ITEM 1. BUSINESS
GENERAL INFORMATION Alaska Airlines, Inc. (Alaska or the Company) is a wholly owned subsidiary of Alaska Air Group, Inc. Alaska Air Group, Inc. is a holding company that also owns Horizon Air Industries, Inc. (Horizon). Alaska is a major airline that was organized in 1932 and incorporated in the state of Alaska in 1937. Alaska became a wholly owned subsidiary of Alaska Air Group, Inc. in 1985 pursuant to a reorganization of Alaska into a holding company structure. Alaska Air Group, Inc. is a registrant pursuant to Section 12(b) of the Securities and Exchange Act of 1934 (Commission File No. 1-8957). Alaska's executive offices are located at 19300 Pacific Highway South, Seattle, Washington 98188. In 1999, Alaska accounted for 81% of Alaska Air Group, Inc.'s total operating revenues.
Horizon, a Washington corporation, began service in 1981 and was acquired by Alaska Air Group, Inc. in 1986. Horizon is a regional airline, that operates in the Pacific Northwest, Northern California and Western Canada.
OPERATIONS Alaska Airlines is an Alaska corporation that was organized in 1932 and incorporated in 1937. Alaska serves 35 cities in six states (Alaska, Washington, Oregon, California, Nevada and Arizona), one city in Canada and six cities in Mexico. In each year since 1973, Alaska has carried more passengers between Alaska and the U.S. mainland than any other airline. In 1999, Alaska carried 13.6 million passengers. Passenger traffic within Alaska and between Alaska and the U.S. mainland accounted for 23% of Alaska's 1999 revenue passenger miles, West Coast traffic (including Vancouver, Canada) accounted for 68% and the Mexico markets 9%. Based on passenger enplanements, Alaska's leading airports are Seattle, Portland, Los Angeles and Anchorage. Based on revenues, its leading nonstop routes are Seattle-Anchorage, Seattle-Los Angeles and Seattle-San Diego. At December 31, 1999, Alaska's operating fleet consisted of 89 jet aircraft.
Alaska distinguishes itself from competitors by providing a higher level of customer service. The airline's excellent service in the form of advance seat assignments, a first class section, attention to customer needs, high-quality food and beverage service, well-maintained aircraft and other amenities has been recognized by independent studies and surveys of air travelers.
ALLIANCES WITH OTHER AIRLINES Alaska and Horizon have marketing alliances with other airlines that allow reciprocal frequent flyer mileage accrual and redemption privileges and codesharing on certain flights as set forth below. The purpose of the alliances is to enhance Alaska's and Horizon's revenues by (a) providing our customers more value by offering them more travel destinations and better mileage accrual/redemption opportunities, (b) gaining access to more connecting traffic from other airlines, and (c) providing members of alliance partners' frequent flyer programs an opportunity to travel on Alaska and Horizon while earning mileage credit in the alliance partners' program.
* This airline does not have its own frequent flyer program. However, Alaska's Mileage Plan members can accrue and redeem miles on this airline's route system.
BUSINESS RISKS The Company's operations and financial results are subject to various uncertainties, such as intense competition, volatile fuel prices, a largely unionized labor force, the need to finance large capital expenditures, government regulation, potential aircraft incidents and general economic conditions. This report may contain forward-looking statements that are based on the best information currently available to management. The forward-looking statements are intended to be subject to the safe harbor protection provided by Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are indicated by phrases such as "the Company believes", "we anticipate" or any other language indicating a prediction of future events. Whether these statements are ultimately accurate depends on a number of outside factors that the Company cannot predict or control. The following discussion of business risks sets forth the principal foreseeable risks and uncertainties that my materially affect these predictions.
COMPETITION Competition in the air transportation industry is intense. Any domestic air carrier deemed fit by the DOT is allowed to operate scheduled passenger service in the United States. Alaska carries 2.2% of all U.S. domestic passenger traffic. Alaska competes with one or more domestic or foreign airlines on most of its routes. Some of these competitors are substantially larger than Alaska, have greater financial resources and have more extensive route systems.
