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ALASKA AIR GROUP, INC. - Quarter Report: 2017 September (Form 10-Q)



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-Q
 

x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2017
 
OR

¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 For the transition period from                      to                      

Commission File Number 1-8957
ALASKA AIR GROUP, INC.
 
Delaware
 
91-1292054
(State of Incorporation)
 
(I.R.S. Employer Identification No.)

 
19300 International Boulevard, Seattle, Washington 98188
Telephone: (206) 392-5040

 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x  No ¨ 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer   x
Accelerated filer  ¨
Non-accelerated filer   ¨ 
(Do not check if a smaller reporting company)
Smaller reporting company   ¨
Emerging growth company   ¨

If an emerging growth company, indicate by checkmark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x
 
The registrant has 123,044,897 common shares, par value $0.01, outstanding at October 31, 2017.




ALASKA AIR GROUP, INC.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2017

 TABLE OF CONTENTS

 

As used in this Form 10-Q, the terms “Air Group,” the "Company," “our,” “we” and "us" refer to Alaska Air Group, Inc. and its subsidiaries, unless the context indicates otherwise. Alaska Airlines, Inc., Virgin America Inc., and Horizon Air Industries, Inc. are referred to as “Alaska,” "Virgin America" and “Horizon” and together as our “airlines.”
 

2




CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
Cautionary Note Regarding Forward-Looking Statements
In addition to historical information, this Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995. Forward-looking statements are those that predict or describe future events or trends and that do not relate solely to historical matters. You can generally identify forward-looking statements as statements containing the words "believe," "expect," "will," "anticipate," "intend," "estimate," "project," "assume" or other similar expressions, although not all forward-looking statements contain these identifying words. Forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from historical experience or the Company’s present expectations. Some of the things that could cause our actual results to differ from our expectations are:

the competitive environment in our industry;
changes in our operating costs, including fuel, which can be volatile;
our ability to meet our cost reduction goals;
labor disputes and our ability to attract and retain qualified personnel;
operational disruptions;
an aircraft accident or incident;
general economic conditions, including the impact of those conditions on customer travel behavior;
the concentration of our revenue from a few key markets;
actual or threatened terrorist attacks, global instability and potential U.S. military actions or activities;
our reliance on automated systems and the risks associated with changes made to those systems;
changes in laws and regulations;
our ability to successfully integrate the operations of Virgin America into those of Alaska;
our ability to achieve anticipated synergies and timing thereof in connection with the acquisition of Virgin America.

You should not place undue reliance on our forward-looking statements because the matters they describe are subject to known and unknown risks, uncertainties and other unpredictable factors, many of which are beyond our control. Our forward-looking statements are based on the information currently available to us and speak only as of the date on which this report was filed with the SEC. We expressly disclaim any obligation to issue any updates or revisions to our forward-looking statements, even if subsequent events cause our expectations to change regarding the matters discussed in those statements. Over time, our actual results, performance or achievements will likely differ from the anticipated results, performance or achievements that are expressed or implied by our forward-looking statements, and such differences might be significant and materially adverse to our shareholders. For a discussion of these and other risk factors, see Item 1A. "Risk Factors” of the Company’s annual report on Form 10-K for the year ended December 31, 2016, and Item 1A. "Risk Factors" included herein. Please consider our forward-looking statements in light of those risks as you read this report.


3



PART I
 
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
(in millions)
September 30, 2017
 
December 31, 2016
ASSETS
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
144

 
$
328

Marketable securities
1,596

 
1,252

Total cash and marketable securities
1,740

 
1,580

Receivables—net
301

 
302

Inventories and supplies—net
57

 
47

Prepaid expenses and other current assets
116

 
121

Total Current Assets
2,214

 
2,050

 
 
 
 
Property and Equipment
 

 
 

Aircraft and other flight equipment
7,590

 
6,947

Other property and equipment
1,187

 
1,103

Deposits for future flight equipment
531

 
545

 
9,308

 
8,595

Less accumulated depreciation and amortization
3,078

 
2,929

Total Property and Equipment—Net
6,230

 
5,666

 
 
 
 
Goodwill
1,934

 
1,934

Intangible assets
135

 
143

Other noncurrent assets
226

 
169

Other Assets
2,295

 
2,246

 
 
 
 
Total Assets
$
10,739

 
$
9,962


See accompanying notes to condensed consolidated financial statements.


4


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)
(in millions, except share amounts)
September 30, 2017
 
December 31, 2016
LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
Current Liabilities
 
 
 
Accounts payable
$
97

 
$
92

Accrued wages, vacation and payroll taxes
345

 
397

Air traffic liability
1,103

 
849

Other accrued liabilities
886

 
878

Current portion of long-term debt
334

 
319

Total Current Liabilities
2,765

 
2,535

 
 
 
 
Long-Term Debt, Net of Current Portion
2,367

 
2,645

Other Liabilities and Credits
 

 
 

Deferred income taxes
682

 
463

Deferred revenue
682

 
640

Obligation for pension and postretirement medical benefits
323

 
331

Other liabilities
429

 
417

 
2,116

 
1,851

Commitments and Contingencies


 


Shareholders' Equity
 

 
 

Preferred stock, $0.01 par value, Authorized: 5,000,000 shares, none issued or outstanding

 

Common stock, $0.01 par value, Authorized: 400,000,000 shares, Issued: 2017 - 129,860,836 shares; 2016 - 129,189,634 shares, Outstanding: 2017 - 123,387,158 shares; 2016 - 123,328,051 shares
1

 
1

Capital in excess of par value
156

 
110

Treasury stock (common), at cost: 2017 - 6,473,678 shares; 2016 - 5,861,583 shares
(494
)
 
(443
)
Accumulated other comprehensive loss
(289
)
 
(305
)
Retained earnings
4,117

 
3,568

 
3,491

 
2,931

Total Liabilities and Shareholders' Equity
$
10,739

 
$
9,962


See accompanying notes to condensed consolidated financial statements.


5


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in millions, except per share amounts)
2017
 
2016
 
2017
 
2016
Operating Revenues
 
 
 
 
 
 
 
Passenger
 
 
 
 
 
 
 
Mainline
$
1,562

 
$
1,073

 
$
4,390

 
$
3,036

Regional
262

 
249

 
725

 
682

Total passenger revenue
1,824

 
1,322

 
5,115

 
3,718

Freight and mail
32

 
31

 
88

 
82

Other—net
264

 
213

 
768

 
607

Total Operating Revenues
2,120

 
1,566

 
5,971

 
4,407

 
 
 
 
 
 
 
 
Operating Expenses
 
 
 
 
 

 
 

Wages and benefits
475

 
340

 
1,392

 
1,008

Variable incentive pay
40

 
31

 
98

 
95

Aircraft fuel, including hedging gains and losses
368

 
225

 
1,051

 
593

Aircraft maintenance
88

 
64

 
271

 
197

Aircraft rent
70

 
25

 
204

 
80

Landing fees and other rentals
124

 
89

 
338

 
232

Contracted services
76

 
63

 
234

 
183

Selling expenses
91

 
58

 
269

 
162

Depreciation and amortization
95

 
101

 
275

 
281

Food and beverage service
50

 
31

 
145

 
93

Third-party regional carrier expense
30

 
25

 
84

 
72

Special items—merger-related costs
24

 
22

 
88

 
36

Other
150

 
92

 
424

 
267

Total Operating Expenses
1,681

 
1,166

 
4,873

 
3,299

Operating Income
439

 
400

 
1,098

 
1,108

 
 
 
 
 
 
 
 
Nonoperating Income (Expense)
 
 
 
 
 

 
 

Interest income
9

 
7

 
25

 
20

Interest expense
(26
)
 
(11
)
 
(77
)
 
(33
)
Interest capitalized
5

 
6

 
13

 
21

Other—net

 

 
(1
)
 
(2
)
 
(12
)
 
2

 
(40
)
 
6

Income before income tax
427

 
402

 
1,058

 
1,114

Income tax expense
161

 
146

 
397

 
414

Net Income
$
266

 
$
256

 
$
661

 
$
700

 
 
 
 
 
 
 
 
Basic Earnings Per Share:
$
2.15

 
$
2.08

 
$
5.35

 
$
5.66

Diluted Earnings Per Share:
$
2.14

 
$
2.07

 
$
5.31

 
$
5.63

Shares used for computation:
 
 
 
 
 
 
 

Basic
123.467

 
123.149

 
123.501

 
123.648

Diluted
124.220

 
123.833

 
124.341

 
124.393

 
 
 
 
 
 
 
 
Cash dividend declared per share:
$
0.30

 
$
0.275

 
$
0.90

 
$
0.825

See accompanying notes to condensed consolidated financial statements.

6


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS (unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(in millions)
2017
 
2016
 
2017
 
2016
Net Income
$
266

 
$
256

 
$
661

 
$
700

 
 
 
 
 
 
 
 
Other Comprehensive Income (Loss):
 
 
 
 
 
 
 
Related to marketable securities:
 
 
 
 
 
 
 
Unrealized holding gain (loss) arising during the period
1

 
(2
)
 
5

 
17

Reclassification of (gain) loss into Other—net nonoperating income (expense)
(1
)
 

 

 
(1
)
Income tax effect

 

 
(2
)
 
(6
)
Total

 
(2
)
 
3

 
10

 
 
 
 
 
 
 
 
Related to employee benefit plans:
 
 
 
 
 
 
 
Reclassification of net pension expense into Wages and benefits
5

 
5

 
16

 
15

Income tax effect
(2
)
 
(1
)
 
(5
)
 
(5
)
Total
3

 
4

 
11

 
10

 
 
 
 
 
 
 
 
Related to interest rate derivative instruments:
 
 
 
 
 
 
 
Unrealized holding gain (loss) arising during the period

 
1

 
(2
)
 
(6
)
Reclassification of (gain) loss into Aircraft rent
2

 
1

 
4

 
4

Income tax effect
(1
)
 
(1
)
 
(1
)
 
1

Total
1

 
1

 
1

 
(1
)
 
 
 
 
 
 
 
 
Other Comprehensive Income
4

 
3

 
15

 
19

 
 
 
 
 
 
 
 
Comprehensive Income
$
270

 
$
259

 
$
676

 
$
719


See accompanying notes to condensed consolidated financial statements.


