ITEM 1. OUR BUSINESS
Alaska Airlines, Inc., an Alaska corporation, is a wholly owned subsidiary of Alaska Air Group, Inc. (Air Group), a Delaware corporation. Air Group is also the parent company of Horizon Air Industries, Inc. (Horizon) and Alaska Air Group Leasing. We are a major airline organized in 1932 and incorporated in the state of Alaska in 1937. We became a wholly owned subsidiary of Air Group in 1985 pursuant to reorganization into a holding company structure. Horizon is a regional airline that operates both turboprop and jet aircraft.
We endeavor to distinguish ourselves from competitors by providing a higher level of customer service and differentiating amenities. Our outstanding employees and excellent service in the form of advance seat assignments, expedited check-in, attention to customer needs, a generous frequent flyer program, well-maintained aircraft, a first-class section aboard our aircraft, and other amenities are regularly recognized by independent studies, awards, and surveys of air travelers. For example, Alaska was named in the top five U.S. carriers for premium service in a recent Zagat survey. We are very proud of these awards and we continue to strive to have the best customer service in the industry.
WHERE YOU CAN FIND MORE INFORMATION
Air Group is a registrant pursuant to Section 12 (b) of the Securities and Exchange Commission Act of 1934 (Commission File No. 1-8957). We maintain an Internet website at www.alaskaair.com. Air Group’s filings with the Securities and Exchange Commission, including its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available on our website at www.alaskaair.com, free of charge, as soon as reasonably practicable after the electronic filing of these reports with the Securities and Exchange Commission. The information contained on our website is not a part of this annual report on Form 10-K.
OUR OPERATIONS
We offer extensive north/south service within the western U.S., Canada and Mexico, passenger and dedicated cargo services to and within the state of Alaska. We also provide long-haul east/west service to eight cities in the continental U.S., primarily from Seattle, where we have our largest concentration of departures; although we do offer long-haul departures from Anchorage, Los Angeles, and Portland, Oregon. During 2007, we also initiated service to Hawaii, with non-stops from Seattle to Honolulu and Lihue and from Anchorage to Honolulu.
In 2007, we carried 17.6 million revenue passengers in our mainline operations, and in each year since 1973, we have carried more passengers between Alaska and the U.S. mainland than any other airline. Based on the number of passengers, our leading airports are Seattle, Los Angeles, Anchorage and Portland. Based on 2007 revenues, the leading nonstop routes are Seattle-Anchorage, Seattle-Los Angeles, and Seattle-San Diego. At December 31, 2007, our operating fleet consisted of 115 jet aircraft, compared to 114 jet aircraft as of December 31, 2006. Our average passenger trip length in 2007 was 1,051 miles.
Passenger traffic by market is presented below:
Alaska and Horizon integrate their flight schedules to provide convenient, competitive connections between most points served by their systems. In 2007 and 2006, approximately 22% and 24%, respectively, of Horizon’s passengers connected to flights operated by Alaska.
For a more in-depth discussion of our business, the industry, regulatory environment, and other important matters, please see Air Group’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 20, 2008.
ITEM 1A.
ITEM 1A. RISK FACTORS
If any of the following occurs, our business, financial condition and results of operations could suffer. These risk factors may not be exhaustive. We operate in a continually changing business environment and new risk factors emerge from time to time. Management cannot predict such developments, nor can it assess the impact, if any, on our business of such new risk factors or of events described in any forward-looking statements.
The airline industry is highly competitive and subject to rapid change. We may be unable to compete effectively against other airlines with greater financial resources or lower operating costs, or to adjust rapidly enough in the event the nature of competition in our markets changes.
The airline industry is highly competitive as to fares, flight frequency, frequent flyer benefits, routes and service. The industry is particularly susceptible to price discounting because airlines incur only nominal costs to provide service to passengers occupying otherwise unsold seats. Over the past few years, airlines have reduced domestic routes and the number of planes available, which has resulted in reduced domestic industry capacity and a trend towards increased fares. Although capacity has declined based on a nationwide average, capacity on the West Coast has actually increased. If airlines decide to increase their capacity further in the future, this could cause fares to decline, which may adversely affect our business and results of operations. Many of our competitors are larger than us and therefore, may have significantly greater financial resources and name recognition or lower operating costs than we do. In addition, competitors who have successfully reorganized out of bankruptcy have lowered their operating costs as a result of renegotiated labor, supply and financing agreements. From time to time in the past, some of these competitors have chosen to add service, reduce their fares, or take other competitive steps in our key markets. We may be unable to compete effectively against other airlines that introduce service or discounted fares in the markets that we serve.
The airline industry also faces competition from ground transportation alternatives, such as buses, trains or automobiles.
The U.S. and Mexico recently amended their bilateral agreement relating to commercial air service. The amendments expand authorized service levels to cities we serve in Mexico. Other airlines have added service to many of the city pairs we currently serve, which has increased competition and has negatively affected our results of operations. Further increases in competition in these markets may result in additional negative pressure on our results of operations.
Our business, financial condition, and results of operations are substantially exposed to the current high prices and variability of jet fuel. Further increases in jet fuel costs would harm our business.
Fuel costs constitute a significant portion of our total operating expenses, accounting for 26% and 27% of total operating expenses for the years ended December 31, 2007 and 2006, respectively. Significant increases in fuel costs during the past several years have negatively affected our results of operations. Further increases will harm our financial condition and results of operations, unless we are able to increase fares.
Historically, fuel costs and availability have been unpredictable and subject to wide price fluctuations based on geopolitical issues and supply and demand. We have not generally been able to increase fares to offset increases in the price of fuel until recently and we may not be able to do so in the future.
We utilize fuel hedges as a form of insurance against the volatility of fuel prices. To manage the risk of fuel price increases, we purchase call options that are designed to cap a portion of our fuel costs at designated per-barrel oil prices. Even with hedges, we are substantially and increasingly exposed to increases in jet fuel costs as the price at which we are hedged increases.
A significant increase in labor costs or change in key personnel could adversely affect our business and results of operations.
We compete against the major U.S. airlines and other businesses for labor in many highly skilled positions. If we are unable to hire, train and retain qualified employees at a reasonable cost, or if we lose the services of key personnel, we may be unable to grow or sustain our business. In such case, our operating results and business prospects could be harmed. We may also have difficulty replacing management or other key personnel who leave and, therefore, the loss of any of these individuals could harm our business.
Labor costs are a significant component of our total expenses, accounting for approximately 27% and 28% of our total operating expenses in 2007 and 2006, respectively. As of December 31, 2007, labor unions represented approximately 84% of our employees. Each of our represented employee groups has a separate collective bargaining agreement, and could make demands that would increase our operating expenses and adversely affect our financial performance. Uncertainty around open contracts could be a distraction to many employees, reduce employee engagement in our business and divert management’s attention from other projects. Disengaged employees could prevent us from achieving the operational improvements in completion rate and on-time performance that we seek.
In 2005, Alaska and the Air Line Pilots Association (ALPA) were unable to reach a new agreement, and therefore, pursuant to the terms of the collective bargaining agreement that existed at the time, the parties submitted the agreement to binding arbitration. That arbitration decision, which was effective May 1, 2005,
resulted in an average pilot wage reduction of 26%. That contract became amendable on May 1, 2007, and we are currently in negotiations with ALPA. Factoring in pay rates, productivity measures, and pension and postretirement medical benefits, we believe our pilot unit costs are among the highest in the industry for the size of aircraft operated.
Our continuing obligation to fund our traditional defined-benefit pension plans could negatively affect our ability to compete in the marketplace. This is because some of our competitors either have eliminated such obligations through bankruptcy or have never had traditional pension plans in place. Currently, all of our defined-benefit pension plans are closed to new entrants, with the exception of the plan covering our pilots.
Finally, to the extent we are unable to maintain the outsourcing or subcontracting of certain services for our business, we would incur substantial costs, including costs associated with hiring new employees, in order to perform these services in-house.
Our failure to successfully reduce unit costs could harm our business.
We continue to strive toward aggressive cost-reduction goals that are an important part of our business strategy of offering the best value to passengers through competitive fares while achieving acceptable profit margins and return on capital. We believe having a lower cost structure better positions us to be able to fund growth and take advantage of market opportunities. If we are unable to further reduce our non-fuel unit costs and achieve targeted profitability, we will likely not be able to grow our business and our financial results may suffer.
Our indebtedness and other fixed obligations could increase the volatility of earnings and otherwise restrict our activities.
We have, and will continue to have for the foreseeable future, a significant amount of debt. Due to our high fixed costs, including aircraft lease commitments and debt service, a decrease in revenues results in a disproportionately greater decrease in earnings. As of December 31, 2007 and 2006, we had approximately $1.2 billion and $1.1 billion of long-term debt outstanding, respectively, approximately all of which was secured by flight equipment and real property. In addition to long-term debt, we have significant other fixed obligations under operating leases related to our aircraft, airport terminal space, other airport facilities and office space. As of December 31, 2007, future minimum lease payments under noncancelable operating leases with initial or remaining terms in excess of one year were $647.6 million for 2008 through 2012 and an aggregate of $281.4 million for the years thereafter.
At December 31, 2007, we had firm orders to purchase 31 aircraft requiring future aggregate payments of approximately $782 million through 2011. Although we have secured financing for a number of these commitments, there is no guarantee that additional financing will be available when required. Our inability to secure the financing could have a material adverse effect on our cash balances or result in delays in or our inability to take delivery of aircraft, which would impair our growth or fleet-simplification plans.
Our outstanding long-term debt and other fixed obligations could have important consequences. For example, they could:
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limit our ability to obtain additional financing to fund growth, capital expenditures, acquisitions, working capital or other purposes;
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require us to dedicate a material portion of our operating cash flow to fund lease payments and interest payments on indebtedness, thereby reducing funds available for other purposes; and
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limit our ability to withstand competitive pressures and reduce our flexibility in responding to changing business and economic conditions, including reacting to any economic slowdown in the airline industry.
We cannot ensure that we will be able to generate sufficient cash flow from our operations to pay our debt and other fixed obligations as they become due. If we fail to do so, our business could be harmed.
We are required to comply with specific financial covenants in certain agreements. We cannot be certain now that we will be able to comply with these covenants or provisions or that these requirements will not limit our ability to finance our future operations or capital needs.
Our operations are often affected by factors beyond our control, including changing economic and other conditions, which could harm our financial condition and results of operations.
Like other airlines, our operations often are affected by changes in economic and other conditions caused by factors largely beyond our control, including:
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economic recession, interest rate increases, inflation, international or domestic conflicts, terrorist activity, or other changes in economic or business conditions;
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air traffic congestion at airports or other air traffic control problems;
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adverse weather conditions; and
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increased security measures or breaches in security.
Delays and cancellations frustrate passengers, reduce aircraft utilization and increase costs, all of which affect our profitability. Due to our geographic area of operations, we believe a significant portion of our operation is more susceptible to adverse weather conditions than that of many of our competitors. A general reduction in airline passenger traffic as a result of any of the above-mentioned factors could harm our business, financial condition and results of operations.
We depend on a few key markets to be successful.
Our strategy is to focus on serving a few key markets, including Seattle, Portland, Los Angeles and Anchorage. A significant portion of our flights occurs to and from our Seattle hub. In 2007, traffic to and from Seattle accounted for 67% of our total traffic.
We believe that concentrating our service offerings in this way allows us to maximize our investment in personnel, aircraft, and ground facilities, as well as to gain greater advantage from sales and marketing efforts in those regions. As a result, we remain highly dependent on our key markets. Our business would be harmed by any circumstances causing a reduction in demand for air transportation in our key markets.
An increase in competition in our key markets could also cause us to reduce fares or take other competitive measures that could harm our business, financial condition and results of operations.
The airline industry continues to face potential security concerns and related costs.
The terrorist attacks of September 11, 2001 and their aftermath have negatively affected the airline industry, including our company. More recently, the foiled terror plot in the United Kingdom in August 2006 resulted in new security measures that also impacted our company. Additional terrorist attacks, the fear of such attacks or other hostilities involving the U.S. could have a further significant negative effect on the airline industry, including us, and could:
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significantly reduce passenger traffic and yields as a result of a potentially dramatic drop in demand for air travel;
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significantly increase security and insurance costs;
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make war risk or other insurance unavailable or extremely expensive;
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increase fuel costs and the volatility of fuel prices;
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increase costs from airport shutdowns, flight cancellations and delays resulting from security breaches and perceived safety threats; and
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result in a grounding of commercial air traffic by the FAA.
The occurrence of any of these events would harm our business, financial condition and results of operations.
Increases in insurance costs or reductions in insurance coverage would harm our business, financial condition and results of operations.
Immediately following the September 11, 2001 terrorist attacks, aviation insurers dramatically increased airline insurance premiums and significantly reduced the insurance coverage available to airlines for third-party claims resulting from acts of terrorism, war or similar events to $50 million per event and in the aggregate. In light of this development, under the Air Transportation Safety and System Stabilization Act and the Homeland Security Act of 2002, as most recently amended by the Consolidated Appropriations Act of 2008, the U.S. government continues to offer domestic airlines either (i) third-party liability war risk coverage above $50 million or (ii), in lieu of commercial war risk insurance, full hull, comprehensive and third-party liability war risk coverage. This provides for the same limits of war and allied perils coverage for hull and comprehensive insurance and twice the limits of third-party liability insurance carried by the airline on September 11, 2001.
