UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q/A

 

(Amendment No. 1)

 

 

 

 

Commission File Number 0-15495

 

 

Mesa Air Group, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code:
(602) 685-4000

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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

 

On May 1, 2007, the registrant had outstanding 31,410,065 shares of Common Stock.

 

 

TABLE OF CONTENTS

 

INDEX

 

 

EXPLANATORY NOTE

 

This Amendment No. 1 on Form 10-Q/A (this “Amendment”) to our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2007, which was filed with the Securities and Exchange Commission on May 15, 2007 (the “Original 10-Q”), is being filed to correct certain clerical errors, formatting and typographical corrections that affected the following items in “Part I, Item 1. Financial Statements” and “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations”: (i) added total amount of liabilities and stockholders’ equity beneath the “Liabilities and Stockholders’ Equity” portion of our Balance Sheets, (ii) changed the description of the line item “Short-term debt permanently financed as long-term debt” contained in our Condensed Consolidated Statements of Cash Flows, (iii) changed the diluted earnings per share for the second quarter of fiscal year 2007 in “General — Executive Overview and Summary Financial Results”, (iv) changed the amount of changes in assets and liabilities in Sources and Uses of Cash in Liquidity and Capital Resources, and (v) certain formatting and typographical corrections.

 

No other amounts presented in the Original 10-Q were impacted by these clerical errors, formatting and typographical corrections.

 

This Amendment contains the complete text of the Original 10-Q with the corrected information appearing in the sections specified above and does not change any other section of the Original 10-Q. We have not updated the disclosures contained in this Amendment to reflect any events that occurred at a date subsequent to the filing of the Original 10-Q.

 

In addition, in accordance with Rule 12b-15 promulgated under the Securities and Exchange Act of 1934, as amended, this Amendment includes currently dated certifications from the Company’s Chief Executive Officer and Chief Financial Officer as required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002.

 

MESA AIR GROUP, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See accompanying notes to condensed consolidated financial statements.

MESA AIR GROUP, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 

 

See accompanying notes to condensed consolidated financial statements.

MESA AIR GROUP, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See accompanying notes to condensed consolidated financial statements.

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

 

The accompanying unaudited, condensed consolidated financial statements of Mesa Air Group, Inc. (“Mesa” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for a complete set of financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the results for the periods presented have been made. Operating results for the three and six month periods ended March 31, 2007, are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2007. These condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the fiscal year ended September 30, 2006.

 

The accompanying condensed consolidated financial statements include the accounts of Mesa Air Group, Inc. and its wholly-owned operating subsidiaries: Mesa Airlines, Inc. (“Mesa Airlines”), a Nevada corporation and certificated air carrier; Freedom Airlines, Inc. (“Freedom”), a Nevada corporation and certificated air carrier; Air Midwest, Inc. (“Air Midwest”), a Kansas corporation and certificated air carrier; Air Midwest, LLC, a Nevada limited liability company, MPD, Inc., a Nevada corporation, doing business as Mesa Pilot Development; Regional Aircraft Services, Inc. (“RAS”) a California company; Mesa Air Group — Airline Inventory Management, LLC (“MAG-AIM”), an Arizona Limited Liability Company; Ritz Hotel Management Corp., a Nevada Corporation; Nilchii, Inc. (“Nilchii”), a Nevada corporation, Patar, Inc. (“Patar”), a Nevada corporation, Ping Shan, SRL (“Ping Shan”), a Barbados, West Indies based investment company, and MAGI Insurance, Ltd. (“MAGI”), a Barbados, West Indies based captive insurance company. Air Midwest, LLC was formed for the purpose of a contemplated conversion of Air Midwest from a corporation to a limited liability company (which has not yet occurred). MPD, Inc. provides pilot training in coordination with San Juan College in Farmington, New Mexico and with Arizona State University in Tempe, Arizona. RAS performs aircraft component repair and overhaul services. MAG-AIM purchases, distributes and manages the Company’s inventory of rotable and expendable spare parts. Ritz Hotel Management is a Phoenix area hotel property that is used for crew-in-training accommodations. MAGI is a captive insurance company established for the purpose of obtaining more favorable aircraft liability insurance rates. Ping Shan was established to invest in a Joint Venture in the People’s Republic of China. Nilchii was established to invest in certain airline related businesses. Patar was established to invest in certain non-aviation related businesses. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

New Accounting Pronouncements

 

In June 2006, the Financial Accounting Standards Board (“FASB”) ratified Emerging Issues Task Force Issue No. 06-3 (“EITF 06-3”), “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation).” EITF 06-3 applies to any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer. EITF 06-3 allows companies to present taxes either gross within revenue and expense or net. If taxes subject to this issue are significant, a company is required to disclose its accounting policy for presenting taxes and the amount of such taxes that are recognized on a gross basis. The Company adopted EITF 06-3 during the second quarter of 2007 by continuing to present such taxes on a net basis. These amounts are not material to the Company’s consolidated financial statements.

 

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” This standard defines fair value, establishes a framework for measuring fair value in accounting principles generally accepted in the United States of America, and expands disclosure about fair value measurements. This pronouncement applies to other accounting standards that require or permit fair value

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

measurements. Accordingly, this statement does not require any new fair value measurement. This statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company will be required to adopt SFAS No. 157 in the first quarter of fiscal year 2009. Management has not yet determined the impact of adopting this statement.

 

In September, 2006, the FASB issued FASB Staff Position (“FSP”) No. AUG AIR-1 “Accounting for Planned Major Maintenance Activities.” This position amends the existing major maintenance accounting guidance contained within the AICPA Industry Audit Guide “Audits of Airlines” and prohibits the use of the accrue in advance method of accounting for planned major maintenance activities for owned aircraft. The provisions of the announcement are applicable for fiscal years beginning after December 15, 2006. Mesa currently uses the direct expense method of accounting for planned major maintenance; therefore, the adoption of FSP No. AUG AIR-1 will not have an impact on the Company’s consolidated financial statements.

 

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in financial statements. FIN 48 requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. Mesa will be required to adopt FIN 48 in the first quarter of fiscal year 2008. Management has not yet determined the impact on the Company’s consolidated financial statements.

 

 

Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires disclosures related to components of a company for which separate financial information is available that is evaluated regularly by a company’s chief operating decision maker in deciding the allocation of resources and assessing performance. The Company has three airline operating subsidiaries, Mesa Airlines, Freedom Airlines and Air Midwest, as well as various other subsidiaries organized to provide support for the Company’s airline operations. The Company has aggregated these subsidiaries into three reportable segments: Mesa Airlines/Freedom, Air Midwest/go! and Other. Operating revenues in the Other segment are primarily sales of rotable and expendable parts to the Company’s operating subsidiaries and ground handling services performed by employees of RAS for Mesa Airlines.

 

Mesa Airlines and Freedom Airlines provide passenger service under revenue-guarantee contracts with United Airlines, Inc. (“United”), Delta Air Lines, Inc. (“Delta”) and US Airways, Inc. (“US Airways”). As of March 31, 2007, Mesa Airlines and Freedom Airlines operated a fleet of 181 aircraft — 61 CRJ 200s, 18 CRJ 700s, 38 CRJ 900s, 36 ERJ 120s and 28 Dash-8’s.

 

Air Midwest and Mesa Airlines, operating as go!, provide passenger service where revenue is derived from ticket sales either independently or through pro-rate agreements. Air Midwest provides passenger service under pro-rate contracts with US Airways, and Midwest Airlines, as well as independently under the brand name Mesa Airlines. As of March 31, 2007, Air Midwest operated a fleet of 20 Beechcraft 1900D turboprop aircraft. Mesa Airlines, operating as go!, provides independent inter-island Hawaiian passenger service. As of March 31, 2007, Mesa’s go! operation operated a fleet of five CRJ-200 aircraft. Air Midwest and Mesa, operating as go!, do not receive contractually-guaranteed revenue for their operations. Air Midwest LLC will be included in Air Midwest/go! when the contemplated conversion to a limited liability company occurs.

 

The Other reportable segment includes Mesa Air Group (the holding company), RAS, MPD, MAG-AIM, MAGI, Shan Yue, Ping Shan, Nilchii, Patar, and Ritz Hotel Management Corp. Activity in the Other category consists primarily of sales of rotable and expendable parts and ground handling services to the Company’s operating subsidiaries, but also includes all administrative functions not directly attributable to any specific operating company. These administrative costs are allocated to the operating companies based upon specific criteria including headcount, available seat miles (“ASM’s”) and other operating statistics.

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The Company has a cash management program which provides for the investment of excess cash balances primarily in short-term money market instruments, US Treasury securities, intermediate-term debt instruments, and common equity securities of companies operating in the airline industry.

