ITEM 1. BUSINESS
GENERAL
We have four main businesses. First, we are a leading U.S. and international provider of air freight carrier services, which means that we transport air freight in airplanes that we charter to third parties. In this business, we charge customers for the use of the entire airplane, regardless of the amount of freight we transport for them, and each airplane flies for only one customer at a time. Second, we are a leading provider of scheduled freight services in the U.S., which means that we transport air freight on scheduled routes, and each airplane generally transports the freight of multiple customers at the same time. In this business, we charge customers by the size and the weight of the freight shipped. Third, we are a leading provider of air logistics services in the U.S., which means that we arrange the delivery of air freight on an expedited basis, whether on our airplanes or those of a third party. Finally, we provide engine overhaul services on JT3 engines used on Douglas DC-8s and JT8 engines used on Boeing 727s, Douglas DC-9s and other aircraft. We also provide engine overhaul services for our fleet of Boeing 727s and Douglas DC-8s and DC-9s and airframe repair services for our fleet of Boeing 727s and Douglas DC-9s.
Our principal executive offices are located at 1515 West 20th Street, P.O. Box 612787, Dallas/Fort Worth International Airport, Texas 75261, and our main telephone number is (972) 456-2200. We maintain a web site at http://www.kha.com.
INDUSTRY OVERVIEW
Air Freight Delivery Services. The market for air freight delivery services is served by an industry which is composed of:
(1) air freight carriers that contract with "freight-forwarders" to provide them with short-term and long-term contract charters;
(2) air freight carriers that provide on-demand charters, as opposed to short-term and long-term charters;
(3) air freight carriers that provide scheduled air freight delivery services; and
(4) "door-to-door" express package delivery companies such as Federal Express and United Parcel Service.
The air freight delivery services industry provides same-day, next-day and/or two-day delivery services. A number of air freight carriers, including us, provide a combination of these services. Specifically, our air freight carrier services business provides on-demand charters and short-term and long-term contract
charters, and our scheduled freight services business provides regularly scheduled freight delivery services between various airports.
Air Logistics Services. Demand for air logistics services is driven by demand for same-day delivery of time sensitive freight. In contrast to the market for next-day and two-day freight delivery services, we believe that the U.S. market for on-demand charters is served by hundreds of air freight carriers, the vast majority of which are privately held, operate from only one location and do not coordinate "door-to-door" charter delivery services to the extent we do.
AIR FREIGHT CARRIER SERVICES
General. We provide air freight carrier services on a contractual basis for a variety of customers, including freight forwarders, other airlines, the U.S. Postal Service and the U.S. Military. In addition, we provide air freight carrier services on an on-demand basis. Kitty Hawk International, Inc. is our wide-body aircraft air freight carrier and Kitty Hawk Aircargo, Inc. is our narrow-body aircraft air freight carrier.
ACMI Domestic. The terms of our contract charters vary, but they typically require us to supply aircraft, crew, maintenance and insurance ("ACMI"), while our customers are responsible for substantially all other aircraft operating expenses, including fuel, fuel servicing, airport freight handling, landing and parking fees, ground handling expenses and aircraft push-back costs. These ACMI contracts also typically require us to operate specific aircraft and/or provide minimum air freight capacity and generally are terminable if we:
(1) fail to meet certain minimum performance levels;
(2) otherwise breach the contract; or
(3) become subject to other customary events of default.
Under our ACMI contracts, we are permitted to utilize and, in fact often do utilize, our aircraft in on-demand service in the periods between ACMI contract flights.
ACMI International. We operate ACMI contracts of varying durations in foreign countries as well as between the U.S. and foreign countries. These ACMI contracts provide that we have exclusive operating control and direction over each aircraft we operate. We have operating authority for Brazil, Colombia, Costa Rica and Ecuador. Where we do not have our own operating authority, our foreign-based customers must obtain foreign government authorizations and permits required for us to fly the designated routes. Our international ACMI contracts traditionally have been concentrated in the South and Central American markets. Currently, we operate one Boeing 747 for AeroFloral and one Boeing 747 for Fast Air between the U.S. and various destinations in South America.
On-Demand. The aircraft of our air freight carrier business also fly on-demand charters for customers of our air logistics services business. In 1998, approximately 21.5% of the on-demand charters managed by our air logistics services business were flown on the aircraft of our air freight carrier business. On-demand charters flown on the aircraft of our air freight carrier business generate a higher gross margin to us than charters subcontracted to third party carriers.
U.S. Postal Service. We have historically performed a variety of services for the U.S. Postal Service, ranging from regularly scheduled delivery throughout the year to special contracts to meet increased demand during the Christmas holiday season. Similar to an ACMI contract, our contracts with the U.S. Postal Service generally allow us to pass-through our fuel costs, landing charges and other variable costs. Accordingly, we are not generally at risk of loss in the event these variable costs increase during the term of these fixed-price arrangements.
Since 1993, we have been the prime contractor for the "Christmas Network" established by the U.S. Postal Service. The Christmas Network supplies air transportation and ground handling services primarily for second-day mail among a network of domestic cities during the December holiday rush. The U.S. Postal Service awards contracts pursuant to a public bidding process that considers quality of service
and other factors, including, to a lesser extent, price. The Christmas Network contract is put up for bid each year.
Of our total revenues for 1998, the U.S. Postal Service accounted for approximately $120 million or 16.8%. All of this revenue was attributable to air freight carrier services and represented 19.9% of the air freight carrier business' total revenues.
BAX Global. BAX Global leases under an ACMI contract 14 of our Boeing 727s for varying terms through March 31, 2003. BAX Global may earlier terminate the contract if, among other reasons, we do not meet certain on-time performance standards or if majority ownership or control of the Company is acquired by a competitor of BAX Global. Of our total revenues in 1998, BAX Global accounted for approximately $71.5 million or 10%. All of this revenue was attributable to air freight carrier services and represented 11.9% of the air freight carrier business' total revenues.
U.S. Military. We have historically provided air freight carrier services for the U.S. Military.
SCHEDULED FREIGHT SERVICES
Domestic. We operate a scheduled airport-to-airport air freight service which provides overnight delivery to and from approximately 46 cities in the U.S. Freight received each evening is delivered the next morning, Tuesday through Friday, throughout the year. The majority of overnight deliveries are routed through our 90,000 square foot sorting center located at the Hulman Regional Airport in Terre Haute, Indiana. In July 1999, we expect to relocate our sorting operation from the Hulman Regional Airport to the Fort Wayne-Allen County Airport in Fort Wayne, Indiana. This new 239,000 square foot sorting facility will permit us to handle more than double the sorting capacity of the Terre Haute facility. In addition, the facility is designed to improve productivity by reducing the time to load and unload aircraft and decreasing sorting times. See "Item 2.
ITEM 2. PROPERTIES
General. Our facilities consist of office space, hangars, maintenance facilities and warehouse and storage space. Some of our hangar facilities are constructed on property ground leased from airport owners. Accordingly, the hangar improvements revert to the owner when the ground lease expires. We also have various agreements with municipalities and governmental authorities that own and operate airports throughout the U.S. These agreements generally relate to our use of general airport facilities, but may also include leases or licenses to use hangar and maintenance space. In addition, we own a number of aircraft. See "Item 1. Business -- Aircraft Fleet."
The following is a summary of our major facilities:
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(1) We own the building and improvements and lease the land from the Dallas/Fort Worth International Airport.
(2) We have constructed a warehouse at the Honolulu International Airport which we lease to AIC.
New Sorting Facility. We currently lease our 90,000 square foot sorting space at the Hulman Regional Airport in Terre Haute, Indiana. Because of the lack of available expansion space and the limited airport facilities in Terre Haute, we plan to move this sorting center to Fort Wayne, Indiana in July 1999. We have entered into a 20 year lease with the Fort Wayne-Allen County Airport Authority for a 239,000 square foot sorting facility. This new sorting facility will more than double the current sorting capacity of our scheduled freight business, to approximately 2 million pounds per day. A separate area of the facility will be dedicated to serving the U.S. Postal Service. We also lease ramp space, a 30,000 square foot maintenance building for aircraft and ground support equipment maintenance and a 15,000 square foot facility for crew quarters and flight operations. In addition, we have access to a 12,000 foot lighted runway equipped for full instrument approach.
Oscoda Base. We sublease our maintenance facility at the former Wurtsmith Air Force Base in Oscoda, Michigan from the Oscoda-Wurtsmith Airport Authority pursuant to a prime lease from the U.S. Government. These subleases vary in duration from month-to-month to long-term and are subject to earlier termination upon termination of the prime lease between the U.S. Government and the Wurtsmith Authority. Under the subleases, we have access to an 11,800 foot lighted runway equipped for full instrument approach, as well as office, hangar, maintenance and storage space. Until 2011, the Oscoda facility is part of a "renaissance" zone which means that we do not pay real or personal property taxes on our facilities and equipment in Oscoda. In connection with the restructuring of Kitty Hawk International, we are closing surplus portions of our Oscoda facility.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Litigation Concerning American International Cargo. As a result of our acquisition of AIA (now Kitty Hawk International), we acquired a 60% interest in AIC. Pacific Aviation Logistics, Inc. ("PAL") owned the remaining 40% interest in AIC and was the managing partner of AIC. Beti Ward, who owns PAL, was the general manager of AIC. AIC operates a scheduled air freight service between Los Angeles, Honolulu and various destinations in the Pacific. AIC does not own any aircraft and currently leases all of its aircraft and facilities from us.
In August 1998, we called a partnership meeting to designate AIA as the managing partner of AIC and to replace Ms. Ward as general manager. In response, Ms. Ward and PAL filed suit to prevent these actions and requested the court to dissolve AIC. While these issues were being addressed in court, we reached a settlement with Ms. Ward and PAL. The terms of the settlement are:
(1) AIC will pay PAL a $5.4 million cash distribution from PAL's capital account in AIC.
(2) We will give Ms. Ward and PAL a promissory note for an additional $2.35 million, payable in three annual installments of $700,000 each and one final payment of $250,000. This promissory note bears interest at a rate of 9.98%, and interest is payable semi-annually.
(3) Ms. Ward and PAL will transfer to us all of their interest in AIC and its business.
(4) Ms. Ward and PAL will broadly covenant not to compete in the Los Angeles and Honolulu air freight markets for a period of three and one-half years.
(5) Ms. Ward and PAL will return approximately $180,000 worth of AIC's property.
(6) All the parties will exchange mutual releases, but we will retain the right to pursue audit actions and seek other limited recoveries against Ms. Ward and PAL.
As a result of the settlement, we now have full ownership and control of AIC and its business is being conducted without interruption. Currently, we anticipate dissolving AIC and combining its operations with our domestic scheduled freight services business.
Routine Litigation. We are subject to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be
predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on our business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
Our executive officers are:
M. Tom Christopher has served as our Chairman of the Board of Directors and Chief Executive Officer since our inception in 1985 and serves in the class of directors whose terms expire at the 2000 Annual Meeting of Stockholders. He has over 20 years of experience in the air freight industry.
James R. Craig has served as our Vice President and General Counsel since April 1, 1998. From October 1994 to November 1997, Mr. Craig served on our Board of Directors. Prior to April 1998, Mr. Craig was of counsel to Burke, Wright & Keiffer, P.C. Prior to his affiliation with Burke, Wright & Keiffer, P.C., Mr. Craig was in private law practice in Dallas since 1971 and in 1989 served as President of Whitehall Development Company, a real estate development firm, of which he is now a director.
Tilmon J. Reeves has served as our President since May 1993 and as our Chief Operating Officer from May 1993 to November 1997 and from April 1998 until the present. Mr. Reeves has over 30 years of aviation experience. Mr. Reeves became a director in October 1994 and serves in the class of directors whose terms expire at the 1999 Annual Meeting of Stockholders.
Richard R. Wadsworth has served as our Senior Vice President -- Finance since October 1992, Chief Financial Officer since September 1994 and Secretary since October 1994. Mr. Wadsworth served on our Board of Directors from October 1994 to November 1997 and from April 1998 to the present. Mr. Wadsworth serves in the class of directors whose terms expire at the 2001 Annual Meeting of Stockholders.
MODIFICATION OF REEVES EMPLOYMENT AGREEMENT AND GRANT OF OPTIONS
In April 1998, we entered into a Modified and Restated Employment Agreement (the "Employment Agreement") with Mr. Reeves. The Employment Agreement modifies and supercedes Mr. Reeves' prior employment agreement in its entirety. The terms of the Employment Agreement are substantially similar to those of Mr. Reeves' prior employment agreement, except for the following:
(1) Mr. Reeves' annual base salary was increased from $115,000 to $400,000.
(2) in the event we terminate Mr. Reeves' employment other than as a result of Mr. Reeves' material breach of the Employment Agreement, Mr. Reeves' guaranteed post-termination compensation was increased from one year at 100% of his then-current salary and two additional years at 50% of his then-current salary to five years at 100% of his then-current salary, payable at the time he would have received it absent termination; and
(3) Mr. Reeves was granted a non-qualified stock option (the "Old Option") to acquire 400,000 shares of common stock at an exercise price of $16.75 per share. The option vested as to
100,000 shares on each of April 27, 1999, 2000, 2001 and 2002. However, in general, in the event of our dissolution or liquidation, our reorganization, merger or consolidation where we were not the surviving entity, or our sale of substantially all of our property, the option became immediately exercisable in full. In addition, upon our termination of Mr. Reeves' employment without cause or upon Mr. Reeves' death or disability, the option became immediately exercisable in full. The option terminated on the earlier of December 31, 2005 or the 12 month anniversary of Mr. Reeves' death. In addition, if we terminated Mr. Reeves' employment for cause or if Mr. Reeves voluntarily terminated his employment before reaching age 65, other than for disability, the option terminated immediately. Further, we could have immediately terminated the option if during or after Mr. Reeves' employment, Mr. Reeves directly or indirectly engaged in competition with us or disclosed any of our proprietary and confidential business information in breach or violation of any agreement. The option generally provided for customary anti-dilution protection for Mr. Reeves and granted Mr. Reeves rights to register shares he received under the option at the same time and in the same proportion as Mr. Christopher registered shares of common stock. Neither Messrs. Christopher or Reeves have contractual rights to cause us to register shares of common stock.