Although our insurance costs have declined to pre-2001 levels, aviation insurers could increase their premiums again in the event of additional terrorist attacks, hijackings, airline accidents or other events adversely affecting the airline industry. Furthermore, the full hull, comprehensive and third-party war risk insurance provided by the government is currently mandated through August 31, 2008. Although the government may extend the deadline for providing such coverage, we cannot be certain that any extension will occur, or if it does, for how long the extension will last. It is expected that, should the government stop providing such coverage to the airline industry, the premiums charged by aviation insurers for this coverage will be substantially higher than the premiums currently charged by the government and the coverage will be much more limited, including smaller aggregate limits and shorter cancellation periods. Significant increases in insurance premiums would adversely affect our business, financial condition and results of operations.
Our reputation and financial results could be harmed in the event of an airline accident or incident.
An accident or incident involving one of our aircraft could involve a significant loss of life and result in a loss of faith in our airline by the flying public. In addition, we could experience significant potential claims from injured passengers and surviving relatives, as well as costs for the repair or replacement of a damaged aircraft and its consequential temporary or permanent loss from service. Although we strive to maintain the highest standards of safety and reliability, should an accident or incident nevertheless occur, we currently maintain liability insurance in amounts and of the type generally consistent with industry practice. However, the amount of such coverage may not be adequate and we may be forced to bear substantial losses from an accident. Substantial claims resulting from an accident in excess of our related insurance coverage would harm our business and financial results. Moreover, any aircraft accident or incident, even if fully insured and even if it does not involve our airline, could cause a public perception that our airline or the equipment it flies is less safe or reliable than other transportation alternatives, which would harm our business.
We rely heavily on automated systems to operate our business, and a failure of these systems or by their operators could harm our business.
We depend on automated systems to operate our business, including our computerized airline reservations system, our telecommunication systems, our website, our maintenance systems, and other systems. Substantially all of our tickets are issued to passengers as electronic tickets. We depend on our computerized reservation system to be able to issue, track and accept these electronic tickets. In order for our operations to work efficiently, our website and reservation system must be able to accommodate a high volume of traffic, maintain secure information, and deliver important flight information. Substantial or repeated website, reservations system or telecommunication systems failures could reduce the attractiveness of our services and cause our customers to purchase tickets from another airline. In addition, we rely on other automated systems for crew scheduling, flight dispatch, and other operational needs. Disruption in, changes to, or a breach of these systems could result in the loss of important data, increase our expenses and possibly cause us to temporarily cease our operations.
We rely on partner airlines for codeshare and frequent flyer marketing arrangements.
We are a party to marketing agreements with a number of domestic and international air carriers, or “partners,” including but not limited to American Airlines, Continental Airlines, Delta Air Lines and Northwest Airlines. These agreements provide that certain flight segments operated by us are held out as partner “codeshare” flights and that certain partner flights are held out for sale as Alaska codeshare flights. In addition, the agreements generally provide that members of our Mileage Plan program can earn miles on or redeem miles for partner flights and vice versa. We receive a significant amount of revenue from flights sold under codeshare arrangements. In addition, we believe that the frequent flyer arrangements are an important part of our Mileage Plan program. The loss of a significant partner or certain partner flights could have a negative effect on our revenues or the attractiveness of our Mileage Plan, which we believe is a source of competitive advantage.
We rely on third-party vendors for certain critical activities.
We have historically relied on outside vendors for a variety of services and functions critical to our business, including airframe and engine maintenance, ground handling, fueling, computer reservation system hosting and software maintenance. As part of our cost-reduction efforts, our reliance on outside vendors has increased and may continue to do so in the future. In recent years, we have subcontracted our heavy aircraft maintenance, fleet service, facilities maintenance, and ground handling services at certain airports, including Seattle-Tacoma International Airport, to outside vendors.
Our use of outside vendors increases our exposure to several risks. In the event that one or more vendors goes into bankruptcy, ceases operation or fails to perform as promised, replacement services may not be readily available at competitive rates, or at all. Although we believe that our vendor oversight and quality control is among the best in the industry, if one of our vendors fails to perform adequately we may experience increased costs, delays, maintenance issues, safety issues or negative public perception of our airline. Vendor bankruptcies, unionization, regulatory compliance issues or significant changes in the competitive marketplace among suppliers could adversely affect vendor services or force us to renegotiate existing agreements on less favorable terms. These events could result in disruptions in our operations or increases in our cost structure.
We are dependent on a limited number of suppliers for aircraft and parts.
We are dependent on Boeing as our sole supplier for aircraft and many aircraft parts. As a result, we are more vulnerable to any problems associated with the supply of those aircraft and parts, including design defects, mechanical problems, contractual performance by the manufacturers, or adverse perception by the public that would result in customer avoidance or in actions by the FAA resulting in an inability to operate our aircraft. Carriers that operate a more diversified fleet are better positioned than we are to manage such events.
Changes in government regulation imposing additional requirements and restrictions on our operations or on the airports at which we operate could increase our operating costs and result in service delays and disruptions.
Airlines are subject to extensive regulatory and legal requirements, both domestically and internationally, that involve significant compliance costs. In the last several years, Congress has passed laws, and the U.S. Department of Transportation, the Transportation Security Administration and the Federal Aviation Administration (the “FAA”) have issued regulations that have required significant expenditures relating to the maintenance and operation of airlines. For example, the FAA has issued regulations covering, among other things, security measures, collision avoidance systems, noise abatement, environmental restrictions, safety procedures and maintenance regulations. Similarly, many aspects of an airline’s operations are subject to increasingly stringent federal, state and local laws protecting the environment.
Because of significantly higher security and other costs incurred by airports since September 11, 2001, many airports have increased their rates and charges to air carriers. Additional laws, regulations, taxes, and airport rates and charges have been proposed from time to time that could significantly increase the cost of airline operations or reduce the demand for air travel. Although lawmakers may impose these additional fees and view them as “pass-through” costs, we believe that a higher total ticket price will influence consumer purchase and travel decisions and may result in an overall decline in passenger traffic, which would harm our business.
Recently, there has been some discussion of an “airline passenger’s bill of rights” at both the national and state levels. Bills have recently been proposed in several states that will regulate airlines when operating in those specific states. If these bills were to become law, they could impose additional economic and resource constraints on our airlines and could negatively impact our financial performance.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
AIRCRAFT
The following tables describe the aircraft we operate and their average age at December 31, 2007:
Note 6 to our financial statements discusses future orders for additional aircraft.
As of December 31, 2007, 47 of the 64 owned aircraft are subject to liens securing long-term debt, and the majority of the other owned aircraft serve as collateral for our $185 million line-of-credit facility. Our leased 737-400, 737-700, 737-800 and MD-80 aircraft have lease expiration dates between 2008 and 2016, between 2009 and 2010, between 2015 and 2018, and between 2008 and 2012, respectively. We have the option to extend most of the leases for additional periods, or the right to purchase the aircraft at the end of the lease term, usually at the then-fair-market value of the aircraft.
In 2006, we announced a plan to transition to an all-Boeing 737 fleet by the end of 2008, which includes the accelerated retirement of our MD-80 fleet. Giving consideration to this fleet transition plan, the following table displays the currently anticipated fleet counts as of the end of each quarter in 2008:
* The total includes one additional leased aircraft in 2008.
** F=Freighter; C=Combination freighter/passenger
Although the number of aircraft in our operating fleet at the end of each period presented remains relatively consistent, it is important to note that the larger B737-800s are replacing the smaller-gauge MD-80s. Therefore, our total capacity, as measured by available seat miles, will increase even though the number of aircraft remains consistent.
GROUND FACILITIES AND SERVICES
We lease ticket counters, gates, cargo and baggage space, office space, and other support areas at the majority of the airports we serve. We also own terminal buildings in various cities in the state of Alaska.
We have centralized operations in several buildings located at or near Seattle-Tacoma International Airport (Sea-Tac) in Seattle, Washington. These include a five-bay hangar and shops complex (used primarily for line maintenance), a flight operations and training center, an air cargo facility, an information technology office and mainframe computer facility, two office buildings, and corporate headquarters complex. We also lease a stores warehouse, and office spaces for a reservation facility and for various administrative functions in Kent, Washington. Our major facilities outside of Seattle include a regional headquarters building, an air cargo facility and a hangar/office facility in Anchorage, as well as leased reservations facilities in Phoenix, Arizona and Boise, Idaho. We use our own employees for ground handling services at most of our airports in the state of Alaska. At other airports throughout our system, those services are contracted to various third-party vendors.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
Grievance with International Association of Machinists
In June 2005, the International Association of Machinists (IAM) filed a grievance under its Collective Bargaining Agreement (CBA) with the Company alleging that we violated the CBA by, among other things, subcontracting the ramp service operation in Seattle. The dispute was referred to an arbitrator and hearings on the grievance commenced in January 2007, with a final hearing date in August 2007. We expect a decision from the arbitrator in the first half of 2008.
Other items
We are a party to routine litigation matters incidental to our business and with respect to which no material liability is expected.
Management believes the ultimate disposition of the matters discussed above is not likely to materially affect 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.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
All of Alaska’s outstanding shares are owned by Air Group. As of February 15, 2008, Alaska had issued outstanding 500 shares of common stock, $1.00 par value per share. There is no established public trading market for Alaska’s common stock.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
As permitted by General Instruction I(2)(a), the following section contains management’s narrative analysis of Alaska’s results of operations as of and for the fiscal year ended December 31, 2007.
OVERVIEW
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand the Company, our operations and our present business environment. MD&A is provided as a supplement to - and should be read in conjunction with - our financial statements and the accompanying notes. All statements in the following discussion that are not reports of historical information or descriptions of current accounting policy are forward-looking statements. Please consider our forward-looking statements in light of the risks referred to in this report’s introductory cautionary note and the risks mentioned in the Company’s filings with the Securities and Exchange Commission. This overview summarizes the MD&A, which includes the following sections:
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Year in Review - highlights from 2007 outlining some of the major events that happened during the year and how they affected our financial performance.
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Results of Operations - an in-depth analysis of the results of our operations for 2007 compared to 2006. We believe this analysis will help the reader better understand our statements of operations. Financial and statistical data are also included here. This section includes forward-looking statements regarding our view of 2008.
YEAR IN REVIEW
The revenue environment in 2007 was characterized by increased competition in our primary markets and a softer demand environment in our West Coast markets. However, yield improved slightly as we and other carriers attempted to raise fares to cover higher fuel costs. We also posted higher passenger traffic. These factors, along with the new capacity purchase arrangement with Horizon (as discussed below), resulted in an increase in total revenues of $377.4 million.
Our total operating expenses increased by $66.4 million during 2007 compared to 2006. This increase is primarily the result of the new capacity purchase arrangement with Horizon that began in January 2007 (see discussion below) and some increases in other operating expenses, offset by the 2006 fleet transition and restructuring charges mentioned above and mark-to-market gains associated with an increase in the value of our fuel hedge portfolio. See “Results of Operations” below for further discussion of changes in revenues and operating expenses.
Accomplishments
Accomplishments from 2007 include:
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We marked our 75th anniversary with several celebration events and the unveiling of the “Starliner 75,” a new Boeing 737-800 aircraft painted in a vintage DC-3 livery.
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In October 2007, we reached another website milestone by processing over 50% of our monthly sales through alaskaair.com for the first time.
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We initiated service to the Hawaiian Islands in October 2007 - something our customers and employees had been looking forward to for many years. We have also initiated or announced additional service in certain existing markets or connected cities already served with new non-stop service.
Airport of the Future
On October 16, 2007, we unveiled the first phase of our patented “Airport of the Future” at Seattle Tacoma International Airport. Once the project is complete, additional facilities are coming online in the first half of 2008, the “Airport of the Future” will allow our customers to check in for their flights and drop bags more quickly, improve our agents’ productivity, and allow us to handle more customers without increasing our airport space. We debuted this concept at the Ted Stevens International Airport in Anchorage in 2004 and since that time, customer wait times have been reduced significantly.
Row 44
In September 2007, we announced our plan to launch in-flight wireless Internet service in 2008 based on Row 44, Inc.’s satellite-based broadband connectivity solution. We plan to test the system on our aircraft in the first half of 2008. If the test is successful, we plan to equip all of our aircraft with this equipment. This technology will provide customers with a unique entertainment and business network in the air. Passengers with Wi-Fi-enabled devices - such as laptop computers, PDAs, smart phones and portable gaming systems - will have high-speed access to the Internet, e-mail, virtual private networks and stored in-flight entertainment content.
Hawaiian Vacations
During the third quarter of 2007, we announced the acquisition of certain assets of Hawaiian Vacations Inc., an Anchorage-based company that charters aircraft and markets package tours to the Hawaiian Islands. The acquisition of these assets will help accelerate our entrance into the Anchorage-Honolulu market, which began December 9, 2007 with one daily round trip.
Labor Costs and Negotiations
We are pleased with the long-term contracts that have been reached with the majority of our labor groups. We are now in the process of negotiating new contracts with our pilots. The pilot contract became amendable May 1, 2007. We hope to reach negotiated agreements with our pilots that recognize the important contributions that they make, without harming our competitive position. Factoring in pay rates, productivity measures, pension, and post-retirement medical benefits, we believe our pilot unit costs are among the highest in the industry for the size of aircraft operated.
We do not know what the final outcome of these negotiations will be or when agreements will be reached. However, uncertainty around open contracts could be a distraction to some employees, reduce employee engagement in our business, and hinder us from achieving the operational goals (such as on-time and completion-rate targets) that we have set.
Fleet Transition
During the first quarter of 2006, we announced our plan to retire our entire MD-80 fleet by the end of 2008 as part of our move to an all-Boeing 737 fleet. We believe this transition, when completed, will provide more than $130 million in annual operating savings by way of lower fuel, maintenance, and training costs.