 

SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” requires that all applicable investments be classified as trading securities, available for sale securities or held-to-maturity securities. The Company currently has $141.5 million in marketable securities that include US Treasury notes, government bonds and corporate bonds. These investments are classified as trading securities during the periods presented and accordingly, are carried at market value with changes in value reflected in the current period operations. Unrealized losses relating to trading securities held at March 31, 2007 and September 30, 2006, were ($4.8) million and ($0.3) million, respectively.

 

The Company has determined that investments in auction rate securities (“ARS”) should be classified as short-term investments. ARS generally have long-term maturities; however, these investments have characteristics similar to short-term investments because at predetermined intervals, generally every 28 days, there is a new auction process. As such, the Company classifies ARS as short-term investments. The balance of marketable securities at March 31, 2007 and September 30, 2006 includes investments in ARS of $0 and $17.4 million, respectively.

 

 

At March 31, 2007, the Company had $12.6 million in restricted cash on deposit with two financial institutions. In September 2004, the Company entered into an agreement with a financial institution for a $9.0 million letter of credit facility and to issue letters of credit for landing fees, workers’ compensation insurance and other business needs. Pursuant to the agreement and amounts held on deposit, the Company had $11.5 million of outstanding letters of credit at March 31, 2007. The Company also maintains $5.0 million on deposit with another financial institution to collateralize its direct deposit payroll obligations.

 

 

The Company has code-share agreements with Delta Air Lines, US Airways and United Airlines. Approximately 98% of the Company’s consolidated passenger revenue for the three month period ended March 31, 2007 was derived from these agreements. Accounts receivable from the Company’s code-share partners were 42% and 45% of total gross accounts receivable at March 31, 2007 and September 30, 2006, respectively.

 

US Airways accounted for approximately 45% of the Company’s total passenger revenue in the three month period ended March 31, 2007. A termination of the US Airways revenue-guarantee code-share agreements would

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

have a material adverse effect on the Company’s business prospects, financial condition, results of operations and cash flows.

 

United Airlines accounted for approximately 35% of the Company’s total passenger revenue in the three month period ended March 31, 2007. A termination of the United agreement would have a material adverse effect on the Company’s business prospects, financial condition, results of operations and cash flows.

 

Delta Air Lines accounted for approximately 18% of the Company’s total passenger revenue in the three month period ended March 31, 2007. A termination of the Delta agreement would have a material adverse effect on the Company’s business prospects, financial condition, results of operations and cash flows.

 

The Company is currently engaged in a dispute with US Airways over fees payable pursuant to its Code Share and Revenue Sharing Agreement (the “Code Share Agreement”). The disagreement stems from payments due the Company from US Airways with respect to reimbursable operating costs and expenses relating to certain of the Company’s CRJ-900 aircraft. The disputed amount that has not been paid by US Airways is $6.9 million. The balance due at March 31, 2007 is $6.9 million and increases by $0.2 million per month during the term of the Code Share Agreement that the dispute remains unresolved. The Company believes that these reimbursable costs and expenses are in accordance with the terms and conditions of the Code Share Agreement and are immediately due and payable. The Company is currently working to amicably resolve this dispute in the near term prior to initiating litigation. If an amicable resolution cannot be reached, the Company is prepared to litigate its claim and believes it has a reasonable probability of succeeding in any such proceedings, although no assurances can be given in that regard.

 

 

In May 2005, the Company amended its code-sharing arrangement with United to allow the Company to put up to an additional 30 50-seat regional jet aircraft into the United Express system. The agreement with respect to the additional 30 50-seat regional jet aircraft expires in April 2010. Additionally, the expiration dates under the existing code-share agreement with respect to certain aircraft were extended. In connection with the amendment, the Company made three $10 million payments to United in the first and second quarter of fiscal 2006. Amounts paid were recorded as a deferred charge and included in other assets on the balance sheet. The deferred charge was then being amortized over the term of the code-share agreement as a reduction of passenger revenue. The unamortized balance of these deferred charges were written off in the second quarter of 2007. See Note 14 regarding impairment.

 

 

Deferred credits consist of aircraft purchase incentives provided by the aircraft manufacturers and deferred gains on the sale and leaseback of interim financed aircraft. These incentives include credits that may be used to purchase spare parts, pay for training expenses or reduce other aircraft operating costs. These deferred credits and gains are amortized on a straight-line basis as a reduction of lease expense over the term of the respective leases.

 

 

At September 30, 2006, the Company had $123.1 million in notes payable to an aircraft manufacturer for five aircraft on interim financing. During the second quarter of 2007, the Company permanently financed these five aircraft as well as a sixth aircraft delivered during the first quarter of 2007 with $135.0 million in long-term debt. Under interim financing arrangements, the Company takes delivery and title to the aircraft prior to securing permanent financing and the acquisition of the aircraft is accounted for as a purchase with debt financing. Accordingly, the Company reflects the aircraft and debt under interim financing on its balance sheet during the interim financing period. After taking delivery of the aircraft, it is the Company’s intention to permanently finance the aircraft as an operating lease through a sale and leaseback transaction with an independent third-party lessor. Upon permanent financing, the proceeds are used to retire the notes payable to the manufacturer. Any gain

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

recognized on the sale and leaseback transaction is deferred and amortized over the life of the lease. The current interim financing agreement with the manufacturer provides for the Company to have a maximum of 15 aircraft on interim financing at a given time.

 

 

Long-term debt consisted of the following:

 

 

 

The Company accounts for earnings per share in accordance with SFAS No. 128, “Earnings per Share.” Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the periods presented. Diluted net income per share reflects the potential dilution that could occur if outstanding stock options and warrants were exercised. In addition, dilutive convertible securities are

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

included in the denominator while interest on convertible debt, net of tax, is added back to the numerator. A reconciliation of the numerator and denominator used in computing net income (loss) per share is as follows:

 

 

The effect of converting the senior convertible notes into 10.7 million shares of common stock in the three and six months ended March 31, 2007, respectively would have been antidilutive to the per share calculation. Accordingly, those convertible shares were excluded from the calculation of dilution.

 

Options to purchase 1,137,064 and 642,480 shares of common stock were outstanding during the three and six months ended March 31, 2007. Options to purchase 1,980,581 and 1,852,277 shares of common stock were excluded from the calculation of dilutive earnings per share for the three and six month periods ended March 31, 2007 because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would have been antidilutive. The remaining options outstanding during the three and six month periods ended March 31, 2007 of 419,425 and 459,280, respectively, were excluded from the calculation of dilutive earnings per share because the Company incurred a net loss during those periods and the effect of including those options would also have been antidilutive.

 

 

The Company’s Board of Directors has authorized the Company to purchase up to 19.4 million shares of the Company’s outstanding common stock. As of March 31, 2007, the Company has acquired and retired approximately 13.7 million shares of its outstanding common stock at an aggregate cost of approximately $91.5 million, leaving approximately 5.7 million shares available for purchase under the current Board authorizations. Purchases are made at management’s discretion based on market conditions and the Company’s financial resources.

 

The Company repurchased the following shares for $20.6 million during the three months ended March 31, 2007:

 

 

Subsequent to the end of the second quarter of 2007 Mesa announced that its Board of Directors has authorized Mesa to repurchase up to an additional 10 million shares of its outstanding common stock. The 10.0 million shares

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

subject to the newly authorized repurchase program are in addition to the 5.7 million shares remaining under the prior repurchase programs.

 

 

In February 2002, the Company entered into an agreement with Raytheon Aircraft Company (the “Raytheon Agreement”) to, among other things, reduce the operating costs of the Company’s Beechcraft 1900D fleet. In connection with the Raytheon Agreement and subject to the terms and conditions contained therein, Raytheon agreed to provide up to $5.5 million in annual operating subsidy payments to the Company contingent upon the Company remaining current on its payment obligations to Raytheon. The amount was subsequently reduced to $5.3 million as a result of a reduction in the Company’s fleet of B1900D aircraft. Approximately $1.3 million was recorded as a reduction to expense during each of the three months ended March 31, 2007 and 2006. In return, the Company granted Raytheon a warrant to purchase up to 233,068 shares of the Company’s common stock at a per share exercise price of $10. The Company recorded the issuance of the warrant at a value of $0.4 million within stockholders’ equity as a debit and credit to common stock. The contra equity value of the warrant was amortized to expense over the vesting period of three years. Raytheon must pay a purchase price of $1.50 per common share underlying the warrant. The warrant was exercisable at any time over a three-year period following its date of purchase. Raytheon is completely vested in the 233,068 shares of common stock underlying the warrant.

