MIAMI — Hawaiian Airlines recorded a net profit of $35.6 million, or $0.56 per diluted share for the third quarter of 2014. Excluding special items, its adjusted net income in the quarter was $49.5 million ($0.79/share), up $12.7 million ($0.10/share) year-over-year (YOY).

Total operating revenue rose 6.7 percent YOY to $639.5 million, led by a 29.5 percent increase YOY in other operating revenues to $72.5 million and a 4.4% increase in passenger revenues to $567.0 million. Belying the trend amongst its mainland peers, cargo revenue increased 21 percent YOY to $19.9 million, marking the ninth consecutive quarter with 20 percent or more growth in cargo revenues. What was once a negligible revenue stream has steadily grown into a high margin contributor of incremental profitability.

The sizzling performance in ancillary revenues was also helped by Hawaiian’s extra comfort seats on its A330 fleet, expanding the number of seats with extra legroom in the main cabin from 24 to 40 per aircraft. This was a strong incremental contributor of incremental revenues, surpassing $2 million per month in both August and September and $5.5 million for the quarter. Passenger revenue per available seat mile (PRASM) rose 2.2 percent YOY to 12.60 cents on a 1.3 percent increase in yields to 15.00 cents and a 2.1 percent increase in capacity as measured by available seat miles (ASMs).

 Hawaiian Airlines Airbus A330. (Credits: Eric Salard)
Hawaiian Airlines Airbus A330. (Credits: Eric Salard)

Turning to region-specific revenue performance, performance for each of its three operational regions belied recent trends, with performance on the mainland and inter-island routes declining and Pacific network performance improving. Mainland routes generated $289.2 million in revenue, up 13.3 percent YOY, though PRASM declined 2.1 percent YOY because of 0.5 percentage points of impact from hurricanes Iselle and Julio, difficult YOY comparison with Q3 2013, and capacity increases of 9 percent YOY on its new routes.

Interisland services contributed $130.4 million in revenue, though PRASM declined 1.9 percent YOY. PRASM growth would have been flat absent the effects of the aforementioned hurricanes, which shut down businesses around the state, and caused the cancellation of 30 inter-island flights. Meanwhile, international routes generated $139.6 million in revenue, and reversed several quarters worth of expansion-driven decline in PRASM, with a YOY increase of 11.5 percent. As CEO Mark Dunkerley noted on the carrier’s quarterly earnings call, Hawaiian’s “competitive capacity is a mixed bag. It’s been helpful to see the scaling back of flights by Japan [Airlines] and Korean [Air] but we see more competition coming from Australia, but overall, we’re pleased with the competitive environment of our international markets.”

Operating expenses rose 1.6 percent YOY to $533.3 million, driven primarily by a 2.1 percent increase in labor expenses to $114.5 million. Fuel expenses were up just 0.5 percent YOY to $182.2 million despite minor hedge losses. Aircraft expenses (combining rentals for leased aircraft and depreciation for owned aircraft) were essentially flat YOY, while maintenance expenses declined 0.8% YOY.

Maintenance expenses are however, going to tick sharply upwards in the fourth quarter as Hawaiian enacts one time cycle-driven checks on its fleet of Boeing 717 aircraft, accounting for 2.5 percentage points of a projected 5.5-8.5 percent increase in operating cost per available seat mile (CASM) excluding fuel. For the third quarter, Hawaiian’s CASM declined 0.4 percent to 11.84 cents, while CASM ex fuel rose slightly, 0.3 percent YOY, to 7.80 cents.

As of September 30, 2014 the company had unrestricted cash, cash equivalents and short-term investments of $582 million. The company posted outstanding debt and capital lease obligations of approximately $1.06 billion, including: $701 million outstanding under secured loan agreements to finance part of the purchase price for 11 Airbus A330-200s; $141 million outstanding under secured loan agreements to finance part of the purchase price for 15 Boeing 717-200s; $104 million in capital lease obligations to finance the acquisition of an A330-200, two 717-200s and aircraft-related equipment; $31 million outstanding under floating rate notes to finance the acquisition of two Boeing 767-300ERs; and $80 million of outstanding convertible senior notes. The carrier also paid off debt on an existing A330 financing using cash in October.

For the quarter, Hawaiian recorded an operating profit of $106.2 million, generating a strong operating margin of 16.6 percent. Hawaiian continues to lack the ability to generate free cash flow, though at present rates, it should be able to generate substantial free cash flow in 2016 when fleet growth, especially for widebody aircraft, tapers off. Trailing 12 months return on invested capital (ROIC) was 14.5 percent pre-tax, and 8.7 percent on a post-tax basis.

A Hawaiian Airlines Boeing 717 at Honolulu International Airport. (Credits: Aero Icarus)
A Hawaiian Airlines Boeing 717 at Honolulu International Airport. (Credits: Aero Icarus)

Hawaiian has finally reversed the PRASM declines that have plagued its Asian operations for the last seven quarter, in part by paring back capacity through the elimination of services to Taipei and Fukuoka and cutting planned capacity growth in other Asian markets. Shifting growth to mainland routes, in particular to secondary routes that bypass Honolulu in favor of Kona, Lihue, or Maui, makes a good deal of sense given the relative strength of the US economy versus slower-growing Asian ones. Moreover, building a presence and customer visibility in these markets, even if they are unprofitable in the short term, could pay off when Hawaiian takes delivery of its fleet of Airbus A321neo aircraft from 2017 onwards. The A321neo is optimized for smaller markets such as these, and should allow Hawaiian to compete profitably with existing rivals such as Alaska Airlines and expected ones such as Southwest Airlines.

The key for Hawaiian in the near term however, will be improving its focus on cash. Over the past five years, Hawaiian has embarked on a transformational expansion of its business, using a new fleet of Airbus A330-200 aircraft to build a brand-new international network in the Pacific. The Pacific network opened Hawaiian up to new revenue opportunities, and (as we have argued in this space) was a worthwhile risk. But the expansionary cycle came at a cost; Hawaiian’s ability to return cash to its investors.

To be fair, Hawaiian has performed in line with peers on most other financial metrics. Its operating margin is in line with that of other network and niche airlines, while its ROIC number is also favorable. Hawaiian has also used some of its cash on hand to de-lever its balance sheet. But Hawaiian has lagged far behind its US airline peers in returning cash to shareholders. Parts of the Asian network have now begun to spool up into profitability, but they were also incredibly expensive on cash basis – Hawaiian’s capital expenditures have been amongst the highest in the US industry relative to its revenue. So Hawaiian’s most critical task over the next 7-9 quarters (through the end of 2016 and our projected expansionary cycle for US airlines) will be to generate free cash flow and then return it to shareholders, whether through a dividend, or (more likely) via share buybacks.