Most major U.S. carriers have developed, independently or in partnership with others, large computerized reservation systems (CRS). Airlines, including Alaska, are charged industry-set
fees to have their flight schedules included in the various CRS displays. These systems are currently the predominant means of distributing airline tickets. In order to reduce anti-competitive practices, the DOT regulates the display of all airline schedules and fares.
FUEL Fuel costs were 13.6% of the Company's total operating expenses in 1999. Fuel prices, which can be volatile and are largely outside of the Company's control, can have a significant impact on the Company's operating results. Currently, a one cent change in the fuel price per gallon affects annual fuel costs by approximately $3.1 million. The Company believes that operating fuel efficient aircraft is an effective hedge against high fuel prices. The Company has in the past hedged against its exposure to fluctuations in the price of jet fuel, but has not done so in recent years. The Company expects to resume hedging in 2000.
UNIONIZED LABOR FORCE Labor costs were 35% of the Company's total operating expenses in 1999. Wage rates can have a significant impact on the Company's operating results. At December 31, 1999, labor unions represented 86% of Alaska's employees. The air transportation industry is regulated under the Railway Labor Act, which vests in the National Mediation Board certain regulatory powers with respect to disputes between airlines and labor unions. The Company cannot predict the outcome of union contract negotiations nor control the variety of actions (e.g. work stoppage or slowdown) unions might take to try to influence those negotiations.
LEVERAGE AND FUTURE CAPITAL REQUIREMENTS The Company, like many airlines, is relatively highly leveraged, which increases the volatility of its earnings. Due to its high fixed costs, including aircraft lease commitments, a decrease in revenues results in a disproportionately greater decrease in earnings. In addition, the Company has an ongoing need to finance new aircraft deliveries and there is no assurance that such financing will be available in sufficient amounts or on acceptable terms. See Item 7 for management's discussion of liquidity and capital resources.
GOVERNMENT REGULATION; INTERNATIONAL ROUTES Like other airlines, the Company is subject to regulation by the Federal Aviation Administration (FAA) and the United States Department of Transportation (DOT). The FAA, under its mandate to ensure aviation safety, has the authority to ground aircraft and to suspend temporarily or revoke permanently the authority of an air carrier or its licensed personnel for failure to comply with Federal Aviation Regulations and to levy civil penalties for such failure. The DOT has the authority to regulate certain airline economic functions including financial and statistical reporting, consumer protection, computerized reservations systems, essential air transportation and international route authority. The Company is subject to bilateral agreements between the United States and the foreign countries to which the Company provides service. There can be no assurance that existing bilateral agreements between the United States and the foreign governments will continue or that the Company's designation to operate such routes will continue.
RISK OF LOSS AND LIABILITY; WEATHER The Company is exposed to potential catastrophic losses in the event of aircraft accidents or terrorist incidents. Consistent with industry standards, the Company maintains vigorous safety, training and maintenance programs, as well as insurance against such losses. However, any aircraft accident, even if fully insured, could cause a negative public perception of the Company with adverse financial consequences. Unusually adverse weather can significantly reduce flight operations, resulting in lost revenues and added expenses.
OTHER INFORMATION EMPLOYEES Alaska had 10,040 active full-time and part-time employees at December 31, 1999. Alaska's union contracts at December 31, 1999 were as follows:
FREQUENT FLYER PROGRAM All major airlines have developed frequent flyer programs as a way of increasing passenger loyalty. Alaska's Mileage Plan allows members to earn mileage by flying on Alaska, Horizon and other participating airlines, and by using the services of non-airline partners, which include a credit card partner, telephone companies, hotels and car rental agencies. Alaska is paid by non-airline partners for the miles it credits to member accounts. With advance notice, Alaska has the ability to change the Mileage Plan terms, conditions, partners, mileage credits and award levels.
