Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-Q
 

x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018
 
OR

¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 For the transition period from                      to                      

Commission File Number 1-8957
ALASKA AIR GROUP, INC.
 
Delaware
 
91-1292054
(State of Incorporation)
 
(I.R.S. Employer Identification No.)

 
19300 International Boulevard, Seattle, Washington 98188
Telephone: (206) 392-5040

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer   x
Accelerated filer  ¨
Non-accelerated filer   ¨ 
(Do not check if a smaller reporting company)
Smaller reporting company   ¨
Emerging growth company   ¨

If an emerging growth company, indicate by checkmark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x
 
The registrant has 123,299,895 common shares, par value $0.01, outstanding at October 31, 2018.




ALASKA AIR GROUP, INC.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2018

 TABLE OF CONTENTS

 

As used in this Form 10-Q, the terms “Air Group,” the “Company,” “our,” “we” and "us" refer to Alaska Air Group, Inc. and its subsidiaries, unless the context indicates otherwise. Alaska Airlines, Inc., Virgin America Inc. (through July 20, 2018, at which point it was legally merged into Alaska Airlines, Inc), and Horizon Air Industries, Inc. are referred to as “Alaska,” “Virgin America” and “Horizon” and together as our “airlines.”
 

2



CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
Cautionary Note Regarding Forward-Looking Statements
In addition to historical information, this Form 10-Q 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 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;
our ability to meet our cost reduction goals;
our ability to achieve anticipated synergies and timing thereof in connection with our acquisition of Virgin America;
our ability to successfully integrate the Boeing and Airbus operations into those of Alaska;
labor disputes and our ability to attract and retain qualified personnel;
operational disruptions;
general economic conditions, including the impact of those conditions on customer travel behavior;
the concentration of our revenue from a few key markets;
an aircraft accident or incident;
actual or threatened terrorist attacks, global instability and potential U.S. military actions or activities;
our reliance on automated systems and the risks associated with changes made to those systems;
changes in laws and regulations.

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, see Item 1A. "Risk Factors” of the Company’s annual report on Form 10-K for the year ended December 31, 2017, and Item 1A. "Risk Factors" included herein. Please consider our forward-looking statements in light of those risks as you read this report.


3



PART I
 
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
(in millions)
September 30, 2018
 
December 31, 2017
ASSETS
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
174

 
$
194

Marketable securities
1,223

 
1,427

Total cash and marketable securities
1,397

 
1,621

Receivables—net
422

 
341

Inventories and supplies—net
57

 
57

Prepaid expenses and other current assets
180

 
133

Total Current Assets
2,056

 
2,152

 
 
 
 
Property and Equipment
 

 
 

Aircraft and other flight equipment
7,911

 
7,559

Other property and equipment
1,322

 
1,222

Deposits for future flight equipment
429

 
494

 
9,662

 
9,275

Less accumulated depreciation and amortization
3,167

 
2,991

Total Property and Equipment—Net
6,495

 
6,284

 
 
 
 
Goodwill
1,943

 
1,943

Intangible assets
128

 
133

Other noncurrent assets
271

 
234

Other Assets
2,342

 
2,310

 
 
 
 
Total Assets
$
10,893

 
$
10,746


Certain historical information has been adjusted to reflect the adoption of new accounting standards. See accompanying notes to condensed consolidated financial statements.


4


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
(in millions, except share amounts)
September 30, 2018
 
December 31, 2017
LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
Current Liabilities
 
 
 
Accounts payable
$
114

 
$
120

Accrued wages, vacation and payroll taxes
334

 
418

Air traffic liability
950

 
806

Other accrued liabilities
452

 
400

Deferred revenue
693

 
635

Current portion of long-term debt
345

 
307

Total Current Liabilities
2,888

 
2,686

 
 
 
 
Long-Term Debt, Net of Current Portion
1,684

 
2,262

Other Liabilities and Credits
 

 
 

Deferred income taxes
494

 
370

Deferred revenue
1,138

 
1,090

Obligation for pension and postretirement medical benefits
470

 
453

Other liabilities
428

 
425

 
2,530

 
2,338

Commitments and Contingencies


 


Shareholders' Equity
 

 
 

Preferred stock, $0.01 par value, Authorized: 5,000,000 shares, none issued or outstanding

 

Common stock, $0.01 par value, Authorized: 400,000,000 shares, Issued: 2018 - 130,786,648 shares; 2017 - 129,903,498 shares, Outstanding: 2018 - 123,360,846 shares; 2017 - 123,060,638 shares
1

 
1

Capital in excess of par value
224

 
164

Treasury stock (common), at cost: 2018 - 7,425,802 shares; 2017 - 6,842,860 shares
(556
)
 
(518
)
Accumulated other comprehensive loss
(428
)
 
(380
)
Retained earnings
4,550

 
4,193

 
3,791

 
3,460

Total Liabilities and Shareholders' Equity
$
10,893

 
$
10,746


Certain historical information has been adjusted to reflect the adoption of new accounting standards. See accompanying notes to condensed consolidated financial statements.



5


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in millions, except per share amounts)
2018
 
2017
 
2018
 
2017
Operating Revenues
 
 
 
 
 
 
 
Passenger revenue
$
2,043

 
$
1,958

 
5,725

 
5,505

Mileage Plan other revenue
114

 
105

 
329

 
314

Cargo and other
55

 
47

 
146

 
133

Total Operating Revenues
2,212

 
2,110

 
6,200

 
5,952

Operating Expenses
 
 
 
 
 

 
 

Wages and benefits
549

 
477

 
1,629

 
1,397

Variable incentive pay
27

 
40

 
104

 
98

Aircraft fuel, including hedging gains and losses
513

 
368

 
1,397

 
1,051

Aircraft maintenance
107

 
88

 
320

 
271

Aircraft rent
82

 
70

 
233

 
204

Landing fees and other rentals
135

 
124

 
371

 
338

Contracted services
70

 
76

 
227

 
234

Selling expenses
79

 
92

 
245

 
277

Depreciation and amortization
99

 
95

 
290

 
275

Food and beverage service
53

 
50

 
158

 
145

Third-party regional carrier expense
38

 
30

 
114

 
84

Other
141

 
150

 
423

 
421

Special items—merger-related costs
22

 
23

 
67

 
86

Special items—other

 

 
25

 

Total Operating Expenses
1,915

 
1,683

 
5,603

 
4,881

Operating Income
297

 
427

 
597

 
1,071

Nonoperating Income (Expense)
 
 
 
 
 

 
 

Interest income
11

 
9

 
29

 
25

Interest expense
(22
)
 
(26
)
 
(71
)
 
(77
)
Interest capitalized
5

 
5

 
14

 
13

Other—net
(7
)
 
2

 
(20
)
 
1

Total Nonoperating Income (Expense)
(13
)
 
(10
)
 
(48
)
 
(38
)
Income Before Income Tax
284

 
417

 
549

 
1,033

Income tax expense
67

 
158

 
135

 
388

Net Income
$
217

 
$
259

 
$
414

 
$
645

 
 
 
 
 
 
 
 
Basic Earnings Per Share:
$
1.76

 
$
2.10

 
$
3.36

 
$
5.22

Diluted Earnings Per Share:
$
1.75

 
$
2.09

 
$
3.34

 
$
5.19

Shares used for computation:
 
 
 
 
 
 
 

Basic
123.224

 
123.467

 
123.216

 
123.501

Diluted
123.864

 
124.220

 
123.804

 
124.341

 
 
 
 
 
 
 
 
Cash dividend declared per share:
$
0.32

 
$
0.30

 
$
0.96

 
$
0.90


Certain historical information has been adjusted to reflect the adoption of new accounting standards. See accompanying notes to condensed consolidated financial statements.

6


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS (unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in millions)
2018
 
2017
 
2018
 
2017
Net Income
$
217

 
$
259

 
$
414

 
$
645

 
 
 
 
 
 
 
 
Other Comprehensive Income (Loss):
 
 
 
 
 
 
 
Related to marketable securities:
 
 
 
 
 
 
 
Unrealized holding gain (loss) arising during the period
(2
)
 
1

 
(19
)
 
5

Reclassification of (gain) loss into Other—net nonoperating income (expense)
2

 
(1
)
 
5

 

Income tax effect
1

 

 
4

 
(2
)
Total
1

 

 
(10
)
 
3

 
 
 
 
 
 
 
 
Related to employee benefit plans:
 
 
 
 
 
 
 
Reclassification of net pension expense into Wages and benefits
7

 
5

 
21

 
16

Income tax effect
(2
)
 
(2
)
 
(5
)
 
(5
)
Total
5

 
3

 
16

 
11

 
 
 
 
 
 
 
 
Related to interest rate derivative instruments:
 
 
 
 
 
 
 
Unrealized holding gain (loss) arising during the period

 

 
8

 
(2
)
Reclassification of (gain) loss into Aircraft rent
2

 
2

 
3

 
4

Income tax effect
(1
)
 
(1
)
 
(3
)
 
(1
)
Total
1

 
1

 
8

 
1

 
 
 
 
 
 
 
 
Other Comprehensive Income
7

 
4

 
14

 
15

 
 
 
 
 
 
 
 
Comprehensive Income
$
224

 
$
263

 
$
428

 
$
660


Certain historical information has been adjusted to reflect the adoption of new accounting standards. See accompanying notes to condensed consolidated financial statements.



7


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
 
Nine Months Ended September 30,
(in millions)
2018
 
2017
Cash flows from operating activities:
 
 
 
Net income
$
414

 
$
645

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
290

 
275

Stock-based compensation and other
34

 
43

Changes in certain assets and liabilities:
 
 
 
Changes in deferred tax provision
122

 
208

Increase in air traffic liability
144

 
223

Increase in deferred revenue
106

 
130

Other—net
(124
)
 
(167
)
Net cash provided by operating activities
986

 
1,357

Cash flows from investing activities:
 

 
 

Property and equipment additions:
 

 
 

Aircraft and aircraft purchase deposits
(349
)
 
(679
)
Other flight equipment
(76
)
 
(70
)
Other property and equipment
(129
)
 
(92
)
Total property and equipment additions, including capitalized interest
(554
)
 
(841
)
Purchases of marketable securities
(672
)
 
(1,408
)
Sales and maturities of marketable securities
857

 
1,069

Other investing activities
36

 
38

Net cash used in investing activities
(333
)
 
(1,142
)
Cash flows from financing activities:
 

 
 

Long-term debt payments
(544
)
 
(265
)
Common stock repurchases
(37
)
 
(50
)
Dividends paid
(118
)
 
(111
)
Other financing activities
33

 
27

Net cash used in financing activities
(666
)
 
(399
)
Net increase (decrease) in cash, cash equivalents, and restricted cash
(13
)
 
(184
)
Cash, cash equivalents, and restricted cash at beginning of year
197

 
328

Cash, cash equivalents, and restricted cash at end of the period
$
184

 
$
144

 
 
 
 
Cash paid during the period for:
 
 
 
Interest (net of amount capitalized)
$
60

 
$
68

Income taxes

 
129

 
 
 
 
Reconciliation of cash, cash equivalents, and restricted cash at end of the period
 
 
 
Cash and cash equivalents
$
174

 
$
144

Restricted cash included in Prepaid expenses and other current assets
10

 

Total cash, cash equivalents, and restricted cash at end of the period
$
184

 
$
144

 
 
 
 
Certain historical information has been adjusted to reflect the adoption of new accounting standards. See accompanying notes to condensed consolidated financial statements.

8



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE 1. GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Basis of Presentation
 
The condensed consolidated financial statements include the accounts of Air Group, or the Company, and its primary subsidiaries, Alaska (including Virgin America) and Horizon. Our condensed consolidated financial statements also include McGee Air Services, a ground services subsidiary of Alaska. The Company conducts substantially all of its operations through these subsidiaries. All significant intercompany balances and transactions have been eliminated. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP) for interim financial information. Consistent with these requirements, this Form 10-Q does not include all the information required by GAAP for complete financial statements. It should be read in conjunction with the consolidated financial statements and accompanying notes in the Form 10-K for the year ended December 31, 2017. In the opinion of management, all adjustments have been made that are necessary to fairly present the Company’s financial position as of September 30, 2018 and the results of operations for the three and nine months ended September 30, 2018 and 2017. Such adjustments were of a normal recurring nature.

Certain reclassifications have been made to prior year financial statements to conform to classifications used in the current year.

In preparing these statements, the Company is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities, as well as the reported amounts of revenues and expenses. Due to seasonal variations in the demand for air travel, the volatility of aircraft fuel prices, changes in global economic conditions, changes in the competitive environment and other factors, operating results for the three and nine months ended September 30, 2018 are not necessarily indicative of operating results for the entire year.

Recently Issued Accounting Pronouncements

In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)," which requires lessees to recognize assets and liabilities for leases currently classified as operating leases. Under the new standard, a lessee will recognize a liability on the balance sheet representing the lease payments owed, and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election not to recognize lease assets and lease liabilities.

In July 2018, the FASB issued ASU 2018-11, "Targeted Improvements - Leases (Topic 842)" which amended Topic 842 to provide companies an alternative transition method which would not require adjusting comparative period financial information. The Company plans to utilize this alternative transition method, and will record a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The new standard is effective for the Company on January 1, 2019. The Company will not early adopt the standard.

At this time, the Company believes the most significant impact to the financial statements from the new lease accounting standard will relate to the recording of a right-of-use asset and related liability associated with leased aircraft. The Company does not expect the new standard to have a material impact on the pattern or amount of expense recognized for aircraft leases on the income statement. Other leases, including airports and real estate, equipment, software and other miscellaneous leases continue to be assessed.

In November 2016, the FASB issued ASU 2016-18, "Statement of Cash Flows—Restricted Cash (Topic 230)" related to the presentation of restricted cash on the statement of cash flows, and within the accompanying footnotes. The Company adopted the standard effective January 1, 2018.

