Form 10-K
Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-K

 

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the fiscal year ended December 31, 2007

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the transition period from                     to                    

 

Commission File Number 1-8957

 

ALASKA AIR GROUP, INC.

 

A Delaware Corporation

 

91-1292054  

19300 International Boulevard, Seattle, Washington 98188

Telephone: (206) 392-5040

(I.R.S. Employer Identification No.)  

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

  

Name of Each Exchange on Which Registered

Common Stock, $1.00 Par Value

   New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x     No  ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

 

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 past 90 days.    Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

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):

 

Large accelerated filer  x      Accelerated filer  ¨      Non-accelerated filer  ¨

 

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

 

As of December 31, 2007, shares of common stock outstanding totaled 38,050,680. The aggregate market value of the shares of common stock of Alaska Air Group, Inc. held by nonaffiliates on June 29, 2007, was approximately $1.12 billion (based on the closing price of $27.86 per share on the New York Stock Exchange on that date).

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Title of Document

  

Part Hereof Into Which Document is to be Incorporated

Definitive Proxy Statement Relating to
2008 Annual Meeting of Shareholders
   Part III

 

 

 


Table of Contents

ALASKA AIR GROUP, INC.

ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2007

 

TABLE OF CONTENTS

 

PART I

   5

  ITEM 1.

  

OUR BUSINESS

   5
  

WHERE YOU CAN FIND MORE INFORMATION

   5
  

OUR AIRLINES

   5
  

ALASKA

   5
  

HORIZON

   6
  

INDUSTRY CONDITIONS

   6
  

FUEL

   7
  

MARKETING AND COMPETITION

   8
  

ALLIANCES WITH OTHER AIRLINES

   8
  

COMPETITION

   8
  

TICKET DISTRIBUTION

   9
  

EMPLOYEES

   9
  

EXECUTIVE OFFICERS OF THE REGISTRANT

   11
  

REGULATION

   12
  

GENERAL

   12
  

AIRLINE FARES

   13
  

ENVIRONMENTAL MATTERS

   13
  

CUSTOMER SERVICE

   14
  

MILEAGE PLAN PROGRAM

   14
  

OTHER INFORMATION

   15
  

SEASONALITY AND OTHER FACTORS

   15
  

INSURANCE

   15
  

OTHER GOVERNMENT MATTERS

   15

ITEM 1A.

  

RISK FACTORS

   16

ITEM 1B.

  

UNRESOLVED STAFF COMMENTS

   21

  ITEM 2.

  

PROPERTIES

   22
  

AIRCRAFT

   22
  

GROUND FACILITIES AND SERVICES

   23

  ITEM 3.

  

LEGAL PROCEEDINGS

   23

  ITEM 4.

  

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

   23

PART II

   24

  ITEM 5.

  

MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

   24
  

SALES OF NON-REGISTERED SECURITIES

   24
  

PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

   24
  

PERFORMANCE GRAPH

   25

  ITEM 6.

  

SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA

   26

  ITEM 7.

  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

   28
  

OVERVIEW

   28
  

YEAR IN REVIEW

   28
  

RESULTS OF OPERATIONS

   32
  

2007 COMPARED WITH 2006

   32
  

Alaska Airlines

   36
  

Horizon Air

   43

 

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Consolidated Nonoperating Income (Expense)

   46
  

Consolidated Income Tax Expense (Benefit)

   47
  

2006 COMPARED WITH 2005

   47
  

Alaska Airlines

   47
  

Horizon Air

   50
  

Consolidated Nonoperating Income (Expense)

   52
  

Consolidated Income Tax Expense (Benefit)

   52
  

CHANGE IN ACCOUNTING POLICY

   52
  

CRITICAL ACCOUNTING ESTIMATES

   53
  

NEW ACCOUNTING STANDARDS

   56
  

LIQUIDITY AND CAPITAL RESOURCES

   57
  

ANALYSIS OF OUR CASH FLOWS

   57
  

CONTRACTUAL OBLIGATIONS, COMMITMENTS AND OFF-BALANCE SHEET ARRANGEMENTS

   58
  

EFFECT OF INFLATION AND PRICE CHANGES

   59
  

OTHER

   59

ITEM 7A.

  

QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

   60
  

MARKET RISK – AIRCRAFT FUEL

   60
  

FINANCIAL MARKET RISK

   60

  ITEM 8.

  

CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

   61
  

SELECTED QUARTERLY CONSOLIDATED FINANCIAL INFORMATION

   61
  

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

   62
  

CONSOLIDATED BALANCE SHEETS

   64
  

CONSOLIDATED STATEMENTS OF OPERATIONS

   66
  

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

   67
  

CONSOLIDATED STATEMENTS OF CASH FLOWS

   69
  

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

   70

  ITEM 9.

  

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

   98

ITEM 9A.

  

CONTROLS AND PROCEDURES

   98
  

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

   98
  

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

   98
  

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

   98
  

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

   99

ITEM 9B.

  

OTHER INFORMATION

   100

PART III

   101

  ITEM 10.

  

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

   101

  ITEM 11.

  

EXECUTIVE COMPENSATION

   101

  ITEM 12.

  

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT, AND RELATED STOCKHOLDER MATTERS

   101

  ITEM 13.

  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

   101

  ITEM 14.

  

PRINCIPAL ACCOUNTANT FEES AND SERVICES

   101

PART IV

   102

  ITEM 15.

  

EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES

   102

  SIGNATURES

      103

 

As used in this Form 10-K, the terms “Air Group,” “our,” “we” and the “Company” refer to Alaska Air Group, Inc. and its subsidiaries, unless the context indicates otherwise. Alaska Airlines, Inc. and Horizon Air Industries, Inc. are referred to as “Alaska” and “Horizon,” respectively, and together as our “airlines.”

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

In addition to historical information, this Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as statements containing the words “believe,” “expect,” “will,” “anticipate,” “intend,” “estimate,” “project,” “assume” or other similar expressions, although not all forward-looking statements contain these identifying words. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from historical experience or the Company’s present expectations. Some of the things that could cause our actual results to differ from our expectations are:

 

   

the competitive environment in our industry;

 

   

changes in our operating costs, including fuel, which can be volatile;

 

   

labor disputes and our ability to attract and retain qualified personnel;

 

   

the amounts of potential lease termination payments with lessors for our remaining MD-80 and Q200 leased aircraft and related sublease payments from sublessees, if applicable;

 

   

our significant indebtedness;

 

   

compliance with our financial covenants;

 

   

potential downgrades of our credit ratings and the availability of financing;

 

   

our ability to meet our cost reduction goals;

 

   

operational disruptions;

 

   

general economic conditions, as well as economic conditions in the geographic regions we serve;

 

 

   

the concentration of our revenue from a few key markets;

 

   

actual or threatened terrorist attacks, global instability and potential U.S. military actions or activities;

 

   

insurance costs;

 

   

our inability to achieve or maintain profitability;

 

   

fluctuations in our quarterly results;

 

   

an aircraft accident or incident;

 

   

liability and other claims asserted against us;

 

   

our reliance on automated systems and the risks associated with changes made to those systems;

 

   

our reliance on third-party vendors and partners;

 

   

changes in laws and regulations; and

 

   

increases in government fees and taxes.

 

You should not place undue reliance on our forward-looking statements because the matters they describe are subject to known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control. Our forward-looking statements are based on the information currently available to us and speak only as of the date on which this report was filed with the SEC. We expressly disclaim any obligation to issue any updates or revisions to our forward-looking statements, even if subsequent events cause our expectations to change regarding the matters discussed in those statements. Over time, our actual results, performance or achievements will likely differ from the anticipated results, performance or achievements that are expressed or implied by our forward-looking statements, and such differences might be significant and materially adverse to our shareholders. For a discussion of these and other risk factors in this Form 10-K, see “Item 1A: Risk Factors.” Please consider our forward-looking statements in light of those risks as you read this report.

 

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PART I

 

ITEM 1. OUR BUSINESS

 

We are a Delaware corporation incorporated in 1985 and we have two principal subsidiaries: Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon). Through these subsidiaries, we provide passenger air service to approximately 25 million passengers per year to nearly 100 destinations. We also provide freight and mail services, primarily to and within the state of Alaska and on the West Coast. Although Alaska and Horizon both operate as airlines, their business plans, competition, and economic risks differ substantially. Alaska is a major airline that operates an all-jet fleet with an average passenger trip length of 1,051 miles. Horizon is a regional airline, operates turboprop and jet aircraft, and its average passenger trip is 386 miles. Individual financial information about Alaska and Horizon is in Note 15 to the consolidated financial statements and throughout this section, specifically in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Both of our airlines endeavor to distinguish themselves from competitors by providing a higher level of customer service and differentiating amenities. Our outstanding employees and excellent service in the form of advance seat assignments, expedited check-in, attention to customer needs, a generous frequent flyer program, well-maintained aircraft, a first-class section aboard Alaska aircraft, and other amenities are regularly recognized by independent studies, awards, and surveys of air travelers. For example, Horizon was named the “2007 Regional Airline of the Year” by Air Transport World, a leading industry publication, and Alaska was named in the top five U.S. carriers for premium service in a recent Zagat survey. We are very proud of these awards and we continue to strive to have the best customer service in the industry.

 

WHERE YOU CAN FIND MORE INFORMATION

 

We maintain an Internet website at www.alaskaair.com. Our filings with the Securities and Exchange Commission, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available on our website at www.alaskaair.com, free of charge, as soon as reasonably practicable after the electronic filing of these reports with the Securities and Exchange Commission. The information contained on our website is not a part of this annual report on Form 10-K.

 

OUR AIRLINES

 

ALASKA

 

Alaska Airlines is an Alaska corporation that was organized in 1932 and incorporated in 1937. We offer extensive north/south service within the western U.S., Canada and Mexico, and passenger and dedicated cargo services to and within the state of Alaska. We also provide long-haul east/west service to eight cities in the continental U.S., primarily from Seattle, where we have our largest concentration of departures; although we do offer long-haul departures from Anchorage, Los Angeles, and Portland, Oregon. During 2007, we also initiated service to Hawaii, with non-stops from Seattle to Honolulu and Lihue and from Anchorage to Honolulu.

 

In 2007, we carried 17.6 million revenue passengers in our mainline operations, and in each year since 1973, we have carried more passengers between Alaska and the U.S. mainland than any other airline. Based on the

 

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number of passengers, Alaska’s leading airports are Seattle, Los Angeles, Anchorage and Portland. Based on 2007 revenues, the leading nonstop routes are Seattle-Anchorage, Seattle-Los Angeles, and Seattle-San Diego. At December 31, 2007, Alaska’s operating fleet consisted of 115 jet aircraft, compared to 114 aircraft as of December 31, 2006.

 

Alaska’s passenger traffic by market is presented below:

 

     2007      2006  

West Coast

  46 %    45 %

Within Alaska and between Alaska and the U.S. mainland

  21 %    20 %

Mexico

  11 %    11 %

Canada

  4 %    4 %

Other, including transcontinental and Hawaii

  18 %    20 %
              

Total

  100 %    100 %
              

 

HORIZON

 

Horizon Air Industries, a Washington corporation that first began service and was incorporated in 1981, and was acquired by Air Group in 1986. It is the largest regional airline in the Pacific Northwest, and serves a number of cities in six states and six cities in Canada under the Horizon brand. In 2008, Horizon began service to Loreto, Mexico, from Los Angeles and will serve its seventh city in Canada when it begins service to Prince George, British Columbia, in May 2008. In addition to operating under its own brand, Horizon operated regional jet service as Frontier JetExpress through the end of November 2007 under an agreement with Frontier Airlines. Horizon terminated this agreement with Frontier at that time and has redeployed the nine CRJ-700s back into the Air Group route structure.

 

In 2007, Horizon carried 7.6 million revenue passengers. Approximately 92% of Horizon’s revenue passenger miles in 2007 were flown domestically, primarily in the states of Washington, Oregon and Idaho, compared to 91% in 2006. The Canada markets accounted for 8% of revenue passenger miles in 2007, compared to 9% in 2006. Based on passenger enplanements, Horizon’s leading airports are Seattle, Portland, Boise, and Spokane. Based on revenues in 2007, the leading nonstop routes are Portland-Seattle, Spokane-Seattle, and Ontario-Portland. At December 31, 2007, Horizon’s operating fleet consisted of 21 jets and 49 turboprop aircraft. Except for those flights that were operated as Frontier JetExpress, Horizon flights are listed under the Alaska Airlines designator code in airline reservation systems.

 

Alaska and Horizon integrate their flight schedules to provide convenient, competitive connections between most points served by their systems. In 2007 and 2006, approximately 22% and 24%, respectively, of Horizon’s passengers connected to flights operated by Alaska.

 

INDUSTRY CONDITIONS

 

Our industry is highly competitive and is characterized by low profit margins and high fixed costs, primarily for wages, aircraft fuel, aircraft ownership costs and facilities rents. Because expenses of a flight do not vary significantly with the number of passengers carried, a relatively small change in the number of passengers or in pricing has a disproportionate effect on an airline’s operating and financial results. In other words, a minor shortfall in expected revenue levels could cause a disproportionately negative impact on our results of operations. Passenger demand and ticket prices are, to a large measure, influenced by the general state of the economy in some parts of the United States, current events and available capacity.

 

In 2007, the airline industry posted its second year of net profits since 2000. However, with the dramatic increase in fuel prices and a softening economy, industry profits were lower than originally predicted by industry experts and analysts. In 2005 and 2006, load factors and unit revenues climbed higher in the wake of strong demand and a healthy economy. That strong demand and a reduction in total capacity in some regions, as other major carriers shifted capacity to international routes, allowed domestic carriers to raise ticket prices. However, there was some softening in demand for air

 

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travel early in 2007, and unit revenues declined on a year-over-year basis during the first half of the year. Unit revenues rebounded later in the year, principally in response to higher passenger load factors and actions taken to help offset increases in jet fuel prices.

 

Several traditional or “legacy” carriers have reorganized through bankruptcy proceedings over the past several years. These carriers have gained a competitive advantage by significantly reducing their costs almost immediately. In addition, so called “low-cost carriers” (LCCs) have grown significantly since 2001 and currently carry more than 30% of total U.S. domestic passenger traffic. However, the line between the LCCs and legacy carriers is becoming more blurred as the legacy carriers make further reductions in unit costs and the LCCs face cost pressures, and as the legacy carriers reduce service offerings. Because of their unit cost advantage, the LCCs and recently reorganized airlines have and continue to exert downward pressure on ticket prices compared to historical levels. Because of the relatively low barriers to entry and financial success of LCCs, we expect the expansion of low-cost and low-fare carriers to continue. We compete with many of these carriers directly now, and expect to compete with new entrants in the future. For example, Virgin America, a new LCC, has announced plans to offer non-stop service between Seattle and Los Angeles and between Seattle and San Francisco in the spring of 2008.

 

FUEL

 

Our business and financial results are highly affected by the price and, potentially, the availability of jet fuel. Fuel prices have increased dramatically over the past few years and these increases have hurt our financial results. We refer to the price we pay at the airport or “into- plane” price, including applicable taxes, as our “raw” fuel price. Raw fuel prices are impacted by world oil prices and refining costs, which can vary by region in the U.S. Generally, West Coast jet fuel prices are somewhat higher and substantially more volatile than prices in the Gulf Coast or on the East Coast, putting both Alaska and Horizon at a competitive disadvantage. Historically, fuel costs have generally represented 10% to 15% of an airline’s operating costs. However, in recent years, fuel costs have risen sharply to represent 20% to 30% of total operating costs for airlines. Both the crude oil and refining cost components of jet fuel are volatile and outside of our control, and they can have a significant and immediate impact on our operating results. Our average raw fuel cost per gallon increased 8%, 17%, and 34%, in 2007, 2006, and 2005, respectively.

 

LOGO

 

We almost exclusively use crude oil call options as hedges to decrease our exposure to the volatility of jet fuel prices. Call options effectively cap our pricing on the crude oil component of fuel prices, limiting our exposure to increasing fuel prices on a percentage of our planned fuel consumption. With these call option contracts, we still benefit from the decline in crude oil prices, as there is no downward exposure other than the premiums we pay to enter into the contracts. We also use collar structures in limited instances for fuel hedging purposes. Additionally, we enter into fuel purchase contracts that fix the refining margin we pay on a certain percentage of our fuel consumption.

 

Fuel costs, including gains and losses stemming from changes in the value of our hedge portfolio, were approximately 27% of our total operating expenses in 2007, 26% in 2006, and 20% in 2005. Currently, a one-cent change in our hedged fuel price per gallon affects annual fuel costs by approximately $4.0 million. In addition

 

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to our hedging program, we believe that operating fuel-efficient aircraft helps to mitigate the effect of high fuel prices.

 

Due to the competitive nature of the airline industry, airlines often have been unable to immediately pass on increased fuel prices to customers by increasing fares. Conversely, any potential benefit of lower fuel prices could be offset by increased fare competition and lower revenues.

 

Although we do not currently anticipate a significant reduction in jet fuel availability, dependency on foreign imports of crude oil and the possibility of changes in government policy on jet fuel production, transportation and marketing make it impossible to predict the future availability of jet fuel. In the event of significant hostilities or other conflicts in oil-producing areas, there could be reductions in the production and/or importation of crude oil resulting in price increases, which could adversely affect our business. If there were major reductions in the availability of jet fuel, our business would be adversely affected.

 

MARKETING AND COMPETITION

 

ALLIANCES WITH OTHER AIRLINES

 

We have marketing alliances with several other airlines that provide reciprocal frequent flyer mileage credit and redemption privileges as well as code sharing on certain flights as shown in the table below. Alliances enhance our revenues by:

 

   

offering our customers more travel destinations and better mileage credit/redemption opportunities;

 

   

giving us access to more connecting traffic from other airlines; and

 

   

providing members of our alliance partners’ frequent flyer programs an opportunity to travel on Alaska and Horizon while earning mileage credit in our partners’ programs.

 

Most of our codeshare relationships are free-sell codeshares, where the marketing carrier sells seats on the operating carrier’s flights from the operating carrier’s inventory, but takes no inventory risk. Our marketing agreements have various termination dates, and at any time, one or more may be in the process of renegotiation.

 

Our marketing alliances with other airlines as of December 31, 2007 are as follows:

 

     Frequent
Flyer
Agreement
    Codeshare—
Alaska
Flight #

on Flights
Operated by
Other Airline
  Codeshare—
Other Airline
Flight # On
Flights
Operated by

Alaska/
Horizon

Major U.S. or
International Airlines

American Airlines/American Eagle

  Yes     Yes   Yes

Air France

  Yes     No   Yes

British Airways

  Yes     No   No

Cathay Pacific Airways

  Yes     No   No

Continental Airlines

  Yes     Yes   Yes

Delta/Delta Connection**

  Yes     Yes   Yes

KLM

  Yes     No   Yes

Lan S.A.

  Yes     No   Yes

Northwest Airlines

  Yes     Yes   Yes

Qantas

  Yes     No   Yes

Regional Airlines

       

Era Aviation

  Yes *   Yes   No

PenAir

  Yes *   Yes   No

Big Sky Airlines

  No     Yes   No

 

* This airline does not have its own frequent flyer program. However, Alaska’s Mileage Plan members can earn and redeem miles on this airline’s route system.
** Alaska has codeshare agreements with the Delta Connection carriers Skywest and ASA as part of its agreement with Delta Air Lines.

