AAWW Atlas Air Worldwide Holdings

Notes to Unaudited Consolidated Financial Statements

June 30, 2019

1. Basis of Presentation

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

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

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

The accompanying unaudited consolidated financial statements and related notes (the “Financial Statements”) have been prepared in accordance with the U.S. Securities and Exchange Commission (the “SEC”) requirements for quarterly reports on Form 10-Q, and consequently exclude certain disclosures normally included in audited consolidated financial statements prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”).  Intercompany accounts and transactions have been eliminated.  The Financial Statements should be read in conjunction with the audited consolidated financial statements and the notes included in the AAWW Annual Report on Form 10-K for the year ended December 31, 2018, which includes additional disclosures and a summary of our significant accounting policies.  The December 31, 2018 balance sheet data was derived from that Annual Report.  In our opinion, the Financial Statements contain all adjustments, consisting of normal recurring items, necessary to fairly state the financial position of AAWW and its consolidated subsidiaries as of June 30, 2019, the results of operations for the three and six months ended June 30, 2019 and 2018, comprehensive income (loss) for the three and six months ended June 30, 2019 and 2018, cash flows for the six months ended June 30, 2019 and 2018, and shareholders’ equity as of and for the three and six months ended June 30, 2019 and 2018.

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

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

2. Summary of Significant Accounting Policies

Warrant Liability

Common stock warrants classified as a liability are marked-to-market at the end of each reporting period with changes in fair value recorded in Unrealized (gain) loss on financial instruments.  We utilize a Monte Carlo simulation approach to estimate the fair value of the warrant liability, which requires inputs such as our common stock price, the warrant strike price, estimated common stock price volatility and risk-free interest rate, among others.  Our earnings are affected by changes in our common stock price due to the impact those changes have on the fair value of our warrant liability (see Note 4 to our Financial Statements).

Heavy Maintenance

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

We account for heavy maintenance costs for airframes and engines used in our Dry Leasing segment and engines used on our 747-8F aircraft using the deferral method.  Under this method, we defer the expense recognition of scheduled heavy maintenance events, which are amortized over the estimated period until the next scheduled heavy maintenance event is required.  Amortization of deferred maintenance expense included in Depreciation and amortization was $5.3 million and $2.9 million for the three months ended June 30, 2019 and 2018, respectively and was $9.7 million and $5.3 million for the six months ended June 30, 2019 and 2018, respectively.

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Deferred maintenance included within Deferred costs and other assets is as follows:

Recent Accounting Pronouncements Adopted in 2019

In February 2016, the Financial Accounting Standards Board (“FASB”) amended its accounting guidance for leases.  Subsequently, the FASB issued several clarifications and updates.  The guidance requires a lessee to recognize assets and liabilities on the balance sheet arising from leases with terms greater than 12 months.  While lessor accounting guidance is relatively unchanged, certain amendments were made to conform with changes made to lessee accounting and the amended revenue recognition guidance.  The new guidance continues to classify leases as either finance or operating, with classification affecting the presentation and pattern of expense and income recognition, in the statement of operations.  It also requires additional quantitative and qualitative disclosures about leasing arrangements.  We adopted the new guidance on January 1, 2019 using the modified retrospective approach, which was applied beginning on the adoption date.  Comparative information has not been restated and continues to be reported under the accounting guidance in effect for those periods.  The adoption did not have a material effect on our consolidated statements of operations or cash flows. We recognized operating lease right-of-use assets, net of pre-existing deferred rent and operating lease intangibles, and operating lease liabilities on our consolidated balance sheets of approximately $596.9 million and $650.0 million, respectively, on the adoption date (see Note 7 to our Financial Statements).

3. Related Parties

Polar

AAWW has a 51% equity interest and 75% voting interest in Polar.  DHL Network Operations (USA), Inc. (“DHL”), a subsidiary of Deutsche Post AG, holds a 49% equity interest and a 25% voting interest in Polar.  Polar is a variable interest entity that we do not consolidate because we are not the primary beneficiary as the risks associated with the direct costs of operation are with DHL.  Under a 20-year blocked space agreement, which began in 2008, Polar provides air cargo capacity to DHL.  Atlas has several agreements with Polar to provide ACMI, CMI, Dry Leasing, administrative, sales and ground support services to one another.  We do not have any financial exposure to fund debt obligations or operating losses of Polar, except for any liquidated damages that we could incur under these agreements.