In August 2017, the FASB issued ASU 2017-12, "Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities." The ASU expands the activities that qualify for hedge accounting and simplifies the rules for reporting hedging relationships. The ASU is effective for the Company beginning January 1, 2019, and is required to be adopted using the modified retrospective approach.

In February 2018, the FASB issued ASU 2018-02, "Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income." The standard allows a reclassification from accumulated other comprehensive income (AOCI) to retained earnings for stranded tax effects resulting

9



from the Tax Cuts and Jobs Act. The amount of the reclassification is the difference between the amount initially recorded directly to other comprehensive income at the previously enacted U.S. federal corporate income tax rate that remains in AOCI and the amount that would have been recorded directly to other comprehensive income using the newly enacted U.S. federal income tax rate. The standard is effective for interim and annual reporting periods beginning after December 15, 2018, and early adoption is permitted. The Company elected to early adopt the standard effective January 1, 2018. As a result, retained earnings increased approximately $62 million in 2018 due to the reclassification of tax effects in AOCI recorded in prior periods at previously enacted tax rates.

NOTE 2. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS

Revenue Recognition and Retirement Benefits Accounting Standards

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)." The Company adopted the new standard as of January 1, 2018, utilizing a full retrospective transition method. Adoption of the new standard resulted in changes to accounting policies for revenue recognition related to frequent flyer activity, certain ancillary revenues such as change fees, air traffic liabilities, and sales and marketing expenses. As a result of adoption, the Company also changed certain financial statement line item disclosure captions. See Note 3 for a discussion of the impact of this standard.

Although less significant, in March 2017 the FASB issued ASU 2017-07, "Compensation - Retirement Benefits (Topic 715)," which requires the Company to present the service cost component of net periodic benefit cost as Wages and benefits in the statement of operations. The Company adopted the new standard as of January 1, 2018, utilizing a full retrospective transition method. Under this new standard, all components of net periodic benefit cost are presented in Nonoperating income (expense), except service cost, which remains in Wages and benefits.

Certain line item captions on the balance sheet and statement of operations changed as a result of the newly implemented standards. Accordingly, historical financial information presented below as reported has been presented using the new captions. The cumulative impact to retained earnings at January 1, 2016 as a result of the new revenue recognition standard was $171 million. Below are the impacts of these newly adopted accounting standards to the financial statements.




10



Condensed consolidated statement of operations for the three and nine months ended September 30, 2017 (in millions):
 
Three Months Ended September 30, 2017
 
Nine Months Ended September 30, 2017
 
 
 
Adjustments
 
 
 
 
 
Adjustments
 
 
 
As Reported
 
Revenue Recognition
 
Retirement Benefits
 
As Adjusted
 
As Reported
 
Revenue Recognition
 
Retirement Benefits
 
As Adjusted
Operating Revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger Revenue
$
1,824

 
$
134

 
$

 
$
1,958

 
$
5,115

 
$
390

 
$

 
$
5,505

Mileage plan other revenue
122

 
(17
)
 

 
105

 
369

 
(55
)
 

 
314

Cargo and other revenue
174

 
(127
)
 

 
47

 
487

 
(354
)
 

 
133

Total Operating Revenue
2,120

 
(10
)
 

 
2,110

 
5,971

 
(19
)
 

 
5,952

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating Expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Wages and benefits
475

 

 
2

 
477

 
1,392

 

 
5

 
1,397

Selling expenses
91

 
1

 

 
92

 
269

 
8

 

 
277

Special items—merger-related costs
24

 
(1
)
 

 
23

 
88

 
(2
)
 

 
86

All other operating expenses
1,091

 

 

 
1,091

 
3,121

 

 

 
3,121

Total Operating Expenses
1,681

 

 
2

 
1,683

 
4,870

 
6

 
5

 
4,881

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating Income
439

 
(10
)
 
(2
)
 
427

 
1,101

 
(25
)
 
(5
)
 
1,071

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nonoperating Income (Expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other—net

 

 
2

 
2

 
(4
)
 

 
5

 
1

All other nonoperating income (expense)
(12
)
 

 

 
(12
)
 
(39
)
 

 

 
(39
)
 
(12
)
 

 
2

 
(10
)
 
(43
)
 

 
5

 
(38
)
Income (loss) before income tax
427

 
(10
)
 

 
417

 
1,058

 
(25
)
 

 
1,033

Income tax expense (benefit)
161

 
(3
)
 

 
158

 
397

 
(9
)
 

 
388

Net Income (Loss)
$
266

 
$
(7
)
 
$

 
$
259

 
$
661

 
$
(16
)
 
$

 
$
645



11



Condensed consolidated statement of cash flows for the nine months ended September 30, 2017 (in millions):
 
Nine Months Ended September 30, 2017
 
As Reported
 
Adjustments - Revenue Recognition
 
As Adjusted
Cash flows from operating activities:
 
 
 
 
 
Net income
$
661

 
$
(16
)
 
$
645

 
 
 
 
 
 
Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 

Depreciation and amortization
275

 

 
275

Stock-based compensation and other
43

 

 
43

Changes in certain assets and liabilities:
 
 
 
 
 
Changes in deferred tax provision
217

 
(9
)
 
208

Increase in air traffic liability
254

 
(31
)
 
223

Increase in deferred revenue
46

 
84

 
130

Other—net
(139
)
 
(28
)
 
(167
)
Net cash provided by operating activities
1,357

 

 
1,357

 
 
 
 
 
 
Net cash used in investing activities
(1,142
)
 

 
(1,142
)
 
 
 
 
 
 
Net cash used in financing activities
(399
)
 

 
(399
)
 
 
 
 
 
 
Net increase (decrease) in cash and cash equivalents
(184
)
 

 
(184
)
Cash and cash equivalents at beginning of year
328

 

 
328

Cash and cash equivalents at end of the period
$
144

 
$

 
$
144


NOTE 3. REVENUE

Ticket revenue is recorded as Passenger revenue, and represents the primary source of the Company's revenue. Also included in Passenger revenue are passenger ancillary revenues such as bag fees, on-board food and beverage, ticket change fees, and certain revenue from the frequent flyer program. Mileage Plan™ other revenue includes brand and marketing revenue from our affinity credit card and other partners and certain interline frequent flyer revenue, net of commissions. Cargo and other revenue includes freight and mail revenue, and to a lesser extent, other ancillary revenue products such as lounge membership and certain commissions.

The Company disaggregates revenue by segment in Note 9. The level of detail within the Company’s statements of operations, segment disclosures, and in this footnote depict the nature, amount, timing and uncertainty of revenue and how cash flows are affected by economic and other factors.

Passenger Ticket and Ancillary Services Revenue

The primary performance obligation on a typical passenger ticket is to provide air travel to the Company’s passenger. Ticket revenue is collected in advance of travel and recorded as Air Traffic Liability (ATL) on the consolidated balance sheets. The Company satisfies its performance obligation and recognizes ticket revenue on each flight segment when the transportation is provided.

Ancillary passenger revenues relate to items such as checked-bag fees, ticket change fees, and on-board food and beverage sales, all of which are provided at time of flight. As such, the obligation to perform these services is satisfied at the time of travel and is recorded with ticket revenue in Passenger revenue.


12



Revenue is also recognized for tickets that are expected to expire unused, a concept referred to as “passenger ticket breakage.” Passenger ticket breakage is recorded at the flight date using estimates made at the time of sale based on the Company’s historical experience of expired tickets, and other facts such as program changes and modifications.

In addition to selling tickets on its own marketed flights, the Company has interline agreements with partner airlines under which it sells multi-city tickets with one or more segments of the trip flown by a partner airline, or it operates a connecting flight sold by a partner airline. Each segment in a connecting flight represents a separate performance obligation. Revenue on segments sold and operated by the Company is recognized as Passenger revenue in the gross amount of the allocated ticket price when the travel occurs, while the commission paid to the partner airline is recognized as a selling expense when the related transportation is provided. Revenue on segments operated by a partner airline is deferred for the full amount of the consideration received at the time the ticket is sold and, once the segment has been flown the Company records the net amount, after compensating the partner airline, as Cargo and other revenue.

A portion of revenue from the Mileage Plan™ program is recorded in Passenger revenue. As members are awarded mileage credits on flown tickets, these credits become a distinct performance obligation for the Company. The Company allocates the transaction price to each performance obligation identified in a passenger ticket contract on a relative standalone selling price basis. The standalone selling price for loyalty mileage credits issued is discussed in the Loyalty Mileage Credits section of this Note below. The amount allocated to the mileage credits is deferred on the balance sheet. Once a member travels using a travel award redeemed with mileage credits on one of the Company's airline carriers, the revenue associated with those mileage credits is recorded as Passenger revenue.

Taxes collected from passengers, including transportation excise taxes, airport and security fees and other fees, are recorded on a net basis within passenger revenue in the consolidated statements of operations.

Passenger revenue recognized in the condensed consolidated statements of operations (in millions):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Passenger ticket revenue, including ticket breakage and net of taxes and fees
$
1,744

 
$
1,683

 
$
4,865

 
$
4,709

Passenger ancillary revenue
146

 
141

 
401

 
391

Mileage PlanTM passenger revenue
153

 
134

 
459

 
405

Total passenger revenue
$
2,043

 
$
1,958

 
$
5,725

 
$
5,505


As passenger tickets and related ancillary services are primarily sold via credit cards, certain amounts due from credit card processors are recorded as airline traffic receivables. These credit card receivables and receivables from our affinity credit card partner represent the majority of the receivables balance on the Balance Sheet.

For performance obligations with performance periods of less than one year, GAAP provides a practical expedient that allows the Company not to disclose the transaction price allocated to remaining performance obligations and the timing of related revenue recognition. As passenger tickets expire one year from ticketing, the Company elected to apply this practical expedient for tickets unused or not exchanged.

Mileage Plan™ Loyalty Program

Loyalty mileage credits

The Company’s Mileage Plan™ loyalty program provides frequent flyer travel awards to program members based upon accumulated loyalty mileage credits. Mileage credits are earned through travel, purchases using the Mileage Plan™ co-branded credit card and purchases from other participating partners. The program has a 24-month expiration period for unused mileage credits from the month of last account activity. The Company offers redemption of mileage credits through free, discounted or upgraded air travel on Alaska flights or on one of its 15 airline partners, as well as redemption at partner hotels.

The Company uses a relative standalone selling price allocation to allocate consideration to material performance obligations in contracts with customers that include loyalty mileage credits. As directly observable selling prices for mileage credits are not available, the Company determines the standalone selling price of mileage credits primarily using actual ticket purchase prices for similar tickets flown, adjusted for the likelihood of redemption, or breakage. In determining similar tickets flown,

13



the Company considers current market prices, class of service, type of award, and other factors. For mileage credits accumulated through travel on partner airlines, the Company uses actual consideration received from the partners.

Revenue related to air transportation is deferred in the amount of the relative standalone selling price allocated to the mileage credits as they are issued. The Company satisfies its performance obligation when the mileage credits are redeemed and the related air transportation is delivered.

The Company estimates breakage for the portion of mileage credits not expected to be redeemed using a statistical analysis of historical data, including actual mileage credits expiring, slow-moving and low-credit accounts, among other factors. The breakage rate for the three and nine months ended September 30, 2018 and 2017 was 17.4%. The Company reviews the breakage rate used on an annual basis.

Co-brand credit card agreement and other

In addition to mileage credits, the co-brand credit card agreement, referred to herein as the Agreement, also includes performance obligations for waived bag fees, Companion Fare™ offers to purchase an additional ticket at a discount, marketing, and the use of intellectual property including the brand (unlimited access to the use of the Company’s brand and frequent flyer member lists), which is the predominant element in the Agreement. The affinity card bank partner is the customer for some elements, including the brand and marketing, while the Mileage Plan™ member is the customer for other elements such as mileage credits, bag waivers, and Companion Fares.

At the inception of the Agreement, management estimated the selling price of each of the performance obligations. The objective was to determine the price at which a sale would be transacted if the product or service was sold on a stand-alone basis. The Company determined its best estimate of selling price for each element by considering multiple inputs and methods including, but not limited to, the estimated selling price of comparable travel, discounted cash flows, brand value, published selling prices, number of miles awarded and number of miles redeemed. The Company estimated the selling prices and volumes over the term of the Agreement in order to determine the allocation of proceeds to each of the multiple deliverables. The estimates of the standalone selling prices of each element do not change subsequent to the original valuation of the contract unless the contract is materially modified, but the allocation between elements may change based upon the actual and updated projected volumes of each element delivered during the term of the contract.

Consideration received from the bank is variable and is primarily from consumer spend on the card, among other items. The Company allocates consideration to each of the performance obligations, including mileage credits, waived bag fees, Companion Fares, and brand and marketing, using their relative standalone selling price. Because the performance obligation related to providing use of intellectual property including the brand is satisfied over time, it is recognized in Mileage PlanTM other revenue in the period that those elements are sold. The Company records passenger revenue related to the air transportation and certificates for discounted companion travel when the transportation is delivered.

In contracts with non-bank partners, the Company has identified two performance obligations in most cases - travel and brand. Revenue is recognized using the residual method, where the travel performance obligation is deferred until transportation is provided in the amount of the estimated standalone selling price of the ticket, less breakage. The residual amount, if any, is recognized as commission revenue when the brand element is sold. Mileage credit sales recorded under the residual approach are immaterial to the overall program.