Mileage can be redeemed for free or discounted travel and for other travel industry awards. Upon accumulating the necessary mileage, members notify Alaska of their award selection. Over
70% of the flight awards selected are subject to blackout dates and capacity-controlled seating. Alaska's miles do not expire. As of the year-end 1998 and 1999, Alaska estimated that 1,101,000 and 1,129,000 round trip flight awards were eligible for redemption by Mileage Plan members who have mileage credits exceeding the 20,000 mile free round trip domestic ticket award threshold. Of these eligible awards, Alaska estimated that 812,000 and 921,000, respectively, would ultimately be redeemed. For the years 1997, 1998 and 1999, approximately 185,000, 191,000 and 226,000 round trip flight awards were redeemed and flown on Alaska and Horizon. These awards represent approximately 3.2% for 1997, 3.1% for 1998, and 3.7% for 1999, of the total passenger miles flown for each period.
Alaska maintains a liability for its Mileage Plan obligation that is based on its total miles outstanding, less an estimate for miles that will never be redeemed. The net miles outstanding are allocated between those credited for travel on Alaska, Horizon or other airline partners and those credited for using the services of non-airline partners. Miles credited for travel on Alaska, Horizon or other airline partners are accrued at Alaska's incremental cost of providing the air travel. The incremental cost includes the cost of meals, fuel, reservations and insurance. The incremental cost does not include a contribution to overhead, aircraft cost or profit. A portion of the proceeds received from non-airline partners is also deferred. At December 31, 1998 and 1999, the total liability for miles outstanding and for estimated payments to partner airlines was $28.0 million and $40.0 million, respectively.
ITEM 2.
ITEM 2. PROPERTIES
AIRCRAFT The following table describes the aircraft operated and their average age at December 31, 1999.
Nineteen of the 38 aircraft owned by Alaska as of December 31, 1999 are subject to liens securing long-term debt. Alaska's leased B737-200C, B737-400 and MD-80 aircraft have lease expiration dates in 2000, between 2002 and 2016, and between 2000 and 2013, respectively. Alaska has 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. For information regarding obligations under capital leases and long-term operating leases, see Notes to Financial Statements.
At December 31, 1999, all of Alaska's aircraft meet the Stage 3 noise requirements under the Airport Noise and Capacity Act of 1990. However, special noise ordinances restrict the timing of
flights operated by Alaska and other airlines at Burbank, Orange County, San Diego and San Jose. In addition, Orange County restricts the type of aircraft and number of flights.
GROUND FACILITIES AND SERVICES Alaska leases ticket counter, gates, cargo and baggage, office space and other support areas at the majority of the airports it serves. Alaska also owns terminal buildings at various Alaska cities.
Alaska has centralized operations in several buildings located at or near Seattle-Tacoma International Airport (Sea-Tac) in Seattle, Washington. The owned buildings, including land unless located on leased airport property, include: a three-bay hangar facility with maintenance shops; a flight operations and training center; an air cargo facility; a reservations and office facility; two office buildings; its corporate headquarters; and two storage warehouses. Alaska also leases a two-bay hangar/office facility at Sea-Tac. Alaska's other major facilities include: a regional headquarters building, an air cargo facility and a leased hangar/office facility in Anchorage; a Phoenix reservations center; and a leased two-bay maintenance facility in Oakland.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS In December 1998, search warrants and a grand jury subpoena (for the U.S. District Court for the Northern District of California) were served on Alaska. In addition, the Federal Aviation Administration (FAA) issued a letter of investigation to Alaska relating to maintenance performed on an MD-80 aircraft. In April 1999, the FAA issued a notice of proposed civil penalty for $44,000. In July 1999, Alaska responded informally to the notice and the FAA has not taken any further action. In November 1999, the grand jury issued a second subpoena on Alaska. To the Company's knowledge, no charges have been filed as a result of the grand jury investigation.
PART II
ITEM 5.