The following table summarizes our transactions with Polar:

In addition to the amounts in the table above, Atlas recognized revenue of $23.1 million and $24.4 million for the three months ended June 30, 2019 and 2018, respectively, and $46.4 million and $36.6 million for the six months ended June 30, 2019 and 2018, respectively, from flying on behalf of Polar.

GATS

We hold a 50% interest in GATS GP (BVI) Ltd. (“GATS”), a joint venture with an unrelated third party.  As of June 30, 2019 and December 31, 2018, our investment in GATS was $21.4 million and $22.3 million, respectively.  We had Accounts payable to GATS of $0.7 million as of June 30, 2019 and $0.5 million as of December 31, 2018.

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4. Amazon

In May 2016, we entered into certain agreements with Amazon.com, Inc. and its subsidiary, Amazon Fulfillment Services, Inc., (collectively “Amazon”), which involves, among other things, CMI operation of up to 20 Boeing 767-300 freighter aircraft for Amazon by Atlas, as well as Dry Leasing by Titan.  The Dry Leases have a term of ten years from the commencement of each agreement, while the CMI operations are for seven years from the commencement of each agreement (with an option for Amazon to extend the term to ten years).  Between August 2016 and November 2018, we placed all 20 767-300 freighter aircraft into service for Amazon.  In February 2019, the number of 767-300 freighters in service for Amazon was reduced to 19 with the loss of an aircraft.

In conjunction with the agreements entered into in May 2016, we granted Amazon a warrant providing the right to acquire up to 20% of our outstanding common shares, after giving effect to the issuance of shares pursuant to the warrants, at an exercise price of $37.50 per share (“Warrant A”).  As of December 31, 2018, this warrant to purchase 7.5 million shares had vested in full.  Warrant A is exercisable in accordance with its terms through 2021.  As of June 30, 2019, no portion of Warrant A has been exercised.

The agreements entered into in May 2016 also provided incentives for future growth of the relationship as Amazon may increase its business with us.  In that regard, we granted Amazon a warrant to acquire up to an additional 10% of our outstanding common shares, after giving effect to the issuance of shares pursuant to the warrants, for an exercise price of $37.50 per share (“Warrant B”).  This warrant to purchase 3.75 million shares will vest in increments of 37,500 shares each time Amazon has paid $4.2 million of revenue to us, up to a total of $420.0 million, for incremental business beyond the original 20 767-300 freighters.  As of June 30, 2019, no portion of Warrant B has vested.  Upon vesting, Warrant B would become exercisable in accordance with its terms through May 2023.

In March 2019, we amended the agreements entered into in 2016 with Amazon, pursuant to which we will provide CMI services using Boeing 737-800 freighter aircraft provided by Amazon.  The 737-800 CMI operations will be for a term of seven years from the commencement of each agreement (with an option for Amazon to extend the term to ten years).  The first three of five 737-800 freighter aircraft entered service during the second quarter of 2019 and the remaining two are expected to enter service during the second half of 2019.  Amazon may, in its sole discretion, place up to 15 additional 737-800 freighter aircraft into service with us by May 31, 2021.

In connection with the amended agreements, we granted Amazon a warrant to acquire up to an additional 9.9% of our outstanding common shares, after giving effect to the issuance of shares pursuant to the warrants, for an exercise price of $52.90 per share (“Warrant C”).  When combined with Warrant A and Warrant B, this would allow Amazon to acquire up to a total of 39.9% (after the issuance) of our outstanding common shares and Amazon would be entitled to vote the shares it owns up to 14.9% of our outstanding common shares, in its discretion.  Amazon would be required to vote any shares it owns in excess of 14.9% of our outstanding common shares in accordance with the recommendation of our board of directors.  After Warrant B has vested in full, this warrant to purchase 6.6 million shares would vest in increments of 45,428 shares each time Amazon has paid $6.9 million of revenue to us, up to a total of $1.0 billion, for incremental business beyond Warrant A and Warrant B.  As of June 30, 2019, no portion of Warrant C has vested.  Upon vesting, Warrant C would become exercisable in accordance with its terms through March 2026.