In February 1999, we replaced the Old Option with a non-qualified stock option (the "New Option") to acquire 400,000 shares of common stock at an exercise price of $16.75 per share. The New Option was granted under the Kitty Hawk, Inc. 1999 Executive Stock Option Plan (the "Option Plan") and is subject to stockholder approval of the Option Plan at the 1999 Annual Meeting of Stockholders. In connection with the grant of the New Option, Mr. Christopher irrevocably agreed to vote all shares of common stock he is entitled to vote in favor of approving the Option Plan at the 1999 Annual Meeting of Stockholders. Mr. Christopher currently has the right to vote approximately 58.2% of the common stock, which is greater than the majority approval required to approve the Option Plan. The terms of the New Option are substantially the same as the terms of the Old Option, except that the New Option vests as to 200,000 shares on February 24, 1999 and an additional 100,000 shares on each of February 24, 2000 and 2001 and fully vests immediately upon a change of control of the Company. In addition, the term of the New Option was extended from December 31, 2005 to February 24, 2009.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is traded on the Nasdaq National Market System under the symbol "KTTY". The following table sets forth the range of high and low closing sale prices of the common stock for the periods shown below.
At March 24, 1999, we had approximately 69 record holders of our common stock. Based upon our last determination of the number of beneficial owners of common stock, we had approximately 3,500 beneficial owners.
We have never declared or paid any cash dividends on the common stock. We presently intend to retain earnings, if any, for development and growth of our business and do not anticipate paying cash dividends on the common stock in the foreseeable future. Our debt agreements contain significant limitations on our ability to pay dividends. Payment of future dividends, if any, will be at the discretion of our Board of Directors, after taking into account various factors, including our earnings, capital requirements and surplus, financial position, contractual restrictions and other relevant business considerations, and there can be no assurance that dividends will be paid. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources."
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
On December 4, 1996, the Company changed its fiscal year end from August 31 to December 31.
The following table sets forth selected financial and operating data with respect to the Company for each of the fiscal years indicated and for the four months ended December 31, 1995 and 1996. This information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements, including the notes thereto, appearing elsewhere in this Form 10-K. The selected statement of operations data for the fiscal year ended August 31, 1996, for the four months ended December 31, 1996 and for each of the fiscal years ended December 31, 1997 and 1998 and the selected balance sheet data as of December 31, 1997 and 1998 have been derived from audited consolidated financial statements of the Company appearing elsewhere in this Form 10-K. The selected balance sheet data as of August 31, 1994, 1995 and 1996 and December 31, 1996 have been derived from audited consolidated financial statements of the Company not appearing in this Form 10-K. The selected statement of operations data for the fiscal years ended August 31, 1994 and 1995 has been derived from audited consolidated financial statements of the Company not appearing in this Form 10-K. Operating results for the four months ended December 31, 1995 and 1996 are not necessarily indicative of results that may be expected for a calendar year. In the opinion of management of the Company, the selected statement of operations data for the four months ended December 31, 1995, which are derived from the Company's unaudited consolidated financial statements appearing elsewhere in this Form 10-K, reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the financial position and results of operations for such periods. In November 1997, the Company acquired the Kalitta Companies. Accordingly, the results of operations of the Kalitta Companies are included in the financial and operating data from their date of acquisition.
Also included in the following table are the Companies' unaudited pro forma consolidated statement of operations data for the fiscal year ended December 31, 1997, giving effect to (i) the November 1997 acquisition of the Kalitta Companies, (ii) the issuance of the Notes, (iii) the incurrence of a $45.9 million term loan and (iv) the September 1997 acquisition of 16 Boeing 727s from the Kalitta Companies, each as if they occurred on January 1, 1997. This information is presented for illustrative purposes only and does not purport to present the Company's results of operations had these transactions occurred on the date indicated, nor are they necessarily indicative of the consolidated results of operations which may be expected to occur in the future. No pro forma adjustments have been applied to reflect (i) revenues or operating costs generated from two Boeing 747s purchased in February 1998 and modified with approximately $56 million of the net proceeds from the sale of the Notes and other internally generated funds or (ii) operating efficiencies or cost savings (other than approximately $1.5 million of insurance savings) resulting from the acquisition of the Kalitta Companies. In addition, pro forma results have not been adjusted to eliminate (i) abnormally high engine maintenance expenses previously incurred in response to certain Directives, (ii) costs previously incurred to add and maintain flight crews in anticipation of increased air freight carrier business which had not yet materialized in part due to delays in acquiring aircraft and (iii) start-up costs previously incurred to establish the Company's wide-body passenger charter business, which was recently terminated.
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(1) Results for the fiscal year ended August 31, 1996 lack comparability to other periods because such periods include nonrecurring grants to two executive officers of stock options that resulted in a charge to earnings of approximately $4,231. Had these grants of stock options not occurred, net income for the fiscal year ended August 31, 1996 would have been approximately $6,648 and net income per share would have been $0.84.
(2) Reflects sums received in settlement of litigation.
(3) Adjusted EBITDA represents net income before minority interest, income tax expense, interest expense, depreciation, amortization and certain items described below. Adjusted EBITDA excludes
approximately $4,231 from stock options granted to executives in 1996 and approximately $1,178 in contract settlements in fiscal 1994, respectively. Adjusted EBITDA is presented because it is a financial indicator of the Company's ability to incur and service debt. However, adjusted EBITDA is not calculated under generally accepted accounting principles (GAAP), is not necessarily comparable to similarly titled measures of other companies and should not be considered in isolation, as a substitute for operating income, net income or cash flow data prepared in accordance with GAAP or as a measure of the Company's profitability or liquidity.
(4) In calculating the ratio of earnings to fixed charges, earnings consist of income before minority interest and income tax expense and fixed charges (less capitalized interest). Fixed charges consist of capitalized interest, interest expense, amortization of debt expense and one-third of rental payments on operating leases (such factor having been deemed by the Company to represent the interest portion of such payments).
(5) As reported by the Company to the Federal Aviation Administration. Flight hours reported are less than block hours, which also include the time an aircraft is operating under its own power whether or not airborne. The Company generally bills its customers on a block hour basis.
(6) Includes on-demand charters flown by the Company's aircraft.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Acquisition of the Kalitta Companies. On November 19, 1997, the Company acquired all of the outstanding stock of the Kalitta Companies. The results of operations for fiscal year 1997 include the results of operations of the Kalitta Companies for the period November 19, 1997 to December 31, 1997, which is generally the highest volume and most profitable period of the year.
Revenues. The Company's revenues are derived from four related businesses (i) an air freight carrier, (ii) a scheduled freight service provider, (iii) an air logistics service provider and (iv) a maintenance operation. Air freight carrier revenues are derived substantially from ACMI contract charters, on-demand charters flown with the Company's aircraft and the Company's passenger charter service. Scheduled freight services revenues are generated through an overnight airport-to-airport air freight service to approximately 46 U.S. cities and an international service between Los Angeles and Honolulu, among the Hawaiian islands and once a week through Melbourne, Hong Kong and other Pacific Rim locations. Revenue for the scheduled freight service is included in the air freight carrier. Air logistics revenues are derived substantially from on-demand air freight charters arranged by the Company for its customers utilizing the flight services of third party air freight carriers. With respect to on-demand charters that are arranged by the Company and flown with its own aircraft, charges to the customer for air transportation are accounted for as air freight carrier revenues and charges for ground handling and transportation are accounted for as air logistics revenues. Maintenance revenue is generated from third party maintenance work performed on engines and airframes.
The Company recently eliminated its passenger charter division and parked the four passenger planes in that division. In addition, the Company has stopped providing third party airframe repairs and engine overhaul services, other than on JT3 engines used on Douglas DC-8s and JT8 engines used on Boeing 727s and Douglas DC-9s. See "Item 1. Business -- Restructuring of Kitty Hawk International."
The principal factors that have contributed to revenue growth over the past several years have been increases in the size of the Company's fleet from 10 aircraft at December 31, 1993 to 117 aircraft at December 31, 1998, the general U.S. economic expansion since 1992 and increased global demand for time sensitive air freight services.
Costs of Revenues. The principal components of the costs of revenues attributable to the air freight carrier business consist of the costs for maintenance and operation of aircraft, including the salaries of pilots and maintenance personnel, charges for fuel, insurance and maintenance and depreciation of engines and airframes. Generally, charges for fuel are only applicable for the on-demand charters flown by the air freight carrier and operations of the Company's scheduled freight services because fuel for the ACMI contract charters is generally provided by the customer or billed to the customer on a direct pass-through basis. The principal components of the costs of revenues attributable to air logistics consist of sub-charter costs paid to third party air freight carriers and costs paid for ground handling and transportation. With respect to on-demand charters that are flown on the Company's aircraft, all related air transportation expenses are allocated to the air freight carrier business and all related cargo ground handling and transportation are allocated to the air logistics business. The principal components of the costs of revenues attributable to maintenance consist of costs related to the provision of third party maintenance services.
Under the Company's Amended and Restated Annual Incentive Compensation Plan, the Company awards semiannual cash bonuses to its employees. The aggregate amount of bonuses for the fiscal year ended August 31, 1996, the fiscal years ended December 31, 1997 and 1998 and the four months ended December 31, 1996 have equaled 9.5%, 7.3%, 10% and 10%, respectively, of the Company's income before the deduction of income taxes, stock option grants to executives and the bonuses that were expensed under this plan.
The Company's gross margins have been substantially higher in its air freight carrier business (which uses Company aircraft) than in its air logistics business (which principally uses third party aircraft). In
addition, the air freight carrier business historically has provided a more predictable revenue base. Accordingly, the Company allocates its aircraft to ACMI contracts prior to allocating them to on-demand service.
Significant Events Affecting Comparability of Results of Operations. Since September 1, 1995, several events have affected the comparability of results of operations for the fiscal years ended August 31, 1996 and December 31, 1997. In fiscal year 1996, the Company granted Messrs. Reeves and Wadsworth options to purchase 390,707 and 153,567 shares of common stock, respectively, for an exercise price of $0.01 per share that resulted in a charge to earnings of approximately $4,231,000. In 1997, the Company acquired the Kalitta Companies and included their results of operations for the period November 19, 1997 to December 31, 1997 in the Company's results of operations, which increased revenues by approximately $58.9 million, costs of revenues by approximately $49.4 million and income before interest, minority interest and income taxes by approximately $6.5 million.
Dependence of Significant Customers. The U.S. Postal Service accounted for revenues of $21.3 million, $44.9 million, $120 million and $26.2 million, or 14.9%, 17.9%, 16.8% and 43.7% of total revenues, for the fiscal year ended August 31, 1996, the years ended December 31, 1997 and 1998 and the four months ended December 31, 1996. BAX Global accounted for revenues of $15.6 million, $44.7 million, $71.5 million and $7.1 million, or 10.9%, 17.9%, 10% and 11.9% of total revenues, for the fiscal year ended August 31, 1996, the years ended December 31, 1997 and 1998 and the four months ended December 31, 1996. Revenues from these two customers are generated by the air freight carrier.
Change in Fiscal Year. On December 4, 1996, the Company changed its fiscal year end from August 31 to December 31.
RESULTS OF OPERATIONS
The following tables set forth, on a comparative basis for the periods indicated, the components of the Company's gross profit and the gross profit margin by revenue type:
The following table presents, for the periods indicated, consolidated income statement data expressed as a percentage of total revenues:
YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE PRO FORMA YEAR ENDED DECEMBER 31,
Due to the impact the acquisition of the Kalitta Companies and related transactions have had on the financial position and results of operations of the Company, management has determined that the historical results of operations for the year ended December 31, 1997 lack meaningful comparability to the results of operations for the year ended December 31, 1998. As a result, the Company has provided a comparison of the pro forma year ended December 31, 1997 to the year ended December 31, 1998, which the Company believes provides the most relevant and useful information to investors. Other than the information
provided above, no further comparison of the historical results of operations for the year ended December 31, 1997 to the year ended December 31, 1998 is provided herein.
Revenues -- Air Freight Carrier. Air freight carrier revenues for 1998 increased to $602.9 million, or 13.4%, from $531.6 million for pro forma 1997. Air freight carrier on-demand, ACMI contract charter, and scheduled freight revenues were $75.5 million, $358.8 million and $166.5 million, or 12.5%, 59.5% and 27.6%, respectively, of total air freight carrier revenues for 1998, as compared to $80.3 million, $283.2 million and $164.1 million, or 15.1%, 53.3% and 30.9%, respectively, of total air freight carrier revenues for pro forma 1997. Revenues from on-demand charters flown by Company aircraft for 1998 decreased 6% as a percent of air freight carrier revenues from pro forma 1997. This was due to aircraft being allocated to ACMI contract charter service rather than on-demand service, consistent with the Company's strategy of using more of its fleet in ACMI business which produces relatively stable revenues. Revenues from the Company's ACMI contracts increased $75.6 million, or 26.7%, during 1998, in part due to a $22.9 million increase in passenger charters from the acquisition of two Boeing 747 passenger aircraft early in 1998 which were subsequently converted to cargo configuration in the fall of 1998. The remaining increase in ACMI contract charter revenue was generated through the addition of three Boeing 727s in August 1998, the conversion of the three Boeing 747 aircraft from passenger to cargo configuration during 1998 (including two of which flew passenger charters for the first half of the year), as well as an overall increase of $12.7 million in the Company's December 1998 ACMI contract with the United States Postal Service (USPS). Scheduled freight service revenue increased $2.5 million, or 1.5%, principally due to higher volumes in the last half of 1998. Prices for the Company's on-demand charters remained relatively constant during this period. The Company implemented selective price increases for its ACMI contract charters and scheduled freight services during 1998.
Revenues -- Air Logistics. Air logistics revenues in 1998 increased $10.2 million, or 14.5%, to $80.8 million from $70.5 million in pro forma 1997. The number of on-demand charters managed increased by 2,341 charters, or 15.2%, to 17,743 charters for 1998 from 15,402 charters for pro forma 1997. Prices for the Company's air logistics services have remained relatively constant.
Revenues -- Maintenance and other. Maintenance and other revenues in 1998 increased $2 million, or 6.9%, to $31.2 million from $29.2 million in pro forma 1997. The increase was principally due to a large third party project started and completed in 1998. This increase was offset by an overall effort begun in late 1998 to reduce third party maintenance as the Company shifts its efforts to performing maintenance on its own fleet.
Costs of Revenues -- Air Freight Carrier. Air freight carrier costs of revenues in 1998 increased $41.8 million, or 9.1%, to $501.8 million, from $460 million in pro forma 1997, reflecting increased air freight carrier business. The gross profit margin from the air freight carrier business increased from 13.5% for pro forma 1997 to 16.8% for 1998. The increase in margins was primarily the result of lower maintenance costs resulting from operational efficiencies associated with performing maintenance with internal resources, higher utilization of aircraft during 1998 and lower average fuel prices in 1998 as compared to pro forma 1997. Fuel prices may increase during 1999 due to reduced oil exports by certain countries.