 

 

In the first half of fiscal 2007, the Company received approximately 41,000 shares of US Airways common stock from its bankruptcy claim against US Airways, Inc. prior to its merger with America West (“Pre-Merger US Airways”). The Company sold the stock and realized proceeds of $2.1 million. In connection with an amendment to and assumption of our existing Delta Connection Agreement, we received a general unsecured claim of $35.0 million as part of Delta’s bankruptcy proceeding. The receipt of this $35.0 million general unsecured claim is not included in the consolidated financial statements for the quarter ended March 31, 2007, but will be reflected in income in the future at its fair market value.

 

 

In accordance with FAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company continually considers events or changes in circumstances that indicate the carrying amount of a long-term asset may not be recoverable. During the second quarter of 2007 the Company evaluated two such cases. In each instance the gross undiscounted cash flows related to a long-term asset was computed and found to be less than the carrying value of the long-lived asset. The fair market value of the two assets was then determined and an impairment charge, equal to the excess of the carrying value over fair value, was recorded totaling $37.7 million.

 

The first impairment charge, totaling $31.7 million, related to the unamortized balance of a $30.0 million nonrefundable cash incentive (“Incentive”) paid to United in the first and second quarter of fiscal 2006, upon amending our code share agreement with United (the “Amendment”). The Amendment primarily allowed us to place 30 additional aircraft with United, bringing the total aircraft in the United code share to 70, and to extend the expiration dates under the existing code share agreement with respect to certain of the other aircraft. The Incentive was included in other assets and was being amortized as a reduction to revenue over the term of the amended code share agreement. Beginning with the second quarter of fiscal 2006 we began experiencing declining margins related to this code share and management initiated an operational analysis in the fourth quarter of fiscal 2006, which was completed in the second quarter of fiscal 2007. During the second quarter of fiscal 2007 the margins deteriorated further, resulting in management concluding that the Company will incur operating losses over the remaining term of the amended code share agreement. The analysis determined that these losses were due primarily to increases in (1) maintenance costs from certain contractual increases in maintenance support agreements that went into effect in the second quarter of fiscal 2007; (2) lower total completion factors primarily attributable to the locations from

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

which we operate the additional 30 aircraft added in the amended code share agreement, resulting in higher operational costs and higher labor costs resulting from employee turnover and; (3) other underlying costs increasing at greater rates than we had originally anticipated when we entered into the amended code share agreement. In order to determine whether or not this asset was impaired, we estimated the future gross undiscounted cash flows related to this code share agreement and found them to be less than the asset’s unamortized balance. The fair value of the asset was determined to be zero. Accordingly, an impairment charge was taken for $25.3 million. We expect the negative cash flows experienced in the second quarter of fiscal 2007 from this code share agreement to continue at this level and could worsen in the future. The largest single item affecting the cash flows from this code share agreement are the 30 incremental 50-seat regional jets the Company added in early fiscal 2006. In addition, leasehold improvements related to certain aircraft under the United code share agreement were evaluated for recoverability and were determined to be impaired and accordingly an impairment charge was taken for $6.4 million. Management is evaluating various alternatives to address the situation, however there can be no assurance that we will be successful in our efforts.

 

The second impairment charge, totaling $6.0 million, related to the unamortized balance of leasehold improvements for 12 Dash 8-100 aircraft operating under one of our Delta code share agreements. During the second quarter of fiscal 2007, Delta exercised its right to reduce the number of aircraft in the code share agreement by notifying us of its intention to remove all 12 aircraft from service by September 2007. In order to determine whether or not this asset was impaired, we estimated the future gross undiscounted cash flows related to these aircraft and found them to be less than the leasehold improvements’ unamortized balance. Accordingly, an impairment charge of $6.0 million was taken. We expect the negative cash flows experienced during the second quarter of fiscal 2007 from this code share agreement to continue into the third and fourth quarter of fiscal 2007 when the aircraft are removed from service with Delta. At this time, unless alternative uses can be found for the aircraft, the Company anticipates that it will continue to incur the respective aircrafts’ lease costs until the aircraft are scheduled to be returned to their respective lessors in the first and second quarters of fiscal 2008. In addition to the negative operational cash flows we expect to incur additional costs for early termination with the respective lessors. These costs will be recognized when the aircraft are no longer in service. Management is evaluating various alternative uses for the aircraft, including additional flying or subleasing the aircraft to other lessors, however there can be no assurance that we will be successful in our efforts.

 

 

In fiscal 2006, the Company participated with a private equity fund in making an investment in the common stock and notes of a closely held airline related business (the “Investee”). The Company, through its subsidiary Nilchii, invested $15 million, which represents approximately 20% and 12% of the Investee’s common stock and notes, respectively.

 

The Company accounts for its investment using the equity method of accounting. Under the equity method, the Company adjusts the carrying amount of its investment for its share of the earnings or losses of the Investee subsequent to the date of investment and reports the recognized earnings or losses in income. The Company’s share of the Investee’s losses subsequent to the date of investment has exceeded the carrying value of the common stock investment, which has been reduced to zero. In accordance with EITF Issue No. 99-10, “Percentage Used to Determine the Amount of Equity Method Losses,” the Company recognized equity method losses based on the ownership level of the Investee common stock held by the Company until the carrying value of its investment in the common stock was reduced to zero, then by the ownership level of the Investee notes held by the Company. During the second quarter of fiscal 2007, the Company recorded equity method losses from this investment of $3.6 million.

 

The Investee notes held by the Company bear interest at 17%. At March 31, 2007, the Company has a receivable for and has recorded interest income related to these notes in the amount of $1.8 million.

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

During the second quarter of fiscal 2007 we placed $1.3 million on deposit pursuant to a subscription agreement in a limited partnership. Upon closing, the Company will account for this investment using the equity method of accounting.

 

 

Stock based compensation expense is calculated by estimating the fair value of stock options at the time of grant and amortized over the stock options’ vesting period.

 

The following amounts were recognized for stock-based compensation (in thousands):

 

 

 

As of March 31, 2007, the Company had firm orders with Bombardier Aerospace, Inc. for two CRJ-700 aircraft and two CRJ-900 which can be converted to CRJ-700s. In conjunction with this purchase agreement, Mesa had $16.0 million on deposit with Bombardier Regional Aircraft Division that was included in lease and equipment deposits at September 30, 2006. The remaining deposits are expected to be returned upon completion of permanent financing on each of the last four aircraft.

 

The Company accrues for potential income tax contingencies when it is probable that a liability has been incurred and the amount of the contingency can be reasonably estimated. The Company’s accrual for income tax contingencies is adjusted for changes in circumstances and additional uncertainties, such as amendments to existing tax law, both legislated and concluded through the various jurisdictions’ tax court systems. At March 31, 2007, the Company had an accrual for income tax contingencies of approximately $2.9 million. If the amounts ultimately settled are greater than the accrued contingencies, the Company would record additional income tax expense in the period in which the assessment is determined. To the extent amounts are ultimately settled for less than the accrued contingencies, or the Company determines that a liability is no longer probable, the liability is reversed as a reduction of income tax expense in the period the determination is made.

 

The Company also has long-term contracts for the performance of engine maintenance and rotable spare parts. A description of each of these contracts is as follows:

 

During the second quarter of fiscal 2007, the Company entered into a memorandum of understanding (“MOU”) with Delta’s Technical Operations division (“DTO”) for its previously uncovered General Electric Aircraft Engines (“GE”) engines. The MOU requires a monthly payment based upon the prior month’s flight hours incurred by the covered engines. The hourly rate increases over time based upon the engine overhaul costs that are expected to be incurred in that year and is subject to escalation based on changes in certain price indices. Maintenance expense is recognized based upon the product of flight hours flown and the rate in effect for the period.

 

In January 1997, the Company entered into a 10-year engine maintenance contract with GE for certain of its CRJ-200 aircraft engines. The agreement was subsequently amended in the first quarter of fiscal 2003. The amended contract requires a monthly payment based upon the prior month’s flight hours incurred by the covered engines. The hourly rate increases over time based upon the engine overhaul costs that are expected to be incurred in that year and is subject to escalation based on changes in certain price indices. Maintenance expense is recognized

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

based upon the product of flight hours flown and the rate in effect for the period. The contract also provides for a fixed number of engine overhauls per year. To the extent that the number of actual overhauls is less than the fixed number, GE is required to issue to Mesa a credit for the number of events less than the fixed number multiplied by an agreed upon price. To the extent that the number of actual overhauls is greater than the fixed number, Mesa is required to pay GE for the number of events greater than the fixed number multiplied by the same agreed upon price. Any adjustment payments or credits are recognized in the period they occur.

