ITEM 1. BUSINESS
GENERAL INFORMATION
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 that was organized in 1932 and incorporated in the state of Alaska in 1937. Alaska became a wholly owned subsidiary of Air Group in 1985 pursuant to a reorganization of Alaska into a holding company structure. Air Group is a registrant pursuant to Section 12(b) of the Securities and Exchange Act of 1934 (Commission File No. 1-8957). Air Group’s filings with the Securities and Exchange Commission, including its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports are accessible free of charge at www.alaskaair.com. Alaska’s executive offices are located at 19300 International Boulevard, Seattle, Washington 98188. In 2004, Alaska accounted for 82% of Air Group’s total operating revenues.
As used in this Form 10-K, the terms “our” and “we” refer to Alaska, unless the content indicates otherwise.
Operations
Alaska Airlines, Inc. is an Alaska corporation that was organized in 1932 and incorporated in 1937. Alaska principally serves 39 cities in six western states (Alaska, Washington, Oregon, California, Nevada, and Arizona) and Canada and nine cities in Mexico. Alaska also provides non-stop service between Seattle and five eastern cities (Washington, D.C., Boston, Miami, Orlando, and Newark), between Seattle and Denver, Seattle and Chicago, between Los Angeles and Washington, D.C. and between Anchorage and Chicago. In each year since 1973, Alaska has carried more passengers between Alaska and the U.S. mainland than any other airline. In 2004, Alaska carried 16.3 million revenue passengers. Passenger traffic within Alaska and between Alaska and the U.S. mainland accounted for 20% of Alaska’s 2004 revenue passenger miles, West Coast traffic (including Canada) accounted for 53%, the Mexico markets accounted for 10% and other markets accounted for 17%. Based on passenger enplanements, Alaska’s leading airports are Seattle, Los Angeles, Portland and Anchorage. Based on 2004 revenues, its leading nonstop routes are Seattle-Anchorage, Seattle-Los Angeles, and Seattle-San Diego. At December 31, 2004, Alaska’s operating fleet consisted of 108 jet aircraft.
We believe we distinguish ourselves from competitors by providing a higher level of customer service in the form of attention to customer needs, advance seat assignments, expedited check-in, well-maintained aircraft, a first-class section aboard our aircraft, and other amenities.
Industry Conditions
The airline industry is highly competitive. Airline results are sensitive to passenger demand, ticket prices, labor costs and fuel costs. Passenger demand and ticket prices are, to a large measure, influenced by the general state of the economy, current events and industry capacity. Our industry was negatively impacted by weak economic conditions during 2001, 2002 and the first half of 2003, the September 11, 2001 terrorist attacks and continued hostilities in the Middle East. Economic conditions in the second half of 2003 and through 2004 improved somewhat, resulting in stronger demand and higher traffic levels. Due to the industry’s high fixed costs in relation to revenue, a small change in load factors or fare levels has a large impact on profits.
Labor costs generally make up 30% to 40% of an airline’s total operating costs. Most major airlines, including ours, have employee groups who are represented by collective bargaining agents. Often, airlines with unionized work forces have higher labor costs than carriers without unionized work forces, and may not have the ability to adjust labor costs downward fast enough to respond to new competition. Our wage and benefit costs increased 3% in 2004, 11% in 2003 and 10% in 2002.
Fuel prices generally make up 15% to 25% of an airline’s operating costs. Fuel prices can be volatile and largely uncontrollable. In 2004, fuel prices increased significantly. Our economic fuel cost per gallon (which is the net price we pay after the benefit of fuel hedges) increased 39% and 14% in 2004 and 2003, respectively, and decreased 10% in 2002.
The industry is currently in a state of flux. So called “Low Cost Carriers” (LCCs) have grown rapidly in recent years and currently enjoy a 30% share of total passengers carried in the United States. Because of their cost advantage, LCCs have contributed to an overall decline in ticket yields. The lower yield environment, coupled with high fuel costs, has been problematic for the higher cost “Legacy Carriers”, a number of which are operating under bankruptcy court protection. Because of the relatively low barriers to entry, we expect the expansion of low cost and low fare carriers to continue. Some legacy carriers, such as Delta and United, have launched their own low fare airlines (Song and Ted). We compete with many of these carriers now, and expect to compete with additional entrants in the future.
Most major US carriers, including Alaska, are working aggressively to cut operating costs, including renegotiation of collective bargaining agreements and vendor agreements.
As discussed in Note 14 to the financial statements, in April 2003, the Emergency Wartime Supplemental Appropriations Act (the Act) was signed into legislation. The Act includes $2.3 billion of one-time cash payments to air carriers, allocated based on each carrier’s share of security fees remitted and carrier fees paid to the Transportation Security Administration (TSA) since its inception in February 2002. Additionally, passenger security fees were not imposed by the TSA and carrier fees were not paid during the period June 1, 2003 through September 30, 2003. In May 2003, we received our share of the one-time cash grant in the amount of $52.8 million.
MARKETING AND COMPETITION
Alliances with Other Airlines
Alaska has marketing alliances with other airlines that provide reciprocal frequent flyer mileage accrual and redemption privileges and code sharing on certain flights as set forth below. Alliances enhance Alaska’s revenues by offering our customers more travel destinations and better mileage accrual/redemption opportunities, gaining us access to more connecting traffic from other airlines, and providing members of our alliance partners’ frequent flyer programs an opportunity to travel on Alaska while earning mileage credit in our partners’ programs. Alaska’s marketing agreements have various termination dates and at any time, one or more may be in the process of renegotiation. If a significant agreement were terminated, it could adversely impact revenues and increase the costs of our other marketing agreements. Most of our code share relationships are free-sell code shares, where the marketing carrier sells seats on the operating carrier’s flights from the operating carrier’s inventory, but takes no inventory risk. The table below identifies our marketing alliances with other airlines as of December 31, 2004.
Codesharing -
Codesharing -
Frequent
Alaska Flight #
Other Airline Flight #
Flyer
on Flights Operated
On Flights Operated
Agreement
by Other Airline
by Alaska/Horizon
Major U.S. or
International Airlines
American Airlines/American Eagle
British Airways
Cathay Pacific Airways
Continental Airlines
Delta
Frontier Airlines
Hawaiian Airlines
KLM
Lan Chile
Northwest Airlines
Qantas
Yes
Yes
Yes
Yes
Yes
No
Yes
Yes
Yes
Yes
Yes
Yes
No
No
Yes
Yes
No
Yes
No
No
Yes
No
Yes
No
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Commuter Airlines
Era Aviation
PenAir
Big Sky Airlines
Helijet International
Yes*
Yes*
Yes*
Yes*
Yes
Yes
Yes
Yes
No
No
No
No
* 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.
Competition
Competition in the airline industry is intense. We believe the principal competitive factors in the industry that are important to customers are:
• safety record and reputation;
Any domestic air carrier issued a certificate of public convenience and necessity by the Department of Transportation is allowed to operate scheduled passenger service in the United States. Currently, Alaska carries approximately 2.8% of all U.S. domestic passenger traffic. Alaska and Horizon compete with one or more domestic or foreign airlines on most of their routes, including Southwest Airlines, United Airlines, Northwest Airlines, Continental Airlines, American Airlines, Delta Airlines and regional affiliates associated with some of these carriers. Many of our competitors are substantially larger than Alaska, have greater financial resources, and have more extensive route systems. In addition, continuing growth of low-cost carriers, including Southwest Airlines, AirTran Airways, American Trans Air, Frontier Airlines and jetBlue Airways in the United States places significant competitive pressures on us and other network carriers since they have the ability to charge a lower fare for travel between similar cities and thus exert downward pressure on yields.
We also compete with other airlines for skilled employees such as pilots, flight attendants, ramp service employees, customer service agents and aircraft mechanics.
Ticket Distribution
Airline tickets are distributed through three primary channels:
• Airline websites such as alaskaair.com. It is less expensive for us to sell through these direct channels and, as a result, we continue to invest heavily in its online capabilities.
• Telephone reservation call centers.
• Traditional and online travel agents. Consumer reliance on traditional travel agencies is shrinking, while usage of online travel agencies is increasing. Both traditional and online travel agencies typically use Global Distribution Systems (GDS), such as Sabre, to obtain their fare and inventory data from airlines. Bookings made through these agencies result in a fee, the “GDS fee”, that is charged to the airline.
We currently participate in all of these distribution channels, but we cannot predict the terms on which we may be able to continue to participate in these or other sites, or their effect on our ability to compete with other airlines.
EMPLOYEES
The airline business is labor intensive. Alaska had 10,850 active full-time and part-time employees at December 31, 2004. Wages, salaries and benefits represented approximately 34% of our total operating expenses in 2004.
At December 31, 2004, labor unions represented 83% of Alaska’s employees. Our relations with our labor organizations are governed by the Railway Labor Act. Under this act, the collective bargaining agreements between the respective airlines and these organizations do not expire but instead become amendable as of a stated date. If either party wishes to modify the terms of any such agreement, it must notify the other party in the manner described in the agreement. After receipt of such notice, the parties must meet for direct negotiations, and if no agreement is reached, either party may request the National Mediation Board to appoint a federal mediator. If no agreement is reached in mediation, the National Mediation Board may declare that an impasse exists, at which point the National Mediation Board proffers binding arbitration to the parties. Either party may decline to submit to arbitration. If arbitration is rejected by either party, a 30-day “cooling off” period commences. During that period, a Presidential Emergency Board may be established, which examines the parties’ positions and recommends a solution. The Presidential Emergency Board process lasts for 30 days and is followed by a “cooling off” period of 30 days. At the end of a “cooling off” period, unless an agreement is reached or action is taken by Congress, the labor organization may strike and the airline may resort to “self-help”, including the imposition of any or all of its proposed amendments and the hiring of workers to replace strikers.
Two of Alaska’s collective bargaining agreements contain provisions for interest arbitration. Under interest arbitration, if the parties have not negotiated the contract by a predetermined date, each side may submit a prescribed number of issues to binding arbitration. The arbitrator’s decision on those issues is incorporated into the collective bargaining agreement, and no strike or company “self-help” may occur.
The collective bargaining agreement with the dispatchers is open for negotiation on wage rates in March 2005. If the parties are unable to reach an agreement, there is an interest arbitration provision related only to wages.
The pilot contract provides that, if an agreement on the entire contract was not reached by December 15, 2004, ten contract issues plus wage rates would be submitted to an interest arbitrator. Issues submitted generally relate to pension plans, medical insurance, profit sharing, code sharing and work rules. The parties did not reach an agreement, and the issues have been submitted to binding arbitration in March 2005 with a decision to be effective in May 2005. The pilot labor contract contains market related standards for wages and non-wage issues.
Alaska’s union contracts at December 31, 2004 were as follows:
* Collective bargaining agreement contains interest arbitration provision.
REGULATION
General
The Airline Deregulation Act of 1978, as amended, eliminated most domestic economic regulation of passenger and freight transportation. However, the Department of Transportation and the Federal Aviation Administration (FAA) still exercise regulatory authority over air carriers. In order to provide passenger and cargo air transportation in the U.S., a domestic airline is required to hold a certificate of public convenience and necessity issued by the Department of Transportation. Subject to certain individual airport capacity, noise and other restrictions, this certificate permits an air carrier to operate between any two points in the U.S. A certificate is of unlimited duration, but may be revoked for failure to comply with federal aviation statutes, regulations, orders or the terms of the certificate itself. In addition, the Department of Transportation maintains jurisdiction over the approval of international code share agreements, alliance agreements between domestic major airlines, international route authorities and certain consumer protection matters, such as advertising, denied boarding compensation and baggage liability.
The FAA regulates aircraft operations generally, including establishing personnel, maintenance and flight operation standards. Domestic airlines are required to hold a valid air carrier operating certificate issued by the FAA. Pursuant to these regulations, we have established, and the FAA has approved, a maintenance program for each type of aircraft we operate that provides for the ongoing maintenance of such aircraft, ranging from frequent routine inspections to major overhauls. From time to time the FAA issues airworthiness directives (ADs) that must be incorporated into our aircraft. We are and expect to be in compliance with all applicable requirements of these ADs within the required time periods.
The Department of Justice has jurisdiction over airline antitrust matters. The U.S. Postal Service has jurisdiction over certain aspects of the transportation of mail and related services. Labor relations in the air transportation industry are regulated under the Railway Labor Act, which vests in the National Mediation Board (NMB) certain functions with respect to disputes between airlines and labor unions relating to union representation and collective bargaining agreements. To the extent we continue to pursue alliances with international carriers, we may be subject to certain regulations of foreign agencies.
In November 2001, the Aviation and Transportation Security Act (the Security Act) was enacted. The Security Act created a new government agency, the Transportation Security Administration (TSA), which is now part of the Department of Homeland Security and is responsible for aviation security. The Security Act mandates that the TSA shall provide for the screening of all passengers and property, including U.S. mail, cargo, carry-on and checked baggage, and other articles that will be carried aboard a passenger aircraft. The TSA performs these functions with its own federal employees. On December 31, 2002, the TSA began explosive detection screening of all checked baggage. The TSA also provides for increased security on flight decks of aircraft and requires federal air marshals to be present on certain flights.
Effective February 1, 2002, the Security Act imposed a $2.50 per enplanement security service fee (maximum $5.00 one-way fee) which is collected by the air carriers and submitted to the government to pay for these enhanced security measures. In addition, carriers are required to pay an additional amount to the TSA to cover the total cost of providing security measures equal to the amount the air carriers paid for screening passengers and property in 2000. We paid $9.0 million, $8.4 million and $7.1 million to the TSA for this security charge in 2004, 2003 and 2002, respectively.
Recently, the United States Department of Homeland Security proposed raising the aviation security fee from $2.50 per one-way segment to $5.50 per one-way segment (or maximum of $8 for a one way trip with multiple segments). Although fees and taxes are often viewed by lawmakers as pass through costs, we believe that the demand for air travel is highly sensitive to price. Since all such increases affect the total ticket price paid by consumers, we believe that they would reduce passenger traffic and could have a negative impact on our results.
The Department of Transportation, under its authority to prevent unfair competitive practices in the industry, has from time to time considered the issuance of pricing and capacity rules that would limit major air carriers’ competitive response to new entrant carriers. Although the Department of Transportation has thus far declined to issue specific competitive guidelines, it reiterated its intent to prevent what it considers to be unfair competitive practices in the industry, and to pursue enforcement actions on a case-by-case basis. To the extent that future Department of Transportation enforcement actions either directly or indirectly impose restrictions upon our ability to respond to competitors, our business may be adversely impacted. Conversely, a relaxation in either unfair competition enforcement or restrictions could limit our ability to enter new markets or harm our operating results for markets that we have recently entered.
Airline Fares
Airlines are permitted to establish their own domestic fares without governmental regulation, and the industry is characterized by vigorous price competition. The Department of Transportation maintains authority over international (generally outside of North America) fares, rates and charges. International fares and rates are also subject to the jurisdiction of the governments of the foreign countries we serve. While air carriers are required to file and adhere to international fare and rate tariffs, substantial commissions, overrides and discounts to travel agents, brokers and wholesalers characterize many international markets.
Legislation, sometimes referred to as the “Passengers’ Bill of Rights,” has been discussed in Congress and state legislatures. This legislation could, if enacted, place various limitations on airline fares and/or affect operating practices such as baggage handling and overbooking. In 1999, we, as well as other domestic airlines, implemented a Customer Service Plan to address a number of service goals, including, but not limited to goals relating to lowest fare availability, delays, cancellations and diversions, baggage delivery and liability, guaranteed fares and ticket refunds.
To the extent legislation is enacted that would inhibit our flexibility with respect to fares, our revenue management system, our operations or other aspects of our customer service operations, our financial results could be adversely affected.
Fare discounting by competitors has historically had a negative effect on our financial results because we generally match competitors’ fares to maintain passenger traffic. During recent years, a number of new low-cost airlines have entered the domestic market and several major airlines, including Alaska and Horizon, implemented efforts to lower their cost structures. Further fare reductions, domestic and international, may occur in the future. If fare reductions are not offset by increases in passenger traffic, cost reductions or changes in the mix of traffic that improves yields, our operating results will be negatively impacted.