ITEM 5. MARKET PRICE FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
All of Alaska's outstanding common stock is held by Alaska Air Group, Inc. and such stock is not traded in any market. No cash dividend has been paid since 1989 and Alaska does not expect to pay regular dividends to Alaska Air Group.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INDUSTRY CONDITIONS The airline industry is cyclical due to a high correlation between demand for air travel and general economic conditions. Generally speaking, economic conditions have been strong during the years covered by this discussion. Because the industry has high fixed costs in relation to revenues, a small change in load factors or fare levels has a large impact on profits.
For most airlines, labor and fuel account for almost half of operating expenses. The strong economy has increased employee turnover and put upward pressure on labor costs. Fuel prices
have been volatile in the last three years. For Alaska Airlines, fuel prices, decreased 4% in 1997, decreased 25% in 1998 and increased 23% in 1999.
In recent years, airlines have reduced their ticket distribution costs by capping travel agent commissions, by decreasing commission rates from 10% to 5%, by partially eliminating paper tickets and by selling tickets directly to passengers via the Internet.
RESULTS OF OPERATIONS 1999 COMPARED WITH 1998 Net income in 1999 was $119.4 million, compared with $116.5 million in 1998. The 1999 results (fourth quarter impact) included an after-tax gain on sale of Equant N.V. of $2.2 million. The 1998 results included an after-tax charge of $10.1 million for a litigation settlement. Operating income was $176.3 million in 1999 compared to $194.0 million in 1998. Higher fuel prices impacted operating income by approximately $35.0 million. Airline financial and statistical data is shown following the financial statements. A discussion of this data follows.
REVENUES Capacity increased by 3.2% primarily due to additional flights in the Arizona, Mexico and Southern California markets Traffic grew by 4.4%, resulting in a 0.8 point increase in passenger load factor. The Canada and Mexico markets experienced the largest increases in load factor. Passenger yields were up 3.2%, with virtually all markets showing an increase over last year. New marketing alliances with other airlines, improved yield management techniques and small fare increases have helped improve yields. The higher load factor combined with the higher yield resulted in a 4.0% increase in revenue per available seat mile (ASM). Consequently, passenger revenues increased 7.7%.
Freight and mail revenues decreased 4.4%, due to lower average freight rates, and lower mail volumes carried. Other-net revenues increased 12.5%, due to increased revenue from travel partners in Alaska's frequent flyer program.
EXPENSES Operating expenses grew by 9.6 % as a result of a 3.2% increase in capacity and a 6.3% increase in cost per ASM. The increase in cost per ASM was partly due to higher fuel prices in 1999. Excluding fuel, cost per ASM increased 4.1%. Explanations of significant year-over-year changes in the components of operating expenses are as follows:
- Wages and benefits increased 8.5% due to a 5.5% increase in the number of employees combined with a 2.8% increase in average wages and benefits per employee. Employees were added in all areas to service the 4.3% increase in passengers carried. Average wage rates increased due to annual increases in the current pilot's contract, combined with the impact of new labor agreements signed in the second half of 1999.
- Contracted services increased 14% due to greater use of temporary employees (particularly in computer systems development), higher rates for ground handling services and increased navigation fees in Canada and Mexico.
- Fuel expense increased 26%, due to a 23% increase in the price of fuel combined with a 3% increase in fuel consumption.
- Maintenance expense increased 24%, exceeding the 3% increase in block hours, due to increased airframe and engine overhaul expense, and higher costs for landing gear repairs. In addition, a $2.7 million credit related to brake repairs was recorded in 1998.
- Commission expense decreased 4% on an 8% increase in passenger revenue. In 1999, 67% of ticket sales were made through travel agents, versus 70% in 1998. In 1999, 6% of ticket sales were made through Alaska's Internet web site versus 2% in 1998. In addition, the commission rate paid to travel agents decreased from 8% to 5% for sales made after October 18, 1999.
- Other selling expenses increased 9%, in line with the 8% increase in passenger revenues.