 

In April 1997, the Company entered into a 10-year engine maintenance contract with Pratt & Whitney Canada Corp. (“PWC”) for its Dash-8 aircraft. The contract requires Mesa to pay PWC for the engine overhaul upon completion of the maintenance based upon a fixed dollar amount per flight hour. The rate under the contract is subject to escalation based on changes in certain price indices.

 

In April 2000, the Company entered into a 10-year engine maintenance contract with Rolls-Royce Allison (“Rolls-Royce”) for its ERJ aircraft. The contract requires Mesa to pay Rolls-Royce for the engine overhaul upon completion of the maintenance based upon a fixed dollar amount per flight hour. The rate per flight hour is based upon certain operational assumptions and may vary if the engines are operated differently than these assumptions. The rate is also subject to escalation based on changes in certain price indices. The agreement with Rolls-Royce also contains a termination clause and look back provision to provide for any shortfall between the cost of maintenance incurred by the provider and the amount paid up to the termination date by the Company and includes a 15% penalty on such amount. The Company does not anticipate an early termination under the contract.

 

In May 2002, the Company entered into a six-year fleet management program with PWC to provide maintenance for the Company’s Beechcraft 1900D turboprop engines. The contract requires a monthly payment based upon flight hours incurred by the covered aircraft. The hourly rate is subject to annual adjustment based on changes in certain price indices and is guaranteed to increase by no less than 1.5% per year. Pursuant to the agreement, the Company sold certain assets of its Desert Turbine Services unit, as well as all spare PT6 engines to PWC for $6.8 million, which approximated the net book value of the assets. Pursuant to the agreement, the Company provided a working capital loan to PWC for the same amount, which is to be repaid through a reduced hourly rate being charged for maintenance. The agreement covers all of the Company’s Beechcraft 1900D turboprop aircraft and engines. The agreement also contains a termination clause and look back provision to provide for any shortfall between the cost of maintenance incurred by the provider and the amount paid up to the termination date by the Company and provides for return of a pro-rated share of the prepaid amount upon early termination. The Company does not anticipate an early termination under the contract.

 

In August 2005, the Company entered into a ten-year agreement with AAR Corp. (the “AAR Agreement”) for the management and repair of certain of the Company’s CRJ-200, -700, -900 and ERJ-145 aircraft rotable spare parts inventory. Under the agreement, the Company sold certain existing spare parts inventory to AAR for $39.6 million in cash and $21.5 million in notes receivable (discounted to $18.8 million) to be paid over four years. The AAR agreement was contingent upon the Company terminating an agreement for the Company’s CRJ-200 aircraft rotable spare parts inventory with GE Commercial Aviation Services (“GECAS”) and including these rotables in the arrangement. The Company terminated the GECAS agreement and finalized the AAR agreement in November 2005. Upon entering into the agreement, the Company received $22.8 million ($23.8 million less $1 million deposit that was retained by AAR), which was recorded as a deposit at September 30, 2005, pending the termination of the GECAS agreement. An additional $15.8 million was received in the quarter ended December 31, 2005. Under the agreement, the Company is required to pay AAR a monthly fee based upon flight hours for access to and maintenance and servicing of the inventory. The agreement also contains certain minimum monthly payments that Mesa must make to AAR. Based on this arrangement, the Company accounts for the transaction as a service agreement and an operating lease of rotable spare parts with AAR. The sale of the rotable spare parts resulted in a gain of $2.1 million, which has been deferred and is being recognized over the term of the agreement. At termination, the Company may elect to purchase the covered inventory at fair value, but is not contractually obligated to do so.

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In June 2006, the Company entered into a separate two-year agreement with AAR for the management and repair of the Company’s CRJ-200 aircraft rotable spare parts inventory associated with its go! operations. Under this agreement, the Company transferred certain existing spare parts inventory to AAR for $1.2 million in cash. AAR was required to purchase an additional $2.9 million in rotable spare parts to support the agreement. Under the agreement, the Company is required to pay AAR a monthly fee based upon flight hours for access to and maintenance of the inventory. At termination, the Company has guaranteed the fair value of the underlying rotables. Based on this arrangement, the Company accounts for the transaction as a financing arrangement, thus recording both the rotable spare parts inventory as an asset and the related payable to AAR as a liability.

 

During the second quarter of fiscal 2007, the Company amended a five-year heavy equipment maintenance agreement with a vendor. The agreement provides a rebate based upon annual volumes up to $10.0 million over the next five years. The agreement also includes penalties in the event our annual volumes fall below certain levels. The maximum penalty possible would be $19.0 million if our annual volumes were zero for all five years. Rebates of approximately $1.0 million have been included in the current quarter.

 

In February 2006, Hawaiian Airlines, Inc. (“Hawaiian”) filed a complaint against the Company in the United States Bankruptcy Court for the District of Hawaii (the “Bankruptcy Court”) alleging that the Company breached the terms of a Confidentiality Agreement entered into in April 2004 with the Trustee in Hawaiian’s bankruptcy proceedings. Hawaiian’s complaint alleges, among other things, that the Company breached the Confidentiality Agreement by (a) using the evaluation material to obtain a competitive advantage over Hawaiian, through the development and implementation of a business plan to compete with Hawaiian in the inter-island market, and (b) failing to return or destroy any evaluation materials after being notified by Hawaiian on or about May 12, 2004 that the Company had not been selected as a potential investor for a transaction with Hawaiian. Hawaiian, in its complaint, seeks unspecified damages, requests that the Company turn over to Hawaiian any evaluation material in the Company’s possession, custody or control (the “Turnover Claim”), and an injunction preventing the Company from providing inter-island transportation services in the State of Hawaii for a period of two years from the date of such injunctive relief.

 

The Company vigorously denies Hawaiian’s allegations and requests for relief contained in its complaint. The Company filed both an answer and an antitrust counterclaim against Hawaiian in response to its complaint. In May 2006, the Company filed a motion to dismiss the Turnover Claim contained in Hawaiian’s complaint, but the Bankruptcy Court denied that motion. On December 8, 2006 the Bankruptcy Court, based on constitutional access to the courts, also granted Hawaiian’s motion for summary judgment against the Company on its antitrust counterclaim. The Company does not believe that either of these decisions has a material impact on the Company’s position in the lawsuit. Finally, in October 2006, the Bankruptcy Court denied Hawaiian’s effort to enjoin the Company’s go! operation from selling tickets claiming that go!’s entry into the inter-island air transport business was based on trade secrets furnished to Mesa during the Hawaiian bankruptcy. The Court found no such misuse of confidential information and rejected Hawaiian’s motion for a preliminary injunction.

 

In June 2006, Hawaiian requested a preliminary injunction to prevent the Company from issuing new airline tickets for the Hawaiian inter-island market for a period of one year. In this request, Hawaiian alleges that initial discovery conducted reveals that the Company breached the Confidentiality Agreement. The Court has recently denied Hawaiian’s request for a preliminary injunction. The case will be tried in September 2007.

 

On October 13, 2006, Aloha Airlines filed suit against Mesa Air Group and two of its Hawaii based employees (individual defendants subsequently dismissed without prejudice). The complaint was filed in State Court in Hawaii and contains 11 counts and seeks damages and injunctive relief. The Company believes the purpose of the complaint is to blunt Mesa’s entry into the Hawaii inter-island market segment. Aloha alleges that Mesa’s inter-island air fares are below cost and that Mesa is, therefore, violating specific provisions of Hawaii antitrust and unfair competition law. Aloha also alleges breach of contract and fraud by Mesa in connection with two confidentiality agreements, one in 2005 and the other in 2006.

 

MESA AIR GROUP, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In 1992, The Supreme Court of the United States decided Morales v. TWA, in which it construed the Airline Deregulation Act as prohibiting any state court, under any state law legal theory, from adjudicating issues which implicated an air carrier’s pricing (or other service) practices. Accordingly, an airline’s pricing decisions can be attacked only under federal laws. In response to the complaint, Mesa filed a motion on December 8, 2006 seeking dismissal of all claims based upon Hawaii Statutory Law that rest on Mesa’s alleged below-cost pricing. Following the filing of Mesa’s Motion to Dismiss, Aloha, on January 10, 2007, voluntarily chose to dismiss the action filed in State Court, and simultaneously filed a new complaint in the United States District Court for the District of Hawaii (filed on January 9, 2007). Aloha’s federal complaint abandoned claims regarding below-cost pricing under Hawaii’s Statutory Law and instead asserted claims under contract and federal antitrust law. On March 19, 2007, the US District Court denied Mesa’s motion to dismiss the contract claims under the authority of Morales and its progeny. Mesa has asked the District Court to certify that ruling for immediate appellate review.