In February 2004, Alaska initiated a fare simplification plan whereby a number of restrictions were eliminated and the gap between the highest and lowest fares was reduced. The goal of this initiative was to increase customer value and simplify the customer’s purchase decision by
reducing the number of fares sold. We believe this initiative was revenue neutral overall.
Airport Access
Heavily used airports may have restrictions with respect to the number of permitted take-offs and landings, the total permitted annual seat capacity to be operated at an airport, the use or allocation of airport slots, or other restrictions. We currently have sufficient authorizations to operate our existing flights and have generally been able to obtain gates to expand our operations and change our schedules. However, we cannot assure you that we will be able to obtain authorizations for these purposes in the future, or be able to do so on economical terms.
Environmental Matters
We are subject to various laws and government regulations concerning environmental matters and employee safety and health in the U.S. and other countries. U.S. federal laws that have a particular impact on us include the Airport Noise and Capacity Act of 1990, the Clean Air Act, the Resource Conservation and Recovery Act, the Clean Water Act, the Safe Drinking Water Act, and the Comprehensive Environmental Response, Compensation and Liability Act, or Superfund Act. We are also subject to the oversight of the Occupational Safety and Health Administration, known as OSHA, concerning employee safety and health matters. The U.S. Environmental Protection Agency, or EPA, OSHA, and other federal agencies have been authorized to promulgate regulations that have an impact on our operations. In addition to these federal activities, various states have been delegated certain authorities under the aforementioned federal statutes. Many state and local governments have adopted environmental and employee safety and health laws and regulations, some of which are similar to federal requirements. We maintain our own continuing safety, health and environmental programs in order to meet or exceed these requirements.
The Airport Noise and Capacity Act recognizes the rights of airport operators with noise problems to implement local noise abatement programs so long as they do not interfere unreasonably with interstate or foreign commerce or the national air transportation system. Authorities in several cities have promulgated aircraft noise reduction programs, including the imposition of nighttime curfews. The Airport Noise and Capacity Act generally requires FAA approval of local noise restrictions on aircraft. While we have had sufficient scheduling flexibility to accommodate local noise restrictions imposed to date, our operations could be adversely affected if such regulations become more restrictive or widespread.
Although we do not currently anticipate that these regulatory matters, individually or collectively, will have a material impact on our financial condition, results of operations or cash flows, we cannot assure you that new regulations or compliance issues that we do not currently anticipate will not harm our financial condition, results of operations or cash flows in future periods.
FUEL
Our operations are significantly affected by the availability and price of jet fuel. Fuel costs were approximately 20% of our total operating expenses in 2004 and 15% in 2003. Fuel prices, which can be volatile and which are outside of our control, can have a significant impact on our operating results. Currently, a one-cent change in the fuel price per gallon affects annual fuel costs by approximately $3.5 million. We believe that operating fuel-efficient aircraft helps to mitigate the effect of high fuel prices.
We purchase fuel hedge contracts to reduce our exposure to fluctuations in the price of jet fuel. Due to the competitive nature of the airline industry, airlines often are unable to pass on increased fuel prices to customers by increasing fares. Conversely, any potential benefit of lower fuel prices may be offset by increased fare competition and lower revenues. Because of rising fuel prices, our fuel hedging program has resulted in significant savings over the last three years. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for a discussion of our fuel hedging activities.
While we do not currently anticipate a significant reduction in fuel availability, dependency on foreign imports of crude oil and the possibility of changes in government policy on jet fuel production, transportation and marketing make it impossible to predict the future availability of jet fuel. In the event of significant hostilities or other conflicts in oil producing areas, there could be reductions in the production and/or importation of crude oil and price increases, which could adversely affect our business. If there were major reductions in the availability of jet fuel, our business would be adversely affected.
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 or terminate the program.
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 75% of the free flight awards on Alaska and Horizon are subject to blackout dates and capacity-controlled seating. Mileage Plan accounts are generally deleted after three years of inactivity in that member’s account. As of December 31, 2004 and 2003, Alaska estimated that 2,493,000 and 2,353,000, respectively, 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 those eligible awards, Alaska estimated that approximately 88% of those awards would ultimately be redeemed. For the years 2004, 2003 and 2002, approximately 631,000, 606,000, and 441,000 round-trip flight awards were redeemed and flown on Alaska and Horizon.
Those awards represent approximately 7.3% for 2004, 8.7% for 2003 and 6.8% for 2002 of the total passenger miles flown on Alaska and Horizon for each period. For the years 2004, 2003 and 2002, approximately 212,000, 174,000 and 174,000, respectively, round-trip flight awards were redeemed and flown on airline partners.
For miles earned by flying on Alaska and travel partners, the estimated incremental cost of providing free travel awards is recognized as a selling expense and accrued as a liability as miles are accumulated. The incremental cost does not include a contribution to overhead, aircraft cost, or profit. Alaska also sells mileage credits to non-airline partners, such as hotels, car rental agencies, and a national bank that rewards users of its credit card. Alaska defers a majority of the sales proceeds, and recognizes these proceeds as revenue when the award transportation is provided on Alaska or another partner airline. The deferred proceeds are recognized as passenger revenue for awards issued and flown on Alaska or Horizon and as other revenue-net for awards issued and flown on other airlines. At December 31, 2004 and 2003, the deferred revenue and the total liability for providing free travel on Alaska and Horizon and for estimated payments to partner airlines was $409.3 million and $336.0 million, respectively, the majority of which is deferred revenue from the sale of mileage credits. Deferred revenue and liabilities associated with the Mileage Plan are carried on Alaska’s balance sheet since Alaska is the sponsor and ticketing carrier.
OTHER INFORMATION
Seasonality and Other Factors
Our results of operations for any interim period are not necessarily indicative of those for the entire year, because our business is subject to seasonal fluctuations. Our operating income is generally lowest (or loss the greatest) during the first and fourth quarters due principally to lower traffic and sometimes due to adverse weather conditions, generally increases in the second quarter and generally reaches its highest level during the third quarter.
The airline industry is characterized generally by low profit margins and high fixed costs, primarily for wages, aircraft fuel, debt service and rent. The expenses of an aircraft flight do not vary significantly with the number of passengers carried and, as a result, a relatively small change in the number of passengers or in pricing has a disproportionate effect on an airline’s operating and financial results. Accordingly, a minor shortfall in expected revenue levels could cause a disproportionately negative impact on our operating results. In addition to passenger loads, factors that could cause our quarterly operating results to vary include:
• changes in fuel, security and insurance costs,
• increases in personnel, marketing, aircraft ownership and other operating expenses to support our existing operation and anticipated growth,
• the timing and amount of maintenance expenditures,
• the timing and success of our growth plan as we increase flights in existing markets and enter new markets and
• pricing initiatives, both internal and external.
In addition, seasonal variations in traffic, various expenditures and weather affect our operating results from quarter to quarter. Given our high proportion of fixed costs, seasonality can affect our profitability from quarter to quarter. Many of our areas of operations experience inclement weather conditions in the winter, causing increased costs associated with deicing aircraft, canceled flights and accommodating displaced passengers. Due to our geographic area of operations, we can be more susceptible to adverse weather conditions than some of our competitors (particularly in the State of Alaska and in the Pacific Northwest), who may be better able to spread weather-related risks over larger route systems.
The results of operations in the air transportation business have also significantly fluctuated in the past in response to general economic conditions. Fare initiatives, fluctuations in fuel prices, labor actions and other factors could impact this seasonal pattern.
No material part of our business or that of our subsidiaries is dependent upon a single customer or very few customers. Consequently, the loss of our largest few customers would not have a materially adverse effect upon our financial condition, results of operations or cash flows.
Insurance
We carry insurance for passenger liability, property damage and hull insurance for damage to our aircraft, in amounts and of the type generally consistent with industry practice.
As a result of the events of September 11, 2001, aviation insurers have significantly reduced the maximum amount of insurance coverage available to commercial air carriers for third-party liability for claims resulting from acts of terrorism, war or similar events. At the same time, they significantly increased the premiums for such coverage as well as for aviation insurance in general. Although insurance rates have declined, they are still somewhat above pre-September 11 levels and will likely remain there for the foreseeable future.
Pursuant to authority granted in the Air Transportation Safety and System Stabilization Act, the Homeland Security Act of 2002, as amended by the Consolidated Appropriations Act, 2005, the Government has offered, and we have accepted, war risk insurance to replace commercial war risk insurance through August 31, 2005.
Other Government Matters
We have elected to participate in the Civil Reserve Air Fleet program, whereby we have agreed to make available to the federal government a certain number of aircraft in the event of a military call-up. The government would reimburse us for the use of such aircraft.
ITEM 2.
ITEM 2. PROPERTIES
Aircraft
The following tables describe the aircraft we operate and their average age at December 31, 2004:
Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” discusses future orders and options for additional aircraft.
32 of the 60 aircraft owned by Alaska as of December 31, 2004 are subject to liens securing long-term debt. The Company expects to have additional aircraft encumbered pending a re-negotiated credit facility. Alaska’s leased 737-200C, 737-400, 737-700 and MD-80 aircraft have lease expiration dates in 2006, between 2006 and 2016, between 2006 and 2020 and between 2007 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 Note 6 to Financial Statements.
At December 31, 2004, all of our aircraft met 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, Long Beach, Orange County, San Diego, San Jose and Palm Springs. In addition, Orange County, Reagan National, O’Hare and Long Beach airports restrict the type of aircraft and number of flights.
Ground Facilities and Services
Alaska leases ticket counters, gates, cargo and baggage space, office space, and other support areas at the majority of the airports they serve. Alaska also owns terminal buildings in various cities in the state of Alaska.
Alaska has centralized operations in several buildings located at or near Seattle-Tacoma International Airport (Sea-Tac) in Seattle, Washington. 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, an information processing center, several office buildings and our corporate headquarters. Alaska also leases a two-bay
hangar/office facility at Sea-Tac, a warehouse and reservation/office facility in Kent, WA, and a reservation center in Boise, ID. Alaska’s other major facilities include a regional headquarters building, an air cargo facility, and a leased hangar/office facility in Anchorage; a reservations center in Phoenix; and a leased two-bay maintenance facility in Oakland.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are a party to routine litigation incidental to our business and with respect to which no material liability is expected. Management believes the ultimate disposition of these matters is not likely to materially affect our financial position or results of operations. This forward-looking statement is based on management’s current understanding of the relevant law and facts; it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.
Our existing pilot contract provides that, if a negotiated agreement on the entire contract was not reached by December 15, 2004, ten contract issues plus wage rates would be submitted to an interest arbitrator. Issues submitted generally relate to pension plans, medical insurance, profit sharing, code sharing and work rules. The parties did not reach an agreement, and the issues have been submitted to binding arbitration in March 2005 with a decision to be effective in May 2005. The pilot labor contract contains market related standards for wages and non-wage issues.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
All of Alaska’s outstanding common stock is held by Air Group 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 Air Group.
Alaska Airlines Financial and Statistical Data
NM = Not Meaningful
(a) See Note A on page 17.
Note A:
Pursuant to Item 10 of Regulation S-K, we are providing disclosure of the reconciliation of reported non-GAAP financial measures to their most directly comparable financial measures reported on a GAAP basis. The non-GAAP financial measures provide management the ability to measure and monitor performance both with and without the cost of aircraft fuel (including the gains and losses associated with our fuel hedging program where appropriate), restructuring charges, aircraft impairment charges, government compensation in 2003 and a large recovery in 2004 of disputed navigation fees paid in prior years (of which $7.7 million was recorded in operating expenses and $3.3 million was recorded in non-operating income). Because the cost and availability of aircraft fuel are subject to many economic and political factors beyond our control and we record changes in the fair value of our hedge portfolio in our income statement, it is our view that the measurement and monitoring of performance without fuel is important.
The following tables reconcile our non-GAAP financial measures to the most directly comparable GAAP financial measures for Alaska Airlines, Inc.:
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our financial statements and the related notes contained elsewhere in this Annual Report on Form 10-K. All statements in the following discussion which are not reports of historical information or descriptions of current accounting policies are forward-looking statements. Please consider our forward-looking statements in light of the risks referred to in this report’s introductory cautionary note. There can be no assurance that actual developments will be those anticipated by us. Actual results could differ materially from those projected as a result of a number of factors, some of which we cannot predict or control. For a discussion of our risk factors, see “Risk Factors,” beginning on page 36.
General
Alaska is a major airline serving primarily Alaska; the U.S. West Coast; five cities on the U.S. East Coast, Denver, Chicago; Vancouver and Calgary, Canada; and Mexico. It operates an all jet fleet and its average passenger trip is 996 miles.
Year in Review and Current Events
Overall, economic conditions in 2004 improved over 2003. The industry generally enjoyed increases in both passenger traffic and load factors, and Alaska was no different - posting record monthly load factors for much of the year. However, ticket yields continued to remain under pressure in the wake of growth of low cost carriers such as Southwest and jetBlue and excess capacity in many markets. Fuel prices reached record highs during much of the year, although moderated somewhat in the fourth quarter, but are still materially above historical averages. These factors, coupled with the high cost structures of many major carriers, resulted in another year of significant losses for the industry.
During 2004, the management team at Alaska was actively focused on cost reductions. Our stated goal for 2004 was to achieve a unit cost (excluding fuel and significant items) of 8.0 cents per available seat mile (ASM) and we achieved a full year unit cost excluding fuel and significant items of 7.92 cents per ASM.
Restructuring Charges
During the third quarter of 2004, Alaska announced a management reorganization and the closure of its Oakland heavy maintenance base, contracting out of related heavy maintenance, contracting out of the Company’s Fleet Service, Ground Support Equipment and facility maintenance functions, maintenance shops and other initiatives. In total, we believe these restructuring activities will result in a reduction of approximately 900 employees when fully implemented in the first half of 2005. Severance and related costs associated with this restructuring are estimated at $53.4 million, of which $27.5 million was recorded during the third quarter of 2004 and $25.9 million was recorded in the fourth quarter. We expect savings from these job-related initiatives to be approximately $35 million per year when fully implemented.
As part of our ongoing cost saving initiatives, we continue to look at all aspects of our business. In 2005, we may outsource other activities or initiate other restructuring activities which would result in further restructuring charges.
Labor Costs and Negotiations
Alaska continues to pursue the restructuring of its labor agreements so that they are in line with what we believe to be the market. Our objectives as we restructure these agreements are to achieve market labor costs, productivity and employee benefit costs. Based on these three objectives, in 2003 Alaska targeted $112 million per year of labor savings. As a result of increases in our wage rates since that time, combined with labor cost decreases achieved by our competitors, we believe that our wages and benefits are now above market by approximately $125 million. Alaska believes that its pilot labor costs represent the majority of this amount. Despite ongoing negotiations in late 2003 and much of 2004, we were unable to reach a new agreement with the Air Line Pilots Association (ALPA) and have therefore submitted to binding arbitration, the decision of which will be effective in May 2005. The arbitration will cover wages plus five issues submitted by each of the Company and ALPA. The pilot labor contract contains market related standards for wages and benefits. Nevertheless, we cannot predict the outcome of this proceeding, particularly whether the arbitrator’s award will reflect cost savings in wage rates, productivity and benefits equal to what we consider to be the current excess over market.
Reducing labor costs and finalizing the agreements with our labor groups is an important objective for 2005.
Mark-to-Market Fuel Hedging Gains
Beginning in the second quarter of 2004, we lost the ability to defer, as a component of comprehensive income, recognition of any unrealized gain or loss on our fuel hedge contracts until the hedged fuel is consumed. We lost this ability because the price correlation between crude oil, the commodity we use to hedge, and West Coast jet fuel fell below required thresholds. For more discussion, see Note 10 to our financial statements.