Costs of Revenues -- Air Logistics. Air logistics costs of revenues in 1998 increased $7.9 million, or 12%, to $73.9 million, from $66 million in pro forma 1997. The gross profit margin from air logistics increased from 6.5% for pro forma 1997 to 8.5% for 1998. The increased margin is a result of directing a larger percentage of on-demand charters to the Company's aircraft (including aircraft acquired as a result of the Kalitta Companies acquisition) rather than to third party aircraft, which results in a higher gross margin to the Company.
Costs of Revenues -- Maintenance and other. Maintenance and other costs of revenues in 1998 increased $861,000, or 3.9%, to $23.1 million, from $22.2 million in pro forma 1997. The gross profit margin increased from 23.9% in pro forma 1997 to 26.1% in 1998 as a result of greater cost efficiencies from third party maintenance.
General and Administrative Expenses. General and administrative expenses in 1998 increased $4.9 million, or 12.8%, to $43 million from $38.1 million in pro forma 1997. The increase was principally due to an increase in support functions and administrative costs associated with the growth of the Company and the increase in its air freight carrier and air logistics businesses. As a percentage of revenues, general and administrative expenses decreased to 6% in 1998 from 6.1% for pro forma 1997.
Non-qualified Employee Profit Sharing Expense. Employee profit sharing expense in 1998 increased $368,000, or 15.2%, to $2.8 million from $2.4 million in pro forma 1997, reflecting the increase of net income before taxes for 1998.
Operating Income. As a result of the above, operating income in 1998 increased $27.8 million, or 65.4%, to $70.3 million from $42.5 million in pro forma 1997. Operating margin increased to 9.8% in 1998 from 6.7% in pro forma 1997.
Income Taxes. The Company's effective tax rate increased to 40.5% in 1998 from 0% in pro forma 1997. The pro forma operating results included no provision for income taxes due to the Company's overall net loss position for the pro forma 1997 operating results. The 1998 effective tax rate is higher than in past years due to an overall increase in non-deductible expenses, principally meals for flight crews.
Net Income. As a result of the above, net income in 1998 increased to $16.6 million from a net loss of $960,000 for pro forma 1997. Net income as a percentage of total revenues increased to 2.3% in 1998 from a net loss of (0.2)% for pro forma 1997.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO THE UNAUDITED YEAR ENDED DECEMBER 31,
Because of the change in year end described above, the following discussion compares the results of operations for the year ended December 31, 1997 to the unaudited 12 month period ended December 31, 1996.
The results of operations data for 1996 referred to below, are taken from the Company's unaudited financial statements, which are not separately presented herein, and are presented for comparative purposes only. In the opinion of management, the 1996 results of operations include all adjustments management believes are necessary for a fair presentation.
Revenues -- Air Freight Carrier. Air freight carrier revenues increased to $177.2 million, or 124.9%, for 1997 from $78.8 million for 1996, principally due to an increase in fleet size and the acquisition of the Kalitta Companies. Approximately $56.8 million of the increase was due to revenues generated by the Kalitta Companies from November 19, 1997 to December 31, 1997, which is the highest volume and most profitable portion of the year. See "-- Seasonality." The remaining increase of approximately $120.4 million is primarily attributable to the growth in the Company's aircraft fleet from 25 aircraft at December 31, 1996 to 42 aircraft immediately prior to the acquisition of the Kalitta Companies and a $18.5 million revenue increase in the Company's December 1997 ACMI contract with the USPS. Air freight carrier on-demand, ACMI contract charter, and scheduled freight services revenues were $22.9 million, $131.9 million and $19.9 million, or 13%, 74.5% and 11.2%, respectively, of total air freight carrier revenues for 1997, as compared to $15.9 million, $61.1 million and $0, or 20.2%, 77.5% and 0%, respectively, of total air freight carrier revenues for 1996. Revenues from on-demand charters flown by Company aircraft for 1997 decreased 25.8% as a percent of air freight carrier revenues from the prior year due to aircraft being shifted from on-demand to ACMI contract charter service, consistent with the Company's strategy of using more of its fleet in ACMI business which produces relatively stable revenues. Prices for the Company's on-demand and ACMI contract charters remained relatively constant during this period. Scheduled freight services began when the Company acquired the Kalitta Companies' scheduled freight operations.
Revenues -- Air Logistics. Air logistics revenues increased $16.7 million, or 31%, to $70.5 million in 1997 from $53.8 million in 1996. The increase was primarily due to increased demand for on-demand charters generally and specifically for charters that require larger aircraft, which generate greater revenues. Prices for the Company's air logistics services remained relatively constant during this period. The number
of on-demand charters managed increased by 995 charters, or 6.9%, to 15,402 charters for 1997 from 14,407 charters for 1996.
Revenues -- Maintenance. Maintenance revenues were $2.1 million for 1997. Third party maintenance work began when the Company acquired the Kalitta Companies' maintenance operations. In 1997, the Company performed maintenance on airframes and engines for third parties.
Costs of Revenues -- Air Freight Carrier. Air freight carrier costs of revenues increased $67.8 million, or 111.9%, to $127.9 million in 1997, from $60.4 million in 1996, reflecting increased costs associated with increased fleet. Maintenance expenses increased $17.2 million, or 150%, to $28.7 million in 1997 from $11.5 million in 1996. Maintenance expenses increased as a percentage of air freight carrier revenues to 16.2% from 14.6%. The increase was primarily attributable to adding the aircraft fleet of the Kalitta Companies which generally have greater maintenance costs as a percentage of revenue. During 1997, the Kalitta Companies accounted for $15.5 million of these maintenance expenses. The gross profit margin from the air freight carrier business increased from 23.4% for 1996 to 27.8% for 1997. The Kalitta Companies and their fleet of aircraft contributed $9.4 million, or 19.1%, of gross profit for 1997 with the remainder of the fleet of the Company contributing $27.2 million, or 80.9%, of gross profit. The increase in margins related to the remainder of the fleet was primarily the result of lower maintenance costs resulting from operational efficiencies associated with increased fleet size, higher utilization of aircraft during 1997 and lower average fuel prices in 1997 as compared to 1996. Fuel prices may increase during 1998 due to reduced oil exports by certain countries.
Costs of Revenues -- Air Logistics. Air logistics costs of revenues increased $16.9 million, or 34.5%, to $65.9 million for 1997, from $49 million for 1996. The gross profit margin from air logistics decreased from 9% for 1996 to 6.5% for 1997. The decrease in margin is attributable to the increase in charters using larger aircraft hired from third party carriers which have a higher cost than charters flown in the Company's aircraft.
Costs of Revenues -- Maintenance. Maintenance costs of revenues are associated with services provided for third parties on airframe and engine maintenance. Gross margin for December 31, 1997 was 15.5%. No third party maintenance services were provided prior to the acquisition of the Kalitta Companies.
General and Administrative Expenses. General and administrative expenses increased $6.2 million, or 68.9%, to $15.1 million for 1997 from $8.9 million for 1996. The acquisition of the Kalitta Companies contributed approximately $3 million to the increase in general and administrative expenses for 1997, representing costs for administrative support after the acquisition of the Kalitta Companies. Excluding the effect of the acquisition of the Kalitta Companies, the Company experienced an increase in general and administrative expenses from $8.9 million for 1996 to $12.2 million for 1997 primarily as a result of an increase in support functions and administrative costs associated with the growth in the aircraft fleet (from 25 aircraft at December 31, 1996 to 42 aircraft at November 18, 1997) and the increased volume of business of the air freight carrier. As a percentage of revenues, general and administrative expenses decreased to 6% in 1997 from 6.7% for 1996.
Non-qualified Employee Profit Sharing Expense. Employee profit sharing expense increased $1.2 million, or 95.9%, to $2.4 million for 1997 from $1.2 million for 1996, reflecting the increase of net income before taxes for 1997.
Operating Income. As a result of the above, operating income increased $27.7 million, or 312.8%, to $36.6 million for 1997 from $8.9 million for 1996. Operating margin increased to 14.7% for 1997 from 6.7% for 1996.
Interest Expense. Interest expense increased to $6.9 million for 1997, as compared to $2.1 million for 1996, an increase of $4.9 million, or 235.8%. The increase is primarily a result of incurring $45.9 million of debt under the Term Loan for the acquisition of 16 Boeing 727 aircraft in September 1997 and issuing the Notes in November 1997 in connection with the acquisition of the Kalitta Companies. Because these borrowings are expected to remain outstanding, interest expense for 1998 will be substantially higher.
Other Income. Other income increased to $1.1 million for 1997 from $0.9 million for 1996. The increase was primarily due to increased interest income during 1997 from the investment of net proceeds from the Company's initial public offering and of approximately $56 million of net proceeds from the Note Offering.
Minority Interest. Minority interest represents the earnings attributable to the 40% interest in AIC owned by a third party, which was approximately $497,000. The results are for the period November 19, 1997 to December 31, 1997, which is generally the highest volume and most profitable portion of the year. See "-- Seasonality."
Income Taxes. The Company's effective tax rate increased to 41% for 1997 as compared to 39.4% for 1996. The increase is primarily due to increased state income taxes.
Net Income. As a result of the above, net income increased to $17.9 million for 1997, compared to $4.7 million for 1996. Net income as a percentage of total revenues increased to 7.2% for 1997 from 3.5% in 1996.
LIQUIDITY AND CAPITAL RESOURCES
The Company's capital requirements are primarily for the acquisition and modification of aircraft and working capital. In addition, the Company has, and will continue to have, capital requirements for the requisite periodic and major overhaul maintenance checks for its fleet and for debt service. The Company also has seasonal working capital needs, because it generates higher revenue in the fourth calendar quarter and lower revenue in the first calendar quarter. Funding requirements have historically been met through internally generated funds, bank borrowings and aircraft sales and from public and private offerings of equity and debt securities. From time to time, the Company has entered into sale/leaseback transactions to acquire aircraft and may do so in the future.
In November 1997, the Company issued $340 million of 9.95% Senior Secured Notes, resulting in net proceeds to the Company of approximately $329.1 million. The Notes provide for semi-annual interest payments of approximately $16.9 million on each May 15 and November 15 and mature in November 2004. The Notes are secured by a fleet of 30 aircraft, including nine Boeing 747s, eight Lockheed L-1011s and 13 Boeing 727s. The Notes are guaranteed by all of the Company's subsidiaries, other than AIC.
The Company has a $45.9 million outstanding term loan (the "Term Loan"). The Term Loan is due in quarterly installments of $2.25 million commencing in March 1999, with the balance of $12.15 million due upon maturity in September 2002. Except as provided below, interest on the Term Loan accrues at LIBOR plus 3% or a Base Rate plus 1.5%, subject to reduction. The Base Rate is the Prime Rate of Wells Fargo Bank, N.A. ("WFB") or the Federal Funds Rate plus 0.5%. At December 31, 1998, the interest rate on the Term Loan was 8.5%. Except as provided below, the Term Loan is secured by accounts receivable, all spare parts (including rotables), inventory, intangibles and contract rights, cash, 15 Boeing 727s and related engines, the stock of each of the Company's subsidiaries, not including the Company's interest in AIC. The Term Loan is guaranteed by all of the Company's subsidiaries, not including AIC.
In addition, to fund ongoing capital requirements, including possible acquisitions, the Company has entered into a Credit Facility with WFB (the "Credit Facility"), individually and as agent for various lenders to provide the Company with up to $100 million in revolving loans (subject to a current borrowing base limitation of approximately $90.2 million, including an increase of $30 million to the borrowing base as a result of an amendment to the Credit Facility (the "Amendment") on December 10, 1998) that is secured by the same collateral as the Term Loan. Except as provided below, the Credit Facility bears interest at LIBOR plus 2.75% or a Base Rate plus 1.25%, subject to adjustment. The Base Rate is WFB's Prime Rate or the Federal Funds Rate plus 0.5%. At December 31, 1998, the interest rate on the Credit Facility was 9.5%. Borrowings under the Credit Facility are subject to borrowing base limitations based on eligible inventory and accounts receivable. The Credit Facility matures in November 2002. As of March 26, 1999, the Company had a balance of approximately $71.9 million outstanding under the Credit
Facility and available borrowings under the Credit Facility of approximately $18.3 million. Borrowings under the Credit Facility and Term Loan are subject to certain financial covenants. As of December 31, 1998, the Company was in compliance with all financial covenants.
In connection with the Amendment, the Company pledged 11 Douglas DC-8-60s and eight Douglas DC-8-50s under the Credit Facility and Term Loan. The Company can request WFB to release its liens on the Douglas DC-8-50 aircraft at any time in connection with a sale of the aircraft for full and fair consideration. With respect to the Douglas DC-8-60 aircraft, the Company can request WFB to release its liens on the Douglas DC-8-60s after first repaying the amount it borrowed, if any, under the Amendment's $30 million increase to the borrowing base. Prior to December 31, 1999, WFB is not obligated to release its liens on the Douglas DC-8-60s except in connection with a sale of the aircraft for full and fair consideration. After December 31, 1999, WFB is not obligated to release its liens on the Douglas DC-8-60s unless the Company meets specified financial criteria.
The Amendment's increase in the borrowing base is available through January 1, 2000, subject to earlier termination by the Company (the "Loan Pricing Increase Period"). During the Loan Pricing Increase Period, the interest rate of the Term Loan and the Credit Facility is either the Prime Rate of WFB plus 1.75% or LIBOR plus 3.25%, regardless of financial covenant performance. Upon termination of this borrowing base increase, the interest rates on the Term Loan and Credit Facility revert to those stated above.
