Analysts square off over Westjet

[Rebel]

Analysts square off over Westjet
Maintenance an issue: Dlouhy's Doerksen disagrees with Mark Rosen

Ian Karleff
Financial Post

May 28, 2004

WestJet Airlines ltd. prides itself on making Canadian air travel fun for its passengers and lately it's also providing plenty of distractions for financial analysts.

The most amusing issue boils down to how westjet accounts for major maintenance checks (d-checks) on its aircraft, which at $2-million to $3-million every five to seven years, can have a significant impact on the bottom line depending on how and when the expense is taken.

A report from accountability research first shed light on the issue in january, and put westjet and its underwriters on the defensive by saying the day of reckoning was near.

This week dlouhy merchant struck back, saying the company is doing the right thing and recent changes to the maintenance regime makes the topic "Irrelevant."

The debate has bounced back and forth for five months, in which time the stock has dropped 28% for a number of reasons above and beyond accounting, including higher fuel costs, rising airport fees, and stiffer competition from a reinvigorated air canada.

The issue is a good example of how accounting is more art than science, and shows how vulnerable earnings and stock valuations are to a slight shift in the way an item finds its way on to the income statement.

To date, westjet has chosen not to expense the "D-checks" as the aircraft accumulates miles during the five- to seven-year period, but capitalizes the maintenance as an asset and depreciates it over time until the next D-check is due.

WestJet treats the D-check in this way because they see it as something that adds value to their aircraft to fly another five to seven years, rather than the restoration of the plane after half a dozen years of service.

"The D check must add value and economic life, and should be treated as a capital improvement in much the same way as adding a new roof to a building adds value and economic life to that asset," wrote Dlouhy Merchant' analyst Cameron Doerksen.

But Mark Rosen at Accountability Research says the method, while conforming to Canadian Generally Accepted Accounting Principles, is an aggressive way of overstating earnings that doesn't match expenses with revenues.

"There is a big difference between restoring an asset to a usable condition and improving an asset ... it's funny that they take the most extreme approach and call it the most conservative."

"We said: they were purchasing new aircraft, running them down to an unusable condition, and not matching expenses on maintenance for running them down."

WestJet's accounting treatment is in line with other airlines, including Southwest Airlines, and is in keeping with GAAP. But WestJet is in a high growth phase, says Mr. Rosen, with its fleet growing sixfold since 1999, which means that the delayed expenses are more significant than for other airlines.

Mr. Rosen says other methods are preferable including the accrual of measurable maintenance expenses on an ongoing basis, even though the cost is incurred at a much later date, recognizing additional depreciation expenses, or expensing the maintenance as it is incurred.

WestJet countered that the Rosen's accrual method is not allowable under GAAP, and in the true spirit of a debate, Mr. Rosen pointed out that it was allowable, and used by steel companies and in the shipping industry.

Mr. Doerksen might just have the last word, saying "the argument is irrelevant" because WestJet has developed a new heavy maintenance regime that replaces the one-time D-check with a rolling D-check. According to the company this system is safer, requires less outsourcing of labour and eliminates what amounts to two or three months of the aircraft being out of service.

The analyst says "it is false to suggest that WestJet's costs are understated" as the company has yet to realize the full benefit of its fleet renewal, and higher future maintenance costs will be tempered by lower future interest expense because of smaller loans for the company's aircraft.

Also, the smoothing out of anticipated maintenance costs would run "contrary to the principles of accounting conservatism", and conservative accounting is what the critics want, he said.

Mr. Rosen says the interest expense argument only clouds the issue, while estimating is a common practice in accounting. In his view, everything boils down to the fact that the airline's rapid growth means that deferred expenses are mushrooming, earnings are overstated, and heady earnings multiples don't take into account the total cost of flying passengers.

Now that the issue is well aired, it's up to the market to decide.

© National Post 2004

[Panama Jack]

Interesting article.

I though I had also read somewhere else that the real money to be made in the airline industry is through creative accounting practices rather than the assumed core business of carrying passengers and cargo from point A to point B. I guess only time will tell. For the sake of the employees at Westjet, I hope the future will be as smooth as the past.

[Rebel]

Creative accounting has gotten a lot of big name companies in trouble with the US regulators. I’m with you, I hope it doesn’t come back and bite the WJ employee group.

There is an interesting rumour going around how unhappy WJ is with the high costs associated with their YYZ operation. I know that AC is having trouble retaining part-time staff with the low wages been paid so I suspect WJ and JG are having the same problem.

I really don’t understand the bean counters, they don’t seem to understand that you get what you pay for. A high turnover of staff coupled with a higher risk of accidents due to folks been new on the job or not caring ends up costing more money then paying a descent wage.