 

Mesa denies any improper use of the data furnished by Aloha while Mesa was considering a bid for Aloha during its bankruptcy. The case is in its early stages and has been set for trial in April 2008.

 

The Company is also involved in various legal proceedings and FAA civil action proceedings that the Company does not believe will have a material adverse effect upon its business, financial condition or results of operations, although no assurance can be given to the ultimate outcome of any such proceedings.

 

The following discussion and analysis provides information which management believes is relevant to an assessment and understanding of the Company’s results of operations and financial condition. The discussion should be read in conjunction with the Consolidated Financial Statements and the related notes thereto, and the Selected Financial Data and Operating Data contained elsewhere herein.

 

Forward-Looking Statements

 

This Quarterly Report on Form 10-Q contains certain statements including, but not limited to, information regarding the replacement, deployment, and acquisition of certain numbers and types of aircraft, and projected expenses associated therewith; costs of compliance with Federal Aviation Administration regulations and other rules and acts of Congress; the passing of taxes, fuel costs, inflation, and various expenses to the consumer; the relocation of certain operations of Mesa; the resolution of litigation in a favorable manner and certain projected financial obligations. These statements, in addition to statements made in conjunction with the words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” and similar expressions, are forward-looking statements within the meaning of the Safe Harbor provision of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements relate to future events or the future financial performance of Mesa and only reflect management’s expectations and estimates. The following is a list of factors, among others, that could cause actual results to differ materially from the forward-looking statements: changing business conditions in certain market segments and industries; changes in Mesa’s code-sharing relationships; the inability of Delta Air Lines, US Airways or United Airlines to pay their obligations under the code-share agreements; an increase in competition along the routes Mesa operates or plans to operate; material delays in completion by the manufacturer of the ordered and yet-to-be delivered aircraft; availability and cost of funds for financing new aircraft; changes in general economic conditions; changes in fuel price; changes in regional economic conditions; Mesa’s relationship with employees and the terms of future collective bargaining agreements; the impact of current and future laws; additional terrorist attacks; Congressional investigations, and governmental regulations affecting the airline industry and Mesa’s operations; bureaucratic delays; amendments to existing legislation; consumers unwilling to incur greater costs for flights; our ability to operate our new Hawaiian airline service profitably; unfavorable resolution of legal proceedings involving Hawaiian Airlines and Aloha Airlines regarding our Hawaiian operation; unfavorable resolution of negotiations with municipalities for the leasing of facilities; and risks associated with the outcome of litigation. One or more of these or other factors may cause Mesa’s actual results to differ materially from any forward-looking statement. Mesa is not undertaking any obligation to update any forward-looking statements contained in this Form 10-Q.

 

All references to “we,” “our,” “us,” or “Mesa” refer to Mesa Air Group, Inc. and its predecessors, direct and indirect subsidiaries and affiliates.

 

GENERAL

 

The following discussion and analysis provides information which management believes is relevant to an assessment and understanding of the Company’s results of operations and financial condition. The discussion should be read in conjunction with the Condensed Consolidated Financial Statements and the related notes thereto, contained elsewhere in this Form 10-Q.

 

Executive Overview and Summary Financial Results

 

The second quarter of fiscal year 2007 was a difficult quarter for us resulting in a loss of $24.0 million or $0.75 per diluted share compared with net income of $5.3 million and $0.14 per diluted share in the second quarter of fiscal 2006. Total gross revenue increased $24.4 million or 7.8% to $336.4 million on 3.8% more capacity over the same period in the preceding year. Due to certain impairment charges reflected against revenue discussed below, our net revenues were $311.1 million for the second fiscal quarter representing a decrease of $1.0 million or 0.3% below that of the preceding year. Our fleet has grown from 180 as of March 31, 2006, to 201 as of March 31, 2007. The

results for the second quarter of fiscal 2007 reflected a number of significant non-cash charges totaling $45.7 million comprised of impairment charges ($37.7 million), unrealized losses on investment securities ($4.5 million), and equity method losses ($3.6 million). These amounts were partially offset by $12.2 million debt conversion costs taken in the second quarter of fiscal 2006. The impairment charges are discussed below.

 

Excluding the impairment charges associated with certain assets related to the Delta and United code share agreements, operational challenges associated with the effects of inclement weather and air traffic control in our United Express operations resulted in a total completion factor well below that of our other operations, adversely affecting operating income as revenue was reduced and many of our expenses were not fully reimbursed. These operational challenges had the greatest effect on Mesa’s 50-seat United Express operations.

 

Our maintenance expenses increased during the quarter on a year over year and sequential basis due primarily to a new power-by-the-hour engine memorandum of understanding covering all of our previously uncovered General Electric engines, contractual increases in our existing power-by-the-hour engine agreement with General Electric, and increased volume due to higher than anticipated usage in our United Express operations as well as contractual increases in our auxiliary power unit (“APU”) overhauls. Power-by-the-hour agreements provide the operator with a fixed engine maintenance cost over an extended period of time.

 

During the current quarter, United assumed responsibility for a portion of our United Express fuel purchases. As a result going forward, our revenues, as well as our fuel expenses related thereto, will be reduced by approximately 4.3 million gallons of fuel per quarter. Due to the pass-through feature of our contracts, this will not impact our income from operations.

 

In accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company continually considers events or changes in circumstances that indicate the carrying amount of a long-term asset may not be recoverable. During the second quarter of 2007 the Company evaluated two such cases. In each instance the gross undiscounted cash flows related to a long-term asset was computed and found to be less than the carrying value of the long-lived asset. The fair market value of the two assets was then determined and an impairment charge, equal to the excess of the carrying value over fair value, was recorded totaling $37.7 million.

 

The first impairment charge, totaling $31.7 million, related to the unamortized balance of a $30.0 million nonrefundable cash incentive (“Incentive”) paid to United in the first and second quarter of fiscal 2006 upon amending our code share agreement with United (the “Amendment”). The Amendment primarily allowed us to place 30 additional aircraft with United, bringing the total aircraft in the United code share to 70, and to extend the expiration dates under the existing code share agreement with respect to certain of the other aircraft. The Incentive was included in other assets and was being amortized as a reduction to revenue over the term of the amended code share agreement. Beginning with the second quarter of fiscal 2006 we began experiencing declining margins related to this code share and management initiated an operational analysis in the fourth quarter of fiscal 2006, which was completed in the second quarter of fiscal 2007. During the second quarter of fiscal 2007 the margins deteriorated further, resulting in management concluding that the Company will incur operating losses over the remaining term of the amended code share agreement. The analysis determined that these losses were due primarily to increases in (1) maintenance costs from certain contractual increases in maintenance support agreements that went into effect in the second quarter of fiscal 2007; (2) lower total completion factors primarily attributable to the locations from which we operate the additional 30 aircraft added in the amended code share agreement, resulting in higher operational costs and higher labor costs resulting from employee turnover and; (3) other underlying costs increasing at greater rates than we had originally anticipated when we entered into the amended code share agreement. In order to determine whether or not this asset was impaired, we estimated the future gross undiscounted cash flows related to this code share agreement and found them to be less than the asset’s unamortized balance. The fair value of the asset was determined to be zero. Accordingly, an impairment charge was taken for $25.3 million. We expect the negative cash flows experienced in the second quarter of fiscal 2007 from this code share agreement to continue at this level and could worsen in the future. The largest single item affecting the cash flows from this code share agreement are the 30 incremental 50-seat regional jets the Company added in early fiscal 2006. In addition, leasehold improvements related to certain aircraft under the United code share agreement were evaluated for recoverability and were determined to be impaired and accordingly an impairment charge was taken for $6.4 million. Management is evaluating various alternatives to address the situation, however there can be no assurance that we will be successful in our efforts.

 

The second impairment charge, totaling $6.0 million related to the unamortized balance of leasehold improvements for 12 Dash 8-100 aircraft operating under one of our Delta code share agreement. During the second quarter of fiscal 2007, Delta exercised its right to reduce the number of aircraft in the code share agreement by notifying us of its intention to remove all 12 Dash 8-100 aircraft from service by September 2007. In order to determine whether or not this asset was impaired, we estimated the future gross undiscounted cash flows related to these aircraft and found them to be less than the leasehold improvements’ unamortized balance. Based on the nature of these leasehold improvements the fair value of the leasehold improvements was determined to be zero. Accordingly, an impairment charge was taken for 6.0 million. We expect the negative cash flows experienced during the second quarter of fiscal 2007 from this code share agreement to continue into the third and fourth quarter of fiscal 2007 when the aircraft are removed from service with Delta. At this time, unless alternative uses can be found for the aircraft, the Company anticipates that it will continue to incur the respective aircrafts’ lease costs until the aircraft are scheduled to be returned to their respective lessors in the first and second quarters of fiscal 2008. In addition to the negative operational cash flows we expect to incur additional costs for early termination with the respective lessors. These costs will be recognized when the aircraft are no longer in service. Management is evaluating various alternative uses for the aircraft, including additional flying or subleasing the aircraft to other lessors, however there can be no assurance that we will be successful in our efforts.

