.1%, primarily due to increased commercial cargo demand, increased cargo and passenger demand from the AMC, lower costs related to crew training and higher commercial cargo Yields.  Partially offsetting these items were higher Heavy Maintenance costs and lower cargo and passenger rates from the AMC.  

Dry Leasing Segment

Dry Leasing Direct Contribution increased $4.9 million, or 20.0%, primarily due to lower interest expense due to the scheduled repayment of debt related to Dry Leased 777-200LRF aircraft and the placement of 767-300 converted freighter aircraft.  Partially offsetting these items were maintenance payments received related to the scheduled return of an aircraft during the first three quarters of 2016.  There were no aircraft returned during the first three quarters of 2017.

Unallocated income and expenses, net

Unallocated income and expenses, net decreased $3.5 million, or 1.9%, primarily due to a 2016 change in control, as defined under certain benefit plans, related to the Amazon transaction (see Note 6 to our Financial Statements) and a 2016 accrual for legal matters.  Partially offsetting these items were higher costs in 2017 due to the Southern Air acquisition, unallocated interest expense, growth initiatives, amortization of the Amazon customer incentive asset, and legal and professional fees related to our request for a preliminary injunction to stop the aforementioned labor-related operational disruptions.

Reconciliation of GAAP to non-GAAP Financial Measures

To supplement our Financial Statements presented in accordance with GAAP, we present certain non-GAAP financial measures to assist in the evaluation of our business performance.  These non-GAAP financial measures include Adjusted Income from continuing operations, net of taxes and Adjusted Diluted EPS from continuing operations, net of taxes, which exclude certain noncash income and expenses, and items impacting year-over-year comparisons of our results.  These non-GAAP financial measures may not be comparable to similarly titled measures used by other companies and should not be considered in isolation or as a substitute for Income from continuing operations, net of taxes and Diluted EPS from continuing operations, which are the most directly comparable measures of performance prepared in accordance with GAAP.

We use these non-GAAP financial measures in assessing the performance of our ongoing operations and in planning and forecasting future periods.  In addition, management’s incentive compensation will be determined, in part, by using Adjusted Income from continuing operations, net of taxes. We believe that these adjusted measures, when considered together with the corresponding GAAP financial measures and the reconciliations to those measures, provide meaningful supplemental information to assist investors and analysts in understanding our business results and assessing our prospects for future performance.

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The following is a reconciliation of Income from continuing operations, net of taxes and Diluted EPS from continuing operations, net of taxes to the corresponding non-GAAP financial measures (in thousands, except per share data):

 

 

 

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Liquidity and Capital Resources

The most significant liquidity events during the first three quarters of 2017 were as follows:

Debt Transactions

In May 2017, we issued $289.0 million of 2017 Convertible Notes with a cash coupon of 1.875%.  In May 2017, we used the majority of the proceeds to repay $150.0 million then outstanding under the Revolver.

In June 2017, we borrowed $18.7 million related to GEnx engine performance upgrade kits and overhauls under an unsecured term loan at a fixed interest rate of 2.17%.

During the second and third quarter of 2017, we borrowed an aggregate of $140.1 million through seven separate term loans related to the purchase and passenger-to-freighter conversion of 767-300 aircraft at fixed rates ranging from 3.02% to 3.62%.

In September 2017, we entered into the Private Placement Facility to finance up to $146.5 million for the purchase and passenger-to-freighter conversion of up to six 767-300 aircraft dry leased to Amazon.  In October 2017, we borrowed $72.6 million for the first three aircraft under the facility.

Operating Activities. Net cash provided by operating activities was $195.1 million for the first three quarters of 2017, which primarily reflected $14.0 million of Net Income, noncash adjustments of $142.0 million for Depreciation and amortization and $36.2 million for Unrealized loss on financial instruments, and a $30.4 million increase in Accounts payable and accrued liabilities.  Partially offsetting these items was a $53.3 million increase in Prepaid expenses, current assets and other assets.  Net cash provided by operating activities was $100.8 million for the first three quarters of 2016, which primarily reflected $13.1 million of Net Income, noncash adjustments of $124.2 million for Depreciation and amortization and $27.9 million for Stock-based compensation expense, and a $32.8 million decrease in Accounts receivable.  Partially offsetting these items were a $79.7 million decrease in Accounts payable and accrued liabilities and a noncash adjustment of $25.0 million for Unrealized gain on financial instruments.

Investing Activities. Net cash used for investing activities was $401.7 million for the first three quarters of 2017, consisting primarily of $338.5 million of payments for flight equipment and modifications, and $66.4 million of core capital expenditures, excluding flight equipment.  Payments for flight equipment and modifications during the first three quarters of 2017 were primarily related to the purchase of 767-300 passenger aircraft and related freighter conversion costs, spare engines and GEnx engine performance upgrade kits.  All capital expenditures for 2017 were funded through working capital and the term loans discussed above.  Net cash used for investing activities was $372.6 million for the first three quarters of 2016, consisting primarily of $237.1 million of purchase deposits and payments for flight equipment, $107.5 million related to the Southern Air acquisition, and $36.9 million of core capital expenditures, excluding flight equipment.  Partially offsetting these investing activities were $8.8 million of proceeds from investments.