During 2007, we sold all 20 of our owned operating MD-80s. The majority of these aircraft are now leased from the buyer under short-term lease arrangements, which will allow us to maintain our current MD-80 retirement schedule through December 2008. We ceased operation of seven of these leased MD-80s in 2007, including one at the end of December that was earlier than anticipated. The charge associated with the early retirement in December 2007 was not material.
We currently have long-term lease arrangements on four MD-80 aircraft that we plan to cease operating before the end of the lease term. We anticipate that once these aircraft have been removed from operation, we will dispose of them through a lease buy-out or a sublease arrangement, or we will store them at a long-term storage facility. It is likely that we will record a charge in our statement of operations if either of these events occurs. Aggregate minimum lease payments for these four aircraft through the end of their lease terms total approximately $68.5 million as of December 31, 2007.
Capacity Purchase Agreements
Alaska and Horizon entered into a Capacity Purchase Agreement (CPA) effective January 1, 2007, whereby Alaska purchases capacity on certain routes (“capacity purchase markets”) from Horizon as specified by the agreement. This agreement has resulted in a new presentation in Alaska’s statement of operations. The actual passenger revenue from the capacity purchase markets is identified as “Passenger revenue - purchased capacity” and the associated costs are identified as “Purchased capacity costs.”
Alaska also has a similar arrangement in place with a third-party carrier for flying between Anchorage and Dutch Harbor, Alaska. Historically, the revenue from this arrangement was presented in “Other revenue - net” and the associated costs were in “Contracted services” in Alaska’s statement of operations. Now, all of these revenues and costs are presented with the Horizon purchased capacity revenues and costs, and the prior period has been reclassified to conform to the current presentation.
Alaska and Horizon entered into the CPA in order to improve the visibility of both the revenues and the costs of flying in the capacity purchase markets. Under the CPA, Alaska pays Horizon a contractual amount for the purchased capacity in the incentive markets regardless of the revenue collected on those flights. The amount paid to Horizon is generally based on Horizon’s operating costs plus a margin. Alaska bears the inventory and revenue risk in those markets. Accordingly, Alaska records the related passenger revenue. Alaska records payments to Horizon in “Purchased capacity costs.” Horizon records the payment from Alaska as “Passenger revenue.”
The Air Group planning department works to strategically deploy certain Horizon aircraft by optimizing the balance of local and “flow” traffic connections with Alaska in order to maximize total returns to Air Group
and to allow Alaska to deploy its larger jets to other routes. Prior to 2007, there was a revenue-sharing arrangement in place whereby Alaska made a payment to Horizon if certain covered markets created losses for Horizon. Alternatively, Horizon made a payment to Alaska if those markets were profitable.
Line of Credit Modification
In April 2007, we announced the Second Amendment of the March 25, 2005, $160 million variable-rate credit facility with a syndicate of financial institutions. The terms of the Second Amendment provide that any borrowings will be secured by either aircraft or cash collateral. The Second Amendment (i) increased the size of the facility to $185 million; (ii) improved the collateral advance rates for certain aircraft; (iii) extended the agreement by two years with a maturity date of March 31, 2010; and (iv) repriced the credit facility to reflect current market rates. We currently have no immediate plans to borrow using this credit facility. In July 2007, we executed the Third Amendment to the credit facility, which amended a covenant restriction to allow borrowings between us and our affiliates of up to $500 million, versus $300 million previously.
Outlook
We currently expect to increase our mainline capacity by 3% in 2008 compared to 2007. The expected capacity increase is due primarily to the anticipated delivery of 17 new B737-800 aircraft in 2008 and the annualization of capacity additions that resulted from 14 B737-800 aircraft delivered in 2007, offset by the retirement of 15 MD-80 aircraft and, to a lesser extent, scheduled retirement of other aircraft.
We will continue to monitor our flight schedules to see if there are further opportunities to reduce unprofitable flying and retire some of our MD-80s sooner than currently planned. We recently announced that we plan to eliminate our Oakland - Orange County route and shift to Horizon our daily flights from Seattle to Reno and Boise in an effort to reduce costs and increase profitability.
On a net basis, we expect that our fleet size will grow by one aircraft in 2008 (from 115 to 116), although the B737-800 aircraft are larger than the MD-80s they are replacing, allowing for the capacity growth mentioned above. The aircraft deliveries in 2008 are planned to replace outgoing aircraft, increase frequency in our existing markets and, to a lesser degree, serve new markets.
For much of the past three years, our operational performance has fallen short of our goals and our customers’ expectations. We currently have several initiatives underway to help improve our on-time performance, completion rates, baggage handling, and other important customer-driven operational measures. Delivering on these core operational promises is one of our highest-priority internal goals for 2008.
RESULTS OF OPERATIONS
2007 COMPARED WITH 2006
In 2007, we reported net income of $135.4 million compared to a net loss of $56.1 million in 2006. The 2006 results included the following items that impact the comparability between the periods:
•
We recorded $189.5 million ($118.5 million after tax) of fleet transition costs related to our MD-80 fleet.
•
We also recorded a $24.8 million ($15.5 million after tax) restructuring charge associated with the voluntary severance package offered to certain of our employees represented by the International Association of Machinists and to our flight attendants as part of new four-year collective bargaining agreements.
Both periods include adjustments to reflect the timing of gain or loss recognition resulting from mark-to-market fuel hedge accounting. We recorded a $43.3 million gain in 2007 compared to a $78.4 million loss in 2006.
We believe disclosure of the impact of these individual charges is useful information to investors and other readers because:
•
it is useful to monitor performance without these items as it improves a reader’s ability to compare our results to the results of other airlines;
•
our results excluding these special items is the basis for our various employee incentive plans, thus allowing investors to better understand the changes in variable incentive pay expense in our statements of operations;
•
our results excluding these items is most often used in internal management and board reporting and decision-making; and
•
we believe it is the basis by which we are evaluated by industry analysts.
Financial and statistical data for are shown on the following page. An in-depth discussion of the results of our operations begins on page 21.
The year’s most important trend was the dramatic increase in raw and economic fuel costs and the related increase in passenger revenue as we (and many of our competitors) attempted to pass along the increased fuel costs. See page 24 for a discussion of raw and economic fuel costs.
Financial and Statistical Data
NM = Not Meaningful
Revenues
Total operating revenues increased $377.4 million, or 14.0%, in 2007 as compared to 2006. The new Capacity Purchase Agreement with Horizon described above made up $265.0 million of the increase, with mainline revenues (defined as passenger revenues from those flights operating on our jets plus freight, mail and other revenues) contributing $112.4 million of the increase. The components of our revenue are summarized in the following table:
NM = Not Meaningful
Operating Revenue-Mainline
Mainline passenger revenue increased 3.8% on a 4.0% increase in available seat miles offset by a slight decline in mainline passenger revenue per available seat mile (PRASM). The decline in PRASM was the result of a 0.3% increase in yields, offset by a 0.4-point decline in load factor compared to the prior period.
Although the load factor for the full year was down from 2006, load factors outpaced 2006 in the second half of the year after lagging 2006 in the first half of the year. These load factor improvements contributed to the increase in unit passenger revenue (PRASM) seen in the third and fourth quarters. We believe the full-year load factor decline is due to capacity growth in connection with the replacement of older aircraft with larger B737-800 aircraft without a commensurate increase in the number of passengers.
Freight and mail revenue was flat compared to 2006. This is primarily due to a decline in freight and mail volumes resulting from lower capacity that stemmed from the delay in the conversion of four of our B737-400 passenger aircraft to combi aircraft, offset by an increase in cargo yields, including those coming through fuel surcharges. We currently anticipate an increase in freight and mail revenues in 2008 as we expect to deploy our full capacity for the entire year.
Other-net revenues increased $17.5 million, or 13.5%, primarily as a result of higher commission revenue associated with the sale of mileage credits to our bank partner. When we sell mileage credits, we defer the majority of the proceeds and recognize that revenue when award travel takes place. Commission revenue represents the difference between the proceeds from the sale of miles and the amount we defer.
Passenger Revenue - Purchased Capacity
Passenger revenue -purchased capacity increased by $265.0 million to $281.4 million because of the CPA with Horizon. During 2007, purchased capacity costs exceeded passenger revenue-purchased capacity by $21.4 million. However, the reported results of purchased capacity flying do not reflect the total contribution of these flights to our mainline operation as many of the flights feed traffic from smaller cities.
Expenses
For the year, total operating expenses increased $66.4 million compared to 2006 as a result of new purchased capacity costs recorded under the CPA with Horizon, offset by a decline in mainline operating costs. The components of our operating expenses are summarized in the following table:
NM = Not meaningful
Mainline Operating Expenses
Total mainline operating costs for 2007 declined by $222.1 million or 8.0% compared to 2006. The absence of the fleet transition costs and restructuring charges as well as lower aircraft fuel expense resulting from mark-to-market gains associated with the value of our fuel hedge portfolio were the primary causes of the decline.
Along with our financial and statistical data on page 20, we are presenting here our line-item expenses on a per-ASM basis (in cents). We believe this information is useful to investors because it highlights areas in which costs have increased or decreased either more or less than capacity:
Additional line item information is provided below.
Wages and Benefits
Wages and benefits were relatively flat in 2007, primarily as a result of the following:
•
a 3.8% increase in full-time equivalents. The number of full-time equivalent employees increased largely as a result of our initiative to improve our on-time performance and other operational goals;
•
an increase in the number of flight attendants as we transition to B737-800s, which have four flight attendants, compared to three in the MD-80 aircraft that are being replaced; and
•
normal step, scale and market-based wage increases.
These increases were offset by the following:
•
2006 included a $2.7 million contract-signing bonus paid to our flight attendants and a $1.9 million contract-signing bonus paid to our clerical, office and passenger service employees and our ramp service and stores agents; and
•
a reduction of $15.6 million in expenses associated with our defined-benefit plans as more of our employees transition to an enhanced defined-contribution plan, offset by a $1.2 million increase in defined-contribution plan expense.
We currently expect wages and benefits to increase slightly in 2008 but decline on a per-ASM basis. This expectation is exclusive of any potential change in pilot wages that may result from our current contract negotiations.
Variable Incentive Pay
Variable incentive pay for 2007 decreased $14.2 million or 51.3%, compared to 2006. The decrease results from lower annual expense under the various Air Group profit-based incentive plans as our profitability was lower than originally expected, offset by higher expenses associated with our Operational
Performance Rewards plan. For purposes of our incentive pay plans, profit is generally defined as results excluding fleet transition costs, restructuring charges, and other amounts specified in the various incentive plan documents and with fuel stated on an economic basis. Air Group maintains several incentive plans that collectively cover all of our employees and create alignment for employees, customers and shareholders. These plans include both operational performance goals and financial performance targets.
Aircraft Fuel
Aircraft fuel expense includes both raw fuel expense (as defined below) plus the effect of mark-to-market adjustments to our fuel hedge portfolio that we include in our income statement as the value of the portfolio increases and decreases. Our aircraft fuel expense is very volatile, even between quarters, because it includes these gains or losses when the underlying instrument increases or decreases in value as crude oil prices increase or decrease. Raw fuel expense is defined as the price that we generally pay at the airport, or the “into-plane” price, including taxes. Raw fuel prices are impacted by world oil prices and refining costs, which can vary by region in the U.S. Raw fuel expense approximates cash paid to suppliers.
Aircraft fuel expense decreased $19.5 million, or 2.6%, compared to 2006. The elements of the change are illustrated in the following table:
NM = Not meaningful
Fuel gallons consumed were flat on a 4.0% increase in capacity because of the improved fuel efficiency of our fleet as we transition out of the less-efficient MD-80 aircraft to newer, more-efficient B737-800 aircraft.
The raw fuel price per gallon increased by 7.9% as a result of higher West Coast jet fuel prices driven by higher crude oil costs.
During 2007, we recorded mark-to-market gains reflecting an increase in the value of our fuel hedge portfolio between December 31, 2006 and December 31, 2007. In 2006, we recorded a mark-to-market loss, as oil prices on December 31, 2006 were lower than they were a year earlier. Our hedge portfolio consists primarily of call options that are based on the prices of crude oil.
We also evaluate economic fuel expense, which we define as raw fuel expense less the cash we receive from hedge counterparties for hedges that settle during the period, offset by the premium expense that we recognize. A key difference between aircraft fuel expense and economic fuel expense is the timing of gain or loss recognition. When we refer to economic fuel expense, we include gains only when they are realized through a cash receipt from our hedge contract counterparties. We believe this is the best measure of the
effect that fuel prices are currently having on our business because it most closely approximates the net cash outflow associated with purchasing fuel for our operation. Accordingly, many industry analysts evaluate our results using this measure, and it is the basis for most internal management reporting and incentive pay plans.
Our economic fuel expense is calculated as follows:
NM = Not meaningful
In 2005 and 2006, we realized significant benefits from in-the-money fuel hedge contracts. However, our fuel hedge protection declined substantially in 2007 as the strike price of our hedges was closer to current oil prices compared to those in place during the previous two years. The total cash benefit from hedges that settled during the period declined to $44.9 million in 2007 down from $87.0 million in 2006 and $108.8 million in 2005.
We currently expect economic fuel expense to be higher in 2008 than in 2007 because of high crude oil prices. For example, if oil were to average $87 per barrel in 2008, we would expect our raw fuel expense to be approximately $2.67 per gallon and the cash benefit of settled hedges to be approximately $55 million, resulting in an economic fuel price per gallon of approximately $2.52.
