UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-K (Mark One) X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the fiscal year ended December 31, 1998 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from . . . . . . . . to . . . . . . . . Commission File Number 1-8957 ALASKA AIR GROUP, INC. (Exact name of registrant as specified in its charter) Delaware 91-1292054 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 19300 Pacific Highway South, Seattle, Washington 98188 (Address of Principal Executive Offices) Registrant's telephone number, including area code: (206) 431-7040 Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered Common Stock, $1.00 Par Value New York Stock Exchange Rights to Purchase Series A Participating Preferred Stock New York Stock Exchange As of December 31, 1998, common shares outstanding totaled 26,224,005. The aggregate market value of the common shares of Alaska Air Group, Inc. held by nonaffiliates, 26,156,752 shares, was approximately $1.157 billion (based on the closing price of these shares, $44.25, on the New York Stock Exchange on such date). Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ____ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ( X ) DOCUMENTS TO BE INCORPORATED BY REFERENCE Title of Document Part Hereof Into Which Document to be Incorporated Definitive Proxy Statement Relating to 1999 Annual Meeting of Shareholders Part III Exhibit Index begins on page 35.
PART I ITEM 1. BUSINESS GENERAL INFORMATION Alaska Air Group, Inc. (Air Group or the Company) is a holding company that was incorporated in Delaware in 1985. Its two principal subsidiaries are Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon). Both subsidiaries operate as airlines, although their business plans, competition and economic risks differ substantially. Alaska is a major airline, operates an all jet fleet, and its average passenger trip length is 864 miles. Horizon is a regional airline, operates jet and turboprop aircraft, and its average passenger trip is 260 miles. Individual financial information for Alaska and Horizon is reported in Note 11 to Consolidated Financial Statements. Air Group's executive offices are located at 19300 Pacific Highway South, Seattle, Washington 98188. The business of the Company is somewhat seasonal. Quarterly operating income tends to peak during the third quarter. Alaska 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 five 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 1998, Alaska carried 13.1 million passengers. Passenger traffic within Alaska and between Alaska and the U.S. mainland accounted for 25% of Alaska's 1998 revenue passenger miles, West Coast traffic (including Vancouver, Canada) accounted for 67% and the Mexico markets 8%. 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, 1998, Alaska's operating fleet consisted of 84 jet aircraft. The majority of Alaska flights, and certain Northwest Airlines flights, are dual-designated in airline computer reservation systems as Alaska Airlines and Northwest Airlines in order to facilitate feed traffic between the two airlines. Alaska Airlines also serves six smaller cities in California, six in Washington, two in Oregon and many small communities in Alaska through code share marketing agreements with local commuter carriers. In October 1998, Alaska suspended its service to Russia due to economic instability in Russia. Horizon Horizon, a Washington corporation, began service in 1981 and was acquired by Air Group in 1986. It is the largest regional airline in the Pacific Northwest, and serves 33 cities in five states (Washington, Oregon, Montana, Idaho, and California) and five cities in Canada. In 1998, Horizon carried 4.4 million passengers. Based on passenger enplanements, Horizon's leading airports are Seattle, Portland, Spokane and Boise. Based on revenues, its leading nonstop routes are Seattle- Portland, Seattle-Spokane and Seattle-Boise. At December 31, 1998, Horizon's operating fleet consisted of 20 jet and 40 turboprop aircraft, with the jets providing 58% of the 1998 capacity. Horizon flights are listed under the Alaska Airlines designator code in airline computer reservation systems. Most Horizon flights are also dual-designated in these reservation systems as Northwest Airlines and Alaska Airlines. In 1998, 25% of Horizon's passengers connected to Alaska and 7% connected to Northwest. Alaska and Horizon integrate their flight schedules to provide the best possible service between any two points served by their systems. Both airlines distinguish themselves from competitors by providing a higher level of customer service. The airlines' excellent service in the form of advance seat assignments, attention to customer needs, high-quality food and beverage service, well-maintained aircraft a first class section aboard Alaska aircraft and other amenities is regularly recognized by independent studies and surveys of air travelers. Alaska and Horizon offer competitive fares. 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. 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. Together, Alaska and Horizon carry 2.5% of all U.S. domestic passenger traffic. Alaska and Horizon compete with one or more domestic or foreign airlines on most of their routes. Some of these competitors are substantially larger than Alaska and Horizon, have greater financial resources and have more extensive route systems. Due to its shorthaul markets, Horizon also competes with the automobile. Most major U.S. carriers have developed, independently or in partnership with others, large computerized reservation systems (CRS). Airlines, including Alaska, and Horizon, are charged industry-set fees to have their flight schedules included in the various CRS displays used by travel agents and airlines. 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 11.4% of the Company's total operating expenses in 1998. 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 $3.5 million. The Company has in the past hedged against its exposure to fluctuations in the price of jet fuel, but does not currently do so. The Company evaluates hedging strategies on an ongoing basis. Unionized Labor Force Labor costs were 35% of the Company's total operating expenses in 1998. Wage rates can have a significant impact on the Company's operating results. At December 31, 1998, labor unions represented 87% of Alaska's and 45% of Horizon'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, can ground aircraft, suspend or revoke the authority of an air carrier or its licensed personnel for failure to comply with Federal Aviation Regulations and levy civil penalties. 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 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. 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. Unlike many other airlines, Alaska's miles do not expire. As of the year-end 1997 and 1998, Alaska estimates that 652,000 and 812,000 round trip flight awards could have been redeemed by Mileage Plan members who have mileage credits exceeding the 20,000 mile free round trip domestic ticket award threshold. At December 31, 1998, fewer than 4% of these flight awards were issued and outstanding. For the years 1996, 1997 and 1998, approximately 173,000, 185,000 and 191,000 round trip flight awards were redeemed and flown on Alaska and Horizon. These awards represent approximately 4.4% for 1996, 3.2% for 1997, and 3.1% for 1998, 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, 1997 and 1998, the total liability for miles outstanding was $22.3 million and $28.0 million, respectively. Employees Alaska had 9,244 active full-time and part-time employees at December 31, 1998. Alaska's union contracts at December 31, 1998 were as follows: <TABLE> <CAPTION> Number of Union Employee Group Employees Contract Status <S> <C> <C> <C> Air Line Pilots Pilots 1,156 Amendable 4/30/03 Association International Association of Flight attendants 1,635 Amendable 3/14/99 Flight Attendants International Rampservice 932 Amendable 8/31/97 Association of and stock clerks In mediation Machinists and Aerospace Workers Clerical, office and 3,211 Amendable 5/20/99 passenger service In negotiation Aircraft Mechanics Mechanics, inspectors 1,031 Initial contract Fraternal Association and cleaners In negotiation Mexico Workers Mexico airport 71 Amendable 4/1/99 Association personnel of Air Transport Transport Workers Dispatchers 16 Amendable 2/9/02 Union of America </TABLE> Horizon had 3,220 active full-time and part-time employees at December 31, 1998. Horizon's union contracts at December 31, 1998 were as follows: <TABLE> <CAPTION> Number of Union Employee Group Employees Contract Status <S> <C> <C> <C> International Brotherhood Pilots 547 Initial