The implications of this change are twofold: First, our earnings are more volatile as we mark our entire hedge portfolio to market each quarter-end and report the gain or loss in other non-operating income or expense, even though the actual consumption will take place in a future period. Second, to a large extent, the impact of our fuel hedge program will not be reflected in fuel expense. For example, we recorded gains from settled fuel hedges totaling $39.8 million during 2004, but only $14.6 million of that gain is reflected as an offset to fuel expense with the balance reported in other non-operating income.
We have provided information on mark-to-market gains or losses, as well as calculations of our economic fuel cost per gallon on pages 17.
We continue to believe that our fuel hedge program is an important part of our strategy to reduce our exposure to volatile fuel prices.
Impairment of 737-200C Aircraft
In June 2004, the Company’s Board approved a plan to accelerate the retirement of its Boeing 737-200C fleet and remove those aircraft from service earlier than initially planned. In July 2004, the Company announced its plan to replace these aircraft by modifying five existing 737-400 aircraft and using other existing 737-400 aircraft for the remaining passenger capacity. At December 31, 2004 the planned modifications have been delayed. However, management currently believes that all 737-200s will still be retired by the end of 2007 as planned. The Company expects to replace the 737-400s with Boeing 737-800 aircraft in 2005 and 2006.
As a result of this decision, the Company evaluated impairment as required by SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” and concluded that the carrying value of the 737-200C fleet was no longer recoverable when compared to the estimated remaining future cash flows. Accordingly, during the second quarter of 2004, the Company recorded an impairment charge totaling $36.8 million (pre-tax) to write down the fleet to its estimated fair market value. In addition, we revised our estimates of the useful lives and residual values of the fleet and related spare equipment and will depreciate the remaining carrying values through 2007, when the last aircraft will be retired.
Navigation Fee Refund
During the third quarter of 2004, we received a refund totaling $11 million (pre-tax) from the Mexican government related to navigation fees paid in 2002 and 2003. Approximately $7.7 million of the refund was recorded as a reduction to operating expenses and $3.3 million was recorded as non-operating income.
Other Events
During the fourth quarter of 2004, Alaska entered into a 10 year “power-by-the-hour” engine maintenance agreement with a third party. Under terms of this arrangement, the third party will provide routine and major overhaul maintenance services on certain engines in our 737-400 fleet at an agreed upon rate per hour flown.
During the fourth quarter, Alaska added a row of seats to its 737-400 fleet. This change will result in an increase of approximately 2.3¢ in available seat miles on an annualized basis. We expect this change will represent a significant portion of our capacity growth in 2005. In late 2004, we also announced that we would be installing winglets on our B737-700 aircraft.
Outlook
For 2005, Alaska expects capacity increases of approximately 3¢. The expected capacity increase is due largely to the annualization of the additional seats added to the B737-400 fleet and the addition of three B737-800s offset by the retirement of two B737-200s.
RESULTS OF OPERATIONS
2004 Compared with 2003
Our net loss for 2004 was $19.1 million, versus net income of $3.0 million, in 2003. The 2004 results include four significant items which impact the comparability to 2003. These items are discussed in the “Year in Review and Current Events” section beginning on page 18. Our 2003 results also include $52.8 million received related to assistance from the government under the Emergency Wartime Supplemental Appropriations Act.
Our operating loss for 2004 was $85.4 million compared to a loss of $19.4 million for 2003. Our pre-tax loss for 2004 was $27.0 million compared to pre-tax income of $11.8 million for 2003. Financial and statistical data comparisons for Alaska are shown on page 16, respectively. On page 17, we have included a reconciliation of reported non-GAAP financial measures to the most directly comparable GAAP financial measures.
Alaska Airlines Revenues
Operating revenues increased $205.6 million, or 10.1¢, during 2004 as compared to the same period in 2003. The increase in revenues resulted from an 11.5¢ increase in passenger traffic, offset by a 1.4¢ decline in ticket yields. For the year ended December 31, 2004, capacity increased 7.1¢ as compared to 2003. The capacity increases are primarily due to the annualization and expansion of our transcontinental flying, including service from Seattle to Chicago and Los Angeles to Reagan National in Washington D.C. The traffic increase of 11.5¢ outpaced the capacity increase of 7.1¢, resulting in an increase in load factor from 70.0¢ to 72.9¢. The decline in yield per passenger mile was a result of continued industry-wide pricing pressure, particularly in the fourth quarter where yield declines were more substantial, dropping 5.8¢ compared to the fourth quarter of 2003. We expect that load factors will continue to be strong but that yields and passenger unit revenues will continue to decline on a year-over-year basis into the first half of 2005.
Freight and mail revenues increased $9.1 million, or 11.8¢, because of a new mail contract we have in the State of Alaska offset by lower freight revenues.
Other-net revenues increased $13.3 million, or 12.1¢, due largely to revenues received from an agreement with Pen Air to provide flight services to Dutch Harbor that began in January of 2004 and higher Mileage Plan revenues.
Alaska Airlines Expenses
For the twelve months ended December 31, 2004, total operating expenses increased $271.6 million, or 13.3¢, as compared to the same period in 2003. Operating expenses per ASM increased 5.8¢ from 9.84 cents in 2003 to 10.41 cents in 2004. The increase in operating expenses per ASM is due largely to significant increase in fuel costs, our restructuring charges, the impairment charge related to our Boeing 737-200 fleet, higher wages and benefits, contracted
services costs and landing fees and other rental costs offset by declines in other selling expenses and commissions and the navigation fee recovery. Operating expense per ASM excluding fuel, the navigation fee recovery, restructuring and impairment charges decreased 5¢ to 7.92 cents per ASM compared to 8.34 cents per ASM in 2003. Explanations of significant period-over-period changes in the components of operating expenses are as follows:
• Aircraft maintenance decreased $7.6 million, or 5%, due largely to fewer engine overhauls during 2004 and a change in the mix of heavy maintenance versus routine maintenance.
We plan to change the accounting for engine and airframe overhauls at Alaska and Horizon, effective January 2005. Under the new method, we will charge the costs of these overhauls directly to expense, as opposed to our current practice of capitalizing and amortizing them. To effect this change, we will write off the unamortized portion of previously capitalized overhauls in January 2005 as a cumulative effect of an accounting change. We expect the one-time charge to be approximately $80 million, after tax.
• Aircraft rent decreased $10.4 million, or 8.4%, due to lower rates on extended leases and fewer leased aircraft in 2004 compared to 2003.
• Other selling expenses and commissions decreased $15.8 million, or 11%, due to a decline in the incentive payments made to Horizon offset by increases in booking fees, credit card fees, and commissions. In 2004, 38.0% of Air Group ticket sales were made through traditional travel agents, compared to 43.0% in 2003. In 2004, 30.4% of the ticket sales were made through Alaska’s Internet web site compared to 27.4% in 2003.
• Depreciation and amortization increased $8.6 million, or 7%, reflecting accelerated depreciation on the planned retirement of the Boeing 737-200C fleet, an increase in depreciation resulting from one aircraft purchased in the last twelve months, and the full year depreciation on aircraft acquired in 2003, and additional provisions for inventory obsolescence.
• Landing fees and other rentals increased $14.2 million, or 11%. The higher rates primarily reflect higher joint-use and exclusive rental fees at Seattle, Portland, Los Angeles and Oakland, combined with modest volume growth. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security due to unfunded government mandates.
• Other expense increased $9.7 million, or 7%, primarily reflecting a $6.3 million increase in professional services costs, higher moving expenses associated with our restructuring initiatives, higher passenger remuneration costs, and supplies costs.
* The Company expects the majority of cash payments will be made during the first and second quarters of 2005.
Nonoperating Income (Expense)
Net nonoperating income was $58.4 million in 2004 compared to $31.2 million in 2003. Interest income increased $11.0 million due to a larger marketable securities portfolio in 2004 combined with a correction of premium and discount amortization on our marketable securities portfolio in 2003. 2004 interest income also includes $3.3 million from the recovery in 2004 of disputed Mexico navigation fees paid in 2002 and 2003.
Other-net includes $25.2 million and $5.4 million in gains from settled fuel hedging contracts in 2004 and 2003, respectively. In addition, other-net includes mark-to-market gains on unsettled hedge contracts of $50.1 million in 2004.
The 2003 results include $52.8 million received in connection with the government reimbursement of security fees remitted and carrier fees paid under the Emergency Wartime Supplemental Appropriations Act.
2003 Compared with 2002
Our net income for 2003 was $3.0 million, compared with a net loss of $69.5 million in 2002. Our 2003 results include $52.8 million received related to assistance from the government under the Emergency Wartime Supplemental Appropriations Act. Our 2002 net loss includes $0.3 million received from the government and $12.5 million related to the write-off of goodwill in connection with the adoption of SFAS No. 142 (see discussion in Note 15 in the Notes to Financial Statements).
Our operating loss for 2003 was $19.4 million compared to $77.6 million for 2002. Our pre-tax income for 2003 was $11.8 million compared with a pre-tax loss before accounting change of $87.3 million for 2002. Financial and statistical data comparisons for Alaska are shown on page 16. On page 17, we have included a reconciliation of reported non-GAAP financial measures to the most directly comparable GAAP financial measures.
Alaska Airlines Revenues
Operating revenues increased $194.3 million, or 10.6%, during 2003 as compared to the same period in 2002, reflecting stronger summer demand and higher than expected fourth quarter traffic as compared to 2002. For the twelve months ended December 31, 2003, capacity increased 7.5% and traffic increased 10.4% as compared to the same period in 2002. The capacity increases are primarily due to the addition of service to new cities (Boston, Denver, Newark, Washington D.C., Orlando and Miami) and an increase in service in the Pacific Northwest, Mexico, and Canada markets, partially offset by lower capacity in the Bay Area, Arizona and Northern Alaska. During 2003, roughly 75% of our ASM growth came from expansion in the Transcontinental and Denver markets. Traffic increases primarily reflect service to new cities and traffic increases in the Pacific Northwest, Mexico and Nevada, partially offset by decreases in traffic in the Bay Area, Northern Alaska and Arizona. Higher traffic resulted in a $172.7 million, or 10.4%, increase in passenger revenues. Our passenger load factor increased 1.9 percentage points to 70.0% during 2003 as compared to 2002.
Our yield per passenger mile remained constant compared to 2002 due to a combination of longer average stage lengths, fewer business travelers, and continued pricing pressure by low cost carriers, partially offset by an increase in revenue from expired Mileage Plan accounts.
Freight and mail revenues increased $5.2 million, or 7.2%, due principally to higher freight and mail volumes attributable to a reduction of security restrictions. Other-net revenues increased $16.4 million, or 17.6%, due largely to cash received from the sale of miles in our frequent flyer program (impacting other revenue currently as a portion is recognized immediately) and redemption of miles on partner airlines.
Alaska Airlines Expenses
For the twelve months ended December 31, 2003, total operating expenses increased $136.1 million, or 7.1%, as compared to the same period in 2002. This increase is due largely to a 7.5% increase in ASMs combined with higher fuel, maintenance, wages and benefits costs and landing fees and other rentals. Operating expense per ASM decreased 0.3% as compared to the same period in 2002 from 9.87 cents to 9.84 cents. Operating expense per ASM excluding fuel decreased 2.1% as compared to the same period in 2002 from 8.52 cents to 8.34 cents. Explanations of significant period-over-period changes in the components of operating expenses are as follows:
insurance program and competitive pressures in the aviation war risk insurance market. However, aviation insurance remains substantially higher than before September 11, 2001.
Nonoperating Income (Expense)
Net nonoperating items were $31.2 million income in 2003 compared to $9.7 million expense in 2002. The 2003 results include $52.8 million received in connection with the government reimbursement of security fees remitted and carrier fees paid under the Act. Interest income decreased $8.0 million due principally to lower interest rates and an adjustment of premium and discount amortization on our marketable securities portfolio. Interest expense (net of capitalized interest) increased $0.8 million, due primarily to increases in debt (See Note 4 in the Notes to Financial Statements).
Other-net includes $6.8 million and $8.5 million in gains resulting from hedge ineffectiveness on fuel hedging contracts in 2003 and 2002, respectively. In 2003, we received an insurance recovery of $3.1 million in connection with legal fees associated with a U.S. Attorney investigation in Oakland. In 2002, we received a $1.4 million insurance recovery and a $0.9 million gain on conversion of Equant N.V. shares (a telecommunications network company owned by many airlines).
Cumulative Effect of Accounting Change
Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” Under this statement, goodwill is no longer amortized, but instead is tested for impairment on a minimum of an annual basis. During the second quarter of 2002, we completed the first step of our impairment test related to our $12.5 million of goodwill. In the fourth quarter of 2002, we completed the second step of our impairment test and determined that all of our goodwill was impaired. As a result, we recorded a one-time, non-cash charge, effective January 1, 2002, of $12.5 million to write-off all of our goodwill. This charge is reflected as a cumulative effect of accounting change in the Statement of Operations for 2002.
Critical Accounting Estimates
The discussion and analysis of our financial position and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect our financial position and results of operations. See Note 1 to Financial Statements for a description of our significant accounting policies. Critical accounting estimates are defined as those that are reflective of significant judgment and uncertainties, and potentially result in materially different results under different assumptions and conditions. We have identified the following critical accounting estimates. We have discussed the development, selection and disclosure of these policies with our audit committee.
Mileage Plan
Our Mileage Plan loyalty program awards miles to member passengers who fly on Alaska or Horizon and our travel partners. Additionally, we sell miles to third parties, such as our credit card partner, for cash. In either case, the outstanding miles may be redeemed for travel on Alaska, Horizon, or any of our alliance partners. As long as the Mileage Plan is in existence, we have an obligation to provide this future travel; therefore, for awards earned by passengers who fly on Alaska, Horizon or our travel partners, we recognize a liability and the corresponding selling expense for this future obligation. For miles sold to third parties, a majority of the sales proceeds are recorded as deferred revenue and recognized when the award transportation is provided. The deferred proceeds are recognized as passenger revenue when awards are issued and flown on Alaska or Horizon, and as other-net revenue for awards issued and flown on other airlines.
At December 31, 2004, we had approximately 86 billion miles outstanding, resulting in an aggregate liability of $409.2 million. The liability is computed based on several assumptions that require significant management judgment to estimate and formulate. There are uncertainties inherent in estimates; therefore, an incorrect assumption impacts the amount and/or timing of revenue recognition or Mileage Plan expenses. The most significant assumptions in accounting for the Mileage Plan are described below.
1. The number of miles that will not be redeemed for travel:
Members may not reach the mileage threshold necessary for a free ticket and outstanding miles may not always be redeemed for travel. Therefore, based on the number of Mileage Plan accounts and the miles in the accounts, we estimate how many miles will never be used (“breakage”), and do not record a liability for those miles. Our estimates of breakage consider activity in our members accounts, account balances, and other factors. We believe our breakage assumptions are reasonable. A hypothetical 1.0% change in our estimate of breakage (currently 12% in the aggregate) has approximately a $4.5 million affect on the liability. However, actual breakage could differ significantly from our estimates given the dynamic nature of the program and our inability to predict our member’s future behavior.
2. The number of miles used per award (i.e., free ticket):
We estimate how many miles will be used per award. If actual miles used are more or less than estimated, we may need to adjust the liability and corresponding expense. Our estimates are based on the current requirements in our Mileage Plan program and historical redemptions on Alaska, Horizon or other airlines.
3. The costs which will be incurred to carry the passenger:
When the frequent flyer travels on his or her award ticket, incremental costs such as food, fuel and insurance are incurred to carry that passenger. We estimate what these costs (excluding any contribution to overhead and profit) will be and accrue a liability. If the passenger travels on another airline on an award ticket, we often must pay the other airline for carrying the
passenger. The other airline costs are based on negotiated agreements and are often substantially higher than the costs we would incur to carry that passenger. We estimate how much we will pay to other airlines for future travel awards based on historical redemptions and settlements with other carriers and accrue a liability accordingly. The costs actually incurred by us or paid to other airlines may be higher or lower than the costs that were estimated and accrued, and therefore we may need to adjust our liability and recognize a corresponding expense.