7


ALASKA AIR GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
 
Nine Months Ended September 30,
(in millions)
2017
 
2016
Cash flows from operating activities:
 
 
 
Net income
$
661

 
$
700

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
275

 
281

Stock-based compensation and other
43

 
19

Changes in certain assets and liabilities:
 
 
 
Changes in deferred tax provision
217

 
47

Increase in air traffic liability
254

 
116

Increase in deferred revenue
46

 
60

Other—net
(139
)
 
(17
)
Net cash provided by operating activities
1,357

 
1,206

 
 
 
 
Cash flows from investing activities:
 

 
 

Property and equipment additions:
 

 
 

Aircraft and aircraft purchase deposits
(679
)
 
(408
)
Other flight equipment
(70
)
 
(35
)
Other property and equipment
(92
)
 
(66
)
Total property and equipment additions, including capitalized interest
(841
)
 
(509
)
Purchases of marketable securities
(1,408
)
 
(775
)
Sales and maturities of marketable securities
1,069

 
638

Other investing activities
38

 
5

Net cash used in investing activities
(1,142
)
 
(641
)
 
 
 
 
Cash flows from financing activities:
 

 
 

Proceeds from issuance of debt

 
1,546

Long-term debt payments
(265
)
 
(93
)
Common stock repurchases
(50
)
 
(193
)
Dividends paid
(111
)
 
(102
)
Other financing activities
27

 
22

Net cash provided (used) by financing activities
(399
)
 
1,180

Net increase (decrease) in cash and cash equivalents
(184
)
 
1,745

Cash and cash equivalents at beginning of year
328

 
73

Cash and cash equivalents at end of the period
$
144

 
$
1,818

 
 
 
 
Supplemental disclosure:
 

 
 

Cash paid during the period for:
 
 
 
Interest (net of amount capitalized)
$
68

 
$
12

Income taxes
129

 
321


See accompanying notes to condensed consolidated financial statements.

8



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE 1. GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Basis of Presentation
 
The condensed consolidated financial statements include the accounts of Air Group, and its primary subsidiaries, Alaska, Horizon, McGee Air Services and, starting December 14, 2016, Virgin America. The Company conducts substantially all of its operations through these subsidiaries. All significant intercompany balances and transactions have been eliminated. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP") for interim financial information. Consistent with these requirements, this Form 10-Q does not include all the information required by GAAP for complete financial statements. It should be read in conjunction with the consolidated financial statements and accompanying notes in the Form 10-K for the year ended December 31, 2016. In the opinion of management, all adjustments have been made that are necessary to fairly present the Company’s financial position as of September 30, 2017 and the results of operations for the three and nine months ended September 30, 2017 and 2016. Such adjustments were of a normal recurring nature.

In preparing these statements, the Company is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities, as well as the reported amounts of revenues and expenses. Due to seasonal variations in the demand for air travel, the volatility of aircraft fuel prices, changes in global economic conditions, changes in the competitive environment and other factors, operating results for the three and nine months ended September 30, 2017 are not necessarily indicative of operating results for the entire year.

Recently Issued Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-09, "Revenue from Contracts with Customers" (Topic 606), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. This comprehensive new standard will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In March 2016, the FASB issued ASU 2016-08, "Revenue from Contracts with Customers (Topic 606), Principal versus Agent Considerations" to clarify the guidance on determining whether the Company is considered the principal or the agent in a revenue transaction where a third party is providing goods or services to a customer. Entities are permitted to use either a full retrospective or cumulative effect transition method, and are required to adopt all parts of the new revenue standard using the same transition method. The new standard is effective for the Company on January 1, 2018.

At this time, the Company believes the most significant impact to the financial statements will be to Mileage Plan™ revenues and liabilities. The Company currently uses the incremental cost approach for miles earned through travel. As this approach will be eliminated with the standard, the Company will be required to allocate a portion of the ticket price through a relative selling price model and defer revenue recognition until the ticket is flown or unused mileage credits expire. Additionally, unused companion certificates that were previously recognized at expiration will be subject to advanced breakage under the new standard. The Company estimates a net increase to Mileage Plan deferred revenues of approximately $340 million to $380 million at the time of adoption. The allocated value to miles earned through travel will offset passenger revenue during the period they are issued, rather than recorded using the incremental cost approach. As the program is growing significantly, the Company expects revenue recognized under Topic 606 will be less on an annual basis than current accounting practice.

The adoption of the new standard is also expected to result in a change in income statement classification of the majority of ancillary revenues from Other revenue to Passenger revenue. This will affect common industry metrics, such as PRASM and RASM. Certain commission revenue from interline arrangements that were previously offset against related expense will now be classified as Other revenue, which will impact RASM and CASM. Unused ticket revenue that was previously recorded at the time of expiration will now be recorded at the original departure date if that ticket has not been changed or refunded prior to that date, based on estimates of expected expiration. This concept is referred to as ticket breakage. The Company estimates the change in ticket breakage methodology will not have a significant impact on the statements of operations, but will decrease air traffic liability by approximately $70 million to $80 million.

The Company continues to evaluate and model the full impact of the standard and will apply the full retrospective transition method. The overall impact to equity as of the beginning of the retroactive reporting period, including the changes discussed above, as well as other less material changes, is expected to be between $160 million and $190 million.

9




In February 2016, the FASB issued ASU 2016-02, "Leases" (Topic 842), which requires lessees to recognize assets and liabilities for leases currently classified as operating leases. Under the new standard, a lessee will recognize a liability on the balance sheet representing the lease payments owed, and a right-of-use-asset representing its right to use the underlying asset for the lease term. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election not to recognize lease assets and lease liabilities. At this time, the Company believes the most significant impact to the financial statements will relate to the recording of a right-of-use asset associated with leased aircraft. Other leases, including airports and real estate, equipment, software and other miscellaneous leases continue to be assessed for impact of the ASU. The new standard is effective for the Company on January 1, 2019. Early adoption of the standard is permitted. The Company has determined that it will not early adopt the standard.

In March 2016, the FASB issued ASU 2016-09, "Compensation—Stock Compensation" (Topic 718), which simplifies several aspects of accounting for employee share-based payment awards, including the accounting for income taxes, forfeitures and statutory tax withholding requirements, as well as classification in the statement of cash flows. The ASU was adopted prospectively as of January 1, 2017. Prior periods have not been adjusted. The adoption of the standard did not have a material impact on the Company's statements of operations or financial position.

In January 2017, the FASB issued ASU 2017-04, "Intangibles—Goodwill and Other" (Topic 350), which eliminates step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. The ASU is effective for the Company beginning January 1, 2019. Early adoption of the standard is permitted. Beginning in fiscal 2017, the Company will be required to perform an impairment test for goodwill arising from its acquisition of Virgin America and has adopted the standard effective January 1, 2017.

In March 2017, the FASB issued ASU 2017-07, "Compensation—Retirement Benefits" (Topic 715), which will require the Company to present the service cost component of net periodic benefit cost as Wages and benefits in the statements of operations. All other components of net periodic benefit cost will be required to be presented in Nonoperating income (expense) in the statements of operations. These components will not be eligible for capitalization in assets.  The ASU is effective for the Company beginning January 1, 2018. Changes to the statements of operations under the ASU are applicable retrospectively. The adoption of this standard will have no impact on Income before income tax or Net income for the periods subject to retrospective reclassification. See Note 6 for the current components of the Company's net periodic benefit costs.

In August 2017, the FASB issued ASU 2017-12, "Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities." The ASU expands the activities that qualify for hedge accounting and simplifies the rules for reporting hedging relationships. The ASU is effective for the Company beginning January 1, 2019. Early adoption is permitted. The Company is currently evaluating the impact and has not yet determined whether it will early adopt.

NOTE 2. ACQUISITION OF VIRGIN AMERICA

Virgin America

On December 14, 2016, the Company acquired 100% of the outstanding common shares and voting interest of Virgin America for $57 per share, or total cash consideration of $2.6 billion. Virgin America offers scheduled air transportation throughout the United States and Mexico primarily from its hub cities of Los Angeles, San Francisco and, to a lesser extent, Dallas Love Field, to other major business and leisure destinations in North America. The Company believes the acquisition of Virgin America will provide broader national reach and position it to better serve guests living on the West Coast. The combined airline has approximately 1,200 daily departures and leverages Alaska's strength in the Pacific Northwest with Virgin America's strength in California. The Company believes that combining loyalty programs and networks will provide greater benefits for its guests and expand its international partner portfolio, giving guests an even more expansive global reach.

Merger-related costs

The Company incurred pretax merger-related costs of $24 million and $22 million for the three months ended September 30, 2017 and 2016, respectively, and $88 million and $36 million for the nine months ended September 30, 2017 and 2016, respectively. Costs classified as merger-related are directly attributable to merger activities and are recorded as "Special items—merger-related costs" within the statements of operations. The Company expects to continue to incur merger-related costs in the future as the integration continues.




10



Fair values of the assets acquired and the liabilities assumed

The transaction has been accounted for as a business combination using the acquisition method of accounting, which requires, among other things, assets acquired and liabilities assumed to be recognized on the balance sheet at their fair values as of the acquisition date. As of September 30, 2017 the fair values of property and equipment and certain liabilities, included in other accrued liabilities and other liabilities, goodwill, intangible assets and deferred income taxes have been prepared on a preliminary basis and are subject to further adjustments as the Company completes its analysis. There were no significant fair value adjustments made during the three and nine months ended September 30, 2017. The Company will finalize the amounts recognized by December 14, 2017.

Fair values of the assets acquired and the liabilities assumed as of the acquisition date of December 14, 2016, at September 30, 2017 and December 31, 2016 were as follows (in millions):
 
September 30, 2017
 
December 31, 2016
Cash and cash equivalents
$
645

 
$
645

Receivables
54

 
44

Prepaid expenses and other current assets
18

 
16

Property and equipment—provisional
561

 
560

Intangible assets—provisional
141

 
143

Goodwill—provisional
1,934

 
1,934

Other assets
89

 
84

Total assets
3,442

 
3,426

 

 
 
Accounts payable
22

 
22

Accrued wages, vacation and payroll taxes
54

 
51

Air traffic liabilities
172

 
172

Other accrued liabilities—provisional
197

 
196

Current portion of long-term debt
125

 
125

Long-term debt, net of current portion
360

 
360

Deferred income taxes—provisional
(307
)
 
(304
)
Deferred revenue
126

 
126

Other liabilities—provisional
97

 
82

Total liabilities
846

 
830

 

 
 
Total purchase price
$
2,596

 
$
2,596


NOTE 3. FAIR VALUE MEASUREMENTS

In determining fair value, there is a three-level hierarchy based on the reliability of the inputs used. Level 1 refers to fair values based on quoted prices in active markets for identical assets or liabilities. Level 2 refers to fair values estimated using significant other observable inputs and Level 3 refers to fair values estimated using significant unobservable inputs.