Capital expenditures were $217.2 million and $115 million for 1998 and 1997, respectively. Capital expenditures for 1998 were primarily for (i) the purchase of two Boeing 747s, (ii) cargo modifications to three Boeing 747s and one Boeing 727, (iii) heavy maintenance checks on four Boeing 727s, (iv) noise abatement modifications for eleven Boeing 727s and one DC-9-15F aircraft, (v) purchase of six JT8D engines, three JT9D engines, one JT3D engine and five GE CJ 610-6 engines, (vi) engine overhauls, (vii) additional office and operational space at Dallas/Fort Worth International Airport and (viii) the purchase of rotable aircraft parts. Capital expenditures for 1997 were primarily for (i) the purchase of 20 Boeing 727 aircraft (including 16 Boeing 727s acquired from the Kalitta Companies), (ii) cargo and noise abatement modifications for three Boeing 727 aircraft and cargo modifications to one Boeing 747 aircraft, (iii) noise abatement equipment purchases for two Douglas DC-9 aircraft, (iv) leasehold improvements to three Boeing 727 aircraft, including a cargo conversion, (v) the purchase of the Company's 40,000 square foot headquarters facility and related ground sublease at Dallas/Fort Worth International Airport, (vi) five major maintenance checks on Boeing 727s, (vii) overhauls on seven JT8D engines and acquisition of 11 JT8D engines and (viii) the purchase of ground service equipment.
During 1999, the Company estimates that capital expenditures will aggregate approximately $110 million and that subsequent years capital expenditures will be substantial as well.
During 1999, the Company anticipates capital expenditures of approximately $16 million for noise abatement modifications to one Douglas DC-9 and eight Boeing 727 aircraft currently in its fleet. The entire fleet must be Stage 3 compliant by the year 2000. In the event more aircraft are acquired, anticipated capital expenditures for noise abatement modifications could materially increase. See "Item 1. Business -- Government Regulation -- Noise Abatement Regulations."
Directives issued under the FAA's "Aging Aircraft" program or issued on an ad hoc basis may cause certain of the Company's aircraft to be subject to extensive aircraft examinations and/or structural inspections and modifications to address problems of corrosion and structural fatigue among other things. Directives applicable to the Company's fleet can be issued at any time in the future. The cost of complying with such potential future Directives cannot currently be estimated, but could be substantial. See "Item 1. Business -- Government Regulation -- Aging Aircraft Regulations; Potential Compliance Costs."
The Company operates a fleet of 31 Boeing 727s, all of which were previously converted from passenger configuration to cargo configuration by the installation of a large cargo door and numerous interior modifications related to the installation of cargo container handling systems. The FAA has issued a
Directive which limits the cargo capacity of these Boeing 727s until certain modifications are made. During 1998, the Company purchased an STC used to modify five of the Company's aircraft to cargo configuration. Recently, the Company received approval from the FAA to modify these five aircraft to increase their cargo capacity. The modifications are expected to take from three to four days to complete and to cost between $25,000 and $50,000 per aircraft, not including aircraft downtime. The Company is currently seeking approval to modify the rest of its Boeing 727 fleet. See "Item 1. Business -- Government Regulation -- Cargo Door and Floor Modifications Regulations."
The Company believes that available funds, bank borrowings and cash flows expected to be generated by operations will be sufficient to meet its anticipated cash needs for working capital, debt service and capital expenditures for at least the next 12 months. Thereafter, if cash generated by operations is insufficient to satisfy the Company's liquidity requirements, the Company may sell additional equity or debt securities or obtain additional credit facilities. However, there can be no assurance that the Company will be able to sell any additional equity or debt securities or obtain additional credit facilities. Notwithstanding the foregoing, the Company may sell additional equity or debt securities or obtain additional credit facilities at any time.
YEAR 2000
The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs or hardware that have date-sensitive software or embedded chips may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in normal business activities.
Based on recent assessments, the Company determined that it will be required to modify or replace portions of its software so that those systems will properly utilize dates beyond December 31, 1999. The Company presently believes that with modifications or replacements of existing software the Year 2000 issue can be mitigated. However, if such modifications and replacements are not made, or are not completed timely, the Year 2000 issue could have a material impact on the operations of the Company.
The Company's plan to resolve the Year 2000 issue involves the following four phases: assessment, remediation, testing, and implementation. To date, the Company has nearly completed its assessment of all systems that could be significantly affected by the Year 2000. The assessment completed to date indicates that most of the Company's significant information technology systems could be affected. The Company has determined that most of the services it has sold and will continue to sell do not require remediation to be Year 2000 compliant. Accordingly, the Company does not believe that the Year 2000 presents a material exposure as it relates to the Company's services. In addition, the Company has plans to gather information about the Year 2000 compliance status of its significant suppliers and subcontractors and will continue to monitor their compliance.
With regard to the Company's information technology exposure, to date the Company is approximately 90% complete on the assessment phase and expects to complete software reprogramming and replacement no later than May 31, 1999. Once software is reprogrammed or replaced, the Company will begin testing and implementation. These phases will run concurrently for different systems. Completion of the testing phase for all significant systems is expected by July 31, 1999, with all remediated systems fully tested and implemented by August 31, 1999, with 100% completion targeted for September 30, 1999.
The Company is in the process of working with third party vendors to ensure that any of the Company's systems that interface directly with third parties are Year 2000 compliant by May 31, 1999.
The Company has launched a program to query its significant suppliers and subcontractors that do not share information systems with the Company ("external agents"). To date, the Company is not aware of any external agent with a Year 2000 issue that would materially impact the Company's results of
operations, liquidity, or capital resources although the Company understands that certain fuel refiners may be particularly susceptible to disruption caused by non-compliant embedded chips, and that certain electrical power suppliers may be similarly affected. The Company has no means of ensuring that external agents will be Year 2000 ready. The inability of certain external agents, such as the FAA, fuel refiners and suppliers generally, and electrical power suppliers, to complete their Year 2000 resolution process in a timely fashion could materially impact the Company. The effect of non-compliance by external agents is not determinable.
The Company will utilize both internal and external resources to reprogram or replace, test, and implement the software and operating equipment for Year 2000 modifications. The total cost of the Year 2000 project is estimated at less than $0.5 million and is being funded through operating cash flows. As of March 31, 1999, the Company has incurred approximately $150,000 related to all phases of the Year 2000 project. The remaining project costs relate to repair of hardware and software and will be expensed as incurred.
Management of the Company believes it has an effective program in place to resolve the Year 2000 issue in a timely manner. However, it is possible that the Company's or third parties' systems and equipment could fail and result in the reduction or suspension of the Company's operations. As noted above, the Company has not yet completed all necessary phases of the Year 2000 program. Disruptions in the economy generally resulting from Year 2000 issues could materially adversely affect the Company. The amount of potential liability and lost revenue cannot be reasonably estimated at this time.
The Company currently has no contingency plans in place in the event it does not complete all phases of the Year 2000 program. The Company plans to evaluate the status of completion in May 1999 and determine whether such a plan is necessary.
If the Company's expectations or assessments of the impact of the Year 2000 issue prove to be incorrect, the Company's business may be materially affected.
SEASONALITY
Certain customers of the Company engage in seasonal businesses, especially the U.S. Postal Service and customers in the U.S. automotive industry. As a result, the Company's air logistics business has historically experienced its highest quarterly revenues and profitability during the fourth quarter of the calendar year due to the peak Christmas season activity of the U.S. Postal Service and during the period from June 1 to November 30 when production schedules of the U.S. automotive industry typically increase. Consequently, the Company experiences its lowest quarterly revenue and profitability during the first quarter of the calendar year.
FACTORS THAT MAY AFFECT FUTURE RESULTS
We operate in a rapidly changing environment that involves numerous risks, some of which are beyond our control. The following discussion highlights some of these risks.
Substantial Debt and Interest Payments. In November 1997, we incurred substantial debt through:
(1) the issuance of $340 million of 9.95% Senior Secured Notes due 2004; and
(2) entering into the Credit Facility, which currently allows us to borrow up to $90.2 million.
In addition, we entered into a $45.9 million Term Loan to refinance a $45.9 million loan incurred in September 1997. At December 31, 1998, our total debt was approximately $489.8 million. At December 31, 1998, we had borrowed $86.9 million under the Credit Facility and owed approximately $45.9 million under the Term Loan. In addition to the debt we have outstanding, the indenture pursuant to which the Notes were issued (the "Indenture") permits us to incur substantial amounts of additional debt for certain specified purposes, including to acquire aircraft and aircraft-related assets.
Our significant debt could have important consequences, including:
(1) we may be unable to obtain additional financing in the future;
(2) we will have to dedicate a substantial portion of our cash flow to principal and interest payments, which will reduce funds available for other purposes;
(3) we may be at a competitive disadvantage to competitors with less debt;
(4) we may be unable to adjust rapidly to changing market conditions; and
(5) we may be more vulnerable to:
(A) downturns in general economic conditions;
(B) downturns in our business; and
(C) the temporary or permanent loss of business from one or more of our customers.
Our ability to make scheduled principal and interest payments or to refinance our debt will depend on our future financial performance, which to a certain extent will be subject to economic, financial, competitive and other factors beyond our control. We cannot assure you that our business will generate sufficient cash flow to make principal and interest payments on time and to make necessary capital expenditures. If we cannot do this, we may be required to seek to refinance all or a portion of our debt, to sell assets or to obtain additional financing, any of which we may be unable to do on acceptable terms.
Restrictive Covenants. Our existing debt agreements contain a number of significant covenants. These covenants generally limit our ability, among other things, to:
(1) pay dividends;
(2) incur additional debt, except for certain specified purposes;
(3) encumber or sell assets;
(4) enter into transactions with stockholders and affiliates;
(5) guarantee debt;
(6) merge or consolidate with another entity; and
(7) transfer or lease all or substantially all of our assets.
These covenants also require us to meet certain financial tests. As of the date hereof, we are in compliance with these covenants. Our ability to comply with these covenants in the future will depend on our future financial performance. If we are unable to comply with these covenants, there would be a default under our debt agreements. If the lender did not waive such a default, the default could result in acceleration of our debt and our bankruptcy.
Integrating the Kalitta Companies. On November 19, 1997, we acquired five companies (collectively, the "Kalitta Companies"):
(1) American International Airways, Inc., which has been renamed Kitty Hawk International, Inc.;
(2) American International Travel, Inc.;
(3) Flight One Logistics, Inc.;
(4) Kalitta Flying Service, Inc., which has been renamed Kitty Hawk Charters, Inc.; and
(5) O.K. Turbines, Inc.
Over the last 16 months, we have been integrating the Kalitta Companies' operations with our pre-acquisition operations. We cannot assure you that we will be able to successfully complete integrating the Kalitta Companies' operations or achieve the goals that motivated us to acquire the Kalitta Companies, either of which could have a material adverse effect on our business and the value of the common stock.
Continued Losses at Kitty Hawk International. From the period January 1, 1997 through November 18, 1997, Kitty Hawk International, then owned by Mr. Kalitta under the name American International Airways, Inc., suffered substantial net losses. Although Kitty Hawk International's 1998 financial results improved from its 1997 financial results, Kitty Hawk International still suffered a net loss of $4.8 million in 1998. In an effort to make Kitty Hawk International profitable, we recently have:
(1) stopped providing third party airframe repair and engine overhaul services, other than for JT3 and JT8 engines;
(2) stopped passenger charters and parked the two Boeing 747s and two Lockheed L-1011s that flew passenger charters pending their disposition, possible cargo conversion or employment in other uses;
(3) outsourced the majority of our major maintenance on our Boeing 747, Lockheed L-1011 and Douglas DC-8 aircraft, except for the overhaul of JT3 engines used on Douglas DC-8 aircraft; and
(4) eliminated approximately 450 jobs at Kitty Hawk International.
In addition, we intend to:
(1) eliminate approximately 1,050 additional jobs at Kitty Hawk International;
(2) close surplus portions of our Oscoda, Michigan maintenance facility; and
(3) reduce Kitty Hawk International's owned and leased operating fleet from 36 aircraft at December 31, 1998 to 19 aircraft at December 31, 1999, consisting of seven Boeing 747s, six Lockheed L-1011s and six Douglas DC-8s.
Failure to make Kitty Hawk International profitable could have a material adverse effect on our business and the value of the common stock.
Dependence on Significant Customers. Our two largest customers are the U.S. Postal Service and BAX Global. Of our total revenues in 1997, the U.S. Postal Service accounted for $44.9 million, or 17.9%, and BAX Global accounted for $44.7 million, or 17.9%. Of our total revenues in 1998, the U.S. Postal Service accounted for $120 million, or 16.8%, and BAX Global accounted for $71.5 million, or 10%.
The U.S. Postal Service awards contracts periodically pursuant to a public bidding process which considers quality of service and other factors, including, to a lesser extent, price. Bids for contracts to provide Christmas season charters generally are submitted in the summer of each year and are typically awarded during the following fall. These contracts are typically for one year or less. Our inability to remain competitive with respect to price and quality of service would have a material adverse effect on our ability to obtain such contracts. Our inability to obtain such contracts in the future would have a material adverse effect on our business and the value of the common stock. Our contracts with the U.S. Postal Service are subject to termination at the convenience of the U.S. Postal Service.
BAX Global leases under an ACMI contract 14 of our Boeing 727s for varying terms through March 31, 2003. BAX Global may earlier terminate the contract if, among other reasons, we do not meet specified on-time performance standards or if majority ownership or control of the Company is acquired by a competitor of BAX Global. The loss of this customer, or a reduction in this customer's use of our services, could have a material adverse effect on our business and the value of the common stock.
Dependence on Aircraft Availability. Our revenues are dependent on having aircraft available for revenue service. In the past, we have experienced unanticipated FAA Airworthiness Directives that have made aircraft unavailable for revenue service. In the event one or more of our aircraft are out of service
for an extended period of time, whether due to Directives, accidents or otherwise, we may be forced to lease or purchase replacement aircraft and may be unable to fulfill our obligations under customer contracts. We cannot assure you that if necessary, we could locate suitable replacement aircraft on acceptable terms. We do not maintain business interruption insurance to cover these risks. Loss of revenue from any such business interruption, damages for non-performance under customer contracts or costs to replace aircraft could have a material adverse effect on our business and the value of the common stock.
Cyclicality and Seasonality. We provide services to numerous industries and customers that experience significant fluctuations in demand based on economic conditions and other factors beyond our control. Demand for our services could be materially adversely affected by downturns in our customers' businesses. We believe a significant percentage of our revenues will continue to be generated from services provided to the U.S. automotive industry, which has historically been a cyclical industry. A contraction in the U.S. automotive industry, a prolonged work stoppage or other significant labor dispute involving that industry, or a reduction in the use of air freight charters by that industry, could have a material adverse effect on our business and the value of the common stock.
Certain of our customers engage in seasonal businesses too, especially the U.S. Postal Service and customers in the U.S. automotive industry. As a result, our air carrier business and air freight charter logistics business have historically experienced their highest quarterly revenues and profitability during the last three months of the year due to the peak Christmas season activity of the U.S. Postal Service and during the period from June 1 to November 30 when production schedules of the U.S. automotive industry typically increase. Consequently, we historically experience our lowest quarterly revenue and profitability during the first three months of the year.