4. Redemption on Alaska or Horizon versus other airlines:
The cost for Alaska or Horizon to carry an award passenger is typically lower than the cost we will pay to other airlines. We estimate the number of awards which will be redeemed on Alaska or Horizon versus other airlines and accrue the costs on this based on our estimate of historical redemption patterns. If the number of awards redeemed on other airlines is higher or lower than estimated, we may need to adjust our liability and corresponding expense.
5. The rate at which we defer sales proceeds from sold miles:
We defer an amount that represents our estimate of the value of a free travel award. As fare levels change, our deferral rate changes, which may result in more or less recognition of cash proceeds in any given quarter.
We review all Mileage Plan estimates each quarter, and change our assumptions if facts and circumstances indicate that a change is necessary. Any such change in assumptions could have a significant effect on our financial position and results of operations.
Pension Plans
We account for the defined benefit pension plans using SFAS No. 87, “Employer’s Accounting for Pensions.” Under SFAS No. 87, pension expense is recognized on an accrual basis over employees’ approximate service periods. Pension expense calculated under SFAS No. 87 is generally independent of funding decisions or requirements. We recognized expense for our defined benefit pension plans of $78.3 million, $73.5 million and $40.0 million in 2004, 2003 and 2002, respectively.
The calculation of pension expense and the corresponding liability requires the use of a number of important assumptions, including the expected long-term rate of return on plan assets and the assumed discount rate. Changes in these assumptions can result in different expense and liability amounts, and future actual experience can differ from these assumptions. At December 31, 2004, the fair value of our pension plan assets totaled $607.0 million. We anticipate making a cash contribution of approximately $58 million during 2005.
Pension expense increases as the expected rate of return on pension plan assets decreases. At December 31, 2004, we estimate that the pension plan assets will generate a long-term rate of return of 8.0%. This rate is equal to the assumed rate of 8.0% used at December 31, 2003, and was
developed by evaluating input from consultants and economists as well as long-term inflation assumptions. We regularly review the actual asset allocation and periodically rebalance investments as considered appropriate. This expected long-term rate of return on plan assets at December 31, 2004 is based on an allocation of U.S. equities and U.S. fixed income securities. Decreasing the expected long-term rate of return by 0.5% (from 8.0% to 7.5%) would increase our estimated 2005 pension expense by approximately $3.1 million.
Pension liability and future pension expense increase as the discount rate is reduced. We discounted future pension obligations using a rate of 5.75% and 6.00% at December 31, 2004 and 2003, respectively. The discount rate is determined based on the current rates earned on high quality long-term bonds. Decreasing the discount rate by 0.5% (from 5.75% to 5.25%) would increase our accumulated benefit obligation at December 31, 2004 by approximately $52.0 million and increase estimated 2005 pension expense by approximately $8.7 million.
The defined benefit plan for management personnel was closed to new entrants in 2003. We are working to restructure the defined benefits plans for other labor groups. Any such change could impact future pension expense and pension liabilities.
Future changes in plan asset returns, assumed discount rates and various other factors related to the participants in our pension plans will impact our future pension expense and liabilities. We cannot predict what these factors will be in the future.
Long-lived Assets
As of December 31, 2004, we had approximately $1.7 billion of property and equipment and related assets. In accounting for these long-lived assets, we make estimates about the expected useful lives of the assets, the expected residual values of the assets, and the potential for impairment based on the fair value of the assets and the cash flows they generate. Factors indicating potential impairment include, but are not limited to, significant decreases in the market value of the long-lived assets, a significant change in the long-lived assets condition, and operating cash flow losses associated with the use of the long-lived asset.
In 2002, 2003 and 2004, due to volatile economic conditions and indications of declining aircraft market values, we evaluated whether the book value of our aircraft was impaired in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” No impairment was necessary based on the results of the evaluations except as related to the B737-200C fleet.
There is inherent risk in estimating the future cash flows used in the impairment test. If cash flows do not materialize as estimated, there is a risk the impairment charges recognized to date may be inaccurate, or further impairment charges may be necessary in the future.
Workers Compensation and Employee Health Care Accruals
The Company uses a combination of insurance and self-insurance mechanisms to provide for workers’ compensation claims and employee health care benefits. Liabilities associated with the risks that are retained by the Company are not discounted and are estimated, in part, by considering historical claims experience and outside expertise, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends.
Restructuring accruals
During the third quarter of 2004, Alaska announced a management reorganization and the closure of its Oakland heavy maintenance base, contracting out of the related maintenance activities, contracting out of the Company’s Fleet Service Ground, Support Equipment and facility maintenance functions and other initiatives. Total severance and related costs associated with this restructuring are estimated at $53.4 million. Our severance package offered to impacted employees included cash payments based on years of service and one year of medical coverage after severance date. Since Alaska self-insures for employee medical coverage, we estimated the projected claims cost for affected employees and recorded a corresponding accrual. Actual experience will likely differ from the estimate if employees accept positions with other employers and no longer need the coverage provided by Alaska or simply submit claims during the one year period that are higher or lower than our estimate. We expect to adjust this accrual quarterly throughout 2005.
Realizability of Deferred Tax Assets
The Company has a net deferred tax liability of $92.3 million at December 31, 2004, which includes gross deferred tax assets of $372.1 million offset by a gross deferred tax liability of $464.4 million. In accordance with SFAS No. 109, “Accounting for Income Taxes.”, we have evaluated whether it is more likely than not that the deferred tax asset will be realized. Based on the available evidence, we have concluded that it is more likely than not that those assets would be realizable and thus no valuation allowance has been recorded as of December 31, 2004. Our conclusion is based on the expected future reversals of existing taxable temporary differences and does not rely on future taxable income. Should we incur additional losses in the future, our ability to realize the net operating loss carryforwards may be subject to greater uncertainty. We will continue to reassess the need for a valuation allowance during each future reporting period.
Liquidity and Capital Resources
The table below presents the major indicators of financial condition and liquidity.
During the year ended December 31, 2004, our cash and marketable securities increased $61.8 million to $873.7 million. This increase reflects cash provided by operating activities of $341.7 million, offset by cash used in financing activities of $114.3 million, cash used for property and equipment additions of $159.6 million and net purchases of marketable securities of $204.5 million.
Cash Provided by Operating Activities
During 2004, net cash provided by operating activities was $341.7 million, compared to $318.6 million during 2003. Operating cash inflows in 2003 included $52.8 million of government compensation, whereas cash inflows in 2004 included $42.7 million of cash received from a tax refund.
Cash Used in Investing Activities
Cash used in investing activities was $365.8 million during 2004, compared to $576.8 million in 2003. We had net purchases of $204.5 million of marketable securities and $159.6 million for property and equipment. During 2004, our aircraft related capital expenditures decreased $150.4 million as compared to 2003, reflecting a reduction in spending for new aircraft and capitalized overhauls. Beginning January 1, 2005, we will have no capital expenditures related to overhauls as those maintenance activities will be expensed as incurred under our maintenance accounting policy that will be adopted on that date.
Cash Provided by (Used in) Financing Activities
Net cash used in financing activities was $114.3 million during 2004 compared to net cash provided by financing activities of $181.8 million during 2003. Debt issuances during 2004 of $94.6 million were secured by flight equipment. These debt issuances have interest rates that vary with the London Interbank Offered Rate (LIBOR) and payment terms ranging from 12 to 16 years. Debt issuances during the period were offset by normal long-term debt payments of $58.9 million and full repayment of our credit facility of $150 million.
We plan to meet our capital and operating commitments through cash flow from operations and cash and marketable securities on hand at December 31, 2004 totaling $873.7 million.
Bank Line of Credit Facility
During 2004, Alaska paid off its $150 million credit facility and, on December 23, 2004, that facility expired. Management is currently negotiating a replacement facility and expects to close the new facility during the first quarter of 2005, although there can be no assurance that this can be accomplished on terms acceptable to us.
The $150 million credit facility that expired in December 2004 contained contractual restrictions, required maintenance of specific levels of net worth, maintenance of certain debt and leases to net worth, leverage and fixed charge coverage ratios, and limits on investments, lease obligations, sales of assets, and additional indebtedness. Such provisions also limited the amount of funds Alaska Airlines can distribute via dividend to Alaska Air Group. As noted above, we are currently negotiating with a replacement facility and hope to have that agreement completed by the end of the first quarter. We expect that the new line of credit facility will be at least as restrictive as the prior credit facility.
Contractual Obligations, Commitments and Off-Balance Sheet Arrangements
Aircraft Purchase Commitments
At December 31, 2004, we had firm orders for 3 aircraft requiring aggregate payments of approximately $77.6 million, as set forth below. In addition, Alaska had options to acquire 26 additional B737’s. We expect to finance the firm orders and to the extent exercised, the option aircraft with leases, long-term debt or internally generated cash. One B737-800 was delivered in February 2005, and two others are expected in March and July of 2005. We have secured lease financing for the March delivery. We purchased the B737-800 aircraft delivered in February 2005 with cash on hand at the time, and expect to do the same for the July delivery.
The following table summarizes aircraft purchase commitments and payments by year, as of December 31, 2004:
In February 2005, we converted options to acquire three B737-800 aircraft into firm orders to be delivered in 2006. This results in additional purchase commitments which are excluded from the table above.
Contractual Obligations
The following table provides a summary of our principal payments under current and long-term debt obligations, operating lease commitments, aircraft purchase commitments and other obligations as of December 31, 2004. This table excludes contributions to our various pension plans, which we expect to be approximately $60 million to $75 million per year through 2008.
(1) For variable rate debt, future obligations are shown above using interest rates in effect as of December 31, 2004.
(2) Includes obligations under our long-term power-by-the-hour maintenance agreement.
(3) Excludes three B737-800 aircraft to be delivered in 2006. In February 2005, options for three were converted to firm orders, resulting in additional purchase obligations.
New Accounting Standards
In March 2004, the Financial Accounting Standards Board’s (FASB) Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (EITF 03-1). The guidance prescribes a three-step model for determining whether an investment is other-than-temporarily impaired and requires disclosures about unrealized losses on investments. The accounting guidance is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. In September 2004, the FASB issued FASB Staff Position EITF 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1 ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (FSP EITF 03-01-1). FSP EITF 03-1-1 delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of EITF Issue 03-01. During the period of the delay, FSP EITF 03-1-1 states that companies should continue to apply relevant “other-than-temporary” guidance. The Company will assess the impact of paragraphs 10-20 of EITF 03-1 once the guidance has been finalized. At December 31, 2004, available-for-sale investments in the Company’s marketable securities portfolio had unrealized losses totaling $4.0 million which are recorded in Other Accumulated Comprehensive Loss. Management does not believe that the securities with unrealized losses as of December 31, 2004 meet the criteria for recognizing the loss under existing other-than-temporary guidance.
During the fourth quarter of 2004, the Financial Accounting Standards Board issued SFAS 123R, “Share Based Payments: An Amendment of FASB No. 123 and 95”. The new standard requires companies to recognize in the income statement the grant date fair value of stock options and other equity based compensation issued to employees. This new standard will apply to both stock options to purchase Air Group common stock that we grant to employees of Alaska Airlines and our Employee Stock Purchase Plan, which features a look-back provision and allows employees to purchase Air Group common stock at a discount in excess of 5%. Our options are typically granted with graded vesting provisions, and we intend to amortize compensation cost over the service period using the straight line method. This new statement is effective for interim or annual periods beginning after June 15, 2005 (our third quarter of 2005). We intend to use the “modified prospective method” upon adoption whereby previously awarded but unvested equity awards are accounted for in accordance with SFAS 123R but prospective amounts are recognized in the income statement instead of simply being disclosed. Our stock based compensation expense, as measured under SFAS 123, approximates $8 to $10 million per year on a pre-tax basis.
In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” FIN 46, as amended by FIN 46 (Revised) in December 2003, requires consolidation of certain types of entities in which the Company absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected returns, or both, as a result of ownership, contractual or other financial interests in the entity. These entities are called “variable interest entities.” The principal characteristics of variable interest entities are (1) an insufficient amount of equity to absorb the entity’s expected losses, (2) equity owners as a group are not able to make decisions about the entity’s activities, and (3) equity that does not absorb the entity’s losses or receive the entity’s residual returns. Variable interests are contractual, ownership or other monetary interests in an entity that change with fluctuations in the entity’s net asset value. As a result, variable interest entities can arise from items such as lease agreements, loan arrangements, guarantees or service contracts.
If an entity is determined to be a variable interest entity, the entity must be consolidated by the “primary beneficiary”. The primary beneficiary is the holder of the variable interests that absorbs a majority of the variable interest entity’s expected losses or receives a majority of the entity’s residual returns in the event no holder has a majority of the expected losses. There is no primary beneficiary in cases where no single holder absorbs the majority of the expected losses or receives a majority of the residual returns. The determination of the primary beneficiary is based on qualitative aspects of the arrangements involved or projected cash flows at the inception of the transaction with the variable interests entity.
FIN 46 was applicable to financial statements of companies that have interests in “special purpose entities”, as defined, during the year ended 2003.
We are the lessee in a series of operating leases covering our leased aircraft. In many instances, the lessors are trusts established by a third party specifically to purchase, finance and lease aircraft
to us. These leasing entities meet the criteria for variable interest entities. However, they do not meet the consolidation requirements of FIN 46 because we are not the primary beneficiary of the entity’s expected gains or losses. Our conclusions are based on the fact that the leasing arrangements involved contain terms which are consistent with market terms at the inception of the lease and do not include residual value guarantees made by us, fixed-price purchase obligations or similar features that obligate us to absorb the majority of expected losses of the variable interest entities. Our maximum exposure under these types of lease arrangements is the remaining lease payments, which are reflected in future lease commitments in Note 6 (plus the cost, if any, of bringing the equipment into compliance with the physical condition required for return).
Effect of Inflation - Inflation and price changes other than for aircraft fuel do not have a significant effect on our operating revenues, operating expenses and operating income.
RISK FACTORS
Our operations and financial results are subject to various uncertainties, such as global and industry instability, 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. If any of the following occurs, our business, financial condition and results of operations could suffer. In such case, the trading price of our common stock could also decline.
The airline industry is highly competitive and subject to rapid change. We may be unable to compete effectively against other airlines with greater financial resources or lower operating costs, or to adjust rapidly enough in the event the basis of competition in our markets changes.
The airline industry is highly competitive as to fares, flight frequency, frequent flyer benefits, routes and service. The industry is particularly susceptible to price discounting because airlines incur only nominal costs to provide service to passengers occupying otherwise unsold seats. We currently compete with one or more other airlines on substantially all of our routes. Many of these airlines are larger and have significantly greater financial resources and name recognition or lower operating costs than our company. Others are operating under bankruptcy court protection and run lower costs more quickly than we can. Some of these competitors have chosen from time to time to add service, reduce their fares, or both, in our markets. We may be unable to compete effectively against other airlines that introduce service or discounted fares in the markets that we serve.
Our strategy is to focus on serving a few key markets, including Seattle, Portland, Los Angeles and Anchorage. Significant portions of our flights occur to and from our Seattle hub. In 2004, this traffic to and from Seattle accounted for 66% of total traffic. We believe that concentrating our service offerings in this way allows us to maximize our investment in personnel, aircraft and ground operations, as well as to gain greater advantage from sales and marketing efforts in these
regions. As a result, we remain highly dependent upon our key markets. Our business would be harmed by any circumstances causing a reduction in demand for air transportation in our key markets, such as adverse changes in local economic conditions, negative public perception of a key market and significant price increases linked to increases in airport access costs and fees imposed on passengers. An increase in competition in our key markets could also cause us to reduce fares or take other competitive measures that harm our operating results.
Many airlines, including ours, have code share and frequent flyer marketing alliances with other airlines. Internet distribution arrangements either in conjunction with other airlines or with independent travel websites have become an important means for selling airline travel. Any consolidation or significant alliance activity within the airline industry, or our loss of key alliance or distribution relationships, could result in our competitors having access to increased route networks and resources, which, in turn, would increase the risks of competition described above.