11



Fair Value of Financial Instruments on a Recurring Basis

As of September 30, 2017, total cost basis for all marketable securities was $1.6 billion. There were no significant differences between the cost basis and fair value of any individual class of marketable securities.

Fair values of financial instruments on the consolidated balance sheet (in millions):
September 30, 2017
Level 1
 
Level 2
 
Total
Assets
 
 
 
 
 
Marketable securities
 
 
 
 
 
U.S. government and agency securities
$
359

 
$

 
$
359

Foreign government bonds

 
48

 
48

Asset-backed securities

 
232

 
232

Mortgage-backed securities

 
113

 
113

Corporate notes and bonds

 
828

 
828

Municipal securities

 
16

 
16

Total Marketable securities
359

 
1,237

 
1,596

Derivative instruments
 
 
 
 
 
Fuel hedge call options

 
10

 
10

Interest rate swap agreements

 
8

 
8

Total Assets
359

 
1,255

 
1,614

 
 
 
 
 
 
Liabilities
 
 
 
 
 
Derivative instruments
 
 
 
 
 
Interest rate swap agreements

 
(11
)
 
(11
)
Total Liabilities

 
(11
)
 
(11
)
December 31, 2016
Level 1
 
Level 2
 
Total
Assets
 
 
 
 
 
Marketable securities
 
 
 
 
 
U.S. government and agency securities
$
287

 
$

 
$
287

Foreign government bonds

 
36

 
36

Asset-backed securities

 
138

 
138

Mortgage-backed securities

 
89

 
89

Corporate notes and bonds

 
691

 
691

Municipal securities

 
11

 
11

Total Marketable securities
287

 
965

 
1,252

Derivative instruments
 
 
 
 
 
Fuel hedge call options

 
20

 
20

Total Assets
287

 
985

 
1,272

 
 
 
 
 
 
Liabilities
 
 
 
 
 
Derivative instruments
 
 
 
 
 
Interest rate swap agreements

 
(5
)
 
(5
)
Total Liabilities

 
(5
)
 
(5
)

The Company uses the market and income approach to determine the fair value of marketable securities. U.S. government securities are Level 1 as the fair value is based on quoted prices in active markets. Foreign government bonds, asset-backed securities, mortgage-backed securities, corporate notes and bonds, and municipal securities are Level 2 as the fair value is based on standard valuation models that are calculated based on observable inputs such as quoted interest rates, yield curves, credit ratings of the security and other observable market information.


12



The Company uses the market approach and the income approach to determine the fair value of derivative instruments. The fair value for fuel hedge call options is determined utilizing an option pricing model based on inputs that are readily available in active markets or can be derived from information available in active markets. In addition, the fair value considers the exposure to credit losses in the event of non-performance by counterparties. Interest rate swap agreements are Level 2 as the fair value of these contracts is determined based on the difference between the fixed interest rate in the agreements and the observable LIBOR-based interest forward rates at period end multiplied by the total notional value.

Activity and Maturities for Marketable Securities

Activity for marketable securities (in millions):  
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Proceeds from sales and maturities
$
528

 
$
280

 
$
1,069

 
$
638


Maturities for marketable securities (in millions):
September 30, 2017
Cost Basis
 
Fair Value
Due in one year or less
$
193

 
$
193

Due after one year through five years
1,367

 
1,367

Due after five years through 10 years
36

 
36

Due after 10 years

 

Total
$
1,596

 
$
1,596


Management does not believe any unrealized losses represent other-than-temporary impairments based on its evaluation of available information as of September 30, 2017.

Fair Value of Other Financial Instruments

The Company uses the following methods and assumptions to determine the fair value of financial instruments that are not recognized at fair value as described below.

Cash and Cash Equivalents: Carried at amortized cost, which approximates fair value.

Debt: The carrying amount of the Company's variable-rate debt approximates fair value. For fixed-rate debt, the Company uses the income approach to determine the estimated fair value, calculated as the sum of future cash flows discounted at borrowing rates for comparable debt over the weighted life of the outstanding debt. The estimated fair value of the fixed-rate debt is Level 3 as certain inputs used are unobservable.

Fixed-rate debt that is not carried at fair value on the consolidated balance sheet and the estimated fair value of long-term fixed-rate debt is as follows (in millions):
 
September 30, 2017
 
December 31, 2016
Carrying amount
$
1,024

 
$
1,179

Fair value
1,034

 
1,199


Assets and Liabilities Measured at Fair Value on Nonrecurring Basis

Certain assets and liabilities are recognized or disclosed at fair value on a nonrecurring basis, including property, plant and equipment, goodwill, and intangible assets. These assets are subject to fair valuation when there is evidence of impairment. No impairment was recognized in the three and nine months ended September 30, 2017 or September 30, 2016.


13



NOTE 4. FREQUENT FLYER PROGRAMS

Frequent flyer program deferred revenue and liabilities included in the consolidated balance sheets (in millions):
 
September 30, 2017
 
December 31, 2016
Current Liabilities:
 
 
 
Other accrued liabilities
$
509

 
$
484

Other Liabilities and Credits:
 
 
 
Deferred revenue
682

 
638

Other liabilities
24

 
21

Total
$
1,215

 
$
1,143

 
Frequent flyer program revenue included in the consolidated statements of operations (in millions):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Passenger revenues
$
94

 
$
73

 
$
276

 
$
215

Other—net revenues
122

 
107

 
369

 
318

Total
$
216

 
$
180

 
$
645

 
$
533


NOTE 5. LONG-TERM DEBT
 
Long-term debt obligations on the consolidated balance sheet (in millions):
 
September 30, 2017
 
December 31, 2016
Fixed-rate notes payable due through 2028
$
1,024

 
$
1,179

Variable-rate notes payable due through 2028
1,693

 
1,803

Less debt issuance costs
(16
)
 
(18
)
Total debt
2,701

 
2,964

Less current portion
334

 
319

Long-term debt, less current portion
$
2,367

 
$
2,645

 
 
 
 
Weighted-average fixed-interest rate
4.3
%
 
4.4
%
Weighted-average variable-interest rate
2.6
%
 
2.4
%

During the nine months ended September 30, 2017, the Company made debt payments of $265 million.

At September 30, 2017, long-term debt principal payments for the next five years and thereafter are as follows (in millions):
 
Total
Remainder of 2017
$
55

2018
350

2019
422

2020
449

2021
422

Thereafter
1,016

Total
$
2,714

 

14



Bank Lines of Credit
 
The Company has three credit facilities with availability totaling $475 million. All three facilities have variable interest rates based on LIBOR plus a specified margin. One credit facility increased from $100 million to $250 million in June 2017. It expires in June 2021 and is secured by aircraft. The second credit facility increased from $52 million to $75 million in September 2017. It expires in September 2018 with a mechanism for annual renewal and is secured by aircraft. The third credit facility increased from $100 million to $150 million in March 2017. It expires in March 2022 and is secured by certain accounts receivable, spare engines, spare parts and ground service equipment. The Company has secured letters of credit against the $75 million facility, but has no plans to borrow using either of the two other facilities. All three credit facilities have a requirement to maintain a minimum unrestricted cash and marketable securities balance of $500 million. The Company is in compliance with this covenant at September 30, 2017.

NOTE 6. EMPLOYEE BENEFIT PLANS

Net periodic benefit costs for the qualified defined-benefit plans included the following components (in millions): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Service cost
$
10

 
$
9

 
$
30

 
$
27

Interest cost
19

 
18

 
55

 
55

Expected return on assets
(27
)
 
(27
)
 
(80
)
 
(81
)
Amortization of prior service cost (credit)
(1
)
 
(1
)
 
(1
)
 
(1
)
Recognized actuarial loss (gain)
7

 
7

 
20

 
19

Total
$
8

 
$
6

 
$
24

 
$
19


The Company contributed $15 million to the defined-benefit pension plan during the three months ended September 30, 2017.

NOTE 7. COMMITMENTS AND CONTINGENCIES

Future minimum payments for commitments as of September 30, 2017 (in millions):
 
Aircraft Leases
 
Facility Leases
 
Aircraft Purchase Commitments
 
Capacity Purchase Agreements (a)
 
Aircraft Maintenance Deposits
 
Aircraft Maintenance and Parts Management
Remainder of 2017
$
77

 
$
34

 
$
168

 
$
21

 
$
15

 
$
8

2018
342

 
73

 
956

 
118

 
61

 
32

2019
344

 
65

 
806

 
151

 
65

 
35

2020
317

 
63

 
352

 
158

 
68

 
37

2021
280

 
55

 
273

 
165

 
63

 
40

Thereafter
1,263

 
204

 
355

 
1,250

 
90

 

Total
$
2,623

 
$
494

 
$
2,910

 
$
1,863

 
$
362

 
$
152

(a)
Includes all non-aircraft lease costs associated with capacity purchase agreements.

Lease Commitments

Aircraft lease commitments include future obligations for all of the Company's operating airlines—Alaska, Virgin America and Horizon, as well as aircraft leases operated by third-parties. At September 30, 2017, the Company had lease contracts for 10 Boeing 737 ("B737") aircraft, 55 Airbus aircraft, 15 Bombardier Q400 aircraft, and 21 Embraer 175 ("E175") with SkyWest Airlines, Inc. ("SkyWest"). The Company has an additional eight scheduled lease deliveries of A321neo aircraft through 2018, as well as 14 scheduled lease deliveries of E175 aircraft through 2018 to be flown by Skywest. All lease contracts have remaining non-cancelable lease terms ranging from 2017 to 2030. The Company has the option to increase capacity flown by SkyWest with eight additional E175 aircraft deliveries in 2020. Options to lease are not reflected in the commitments table above.


15



Facility lease commitments primarily include airport and terminal facilities and building leases. Total rent expense for aircraft and facility leases was $145 million and $82 million for the three months ended September 30, 2017 and 2016, and $406 million and $226 million for the nine months ended September 30, 2017 and 2016.

Aircraft Purchase Commitments
 
Aircraft purchase commitments include non-cancelable contractual commitments for aircraft and engines. As of September 30, 2017, the Company had commitments to purchase 48 B737 aircraft (16 B737 NextGen aircraft and 32 B737 MAX aircraft, with deliveries in the remainder of 2017 through 2023) and 23 E175 aircraft with deliveries in 2018 through 2019, which reflects Horizon's deferral of three E175 aircraft from 2017 to 2018. The Company also has cancelable purchase commitments for 30 Airbus A320neo aircraft with deliveries from 2020 through 2022. In addition, the Company has options to purchase 37 B737 aircraft and 30 E175 aircraft. The cancelable purchase commitments and option payments are not reflected in the table above.