contract of Teamsters In negotiation Association of Flight attendants 343 Amendable 1/28/03 Flight Attendants Transport Workers Mechanics and 490 Amendable 5/18/01 Union of America related classifications Dispatchers 25 Amendable 5/10/02 National Automobile, Station personnel 50 Amendable 1/17/01 Aerospace, Transportation in Canada and General Workers </TABLE> ITEM 2. PROPERTIES Aircraft The following table describes the aircraft operated and their average age at December 31, 1998. <TABLE> <CAPTION> Passenger Average Age Aircraft Type Capacity Owned Leased Total in Years <S> <C> <C> <C> <C> <C> Alaska Airlines Boeing 737-200C 111 7 1 8 18.4 Boeing 737-400 140 4 33 37 3.8 McDonnell Douglas MD-80 140 16 23 39 9.0 27 57 84 7.6 Horizon Air de Havilland Dash 8 37 -- 40 40 4.1 Fokker F-28 69 7 13 20 14.8 7 53 60 7.8 </TABLE> Part II, Item 7, "Management's Discussion and Analysis of Results of Operations and Financial Condition," discusses future orders and options for additional aircraft. Eleven of the 27 aircraft owned by Alaska as of December 31, 1998 are subject to liens securing long-term debt. Alaska's leased B737-200C, B737-400 and MD-80 aircraft have lease expiration dates in 1999, between 2002 and 2016, and between 1999 and 2013, respectively. Horizon's leased de Havilland Dash 8 and Fokker F-28 aircraft have expiration dates between 2000 and 2013 and 2000 and 2002, respectively. Alaska and Horizon have the option to extend most of the leases for additional periods, or the right to purchase the aircraft at the end of the lease term, usually at the then fair market value of the aircraft. For information regarding obligations under capital leases and long-term operating leases, see Notes to Consolidated Financial Statements. Special noise ordinances or agreements restrict the type of aircraft, the timing and the number of flights operated by Alaska and other air carriers at four Los Angeles area airports plus San Diego, San Jose, San Francisco, Seattle and Vancouver. At December 31, 1998, all of Alaska's aircraft meet the Stage 3 noise requirements under the Airport Noise and Capacity Act of 1990. Ground Facilities and Services Alaska and Horizon lease ticket counters, gates, cargo and baggage, office space and other support areas at the majority of the airports they serve. 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. Horizon owns its Seattle corporate headquarters building. It leases an operations, training and aircraft maintenance facility (completed in 1998) in Portland, and a maintenance facility in Boise. ITEM 3. LEGAL PROCEEDINGS In July 1998, the Company announced that it had reached an agreement in principle with the trustee for creditors of the defunct MarkAir, Inc. regarding a breach of contract lawsuit. Subsequently, a formal settlement agreement was approved by the bankruptcy court. The $16.5 million settlement resulted in an after-tax charge of $10.1 million ($0.38 per diluted share) in the third quarter of 1998. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of Alaska Air Group, Inc., their positions and their respective ages (as of March 1, 1999) are as follows: <TABLE> <CAPTION> Name Position Age Officer Since <S> <C> <C> <C> John F. Kelly Chairman, President and Chief 54 1981 Executive Officer of Alaska Air Group, Inc.; Chairman and and CEO of Alaska Airlines, Inc.; Chairman of Horizon Air Industries, Inc. Harry G. Lehr Senior Vice President/Finance 58 1986 of Alaska Air Group, Inc. and Alaska Airlines, Inc. Steven G. Hamilton Vice President/Legal and General 59 1988 Counsel of Alaska Air Group, Inc. and Alaska Airlines, Inc. Keith Loveless Corporate Secretary and Associate 42 1996 General Counsel of Alaska Air Group, Inc. and Alaska Airlines, Inc. </TABLE> The above officers have been employed as officers of Air Group or its subsidiary, Alaska Airlines, for more than five years except for Keith Loveless, who was elected as Corporate Secretary in 1996. Mr. Loveless joined the Alaska Airlines legal department in 1986 and continues to hold his current position as associate general counsel of Alaska Airlines, a post he has held since 1993. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS As of December 31, 1998, there were 26,224,005 shares of common stock issued and outstanding and 4,687 shareholders of record. The Company also held 2,750,102 treasury shares at a cost of $62.7 million. The Company has not paid dividends on the common stock since 1992. Air Group's common stock is listed on the New York Stock Exchange (symbol: ALK). The following table shows the trading range of Alaska Air Group common stock on the New York Stock Exchange for 1997 and 1998. <TABLE> <CAPTION> 1997 1998 High Low High Low <S> <C> <C> <C> <C> First Quarter 27-5/8 20-3/4 61 38-1/4 Second Quarter 26-1/4 23 62-9/16 43-3/8 Third Quarter 33-5/16 25-1/16 61-3/16 32-1/16 Fourth Quarter 40-1/8 30-3/16 45-11/16 26 </TABLE>
<TABLE> ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA <CAPTION> 1994 1995 1996 1997 1998 <S> <C> <C> <C> <C> <C> Consolidated Financial Data: Year Ended December 31 (in millions, except per share amounts): Operating Revenues $1,315.6 $1,417.5 $1,592.2 $1,739.4 $1,897.7 Operating Expenses 1,241.6 1,341.8 1,503.2 1,600.4 1,686.7 Operating Income 74.0 75.7 89.0 139.0 211.0 Nonoperating expense, net (a) (33.0) (41.7) (24.7) (15.4) (6.6) Income before income tax 41.0 34.0 64.3 123.6 204.4 Net Income $22.5 $17.3 $38.0 $72.4 $124.4 Average shares outstanding 13.367 13.485 14.241 14.785 23.388 Basic earnings per share $1.69 $1.28 $2.67 $4.90 $5.32 Diluted earnings per share 1.62 1.26 2.05 3.53 4.81 At End of Period (in millions, except ratio): Total assets $1,315.8 $1,313.4 $1,311.4 $1,533.1 $1,731.8 Long-term debt and capital lease obligation 589.9 522.4 404.1 401.4 171.5 Shareholders' equity 191.3 212.5 272.5 475.3 789.5 Ratio of earnings to fixed charges 1.36 1.28 1.57 2.10 2.93 Alaska Airlines Operating Data: Revenue passengers (000) 8,958 10,140 11,805 12,284 13,056 Revenue passenger miles (RPM) (000,000) 7,587 8,584 9,831 10,386 11,283 Available seat miles (ASM) (000,000) 12,082 13,885 14,904 15,436 16,807 Revenue passenger load factor 62.8% 61.8% 66.0% 67.3% 67.1% Yield per passenger mile 12.20c 11.59c 11.67c 12.49c 12.50c Operating revenues per ASM 8.79c 8.23c 8.70c 9.38c 9.32c Operating expenses per ASM 8.27c 7.71c 8.10c 8.51c 8.17c Average full-time equivalent employees 6,486 6,993 7,652 8,236 8,704 Horizon Air Operating Data: Revenue passengers (000) 3,482 3,796 3,753 3,686 4,389 Revenue passenger miles (RPM) (000,000) 733 841 867 889 1,143 Available seat miles (ASM) (000,000) 1,165 1,414 1,462 1,446 1,815 Revenue passenger load factor 62.9% 59.5% 59.3% 61.5% 63.0% Yield per passenger mile 33.35c 31.48c 33.14c 32.56c 29.01c Operating revenues per ASM 22.06c 19.77c 20.61c 21.00c 19.16c Operating expenses per ASM 20.95c 19.47c 20.60c 20.60c 18.16c Average full-time equivalent employees 2,557 2,864 2,891 2,756 3,019 (a) Includes capitalized interest of $.4 million, $.2 million, $1.0 million, $5.3 million and $6.6 million for 1994, 1995, 1996, 1997, and 1998, respectively. c=cents </TABLE>
<TABLE> <CAPTION> Alaska Airlines Financial and Statistical Data Quarter Ended December 31 Year Ended December 31 Financial Data (in millions): 1997 1998 % Change 1997 1998 % Change <S> <C> <C> <C> <C> <C> <C> Operating Revenues: Passenger $313.0 $333.5 6.5 $1,297.0 $1,410.4 8.7 Freight and mail 20.7 19.8 (4.3) 82.9 83.7 1.0 Other - net 16.2 19.4 19.8 68.0 72.2 6.2 Total Operating Revenues 349.9 372.7 6.5 1,447.9 1,566.3 8.2 Operating Expenses: Wages and benefits 106.1 115.0 8.4 423.8 466.1 10.0 Employee profit sharing 2.4 3.7 54.2 12.1 19.7 62.8 Contracted services 11.6 11.8 1.7 42.5 48.7 14.6 Aircraft fuel 49.3 39.1 (20.7) 199.7 162.3 (18.7) Aircraft maintenance 18.6 17.2 (7.5) 67.4 77.6 15.1 Aircraft rent 38.2 41.2 7.9 148.5 158.9 7.0 Food and beverage service 11.8 12.5 5.9 46.7 49.1 5.1 Commissions 22.9 22.5 (1.7) 100.8 94.4 (6.3) Other selling expenses 11.7 18.9 61.5 63.9 75.2 17.7 Depreciation and amortization 14.9 15.9 6.7 56.9 61.9 8.8 Loss (gain) on sale of assets (0.9) 0.6 NM (1.2) 1.0 NM Landing fees and other rentals 12.7 14.8 16.5 53.1 59.4 11.9 Other 26.2 24.9 (5.0) 99.4 98.0 (1.4) Total Operating Expenses 325.5 338.1 3.9 1,313.6 1,372.3 4.5 Operating Income 24.4 34.6 41.8 134.3 194.0 44.5 Interest income 3.9 6.8 12.2 23.2 Interest expense (5.9) (4.0) (25.0) (17.4) Interest capitalized 1.1 1.5 3.4 5.1 Other - net 0.1 (0.1) 2.5 (14.4) (0.8) 4.2 (6.9) (3.5) Income Before Income Tax $23.6 $38.8 64.4 $127.4 $190.5 49.5 Operating Statistics: Revenue passengers (000) 2,958 3,211 8.5 12,284 13,056 6.3 RPMs (000,000) 2,490 2,749 10.4 10,386 11,283 8.6 ASMs (000,000) 3,847 4,204 9.3 15,436 16,807 8.9 Passenger load factor 64.7% 65.4% 0.7 pts 67.3% 67.1% (0.2)pts Breakeven load factor 60.2% 58.0% (2.2)pts 60.5% 58.0% (2.5)pts Yield per passenger mile 12.57c 12.13c (3.5) 12.49c 12.50c 0.1 Operating revenue per ASM 9.10c 8.87c (2.5) 9.38c 9.32c (0.6) Operating expenses per ASM 8.46c 8.04c (5.0) 8.51c 8.17c (4.1) Fuel cost per gallon 71.7c 52.6c (26.7) 72.6c 54.6c (24.8) Fuel gallons (000,000) 68.8 74.3 8.0 275.2 297.4 8.1 Average number of employees 8,223 8,787 6.9 8,236 8,704 5.7 Aircraft utilization (block hours) 11.2 11.2 0.0 11.4 11.5 0.9 Operating fleet at period-end 78 84 7.7 78 84 7.7 NM = Not Meaningful c=cents </TABLE>