The airline industry, particularly the regional airlines, also faces competition from ground transportation alternatives, such as the bus, train or automobile. Video teleconferencing and other methods of electronic communication may add a new dimension of competition to the industry as business travelers seek lower-cost substitutes for air travel.
Our business, financial condition, and results of operations are substantially exposed to the current high prices and variability of jet fuel. Further increases in jet fuel costs would harm our business.
Fuel costs constitute a significant portion of our total operating expenses, comprising 20% of total operating expenses for the year ended December 31, 2004. Significant increases in fuel costs during 2004 have negatively impacted our results of operations. Further increases would harm our financial condition and results of operations. We estimate that during the year ended December 31, 2004 and during the year ended December 31, 2003 a one-cent increase in the price per gallon of fuel would have increased our fuel expenses by $3.5 million and $3.4 million, respectively. Average economic fuel prices (which include the benefits of our hedging program) during 2004 were 35.1 cents higher than in 2003. Total fuel costs, net of the benefit received from fuel hedges settled during the period were $140.1 million higher in 2004 compared to 2003.
Historically, fuel costs have been unpredictable and subject to wide price fluctuations based on geopolitical issues and supply and demand. Fuel availability is also subject to periods of market surplus and shortage and is affected by demand for both home heating oil and gasoline. Because of the effect of these events on the price and availability of fuel, the cost and future availability of fuel cannot be predicted with any degree of certainty. In the event of a fuel supply shortage, higher fuel prices or the curtailment of scheduled service could result. Some of our competitors may have more leverage in obtaining fuel. We may be unable to offset increases in the price of fuel through higher fares. We utilize our fuel hedges as a form of insurance against significant increases in fuel prices. To hedge our exposure to fuel price fluctuations, we began purchasing
hedging instruments, primarily instruments that cap the price paid. At December 31, 2004, we had fuel hedge contracts in place to hedge 50% of our anticipated fuel consumption in 2005 and 35% and 9% of our anticipated fuel consumption in 2006 and 2007, respectively. Even with hedges, we are substantially exposed to increases in jet fuel costs.
If we are unable to meet our cost reduction goals, our results of operations and financial condition may suffer.
We, along with other airlines, have announced aggressive cost reduction goals that are an important part of our business strategy of offering the best value to passengers through competitive fares while at the same time achieving acceptable profit margins and return on capital. We believe having a lower cost structure better positions us to be able to grow our business and take advantage of market opportunities.
We have implemented initiatives that we believe will reduce our annual operating costs by approximately $185 million and seek additional savings of approximately $155 million, the majority of which is being sought from our labor groups and, to a lesser extent, additional cost reductions in ticket distribution, maintenance, and other costs. We hope to achieve labor savings through a combination of market-based wage adjustments, a common health and retirement benefits package for every work group, and work rule changes focusing on greater efficiency in operations. We cannot be certain that we will be able to implement changes in our operations sufficient to generate this level of additional targeted savings, or that if such changes are implemented, that forecasted savings will be achieved. In the event that we are unable to achieve our cost reduction goals, or our efforts prove less successful than those of our competitors, our results of operations will likely be below our own expectations and may be below those of outside financial analysts, and our financial condition may be harmed.
Many of our employees are covered by collective bargaining agreements. A failure to negotiate new agreements, or to do so on terms competitive with the labor costs and practices of our competitors, could disrupt our business and increase our costs.
As of December 31, 2004, labor unions represented 83% of Alaska’s employees. Labor costs generally are a significant component of our total expenses, comprising approximately 34% of our total operating expenses in 2004. Each of our different employee groups has separate collective bargaining agreements, and may make demands that would increase our operating expenses and adversely affect our profitability.
At December 31, 2004 we were in contract talks with most labor groups and had submitted to binding arbitration with the Airline Pilots Association (ALPA). The degree to which we meet our overall labor savings goals will be determined to a large extent by the results of the pilot arbitration.
The pilot contract provides that, if an agreement on the entire contract was not reached by December 15, 2004, ten contract issues plus wage rates would be submitted to an interest arbitrator. Issues submitted generally relate to pension plans, medical insurance, profit sharing, code sharing and work rules. The parties did not reach an agreement, and the issues have been submitted to binding arbitration in March 2005 with a decision to be effective in May 2005. The pilot labor contract contains market related standards for wages and non-wage issues.
If we were unable to reach agreement on the terms of any collective bargaining agreement with any group of our employees or were to experience widespread employee dissatisfaction, we could be subject to work slowdowns or stoppages. We could also become subject to protests or picketing by organized labor groups representing our employees. Any of these events would be disruptive to our operations and could harm our business. In the event any agreement we reach with an organized labor group requires us to pay wages or to incur costs that are materially higher than those we currently pay or we are unable to fully offset such increased costs through fare increases, our expenses would increase and our operating margin would be harmed.
Weakness in the general economy, and in the airline industry in particular, could have an adverse effect on our business.
We believe that airline traffic, including business traffic, is particularly sensitive to changes in economic growth and expectations. Weak economic growth in 2001 through the first half of 2003, low ticket yields, and escalating fuel prices contributed to much of the airline industry suffering significant losses from 2001 through 2004. Currently, US Airways, United Airlines and ATA Airlines, as well as other carriers, operate under bankruptcy protection. Because airlines operating under bankruptcy protection receive increased flexibility to reduce their costs by voiding contracts and renegotiating existing business obligations, current and future airline bankruptcies could have a substantial impact on industry competition. In the event airlines who have received bankruptcy protection choose to apply some or all of the cost savings they obtain toward reduced fares, bankruptcy by airlines who compete with us may cause us to reduce our fares and result in a substantial reduction in revenue and operating margin. Continued weakness in the airline industry may also result in additional industry consolidation, greater reliance on industry alliances, such as code sharing and frequent flyer reciprocity arrangements, and increased price competition among existing carriers, each of which could dramatically alter the competitive environment in the markets we serve and harm our operating results. Continued weak economic performance in the airline industry may also result in a further reduction in our credit rating and make it more difficult for us to raise capital on economical terms. Any general reduction in airline passenger traffic as a result of a soft economy would harm our business.
We rely heavily on automated systems to operate our business and any failure of these systems could harm our business.
We depend on automated systems to operate our business, including our computerized airline
reservation system, our telecommunication systems and our website. We also issue a substantial number of our tickets to passengers as electronic tickets. We depend on our computerized reservation system to be able to issue, track and accept these electronic tickets. In order for our operations to work efficiently, our website and reservation system must be able to accommodate a high volume of traffic and deliver important flight information. Substantial or repeated website, reservations system or telecommunication systems failures could reduce the attractiveness of our services and cause our customers to purchase tickets from another airline. Any disruption in these systems could result in the loss of important data, increase our expenses and generally harm our business.
Increases in government taxes and fees could reduce demand for air travel and harm our business
Airlines pay or are responsible for collecting a number of different taxes and fees including, but not limited to, fuel taxes, airport facility charges, immigration fees, security fees, excise taxes on ticket sales, and fuel taxes. Recently, the United States Department of Homeland Security proposed raising the aviation security fee from $2.50 per one-way segment to $5.50 per one-way segment.
We believe the demand for air travel is highly sensitive to fare levels. Although law makers may impose additional fees and view them as “pass through costs”, we believe that a higher total ticket price in the eyes of the consumer will influence their purchase and travel decisions and may result in an overall decline in passenger traffic, which would harm our business.
Moreover, we believe that the impact of higher fees is proportionally greater for low fare carriers, carriers with a high percentage of leisure travelers, and carriers that fly relatively short segments. Because Alaska carries many leisure travelers, we believe higher security fees and (other fee increases generally) could negatively impact us more than some of our competitors.
The September 11, 2001 terrorist attacks negatively impacted our industry and our business and further threatened or actual terrorist attacks, or other hostilities involving the U.S., may significantly harm our industry and our business in the future.
The terrorist attacks of September 11, 2001 and their aftermath have negatively impacted the airline industry, including our company. Because a substantial portion of our costs are fixed in the short-term, we were unable to offset the reduction in customer demand through cost savings, and operating results were harmed to a proportionately greater degree. Additional terrorist attacks, the fear of such attacks or other hostilities involving the U.S. could have a further significant negative impact on the airline industry, including us, and could:
• result in a grounding of commercial air traffic by the FAA,
• significantly reduce passenger traffic and yields due to a potentially dramatic drop in demand for air travel,
• increase security and insurance costs,
• increase fuel costs and the volatility of fuel prices,
• make it more difficult for us to obtain war risk or other insurance, and
• increase costs from airport shutdowns, flight cancellations and delays resulting from security breaches and perceived safety threats.
Our insurance costs have increased as a result of the September 11, 2001 terrorist attacks, and further increases in insurance costs would harm our business, financial condition and results of operations.
Following the September 11, 2001 terrorist attacks, aviation insurers dramatically increased airline insurance premiums and significantly reduced the maximum amount of insurance available to airlines for third-party claims resulting from acts of terrorism, war or similar events to $50 million per event and in the aggregate. In light of this development, under the Air Transportation Safety and Stabilization Act, the Homeland Security Act of 2002, as amended by the Consolidated Appropriations Act of 2005, the government is currently offering domestic airlines either (i) third-party liability war risk coverage above $50 million, or (ii) in lieu of commercial war risk insurance, full hull, comprehensive and third-party liability war risk coverage. This coverage provides for the same limits of hull and comprehensive insurance and twice the limits of third-party liability insurance carried by the airline on September 11, 2001.
Aviation insurers could increase their premiums even further in the event of additional terrorist attacks, hijackings, airline accidents or other events adversely affecting the airline industry. Furthermore, the full hull, comprehensive and third-party war risk insurance provided by the government is mandated through August 31, 2005. While the government may extend the deadline for when it will stop providing such coverage, we cannot be certain that any extension will occur, or if it does, how long the extension will last. It is expected that, should the government stop providing such coverage to the airline industry, the premiums charged by aviation insurers for this coverage will be substantially higher than the premiums currently charged by the government. Significant increases in insurance premiums would adversely impact our business, financial condition and results of operations.
Changes in government regulation imposing additional requirements and restrictions on our operations could increase our operating costs and result in service delays and disruptions.
Airlines are subject to extensive regulatory and legal requirements, both domestically and internationally, that involve significant compliance costs. In the last several years, Congress has passed laws, and the DOT and the FAA have issued regulations, relating to the operation of airlines that have required significant expenditures. Additional laws, regulations, taxes and airport rates and charges have been proposed from time to time that could significantly increase
the cost of airline operations or reduce the demand for air travel. If adopted, these measures could have the effect of raising ticket prices, reducing revenue and/or increasing costs.
Our reputation and financial results could be harmed in the event of an airline accident or incident.
An accident or incident involving one of our aircraft could involve a significant loss of life and result in a loss of faith in our airlines by the flying public. In addition, we could experience significant potential claims from injured passengers and surviving relatives, as well as costs for the repair or replacement of a damaged aircraft and its consequential temporary or permanent loss from service. Although we believe that we currently maintain liability insurance in amounts and of the type generally consistent with industry practice, the amount of such coverage may not be adequate and we may be forced to bear substantial losses from an accident. Substantial claims resulting from an accident in excess of our related insurance coverage would harm our business and financial results. Moreover, any aircraft accident or incident, even if fully insured and even if it does not involve one of our airlines, could cause a public perception that our airlines or the equipment they fly is less safe or reliable than other transportation alternatives, which would harm our business.
Our operations are often affected by factors beyond our control, including traffic congestion at airports, weather conditions and increased security measures, any of which could harm our financial condition and results of operations.
Like other airlines, our operations are subject to delays caused by factors beyond our control, including air traffic congestion at airports, adverse weather conditions and increased security measures. Delays frustrate passengers, reduce aircraft utilization and increase costs, all of which in turn affect our profitability. During periods of fog, snow, rain, freezing rain, storms or other adverse weather conditions, flights may be canceled or significantly delayed. Due to our geographic area of operations, we believe a significant portion of our operation is more susceptible to adverse weather conditions than many of our competitors. Cancellations or delays due to weather conditions, traffic control problems and breaches in security could harm our financial condition and results of operations.
If Alaska fails to comply with financial covenants, some of its financing agreements may be terminated.
Alaska is required to comply with specific financial covenants in certain agreements. Although our $150 million revolving credit facility expired in December 2004, we are currently negotiating a replacement facility. We expect this facility to have covenants that are as restrictive, if not more, than those in our recently expired agreement. We cannot ensure that Alaska will be able to comply with these covenants or provisions or that these requirements will not limit our ability to finance our future operations or capital needs. Alaska’s inability to comply with the required
financial maintenance covenants or provisions could result in default under these financing agreements and could result in a cross default under Alaska’s other financing agreements. In the event of any such default and our inability to obtain a waiver of the default, all amounts outstanding under the agreements could be declared to be immediately due and payable. If Alaska did not have sufficient available cash to pay all amounts that became due and payable, Air Group or Alaska would have to seek additional debt or equity financing, which may not be available on acceptable terms, or at all. If such financing were not available, Alaska would have to sell assets in order to obtain the funds required to make accelerated payments or risk its aircraft becoming subject to repossession, which could harm our business.
Our business could be harmed if we are unable to attract and retain qualified personnel at reasonable costs.
Our business is labor intensive, with labor costs representing approximately 34% of our operating expenses for the year ended December 31, 2004. We expect salaries, wages and benefits to increase on a gross basis and that these costs could increase as a percentage of our overall costs, which could harm our business. We compete against the major U.S. airlines for labor in many highly skilled positions. If we are unable to hire, train and retain qualified employees at a reasonable cost, or if we lose the services of key personnel we may be unable to grow or sustain our business and our operating results and business prospects could be harmed. We may also have difficulty replacing management or other key personnel who leave and, therefore, the loss of any of these individuals could harm our business.
We rely on third-party vendors for certain critical activities
We have historically relied on outside vendors for a variety of services and functions critical to our business, including airframe and engine maintenance, ground handling, fueling, catering, computer reservation system hosting and software maintenance. As part of its cost control efforts, the reliance on outside vendors will increase. In September 2004, Alaska Airlines announced that it was sub-contracting the remaining heavy aircraft maintenance that it was then performing to outside vendors. In addition, Alaska retained outside suppliers for fleet service and facilities maintenance. In January 2005, Alaska signed an agreement with a vendor for ground handling services at Seattle in the event that it does not reach an agreement with the IAM representing its ramp employees.
Our increased use of outside vendors increases our exposure to several risks. In the event that one or more vendors goes into bankruptcy, ceases operation or fails to perform as promised, replacement services may not be readily available at competitive rates, or at all. Vendor bankruptcies, unionization, regulatory compliance issues or significant changes in the competitive marketplace among suppliers could adversely affect vendor services or force Alaska to renegotiate existing agreements on less favorable terms. These events could result in disruptions in Alaska’s operations or increases in its cost structure.
We have incurred operating losses in each year since 2000 and may incur substantial operating losses in the future. In addition, our quarterly results can fluctuate substantially.
For the year ended December 31, 2004, Alaska incurred an operating loss of $85.4 million. Prior to that, we incurred operating losses of $19.4 million and $77.6 million for the years ended December 31, 2003 and 2002, respectively. The inability to achieve or sustain profitability may hinder our ability to honor our existing obligations as they become due, to obtain future equity or debt financing or to do so on economical terms, and to sustain and expand our business.
In addition, our quarterly results can fluctuate substantially due to a variety of factors including seasonal variations in traffic, the timing of various expenditures, and weather. Because expenses of an aircraft flight do not vary significantly with the number of passengers carried, a relatively small change in the number of passengers or in pricing has a disproportionate effect on an airline’s operating and financial results. Accordingly, a minor shortfall in expected revenue levels could cause a disproportionately negative impact on our operating results. Due to these factors, as well as other risk factors described in this Form 10-K, quarter-to-quarter comparisons of our results may not be good indicators of our future performance.