 

COMPETITION

 

Competition in the airline industry is intense. We believe the principal competitive factors in the industry that are important to customers are:

 

   

safety record and reputation,

 

   

flight schedules,

 

   

fares,

 

   

customer service,

 

   

routes served,

 

   

frequent flyer programs,

 

   

on-time arrivals,

 

   

baggage handling,

 

   

on-board amenities,

 

   

type of aircraft, and

 

   

code-sharing relationships.

 

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Together, Alaska and Horizon carry approximately 3.2% of all U.S. domestic passenger traffic. We compete with one or more domestic or foreign airlines on most of our routes, including Southwest Airlines, United Airlines, Northwest Airlines, Continental Airlines, American Airlines, Delta Air Lines, US Airways, and regional affiliates associated with some of these carriers. Most of these airlines are larger and have greater financial resources and name recognition or lower operating costs than our companies. In addition, competitors that have successfully reorganized out of bankruptcy have lower operating costs derived from renegotiated labor, supply and financing agreements. Some of these competitors have chosen to add service, reduce their fares, or both in our markets. Continuing growth of LCCs, including Southwest Airlines, AirTran Airways, Frontier Airlines, jetBlue Airways, and Virgin America, places significant competitive pressures on us and other network carriers because the LCCs have the ability to charge a lower fare for travel between similar cities. As such, we may be unable to compete effectively against other airlines that introduce service or discounted fares in the markets that we serve. Due to its short-haul markets, Horizon also competes with ground transportation in many markets, including train, bus and automobile transportation.

 

TICKET DISTRIBUTION

 

Airline tickets are distributed through three primary channels:

 

   

Airline websites such as alaskaair.com or horizonair.com. It is less expensive for us to sell through these direct channels and, as a result, we continue to take steps to drive more business to our websites. In addition, we believe this channel is preferable from a branding and customer-relationship standpoint in that we can establish ongoing communication with the customer and tailor offers accordingly. In October 2007, we passed a significant milestone by processing over 50% of our monthly sales through our website – a sign of progress toward our goal of transitioning more of our customers to this direct sales channel.

 

   

Traditional and online travel agents. Consumer reliance on traditional travel agencies is shrinking, giving way to online travel agencies. Both traditional and online travel agencies typically use Global Distribution Systems (GDS), such as Sabre, to obtain their fare and inventory data from airlines. Bookings made through these agencies result in a fee that is charged to the airline. Many of our large corporate customers require that we use these agencies. Some of our competitors do not use this distribution channel and, as a result, have lower ticket distribution costs.

 

   

Reservation call centers. These call centers are located in Phoenix, Arizona; Kent, Washington; and Boise, Idaho. We generally charge a $10 fee for booking reservations through these call centers.

 

Our sales by channel are presented below:

 

      2007     2006  

Alaskaair.com/horizonair.com

   43 %   39 %

Traditional and online travel agencies

   43 %   47 %

Reservations call center

   12 %   12 %

All other channels

   2 %   2 %
              

Total

   100 %   100 %
              

 

EMPLOYEES

 

Labor costs have historically made up 30% to 40% of an airline’s total operating costs. Most major airlines, including ours, have employee groups that are covered by collective bargaining agreements. Often, airlines with unionized work forces have higher labor costs than carriers without unionized work forces, and they may not have the ability to adjust labor costs downward quickly enough to respond to new competition. New entrants into the U.S. airline industry generally do not have unionized work forces, which can be a competitive advantage for those airlines. Alaska has been able to reduce wages and benefits costs from 2004 levels through a number of initiatives, but we have experienced recent increases in wage and benefit costs because of normal scale and step increases,

 

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market wage increases, and higher healthcare costs. Horizon faces similar pressures on wages and benefits. We expect to see continued upward pressure on wages and benefits in the future. We recognize the need to continue to improve employee productivity in order to mitigate this cost pressure and to reduce our wages and benefits on an available-seat-mile basis. We have initiatives underway to increase productivity and efficiency.

 

We had 14,710 (Alaska and Horizon had 10,526 and 4,184, respectively) active full-time and part-time employees at December 31, 2007, compared to 14,485 (10,454 at Alaska and 4,031 at Horizon) as of December 31, 2006. Wages, salaries and benefits (including variable incentive pay) represented approximately 30% and 28% of our total operating expenses in 2007 and 2006, respectively.

 

At December 31, 2007, labor unions represented 84% of Alaska’s and 48% of Horizon’s employees. Our relations with our labor organizations are governed by the Railway Labor Act (RLA). Under this act, collective bargaining agreements do not expire but instead become amendable as of a stated date. If either party wishes to modify the terms of any such agreement, it must notify the other party in the manner prescribed by the RLA and/or described in the agreement. After receipt of such notice, the parties must meet for direct negotiations, and if no agreement is reached, either party may request the National Mediation Board to appoint a federal mediator. If no agreement is reached in mediation, the National Mediation Board may declare that an impasse exists, at which point the National Mediation Board offers binding arbitration to the parties. Either party may decline to submit to arbitration. If either party rejects arbitration, a 30-day “cooling-off” period commences. During that period, a Presidential Emergency Board may be established, which examines the parties’ positions and recommends a solution. The Presidential Emergency Board process, if invoked, lasts for 30 days and is followed by another “cooling-off” period of 30 days. At the end of the applicable “cooling-off” period, unless an agreement is reached or action is taken by Congress, the labor organization may strike and the airline may resort to “self-help,” including the imposition of any or all of its proposed amendments on the collective bargaining agreements and/or the hiring of workers to replace strikers.

 

Alaska’s union contracts at December 31, 2007 were as follows:

 

Union

  

Employee Group

   Number of
Employees
   Contract Status
Air Line Pilots Association International (ALPA)    Pilots    1,483    In Negotiations
   
Association of Flight Attendants (AFA)    Flight attendants    2,720    Amendable 4/27/10
   
International Association of Machinists and    Ramp service and stock clerks; and Clerical, office and passenger service    664    Amendable 7/17/10
Aerospace Workers (IAM/RSSA)       3,121    Amendable 7/17/10
   
Aircraft Mechanics Fraternal Association (AMFA)    Technicians, inspectors and cleaners    678    Amendable 10/01/09
   
Mexico Workers Association of Air Transport    Station personnel in Mexico    111    Amendable 9/29/09
   
Transport Workers Union of America (TWU)    Dispatchers    35    Amendable 7/01/10*

 

* Collective bargaining agreement contains interest arbitration provision.

 

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Horizon’s union contracts at December 31, 2007 were as follows:

 

Union

  

Employee Group

   Number of
Employees
   Contract Status
International Brotherhood of Teamsters (IBT)    Pilots    722    In Negotiations
   
AFA    Flight attendants    672    In Negotiations
   
AMFA    Technicians and related classifications    507    Amendable 11/30/08
   
TWU    Dispatchers    21    Amendable 10/6/08
   
National Automobile, Aerospace, Transportation and General Workers    Station personnel in Vancouver and Victoria, BC, Canada    85    Expires 2/14/10

 

EXECUTIVE OFFICERS OF THE REGISTRANT

 

The executive officers of Alaska Air Group, Inc. (including its subsidiaries Alaska and Horizon), their positions and their respective ages (as of February 1, 2008) are as follows:

 

Name

  

Position

   Age    Air Group
or Subsidiary
Officer Since

William S. Ayer

   Chairman, President and Chief Executive Officer of Alaska Air Group, Inc. and Alaska Airlines, Inc.    53    1985
   

Bradley D. Tilden

   Executive Vice President/Finance and Planning and Chief Financial Officer of Alaska Air Group, Inc. and Alaska Airlines, Inc.    47    1994
   

Keith Loveless

   Vice President/Legal and Corporate Affairs, General Counsel and Corporate Secretary of Alaska Air Group, Inc. and Alaska Airlines, Inc.    51    1996
   

Gregg Saretsky

   Executive Vice President/Flight and Marketing of Alaska Airlines, Inc.    48    1998
   

Glenn S. Johnson

   Executive Vice President/Airports, Maintenance and Engineering of Alaska Airlines, Inc.    49    1991
   

Jeffrey D. Pinneo

   President and Chief Executive Officer of Horizon Air Industries, Inc.    51    1990
   

Brandon S. Pedersen

   Vice President/Finance and Controller of Alaska Air Group, Inc. and Alaska Airlines, Inc. (Principal Accounting Officer)    41    2003

 

Mr. Ayer has been President since February 2003 and became Chairman and Chief Executive Officer in May 2003. Mr. Ayer is also Chairman, President and Chief Executive Officer of Alaska Airlines. He has served as Alaska Airlines’ Chairman since February 2003, as Chief Executive Officer since January 2002 and as President since November 1997. Prior to that, he was Sr. Vice President/Customer Service, Marketing and Planning of Alaska Airlines from January 1997, and Vice President/Marketing and Planning from August 1995. Prior thereto, he served as Sr. Vice President/Operations of Horizon Air from January 1995. Mr. Ayer serves on the boards of Alaska Airlines, Puget Energy, Inc., the Alaska Airlines Foundation, Angel Flight West, Inc., and the Museum of Flight. He also serves on the University of Washington Business School Advisory Board, and was recently appointed a director of the Seattle branch of the Federal Reserve Board.

 

Mr. Tilden joined Alaska Airlines in 1991, became controller of Alaska Airlines and Alaska Air Group in 1994, CFO in February 2000, Executive Vice President/Finance in January 2002, and Executive Vice President/Finance and Planning in 2007.

 

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Mr. Loveless became Corporate Secretary and Assistant General Counsel of Alaska Air Group and Alaska Airlines in 1996. In 1999, he was named Vice President/Legal and Corporate Affairs, General Counsel and Corporate Secretary of Alaska Air Group and Alaska Airlines.

 

Mr. Saretsky joined Alaska Airlines in March 1998 as Vice President/Marketing and Planning. In 2000, he became Senior Vice President/Marketing and Planning. He was elected Executive Vice President/Marketing and Planning of Alaska Airlines in 2002, and in 2007 he was elected Executive Vice President/ Flight and Marketing.

 

Mr. Johnson became Vice President/Controller and Treasurer of Horizon Air Industries in 1991 and Vice President/Customer Services in 2002. He moved to Alaska Airlines in 2003 where he has served in several roles, including Vice President/Finance and Controller and Vice President/Finance and Treasurer. Most recently, he has served as Senior Vice President/Customer Service – Airports from January 2006 through April 2007. In April 2007, he was elected Executive Vice President/Airports and Maintenance and Engineering.

 

Mr. Pinneo became Vice President/Passenger Service of Horizon Air Industries in 1990 following nine years at Alaska Airlines in various marketing roles. In January 2002, he was named President and CEO of Horizon Air.

 

Mr. Pedersen joined Alaska Airlines in 2003 as Staff Vice President/Finance and Controller of Alaska Air Group and Alaska Airlines and was elected Vice President/Finance and Controller for both entities in 2006.

 

REGULATION

 

GENERAL

 

The Department of Transportation (DOT) and the Federal Aviation Administration (FAA) exercise significant regulatory authority over air carriers.

 

   

DOT: In order to provide passenger and cargo air transportation in the U.S., a domestic airline is required to hold a certificate of public convenience and necessity issued by the DOT. Subject to certain individual airport capacity, noise and other restrictions, this certificate permits an air carrier to operate between any two points in the U.S. Certificates do not expire, but may be revoked for failure to comply with federal aviation statutes, regulations, orders or the terms of the certificates. In addition, the DOT has jurisdiction over the approval of international codeshare agreements, alliance agreements between domestic major airlines, international route authorities and certain consumer protection matters, such as advertising, denied boarding compensation and baggage liability. International treaties may also contain restrictions or requirements for flying outside of the U.S.

 

   

FAA: The FAA, through Federal Aviation Regulations (FARs), generally regulates all aspects of airline operations, including establishing personnel, maintenance and flight operation standards. Domestic airlines are required to hold a valid air carrier operating certificate issued by the FAA. Pursuant to these regulations we have established, and the FAA has approved, both our operations specifications and a maintenance program for each type of aircraft we operate. The maintenance program provides for the ongoing maintenance of such aircraft, ranging from frequent routine inspections to major overhauls. From time to time the FAA issues airworthiness directives (ADs) that must be incorporated into our aircraft maintenance program and operations. All airlines are subject to enforcement actions that are brought by the FAA from time to time for alleged violations of FARs or ADs. At this time, we are not aware of any enforcement proceedings that could either materially affect our financial position or impact our authority to operate.

 

The Aviation and Transportation Security Act (the Security Act) generally provides for enhanced aviation security measures. Pursuant to the

 

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Security Act, the Transportation Security Administration (TSA) is responsible for aviation security. The Security Act mandates that the TSA shall provide for the screening of passengers and property, including U.S. mail, cargo, carry-on and checked baggage, and other articles that will be carried aboard a passenger aircraft. The TSA performs most of these functions with its own federal employees. The TSA also provides for increased security on flight decks of aircraft and requires federal air marshals to be present on certain flights. The Security Act imposes a $2.50 per enplanement security service fee (maximum $5.00 one-way fee), which is collected by the air carriers and submitted to the government to pay for these enhanced security measures. In addition, carriers are required to pay an additional amount to the TSA to cover the cost of providing security measures equal to the amount the air carriers paid for screening passengers and property in 2000. We paid $12.6 million to the TSA for this security charge in 2007, 2006 and 2005.

 

The Department of Justice has jurisdiction over airline antitrust matters. The U.S. Postal Service has jurisdiction over certain aspects of the transportation of mail and related services. Labor relations in the air transportation industry are regulated under the Railway Labor Act, which vests in the National Mediation Board (NMB) certain functions with respect to disputes between airlines and labor unions relating to union representation and collective bargaining agreements. To the extent we continue to fly to foreign countries and pursue alliances with international carriers, we may be subject to certain regulations of foreign agencies.

 

AIRLINE FARES

 

Airlines are permitted to establish their own domestic fares without governmental regulation, and the industry is characterized by vigorous price competition. The DOT maintains authority over international (generally outside of North America) fares, rates and charges. International fares and rates are also subject to the jurisdiction of the governments of the foreign countries we serve. Although air carriers are required to file and adhere to international fare and rate tariffs, substantial commissions, overrides and discounts given to travel agents, brokers and wholesalers characterize many international markets.

 

ENVIRONMENTAL MATTERS

 

We are subject to various laws and government regulations concerning environmental matters and employee safety and health in the U.S. and other countries. U.S. federal laws that have a particular effect on us include the Airport Noise and Capacity Act of 1990, the Clean Air Act, the Resource Conservation and Recovery Act, the Clean Water Act, the Safe Drinking Water Act, and the Comprehensive Environmental Response, Compensation and Liability Act, or Superfund Act. We are also subject to the oversight of the Occupational Safety and Health Administration (OSHA) concerning employee safety and health matters. The U.S. Environmental Protection Agency, or EPA, OSHA, and other federal agencies have been authorized to create and enforce regulations that have an impact on our operations. In addition to these federal activities, various states have been delegated certain authorities under these federal statutes. Many state and local governments have adopted environmental and employee safety and health laws and regulations, some of which are similar to federal requirements. We maintain our own continuing safety, health and environmental programs in order to meet or exceed these requirements.

 

The Airport Noise and Capacity Act recognizes the rights of airport operators with noise problems to implement local noise abatement programs so long as they do not interfere unreasonably with interstate or foreign commerce or the national air transportation system. Authorities in several cities have established aircraft noise reduction programs, including the imposition of nighttime curfews. The Airport Noise and Capacity Act generally requires FAA approval of local noise restrictions on aircraft. We believe we have sufficient scheduling flexibility to accommodate local noise restrictions.

 

At December 31, 2007, all of our aircraft met the Stage 3 noise requirements under the Airport

Noise and Capacity Act of 1990. However,

 

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special noise ordinances restrict the timing of flights operated by Alaska, Horizon and other airlines at Burbank, Long Beach, Orange County, San Diego, San Jose, and Sun Valley. In addition, due to capacity restrictions, Orange County, Reagan National, Long Beach, Chicago O’Hare, Newark, and Vancouver, B.C. airports restrict the type of aircraft, number of flights, or the time of day that airlines can operate.

 

Although we do not currently anticipate that these regulatory matters, individually or collectively, will have a material effect on our financial condition, results of operations or cash flows, new regulations or compliance issues that we do not currently anticipate could have the potential to harm our financial condition, results of operations or cash flows in future periods.

 

CUSTOMER SERVICE

 

Along with other domestic airlines, we have implemented a customer service commitment plan to address a number of service goals, including, but not limited to, goals relating to lowest fare availability, delays, cancellations and diversions, baggage delivery and liability, guaranteed fares and ticket refunds.

 

MILEAGE PLAN PROGRAM

 

All major airlines have developed frequent flyer programs as a way of increasing passenger loyalty. Alaska’s Mileage Plan allows members to earn mileage by flying on Alaska, Horizon and other participating airlines and by using the services of non-airline partners, which include a credit card partner, a grocery store chain, a telephone company, hotels, car rental agencies, and other businesses. Alaska is paid by non-airline partners for the miles it credits to member accounts. With advance notice, Alaska has the ability to change the Mileage Plan terms, conditions, partners, mileage credits, and award levels or to terminate the program.

 

Mileage can be redeemed for free or discounted travel and for various other awards. Upon accumulating the necessary mileage, members notify Alaska of their award selection. Over 75% of the free flight awards on Alaska and Horizon are subject to capacity-controlled seating. Mileage Plan accounts are generally deleted after three years of inactivity in a member’s account. However, we have announced plans to reduce this to two years beginning in April 2008. As of December 31, 2007 and 2006, Alaska estimated that approximately 3.7 million and 3.2 million, respectively, round-trip flight awards were eligible for redemption by Mileage Plan members. Of those eligible awards, Alaska estimated that approximately 88% would ultimately be redeemed. For the year 2007, approximately 870,000 round-trip and 270,000 one-way flight awards were redeemed and flown on Alaska and Horizon. One-way awards were introduced in February 2007. For the years 2006 and 2005, approximately 850,000 and 750,000 round-trip flight awards, respectively, were redeemed and flown on Alaska and Horizon. Those awards represent approximately 9.7%, 8.6%, and 7.9% for 2007, 2006, and 2005, respectively, of the total passenger miles flown on Alaska and Horizon. For the years 2007, 2006, and 2005, approximately 243,200, 252,600, and 239,900, respectively, round-trip flight awards were redeemed and flown on airline partners.

 

For miles earned through travel on Alaska or Horizon and their airline partners, the estimated incremental cost of providing free travel awards in the future is recognized as a selling expense and accrued as a liability as miles are accumulated. The incremental cost of providing award travel on Alaska or Horizon does not include a contribution to overhead, aircraft ownership cost, or profit. Alaska also sells mileage credits to its non-airline partners. Alaska defers a majority of the sales proceeds and recognizes revenue when award transportation is provided on Alaska, Horizon or another partner airline. At December 31, 2007 and 2006, the deferred revenue and the total liability for providing free travel on Alaska and Horizon and for estimated payments to partner airlines was $648.5 million and $545.6 million, respectively, the majority of which is deferred revenue from the sale of mileage credits. Revenue attributable to the Mileage Plan was $227.6 million, $194.2 million, and $180.2 million in 2007, 2006 and 2005, respectively.

 

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OTHER INFORMATION

 

SEASONALITY AND OTHER FACTORS

 

Our results of operations for any interim period are not necessarily indicative of those for the entire year because our business is subject to seasonal fluctuations. Our operating income is generally lowest (or if it be the case, our loss the greatest) during the first and fourth quarters due principally to lower traffic, generally increases in the second quarter and typically reaches its highest level during the third quarter as a result of vacation travel, including increased activity in the state of Alaska.