Interline loyalty

The Company has interline arrangements with certain airlines whereby its members may earn and redeem Mileage Plan™ credits on those airlines, and members of a partner airline’s loyalty program may earn and redeem frequent flyer program credits on Alaska. When a Mileage Plan™ member earns credits on a partner airline, the partner airline remits a contractually-agreed upon fee to the Company which is deferred until credits are redeemed. When a Mileage Plan™ member redeems credits on a partner airline, the Company pays a contractually agreed upon fee to the other airline, which offsets the revenue recognized associated with the award travel. When a member of a partner airline redeems frequent flyer credits on Alaska, the partner airline remits a contractually-agreed upon amount to the Company, recognized as Passenger revenue upon travel. If the partner airline’s member earns frequent flyer program credits on an Alaska flight, the Company remits a contractually-agreed upon fee to the partner airline and records a commission expense.


14



Mileage Plan™ revenue included in the condensed consolidated statements of operations (in millions):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Passenger revenue
$
153

 
$
134

 
$
459

 
$
405

Mileage PlanTM other revenue
114

 
105

 
329

 
314

Total Mileage Plan™ revenue
$
267

 
$
239

 
$
788

 
$
719


Mileage Plan™ other revenue is primarily brand and marketing revenue from our affinity card products.

Cargo and Other

The Company provides freight and mail services (cargo). The majority of cargo services are provided to commercial businesses and the United States Postal Service. The Company satisfies cargo service performance obligations and recognizes revenue when the shipment arrives at its final destination or is transferred to a third-party carrier for delivery.

The Company also earns other revenue for lounge memberships, hotel and car commissions, and certain other immaterial items not intrinsically tied to providing air travel to passengers. Revenue is recognized when these services are rendered and recorded as Cargo and other revenue. The transaction price for Cargo and other revenue is the price paid by the customer.

Cargo and other revenue included in the condensed consolidated statements of operations (in millions):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Cargo revenue
$
36

 
$
32

 
$
96

 
$
88

Other revenue
19

 
15

 
50

 
45

Total Cargo and other revenue
$
55

 
$
47

 
$
146

 
$
133


Air Traffic Liability and Deferred Revenue

Passenger ticket and ancillary services liabilities

Air traffic liability included on the condensed consolidated balance sheets represents the remaining obligation associated with passenger tickets and ancillary services. The air traffic liability balance fluctuates with seasonal travel patterns. The Company recognized Passenger revenue of $27 million and $23 million from the prior year-end air traffic liability balance for the three months ended September 30, 2018 and 2017, and $540 million and $543 million for the nine months ended September 30, 2018 and 2017.

Mileage PlanTM liabilities

The total deferred revenue liability included on the condensed consolidated balance sheets represents the remaining transaction price that has been allocated to Mileage PlanTM performance obligations not yet satisfied by the Company. In general, the current amounts will be recognized as revenue within 12 months and the long-term amounts will be recognized as revenue over, on average, a period of approximately three to four years. This period of time represents the average time that members have historically taken to earn and redeem miles.

The Company records a receivable for amounts due from the bank partner and from other partners as mileage credits are sold until the payments are collected. The Company had $106 million of such receivables as of September 30, 2018 and $101 million as of December 31, 2017.


15



Mileage credits are combined in one homogeneous pool and are not specifically identifiable. As such, loyalty revenues disclosed earlier in this Note are comprised of miles that were part of the deferred revenue and liabilities balances at the beginning of the period and miles that were issued during the period. The table below presents a roll forward of the total frequent flyer liability (in millions):
 
 
Nine Months Ended September 30,
 
 
2018
 
2017
Total Deferred Revenue balance at January 1
 
$
1,725

 
$
1,534

Travel miles and companion certificate redemption - Passenger revenue
 
(459
)
 
(405
)
Miles redeemed on partner airlines - Other revenue
 
(66
)
 
(54
)
Increase in liability for mileage credits issued
 
631

 
586

Total Deferred Revenue balance at September 30
 
$
1,831

 
$
1,661

 
Selling Costs

Certain costs such as credit card fees, travel agency and other commissions paid, as well as Global Distribution Systems (GDS) booking fees are incurred when the Company sells passenger tickets and ancillary services in advance of the travel date. The Company defers such costs and recognizes them as expenses when the travel occurs. Prepaid expense recorded on the consolidated balance sheets for such costs was $27 million and $24 million as of September 30, 2018 and December 31, 2017. The Company recorded related expense on the condensed consolidated statement of operations of $57 million and $61 million for the three months ended September 30, 2018 and 2017, and $166 million and $183 million for the nine months ended September 30, 2018 and 2017.

NOTE 4. FAIR VALUE MEASUREMENTS

In determining fair value, there is a three-level hierarchy based on the reliability of the inputs used. Level 1 refers to fair values based on quoted prices in active markets for identical assets or liabilities. Level 2 refers to fair values estimated using significant other observable inputs and Level 3 refers to fair values estimated using significant unobservable inputs.


16



Fair Value of Financial Instruments on a Recurring Basis

As of September 30, 2018, total cost basis for all marketable securities was $1.2 billion. There were no significant differences between the cost basis and fair value of any individual class of marketable securities.

Fair values of financial instruments on the consolidated balance sheet (in millions):
September 30, 2018
Level 1
 
Level 2
 
Total
Assets
 
 
 
 
 
Marketable securities
 
 
 
 
 
U.S. government and agency securities
$
338

 
$

 
$
338

Foreign government bonds

 
29

 
29

Asset-backed securities

 
209

 
209

Mortgage-backed securities

 
79

 
79

Corporate notes and bonds

 
559

 
559

Municipal securities

 
9

 
9

Total Marketable securities
338

 
885

 
1,223

Derivative instruments
 
 
 
 
 
Fuel hedge—call options

 
54

 
54

Interest rate swap agreements

 
15

 
15

Total Assets
$
338

 
$
954

 
$
1,292

 
 
 
 
 
 
Liabilities
 
 
 
 
 
Derivative instruments
 
 
 
 
 
Interest rate swap agreements

 
(3
)
 
(3
)
Total Liabilities
$

 
$
(3
)
 
$
(3
)
December 31, 2017
Level 1
 
Level 2
 
Total
Assets
 
 
 
 
 
Marketable securities
 
 
 
 
 
U.S. government and agency securities
$
328

 
$

 
$
328

Foreign government bonds

 
43

 
43

Asset-backed securities

 
209

 
209

Mortgage-backed securities

 
99

 
99

Corporate notes and bonds

 
726

 
726

Municipal securities

 
22

 
22

Total Marketable securities
328

 
1,099

 
1,427

Derivative instruments
 
 
 
 
 
Fuel hedge—call options

 
22

 
22

Interest rate swap agreements

 
9

 
9

Total Assets
$
328

 
$
1,130

 
$
1,458

 
 
 
 
 
 
Liabilities
 
 
 
 
 
Derivative instruments
 
 
 
 
 
Interest rate swap agreements

 
(8
)
 
(8
)
Total Liabilities
$

 
$
(8
)
 
$
(8
)

The Company uses both the market and income approach to determine the fair value of marketable securities. U.S. government securities are Level 1 as the fair value is based on quoted prices in active markets. Foreign government bonds, asset-backed securities, mortgage-backed securities, corporate notes and bonds, and municipal securities are Level 2 as the fair value is based on standard valuation models that are calculated based on observable inputs such as quoted interest rates, yield curves, credit ratings of the security and other observable market information.


17



The Company uses the market approach and the income approach to determine the fair value of derivative instruments. The fair value for fuel hedge call options is determined utilizing an option pricing model based on inputs that are readily available in active markets or can be derived from information available in active markets. In addition, the fair value considers the exposure to credit losses in the event of non-performance by counterparties. Interest rate swap agreements are Level 2 as the fair value of these contracts is determined based on the difference between the fixed interest rate in the agreements and the observable LIBOR-based interest forward rates at period end multiplied by the total notional value.

Activity and Maturities for Marketable Securities

Unrealized losses from marketable securities are primarily attributable to changes in interest rates. Management does not believe any unrealized losses represent other-than-temporary impairments based on its evaluation of available information as of September 30, 2018.

Maturities for marketable securities (in millions):
September 30, 2018
Cost Basis
 
Fair Value
Due in one year or less
$
126

 
$
126

Due after one year through five years
1,094

 
1,072

Due after five years through 10 years
26

 
25

Total
$
1,246

 
$
1,223


Fair Value of Other Financial Instruments

The Company uses the following methods and assumptions to determine the fair value of financial instruments that are not recognized at fair value as described below.

Cash, Cash Equivalents and Restricted Cash: Cash equivalents consist of highly liquid investments with original maturities of three months or less, such as money market funds, commercial paper and certificates of deposit. They are carried at cost, which approximates fair value.

The Company's restricted cash balances are primarily used to guarantee various letters of credit, self-insurance programs or other contractual rights. Restricted cash consists of highly liquid securities with original maturities of three months or less. They are carried at cost, which approximates fair value.

Debt: Debt assumed in the acquisition of Virgin America was subject to a non-recurring fair valuation adjustment as part of purchase price accounting. The adjustment is amortized over the life of the associated debt. All other fixed-rate debt is carried at cost. To estimate the fair value of all fixed-rate debt as of September 30, 2018, the Company uses the income approach by discounting cash flows using borrowing rates for comparable debt over the remaining life of the outstanding debt. The estimated fair value of the fixed-rate debt is Level 3 as certain inputs used are unobservable.

Fixed-rate debt on the consolidated balance sheet and the estimated fair value of long-term fixed-rate debt is as follows (in millions):
 
September 30, 2018
 
December 31, 2017
Fixed-rate debt at cost
$
703

 
$
956

Non-recurring purchase price accounting fair value adjustment
3

 
3

Total fixed-rate debt
$
706

 
$
959

 
 
 
 
Estimated fair value
$
700

 
$
959


Assets and Liabilities Measured at Fair Value on Nonrecurring Basis

Certain assets and liabilities are recognized or disclosed at fair value on a nonrecurring basis, including property, plant and equipment, goodwill, and intangible assets. These assets are subject to fair valuation when there is evidence of impairment. No material impairment charges were taken in the three and nine months ended September 30, 2018 and September 30, 2017.


18



NOTE 5. LONG-TERM DEBT
 
Long-term debt obligations on the consolidated balance sheet (in millions):
 
September 30, 2018
 
December 31, 2017
Fixed-rate notes payable due through 2028
$
706

 
$
959

Variable-rate notes payable due through 2028
1,335

 
1,625

Less debt issuance costs
(12
)
 
(15
)
Total debt
2,029

 
2,569

Less current portion
345

 
307

Long-term debt, less current portion
$
1,684

 
$
2,262

 
 
 
 
Weighted-average fixed-interest rate
4.1
%
 
4.2
%
Weighted-average variable-interest rate
3.4
%
 
2.8
%

During the nine months ended September 30, 2018 the Company made debt payments of $544 million, including the prepayment of $231 million of debt.

At September 30, 2018 long-term debt principal payments for the next five years and thereafter are as follows (in millions):
 
Total
Remainder of 2018
$
123

2019
267

2020
381

2021
363

2022
179

Thereafter
725

Total
$
2,038

 
Bank Lines of Credit
 
The Company had three credit facilities totaling $516 million as of September 30, 2018. All three facilities have variable interest rates based on LIBOR plus a specified margin. One credit facility for $250 million expires in June 2021 and is secured by aircraft. The second credit facility increased from $75 million to $116 million in July 2018. It expires in July 2019, with a mechanism for annual renewal, and is secured by aircraft. A third credit facility for $150 million expires in March 2022 and is secured by certain accounts receivable, spare engines, spare parts and ground service equipment. The Company has secured letters of credit against the $116 million facility, but has no plans to borrow using either of the two other facilities. All three credit facilities have a requirement to maintain a minimum unrestricted cash and marketable securities balance of $500 million. The Company was in compliance with this covenant at September 30, 2018.


19



NOTE 6. EMPLOYEE BENEFIT PLANS

Net periodic benefit costs for qualified defined-benefit plans include the following (in millions): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Service cost
$
12

 
$
10

 
$
36

 
$
30

Pension expense included in Wages and benefits
12

 
10

 
36

 
30

 
 
 
 
 
 
 
 
Interest cost
20

 
19

 
59

 
55

Expected return on assets
(27
)
 
(27
)
 
(80
)
 
(80
)
Amortization of prior service cost (credit)
(1
)
 
(1
)
 
(1
)
 
(1
)
Recognized actuarial loss (gain)
9

 
7

 
25

 
20

Pension expense (benefit) included in Nonoperating Income (Expense)
$
1

 
$
(2
)
 
$
3

 
$
(6
)

NOTE 7. COMMITMENTS AND CONTINGENCIES

Future minimum payments for commitments as of September 30, 2018 (in millions):
 
Aircraft Leases
 
Facility Leases
 
Aircraft Commitments(a)
 
Capacity Purchase Agreements (b)
 
Aircraft Maintenance Deposits
Remainder of 2018
$
88

 
$
18

 
$
378

 
$
33

 
$
16

2019
349

 
64

 
514

 
138

 
65

2020
324

 
56

 
525

 
145

 
68

2021
282

 
50

 
558

 
166

 
64

2022
265

 
35

 
302

 
174

 
52

Thereafter
1,070

 
149

 
140

 
1,205

 
38

Total
$
2,378

 
$
372

 
$
2,417

 
$
1,861

 
$
303

(a)
Includes non-cancelable contractual commitments for aircraft and engines, buyer furnished equipment, and aircraft maintenance and parts management.
(b)
Includes all non-aircraft lease costs associated with capacity purchase agreements.

Lease Commitments

Aircraft lease commitments include future obligations for all of the Company's operating aircraft, as well as aircraft leases operated by third-parties. At September 30, 2018, the Company had lease contracts for 10 Boeing 737 (B737) aircraft, 61 Airbus aircraft, 9 Bombardier Q400 aircraft, and 32 Embraer 175 (E175) aircraft with SkyWest Airlines, Inc. (SkyWest). The Company has an additional two scheduled lease deliveries of A321neo aircraft through 2019, as well as three scheduled lease deliveries of E175 aircraft in 2021 to be operated by SkyWest. The Company does not intend to operate the three E175 aircraft currently scheduled for delivery in 2021, and is working to remove those aircraft from the capacity purchase agreement. All lease contracts have remaining non-cancelable lease terms ranging from 2018 to 2033. The Company has the option to increase capacity flown by SkyWest with eight additional E175 aircraft with deliveries from 2021 to 2022. Options to lease are not reflected in the commitments table above.