At the time of vesting, the fair value of the vested portion of the warrants issued to Amazon is recorded as a warrant liability within Financial instruments and other liabilities (the “Amazon Warrant”).  The initial fair value of the vested portion of Warrant A was recognized as a customer incentive asset within Deferred costs and other assets, net and is amortized as a reduction of Operating Revenue in proportion to the amount of revenue recognized over the terms of the Dry Leases and CMI agreements.  Determining the amount of amortization related to the CMI agreements requires significant judgment to estimate the total number of Block Hours expected over the terms of those agreements.  

When it becomes probable that an increment of either Warrant B or C will vest and the related revenue begins to be recognized, the fair value of such portion is recorded as Additional paid-in-capital. The initial fair value of such increment is also recognized as a customer incentive asset within Deferred costs and other assets, net and is amortized as a reduction of Operating Revenue in proportion to the amount of related revenue recognized. At the time of vesting, the amount recorded in Additional paid-in-capital would be reclassified to the Amazon Warrant liability.

The following table provides a summary of the customer incentive asset:

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We amortized $6.9 million and $3.3 million of the customer incentive asset for the three months ended June 30, 2019 and 2018, respectively.  We amortized $13.2 million and $5.9 million of the customer incentive asset for the six months ended June 30, 2019 and 2018, respectively.  There were no impairment losses for the six months ended June 30, 2019 and 2018.  

The Amazon Warrant liability is marked-to-market at the end of each reporting period with changes in fair value recorded in Unrealized (gain) loss on financial instruments.  We recognized a net unrealized gain of $42.3 million and a net unrealized loss of $4.3 million on the Amazon Warrant during the three and six months ended June 30, 2019, respectively. We recognized net unrealized losses of $50.0 million and $57.8 million on the Amazon Warrant during the three and six months ended June 30, 2018, respectively. The fair value of the Amazon Warrant liability was $103.3 million as of June 30, 2019 and $99.0 million as of December 31, 2018.

5. Supplemental Balance Sheet and Cash Flow Information

Accounts Receivable

Accounts receivable, net of allowance related to customer contracts, excluding Dry Leasing contracts, was $204.2 million as of June 30, 2019 and $227.1 million as of December 31, 2018.

Revenue Contract Liability

Deferred revenue for customer contracts, excluding Dry Leasing contracts, represents amounts collected from, or invoiced to, customers in advance of revenue recognition.  The balance of Deferred revenue will increase or decrease based on the timing of invoices and recognition of revenue.

Significant changes in our Revenue contract liability balances during the six months ended June 30, 2019 were as follows:

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6. Debt

Term Loans

In March 2019, we borrowed $19.7 million under an unsecured five-year term loan due in March 2024 (the “First 2019 Term Loan”) for GEnx engine performance upgrade kits and overhauls.  The First 2019 Term Loan contains customary covenants, events of default and accrues interest at a fixed rate of 2.73%, with principal and interest payable quarterly.

In March 2019, we received $41.1 million in proceeds from insurance related to the loss of a 767-300 freighter aircraft and used $20.7 million of the proceeds to repay two term loans related to the aircraft.  In connection with the repayment, we recognized a $0.2 million loss on early of extinguishment of debt.  During the six months ended June 30, 2019, we also recognized a net insurance recovery of $3.4 million resulting from the excess of insurance proceeds over the carrying amount of the aircraft and other related costs within Other income, net.  

Convertible Notes

In May 2017, we issued $289.0 million aggregate principal amount of 1.875% convertible senior notes that mature on June 1, 2024 (the “2017 Convertible Notes”) in an underwritten public offering.  In June 2015, we issued $224.5 million aggregate principal amount of 2.25% convertible senior notes that mature on June 1, 2022 (the “2015 Convertible Notes”) in an underwritten public offering.  The 2017 Convertible Notes and the 2015 Convertible Notes (collectively, the “Convertible Notes”) are senior unsecured obligations and accrue interest payable semiannually on June 1 and December 1 of each year.  The Convertible Notes are due on their respective maturity dates, unless earlier converted or repurchased pursuant to their respective terms.

The Convertible Notes consisted of the following as of June 30, 2019:

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