 

In addition to passenger loads, factors that could cause our quarterly operating results to vary include:

 

   

pricing initiatives by us and our competitors,

 

   

changes in fuel costs,

 

   

the timing and amount of maintenance expenditures (both planned and unplanned),

 

   

increases or decreases in passenger and volume-driven variable costs, and

 

   

labor actions.

 

In addition to those factors listed above, seasonal variations in traffic, the timing of various expenditures such as maintenance events and adverse weather conditions may affect our operating results from quarter to quarter. Many of the markets we serve experience inclement weather conditions in the winter, causing increased costs associated with deicing aircraft, canceled flights and accommodating displaced passengers. Due to our geographic area of operations, we can be more susceptible to adverse weather conditions (particularly in the state of Alaska and the Pacific Northwest) than some of our competitors, who may be better able to spread weather-related risks over larger route systems.

 

No material part of our business or that of our subsidiaries is dependent upon a single customer, or upon a few high-volume customers. Consequently, the loss of one or more of even our largest customers would likely not have a material adverse effect upon our financial condition, results of operations or cash flows.

 

INSURANCE

 

We carry insurance for passenger liability and property and aircraft damage in amounts and of the type generally consistent with industry practice.

 

After September 11, 2001, aviation insurers significantly reduced the amount of insurance coverage for third-party liability for claims resulting from acts of terrorism, war or similar events. At the same time, the insurers significantly increased the premiums for such coverage as well as for aviation insurance in general. Since then, however, our insurance rates have been declining. During 2006 and 2007, our insurance rates fell below 2001 levels. We attribute this decline to general rate reductions as well as the extensive safety programs maintained by both of our airlines.

 

Pursuant to authority granted in the Air Transportation Safety and System Stabilization Act, the Homeland Security Act of 2002, as amended by the Consolidated Appropriations Act 2008, the U.S. government has offered, and we have accepted, war risk insurance to replace commercial war risk insurance through August 31, 2008.

 

OTHER GOVERNMENT MATTERS

 

We have elected to participate in the Civil Reserve Air Fleet program, whereby we have agreed to make available to the federal government a certain number of aircraft in the event of a military call-up. The government would reimburse us for the use of such aircraft. Participation in the program is a prerequisite for bidding on various governmental travel contracts.

 

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ITEM 1A. RISK FACTORS

 

If any of the following occurs, our business, financial condition and results of operations could suffer. In such case, the trading price of our common stock could also decline. These risk factors may not be exhaustive. We operate in a continually changing business environment and new risk factors emerge from time to time. Management cannot predict such developments, nor can it assess the impact, if any, on our business of such new risk factors or of events described in any forward-looking statements.

 

The airline industry is highly competitive and subject to rapid change. We may be unable to compete effectively against other airlines with greater financial resources or lower operating costs, or to adjust rapidly enough in the event the nature of competition in our markets changes.

 

The airline industry is highly competitive as to fares, flight frequency, frequent flyer benefits, routes and service. The industry is particularly susceptible to price discounting because airlines incur only nominal costs to provide service to passengers occupying otherwise unsold seats. Over the past few years, airlines have reduced domestic routes and the number of planes available, which has resulted in reduced domestic industry capacity and a trend towards increased fares. Although capacity has declined based on a nationwide average, capacity on the West Coast has actually increased. If airlines decide to increase their capacity further in the future, this could cause fares to decline, which may adversely affect our business and results of operations. Many of our competitors are larger than our airlines and therefore, may have significantly greater financial resources and name recognition or lower operating costs than we do. In addition, competitors who have successfully reorganized out of bankruptcy have lowered their operating costs as a result of renegotiated labor, supply and financing agreements. From time to time in the past, some of these competitors have chosen to add service, reduce their fares, or take other such competitive steps in our key markets. We may be unable to compete effectively against such other airlines that introduce service or discounted fares in the markets that we serve.

 

The airline industry, and particularly regional airlines like Horizon, also faces competition from ground transportation alternatives, such as buses, trains or automobiles.

 

The U.S. and Mexico recently amended their bilateral agreement relating to commercial air service. The amendments expand authorized service levels to cities we serve in Mexico. Other airlines have added service to many of the city pairs we currently serve, which has increased competition and has negatively affected our results of operations. Further increases in competition in these markets may result in additional negative pressure on our results of operations.

 

Our business, financial condition, and results of operations are substantially exposed to the current high prices and variability of jet fuel. Further increases in jet fuel costs would harm our business.

 

Fuel costs constitute a significant portion of our total operating expenses, accounting for 27% and 26% of total operating expenses for the years ended December 31, 2007 and 2006, respectively. Significant increases in fuel costs during the past several years have negatively affected our results of operations. Further increases will harm our financial condition and results of operations, unless we are able to increase fares.

 

Historically, fuel costs and availability have been unpredictable and subject to wide price fluctuations based on geopolitical issues and supply and demand. We have not generally been able to increase fares to offset increases in the price of fuel until recently and we may not be able to do so in the future.

 

We utilize fuel hedges as a form of insurance against the volatility of fuel prices. To manage the risk of fuel price increases, we purchase call options that are designed to cap a portion of our fuel costs at designated per-barrel oil prices. Even with hedges, we are substantially and increasingly exposed to increases in jet fuel costs as the price at which we are hedged increases.

 

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A significant increase in labor costs or change in key personnel could adversely affect our business and results of operations.

 

We compete against the major U.S. airlines and other businesses for labor in many highly skilled positions. If we are unable to hire, train and retain qualified employees at a reasonable cost, or if we lose the services of key personnel, we may be unable to grow or sustain our business. In such case, our operating results and business prospects could be harmed. We may also have difficulty replacing management or other key personnel who leave and, therefore, the loss of any of these individuals could harm our business.

 

Labor costs are a significant component of our total expenses, accounting for approximately 30% and 28% of our total operating expenses in 2007 and 2006, respectively. As of December 31, 2007, labor unions represented approximately 84% of Alaska’s and 48% of Horizon’s employees. Each of our represented employee groups has a separate collective bargaining agreement, and could make demands that would increase our operating expenses and adversely affect our financial performance. Uncertainty around open contracts could be a distraction to many employees, reduce employee engagement in our business and divert management’s attention from other projects. Disengaged employees could prevent us from achieving the operational improvements in completion rate and on-time performance that we seek.

 

In 2005, Alaska and the Air Line Pilots Association (ALPA) were unable to reach a new agreement, and therefore, pursuant to the terms of the collective bargaining agreement that existed at the time, the parties submitted the agreement to binding arbitration. That arbitration decision, which was effective May 1, 2005, resulted in an average pilot wage reduction of 26%. That contract became amendable on May 1, 2007, and Alaska is currently in negotiations with ALPA. Horizon is also in negotiations with the International Brotherhood of Teamsters on a new pilot agreement. The Horizon pilot contract became amendable in September 2006. Factoring in pay rates, productivity measures, and pension and postretirement medical benefits, we believe our pilot unit costs at both Alaska and Horizon are among the highest in the industry for the size of aircraft operated.

 

Our continuing obligation to fund our traditional defined-benefit pension plans could negatively affect our ability to compete in the marketplace. This is because some of our competitors either have eliminated such obligations through bankruptcy or have never had traditional pension plans in place. Currently, all of our defined-benefit pension plans are closed to new entrants, with the exception of the plan covering Alaska’s pilots.

 

Finally, to the extent we are unable to maintain the outsourcing or subcontracting of certain services for our business, we would incur substantial costs, including costs associated with hiring new employees, in order to perform these services in-house.

 

Our failure to successfully reduce unit costs at both Alaska and Horizon could harm our business.

 

We continue to strive toward aggressive cost-reduction goals that are an important part of our business strategy of offering the best value to passengers through competitive fares while achieving acceptable profit margins and return on capital. We believe having a lower cost structure better positions us to be able to fund growth and take advantage of market opportunities. If we are unable to further reduce our non-fuel unit costs and achieve targeted profitability, we will likely not be able to grow our business and therefore our financial results may suffer.

 

Our indebtedness and other fixed obligations could increase the volatility of earnings and otherwise restrict our activities.

 

We have, and will continue to have for the foreseeable future, a significant amount of debt. Due to our high fixed costs, including aircraft lease commitments and debt service, a decrease in revenues results in a disproportionately greater decrease in earnings.

As of December 31, 2007 and 2006, we had approximately $1.3 billion and $1.2 billion of long-term debt outstanding, respectively, approximately $1.3 billion and $1.1 billion of which was secured by flight equipment and real property. In addition to long-term debt, we have

significant other fixed obligations under operating

 

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leases related to our aircraft, airport terminal space, other airport facilities and office space. As of December 31, 2007, future minimum lease payments under noncancelable operating leases with initial or remaining terms in excess of one year were approximately $1.1 billion for 2008 through 2012 and an aggregate of $526.2 million for the years thereafter.

 

At December 31, 2007, we had firm orders to purchase 46 aircraft requiring future aggregate payments of approximately $1.0 billion through 2011. Although we have secured financing for a number of these commitments, there is no guarantee that additional financing will be available when required. Our inability to secure the financing could have a material adverse effect on our cash balances or result in delays in or our inability to take delivery of aircraft, which would impair our growth or fleet-simplification plans.

 

Our outstanding long-term debt and other fixed obligations could have important consequences. For example, they could:

 

   

limit our ability to obtain additional financing to fund our growth strategy, capital expenditures, acquisitions, working capital or other purposes;

 

   

require us to dedicate a material portion of our operating cash flow to fund lease payments and interest payments on indebtedness, thereby reducing funds available for other purposes; and

 

   

limit our ability to withstand competitive pressures and reduce our flexibility in responding to changing business and economic conditions, including reacting to any economic slowdown in the airline industry.

 

We cannot ensure that we will be able to generate sufficient cash flow from our operations to pay our debt and other fixed obligations as they become due. If we fail to do so, our business could be harmed.

 

Alaska is required to comply with specific financial covenants in certain agreements. We cannot be certain now that Alaska will be able to comply with these covenants or provisions or that these requirements will not limit our ability to finance our future operations or capital needs.

 

Our operations are often affected by factors beyond our control, including changing economic and other conditions, which could harm our financial condition and results of operations.

 

Like other airlines, our operations often are affected by changes in economic and other conditions caused by factors largely beyond our control, including:

 

   

economic recession, interest rate increases, inflation, international or domestic conflicts, terrorist activity, or other changes in economic or business conditions;

 

   

air traffic congestion at airports or other air traffic control problems;

 

   

adverse weather conditions; and

 

   

increased security measures or breaches in security.

 

Delays and cancellations frustrate passengers, reduce aircraft utilization and increase costs, all of which affect our profitability. Due to our geographic area of operations, we believe a significant portion of our operation is more susceptible to adverse weather conditions than that of many of our competitors. Any general reduction in airline passenger traffic as a result of any of the above-mentioned factors could harm our business, financial condition and results of operations.

 

We depend on a few key markets to be successful.

 

Our strategy is to focus on serving a few key markets, including Seattle, Portland, Los Angeles and Anchorage. A significant portion of our flights occurs to and from our Seattle hub. In 2007, traffic to and from Seattle accounted for 62% of our total traffic.

 

We believe that concentrating our service offerings in this way allows us to maximize our investment in personnel, aircraft, and ground facilities, as well as to gain greater advantage

 

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from sales and marketing efforts in those regions. As a result, we remain highly dependent on our key markets. Our business would be harmed by any circumstances causing a reduction in demand for air transportation in our key markets. An increase in competition in our key markets could also cause us to reduce fares or take other competitive measures that could harm our business, financial condition and results of operations.

 

The airline industry continues to face potential security concerns and related costs.

 

The terrorist attacks of September 11, 2001 and their aftermath have negatively affected the airline industry, including our company. More recently, the foiled terror plot in the United Kingdom in August 2006 resulted in new security measures that also impacted our company. Additional terrorist attacks, the fear of such attacks or other hostilities involving the U.S. could have a further significant negative effect on the airline industry, including us, and could:

 

   

significantly reduce passenger traffic and yields due to a potentially dramatic drop in demand for air travel;

 

   

significantly increase security and insurance costs;

 

   

make war risk or other insurance unavailable or extremely expensive;

 

   

increase fuel costs and the volatility of fuel prices;

 

   

increase costs from airport shutdowns, flight cancellations and delays resulting from security breaches and perceived safety threats; and

 

   

result in a grounding of commercial air traffic by the FAA.

 

The occurrence of any of these events would harm our business, financial condition and results of operations.

 

Increases in insurance costs or reductions in insurance coverage would harm our business, financial condition and results of operations.

 

Immediately following the September 11, 2001 terrorist attacks, aviation insurers dramatically increased airline insurance premiums and significantly reduced the insurance coverage available to airlines for third-party claims resulting from acts of terrorism, war or similar events to $50 million per event and in the aggregate. In light of this development, under the Air Transportation Safety and System Stabilization Act and the Homeland Security Act of 2002, as most recently amended by the Consolidated Appropriations Act of 2008, the U.S. government continues to offer domestic airlines either (i) third-party liability war risk coverage above $50 million, or (ii) in lieu of commercial war risk insurance, full hull, comprehensive and third-party liability war risk coverage. This coverage provides for the same limits of war and allied perils coverage for hull and comprehensive insurance and twice the limits of third-party liability insurance carried by the airline on September 11, 2001.

 

Although our insurance costs have declined to pre-2001 levels, aviation insurers could increase their premiums again in the event of additional terrorist attacks, hijackings, airline accidents or other events adversely affecting the airline industry. Furthermore, the full hull, comprehensive and third-party war risk insurance provided by the government is currently mandated through August 31, 2008. Although the government may extend the deadline for providing such coverage, we cannot be certain that any extension will occur, or if it does, for how long the extension will last. It is expected that, should the government stop providing such coverage to the airline industry, the premiums charged by aviation insurers for this coverage will be substantially higher than the premiums currently charged by the government and the coverage will be much more limited, including smaller aggregate limits and shorter cancellation periods. Significant increases in insurance premiums would adversely affect our business, financial condition and results of operations.

 

Our reputation and financial results could be harmed in the event of an airline accident or incident.

 

An accident or incident involving one of our aircraft could involve a significant loss of life and

 

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result in a loss of faith in our airlines by the flying public. In addition, we could experience

significant potential claims from injured passengers and surviving relatives, as well as

costs for the repair or replacement of a damaged aircraft and its consequential temporary or

permanent loss from service. Although we strive to maintain the highest standards of safety and reliability and believe that should an accident or

incident nevertheless occur, we also currently

maintain liability insurance in amounts and of the type generally consistent with industry practice. However, the amount of such coverage may not be adequate and we may be forced to bear substantial losses from an accident. Substantial claims resulting from an accident in excess of our related insurance coverage would harm our business and financial results. Moreover, any aircraft accident or incident, even if fully insured and even if it does not involve one of our airlines, could cause a public perception that our airlines or the equipment they fly is less safe or reliable than other transportation alternatives, which would harm our business.

 

We rely heavily on automated systems to operate our business, and a failure of these systems or by their operators could harm our business.

 

We depend on automated systems to operate our business, including our computerized airline reservation system, our telecommunication systems, our website, our maintenance systems, and other systems. Substantially all of our tickets are issued to passengers as electronic tickets. We depend on our computerized reservation system to be able to issue, track and accept these electronic tickets. In order for our operations to work efficiently, our website and reservation system must be able to accommodate a high volume of traffic, maintain secure information, and deliver important flight information. Substantial or repeated website, reservations system or telecommunication systems failures could reduce the attractiveness of our services and cause our customers to purchase tickets from another airline. In addition, we rely on other automated systems for crew scheduling, flight dispatch, and other operational needs. Disruption in, changes to, or a breach of these systems could result in the loss of important data, increase our expenses and possibly cause us to temporarily cease our operations.

 

We rely on partner airlines for codeshare and frequent flyer marketing arrangements.

 

Alaska and Horizon are parties to marketing agreements with a number of domestic and international air carriers, or “partners,” including but not limited to American Airlines, Continental Airlines, Delta Air Lines and Northwest Airlines. These agreements provide that certain flight segments operated by us are held out as partner “codeshare” flights and that certain partner flights are held out for sale as Alaska codeshare flights. In addition, the agreements generally provide that members of Alaska’s Mileage Plan program can earn miles on or redeem miles for partner flights and vice versa. We receive a significant amount of revenue from flights sold under codeshare arrangements. In addition, we believe that the frequent flyer arrangements are an important part of our Mileage Plan program. The loss of a significant partner or certain partner flights could have a negative effect on our revenues or the attractiveness of our Mileage Plan, which we believe is a source of competitive advantage.

 

We rely on third-party vendors for certain critical activities.

 

We have historically relied on outside vendors for a variety of services and functions critical to our business, including airframe and engine maintenance, ground handling, fueling, computer reservation system hosting and software maintenance. As part of our cost-reduction efforts, our reliance on outside vendors has increased and may continue to do so in the future. In recent years, Alaska has subcontracted its heavy aircraft maintenance, fleet service, facilities maintenance, and ground handling services at certain airports, including Seattle-Tacoma International Airport, to outside vendors.

 

Our use of outside vendors increases our exposure to several risks. In the event that one or more

vendors goes into bankruptcy, ceases operation or fails to perform as promised, replacement services may not be readily available at competitive rates, or at all. Although we believe that our vendor oversight and quality control is among the best in the industry, if one of our vendors fails to perform adequately we may experience increased costs, delays, maintenance issues, safety issues or negative public perception of our airline. Vendor

 

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bankruptcies, unionization, regulatory compliance issues or significant changes in the competitive marketplace among suppliers could adversely affect vendor services or force Alaska to renegotiate

existing agreements on less favorable terms. These events could result in disruptions in Alaska’s operations or increases in its cost structure.

 

We are dependent on a limited number of suppliers for aircraft and parts.

 

Alaska is dependent on Boeing as its sole supplier for aircraft and many aircraft parts. Horizon is similarly dependent on Bombardier. As a result, we are more vulnerable to any problems associated with the supply of those aircraft and parts, including design defects, mechanical problems, contractual performance by the manufacturers, or adverse perception by the public that would result in customer avoidance or in actions by the FAA resulting in an inability to operate our aircraft. Carriers that operate a more diversified fleet are better positioned than we are to manage such events.

 

Changes in government regulation imposing additional requirements and restrictions on our operations or on the airports at which we operate could increase our operating costs and result in service delays and disruptions.

 

Airlines are subject to extensive regulatory and legal requirements, both domestically and internationally, that involve significant compliance costs. In the last several years, Congress has passed laws, and the U.S. Department of Transportation, the Transportation Security Administration and the Federal Aviation Administration (the “FAA”) have issued regulations that have required significant expenditures relating to the maintenance and operation of airlines. For example, the FAA has issued regulations covering, among other things, security measures, collision avoidance systems, noise abatement, environmental restrictions, safety procedures and maintenance regulations. Similarly, many aspects of an airline’s operations are subject to increasingly stringent federal, state and local laws protecting the environment.

 

Because of significantly higher security and other costs incurred by airports since September 11, 2001, many airports have increased their rates and charges to air carriers. Additional laws, regulations, taxes, and airport rates and charges have been proposed from time to time that could significantly increase the cost of airline operations or reduce the demand for air travel. Although lawmakers may impose these additional fees and view them as “pass-through” costs, we believe that a higher total ticket price will influence consumer purchase and travel decisions and may result in an overall decline in passenger traffic, which would harm our business.

 

Recently, there has been some discussion of an “airline passenger’s bill of rights” at both the national and state levels. Bills have recently been proposed in several states that will regulate airlines when operating in those specific states. If these bills were to become law, they could impose additional economic and resource constraints on our airlines and could negatively impact our financial performance.

 

The market price of our common stock may be volatile.