Facility lease commitments primarily include airport and terminal facilities and building leases. Total rent expense for aircraft and facility leases was $165 million and $145 million for the three months ended September 30, 2018 and 2017, and $455 million and $406 million for the nine months ended September 30, 2018 and 2017.


20



Aircraft Commitments
 
Aircraft purchase commitments include non-cancelable contractual commitments for aircraft and engines. As of September 30, 2018, the Company had commitments to purchase 38 B737 aircraft (6 B737 NextGen aircraft and 32 B737 MAX aircraft), with deliveries in the remainder of 2018 through 2023. In the first quarter of 2018 the Company entered into a supplemental agreement with Boeing to defer certain B737 deliveries and to convert 15 MAX8 aircraft orders to MAX9 aircraft orders. The Company also has commitments to purchase 17 E175 aircraft with deliveries in the remainder of 2018 through 2021 and has cancelable purchase commitments for 30 Airbus A320neo aircraft with deliveries from 2022 through 2024. In addition, the Company has options to purchase 37 B737 aircraft from 2021 through 2024 and 30 E175 aircraft from 2021 through 2023. The cancelable purchase commitments and option payments are not reflected in the table above.

Contingencies

The Company is a party to routine litigation matters incidental to its business and with respect to which no material liability is expected. Liabilities for litigation related contingencies are recorded when a loss is determined to be probable and estimable.

In 2015, three flight attendants filed a class action lawsuit seeking to represent all Virgin America flight attendants for damages based on alleged violations of California and City of San Francisco wage and hour laws. Two thousand flight attendants were certified as a class in November 2016. The Company believes the claims in this case are without factual and legal merit.

In July 2018, the Court granted in part Plaintiffs' motion for summary judgment, finding Virgin America responsible for various damages and penalties sought by the class members. Plaintiffs value these damages and penalties at $85 million, and as of November 1, 2018, moved the Court to enter judgment against Virgin America in that amount. Plaintiffs do not seek monetary or behavioral relief from Alaska Airlines.

The Court will render its final judgment in March 2019. The Company will then seek an appellate court ruling that the California laws on which the judgment is based are invalid as applied to national airlines pursuant to the U.S. Constitution and federal law. The Company remains confident that a higher court will respect the federal preemption principles that were enacted to shield inter-state common carriers from a patchwork of state and local wage and hour regulations such as those at issue in this case.

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.

NOTE 8. SHAREHOLDERS' EQUITY

Dividends

During the three months ended September 30, 2018, the Company declared and paid cash dividends of $0.32 per share, or $39 million. During the nine months ended September 30, 2018, the Company declared and paid cash dividends of $0.96 per share, or $118 million.

Common Stock Repurchase

In August 2015, the Board of Directors authorized a $1 billion share repurchase program. As of September 30, 2018, the Company has repurchased 5.7 million shares for $426 million under this program.
Share repurchase activity (in millions, except share amounts):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
 
Shares
 
Amount
 
Shares
 
Amount
 
Shares
 
Amount
 
Shares
 
Amount
2015 Repurchase Program—$1 billion
193,203

 
$
12

 
355,415

 
$
28

 
582,942

 
$
37

 
612,095

 
$
50



21



Accumulated Other Comprehensive Loss
 
Components of accumulated other comprehensive loss, net of tax (in millions):
 
September 30, 2018
 
December 31, 2017
Related to marketable securities
$
(17
)
 
$
(5
)
Related to employee benefit plans
(420
)
 
(376
)
Related to interest rate derivatives
9

 
1

Total
$
(428
)
 
$
(380
)

The Company elected to early adopt ASU 2018-02 in the first quarter of 2018. As a result, the Company reclassified approximately $62 million of tax effects in AOCI recorded in prior periods at previously enacted tax rates thus increasing Retained earnings.

Earnings Per Share (EPS)

Diluted EPS is calculated by dividing net income by the average number of common shares outstanding plus the number of additional common shares that would have been outstanding assuming the exercise of in-the-money stock options and restricted stock units, using the treasury-stock method. For the three and nine months ended September 30, 2018 and 2017, anti-dilutive shares excluded from the calculation of EPS were not material.

NOTE 9. OPERATING SEGMENT INFORMATION

Alaska Air Group has two operating airlines—Alaska (including Virgin America after the single operating certificate was received in January 2018) and Horizon. Each is regulated by the U.S. Department of Transportation’s Federal Aviation Administration. Alaska has CPAs for regional capacity with Horizon, as well as with third-party carriers SkyWest and PenAir, under which Alaska receives all passenger revenues.

Under U.S. GAAP, operating segments are defined as components of a business for which there is discrete financial information that is regularly assessed by the Chief Operating Decision Maker (CODM) in making resource allocation decisions. Financial performance for the operating airlines and CPAs is managed and reviewed by the Company's CODM as part of three reportable operating segments:
 
Mainline - includes scheduled air transportation on Alaska's Boeing or Airbus jet aircraft for passengers and cargo throughout the U.S., and in parts of Canada, Mexico, and Costa Rica.
Regional - includes Horizon's and other third-party carriers’ scheduled air transportation for passengers across a shorter distance network within the U.S. under CPAs. This segment includes the actual revenues and expenses associated with regional flying, as well as an allocation of corporate overhead incurred by Air Group on behalf of the regional operations.
Horizon - includes the capacity sold to Alaska under CPA. Expenses include those typically borne by regional airlines such as crew costs, ownership costs and maintenance costs.

The CODM makes resource allocation decisions for these reporting segments based on flight profitability data, aircraft type, route economics and other financial information.

The "Consolidating and Other" column reflects Air Group parent company activity, McGee Air Services, consolidating entries and other immaterial business units of the company. The “Air Group Adjusted” column represents a non-GAAP measure that is used by the Company's CODM to evaluate performance and allocate resources. Adjustments are further explained below in reconciling to consolidated GAAP results.


22



Operating segment information is as follows (in millions):
 
Three Months Ended September 30, 2018
 
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger revenues
$
1,727

 
$
316

 
$

 
$

 
$
2,043

 
$

 
$
2,043

CPA revenues

 

 
128

 
(128
)
 

 

 

Mileage Plan other revenue
104

 
10

 

 

 
114

 

 
114

Cargo and other
53

 

 
2

 

 
55

 

 
55

Total operating revenues
1,884

 
326

 
130

 
(128
)
 
2,212

 

 
2,212

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
1,126

 
267

 
118

 
(131
)
 
1,380

 
22

 
1,402

Economic fuel
438

 
70

 

 

 
508

 
5

 
513

Total operating expenses
1,564

 
337

 
118

 
(131
)
 
1,888

 
27

 
1,915

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
15

 

 

 
(4
)
 
11

 

 
11

Interest expense
(20
)
 

 
(6
)
 
4

 
(22
)
 

 
(22
)
Interest capitalized
4

 

 
1

 

 
5

 

 
5

Other—net
(5
)
 
(2
)
 

 

 
(7
)
 

 
(7
)
Total Nonoperating income (expense)
(6
)
 
(2
)
 
(5
)
 

 
(13
)
 

 
(13
)
Income (loss) before income tax
$
314

 
$
(13
)
 
$
7

 
$
3

 
$
311

 
$
(27
)
 
$
284

 
Three Months Ended September 30, 2017(d)
 
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger revenues
$
1,677

 
$
281

 
$

 
$

 
$
1,958

 
$

 
$
1,958

CPA revenues

 

 
112

 
(112
)
 

 

 

Mileage Plan other revenue
97

 
8

 

 

 
105

 

 
105

Cargo and other
46

 

 
1

 

 
47

 

 
47

Total operating revenues
1,820

 
289

 
113

 
(112
)
 
2,110

 

 
2,110

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
1,081

 
219

 
104

 
(112
)
 
1,292

 
23

 
1,315

Economic fuel
328

 
45

 

 

 
373

 
(5
)
 
368

Total operating expenses
1,409

 
264

 
104

 
(112
)
 
1,665

 
18

 
1,683

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
12

 

 

 
(3
)
 
9

 

 
9

Interest expense
(25
)
 

 
(4
)
 
3

 
(26
)
 

 
(26
)
Interest capitalized
5

 

 

 

 
5

 

 
5

Other—net
2

 

 

 

 
2

 

 
2

Total Nonoperating income (expense)
(6
)
 

 
(4
)
 

 
(10
)
 

 
(10
)
Income (loss) before income tax
$
405

 
$
25

 
$
5

 
$

 
$
435

 
$
(18
)
 
$
417


23



 
Nine Months Ended September 30, 2018
(in millions)
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger revenues
$
4,880

 
$
845

 
$

 
$

 
$
5,725

 
$

 
$
5,725

CPA revenues

 

 
375

 
(375
)
 

 

 

Mileage Plan other revenue
301

 
28

 

 

 
329

 

 
329

Cargo and other
141

 
1

 
4

 

 
146

 

 
146

Total operating revenues
5,322

 
874

 
379

 
(375
)
 
6,200

 

 
6,200

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
3,392

 
755

 
345

 
(378
)
 
4,114

 
92

 
4,206

Economic fuel
1,237

 
190

 

 

 
1,427

 
(30
)
 
1,397

Total operating expenses
4,629

 
945

 
345

 
(378
)
 
5,541

 
62

 
5,603

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
39

 

 

 
(10
)
 
29

 

 
29

Interest expense
(64
)
 

 
(16
)
 
9

 
(71
)
 

 
(71
)
Interest capitalized
12

 

 
2

 

 
14

 

 
14

Other
(9
)
 
(11
)
 

 

 
(20
)
 

 
(20
)
Total Nonoperating income (expense)
(22
)
 
(11
)
 
(14
)
 
(1
)
 
(48
)
 

 
(48
)
Income (loss) before income tax
$
671

 
$
(82
)
 
$
20

 
$
2

 
$
611

 
$
(62
)
 
$
549

 
Nine Months Ended September 30, 2017(d)
(in millions)
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger revenues
$
4,729

 
$
776

 
$

 
$

 
$
5,505

 
$

 
$
5,505

CPA revenues

 

 
317

 
(317
)
 

 

 

Mileage Plan other revenue
291

 
23

 

 

 
314

 

 
314

Cargo and other
127

 
3

 
3

 

 
133

 

 
133

Total operating revenues
5,147

 
802

 
320

 
(317
)
 
5,952

 

 
5,952

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
3,111

 
625

 
323

 
(315
)
 
3,744

 
86

 
3,830

Economic fuel
924

 
120

 

 

 
1,044

 
7

 
1,051

Total operating expenses
4,035

 
745

 
323

 
(315
)
 
4,788

 
93

 
4,881

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
29

 

 

 
(4
)
 
25

 

 
25

Interest expense
(72
)
 

 
(9
)
 
4

 
(77
)
 

 
(77
)
Interest capitalized
12

 

 
1

 

 
13

 

 
13

Other
1

 

 

 

 
1

 

 
1

Total Nonoperating income (expense)
(30
)
 

 
(8
)
 

 
(38
)
 

 
(38
)
Income (loss) before income tax
$
1,082

 
$
57

 
$
(11
)
 
$
(2
)
 
$
1,126

 
$
(93
)
 
$
1,033

(a)
Includes consolidating entries, Air Group parent company, McGee Air Services, and other immaterial business units.
(b)
The Air Group Adjusted column represents the financial information that is reviewed by management to assess performance of operations and determine capital allocations and does not include certain income and charges.
(c)
Includes merger-related costs, mark-to-market fuel-hedge accounting charges, and other special items.
(d)
Certain historical information has been adjusted to reflect the adoption of new accounting standards.


24



Total assets were as follows (in millions):
 
September 30, 2018
 
December 31, 2017
Mainline
$
14,725

 
$
16,663

Horizon
1,037

 
929

Consolidating & Other
(4,869
)
 
(6,846
)
Consolidated
$
10,893

 
$
10,746


ITEM 2. 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 our company, segment operations and the 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 statements 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 "Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2017. This overview summarizes the MD&A, which includes the following sections:
 
Third Quarter Review—highlights from the third quarter of 2018 outlining some of the major events that happened during the period and how they affected our financial performance.
 
Results of Operations—an in-depth analysis of our revenues by segment and our expenses from a consolidated perspective for the three and nine months ended September 30, 2018. To the extent material to the understanding of segment profitability, we more fully describe the segment expenses per financial statement line item. Financial and statistical data is also included here. This section includes forward-looking statements regarding our view of the remainder of 2018

Liquidity and Capital Resources—an overview of our financial position, analysis of cash flows, and relevant contractual obligations and commitments.

THIRD QUARTER REVIEW

Our consolidated pretax income was $284 million during the third quarter of 2018, compared to $417 million in the third quarter of 2017. The decrease in pretax income of $133 million was driven largely by an increase in fuel expense of $145 million and an increase in non-fuel operating expenses of $87 million, partially offset by an increase in operating revenues of $102 million.

See “Results of Operations” below for further discussion of changes in revenues and operating expenses and our reconciliation of non-GAAP measures to the most directly comparable GAAP measure.

Operations Performance

During the third quarter of 2018, our on-time performance was 80.9% for our Mainline operations and 81.2% for our Regional operations. These on-time results are in-line with our historical high standard of running an excellent operation.

New Markets

We launched two new routes and announced three new routes during the third quarter of 2018. Approximately 88% of our growth in 2018 is from additional flight frequency within our core markets and annualization of new markets announced in 2017. The remaining growth is attributable to adding more routes connecting guests along the West Coast to high demand markets in the lower 48 states and Hawaii.