Capacity Purchase Agreements ("CPAs")
 
At September 30, 2017, Alaska had CPAs with three carriers, including the Company's wholly-owned subsidiary, Horizon. Horizon sells 100% of its capacity to Alaska under a CPA with Alaska. In addition, Alaska has CPAs with SkyWest to fly certain routes in the Lower 48 and Canada and with Peninsula Airways, Inc. ("PenAir") to fly certain routes in the state of Alaska. Under these agreements, Alaska pays the carriers an amount which is based on a determination of their cost of operating those flights and other factors intended to approximate market rates for those services. Future payments (excluding Horizon) are based on minimum levels of flying by the third-party carriers, which could differ materially due to variable payments based on actual levels of flying and certain costs associated with operating flights such as fuel.

Aircraft Maintenance Deposits

Virgin America is contractually required to make maintenance deposit payments to aircraft lessors, which represent maintenance reserves made solely to collateralize the lessor for future maintenance events should the Company not perform required maintenance. Most lease agreements provide that maintenance reserves are reimbursable upon completion of the major maintenance event in an amount equal to the lesser of (i) the amount qualified for reimbursement from maintenance reserves held by the lessor associated with the specific major maintenance event or (ii) the qualifying costs related to the specific major maintenance event.

Aircraft Maintenance and Parts Management

Through its acquisition of Virgin America, the Company has a separate maintenance-cost-per-hour contract for management and repair of certain rotable parts to support airframe and engine maintenance and repair. This agreement requires monthly payments based upon utilization, such as flight hours, cycles and age of the aircraft, and, in turn, the agreement transfers certain risks to the third-party service provider. There are minimum payments under this agreement. Accordingly, payments could differ materially based on actual aircraft utilization.

Subsequent to September 30, 2017, Alaska entered into a similar contract for maintenance on its B737-800 aircraft engines. Payments under this agreement are not reflected in the table above.

Contingencies

The Company is a party to routine litigation matters incidental to its business and with respect to which no material liability is expected. Liabilities for litigation related contingencies are recorded when a loss is determined to be probable and estimable.

In 2015, three flight attendants filed a class action lawsuit seeking to represent all Virgin America flight attendants for damages based on alleged violations of California and City of San Francisco wage and hour laws. Plaintiffs received class certification in November 2016. Virgin America filed a motion for summary judgment seeking to dismiss all claims on various federal preemption grounds. In January 2017, the Court denied in part and granted in part Virgin America’s motion. The Company believes the claims in this case are without factual and legal merit and intends to defend this lawsuit.

Management believes the ultimate disposition of these matters is not likely to materially affect the Company's financial position or results of operations. This forward-looking statement is based on management's current understanding of the relevant law and facts, and it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of arbitrators, judges and juries.

16




NOTE 8. SHAREHOLDERS' EQUITY

Dividends

During the three months ended September 30, 2017, the Company declared and paid cash dividends of $0.30 per share, or $37 million. During the nine months ended September 30, 2017, the Company declared and paid cash dividends of $0.90 per share, or $111 million.

Common Stock Repurchase

In August 2015, the Board of Directors authorized a $1 billion share repurchase program. The program was paused in the second quarter of 2016 in anticipation of the acquisition of Virgin America. The Company resumed the share repurchase program in the second quarter of 2017. As of September 30, 2017, the Company has repurchased 4.7 million shares for $363 million under this program. Subsequent to September 30, 2017, the Company repurchased an additional 369,182 shares for $25 million.
Share repurchase activity (in millions, except share amounts):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
 
Shares
 
Amount
 
Shares
 
Amount
 
Shares
 
Amount
 
Shares
 
Amount
2015 Repurchase Program—$1 billion
355,415

 
$
28

 

 
$

 
612,095

 
$
50

 
2,594,809

 
$
193


Accumulated Other Comprehensive Loss
 
Components of accumulated other comprehensive loss, net of tax (in millions):
 
September 30, 2017
 
December 31, 2016
Marketable securities
$

 
$
(3
)
Employee benefit plans
(287
)
 
(299
)
Interest rate derivatives
(2
)
 
(3
)
Total
$
(289
)
 
$
(305
)

Earnings Per Share ("EPS")

Diluted EPS is calculated by dividing net income by the average number of common shares outstanding plus the number of additional common shares that would have been outstanding assuming the exercise of in-the-money stock options and restricted stock units, using the treasury-stock method. For the three and nine months ended September 30, 2017 and 2016, anti-dilutive shares excluded from the calculation of EPS were not material.

NOTE 9. OPERATING SEGMENT INFORMATION

Alaska Air Group has three operating airlines—Alaska, Virgin America and Horizon. Each is regulated by the U.S. Department of Transportation’s Federal Aviation Administration. Alaska has CPAs for regional capacity with Horizon, as well as with third-party carriers SkyWest and PenAir, under which Alaska receives all passenger revenues.

Under U.S. GAAP, operating segments are defined as components of a business for which there is discrete financial information that is regularly assessed by the Chief Operating Decision Maker ("CODM") in making resource allocation decisions. Financial performance for the operating airlines and CPAs is managed and reviewed by the Company's CODM as part of three reportable operating segments:
 
Mainline - includes Alaska's and Virgin America’s scheduled air transportation for passengers and cargo throughout the U.S., and in parts of Canada, Mexico, Costa Rica and Cuba.

17



Regional - includes Horizon's and other third-party carriers’ scheduled air transportation for passengers across a shorter distance network within the U.S. under CPAs. This segment includes the actual revenues and expenses associated with regional flying, as well as an allocation of corporate overhead incurred by Air Group on behalf of the regional operations.
Horizon - includes the capacity sold to Alaska under CPA. Expenses include those typically borne by regional airlines such as crew costs, ownership costs and maintenance costs.

The CODM makes resource allocation decisions for these reporting segments based on flight profitability data, aircraft type, route economics and other financial information. The "Consolidating and Other" column reflects parent company activity, consolidating entries and other immaterial business units of the company. The “Air Group Adjusted” column represents a non-GAAP measure that is used by the Company CODM to evaluate performance and allocate resources. Adjustments are further explained below in reconciling to consolidated GAAP results.

18



Operating segment information is as follows (in millions):
 
Three Months Ended September 30, 2017
 
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger
 
 
 
 
 
 
 
 
 
 
 
 
 
Mainline
$
1,562

 
$

 
$

 
$

 
$
1,562

 
$

 
$
1,562

Regional

 
262

 

 

 
262

 

 
262

Total passenger revenues
1,562

 
262

 

 

 
1,824

 

 
1,824

CPA revenues

 

 
112

 
(112
)
 

 

 

Freight and mail
30

 
1

 
1

 

 
32

 

 
32

Other—net
242

 
21

 
1

 

 
264

 

 
264

Total operating revenues
1,834

 
284

 
114

 
(112
)
 
2,120

 

 
2,120

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
1,077

 
219

 
105

 
(112
)
 
1,289

 
24

 
1,313

Economic fuel
328

 
45

 

 

 
373

 
(5
)
 
368

Total operating expenses
1,405

 
264

 
105

 
(112
)
 
1,662

 
19

 
1,681

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
11

 

 

 
(2
)
 
9

 

 
9

Interest expense
(23
)
 

 
(4
)
 
1

 
(26
)
 

 
(26
)
Other
5

 

 

 

 
5

 

 
5

Total Nonoperating income (expense)
(7
)
 

 
(4
)
 
(1
)
 
(12
)
 

 
(12
)
Income (loss) before income tax
$
422

 
$
20

 
$
5

 
$
(1
)
 
$
446

 
$
(19
)
 
$
427

 
Three Months Ended September 30, 2016
 
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger
 
 
 
 
 
 
 
 
 
 
 
 
 
Mainline
$
1,073

 
$

 
$

 
$

 
$
1,073

 
$

 
$
1,073

Regional

 
249

 

 

 
249

 

 
249

Total passenger revenues
1,073

 
249

 

 

 
1,322

 

 
1,322

CPA revenues

 

 
109

 
(109
)
 

 

 

Freight and mail
30

 
1

 

 

 
31

 

 
31

Other—net
190

 
21

 
1

 
1

 
213

 

 
213

Total operating revenues
1,293

 
271

 
110

 
(108
)
 
1,566

 

 
1,566

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
727

 
202

 
99

 
(109
)
 
919

 
22

 
941

Economic fuel
188

 
34

 

 

 
222

 
3

 
225

Total operating expenses
915

 
236

 
99

 
(109
)
 
1,141

 
25

 
1,166

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
7

 

 

 

 
7

 

 
7

Interest expense
(7
)
 

 
(2
)
 
(2
)
 
(11
)
 

 
(11
)
Other
5

 

 

 
1

 
6

 

 
6

Total Nonoperating income (expense)
5

 

 
(2
)
 
(1
)
 
2

 

 
2

Income (loss) before income tax
$
383

 
$
35

 
$
9

 
$

 
$
427

 
$
(25
)
 
$
402



19



 
Nine Months Ended September 30, 2017
 
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger
 
 
 
 
 
 
 
 
 
 
 
 
 
Mainline
$
4,390

 
$

 
$

 
$

 
$
4,390

 
$

 
$
4,390

Regional

 
725

 

 

 
725

 

 
725

Total passenger revenues
4,390

 
725

 

 

 
5,115

 

 
5,115

CPA revenues

 

 
317

 
(317
)
 

 

 

Freight and mail
84

 
3

 
1

 

 
88

 

 
88

Other—net
708

 
57

 
3

 

 
768

 

 
768

Total operating revenues
5,182

 
785

 
321

 
(317
)
 
5,971

 

 
5,971

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
3,101

 
625

 
324

 
(316
)
 
3,734

 
88

 
3,822

Economic fuel
924

 
120

 

 

 
1,044

 
7

 
1,051

Total operating expenses
4,025

 
745

 
324

 
(316
)
 
4,778

 
95

 
4,873

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
27

 

 

 
(2
)
 
25

 

 
25

Interest expense
(68
)
 

 
(9
)
 

 
(77
)
 

 
(77
)
Other
11

 

 
1

 

 
12

 

 
12

Total Nonoperating income (expense)
(30
)
 

 
(8
)
 
(2
)
 
(40
)
 

