ALK

Business Context and Reporting Period

Company: Alaska Air Group, Inc.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2006
Operations: The Company operates two principal airline subsidiaries: Alaska Airlines, Inc. (a major carrier serving Alaska, the Western U.S., Canada, and Mexico) and Horizon Air Industries, Inc. (a regional carrier serving the Pacific Northwest and Western Canada). As of December 31, 2006, the combined operating fleet consisted of 183 aircraft (114 for Alaska, 69 for Horizon).

Key Financial Metrics

Unit Metrics (Alaska Airlines): Operating expenses per Available Seat Mile (ASM) were 11.98 cents in 2006 compared to 10.21 cents in 2005. Excluding fuel, fleet transition costs, and restructuring charges, unit costs decreased to 7.81 cents per ASM in 2006 from 8.01 cents in 2005.

Material Changes Versus Prior Period

• Revenue Growth: Operating revenues increased 12.1% to $3.33 billion, driven by a 6.7% increase in ticket yields and a 4.4% increase in capacity.
• Operating Loss: The Company reported an operating loss of $87.3 million in 2006, a significant decline from an operating income of $166.5 million in 2005.
• Fleet Transition Costs: A primary driver of the loss was $189.5 million in fleet transition costs related to the accelerated retirement of the MD-80 fleet to transition to an all-Boeing 737 fleet by the end of 2008. This included impairment charges of $131.1 million in Q1 and $58.4 million in Q3.
• Fuel Costs: Aircraft fuel expenses increased 59.0% to $873.5 million. While raw fuel costs rose, the increase in reported expense was exacerbated by the absence of the significant mark-to-market hedging gains recorded in 2005.
• Restructuring: Restructuring charges totaled $24.8 million in 2006 (vs. $20.4 million in 2005), primarily related to severance packages for flight attendants and ground service employees.

Guidance, Outlook, and Risks

Outlook for 2007:

• Capacity: Alaska Airlines expects capacity growth of 4.0% to 4.5%, while Horizon Air expects approximately 10.5% growth.
• Fleet: Alaska plans to introduce 14 new B737-800 aircraft. Horizon expects to deliver 13 new Q400 aircraft.
• Costs: Management estimates operating costs per ASM (excluding fuel) for Alaska will be between 7.5 and 7.6 cents for the full year 2007.

Key Risks and Contingencies:

• Fuel Volatility: Fuel costs represented 26% of total operating expenses in 2006. The Company remains exposed to price increases, though it maintains a hedging program (call options) covering approximately 50% of Q1 2007 requirements.
• Labor Negotiations: Contracts with pilots at both Alaska and Horizon are amendable in 2007. Management believes the risk of a work stoppage is currently low.
• Legal Proceedings: The Company is disputing significant retroactive and future terminal charge increases at Los Angeles International Airport (LAX) with the Department of Transportation.
• Frontier JetExpress: Horizon is terminating its contract flying with Frontier Airlines, returning nine CRJ-700 aircraft to its fleet in 2007. Successful redeployment of this capacity is critical to financial performance.

Investor Verification Checklist

• Fleet Transition Execution: Verify the timeline and cost implications of retiring the remaining MD-80 aircraft and the integration of new B737-800s.
• Fuel Hedging Effectiveness: Monitor the settlement of fuel hedges and the impact of rising crude oil prices on "economic" fuel costs versus GAAP fuel costs.
• Labor Contract Outcomes: Track the progress of pilot negotiations at Alaska and Horizon, as labor costs represent approximately 27-33% of operating expenses.
• LAX Dispute Resolution: Follow the Department of Transportation's decision regarding the LAX terminal charge increases, which could materially impact costs.
• Non-GAAP Reconciliation: Review the reconciliation of GAAP net loss to non-GAAP measures (excluding fleet transition and restructuring) to assess underlying operational profitability, which management cites as $137.7 million for 2006.