 

Our gross operating revenues were $684.0 million for the six months ended March 31, 2007, an increase of $48.4 million or 7.6% over the same period in the preceding year. Due to certain impairment charges reflected against revenue discussed above, our net revenues were $658.7 million for the six months ended March 31, 2007 representing an increase of $23.0 million or 3.6% above that of the preceding year. The net loss for the first six months of fiscal 2007 was $16.0 million or $0.49 per diluted share compared with net income of $18.3 million and $0.48 per diluted share in the first six months of fiscal 2006. The year over year variances for the first six months of 2007 versus 2006 are largely explained above, except for a $2.1 million decrease in operating costs resulting from a bankruptcy settlement in the first half of fiscal 2007.

 

The new CRJ-900s are expected to begin service in November 2007. We began removing the twelve Dash-8 aircraft in April 2007 and expect to have all twelve Dash-8’s removed from service by August 2007.

 

Our joint venture agreement with Shenzhen Airlines to operate regional jets throughout China is progressing, with plans to send the initial aircraft by the end of summer.

 

Code-Share Agreements

 

The Company has reached an agreement with Delta Air Lines (“Delta”) under its Delta Connection Agreements (“DCA”) to remove twelve Dash-8 aircraft operated under the DCA by Mesa’s subsidiary Freedom Airlines. Mesa’s recently announced expanded code share agreement with Delta to operate 14 CRJ-900 regional jet aircraft (“Expansion DCA”) will remain in place. After service begins pursuant to the Expansion DCA and the amended DCA, the Mesa regional jet fleet flying for Delta will consist of 14 CRJ-900s and 36 ERJ-145s.

 

Fleet

 

Aircraft in operation at March 31, 2007:

 

 

Approximately 98% of our consolidated passenger revenues for the quarter ended March 31, 2007 were derived from operations associated with code-share agreements. Our subsidiaries have code-share agreements with

US Airways, Delta Air Lines, Midwest Airlines and United Airlines. The remaining passenger revenues are derived from our independent operations, go! and Mesa Airlines.

 

The following tables set forth quarterly comparisons for the periods indicated below:

 

OPERATING DATA

 

 

CONSOLIDATED FINANCIAL DATA

 

 

Note: numbers in table may not recalculate due to rounding

FINANCIAL DATA BY OPERATING SEGMENT

 

 

RESULTS OF OPERATIONS

 

For the three months ended March 31, 2007 versus the three months ended March 31, 2006

 

Operating Revenues

 

In the three months ended March 31, 2007, gross operating revenue increased by $24.3 million or 7.8% from $312.1 million in the three months ended March 31, 2006 to $336.4 million. The increase in revenue is primarily attributable to a $19.4 million increase in contract revenue at Mesa/Freedom, driven by higher activity-based revenue as a result of the increased number of aircraft in service with our code-share partners. In addition, Air Midwest/go! revenue increased $7.8 million primarily due to a $4.5 million increase in prorate revenue and a $2.0 million increase in Essential Air Service revenue. Due to certain impairment charges reflected against revenue discussed above, our net revenues were $311.1 million for the second fiscal quarter representing a decrease of $0.9 million or 0.3% below that of the preceding year.

 

Operating Expenses

 

Flight Operations

 

In the three months ended March 31, 2007, flight operations expense increased $4.3 million, or 4.7%, to $95.1 million from $90.8 million for the three months ended March 31, 2006. On an ASM basis in the three months ended March 31, 2007, flight operations expense of $0.042 per ASM remained unchanged from the three months ended March 31, 2006. The increase is due primarily to incremental aircraft leases associated with additional Delta

Dash-8’s at Mesa/Freedom and CRJ-200’s at go! and increased lodging expenses due to the startup of our Delta Dash-8 operation in JFK.

 

Fuel

 

In the three months ended March 31, 2007, fuel expense increased $1.9 million, or 1.9%, to $105.1 million from $103.2 million for the three months ended March 31, 2006. On an ASM basis, fuel expense decreased 1.8% to $0.046 per ASM in the three months ended March 31, 2007 compared to $0.047 per ASM in the three months ended March 31, 2006. Overall consumption of fuel increased by 2.7 million gallons or 5.3% in the three months ended in March 31, 2007 to 53.0 million gallons from 50.3 million gallons in the three months ended March 31, 2006; resulting in a $5.3 million expense increase due to volume. The additional fuel expense was mainly driven by the addition of go! and the increase in flights flown for Delta. These increases were offset by a 3.2% reduction in our “into-plane” fuel cost in the three months ended March 31, 2007 to $1.98 per gallon from $2.05 per gallon in the three months ended March 31, 2006. However, total gallons would have increased more in line with the increase in block hours, which increased 15.5% in the three months ended March 31, 2007, except that United, beginning in January 2007 in the Chicago O’Hare station, began purchasing its own fuel which reduced Mesa’s fuel expense and revenue by 4.25 million gallons or approximately $8.4 million, respectively.

 

Maintenance Expense

 

In the three months ended March 31, 2007, maintenance expense increased $25.1 million, or 52.7%, to $72.7 million from $47.6 million for the three months ended March 31, 2006. Maintenance expense increased primarily due to (1) higher engine overhaul costs driven by a new power-by-the-hour engine agreement covering all of our previously uncovered GE engines and contractual rate increases, (2) high costs related to airframe checks which did not occur in the three months ended March 31, 2006, and (3) increased material/repair services expense primarily for engine components and landing gear overhauls. Maintenance expense at Air Midwest/go! increased $2.0 million year over year. On an ASM basis, maintenance expense increased 47.1% to $0.032 per ASM in the three months ended March 31, 2007 from $0.022 per ASM in the three months ended March 31, 2006.

 

Aircraft and Traffic Servicing

 

In the three months ended March 31, 2007, aircraft and traffic servicing expense increased by $5.6 million, or 30.6%, to $23.9 million from $18.3 million for the three months ended March 31, 2006. On an ASM basis, aircraft and traffic servicing expense increased 25.9% to $0.011 per ASM in the three months ended March 31, 2007 from $0.008 per ASM in the three months ended March 31, 2006. Aircraft and traffic servicing expense in the Mesa/Freedom segment increased $3.1 million, which included a $1.3 million increase in station rents and a $2.2 million increase in passenger related costs, primarily landing fees. These increases were primarily a result of moving into higher cost East Coast cities for United and Delta. These costs are reimbursed by our code-share partners. Aircraft and traffic servicing expense in the Air Midwest/ go! segment increased $2.5 million primarily due to the start up of go!

 

Promotion and Sales

 

In the three months ended March 31, 2007, promotion and sales expense increased by $0.9 million, or 105%, to $1.8 million from $0.9 million for the three months ended March 31, 2006. The increase is primarily due to promotional expenses at go!.

 

General and Administrative

 

In the three months ended March 31, 2007, general and administrative expense increased $1.7 million, or 11.7%, to $16.2 million from $14.5 million for the three months ended March 31, 2006 due primarily to increased workers’ compensation costs.

Depreciation and Amortization

 

In the three months ended March 31, 2007, depreciation and amortization expense increased $1.4 million, or 16.2%, to $10.3 million from $8.8 million for the three months ended March 31, 2006. The increase is primarily due to the addition of 3 CRJ-700 aircraft during the second quarter of 2007. Depreciation and amortization for Air Midwest /go! increased $0.6 million primarily due to the launch of go! and the depreciation of certain assets acquired to support go!’s operations.

 

US Airways Bankruptcy Settlement

 

In the three months ended March 31, 2007, the Company received approximately 28,000 shares of US Airways stock which it sold for $1.5 million. This benefit was recorded as a settlement of its US Airways related bankruptcy claim. There were no such settlements in the three months ended March 31, 2006.

 

Interest Expense

 

In the three months ended March 31, 2007, interest expense increased $0.8 million, or 9.0%, to $9.5 million from $8.7 million for the three months ended March 31, 2006. The net increase in interest expense is primarily due to additional debt associated with the addition of 3 CRJ-700 aircraft during the second quarter of 2007.

 

Interest Income

 

In the three months ended March 31, 2007, interest income increased $1.3 million to $3.9 million from $2.6 million for the three months ended March 31, 2006. The increase is due to increases in the rates of return on our cash and marketable securities portfolio.