- Depreciation increased 10%, primarily due to purchasing nine new aircraft in 1999.
- Landing fees and other rentals increased 12%, higher than the 2% increase in landings, due to rate increases at Seattle, Portland and several other airports.
- Other expense increased 12%, partly due to recording a $2.7 million property tax credit in 1998. Absent this tax credit, the increase would have been 9%, higher than the 3% increase in capacity, due to higher expenditures for personnel expenses, professional services, operating supplies, passenger remuneration and recruiting. Insurance costs decreased due to lower passenger liability rates.
NONOPERATING INCOME (EXPENSE) Net nonoperating items improved $23.6 million over 1998 due to a $16.5 million litigation settlement charge in 1998, $3.2 million more capitalized interest and a $3.6 million gain on sale of Equant N.V. (a telecommunication network company owned by many airlines) in 1999.
LIQUIDITY AND CAPITAL RESOURCES The table below presents the major indicators of financial condition and liquidity.
1999 FINANCIAL CHANGES The Company's cash and marketable securities portfolio increased by $23 million during 1999. Operating activities provided $295 million of cash in 1999. Additional cash was provided by the issuance of new debt ($232 million). Cash was used for $483 million of capital expenditures, including the purchase of nine new Boeing 737 aircraft, two formerly leased Boeing 737s, flight equipment deposits, an aircraft simulator and airframe and engine overhauls, and for $27 million of debt repayment.
Like many airlines, the Company has a working capital deficit. The existence of a working capital deficit has not in the past impaired the Company's ability to meet its obligations as they become due and it is not expected to do so in the future.
FINANCING ARRANGEMENTS During the fourth quarter of 1999, Alaska issued $232 million of 7.6% fixed rate debt secured by eight aircraft.
COMMITMENTS At December 31, 1999, the Company had firm orders for 23 aircraft requiring aggregate payments of approximately $577 million, as set forth below. In addition, Alaska has options to acquire 26 more B737s. Alaska expects to finance the new planes with either leases, long-term debt or internally generated cash.
DEFERRED TAXES At December 31, 1998, net deferred tax liabilities were $141 million, which includes $145 million of net temporary differences offset by $4 million of Alternative Minimum Tax (AMT) credits. The Company believes that all of its deferred tax assets, including its AMT credits, will be realized through profitable operations.
YEAR 2000 COMPUTER ISSUE The Company implemented a project to ensure that its systems will function properly in the year 2000 and thereafter. In fact, virtually all systems have worked properly in the year 2000. In addition, the Company has not experienced any year 2000 related problems with its significant suppliers with which its systems interface or exchange data. The direct costs of projects solely intended to correct year 2000 problems were approximately $2 million. Due to lower than normal passenger traffic, Alaska and canceled, in advance, flights late in the day on December 31, 1999 and early in the day on January 1, 2000. Lost operating profit on each day was estimated at $600,000.
NEW ACCOUNTING STANDARDS During June 1998, the Financial Accounting Standards Board issued FAS 133, Accounting for Derivative Instruments and Hedging Activities The new standard requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the use of the derivative and whether it qualifies for hedge
accounting. Due to the Company's minimal use of derivatives, the new standard is expected to have no material impact on its financial position or results of operations. FAS 133 will be effective for the Company's fiscal year beginning January 1, 2000.
AIRCRAFT ACCIDENT On January 31, 2000, Alaska Airlines flight 261 from Puerto Vallarta enroute to San Francisco, went down in the water off the coast of California near Point Mugu. The flight carried 83 passengers and five crew members. There were no survivors. Consistent with industry standards, the Company maintains insurance against aircraft accidents. Any aircraft accident, even if fully insured, could cause a negative public perception of the Company with adverse financial consequences. However, the Company believes this accident will not result in a material adverse impact on the financial position or results of operations of the Company.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS
See Item 14.
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ALASKA AIRLINES, INC.