25



Shareholder Return

During the third quarter of 2018, we paid cash dividends of $39 million and repurchased 193,203 shares for $12 million.

Recent Events

On August 10, 2018, one of our Q400 aircraft was taken without authorization by an employee from Sea-Tac International Airport. The aircraft crashed in a remote area south of the airport, resulting in the loss of life of the individual flying the aircraft. There were no other fatalities, and no ground structures were involved at the crash site. The loss of the aircraft is a fully insured event with no deductibles. Air Group's aviation insurance program is secured with a number of highly rated insurers on quota share programs. Presenting a claim to all insurers on the programs commenced only after the aircraft wreckage was released from governmental authorities in late September 2018. Air Group expects to finalize the claim process after the FBI ends its current investigation.

Labor Update

In July 2018, Alaska dispatchers, represented by the Transport Workers Union (TWU), ratified a merger transition agreement. In the third quarter, we also finalized the integrated seniority list for the Alaska pilot group. As a result, all Mainline groups except for aircraft technicians are now under a single contract and have an integrated seniority list.

Outlook

In 2018 and beyond, we are focused on successfully completing the integration of Virgin America. We have completed a number of significant integration milestones to date and continue to make progress on our integration. In January 2018, Alaska and Virgin America received a Single Operating Certificate (SOC) from the FAA, which recognizes Alaska and Virgin America as one airline. In April, we transitioned to a single Passenger Service System (PSS), which allows us to provide one reservation system, one website and one inventory of flights to our guests. Our transition to a single PSS allows us to unlock many of the revenue synergies expected from the acquisition, as well as provide consistent branding to our guests at all airports gates, ticketing, and check-in areas.

Additionally, in June, we received FAA approval for our Airbus emergency procedures. This allowed us to move forward with transition training for flight attendants so they can work on both Boeing and Airbus aircraft, which will begin to occur in early 2019. We also integrated to a single weight and balance system in June. This allowed us to take cargo on Airbus aircraft, which provides an important revenue synergy beginning in the third quarter of 2018 and beyond.

With the completion of our most recent milestones, our integration is now approximately 90 percent complete. One major milestone remaining to complete is our Airbus fleet reconfiguration. Between now and the end of 2019, we will complete painting all of our Airbus aircraft with the Alaska livery and will continue reconfiguring Airbus aircraft to align with the Boeing aircraft to achieve one consistent cabin experience for our guests. We will also be integrating our crew management systems in early 2019.

We continue to make investments to enhance our onboard guest experience. We began our fleet-wide installation of high-speed satellite Wi-Fi, we completed the updates and expansion of our airport lounges in the JFK and Seattle airports, and we continue to make headway in our investment in our Seattle hub airport to open a state-of-the-art 20-gate North Terminal facility. Throughout 2018 we have also introduced new food and beverage menus, which include more fresh, local, and healthy offerings with a distinct West Coast vibe including salads, protein plates, and fresh snacks. All Boeing and Airbus flights introduced new beverage offerings, including craft beers, new juices and, coming later this fall, an updated wine selection.

In April, we entered into an agreement to lease 12 airport slots at LaGuardia Airport (LGA) and eight airport slots at Regan National Airport (DCA) to another carrier. The lease began in October 2018 and continues through 2028. This agreement enables us to monetize these valuable slots, and reallocate flying from Dallas Love Field (DAL) to more strategic and profitable opportunities on the West Coast. We maintain the right to resume flying using these slots, should we choose to do so, in 2028 when the agreement expires, or if perimeter restrictions change.

We have also announced new revenue initiatives that are incremental to merger synergies. This fall, we will introduce a new option for our guests called the "Saver Fare," a low-priced product which we believe will result in incremental annual revenue of approximately $100 million. In addition, we have implemented a series of other revenue initiatives, such as offering exit rows for sale, introducing demand-based pricing for our premium class seats, leveraging new technology to better manage revenue post-sale, and eliminating fee waivers for changes made outside of 60 days. Furthermore, we recently announced an

26



increase in our checked bag fees which is expected to add approximately $50 million of incremental revenue. We believe these changes provide guests with more options and reflect the significant increase in the value of our expanded network and product, as well as unlocking the substantial synergies from the merger.

Currently, we expect to grow our combined network capacity by approximately 5% in 2018 and approximately 2% in 2019. Current schedules indicate competitive capacity will increase by approximately 4% in the fourth quarter of 2018, and approximately 6% in the first quarter of 2019. We believe that our product, our operation, our engaged employees, our award-winning service, and our competitive Mileage Plan™ program, combined with our strong balance sheet and focus on low costs, give us a competitive advantage in our markets.

Our current expectations for capacity and CASM excluding fuel and special items for the fourth quarter and full year 2018 are summarized below:
 
Forecast
Q4 2018
 
Q4 2017
 
% Change
Capacity (ASMs in millions)
16,120 - 16,170
 
15,901
 
~ 1.4%
Cost per ASM excluding fuel and special items (cents)(a)
8.97¢ - 9.01¢
 
8.68¢
 
~ 3.6%
 
Forecast
Full Year 2018
 
Full Year 2017
 
% Change
Capacity (ASMs in millions)
65,375 - 65,425
 
62,072
 
~ 5.3%
Cost per ASM excluding fuel and special items (cents)(a)
8.50¢ - 8.52¢
 
8.25¢
 
~ 3.2%
(a)
2017 CASMex reflects the impacts of the updated accounting standards, effective for the Company January 1, 2018.

RESULTS OF OPERATIONS

ADJUSTED (NON-GAAP) RESULTS AND PER-SHARE AMOUNTS

We believe disclosure of earnings excluding the impact of merger-related costs, mark-to-market gains or losses or other individual special revenues or expenses is useful information to investors because:

By excluding fuel expense and certain special items (including merger-related costs) from our unit metrics, we believe that we have better visibility into the results of operations and our non-fuel cost initiatives. Our industry is highly competitive and is characterized by high fixed costs, so even a small reduction in non-fuel operating costs can lead to 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.

Cost per ASM (CASM) excluding fuel and certain special items, such as merger-related costs, is one of the most important measures used by management and by the Air Group Board of Directors in assessing quarterly and annual cost performance.

Adjusted income before income tax and CASM excluding fuel (and other items as specified in our plan documents) are important metrics for the employee cash incentive plan, which covers the majority of employees within the Air Group organization.

CASM excluding fuel and certain special items is a measure commonly used by industry analysts and we believe it is an important metric by which they compare our airlines to others in the industry. The measure is also the subject of frequent questions from investors.

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 certain items, such as merger-related costs, and mark-to-market hedging adjustments, is important because it provides information on significant items that are not necessarily indicative of future performance. Industry analysts and investors consistently measure our performance without these items for better comparability between periods and among other airlines.


27



Although we disclose our unit revenues, we do not (nor are we able to) evaluate unit revenues excluding the impact that changes in fuel costs have had on ticket prices. Fuel expense represents a large percentage of our total operating expenses. Fluctuations in 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.

Although we are presenting these non-GAAP amounts for the reasons above, investors and other readers should not necessarily conclude that these amounts are non-recurring, infrequent, or unusual in nature.

28



OPERATING STATISTICS SUMMARY (unaudited)
Below are operating statistics we use to measure operating performance. We often refer to unit revenues and adjusted unit costs, which are non-GAAP measures.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
Change
 
2018
 
2017
 
Change
Consolidated Operating Statistics:(a)
 
 
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
12,128
 
11,639
 
4.2%
 
34,685
 
33,038
 
5.0%
RPMs (000,000) "traffic"
14,386
 
13,811
 
4.2%
 
41,272
 
39,072
 
5.6%
ASMs (000,000) "capacity"
16,943
 
16,164
 
4.8%
 
49,256
 
46,169
 
6.7%
Load factor
84.9%
 
85.4%
 
(0.5) pts
 
83.8%
 
84.6%
 
(0.8) pts
Yield(d)
14.20¢
 
14.18¢
 
0.1%
 
13.87¢
 
14.10¢
 
(1.6)%
RASM(d)
13.05¢
 
13.06¢
 
(0.1)%
 
12.59¢
 
12.89¢
 
(2.3)%
CASM excluding fuel and special items(b)(d)
8.15¢
 
8.00¢
 
1.9%
 
8.35¢
 
8.11¢
 
3.0%
Economic fuel cost per gallon(b)
$2.33
 
$1.80
 
29.4%
 
$2.26
 
$1.76
 
28.4%
Fuel gallons (000,000)
218
 
207
 
5.3%
 
631
 
592
 
6.6%
ASMs per fuel gallon
77.7
 
78.1
 
(0.5)%
 
78.1
 
78.0
 
0.1%
Average full-time equivalent employees (FTEs)
21,804
 
20,743
 
5.1%
 
21,575
 
19,723
 
9.4%
Mainline Operating Statistics:
 
 
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
9,435
 
9,136
 
3.3%
 
27,107
 
25,850
 
4.9%
RPMs (000,000) "traffic"
13,096
 
12,694
 
3.2%
 
37,677
 
36,045
 
4.5%
ASMs (000,000) "capacity"
15,343
 
14,796
 
3.7%
 
44,730
 
42,397
 
5.5%
Load factor
85.4%
 
85.8%
 
(0.4) pts
 
84.2%
 
85.0%
 
(0.8) pts
Yield(d)
13.18¢
 
13.23¢
 
(0.4)%
 
12.95¢
 
13.13¢
 
(1.4)%
RASM(d)
12.28¢
 
12.35¢
 
(0.6)%
 
11.90¢
 
12.19¢
 
(2.4)%
CASM excluding fuel and special items(b)(d)
7.34¢
 
7.30¢
 
0.5%
 
7.58¢
 
7.34¢
 
3.3%
Economic fuel cost per gallon(b)
$2.32
 
$1.79
 
29.6%
 
$2.25
 
$1.76
 
27.8%
Fuel gallons (000,000)
189
 
183
 
3.3%
 
549
 
526
 
4.4%
ASMs per fuel gallon
81.2
 
80.9
 
0.4%
 
81.5
 
80.6
 
1.1%
Average FTEs
16,499
 
15,862
 
4.0%
 
16,330
 
15,439
 
5.8%
Aircraft utilization
11.4
 
11.4
 
—%
 
11.4
 
11.1
 
2.7%
Average aircraft stage length
1,291
 
1,300
 
(0.7)%
 
1,293
 
1,296
 
(0.2)%
Operating fleet
231
 
218
 
13 a/c
 
231
 
218
 
13 a/c
Regional Operating Statistics:(c)
 
 
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
2,693
 
2,503
 
7.6%
 
7,578
 
7,188
 
5.4%
RPMs (000,000) "traffic"
1,290
 
1,117
 
15.5%
 
3,595
 
3,027
 
18.8%
ASMs (000,000) "capacity"
1,600
 
1,368
 
17.0%
 
4,526
 
3,772
 
20.0%
Load factor
80.6%
 
81.7%
 
(1.1 pts)
 
79.4%
 
80.2%
 
(0.8 pts)
Yield(d)
24.50¢
 
25.15¢
 
(2.6)%
 
23.49¢
 
25.65¢
 
(8.4)%
RASM(d)
20.41¢
 
20.61¢
 
(1.0)%
 
19.32¢
 
20.67¢
 
(6.5)%
Operating fleet
89
 
83
 
6 a/c
 
89
 
83
 
6 a/c
(a)
Except for FTEs, data includes information related to third-party regional capacity purchase flying arrangements.
(b)
See reconciliation of this non-GAAP measure to the most directly related GAAP measure in the accompanying pages.
(c)
Data presented includes information related to flights operated by Horizon and third-party carriers.
(d)
Certain historical information has been adjusted to reflect the adoption of new accounting standards.


29



COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2018 TO THREE MONTHS ENDED SEPTEMBER 30, 2017

Our consolidated net income for the three months ended September 30, 2018 was $217 million, or $1.75 per diluted share, compared to net income of $259 million, or $2.09 per diluted share, for the three months ended September 30, 2017.

Excluding the impact of merger-related costs and mark-to-market fuel hedge adjustments, our adjusted net income for the third quarter of 2018 was $237 million, or $1.91 per diluted share, compared to an adjusted net income of $270 million, or $2.18 per diluted share, in the third quarter of 2017. Historical information has been adjusted to reflect the adoption of new accounting standards effective for the Company January 1, 2018. The following tables reconcile our adjusted net income and adjusted earnings per diluted share (EPS) to amounts as reported in accordance with GAAP:
 
Three Months Ended September 30,
 
2018
 
2017
(in millions, except per share amounts)
Dollars
 
Diluted EPS
 
Dollars
 
Diluted EPS
GAAP net income and diluted EPS
$
217

 
$
1.75

 
$
259

 
$
2.09

Mark-to-market fuel hedge adjustments
5

 
0.04

 
(5
)
 
(0.04
)
Special items—merger-related costs
22

 
0.18

 
23

 
0.19

Income tax effect of reconciling items above
(7
)
 
(0.06
)
 
(7
)
 
(0.06
)
Non-GAAP adjusted net income and diluted EPS
$
237

 
$
1.91

 
$
270

 
$
2.18


CASM reconciliation is summarized below:
 
Three Months Ended September 30,
(in cents)
2018
 
2017
 
% Change
Consolidated:
 
 
 
 
 
CASM

11.30
¢
 

10.41
¢
 
9
 %
Less the following components:
 
 
 

 
 
Aircraft fuel, including hedging gains and losses
3.02

 
2.27

 
33
 %
Special items—merger-related costs and other
0.13

 
0.14

 
(7
)%
CASM excluding fuel and special items

8.15
¢
 

8.00
¢
 
2
 %
 
 
 
 
 
 
Mainline:
 
 
 
 
 
CASM

10.37
¢
 

9.64
¢
 
8
 %
Less the following components:
 
 
 

 
 
Aircraft fuel, including hedging gains and losses
2.89

 
2.18

 
33
 %
Special items—merger-related costs and other
0.14

 
0.16

 
(13
)%
CASM excluding fuel and special items

7.34
¢
 

7.30
¢
 
1
 %

OPERATING REVENUES

Total operating revenues increased $102 million, or 5%, during the third quarter of 2018 compared to the same period in 2017. The changes are summarized in the following table:
 
Three Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Passenger revenue
$
2,043

 
$
1,958

 
4
%
Mileage Plan other revenue
114

 
105

 
9
%
Cargo and other
55

 
47

 
17
%
Total operating revenues
$
2,212

 
$
2,110

 
5
%


30



Passenger Revenue

On a consolidated basis, Passenger revenue for the third quarter of 2018 increased by $85 million, or 4%, on a 5% increase in capacity, partially offset by a 0.5 pt decrease in load factor. The increase in capacity was driven by our continued network expansion and aircraft added to our fleet since the third quarter of 2017. As discussed above, we are working on a number of revenue initiatives to help improve our revenue performance.