[Bcn-In-Bnd]

"WestJet has developed a new heavy maintenance regime that replaces the one-time D-check with a rolling D-check. According to the company this system is safer, requires less outsourcing of labour and eliminates what amounts to two or three months of the aircraft being out of service. "

Does this mean that they are doing there D-checks this way OR this is what they have come up with and are waiting for TC/FAA/BOEING to approve it.
One other thing, does this not just SPREAD the cost of a d-ckeck out over a longer time period? (a cost is a cost)



Now you WJ people dont get all up-set I am just asking a question not commenting on how you do things.

[CAPGEN]

One other thing, does this not just SPREAD the cost of a d-ckeck out over a longer time period? (a cost is a cost)

You're right, but that was the point of the article. GAAP requires you to match your expenses with your revenues in a given period. If a "D" check only happens every 5 years, your expenses will be understated in years 1-4, and then overstated in year 5, when the maintenance expense comes due. So in year 4 your books could show you MADE 1 million, and in year 5 the show you LOST 4 million simply because your maintenance came due in year 5.

In this case, you're supposed to "pay yourself" 1/5th of the "D" check cost each year, to reflect the "wear and tear" that requires the maintenance, and thus will match your expenses with your revenues.

In the case of the rolling check, perhaps they will actually do 1/5 of the "D" check maintenance each year, and those costs will be incurred during that year, not 5 years later, and therefore satisfying GAAP's matching principle.

[Mitch Cronin]

This "rolling D check" is actually a "phase check" system done on all later generation machines and is a maintenance schedule known as "MSG-3" (Maintenance steering group, 3rd kick at the can)... develloped by a/c manufacturers (in this case, Boeing) and the FAA, not WJ.

Likely, the -200's will still have to undergo D checks, should they elect to keep them 'til they're due and beyond... (but I doubt that)

[hz2p]

The airline business is not only a commodity business (which in the absence of a legislated monopoly virtually guarantees low margins), it's a capital-intensive commodity business, which is techno-babble for financial suicide.

I don't know why anyone would put money into such a business activity. Only a fool would expect to profit by it.

[MurtsAir]

Ok Just my two cents here. Are they refering to the old 737-200 that are being phased out or even the new 700's. My way of thinking is if your going to get rid of the old 200 why invest 2 million or so in an aircraft that is worth 2 million. First off there isnt really a market for the old 200 anymore most airlines have the newer generation 737's. One question though arnt "d" checks required per time.

[Bcn-In-Bnd]

One question though arnt "d" checks required per time.

Ya if I understand this stuff. The only reason you would do a
"rolling D check" / "phase check" is so that the accounting books always look good (soto speak). yes-no.

[DragEraser]

When they purchase another aircraft, hire pilots and issue(make) more shares which drives the stock up a few points each quarter or so scare you people? What will happen to your profit sharing cheques when the company stops growing? How has the profit sharing been this quarter compared to the same quarter last year?

It wasn't a bad deal when the fleet consisted of just 200's. Lots more profit to share.

[cyyz]

What will happen to your profit sharing cheques when the company stops growing?

If we want it to ever fill in the void for A/C it won't stop growing for many years to come..

Sketchy accounting practices that are approved by the government c'est la vie...

[Mitch Cronin]

One question though arnt "d" checks required per time.

Ya if I understand this stuff. The only reason you would do a
"rolling D check" / "phase check" is so that the accounting books always look good (soto speak). yes-no.

Negative... All the more recent birds (Airbus's, and NG Boeing beasts) are maintained IAW that MSG-3 sked... ie-phase checks... in any airline I know of... The biggest saving is that the bird is never out of service for any huge length of time...

D checks still apply to the older beasties though. No gettin' 'round that that I'm aware of. My bet is WJ will be kissing their -200's buhbye as they come due.

[Bcn-In-Bnd]

Griffon,
thanks for the good info.

[Arthur Q]

Long time listener first time caller

Just to expaned on phase checks, I was talking to our maintenance and they said down time for a 737-700 was 5 days a year. The 737-200 worked to about 35 days a year. He also said that they were saving so much time and money that hiring on the maintenance side has slowed as well.

[Rebel]

This from the AC forum:

"Segmented D-checks spread maintenance costs over the 5-7 year period. Much of our own fleet was or still is on similar programs. (Narrow body Airbus ‘Phase Check' is a segmented C-check program)

Segmented checks have an initial higher cost because some of the work must be done in advance of due dates so that by the entire aircraft is complete by the time the aircraft reaches OEM specified hours and cycles. The benefit can be a significant reduction in total down days for maintenance. To the extreme some carriers have used manufacturer approved programs that eliminated removing aircraft from service by doing inspections and repairs on very small areas of the aircraft on an overnight bases. Aloha was on such a program prior to the infamous flt-243 incident where the fwd upper crown section separated on a B737-200, back in 1988. I don’t think that a segmented program to this extreme exists any longer.