By: /s/ John F. Kelly Date: February 25, 2000 ------------------------- John F. Kelly CHAIRMAN AND CHIEF EXECUTIVE OFFICER
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on February 25, 2000 on behalf of the registrant and in the capacities indicated.
BALANCE SHEET Alaska Airlines, Inc.
See accompanying notes to financial statements.
BALANCE SHEET Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENT OF INCOME Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENT OF SHAREHOLDER'S EQUITY Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENT OF CASH FLOWS Alaska Airlines, Inc.
See accompanying notes to financial statements.
NOTES TO FINANCIAL STATEMENTS Alaska Airlines, Inc. December 31, 1999
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND NATURE OF OPERATIONS 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 Alaska Air Group Leasing (AAGL) and Horizon Air Industries, Inc. (Horizon). Alaska is a major airline serving Alaska; Vancouver, Canada; the U.S. West Coast and Mexico. It operates an all jet fleet and its average passenger trip is 865 miles.
BASIS OF PRESENTATION Preparation of financial statements requires the use of management's estimates. Actual results could differ from those estimates. Certain reclassifications have been made in prior years' financial statements to conform to the 1999 presentation.
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 its cash balance when checks are disbursed. Due to the time delay in checks clearing the banks, the Company normally maintains a negative cash balance on its books which is reported as a current liability. The amount of the negative cash balance was $14.9 million and $19.0 million at December 31, 1998 and 1999, respectively.
INVENTORIES AND SUPPLIES Expendable and repairable aircraft parts, as well as other materials and supplies, are stated at average cost. An allowance for obsolescence of flight equipment expendable and repairable parts is accrued based on estimated disposal date and salvage value. Surplus inventories are carried at their net realizable value. The allowance at December 31, 1998 and 1999 for all inventories was $15.6 million and $18.5 million, respectively.
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:
Assets and related obligations for items financed under capital leases are initially recorded at an amount equal to the present value of the future minimum lease payments. The cost of major airframe overhauls, engine overhauls, and other modifications which extend the life or improve the usefulness of aircraft are capitalized and amortized over their estimated period of use. Other repair and maintenance costs are expensed when incurred. The Company periodically reviews long-lived assets for impairment.
INTANGIBLE ASSETS-SUBSIDIARIES The excess of the purchase price over the fair value of net assets acquired is recorded as an intangible asset and is amortized over 40 years. Accumulated amortization at December 31, 1998 and 1999 was $6.4 million and $6.9 million, respectively.
FREQUENT FLYER AWARDS Alaska operates a frequent flyer award program that provides travel awards to members based on accumulated mileage. The estimated incremental cost of providing free travel is recognized as an expense and
accrued as a liability as miles are accumulated. Alaska also defers recognition of income on a portion of the payments it receives from travel partners associated with its frequent flyer program. The frequent flyer award liability, which is included with other accrued liabilities, is relieved as travel awards are issued. The liability at December 31, 1998 and 1999 was $28.0 million and $40.0 million, respectively.
DEFERRED INCOME Deferred income results from the sale and leaseback of aircraft, the receipt of manufacturer or vendor credits, and from the sale of foreign tax benefits. This income is recognized over the term of the applicable agreements.
LEASED AIRCRAFT RETURN COSTS The costs associated with returning leased aircraft are accrued over the lease period. As leased aircraft are retired, the costs are charged against the established reserve. The reserve is part of other liabilities, and at December 31, 1998 and 1999 was $45.2 million and $43.2 million, respectively.
PASSENGER REVENUES Passenger revenues are considered earned at the time service is provided. Tickets sold but not yet used are reported as air traffic liability.
CONTRACTED SERVICES Contracted services includes the expenses for aircraft ground handling, security, temporary employees and other similar services.
OTHER SELLING EXPENSES Other selling expenses includes credit card commissions, computerized reservations systems (CRS) charges, advertising and promotional costs. The costs of advertising are expensed the first time the advertising takes place. Advertising expense was $8.8 million, $15.5 million, and $14.6 million, respectively, in 1997, 1998 and 1999.