 

The market price of our stock can be influenced by many factors, a number of which are outside of our control, including those discussed above. Some of the primary factors in the volatility of our stock price are:

 

   

our actual or anticipated financial performance;

 

   

the overall financial performance of the industry;

 

   

other industry factors, such as discussion of consolidation;

 

   

the price of crude oil; and

 

   

other macro or geopolitical factors.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None

 

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ITEM 2. PROPERTIES

 

AIRCRAFT

 

The following tables describe the aircraft we operate and their average age at December 31, 2007:

 

Aircraft Type

  Passenger
Capacity
  Owned   Leased   Total   Average Age
in Years

Alaska Airlines

           

Boeing 737-400

  144   3   31   34   12.4

Boeing
737-400C

  72   5   —     5   15.3

Boeing
737-400F

  —     1   —     1   8.8

Boeing 737-700

  124   17   3   20   7.0

Boeing 737-800

  157   26   3   29   1.1

Boeing 737-900

  172   12   —     12   5.4

Boeing MD-80

  140   —     14   14   15.1
                   
      64   51   115   8.3
                   

Horizon Air

           

Bombardier Q200

  37   —     16   16   10.2

Bombardier Q400

  74–76   18   15   33   4.0

Bombardier
CRJ-700

  70   2   19   21   5.5
                   
      20   50   70   5.9
                     

 

Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” discusses future orders and options for additional aircraft.

 

As of December 31, 2007, 47 of the 64 aircraft owned by Alaska and five of the 20 aircraft owned by Horizon are subject to liens securing long-term debt, and the majority of the other owned Alaska aircraft serve as collateral for our $185 million line-of-credit facility. Alaska’s leased 737-400, 737-700, 737-800 and MD-80 aircraft have lease expiration dates between 2008 and 2016, between 2009 and 2010, between 2015 and 2018, and between 2008 and 2012, respectively. Horizon’s leased Q200, Q400 and CRJ-700 aircraft have expiration dates between 2012 and 2014, in 2018, and between 2008 and 2020, respectively. Alaska and Horizon have the option to extend most of the leases for additional periods, or the right to purchase the aircraft at the end of the lease term, usually at the then-fair-market value of the aircraft.

 

In 2006, Alaska announced a plan to transition to an all-Boeing 737 fleet by the end of 2008, which includes the accelerated retirement of our MD-80 fleet. In 2007, Horizon announced its plan to transition out of the Q200 aircraft by the end of 2009 and replace them with larger Q400 aircraft. Giving consideration to these fleet transition plans, the following table displays the currently anticipated fleet counts for Alaska and Horizon as of the end of each quarter in 2008:

 

     31-Mar-08   30-Jun-08   30-Sep-08   31-Dec-08

Alaska Airlines

         

MD80

  9   7   4   —  

737-400

  34   34   34   32

737-400F**

  1   1   1   1

737-400C**

  5   5   5   5

737-700

  20   20   20   20

737-800*

  33   36   41   46

737-900

  12   12   12   12
                 

Totals

  114   115   117   116
                 

Horizon Air

         

Q200

  13   12   12   10

Q400

  33   33   33   36

CRJ-700

  20   20   20   20
                 

Totals

  66   65   65   66
                 

 

* The total includes one additional leased aircraft in 2008.
** F=Freighter; C=Combination freighter/passenger

 

Although the number of aircraft in our operating fleet at the end of each period presented remains relatively consistent, it is important to note that the larger B737-800s and the Q400s are replacing the smaller-gauge MD-80s and Q200s. Therefore, our total capacity, as measured by available seat miles, will increase even though the number of aircraft remains consistent.

 

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GROUND FACILITIES AND SERVICES

 

Alaska and Horizon lease ticket counters, gates, cargo and baggage space, office space, and other support areas at the majority of the airports they serve. Alaska also owns terminal buildings in various cities in the state of Alaska.

 

Alaska has centralized operations in several buildings located at or near Seattle-Tacoma International Airport (Sea-Tac) in Seattle, Washington. These include a five-bay hangar and shops complex (used primarily for line maintenance), a flight operations and training center, an air cargo facility, an information technology office and mainframe computer facility, two office buildings, and corporate headquarters complex. Alaska also leases a stores warehouse, and office spaces for a reservation facility and for various administrative functions in Kent, Washington. Alaska’s major facilities outside of Seattle include a regional headquarters building, an air cargo facility and a hangar/office facility in Anchorage, as well as leased reservations facilities in Phoenix, Arizona and Boise, Idaho. Alaska uses its own employees for ground handling services at most of our airports in the state of Alaska. At other airports throughout our system, those services are contracted to various third-party vendors.

 

Horizon owns its Seattle corporate headquarters building. It leases an operations, training, and aircraft maintenance facility in Portland; line maintenance stations in Boise, Pasco and Seattle; and temporary hangar facility in Spokane for Q400 modification work.

 

ITEM 3. LEGAL PROCEEDINGS

 

Grievance with International Association of Machinists

 

In June 2005, the International Association of Machinists (IAM) filed a grievance under its Collective Bargaining Agreement (CBA) with Alaska alleging that Alaska violated the CBA by, among other things, subcontracting the ramp service operation in Seattle. The dispute was referred to an arbitrator and hearings on the grievance commenced in January 2007, with a final hearing date in August 2007. We expect a decision from the arbitrator in the first half of 2008.

 

Other items

 

The Company is a party to routine litigation matters incidental to its business and with respect to which no material liability is expected.

 

Management believes the ultimate disposition of the matters discussed above is not likely to materially affect the Company’s financial position or results of operations. This forward-looking statement is based on management’s current understanding of the relevant law and facts, and it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF
SECURITY HOLDERS

 

None

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

 

As of December 31, 2007, there were 38,050,680 shares of common stock of Alaska Air Group, Inc. issued and outstanding and 3,609 shareholders of record. We also held 4,771,306 treasury shares at a cost of $112.5 million. We have not paid dividends on the common stock since 1992. Our common stock is listed on the New York Stock Exchange (symbol: ALK).

 

The following table shows the trading range of Alaska Air Group, Inc. common stock on the New York Stock Exchange.

 

     2007   2006
     High   Low   High   Low

First Quarter

  $ 44.52   $ 36.56   $ 36.19   $ 29.44

Second Quarter

    38.99     25.90     40.54     33.86

Third Quarter

    29.09     21.50     41.09     33.60

Fourth Quarter

    28.00     21.15     45.85     37.50

 

SALES OF NON-REGISTERED SECURITIES

 

None

 

PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

 

In September 2007, the Board of Directors authorized the Company to repurchase up to $100 million of its common stock over a period of twelve months. As of December 31, 2007, the Company had repurchased 2,593,282 shares of common stock for a total of $62.8 million under this authorization as noted in the following table. The repurchased shares have been recorded as treasury shares in the accompanying consolidated balance sheet.

 

     Total
Number of

Shares
Purchased
  Average
Price

Paid
per
Share
  Maximum
remaining
dollar value
of shares
that can be
purchased
under the
plan

September 18, 2007 through September 30, 2007

  210,000   $ 24.03    

October 1, 2007 – October 31, 2007

  590,000   $ 24.81    

November 1, 2007 – November 30, 2007

  1,189,482   $ 23.36    

December 1, 2007 – December 31, 2007

  603,800   $ 25.42    
                 

Total

  2,593,282   $ 24.22   $ 37,190,231
                 

 

All of the shares purchased in the period were under the plan noted above.

 

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PERFORMANCE GRAPH

 

The following graph compares our cumulative total stockholder return since December 31, 2002 with the S&P 500 Index and the Dow Jones U.S. Airlines Index. The graph assumes that the value of the investment in our common stock and each index (including reinvestment of dividends) was $100 on December 31, 2002.

 

LOGO

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND
OPERATING DATA

 

     2007     2006     2005     2004     2003  

Consolidated Operating Results

           

Year Ended December 31 (in millions, except per share amounts):

           

Operating Revenues

  $ 3,506.0     $ 3,334.4     $ 2,975.3     $ 2,723.8     $ 2,444.8  

Operating Expenses

    3,294.0       3,421.7       2,808.8       2,718.1       2,455.9  

Operating Income (Loss)

    212.0       (87.3 )     166.5       5.7       (17.5 )

Nonoperating income (expense), net of interest capitalized (a)

    (10.4 )     (0.5 )     (29.3 )     (26.3 )     46.5  

Income (loss) before income tax and accounting change

    201.6       (87.8 )     137.2       (20.6 )     29.0  

Income (loss) before accounting change

    125.0       (52.6 )     84.5       (15.3 )     13.5  

Net Income (Loss)

  $ 125.0     $ (52.6 )   $ (5.9 )   $ (15.3 )   $ 13.5  

Average basic shares outstanding

    40.125       37.939       27.609       26.859       26.648  

Average diluted shares outstanding

    40.424       37.939       33.917       26.859       26.730  

Basic earnings (loss) per share before accounting change

  $ 3.12     $ (1.39 )   $ 3.06     $ (0.57 )   $ 0.51  

Basic earnings (loss) per share

    3.12       (1.39 )     (0.21 )     (0.57 )     0.51  

Diluted earnings (loss) per share before accounting change

    3.09       (1.39 )     2.65       (0.57 )     0.51  

Diluted earnings (loss) per share

    3.09       (1.39 )     (0.01 )     (0.57 )     0.51  

Consolidated Financial Position

           

At End of Period (in millions, except ratio):

           

Total assets

  $ 4,490.9     $ 4,077.1     $ 3,792.0     $ 3,335.0     $ 3,259.2  

Long-term debt and capital lease obligations, net of current portion

    1,124.6       1,031.7       969.1       989.6       906.9  

Shareholders’ equity

    1,024.0       885.5       827.6       664.8       674.2  

Ratio of earnings to fixed charges (b)

    1.52       0.42       1.78       0.89       1.22  

Statistics

           

Alaska Airlines Mainline Operating Data:

           

Revenue passengers (000)

    17,558       17,165       16,759       16,295       15,047  

Revenue passenger miles (RPM) (000,000)

    18,451       17,822       16,915       16,231       14,554  

Available seat miles (ASM) (000,000)

    24,208       23,278       22,292       22,276       20,804  

Revenue passenger load factor

    76.2 %     76.6 %     75.9 %     72.9 %     70.0 %

Yield per passenger mile

    13.81 ¢     13.76 ¢     12.91 ¢     12.47 ¢     12.65 ¢

Operating revenues per ASM

    11.52 ¢     11.50 ¢     10.76 ¢     10.02 ¢     9.74 ¢

Operating expenses per ASM

    10.54 ¢     11.92 ¢     10.14 ¢     10.07 ¢     9.81 ¢

Average number of full-time equivalent employees

    9,679       9,322       9,065       9,968       10,040  

Operating fleet at period-end

    115       114       110       108       109  

Horizon Air Combined Operating Data (c):

           

Revenue passengers (000)

    7,552       6,860       6,481       5,930       4,934  

Revenue passenger miles (RPM) (000,000)

    2,918       2,691       2,475       2,155       1,640  

Available seat miles (ASM) (000,000)

    3,978       3,632       3,400       3,107       2,569  

Revenue passenger load factor

    73.4 %     74.1 %     72.8 %     69.3 %     63.9 %

Yield per passenger mile

    24.30 ¢     23.53 ¢     21.98 ¢     22.61 ¢     26.96 ¢

Operating revenues per ASM

    18.06 ¢     17.73 ¢     16.36 ¢     16.20 ¢     18.06 ¢

Operating expenses per ASM

    18.07 ¢     17.40 ¢     15.50 ¢     15.57 ¢     17.79 ¢

Average number of full-time equivalent employees

    3,806       3,611       3,456       3,423       3,361  

Operating fleet at period-end

    70       69       65       65       62  

 

(a) Includes capitalized interest of $27.8 million, $24.7 million, $8.9 million, $1.7 million, $2.3 million, $2.7 million, $10.6 million, $17.7 million, $12.6 million, $7.0 million, and $5.3 million for 2007, 2006, 2005, 2004, 2003, 2002, 2001, 2000, 1999, 1998, and 1997, respectively.
(b) For 2006, 2004, 2002, 2001, and 2000 earnings are inadequate to cover fixed charges by $107.6 million, $17.4 million, $99.5 million, $69.1 million, and $44.6 million, respectively. See Exhibit 12.1 to this Form 10-K.
(c) Includes Horizon services operated as Frontier JetExpress in 2004 through 2007 and flights operated under the Capacity Purchase Agreement with Alaska in 2007.

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND
OPERATING DATA—(Continued)

 

     2002     2001     2000     1999     1998     1997  

Consolidated Operating Results

             

Year Ended December 31 (in millions, except per share amounts):

             

Operating Revenues

  $ 2,224.1     $ 2,152.8     $ 2,194.0     $ 2,091.5     $ 1,912.0     $ 1,747.4  

Operating Expenses

    2,317.3       2,279.1       2,227.1       1,901.7       1,700.1       1,606.2  

Operating Income (Loss)

    (93.2 )     (126.3 )     (33.1 )     189.8       211.9       141.2  

Nonoperating income (expense), net of interest capitalized (a)

    (8.6 )     62.8       6.2       23.2       (6.2 )     (15.5 )

Income (loss) before income tax and accounting change

    (101.8 )     (63.5 )     (26.9 )     213.0       205.7       125.7  

Income (loss) before accounting change

    (67.2 )     (43.4 )     (20.4 )     129.4       125.3       73.8  

Net Income (Loss)

  $ (118.6 )   $ (43.4 )   $ (67.2 )   $ 129.4     $ 125.3     $ 73.8  

Average basic shares outstanding

    26.546       26.499       26.440       26.372       23.388       14.785  

Average diluted shares outstanding

    26.546       26.499       26.440       26.507       26.367       22.689  

Basic earnings (loss) per share before accounting change

  $ (2.53 )   $ (1.64 )   $ (0.77 )   $ 4.91     $ 5.36     $ 4.99  

Basic earnings (loss) per share

    (4.47 )     (1.64 )     (2.54 )     4.91       5.36       4.99  

Diluted earnings (loss) per share before accounting change

    (2.53 )     (1.64 )     (0.77 )     4.88       4.75       3.25  

Diluted earnings (loss) per share

    (4.47 )     (1.64 )     (2.54 )     4.88       4.75       3.25  

Consolidated Financial Position

             

At End of Period (in millions, except ratio):

             

Total assets

  $ 2,880.7     $ 2,950.5     $ 2,528.1     $ 2,196.0     $ 1,742.6     $ 1,533.3  

Long-term debt and capital lease obligations, net of current portion

    856.7       852.2       509.2       337.0       171.5       401.4  

Shareholders’ equity

    655.7       851.3       895.1       959.2       822.1       509.4  

Ratio of earnings to fixed charges (b)

    0.28       0.48       0.66       3.07       2.94       2.12  

STATISTICS

             

Alaska Airlines Mainline Operating Data:

             

Revenue passengers (000)

    14,154       13,668       13,525       13,620       13,056       12,284  

Revenue passenger miles (RPM) (000,000)

    13,186       12,249       11,986       11,777       11,283       10,386  

Available seat miles (ASM) (000,000)

    19,360       17,919       17,315       17,341       16,807       15,436  

Revenue passenger load factor

    68.1 %     68.4 %     69.2 %     67.9 %     67.1 %     67.3 %

Yield per passenger mile

    12.65 ¢     13.12 ¢     13.56 ¢     12.86 ¢     12.51 ¢     12.49 ¢

Operating revenues per ASM

    9.47 ¢     9.84 ¢     10.20 ¢     9.75 ¢     9.41 ¢     9.43 ¢

Operating expenses per ASM

    9.87 ¢     10.24 ¢     10.35 ¢     9.81 ¢     8.25 ¢     8.54 ¢

Average number of full-time equivalent employees

    10,142       10,115       9,611       9,183       8,704       8,236  

Operating fleet at period-end

    102       101       95       89       84       78  

Horizon Air Combined Operating Data (c):

             

Revenue passengers (000)

    4,815       4,668       5,044       4,984       4,389       3,686  

Revenue passenger miles (RPM) (000,000)

    1,514       1,350       1,428       1,379       1,143       889  

Available seat miles (ASM) (000,000)

    2,428       2,148       2,299       2,194       1,815       1,446  

Revenue passenger load factor

    62.4 %     62.8 %     62.1 %     62.9 %     63.0 %     61.5 %

Yield per passenger mile

    26.02 ¢     28.15 ¢     29.82 ¢     28.77 ¢     29.02 ¢     32.56 ¢

Operating revenues per ASM

    17.29 ¢     19.02 ¢     19.27 ¢     18.96 ¢     19.16 ¢     21.00 ¢

Operating expenses per ASM

    17.87 ¢     21.02 ¢     19.53 ¢     17.74 ¢     18.16 ¢     20.64 ¢

Average number of full-time equivalent employees

    3,476       3,764       3,795       3,603       3,019       2,756  

Operating fleet at period-end

    63       60       62       62       60       62  

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand the Company, our operations and our present business environment. MD&A is provided as a supplement to – and should be read in conjunction with – our consolidated financial statements and the accompanying notes. All statements in the following discussion that are not reports of historical information or descriptions of current accounting policy are forward-looking statements. Please consider our forward-looking statements in light of the risks referred to in this report’s introductory cautionary note and the risks mentioned in the Company’s filings with the Securities and Exchange Commission. This overview summarizes the MD&A, which includes the following sections:

 

   

Year in Review—highlights from 2007 outlining some of the major events that happened during the year and how they affected our financial performance.

 

   

Results of Operations—an in-depth analysis of the results of operations of Alaska and Horizon for the three years presented in our consolidated financial statements. We believe this analysis will help the reader better understand our consolidated statements of operations. Financial and statistical data for Alaska and Horizon are also included here. This section includes forward-looking statements regarding our view of 2008.

 

   

Critical Accounting Estimates—a discussion of our accounting estimates that involve significant judgment and uncertainties.

 

   

Liquidity and Capital Resources—an analysis of cash flows, sources and uses of cash, contractual obligations, commitments and off-balance sheet arrangements, an overview of financial position and the impact of inflation and changing prices.

 

YEAR IN REVIEW

 

In 2007, we reported consolidated net income of $125.0 million compared to a net loss of $52.6 million in 2006. The 2006 results included the following items that impact the comparability between the periods:

 

   

We recorded $189.5 million ($118.5 million after tax) of fleet transition costs related to our MD-80 fleet.

 

   

We also recorded a $24.8 million ($15.5 million after tax) restructuring charge associated with the voluntary severance package offered to certain of our employees represented by the International Association of Machinists and to our flight attendants as part of new four-year collective bargaining agreements.

 

Both periods include adjustments to reflect the timing of gain or loss recognition resulting from mark-to-market fuel hedge accounting – we recorded a $52.2 million gain in 2007 compared to an $89.9 million loss in 2006.

 

The revenue environment in 2007 was characterized by increased competition in our primary markets and a softer demand environment in our West Coast market. However, yield at Alaska (which represents approximately 88% of consolidated revenues) improved slightly as we and other carriers attempted to raise fares to cover higher fuel costs. Both Alaska and Horizon posted higher passenger traffic. These factors resulted in an increase in total consolidated revenues of $171.6 million.

 

Our total operating expenses declined by $127.7 million during 2007 compared to 2006. This decrease is primarily due to the 2006 fleet transition and restructuring charges mentioned above and mark-to-market gains associated with an increase in the value of our fuel hedge portfolio, offset by increases in other operating expenses in 2007. See “Results of Operations” below for further discussion of changes in revenues and operating expenses for both Alaska and Horizon.