<TABLE> <CAPTION> Horizon Air Financial and Statistical Data Quarter Ended December 31 Year Ended December 31 Financial Data (in millions): 1997 1998 % Change 1997 1998 % Change <S> <C> <C> <C> <C> <C> <C> Operating Revenues: Passenger $72.7 $84.9 16.8 $289.5 $331.7 14.6 Freight and mail 2.7 2.7 0.0 11.2 10.7 (4.5) Other - net 1.0 1.5 50.0 2.9 5.4 86.2 Total Operating Revenues 76.4 89.1 16.6 303.6 347.8 14.6 Operating Expenses: Wages and benefits 23.9 28.1 17.6 94.4 105.1 11.3 Employee profit sharing 0.8 0.4 (50.0) 1.4 3.5 150.0 Contracted services 1.7 2.5 47.1 6.3 9.0 42.9 Aircraft fuel 8.4 8.0 (4.8) 32.8 30.2 (7.9) Aircraft maintenance 8.0 11.3 41.3 41.4 43.3 4.6 Aircraft rent 9.4 10.2 8.5 35.5 40.6 14.4 Food and beverage service 0.5 0.7 40.0 1.9 2.5 31.6 Commissions 4.1 4.3 4.9 17.9 17.3 (3.4) Other selling expenses 3.6 5.5 52.8 16.5 19.6 18.8 Depreciation and amortization 2.7 4.1 51.9 11.2 12.9 15.2 Loss (gain) on sale of assets (0.1) (0.1) NM (0.7) 0.0 NM Landing fees and other rentals 3.5 4.7 34.3 13.5 17.2 27.4 Other 6.7 7.3 9.0 25.7 28.4 10.5 Total Operating Expenses 73.2 87.0 18.9 297.8 329.6 10.7 Operating Income 3.2 2.1 (34.4) 5.8 18.2 213.8 Interest income 0.0 0.0 0.1 0.0 Interest expense (0.3) (0.1) (1.8) (1.0) Interest capitalized 0.6 0.3 1.8 1.5 Other - net 0.1 0.1 0.4 0.2 0.4 0.3 0.5 0.7 Income Before Income Tax $3.6 $2.4 (33.3) $6.3 $18.9 200.0 Operating Statistics: Revenue passengers (000) 938 1,186 26.4 3,686 4,389 19.1 RPMs (000,000) 231 311 34.7 889 1,143 28.6 ASMs (000,000) 376 486 29.4 1,446 1,815 25.5 Passenger load factor 61.5% 64.0% 2.5 pts 61.5% 63.0% 1.5 pts Breakeven load factor 58.3% 62.2% 3.9 pts 60.2% 59.1% (1.1)pts Yield per passenger mile 31.48c 27.28c (13.3) 32.56c 29.01c (10.9) Operating revenue per ASM 20.32c 18.32c (9.9) 21.00c 19.16c (8.8) Operating expenses per ASM 19.47c 17.89c (8.1) 20.60c 18.16c (11.9) Fuel cost per gallon 76.3c 55.6c (27.1) 77.5c 57.7c (25.7) Fuel gallons (000,000) 11.0 14.4 30.9 42.4 52.5 23.8 Average number of employees 2,774 3,257 17.4 2,756 3,019 9.5 Aircraft utilization (block hours) 7.1 7.8 9.9 7.1 7.9 11.3 Operating fleet at period-end 62 60 (3.2) 62 60 (3.2) NM = Not Meaningful c=cents </TABLE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION 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 increased 20% in 1996, decreased 4% in 1997 and decreased another 25% in 1998. In recent years, airlines have reduced their ticket distribution costs by capping travel agent commissions, by decreasing commission rates from 10% to 8%, by partially eliminating paper tickets and by selling tickets directly to passengers via the Internet. RESULTS OF OPERATIONS 1998 Compared with 1997 Consolidated net income in 1998 was $124.4 million, or $4.81 per share (diluted), compared with net income of $72.4 million, or $3.53 per share in 1997. The 1998 results include an after- tax charge of $10.1 million ($0.38 per diluted share) for settlement of the MarkAir litigation. Consolidated operating income was $211.0 million in 1998 compared with $139.0 million in 1997. Lower fuel prices accounted for $56.9 million of the $72.0 million improvement in operating income. Alaska's annual operating income improved by $59.7 million, while Horizon's improved by $12.4 million. A discussion of operating results for the two airlines follows. Alaska Airlines (Refer to Alaska's operating and statistical data in Item 6.) Operating income increased 44.5% to $194.0 million, resulting in a 12.4% operating margin as compared to a 9.3% margin in 1997. Operating revenue per available seat mile (ASM) decreased 0.6% to 9.32 cents while operating expenses per ASM decreased 4.1% to 8.17 cents. The decrease in revenue per ASM was primarily due to a 0.2 point decrease in passenger load factor. The Pacific Northwest-Southern California and Pacific Northwest-Northern California markets experienced modest increases in load factor, while the Seattle-Anchorage market experienced a small decrease. Alaska's top five markets, which represent 79% of its traffic, experienced increases in passenger yield. Several smaller markets, including the new Canadian market, had decreases in yield. Freight and mail revenues increased 1.0% primarily due to a 4.7% increase in mail pounds and a 0.5% increase in freight pounds carried. Freight rates were down due to increased competition in the Seattle- Anchorage market. Other-net revenues increased 6.2% due to increased revenue from travel partners in Alaska's frequent flyer program. Wages and benefits increased 10.0% due to a 5.7% increase in the number of employees combined with a 4.1% increase in average wages and benefits per employee. Employees were added in all areas to service the 8.9% capacity (ASM) increase and the 6.3% increase in passengers carried. Average wages and benefits per employee increased primarily due to higher pilot wage rates and pension costs that resulted from a new pilot contract signed in late 1997. Profit sharing expense increased 63% due to a large increase in pretax income. Contracted services increased 15%, due to growth in ground handling and security charges as a result of more flights to Canada and other cities, greater use of temporary employees (particularly in computer systems development), higher shipping charges incurred and increased navigation fees in Canada and Mexico. Fuel expense decreased 19%, as the 8% increase in fuel consumption was more than offset by a 25% decrease in the price of fuel. Maintenance expense increased 15%, exceeding the 9% increase in capacity, due to a greater number of annual aircraft inspections (C checks) performed, and increased engine overhaul expense. Aircraft rent increased 7%, primarily due to leasing nine new aircraft in 1998. Food and beverage expense increased 5%, in line with the 6% increase in passengers carried. Commission expense decreased 6% (in spite of a 9% increase in passenger revenue), primarily because the commission rate paid to travel agents decreased from 10% to 8% for sales made since October, 1997. As a percentage of passenger revenue, commission expense decreased 14%, from 7.8% to 6.7%. In 1998, 70% of ticket sales were made through travel agents, versus 72% in 1997. Other selling expenses increased 18%, higher than the 9% increase in passenger revenues, due to increased advertising to promote the new Canada market and other markets. Depreciation and amortization expense increased 9%, primarily due to modifications (made in late 1997) to the B737-200C fleet to meet Stage 3 noise requirements, a full year of depreciation on two MD-80s purchased in 1997 and added depreciation on computers and related equipment. Landing fees and other rentals increased 12%, higher than the 9% increase in capacity, primarily due to rental rate and space increases at several airports and higher than average fees in Canada. Other expense decreased 1%, primarily due to a $2.7 million recovery of California property taxes that resulted from settlement of industry litigation, lower long distance telephone rates and lower insurance rates. These savings were partly offset by higher expenditures for operating supplies, employee hiring, flight crew hotels and legal fees. Horizon Air (Refer to Horizon's operating and statistical data in Item 6.) During 1998, Horizon completed its transition to a simplified fleet (which at year-end 1998 comprised 20 Fokker F-28-4000 jets and 40 de Havilland Dash 8-200 turboprop aircraft). Over the last few years, Horizon's route structure changed from a largely hub-and-spoke system to more of a point-to-point one, flying people longer distances (260 miles on the average in 1998 versus 241 miles in 1997) with fewer connections. Due to their higher capacity and longer stage lengths, the jets accounted for 58% of the ASMs flown in 1998, versus 21% four years ago. These changes have resulted in a more efficient operation, with lower unit revenues (down 8.8%) and even lower unit costs (down 11.9%). As a result, operating income increased from $5.8 million to $18.2 million, resulting in a 5.2% operating margin as compared to 1.9% in 1997. Freight and mail revenues decreased 5% primarily