 
(40
)
Income (loss) before income tax
1,127

 
40

 
(11
)
 
(3
)
 
1,153

 
(95
)
 
1,058

 
Nine Months Ended September 30, 2016
 
Mainline
 
Regional
 
Horizon
 
Consolidating & Other(a)
 
Air Group Adjusted(b)
 
Special Items(c)
 
Consolidated
Operating revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
Passenger
 
 
 
 
 
 
 
 
 
 
 
 
 
Mainline
$
3,036

 
$

 
$

 
$

 
$
3,036

 
$

 
$
3,036

Regional

 
682

 

 

 
682

 

 
682

Total passenger revenues
3,036

 
682

 

 

 
3,718

 

 
3,718

CPA revenues

 

 
322

 
(322
)
 

 

 

Freight and mail
79

 
3

 

 

 
82

 

 
82

Other—net
546

 
57

 
3

 
1

 
607

 

 
607

Total operating revenues
3,661

 
742

 
325

 
(321
)
 
4,407

 

 
4,407

Operating expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses, excluding fuel
2,107

 
580

 
305

 
(322
)
 
2,670

 
36

 
2,706

Economic fuel
512

 
90

 

 

 
602

 
(9
)
 
593

Total operating expenses
2,619

 
670

 
305

 
(322
)
 
3,272

 
27

 
3,299

Nonoperating income (expense)
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
19

 

 
1

 

 
20

 

 
20

Interest expense
(23
)
 

 
(7
)
 
(3
)
 
(33
)
 

 
(33
)
Other
15

 

 

 
4

 
19

 

 
19

Total Nonoperating income (expense)
11

 

 
(6
)
 
1

 
6

 

 
6

Income (loss) before income tax
1,053

 
72

 
14

 
2

 
1,141

 
(27
)
 
1,114

(a)
Includes consolidating entries, Parent Company, McGee Air Services, and other immaterial business units.
(b)
The Air Group Adjusted column represents the financial information that is reviewed by management to assess performance of operations and determine capital allocations and does not include certain income and charges.
(c)
Includes merger-related costs and mark-to-market fuel-hedge accounting charges.



20



Total assets were as follows (in millions):
 
September 30, 2017
 
December 31, 2016
Mainline
$
16,382

 
$
15,260

Horizon
914

 
690

Consolidating & Other
(6,557
)
 
(5,988
)
Consolidated
$
10,739

 
$
9,962


NOTE 10. SUBSEQUENT EVENTS

On October 30, 2017, the Company received a final decision from a third-party arbitration panel on increased wage rates and retirement contributions for pilots of Alaska Airlines and Virgin America.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
OVERVIEW
 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to help the reader understand our company, segment operations and present business environment. MD&A is provided as a supplement to – and should be read in conjunction with – our consolidated financial statements and the accompanying notes. All statements in the following discussion that are not statements of historical information or descriptions of current accounting policy are forward-looking statements. Please consider our forward-looking statements in light of the risks referred to in this report’s introductory cautionary note and the risks mentioned in "Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2016. This overview summarizes the MD&A, which includes the following sections:
 
Third Quarter Review—highlights from the third quarter of 2017 outlining some of the major events that happened during the period and how they affected our financial performance.
 
Results of Operations—an in-depth analysis of our revenues by segment and our expenses from a consolidated perspective for the three and nine months ended September 30, 2017. To the extent material to the understanding of segment profitability, we more fully describe the segment expenses per financial statement line item. Financial and statistical data is also included here. As Virgin America was acquired on December 14, 2016, its financial and operational results are reflected in the three and nine months ended September 30, 2017 but not in the comparative prior period. However, for comparability purposes, we have added "Combined Comparative" information for the prior year, which is more fully described below. This section includes forward-looking statements regarding our view of the remainder of 2017
  
Liquidity and Capital Resources—an overview of our financial position, analysis of cash flows, and relevant contractual obligations and commitments.

THIRD QUARTER REVIEW

Our consolidated pretax income was $427 million during the third quarter of 2017, compared to $402 million in the third quarter of 2016. The increase in pretax income of $25 million was primarily driven by an increase in revenues of $554 million, partially offset by a $372 million increase in non-fuel expense and a $143 million increase in fuel expense.

As we completed the acquisition of Virgin America on December 14, 2016, our results of operations for the three months ended September 30, 2017 include those of Virgin America and the impact of purchase accounting. Our results of operations for the three months ended September 30, 2016 do not include those of Virgin America.

See “Results of Operations” below for further discussion of changes in revenues and operating expenses and our reconciliation of non-GAAP measures to the most directly comparable GAAP measure.


21



Operations Performance

During the third quarter of 2017, our on-time performance was 85.0% for Alaska, 73.3% for Virgin America and 78.6% for Horizon. Air traffic control issues and airport runway construction have negatively impacted our on-time performance, particularly in Seattle, Los Angeles, and San Francisco where we have a large concentration of flights. While these challenges negatively impact all airlines that operate in the affected markets, we plan to continue working to mitigate the impact in 2018. Additionally, pilot shortages at Horizon resulted in approximately 1,300 canceled flights and a reduction in scheduled service into the fourth quarter and early 2018. As a result of these adjustments to the flight schedule and our recent pilot hiring efforts, we anticipate that operational headwinds will be behind us by year end.

New Markets

We launched 20 new routes during the quarter, which is the most we have ever launched in one quarter. In total, we have announced approximately 40 new markets since the acquisition of Virgin America as we begin to realize the network and revenue synergies from bringing our two airlines together.

Shareholder Return

During the third quarter of 2017, we paid cash dividends of $37 million and repurchased 355,415 shares for $28 million. Subsequent to September 30, 2017, we repurchased an additional 369,182 shares for $25 million.

Labor Update

Each of our represented groups, other than aircraft technicians, has been certified by the National Mediation Board as having single carrier status which allows for Virgin America teammates to be represented by unions that currently represent Alaska's work groups and enables work toward single collective bargaining agreements.

We were not able to come to an agreement during negotiations or mediation with our pilots, so Alaska and the Air Line Pilots Association presented their respective positions to a third-party arbitration panel during the third quarter. On October 30, 2017, we received a decision from the arbitration panel on new wage rates and retirement contributions for pilots of Alaska Airlines and Virgin America. This award is binding and is effective November 1, 2017. The wage rates equate to an approximately 33% increase for top-of-scale captains at Virgin America and approximately 16% for top-of-scale captains at Alaska Airlines with a 3% increase in rates effective April 1, 2018 and April 1, 2019.

The decision increases contribution rates for pilots in defined contribution only retirement plans from 13.5% at Alaska and 12% at Virgin America to 15% effective immediately and to 15.5% effective January 1, 2019.

We estimate the impact of this new contract over the status quo to be an incremental cost of approximately $24 million for the remainder of 2017, $150 million in 2018, and $180 million in 2019. Over the life of the contract, the average annualized impact is approximately $160 million to $165 million compared to the $140 million estimate of our proposal at arbitration.

Outlook

We completed the acquisition of Virgin America on December 14, 2016, positioning us as the fifth largest airline in the U.S. with a unique ability to serve West Coast travelers. The acquisition of Virgin America provides a platform for growth of our low-fare, premium product, a powerful West Coast network for our guests and enhanced international partnerships. Additionally, Virgin America provides access to constrained gates, particularly on the East Coast, creating increased utility for our guests.


22



We are focused on the successful integration of Virgin America, which includes obtaining a Single Operating Certificate ("SOC") in early 2018 and a single Passenger Service System ("PSS"), or more commonly known as the reservations system, in the second quarter of 2018. The single PSS has been accelerated from later in 2018 and is expected to bring forward approximately $20 million of revenue synergies into 2018. Our priority throughout the integration process is to run our airlines well and maintain a safe, compliant and low-cost operation, while providing a remarkable experience for our guests. The combined airline will adopt Alaska’s name and logo, retiring the Virgin America name sometime in late 2019. Over the next several months we will focus on enhancing our guest experience and will adopt certain aspects of Virgin America’s brand elements, including enhanced inflight connectivity, inflight entertainment content, mood lighting, music and the relentless desire to make flying a different experience for guests. We will continue to enhance our fresh, healthy, West Coast-inspired onboard food and beverage menus and expect our First Class guests on Alaska will be able to pre-select meals before they fly starting this year. Alaska’s main cabin guests will also be able to pre-pay for their meals in advance in 2018, with Airbus flights soon to follow. Our onboard Free Chat service and free entertainment was added to Airbus flights in August 2017. We also plan to expand the premium class offering on our Airbus fleet beginning in 2018 and have our entire fleet equipped with high-speed satellite Wi-Fi by early 2020. 

In January 2018, Alaska Mileage Plan™ will become our sole loyalty program, offering guests more rewards, an expansive global partner network and the only major airline loyalty program that still rewards a mile flown with a mile earned on Alaska and Virgin America flights. 

We intend to minimize any disruption to our guests during the integration efforts by being transparent about the progress we are making and how the changes may affect them. Employee engagement throughout the integration will remain a top priority as well, ensuring that employees remain engaged, informed and excited about the changes. We remain focused on capturing the value and synergies created by combining these two great airlines.

Currently, we expect to grow our combined network capacity in 2017 by 7.2%. The growth rate compares 2017 system-wide capacity to historical Air Group and Virgin America combined capacity in 2016. Current schedules indicate competitive capacity will increase by approximately 5% in the fourth quarter of 2017, and approximately 9% in the first quarter of 2018. We believe that our product, our operation, our low-cost structure, our engaged employees, our award-winning service, and our award-winning Mileage Plan™ program, combined with our strong balance sheet, give us the ability to compete effectively in our markets.

Our current expectations for capacity and CASM excluding fuel and special items for the remainder of 2017 are summarized below. These expectations are from a "Combined Comparative" perspective, calculated as the sum of historical results for Alaska Air Group and Virgin America for the 2016 comparative periods:
 
Forecast
Q4 2017
 
Q4 2016 Combined Comparative(a)
% Change
Capacity (ASMs in millions)
15,950 - 16,000
 
14,404
~ 11%
Cost per ASM excluding fuel and special items (cents) 
8.50¢ - 8.55¢
 
8.25¢
~ 3%
Fuel gallons (millions)
204
 
184
~ 11%
Economic fuel cost per gallon
$1.95
 
$1.66
~ 17.5%
 
Forecast
Full Year 2017
 
2016 Combined Comparative(a)
% Change
Capacity (ASMs in millions)
62,130 - 62,160
 
57,953
~ 7.2%
Cost per ASM excluding fuel and special items (cents)
8.19¢ - 8.21¢
 
8.04¢
~ 2%
Fuel gallons (millions)
795
 
739
~ 7.5%
Economic fuel cost per gallon
$1.81
 
$1.54
~ 17.5%
(a) 
Refer to our Investor Update issued on October 25, 2017 on Form 8-K for further details of the calculation of the three and twelve months ended December 31, 2016 combined data.