Our indebtedness could increase the volatility of earnings and otherwise restrict our activities.
We have and will continue to have for the foreseeable future a significant amount of indebtedness. Due to our high fixed costs, including aircraft lease commitments and debt service, a decrease in revenues results in a disproportionately greater decrease in earnings. As of December 31, 2004, we had approximately $849.3 million of indebtedness outstanding, all of which was secured by flight equipment and real property.
Our outstanding indebtedness could have important consequences. For example, it could:
• limit our ability to obtain additional financing for funding our growth strategy, capital expenditures, acquisitions, working capital or other purposes,
• require us to dedicate a material portion of our operating cash flow to fund interest payments on indebtedness, thereby reducing funds available for other purposes, and
• limit our ability to withstand competitive pressures and reduce our flexibility in responding to changing business and economic conditions, including reacting to any economic slowdown in the airline industry.
In addition, we have an ongoing need to finance new aircraft deliveries, and there is no assurance that such financing will be available to us in sufficient amounts or on acceptable terms.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We have interest rate risk in our floating rate debt obligations and our available for sale marketable investment portfolio, and commodity price risk in jet fuel required to operate our aircraft fleet. We purchase jet fuel at prevailing market prices, and seek to manage market risk through execution of a documented hedging strategy. We have market sensitive instruments in the form of fixed rate debt instruments and financial derivative instruments used to hedge our exposure to jet fuel price increases. We do not purchase or hold any derivative financial instruments for trading purposes.
Fuel Hedging
We purchase jet fuel at prevailing market prices, and seek to manage the risk of price fluctuations through execution of a documented hedging strategy. We utilize derivative financial instruments as hedges to decrease our exposure to the volatility of jet fuel prices. We believe there is risk in not hedging against the possibility of fuel price increases. At December 31, 2004, we had fuel hedge contracts in place to hedge 182.5 million gallons of our expected jet fuel usage during 2005, 131.0 million gallons in 2006 and 34.0 million gallons in 2007. This represents 50%, 35% and 9% of our anticipated fuel consumption in 2005, 2006 and 2007, respectively. Prices of these agreements range from $28.81 to $42.65 per crude oil barrel. We estimate that a 10% increase or decrease in crude oil prices as of December 31, 2004 would impact hedging positions by approximately $17.6 million.
As of December 31, 2004 and 2003, the fair values of our fuel hedge positions were $84.5 million and $15.7 million, respectively. Of these amounts, $57.9 million of the 2004 fair value amounts and $10.3 million of the 2003 fair value amounts were included in prepaid expenses and other current assets in the balance sheets based on settlement dates for the underlying contracts. The remaining $26.6 million 2004 fair value and $5.4 million 2003 fair value is reflected in other assets in the balance sheets.
Please refer to page 17, as well as to Note 10 in the financial statements, for company specific data on the results of our fuel hedging program.
Financial Market Risk
We have exposure to market risk associated with changes in interest rates related primarily to our debt obligations and short-term investment portfolio. Our debt obligations include variable rates, which have exposure to changes in interest rates. A hypothetical 10% change in the average interest rates incurred on variable rate debt during 2004 would correspondingly change our net earnings and cash flows associated with these items by approximately $3.1 million.
We also have investments in marketable securities, which are exposed to market risk associated with changes in interest rates. If short-term interest rates were to average 1% more than they did in 2004, interest income would increase by approximately 20 basis points.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Item 15.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
On August 10, 2004 , Alaska Air Group, Inc. (Air Group) determined for itself and on behalf of its subsidiaries, Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon), to dismiss its independent auditors, Deloitte & Touche LLP (Deloitte) and to select KPMG LLP (KPMG) to serve as its new independent auditors for the year ending December 31, 2004. The dismissal of Deloitte and engagement of KPMG was approved by Air Group’s Audit Committee. On August 10, 2004, Deloitte was notified of their dismissal.
Deloitte’s report on Alaska’s financial statements for the years ended December 31, 2003 and December 31, 2002 did not contain an adverse opinion or disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit scope or accounting principles, except the report contained an explanatory paragraph relating to the adoption of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”.
There were no disagreements with KPMG LLP or Deloitte & Touche LLP on accounting or financial disclosure matters during 2004.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of December 31, 2004, an evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer (collectively, our “certifying officers”), of the effectiveness of the design and operation of our disclosure controls and procedures. These disclosure controls and procedures are designed to ensure that the information required to be disclosed by us in our periodic reports filed with the Securities and Exchange Commission (the SEC) is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that the information is communicated to our certifying officers on a timely basis.
Our certifying officers concluded, based on their evaluation, that disclosure controls and procedures were effective.
We made no changes in our internal controls over financial reporting during the fiscal quarter ended December 31, 2004, that our certifying officers concluded materially affected, or are reasonably likely to materially effect, our internal control over financial reporting, except with respect to our Mileage Plan deferred revenue calculation as described in the next paragraph.
In December 2004, we discovered a clerical error in our calculation of deferred Mileage Plan revenue that existed at September 30, 2004. As a result, we revised our third quarter and year to date condensed financial statements to adjust for this item. In response to this finding, management has taken appropriate steps to strengthen preventive and detective internal controls over the Mileage Plan deferred revenue calculation.
We intend to regularly review and evaluate the design and effectiveness of our disclosure controls and procedures and internal controls over financial reporting on an ongoing basis and to improve these controls and procedures over time and to correct any deficiencies that we may discover in the future. While we believe the present design of our disclosure controls and procedures and internal controls over financial reporting are effective, future events affecting our business may cause us to modify our these controls and procedures in the future.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
See Exhibit Index on page 84.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on February 22, 2005 on behalf of the registrant and in the capacities indicated.
/s/ William S. Ayer
Chairman, President, Chief Executive Officer and Director
William S. Ayer
/s/ Bradley D. Tilden
Executive Vice President/Finance and Chief Financial Officer
Bradley D. Tilden
(Principal Financial Officer)
/s/ Brandon S. Pedersen
Staff Vice President/Finance and Controller
Brandon S. Pedersen
(Principal Accounting Officer)
/s/ George D. Bagley
Director
George D. Bagley
/s/ Phyllis J. Campbell
Director
Phyllis J. Campbell
/s/ Jessie J. Knight, Jr.
Director
Jessie J. Knight, Jr.
/s/ Dennis F. Madsen
Director
Dennis F. Madsen
/s/ Byron I. Mallott
Director
Byron I. Mallott
/s/ Richard A. Wien
Director
Richard A. Wien
BALANCE SHEETS
Alaska Airlines, Inc.
ASSETS
See accompanying notes to financial statements.
BALANCE SHEETS
Alaska Airlines, Inc.
LIABILITIES AND SHAREHOLDER’S EQUITY
See accompanying notes to financial statements.
STATEMENTS OF OPERATIONS
Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENTS OF SHAREHOLDER’S EQUITY
Alaska Airlines, Inc.
See accompanying notes to financial statements.
STATEMENTS OF CASH FLOWS
Alaska Airlines, Inc.
See accompanying notes to financial statements.
NOTES TO FINANCIAL STATEMENTS
Alaska Airlines, Inc.
December 31, 2004
Note 1. Summary of Significant Accounting Policies
Organization and Basis of Presentation
Alaska Airlines, Inc. (Alaska or the Company), an Alaska corporation, is a wholly owned subsidiary of Alaska Air Group, Inc. (Air Group), a Delaware corporation. Air Group is also the parent company of Alaska Air Group Leasing (AAGL) and Horizon Air Industries, Inc. (Horizon).
These financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and their preparation requires the use of management’s estimates. Actual results could differ from these estimates.
Nature of Operations
Alaska is a major airline serving primarily Alaska; the U.S. West Coast; Chicago, Denver, five cities on the U.S. East Coast; Vancouver, Canada; and Mexico. It operates an all jet fleet and its average passenger trip is 996 miles. Substantially all of Alaska’s sales occur in the United States.
The Company’s operations and financial results are subject to various uncertainties, such as industry instability, general economic conditions, intense competition and the actions of competing airlines, volatile fuel prices, a largely unionized work force, the need to finance large capital expenditures, government regulation, and potential aircraft incidents.
The airlines are characterized by high fixed costs. Small fluctuations in load factors and yield can have a significant impact on operating results. The Company has reported a net operating loss each year since 2001 and is working to reduce unit costs to better compete with carriers that have lower cost structures.
Cash and Cash Equivalents
Cash equivalents consist of highly liquid investments with original maturities of three months or less. They are carried at cost, which approximates market. The Company reduces cash balances when checks are disbursed. Due to the time delay in checks clearing the banks, the Company normally maintains a negative cash balance, which is reported as a current liability. The amount of the negative cash balance was $25.2 million and $22.6 million at December 31, 2004 and 2003, respectively, and is included in accounts payable.
Receivables
Receivables consist primarily of airline traffic (including credit card) receivables, amounts from customers, mileage plan partners, government tax authorities, and other miscellaneous amounts due to the Company, and are net of an allowance for doubtful accounts of $2.5 million at December 31, 2004 and $1.6 million at December 31, 2003. Management determines the allowance for doubtful accounts based on known troubled accounts and historical experience applied to an aging of accounts.
Inventories and Supplies - net
Expendable aircraft parts, materials and supplies are stated at average cost and are included in inventories and supplies-net. An obsolescence allowance for flight equipment expendable parts is accrued based on estimated disposal dates and salvage values. Surplus inventories are carried at their net realizable value. The allowance for all non-surplus expendable inventories was $11.5 million at December 31, 2004, and $11.7 million at December 31, 2003. Inventory and supplies-net also includes fuel inventory of $3.6 million and $2.5 million at December 31, 2004 and 2003, respectively. Repairable and Rotable aircraft parts inventory are included in flight equipment.
Property, Equipment and Depreciation
Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which are as follows:
* As a result of our announced intent to retire the B737-200C fleet, all aircraft and related flight equipment are being depreciated through 2007.
Flight equipment includes repairable inventory parts, net of an obsolescence allowance. As of December 31, 2004 and 2003, this allowance totaled $13.4 million and $12.6 million, respectively.
Routine maintenance and repairs are expensed when incurred. The costs of major airframe and engine overhauls are capitalized and amortized to maintenance expense over the shorter of the life of the overhaul or the remaining lease term. However, effective January 1, 2005, the Company plans to change the way it accounts for airframe and engine overhauls. Under the new policy, those activities will be expensed as incurred. This change will result in a cumulative impact of accounting change totaling approximately $80 million, after tax, in the first quarter of 2005. Major modifications that extend the life or improve the usefulness of aircraft are capitalized and depreciated over their estimated period of use. 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 Company evaluates long-lived assets to be held and used for impairment whenever events or changes in circumstances indicate that the total carrying amount of an asset or asset group may not be recoverable. The Company groups assets for purposes of such reviews at the lowest level for which identifiable cash flows of the asset group are largely independent of the cash flows of
other groups of assets and liabilities. An impairment loss is recognized when estimated future undiscounted cash flows expected to result from the use of the asset or asset group and its eventual disposition are less than its carrying amount. If the asset or asset group is not considered recoverable, a write-down equal to the excess of the carrying amount over the fair value will be recorded.
Internally-Used Software Costs
The Company capitalizes costs to develop internal-use software that are incurred in the application development stage. Amortization commences when the software is ready for its intended use and the amortization period is the estimated useful life of the software, generally three to five years. Capitalized costs primarily include contract labor and payroll costs of the individuals dedicated to the development of internal use software. The Company capitalized software development costs of $6.7 million, $3.2 million and $6.9 million during the years ended December 31, 2004, 2003, and 2002, respectively.
Workers Compensation and Employee Health Care Accruals
The Company uses a combination of insurance and self-insurance mechanisms to provide for workers’ compensation claims and employee health care benefits. Liabilities associated with the risks that are retained by the Company are not discounted and are estimated, in part, by considering historical claims experience and outside expertise, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends.
Deferred Revenue
Deferred revenue results primarily from the sale of mileage credits, the sale and leaseback of aircraft, and the receipt of manufacturer or vendor credits. This revenue is recognized when award transportation is provided or over the term of the applicable agreements.
Leased Aircraft Return Costs
Cash payments associated with returning leased aircraft are accrued beginning immediately after the last heavy maintenance visit prior to the scheduled aircraft return date based on the time remaining on the lease, planned aircraft usage and the provisions included in the lease agreement, although the actual amount due to any lessor upon return will not be known with certainty until the end of the lease.
As leased aircraft are returned, any payments are charged against the established accrual. The accrual is part of other current and long-term liabilities, and was $6.9 million and $14.2 million as of December 31, 2004 and December 31, 2003.
Revenue Recognition
Passenger revenue is recognized when the passenger travels. Tickets sold but not yet used are reported as air traffic liability. Passenger traffic commissions and related fees are expensed when the related revenue is recognized. Passenger traffic commissions and related fees not yet recognized are included as a prepaid expense. Due to complex pricing structures, refund and exchange policies, and interline agreements with other airlines, certain amounts are recognized in revenue using estimates regarding both the timing of the revenue recognition and the amount of revenue to be recognized. These estimates are generally based on the statistical analysis of the Company’s historical data. Any adjustments resulting from periodic evaluations of the estimated air traffic liability are included in results of operations during the period in which the evaluations are completed. Historically, any such adjustments have not been significant.
Freight and mail revenues are recognized when service is provided. Other-net revenues are primarily related to the Mileage Plan and they are recognized as described in the “Frequent Flyer Awards” paragraph below.
Frequent Flyer Awards
Alaska operates a frequent flyer program (“Mileage Plan”) that provides travel awards to members based on accumulated mileage. For miles earned by flying on Alaska and through airline partners, the estimated incremental cost of providing free travel awards is recognized as a selling expense and accrued as a liability as miles are accumulated. Alaska also sells mileage credits to non-airline partners such as hotels, car rental agencies, and a major bank that offers Alaska Airlines affinity credit cards. The Company defers the portion of the sales proceeds that represents the estimated fair value of the award transportation and recognizes that amount as revenue when the award transportation is provided. The deferred proceeds are recognized as passenger revenue for awards redeemed on Alaska or Horizon, and as other-net revenue for awards redeemed on other airlines. Deferred revenue and liabilities associated with the Mileage Plan are carried on Alaska’s balance sheet since Alaska is the sponsor and ticketing carrier. Alaska’s Mileage Plan deferred revenue and liabilities are included under the following balance sheet captions at December 31 (in millions):
The amounts recorded in other accrued liabilities relate primarily to deferred revenue expected to be realized within one year, including $25.0 million and $19.5 million at December 31, 2004 and 2003, respectively, associated with mileage plan awards issued but not yet flown.
Contracted Services
Contracted services includes expenses for ground handling, security, navigation fees, temporary employees, data processing fees, and other similar services.
Other Selling Expenses and Commissions
Other selling expenses and commissions include credit card commissions, global distribution systems charges, Mileage Plan free travel awards, advertising, promotional costs, commissions and incentives. Advertising production costs are expensed the first time the advertising takes place. Advertising expense was $14.9 million, $15.3 million, and $14.3 million, respectively, in 2004, 2003, and 2002.
Capitalized Interest
Interest is capitalized on flight equipment purchase deposits and ground facility progress payments as a cost of the related asset. The interest cost is based on the Company’s weighted average borrowing rate and is depreciated over the estimated useful life of the asset. The Company ceases capitalization of interest on aircraft when delivery dates are deferred. Capitalization continues when the deferral period is over.
Income Taxes
The Company uses the asset and liability approach for accounting and reporting income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. A valuation allowance is established, if necessary, for the amount of any tax benefits that, based on available evidence, are not expected to be realized.
Stock Options
The Company applies the intrinsic value method in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations in accounting for stock options.
The following table represents the pro forma net income (loss) before accounting change had compensation cost for the Company’s stock options been determined in accordance with Statement of Financial Accounting Standards (SFAS) No. 123. In accordance with SFAS No. 123, the fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model and then amortized ratably over the vesting period. The following assumptions were used for grants in 2004, 2003, and 2002, respectively: dividend yield of 0% for all years; volatility of 37%, 43%, and 49%; risk-free interest rates of 3.43%, 2.97%, and 3.82%; and
expected lives of 5 years for all years. Using these assumptions, the weighted average fair value of options granted was $11.74, $8.98, and $13.61 in 2004, 2003, and 2002, respectively.