Dependence on Key Personnel. We believe that our success depends on, and will continue to depend on, the services of:
(1) M. Tom Christopher, our founder and our Chairman of the Board of Directors and Chief Executive Officer;
(2) Tilmon J. Reeves, our President and Chief Operating Officer; and
(3) Richard R. Wadsworth, our Senior Vice President -- Finance, Chief Financial Officer and Secretary.
If we lose the services of any of them, and in particular Mr. Christopher, our business and the value of the common stock could be materially adversely affected. Each of Messrs. Christopher, Reeves and Wadsworth have employment agreements with the Company.
Employee Relations. The pilots and flight engineers employed by Kitty Hawk International are members of the International Brotherhood of Teamsters and are employed pursuant to a collective bargaining agreement. We are in the process of renegotiating this collective bargaining agreement with representatives of the Teamsters. These pilots and flight engineers have rejected one proposed new collective bargaining agreement.
We believe the current collective bargaining agreement's system for scheduling pilots and flight engineers is inefficient, which results in higher costs to us. While we are negotiating to make this scheduling system more efficient, we cannot assure you that we will be successful in these negotiations. Failure to negotiate a more efficient scheduling system could have a material adverse effect on our business and the value of the common stock.
While we intend to negotiate with the Teamsters in good faith, we cannot assure you that we will be able to enter into a new collective bargaining agreement. In addition, negotiations could result in work stoppages, a substantial increase in salaries or wages, changes in work rules or other changes adverse to our business. Also, we cannot assure you that our non-union cockpit crews will remain non-union. Unionization of our non-union cockpit crews, work stoppages, increased wages or other labor-related matters could have a material adverse effect on our business and the value of the common stock.
Dependence on Computer Systems. We utilize a number of computer systems to schedule flights and personnel, track aircraft and freight, bill customers, pay expenses and monitor a variety of our activities, ranging from maintenance and safety compliance to financial performance. The failure of the hardware or software that support these computer systems, or the loss of data contained in any of them, could significantly disrupt our operations, which could have a material adverse effect on our business and the value of the common stock.
While we believe our computer systems are generally year 2000 compliant, the computer systems of the FAA and our customers, suppliers, vendors, bankers, maintenance providers and air logistics service providers may not be year 2000 compliant. Failure of the computer systems of the FAA or one or more of our significant customers, suppliers, vendors or air logistics service providers to correctly record, manipulate or retrieve dates from the year 2000 and beyond could have a material adverse effect on our business and the value of the common stock. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Year 2000."
Certain Anti-Takeover Provisions; Preferred Stock. Our Certificate of Incorporation, as amended, and Bylaws, as amended, include certain provisions that have anti-takeover effects and that could make it more difficult for a third party to acquire control of the Company, even if such change in control would be beneficial to our stockholders. In addition, the Certificate of Incorporation limits the aggregate voting power of non-U.S. persons to 22 1/2% of the votes voting on or consenting to any matter and prohibits non-U.S. citizens from serving as directors or officers of the Company.
The Certificate of Incorporation allows us to issue up to 1,000,000 shares of preferred stock without stockholder approval. In addition, we could issue preferred stock with voting and conversion rights that could adversely affect the voting power of holders of common stock. The issuance of preferred stock could also result in a series of securities outstanding that would have preferences over the common stock with respect to dividends and in liquidation. Any of the foregoing could have a material adverse effect on the value of the common stock.
Effects of a Change of Control. Holders of the Notes have the right to require us to repurchase the Notes upon a Change of Control (as defined in the Indenture) and all debt under the Credit Facility and Term Loan must be repaid upon a Change of Control (as defined in the Credit Facility). Any of the foregoing provisions could have a material adverse effect on our business and the value of the common stock.
Government Regulation. We are subject to Title 49 of the United States Code (formerly the Federal Aviation Act of 1958, as amended), under which the DOT and the FAA exercise regulatory authority over air carriers. The DOT and the FAA have the authority to modify, amend, suspend or revoke the authority and licenses issued to us for failure to comply with the provisions of law or applicable regulations. In addition, the DOT and the FAA may impose civil or criminal penalties for violations of applicable rules and regulations. Such actions by the FAA or the DOT, if taken, could have a material adverse effect on our business and the value of the common stock.
The adoption of new laws, policies or regulations or changes in the interpretation or application of existing laws, policies or regulations, whether by the FAA, the DOT, the U.S. government or any foreign, state or local government, could have a material adverse effect on our business and the value of the common stock. In addition, we are subject to regulation by various other federal, state, local and foreign authorities, including the Department of Defense and the Environmental Protection Agency.
Our international operations are governed by air services agreements between the U.S. and foreign countries where we operate. Under some of these air services agreements, traffic rights in those countries are available to only a limited number of and in some cases only one or two, U.S. air carriers and are subject to approval by the applicable foreign regulators, limiting growth opportunities in such countries.
Safety, Training and Maintenance Regulations. Virtually every aspect of our air carrier operations are subject to extensive FAA regulation, including the areas of safety, training and maintenance. To ensure compliance with FAA rules and regulations, the FAA routinely inspects air carrier operations and aircraft
and proposes civil monetary penalties in the event of non-compliance. The imposition of civil penalties by the FAA could have a material adverse effect on our business and the value of the common stock.
Periodically, the FAA focuses on particular aspects of air carrier operations. For example, after the Valujet accident, the FAA adopted new procedures concerning oversight of contract maintenance, and after the Fine Air crash, the FAA conducted extensive inspections of procedures for loading cargo aircraft. These types of inspections and regulations often impose additional burdens on air carriers and increase their operating costs. We cannot predict when we will be subject to such inspections or regulations, nor the impact of such inspections or regulations. Any such inspections or regulations could have a material adverse effect on our business and the value of the common stock.
Aging Aircraft Regulations; Potential Compliance Costs. All of our aircraft are subject to FAA Directives issued at any time under the FAA's "Aging Aircraft" program or issued on an ad hoc basis. These Directives can cause us to conduct extensive examinations and structural inspections of our aircraft and to make modifications to our aircraft to address or prevent problems of corrosion and structural fatigue.
Our cost to comply with FAA Directives issued under the Aging Aircraft program cannot currently be estimated, but could be substantial and could have a material adverse effect on our business and the value of the common stock.
Hazardous Materials Regulations. The FAA exercises regulatory jurisdiction over transporting hazardous materials. From time to time, we transport articles that are subject to these regulations. Shippers of hazardous materials share responsibility with the air carrier for compliance with these regulations and are primarily responsible for proper packaging and labeling. If we fail to discover any undisclosed hazardous materials or mislabel or otherwise ship hazardous materials, we may suffer possible aircraft damage or liability, as well as, substantial monetary penalties. Any of these events could have a material adverse effect on our business and the value of the common stock. The FAA has recently increased its monitoring of shipments of hazardous materials.
Contraband Risks. Although required to do so, customers may fail to inform us about cargo that must be processed by applicable customs authorities. If we fail to properly process cargo through customs, our aircraft could be seized and/or we may suffer substantial monetary penalties. Any of these events could have a material adverse effect on our business and the value of the common stock.
In addition, some of our aircraft fly to and from countries, such as Colombia, where substantial quantities of illegal drugs are manufactured. In the past, without our prior knowledge, individuals have tried to smuggle illegal drugs into the U.S. on our aircraft. If we fail to discover any illegal drugs or other illegal cargo on our aircraft, the aircraft could be seized and/or we may suffer substantial monetary penalties. Any of these events could have a material adverse effect on our business and the value of the common stock.
Competition. The market for air freight services is highly competitive. Our air freight carrier services are also subject to competition from other modes of transportation, including, but not limited to, railroads and trucking. Additional demand for air freight carrier services over the last few years has resulted in numerous new entrants in this business. We believe there are limited barriers to entry into this business and that increased demand may stimulate additional competition.
The market for air logistics also has been and is expected to remain highly competitive. Our principal competitors for on-demand air logistics services are other air logistics companies, air freight carriers which seek to book charters directly with customers and air freight companies that offer expedited service.
Our ability to attract and retain business also is affected by whether and to what extent our customers decide to coordinate their own transportation needs. With respect to our contract charter business, it could be adversely affected by the decision of our air carrier customers to acquire additional aircraft or by our non-air carrier customers to acquire and operate their own aircraft. In this regard, many of our competitors and customers have substantially greater financial resources than us.
Environmental Matters. Our operations must comply with numerous environmental laws, ordinances and regulations. Under current federal, state and local environmental laws, ordinances and regulations, a current or previous owner or operator of real property may be liable for the costs of removal or clean up of hazardous or toxic substances on, under or in such property. Such laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to clean up such contaminated property properly, may adversely affect the ability of the owner of the property to use such property as collateral for a loan or to sell such property. Environmental laws also may impose restrictions on the manner in which a property may be used or transferred or in which businesses may be operated and may impose remedial or compliance costs. The costs of defending against claims of liability or cleaning up contaminated property and the cost of complying with environmental laws could have a material adverse effect on our business and the value of the common stock.
Currently, we are not aware of any environmental contamination for which we are liable for the cost of removal or cleanup. Until May 2001, Mr. Kalitta has agreed, subject to certain limitations, to indemnify us against any losses arising from any environmental liability at any of the Kalitta Companies' facilities.
In part because of the highly industrialized nature of many of the locations at which we operate, there can be no assurance that we have discovered all environmental contamination for which we may be responsible.
Capital Intensive Nature of Aircraft Ownership. Our air freight carrier business is highly capital intensive. In order to expand our air freight carrier business, we intend to purchase new or used jet aircraft. Used jet aircraft typically require certain modifications, including reconfiguring the aircraft from passenger to cargo use and installing equipment to comply with the Noise Regulations. The market for used jet aircraft is volatile and can be adversely affected by limited supply, increased demand and other market factors. We cannot assure you that we will be able to purchase and, if necessary, modify additional aircraft at favorable prices or that we will have or be able to obtain sufficient resources with which to make such purchases and, if necessary, modifications. The capital intensive nature of our business could adversely impact the value of the common stock.
In the future, we may acquire domestic and/or international air freight carriers as a means of acquiring used jet aircraft. Such an acquisition would involve substantial risks, including overvaluing the acquired business and inadequately or unsuccessfully integrating the acquired business. In addition, the terms of the Credit Facility and Term Loan restrict our ability to make certain acquisitions. Further, acquisitions can result in increased amortization which would reduce earnings per share in the future. We may finance future acquisitions, if any, by issuing shares of common stock. Any future issuance of common stock may result in substantial dilution to you.
Operating Costs. The operation of our air freight carrier business involves considerable operational, maintenance, fuel and personnel costs. Our financial results can be adversely affected by unexpected engine or airframe repairs, compliance with Directives and regulations of the FAA and associated aircraft downtime. In addition, spare or replacement parts and components may not be readily available in the marketplace. Failure to obtain necessary parts or components in a timely manner or at favorable prices could have a material adverse effect on our business and the value of the common stock.
Fuel is a significant cost of operating aircraft. Both the cost and availability of fuel are subject to many economic and political factors and events occurring throughout the world and recently the cost of fuel has fluctuated markedly and may rise in 1999. We have no agreement with any fuel supplier assuring the availability or price stability of fuel and such agreements are generally not available in the industry. We generally pass on fuel cost increases to our customers under ACMI charter contracts. However, under some of our contracts and in our scheduled operations, we absorb increased fuel costs. Accordingly, the future cost and availability of fuel to us cannot be predicted and substantial price increases in, or the unavailability of adequate supplies of, fuel may have a material adverse effect on our business and the value of the common stock.
Volatility of Air Freight Services Market. The demand for air freight services is highly dependent on the strength of both the domestic and global economy. Although the air freight services industry has experienced strong growth over the last several years, general economic downturns could have a material adverse effect on our business and the value of the common stock.
Utilization of Aircraft. Our operating results are highly dependent on our ability to effectively utilize our diverse fleet of aircraft. There can be no assurance, however, that operation of any of the various types of aircraft in our fleet will prove to be profitable. Inability to keep our aircraft in revenue service or achieve an acceptable level of aircraft utilization could have a material adverse effect on our business and the value of the common stock.
Risk of Accident; Insurance Coverage and Expenses. Our operations involve risks of potential liability against us in the event of aircraft accidents and, in the case of our air ambulance services, for medical malpractice. We are required by the DOT to carry liability insurance on each of our aircraft. We also carry medical liability insurance for our air ambulance business. Although we believe our current insurance coverage is adequate and consistent with current industry practice, we cannot assure you that our coverage will not be changed or that we will not suffer substantial losses and lost revenues from accidents. See "-- Dependence on Aircraft Availability." Substantial claims resulting from an accident in excess of our insurance coverage could have a material adverse effect on our business and the value of the common stock. In addition, any significant increase in our current insurance expense could have a material adverse effect on our business and the value of the common stock. Moreover, any aircraft accident, even if fully insured, could result in Directives or investigations or could cause a public perception that some of our aircraft are less safe or reliable than other aircraft, which could have a material adverse effect on our business and the value of the common stock.
International Business Risk. We expect to continue to derive a substantial portion of our revenues from providing air freight carrier services to customers in South and Central America and the Pacific Rim. The risks of doing business in foreign countries include:
(1) potential adverse changes in the diplomatic relations between foreign countries and the U.S.;
(2) hostility from local populations directed at a U.S. flag carrier;
(3) government policies against foreign-owned businesses;
(4) adverse effects of currency exchange controls;
(5) restrictions on the withdrawal of foreign investment and earnings; and
(6) the risk of expropriation and insurrections that could result in losses against which we are not insured.
Our international operations also are subject to economic uncertainties, including risks of renegotiation or modification of existing agreements or arrangements with exchange restrictions and changes in taxation. Any of these events could have a material adverse effect on our business and the value of the common stock.
Nearly all of our revenue is in U.S. dollars. However, a meaningful portion of our revenue is from customers whose revenue is not in U.S. dollars. Therefore, any significant devaluation in our customers' currencies relative to the U.S. dollar could adversely effect their ability to pay us in U.S. dollars or to continue to use our services, which could have a material adverse effect on our business and the value of the common stock.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In 1997, the Securities and Exchange Commission issued new rules (Item 305 of Regulation S-K) which require disclosure of material risks, as defined in Item 305, related to market risk sensitive financial instruments. The rules apply to the Company for the first time in 1998. The Company has market risk sensitive instruments related to interest rates.