Aircraft Maintenance
Aircraft maintenance declined by $7.0 million, or 4.5%, compared to the prior year largely as a result of the benefits of our fleet transition as we replace our aging MD-80s and B737-200C aircraft with newer B737-800 and converted B737-400 aircraft, respectively. We currently expect maintenance expense to increase slightly in 2008 because of the timing of certain required maintenance events, offset by additional benefit to be realized from the fleet transition.
Aircraft Rent
Aircraft rent increased by $1.9 million, or 1.7%, because of the sale and short-term leaseback of substantially all of our owned MD-80 aircraft during the second quarter of 2007 and the addition of two new leased B737-800 aircraft in the fourth quarter of 2006, partially offset by the buyout of five leased MD-80 aircraft in the third quarter of 2006. We expect a year-over-year increase in aircraft rent in 2008 as we lease an additional B737-800, offset by the retirement of the MD-80s.
Landing Fees and Other Rentals
Landing fees and other rentals increased by $11.9 million, or 7.5%, compared to 2006 as a result of higher costs at Seattle-Tacoma International and other airports. We expect year-over-year increases in 2008 as a result of fees in our new Hawaiian stations and for the continuing transition to 737-800 aircraft that are larger than the outgoing MD-80 aircraft.
Selling Expenses
Selling expenses declined by $12.2 million, or 8.6%, compared to 2006 as a result of lower ticket distribution costs and credit card fees that resulted from new contracts that were put into place in the fourth quarter of 2006. The 2006 amount also included $3.7 million paid to Horizon under the revenue-sharing arrangement in certain designated markets that existed in 2006, compared to zero in the current year because of the new CPA. These declines were partially offset by higher advertising costs. We currently expect that selling expenses will decline slightly in 2008 as we continue to focus our efforts on shifting sales to our web sites, which reduces the commission we pay to outside providers.
Depreciation and Amortization
Depreciation and amortization increased $4.5 million, or 3.3%, compared to 2006. This is primarily the result of 10 new B737-800 aircraft delivered in 2006 and 14 in 2007, partially offset by the sale and leaseback of 20 MD-80s in 2007. We expect depreciation and amortization to increase by about 14% in 2008 as we acquire more new B737-800 aircraft.
Other Operating Expenses
Other operating expenses increased because of higher passenger remuneration costs, crew costs, professional fees, software license and maintenance costs, higher property taxes, and other costs, offset by lower liability insurance expense because of better rates negotiated in December 2006.
Mainline Operating Costs per Available Seat Mile (CASM)
Operating costs per ASM (CASM) is an important metric in the industry, and we use it to gauge the effectiveness of our cost-reduction efforts. Our effort to reduce unit costs focuses not only on controlling the actual dollars we spend, but also on increasing our capacity without adding a commensurate amount of cost.
Our mainline operating costs per mainline ASM are summarized below:
NM = Not meaningful
We have separately listed in the above table our fuel costs per ASM, fleet transition costs per ASM and restructuring charges per ASM. These amounts are included in CASM, but for internal purposes we
consistently use unit cost metrics that exclude these items in order to measure our cost-reduction progress. We do so, and believe that such analysis may be important to readers of these financial statements for the following reasons:
•
Mainline cost per ASM excluding fuel is one of the most important measures used by our management and the Air Group Board of Directors in assessing quarterly and annual cost performance. These decision-makers evaluate operating results of the “mainline” operation, which includes the operation of the B737 and MD-80 aircraft fleets branded in Alaska Airlines livery. The revenues and expenses associated with purchased capacity are evaluated separately.
•
Mainline cost per ASM excluding fuel (and other items as specified in our governing documents) is an important metric for the employee incentive plan that covers company management and executives.
•
By eliminating fuel expense from our unit cost metrics, we believe that we have better visibility into the results of our non-fuel cost-reduction initiatives. Our industry is highly competitive and is characterized by high fixed costs, so even a small reduction in non-fuel operating costs can result in a significant improvement in operating results. In addition, we believe that all domestic carriers are similarly impacted by changes in jet fuel costs over the long run, so it is important for management (and thus investors) to understand the impact of (and trends in) company-specific cost drivers such as labor rates and productivity, airport costs, maintenance costs, etc., which are more controllable by management.
•
Mainline cost per ASM excluding fuel is a measure commonly used by industry analysts, and we believe it is the basis by which they compare our airlines to others in the industry. The measure is also the subject of frequent questions from holders of Air Group’s common stock.
•
Disclosure of the individual impact of certain noted items provides investors the ability to measure and monitor performance both with and without these special items. We believe that disclosing the impact of items such as the fleet transition costs and restructuring charges is important because it provides information on significant items that are not necessarily indicative of future performance. Industry analysts consistently measure the Company’s performance without these items for better comparability between periods and among other airlines.
•
Although we disclose our “mainline” passenger unit revenues, we do not (nor are we able to) evaluate mainline unit revenues excluding the impact that rising fuel costs have had on ticket prices. Fuel represents nearly 30% of our total mainline operating expenses, and fluctuations in our fuel prices often drive changes in unit revenues in the mid-to-long term. Although we believe it is useful to evaluate non-fuel unit costs for the reasons noted above, we would caution readers of these financial statements not to place undue reliance on unit costs excluding fuel as a measure or predictor of future profitability because of the significant impact of fuel costs on our business.
Our mainline unit costs excluding fuel and other special items for the first quarter and full year 2008 are expected to remain flat from similar measures in 2007. Our primary goal in 2008 is to improve our operational reliability, including our on-time performance, completion of scheduled flights, and baggage delivery metrics, with a special focus on our Seattle operations.
Purchased Capacity Costs
Purchased capacity costs increased $288.5 million, from $14.3 million in 2006 to $302.8 million in 2007. Of the total, $283.4 million was paid to Horizon under the new CPA for 1.4 billion ASMs. The balance includes amounts paid to a third party for the Dutch Harbor flying (which approximates the amount paid in 2006) and certain administrative and information technology costs borne by Alaska that are allocated to purchased capacity flying costs.
In the aggregate, costs of purchased capacity exceeded revenues in these markets by $21.4 million. The markets covered by the CPA with Horizon are both “flow” markets that provide connecting traffic to Alaska and “local” markets where Horizon’s regional jets are used to maximize returns (or minimize losses) to Air Group and allow Alaska to deploy its larger jets to other routes. Generally speaking, revenues in the flow markets exceed costs. However, revenue in most of the local markets falls short of costs. With high fuel prices and relatively high non-fuel costs, some of these routes operated by Horizon are unprofitable with CRJ-700s and are too small to support 737 service. Air Group is evaluating alternatives to improve the results of these routes. Alternatives include reducing the size of Horizon’s CRJ-700 fleet, moving some of the flying to Horizon’s Q400, and having a portion of the capacity in these markets performed by a third party with larger, more efficient aircraft.
Nonoperating Income (Expense)
Net nonoperating income was $1.2 million in 2007 compared to $4.0 million in 2006. Interest income increased by $8.5 million compared to 2006, primarily as a result of a higher average balance on the receivable from Horizon since we loan Horizon the funds to purchase new Q400 aircraft and generally higher average portfolio returns on our cash and marketable securities balance, partially offset by a lower average cash and marketable securities balance. Interest expense increased $12.9 million because of new debt arrangements in 2006 and 2007 and increases in the average interest rate on our variable-rate debt. Other-net increased $2.6 million, and includes a $3.75 million expense associated with our investment in Row 44 given their early stage of development. Capitalized interest increased $4.2 million from 2006, resulting from an increase in pre-delivery deposits in connection with our orders for B737-800 aircraft.
Income Tax Expense (Benefit)
We file a consolidated tax return with Air Group and other Air Group subsidiaries. Each member of the consolidated group calculates its tax provision and tax liability, if applicable, on a separate-entity basis. Our effective income tax rate on income (loss) before income taxes for 2007 was 37.3% compared to an effective income tax rate of 39.2% in 2006. The effective rate for 2007 was positively impacted by $2.1 million in credits resulting from a favorable outcome of the state income tax matters referred to in Note 11. Excluding this benefit, our effective tax rate would have been 38.3%, which is different from our marginal 2007 tax rate of 37.4%. The difference is primarily due to the magnitude of nondeductible expenses, such as employee per-diem costs and stock-based compensation expense recorded for certain stock awards. The 2006 year includes $4.2 million of tax benefits associated with the reduction of certain tax contingency accruals for periods for which the statute of limitations expired in 2006. Excluding this benefit, our effective tax benefit rate for 2006 would have been 34.6%.
CHANGE IN ACCOUNTING POLICY
Effective January 1, 2005, we changed our method of accounting for major airframe and engine overhauls from the capitalize and amortize method to the direct expense method. Under the former method, these costs were capitalized and amortized to maintenance expense over the shorter of the life of the overhaul or the remaining lease term. Under the direct expense method, overhaul costs are expensed as incurred. We believe that the direct expense method is preferable because it eliminates the judgment and estimation needed to determine overhaul versus repair allocations in maintenance activities. Additionally, our approved maintenance program for the majority of our airframes now focuses more on shorter, but more frequent, maintenance visits. We also believe that the direct expense method is the predominant method used in the airline industry. Accordingly, effective January 1, 2005, we wrote off the net book value of our previously capitalized airframe and engine overhauls for all aircraft resulting in a charge of $128.2 million pretax ($80.1 million after tax). We do not believe disclosing the effect of adopting the direct expense method on net income for 2005 provides meaningful information because of changes in our maintenance program, including the execution of a “power-by-the-hour” engine maintenance agreement with a third party in late 2004.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We have interest rate risk on our floating-rate debt obligations and our available-for-sale marketable investment portfolio, and commodity price risk in jet fuel required to operate our aircraft fleet. We purchase the majority of our jet fuel at prevailing market prices and seek to manage market risk through execution of a documented hedging strategy and other means. We have market-sensitive instruments in the form of fixed-rate debt instruments and financial derivative instruments used to hedge our exposure to jet-fuel price increases. We do not purchase or hold any derivative financial instruments for trading purposes.
MARKET RISK - AIRCRAFT FUEL
Currently, our fuel-hedging portfolio consists almost exclusively of crude oil call options. We utilize the contracts in our portfolio as hedges to decrease our exposure to the volatility of jet fuel prices. Call options are designed to effectively cap our cost of the crude oil component of fuel prices, allowing us to limit our exposure to increasing fuel prices. With these call option contracts, we still benefit from the decline in crude oil prices, as there is no downward exposure other than the premiums that we pay to enter into the contracts. Although to a lesser extent, we also use collar structures for fuel hedging purposes. We believe there is risk in not hedging against the possibility of fuel price increases. We estimate that a 10% increase or decrease in crude oil prices as of December 31, 2007 would increase or decrease the fair value of our hedge portfolio by approximately $29.7 million and $28.1 million, respectively.
Additionally, we have entered into fuel purchase contracts that fix the refining margin we pay for approximately 50% of our fuel consumption in the first quarter of 2008.
Our portfolio of fuel hedge contracts was worth $94.5 million at December 31, 2007, including $26.0 million of capitalized premiums paid to counterparties, compared to a portfolio value of $59.1 million at December 31, 2006.
We continue to believe that our fuel hedge program is an important part of our strategy to reduce our exposure to volatile fuel prices. We expect to continue to enter into these types of contracts prospectively, although significant changes in market conditions could affect our decisions. For more discussion, see Note 3 to our financial statements.
FINANCIAL MARKET RISK
We have exposure to market risk associated with changes in interest rates related primarily to our debt obligations and short-term investment portfolio. Our debt obligations include variable-rate instruments, which have exposure to changes in interest rates. This exposure is somewhat mitigated through our variable-rate investment portfolio. A hypothetical 10% change in the average interest rates incurred on variable-rate debt during 2007 would correspondingly change our net earnings and cash flows associated with these items by approximately $2.7 million. In order to help mitigate the risk of interest rate fluctuations, we fixed the interest rates on certain existing variable-rate debt agreements in 2005 and 2006. Additionally, several of our new debt arrangements in 2006 and 2007 were fixed-rate. We continue to enter into both variable-rate and fixed-rate arrangements in order to diversify our loan portfolio, so that we mitigate risk of severe market fluctuations. Our variable-rate debt is approximately 41% of our total long-term debt at December 31, 2007 compared to 38% at December 31, 2006. Subsequent to December 31, 2007 and through February 27, 2008, we have converted approximately $60 million of our variable-rate debt arrangements into fixed-rate arrangements and we intend to convert more in the future.
We also have investments in marketable securities, which are exposed to market risk associated with changes in interest rates. If short-term interest rates were to average 1% more than they did in 2007, interest income would increase by approximately $9.2 million.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
SELECTED QUARTERLY FINANCIAL INFORMATION
(unaudited)
* Third quarter results have been adjusted for an error in our calculation of deferred Mileage Plan revenues. The error resulted in an overstatement of passenger revenue of $6.3 million ($4.0 million, net of tax). We have concluded that this item is not material, and in accordance with SEC Staff Accounting Bulletin No. 108, we will make appropriate adjustments to our previously filed financial statements when they are presented in future Exchange Act reports.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholder
Alaska Airlines, Inc.:
We have audited the accompanying balance sheets of Alaska Airlines, Inc. as of December 31, 2007 and 2006, and the related statements of operations, shareholder’s equity, and cash flows for each of the years in the three-year period ended December 31, 2007. In connection with our audits of the financial statements, we also have audited financial statement schedule II. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Alaska Airlines, Inc. as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth thereon.
As discussed in the notes to the financial statements, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment, SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, and SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106 and 132(R), effective January 1, 2006.