 

Other Expense

 

In the three months ended March 31, 2007, other expense decreased $5.1 million or 38.7% to $8.1 million from $13.2 million for the three months ended March 31, 2006. This decrease is due primarily to a $12.2 million reduction in debt conversion costs offset by increases of $4.6 million in unrealized losses on investment securities and $3.5 million from equity method losses. The equity method losses were due primarily to the investee recording noncash accounting charges.

 

Income Taxes

 

In the second quarter of fiscal 2007 we recorded a tax benefit of $14.6 million compared to income tax expense of $3.3 million in the second quarter of fiscal 2006. The effective tax rates of 37.8% and 38.5%, respectively, are higher than the statutory rate due to varying state income tax rates and non-deductible permanent differences.

 

RESULTS OF OPERATIONS

 

For the six months ended March 31, 2007 versus the six months ended March 31, 2006

 

Operating Revenues

 

In the six months ended March 31, 2007, gross operating revenue increased by $48.3 million or 7.6% from $635.7 million in the six months ended March 31, 2006 to $684.0 million. The increase in revenue is primarily attributable to a $40.3 million increase in contract revenue for Mesa/Freedom, driven primarily by higher activity-based revenue as a result of the increased number of aircraft in service with our code-share partners. Air Midwest/go! revenue increased $15.5 million primarily due to a $10.9 million increase in prorate revenue and a $3.3 million increase in Essential Air Service revenue due to additional EAS cities. Due to certain impairment charges reflected against revenue as discussed above, our net revenues were $658.7 million for the six months ended March 31, 2007 representing an increase of $23.0 million or 3.6% above that of the preceding year.

Operating Expenses

 

Flight Operations

 

In the six months ended March 31, 2007, flight operations expense increased $11.1 million, or 6.2%, to $191.8 million from $180.7 million for the six months ended March 31, 2006. On an ASM basis in the six months ended March 31, 2007, flight operations expense increased 3.3% to $0.042 per ASM compared to $0.040 per ASM in the six months ended March 31, 2006. The increase is primarily due to increased aircraft lease expenses associated with additional Delta Dash-8’s at Mesa/Freedom and CRJ-200s at go! and increased lodging expenses due to the startup of our Delta Dash-8 operation in JFK.

 

Fuel

 

In the six months ended March 31, 2007, fuel expense increased $14.9 million, or 7.2%, to $222.9 million from $208.0 million for the six months ended March 31, 2006. On an ASM basis, fuel expense increased 4.3% to $0.048 per ASM in the six months ended March 31, 2007 compared to $0.046 per ASM in the six months ended March 31, 2006. This increased volume was mainly driven by the addition of go! and the increase in flights flown for Delta by Mesa/Freedom. These increases were partially offset by a slight reduction in our “into-plane” fuel cost in the six months ended March 31, 2007 versus that of the proceeding year. However, total gallons would have increased more in line with the increase in block hours, which increased 13.0% in the six months ended March 31, 2007, except that United, beginning in January 2007 in the Chicago O’Hare station, began purchasing its own fuel and reduced Mesa/Freedom’s fuel expense and revenue by 4.25 million gallons or $8.4 million, respectively.

 

Maintenance Expense

 

In the six months ended March 31, 2007, maintenance expense increased $33.0 million, or 31.9%, to $136.1 million from $103.1 million for the six months ended March 31, 2006. Maintenance expense increased primarily due to (1) high cost airframe checks, (2) increased material repair/services, (3) increased base maintenance expense related to increased costs to support our JFK and Dulles operations, and (4) higher engine overhaul costs driven by contractual rate increases and a new power-by-the-hour engine agreement covering all of our previously uncovered GE engines. Maintenance expense at Air Midwest/go! increased $3.3 million year over year. On an ASM basis, maintenance expense increased 28.4% to $0.029 per ASM in the six months ended March 31, 2007 from $0.023 per ASM in the six months ended March 31, 2006.

 

Aircraft and Traffic Servicing

 

In the six months ended March 31, 2007, aircraft and traffic servicing expense increased by $10.8 million, or 31.2%, to $45.3 million from $34.5 million for the six months ended March 31, 2006. On an ASM basis, aircraft and traffic servicing expense increased 27.7% to $0.010 per ASM in the six months ended March 31, 2007 from $0.008 per ASM in the six months ended March 31, 2006. Aircraft and traffic servicing expense in the Mesa/Freedom segment increased $6.7 million, which included an increase in station rents and an increase in passenger related costs, primarily landing fees. These increases were primarily the result of moving into higher cost East Coast cities for United and Delta. These costs are largely reimbursed by our code-share partners. Aircraft and traffic servicing expense in the Air Midwest/ go! segment increased $4.2 million primarily due to the start up of go!

 

Promotion and Sales

 

In the six months ended March 31, 2007, promotion and sales expense increased by $1.7 million, or 104.4%, to $3.4 million from $1.7 million for the six months ended March 31, 2006. The increase is primarily due to promotional expenses at go!.

 

General and Administrative

 

In the six months ended March 31, 2007, general and administrative expense was comparable to the same period in 2006 increasing $0.8 million, or 2.3%, to $33.7 million from $32.9 million due primarily to increases related to workers’ compensation.

Depreciation and Amortization

 

In the six months ended March 31, 2007, depreciation and amortization expense increased $3.0 million, or 16.4%, to $21.0 million from $18.0 million for the six months ended March 31, 2006. The increase is primarily due to the addition of 3 CRJ-700 aircraft during the second quarter of 2007. Depreciation and amortization for Air Midwest /go! increased $1.3 million primarily due to the launch of go! and the depreciation of certain assets acquired to support go!’s operations .

 

US Airways Bankruptcy Settlement

 

In the six months ended March 31, 2007, the Company received approximately 41,000 shares of US Airways stock which it sold for $2.1 million. This benefit was recorded as a settlement of its US Airways related bankruptcy claim. There were no such settlements in the six months ended March 31, 2006.

 

Interest Expense

 

In the six months ended March 31, 2007, interest expense increased $1.9 million, or 10.2%, to $20.2 million from $18.3 million for the six months ended March 31, 2006. The net increase in interest expense is primarily due to additional debt associated with the addition of 3 CRJ-700 aircraft during the second quarter of 2007.

 

Interest Income

 

In the six months ended March 31, 2007, interest income increased $2.8 million to $8.4 million from $5.6 million for the six months ended March 31, 2006. The increase is due to increases in the rates of return on our cash and marketable securities portfolio.

 

Other Expense

 

In the six months ended March 31, 2007, other expense decreased $6.3 million or 44.4% to $8.0 million from $14.3 million for the six months ended March 31, 2006. This decrease is due primarily to a $12.2 million reduction in debt conversion costs offset by increases of $4.6 million in unrealized losses on investment securities and $3.5 million from equity method losses. The equity method losses were due primarily to the investee recording noncash accounting charges.

 

Income Taxes

 

In the six months ended March 31, 2007 we recorded a tax benefit of $9.4 million compared to income tax expense of $11.4 million in the six months ended March 31, 2006. The effective tax rates of 37.0% and 38.5%, respectively differ from the statutory rate due to varying state income taxes and to non-deductible permanent differences.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Sources and Uses of Cash

 

At March 31, 2007, we had cash, cash equivalents, and marketable securities (including restricted cash) of $198.1 million, compared to $234.3 million at September 30, 2006. Our cash and cash equivalents and marketable securities are intended to be used for working capital, capital expenditures, acquisitions, and to fund our obligations with respect to regional jet deliveries.

 

Sources of cash for the six months ended March 31, 2007 were due primarily to cash flow from operations before changes in assets and liabilities of $38.0 million. Changes in assets and liabilities added $22.7 million in positive cash flow to obtain $60.7 million in cash provided by operating activities. The $22.7 million was due primarily to proceeds from sales of investment securities, and an increase in accounts payable offset by an increase in receivables, prepaid expenses and expendable parts.

 

Cash used in operating activities was $6.1 million due primarily to capital expenditures of $13.5 million related to the expansion of our regional jet fleet and related provisioning of rotable inventory to support the

additional jets and an additional equity method investment of $1.3 million. These amounts were offset by returns of deposits previously paid on leases and equipment and a decrease in other assets.

 

Cash used in financing activities were $46.1 million due primarily to net paydowns on long-term debt totaling $27.4 million and $24.8 million in common stock repurchased by the Company.