CAPITALIZED INTEREST Interest is capitalized on flight equipment purchase deposits and ground facility progress payments as a cost of the related asset and is depreciated over the estimated useful life of the asset.
INCOME TAXES Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns.
DERIVATIVE FINANCIAL INSTRUMENTS The Company enters into foreign exchange forward contracts, generally with maturities of less than one month, to manage risk associated with net foreign currency transactions. Resulting gains and losses are recognized currently in other operating expense. The Company periodically enters into interest rate swap agreements to hedge interest rate risk. The differential to be paid or received from these agreements is accrued as interest rates change and is recognized currently in the income statement. The Company periodically enters into hedge agreements to reduce its exposure to fluctuations in the price of jet fuel. A gain or loss is recorded if the fuel index average exceeds the ceiling price or falls below the floor price. There were no interest rate swaps or fuel hedges entered into in 1999.
NOTE 2. MARKETABLE SECURITIES
Marketable securities are investments that are readily convertible to cash and have original maturities that exceed three months. They are classified as available for sale and consisted of the following at December 31 (in millions):
There were no material unrealized holding gains or losses at December 31, 1998 or 1999.
Of the marketable securities on hand at December 31, 1999, 63% will mature during 2000 and the remainder will mature during 2001. Based on specific identification of securities sold, the following occurred in 1998 and 1999 (in millions):
Realized gains and losses are reported as a component of interest income.
NOTE 3. OTHER ASSETS
Other assets consisted of the following at December 31 (in millions):
At December 31, 1999, Alaska owned approximately 80,000 depository certificates convertible, subject to certain restrictions, into the common stock of Equant N.V., a telecommunication network company. The certificates had an estimated fair value of $7 million. Alaska's carrying value of the certificates was de minimis.
NOTE 4. RELATED COMPANY TRANSACTIONS
During 1999, Alaska transferred a flight simulator to AAGL in exchange for an $8.8 million note receivable from AAGL and a $2.2 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 Alaska for 12 years. At December 31, 1999, the receivables from related companies included $8.8 million from AAGL, $5.2 million from Air Group and $13.1 million from Horizon. At December 31, 1999, the payables to related companies consisted primarily of a non-interest bearing payable, which is due on demand, to Air Group.
NOTE 5. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
At December 31, 1998 and 1999, long-term debt and capital lease obligations were as follows (in millions):
At December 31, 1999, borrowings of $383.0 million are secured by flight equipment and real property. During 1999, Alaska issued $232 million of debt secured by flight equipment. The new debt has repayment terms of 12 to 16 years at fixed interest rates of approximately 7.6%.
At December 31, 1999, Alaska had a credit facility with commercial banks that allows it to borrow up to $150 million until December
2004. Borrowings under this facility bear interest at a rate that varies based on LIBOR. At December 31, 1999, no borrowings were outstanding under this credit facility.
Certain Alaska loan agreements contain provisions that require maintenance of specific levels of net worth, leverage and fixed charge coverage, and limit investments, lease obligations, sales of assets and additional indebtedness. At December 31, 1999 the Company was in compliance with all loan provisions, and under the most restrictive loan provisions, Alaska had $209 million of net worth above the minimum.
At December 31, 1999, long-term debt principal payments for the next five years were (in millions):
NOTE 6. COMMITMENTS
LEASE COMMITMENTS
Lease contracts for 51 aircraft have remaining lease terms of one to 17 years. The majority of airport and terminal facilities are also leased. Total rent expense was $177.7 million, $193.6 million and $192.5 million, in 1997, 1998 and 1999, respectively. Future minimum lease payments under long-term operating leases and capital leases as of December 31, 1999 are shown below (in millions):
AIRCRAFT COMMITMENTS The Company has firm orders for 23 Boeing 737 series aircraft to be delivered between 2000 and 2002. The firm orders require payments of approximately $580 million between 2000 and 2002. As of December 31, 1999, deposits of $158 million related to the firm orders had been made. In addition to the ordered aircraft, the Company holds purchase options on 26 Boeing 737s.