 

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Accomplishments

 

Accomplishments from 2007 include:

 

 

 

Alaska marked its 75th anniversary with several celebration events and the unveiling of the “Starliner 75,” a new Boeing 737-800 aircraft painted in a vintage DC-3 livery.

 

   

Horizon was named “2007 Regional Airline of the Year” by Air Transport World. The publication cited, among other positive items, an exemplary safety record, superior commitment to customer service, and positive financial results during challenging industry times.

 

   

In October 2007, we reached another website milestone by processing over 50% of our monthly sales through alaskaair.com for the first time.

 

   

Alaska initiated service to the Hawaiian Islands in October 2007– something our customers and employees had been looking forward to for many years. Horizon also began non-stop service between Portland, Oregon and Santa Rosa, California. Alaska and Horizon have also initiated or announced additional service in certain existing markets or connected cities already served with new non-stop service.

 

Common Stock Repurchase

 

In September 2007, our Board of Directors authorized the Company to repurchase up to $100 million of our common stock over a period of twelve months. At December 31, 2007, we had repurchased 2.6 million shares of common stock for a total of $62.8 million. We believe this repurchase program enhances shareholder value and demonstrates our commitment to providing investors a return on capital employed in our business. The repurchased shares have been recorded as treasury shares in our consolidated balance sheet.

 

Airport of the Future

 

On October 16, 2007, we unveiled the first phase of our patented “Airport of the Future” at Seattle Tacoma International Airport. Once the project is complete, additional facilities are coming online in the first half of 2008, the “Airport of the Future” will allow both Alaska and Horizon customers to check in for their flights and drop bags more quickly, improve our agents’ productivity, and allow us to handle more customers without increasing our airport space. We debuted this concept at the Ted Stevens International Airport in Anchorage in 2004 and since that time, customer wait times have been reduced significantly.

 

Row 44

 

In September 2007, Alaska announced its plan to launch in-flight wireless Internet service in 2008 based on Row 44, Inc.’s satellite-based broadband connectivity solution. We plan to test the system on Alaska’s aircraft in the first half of 2008. If the test is successful, we plan to equip all of our aircraft at Alaska with this equipment. This technology will provide customers with a unique entertainment and business network in the air. Passengers with Wi-Fi-enabled devices – such as laptop computers, PDAs, smart phones and portable gaming systems – will have high-speed access to the Internet, e-mail, virtual private networks and stored in-flight entertainment content.

 

Hawaiian Vacations

 

During the third quarter of 2007, Alaska announced the acquisition of certain assets of Hawaiian Vacations Inc., an Anchorage-based company that charters aircraft and markets package tours to the Hawaiian Islands. The acquisition of these assets will help accelerate our entrance into the Anchorage-Honolulu market, which began December 9, 2007 with one daily round trip.

 

Q400 Landing Gear Inspections

 

On September 12, 2007, Horizon temporarily grounded 19 of its 33 Bombardier Q400 turboprops as a precautionary measure following an all-operator message from Bombardier Aerospace of Canada. On September 13, in response to a Transport Canada airworthiness directive (AD), Horizon grounded its entire Q400

 

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fleet to begin the required landing gear inspections. The AD was produced in the wake of two landing gear failure incidents involving Scandinavian Airlines (SAS) in Europe. Horizon, which has operated the Canadian-manufactured Q400 since 2001, has never experienced any issues like those encountered by SAS in these incidents. The inspections were completed over a 13-day period and the aircraft were put back into service after that time.

 

Labor Costs and Negotiations

 

We are pleased with the long-term contracts that have been reached with the majority of our labor groups. We are now in the process of negotiating new contracts with pilots at both Alaska and Horizon and with flight attendants at Horizon. The contract with Alaska’s pilots became amendable May 1, 2007, and the contract with Horizon’s pilots became amendable September 12, 2006. We hope to reach negotiated agreements with each of these groups that recognize the important contributions that they make to both of our airlines, without harming either company’s competitive position. Factoring in pay rates, productivity measures, pension, and post-retirement medical benefits, we believe our pilot unit costs are among the highest in the industry for the size of aircraft operated.

 

We do not know what the final outcome of these negotiations will be or when agreements will be reached. However, uncertainty around open contracts could be a distraction to some employees, reduce employee engagement in our business, and hinder us from achieving the operational goals (such as on-time and completion-rate targets) that we have set.

 

Alaska Fleet Transition

 

During the first quarter of 2006, we announced our plan to retire our entire MD-80 fleet by the end of 2008 as part of Alaska’s move to an all-Boeing 737 fleet. We believe this transition, when completed, will provide more than $130 million in annual operating savings by way of lower fuel, maintenance, and training costs.

 

During 2007, we sold all 20 of our owned operating MD-80s. The majority of these aircraft are now leased from the buyer under short-term lease arrangements, which will allow us to maintain our current MD-80 retirement schedule through December 2008. We ceased operation of seven of these leased MD-80s in 2007, including one at the end of December that was earlier than anticipated. The charge associated with the early retirement in December 2007 was not material.

 

We currently have long-term lease arrangements on four MD-80 aircraft that we plan to cease operating before the end of the lease term. We anticipate that once these aircraft have been removed from operation, we will dispose of them through a lease buy-out or a sublease arrangement, or we will store them at a long-term storage facility. It is likely that we will record a charge in our statement of operations if either of these events occurs. Aggregate minimum lease payments for these four aircraft through the end of their lease terms total approximately $68.5 million as of December 31, 2007.

 

Horizon Fleet Transition

 

In 2006, Horizon entered into an agreement to sublease 16 of its Bombardier Q200 aircraft to a third party. During 2007, 11 aircraft were transferred, resulting in a loss on the sublease arrangement of $14.1 million that is reflected as “Fleet transition costs – Horizon” in the consolidated statements of operations. We expect the average loss per aircraft to be approximately $1.4 million, which will be recorded as each aircraft leaves the fleet.

 

In April 2007, Horizon announced an order for 15 additional Q400 aircraft, with options for 20 more. These aircraft will be delivered in 2008 and 2009. With this order, we plan to phase out the remaining leased Q200 aircraft by the end of 2009, and we are in the process of negotiating transactions that would allow for their exit from the fleet. We believe the market has improved since the earlier Q200 sublease transaction, but the amount or timing of any potential loss or gain cannot be reasonably estimated at this time.

 

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In 2007, Horizon posted a pretax loss of $10.6 million. We have a number of initiatives underway to improve Horizon’s operating results, including evaluating whether further fleet simplification of Horizon’s fleet away from regional jets to an all-Q400 fleet would be beneficial. However, no decisions have been made at this time.

 

Capacity Purchase Agreements

 

Alaska and Horizon entered into a Capacity Purchase Agreement (CPA) effective January 1, 2007, whereby Alaska purchases capacity on certain routes (“capacity purchase markets”) from Horizon as specified by the agreement. This agreement has resulted in a new presentation in Alaska’s statement of operations. The actual passenger revenue from the capacity purchase markets is identified as “Passenger revenue – purchased capacity” and the associated costs are identified as “Purchased capacity costs.”

 

Alaska also has a similar arrangement in place with a third-party carrier for flying between Anchorage and Dutch Harbor, Alaska. Historically, the revenue from this arrangement was presented in “Other revenue – net” and the associated costs were in “Contracted services” in Alaska’s statement of operations. Now, all of these revenues and costs are presented with the Horizon purchased capacity revenues and costs, and the prior period has been reclassified to conform to the current presentation.

 

Alaska and Horizon entered into the CPA in order to improve the visibility of both the revenues and the costs of flying in the capacity purchase markets. Under the CPA, Alaska pays Horizon a contractual amount for the purchased capacity in the incentive markets regardless of the revenue collected on those flights. The amount paid to Horizon is generally based on Horizon’s operating costs plus a margin. Alaska bears the inventory and revenue risk in those markets. Accordingly, Alaska records the related passenger revenue. Alaska records payments to Horizon in “Purchased capacity costs.” Horizon records the payment from Alaska as “Passenger revenue.”

 

The Air Group planning department works to strategically deploy certain Horizon aircraft by optimizing the balance of local and “flow” traffic connections with Alaska in order to maximize total returns to the Company and to allow Alaska to deploy its larger jets to other routes. Prior to 2007, there was a revenue-sharing arrangement in place whereby Alaska made a payment to Horizon if certain covered markets created losses for Horizon. Alternatively, Horizon made a payment to Alaska if those markets were profitable.

 

Under both the revenue-sharing arrangement that was previously in place and the new CPA, the payments made from Alaska to Horizon are eliminated in consolidation and do not impact Air Group’s consolidated results.

 

Frontier JetExpress

 

In November 2007, Horizon discontinued its contract flying with Frontier Airlines as Frontier JetExpress. We had nine CRJ-700 aircraft dedicated to this program, all of which have returned to Horizon’s operating fleet. Two of these aircraft were returned in the first quarter, one in the third quarter and the remaining six in the fourth quarter of 2007. We have used these aircraft for productive and strategic redeployments throughout Horizon’s network and in capacity purchase markets with Alaska. However, the influx of new capacity has depressed yields in some of our markets.

 

Line of Credit Modification

 

In April 2007, we announced the Second Amendment of the March 25, 2005, $160 million variable-rate credit facility with a syndicate of financial institutions. The terms of the Second Amendment provide that any borrowings will be secured by either aircraft or cash collateral. The Second Amendment: (i) increased the size of the facility to $185 million; (ii) improved the collateral advance rates for certain aircraft; (iii) extended the agreement by two years with a maturity date of March 31, 2010; and (iv) repriced the credit facility to reflect current market rates. We currently have no immediate plans to borrow using this credit facility. In July 2007, we executed the Third Amendment to the credit facility, which amended a covenant restriction to allow borrowings between Alaska Airlines and its affiliates of up to $500 million, from $300 million previously.

 

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Outlook

 

We currently expect to increase Alaska mainline capacity by 3% and reduce Horizon total system capacity by 4% in 2008 compared to 2007. The expected capacity increase at Alaska is due primarily to the anticipated delivery of 17 new B737-800 aircraft in 2008 and the annualization of capacity additions that resulted from 14 B737-800 aircraft delivered in 2007, offset by the retirement of 15 MD-80 aircraft and, to a lesser extent, scheduled retirement of other aircraft.

 

We will continue to monitor our flight schedules to see if there are further opportunities to reduce unprofitable flying and perhaps retire some of our MD-80s sooner than currently planned. We recently announced that we will be eliminating our Oakland – Orange County route and Alaska will shift to Horizon its daily flights from Seattle to Reno and Boise in an effort to reduce costs and increase profitability.

 

On a net basis, we expect that Alaska’s fleet size will grow by one aircraft in 2008 (from 115 to 116), although the B737-800 aircraft are larger than the MD-80s, allowing for the capacity growth mentioned above. Horizon’s expected capacity decrease is due largely to the anticipated reduction of several Q200 aircraft and the retirement of one CRJ700, offset by the delivery of four new Q400 aircraft in 2008 and the annualization of 13 new Q400 aircraft delivered in 2007. Additionally, there has been an increase in the number of seats on a portion of the fleet of Q400s from 74 seats to 76 seats (all Q400 aircraft will have 76 seats by the end of 2008). The aircraft deliveries in 2008 at both Alaska and Horizon are planned to replace outgoing aircraft, increase frequency in our existing markets and, to a lesser degree, serve new markets.

 

For much of the past three years, Alaska’s operational performance has fallen short of our goals and our customers’ expectations. We currently have several initiatives underway to help improve our on-time performance, completion rates, baggage handling, and other important customer-driven operational measures. Delivering on these core operational promises is one of our highest-priority internal goals for 2008.

 

RESULTS OF OPERATIONS

 

2007 COMPARED WITH 2006

 

Our consolidated net income for 2007 was $125.0 million, or $3.09 per diluted share, compared to a net loss of $52.6 million, or $1.39 per diluted share, in 2006. Several items, as noted below, affect the comparability between the two periods:

 

   

During 2006, we recorded fleet transition costs of $189.5 million ($118.5 million after tax, or $3.12 per share) associated with our fleet transition plan. See Note 2 to the consolidated financial statements.

 

   

In 2006, we recognized restructuring charges of $24.8 million ($15.5 million after tax, or $0.41 per share) associated with an offer of voluntary severance to certain of Alaska’s employees represented by the IAM and the AFA.

 

   

Both periods include adjustments to reflect the timing of gain or loss recognition resulting from mark-to-market fuel hedge accounting. In 2007, we recognized mark-to-market gains of $52.2 million ($32.7 million after tax, or $0.81 per diluted share), compared to a loss of $89.9 million ($56.3 million after tax, or $1.48 per share) in 2006.

 

We believe disclosure of the impact of these individual charges is useful information to investors and other readers because:

 

   

it is useful to monitor performance without these items as it improves a reader’s ability to compare our results to other airlines;

 

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our results excluding these special items is the basis for our various employee incentive plans, thus allowing investors to better understand the changes in variable incentive pay expense in our consolidated statements of operations;

 

   

our results excluding these items is most often used in internal management and board reporting and decision-making; and

 

   

we believe it is the basis by which we are evaluated by industry analysts.

 

Our consolidated results are primarily driven by the results of our two operating carriers. Alaska reported pretax income of $216.0 million in 2007, while Horizon reported a pretax loss of $10.6 million in 2007. Financial and statistical data for Alaska and Horizon are shown on pages 34 and 35, respectively. An in-depth discussion of the results of Alaska and Horizon begins on page 36.

 

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ALASKA AIRLINES FINANCIAL AND STATISTICAL DATA

 

     Quarter Ended December 31     Year Ended December 31  
       2007         2006       %
  Change  
    2007     2006     %
Change
    2005     %
Change
 

Financial Data (in millions):

                 

Operating Revenues:

                 

Passenger

  $ 612.8     $ 570.6     7.4     $ 2,547.2     $ 2,453.1     3.8     $ 2,183.0     12.4  

Freight and mail

    21.3       21.6     (1.4 )     94.2       93.4     0.9       90.3     3.4  

Other—net

    41.3       36.6     12.8       147.1       129.6     13.5       125.9     2.9  
                                                 

Total mainline operating revenues

    675.4       628.8     7.4       2,788.5       2,676.1         2,399.2     11.5  

Passenger—purchased capacity

    71.9       3.4     NM       281.4       16.4     NM       16.9     (3.0 )
                                                 

Total Operating Revenues

    747.3       632.2     18.2       3,069.9       2,692.5     14.0       2,416.1     11.4  
                                                 

Operating Expenses:

                 

Wages and benefits

    191.0       190.4     0.3       752.9       743.3     1.3       722.1     2.9  

Variable incentive pay

    2.3       10.4     (77.9 )     13.5       27.7     (51.3 )     15.3     81.0  

Aircraft fuel, including hedging gains and losses

    182.2       189.8     (4.0 )     737.5       757.0     (2.6 )     476.0     59.0  

Aircraft maintenance

    42.0       38.2     9.9       149.8       156.8     (4.5 )     185.2     (15.3 )

Aircraft rent

    29.5       26.3     12.2       112.8       110.9     1.7       116.8     (5.1 )

Landing fees and other rentals

    42.8       40.3     6.2       170.1       158.2     7.5       156.2     1.3  

Contracted services

    32.9       30.2     8.9       124.1       117.5     5.6       104.9     12.0  

Selling expenses

    30.0       31.5     (4.8 )     129.3       141.5     (8.6 )     132.6     6.7  

Depreciation and amortization

    36.2       38.2     (5.2 )     142.3       137.8     3.3       125.4     9.9  

Food and beverage service

    12.1       12.2     (0.8 )     46.9       48.3     (2.9 )     48.8     (1.0 )

Other

    48.1       42.7     12.6       173.1       161.1     7.4       157.6     2.2  

Fleet transition costs

    —         —       NM       —         189.5     NM       —       NM  

Restructuring charges and adjustments

    —         (7.6 )   NM       —         24.8     NM       20.4     NM  
                                                 

Total mainline operating expenses

    649.1       642.6     1.0       2,552.3       2,774.4     (8.0 )     2,261.3     22.7  

Purchased capacity costs

    80.7       3.2     NM       302.8       14.3     NM       15.0     (4.7 )
                                                 

Total Operating Expenses

    729.8       645.8     13.0       2,855.1       2,788.7     2.4       2,276.3     22.5  
                                                 

Operating Income (Loss)

    17.5       (13.6 )   NM       214.8       (96.2 )   NM       139.8     NM  
                                                 

Interest income

    15.1       15.1         64.8       56.3         32.5      

Interest expense

    (21.3 )     (19.8 )       (86.2 )     (73.3 )       (51.2 )    

Interest capitalized

    6.6       6.0         25.7       21.5         8.1      

Other—net

    (2.7 )     0.2         (3.1 )     (0.5 )       (5.0 )    
                                                 
      (2.3 )     1.5         1.2       4.0         (15.6 )    
                                                 

Income (Loss) Before Income Tax and Accounting Change

  $ 15.2     $ (12.1 )   NM     $ 216.0     $ (92.2 )   NM     $ 124.2     NM  
                                                 

Mainline Operating Statistics:

                 

Revenue passengers (000)

    4,191       4,107     2.0       17,558       17,165     2.3       16,759     2.4  

RPMs (000,000) “traffic”

    4,498       4,243     6.0       18,451       17,822     3.5       16,915     5.4  

ASMs (000,000) “capacity”

    6,020       5,755     4.6       24,208       23,278     4.0       22,292     4.4  

Passenger load factor

    74.7 %     73.7 %   1.0 pts     76.2 %     76.6 %   (0.4 )pts     75.9 %   0.7 pts

Yield per passenger mile

    13.62 ¢     13.45 ¢   1.3       13.81 ¢     13.76 ¢   0.3       12.91 ¢   6.7  

Operating revenues per ASM

    11.22 ¢     10.93 ¢   2.7       11.52 ¢     11.50 ¢   0.2       10.76 ¢   6.8  

Passenger revenue per ASM

    10.18 ¢     9.91 ¢   2.7       10.52 ¢     10.54 ¢   (0.2 )     9.79 ¢   7.6  

Operating expenses per ASM

    10.78 ¢     11.17 ¢   (3.5 )     10.54 ¢     11.92 ¢   (11.6 )     10.14 ¢   17.6  

Aircraft fuel cost per ASM

    3.02 ¢     3.30 ¢   (8.3 )     3.04 ¢     3.25 ¢   (6.4 )     2.13 ¢   53.0  

Fleet transition costs per ASM

    —         —       NM       —         0.81 ¢   NM       0.00 ¢   NM  

Restructuring charges per ASM

    —         -0.13 ¢   NM       —         0.11 ¢   NM       0.09 ¢   NM  

Navigation fee refund per ASM

    —         —       —         —         —       —         0.02 ¢   NM  

Aircraft fuel cost per gallon

  $ 2.09     $ 2.18     (4.1 )   $ 2.08     $ 2.14     (2.8 )   $ 1.37     56.2  

Economic fuel cost per gallon

  $ 2.48     $ 1.98     25.2     $ 2.20     $ 1.92     14.6     $ 1.53     25.5  

Fuel gallons (000,000)

    87.2       87.1     0.1       354.3       354.3     0.0       346.4     2.3  

Average number of full-time equivalent employees

    9,672       9,485     2.0       9,679       9,322     3.8       9,065     2.8  

Aircraft utilization (blk hrs/day)

    10.7       10.6     0.9       10.9       11.0     (0.9 )     10.8     1.9  

Average aircraft stage length (miles)

    946       914     3.5       926       919     0.8       898     2.3  

Operating fleet at period-end

    115       114     1 a/c     115       114     1 a/c     110     4 a/c

Purchased Capacity Operating Statistics:

                 

RPMs (000,000)

    287       9     NM       1,099       41     NM       42     NM  

ASMs (000,000)

    386       15     NM       1,453       67     NM       71     NM  

 

NM = Not Meaningful

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HORIZON AIR FINANCIAL AND STATISTICAL DATA

 

     Quarter Ended December 31     Year Ended December 31  
     2007     2006     %
Change
    2007     2006     %
Change
    2005     %
Change
 

Financial Data (in millions):

                 

Operating Revenues:

                 

Passenger

  $ 179.6     $ 155.0     15.9     $ 709.2     $ 633.1     12.0     $ 544.0     16.4  

Freight and mail

    0.5       0.9     (44.4 )     2.3       3.9     (41.0 )     3.8     2.6  

Other—net

    1.8       2.9     (37.9 )     6.9       7.0     (1.4 )     8.6     (18.6 )
                                                 

Total Operating Revenues

    181.9       158.8     14.5       718.4       644.0     11.6       556.4     15.7  
                                                 

Operating Expenses:

                 

Wages and benefits

    51.1       49.0     4.3       201.2       189.3     6.3       173.7     9.0  

Variable incentive pay

    1.3       2.3     (43.5 )     7.3       9.1     (19.8 )     4.7     93.6  

Aircraft fuel, including hedging gains and losses

    38.3       30.0     27.7       138.8       116.5     19.1       72.9     59.8  

Aircraft maintenance

    23.1       23.9     (3.3 )     92.0       73.9     24.5       43.3     70.7  

Aircraft rent

    15.7       17.3     (9.2 )     65.6       69.3     (5.3 )     70.2     (1.3 )

Landing fees and other rentals

    14.1       11.6     21.6       56.9       46.9     21.3       47.7     (1.7 )

Contracted services

    7.2       6.9     4.3       27.1       27.0     0.4       23.8     13.4  

Selling expenses

    7.7       6.3     22.2       31.2       31.5     (1.0 )     29.1     8.2  

Depreciation and amortization

    8.6       4.9     75.5       33.9       18.5     83.2       16.8     10.1  

Food and beverage service

    0.7       0.7     0.0       2.8       2.9     (3.4 )     2.5     16.0  

Other

    12.3       9.9     24.2       48.0       46.9     2.3       42.2     11.1  

Fleet transition costs

    3.5       —       NM       14.1       —       NM       —       NM  
                                                 

Total Operating Expenses

    183.6       162.8     12.8       718.9       631.8     13.8       526.9     19.9  
                                                 

Operating Income (Loss)

    (1.7 )     (4.0 )   NM       (0.5 )     12.2     NM       29.5     NM  
                                                 

Interest income

    1.1       1.0         4.5       3.7         1.6      

Interest expense

    (4.5 )     (1.6 )       (16.6 )     (7.4 )       (5.5 )    

Interest capitalized

    0.3       1.1         2.1       3.2         0.8      

Other—net

    —         —           (0.1 )     —           —        
                                                 
      (3.1 )     0.5         (10.1 )     (0.5 )       (3.1 )    
                                                 

Income (Loss) Before Income Tax and Accounting Change

  $ (4.8 )   $ (3.5 )   NM     $ (10.6 )   $ 11.7     NM     $ 26.4     NM  
                                                 

Combined Operating Statistics: (a)

                 

Revenue passengers (000)

    1,930       1,689     14.3       7,552       6,860     10.1       6,481     5.8  

RPMs (000,000) “traffic”

    723       659     9.7       2,918       2,691     8.4       2,475     8.7  

ASMs (000,000) “capacity”

    996       903     10.3       3,978       3,632     9.5       3,400     6.8  

Passenger load factor

    72.6 %     73.0 %   (0.4 )pts     73.4 %     74.1 %   (0.7 )pts     72.8 %   1.3 pts

Yield per passenger mile

    24.84 ¢     23.52 ¢   5.6       24.30 ¢     23.53 ¢   3.3       21.98 ¢   7.0  

Operating revenues per ASM

    18.26 ¢     17.59 ¢   3.9       18.06 ¢     17.73 ¢   1.9       16.36 ¢   8.4  

Operating expenses per ASM

    18.43 ¢     18.03 ¢   2.2       18.07 ¢     17.40 ¢   3.9       15.50 ¢   12.2  

Aircraft fuel cost per ASM

    3.85 ¢     3.32 ¢   16.0       3.49 ¢     3.21 ¢   8.7       2.14 ¢   50.0  

Fleet transition costs per ASM

    0.35 ¢     —       NM       0.35 ¢     —       NM       —       NM  

Aircraft fuel cost per gallon (a)

  $ 2.18     $ 2.19     (0.5 )   $ 2.14     $ 2.14     0.0     $ 1.41     51.8  

Economic fuel cost per gallon (a)

  $ 2.54     $ 1.98     28.3     $ 2.28     $ 1.93     18.1     $ 1.58     22.2  

Fuel gallons (000,000)

    17.6       13.7     28.5       64.8       54.3     19.3       51.3     5.8  

Average number of full-time equivalent employees

    3,887       3,670     5.9       3,806       3,611     5.4       3,456     4.5  

Aircraft utilization (blk hrs/day)

    8.4       8.6     (2.3 )     8.6       8.8     (2.3 )     8.7     1.1  

Operating fleet at period-end

    70       69     1 a/c     70       69     1 a/c     65     4 a/c

 

NM = Not Meaningful
(a) Represents combined information for all Horizon flights, including those operated under Capacity Purchase Agreements with Alaska and as Frontier JetExpress. See page 43 for additional line of business information.

 

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ALASKA AIRLINES

 

Alaska reported income before income taxes of $216.0 million during 2007 compared to a loss before income taxes of $92.2 million in 2006. The $308.2 million difference between the periods is primarily the result of the fleet transition and restructuring charges recognized in 2006 totaling $214.3 million, combined with a reduction in fuel expense following mark-to-market fuel-hedging losses recorded in 2006 as compared to mark-to-market fuel- hedging gains in the current year. These mark-to-market adjustments are a result of changes in the value of our fuel hedge portfolio driven by changes in the price of crude oil.

 

The year’s most important trend was the dramatic increase in raw and economic fuel costs and the commensurate increase in passenger revenue as we (and many of our competitors) attempted to pass along the increased fuel costs. See page 39 for a discussion of raw and economic fuel costs.

 

ALASKA REVENUES

 

Total operating revenues increased $377.4 million, or 14.0%, in 2007 as compared to 2006. The new Capacity Purchase Agreement with Horizon described above made up $265.0 million of the increase, with mainline revenues (defined as passenger revenues from those flights operating on Alaska Airlines jets plus freight, mail and other revenues) contributing $112.4 million of the increase. The components of Alaska’s revenue are summarized in the following table:

 

     Years Ended December 31

(in millions)

  2007   2006   %
Change

Passenger Revenue—
mainline

  $ 2,547.2   $ 2,453.1   3.8

Freight and mail

    94.2     93.4   0.9

Other—net

    147.1     129.6   13.5
                 

Total Mainline Revenues

  $ 2,788.5   $ 2,676.1   4.2
                 

Passenger Revenue—purchased capacity

    281.4     16.4   NM
                 

Total Operating Revenues

  $ 3,069.9   $ 2,692.5   14.0
                 

 

NM = Not Meaningful

 

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Operating Revenue—Mainline

 

Mainline passenger revenue increased 3.8% on a 4.0% increase in available seat miles offset by a modest decline in mainline passenger revenue per available seat mile (PRASM). The slight decline in PRASM was the result of a 0.3% increase in yields, offset by a 0.4-point decline in load factor compared to 2006.

 

Although the load factor for the full year was down from 2006, load factors outpaced 2006 in the second half of the year after lagging 2006 in the first half of the year. These load factor improvements contributed to the increase in unit passenger revenue (PRASM) seen in the third and fourth quarters. We believe the full-year load factor decline is due to capacity growth in connection with the replacement of older aircraft with larger B737-800 aircraft without a commensurate increase in the number of passengers. Our advance bookings currently suggest that load factors will be up 2 to 3 points in the first quarter of 2008 compared to the same period in 2007.

 

LOGO   LOGO

 

Freight and mail revenue was flat compared to 2006. This is primarily due to a decline in freight and mail volumes resulting from lower capacity that stemmed from the delay in the conversion of four of our B737-400 passenger aircraft to combi aircraft, offset by an increase in cargo yields, including those coming through fuel surcharges. We currently anticipate an increase in freight and mail revenues in 2008 as we expect to deploy our full capacity for the entire year.

 

Other—net revenues increased $17.5 million, or 13.5%, primarily as a result of higher commission revenue associated with the sale of mileage credits to our bank partner. When we sell mileage credits, we defer the majority of the proceeds and recognize that revenue when award travel takes place. Commission revenue represents the difference between the proceeds from the sale of miles and the amount we defer.

 

Passenger Revenue—Purchased Capacity

 

Passenger revenue—purchased capacity increased by $265.0 million to $281.4 million because of the CPA with Horizon.

 

Although the markets subject to the CPA have changed slightly compared to those included under the prior revenue-sharing arrangement, we believe it is useful to evaluate year-over-year revenue information to gauge actual trends in those markets. This factors out the impact of the intercompany capacity purchase agreement and, as a result, gives readers information about the aggregate impact to Air Group revenues. In 2006, Horizon recorded $221.5 million in revenues for markets covered by the prior revenue- sharing arrangement. Yields in those markets declined 3.3% and load factor increased 1.5 points on a 29.7% increase in capacity.

 

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During 2007, purchased capacity costs exceeded passenger revenue—purchased capacity by $21.4 million. However, the reported results of purchased capacity flying do not reflect the total contribution of these flights to our mainline operation as many of the flights feed traffic from smaller cities.

 

ALASKA EXPENSES

 

For the year, total operating expenses increased $66.4 million compared to 2006 as a result of new purchased capacity costs recorded under the CPA with Horizon, offset by a decline in mainline operating costs. The components of Alaska’s operating expenses are summarized in the following table:

 

     Years Ended December 31  

Operating
Expenses (in
millions)

  2007    2006    %
Change
 

Mainline operating expenses

  $ 2,552.3    $ 2,774.4    (8.0 )

Purchased capacity costs

    302.8      14.3    NM  
                     

Total Operating Expenses

  $ 2,855.1    $ 2,788.7    2.4  
                     

 

NM = Not meaningful

 

Mainline Operating Expenses

 

Total mainline operating costs for 2007 declined by $222.1 million or 8.0% compared to 2006. The absence of the fleet transition costs and restructuring charges in 2007, and lower aircraft fuel expense resulting from mark-to-market gains associated with the value of our fuel hedge portfolio were the primary causes of the decline.

 

Along with our financial and statistical data on page 34, we are presenting here our line-item expenses on a per-ASM basis (in cents). We believe this information is useful to investors because it highlights areas in which costs have increased or decreased either more or less than capacity:

 

     Years Ended
December 31,
  CASM Change  
     2007   2006   2005   2007 vs.
2006
    2006 vs.
2005
 

Wages and benefits

  3.11   3.19   3.24   (0.08 )   (0.05 )

Variable incentive pay

  0.06   0.12   0.07   (0.06 )   0.05  

Aircraft fuel, including hedging gains and losses

  3.04   3.25   2.13   (0.21 )   1.12  

Aircraft maintenance

  0.62   0.67   0.83   (0.05 )   (0.16 )

Aircraft rent

  0.47   0.48   0.52   (0.01 )   (0.04 )

Landing fees and other rentals

  0.70   0.68   0.70   0.02     (0.02 )

Contracted services

  0.51   0.51   0.47   —       0.04  

Selling expenses

  0.53   0.61   0.59   (0.08 )   0.02  

Depreciation and amortization

  0.59   0.59   0.56   —       0.03  

Food and beverage service

  0.19   0.21   0.22   (0.02 )   (0.01 )

Other

  0.72   0.69   0.72   0.03     (0.03 )

Fleet transition costs

  —     0.81   —     (0.81 )   0.81  

Restructuring charges and adjustments

  —     0.11   0.09   (0.11 )   0.02  
                         

Total Mainline Operating Expenses per ASM

  10.54   11.92   10.14   (1.37 )   1.78  
                         

 

Additional line item information is provided below.

 

Wages and Benefits

 

Wages and benefits were relatively flat in 2007, primarily as a result of the following:

 

   

a 3.8% increase in full-time equivalents. The number of full-time equivalent employees increased largely as a result of our initiative to improve our on-time performance and other operational goals;

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an increase in the number of flight attendants as we transition to B737-800s, which have four flight attendants, compared to three in the MD-80 aircraft that are being replaced; and

 

   

normal step, scale and market-based wage increases.

 

These increases were offset by the following:

 

   

2006 included a $2.7 million contract-signing bonus paid to our flight attendants and a $1.9 million contract-signing bonus paid to our clerical, office and passenger service employees and our ramp service and stores agents; and

 

   

a reduction of $15.6 million in expenses associated with our defined-benefit plans as more of our employees transition over to an enhanced defined-contribution plan, offset by a $1.2 million increase in defined-contribution plan expense.

 

We currently expect wages and benefits to increase slightly in 2008 but decline on a per-ASM basis. This expectation is exclusive of any potential change in pilot wages that may result from our current contract negotiations.

 

Variable Incentive Pay

 

Variable incentive pay for 2007 decreased $14.2 million or 51.3%, compared to 2006. The decrease results from lower annual expense under the various Air Group profit-based incentive plans as our profitability was lower than originally expected, offset by higher expenses associated with our Operational Performance Rewards plan. For purposes of our incentive pay plans, profit is generally defined as results excluding fleet transition costs, restructuring charges, and other amounts specified in the various incentive plan documents and with fuel stated on an economic basis. Air Group maintains several incentive plans that collectively cover all of our employees and create alignment for employees, customers and shareholders. These plans include both operational and financial performance metrics that, to a large extent, are based on certain annual financial targets.

 

Aircraft Fuel

 

Aircraft fuel expense includes both raw fuel expense (as defined below) plus the effect of mark-to-market adjustments to our fuel hedge portfolio that we include in our income statement as the value of the portfolio increases and decreases. By definition, our aircraft fuel expense is very volatile, even between quarters, because it includes these gains or losses when the underlying instrument increases or decreases in value as crude oil prices increase or decrease. Raw fuel expense is defined as the price that we generally pay at the airport, or the “into-plane” price, including taxes. Raw fuel prices are impacted by world oil prices and refining costs, which can vary by region in the U.S. Raw fuel expense approximates cash paid to suppliers.

 

Aircraft fuel expense decreased $19.5 million, or 2.6%, compared to 2006. The elements of the change are illustrated in the following table:

 

      Years Ended December 31  
(in millions, except
per-gallon amounts)
   2007     2006     %
Change
 

Fuel gallons consumed

     354.3       354.3     0.0  

Raw price per gallon

   $ 2.33     $ 2.16     7.9  
                        

Total raw fuel expense

   $ 825.7     $ 765.6     7.9  
                        

Impact on fuel expense from changes in value of the fuel hedge portfolio (gain)

     (88.2 )     (8.6 )   NM  
                        

Aircraft fuel expense

   $ 737.5     $ 757.0     (2.6 )
                        

 

NM = Not meaningful

 

Fuel gallons consumed were flat on a 4.0% increase in capacity because of the improved fuel efficiency of our fleet as we transition out of the less-efficient MD-80 aircraft to newer, more-efficient B737-800 aircraft.

 

The raw fuel price per gallon increased by 7.9% as a result of higher West Coast jet fuel prices driven by higher crude oil costs.

 

During 2007, we recorded mark-to-market gains reflecting an increase in the value of our fuel hedge portfolio between December 31, 2006 and December 31, 2007. In 2006, we recorded a mark-to-market loss, as oil prices on

 

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December 31, 2006 were lower than they were a year earlier. Our hedge portfolio consists primarily of call options that are based on the prices of crude oil.

 

We also evaluate economic fuel expense, which we define as raw fuel expense less the cash we receive from hedge counterparties for hedges that settle during the period, offset by the premium expense that we recognize. A key difference between aircraft fuel expense and economic fuel expense is the timing of gain or loss recognition. When we refer to economic fuel expense, we include gains only when they are realized through a cash receipt from our hedge contract counterparties. We believe this is the best measure of the effect that fuel prices are currently having on our business because it most closely approximates the net cash outflow associated with purchasing fuel for our operation. Accordingly, many industry analysts evaluate our results using this measure, and it is the basis for most internal management reporting and incentive pay plans.

 

Our economic fuel expense is calculated as follows:

 

     Years Ended December 31
(in millions, except
per-gallon amounts)
  2007     2006     %
Change

Raw fuel expense

  $ 825.7     $ 765.6     7.9

Less: cash received from settled hedges

    (44.9 )     (87.0 )   NM
                     

Economic fuel expense

  $ 780.8     $ 678.6     15.1
                     

Fuel gallons consumed

    354.3       354.3     0.0
                     

Economic fuel cost per gallon

  $ 2.20     $ 1.92     14.6
                     

 

NM = Not meaningful

 

In 2005 and 2006, we realized significant benefits from in-the-money fuel hedge contracts. However, our fuel hedge protection declined substantially in 2007 as the strike price of our hedges was closer to current oil prices compared to those in place during the previous two years. The total cash benefit from hedges that settled during the period declined to $44.9 million in 2007 down from $87.0 million in 2006 and $108.8 million in 2005.

 

We currently expect economic fuel expense to be higher in 2008 than in 2007 because of high crude oil prices. For example, if oil were to average $87 per barrel in 2008, we would expect our raw fuel expense to be approximately $2.67 per gallon and the cash benefit of settled hedges to be approximately $55 million, resulting in an economic fuel price per gallon of approximately $2.52.

 

Aircraft Maintenance

 

Aircraft maintenance declined by $7.0 million, or 4.5%, compared to the prior year largely as a result of the benefits of our fleet transition as we replace our aging MD-80s and B737-200C aircraft with newer B737-800 and converted B737-400 aircraft, respectively. We currently expect maintenance expense to increase slightly in 2008 because of the timing of certain required maintenance events, offset by additional benefits to be realized from the fleet transition.

 

Aircraft Rent

 

Aircraft rent increased by $1.9 million, or 1.7%, because of the sale and short-term leaseback of substantially all of our owned MD-80 aircraft during the second quarter of 2007 and the addition of two new leased B737-800 aircraft in the fourth quarter of 2006, partially offset by the buyout of five leased MD-80 aircraft in the third quarter of 2006. We expect a year-over-year increase in aircraft rent in 2008 as we lease an additional B737-800, offset by the retirement of the MD-80s.

 

Landing Fees and Other Rentals

 

Landing fees and other rentals increased by $11.9 million, or 7.5%, compared to 2006 as a result of higher costs at Seattle-Tacoma International and other airports. We expect year-over-year increases in 2008 as a result of fees in our new Hawaii stations and for the continuing transition to 737-800 aircraft that are larger than the outgoing MD-80 aircraft.

 

Selling Expenses

 

Selling expenses declined by $12.2 million, or 8.6%, compared to 2006 as a result of lower

 

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ticket distribution costs and credit card fees that resulted from new contracts that were put into place in the fourth quarter of 2006. The 2006 amount also included $3.7 million paid to Horizon under the revenue-sharing arrangement in certain designated markets that existed in 2006, compared to zero in the current year because of the new CPA. These declines were partially offset by higher advertising costs. We currently expect that selling expenses will decline slightly in 2008 as we continue to focus our efforts on shifting sales to our web sites, which reduces the commission we pay to outside providers.