It is a Boeing re-design concept for the new generation 737-600/700/800/900 to be on a phased check program and have a significantly reduced maintenance cost over any other competitive aircraft. In YVR, we are currently doing the heavy maintenance on the Aloha fleet of B-737’s. The legacy 200’s and the new generation 700,s and it is impressive to see the redesigned version of the B-737."

[scubasteve]

Hey Rebel - going back to your earlier post about WJ higher costs at YYZ....Thats something I dont understand. Part of WestJets advantage was the lower costs at YHM and YXU as well as easier access and cheaper parking. I've done the Calgary to London/Hamilton route a number of times and have taken WestJet everytime. If I have to travel to YYZ, then I'm more likely to consider AC and JG. I think they are moving away from what made them successful and the fares seem to be more now as well.

As for their accounting practices...if its allowed why wouldn't they do it? Most businesses would follow accounting methods that would make them better off dont you think? Technically it doesn't follow the matching principle but it is legal so why the fuss. Smart investors or at least those willing to invest some time and investigate the company would know that the books might be overstated and can make decisions with that knowledge in hand. Companies have choices in how they depreciate assets etc and that also changes the books but discussions like this dont happen over that. The new phase checks should make things simpler and make the books more closely reflect the real situation.

[Rebel]

scubasteve

I agree WJ appears to have moved off their business plan with the move into YYZ. It is surprising, as anyone could have seen that the GTAA was in the business of empire building. Down the road this GTAA unaccountability is going to cost the airlines big bucks, which then will be passed on to the consumer.

The accountability for WJ’s creative accounting practices will be determined by the stock market. If the folks that speculate in airline stocks don’t like what they see they’ll dump the stock. Unfortunately the WJ employees will get hurt as their stock options account for a sizeable part of their salary.

[Flyin' Hack]

I don't really see what the big fuss is about anyway. If the way they do their books is legal under law, then I agree with scubasteve, why wouldn't they do it? I did taxes and accounting for various businesses over four years. There's a lot more to it than just the tax return, with various other reports to follow. If anyone looks at any business just by looking at one set of documents for one year, then they don't know much about that business at all. You need to look at the big picture, and no type of creative accounting can hide that. It's like saying it's a good/bad book by only reading one chapter and missing the point of the story.

[Rebel]

..Chapter ll

"WestJet Airlines has lost its bid to have Air Canada's lawsuit, accusing the Calgary-based discount carrier of corporate espionage, moved from an Ontario court to Alberta.

Ontario Superior Court Justice Ian Nordheimer said Monday that all the factors regarding where the case should be heard were neutral, with the exception of the location of key witnesses which favoured Alberta.

However, he wrote, that was not enough to move the case.

"The fact remains that the defendants must show that Alberta is plainly a more appropriate forum than Ontario," Judge Nordheimer wrote in a 19-page decision.

"The defendants have failed to discharge that burden."

WestJet lawyers had argued the case should be heard in Alberta where the airline's head office and the base for two employees named in the lawsuit - financial analyst Jeffrey Lafond and strategic planning vice-president Mark Hill.

In its statement of claim filed in April, Air Canada alleged WestJet used the personal identification number of Lafond, a former Canadian Airlines International employee, to get access to a private Air Canada website.

The site is used by current and former Air Canada employees to book personal travel. Lafond was allowed this privilege in October 2000 after leaving Canadian Airlines, which was acquired earlier by Air Canada.

The website shows when space is available on planes and whether that space is likely to remain available.

Air Canada alleges WestJet used Lafond's code to access the site 243,630 times between May 15, 2003 and March 19, 2004. With that information, WestJet could alter its routes and improve their expansion plans, Air Canada charges.

The statement of claim contains allegations that haven't been tested in court.

The suit seeks punitive damages of $5 million, but could involve millions of dollars more in revenues and profits that Air Canada, which is operating under bankruptcy-court protection, says it lost because of the alleged snooping.

WestJet, which has been eating up domestic market share at Air Canada's expense, stepped up the pressure in April when it shifted the hub of its operations in Ontario from Hamilton to Toronto and more than doubled its flights through Canada's largest city."

[cyyz]

"Air Canada alleges WestJet used Lafond's code to access the site 243,630 times between May 15, 2003 and March 19, 2004. With that information, WestJet could alter its routes and improve their expansion plans, Air Canada charges"

Hey Doug, Lafond guy has been on our comp system 100k times in the last month.

That's cool

Doug, 150k

That's cool

Doug, 200k

That's cool..

Doug 243k!

OH MY GOD HE's a SPY.. AHHHHHHHHHHHHh..