due to increased competition from overnight trucking. Other-net revenues increased 86% primarily due to increased freight and ground handling services provided to other airlines. Wages and benefits increased 11.3% due to a 9.5% increase in the number of employees combined with a 1.6% increase in average wages and benefits per employee. Employees were added in all areas to service the 19% increase in passengers carried. Profit sharing expense increased 150% due to a large increase in pretax income. Contracted services increased 43%, due to increased navigation fees in Canada, higher ground handling and security charges and greater use of computer and other consultants. Fuel expense decreased 8%, as the 24% increase in fuel consumption was more than offset by a 26% decrease in the price of fuel. Maintenance expense increased 5%, much less than the 26% increase in capacity, due to fewer maintenance requirements for the many new Dash 8- 200 aircraft acquired during 1997-1998, better reliability of F-28 4000 jets that have replaced the F-28 1000s and other efficiencies of a more simplified fleet. Aircraft rent increased 14%, as most of the new aircraft acquired in 1998 were leased. Food and beverage expense increased 32%, in line with the 29% increase in revenue passenger miles. Commission expense decreased 3% (in spite of a 15% increase in passenger revenue), primarily because the commission rate paid to travel agents decreased from 10% to 8% for sales made since October, 1997. As a percentage of passenger revenue, commission expense decreased 16%, from 6.2% to 5.2%. Other selling expenses increased 19%, in line with the 15% increase in passenger revenues. Depreciation and amortization expense increased 15%, primarily due to purchase of more F-28s in 1998 and added depreciation on aircraft spare parts and station equipment. Landing fees and other rentals increased 27%, in line with the 26% increase in capacity. Other expense increased 11%, primarily due to higher expenditures for flight crew training, hotels, per diem charges, employee hiring and computers. These increases were partly offset by lower insurance charges and property taxes. Consolidated Nonoperating Income (Expense) Net nonoperating items improved $8.8 million over 1997 due to lower interest expense (due to conversion of convertible bonds in 1998 and other debt repayments) and higher interest income (due to higher cash balances). These were partly offset by a $16.5 million charge for a settlement of the MarkAir litigation. 1997 Compared with 1996 Consolidated net income in 1997 was $72.4 million, or $3.53 per share (diluted), compared with net income of $38.0 million, or $2.05 per share in 1996. Consolidated operating income was $139.0 million in 1997 compared with $89.0 million in 1996. Severe winter storms, high fuel prices and matching of competitors' lower fares adversely affected the 1996 results. Alaska Airlines Operating income increased 49.2% to $134.3 million, resulting in a 9.3% operating margin as compared with a 6.9% margin in 1996. Operating revenue per ASM increased 7.8% to 9.38 cents while operating expenses per ASM increased 5.1% to 8.51 cents. The increase in revenue per ASM was primarily due to a 7.1% increase in system passenger yield. Higher unit costs were largely due to increased labor costs. Horizon Air Operating income increased from $0.1 million to $5.8 million, resulting in a 1.9% operating margin as compared to a zero margin in 1996. Operating revenue per ASM increased 1.9% to 21.00 cents while operating expenses per available seat mile remained even at 20.60 cents. Consolidated Nonoperating Income (Expense) Nonoperating expense decreased $9.3 million to $15.4 million, primarily due to smaller average debt balances, lower interest rates on variable interest rate debt and more interest capitalized. Liquidity and Capital Resources The table below presents the major indicators of financial condition and liquidity. <TABLE> <CAPTION> Dec. 31, 1997 Dec. 31, 1998 Change (In millions, except debt-to-equity and per share amounts) <S> <C> <C> <C> Cash and marketable securities $212.7 $306.6 $93.9 Working capital (deficit) (48.7) 2.9 51.6 Long-term debt and capital lease obligations 401.4 171.5 (229.9) Shareholders' equity 475.3 789.5 314.2 Book value per common share $26.00 $30.11 $4.11 Debt-to-equity 46%:54% 18%:82% NA </TABLE> 1998 Financial Changes The Company's cash and marketable securities portfolio increased by $94 million during 1998. Operating activities provided $310 million of cash in 1998. Additional cash was provided by the sale and leaseback of nine B737-400 aircraft and 12 Dash 8-200 aircraft ($402 million) and the return of $33 million of equipment deposits. Cash was used for $613 million of capital expenditures, including the purchase of nine new B737-400 aircraft, a previously leased B737-400 aircraft, 12 new Dash 8-200 aircraft, flight equipment deposits and airframe and engine overhauls and the repayment of debt ($46 million). Shareholders' equity increased $314 million due to the conversion of $186 million of convertible bonds into common stock, net income of $124 million and issuance of $7 million of common stock under stock plans. Financing Activities During 1998, Alaska sold nine B737-400 aircraft and leased them back for 18 years; Horizon sold 12 Dash 8-200 aircraft and leased them back for 15 years. In February 1998, substantially all of the 6-7/8% convertible subordinated debentures were converted into 1.6 million shares of common stock. In June 1998, all of the 6-1/2% convertible subordinated debentures were converted into 6.1 million shares of common stock. Commitments During 1998, Alaska's lease commitments increased approximately $414 million due to the sale and leaseback of nine B737- 400 aircraft. In addition, Alaska ordered eight Boeing 737 aircraft with a cost of approximately $256 million. Horizon's lease commitments increased approximately $162 million due to the acquisition of 12 new Dash 8-200 aircraft. In addition, Horizon ordered 25 Canadair regional jets with a cost of approximately $580 million. At December 31, 1998, the Company had firm orders for 53 aircraft with a total cost of approximately $1.4 billion as set forth below. In addition, Alaska has options to acquire 26 more B737s and Horizon has options to acquire five CRJ 700s. Alaska and Horizon expect to finance the new planes with either leases, long-term debt or internally generated cash. <TABLE> <CAPTION> Delivery Period - Firm Orders Aircraft 1999 2000 2001 2002 2003-05 Total <S> <C> <C> <C> <C> <C> <C> Boeing 737-400 3 -- -- -- -- 3 Boeing 737-700 5 7 -- -- -- 12 Boeing 737-900 -- -- 5 5 -- 10 de Havilland Dash 8-200 3 -- -- -- -- 3 Canadair RJ 700 -- -- -- 4 21 25 Total 11 7 5 9 21 53 Cost (Millions) $281 $217 $175 $267 $483 $1,423 </TABLE> The Company accrues the costs associated with returning leased aircraft over the lease period. As leased aircraft are retired, the costs are charged against the established reserve. At December 31, 1998, $49 million was reserved for leased aircraft returns. Deferred Taxes At December 31, 1998, net deferred tax liabilities were $91 million, which includes $114 million of net temporary differences offset by $23 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 uses a significant number of computer software programs and embedded operating systems that were not originally designed to process dates beyond 1999. The Company has implemented a project to ensure that the Company's systems will function properly in the year 2000 and thereafter. The Company expects to remediate most of its major systems by early 1999 and substantially to complete the project by the end of June 1999. The Company believes that, with modifications to its existing software and systems and/or conversions to new software, the year 2000 issue will not pose significant operational problems. Most of the Company's information technology projects in the last several years have made the affected systems year 2000 compliant. The direct costs of projects solely intended to correct year 2000 problems are currently estimated at less than $2 million. The Company does not track certain costs attributable to year 2000, such as salaries of information technology staff not dedicated entirely to the project. Additional systems currently under review may require further resources. The Company does not expect any cost increases to have a material effect on its results of operations. The Company is also in contact with its significant suppliers and vendors with which its systems interface and exchange data or upon which its business depends. These efforts are designed to minimize the extent to which its business will be vulnerable to their failure to remediate their