During the fourth quarter of 2004, the Financial Accounting Standards Board issued SFAS 123R, “Share Based Payments: An Amendment of FASB No. 123 and 95”. The new standard requires companies to recognize in the income statement the grant-date fair value of stock options and other equity based compensation issued to employees. This new standard will apply to both stock options to purchase Air Group common stock that the Company grants to employees of Alaska Airlines and the Employee Stock Purchase Plan, which features a look-back provision and allows employees to purchase Air Group common stock at a discount in excess of 5%. The Company’s options are typically granted with graded vesting provisions, and the Company intends to amortize compensation cost over the service period using the straight-line method. This new statement is effective for interim or annual periods beginning after June 15, 2005 (the Company’s third quarter of 2005). The Company intends to use the “modified prospective method” upon adoption whereby unvested equity awards are accounted for in accordance with SFAS 123 but amounts are recognized in the income statement instead. The Company’s stock based compensation expense, as measured under SFAS 123, approximates $7 to $9 million per year on a pre-tax basis.
New Accounting Standards
In March 2004, the Financial Accounting Standards Board’s (FASB) Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (EITF 03-1). The guidance prescribes a three-step model for determining whether an investment is other-than-temporarily impaired and requires disclosures about unrealized losses on investments. The accounting guidance is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements are effective
for annual reporting periods ending after June 15, 2004. In September 2004, the FASB issued FASB Staff Position EITF 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1 ‘The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” (FSP EITF 03-01-1). FSP EITF 03-1-1 delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of EITF Issue 03-01. During the period of the delay, FSP EITF 03-1-1 states that companies should continue to apply relevant “other-than-temporary” guidance. The Company will assess the impact of paragraphs 10-20 of EITF 03-1 once the guidance has been finalized. At December 31, 2004, available-for-sale investments in the Company’s marketable securities portfolio had unrealized losses totaling $4.0 million which are recorded in Other Accumulated Comprehensive Loss. Management does not believe that the securities with unrealized losses as of December 31, 2004 meet the criteria for recognizing the loss under existing other-than-temporary guidance.
In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” FIN 46, as amended by FIN 46 (Revised) in December 2003, requires consolidation of certain types of entities in which the Company absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected returns, or both, as a result of ownership, contractual or other financial interests in the entity. These entities are called “variable interest entities.” The principal characteristics of variable interest entities are (1) an insufficient amount of equity to absorb the entity’s expected losses, (2) equity owners as a group are not able to make decisions about the entity’s activities, and (3) equity that does not absorb the entity’s losses or receive the entity’s residual returns. Variable interests are contractual, ownership or other monetary interests in an entity that change with fluctuations in the entity’s net asset value. As a result, variable interest entities can arise from items such as lease agreements, loan arrangements, guarantees or service contracts.
If an entity is determined to be a variable interest entity, the entity must be consolidated by the “primary beneficiary”. The primary beneficiary is the holder of the variable interests that absorbs a majority of the variable interest entity’s expected losses or receives a majority of the entity’s residual returns in the event no holder has a majority of the expected losses. There is no primary beneficiary in cases where no single holder absorbs the majority of the expected losses or receives a majority of the residual returns. The determination of the primary beneficiary is based on qualitative aspects of the arrangements involved or projected cash flows at the inception of the transaction with the variable interests entity.
FIN 46 is applicable to financial statements of companies that have interests in “special purpose entities”, as defined, beginning with the year ended 2003.
The Company is the lessee in a series of operating leases covering our leased aircraft. In many instances, the lessors are trusts established by a third party specifically to purchase, finance and lease aircraft to the Company. These leasing entities meet the criteria for variable interest entities. However, they do not meet the consolidation requirements of FIN 46 because the Company is not
the primary beneficiary of the entity’s expected gains or losses. The Company’s conclusions are based on the fact that the leasing arrangements involved contain terms which are consistent with market terms at the inception of the lease and do not include residual value guarantees made by the Company, fixed-price purchase obligations or similar features that obligate the Company to absorb the majority of expected losses of the variable interest entities. The Company’s maximum exposure under these types of lease arrangements is the remaining lease payments, which are reflected in future lease commitments in Note 6 (plus the cost, if any, of bringing the equipment into compliance with the physical condition required for return).
As discussed in “Property, Equipment and Depreciation,” the Company currently capitalizes costs related to major airframe and engine overhauls and amortizes those costs to maintenance expense over the shorter of the life of the overhaul or the remaining lease term.
Fourth Quarter Adjustments
Operating loss for the three months ended December 31, 2004 includes the following items:
Operating loss for the three months and year ended December 31, 2003 includes adjustments to increase operating expenses by $2.4 million (pretax) related to prior years. Operating loss for the three months ended December 31, 2003 also includes adjustments to increase operating expenses by $1.8 million (pretax) and increase operating revenues by $6.3 million (pretax), both related to previous quarters in 2003. Management does not believe that these amounts are material to the periods affected.
Note 2. Marketable Securities
At December 31, 2004 and 2003 all of the Company’s marketable securities were classified as available-for-sale. The securities are carried at fair value, with the unrealized gains and losses reported in shareholders’ equity under the caption “Accumulated Other Comprehensive Loss”. Realized gains and losses are included in other nonoperating income (expense) in the statements of operations. The cost of securities sold is based on the specific identification method. Interest and dividends on marketable securities are included in interest income in the statements of operations.
Marketable securities consisted of the following at December 31 (in millions):
At December 31, 2004 and 2003, gross unrealized gains and losses were not material to the financial statements.
Of the marketable securities on hand at December 31, 2004, 39% mature in 2005, 46% in 2006, and 15% thereafter.
Note 3. Detail of Other Financial Statement Captions
Other Assets
Other assets consisted of the following at December 31 (in millions):
At December 31, 2004, the Company had $66.3 million in restricted deposits, which were primarily restricted investments used to guarantee various letters of credit and workers compensation self insurance programs. The restricted investments consist of highly liquid securities with original maturities of three months or less. They are carried at cost, which approximates market. Deferred costs and other includes deferred financing costs, long-term prepaid rent, lease deposits and other items.
Accumulated Other Comprehensive Loss
Accumulated other comprehensive loss consisted of the following at December 31 (in millions, net of tax):
Other-net Nonoperating Income
Other - net consisted of the following at December 31 (in millions):
Note 4. Long-term Debt and Capital Lease Obligations
At December 31, 2004 and 2003, long-term debt and capital lease obligations were as follows (in millions):
*The weighted average fixed interest rate was 7.3% during 2004 and 7.4% during 2003. The weighted average variable interest rate was 2.9% during 2004 and 2.5% during 2003.
At December 31, 2004, borrowings of $848.9 million were secured by flight equipment and real property.
At December 31, 2004, long-term debt principal payments for the next five years were as follows (in millions):
During 2004, Alaska issued $94.6 million of debt secured by flight equipment, having interest rates that vary with LIBOR and payment terms ranging from 12 to 16 years. Debt issuances during the period were offset by normal long-term debt payments of $58.9 million and full repayment of the Company’s credit facility of $150.0 million.
Note 5. Related Company Transactions
During 2003, the Company received capital contributions of $123.6 million from Air Group. This amount is reflected in capital in excess of par value in the Company’s December 31, 2003 balance sheet.
During 2000, Alaska transferred a flight simulator to AAGL in exchange for a $2.4 million note receivable from AAGL and a $0.6 million reduction in its payable to Air Group. The loan has repayment terms of 12 years at 6.5% interest. AAGL is leasing the simulator to Alaska for 12 years.
Alaska performs all ticket processing for Horizon. Horizon’s ticket sales are recorded by Alaska as air traffic liability and remitted to Horizon when transportation is provided.
Alaska’s Mileage Plan participants may redeem miles on Horizon flights. Additionally, participants who fly on Horizon may earn miles in Alaska’s Mileage Plan. Alaska does not pay nor receive any amounts from Horizon for its participation in the plan.
The Company periodically loans Horizon funds at varying interest rates. All amounts are payable on demand. Interest income recognized related to the Horizon loans totaled $2.0 million, $2.4 million, and $2.1 million during 2004, 2003, and 2002, respectively. At December 31, 2004, receivables from related companies include $46.7 million from Horizon, $9.3 million from AAGL and $8.9 million from Air Group.
Alaska has an agreement with Horizon to provide revenue sharing on certain markets. Under the arrangement, Alaska makes a monthly payment to Horizon for markets that provide connecting traffic to Alaska but create losses for Horizon (the incentive markets). The payment is based on fully-allocated cost for Horizon to provide the transportation service, plus a 5% mark-up. Incentive markets are analyzed quarterly and the monthly reimbursement amount is adjusted to reflect the prior quarter’s actual performance. Alaska made incentive payments to Horizon of $13.8 million, $39.6 million, and $24.0 million in 2004, 2003, and 2002, respectively, which are reflected as commission expense in the statements of operations.
Alaska also provides certain services to Horizon for which Alaska receives payment from Horizon based on the cost of the services, including personnel expenses related to development and maintenance of alaskaair.com, the maintenance of telecommunications lines and related software, personnel and systems expenses to process Horizon’s revenue transactions, and printing and graphics services. Alaska also pays certain leasing and other facilities costs on Horizon’s behalf that are reimbursed monthly by Horizon. Total amounts received by Alaska from Horizon were $10.5 million, $9.1 million, and $4.4 million in 2004, 2003, and 2002, respectively.
In the normal course of business, Alaska and Horizon provide certain ground handling services to the other company. Charges for ground services provided by Alaska to Horizon totaled $2.0 million, $2.4 million, and $1.7 million during 2004, 2003, and 2002, respectively. Charges for ground services provided by Horizon to Alaska totaled $4.8 million, $4.1 million, and $2.6 million during 2004, 2003, and 2002, respectively.
Note 6. Commitments
Lease Commitments
At December 31, 2004, the Company had lease contracts for 48 aircraft that have remaining noncancelable lease terms of one to 16 years. The majority of airport and terminal facilities are also leased. Total rent expense was $211.5 million, $199.8 million and $197.8 million, in 2004, 2003, and 2002, respectively.
Future minimum lease payments with noncancelable terms in excess of one year as of December 31, 2004 are shown below (in millions):
Aircraft Commitments
At December 31, 2004, the Company had firm purchase commitments for 3 aircraft requiring aggregate payments of approximately $77.6 million. In addition, Alaska had options to acquire 26 additional B737’s. The Company expects to finance the firm orders and, to the extent exercised, the option aircraft with leases, long-term debt or internally generated cash.
In February 2005, the Company converted options to acquire three B737-800 aircraft into firm orders to be delivered in 2006. This results in additional purchase commitments of $119.6 million.
Note 7. Employee Benefit Plans
Four defined benefit and four defined contribution retirement plans cover various employee groups. The defined benefit plans provide benefits based on an employee’s term of service and average compensation for a specified period of time before retirement. The Company also maintains unfunded, noncontributory defined benefit plans for certain elected officers. A summary of each plan follows:
Pension Plans-Defined Benefit
The Company’s pension plans are funded as required by the Employee Retirement Income Security Act of 1974 (ERISA). The defined benefit plan assets consist primarily of marketable equity and fixed income securities. The Company uses a December 31 measurement date for these plans. The following table sets forth the status of the plans for 2004 and 2003 (in millions):
The accumulated benefit obligation for the defined benefit pension plan was $767.9 million and $663.8 million at December 31, 2004 and 2003, respectively.
Weighted average assumptions used to determine benefit obligations as of December 31:
Discount rates of 5.75% and 6.00% were used as of December 31, 2004 and 2003, respectively. For both years, the rate of compensation increase used varied from 3.47% to 6.80% depending on the plan.
Weighted average assumptions used to determine net periodic benefit cost as of December 31:
Discount rates of 6.00% and 6.75% were used as of December 31, 2004 and 2003, respectively. For both years, the expected return on plan assets used was 8.0% and the rate of compensation increase used varied from 3.47% to 6.80% depending on the plan.
In determining the expected return on plan assets, the Company assesses the current level of expected returns on risk free investments (primarily government bonds), the historical level of the risk premium associated with the other asset classes in which the portfolio is invested and the expectations for future returns of each asset class. The expected return for each asset class is then weighted based on the target asset allocation to develop the expected long-term rate of return on assets assumption for the portfolio.
The asset allocation of the defined benefit plans, by asset category, is as follows as of the end of 2004 and 2003:
The Company’s investment policy focuses on achieving maximum returns at a reasonable risk for pension assets over a full market cycle. The Company uses a number of fund managers and invests in various asset classes to diversify risk. Target allocations for the primary asset classes are approximately:
Pension assets are rebalanced periodically to maintain the above target asset allocations. An individual equity investment will not exceed 10% of the entire equity portfolio. Fixed income securities carry a minimum “A” rating by Moody’s and/or Standard and Poor’s and the average life of the bond portfolio may not exceed 10 years. The Company does not currently have the intent to invest plan assets in the Company’s common stock.
Net pension expense for the defined benefit plans included the following components for 2004, 2003, and 2002 (in millions):
In 2002, the Company recorded an $87.2 million (net of taxes of $52.5 million) non-cash charge to equity in connection with the defined benefit plans that the Company sponsors for eligible employees. This charge resulted from an unfunded accrued benefit obligation resulting from lower than expected returns on plan assets and a reduction in discount rate. In 2003, the Company recorded a reduction of this equity charge of $5.2 million (net of taxes of $3.3 million) primarily reflecting higher than expected return on assets. In 2004, the Company recorded a $2.3 million (net of taxes of $1.2 million) non-cash charge to equity in connection with the defined benefit plans that the Company sponsors for eligible employees.
The Company expects to contribute $57.8 million to these defined benefit pension plans during 2005.
Future benefits expected to be paid under the defined benefit pension plans from the assets of those plans as of December 31, 2004 are as follows (in millions):
Pension Plans-Noncontributory
The Company also maintains unfunded, noncontributory defined benefit plans for certain elected officers. These plans use a December 31 measurement date. The following table sets forth the status of the plans for 2004 and 2003 (in millions):
The accumulated benefit obligation for the noncontributory defined benefit plan was $33.3 million and $34.3 million at December 31, 2004 and 2003, respectively.
Weighted average assumptions used to determine benefit obligations as of December 31:
Discount rates of 5.75% and 6.00% were used as of December 31, 2004 and 2003, respectively. For both years, the rate of compensation increase used varied from 3.47% to 6.80% depending on the plan.
Weighted average assumptions used to determine net periodic benefit cost as of December 31:
Discount rates of 6.00% and 6.75% were used as of December 31, 2004 and 2003, respectively. For both years, the rate of compensation increase used varied from 3.47% to 6.80% depending on the plan.
Net pension expense for the noncontributory defined benefit plans included the following components for 2004, 2003 and 2002 (in millions):
Future benefits expected to be paid under the noncontributory defined benefit pension plans as of December 31, 2004 are as follows (in millions):
Defined Contribution Plans
The defined contribution plans are deferred compensation plans under section 401(k) of the Internal Revenue Code. All of these plans require Company contributions. Total expense for the defined contribution plans was $15.5 million, $14.7 million, and $12.4 million, respectively, in 2004, 2003, and 2002.
Profit Sharing Plans
The Company has employee profit sharing plans. In 2004, the Company recorded profit sharing expense of $1.2 million. In 2003, the Company recorded profit sharing expense of $2.9 million. In January 2005, the Company introduced a new reward program for all employees that entitles employees to quarterly payouts of up to $300 per person if operational and customer service objectives are met. Based on expected headcount, the total payout could be as high as $12 million
if all objectives are met. The profit sharing participation percentage was also reduced from its 2004 level.