NOTE 7. EMPLOYEE BENEFIT PLANS PENSION PLANS Four defined benefit and four defined contribution retirement plans cover essentially all employees. 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. 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 following table sets forth the status of the plans for 1998 and 1999 (in millions):
[GRAPHIC OMITTED]
Net pension expense for the defined benefit plans included the following components for 1997, 1998 and 1999 (in millions):
Alaska and Horizon also maintain an unfunded, noncontributory benefit plan for certain elected officers. The $23 million unfunded accrued pension cost for this plan was accrued as of December 31, 1999.
The defined contribution plans are deferred compensation plans under section 401(k) of the Internal Revenue Code. Some of these plans require Company matching contributions based on a percentage of participants' contributions. One plan has an Employee Stock Ownership Plan (ESOP) feature. The ESOP owns Air Group common shares, which are held in trust for eligible employees. The Company records compensation for payments made to the Plan. As Alaska's contributions are received, the Plan releases the shares of common stock to the employees' accounts. Total expense for the defined contribution plans was $6.8 million, $6.7 million and $8.0 million, respectively, in 1997, 1998 and 1999.
PROFIT SHARING PLANS Alaska has an employee profit sharing plan. Profit sharing expense for 1997, 1998 and 1999 was $12.1 million, $19.7 million and $18.4 million, respectively.
OTHER POSTRETIREMENT 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 at December 31, 1998 and 1999 was $20.1 million and $25.4 million, respectively. The APBO is unfunded and is included with other liabilities on the Balance Sheet. Annual expense related to this subsidy is not considered material to disclose.
NOTE 8. INCOME TAXES Alaska files a consolidated tax return with Air Group and other Air Group subsidiaries. Each member of the consolidated group, including Alaska, calculates its tax provision and tax liability, if applicable, on a separate-entity basis. Any differences between the consolidated amounts and the total of the subsidiaries' amounts are included in the tax provision of the parent company.
After consideration of temporary differences, taxable income for 1999 was approximately $129 million.
The components of income tax expense were as follows (in millions):
Income tax expense reconciles to the amount computed by applying the U.S. federal rate of 35% to income before taxes as follows (in millions):
Deferred income taxes result from temporary differences in the timing of recognition of revenue and expense for tax and financial reporting purposes. Deferred tax assets and liabilities comprise the following at December 31 (in millions):
NOTE 9. FINANCIAL INSTRUMENTS
The estimated fair values of the Company's financial instruments were as follows (in millions):
The fair value of cash equivalents approximates carrying value due to the short maturity of these instruments. The fair value of marketable securities is based on quoted market prices. The fair value of restricted deposits approximates the carrying amount. The fair value of restricted depository certificates convertible into the common stock of Equant N.V. is $7 million based on sales of Equant N.V. stock in 1999. The fair value of long-term debt approximates carrying value.
ALASKA AIRLINES FINANCIAL AND STATISTICAL DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholder of Alaska Airlines, Inc.:
We have audited the accompanying balance sheet of Alaska Airlines, Inc. (an Alaska corporation) as of December 31, 1999 and 1998, and the related statements of income, shareholder's equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. 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, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in Item 14(a) is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/ Arthur Andersen LLP ARTHUR ANDERSEN LLP
Seattle, Washington January 25, 2000
VALUATION AND QUALIFYING ACCOUNTS Alaska Airlines, Inc. Schedule II
(A) Deduction from reserve for purpose for which reserve was created.
EXHIBIT INDEX
Certain of the following exhibits have heretofore been filed with the Commission and are incorporated herein by reference from the document described in parenthesis. Certain others are filed herewith.
* Filed herewith. # Confidential treatment was granted as to a portion of this document.