own year 2000 issues. The Company's business is also dependent upon certain governmental organizations or entities such as the Federal Aviation Administration (FAA) that provide essential aviation industry infrastructure. The Company is working with the Airline Transport Association (ATA) and the International Airline Transport Association (IATA) to monitor the progress of FAA and airports in making their systems year 2000 compliant. In addition, the Company is independently working with certain rural Alaska airports not within ATA's purview. There can be no assurance that such third parties on which the Company's business relies will successfully remediate their systems on a timely basis. The Company's business, financial condition or results of operations could be materially adversely affected by the failure of its systems or those operated by other parties to operate properly beyond 1999. Areas that could be adversely affected include flight operations, maintenance, planning, reservations, sales, accounting and the frequent flyer program. The Company already has in place certain disaster contingency plans anticipating the potential loss of essential services such as electricity and financial accounting systems. The Company will leverage its year 2000 contingency planning off these existing plans. In addition, the Company is developing and executing additional contingency plans designed to allow continued operation in the event of failure of key third party systems or products. The foregoing Year 2000 Computer Issue comments include forward-looking statements regarding the performance of the Company. Actual results may differ materially from these projections. Factors that could cause results to differ include the availability of adequate resources to complete the Company's year 2000 plan, the ability to identify and remediate noncompliant systems, and the success of third parties in remediating their year 2000 issues. 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. 1997 Financial Changes The Company's cash and marketable securities portfolio increased by $111 million during 1997. Operating activities provided $205 million of cash in 1997. Additional cash was provided by the sale and leaseback of four B737-400 aircraft and 13 Dash 8-200 aircraft ($247 million), issuance of common stock ($129 million) and issuance of long-term debt ($28 million). Cash was used for $439 million of capital expenditures including the purchase of two new MD-83 aircraft, three new B737-400 aircraft, a previously leased B737-400 aircraft, 13 new Dash 8-200 aircraft, flight equipment deposits and airframe and engine overhauls, net repayment of short-term borrowings ($47 million) and the repayment of debt ($26 million). 1996 Financial Changes The Company's cash and marketable securities portfolio decreased by $33 million during 1996. Operating activities provided $223 million of cash in 1996. Additional cash was provided by the sale and leaseback of three B737-400 aircraft ($86 million), the sale of three MD-80 aircraft ($52 million) and proceeds received from the issuance of common stock ($21 million). Cash was used for the purchase of two new MD-83 aircraft, two used B737-400 aircraft, two previously leased B737-200Cs, airframe and engine overhauls and other capital expenditures ($209 million), and aircraft purchase deposits ($61 million). Cash was also used to repay net short-term borrowings ($19 million), and $134 million of long-term debt (including $100 million repaid early). During 1996, Alaska replaced its $75 million credit facility with a $125 million credit facility with substantially the same terms and conditions. Effect of Inflation Inflation and specific price changes do not have a significant effect on the Company's operating revenues, operating expenses and operating income, because such revenues and expenses generally reflect current price levels. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14. <TABLE> Selected Quarterly Consolidated Financial Information (Unaudited) <CAPTION> 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter 1997 1998 1997 1998 1997 1998 1997 1998 (in millions, except per share) <S> <C> <C> <C> <C> <C> <C> <C> <C> Operating revenues $380.4 $416.4 $435.0 $484.9 $501.2 $539.4 $422.8 $457.0 Operating income (loss) (5.4) 22.5 40.9 62.6 76.3 89.5 27.2 36.4 Net income (loss) (5.7) 13.1 20.8 38.9 42.2 45.4 15.1 27.0 Earnings (loss) per share: Basic (0.39) 0.69 1.43 1.77 2.88 1.73 0.98 1.03 Diluted (0.39) 0.56 1.01 1.51 1.96 1.72 0.73 1.02 </TABLE> The total of the amounts shown as quarterly earnings per share (EPS) may differ from the amounts shown on the Consolidated Statement of Income because the annual computation is made separately and is based upon average number of shares (and equivalent shares for diluted EPS) outstanding for the year. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See "Election of Directors," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 18, 1999. See "Executive Officers of the Registrant" in Part I following Item 4 for information relating to executive officers. ITEM 11. EXECUTIVE COMPENSATION See "Executive Compensation," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 18, 1999. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Security Ownership of Certain Beneficial Owners and Management," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 18, 1999. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Transactions with Management and Others," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 18, 1999. PART IV ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Consolidated Financial Statements: Page(s) Selected Quarterly Consolidated Financial Information (Unaudited) 17 Consolidated Balance Sheet as of December 31, 1997 and 1998 20-21 Consolidated Statement of Income for the years ended December 31, 1996, 1997 and 1998 22 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1996, 1997 and 1998 23 Consolidated Statement of Cash Flows for the years ended December 31, 1996, 1997 and 1998 24 Notes to Consolidated Financial Statements 25-32 Report of Independent Public Accountants 33 Consolidated Financial Statement Schedule II, Valuation and Qualifying Accounts, for the years ended December 31, 1996, 1997 and 1998 34 See Exhibit Index on page 35. (b) A report on Form 8-K announcing orders for 25 Canadair Regional Jets Series 700 aircraft was filed on December 22, 1998 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALASKA AIR GROUP, INC. By: /s/ John F. Kelly Date: February 10, 1999 John F. Kelly, Chairman, Chief Executive Officer and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on February 10, 1999 on behalf of the registrant and in the capacities indicated. /s/ John F. Kelly Chairman, Chief Executive Officer, President and Director John F. Kelly /s/ Harry G. Lehr Senior Vice President/Finance Harry G. Lehr (Principal Financial Officer) /s/ Bradley D. Tilden Controller Bradley D. Tilden (Principal Accounting Officer) /s/ Ronald F. Cosgrave Director Ronald F. Cosgrave /s/ Mary Jane Fate Director Mary Jane Fate /s/ Bruce R. Kennedy Director Bruce R. Kennedy /s/ R. Marc Langland Director R. Marc Langland /s/ Byron I. Mallott Director Byron I. Mallott /s/ Robert L. Parker, Jr. Director Robert L. Parker, Jr. /s/ John V. Rindlaub Director John V. Rindlaub /s/ Patricia Q. Stonesifer Director Patricia Q. Stonesifer /s/ Richard A. Wien Director Richard A. Wien
<TABLE> CONSOLIDATED BALANCE SHEET Alaska Air Group, Inc. <CAPTION> ASSETS As of December 31 (In Millions) 1997 1998 <S> <C> <C> Current Assets Cash and cash equivalents $102.6 $29.4 Marketable securities 110.1 277.2 Receivables - less allowance for doubtful accounts (1997 - $1.2; 1998 - $1.0) 72.6 70.6 Inventories and supplies 47.2 44.1 Prepaid expenses and other assets 92.1 107.5 Total Current Assets 424.6 528.8 Property and Equipment Flight equipment 950.1 1,015.4 Other property and equipment 258.5 283.2 Deposits for future flight equipment 108.9 164.9 1,317.5 1,463.5 Less accumulated depreciation and amortization 373.8 417.0 943.7 1,046.5 Capital leases: Flight and other equipment 44.4 44.4 Less accumulated amortization 27.5 29.6 16.9 14.8 Total Property and Equipment - Net 960.6 1,061.3 Intangible Assets - Subsidiaries 59.6 57.5 Other Assets 88.3 84.2 Total Assets $1,533.1 $1,731.8 See accompanying notes to consolidated financial statements. </TABLE>