Airline operators are inherently capital intensive. The vast majority of the Company's assets are aircraft, which are long lived. The Company has maintained a B+, B1 or equivalent credit ratings on its Notes with three rating agencies (Standard & Poor's, Moody's and Duff & Phelps).
As disclosed in Note 4 to the Consolidated Financial Statements, the Company had outstanding debt of $489.8 million and $404.6 million at December 31, 1998 and 1997, respectively. This debt represents 49.8% and 48.3% of total assets at December 31, 1998 and 1997, respectively. The Company's long-term debt currently has an average maturity of 5.4 years and interest rates averaging 9.7%.
At December 31, 1998, the Company operated six aircraft under operating leases at rates that are substantially fixed. As defined in Item 305, leases are not market risk sensitive financial instruments and, therefore, are not included in the interest rate sensitivity analysis below. Commitments related to leases are disclosed in Note 6 to the Consolidated Financial Statements.
The Company does not have significant exposure to changing interest rates on its $340 million 9.95% Senior Secured Notes because the interest rate on the Notes is fixed. The interest rates on its Term Loan and Credit Facility are variable with interest rates based on prime plus 1.75% or LIBOR plus 3.25%, and can be locked in for a period of three months. At December 31, 1998, the Company had approximately $45.9 million outstanding under the Term Loan and approximately $86.9 million outstanding under the Credit Facility.
Additionally, the Company does not have significant exposure to changing interest rates on invested cash, which was approximately $17 million and $75 million at December 31, 1998 and 1997, respectively. The Company invests its cash mainly in money market accounts.
The Company has not undertaken any additional actions to cover interest rate market risk and is not a party to any interest rate market risk management activities.
A hypothetical 10% decline in market interest rates over the next year would impact the Company's earnings or cash flow by less than $1 million because the interest rate on the Notes is fixed and its cash investments are short-term. A hypothetical 10% decline in market interest rates over the next year would increase the fair value of the Notes by approximately $15 million.
The Company does not purchase or hold any derivative financial instruments for trading purposes.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The response to Item 8 is submitted as a separate section of this Form 10-K. See "Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information regarding directors required by Item 10 is incorporated by reference from our definitive proxy statement for our 1999 Annual Meeting of Stockholders to be held on May 28, 1999. The information regarding executive officers required by Item 10 is submitted as a separate section of this Form 10-K. See "Item 4A. Executive Officers of the Registrant."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference from our definitive proxy statement for our 1999 Annual Meeting of Stockholders to be held on May 28, 1999.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated by reference from our definitive proxy statement for our 1999 Annual Meeting of Stockholders to be held on May 28, 1999.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated by reference from our definitive proxy statement for our 1999 Annual Meeting of Stockholders to be held on May 28, 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(A) 1. FINANCIAL STATEMENTS
The following financial statements are filed as a part of this report:
(A) 2. FINANCIAL STATEMENT SCHEDULES
No financial statement schedules are filed as part of this Annual Report on Form 10-K because the required information is included in the financial statements, including the notes thereto, or circumstances requiring the inclusion of such schedules are not present.
(A) 3. EXHIBITS
The following exhibits are filed herewith or are incorporated by reference to exhibits previously filed with the Securities and Exchange Commission.
- ---------------
* Filed herewith.
** This exhibit is a management contract or compensatory plan or arrangement.
(b) REPORTS ON FORM 8-K
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on our behalf by the undersigned, thereunto duly authorized, on the 30th day of March, 1999.
KITTY HAWK, INC.
By: /s/ RICHARD R. WADSWORTH ---------------------------------- Richard R. Wadsworth Senior Vice President -- Finance, Chief Financial Officer and Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 30th day of March, 1999.
KITTY HAWK, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT AUDITORS
Stockholders Kitty Hawk, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Kitty Hawk, Inc. and subsidiaries as of December 31, 1997 and 1998 and the related consolidated statements of income, stockholders' equity, and cash flows for the year ended August 31, 1996, for each of the two years in the period ended December 31, 1998 and for the four months ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Kitty Hawk, Inc. and subsidiaries at December 31, 1997 and 1998 and the consolidated results of their operations and their cash flows for the year ended August 31, 1996, for each of the two years in the period ended December 31, 1998 and for the four months ended December 31, 1996, in conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
Dallas, Texas March 26, 1999
KITTY HAWK, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
ASSETS
See accompanying notes.
KITTY HAWK, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
See accompanying notes.
KITTY HAWK, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes.
KITTY HAWK, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes.
KITTY HAWK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1998
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
Kitty Hawk, Inc. and its subsidiaries (the "Company") provide air freight services through four related businesses: (i) an air freight carrier, (ii) a scheduled freight service provider, (iii) an air logistics service provider and (iv) a maintenance operation. The air freight carrier provides ACMI services (includes supplying the aircraft, crew, maintenance, and insurance for the customer), passenger and freight charter services. The air logistics service provider arranges the delivery of time sensitive freight utilizing third parties as well as its own fleet of wide-body and narrow-body jet aircraft and small jet and prop aircraft. The scheduled freight service provides an overnight freight service within a network of approximately 46 North American cities and a service between Los Angeles, the Hawaiian islands and several Pacific Rim countries utilizing its own aircraft. The maintenance operation provides engine overhaul services to third parties on JT3 engines used on Douglas DC8s and JT8 engines used on Boeing 727s, Douglas DC9s and other aircraft. Revenues and costs of revenues related to the scheduled freight services and its small aircraft operations are currently reported as a component of the air freight carrier in the accompanying statements of income. The Company has discontinued its passenger charter operations and curtailed its third party maintenance operations. See Notes 14 and 19.
In November 1997, the Company acquired the Kalitta Companies (see Note 2). The results of operations of the Kalitta Companies are included in the accompanying financial statements from November 19, 1997, the date of their acquisition by the Company.
On December 4, 1996, the Company elected to change its fiscal year end to December 31. Operating results for the four month periods ended December 31, 1996 and 1995 are not necessarily indicative of the results that may be expected for a calendar year. Operating results for the four month period ended December 31, 1995 (unaudited) include all adjustments management believes are necessary for a fair presentation.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, which include Kitty Hawk Charters, Inc., Kitty Hawk Aircargo, Inc., Aircraft Leasing, Inc., Kitty Hawk International, Inc. (formerly named American International Airways, Inc. ("AIA")), (including its partnership interest in American International Cargo ("AIC"), which at December 31, 1998 was a 60% interest), Flight One Logistics, Inc. ("FOL"), O.K. Turbines, Inc. ("OKT"), American International Travel, Inc. ("AIT") and Longhorn Solutions, Inc. ("LSI"). All significant intercompany accounts and transactions have been eliminated in consolidation. See Note 2.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand and held in banks, money market funds, and other investments with original maturities of three months or less.
KITTY HAWK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Restricted Cash and Short-Term Investments
At December 31, 1997 and 1998, restricted cash and short-term investments equaled approximately $58.6 million and $2 million, respectively. Of the balance at the end of 1997, $56 million represents a portion of the proceeds from the issuance of $340 million of 9.95% Senior Secured Notes due 2004 (the "Notes") (see Note 4) reserved for the acquisition and subsequent modification of two Boeing 747 aircraft, which were acquired and modified to cargo configuration during 1998 at a cost of approximately $75 million. These two aircraft are pledged to secure the Notes. The remaining $2.6 million at the end of 1997 of and the balance of $2 million at the end of 1998 represents passenger cash deposits held in escrow until charter services are provided. The Company has subsequently discontinued its passenger charter operations.
Financial Instruments
The fair value of the 9.95% Senior Secured Notes is approximately $333.2 million based on the quoted price at December 31, 1998. Based on floating interest rates provided in the remaining financial instruments, management believes the recorded value of the remaining financial instruments included in the financial statements approximates fair value.
Inventory and Aircraft Supplies
Inventory and aircraft supplies consist of aircraft parts and supplies and are stated at the lower of cost (using the first-in, first-out or average cost convention) or market.
Property and Equipment
Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, with estimated residual values of up to 10% for aircraft and core values of up to $300,000 for engines. Estimated useful lives are as follows:
Expenditures for additions, improvements, aircraft modifications, engine overhauls and major maintenance costs are capitalized. Routine maintenance and repairs are charged to expense when incurred. Costs of periodic airframe maintenance (C-checks) are accrued. Major maintenance and engine overhauls are depreciated on a straight line basis to the next scheduled major maintenance or overhaul date.
Revenue Recognition
Revenues are recognized as services are provided.
KITTY HAWK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Concentration of Credit Risk
Credit is extended based on an evaluation of a customer's financial condition and, except in the case of passenger charters, the Company does not require a deposit or collateral. The Company's allowance for doubtful accounts is based on current market conditions and continuous evaluation of the customer's credit worthiness and has consistently been within management's expectations.
Stock-Based Compensation
The Company accounts for stock-based compensation utilizing Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock- Based Compensation" ("SFAS No. 123"). Under the provisions of SFAS No. 123, the Company has elected to continue to apply the provisions of APB Opinion No. 25 to its stock-based compensation arrangements and provide supplementary financial statement disclosures as required under SFAS No. 123. See Note 8.
Comprehensive Income
In 1997, the FASB issued Statement of Financial Accounting Standards No. 130 ("SFAS 130") "Reporting Comprehensive Income." SFAS 130 establishes standards for reporting and displaying comprehensive income and its components in a full set of financial statements. The Company's comprehensive income equals its net income as the Company has no elements of other comprehensive income.
Reclassifications
Certain amounts from prior years have been reclassified to conform to the current year presentation, including the reclassification of revenues and related costs of revenues for the Company's Christmas work for the United States Postal Service from air logistics to air freight carrier.
Pending Accounting Pronouncements
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging Activities," which is effective for fiscal years beginning after June 15, 1999. SFAS 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. The Company is assessing the impact that the adoption of SFAS 133 will have on its consolidated financial statements.
2. ACQUISITIONS
On November 19, 1997, the Company acquired by merger all of the outstanding common stock of AIA, Kalitta Flying Service, Inc., FOL, OKT and AIT (collectively, the "Kalitta Companies") in exchange for 4,099,150 shares of the Company's common stock valued by an independent appraisal at approximately $60.3 million and $20 million in cash. The transaction has been accounted for as a purchase and accordingly the results of operations of the Kalitta Companies are included in the accompanying financial statements from November 19, 1997. See Note 18. Since then, AIA has been renamed Kitty Hawk International, Inc. and Kalitta Flying Service, Inc. has been renamed Kitty Hawk Charters, Inc.
In accordance with the merger agreement, $3 million in cash and 650,000 shares of the Company's common stock issued to the former owner of the Kalitta Companies are being held in escrow to secure certain indemnity obligations. Generally the Company cannot bring any indemnification claims after
KITTY HAWK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
May 19, 2000, except the Company may make indemnity claims for certain environmental matters until May 19, 2001.
In September 1997, as an interim step to the acquisition of the Kalitta Companies, the Company acquired 16 Boeing 727s from AIA for approximately $51 million cash. Of the $51 million, $45.9 million was financed with a note payable under the Company's existing credit facility. This note payable was subsequently refinanced upon the consummation of the acquisition of the Kalitta Companies. See Note 4.
On June 26, 1998, the Company acquired all the outstanding stock of LSI in exchange for 150,000 shares of the Company's common stock, valued at $15 per share, which approximated market value at the date of acquisition. The transaction was accounted for as a purchase and accordingly the results of operations for the year ended December 31, 1998 include the results of operations of LSI from June 26, 1998. LSI has developed and markets an aircraft maintenance software package. No pro forma financial statements are provided for the acquisition of LSI due to the immateriality of the acquisition.
3. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
4. LONG-TERM DEBT AND REVOLVING CREDIT FACILITY
Long-term debt and Revolving Credit Facility consist of the following:
KITTY HAWK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Maturities of long-term debt at December 31, 1998 are as follows:
In connection with the acquisition of the Kalitta Companies in November 1997, the Company privately placed the Notes pursuant to Rule 144A of the Securities Act of 1933. Net proceeds to the Company were $329.1 million. Costs incurred in issuing the Notes are being amortized over seven years. The net proceeds of the Notes, along with the net proceeds of a November 1997 3,000,000 share common stock offering, were used to (i) refinance approximately $33 million of existing Kitty Hawk debt and to pay off approximately $250 million of the Kalitta Companies' pre-acquisition debt, (ii) provide for $56 million of cash to acquire and modify two Boeing 747s and (iii) provide for $20 million of cash to acquire the Kalitta Companies. The balance was used for working capital and expenses incurred in connection with the acquisition.
Interest on the Notes is due on May 15 and November 15. The Notes are secured by a fleet of aircraft including nine Boeing 747s, eight Lockheed L-1011s and 13 Boeing 727s. At December 31, 1998 the carrying value of the aircraft securing the Notes is approximately $415 million. Each of the Company's subsidiaries are guarantors of the Notes, excluding the Company's interest in AIC. The Company is in the process of dissolving AIC. Once AIC is dissolved, all of the Company's subsidiaries will be guarantors of the Notes. In March 1998, the Company concluded an exchange offer for the Notes thereby exchanging the Notes for new 9.95% Senior Secured Notes due 2004 (the "New Notes"). The form and terms of the New Notes are identical to the Notes, except the New Notes are registered under the Securities Act of 1933 and therefore do not bear a legend restricting their transfer.
The New Notes provide for certain covenants which limit the amount of indebtedness of the Company and its subsidiaries, restrict the payment of dividends, restrict the selling of subsidiary stock and provide for an interest coverage ratio. As of December 31, 1998, the Company was in compliance with all applicable covenants.
The New Notes are due in full in November 2004. However, at any time after November 15, 2001, the Company at its option may redeem the New Notes based on a percentage of the principal balance plus accrued and unpaid interest. The redemption rates are: (i) during the 12 month period beginning November 15, 2001, 104.975%, (ii) during the 12 month period beginning November 15, 2002, 102.488% and (iii) during the 12 month period beginning November 15, 2003, 100%. Additionally, any time prior to November 15, 2000, the Company may redeem up to 35% of the original principal amount of the New Notes with the proceeds of one or more public offerings at a redemption price of 109.95% plus accrued and unpaid interest, provided that at least $150 million of aggregate principal amount of the New Notes remains outstanding after each redemption.