/s/ KPMG LLP
Seattle, Washington
February 28, 2008
BALANCE SHEETS
Alaska Airlines, Inc.
See accompanying notes to financial statements.
BALANCE SHEETS (continued)
Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENTS OF OPERATIONS
Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENTS OF SHAREHOLDER’S EQUITY
Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENTS OF SHAREHOLDER’S EQUITY-(Continued)
Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENTS OF CASH FLOWS
Alaska Airlines, Inc.
See accompanying notes to financial statements.
NOTES TO FINANCIAL STATEMENTS
Alaska Airlines, Inc.
December 31, 2007
Note 1. General and Summary of Significant Accounting Policies
Organization and Basis of Presentation
Alaska Airlines, Inc. (Alaska or the Company), an Alaska corporation, is a wholly owned subsidiary of Alaska Air Group, Inc. (Air Group), a Delaware corporation. Air Group is also the parent company of Horizon Air Industries, Inc. (Horizon) and Alaska Air Group Leasing (AAGL). Horizon is a regional airline that operates both turboprop and jet aircraft. These financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and their preparation requires the use of management’s estimates. Actual results may differ from these estimates.
Nature of Operations
Alaska is a major airline and principally serves destinations in the state of Alaska and provides north/south service between cities in the western U.S., Canada and Mexico. Alaska also provides east/west service to eight cities, primarily from Seattle and to a lesser extent, from Portland. In 2007, Alaska also initiated service to Hawaii from Seattle and Anchorage. It operates an all-jet fleet and its average passenger trip in 2007 was 1,051 miles.
West Coast passenger traffic accounted for 46% of 2007 revenue passenger miles, passenger traffic within Alaska and between Alaska and the U.S. mainland accounted for 21%, the Mexico markets accounted for 11%, the Canada markets accounted for 4%, and other markets accounted for 18%. Based on passenger enplanements, the Company’s leading airports are Seattle, Los Angeles, Anchorage, and Portland. Based on 2007 revenues, its leading nonstop routes are Anchorage-Seattle, Los Angeles-Seattle, and San Diego-Seattle.
The Company’s operations and financial results are subject to various uncertainties, such as industry instability, which has lead to bankruptcy filings by some of the major carriers, general economic conditions, intense competition, volatile fuel prices, a largely unionized work force, the need to finance large capital expenditures, government regulation, and potential aircraft incidents.
Approximately 84% of the Company’s employees are covered by collective bargaining agreements. Approximately 14% of the Company’s employees are covered under agreements that are currently in negotiations or become amendable prior to December 31, 2008.
The airline industry is characterized by high fixed costs. Small fluctuations in load factors and yield (a measure of ticket prices) can have a significant impact on operating results. The Company has been and continues working to reduce unit costs to better compete with carriers that have lower cost structures.
Substantially all of Alaska’s sales occur in the United States.
Reclassifications
Certain reclassifications have been made to conform the prior year’s data to the current format.
Cash and Cash Equivalents
Cash equivalents consist of highly liquid investments with original maturities of three months or less. They are carried at cost, which approximates market. The Company reduces cash balances when checks are disbursed. Due to the time delay in checks clearing the banks, the Company normally maintains a negative balance in its cash disbursement accounts, which is reported as a current liability. The amount of the negative cash balance was $15.6 million and $22.9 million at December 31, 2007 and 2006, respectively, and is included in accounts payable.
Securities Lending
From time to time, the Company lends certain marketable securities to third parties for a period of less than one year to enhance investment income. During the time period in which these securities are loaned to the third parties, the Company requires cash collateral for 102% of the daily market value of the loaned securities. This cash collateral is restricted and is deposited with a lending agent and invested by that agent in accordance with the Company’s guidelines. The Company maintains full ownership rights to the securities loaned and continues to earn interest and appreciation on them. As of December 31, 2007 and 2006, the Company had $109.8 million and $108.4 million of securities on loan under the program. These affected securities are included as marketable securities in the balance sheets.
Receivables
Receivables consist primarily of airline traffic (including credit card) receivables, amounts from customers, mileage plan partners, government tax authorities, and other miscellaneous amounts due to the Company, and are net of an allowance for doubtful accounts. Management determines the allowance for doubtful accounts based on known troubled accounts and historical experience applied to an aging of accounts.
Inventories and Supplies-net
Expendable aircraft parts, materials and supplies are stated at average cost and are included in inventories and supplies-net. An obsolescence allowance for expendable parts is accrued based on estimated lives of the corresponding fleet type and salvage values. Surplus inventories are carried at their net realizable value. The allowance for all non-surplus expendable inventories was $15.1 million and $14.0 million at December 31, 2007 and 2006, respectively. Inventory and supplies-net also includes fuel inventory of $5.1 million and $6.6 million at December 31, 2007 and 2006, respectively. Repairable and rotable aircraft parts inventory are included in flight equipment.
Property, Equipment and Depreciation
Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which are as follows:
As a result of the expected early retirement of the MD-80 fleet, all aircraft and related flight equipment are being depreciated through 2008, depending on the scheduled retirement dates.
“Related flight equipment” includes rotable and repairable spare inventory, which are depreciated over the associated fleet life unless otherwise noted.
Maintenance and repairs are expensed when incurred. Major modifications that extend the life or improve the usefulness of aircraft are capitalized and depreciated over their estimated period of use.
The Company evaluates long-lived assets to be held and used for impairment whenever events or changes in circumstances indicate that the total carrying amount of an asset or asset group may not be recoverable. The Company groups assets for purposes of such reviews at the lowest level for which identifiable cash flows of the asset group are largely independent of the cash flows of other groups of assets and liabilities. An impairment loss is recognized when estimated future undiscounted cash flows expected to result from the use of the asset or asset group and its eventual disposition are less than its carrying amount. If the asset or asset group is not considered recoverable, a write-down equal to the excess of the carrying amount over the fair value will be recorded.
Internally Used Software Costs
The Company capitalizes costs to develop internal-use software that are incurred in the application development stage. Amortization commences when the software is ready for its intended use and the amortization period is the estimated useful life of the software, generally three to five years. Capitalized costs primarily include contract labor and payroll costs of the individuals dedicated to the development of internal-use software. The Company capitalized software development costs of $3.0 million, $2.4 million, and $2.3 million during the years ended December 31, 2007, 2006, and 2005, respectively.
Workers Compensation and Employee Health-Care Accruals
The Company uses a combination of self-insurance and insurance mechanisms to provide for workers compensation claims and employee health care benefits. Liabilities associated with the risks that are retained by the Company are not discounted and are estimated, in part, by considering historical claims experience, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends.
Deferred Revenue
Deferred revenue results primarily from the sale of mileage credits. This revenue is recognized when award transportation is provided or over the term of the applicable agreements.
Operating Leases
The Company leases aircraft, airport and terminal facilities, office space, and other equipment under operating leases. Some of these lease agreements contain rent escalation clauses or rent holidays. For scheduled rent escalation clauses during the lease terms or for rental payments commencing at a date other than the date of initial occupancy, the Company records minimum rental expenses on a straight-line basis over the terms of the leases in the statements of operations.
Leased Aircraft Return Costs
Cash payments associated with returning leased aircraft are accrued beginning immediately after the last heavy maintenance visit prior to the scheduled aircraft return date. This accrual is based on the time remaining on the lease, planned aircraft usage and the provisions included in the lease agreement, although the actual amount due to any lessor upon return will not be known with certainty until lease termination.
As leased aircraft are returned, any payments are charged against the established accrual. The accrual is part of other current and long-term liabilities, and was $6.9 million and $9.2 million as of December 31, 2007 and December 31, 2006, respectively. There have been no material changes in our estimate of leased aircraft return costs during 2007.
Revenue Recognition
Passenger revenue is recognized when the passenger travels. Tickets sold but not yet used are reported as air traffic liability. Passenger traffic commissions and related fees are expensed when the related revenue is recognized. Passenger traffic commissions and related fees not yet recognized are included as a prepaid expense. Due to complex pricing structures, refund and exchange policies, and interline agreements with other airlines, certain amounts are recognized as revenue using estimates regarding both the timing of the revenue recognition and the amount of revenue to be recognized. These estimates are generally based on the Company’s historical data.
Freight and mail revenues are recognized when service is provided. Other-net revenues are primarily related to the Mileage Plan and they are recognized as described in the “Mileage Plan” paragraph below.
Mileage Plan
Alaska operates a frequent flyer program (“Mileage Plan”) that provides travel awards to members based on accumulated mileage. For miles earned by flying on Alaska, Horizon and through other airline partners, the estimated cost of providing free travel awards is recognized as a selling expense and accrued as a liability as miles are earned and accumulated. Alaska also sells mileage credits to non-airline partners such as hotels, car rental agencies, a grocery store chain, and a major bank that offers Alaska Airlines affinity credit cards. The Company defers the portion of the sales proceeds that represents the estimated fair value of the award transportation and recognizes that amount as revenue when the award transportation is provided. The deferred proceeds are recognized as passenger revenue for awards redeemed and flown on Alaska or Horizon, and as other-net revenue for awards redeemed and flown on other airlines. The portion of the sales proceeds not deferred is recognized as commission income and included in other-net revenue in the statements of operations. Alaska’s Mileage Plan deferred revenue and liabilities are included under the following balance sheet captions at December 31 (in millions):
The amounts recorded in other accrued liabilities relate primarily to deferred revenue expected to be realized within one year, including $37.1 million and $32.7 million at December 31, 2007 and 2006, respectively, associated with Mileage Plan awards issued but not yet flown.
Alaska’s Mileage Plan revenue is included under the following statements of operations captions for the years ended December 31 (in millions):
Aircraft Fuel
Aircraft fuel includes raw jet fuel and associated “into-plane” costs, fuel taxes, oil, and all of the gains and losses associated with fuel hedge contracts.
Contracted Services
Contracted services includes expenses for ground handling, security, navigation fees, temporary employees, data processing fees, and other similar services.
Selling Expenses
Selling expenses include credit card fees, global distribution systems charges, the estimated cost of Mileage Plan free travel awards, advertising, promotional costs, commissions, and incentives. Advertising production costs are expensed the first time the advertising takes place. Advertising expense was $12.0 million, $13.0 million, and $12.7 million during the years ended December 31, 2007, 2006, and 2005, respectively.
Capitalized Interest
Interest is capitalized on flight equipment purchase deposits as a cost of the related asset, and is depreciated over the estimated useful life of the asset. The capitalized interest is based on the Company’s weighted-average borrowing rate.
Derivative Financial Instruments
The Company accounts for financial derivative instruments utilizing Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities, as amended. See Note 3 for further discussion.
Income Taxes
The Company uses the asset and liability approach for accounting and reporting income taxes. Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in the period that includes the enactment date. A valuation allowance would be established, if necessary, for the amount of any tax benefits that, based on available evidence, are not expected to be realized. The Company accounts for unrecognized tax benefits in accordance with Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48). See Note 11 for further discussion.
Taxes Collected from Passengers
Taxes collected from passengers, which include sales taxes, airport and security fees and other fees, are recorded on a net basis within passenger revenue in the statements of operations.
Stock-Based Compensation
The Company adopted Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment: An Amendment of SFAS Nos. 123 and 95, as of January 1, 2006. This standard requires companies to recognize as expense the fair value of stock options and other equity-based compensation issued to employees as of the grant date. The standard applies to stock options, restricted stock units, and performance stock units that Air Group grants to the Company’s employees as well as the Air Group Employee Stock Purchase Plan (ESPP), which features a look-back provision and allows employees to purchase stock at a 15% discount. The Company used the “modified prospective method” to adopt SFAS 123R, which is explained below.
The adoption of SFAS 123R changed the accounting for stock options under Air Group’s long-term incentive equity plans and for the ESPP. Accounting for restricted stock awards did not change with the adoption of the standard. All stock-based compensation expense is recorded in wages and benefits in the statements of operations.
For stock options granted prior to January 1, 2006, for which the vesting period is not complete, the “modified prospective method” for transition permitted by SFAS 123R was used. Under this method, the Company accounts for the unvested portion of these awards on a prospective basis, with expense recognized in the statements of operations beginning January 1, 2006 using the grant-date fair values previously calculated for pro-forma disclosures. The Company selected this method due to the relatively limited use of stock-based awards and the immaterial impact on the comparability between periods. The standard also requires that tax benefits realized from stock award exercise gains in excess of stock-based compensation expense recognized for financial statement purposes be reported as cash flows from financing activities rather than as operating cash flows.
Previously, the Company applied the intrinsic value method in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for stock options. As such, no compensation cost was recognized for option grants or ESPP awards in periods prior to 2006. Had compensation cost for the Company’s stock options been determined using the fair-value method in 2005, the Company would have reported a net loss of $5.1 million compared to the $2.3 million net loss as reported.
Variable Interest Entities
The Company is the lessee in a series of operating leases covering our leased aircraft. In many instances, the lessors are trusts established by a third party specifically to purchase, finance and lease aircraft to the
Company. These leasing entities meet the criteria for variable interest entities. However, they do not meet the consolidation requirements of Financial Accounting Standards Board (FASB) issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46), because the Company is not the primary beneficiary of the entity’s expected gains or losses. The Company’s conclusions are based on the fact that the leasing arrangements involved contain terms which are consistent with market terms at the inception of the lease and do not include residual value guarantees made by the Company, fixed-price purchase obligations or similar features that obligate the Company to absorb the majority of expected losses of the variable interest entities. The Company’s maximum exposure under these types of lease arrangements is the remaining lease payments, which are reflected in future lease commitments in Note 6 (plus the cost, if any, of bringing the equipment into compliance with the physical condition required for return, which is accrued as leased aircraft return costs).