We currently expect capacity growth of approximately 8% for the full year 2018. We expect unit costs to increase in 2018. This increase is driven by increases in pilot wages as a result of the pilot arbitration decision, a new engine services deal, our growing mix of regional flying, and continued costs associated with the integration.

RESULTS OF OPERATIONS

ADJUSTED (NON-GAAP) RESULTS AND PER-SHARE AMOUNTS

We believe disclosure of earnings excluding the impact of merger-related costs, mark-to-market gains or losses or other individual special revenues or expenses is useful information to investors because:

By excluding fuel expense and certain special items (including merger-related costs) from our unit metrics, we believe it provides management better visibility into the results of operations and our non-fuel cost initiatives. Our industry is highly competitive and is characterized by high fixed costs, so even a small reduction in non-fuel operating costs can lead to a significant improvement in operating results. In addition, we believe that all domestic carriers are similarly impacted by changes in jet fuel costs over the long run, so it is important for management (and thus investors) to understand the impact of (and trends in) company-specific cost drivers, such as labor rates and productivity, airport costs, maintenance costs, etc., which are more controllable by management.

Cost per ASM ("CASM") excluding fuel and certain special items, such as merger-related costs, is one of the most important measures used by management and by the Air Group Board of Directors in assessing quarterly and annual cost performance.

Adjusted income before income tax and CASM excluding fuel (and other items as specified in our plan documents) are important metrics for the employee incentive plan, which covers the majority of Air Group employees.

CASM excluding fuel and certain special items is a measure commonly used by industry analysts and we believe it is an important metric by which they compare our airlines to others in the industry. The measure is also the subject of frequent questions from investors.


23



Disclosure of the individual impact of certain noted items provides investors the ability to measure and monitor performance both with and without these special items. We believe that disclosing the impact of certain items, such as merger-related costs and mark-to-market hedging adjustments, is important because it provides information on significant items that are not necessarily indicative of future performance. Industry analysts and investors consistently measure our performance without these items for better comparability between periods and among other airlines.

Although we disclose our passenger unit revenues, we do not (nor are we able to) evaluate unit revenues excluding the impact that changes in fuel costs have had on ticket prices. Fuel expense represents a large percentage of our total operating expenses. Fluctuations in fuel prices often drive changes in unit revenues in the mid-to-long term. Although we believe it is useful to evaluate non-fuel unit costs for the reasons noted above, we would caution readers of these financial statements not to place undue reliance on unit costs excluding fuel as a measure or predictor of future profitability because of the significant impact of fuel costs on our business.

Although we are presenting these non-GAAP amounts for the reasons above, investors and other readers should not necessarily conclude that these amounts are non-recurring, infrequent, or unusual in nature.

24



OPERATING STATISTICS SUMMARY
As the acquisition closed on December 14, 2016, Consolidated and Mainline amounts presented below include Virgin America results for the three and nine months ended September 30, 2017 and not for the prior period.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
Change(d)
 
2017
 
2016
 
Change(d)
Consolidated Operating Statistics:(a)
 
 
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
11,645
 
9,054
 
28.6%
 
33,063
 
25,536
 
29.5%
RPMs (000,000) "traffic"
13,811
 
9,601
 
43.8%
 
39,073
 
27,569
 
41.7%
ASMs (000,000) "capacity"
16,164
 
11,212
 
44.2%
 
46,170
 
32,728
 
41.1%
Load factor
85.4%
 
85.6%
 
(0.2) pts
 
84.6%
 
84.2%
 
0.4 pts
Yield
13.21¢
 
13.77¢
 
(4.1)%
 
13.09¢
 
13.49¢
 
(3.0)%
PRASM
11.29¢
 
11.79¢
 
(4.2)%
 
11.08¢
 
11.36¢
 
(2.5)%
RASM
13.12¢
 
13.97¢
 
(6.1)%
 
12.93¢
 
13.47¢
 
(4.0)%
CASM excluding fuel and special items(b)
7.98¢
 
8.20¢
 
(2.7)%
 
8.09¢
 
8.16¢
 
(0.9)%
Economic fuel cost per gallon(b)
$1.80
 
$1.58
 
13.9%
 
$1.76
 
$1.47
 
19.7%
Fuel gallons (000,000)
207
 
140
 
47.9%
 
592
 
410
 
44.4%
ASMs per fuel gallon
78.1
 
80.1
 
(2.5)%
 
78.0
 
79.8
 
(2.3)%
Average full-time equivalent employees (FTEs)
20,743
 
14,674
 
41.4%
 
19,723
 
14,500
 
36.0%
Mainline Operating Statistics:
 
 
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
9,142
 
6,507
 
40.5%
 
25,875
 
18,432
 
40.4%
RPMs (000,000) "traffic"
12,694
 
8,595
 
47.7%
 
36,046
 
24,767
 
45.5%
ASMs (000,000) "capacity"
14,796
 
9,987
 
48.2%
 
42,398
 
29,216
 
45.1%
Load factor
85.8%
 
86.1%
 
(0.3) pts
 
85.0%
 
84.8%
 
0.2 pts
Yield
12.31¢
 
12.49¢
 
(1.4)%
 
12.18¢
 
12.26¢
 
(0.7)%
PRASM
10.56¢
 
10.75¢
 
(1.8)%
 
10.36¢
 
10.39¢
 
(0.3)%
RASM
12.40¢
 
12.96¢
 
(4.3)%
 
12.22¢
 
12.53¢
 
(2.5)%
CASM excluding fuel and special items(b)
7.28¢
 
7.28¢
 
—%
 
7.32¢
 
7.21¢
 
1.5%
Economic fuel cost per gallon(b)
$1.79
 
$1.57
 
14.0%
 
$1.76
 
$1.46
 
20.5%
Fuel gallons (000,000)
183
 
119
 
53.8%
 
526
 
350
 
50.3%
ASMs per fuel gallon
80.9
 
83.9
 
(3.6)%
 
80.6
 
83.5
 
(3.5)%
Average FTEs
15,862
 
11,397
 
39.2%
 
15,439
 
11,260
 
37.1%
Aircraft utilization
11.4
 
10.6
 
7.5%
 
11.1
 
10.7
 
3.7%
Average aircraft stage length
1,300
 
1,203
 
8.1%
 
1,296
 
1,218
 
6.4%
Operating fleet
218
 
154
 
64 a/c
 
218
 
154
 
64 a/c
Regional Operating Statistics:(c)
 
 
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
2,503
 
2,547
 
(1.7)%
 
7,188
 
7,105
 
1.2%
RPMs (000,000) "traffic"
1,117
 
1,006
 
11.0%
 
3,027
 
2,801
 
8.1%
ASMs (000,000) "capacity"
1,368
 
1,225
 
11.7%
 
3,772
 
3,512
 
7.4%
Load factor
81.7%
 
82.1%
 
(0.4 pts)
 
80.2%
 
79.8%
 
0.4 pts
Yield
23.48¢
 
24.75¢
 
(5.1)%
 
23.95¢
 
24.35¢
 
(1.6)%
PRASM
19.17¢
 
20.32¢
 
(5.7)%
 
19.22¢
 
19.43¢
 
(1.1)%
Operating fleet
83
 
69
 
14 a/c
 
83
 
69
 
14 a/c
(a) 
Except for FTEs, data includes information related to third-party regional capacity purchase flying arrangements.
(b) 
See reconciliation of this non-GAAP measure to the most directly related GAAP measure in the accompanying pages.
(c) 
Data presented includes information related to flights operated by Horizon and third-party carriers.
(d) 
See Combined Comparative information in the accompanying pages for year-over-year comparisons including Virgin America.

25



COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2017 TO THREE MONTHS ENDED SEPTEMBER 30, 2016

Our consolidated net income for the three months ended September 30, 2017 was $266 million, or $2.14 per diluted share, compared to net income of $256 million, or $2.07 per diluted share, for the three months ended September 30, 2016. As the acquisition of Virgin America closed on December 14, 2016, our financial results include results of Virgin America for the three months ended September 30, 2017, but not for the comparable prior period.

Excluding the impact of merger-related costs and mark-to-market fuel hedge adjustments, our adjusted net income for the third quarter of 2017 was $278 million, or $2.24 per diluted share, compared to an adjusted net income of $272 million, or $2.20 per diluted share, in the third quarter of 2016. The following tables reconcile our adjusted net income and adjusted earnings per diluted share ("EPS") to amounts as reported in accordance with GAAP:
 
Three Months Ended September 30,
 
2017
 
2016
(in millions, except per share amounts)
Dollars
 
Diluted EPS
 
Dollars
 
Diluted EPS
Reported GAAP net income and diluted EPS
$
266

 
$
2.14

 
$
256

 
$
2.07

Mark-to-market fuel hedge adjustments
(5
)
 
(0.04
)
 
3

 
0.02

Special items—merger-related costs
24

 
0.20

 
22

 
0.18

Income tax effect on special items and fuel hedge adjustments
(7
)
 
(0.06
)
 
(9
)
 
(0.07
)
Non-GAAP adjusted net income and diluted EPS
$
278

 
$
2.24

 
$
272

 
$
2.20


CASM reconciliation is summarized below:
 
Three Months Ended September 30,
(in cents)
2017
 
2016
 
% Change
Consolidated:
 
 
 
 
 
CASM

10.40
¢
 

10.40
¢
 
 %
Less the following components:
 
 
 

 
 
Aircraft fuel, including hedging gains and losses
2.27

 
2.01

 
12.9
 %
Special items—merger-related costs
0.15

 
0.19

 
(21.1
)%
CASM excluding fuel and special items

7.98
¢
 

8.20
¢
 
(2.7
)%
 
 
 
 
 
 
Mainline:
 
 
 
 
 
CASM

9.63
¢
 

9.41
¢
 
2.3
 %
Less the following components:
 
 
 

 
 
Aircraft fuel, including hedging gains and losses
2.19

 
1.91

 
14.7
 %
Special items—merger-related costs
0.16

 
0.22

 
(27.3
)%
CASM excluding fuel and special items

7.28
¢
 

7.28
¢
 
 %

We believe that analysis of specific financial and operational results on a combined basis provides more meaningful year-over-year comparisons. The discussion below includes "Combined Comparative" results for the three months ended September 30, 2016, determined as the sum of the historical consolidated results of Air Group and of Virgin America. Virgin America's financial information has been conformed to reflect Air Group's historical financial statement presentation. This information does not purport to reflect what our financial and operational results would have been had the acquisition been consummated at the beginning of the periods presented.