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 is unfunded, and at December 31, 2004 and 2003 was $76.2 million and $77.3 million, respectively. This liability was determined using an assumed discount rate of 5.75% and 6.00% in 2004 and 2003, respectively. The accrued liability related to the subsidy is included within other liabilities on the Balance Sheet, and totaled $47.2 million and $39.2 million at December 31, 2004 and 2003, respectively. Annual expense related to this subsidy was approximately $9.3 million in 2004, $9.6 million in 2003, and $4.4 million in 2002.
The Company uses a December 31 measurement date to assess obligations associated with the subsidy. Net periodic benefit cost for the postretirement medical plans included the following components for 2004, 2003, and 2002 (in millions):
A 1% higher or lower trend rate has the following effect on the Company’s postretirement medical plans during 2004, 2003, and 2002 (in millions):
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.
Deferred income taxes reflect the impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and such amounts for tax purposes.
* Federal loss carryforwards of $41.6 million ($14.6 million tax effected) expire beginning in 2023 and ending in 2024. State loss carryforwards of $97.5 million ($4.3 million tax effected) expire beginning in 2005 and ending in 2024.
The Company has concluded that it is more likely than not that its deferred tax assets would be realizable and thus no valuation allowance has been recorded as of December 31, 2004. This conclusion is based on the expected future reversals of existing taxable temporary differences and does not rely on future taxable income. Should the Company incur additional losses in the future, the Company’s ability to realize the net operating loss carryforwards may be subject to greater uncertainty. The Company will continue to reassess the need for a valuation allowance during each future reporting period.
At December 31, 2004 and 2003, the Company had tax receivables from (payable to) affiliated companies of $(14.9) million and $14.7 million, respectively.
Note 9. Financial Instruments
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 fuel hedge contracts is based on commodity exchange prices. The fair value of restricted deposits approximates the carrying amount. The fair value of long-term debt is based on a discounted cash flow analysis using the Company’s current borrowing rate.
Concentrations of Credit
The Company continually monitors its positions with, and the credit quality of, the financial institutions that are counterparties to its derivative financial instruments and does not anticipate nonperformance by the counterparties.
The Company could realize a material loss in the event of nonperformance by any single counterparty to its fuel hedge positions. However, the Company enters into transactions only with large, well-known financial institution counterparties that have strong credit ratings. In addition, the Company limits the amount of investment credit exposure with any one institution.
The Company’s trade receivables do not represent a significant concentration of credit risk at December 31, 2004 due to the frequency that settlement takes place and the dispersion across many industry and government segments.
Note 10. Derivative Financial Instruments
The Company records all derivative instruments on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in earnings or other comprehensive income, depending on the type of hedging instrument and the effectiveness of the hedges.
The Company’s operations are inherently dependent upon the price and availability of aircraft fuel, which accounted for 20% and 15% of 2004 and 2003 operating expenses (excluding impairment and restructuring charges), respectively. To manage economic risks associated with fluctuations in aircraft fuel prices, the Company enters into swap agreements and call options for crude oil. Prior to the second quarter of 2004, these hedging contracts were “highly correlated” to changes in aircraft fuel prices, and therefore qualified as “cash flow hedges” under SFAS No. 133
whereby the majority of the changes in fair value were deferred in Accumulated Other Comprehensive Loss on the Company’s Balance Sheet until these hedge positions were settled at which point they were recognized in earnings.
The Company’s current fuel hedge program includes the same underlying commodities used historically. However, because of variations in the spread between the prices of West Texas Intermediate crude oil and jet fuel since April 1, 2004, the Company’s hedge contracts are no longer “highly correlated” to changes in prices of aircraft fuel, as defined in SFAS No. 133. The impacts on the Company’s reported results are as follows:
• All changes in the fair value of fuel hedge contracts that existed as of March 31, 2004 or hedge positions entered into subsequent to March 31, 2004 (the end of the first quarter of 2004) are reported in other non-operating income (expense).
• Because the Company will be recording fair value changes in its statement of operations as they occur (in non-operating income (expense)), actual gains or losses realized upon settlement of the hedge contracts entered into subsequent to March 31, 2004 will not be reflected in fuel expense.
• Reported fuel expense will include the effective portion of gains associated with hedge positions that settled during the current period on contracts that existed at March 31, 2004 to the extent that mark-to-market gains were already included in Accumulated Other Comprehensive Loss at March 31, 2004.
The following table summarizes Alaska’s realized fuel hedging gains and changes in fair value of hedging contracts outstanding as of December 31, 2004 and 2003 (in millions):
Fuel hedge positions entered into by Alaska are currently as follows:
As of December 31, 2004 and 2003, the fair values of the Company’s fuel hedge positions were $84.5 million and $15.7 million, respectively, and are presented in the balance sheets as follows (in millions):
The Company periodically enters into foreign exchange forward contracts, generally with maturities of less than one month, to manage the 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. At December 31, 2004, there were no foreign currency contracts or interest rate swap agreements outstanding.
Note 11. Impairment Charges
Impairment of 737-200C Aircraft
In June 2004, the Company’s Board approved a plan to accelerate the retirement of Alaska’s Boeing 737-200C fleet and remove those aircraft from service (by the end of 2007) earlier than initially planned. In July 2004, the Company announced its plan to replace these aircraft by modifying five existing 737-400 aircraft and using other existing 737-400 aircraft for the remaining passenger capacity. Four of the five modified airplanes will be converted into combination passenger/cargo aircraft and one will be converted to an all cargo aircraft. The Company expects to backfill the 737-400s with Boeing 737-800s to be delivered in 2005 and 2006.
As a result of this decision, the Company evaluated impairment as required by SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” and concluded that the carrying value of the 737-200C fleet was no longer recoverable when compared to the estimated remaining future cash flows. Accordingly, during the second quarter of 2004, Alaska recorded an impairment charge totaling $36.8 million (pre-tax) to write down the fleet to its estimated fair market value.
The estimated fair value of the Company’s aircraft was derived using third-party appraisals and market data compiled by an independent pricing authority, and adjusted for other factors that management deemed appropriate. In conjunction with the fair value determination, the Company has reassessed the useful lives and residual values of the fleet and related spare equipment and will depreciate the remaining carrying values through 2007 when the last aircraft will be retired.
Note 12. Restructuring Charges
During the third quarter of 2004, Alaska announced a management reorganization and the closure of its Oakland heavy maintenance base, contracting out of the related maintenance activities, contracting out of the Company’s Fleet Service and Ground Support Equipment maintenance functions and other initiatives. In total, these restructuring activities will result in a reduction of approximately 900 employees when fully implemented in 2005. Severance and related costs associated with this restructuring are estimated at $53.4 million, of which $27.5 million was recorded during the third quarter of 2004 and $25.9 million was recorded in the fourth quarter. The severance package offered to impacted employees included cash payments based on years of service and one year of medical coverage after severance date. Since Alaska self-insures for employee medical coverage, the Company estimated the projected claims cost for affected employees and recorded a corresponding accrual. Actual experience will likely differ from the estimate if employees accept positions with other employers and no longer need the coverage provided by Alaska or simply submit claims during the one year period that are higher or lower than our estimate. The Company expects to adjust this accrual quarterly throughout 2005.
The following table displays the activity and balances of the restructuring charges for year ended December 31, 2004. There were no restructuring charges during the same period of 2003 ($ in millions):
* The Company expects the majority of cash payments will be made during the first and second quarters of 2005.
Note 13. Contingencies
The Company is a party to routine commercial and employment litigation incidental to its business and with respect to which no material liability is expected. Management believes the ultimate disposition of these matters is not likely to materially affect the Company’s financial position or results of operations. However, this belief is based on management’s current understanding of the relevant law and facts; it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.
The Company’s existing pilot contract provides that, if a negotiated agreement on the entire contract was not reached by December 15, 2004, ten contract issues plus wage rates would be submitted to an interest arbitrator. Issues submitted generally relate to pension plans, medical insurance, profit sharing, code sharing and work rules. The parties did not reach an agreement, and the issues have been submitted to binding arbitration in March 2005 with a decision to be effective in May 2005. The pilot labor contract contains market related standards for wages and non-wage issues.
The Company could potentially be responsible for environmental remediation costs primarily related to jet fuel and other petroleum contamination that occurs in the normal course of business at various locations in the Company’s system. The Company has established an accrual for estimated remediation costs for known contamination based on information currently available. The accrual was not significant at December 31, 2004 or 2003.
Note 14. U.S. Government Compensation
On April 16, 2003, the Emergency Wartime Supplemental Appropriations Act (the Act) was signed into legislation. The Act includes $2.3 billion of one-time cash payments to air carriers, allocated based on each carrier’s share of security fees remitted and carrier fees paid to the Transportation Security Administration (TSA) since its inception in February 2002. Additionally, passenger security fees were not imposed by the TSA and carrier fees were not paid during the period June 1, 2003 through September 30, 2003. In May 2003, the Company received its share of the one-time cash grant in the amount of $52.8 million.
In August 2003, the Company received $2.5 million from the Federal Aviation Administration in reimbursement of flight deck reinforcement expenditures. The reimbursement was recorded as an offset to capital costs.
Note 15. Change in Accounting Principle
In June 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” Under this statement, goodwill is considered to have an indefinite life and is no longer amortized but instead is subject to periodic impairment testing. Effective January 1, 2002, the Company adopted SFAS No. 142. Assuming the Company had adopted this standard as of January 1, 2001, the Company’s net loss for the year ended December 31, 2001 would have been reduced by approximately $0.5 million for the impact of goodwill amortization.
During the second quarter of 2002, the Company completed the first step of its impairment test related to its $12.5 million of goodwill and determined that the net book value exceeded its fair value. In the fourth quarter of 2002, the Company completed the second step of its impairment test and determined that all of the Company’s goodwill was impaired. As a result, the Company recorded a one-time, non-cash charge, effective January 1, 2002 of $12.5 million to write-off all of its goodwill. This charge is reflected as a cumulative effect of accounting change in the 2002 statement of operations.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholder
Alaska Airlines, Inc.:
We have audited the accompanying balance sheet of Alaska Airlines, Inc. as of December 31, 2004, and the related statements of operations, shareholder’s equity and cash flows for the year then ended. In connection with our audit of the financial statements, we also have audited financial statement schedule II. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides 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, 2004, and the results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
KPMG LLP
Seattle, Washington
February 22, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholder of Alaska Airlines, Inc.
Seattle, Washington
We have audited the accompanying balance sheet of Alaska Airlines, Inc. (the Company) as of December 31, 2003, and the related statements of operations, shareholder’s equity, and cash flows for the years ended December 31, 2003 and 2002. Our audits also included the financial statement schedule for the years ended December 31, 2003 and 2002, listed in the Index at Item 15(a). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of Alaska Airlines, Inc. as of December 31, 2003, and the results of its operations and its cash flows for the years ended December 31, 2003 and 2002, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule for the years ended December 31, 2003 and 2002, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 15 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002.
DELOITTE & TOUCHE LLP
Seattle, Washington
February 27, 2004
VALUATION AND QUALIFYING ACCOUNTS
Alaska Airlines, Inc.
Schedule II
(A) Deduction from reserve for purpose for which reserve was created. For leased aircraft return provisions, the balance is reclassified to other long-term liabilities if the lease is extended on the underlying aircraft.
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.
*3.1
Articles of Incorporation of Alaska Airlines, Inc. as amended through March 7, 1991 (Exhibit 3.1 to Form 10-Q for the six months ended June 30, 2002)
**3.2
Bylaws of Alaska Airlines, Inc. as amended and in effect November 4, 1997
*4.1
Trust Indentures and Security Agreement for Alaska Airlines Equipment Trust Certificates, Series A and B (Exhibit No. 4(a)(1) to Form S-3, Amendment No. 1, Registration No. 33-46668)
*4.2
Trust Indentures and Security Agreement for Alaska Airlines Equipment Trust Certificates, Series C and D (Exhibit No. 4(a)(1) to Form S-3, Amendment No. 2, Registration No. 33-46668)
*4.3
Participation Agreement for Alaska Airlines Equipment Trust Certificates, Series A and B (Exhibit No. 4(b)(1) to Form S-3, Amendment No. 1, Registration No. 33-46668)
*4.4
Participation Agreement for Alaska Airlines Equipment Trust Certificates, Series C and D (Exhibit No. 4(b)(1) to Form S-3, Amendment No. 2, Registration No. 33-46668)
*4.5
Lease Agreement for Alaska Airlines Equipment Trust Certificates (Exhibit No. 4(b)(2) to Form S-3, Registration No. 33-46668)
*10
Employment agreement between Alaska Airlines, Inc. and George D. Bagley (Exhibit 10 to Alaska Air Group, Inc. First Quarter 2002 10-Q)***
*10.1
Alaska Air Group, Inc. Performance Based Pay Plan (formerly “Management Incentive Plan”)*** (Exhibit 10.19 to Alaska Air Group, Inc. Third Quarter 2004 10-Q)
**10.2
2004 Alaska Air Group, Inc. Long-Term Incentive Equity Plan and form of stock option and restricted stock unit agreements***
*10.3
Alaska Air Group, Inc. 1988 Stock Option Plan, as amended through May 19, 1992 (Alaska Air Group, Inc. Registration Statement No. 33-52242)***
*#10.4
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 Alaska Air Group, Inc. 10-K)
*#10.4(a)
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 Alaska Air Group, Inc. 10-Q)
*#10.4(b)
Supplemental Agreement 6 to Agreement dated September 18, 1996 between Alaska Airlines, Inc. and Boeing for the purchase of 12 Boeing 737-400 aircraft (Exhibit 10.5(b) to 2002 Alaska Air Group, Inc. Form 10-K)
*10.5
Alaska Air Group, Inc. 1981 Supplementary Retirement Plan for Elected Officers, as amended by First Amendment to the Alaska Airlines, Inc. and Alaska Air Group, Inc. Supplementary Retirement Plan for Officers (Exhibit 10.15 to Alaska Air Group, Inc. 1997 10-K)***
*10.6
Alaska Air Group, Inc. 1995 Supplementary Retirement Plan for Elected Officers, as amended by First Amendment to the Alaska Air Group, Inc. 1995 Elected Officers Supplementary Retirement Plan and Second Amendment to the Alaska Air Group, Inc. 1995 Elected Officers Supplementary Retirement Plan (Exhibit 10.16 to Alaska Air Group, Inc. 1997 10-K)***
*10.8
Alaska Air Group, Inc. 1996 Long-Term Incentive Equity Plan (Registration Statement 333-09547)***
*10.9
Alaska Air Group, Inc. Non Employee Director Stock Plan (Registration Statement 333-33727)***
*10.11
Alaska Air Group, Inc. 1997 Non Officer Long-Term Incentive Equity Plan (Registration Statement 333-39899)***
*10.15
Alaska Air Group, Inc. 1999 Long-Term Incentive Equity Plan (Registration Statement 333-87563)***
*10.16
Alaska Air Group, Inc. Change of Control Agreement dated October 27, 1999 (Exhibit 10.18 to Alaska Air Group, Inc.1999 Form 10-K)
*10.17
Alaska Air Group, Inc. Nonqualified Deferred Compensation Plan, as amended by First Amendment to the Alaska Air Group, Inc. Nonqualified Deferred Compensation Plan (Exhibit 10.17 to Alaska Air Group, Inc. Amendment No. 1 to Registration Statement No. 333-107177 dated September 23, 2003)
**10.19
Supplemental retirement plan arrangement dated as of December 29, 1996 between Alaska Airlines, Inc. and George Bagley***
**12.1
Calculation of Ratio of Earnings to Fixed Charges
**23.1
Consent of Independent Registered Public Accounting Firm (KPMG LLP)
**23.2
Consent of Independent Registered Public Accounting Firm(Deloitte & Touche LLP)
**31.1
Section 302 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
**31.2
Section 302 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
**32.1
Section 906 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
**32.2
Section 906 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
*
Previously filed.
**
Filed herewith.
***
Indicates management contract or compensatory plan or arrangement.
#
Confidential treatment was requested as to a portion of this document.