<TABLE> CONSOLIDATED BALANCE SHEET Alaska Air Group, Inc. <CAPTION> LIABILITIES AND SHAREHOLDERS' EQUITY As of December 31 (In Millions) 1997 1998 <S> <C> <C> Current Liabilities Accounts payable $73.9 $84.3 Accrued aircraft rent 60.7 75.5 Accrued wages, vacation and payroll taxes 70.1 79.4 Other accrued liabilities 73.5 80.9 Air traffic liability 166.4 178.6 Current portion of long-term debt and capital lease obligations 28.7 27.2 Total Current Liabilities 473.3 525.9 Long-Term Debt and Capital Lease Obligations 401.4 171.5 Other Liabilities and Credits Deferred income taxes 72.3 99.2 Deferred income 19.5 41.5 Other liabilities 91.3 104.2 183.1 244.9 Commitments Shareholders' Equity Preferred stock, $1 par value Authorized: 5,000,000 shares - - Common stock, $1 par value Authorized: 50,000,000 shares Issued: 1997 - 21,030,762 shares 1998 - 28,974,107 shares 21.0 29.0 Capital in excess of par value 292.5 473.9 Treasury stock, at cost: 1997 - 2,748,030 shares 1998 - 2,750,102 shares (62.6) (62.7) Deferred compensation (1.8) (1.3) Retained earnings 226.2 350.6 475.3 789.5 Total Liabilities and Shareholders' Equity $1,533.1 $1,731.8 See accompanying notes to consolidated financial statements. </TABLE>
<TABLE> CONSOLIDATED STATEMENT OF INCOME Alaska Air Group, Inc. <CAPTION> Year Ended December 31 (In Millions Except Per Share Amounts) 1996 1997 1998 <S> <C> <C> <C> Operating Revenues Passenger $1,427.7 $1,574.5 $1,728.0 Freight and mail 93.9 94.1 94.4 Other - net 70.6 70.8 75.3 Total Operating Revenues 1,592.2 1,739.4 1,897.7 Operating Expenses Wages and benefits 477.0 531.7 594.4 Contracted services 42.7 48.8 55.5 Aircraft fuel 234.2 232.6 192.5 Aircraft maintenance 98.7 108.7 120.9 Aircraft rent 181.2 183.9 199.5 Food and beverage service 46.6 48.5 51.6 Commissions 101.5 106.6 97.5 Other selling expenses 81.8 80.4 94.8 Depreciation and amortization 67.5 68.3 75.1 Loss (gain) on sale of assets (9.1) (1.9) 1.0 Landing fees and other rentals 62.4 66.2 76.3 Other 118.7 126.6 127.6 Total Operating Expenses 1,503.2 1,600.4 1,686.7 Operating Income 89.0 139.0 211.0 Nonoperating Income (Expense) Interest income 11.1 10.6 22.2 Interest expense (38.4) (33.6) (21.2) Interest capitalized 1.0 5.3 6.6 Other - net 1.6 2.3 (14.2) (24.7) (15.4) (6.6) Income before income tax 64.3 123.6 204.4 Income tax expense 26.3 51.2 80.0 Net Income $38.0 $72.4 $124.4 Basic Earnings Per Share $2.67 $4.90 $5.32 Diluted Earnings Per Share $2.05 $3.53 $4.81 Shares used for computation: Basic 14.241 14.785 23.388 Diluted 22.458 22.689 26.367 See accompanying notes to consolidated financial statements. </TABLE>
<TABLE> CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY Alaska Air Group, Inc. <CAPTION> Common Capital in Treasury Deferred Shares Common Excess of Stock Compen- Retained (In Millions) Outstanding Stock Par Value at Cost sation Earnings Total <S> <C> <C> <C> <C> <C> <C> <C> Balances at December 31, 1995 13.565 $16.7 $155.4 $(71.8) $(3.6) $115.8 $212.5 1996 net income 38.0 38.0 Stock issued under stock plans 0.505 0.5 9.7 10.2 Treasury stock sale 0.405 1.7 9.2 10.9 Employee Stock Ownership Plan shares allocated 0.9 0.9 Balances at December 31, 1996 14.475 17.2 166.8 (62.6) (2.7) 153.8 272.5 1997 net income 72.4 72.4 Issuance of common stock 3.450 3.5 118.4 121.9 Stock issued under stock plans 0.349 0.3 7.1 7.4 Stock issued for convertible subordinated debentures 0.008 0.0 0.2 0.2 Treasury stock sale 0.001 Employee Stock Ownership Plan shares allocated 0.9 0.9 Balances at December 31, 1997 18.283 21.0 292.5 (62.6) (1.8) 226.2 475.3 1998 net income 124.4 124.4 Stock issued under stock plans 0.196 0.3 6.4 6.7 Stock issued for convertible subordinated debentures 7.747 7.7 175.0 182.7 Treasury stock purchase (0.002) (0.1) (0.1) Employee Stock Ownership Plan 0.0 shares allocated 0.5 0.5 Balances at December 31, 1998 26.224 $29.0 $473.9 $(62.7) $(1.3) $350.6 $789.5 See accompanying notes to consolidated financial statements. </TABLE>
<TABLE> CONSOLIDATED STATEMENT OF CASH FLOWS Alaska Air Group, Inc. <CAPTION> Year Ended December 31 (In Millions) 1996 1997 1998 <S> <C> <C> <C> Cash flows from operating activities: Net income $38.0 $72.4 $124.4 Adjustments to reconcile net income to cash: Depreciation and amortization 67.5 68.3 75.1 Amortization of airframe and engine overhauls 34.6 35.1 41.1 Loss (gain) on sale of assets (9.1) (1.9) 1.0 Increase in deferred income taxes 8.5 22.8 26.9 Decrease (increase) in accounts receivable 18.8 (2.9) 2.0 Increase in other current assets (13.9) (10.6) (12.3) Increase in air traffic liability 38.6 3.4 12.2 Increase in other current liabilities 36.9 26.5 41.9 Other-net 3.0 (7.9) (2.1) Net cash provided by operating activities 222.9 205.2 310.2 Cash flows from investing activities: Proceeds from disposition of assets 58.1 6.9 2.1 Purchases of marketable securities (53.5) (443.6) (323.4) Sales and maturities of marketable securities 110.4 385.9 156.3 Flight equipment deposits returned 1.1 8.7 33.2 Additions to flight equipment deposits (60.5) (68.4) (182.1) Additions to property and equipment (209.3) (370.6) (431.3) Restricted deposits and other 0.5 (2.0) (1.3) Net cash used in investing activities (153.2) (483.1) (746.5) Cash flows from financing activities: Proceeds from short-term borrowings 47.0 56.4 - Repayment of short-term borrowings (65.9) (103.4) - Proceeds from sale and leaseback transactions 85.6 246.7 402.0 Proceeds from issuance of long-term debt - 28.0 - Long-term debt and capital lease payments (133.9) (25.9) (45.5) Proceeds from issuance of common stock 10.2 129.3 6.6 Proceeds from sale of treasury stock 10.9 - - Net cash provided by (used in) financing activities (46.1) 331.1 363.1 Net increase (decrease) in cash and cash equivalents 23.6 53.2 (73.2) Cash and cash equivalents at beginning of year 25.8 49.4 102.6 Cash and cash equivalents at end of year $49.4 $102.6 $29.4 Supplemental disclosure of cash paid during the year for: Interest (net of amount capitalized) $43.5 $28.7 $15.8 Income taxes 20.6 22.1 48.5 Noncash investing and financing activities: 1996 and 1997 - None 1998 - $186.0 million of convertible debentures were converted into 7.7 million shares of common stock. See accompanying notes to consolidated financial statements. </TABLE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Alaska Air Group, Inc. December 31, 1998 Note 1. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of Alaska Air Group, Inc. (Company or Air Group) and its subsidiaries, the principal subsidiaries being Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon). All significant intercompany transactions are eliminated. 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 1998 presentation. Alaska and Horizon operate as airlines. However, their business plans, competition and economic risks differ substantially. 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 864 miles. Horizon is a regional airline serving the Pacific Northwest, Northern California and Western Canada. It operates both jet and turboprop aircraft, and its average passenger trip is 260 miles. Substantially all of Alaska's and Horizon's sales occur in the United States. See Note 11 for operating segment information. 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 $10.1 million and $18.2 million at December 31, 1997 and 1998, 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 is accrued on a straight-line basis over the estimated useful lives of the aircraft. Inventories related to the retired B727 fleet and other surplus items are carried at their net realizable value. The allowance at December 31, 1997 and 1998 for all inventories was $18.0 million and $20.2 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: Aircraft and other flight equipment 8-20 years Buildings 10-30 years Capitalized leases and leasehold improvements Term of lease Other equipment 3-15 years 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. Capitalized Interest Interest is capitalized on flight equipment purchase deposits and ground facilities progress payments as a cost of the related asset and is depreciated over the estimated useful life of the asset. 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, 1997 and 1998 was $23.1 million and $25.2 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. 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 is relieved as travel awards are issued. 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 $15.6 million, $11.0 million, and $17.9 million, respectively, in 1996, 1997 and 1998. Nonoperating Expense During 1998, the Company settled a breach of contract lawsuit with MarkAir, Inc., which resulted in a $16.5 million charge to other nonoperating expense. 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. Stock Options The Company applies APB Opinion No. 25 and related Interpretations in accounting for stock options. See Note 6 for more information. 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 1998. 