New Accounting Standards
In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). SAB 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether those misstatements are material to the Company’s financial statements. SAB 108 was effective for fiscal years ending after November 15, 2006. The Company adopted SAB 108 in the fourth quarter of 2006 with an effective date of January 1, 2006. See Note 14 for further discussion.
FIN 48 was adopted by the Company and became effective January 1, 2007. See Note 11 for a discussion of the impact of this interpretation on the Company’s financial position.
Fourth Quarter Adjustments
There were no significant adjustments in the fourth quarters of 2007 or 2005. Fourth quarter 2006 adjustments included a favorable $7.6 million adjustment to restructuring charges to adjust for the number of employees that withdrew their participation in the severance program. See Note 8 for further discussion.
Note 2. Fleet Transition and Impairment
Transition to All-Boeing 737 Fleet
In March 2006, the Company’s Board approved a plan to accelerate the retirement of its MD-80 fleet (15 owned and 11 leased aircraft at the time) and remove those aircraft from service by the end of 2008. As a result of this decision, the Company evaluated impairment as required by SFAS No. 144 and concluded that the carrying value of the MD-80 fleet was no longer recoverable when compared to the estimated remaining future cash flows. Accordingly, during the first quarter of 2006, the Company recorded an impairment charge totaling $131.1 million (pretax) to write down the fleet to its estimated fair market value.
During the third quarter of 2006, the Company purchased five MD-80 aircraft from lessors and, in conjunction with the purchases, terminated the leases for those five aircraft, resulting in a pretax charge of $58.4 million.
During the second quarter of 2007, the Company sold 19 of its 20 owned MD-80s, and sold the 20th aircraft subsequent to the end of the third quarter. The majority of these aircraft are being leased from the buyer under short-term lease arrangements that will allow the Company to maintain the current MD-80 retirement schedule through December 2008.
Alaska currently has four MD-80 aircraft under long-term lease arrangements that it plans to cease operating before the end of the lease term. Management anticipates that once these aircraft have been removed from operation, the Company will dispose of these aircraft through a lease buy-out, a sublease arrangement, or store them at a long-term storage facility. It is likely that the Company will record a charge in its statement of operations if any of these options occurs.
Note 3. Fuel Hedge Contracts
The Company’s operations are inherently dependent upon the price and availability of aircraft fuel. To manage economic risks associated with fluctuations in aircraft fuel prices, the Company periodically enters into call options, collar structures, and swap agreements for crude oil, among other initiatives.
The Company records derivative instruments, all of which are currently fuel hedge contracts, on the balance sheet at their fair value. Changes in the fair value of these fuel hedge contracts are recorded each period in aircraft fuel expense.
The following table summarizes the components of aircraft fuel expense for the years ended December 31, 2007, 2006 and 2005 (in millions):
The Company realized gains of $44.9 million, $87.0 million, and $108.8 million in 2007, 2006, and 2005, respectively, on fuel hedge contracts that settled during the period.
Outstanding fuel hedge positions as of December 31, 2007 are as follows:
As of December 31, 2007 and 2006, the fair values of the Company’s fuel hedge positions were $94.5 million and $59.1 million, respectively, including capitalized premiums paid of $26.0 million and $33.8 million, respectively, and are presented as both current and non-current assets in the in the balance sheets.
Note 4. Marketable Securities
At December 31, 2007 and 2006 all of the Company’s marketable securities, including securities pledged under the securities lending program, were classified as available-for-sale. The securities are carried at fair value, with the unrealized gains and losses reported in shareholders’ equity under the caption “Accumulated Other Comprehensive Loss.” Realized gains and losses are included in other nonoperating income (expense) in the statements of operations. The cost of securities sold is based on the specific identification method. Interest and dividends on marketable securities are included in interest income in the statements of operations.
Marketable securities consisted of the following at December 31 (in millions):
The Company’s overall investment strategy has a primary goal of maintaining and securing its investment principal. The Company’s investment portfolio is managed by reputable financial institutions and continually reviewed to ensure that the investments are aligned with the Company’s documented strategy.
At December 31, 2007, available-for-sale investments in the Company’s marketable securities portfolio had net unrealized gains totaling $3.1 million, net of taxes, which are recorded in accumulated other comprehensive loss. Management does not believe that the securities with unrealized losses as of December 31, 2007 meet the criteria for recognition under existing other-than-temporary loss guidance. At December 31, 2007 and 2006, gross unrealized gains and losses were not material.
Of the marketable securities on hand at December 31, 2007, 13% mature in 2008, 33% in 2009, and 54% thereafter.
Activity for marketable securities for the years ended December 31, 2007, 2006 and 2005 is as follows:
Note 5. Long-term Debt
At December 31, 2007 and 2006, long-term debt obligations were as follows (in millions):
* The weighted-average fixed-interest rate was 6.9% as of December 31, 2007 and 2006. The weighted-average variable-interest rate, including the interest rate on the pre-delivery payment facility, was 6.5% and 6.8% as of December 31, 2007 and 2006, respectively.
At December 31, 2007, substantially all of the Company’s borrowings were secured by flight equipment, future delivery positions, and real property.
The Company has a $172 million variable-rate revolving pre-delivery payment (PDP) facility with a syndicate of lenders to provide a portion of the pre-delivery funding requirements for the purchase of new Boeing 737-800 aircraft under the current aircraft purchase agreement. The interest rate is based on the one-month LIBOR plus a specified margin. Borrowings are secured by the Company’s rights under the Boeing purchase agreement. The principal amounts outstanding on the PDP facility relate to specified aircraft and will be repaid at the time the Company takes delivery of the aircraft, if not before, likely using cash on hand or proceeds from long-term debt financing on those aircraft. The Company executed an amendment to the facility in 2007 that extended the expiration date from August 2009 to August 2011. The amendment also reduced the maximum available amount from $172 million to $152 million beginning in August 2009.
At December 31, 2007, long-term debt principal payments for the next five years are as follows (in millions):
During 2007, the Company borrowed $196.1 million using fixed-rate and variable-rate debt secured by flight equipment and had gross borrowings on its pre-delivery payment facility of $85.8 million. The increase in debt from borrowings was offset by normal debt payments of $88.0 million and $39.2 million of payments on the pre-delivery payment facility.
Bank Line of Credit
The Company has a $185 million credit facility with a syndicate of financial institutions. The interest rate on the credit facility varies depending on certain financial ratios specified in the agreement with a minimum interest rate of LIBOR plus 2%. The agreement provides that any borrowings will be secured by either aircraft or cash collateral. This credit facility contains contractual restrictions and requires maintenance of specific levels of net worth, maintenance of certain debt and leases to net worth, leverage and fixed-charge coverage ratios, and limits on liens, asset dispositions, dividends, and certain other expenditures. Such provisions restrict the Company from distributing any funds to Alaska Air Group in the form of dividends and limit the amount of funds the Company can loan to its affiliates. In April 2007, the Company entered into the Second Amendment of the facility. The Second Amendment (i) increased the size of the facility from $160 million to $185 million; (ii) improved the collateral advance rates for certain aircraft; (iii) extended the agreement by two years with a maturity date of March 31, 2010; and (iv) repriced the credit facility to reflect current market rates. The Company currently has no immediate plans to borrow using this credit facility. In July 2007, the Company executed the Third Amendment to the credit facility, which increased the amount of allowed borrowings between Alaska Airlines and its affiliates from $300 million to $500 million. As of December 31, 2007, there were no outstanding borrowings on this credit facility.
Certain loan agreements contain provisions that require maintenance of specified financial covenants. At December 31, 2007, the Company was in compliance with all financial covenants.
Note 6. Commitments
Lease Commitments
At December 31, 2007, the Company had lease contracts for 51 aircraft that have remaining noncancelable lease terms of less than one year to ten years. The majority of airport and terminal facilities are also leased. Total rent expense was $231.1 million, $221.4 million, and $224.1 million, in 2007, 2006, and 2005, respectively.
Future minimum lease payments with noncancelable terms in excess of one year as of December 31, 2007 are shown below (in millions):
Aircraft Commitments
In June 2005, the Company entered into an aircraft purchase agreement to acquire B737-800 aircraft with deliveries beginning in January 2006 and continuing through April 2011. The purchase agreement also includes options rights to purchase additional aircraft under similar terms. As of December 31, 2007, the Company was committed to purchasing 31 B737-800 aircraft, 16 of which will be delivered in 2008 and has committed to an operating lease for an additional B737-800 aircraft to be delivered in the first quarter of 2008.
The commitment to purchase 31 aircraft will require remaining aggregate payments of approximately $782 million.
The Company expects to finance the firm orders and, to the extent exercised, the option aircraft with leases, long-term debt, and internally generated cash.
Note 7. Employee Benefit Plans
Four defined-benefit and four defined-contribution retirement plans cover various employee groups of the Company. The defined-benefit plans provide benefits based on an employee’s term of service and average compensation for a specified period of time before retirement. The Company also maintains an unfunded, noncontributory defined-benefit plan for certain elected officers and an unfunded, noncontributory defined-contribution plan for other elected officers.
In 2006, the Company adopted SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R) (SFAS 158). SFAS 158 requires recognition of the overfunded or underfunded status of an entity’s defined-benefit pension and other postretirement plan as an asset or liability in the financial statements and requires recognition of the funded status in other comprehensive income.
Qualified Defined-Benefit Pension Plans
The Company’s pension plans are funded as required by the Employee Retirement Income Security Act of 1974 (ERISA). The defined-benefit plan assets consist primarily of marketable equity and fixed-income securities. The Company uses a December 31 measurement date for these plans.
Weighted average assumptions used to determine benefit obligations as of December 31:
Discount rates of 6.00% and 5.75% were used as of December 31, 2007 and 2006, respectively. For both 2007 and 2006, the rate of compensation increase used varied from 3.52% to 4.53%, depending on the plan and the related workgroup.
Weighted average assumptions used to determine net periodic benefit cost for the years ended December 31:
Discount rates of 5.75% and 5.50% were used for the years ended December 31, 2007 and 2006, respectively. For 2007 and 2006, the expected return on plan assets used was 7.75%, and the rate of compensation increase used varied from 3.52% to 4.53%, depending on the plan and the related workgroup.
In determining the discount rate used, the Company’s policy is to use the rates on high-quality long-term bonds near the end of the year and round to the nearest 25 basis points. In determining the expected return on plan assets, the Company assesses the current level of expected returns on risk-free investments (primarily government bonds), the historical level of the risk premium associated with the other asset classes in which the portfolio is invested and the expectations for future returns of each asset class. The expected return for each asset class is then weighted based on the target asset allocation to develop the expected long-term rate of return on assets assumption for the portfolio.
The asset allocation of the qualified defined-benefit plans, by asset category, is as follows as of the end of 2007 and 2006:
The Company’s investment policy focuses on achieving maximum returns at a reasonable risk for pension assets over a full market cycle. The Company uses a number of fund managers and invests in various asset classes to diversify risk. Target allocations for the primary asset classes are approximately:
Pension assets are rebalanced periodically to maintain these target asset allocations. An individual equity investment will not exceed 10% of the entire equity portfolio. Fixed-income securities carry a minimum “A” rating by Moody’s and/or Standard and Poor’s and the average life of the bond portfolio may not exceed ten years. The Company does not currently intend to invest plan assets in the Company’s common stock.
Nonqualified Defined-Benefit Pension Plan
Alaska also maintains an unfunded, noncontributory defined-benefit plan for certain elected officers. This plan uses a December 31 measurement date.
Weighted average assumptions used to determine benefit obligations as of December 31:
Discount rates of 6.00% and 5.75% were used as of December 31, 2007 and 2006, respectively. The rate of compensation increase used was 5.00% as of December 31, 2007 and 2006.
Weighted average assumptions used to determine net periodic benefit cost for the years ended December 31:
Discount rates of 5.75% and 5.50% were used for the years ended December 31, 2007 and 2006, respectively. The rate of compensation increase used was 5.00% for the years ended December 31, 2007 and 2006.
Combined Disclosures for Defined-Benefit Pension Plans
The following table sets forth the status of the plans for 2007 and 2006 (in millions):
The accumulated benefit obligation for the qualified defined-benefit pension plans was $939.0 million and $964.8 million at December 31, 2007 and 2006, respectively. The accumulated benefit obligation for the nonqualified defined-benefit plan was $34.6 million and $33.4 million at December 31, 2007 and 2006, respectively.
As of December 31, 2007 and 2006, the amounts recognized in the balance sheets were as follows (in millions):
Amounts not yet reflected in net periodic benefit cost and included in accumulated other comprehensive income or loss (AOCI):
The estimated amortization of prior service cost and net loss from AOCI in 2008 is $4.5 million and $5.2 million, respectively, for the qualified defined-benefit pension plans. For the nonqualified defined-benefit pension plans, the estimated amortization of prior service cost and net loss from AOCI in 2008 is $0.1 million and $0.2 million, respectively.
Net pension expense for the defined-benefit plans included the following components for 2007, 2006, and 2005 (in millions):
With the adoption of SFAS 158 in 2006, the Company now records all of the unrecognized prior service cost and net loss into AOCI in order to fully recognize the funded status of the plans. In 2005, the Company recorded $41.2 million (net of taxes of $24.4 million) in non-cash charges to equity in connection with the defined-benefit plans that the Company sponsors for eligible employees. The charge in 2005 can be partially attributed to the reduction of the discount rate and a change from the GAM83 mortality tables to the RP2000 tables.