 

As of March 31, 2007, we had net receivables of approximately $60.1 million (net of an allowance for doubtful accounts of $1.8 million), compared to receivables of approximately $47.4 million (net of an allowance for doubtful accounts of $1.6 million) as of September 30, 2006. The amounts due consist primarily of receivables due from our code-share partners, subsidy payments due from Raytheon, Federal excise tax refunds on fuel, insurance proceeds, manufacturers credits and passenger ticket receivables due through the Airline Clearing House. Accounts receivable from our code-share partners was 42.0% of total gross accounts receivable at March 31, 2007.

 

Sources of cash for the six months ended March 31, 2006 were due primarily to cash flow from operations before changes in assets and liabilities of $39.8 million. Changes in assets and liabilities used $62.6 million in negative cash flow to obtain $22.8 million in cash used by operating activities. The $62.6 million was due primarily to purchases of investment securities and incentive payments made in connection with the United amendment. Cash provided by investing activities was $6.5 million due primarily to proceeds from the sale of flight equipment offset by capital expenditures and an increase in restricted cash. Cash flows used in financing activities totaling $23.9 million consisted primarily of principal payments on long-term debt and payments made to finance our rotable inventory.

 

Subsequent to the end of the second quarter of 2007 Mesa announced that its Board of Directors has authorized Mesa to repurchase up to an additional 10 million shares of its outstanding common stock. The 10 million shares subject to the newly authorized repurchase program are in addition to the 5.7 million shares remaining under the prior repurchase programs.

 

Operating Leases

 

We have significant long-term lease obligations primarily relating to our aircraft fleet. These leases are classified as operating leases and are therefore excluded from our consolidated balance sheets. At March 31, 2007, we leased 157 aircraft with remaining lease terms ranging from one to 18.3 years. Future minimum lease payments due under all long-term operating leases were approximately $2.1 billion at March 31, 2007.

 

3.625% Senior Convertible Notes due 2024

 

In February 2004, we completed the private placement of senior convertible notes due 2024, which resulted in gross proceeds of $100.0 million ($97.0 million, net). Cash interest is payable on the notes at the rate of 2.115% per year on the aggregate amount due at maturity, payable semiannually in arrears on February 10 and August 10 of each year, beginning August 10, 2004, until February 10, 2009. After that date, we will not pay cash interest on the notes prior to maturity, and the notes will begin accruing original issue discount at a rate of 3.625% until maturity. On February 10, 2024, the maturity date of the notes, the principal amount of each note will be $1,000. The aggregate amount due at maturity, including interest accrued from February 10, 2009, will be $171.4 million. Each of our wholly owned domestic subsidiaries guarantees the notes on an unsecured senior basis. The notes and the note guarantees are senior unsecured obligations and rank equally with our existing and future senior unsecured indebtedness. The notes and the note guarantees are junior to the secured obligations of our wholly owned subsidiaries to the extent of the collateral pledged.

 

The notes were sold at an issue price of $583.40 per note and are convertible into shares of our common stock at a conversion rate of 40.3737 shares per note, which equals a conversion price of $14.45 per share. This conversion rate is subject to adjustment in certain circumstances. Holders of the notes may convert their notes only if: (i) after March 31, 2004, the sale price of our common stock exceeds 110% of the accreted conversion price for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of the preceding quarter; (ii) on or prior to February 10, 2019, the trading price for the notes falls below certain thresholds; (iii) the notes have been called for redemption; or (iv) specified corporate transactions occur. These notes are not yet convertible. We may redeem the notes, in whole or in part, beginning on February 10, 2009, at a redemption price equal to the issue price,

plus accrued original issue discount, plus any accrued and unpaid cash interest. The holders of the notes may require us to repurchase the notes on February 10, 2009 at a price of $583.40 per note plus accrued and unpaid cash interest, if any, on February 10, 2014 at a price of $698.20 per note plus accrued and unpaid cash interest, if any, and on February 10, 2019 at a price of $835.58 per note plus accrued and unpaid cash interest, if any.

 

6.25% Senior Convertible Notes Due 2023

 

In June 2003, we completed the private placement of senior convertible notes due 2023, which resulted in gross proceeds of $100.1 million ($96.9 million net). Cash interest is payable on the notes at the rate of 2.4829% per year on the aggregate amount due at maturity, payable semiannually in arrears on June 16 and December 16 of each year, beginning December 16, 2003, until June 16, 2008. After that date, we will not pay cash interest on the notes prior to maturity, and the notes will begin accruing original issue discount at a rate of 6.25% until maturity. On June 16, 2023, the maturity date of the notes, the principal amount of each note will be $1,000. The aggregate amount due at maturity, including interest accrued from June 16, 2008, will be $252 million. Each of our wholly owned domestic subsidiaries guarantees the notes on an unsecured senior basis. The notes and the note guarantees are senior unsecured obligations and rank equally with our existing and future senior unsecured indebtedness. The notes and the note guarantees are junior to the secured obligations of our wholly owned subsidiaries to the extent of the collateral pledged.

 

The notes were sold at an issue price of $397.27 per note and are convertible into shares of our common stock at a conversion rate of 39.727 shares per note, which equals a conversion price of $10 per share. This conversion rate is subject to adjustment in certain circumstances. Holders of the notes may convert their notes only if: (i) the sale price of our common stock exceeds 110% of the accreted conversion price for at least 20 trading days in the 30 consecutive trading days ending on the last trading day of the preceding quarter; (ii) prior to June 16, 2018, the trading price for the notes falls below certain thresholds; (iii) the notes have been called for redemption; or (iv) specified corporate transactions occur. These notes became convertible in 2003. The Company may redeem the notes, in whole or in part, beginning on June 16, 2008, at a redemption price equal to the issue price, plus accrued original issue discount, plus any accrued and unpaid cash interest. The holders of the notes may require the Company to repurchase the notes on June 16, 2008 at a price of $397.27 per note plus accrued and unpaid cash interest, if any, on June 16, 2013 at a price of $540.41 per note plus accrued and unpaid cash interest, if any, and on June 16, 2018 at a price of $735.13 per note plus accrued and unpaid cash interest, if any.

 

In fiscal 2006, holders of $156.8 million in aggregate principal amount at maturity ($62.3 million carrying amount) of these senior convertible notes due 2023 converted their notes into shares of Mesa common stock. In connection with these conversions, we issued an aggregate of 6.2 million shares of Mesa common stock and also paid approximately $11.3 million in debt conversion costs to these noteholders. We also wrote off $1.8 million in debt issue costs related to these notes.

 

Interim and Permanent Aircraft Financing Arrangements

 

At September 30, 2006, the Company had an aggregate of $123.1 million in notes payable to an aircraft manufacturer for five aircraft on interim financing. During the second quarter of 2007, the Company permanently financed these five aircraft as well as a sixth aircraft delivered during the first quarter of 2007 with $135.0 million in long-term debt. Under interim financing arrangements, we take delivery and title of the aircraft prior to securing permanent financing and the acquisition of the aircraft is accounted for as a purchase with debt financing. Accordingly, we reflect the aircraft and debt under interim financing on our balance sheet during the interim financing period. After taking delivery of the aircraft, it is our practice and our intention to subsequently enter into a sale and leaseback transaction with an independent third-party lessor. Upon permanent financing, the proceeds from the sale and leaseback transaction are used to retire the notes payable to the aircraft manufacturer. Any gain recognized on the sale and leaseback transaction is deferred and amortized over the life of the lease. These interim financing agreements typically have a term of six months and provide for monthly interest only payments at LIBOR plus three percent. The current interim financing agreement with the manufacturer provides for us to have a maximum of 15 aircraft on interim financing at any one time.

 

Other Indebtedness and Obligations

 

In October 2004, the Company permanently financed five CRJ-900 aircraft with $118.0 million in debt. The debt bears interest at the monthly LIBOR plus three percent and requires monthly principal and interest payments.

 

In January and March 2004, the Company permanently financed five CRJ-700 and six CRJ-900 aircraft with $254.7 million in debt. The debt bears interest at the monthly LIBOR plus three percent and requires monthly principal and interest payments.

 

In December 2003, we assumed $24.1 million of debt in connection with our purchase of two CRJ-200 aircraft in the Midway Chapter 7 bankruptcy proceedings. The debt, due in 2013, bears interest at the rate of 7% per annum through 2008, converting to 12.5% thereafter, with principal and interest due monthly.

 

As of March 31, 2007, we had $12.6 million in restricted cash on deposit collateralizing various letters of credit outstanding and the ACH funding of our payroll.

 

Contractual Obligations

 

As of March 31, 2007, we had $691.5 million of long-term debt (including current maturities). This amount consisted of $552.7 million in notes payable related to owned aircraft, $137.8 million in aggregate principal amount of our senior convertible notes due 2023 and 2024 and $1.0 million in other miscellaneous debt.

 

The following table sets forth our cash obligations (including principal and interest) as of March 31, 2007.