On November 19, 1997, the Company entered into a credit agreement (the "Credit Agreement") with a bank which provides for a $45.9 million Term Loan (the "Term Loan") and a $100 million Revolving Credit Facility (the "Revolver"). The proceeds of the Term Loan were used to fully refinance a note previously entered into in September 1997, the proceeds of which were used to acquire 16 Boeing 727s from AIA prior to the acquisition of the Kalitta Companies (see Note 2). The Term Loan is
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
due in 16 quarterly principal installments of $2.25 million each beginning in March 1999, with the balance due upon maturity in November 2002. Except as provided below, the Term Loan bears interest at the Company's option at either prime plus 0% to 1.5% or LIBOR plus 1.25% to 3% (margins above prime and LIBOR are based on certain financial covenant performance as defined in the Credit Agreement). The applicable rate at December 31, 1998 was 8.5%.
Borrowings under the Revolver provide the Company with cash availability for working capital and general corporate purposes. Except as provided below, advances under the Revolver bear interest at the Company's option at either prime plus 0% to 1.25% or LIBOR plus 1.25% to 2.75% (margins above prime and LIBOR are based on certain financial covenant performance as defined in the Credit Agreement). The applicable rate at December 31, 1998 was 9.5%. All principal balances outstanding under the Revolver are due in full upon maturity in November 2002. Balances drawn on the Revolver are subject to certain borrowing base provisions as defined. The borrowing base at December 31, 1998 was $93.9 million (including an increase of $30 million to the borrowing base as a result of an amendment to the Credit Agreement ("the Amendment") on December 10, 1998). Available borrowings as of December 31, 1998 were approximately $6.1 million.
In connection with the Amendment, the Company pledged 11 Douglas DC-8-60s and eight Douglas DC-8-50s under the Credit Facility and Term Loan. The Company can request WFB to release its liens on the Douglas DC-8-50 aircraft at any time in connection with a sale of the aircraft for full and fair consideration. With respect to the Douglas DC-8-60 aircraft, the Company can request WFB to release its liens on the Douglas DC-8-60s after first repaying the amount it borrowed, if any, under the Amendment's $30 million increase to the borrowing base. Prior to December 31, 1999, WFB is not obligated to release its liens on the Douglas DC-8-60s except in connection with a sale of the aircraft for full and fair consideration. After December 31, 1999, WFB is not obligated to release its liens on the Douglas DC-8-60s unless the Company meets specified financial criteria.
The Amendment's increase in the borrowing base is available through January 1, 2000, or until earlier terminated by the Company ("Loan Pricing Increase Period"). During the Loan Pricing Increase Period, the interest rate of the Term Loan and the Revolver is either prime plus 1.75% or LIBOR plus 3.25%, regardless of financial covenant performance. Upon termination of this borrowing base increase, the interest rates on the Term Loan and the Revolver revert to those stated above.
The balances outstanding under the Credit Agreement are secured by 15 Boeing 727s and 19 Douglas DC-8s with a total combined carrying value of approximately $134 million at December 31, 1998, cash, accounts receivable, rotable parts, inventory, intangibles and contract rights of the Company, and the stock of each of the Company's subsidiaries, not including the Company's interest in AIC. Each of the Company's subsidiaries are guarantors on the Credit Agreement, exclusive of AIC. Costs incurred in connection with the Credit Agreement are being amortized over a period of five years. The Credit Agreement allows for up to $20 million of outstanding letters of credit, subject to the borrowing base provisions, as defined. As of December 31, 1998, the Company had approximately $0.9 million of letters of credit outstanding. Borrowings under the Credit Agreement are subject to certain financial covenants, including a funded debt to EBITDA ratio, a minimum debt service coverage ratio and limitations on capital expenditures. As of December 31, 1998, the Company was in compliance with all covenants under the Credit Agreement.
The Company made total cash interest payments of $1.8 million, $3.1 million, $40.7 million and $664,000 during fiscal year ended August 31, 1996, the fiscal years ended December 31, 1997 and 1998 and for the four months ended December 31, 1996, respectively. Interest expense capitalized during fiscal years ended December 31, 1997 and 1998, was $325,000 and $3.4 million, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. INCOME TAXES
The provision for income taxes consists of the following:
The differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to income before income taxes are as follows:
The components of the net deferred tax liabilities recognized on the accompanying balance sheets are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 1998, the Company has approximately $69 million of federal net operating loss carryforwards which begin to expire in 2018. The Company has approximately $1.2 million of state net operating losses as of December 31, 1998.
The Company made cash income tax payments of $2.1 million, $3.6 million, $817,000 and $571,000 during fiscal year ended August 31, 1996, the fiscal years ended December 31, 1997 and 1998 and for the four months ended December 31, 1996, respectively.
6. COMMITMENTS AND CONTINGENCIES
In December 1996, the Company sold at cost two recently acquired and modified Boeing 727 aircraft to a third party and entered into a 12 month operating lease agreement for such aircraft commencing January 1, 1997. The lease provided for monthly lease payments of approximately $252,000, and five successive one year renewal options. The Company has an option to purchase the aircraft at the end of each year, and guarantees to the lessor certain minimum sale values if the Company elects not to renew the lease or exercise its purchase option. On each of January 1, 1998 and 1999, the Company elected to renew the lease for another year. Lease expense during 1997 and 1998 was approximately $3.03 million for each year.
The Company also leases a Boeing 727 aircraft in cargo configuration under a seven year operating lease at a monthly rate of $50,000. The lease expires in 2003. Lease expense during 1997 and 1998 was $450,000 and $600,000, respectively.
In August 1998, the Company leased 3 Boeing 727 aircraft in cargo configuration under a six year operating lease at a monthly rate of $184,000. The lease expires in 2004. Lease expense during 1998 was $921,000.
The Company also leases office buildings, hangars, cargo storage and related facilities under noncancelable operating leases which expire on various dates through 2011. See also Note 9. In addition, the Company periodically leases aircraft and other equipment under month-to-month lease agreements. Total rent expense during 1997 (including lease expense incurred from the acquisition of the Kalitta Companies from November 19, 1997 through December 31, 1997) and 1998 was approximately $809,000 and $7.7 million, respectively.
Minimum annual rentals at December 31, 1998 are as follows:
The Company currently leases its sorting space for its overnight freight service at the Hulman Regional Airport in Terre Haute, Indiana on a month to month basis until the Company relocates its sorting center to Fort Wayne, Indiana in the summer of 1999. The move to Fort Wayne is due to the lack of available expansion space and the limited airport facilities in Terre Haute. During fiscal years 1997 and 1998, the Company incurred rent expense in Terre Haute of $60,000 and $499,000, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Airline operators must comply with Federal Aviation Administration noise regulations primarily promulgated under the Airport Noise and Capacity Act of 1990 (the "Noise Regulations"). Currently, the Company is in compliance with the Noise Regulations. The Company owns 71 aircraft and leases 6 aircraft which are affected by the Noise Regulations of which 55 are currently in compliance with Stage III noise control standards of the Noise Regulations or are currently being modified to be in compliance with such standards. Any aircraft not in compliance with the Noise Regulations by January 1, 2000 may not be operated in the United States until it complies with such standards. European countries have similar regulations.
The Company has elected not to modify 13 of its Douglas DC-8 aircraft to meet the Noise Regulation standards because the estimated cost exceeds the economic benefits of such modifications. These aircraft will be removed from its fleet in the United States before January 1, 2000.
The Company currently has eight Boeing 727 aircraft and one Douglas DC-9 aircraft which do not comply with the Noise Regulation standards. The Company intends to modify these aircraft during 1999 at an approximate aggregate cost of $15.9 million, not including aircraft downtime.
The Company is currently unaware of any environmental contamination for which the Company is liable for the cost of removal or cleanup. Until May 2001, Conrad A. Kalitta, the former owner of the Kalitta Companies, has agreed, subject to certain limitations, to indemnify the Company against any losses arising from any environmental liability at any of the Kalitta Companies facilities which were acquired in November 1997.
Directives issued under the FAA's "Aging Aircraft" program or issued on an ad hoc basis may cause certain of the Company's aircraft to be subject to extensive aircraft examinations and/or structural inspections and modifications to address problems of corrosion and structural fatigue, among other things. Directives applicable to the Company's fleet can be issued at any time in the future. The cost of complying with such potential future Directives and Service Bulletins cannot currently be estimated, but could be substantial.
The Company operates a fleet of 31 Boeing 727s, all of which were previously converted from passenger configuration to cargo configuration by the installation of a large cargo door and numerous interior modifications related to the installation of cargo container handling systems. The FAA has issued a Directive, directed at the structural strength of the aircraft floor, which limits the cargo capacity of these Boeing 727s until certain modifications are made. The weight limitations involve lowering the average capacity of the cargo positions from 8,000 pounds to 4,000 pounds and after June 2001, to 3,000 pounds.
To address this problem, during 1998, the Company purchased one of the Supplemental Type Certificates ("STCs") which was used to convert five of the Company's aircraft from passenger to cargo configuration. The Company has received authority from the FAA to modify these five Boeing 727 aircraft to raise the permissible weight of each cargo container position to approximately 6,000 pounds. The modifications will occur in the Company's maintenance facilities and will take approximately three to four days with an anticipated cost between $25,000 and $50,000, not including aircraft downtime. The Company has applied to the FAA for the authority to modify the remaining fleet of Boeing 727 aircraft to raise the permissible weight per cargo container position to approximately 6,000 pounds. These modifications are not expected to have a material adverse effect of the Company's results of operations or financial position.
7. LEGAL PROCEEDINGS
In the normal course of business, the Company is a party to various matters of litigation. In the opinion of management, none of these matters will have a material adverse effect on the Company's financial condition or results of operations.
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8. STOCKHOLDERS' EQUITY
During the fiscal year ended August 31, 1996, the Company canceled 245,708 of the options outstanding and granted to an executive a non-qualified option to purchase 390,707 shares of common stock at $0.01 per share. The new option had a term of nine years and was fully vested. In June 1996, the Company canceled the remaining 92,140 options outstanding and granted to another executive a non- qualified option to purchase 153,567 shares of common stock at $0.01 per share. The new option had a term of nine years and was fully vested. On June 26, 1996, the executives fully exercised their options. Based on an independent appraisal commissioned by the Company, the fair value of the options of $4.2 million is reflected as a charge to earnings in the accompanying statement of income for the year ended August 31, 1996.
The Company has an Annual Incentive Compensation Plan (the "Compensation Plan") under which the Compensation Committee awards semi-annual bonuses to employees of the Company. The aggregate amount of bonuses available for award is limited to 10% of the Company's income before income taxes and the bonuses to be paid under the Compensation Plan. The Company may elect to pay the full amount of the bonuses in common stock, which is limited to total stock distributions of 200,000 shares of common stock. As of December 31, 1998, 198,193 shares were available for distribution under the Compensation Plan.
The Company also has an Employee Stock Purchase Plan under which up to 100,000 shares of the Company's common stock are reserved for purchase by Company employees. The Employee Stock Purchase Plan allows eligible employees to authorize the Company to withhold from 1% to 15% of their gross earnings subject to specified limitations. Shares are purchased by participants at the lower of 85 percent of the fair market value per share at the beginning or end of each offering period. During 1998 and in January 1999, 20,145 shares and 68,045 shares, respectively, were issued under the plan, leaving 11,810 shares available under the plan.
Additionally, the Company has an Omnibus Securities Plan (the "Omnibus Plan") under which 300,000 shares of its common stock are reserved for issuance to its employees and members of its board of directors. The Omnibus Plan is administered by the Company's Compensation Committee which may grant stock based and non-stock based compensation to the Omnibus Plan participants. In March 1998, 6,840 total shares of common stock were issued to current and former members of the Board of Directors for services performed during 1996 and 1997. During 1998, stock options covering 280,000 shares of common stock were granted to employees and directors with an exercise price equal to the fair value of the common stock on the date of grant. All of the options issued under the Omnibus Plan have a 10 year term and vest over no more than four years.
Transactions during 1998 under the Omnibus Plan were as follows:
In accordance with the terms of APB No. 25, the Company records no compensation expense for its stock option awards issued with exercise prices at least equal to the current market value on the date of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
grant. As required by SFAS No. 123, the Company provides the following disclosure of hypothetical values for these awards. The weighted-average grant date value of options granted during 1998 was estimated to be $6.36 under the Omnibus Plan and $6.05 under the Employee Stock Purchase Plan. This value was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions: expected volatility of 0.67, risk free interest rate of 5.5%, expected life of 4 years (Omnibus Plan) and 6 months (Employee Stock Purchase Plan) and expected dividend yield of 0%.
In April 1998, the Company granted its President options to purchase 400,000 shares of common stock outside any of the Company's established plans with an exercise price of $16.75 per share, the market value of the Company's common stock on the date of the grant. In February 1999, the Company canceled these options and granted its President options to purchase 400,000 shares of common stock with an exercise price of $16.75 pursuant to the Kitty Hawk, Inc. 1999 Executive Stock Option Plan. The grant date value of these options was estimated to be $3.39 using the Black-Scholes option pricing model with the following assumptions: expected volatility of .67, risk free interest rate of 5.50%, expected life of 4 years and expected dividend yield of 0%.
Had compensation expense been recorded based on these hypothetical values, the Company's 1998 net income would have been $15.5 million, or $.92 per share on a diluted basis. Because options vest over several years and additional option grants are expected, the effects of these hypothetical calculations are not likely to be representative of similar future calculations. Because no options were granted or outstanding during 1997 and the options granted during 1996 were compensatory, no supplemental disclosures under FAS 123 are necessary for 1997 and 1996.
Summarized information about stock options outstanding under the Omnibus Plan at December 31, 1998 is as follows:
At December 31, 1998, 13,160 shares were available for future grants under the Omnibus Plan.
9. RELATED PARTY TRANSACTIONS
Until February 1997, the Company leased its primary office and maintenance space in Dallas, Texas under an operating lease from a person who was at the time a member of the Company's Board of Directors until August 1997. Rent expense under this lease was, $255,000, $21,000 and $84,000 for the fiscal year ended August 31, 1996, the year ended December 31, 1997 and for the four months ended December 31, 1996, respectively. Under the lease agreement, the Company had the option to purchase the office facilities and the landlord's interest in the associated ground lease at any time prior to March 1, 1997. In February 1997, the Company exercised its option and purchased the facility and the interest in the ground lease for $1.76 million.