Financing Activities. Net cash provided by financing activities was $244.6 million for the first three quarters of 2017, which primarily reflected proceeds from debt issuance of $447.9 million, $38.1 million from the sale of convertible note warrants and $22.0 million of customer maintenance reserves and deposits received, partially offset by $153.3 million of payments on debt obligations and $70.1 million for the purchase of convertible note hedges.  Net cash used for financing activities was $51.6 million for the first three quarters of 2016, which primarily reflected $135.8 million of payments on debt, partially offset by $84.8 million of proceeds from debt issuance.

We consider Cash and cash equivalents, Short-term investments, Restricted cash and Net cash provided by operating activities to be sufficient to meet our debt and lease obligations, to fund core capital expenditures for 2017, and to pay amounts due related to the settlement of the U.S. class action litigation.  Core capital expenditures for the remainder of 2017 are expected to range between $10.0 to $15.0 million, which excludes flight equipment and capitalized interest.  Our payments remaining for flight equipment purchase and passenger-to-freighter conversion commitments are expected to be approximately $143.8 million, of which approximately $63.5 million is expected to be made during 2017.  We expect to finance the acquisition and conversion of this flight equipment with working capital prior to obtaining permanent financing for the converted aircraft.

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We may access external sources of capital from time to time depending on our cash requirements, assessments of current and anticipated market conditions, and the after-tax cost of capital.  To that end, we filed a shelf registration statement with the SEC in May 2017 that enables us to sell a yet to be determined amount of debt and/or equity securities over the subsequent three years, depending on market conditions, our capital needs and other factors.  Our access to capital markets can be adversely impacted by prevailing economic conditions and by financial, business and other factors, some of which are beyond our control.  Additionally, our borrowing costs are affected by market conditions and may be adversely impacted by a tightening in credit markets.

We do not expect to pay any significant U.S. federal income tax until 2025 or later.  Our business operations are subject to income tax in several foreign jurisdictions.  We do not expect to pay any significant cash income taxes in foreign jurisdictions for at least several years.  We currently do not intend to repatriate cash from certain foreign subsidiaries that is indefinitely reinvested outside the U.S.  Any repatriation of cash from these subsidiaries or certain changes in U.S. tax laws could result in additional tax expense.

Contractual Obligations and Debt Agreements

See Note 8 to our Financial Statements for a description of our new debt obligations.  See our 2016 Annual Report on Form 10-K for a tabular disclosure of our contractual obligations as of December 31, 2016 and a description of our other debt obligations and amendments thereto.

Off-Balance Sheet Arrangements

There were no material changes in our off-balance sheet arrangements during the nine months ended September 30, 2017.

Recent Accounting Pronouncements

See Note 2 to our Financial Statements for a discussion of recent accounting pronouncements.

Forward-Looking Statements

This Quarterly Report on Form 10-Q (this “Report”), as well as other reports, releases and written and oral communications issued or made from time to time by or on behalf of AAWW, contain statements that may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  Those statements are based on management’s beliefs, plans, expectations and assumptions, and on information currently available to management.  Generally, the words “will,” “may,” “should,” “expect,” “anticipate,” “intend,” “plan,” “continue,” “believe,” “seek,” “project,” “estimate” and similar expressions used in this Report that do not relate to historical facts are intended to identify forward-looking statements.

The forward-looking statements in this Report are not representations or guarantees of future performance and involve certain risks, uncertainties and assumptions. Such risks, uncertainties and assumptions include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2016.  Many of such factors are beyond AAWW’s control and are difficult to predict.  As a result, AAWW’s future actions, financial position, results of operations and the market price for shares of AAWW’s common stock could differ materially from those expressed in any forward-looking statements. Readers are therefore cautioned not to place undue reliance on forward-looking statements.  AAWW does not intend to publicly update any forward-looking statements that may be made from time to time by, or on behalf of, AAWW, whether as a result of new information, future events or otherwise, except as required by law.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes to our market risk during the nine months ended September 30, 2017.  For additional discussion of our exposure to market risk, refer to Part II, Item 7A “Quantitative and Qualitative Disclosures About Market Risk” included in our 2016 Annual Report on Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d - 15(e) under the Exchange Act) as of September 30, 2017. Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in

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reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and is accumulated and communicated to our management, including our CEO and CFO, to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

There has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the three months ended September 30, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

With respect to the fiscal quarter ended September 30, 2017, the information required in response to this Item is set forth in Note 13 to our Financial Statements and such information is incorporated herein by reference. Such description contains all of the information required with respect hereto.

ITEM 1A. RISK FACTORS

For risk factors that may cause actual results to differ materially from those anticipated, please refer to our 2016 Annual Report on Form 10-K.

ITEM 6. EXHIBITS

See accompanying Exhibit Index included after the signature page of this report for a list of exhibits filed or furnished with this report.

 

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EXHIBIT INDEX

 

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

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