 

Depreciation and Amortization

 

Depreciation and amortization increased $4.5 million, or 3.3%, compared to 2006. This is primarily the result of 10 new B737-800 aircraft delivered in 2006 and 14 in 2007, partially offset by the sale and leaseback of 20 MD-80s in 2007. We expect depreciation and amortization to increase by about 14% in 2008 as we acquire more new B737-800 aircraft.

 

Other Operating Expenses

 

Other operating expenses increased because of higher passenger remuneration costs, crew costs, professional fees, software license and maintenance costs, higher property taxes, and other costs, offset by lower liability insurance expense because of better rates negotiated in December 2006.

 

Mainline Operating Costs per Available Seat Mile (CASM)

 

Operating costs per ASM (CASM) is an important metric in the industry, and we use it to gauge the effectiveness of our cost-reduction efforts. Our effort to reduce unit costs focuses not only on controlling the actual dollars we spend, but also on increasing our capacity without adding a commensurate amount of cost.

 

Our mainline operating costs per mainline ASM are summarized below:

 

     Years Ended
December 31
 
     2007     2006     %Change  

Total mainline operating expenses per ASM (CASM)

  10.54 ¢   11.92 ¢   (11.6 )

CASM includes the following components:

       

Fuel costs per ASM

  3.04 ¢   3.25 ¢   (6.4 )

Fleet transition costs per ASM

  —       0.81 ¢   NM  

Restructuring charges per ASM

  —       0.11 ¢   NM  

 

NM = Not meaningful

 

We have separately listed in the above table our fuels costs per ASM, fleet transition costs per ASM and restructuring charges per ASM. These amounts are included in CASM, but for internal purposes we consistently use unit cost metrics that exclude these items to measure our cost-reduction progress. We do so, and believe that such analysis may be important to investors and other readers of these financial statements for the following reasons:

 

   

Mainline cost per ASM excluding fuel is one of the most important measures used by managements of both Alaska and Horizon and the Air Group Board of Directors in assessing quarterly and annual cost performance. For Alaska Airlines, these decision-makers evaluate operating results of the “mainline” operation, which includes the operation of the B737 and MD-80 aircraft fleets branded in Alaska Airlines livery. The revenues and expenses associated with purchased capacity are evaluated separately.

 

   

Mainline cost per ASM excluding fuel (and other items as specified in our governing documents) is an important metric for the employee incentive plan that covers company management and executives.

 

   

By eliminating fuel expense from our unit cost metrics, we believe that we have better visibility into the results of our

 

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non-fuel cost-reduction initiatives. Our industry is highly competitive and is characterized by high fixed costs, so even a small reduction in non-fuel operating costs can result in a significant improvement in operating results. In addition, we believe that all domestic carriers are similarly impacted by changes in jet fuel costs over the long run, so it is important for management (and thus investors) to understand the impact of (and trends in) company-specific cost drivers such as labor rates and productivity, airport costs, maintenance costs, etc., which are more controllable by management.

 

   

Mainline cost per ASM excluding fuel is a measure commonly used by industry analysts, and we believe it is the basis by which they compare our airlines to others in the industry. The measure is also the subject of frequent questions from holders of our common stock.

 

   

Disclosure of the individual impact of certain noted items provides investors the ability to measure and monitor performance both with and without these special items. We believe that disclosing the impact of items such as the fleet transition costs and restructuring charges is important because it provides information on significant items that are not necessarily indicative of future performance. Industry analysts and investors consistently measure the Company’s performance without these items for better comparability between periods and among other airlines.

 

   

Although we disclose our “mainline” passenger unit revenues for Alaska, we do not (nor are we able to) evaluate mainline unit revenues excluding the impact that rising fuel costs have had on ticket prices. Fuel represents nearly 30% of our total mainline operating expenses, and fluctuations in our fuel prices often drive changes in unit revenues in the mid-to-long term. Although we believe it is useful to evaluate non-fuel unit costs for the reasons noted above, we would caution readers of these financial statements not to place undue reliance on unit costs excluding fuel as a measure or predictor of future profitability because of the significant impact of fuel costs on our business.

 

Our mainline unit costs excluding fuel and other special items for the first quarter and full year 2008 are expected to remain flat from similar measures in 2007. Our primary goal in 2008 is to improve our operational reliability, including our on-time performance, completion of scheduled flights, and baggage delivery metrics, with a special focus on our Seattle operations.

 

Purchased Capacity Costs

 

Purchased capacity costs increased $288.5 million, from $14.3 million in 2006 to $302.8 million in 2007. Of the total, $283.4 million was paid to Horizon under the new CPA for 1.4 billion ASMs. The balance includes amounts paid to a third party for the Dutch Harbor flying (which approximates the amount paid in 2006) and certain administrative and information technology costs borne by Alaska that are allocated to purchased capacity flying costs.

 

In the aggregate, costs of purchased capacity exceeded revenues in these markets by $21.4 million. The markets covered by the CPA with Horizon are both “flow” markets that provide connecting traffic to Alaska and “local” markets where Horizon’s regional jets are used to maximize returns (or minimize losses) to Air Group and allow Alaska to deploy its larger jets to other routes. Generally speaking, revenues in the flow markets exceed costs. However, revenue in most of the local markets falls short of costs. With high fuel prices and relatively high non-fuel costs, some of these routes operated by Horizon are unprofitable with CRJ-700s and are too small to support 737 service. We are evaluating alternatives to improve the results of these routes. Alternatives include reducing the size of the CRJ-700 fleet, moving some of the flying to the Q400, and having a portion of the capacity in these markets performed by a third party with larger, more efficient aircraft.

 

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HORIZON AIR

 

Horizon reported a loss before income taxes of $10.6 million during 2007 compared to income before income taxes of $11.7 million in 2006. The $22.3 million decrease is primarily due to higher operating costs, including higher fuel costs and fleet transition costs of $14.1 million, partially offset by higher operating revenues.

 

There were several significant events in 2007 that impacted Horizon’s financial results, including charges associated with the transition of the Q200 fleet, a significant increase in maintenance costs related to scheduled engine overhauls, and the integration of the nine regional jets from Frontier JetExpress into the Horizon network. The extra capacity from the Frontier JetExpress operations proved harder to integrate than was originally planned because of a softer revenue environment and unexpected competition in some of our markets. Despite the dramatic increase in capacity, load factor declined only 0.7 points. However, the stable load factor came at the expense of yield on flying done under Horizon’s own brand, which declined 5.9%. In addition to assimilating the capacity from the Frontier JetExpress flying, Horizon also absorbed the operating costs for the returning jets, including fuel costs, which were previously the responsibility of Frontier.

 

HORIZON REVENUES

 

In 2007, operating revenues increased $74.4 million, or 11.6%, compared to 2006. Horizon’s passenger revenues are summarized in the table below:

 

Revenues

(in millions)

and % of ASMs

  Years Ended December 31  
  2007     2006  
  Revenues   %ASMs     Revenues   %ASMs  

Passenger revenue from Horizon “brand” flying

  $ 391.3   52     $ 359.1   48  

Revenue from CPA with Alaska

    283.4   35       n/a   n/a  

Passenger revenue—Alaska revenue share markets

    n/a   n/a       221.5   29  

Revenue from CPA with Frontier JetExpress

    34.5   13       52.5   23  
                         

Total Passenger Revenue and % of ASMs

  $ 709.2   100 %   $ 633.1   100 %
                         

 

Horizon’s system-wide operating revenues per ASM increased by 1.9% from 2006. The increase was largely due to the shift in capacity out of Frontier JetExpress flying (which produced relatively low RASM because of the terms of the contract and the longer-haul nature of the flying) to higher RASM brand and Alaska CPA flying. As mentioned earlier, the Frontier JetExpress operation ceased in November 2007.

 

Line-of-business information is presented in the table below. In both CPA arrangements, Horizon is insulated from market revenue factors and is guaranteed contractual revenue amounts based on operational capacity. As a result, yield and load factor information for the CPA arrangements are not presented.

 

     Year Ended December 31, 2007
     Capacity and Mix     Load Factor     Yield   RASM
     Actual
(000,000)
  %
Change

Yr-over-Yr
  Current
% Total
    Point
Change
Yr-over-Yr
    Actual     Point
Change
Yr-over-Yr
    Actual     %
Change

Yr-over-Yr
  Actual     %
Change

Yr-over-Yr

Brand Flying

  2,086   19.6   52 %   4 pts   71.8 %   (2.4) pts   26.14 ¢   (5.9)   19.20 ¢   (8.8)

Alaska CPA

  1,383   29.7   35 %   6 pts   NM     NM     NM     NM   20.49 ¢   (2.7)

Frontier CPA

  509   (38.1)   13 %   (10) pts   NM     NM     NM     NM   6.77 ¢   6.0
                                                     

System Total

  3,978   9.5   100 %   —       73.4 %   (0.7) pts   24.30 ¢   3.3   18.06 ¢   1.9
                                                     

 

NM = Not meaningful

 

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Horizon brand flying includes routes in the Horizon system not covered by the Alaska CPA. Horizon has the inventory and revenue risk in these markets. Passenger revenue from Horizon brand flying increased $32.2 million, or 9.0%, on a 19.6% increase in brand capacity offset by an 8.8% decline in unit revenues. The decline in unit revenues was due to a 2.4-point reduction in load factor, along with a 5.9% decline in yields, resulting from increased competition in many of these brand markets and from intentional pricing actions taken in certain markets to fill the additional capacity.

 

Revenue from the CPA with Alaska totaled $283.4 million during 2007. Under the CPA, the fee paid by Alaska is based on Horizon’s actual operating costs plus a specified margin. Under the prior revenue-sharing arrangement, Alaska made a payment to Horizon equal to Horizon’s loss in those markets, if any, and a quarterly bonus that was based on Alaska’s overall operating margin. Alternatively, Horizon made a payment to Alaska if those markets were profitable.

 

Revenue from the Frontier JetExpress flying declined 34.3% from $52.5 million in 2006 to $34.5 million in 2007 on a 38.1% decline in ASMs. The ASM decline is consistent with the wind-down of the JetExpress arrangement that occurred throughout 2007.

 

HORIZON EXPENSES

 

Total operating expenses increased $87.1 million, or 13.8%, as compared to 2006. Along with our financial and statistical data on page 35, we are presenting here our line item expenses on a per-ASM basis (in cents):

 

      Years Ended
December 31,
   CASM Change  
      2007    2006    2005    2007 vs.
2006
    2006 vs.
2005
 

Wages and benefits

   5.06    5.21    5.11    (0.15 )   0.10  

Variable incentive pay

   0.18    0.25    0.14    (0.07 )   0.11  

Aircraft fuel, including hedging gains and losses

   3.49    3.21    2.14    0.28     1.07  

Aircraft maintenance

   2.31    2.03    1.27    0.28     0.76  

Aircraft rent

   1.65    1.91    2.07    (0.26 )   (0.16 )

Landing fees and other rentals

   1.43    1.29    1.40    0.14     (0.11 )

Contracted services

   0.68    0.74    0.70    (0.06 )   0.04  

Selling expenses

   0.79    0.87    0.86    (0.08 )   0.01  

Depreciation and amortization

   0.85    0.51    0.49    0.34     0.02  

Food and beverage service

   0.07    0.08    0.07    (0.01 )   0.01  

Other

   1.21    1.30    1.24    (0.09 )   0.06  

Fleet transition costs

   0.35    —      —      0.35     —    
                             

Total Operating Expenses per ASM

   18.07    17.40    15.49    0.67     1.91  
                             

 

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Significant period-over-period changes in the components of operating expenses are as follows:

 

Wages and Benefits

 

Wages and benefits increased $11.9 million, or 6.3%, as a result of a slight increase in full-time equivalent employees, higher wages due to market and step increases, and an increase in our group medical costs. We expect that wages and benefits will be flat in 2008 compared to 2007.

 

Aircraft Fuel

 

Aircraft fuel expense increased $22.3 million, or 19.1%, compared to 2006. The elements of the change are illustrated in the following table:

 

     Years Ended
December 31
(in millions, except per-gallon
amounts)
  2007     2006     %
Change

Fuel gallons consumed

    64.8       54.3     19.3

Raw price per gallon

  $ 2.41     $ 2.19     10.0
                     

Total raw fuel expense

  $ 156.2     $ 119.1     31.2
                     

Impact on fuel expense from changes in value of the fuel hedge portfolio (gain)

    (17.4 )     (2.6 )   NM
                     

Aircraft fuel expense

  $ 138.8     $ 116.5     19.1
                     

 

NM = Not meaningful

 

The 19.3% increase in consumption was driven by the return of all nine CRJ-700s from Frontier JetExpress and the introduction of several new Q400s into the fleet, replacing smaller Q200s. Under the Frontier JetExpress arrangement, fuel was purchased by Frontier. We expect to see a year-over-year increase in the number of gallons consumed in 2008 as we see the full effect of the fleet changes. Offsetting these increases in fuel consumption is the improved fuel efficiency of our fleet resulting from new Q400 aircraft deliveries. These more fuel-efficient aircraft have helped to improve the overall fuel-burn rate per ASM by approximately 3% from 2006.

 

The raw fuel price per gallon increased by 10% as a result of higher West Coast jet fuel prices driven by higher crude oil costs.

 

During 2007, we recorded mark-to-market gains reflecting an increase in the value of our fuel hedge portfolio between December 31, 2006 and December 31, 2007. In 2006, we recorded a mark-to-market loss, as oil prices on December 31, 2006 were lower than they were a year earlier. Our hedge portfolio consists primarily of call options that are based on the price of crude oil.

 

We realized gains of $8.5 million from settled hedge contracts in 2007, compared to $14.1 million in 2006. Our economic fuel expense is calculated as follows:

 

     Years Ended
December 31
(in millions, except per-gallon
amounts)
  2007     2006     %
Change

Raw fuel expense

  $ 156.2     $ 119.1     31.2

Less: cash received from settled hedges

    (8.5 )     (14.1 )   NM

Economic fuel expense

  $ 147.7     $ 105.0     40.7
                     

Fuel gallons consumed

    64.8       54.3     19.3
                     

Economic fuel cost per gallon

  $ 2.28     $ 1.93     18.1
                     

 

NM = Not meaningful

 

Like Alaska, our fuel hedge protection declined substantially in 2007 as the strike price of our hedges was closer to current oil prices compared to those in place during the previous two years. The total cash benefit from hedges that settled during the period declined to $8.5 million in 2007 from $14.1 million in 2006 and $16.2 million in 2005.

 

We currently expect economic fuel expense to be higher in 2008 than in 2007 because of high crude oil prices. For example, if oil were to average $87 per barrel in 2008, we would expect our raw fuel expense to be approximately $2.72 per gallon and the cash benefit of settled hedges to be approximately $10 million, resulting in an economic fuel price per gallon of approximately $2.59.

 

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Table of Contents

Aircraft Maintenance

 

Aircraft maintenance expense increased $18.1 million, or 24.5%, primarily as a result of a higher number of engine events, including scheduled events on our CRJ-700 engines. We expect maintenance expense in 2008 to be approximately $15 million lower than in 2007, primarily because of fewer CRJ-700 engine events. However, actual results could differ materially if the maintenance schedule is modified or we are forced to perform unforeseen maintenance activities.

 

Aircraft Rent

 

Aircraft rent declined by $3.7 million, or 5.3%, primarily as a result of the reduction in the number of leased Q200 aircraft in our operating fleet. These leased aircraft were replaced with new, owned Q400s during the year.

 

Depreciation and Amortization

 

Depreciation and amortization increased $15.4 million, or 83.2%, as a result of the 13 new Q400s that were delivered in 2007. We own all of these new aircraft. Additionally, we recorded higher depreciation expense on Q200 rotable and repairable parts since we now intend to phase out those aircraft by the end of 2009. We anticipate that depreciation and amortization expense will continue to increase in 2008 as we take more Q400 deliveries throughout the year.

 

Fleet Transition Costs

 

Fleet transition costs associated with the sublease of Q200 aircraft were $14.1 million in 2007 as a result of the 11 Q200 aircraft that were delivered to a third party. We expect total fleet transition costs to be approximately $8 million during 2008 as five additional Q200s leave the fleet and we record losses arising from the subleases.

 

Operating Costs per Available Seat Mile (CASM)

 

As discussed above, operating costs per ASM (CASM) is an important metric in the industry and we use it to gauge the effectiveness of our cost- reduction efforts. Like Alaska’s, Horizon’s efforts to reduce unit costs over the long term focus not only on controlling the actual dollars we spend, but also on increasing available seat miles without adding a commensurate amount of cost. We intend to increase capacity in the future primarily through larger-gauge aircraft as we replace our Q200 aircraft with larger Q400 aircraft. However, we expect a reduction of capacity in 2008 as noted previously, which puts upward pressure on our unit costs.

 

Our operating costs per ASM are summarized below:

 

      Years Ended December 31
      2007     2006     %
Change

Total operating expenses per ASM (CASM)

   18.07 ¢   17.40 ¢   3.9

CASM includes the following components:

        

Fuel costs per ASM

   3.49 ¢   3.21 ¢   8.8

Fleet transition costs per ASM

   0.35 ¢   —       NM

 

NM = Not meaningful

 

We currently forecast our costs per ASM excluding fuel and the fleet transition costs for the first quarter and full year of 2008 to be up about 1% and flat, respectively, compared to 2007.

 

CONSOLIDATED NONOPERATING INCOME (EXPENSE)

 

Net nonoperating expense was $10.4 million in 2007 compared to $0.5 million in 2006. Interest income declined by $0.4 million compared to 2006, primarily as a result of a lower average cash and marketable securities balance, partially offset by higher average portfolio returns. Interest expense increased $10.0 million because of new debt arrangements in 2006 and 2007 and increases in the average interest rate on our variable-rate debt. This increase was offset by the conversion to equity of our $150 million senior convertible notes in April 2006, which eliminated further interest expense on those notes. Other-net increased $2.6 million, and includes a $3.75 million expense associated with our investment in Row 44 given their early

 

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stage nature. Capitalized interest increased $3.1 million from 2006, resulting from an increase in pre-delivery deposits in connection with our orders for B737-800 and Bombardier Q400 aircraft.

 

CONSOLIDATED INCOME TAX EXPENSE (BENEFIT)

 

Our consolidated effective income tax rate on income (loss) before income taxes for 2007 was 38.0% compared to an effective income tax rate of 40.1% in 2006. The effective rate for 2007 was positively impacted by $2.1 million in credits resulting from a favorable outcome of the state income tax matters referred to in Note 13. Excluding this benefit, our effective tax rate would have been 39.0%, which is different from our marginal 2007 tax rate of 37.4%. The difference is primarily due to the magnitude of nondeductible expenses, such as employee per-diem costs and stock-based compensation expense recorded for certain stock awards. The 2006 year includes $5.5 million of tax benefits associated with the reduction of certain tax contingency accruals for periods for which the statute of limitations expired in 2006. Excluding this benefit, our effective tax benefit rate for 2006 would have been 33.8%.

 

2006 COMPARED WITH 2005

 

Our consolidated net loss for 2006 was $52.6 million, or $1.39 per share, compared to a net loss of $5.9 million, or $0.01 per diluted share, in 2005.