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): 1997 1998 Cost: U.S. government securities $75.1 $214.1 Asset backed obligations 35.0 31.7 Other corporate obligations -- 31.4 $110.1 $277.2 Fair value: U.S. government securities $75.2 $214.9 Asset backed obligations 35.0 31.8 Other corporate obligations -- 31.3 $110.2 $278.0 There were no material unrealized holding gains or losses at December 31, 1997 or 1998. Of the marketable securities on hand at December 31, 1998, 49% will mature during 1999 and the remainder will mature during 2000. Based on specific identification of securities sold, the following occurred in 1997 and 1998 (in millions): 1997 1998 Proceeds from sales $385.9 $156.3 Gross realized gains 0.1 0.2 Gross realized losses 0.1 -- 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): 1997 1998 Restricted deposits $67.5 $69.1 Deferred costs and other 20.8 15.1 $88.3 $84.2 Deferred costs are amortized over the term of the related lease or contract. Note 4. Long-term Debt and Capital Lease Obligations At December 31, 1997 and 1998, long-term debt and capital lease obligations were as follows (in millions): 1997 1998 8.5%* fixed rate notes payable due through 2001 $103.5 $90.3 6.0%* variable rate notes payable due through 2009 114.9 85.2 6-1/2% convertible senior debentures due 2005 132.1 -- 6-7/8% convertible subordinated debentures due 2004-2014 54.0 -- Long-term debt 404.5 175.5 Capital lease obligations 25.6 23.2 Less current portion (28.7) (27.2) $401.4 $171.5 * weighted average for 1998 At December 31, 1998, borrowings of $175.5 million are secured by flight equipment and real property. During 1998, substantially all of the convertible subordinated debentures were converted into 7.747 million shares of common stock. At December 31, 1998, Alaska had a $115 million credit facility with commercial banks. Advances under this facility may be for up to a maximum maturity of four years. Borrowings may be used for aircraft acquisitions or other corporate purposes, and they bear interest at a rate that varies based on LIBOR. At December 31, 1998, 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, 1998, the Company was in compliance with all loan provisions, and under the most restrictive loan provisions, Alaska had $175 million of net worth above the minimum. At December 31, 1998, long-term debt principal payments for the next five years were (in millions): 1999 $24.5 2000 $55.5 2001 $45.4 2002 $12.1 2003 $12.3 Note 5. Commitments Lease Commitments Lease contracts for 111 aircraft have remaining lease terms of one to 18 years. The majority of airport and terminal facilities are also leased. Total rent expense was $214.7 million, $218.7 million and $241.6 million, in 1996, 1997 and 1998, respectively. Future minimum lease payments under long-term operating leases and capital leases as of December 31, 1998 are shown below (in millions): Operating Leases Capital Aircraft Facilities Leases 1999 $ 192.9 $24.8 $ 4.1 2000 180.2 22.8 4.1 2001 165.6 16.5 4.1 2002 163.0 10.5 4.1 2003 143.5 9.7 4.1 Thereafter 1,087.1 131.0 9.0 Total lease payments $1,932.3 $215.3 29.5 Less amount representing interest (6.3) Present value of capital lease payments $23.2 Aircraft Commitments The Company has firm orders for 25 Boeing 737 series aircraft to be delivered between 1999 and 2002, three Dash 8-200s during 1999, and 25 Canadair RJ 700 jets between 2002 and 2005. The total amount of these commitments is approximately $1.4 billion. As of December 31, 1998, deposits related to the future equipment deliveries were $160 million. In addition to the ordered aircraft, the Company holds purchase options on 26 Boeing 737s and five CRJ 700s. Note 6. Stock Plans Air Group has three stock option plans, which provide for the purchase of Air Group common stock at a stipulated price on the date of grant by certain officers and key employees of Air Group and its subsidiaries. Under the 1988 Plan, options for 1,730,700 shares have been granted. Under the 1996 and 1997 Plans, options for 836,600 shares have been granted and, at December 31, 1998, 90,400 shares were available for grant. Under all plans, the incentive and nonqualified stock options granted have terms of up to approximately ten years. Grantees are 25% vested after one year, 50% after two years, 75% after three years and 100% after four years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in 1996, 1997 and 1998, respectively: dividend yield of 0%, 0% and 0%; volatility of 36%, 34% and 35%; risk- free interest rates of 6.33%, 5.69% and 5.67%; and expected lives of 5, 5 and 5 years. Using these assumptions, the weighted average fair value of options granted was $9.58, $14.04 and $19.33 in 1996, 1997 and 1998, respectively. Air Group follows APB Opinion 25 and related Interpretations in accounting for stock options. Accordingly, no compensation cost has been recognized for these plans. Had compensation cost for the Company's stock options been determined in accordance with Financial Accounting Standard 123, net income and earnings per share (EPS) would have been reduced to the pro forma amounts indicated below. 1996 1997 1998 Net income (in millions): As reported $38.0 $72.4 $124.4 Pro forma 37.4 71.4 122.2 Basic EPS: As reported $2.67 $4.90 $5.32 Pro forma 2.63 4.83 5.23 Diluted EPS: As reported $2.05 $3.53 $4.81 Pro forma 2.03 3.48 4.73 Changes in the number of shares subject to option, with their weighted average exercise prices, are summarized below: Shares Price Outstanding, Dec. 31, 1995 1,161,588 $16.56 Granted 379,900 22.51 Exercised (504,138) 17.05 Canceled (45,525) 17.13 Outstanding, Dec. 31, 1996 991,825 18.57 Granted 245,800 35.25 Exercised (349,575) 17.36 Canceled (8,125) 17.03 Outstanding, Dec. 31, 1997 879,925 23.72 Granted 324,900 47.45 Exercised (159,475) 17.88 Canceled (5,200) 36.88 Outstanding, Dec. 31, 1998 1,040,150 $31.96 Exercisable at year-end December 31, 1996 243,675 $16.70 December 31, 1997 161,775 19.08 December 31, 1998 253,350 22.92 The following table summarizes stock options outstanding and exercisable at December 31, 1998 with their weighted average remaining contractual lives: Range of Remaining Exercise prices Life (years) Shares Price Outstanding: $15.00 to $17.50 6.4 191,275 $15.57 $21.50 to $24.00 7.6 283,175 22.49 $35.25 9.0 241,800 35.25 $47.00 to $57.31 9.3 323,900 47.45 $15.00 to $57.31 8.3 1,040,150 $31.96 Exercisable: $15.00 to $17.50 98,125 $15.75 $21.50 to $24.00 94,775 22.49 $35.25 60,450 35.25 $47.00 to $57.31 -- 47.45 $15.00 to $57.31 253,350 $22.92 Note 7. Employee Benefit Plans Pension Plans Four defined benefit and five defined contribution retirement plans cover various employee groups of Alaska and Horizon. 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 are primarily common stocks and fixed income securities. The following table sets forth the status of the plans for 1997 and 1998 (in millions): 1997 1998 Projected benefit obligation Beginning of year $230.7 $307.4 Service cost 17.3 22.5 Interest cost 17.3 21.9 Amendments 57.7 -- Change in assumptions (8.7) 27.1 Actuarial loss (gain) 1.7 (0.4) Benefits paid (8.6) (6.7) End of year $307.4 $371.8 Plan assets at fair value Beginning of year $223.7 $289.2 Actual return on plan assets 47.6 54.4 Employer contributions 26.5 36.1 Benefits paid (8.6) (6.7) End of year $289.2 $373.0 Funded status (18.2) 1.2 Unrecognized loss (gain) (0.8) 7.2 Unrecognized transition asset (0.5) (0.3) Unrecognized prior service cost 60.1 49.4 Prepaid pension cost $ 40.6 $ 57.5 Weighted average assumptions as of December 31 Discount rate 7.25% 6.75% Expected return on plan assets 10.0% 10.0% Rate of compensation increase 3.2% 5.5% Net pension expense for the defined benefit plans included the following components for 1996, 1997 and 1998 (in millions): 1996 1997 1998 Service cost $ 15.9 $ 17.3 $ 22.4 Interest cost 15.4 17.3 21.9 Expected return on assets (18.5) (22.1) (28.7) Amortization of prior service cost 0.3 0.2 3.8 Recognized actuarial loss 1.4 1.0 -- Amortization of transition asset (0.3) (0.3) (0.2) Net pension expense $ 14.2 $ 13.4 $ 19.2 Alaska and Horizon also maintain an unfunded, noncontributory benefit plan for certain elected officers. The $21 million unfunded accrued pension cost for this plan was accrued as of December 31, 1998. 