As a result of the acquisition of the Kalitta Companies, one of the Company's vendors became a related party as the vendor is owned by a relative of the former owner of the Kalitta Companies. The Kalitta Companies also leased certain aircraft to this vendor as well as provided ground handling services in certain locations. Additionally, the Company used this related company for subcharter flight and lift
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capacity for the Company's overnight scheduled cargo service. Total revenues earned during 1997 (subsequent to the acquisition of the Kalitta Companies) were approximately $379,000 with related accounts receivable of approximately $813,000 as of December 31, 1997. Subsequent to the acquisition of the Kalitta Companies, the Company incurred approximately $1.8 million of expenses with this related party during 1997 and owed approximately $200,000 to this related party at December 31, 1997. In 1998, the Company sold a DC-8 to this company for $1 million. The Company recognized no gain or loss on the transaction.
In September 1998, the Company leased 4 JT9 engines from a company owned by the former owner of the Kalitta Companies. The lease expired in January 1999. Total lease expense incurred during 1998 was $834,000. At December 31, 1998, the Company owed $343,000 to the leasing company.
Prior to December 31, 1998, the Company leased an office facility from a company owned by the former owner of the Kalitta Companies and two of his relatives. The Company terminated the lease during October 1998. Rent expense incurred from November 19, 1997 through December 31, 1997 and for fiscal year 1998 was $143,000 and $295,000, respectively.
In connection with the acquisition of the Kalitta Companies, the Company entered into an agreement to sponsor the racing activities of a racing team owned by the former owner of the Kalitta Companies. The agreement provides for annual payments of up to $2 million for two years and expires in November 1999.
10. EMPLOYEE COMPENSATION PLANS AND ARRANGEMENTS
The Company has three retirement savings plan under Section 401(k) of the Internal Revenue Code which cover substantially all employees meeting minimum service requirements. Under the plans, voluntary contributions are made by employees and the Company provides matching contributions based upon the employees' contribution. The Company incurred $160,000, $308,000, $841,000 and $56,000 in matching contributions related to this plan during fiscal year ended August 31, 1996, the fiscal years ended December 31, 1997 and 1998 and for the four months ended December 31, 1996, respectively.
11. SIGNIFICANT CUSTOMERS
The Company provided air logistics services to one customer which accounted for approximately 41%, 18%, 7.7% and 16.8% of its total revenues in the fiscal year ended August 31, 1996, the years ended December 31, 1997 and 1998 and for the four months ended December 31, 1996, respectively. The contract for these services is effective through May 31, 2000; however, such contract may be canceled by either party with 30 days notice. The Company provided air freight carrier services to one customer which accounted for approximately 10.8%, 18%, 10% and 11.9% of its total revenues in the fiscal year ended August 31, 1996, the years ended December 31, 1997 and 1998 and for the four months ended December 31, 1996, respectively. Another air freight carrier customer accounted for approximately 15%, 18%, 16.8% and 44% of the Company's total revenues in the fiscal year ended August 31, 1996, the years ended December 31, 1997 and 1998 and for the four months ended December 31, 1996, respectively. Related accounts receivable from this customer at December 31, 1997 and 1998 were approximately $44.5 million and $68.7 million, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted net income per share:
The weighted average number of common shares outstanding during the year ended August 31, 1996 includes the effect of options to purchase 390,707 and 153,567 shares of the Company's common stock at $0.01 granted to certain executives in December 1995 and June 1996, respectively, in accordance with Securities and Exchange Commission Staff Accounting Bulletin 98. The weighted average number of common shares outstanding at December 31, 1998 excludes the effect of options to purchase 460,000 shares of the Company's common stock because their exercise prices were higher than the market price of the common stock.
On June 28, 1996 the Company approved a 1.2285391-for-1 stock split effected as a stock dividend. All references to common stock and per share data have been restated to give effect to the split.
13. COLLECTIVE BARGAINING AGREEMENTS
Approximately 13% of the Company's employees, consisting of pilots and flight engineers are members of the International Brotherhood of Teamsters ("Teamsters") and are employed pursuant to a Collective Bargaining Agreement. The Collective Bargaining Agreement became amendable on August 29, 1997, but remains in effect while the parties are in negotiations for a successor collective bargaining agreement. Although the Company and the Teamsters have commenced "interest-based" bargaining, there can be no assurance that a new Collective Bargaining Agreement can be reached or that negotiations will not result in work stoppages, substantial increases in salaries or wages, changes in work rules or other changes adverse to the Company.
14. BUSINESS SEGMENT DATA
The Company operates four principal businesses: an air freight carrier, a scheduled freight service provider, an air logistics service provider and a maintenance operation. Each of these is a business segment, with its respective financial performance detailed below. Included in each are intersegment transactions for revenues and costs of revenues which generally approximate market prices. Each business segment is currently evaluated on financial performance at the operating income line.
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The Company's air freight carrier provides services to third parties under contractual arrangements where the Company provides the aircraft, crew, maintenance and insurance (ACMI). Additionally, the air freight carrier performs ad hoc charters for the air logistics service provider. The air freight carrier is further divided into a wide-body division (Kitty Hawk International, Inc., formerly AIA) and a narrow-body division (Kitty Hawk Aircargo, Inc.). The air freight carrier also provided passenger charters during fiscal years 1997 and 1998. The Company has recently eliminated its passenger charter division.
The Company's scheduled freight service consists of an overnight freight service provider operating in a network of approximately 46 North American cities, as well as a service between Los Angeles, the Hawaiian Islands and several Pacific Rim countries.
The Company's air logistics service provider arranges the delivery of time sensitive freight within North America principally the United States. Also included in this segment is the Company's fleet of small jet and prop aircraft. The air logistics service provider utilizes third party aircraft as well as its own fleet of small aircraft and the fleet of the air freight carrier.
The Company's maintenance operation provides engine overhauls for third parties as well as for the Company's aircraft. The Company has recently curtailed its third party maintenance operation to provide only engine overhauls on JT3 engines for Douglas DC8s and JT8 engines for Boeing 727s and Douglas DC9s. The Company's maintenance operation also provides airframe repairs for the Company's Boeing 727s and Douglas DC-9s.
The other category consists of corporate activities as well as activities of LSI.
Business assets are owned by or allocated to each of the business segments. Assets included in other include cash, investment in subsidiaries and deferred income taxes.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company does not separately report results of its maintenance operation and related asset information to the Company's chief operating decision maker. Accordingly, financial data for the maintenance operation is included under the ACMI Wide-Body and Air Logistics caption above. Third party maintenance revenue included under the ACMI Wide-Body and Air Logistics captions above amounted to $18.4 million and $12.7 million for the fiscal year ended December 31, 1998, respectively, and $2.1 million and $0 for the fiscal year ended December 31, 1997, respectively.
The Company's air freight carrier and scheduled freight services operate internationally. The air logistics service operates mainly in North America, principally the United States. The following table breaks out total revenues earned in North America, principally the United States, and the rest of the
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world, as revenues from no one country, other than the United States, exceeded 10% of the Company's total revenues.
All of the Company's long-lived assets are based in North America.
15. SUPPLEMENTAL GUARANTOR INFORMATION
In connection with the issuance of the Notes in November 1997, each of the Company's subsidiaries, with the exception of AIC, (collectively, the "Guarantors") have fully and unconditionally and jointly and severally guaranteed (the "Guarantees") on a senior basis, the full and prompt performance of the Company's obligations under the Notes. The Guarantees are limited to the largest amount that would not render such Guarantees subject to avoidance under any applicable federal or state fraudulent conveyance or similar law. The Guarantees rank senior in right of payment to any subordinated indebtedness and, except with respect to collateral, pari passu with all existing and future unsubordinated indebtedness of the Guarantors. Each of the Guarantors is a wholly-owned subsidiary of the Company.
Supplemental financial information is presented for the fiscal years ended December 31, 1997 and 1998. No supplemental financial information is provided for the fiscal year ended August 31, 1996 and the four months ended December 31, 1996 because AIC, the only non-guarantor subsidiary, was not acquired by the Company until November 1997. the outstanding debt of the Company. The Company has not presented separate financial statements and other disclosures concerning the Guarantors because the Company's management believes that such information is not material to investors because the guarantees did not exist until 1997.
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KITTY HAWK, INC.
SUPPLEMENTAL CONSOLIDATING BALANCE SHEET CONDENSED FINANCIAL INFORMATION (UNAUDITED) DECEMBER 31, 1997
ASSETS
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SUPPLEMENTAL CONSOLIDATING STATEMENT OF OPERATIONS CONDENSED FINANCIAL INFORMATION (UNAUDITED) FOR THE YEAR ENDED DECEMBER 31, 1997
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SUPPLEMENTAL CONSOLIDATING STATEMENT OF CASH FLOWS CONDENSED FINANCIAL INFORMATION (UNAUDITED) FOR THE YEAR ENDED DECEMBER 31, 1997
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SUPPLEMENTAL CONSOLIDATING BALANCE SHEET CONDENSED FINANCIAL INFORMATION (UNAUDITED) DECEMBER 31, 1998
ASSETS
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KITTY HAWK, INC.
SUPPLEMENTAL CONSOLIDATING STATEMENT OF OPERATIONS CONDENSED FINANCIAL INFORMATION (UNAUDITED) FOR THE YEAR ENDED DECEMBER 31, 1998
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KITTY HAWK, INC.
SUPPLEMENTAL CONSOLIDATING STATEMENT OF CASH FLOWS CONDENSED FINANCIAL INFORMATION (UNAUDITED) FOR THE YEAR ENDED DECEMBER 31, 1998
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16. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
The following table reflects selected quarterly operating results, which have not been audited or reviewed. The information has been prepared on the same basis as the consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the information shown. The Company's results may vary significantly from quarter to quarter and the operating results for any quarter are not necessarily indicative of the results that may be expected for any future period.
17. SUBSEQUENT EVENTS
During January 1999, the Company entered into an operating lease agreement to lease nine Boeing 727 aircraft for a period of seven years each. The lessor will pay all costs associated with modifying the aircraft to cargo configuration and to bring the aircraft into compliance with the FAA Noise Regulations. The Company expects to place three of these aircraft into revenue service during 1999 with the remainder placed into revenue service during 2000. The monthly aggregate lease expense for all nine aircraft will be approximately $1 million.
As a result of the acquisition of AIA, the Company acquired a 60% interest in the AIC general partnership. Pacific Aviation Logistics ("PAL") owned the remaining 40% interest in AIC and was the managing partner of AIC. Beti Ward, who owned PAL, was the general manager of AIC. AIC operates a scheduled air freight service between Los Angeles, Honolulu and various destinations in the Pacific. AIC does not own any aircraft and currently leases all of its aircraft and facilities from the Company.
In August 1998, the Company called a partnership meeting to designate AIA as the managing partner of AIC and to replace Ms. Ward as general manager. In response, Ms. Ward and PAL filed suit to prevent these actions and requested the court to dissolve AIC. While these issues were being addressed in court, the Company reached a settlement with Ms. Ward and PAL. The terms of the settlement are (i) AIC will pay PAL a $5.4 million cash distribution from PAL's capital account in AIC, (ii) the Company will give Ms. Ward and PAL a promissory note for an additional $2.35 million, payable in three annual installments of $700,000 each and one final payment of $250,000 (the note bears interest at 9.98% and is payable semi-annually), (iii) Ms. Ward and PAL will transfer to the Company all of their interest in AIC and its business, (iv) Ms. Ward and PAL will broadly covenant not to compete in the Los Angeles and Honolulu air freight markets for a period of three and one-half years, (v) Ms. Ward and PAL will return approximately $180,000 worth of AIC's property and (vi) all the parties will exchange mutual releases, but the Company will retain the right to pursue audit actions and seek other limited recoveries against Ms. Ward and PAL. As a result of the settlement, the Company now has full ownership and control of AIC and its business in being conducted without interruption.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
18. PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
The following sets forth the unaudited pro forma consolidated statement of operations for the years ended December 31, 1996 and 1997, in each case giving effect to the acquisition of the Kalitta Companies, the issuance of the Notes, Term Loan, and the acquisition of 16 Boeing 727s from the Kalitta Companies as if each of the transactions had been consummated at the beginning of 1996 and 1997 for each of the respective years. This information is presented for illustrative purposes only and does not purport to present the results of operations of the Company had these transactions occurred on the dates indicated, nor are they necessarily indicative of the consolidated results of operations which may be expected to occur in the future.
No pro forma adjustments have been applied to reflect (i) revenues or operating costs expected to be generated from the Boeing 747s purchased during 1998 and modified to cargo configuration with approximately $56 million of the net proceeds from the Notes or (ii) operating efficiencies or cost savings (other than approximately $1.5 million of insurance savings) expected to result from the acquisition of the Kalitta Companies. In addition, pro forma results have not been adjusted to eliminate abnormally high engine maintenance expenses, costs incurred to add and maintain flight crews in anticipation of increased air freight carrier business which had not yet materialized in part due to delays in acquiring aircraft and start-up costs associated with establishing the Kalitta Companies' wide-body passenger charter business, which has recently been discontinued.
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Certain reclassifications have been made consistent with the reclassifications on the Company's statement of operations.
PRO FORMA CONSOLIDATED STATEMENTS OF OPERATIONS
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(1) Adjusted EBITDA is calculated as income (loss) before minority interest, income taxes, interest expense and depreciation and amortization. Adjusted EBITDA excludes approximately $4,231 from stock options granted to executives in 1996.
KITTY HAWK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
19. 1999 REPORTING (UNAUDITED)
Subsequent to the acquisition of the Kalitta Companies and pursuant to the integration of these companies into Kitty Hawk, the Company has refined its financial reporting. Throughout this transition and reorganization of common business segments under common management, the Company has developed a corresponding methodology for its financial reporting. Beginning in the first quarter of 1999, the Company expects to report operating results in its statement of income in a manner consistent with the presentation below.
Differences in revenue from the prior presentation include the following: (i) revenues from charters performed by the Company's small aircraft will be reported as a component of air logistics revenue instead of the 1998 presentation as air freight carrier revenues, (ii) revenues from the Company's scheduled freight services will be reported separate from air freight carrier revenues, and (iii) charters arranged by the air logistics service provider which are flown in the air freight carrier will no longer be reported as a component of air freight carrier revenues; they will be included in air logistics revenue. Differences in costs of revenues include breaking each component of air logistics, air freight carrier and scheduled freight costs of revenues into their respective components which include flight expense, maintenance expense, aircraft fuel expense, depreciation expense and other expense. The following information is provided for informational purposes only.
KITTY HAWK, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
INDEX TO EXHIBITS
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* Filed herewith.
** This exhibit is a management contract or compensatory plan or arrangement.