OPERATING EXPENSES

Total operating expenses increased $232 million, or 14%, compared to the third quarter of 2017. We believe it is useful to summarize operating expenses as follows, which is consistent with the way expenses are reported internally and evaluated by management:
 
Three Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Fuel expense
$
513

 
$
368

 
39
 %
Non-fuel operating expenses, excluding special items
1,380

 
1,292

 
7
 %
Special items—merger-related costs
22

 
23

 
(4
)%
Total operating expenses
$
1,915

 
$
1,683

 
14
 %

Fuel Expense

Aircraft fuel expense includes raw fuel expense (as defined below) plus the effect of mark-to-market adjustments to our fuel hedge portfolio as the value of that portfolio increases and decreases. Our aircraft fuel expense can be volatile because it includes these gains or losses in the value of the underlying instrument as crude oil prices and refining margins 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 and fees. 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 and does not reflect the effect of our fuel hedges.

Aircraft fuel expense increased $145 million, or 39%, compared to the third quarter of 2017. The elements of the change are illustrated in the following table: 
 
Three Months Ended September 30,
 
2018
 
2017
(in millions, except for per gallon amounts)
Dollars
 
Cost/Gal
 
Dollars
 
Cost/Gal
Raw or "into-plane" fuel cost
$
520

 
$
2.38

 
$
368

 
$
1.78

(Gains) losses on settled hedges
(12
)
 
(0.05
)
 
5

 
0.02

Consolidated economic fuel expense
508

 
2.33

 
$
373

 
$
1.80

Mark-to-market fuel hedge adjustments
5

 
0.02

 
(5
)
 
(0.02
)
GAAP fuel expense
$
513

 
$
2.35

 
$
368

 
$
1.78

Fuel gallons
218

 
 
 
207

 
 

Raw fuel expense per gallon for the three months ended September 30, 2018 increased by approximately 34% due to higher West Coast jet fuel prices. West Coast jet fuel prices are impacted by both the price of crude oil, and refining margins associated with the conversion of crude oil to jet fuel. The increase in raw fuel price per gallon during the third quarter of 2018 was primarily driven by a 43% increase in crude oil prices and a 6% increase in refining margins, when compared to the prior year. Fuel gallons consumed increased by 11 million gallons, or 5%, in line with the increase in capacity.

We also evaluate economic fuel expense, which we define as raw fuel expense adjusted for the cash we receive from, or pay to, hedge counterparties for hedges that settle during the period, and for the premium expense that we paid for those contracts. A key difference between aircraft fuel expense and economic fuel expense is the timing of gain or loss recognition on our hedge portfolio. When we refer to economic fuel expense, we include gains and losses only when they are realized for those contracts that were settled during the period based on their original contract terms. We believe this is the best measure of the effect that fuel prices are currently having on our business as it most closely approximates the net cash outflow associated with purchasing

31



fuel for our operations. Accordingly, many industry analysts evaluate our results using this measure, and it is the basis for most internal management reporting and incentive pay plans.

Gains recognized for hedges that settled during the third quarter were $12 million in 2018, compared to losses of $5 million in the same period in 2017. These amounts represent cash received from hedges at settlement, offset by cash paid for premium expense.

Non-fuel Expenses

The table below provides the reconciliation of the operating expense line items, excluding fuel and special items. Significant operating expense variances from 2017 are more fully described below.
 
Three Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Wages and benefits
$
549

 
$
477

 
15
 %
Variable incentive pay
27

 
40

 
(33
)%
Aircraft maintenance
107

 
88

 
22
 %
Aircraft rent
82

 
70

 
17
 %
Landing fees and other rentals
135

 
124

 
9
 %
Contracted services
70

 
76

 
(8
)%
Selling expenses
79

 
92

 
(14
)%
Depreciation and amortization
99

 
95

 
4
 %
Food and beverage service
53

 
50

 
6
 %
Third-party regional carrier expense
38

 
30

 
27
 %
Other
141

 
150

 
(6
)%
Total non-fuel operating expenses, excluding special items
$
1,380

 
$
1,292

 
7
 %

Wages and Benefits

Wages and benefits increased during the third quarter of 2018 by $72 million, or 15%. The primary components of Wages and benefits are shown in the following table:
 
Three Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Wages
$
412

 
$
359

 
15
%
Pension—Defined benefit plans service cost
12

 
10

 
20
%
Defined contribution plans
30

 
25

 
20
%
Medical and other benefits
65

 
58

 
12
%
Payroll taxes
30

 
25

 
20
%
Total wages and benefits
$
549

 
$
477

 
15
%

Wages increased 15% on a 5% increase in FTEs. The increase in FTEs is primarily attributable to the growth in McGee Air Services, which has assumed certain airport group service functions that were previously provided by third-party vendors and reflected in Contracted Services expense. To a lesser extent, we have experienced FTE growth in other areas as the business has grown. Additionally, the increase in wages is driven by increased wage rates in many work groups, including on average a 24% increase for our Mainline pilots and a 10% increase for our Mainline flight attendants, whose new contract rates became effective in the fourth quarter of 2017 and first quarter of 2018, respectively.

Variable Incentive Pay

Variable incentive pay expense decreased by $13 million, or 33%, during the third quarter of 2018 compared to the same period in 2017. This decrease was primarily due to adjustments taken in the third quarter of 2018 to revise our estimate of full year performance-based pay based on our tracking in relation to the current year's goals.


32



Aircraft Maintenance

Aircraft maintenance expense increased by $19 million, or 22%, during the third quarter of 2018 compared to the same period in 2017. Maintenance costs increased primarily due to a power-by-the-hour engine maintenance arrangement on our B737-800 aircraft which was entered into, and became effective, in the fourth quarter of 2017. Although the agreement results in increased expense earlier in the engine life cycle of B737-800 aircraft, it allows for much more predictable expense patterns over the fleet life. The remaining increase was due to a higher volume of scheduled airframe maintenance events as compared to the prior period.

Aircraft Rent

Aircraft rent expense increased by $12 million, or 17%, during the third quarter of 2018 compared to the same period in 2017, primarily due to the addition of six A321neos to our Mainline fleet and 11 E175s to our regional fleet since September 30, 2017, partially offset by the return of two Q400 aircraft.

Landing Fees and Other Rentals

Landing fees and other rental expenses increased by $11 million, or 9%, during the third quarter of 2018 compared to the same period in 2017. This increase was primarily driven by our 5% increase in capacity and rate increases at many of our hub airports.

Selling Expenses

Selling expenses decreased $13 million, or 14%, during the third quarter of 2018 compared to the same period in 2017. This decrease was primarily due to lower credit card commissions and decreased promotional and advertising activities, notably those related to Virgin America.

ADDITIONAL SEGMENT INFORMATION

Refer to Note 9 of the consolidated financial statements for a detailed description of each segment. Below is a summary of each segment's profitability.

Mainline

Mainline recorded pretax profit of $314 million in the third quarter of 2018, compared to $405 million in the third quarter of 2017. The $91 million decrease in pretax profit was primarily driven by a $110 million increase in economic fuel cost and a $45 million increase in non-fuel operating expenses, partially offset by a $50 million increase in passenger revenues and a $7 million increase in Mileage Plan™ other revenue.

The increase in Mainline passenger revenue for the third quarter of 2018 was primarily driven by capacity growth, partially offset by lower average fares.

Higher raw fuel prices and an increase in gallons consumed to support additional flying drove the increase in Mainline fuel expense. Non-fuel operating expenses increased due to higher wages to support our growth, and higher operating expenses as described above.

Regional

Our Regional operations incurred a pretax loss of $13 million in the third quarter of 2018, compared to a pretax profit of $25 million in the third quarter of 2017. The pretax loss was attributable to a $25 million increase in fuel costs and a $48 million increase in non-fuel operating expenses, partially offset by a $37 million increase in operating revenues.


33



Regional passenger revenue increased 12% compared to the third quarter of 2017, primarily driven by a 17% increase in capacity, partially offset by 3% lower ticket yields and a decrease in load factor of 1.1 pts. The increase in capacity is due to an increase in departures from new E175 deliveries, an increase in average aircraft stage length, and the annualization of new routes introduced over the past 12 months. Lower yields are a result of competitive pricing pressure we are experiencing, specifically on the West Coast.

The increase in non-fuel operating expenses is primarily due to higher ownership costs associated with 11 E175 aircraft operated by SkyWest that were added to the regional fleet over the past twelve months, as well as higher CPA rates on a 17% increase in capacity.

Horizon

Horizon achieved a pretax profit of $7 million in the third quarter of 2018, compared to a pretax profit of $5 million in the third quarter of 2017. The change was primarily driven by a $17 million increase in operating revenue, attributable to the additional 6 E175 aircraft added to Horizon's fleet since the third quarter of 2017 and better operating performance in 2018.

COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2018 TO NINE MONTHS ENDED SEPTEMBER 30, 2017

Our consolidated net income for the nine months ended September 30, 2018 was $414 million, or $3.34 per diluted share, compared to net income of $645 million, or $5.19 per diluted share, for the nine months ended September 30, 2017.

Excluding the impact of merger-related costs, mark-to-market fuel hedge adjustments, and a special employee tax reform bonus in connection with the passing of the Tax Cuts and Jobs Act (TCJA), our adjusted net income for the nine months ended September 30, 2018 was $461 million, or $3.72 per diluted share, compared to an adjusted net income of $703 million, or $5.66 per diluted share, in the nine months ended September 30, 2017. Historical information has been adjusted to reflect the adoption of new accounting standards effective for the Company as of January 1, 2018. The following tables reconcile our adjusted net income and adjusted earnings per diluted share (EPS) to amounts as reported in accordance with GAAP:
 
Nine Months Ended September 30,
 
2018
 
2017
(in millions, except per share amounts)
Dollars
 
Diluted EPS
 
Dollars
 
Diluted EPS
Reported GAAP net income and diluted EPS
$
414

 
$
3.34

 
$
645

 
$
5.19

Mark-to-market fuel hedge adjustments
(30
)
 
(0.24
)
 
7

 
0.06

Special items—employee tax reform bonus
25

 
0.20

 

 

Special items—merger-related costs
67

 
0.54

 
86

 
0.69

Income tax effect on special items and fuel hedge adjustments
(15
)
 
(0.12
)
 
(35
)
 
(0.28
)
Non-GAAP adjusted net income and diluted EPS
$
461

 
$
3.72

 
$
703

 
$
5.66



34



Our operating costs per ASM are summarized below:
 
Nine Months Ended September 30,
(in cents)
2018
 
2017
 
% Change
Consolidated:
 
 
 
 
 
CASM

11.38
¢
 

10.57
¢
 
8
%
Less the following components:
 
 
 
 
 
Aircraft fuel, including hedging gains and losses
2.84

 
2.27

 
25
%
Special items—merger-related costs
0.19

 
0.19

 
%
CASM excluding fuel and special items

8.35
¢
 

8.11
¢
 
3
%
 
 
 
 
 
 
Mainline:
 
 
 
 
 
CASM

10.49
¢
 

9.74
¢
 
8
%
Less the following components:
 
 
 
 
 
Aircraft fuel, including hedging gains and losses
2.70

 
2.20

 
23
%
Special items—merger-related costs
0.21

 
0.20

 
5
%
CASM excluding fuel and special items

7.58
¢
 

7.34
¢
 
3
%

OPERATING REVENUES

Total operating revenues increased $248 million, or 4%, during the first nine months of 2018 compared to the same period in 2017. The changes are summarized in the following table:
 
Nine Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Passenger revenue
$
5,725

 
$
5,505

 
4
%
Mileage Plan other revenue
329

 
314

 
5
%
Cargo and other
146

 
133

 
10
%
Total operating revenues
$
6,200

 
$
5,952

 
4
%

Passenger Revenue

On a consolidated basis, Passenger revenue for the first nine months of 2018 increased by $220 million, or 4%, on a 7% increase in capacity, partially offset by 1.6% lower ticket yields and a 0.8 pt decrease in load factor. The increase in capacity was driven by our continued network expansion and aircraft added to our fleet since September 30, 2017. Lower yields are a result of competitive pricing pressure we are experiencing, specifically on the West Coast, while lower load factor is a result of significant capacity growth in our markets by us and our competitors. We began executing on a number of initiatives to help improve our revenue performance, including changing our bag fees, reconfiguring our Airbus cabins, and we will be introducing our "Saver Fare" in the fourth quarter of 2018.

Cargo and Other Revenue

On a consolidated basis, Cargo and other revenue increased $13 million, or 10%, in the first nine months of 2018 compared to the first nine months of 2017. The increase is primarily attributable to increased freight and mail capacity from our three freighters and utilizing our Airbus fleet to transport cargo. The remainder of the increase was due to increased lounge revenue as a result of our new lounges at JFK and SeaTac Airport.