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 has recorded deferred compensation to reflect the value of the shares not yet allocated to eligible employees' accounts. As these shares are allocated to employees, compensation expense is recorded and deferred compensation is reduced. Total expense for the defined contribution plans was $10.1 million, $11.7 million and $11.6 million, respectively, in 1996, 1997 and 1998. Profit Sharing Plans Alaska and Horizon have employee profit sharing plans. Profit sharing expense for 1996, 1997 and 1998 was $0.9 million, $13.5 million and $23.2 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, 1997 and 1998 was $15.7 million and $20.1 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 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): 1997 1998 Excess of tax over book depreciation $161.8 $162.9 Other - net 1.3 3.7 Gross deferred tax liabilities 163.1 166.6 Loss carryforward (0.5) (0.1) Alternative minimum tax (50.1) (22.7) Capital leases (4.5) (2.6) Ticket pricing adjustments (1.2) (2.2) Frequent flyer program (8.5) (10.5) Employee benefits (7.8) (5.7) Aircraft return provisions (16.0) (16.4) Deferred gains (4.8) (8.4) Capitalized interest (1.4) (2.2) Inventory obsolescence (6.5) (4.8) Gross deferred tax assets (101.3) (75.6) Net deferred tax liabilities $ 61.8 $ 91.0 Current deferred tax asset $(10.5) $ (8.2) Noncurrent deferred tax liability 72.3 99.2 Net deferred tax liabilities $ 61.8 $ 91.0 After consideration of temporary differences, taxable income for 1998 was approximately $206 million. The components of income tax expense were as follows (in millions): 1996 1997 1998 Current tax expense: Federal $17.5 $26.4 $43.0 State 0.9 1.9 7.8 Total current 18.4 28.3 50.8 Deferred tax expense: Federal 6.7 18.5 27.8 State 1.2 4.4 1.4 Total deferred 7.9 22.9 29.2 Total tax expense $26.3 $51.2 $80.0 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): 1996 1997 1998 Income before income tax $64.3 $123.6 $204.4 Expected tax expense $22.5 $43.3 $71.5 Nondeductible expenses 2.8 2.9 3.0 State income tax 1.0 4.1 6.2 Other - net -- 0.9 (0.7) Actual tax expense $26.3 $51.2 $80.0 Effective tax rate 40.9% 41.4% 39.1% Note 9. Earnings per Share Basic EPS is calculated by dividing net income by the average number of common shares outstanding. Diluted EPS is calculated by dividing net income plus the after-tax interest expense on convertible debt by the average common shares outstanding plus additional common shares that would have been outstanding if conversion of the convertible debt and exercise of in-the-money stock options is assumed. EPS calculations were as follows (in millions except per share amounts): 1996 1997 1998 Net income $38.0 $72.4 $124.4 Avg. shares outstanding 14.241 14.785 23.388 Basic earnings per share $2.67 $4.90 $5.32 Net income $38.0 $72.4 $124.4 After-tax interest on: 6-1/2% debentures 5.3 5.3 2.2 6-7/8% debentures 2.3 2.3 0.3 7-3/4% debentures 0.5 -- -- Diluted EPS income $46.1 $80.0 $126.9 Avg. shares outstanding 14.241 14.785 23.388 Assumed conversion of: 6-1/2% debentures 6.151 6.151 2.543 6-7/8% debentures 1.608 1.608 0.255 7-3/4% debentures 0.361 -- -- Assumed exercise of stock options 0.097 0.145 0.181 Diluted EPS shares 22.458 22.689 26.367 Diluted earnings per share $2.05 $3.53 $4.81 Note 10. Financial Instruments The estimated fair values of the Company's financial instruments were as follows (in millions): December 31, 1997 Carrying Fair Amount Value Cash and cash equivalents $102.6 $102.6 Marketable securities 110.1 110.2 Restricted deposits 67.5 67.5 Long-term debt 404.5 521.7 December 31, 1998 Carrying Fair Amount Value Cash and cash equivalents $29.4 $29.4 Marketable securities 277.2 278.0 Restricted deposits 69.1 69.1 Long-term debt 175.5 175.5 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 publicly traded long-term debt is based on quoted market prices, and the fair value of other debt approximates carrying value. Note 11. Operating Segment Information Financial information for Alaska and Horizon follows (in millions): 1996 1997 1998 Operating revenues: Alaska $1,297.3 $1,447.9 $1,566.3 Horizon 301.3 303.6 347.8 Elimination of intercompany revenues (6.4) (12.1) (16.4) Consolidated 1,592.2 1,739.4 1,897.7 Depreciation and amortization expense: Alaska 55.9 56.9 61.9 Horizon 11.4 11.2 12.9 Interest income: Alaska 11.5 12.2 23.2 Horizon 0.3 0.1 -- Interest expense: Alaska 29.7 25.0 17.4 Horizon 0.9 1.8 1.0 Pretax income: Alaska 74.5 127.4 190.5 Horizon 0.3 6.3 18.9 Air Group (10.5) (10.1) (5.0) Consolidated 64.3 123.6 204.4 Capital expenditures: Alaska 229.9 293.0 420.1 Horizon 39.9 145.9 193.4 Total assets at end of period: Alaska 1,247.9 1,370.7 1,548.8 Horizon 173.3 158.0 187.1 Air Group 524.3 668.0 790.5 Elimination of intercompany accounts (634.1) (663.6) (794.6) Consolidated 1,311.4 1,533.1 1,731.8
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of Alaska Air Group, Inc.: We have audited the accompanying consolidated balance sheet of Alaska Air Group, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1998. 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 Air Group, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, 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, 1999
<TABLE> VALUATION AND QUALIFYING ACCOUNTS Alaska Air Group, Inc. Schedule II <CAPTION> Additions Beginning Charged (A) Ending (In Millions) Balance to Expense Deductions Balance <S> <C> <C> <C> <C> Year Ended December 31, 1996 (a) Reserve deducted from asset to which it applies: Allowance for doubtful accounts $1.6 $0.7 $(1.0) $1.3 Obsolescence allowance for flight equipment spare parts $13.5 $3.5 $(0.9) $16.1 (b) Reserve recorded as other long-term liabilities: Leased aircraft return provision $32.5 $9.4 $(3.3) $38.6 Year Ended December 31, 1997 (a) Reserve deducted from asset to which it applies: Allowance for doubtful accounts $1.3 $1.0 $(1.1) $1.2 Obsolescence allowance for flight equipment spare parts $16.1 $3.4 $(1.5) $18.0 (b) Reserve recorded as other long-term liabilities: Leased aircraft return provision $38.6 $11.4 $(6.8) $43.2 Year Ended December 31, 1998 (a) Reserve deducted from asset to which it applies: Allowance for doubtful accounts $1.2 $1.2 $(1.4) $1.0 Obsolescence allowance for flight equipment spare parts $18.0 $6.2 $(4.0) $20.2 (b) Reserve recorded as other long-term liabilities: Leased aircraft return provision $43.2 $13.1 $(7.6) $48.7 (A) Deduction from reserve for purpose for which reserve was created. </TABLE>
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. 3.(i) Articles of Incorporation of Alaska Air Group, Inc. as amended through May 21, 1996 3.(ii) Bylaws of Alaska Air Group, Inc., as amended through Feb. 8, 1996 (Exhibit 3.(ii) to 1995 10-K) 4.1 Amended and Restated Rights Agreement dated 8/7/96 between Alaska Air Group, Inc. and The First National Bank of Boston, as Rights Agent (Exhibit 2.1 to Form 8A-A filed 8/8/96) 10.1 Lease Agreement dated Feb. 1, 1979 between Alaska Airlines, Inc. and the Alaska Industrial Development Authority (AIDA) (Exhibit 10-15 to Registration Statement No. 2-70742) 10.2 Lease Agreement dated April 1, 1978 between Alaska Airlines, Inc. and the AIDA (Exhibit 10-16 to Registration Statement No. 2-70742) 10.3 Management Incentive Plan (1992 Proxy Statement) 10.4 Loan Agreement dated as of December 1, 1984, between Alaska Airlines, Inc. and the Industrial Development Corporation of the Port of Seattle (Exhibit 10-38 to 1984 10-K) 10.5 Alaska Air Group, Inc. 1988 Stock Option Plan, as amended through May 19, 1992 (Registration Statement No. 33-52242) #10.6 Lease Agreement dated January 22, 1990 between International Lease Finance Corporation and Alaska Airlines, Inc. for the lease of a B737- 400 aircraft, summaries of 19 substantially identical lease agreements and Letter Agreement #1 dated January 22, 1990 (Exhibit 10-14 to 1990 10-K) #10.7 Agreement dated September 18, 1996 between Alaska Airlines, Inc. and Boeing for the purchase of 12 Boeing 737-400 aircraft (Exhibit 10.1 to Third Quarter 1996 10-Q) #10.8 Agreement dated August 28, 1996 between Horizon Air Industries, Inc. and Bombardier for the purchase of 25 de Havilland Dash 8-200 aircraft (Exhibit 10.2 to Third Quarter 1996 10-Q) 10.9 Supplemental retirement plan arrangement between Horizon Air Industries, Inc. and George D. Bagley (1996 Proxy Statement) 10.10 Alaska Air Group, Inc. 1996 Long-Term Incentive Equity Plan (Registration Statement 333-09547) 10.11 Alaska Air Group, Inc. Non Employee Director Stock Plan (Registration Statement 333-33727) 10.12 Alaska Air Group, Inc. Profit Sharing Stock Purchase Plan (Registration Statement 333-39889) 10.13 Alaska Air Group, Inc. 1997 Non Officer Long-Term Incentive Equity Plan (Registration Statement 333-39899) 10.14 Alaska Air Group, Inc. Supplementary Retirement Plan for Elected Officers (Exhibit 10.15 to 1997 10-K) 10.15 1995 Elected Officers Supplementary Retirement Plan (Exhibit 10.16 to 1997 10-K) *#10.16 Agreement dated December 21, 1998 between Horizon Air Industries, Inc. and Bombardier for the purchase of 25 Canadair regional jets series 700 aircraft *12 Calculation of Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant (Exhibit 22-01 to 1987 10-K) *23 Consent of Arthur Andersen LLP *27 Financial Data Schedule * Filed herewith. # Confidential treatment was granted as to a portion of this document.