The Company expects to contribute approximately $50 million and $2 million to the qualified and nonqualified defined-benefit pension plans, respectively, during 2008.
Future benefits expected to be paid over the next ten years under the defined-benefit pension plans from the assets of those plans as of December 31, 2007 are as follows (in millions):
Postretirement Medical Benefits
The Company allows retirees to continue their medical, dental, and vision benefits by paying all or a portion of the active employee plan premium until eligible for Medicare, currently age 65. This results in a subsidy to retirees, because the premiums received by the Company are less than the actual cost of the retirees’ claims. The accumulated postretirement benefit obligation (APBO) for this subsidy is unfunded, and at December 31, 2007 and 2006 was $101.7 million and $97.5 million, respectively. This liability was determined using an assumed discount rate of 6.00% and 5.75% at December 31, 2007 and 2006, respectively.
As of December 31, 2007 and 2006, the amounts recognized in the balance sheets were as follows (in millions):
Amounts not yet reflected in net periodic benefit cost and included in AOCI:
The estimated amortization of prior service cost (credit) and net loss from AOCI in 2008 is $(0.4) million and $0.9 million, respectively.
The Company uses a December 31 measurement date to assess obligations associated with the subsidy of retiree medical costs. Net periodic benefit cost for the postretirement medical plans included the following components for 2007, 2006 and 2005 (in millions):
As this is a non-funded plan, the Company expects to contribute approximately $4.7 million to the postretirement medical benefits plan in 2008, which is equal to the expected benefit payments.
Future benefits expected to be paid over the next ten years under the postretirement medical benefits plan as of December 31, 2007 are as follows (in millions):
A 1% higher or lower trend rate in health care costs has the following effect on the Company’s postretirement medical plans during 2007, 2006 and 2005 (in millions):
Defined-Contribution Plans
The defined-contribution plans are deferred compensation plans under section 401(k) of the Internal Revenue Code. All of these plans require Company contributions. Total expense for the defined-contribution plans was $16.4 million, $15.2 million, and $14.6 million in 2007, 2006, and 2005, respectively.
In 2006, the Company established a noncontributory, unfunded defined-contribution plan for certain elected officers of the Company who were ineligible for the nonqualified defined-benefit pension plan. Amounts recorded as liabilities under the plan are not material to the balance sheet at December 31, 2007.
Employee Incentive-Pay Plans
The Company (or through Air Group) has four separate plans that pay employees based on certain financial and operational metrics. The aggregate expense under these plans in 2007, 2006 and 2005 was $13.5 million, $27.7 million, and $15.3 million, respectively. The plans are summarized below:
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The Profit Sharing Plan is based on Air Group profitability. Alaska’s pilots, ramp service and clerical, office and passenger service employees participate in this plan.
•
The Variable Pay Plans pay Alaska’s mechanics and Alaska’s flight attendants a percentage of their earnings as certain pretax margin levels are achieved.
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Performance-Based Pay is a program that rewards non-union employees and Alaska dispatchers, represented by TWU, based on four separate metrics related to: (1) Air Group profitability, (2) safety, (3) achievement of unit-cost goals, and (4) employee engagement.
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The Operational Performance Rewards Program entitles all Air Group employees to quarterly payouts of up to $300 per person if certain operational and customer satisfaction objectives are met.
Note 8. Restructuring Charges
In July 2006, the Company reached new four-year agreements with approximately 3,700 clerical, office and passenger service employees and the ramp service and stores agents, all represented by the International Association of Machinists. These agreements included a signing bonus, in aggregate, of $1.9 million paid in July 2006, which is included in wages and benefits in the statement of operations, and an immediate 2% wage increase. Additionally, the agreements included a severance package offered to employees in the top four wage-scale steps that included cash payments based on years of service, one year of medical coverage after the severance date, and continued travel privileges for a period of time. The resulting charge was $21.0 million in 2006.
A new four-year contract with the Association of Flight Attendants for approximately 2,500 flight attendants was ratified on April 26, 2006. Under this agreement, the Company paid a signing bonus, in aggregate, of $2.7 million in May 2006, which is included in wages and benefits in the statement of operations. The new agreement also included an immediate 3% pay increase. Additionally, the Company offered a voluntary severance package to a number of flight attendants that included, among other things, a lump-sum payment of $2,000 per year of service up to a maximum of 25 years and continuing travel privileges. As a result, the Company recorded a restructuring charge of $3.8 million related to the severance amounts.
During the second quarter of 2005, the Company contracted out ramp services at the Seattle-Tacoma International Airport. This event resulted in a reduction of approximately 475 employees in Seattle. Severance and related costs associated with this restructuring were originally estimated at $16.1 million, which was recorded in the second quarter of 2005.
The following table displays the activity and balance of the severance and related cost components of the Company’s restructuring accrual as of and for the years ended December 31, 2007, 2006 and 2005 (in millions):
The Company will make the majority of the remaining cash payments in the first quarter of 2008. The accrual for severance and related costs is included in accrued wages, vacation and payroll taxes in the balance sheets.
During March 2005, the Company notified the Port of Oakland of its decision to terminate the lease for the Oakland hangar as part of its ongoing restructuring efforts. Accordingly, the Company recorded an impairment charge of $7.7 million in the first quarter of 2005 for the leasehold improvements that were abandoned as a result of the lease termination. Additionally, the Company recorded a charge of $0.3 million for certain costs associated with the lease termination, which have been paid.
Note 9. Detail of Other Financial Statement Captions
Receivables
Receivables consisted of the following at December 31 (in millions):
Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consisted of the following at December 31 (in millions):
Other Assets
Other assets consisted of the following at December 31 (in millions):
* Deferred costs and other includes deferred financing costs, long-term prepaid rent, lease deposits and other items.
At December 31, 2007, the Company’s restricted deposits were primarily restricted investments used to guarantee various letters of credit and workers compensation self-insurance programs. The restricted investments consist of highly liquid securities with original maturities of three months or less. They are carried at cost, which approximates market.
Other Accrued Liabilities (current)
Other accrued liabilities consisted of the following at December 31 (in millions):
* Other consists of property and transportation taxes and accruals related to ground operations, facilities rent, maintenance, and fuel, among other items.
Other Liabilities (noncurrent)
Other liabilities consisted of the following at December 31 (in millions):
* Other consists of accrued aircraft rent, workers’ compensation, and deferred credits on aircraft purchases, among other items.
Accumulated Other Comprehensive Loss
Accumulated other comprehensive loss consisted of the following at December 31 (in millions, net of tax):
Note 10. Stock-Based Compensation Plans
Stock-based compensation recorded by the Company relates to stock awards granted to Company employees by Air Group. As the Company does not have common stock that is traded on an exchange and all equity-based awards are related to Air Group common stock, the disclosures below have been limited. For a full disclosure of the Air Group stock-based compensation plans, please see the Alaska Air Group annual report on Form 10-K filed on February 20, 2008.
As described in Note 1, the Company adopted SFAS 123R, effective for all stock options granted beginning January 1, 2006. For stock options granted prior to January 1, 2006, for which the vesting period is not complete, the “modified prospective method” for transition permitted by SFAS 123R was used. Under this method, the Company accounts for the unvested portion of these awards on a prospective basis, with expense recognized in the statements of operations beginning January 1, 2006 using the grant-date fair values previously calculated for pro-forma disclosures.
Stock Options
The Company has stock option awards outstanding under a number of Air Group’s long-term incentive equity plans, only one of which (the 2004 Long-Term Incentive Equity Plan) continues to provide for the granting of options to purchase Air Group’s common stock at market prices on the date of grant to directors, officers and employees of Air Group and its subsidiaries. Under the various plans, options for 7,513,563 shares have been granted and, at December 31, 2007, 632,411 shares of Air Group’s common stock were available for future grant of either options or stock awards. Substantially all grantees are 25% vested after one year, 50% after two years, 75% after three years, and 100% after four years. Compensation cost is amortized over the service period using the straight-line method.
During 2007, Air Group granted 164,493 options to the Company’s employees with a weighted-average exercise price of $39.23 per share and a weighted-average fair value of $19.27 per share. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2007, 2006, and 2005:
The expected market price volatility of Air Group’s common stock is based on the historical volatility over a time period commensurate with the expected term of the awards. The risk-free interest rate is based on the U.S. Treasury yield curve in effect for the term nearest the expected term of the option at the time of grant. The dividend yield is zero as Air Group does not pay dividends and has no plans to do so in the immediate future. The expected term of the options and the expected forfeiture rates are based on historical experience for various homogenous employee groups. Prior to the adoption of SFAS 123R, the expected term was based on an average historical term of all options and there was no estimate of forfeiture rate as forfeitures were accounted for when they occurred.
The Company recorded stock-based compensation expense related to stock options of $3.3 million ($2.2 million, net of tax) and $2.8 million ($2.1 million, net of tax) in 2007 and 2006, respectively. The total intrinsic value of options exercised during 2007 was $1.1 million. As of December 31, 2007, $6.2 million of compensation cost associated with unvested stock option awards attributable to future service had not yet been recognized. This amount will be recognized as expense over a weighted-average period of 2.6 years.
Restricted Stock Awards
Air Group grants restricted stock units (RSUs) to the Company’s employees under the 2004 Long-term Incentive Equity Plan. The RSUs are non-voting and are not eligible for dividends. The fair value of the RSU awards is based on the closing price of Air Group’s common stock on the date of grant. During 2007, Air Group awarded 59,116 RSUs to certain employees of the Company, with a weighted-average grant date fair value of $39.98. Compensation cost for RSUs is recognized over three years from the date of grant as the awards “cliff vest” after three years. The Company recorded stock-based compensation expense related to RSUs of $4.5 million ($2.8 million after tax) and $3.2 million ($2.0 million after tax) in 2007 and 2006, respectively. These amounts are included in wages and benefits in the statements of operations. As of December 31, 2007, 327,616 RSUs awarded to the Company’s employees were outstanding, with an aggregate intrinsic value of $8.2 million.
As of December 31, 2007, $5.0 million of compensation cost associated with unvested restricted stock awards attributable to future service had not yet been recognized. This amount will be recognized as expense over a weighted-average period of 1.6 years.
Performance Stock Awards
During the first quarter of 2007, Air Group awarded Performance Share Unit awards (PSUs) to certain executives of the Company. PSUs are similar to RSUs, but vesting is based on a performance condition tied to Air Group achieving a specified pretax margin over a three-year period. The PSU plan allows a portion of the PSUs to vest even if the specified pretax margin falls below the target, and additional shares to be granted if the margin target is exceeded, subject to a maximum. The Company intends to regularly review its assumptions about meeting the performance goal and expected vesting, and to adjust the related compensation expense accordingly. The Company recorded compensation expense related to PSUs of $0.3 million for the year ended December 31, 2007.
Employee Stock Purchase Plan
Air Group sponsors the ESPP, which is intended to qualify under Section 423 of the Internal Revenue Code. Under the terms of the ESPP, employees can purchase Air Group common stock at 85% of the closing market price on the first day of the offering period or the quarterly purchase date, whichever is
lower. Because of these attributes, the ESPP is considered compensatory under SFAS 123R and as such, compensation cost is recognized. Compensation cost associated with the ESPP was $1.4 million and $0.9 million in 2007 and 2006, respectively. The grant date fair value is calculated using the Black-Scholes model in the same manner as the Company’s option awards for 85% of the share award plus the intrinsic value of the 15% discount.
Summary of Stock-Based Compensation
The table below summarizes the components of total stock-based compensation for the years ended December 31, 2007 and 2006:
Note 11. Income Taxes
In July 2006, the FASB issued FASB Interpretation No 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48). The purpose of FIN 48 is to clarify certain aspects of the recognition and measurement related to accounting for income tax uncertainties. Under FIN 48, the impact of an uncertain income tax position must be recognized at the largest amount that is more likely than not of being sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained.
The Company was subject to the provisions of FIN 48 as of January 1, 2007. Upon adoption, no cumulative effect of accounting change was necessary or recorded in the financial statements. The total amount of unrecognized tax benefits as of the date of adoption was $16.5 million. This number includes a $15.1 million increase in the tax liability and a corresponding increase in deferred tax assets for unrecognized tax benefits as a result of the implementation of FIN 48 and $1.4 million of tax benefits that, if recognized, would impact the effective tax rate.
Changes in the FIN 48 liability for unrecognized tax benefits during 2007 are as follows (in millions):
At December 31, 2007, the total amount of unrecognized tax benefits of $13.6 million includes $12.5 million recorded as a liability and a corresponding increase in deferred tax assets and $0.7 million of tax benefits that, if recognized, would impact the effective tax rate.
Accrued interest on tax positions is recorded as a component of interest expense. Total accrued interest on tax positions included in the FIN 48 liability was zero at January 1, 2007 and $0.4 million at December 31, 2007. No penalties were accrued at January 1, 2007 or at December 31, 2007.
The periods subject to examination for Air Group’s federal income tax returns are the 2003 through 2006 tax years; however, the 2003 tax return is subject to examination only to the extent of the net operating loss carryforwards from 2003 that were utilized in 2005. The periods subject to examination for the Company’s major state income tax returns other than California are also the years 2003 through 2006. In California, the income tax years 2002 through 2006 remain open to examination.
The Company does not believe that it is reasonably possible that the total unrecognized tax benefit would significantly increase or decrease in the next 12 months. The FIN 48 liability for the Company’s unrecognized tax benefit is classified in other liabilities (noncurrent) in the balance sheets. The Company anticipates that total unrecognized tax benefits will not materially decrease due to the expiration of the statute of limitations for tax years prior to December 31, 2007.