35



OPERATING EXPENSES

Total operating expenses increased $722 million, or 15%, compared to the first nine months of 2017. We believe it is useful to summarize operating expenses as follows, which is consistent with the way expenses are reported internally and evaluated by management:
 
Nine Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Fuel expense
$
1,397

 
$
1,051

 
33
 %
Non-fuel operating expenses, excluding special items
4,114

 
3,744

 
10
 %
Special items—merger-related costs
67

 
86

 
(22
)%
Special items—employee tax reform bonus
25

 

 
NM

Total operating expenses
$
5,603

 
$
4,881

 
15
 %

Fuel Expense

Aircraft fuel expense increased $346 million, or 33%, compared to the nine months ended September 30, 2017. The elements of the change are illustrated in the following table: 
 
Nine Months Ended September 30,
 
2018
 
2017
(in millions, except for per gallon amounts)
Dollars
 
Cost/Gal
 
Dollars
 
Cost/Gal
Raw or "into-plane" fuel cost
$
1,450

 
$
2.30

 
$
1,030

 
$
1.74

(Gains) losses on settled hedges
(23
)
 
(0.04
)
 
14

 
0.02

Consolidated economic fuel expense
1,427

 
2.26

 
$
1,044

 
$
1.76

Mark-to-market fuel hedge adjustments
(30
)
 
(0.05
)
 
7

 
0.01

GAAP fuel expense
$
1,397

 
$
2.21

 
$
1,051

 
$
1.77

Fuel gallons
631

 
 
 
592

 
 

The raw fuel price per gallon increased 32% due to higher West Coast jet fuel prices. West Coast jet fuel prices are impacted by both the price of crude oil, as well as refining margins associated with the conversion of crude oil to jet fuel. The increase in raw fuel price per gallon during the first nine months of 2018 was driven by a 35% increase in crude oil prices and a 30% increase in refining margins.

Gains recognized for hedges that settled in the first nine months of 2018 were $23 million, compared to losses of $14 million in the same period in 2017. These amounts represent cash received from settled hedges, offset by cash paid for premium expense.

We currently expect our economic fuel price per gallon to be approximately 18.5% higher in the fourth quarter of 2018 compared to the fourth quarter of 2017 due to our current estimate of higher crude prices and higher refining margins.


36



Non-fuel Expense and Non- special items
 
Nine Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Wages and benefits
$
1,629

 
$
1,397

 
17
 %
Variable incentive pay
104

 
98

 
6
 %
Aircraft maintenance
320

 
271

 
18
 %
Aircraft rent
233

 
204

 
14
 %
Landing fees and other rentals
371

 
338

 
10
 %
Contracted services
227

 
234

 
(3
)%
Selling expenses
245

 
277

 
(12
)%
Depreciation and amortization
290

 
275

 
5
 %
Food and beverage service
158

 
145

 
9
 %
Third-party regional carrier expense
114

 
84

 
36
 %
Other
423

 
421

 
 %
Total non-fuel operating expenses, excluding special items
$
4,114

 
$
3,744

 
10
 %

Wages and Benefits

Wages and benefits increased during the first nine months of 2018 by $232 million, or 17%, compared to 2017. The primary components of wages and benefits are shown in the following table:
 
Nine Months Ended September 30,
(in millions)
2018
 
2017
 
% Change
Wages
$
1,230

 
$
1,055

 
17
%
Pension—Defined benefit plans service cost
36

 
30

 
20
%
Defined contribution plans
88

 
73

 
21
%
Medical and other benefits
186

 
162

 
15
%
Payroll taxes
89

 
77

 
16
%
Total wages and benefits
$
1,629

 
$
1,397

 
17
%

Wages increased $175 million, or 17%, on a 9% increase in FTEs. The increase in FTEs is primarily attributable to the growth in McGee Air Services, which has assumed certain airport ground service functions that were previously provided by third-party vendors and reflected in Contracted services expense. Additionally, the increase in wages is driven by higher wage rates for many work groups, including on average a 24% increase for our Mainline pilots and a 10% increase for our Mainline flight attendants whose new contract rates became effective in the fourth quarter of 2017 and the first quarter of 2018, respectively.

Costs associated with our defined contribution plans increased $15 million, or 21%, due to FTE growth, increased participation throughout all labor groups, and higher contribution rates for Mainline pilots and flight attendants as a result of new contract rates effective in the fourth quarter of 2017 and the first quarter of 2018, respectively.

Medical and other benefits expense increased $24 million, or 15%, primarily due to FTE growth and rising medical costs.

For the full year, we expect wages and benefits to increase at a rate greater than capacity growth, due to higher wage rates for certain labor groups and the continued growth of McGee Air Services.

Aircraft Maintenance

Aircraft maintenance expense increased by $49 million, or 18%, during the first nine months of 2018 compared to the same period in 2017. Maintenance costs increased primarily due to a power-by-the-hour engine maintenance arrangement on our B737-800 aircraft that we entered into, and became effective, in the fourth quarter of 2017, as well as a higher volume of scheduled maintenance events as compared to the prior period.


37



For the full year, we expect aircraft maintenance expense to be approximately 9-10% higher than in 2017 for the same reasons mentioned above.

Aircraft Rent

Aircraft rent expense increased by $29 million, or 14%, during the first nine months of 2018 compared to the same period in 2017. Aircraft rent increased primarily due to the addition of six A321neos to our mainline fleet and 11 E175s to our regional fleet since September 30, 2017, partially offset by the return of six Q400 aircraft.

For the full year, we expect aircraft rent to be approximately 15-16% higher than in 2017 due to leased A321neo and E175 aircraft added to our fleet in 2018.

Landing Fees and Other Rentals

Landing fees and other rental expenses increased by $33 million, or 10%, during the first nine months of 2018 compared to the same period in 2017. This increase was primarily driven by our capacity increase of 7% and rate increases at airports across our network.

For the full year, we expect landing fees and other rental expense to be approximately 9-10% higher than in 2017 due to the same reasons noted above.

Selling Expenses

Selling expenses decreased $32 million, or 12%, during the first nine months of 2018 compared to the same period in 2017. This decrease was primarily due to decreased commission costs from other airlines for transporting their frequent flyer members, lower credit card commissions, and decreased promotional and advertising activities, notably those related to Virgin America.

For the full year, we expect selling expenses to be approximately 8-9% lower than in 2017 for the reasons mentioned above.

Third-Party Regional Carrier Expense

Third-party regional carrier expense, which represents payments made to SkyWest and PenAir under our CPAs, increased $30 million, or 36%, during the first nine months of 2018 compared to the same period in 2017. The increase is primarily due to the additional 11 E175 aircraft operated by SkyWest in the current year.

For the full year, we expect third-party regional carrier expense to be higher than in 2017 due to increased flying by our regional partners.
 
Special Items—Merger-Related Costs

We recorded special items of $67 million for merger-related costs associated with our acquisition of Virgin America in the first nine months of 2018, compared to $86 million in the first nine months of 2017. Costs incurred in the first nine months of 2018 consisted primarily of severance and retention costs, IT integration costs, and the write off of Virgin America related assets connected with our transition to a single PSS in April. We expect to incur merger-related costs for the remainder of 2018, and continuing through 2019.

ADDITIONAL SEGMENT INFORMATION

Refer to Note 9 of the condensed consolidated financial statements for a detailed description of each segment. Below is a summary of each segment's profitability.

Mainline

Mainline adjusted pretax profit was $671 million in the first nine months of 2018, compared to $1.08 billion in the same period in 2017. The $411 million decrease in pretax profit was primarily driven by a $281 million increase in Mainline non-fuel operating expenses and a $313 million increase in Mainline fuel expense. These increases were partially offset by a $175 million increase in Mainline operating revenue.


38



Non-fuel operating expenses increased on higher wages related to new contract wage rates for pilots and flight attendants, and higher other operating expense categories as described above. Higher raw fuel prices and an increase in gallons consumed drove an increase in Mainline fuel expense. Mainline revenue increased primarily due to increased revenue passengers on lower average fares.

Regional

Our Regional operations incurred a pretax loss of $82 million in the first nine months of 2018, compared to a pretax profit of $57 million in the first nine months of 2017. The pretax loss was attributable to a $70 million increase in fuel costs and a $130 million increase in non-fuel operating expenses, partially offset by a $72 million increase in operating revenues. The increase in non-fuel operating expenses is primarily due to higher ownership costs associated with 11 E175 aircraft operated by SkyWest that were added to the regional fleet over the past twelve months, as well as higher CPA rates on a 20% increase in capacity.

Horizon

Horizon achieved a pretax profit of $20 million in the first nine months of 2018, compared to pretax loss of $11 million in the same period in 2017. The change was primarily driven by a $59 million increase in operating revenue, attributable to the addition of six E175 aircraft added to Horizon's fleet over the past twelve months, a $17 million decrease in aircraft maintenance expense due to a lower volume of scheduled maintenance events as compared to the prior period, and a significantly improved operation in 2018 compared to 2017.

LIQUIDITY AND CAPITAL RESOURCES
 
Our primary sources of liquidity are:
 
Our existing cash and marketable securities balance of $1.4 billion, and our expected cash from operations;

Our 98 unencumbered aircraft that could be financed, if necessary;

Our combined bank line-of-credit facilities, with no outstanding borrowings, of $400 million. Information about these facilities can be found in Note 5 to the condensed consolidated financial statements.

During the nine months ended September 30, 2018, we took free and clear delivery of six B737-900ER aircraft and six E175 aircraft. We made debt payments totaling $544 million, including the prepayment of $231 million of debt, and paid dividends totaling $118 million.


39



The table below presents the major indicators of financial condition and liquidity: 
(in millions)
September 30, 2018
 
December 31, 2017
 
Change
Cash and marketable securities
$
1,397

 
$
1,621

 
(14) %
Cash, marketable securities, and unused lines of credit as a percentage of trailing twelve months' revenue
22
%
 
26
%
 
(4) pts
Long-term debt, net of current portion
$
1,684

 
$
2,262

 
(26)%
Shareholders’ equity
$
3,791

 
$
3,460

 
10%
Debt-to-capitalization, adjusted for aircraft operating leases
 
 
 
 
 
(in millions)
September 30, 2018
 
December 31, 2017
 
Change
Long-term debt
$
1,684

 
$
2,262

 
(26)%
Capitalization of aircraft operating leases(a)
1,887

 
1,671

 
13%
Adjusted debt
$
3,571

 
$
3,933

 
(9)%
Shareholders' equity
3,791

 
3,460

 
10%
Total Capital
$
7,362

 
$
7,393

 
—%
 
 
 
 
 
 
Debt-to-capitalization, adjusted for aircraft operating leases
49
%
 
53
%
 
(4) pts
(a)
Calculated using the present value of remaining aircraft lease payments for aircraft in our operating fleet as of the balance sheet date.

The following discussion summarizes the primary drivers of the increase in our cash and marketable securities balance and our expectation of future cash requirements.

ANALYSIS OF OUR CASH FLOWS
 
Cash Provided by Operating Activities
 
For the first nine months of 2018, net cash provided by operating activities was $986 million, compared to $1.4 billion during the same period in 2017. The $371 million decrease in our operating cash flows is primarily attributable to a decrease in net income, driven by rising fuel prices, higher non-fuel operating costs, significant new market development, and continuing competitive pressures. Cash collected for future travel is down relative to the prior year primarily as a result of lower yields driven by competitive pricing pressure on the West Coast.

We typically generate positive cash flows from operations and expect to use that cash flow to purchase aircraft and capital equipment, make scheduled debt payments, and return capital to shareholders.
 
Cash Used in Investing Activities
 
Cash used in investing activities was $333 million during the first nine months of 2018, compared to $1.1 billion during the same period of 2017. Our capital expenditures were $554 million in the first nine months of 2018, a decrease of $287 million compared to the nine months ended September 30, 2017. This is primarily driven by fewer aircraft deliveries as compared to the same period of 2017. Our net sales of marketable securities were 185 million in the first nine months of 2018, compared to net purchases of 339 million in the nine months ended September 30, 2017. The shift to net sales is primarily due to funds being utilized to prepay certain debt. Internally, we analyze and manage our cash and marketable securities balance in the aggregate.


40



The table below reflects our full-year expectation for capital expenditures based on our current intentions. It does not reflect our actual contractual obligations at this time, nor does it reflect the capital expenditures that would be incurred if we exercised options or cancellable purchase commitments that are available to us. We have options to acquire 37 B737 aircraft with deliveries from 2021 through 2024, and options to acquire 30 E175 aircraft with deliveries in 2021 to 2023. Options will be exercised only if we believe return on invested capital targets can be met. The table below excludes any associated capitalized interest.
(in millions)
2018
 
2019
 
2020
Targeted capital expenditures
$
1,000

 
$
750

 
$
750


Cash Used in Financing Activities
 
Cash used in financing activities was $666 million during the first nine months of 2018 compared to $399 million during the same period in 2017. During the first nine months of 2018 we made debt payments of $544 million, including the prepayment of $231 million of debt, dividend payments totaling $118 million, and had $37 million in common stock repurchases.

CONTRACTUAL OBLIGATIONS AND COMMITMENTS
 
Aircraft Commitments
 
As of September 30, 2018, we have firm orders to purchase or lease 60 aircraft. We also have cancelable purchase commitments for 30 Airbus A320neo with deliveries from 2022 through 2024. We could incur a loss of pre-delivery payments and credits as a cancellation fee. We also have options to acquire 37 B737 aircraft with deliveries from 2021 through 2024 and 30 E175 aircraft with deliveries from 2021 through 2023. In addition to the 32 E175 aircraft currently operated by SkyWest in our regional fleet, we have options in future periods to add regional capacity by having SkyWest operate up to eight more E175 aircraft.