26



COMBINED COMPARATIVE OPERATING STATISTICS
 
Three Months Ended September 30,
 
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
Change
Consolidated:
 
 
 
 
 
 
 
 
 
Revenue passengers (in 000)
11,645
 
9,054
 
2,175
 
11,229
 
3.7%
RPMs (in 000,000)
13,811
 
9,601
 
3,321
 
12,922
 
6.9%
ASMs (in 000,000)
16,164
 
11,212
 
3,867
 
15,079
 
7.2%
Load Factor
85.4%
 
85.6%
 
(a)
 
85.7%
 
(0.3) pts
PRASM
11.29¢
 
11.79¢
 
(a)
 
11.43¢
 
(1.2)%
RASM
13.12¢
 
13.97¢
 
(a)
 
13.34¢
 
(1.6)%
CASMex
7.98¢
 
8.20¢
 
(a)
 
7.90¢
 
1.0%
FTEs
20,743
 
14,674
 
2,888
 
17,562
 
18.1%
 
 
 
 
 
 
 
 
 
 
Mainline:
 
 
 
 
 
 
 
 
 
RPMs (in 000,000)
12,694
 
8,595
 
3,321
 
11,916
 
6.5%
ASMs (in 000,000)
14,796
 
9,987
 
3,867
 
13,854
 
6.8%
Load Factor
85.8%
 
86.1%
 
(a)
 
86.0%
 
(0.2) pts
PRASM
10.56¢
 
10.75¢
 
(a)
 
10.65¢
 
(0.8)%
(a) 
2016 Combined operating statistics have been recalculated using the combined results.

COMBINED COMPARATIVE OPERATING REVENUES

Total operating revenues increased $554 million, or 35%, during the third quarter of 2017 compared to the same period in 2016. On a Combined Comparative basis, total operating revenues increased $108 million or 5%. The changes, including the reconciliation of the impact of Virgin America on the comparative results, are summarized in the following table:
 
Three Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Passenger
 
 
 
 
 
 
 
 
 
 
 
Mainline
$
1,562

 
$
1,073

 
$
402

 
$
1,475

 
$
87

 
5.9
%
Regional
262

 
249

 

 
249

 
13

 
5.2
%
Total passenger revenue
1,824

 
1,322

 
402

 
1,724

 
100

 
5.8
%
Freight and mail
32

 
31

 

 
31

 
1

 
3.2
%
Other—net
264

 
213

 
44

 
257

 
7

 
2.7
%
Total operating revenues
$
2,120

 
$
1,566

 
$
446

 
$
2,012

 
$
108

 
5.4
%

Passenger Revenue—Mainline

On a consolidated basis, Mainline passenger revenue for the third quarter of 2017 increased by $489 million, or 46%, on a 48% increase in capacity driven by the acquisition of Virgin America, partially offset by a 2% decrease in unit revenues. On a Combined Comparative basis, Mainline passenger revenue for the third quarter of 2017 increased by 6%, due to a 7% increase in capacity, slightly offset by a 1% decrease in unit revenues compared to the combined third quarter of 2016. The increase in capacity was driven by our continued network expansion and aircraft added to our fleet since the third quarter of 2016. The decrease in PRASM was driven by decreased load factors coupled with lower ticket yields. The lower yields were impacted by our new market growth and by competitor pricing actions felt more acutely in our California markets.

Passenger Revenue—Regional

Regional passenger revenue increased 5% compared to the third quarter of 2016 primarily, driven by a 12% increase in capacity. The increase in capacity was offset by a 6% decrease in PRASM. The decrease in Regional PRASM was largely driven by growth and competitive pricing actions. The operational challenges at Horizon, due in large part to a shortage of pilot

27



s, resulted in a significant number of flight cancellations that led us to either refund or re-accommodate passengers. We estimate these cancellations resulted in lost revenues for Air Group of approximately $25 million to $30 million.

Other—Net

Other—net revenue increased $51 million, or 24%, from the third quarter of 2016. Frequent flyer revenue contributed $15 million of the increase, primarily driven by a significant increase in miles sold to our affinity credit card partner in the Mileage Plan program. The remainder of the increase was due to higher ancillary revenues. On a Combined Comparative basis, Other—net revenue increased $7 million, or 3%.

COMBINED COMPARATIVE OPERATING EXPENSES

Total operating expenses increased $515 million, or 44%, compared to the third quarter of 2016. On a Combined Comparative basis, total operating expenses increased $159 million, or 10%. We believe it is useful to summarize operating expenses as follows, which is consistent with the way expenses are reported internally and evaluated by management:
 
Three Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Fuel expense
$
368

 
$
225

 
$
81

 
$
306

 
$
62

 
20.3
%
Non-fuel expenses
1,289

 
919

 
273

 
1,192

 
97

 
8.1
%
Special items—merger-related costs
24

 
22

 
2

 
24

 

 
%
Total operating expenses
$
1,681

 
$
1,166

 
$
356

 
$
1,522

 
$
159

 
10.4
%

Fuel Expense

Aircraft fuel expense includes both raw fuel expense (as defined below) plus the effect of mark-to-market adjustments to our fuel hedge portfolio included in our consolidated statement of operations as the value of that portfolio increases and decreases. Our aircraft fuel expense can be volatile, because it includes these gains or losses in the value of the underlying instrument as crude oil prices and refining margins increase or decrease. Raw fuel expense is defined as the price that we generally pay at the airport, or the “into-plane” price, including taxes and fees. Raw fuel prices are impacted by world oil prices and refining costs, which can vary by region in the U.S.  Raw fuel expense approximates cash paid to suppliers and does not reflect the effect of our fuel hedges.

Aircraft fuel expense increased $143 million, or 64% compared to the third quarter of 2016. On a Combined Comparative basis, aircraft fuel expense increased $62 million or 20%. The elements of the change are illustrated in the following table: 
 
Three Months Ended September 30,
 
2017
 
2016 as Reported
 
2016 Combined
(in millions, except for per gallon amounts)
Dollars
 
Cost/Gal
 
Dollars
 
Cost/Gal
 
Dollars
 
Cost/Gal
Raw or "into-plane" fuel cost
$
368

 
$
1.78

 
$
218

 
$
1.55

 
$
298

 
$
1.54

Losses on settled hedges
5

 
0.02

 
4

 
0.03

 
5

 
0.03

Consolidated economic fuel expense
373

 
1.80

 
222

 
1.58

 
$
303

 
$
1.57

Mark-to-market fuel hedge adjustments
(5
)
 
(0.02
)
 
3

 
0.02

 
3

 
0.02

GAAP fuel expense
$
368

 
$
1.78

 
$
225

 
$
1.60

 
$
306

 
$
1.59

Fuel gallons
207

 
 
 
140

 
 
 
192

 
 

On a Combined Comparative basis, raw fuel expense per gallon for the three months ended September 30, 2017 increased by 16% due to higher West Coast jet fuel prices. West Coast jet fuel prices are impacted by both the price of crude oil, as well as refining margins associated with the conversion of crude oil to jet fuel. The increase in raw fuel price per gallon during the third quarter of 2017 was primarily driven by a 76% increase in refining margins and an 8% increase in crude oil prices, when compared to the prior year. Fuel gallons consumed increased by 15 million gallons, or 8%, in line with the increase in capacity.
 
We also evaluate economic fuel expense, which we define as raw fuel expense adjusted for the cash we receive from, or pay to, hedge counterparties for hedges that settle during the period, and for the premium expense that we paid for those contracts. A

28



key difference between aircraft fuel expense and economic fuel expense is the timing of gain or loss recognition on our hedge portfolio. When we refer to economic fuel expense, we include gains and losses only when they are realized for those contracts that were settled during the period based on their original contract terms. We believe this is the best measure of the effect that fuel prices are currently having on our business because it most closely approximates the net cash outflow associated with purchasing fuel for our operations. Accordingly, many industry analysts evaluate our results using this measure, and it is the basis for most internal management reporting and incentive pay plans.

We recognized total losses of $5 million and $4 million for hedges that settled during the third quarter of 2017 and 2016 as reported. These amounts represent the net cash paid, including the premium expense recognized for those hedges.

Non-fuel Expenses and Non-special Items

The table below provides the reconciliation of the impact of Virgin America on the comparative results for each of our operating expense line items, excluding fuel and special items. Significant operating expense variances from 2016 are more fully described below.
 
Three Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Wages and benefits
$
475

 
$
340

 
$
72

 
$
412

 
$
63

 
15.3
 %
Variable incentive pay
40

 
31

 
11

 
42

 
(2
)
 
(4.8
)%
Aircraft maintenance
88

 
64

 
17

 
81

 
7

 
8.6
 %
Aircraft rent
70

 
25

 
48

 
73

 
(3
)
 
(4.1
)%
Landing fees and other rentals
124

 
89

 
28

 
117

 
7

 
6.0
 %
Contracted services
76

 
63

 
16

 
79

 
(3
)
 
(3.8
)%
Selling expenses
91

 
58

 
34

 
92

 
(1
)
 
(1.1
)%
Depreciation and amortization
95

 
101

 
11

 
112

 
(17
)
 
(15.2
)%
Food and beverage service
50

 
31

 
13

 
44

 
6

 
13.6
 %
Third-party regional carrier expense
30

 
25

 

 
25

 
5

 
20.0
 %
Other
150

 
92

 
23

 
115

 
35

 
30.4
 %
Total non-fuel and non-special operating expenses
$
1,289

 
$
919

 
273

 
1,192

 
97

 
8.1
 %

Wages and Benefits

Wages and benefits increased during the third quarter of 2017 by $135 million, or 40%. On a Combined Comparative basis, total wages and benefits increased by $63 million, or 15%. The primary components of wages and benefits, including a reconciliation of 2016 on a Combined Comparative basis, are shown in the following table:
 
Three Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Wages
$
358

 
$
250

 
$
58

 
$
308

 
$
50

 
16.2
%
Pension—Defined benefit plans
8

 
6

 

 
6

 
2

 
33.3
%
Defined contribution plans
25

 
16

 
5

 
21

 
4

 
19.0
%
Medical and other benefits
59

 
50

 
6

 
56

 
3

 
5.4
%
Payroll taxes
25

 
18

 
3

 
21

 
4

 
19.0
%
Total wages and benefits
$
475

 
$
340

 
$
72

 
$
412

 
$
63

 
15.3
%

On a Combined Comparative basis, wages increased 16% with an 18% increase in FTEs. The increase in FTEs is attributable to the growth in our business, as well as the growth in McGee Air Services which has brought certain airport ground service positions in-house that were previously reflected in our Contracted services expense. Additionally, irregular operations and flight cancellations during the third quarter resulted in significant overtime for our customer service agents and reservations agents.