 

Both the 2006 and 2005 results include certain significant items that affect the comparability of the years:

 

   

Our 2006 consolidated net loss includes charges of $189.5 million ($118.5 million after tax) associated with our fleet transition plan (See Note 2 to the consolidated financial statements);

 

   

We recorded restructuring charges of $24.8 million ($15.5 million after tax) in 2006 associated with the severance packages offered to eligible employees affected by new contracts this year compared to $20.4 million ($12.7 million after tax) in 2005 related to severance costs resulting from the subcontracting of the ramp services operation in Seattle and costs associated with the termination of the lease at our Oakland heavy maintenance base;

 

   

Adjustments to reflect the timing of gain or loss recognition resulting from mark-to-market fuel hedge accounting totaling $89.9 million ($56.3 million after tax) of losses and $61.7 million ($38.6 million after tax) of gains in 2006 and 2005, respectively;

 

   

Our 2005 consolidated net loss includes a $144.7 million pretax ($90.4 million after tax) charge resulting from the change in the method of accounting for major airframe and engine overhauls as discussed in Note 17 to the consolidated financial statements; and

 

   

Our 2005 results also include a $5.7 million ($3.6 million after tax) refund, including $1.0 million of related interest income, for navigation fees paid in Mexico.

 

We believe disclosure of the impact of these individual charges is useful information to investors and other readers because of the reasons provided above in the “2007 Compared With 2006” section.

 

Alaska reported a 2006 loss before income taxes of $92.2 million, while Horizon reported income before income taxes of $11.7 million. Financial and statistical data for Alaska and Horizon are shown on pages 34 and 35, respectively.

 

ALASKA AIRLINES

 

Alaska reported a loss before income taxes of $92.2 million during 2006 compared to income before income taxes and accounting change of $124.2 million in 2005. The $216.4 million difference between the years is primarily the result of the fleet transition and restructuring charges recognized in 2006 totaling $218.4 million, combined with a significant increase in fuel expenses, offset by an 11.4% increase in operating revenues and a reduction in maintenance costs and aircraft rent.

 

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As purchased capacity activity was not significant in 2006 and 2005, the ensuing discussion will be focused on mainline operations only.

 

ALASKA MAINLINE REVENUES

 

Mainline operating revenues increased $276.9 million, or 11.5%, during 2006 primarily as a result of a 6.8% increase in operating revenue per available seat mile (RASM) and a 4.4% increase in capacity. The increase in mainline RASM was driven almost entirely by a 6.7% increase in ticket yields resulting largely from higher ticket prices. The increase in capacity is primarily the result of having a larger aircraft fleet and a longer average stage length in 2006.

 

Load factor increased slightly by 0.7 percentage points to 76.6% during 2006.

 

Freight and mail revenues increased $3.1 million, or 3.4%, compared to 2005 primarily resulting from higher mail and freight yields and fuel surcharges that we added to our freight services beginning in the third quarter of 2005, offset by lower freight volumes. Revenues from our cargo operations were lower than expected for 2006 due to the delay in the delivery of our modified 737-400 cargo aircraft. Three of the four were originally scheduled for delivery in 2006, but none was actually delivered until 2007. These delays kept the cargo operations from increasing capacity and thereby the volume of cargo shipped.

 

Other-net revenues increased only slightly by $3.7 million, or 2.9%. Mileage Plan revenues were slightly lower than in 2006, primarily as a result of lower commissions recognized for sold miles. As yields increased in 2006, the rate at which we defer the revenue related to sold miles increased, resulting in a smaller percentage of cash receipts recorded as commission revenue during the period. The decline in commission revenue associated with sold miles was partially offset by higher net revenues from award redemption on our partner airlines.

 

ALASKA AIRLINES MAINLINE EXPENSES

 

Total mainline operating expenses increased $513.1 million, or 22.7%, as compared to 2005. This increase is largely due to fleet transition costs in 2006, a significant increase in aircraft fuel (including hedging gains and losses as we adjust the value of our hedges that will benefit future periods), and increases in wages and benefits, variable incentive pay, contracted services, selling expenses, depreciation and amortization, and restructuring charges, offset by a decline in aircraft maintenance and aircraft rent. Additional line item information is provided below.

 

Wages and Benefits

 

Wages and benefits increased by $21.2 million, or 2.9%, during 2006 compared to 2005 primarily as a result of the following:

 

   

a $2.7 million signing bonus and an increase in wages resulting from the new four-year contract with our flight attendants that was ratified during the second quarter of 2006;

 

   

a $1.9 million signing bonus and an increase in wages resulting from the new four-year contract with our clerical, office and passenger service employees and our ramp service and stores agents that was ratified during the third quarter of 2006;

 

   

market-based pay adjustments for our non-union personnel in the spring of 2006 and an increase in stock-based compensation expense following the adoption of SFAS 123R;

 

   

an increase in mechanics wages resulting from the contract ratified in the fourth quarter of 2005; and

 

   

increased postretirement medical and pension costs.

 

The increase from the prior year was partially offset by the following:

 

   

the reduction in pilot wages resulting from the pilot contract that took effect in May 2005; and

 

   

the subcontracting of our ramp services operation in Seattle in the second quarter of 2005.

 

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Variable Incentive Pay

 

Variable incentive pay increased $12.4 million, or 81.0%, over 2005, primarily as a result of a significant improvement in Air Group’s 2006 profit, as defined in the incentive agreements.

 

Aircraft Fuel

 

Aircraft fuel increased $281.0 million, or 59.0%, in 2006 compared to 2005. The elements of the change are illustrated in the following table:

 

     Year Ended December 31
(in millions, except per-gallon
amounts)
  2006     2005     % Change

Fuel gallons consumed

    354.3       346.4     2.3

Raw price per gallon

  $ 2.16     $ 1.84     17.4
                     

Total raw fuel expense

  $ 765.6     $ 637.9     20.0
                     

Impact on fuel expense from value changes in the fuel hedge portfolio (gain)

    (8.6 )     (161.9 )   NM
                     

Aircraft fuel expense

  $ 757.0     $ 476.0     59.0
                     

 

NM = Not meaningful

 

Fuel gallons consumed increased by 2.3% primarily as a result of the increased capacity and the addition of new aircraft. Raw fuel cost per gallon increased by 17.4% as a result of higher West Coast jet fuel prices driven by the sharp increase in average world oil prices.

 

During 2006, we recorded a $78.4 million mark-to-market loss, reflecting a decline in the value of our fuel hedge portfolio between December 31, 2005 and December 31, 2006. In 2005, we recorded a $53.1 million mark-to-market gain, reflecting an increase in the value of the portfolio from the previous year. These mark-to-market adjustments are largely driven by the closing price of crude oil on the last date of the reporting period and can fluctuate significantly from period to period.

 

The total cash benefit from hedges that settled during the period declined from $108.8 million in 2005 to $87.0 million in 2006. Our economic fuel expense is calculated as follows:

 

     Year Ended December 31
(in millions, except per-gallon
amounts)
  2006     2005     % Change

Raw fuel expense

  $ 765.6     $ 637.9     20.0

Less: cash received from settled hedges

    (87.0 )     (108.8 )   NM
                     

Economic fuel expense

  $ 678.6     $ 529.1     28.3
                     

Fuel gallons consumed

    354.3       346.4     2.3
                     

Economic fuel cost per gallon

  $ 1.92     $ 1.53     25.5
                     

 

NM = Not meaningful

 

Aircraft Maintenance

 

Aircraft maintenance decreased by $28.4 million, or 15.3%, mostly as a result of fewer high-dollar engine maintenance events, a decline in the number and change in the mix of airframe events, lower per-event costs due to renegotiated contracts with our outside vendors, and savings from process improvement initiatives.

 

Aircraft Rent

 

Aircraft rent decreased by $5.9 million, or 5.1%, primarily as a result of the buyout of five MD-80 aircraft from leases during the third quarter of 2006, offset by two new B737-800 operating leases entered into in the fourth quarter of 2006.

 

Landing Fees and Other Rentals

 

Landing fees and other rentals increased slightly by $2.0 million, or 1.3%, as a result of slightly higher airport and security costs, specifically at Los Angeles International Airport (LAX) where a retroactive increase to the beginning of 2006 was imposed on certain carriers late in the year.

 

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The increase for Alaska was approximately $1.5 million. A large portion of this rate increase and retroactive charge was reversed and returned in 2007.

 

Contracted Services

 

Contracted services increased $12.6 million, or 12.0%, primarily resulting from the subcontracting of the Company’s Seattle ramp operations in May 2005. Additionally, a $4.7 million navigation fee refund was received in 2005, which reduced our 2005 expenses.

 

Selling Expenses

 

Selling expenses increased $8.9 million, or 6.7%, primarily as a result of an increase in revenue-related expenses such as credit card and codeshare commissions in connection with the rise in revenues over the prior period and an increase in incentive payments to Horizon for certain flying under the former revenue-sharing arrangement.

 

Depreciation and Amortization

 

Depreciation and amortization increased $12.4 million, or 9.9%, compared to 2005. This increase is primarily due to the delivery of two new owned B737-800 aircraft in 2005 and ten new, owned B737-800 aircraft in 2006, the purchase of five MD-80 aircraft from lessors during the third quarter of 2006, and the acceleration of depreciation on our owned MD-80 fleet to reduce the carrying value to estimated realizable value as they come out of the fleet, offset by the lower depreciable base on the MD-80 fleet following the impairment charge taken in the first quarter of 2006.

 

Operating Costs per Available Seat Mile (CASM)

 

As discussed above, operating costs per ASM (CASM) is an important metric in the industry and we use it to gauge the effectiveness of our cost- reduction efforts. Our mainline operating costs per mainline ASM are summarized below:

 

     Years Ended December 31
     2006     2005     % Change

Total mainline operating expenses per ASM (CASM)

  11.92 ¢   10.14 ¢   17.6

CASM includes the following components:

       

Fuel costs per ASM

  3.25 ¢   2.13 ¢   52.6

Fleet transition costs per ASM

  0.81 ¢   —       NM

Restructuring charges per ASM

  0.11 ¢   0.09 ¢   NM

Navigation fee refund per ASM

  —       (0.02    

 

NM = Not meaningful

 

HORIZON AIR

 

Horizon reported pretax income of $11.7 million during 2006 compared to income before income taxes and accounting change of $26.4 million in 2005. The $14.7 million decrease is primarily due to a 19.9% increase in operating costs, driven primarily by increased fuel and maintenance costs, offset by a 15.7% increase in operating revenues.

 

HORIZON AIR REVENUES

 

Operating revenues increased $87.6 million, or 15.7%, in 2006 compared to 2005. This increase reflects an 8.4% increase in per unit revenues (RASM) and a 6.8% increase in capacity.

 

Horizon’s passenger revenues are summarized in the table below:

 

Revenues

(in millions)

and % of ASMs

  Year Ended December 31
  2006   2005
  Revenues   % ASMs   Revenues   % ASMs

Passenger revenue from Horizon “brand” flying

  $ 359.1   48   $ 270.2   44

Passenger revenue—Alaska revenue share markets

    221.5   29     223.4   33

Revenue from CPA with Frontier JetExpress

    52.5   23     50.4   23
                     

Total Passenger Revenue and % of ASMs

  $ 633.1   100   $ 544.0   100
                     

 

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The capacity increase is primarily due to the addition of one CRJ-700 in January 2006, two Q400s that began operating in June and August 2006, increased capacity from adding four more seats to our Q400s in the third quarter of 2005, and increased flying for Frontier. Revenue and capacity from the Frontier contract flying represented approximately 8% of passenger revenues and 23% of capacity in 2006, similar to 2005.

 

The RASM increase from the prior-year period resulted from a 9.1% RASM increase in our native network flying (including “brand” flying and Alaska revenue share markets), offset by a 1.4% decline in RASM from the Frontier contract flying. The Frontier decline is a function of a 5.7% increase in capacity coupled with a fee arrangement based on certain measures that did not correspond to capacity. As such, the per-unit revenues were diluted as more capacity was added. Passenger load factor increased 1.3 percentage points to 74.1% as a result of an increase in demand. Passenger yield increased 7.0% to 23.53 cents, largely benefiting from industry-wide fare increases.

 

HORIZON EXPENSES

 

Operating expenses for 2006 increased $104.9 million, or 19.9%, compared to 2005, primarily due to increases in aircraft fuel, wages and benefits, and aircraft maintenance.

 

Explanations of significant year-over-year changes in the components of operating expenses in dollar terms are as follows:

 

Wages and Benefits

 

Wages and benefits increased $15.6 million, or 9.0%, over 2005, reflecting a 4.5% increase in the average number of full-time equivalent employees and an increase in wages per employee resulting from market and contract step increases.

 

Variable Incentive Pay

 

Variable incentive pay increased $4.4 million, or 93.6%, over 2005, as a result of the same reasons noted above in the Alaska discussion.

 

Aircraft Fuel

 

Aircraft fuel increased $43.6 million, or 59.8%, in 2006 compared to 2005. The elements of the change are illustrated in the following table:

 

(in millions, except
per-gallon amounts)
  Year Ended December 31
  2006     2005     % Change

Fuel gallons consumed

    54.3       51.3     5.8

Raw price per gallon

  $ 2.19     $ 1.90     15.3
                     

Total raw fuel expense

  $ 119.1     $ 97.7     21.9
                     

Impact on fuel expense from value changes in the fuel hedge portfolio (gain)

    (2.6 )     (24.8 )   NM
                     

Aircraft fuel expense

  $ 116.5     $ 72.9     59.8
                     

 

NM = Not meaningful

 

Fuel gallons consumed increased by 5.8% primarily as a result of an increase in capacity and block hours. Raw fuel cost per gallon increased by 15.3% as a result of higher West Coast jet fuel prices driven by the sharp increase in average world oil prices.

 

During 2006, we recorded an $11.5 million mark-to-market loss reflecting a decline in the value of our fuel hedge portfolio between December 31, 2005 and December 31, 2006. In 2005, we recorded an $8.6 million mark-to-market gain reflecting an increase in the value of the portfolio from the previous year. These mark-to-market adjustments are largely driven by the closing price of crude oil on the last date of the reporting period and can fluctuate significantly from period to period.

 

The total cash benefit from hedges that settled during the period declined from $16.2 million in 2005 to $14.1 million in 2006. Our economic fuel expense is calculated as follows:

 

(in millions, except
per-gallon amounts)
  Year Ended December 31
  2006     2005     % Change

Raw fuel expense

  $ 119.1     $ 97.7     21.9

Less: cash received from settled hedges

    (14.1 )     (16.2 )   NM
                     

Economic fuel expense

  $ 105.0     $ 81.5     28.8
                     

Fuel gallons consumed

    54.3       51.3     5.8
                     

Economic fuel cost per gallon

  $ 1.93     $ 1.58     22.2
                     

 

NM = Not meaningful

 

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Aircraft Maintenance

 

Aircraft maintenance expense increased $30.6 million, or 70.7%, primarily as a result of more scheduled heavy checks and engine overhauls for the Q200 and Q400 fleets with fewer aircraft covered under warranty.

 

Aircraft Rent

 

Aircraft rent declined slightly by $0.9 million, or 1.3%, in 2006 primarily resulting from the annualization of lower rates on extended leases and fewer leased engines.

 

Other Operating Expenses

 

Other operating expenses increased by $4.7 million, or 11.1%, largely as a result of higher crew expenses and passenger remuneration costs.

 

Operating Costs per Available Seat Mile (CASM)

 

As discussed above, operating costs per ASM (CASM) is an important metric in the industry and we use it to gauge the effectiveness of our cost-reduction efforts. Like Alaska, Horizon’s efforts to reduce unit costs focus not only on controlling the actual dollars we spend, but also on increasing available seat miles without adding a commensurate amount of cost.

 

Our operating costs per ASM are summarized below:

 

      Years Ended December 31
      2006     2005     % Change

Total operating expenses per ASM (CASM)

   17.40 ¢   15.50 ¢   12.2

CASM includes the following components:

        

Fuel costs per ASM

   3.21 ¢   2.14 ¢   50.0

 

CONSOLIDATED NONOPERATING INCOME (EXPENSE)

 

Net nonoperating expense was $0.5 million in 2006 compared to $29.3 million in 2005. Interest income increased $23.4 million compared to 2005, primarily as a result of higher average portfolio returns and a higher average

cash and marketable securities balance. Interest expense increased $15.0 million primarily resulting from interest rate increases on our variable-rate debt, new debt arrangements in 2006, and the changes to some of our variable-rate debt arrangements to slightly higher fixed rates. This increase was offset by the conversion of our $150 million senior convertible notes to equity in April 2006, which eliminated further interest expense on those notes. Capitalized interest increased $15.8 million from $8.9 million in 2005 to $24.7 million during 2006. This is due to the significant increase in pre-delivery deposits in connection with our orders for B737-800 and Bombardier Q400 aircraft.

 

CONSOLIDATED INCOME TAX EXPENSE (BENEFIT)

 

Our consolidated effective income tax rate on pretax income before the cumulative effect of the accounting change for 2006 was 40.1% compared to an effective income tax rate of 38.4% in 2005. The 2006 year also includes $5.5 million of tax benefits associated with the reduction of certain tax contingency accruals for periods for which the statute of limitations expired in 2006. Excluding this benefit, our effective tax benefit rate for 2006 would have been 33.8%, which is different from our marginal 2006 tax rate of 37.4%. The difference is primarily due to the magnitude of nondeductible expenses, such as employee per-diem costs and stock-based compensation expense recorded for certain stock awards. We applied our 2005 marginal rate of 37.5% to the cumulative effect of the accounting change.

 

CHANGE IN ACCOUNTING POLICY

 

Effective January 1, 2005, we changed our method of accounting for major airframe and engine overhauls from the capitalize and amortize method to the direct expense method. Under the former method, these costs were capitalized and amortized to maintenance expense over the shorter of the life of the overhaul or the remaining lease term. Under the direct expense method, overhaul costs are expensed as incurred. We believe that the direct expense method is preferable because it

 

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eliminates the judgment and estimation needed to determine overhaul versus repair allocations in maintenance activities. Additionally, our approved maintenance program for the majority of our airframes now focuses more on shorter, but more frequent, maintenance visits. We also believe that the direct expense method is the predominant method used in the airline industry. Accordingly, effective January 1, 2005, we wrote off the net book value of our previously capitalized airframe and engine overhauls for all aircraft resulting in a charge of $144.7 million pretax ($90.4 million after tax). We do not believe disclosing the effect of adopting the direct expense method on net income for 2005 provides meaningful information because of

changes in our maintenance program, including the execution of a “power-by-the-hour” engine maintenance agreement with a third party in late 2004.

 

CRITICAL ACCOUNTING ESTIMATES

 

The discussion and analysis of our financial position and results of operations in this MD&A is based upon our consolidated financial statements. The preparation of these financial statements requires us to make estimates and judgments that affect our financial position and results of operations. See Note 1 to the consolidated financial statements for a description of our significant accounting policies. Critical accounting estimates are defined as those that are reflective of significant judgment and uncertainties, and that potentially may result in materially different results under varying assumptions and conditions. Management has identified the following critical accounting estimates and has discussed the development, selection and disclosure of these policies with our audit committee.

 

MILEAGE PLAN

 

Our Mileage Plan loyalty program awards miles to member passengers who fly on Alaska or Horizon and our many travel partners. Additionally, we sell miles to third parties, such as our bank partner, for cash. In either case, the outstanding miles may be redeemed for travel on Alaska, Horizon or any of our alliance partners. As long

as the Mileage Plan is in existence, we have an obligation to provide this future travel. For awards earned by passengers who fly on Alaska, Horizon or our travel partners, we recognize a liability and the corresponding selling expense for this future obligation. For miles sold to third parties, the majority of the sales proceeds are recorded as deferred revenue and recognized when the award transportation is provided. The commission component of these sales proceeds (defined as the proceeds we receive from the sale of mileage credits minus the amount we defer) is recorded as other-net revenue when the cash is received. The deferred revenue is recognized as passenger revenue when awards are issued and flown on Alaska or Horizon, and as other-net revenue for awards issued