During the first quarter of 2007, the Company received a favorable decision in a matter with the State of California. As a result of the decision, the Company reduced its FIN 48 liability by $0.7 million, recorded a previously unrecognized tax benefit of $1.0 million, and accrued interest income of $1.5 million. The refund was received in August 2007.
Deferred income taxes reflect the impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and such amounts for tax purposes.
Deferred tax (assets) and liabilities comprise the following at December 31 (in millions):
* State loss carryforwards of $32.2 million ($1.2 million tax effected) expire beginning in 2008 and ending in 2026.
The Company has concluded that it is more likely than not that its deferred tax assets will be realizable and thus no valuation allowance has been recorded as of December 31, 2007. This conclusion is based on the expected future reversals of existing taxable temporary differences and does not rely on future taxable income. The Company will continue to reassess the need for a valuation allowance during each future reporting period.
The components of income tax expense (benefit) were as follows (in millions):
In 2005, the deferred tax benefit related to the cumulative effect of the accounting change for federal and state income taxes was $42.8 million and $5.3 million, respectively.
Income tax expense (benefit) reconciles to the amount computed by applying the U.S. federal rate of 35% to income (loss) before income tax and accounting change as follows (in millions):
* In 2007, other-net includes $1.0 million of tax benefits due to a favorable decision in a matter with the State of California and $1.0 million of tax benefits related to the recognition of California income tax credit carryforwards. Other-net in 2006 includes $4.2 million of tax benefits associated with the reduction of certain tax contingency accruals for periods for which the statute of limitations expired in 2006.
Note 12. Related Party Transactions
Capacity Purchase Agreement
The Company has entered into a Capacity Purchase Agreement (CPA) with its sister company, Horizon Air Industries, Inc. (Horizon) effective January 1, 2007, whereby the Company purchases capacity in certain routes (“incentive markets”) from Horizon as specified by the agreement. Under the CPA, the Company pays Horizon a contractual amount for the purchased capacity in the incentive markets, regardless of the revenue collected on those flights. The amount paid to Horizon is generally based on Horizon’s operating costs, plus a margin. The Company establishes the scheduling, routes and pricing for the flights, and has the inventory and revenue risk in those markets.
Under the prior revenue-sharing agreement, the Company made a payment to Horizon equal to Horizon’s loss in those markets, if any, and a quarterly bonus that was based on Alaska’s overall operating margin.
The Company paid $283.4 million to Horizon under the CPA agreement during the year ended December 31, 2007 and $3.7 million under the prior revenue-sharing agreement during the year ended December 31, 2006. The Company received incentive payments from Horizon under the revenue-sharing agreement of $1.7 million in 2005.
Intercompany Services
The Company performs all ticket processing for Horizon. Horizon’s ticket sales are recorded by Alaska as air traffic liability and revenue is allocated to and recorded by Horizon when transportation is provided.
Mileage Plan participants may redeem miles on Horizon flights. Additionally, participants who fly on Horizon may earn miles in the Company’s Mileage Plan. The Company does not pay or receive amounts from Horizon for its participation in the plan.
The Company also provides certain services to Horizon for which the Company receives payment from Horizon based on the cost of the services, including personnel expenses related to development and maintenance of certain information and communication systems, processing Horizon’s revenue
transactions, accounting and payroll services, and other administrative services. Additionally, the Company pays certain leasing and other facilities costs on Horizon’s behalf that are reimbursed monthly by Horizon. Total amounts received by the Company from Horizon were $10.8 million, $11.2 million and $9.7 million for the years ended December 31, 2007, 2006 and 2005, respectively.
In the normal course of business, Alaska and Horizon each provide certain ground handling services to the other company. Charges for ground services provided by the Company to Horizon totaled $7.1 million, $6.0 million and $2.5 million during the years ended December 31, 2007, 2006 and 2005, respectively. Charges for ground services provided by Horizon to the Company totaled $9.8 million, $10.1 million and $4.8 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company also advances Horizon funds at varying interest rates. All amounts are payable on demand. Interest income recognized related to the Horizon receivable totaled $11.9 million, $3.1 million and $2.5 million for the years ended December 31, 2007, 2006 and 2005, respectively. Offsetting this amount is interest paid to Horizon on ticket sales processed by Alaska. Interest expense related to these ticket sales was $3.6 million, $2.7 million and $1.0 million for the years ended December 31, 2007, 2006 and 2005, respectively.
At December 31, 2007, receivables from related companies include $274.2 million from Horizon, $7.9 million from Alaska Air Group Leasing (AAGL) and $83.9 million from Air Group. At December 31, 2007, payables to related companies include $1.2 million to Horizon, $0.7 million to AAGL and $46.0 million to Air Group. The receivable from Horizon has increased significantly from December 31, 2006 as a result of loans to Horizon for the purchase of new Q400 aircraft. Additionally, the receivable from Air Group has increased significantly from December 31, 2006 as a result of Air Group’s $100 million share repurchase program.
During 2000, the Company transferred a flight simulator to AAGL in exchange for a $2.4 million note receivable from AAGL and a $0.6 million reduction in its payable to Air Group. The loan has repayment terms of 12 years at 6.5% interest. AAGL is leasing the simulator to the Company for 12 years.
The Company files a consolidated tax return with Air Group and other Air Group subsidiaries. As a result, the Company has current and non-current payables to Air Group for accrued income taxes. At December 31, 2007 and 2006, the amount payable to Air Group for income taxes was $63.6 million and $32.6 million, respectively, and is recorded as other accrued liabilities in the balance sheets. Additionally, as of December 31, 2006, the long-term accrued income taxes payable to Air Group was $1.4 million and is recorded as other liabilities in the balance sheet. There was no long-term income tax payable to Air Group as of December 31, 2007.
Note 13. Financial Instruments
The majority of the Company’s financial instruments are carried at fair value. Those include cash and cash equivalents, marketable securities (Note 4), securities lending collateral, restricted deposits (Note 9), and fuel hedge contracts (Note 3). The Company’s long-term fixed-rate debt is not carried at fair value. The estimated fair value of the Company’s long-term debt was as follows (in millions):
The fair value of cash equivalents and securities lending collateral approximates carrying values due to the short maturity of these instruments. The fair value of marketable securities is based on quoted market prices. The fair value of fuel hedge contracts is based on commodity exchange prices. The fair value of restricted deposits approximates the carrying amount. The fair value of long-term debt is based on a discounted cash flow analysis using the Company’s current borrowing rate.
Concentrations of Credit
The Company continually monitors its positions with, and the credit quality of, the financial institutions that are counterparties to its fuel-hedging contracts and does not anticipate nonperformance by the counterparties.
The Company could realize a material loss in the event of nonperformance by any single counterparty to its fuel hedge positions. However, the Company enters into transactions only with large, well-known financial institution counterparties that have strong credit ratings. In addition, the Company limits the amount of investment credit exposure with any one institution.
The Company’s trade receivables do not represent a significant concentration of credit risk at December 31, 2007 due to the frequency that settlement takes place and the dispersion across many industry and government segments.
Note 14. Impact of Staff Accounting Bulletin No. 108 (SAB 108)
In September 2006, the SEC issued SAB 108. SAB 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether those misstatements are material to the Company’s financial statements. SAB 108 was effective for fiscal years ending after November 15, 2006. The transition provisions of the bulletin permit the Company to adjust beginning retained earnings for the cumulative effect of immaterial errors relating to prior years. The Company adopted SAB 108 in the fourth quarter of 2006, with an effective date of January 1, 2006. In accordance with the bulletin, the Company adjusted beginning retained earnings for 2006 in the accompanying financial statements for the items described below. Management of the Company considers these adjustments to be immaterial to prior periods.
Depreciation of Leasehold Improvements
The Company historically has depreciated substantially all leasehold improvements over the shorter of the lease term or their estimated economic useful life. However, leasehold improvements at airports were generally depreciated over their estimated useful lives. The Company followed the practice of depreciating leasehold improvements over the longer period due to the expectation that the underlying lease would be renewed for at least the period over which the leasehold improvements were being depreciated. In February 2005, the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) issued interpretive guidance clarifying its position that leasehold improvements in an operating lease should be depreciated by the lessee over the shorter of their economic lives or the remaining lease term, as defined in SFAS 13. Our airport lease agreements do not generally carry a renewal right in them, which is a key consideration for SFAS 13 “lease term” definitions.
The difference between the depreciation expense recorded and the depreciation expense that would have been recorded had the Company depreciated those leasehold improvements using the shorter life of the lease term was not material to the statements of operations in any individual year, nor was the accumulated difference deemed material to the Company’s balance sheets. However, the accumulated difference would have been material to the statements of operations. As such, in order to correct the accumulated depreciation of leasehold improvements to depreciate them over the shorter of their economic lives or the remaining lease term, the Company adjusted its beginning retained earnings for 2006.
Impact of Adjustment
The impact of the item noted above, net of tax, on 2006 beginning balances is presented below (in millions):
Note 15. Change in Accounting Principle
Effective January 1, 2005, the Company changed its method of accounting for major airframe and engine overhauls from the capitalize and amortize method to the direct expense method. Under the former method, these costs were capitalized and amortized to maintenance expense over the shorter of the life of the overhaul or the remaining lease term. Under the direct expense method, overhaul costs are expensed as incurred. The Company believes that the direct expense method is preferable because it eliminates the judgment and estimation needed to determine overhaul versus repair allocations in maintenance activities. Additionally, the Company’s approved maintenance program for the majority of its airframes now focuses more on shorter, but more frequent, maintenance visits. Management also believes that the direct expense method is the predominant method used in the airline industry. Accordingly, effective January 1, 2005, the Company wrote off the net book value of its previously capitalized airframe and
engine overhauls for all aircraft resulting in a charge of $128.2 million pretax ($80.1 million after tax). The Company does not believe disclosing the effect of adopting the direct expense method on net income for 2005 provides meaningful information because of changes in the Company’s maintenance program, including the execution of a “power-by-the-hour” engine maintenance agreement with a third party in late 2004.
Note 16. Contingencies
Grievance with International Association of Machinists
In June 2005, the International Association of Machinists (IAM) filed a grievance under its Collective Bargaining Agreement (CBA) with the Company alleging that Alaska violated the CBA by, among other things, subcontracting the ramp service operation in Seattle. The dispute was referred to an arbitrator and hearings on the grievance commenced in January 2007, with a final hearing date in August. It is likely that a decision from the arbitrator will not be issued until early to mid-2008.
Other items
The Company is a party to routine litigation matters incidental to its business and with respect to which no material liability is expected.
Management believes the ultimate disposition of the matters discussed above is not likely to materially affect the Company’s financial position or results of operations. This forward-looking statement is based on management’s current understanding of the relevant law and facts, and it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of December 31, 2007, 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 current and 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 that the information is accumulated and communicated to our management, including our certifying officers, on a timely basis. Our certifying officers concluded, based on their evaluation, that disclosure controls and procedures were effective as of December 31, 2007.
Changes in Internal Control over Financial Reporting
During 2007, we converted to an integrated Human Resources, Benefits and Payroll system. There were no changes to the our internal control over financial reporting, including the changes described above, identified in management’s evaluation during the year ended December 31, 2007, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO Framework). Based on our evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.
We intend to regularly review and evaluate the design and effectiveness of our disclosure controls and procedures and internal control over financial reporting on an ongoing basis and to improve these controls and procedures over time and to correct any deficiencies that we may discover in the future. While we believe the present design of our disclosure controls and procedures and internal control over financial reporting are effective, future events affecting our business may cause us to modify our controls and procedures.
The Company’s independent registered public accounting firm has not issued an attestation report regarding its assessment of the Company’s internal control over financial reporting as of December 31, 2007.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
The following documents are filed as part of this report:
1. Financial Statement Schedules: Financial Statement Schedule II, Valuation and Qualifying Accounts, for the years ended December 31, 2007, 2006 and 2005 on page 75.
2. Exhibits: See Exhibit Index on page 71.
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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on February 20, 2008 on behalf of the registrant and in the capacities indicated.
/s/ William S. Ayer
Chairman, President, Chief Executive Officer and Director
(Principal Executive Officer)
William S. Ayer
/s/ Bradley D. Tilden
Executive Vice President/Finance and Planning and Chief Financial Officer
(Principal Financial Officer)
Bradley D. Tilden
/s/ Brandon S. Pedersen
Vice President/Finance and Controller
(Principal Accounting Officer)
Brandon S. Pedersen
/s/ Patricia M. Bedient
Director
Patricia M. Bedient
/s/ Phyllis J. Campbell
Director
Phyllis J. Campbell
/s/ Jessie J. Knight, Jr.
Director
Jessie J. Knight, Jr.
/s/ Dennis F. Madsen
Director
Dennis F. Madsen
/s/ Byron I. Mallott
Director
Byron I. Mallott
/s/ Richard A. Wien
Director
Richard A. Wien
EXHIBIT INDEX
Pursuant to Item 601(a)(2) of Regulation S-K, this Exhibit Index immediately precedes the exhibits.
Certain of the following exhibits have heretofore been filed with the Securities and Exchange Commission and are incorporated by reference from the documents described in parentheses. Certain others are filed herewith. The exhibits are numbered in accordance with Item 601 of Regulation S-K.
 Filed herewith.
* Indicates management contract or compensatory plan or arrangement.
# Pursuant to 17 CFR 240.24b-2, confidential information has been omitted and filed separately with the Securities and Exchange Commission pursuant to a Confidential Treatment Application filed with the Commission.
VALUATION AND QUALIFYING ACCOUNTS
Alaska Airlines, Inc.
Schedule II