The following table summarizes expected fleet activity by year as of September 30, 2018:
 
Actual Fleet
 
Expected Fleet Activity(a)
Aircraft
September 30, 2018
 
2018 Additions
 
2018 Removals
 
December 31, 2018
 
2019 Changes
 
December 31, 2019
B737 Freighters
3

 

 

 
3

 

 
3

B737 Passenger Aircraft(c)
157

 
2

 

 
159

 
7

 
166

Airbus Passenger Aircraft
71

 

 

 
71

 
1

 
72

Total Mainline Fleet
231

 
2

 

 
233

 
8

 
241

Q400 operated by Horizon(b)
41

 

 
(4
)
 
37

 
(7
)
 
30

E175 operated by Horizon(b)
16

 
10

 

 
26

 
4

 
30

E175 operated by third party(b)
32

 

 

 
32

 

 
32

Total Regional Fleet
89

 
10

 
(4
)
 
95

 
(3
)
 
92

Total
320

 
12

 
(4
)
 
328

 
5

 
333

(a)
The expected fleet counts at December 31, 2018 and 2019 are subject to change. 
(b)
Aircraft are either owned or leased by Horizon or operated under capacity purchase agreement with a third party.
(c)
Aircraft deliveries reflect the supplemental agreement entered with Boeing in the first quarter of 2018 which deferred certain B737 deliveries. Our first MAX9 delivery is scheduled for 2019.

For future firm orders and option exercises, we may finance the aircraft through cash flow from operations, long-term debt, or lease arrangements.


41



Fuel Hedge Positions

All of our future oil positions are call options, which are designed to effectively cap the cost of the crude oil component of our jet fuel purchases. With call options, we are hedged against volatile crude oil price increases. During a period of decline in crude oil prices, we only forfeit cash previously paid for hedge premiums. Our crude oil positions are as follows:
 
Approximate % of Expected Fuel Requirements
 
Weighted-Average Crude Oil Price per Barrel
 
Average Premium Cost per Barrel
Remainder 2018
51
%
 
$
68

 
$
1

First Quarter 2019
50
%
 
72

 
1

Second Quarter 2019
40
%
 
73

 
2

Third Quarter 2019
30
%
 
75

 
2

Fourth Quarter 2019
20
%
 
77

 
2

Full Year 2019
35
%
 
$
74

 
$
2

First Quarter 2020
10
%
 
76

 
3

Full Year 2020
2
%
 
$
76

 
$
3


Contractual Obligations
 
The following table provides a summary of our obligations as of September 30, 2018. For agreements with variable terms, amounts included reflect our minimum obligations.
(in millions)
Remainder of 2018
 
2019
 
2020
 
2021
 
2022
 
Beyond 2022
 
Total
Current and long-term debt obligations
$
123

 
$
267

 
$
381

 
$
363

 
$
179

 
$
725

 
$
2,038

Operating lease commitments (a)
106

 
413

 
380

 
332

 
300

 
1,219

 
2,750

Aircraft maintenance deposits (b)
16

 
65

 
68

 
64

 
52

 
38

 
303

Aircraft commitments (c)
378

 
514

 
525

 
558

 
302

 
140

 
2,417

Interest obligations (d)
16

 
73

 
63

 
46

 
33

 
69

 
300

Other obligations
35

 
145

 
152

 
173

 
181

 
1,225

 
1,911

Total
$
674

 
$
1,477

 
$
1,569

 
$
1,536

 
$
1,047

 
$
3,416

 
$
9,719

(a)
Operating lease commitments generally include aircraft operating leases, airport property and hangar leases, office space, and other equipment leases. Included here are E175 aircraft operated by SkyWest under a capacity purchase agreement.
(b)
Aircraft maintenance deposits relate to leased Airbus aircraft.
(c)
Represents non-cancelable contractual payment commitments for aircraft and engines, buyer furnished equipment, and aircraft maintenance and parts management.
(d)
For variable-rate debt, future obligations are shown above using forecasted interest rates as of September 30, 2018.

Credit Card Agreements
 
We have agreements with a number of credit card companies to process the sale of tickets and other services. Under these agreements, there are material adverse change clauses that, if triggered, could result in the credit card companies holding back a reserve from our credit card receivables. Under one such agreement, we could be required to maintain a reserve if our credit rating is downgraded to or below a rating specified by the agreement or our cash and marketable securities balance fell below $500 million. Under another such agreement, we could be required to maintain a reserve if our cash and marketable securities balance fell below $500 million. We are not currently required to maintain any reserve under these agreements, but if we were, our financial position and liquidity could be materially harmed.

Deferred Income Taxes

For federal income tax purposes, the majority of our assets are fully depreciated over a seven-year life using an accelerated depreciation method or bonus depreciation, if available. For financial reporting purposes, the majority of our assets are depreciated over 15 to 25 years to an estimated salvage value using the straight-line basis. This difference has created a significant deferred tax liability. At some point in the future the depreciation basis will reverse, potentially resulting in an increase in income taxes paid.

42




While it is possible that we could have material cash obligations for this deferred liability at some point in the future, we cannot estimate the timing of long-term cash flows with reasonable accuracy. Taxable income and cash taxes payable in the short-term are impacted by many items, including the amount of book income generated (which can be volatile depending on revenue and fuel prices), usage of net operating losses, whether "bonus depreciation" provisions are available, any future tax reform efforts at the federal level, as well as other legislative changes that are beyond our control. We believe that we will have the liquidity available to make our future tax payments.

CRITICAL ACCOUNTING ESTIMATES

With the exception of the items noted below, there have been no material changes to our critical accounting estimates for the nine months ended September 30, 2018. For information on our critical accounting estimates, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the year ended December 31, 2017.

Frequent Flyer Programs

Alaska's Mileage PlanTM loyalty program awards mileage credits to members who fly on our airlines and our airline partners, referred to as flown miles. We also sell services, including miles for transportation, Companion FareTM certificates, bag fee waivers, and access to our brand and customer lists to a major bank that offers Alaska affinity credit cards. To a lesser extent, miles for transportation are also sold to other non-airline partners, such as hotels and car rental agencies. The outstanding miles may be redeemed for travel on our airlines or any of our airline partners. As long as Mileage PlanTM is in existence, we have an obligation to provide this future travel.

Mileage credits and the various other services we sell under our loyalty program represent performance obligations that are part of a multiple deliverable revenue arrangement. Accounting guidance requires that we use a relative standalone selling price allocation to allocate consideration received to the material performance obligations in these contracts. Our relative standalone selling price allocation models are refreshed when contracts originate or are materially modified.

At September 30, 2018 we had approximately 236 billion miles outstanding, resulting in an aggregate deferred revenue balance of $1.8 billion. The deferred revenue resulting from our relative selling price allocations requires significant management judgment. There are uncertainties inherent in these estimates. Therefore, different assumptions could affect the amount and/or timing of revenue recognition. The most significant assumptions are described below.

1.
The rate at which we defer sales proceeds related to services sold:

We estimate the standalone selling price for each performance obligation, including mileage credits, by considering multiple inputs and methods, including but not limited to, the estimated selling price of comparable travel, discounted cash flows, brand value published selling prices, number of miles awarded and the number of miles redeemed. We estimate the selling prices and volumes over the terms of the agreements in order to determine the allocation of proceeds to each of the multiple deliverables.

2.
The number of miles that will not be redeemed for travel (breakage):

We estimate how many miles will be used per award. For example, our members may redeem mileage credits for award travel to various locations or choose between a highly restricted award and an unrestricted award. Our estimates are based on the current requirements in our Mileage PlanTM program and historical award redemption patterns.

We regularly review significant Mileage PlanTM assumptions and change our assumptions if facts and circumstances indicate that a change is necessary. Any such change in assumptions could have a significant effect on our financial position and results of operations.

GLOSSARY OF AIRLINE TERMS

Aircraft Utilization - block hours per day; this represents the average number of hours per day our aircraft are in transit

Aircraft Stage Length - represents the average miles flown per aircraft departure


43



ASMs - available seat miles, or “capacity”; represents total seats available across the fleet multiplied by the number of miles flown

CASM - operating costs per ASM, or "unit cost"; represents all operating expenses including fuel and special items

CASMex - operating costs excluding fuel and special items per ASM; this metric is used to help track progress toward reduction of non-fuel operating costs since fuel is largely out of our control

Debt-to-capitalization ratio - represents adjusted debt (long-term debt plus the present value of future operating lease payments) divided by total equity plus adjusted debt

Diluted Earnings per Share - represents earnings per share (EPS) using fully diluted shares outstanding

Diluted Shares - represents the total number of shares that would be outstanding if all possible sources of conversion, such as stock options, were exercised

Economic Fuel - best estimate of the cash cost of fuel, net of the impact of settled fuel-hedging contracts in the period

Free Cash Flow - total operating cash flow generated less cash paid for capital expenditures

Load Factor - RPMs as a percentage of ASMs; represents the number of available seats that were filled with paying passengers

Mainline - represents flying Boeing 737 and Airbus 320 family jets and all associated revenues and costs

Productivity - number of revenue passengers per full-time equivalent employee

RASM - operating revenue per ASMs, or "unit revenue"; operating revenue includes all passenger revenue, freight & mail, Mileage Plan™ and other ancillary revenue; represents the average total revenue for flying one seat one mile

Regional - represents capacity purchased by Alaska from Horizon, SkyWest and PenAir. In this segment, Regional records actual on-board passenger revenue, less costs such as fuel, distribution costs, and payments made to Horizon, SkyWest and PenAir under the respective capacity purchase arrangement (CPAs). Additionally, Regional includes an allocation of corporate overhead such as IT, finance, other administrative costs incurred by Alaska and on behalf of Horizon.

RPMs - revenue passenger miles, or "traffic"; represents the number of seats that were filled with paying passengers; one passenger traveling one mile is one RPM

Yield - passenger revenue per RPM; represents the average revenue for flying one passenger one mile

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
There have been no material changes in market risk from the information provided in Item 7A. “Quantitative and Qualitative Disclosure About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2017.
 

44



ITEM 4. CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures

As of September 30, 2018, an evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer (collectively, our “certifying officers”), of the effectiveness of the design and operation of our disclosure controls and procedures. These disclosure controls and procedures are designed to ensure that the information required to be disclosed by us in our periodic reports filed with or submitted to the Securities and Exchange Commission (the SEC) is recorded, processed, summarized and reported within the time periods specified by the SEC's rules and forms, and includes, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to our management, including our certifying officers, as appropriate, to allow timely decisions regarding required disclosure. Our certifying officers concluded, based on their evaluation, that disclosure controls and procedures were effective as of September 30, 2018.
 
Changes in Internal Control over Financial Reporting
 
There have been no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2018, that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Our internal control over financial reporting is based on the 2013 framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO Framework).

45



PART II

ITEM 1. LEGAL PROCEEDINGS
 
We are a party to routine litigation matters incidental to our business. Management believes the ultimate disposition of these matters is not likely to materially affect our 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.

In 2015, three flight attendants filed a class action lawsuit seeking to represent all Virgin America flight attendants for damages based on alleged violations of California and City of San Francisco wage and hour laws. Two thousand flight attendants were certified as a class in November 2016. The Company believes the claims in this case are without factual and legal merit.

In July 2018, the Court granted in part Plaintiffs' motion for summary judgment, finding Virgin America responsible for various damages and penalties sought by the class members. Plaintiffs value these damages and penalties at $85 million, and as of November 1, 2018, moved the Court to enter judgment against Virgin America in that amount. Plaintiffs do not seek monetary or behavioral relief from Alaska Airlines.

The Court will render its final judgment in March 2019. The Company will then seek an appellate court ruling that the California laws on which the judgment is based are invalid as applied to national airlines pursuant to the U.S. Constitution and federal law. The Company remains confident that a higher court will respect the federal preemption principles that were enacted to shield inter-state common carriers from a patchwork of state and local wage and hour regulations such as those at issue in this case.

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors affecting our business, financial condition or future results from those set forth in Item 1A."Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

This table provides certain information with respect to our purchases of shares of our common stock during the third quarter of 2018.
 
Total Number of
Shares Purchased
 
Average Price
Paid per Share
 
Maximum remaining
dollar value of shares
that can be purchased
under the plan
(in millions)
July 1, 2018 - July 31, 2018
67,915

 
$
61.83

 
 
August 1, 2018 - August 31, 2018
69,777

 
64.51

 
 
September 1, 2018 - September 30, 2018
55,511

 
68.44

 
 
Total
193,203

 
$
64.70

 
$
574


The shares were purchased pursuant to a $1 billion repurchase plan authorized by the Board of Directors in August 2015.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

None.

46




ITEM 5. OTHER INFORMATION
 
None.

ITEM 6. EXHIBITS
 
The following documents are filed as part of this report:

1.
Exhibits: See Exhibit Index.

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

ALASKA AIR GROUP, INC.
 
 
 
/s/ CHRISTOPHER M. BERRY
 
Christopher M. Berry
 
Vice President Finance and Controller
 
 
 
November 2, 2018
 
 

47



EXHIBIT INDEX
Exhibit
Number
Exhibit
Description
Form
Date of First Filing
Exhibit Number
3.1
10-Q
August 3, 2017
3.1
10.1*
10-K
February 15, 2018
10.25
10.2*
10-K
February 15, 2018
10.26
31.1†
10-Q
 
 
31.2†
10-Q
 
 
32.1†
10-Q
 
 
32.2†
10-Q
 
 
101.INS†
XBRL Instance Document
 
 
 
101.SCH†
XBRL Taxonomy Extension Schema Document
 
 
 
101.CAL†
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
101.DEF†
XBRL Taxonomy Extension Definition Linkbase Document
 
 
 
101.LAB†
XBRL Taxonomy Extension Label Linkbase Document
 
 
 
101.PRE†
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 
 
 
 
 
 
Filed herewith
*
Indicates management contract or compensatory plan arrangement


48