29



Depreciation and Amortization

Depreciation and amortization expense decreased by $6 million, or 6%, during the third quarter of 2017 compared to the same period in 2016. On a Combined Comparative basis, depreciation and amortization expense decreased by $17 million, or 15%. This decrease was primarily driven by a change in the estimated useful lives of certain B737 operating aircraft and related parts from 20 years to 25 years, which was effective October 1, 2016, partially offset by aircraft additions since September 30, 2016.

Other Operating Expenses
 
Other operating expenses increased by $58 million, or 63%, during the third quarter of 2017 compared to the same period in 2016. On a Combined Comparative basis, other operating expenses increased by $35 million, or 30%. The increase is primarily due to additional costs incurred for crew hotel costs, passenger disruption costs, training costs for front-line employees, scrapped parts inventory, and certain information technology costs. These increases were largely driven by the growth in our business and increased costs from flight cancellations and delays during the quarter. .

Nonoperating Income (Expense)

During the third quarter of 2017 we recorded nonoperating expense of $12 million compared to income of $2 million in the same period in 2016. On a Combined Comparative basis, nonoperating expense increased by $9 million, primarily due to interest expense incurred in the current year on the debt issued in 2016 to finance the acquisition of Virgin America.

Additional Segment Information

Refer to Note 9 of the consolidated financial statements for a detailed description of each segment. Below is a summary of each segment's profitability.

Mainline

Mainline recorded adjusted pretax profit of $422 million in the third quarter of 2017 compared to $383 million in the third quarter of 2016. On a Combined Comparative basis, Mainline adjusted pretax profit decreased by $48 million. The table below provides the reconciliation of the impact of Virgin America on the comparative results for our Mainline segment, excluding merger-related costs and mark-to-market fuel-hedge accounting charges:
 
Three Months Ended September 30,
 
 
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Change
Mainline
 
 
 
 
 
 
 
 
 
Operating revenues
$
1,834

 
$
1,293

 
$
446

 
$
1,739

 
$
95

Non-fuel, non-special operating expenses
1,077

 
727

 
273

 
1,000

 
77

Economic fuel
328

 
188

 
81

 
269

 
59

Operating income
429

 
378

 
92

 
470

 
(41
)
Nonoperating income (expense)
(7
)
 
5

 
(5
)
 

 
(7
)
Pretax profit
$
422

 
$
383

 
$
87

 
$
470

 
$
(48
)

The $48 million decrease in Combined Comparative pretax profit was primarily driven by a $77 million increase in non-fuel operating expenses and a $59 million increase in economic fuel cost, partially offset by a $95 million increase in operating revenues. The increase in non-fuel expense was primarily driven by higher wages to support our growth and higher other operating expenses as described above. The increase in economic fuel expense was driven by higher raw fuel costs and refining margins. The increase in operating revenues was primarily driven by higher capacity and an increase in frequent flyer revenue as described above.

Regional

Our Regional operations contributed a pretax profit of $20 million in the third quarter of 2017 compared to $35 million in the third quarter of 2016. The decrease in pretax profit was attributable to higher non-fuel operating expense, due to increased capacity and the operational disruptions at Horizon during the third quarter. Increased costs were partially offset by a $13 million increase in operating revenues as described in Passenger Revenue—Regional.

30




Horizon

Horizon incurred a pretax profit of $5 million in the third quarter of 2017 compared to $9 million in the third quarter of 2016. The change in pretax profit was primarily driven by a $4 million increase in operating revenue, partially offset by higher non-fuel operating expenses attributable to higher wage and pilot training expense as a result of the increase in FTEs, along with other increased costs associated with flight cancellations during the current quarter.    

COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2017 TO NINE MONTHS ENDED SEPTEMBER 30, 2016

Our consolidated net income for the nine months ended September 30, 2017 was $661 million, or $5.31 per diluted share, compared to net income of $700 million, or $5.63 per diluted share, for the nine months ended September 30, 2016. As the acquisition of Virgin America closed on December 14, 2016, our financial results include results of Virgin America for the nine months ended September 30, 2017, but not for the prior periods.

Excluding the impact of merger-related costs and mark-to-market fuel hedge adjustments, our adjusted net income for the nine months ended September 30, 2017 was $721 million, or $5.79 per diluted share, compared to an adjusted net income of $717 million, or $5.77 per diluted share, in the nine months ended September 30, 2016. The following tables reconcile our adjusted net income and diluted EPS to amounts as reported in accordance with GAAP:
 
Nine Months Ended September 30,
 
2017
 
2016
(in millions, except per share amounts)
Dollars
 
Diluted EPS
 
Dollars
 
Diluted EPS
Reported GAAP net income and diluted EPS
$
661

 
$
5.31

 
$
700

 
$
5.63

Mark-to-market fuel hedge adjustments
7

 
0.06

 
(9
)
 
(0.07
)
Special items—merger-related costs
88

 
0.70

 
36

 
0.29

Income tax effect on special items and fuel hedge adjustments
(35
)
 
(0.28
)
 
(10
)
 
(0.08
)
Non-GAAP adjusted net income and diluted EPS
$
721

 
$
5.79

 
$
717

 
$
5.77



31



Our operating costs per ASM are summarized below:
 
Nine Months Ended September 30,
(in cents)
2017
 
2016
 
% Change
Consolidated:
 
 
 
 
 
CASM

10.55
¢
 

10.08
¢
 
4.7
 %
Less the following components:
 
 
 
 
 
Aircraft fuel, including hedging gains and losses
2.27

 
1.81

 
25.4
 %
Special items—merger-related costs
0.19

 
0.11

 
72.7
 %
CASM excluding fuel and special items

8.09
¢
 

8.16
¢
 
(0.9
)%
 
 
 
 
 
 
Mainline:
 
 
 
 
 
CASM

9.72
¢
 

9.06
¢
 
7.3
 %
Less the following components:
 
 
 
 
 
Aircraft fuel, including hedging gains and losses
2.19

 
1.72

 
27.3
 %
Special items—merger-related costs
0.21

 
0.13

 
61.5
 %
CASM excluding fuel and special items

7.32
¢
 

7.21
¢
 
1.5
 %


32



COMBINED COMPARATIVE OPERATING STATISTICS
 
Nine Months Ended September 30,
 
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
Change
Consolidated:
 
 
 
 
 
 
 
 
 
Revenue passengers (in 000)
33,063
 
25,536
 
6,029
 
31,565
 
4.7%
RPMs (in 000,000)
39,073
 
27,569
 
9,101
 
36,670
 
6.6%
ASMs (in 000,000)
46,170
 
32,728
 
10,821
 
43,549
 
6.0%
Load Factor
84.6%
 
84.2%
 
(a)
 
84.2%
 
0.4 pts
PRASM
11.08¢
 
11.36¢
 
(a)
 
11.10¢
 
(0.2)%
RASM
12.93¢
 
13.47¢
 
(a)
 
12.95¢
 
(0.2)%
CASMex
8.09¢
 
8.16¢
 
(a)
 
7.98¢
 
1.4%
FTEs
19,723
 
14,500
 
2,771
 
17,271
 
14.2%
 
 
 
 
 
 
 
 
 
 
Mainline:
 
 
 
 
 
 
 
 
 
RPMs (in 000,000)
36,046
 
24,767
 
9,101
 
33,868
 
6.4%
ASMs (in 000,000)
42,398
 
29,216
 
10,821
 
40,037
 
5.9%
Load Factor
85.0%
 
84.8%
 
(a)
 
84.6%
 
0.4 pts
PRASM
10.36¢
 
10.39¢
 
(a)
 
10.37¢
 
(0.1)%
(a)
2016 Combined operating statistics have been recalculated using the combined results.


33




COMBINED COMPARATIVE OPERATING REVENUES

Total operating revenues increased $1.6 billion, or 35%, during the first nine months of 2017 compared to the same period in 2016. On a Combined Comparative basis, total operating revenues increased $330 million, or 6%. The changes, including the reconciliation of the impact of Virgin America on the comparative results, are summarized in the following table:
 
Nine Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Passenger
 
 
 
 
 
 
 
 
 
 
 
Mainline
$
4,390

 
$
3,036

 
$
1,115

 
$
4,151

 
$
239

 
5.8
%
Regional
725

 
682

 

 
682

 
43

 
6.3
%
Total passenger revenue
5,115

 
3,718

 
1,115

 
4,833

 
282

 
5.8
%
Freight and mail
88

 
82

 

 
82

 
6

 
7.3
%
Other—net
768

 
607

 
119

 
726

 
42

 
5.8
%
Total operating revenues
$
5,971

 
$
4,407

 
$
1,234

 
$
5,641

 
$
330

 
5.9
%

Passenger Revenue—Mainline

Mainline passenger revenue for the first nine months of 2017 increased 45% on a 45% increase in capacity, driven primarily by the acquisition of Virgin America, and flat PRASM compared to the same period in 2016. On a Combined Comparative basis, mainline passenger revenue for the nine months ended September 30, 2017 increased 6%, primarily due to a 6% increase in capacity on flat PRASM. The increase in capacity was driven by our network expansion since September 30, 2016.

Passenger Revenue—Regional

Regional passenger revenue increased by $43 million, or 6%, compared to the first nine months of 2016, due to a 7% increase in capacity on more regional flying, partially offset by a 1% decrease in PRASM.

Other—Net

Other—net revenue increased $161 million, or 27%, from the first nine months of 2016. On a Combined Comparative basis, other—net revenue increased $42 million, or 6%. Mileage Plan revenue contributed $40 million of the increase primarily driven by an increase in miles sold to our affinity credit card partner.


34



COMBINED COMPARATIVE OPERATING EXPENSES

Total operating expenses increased $1.6 billion, or 48%, compared to the first nine months of 2016. On a Combined Comparative basis, total operating expenses increased $533 million, or 12%. We believe it is useful to summarize operating expenses as follows, which is consistent with the way expenses are reported internally and evaluated by management:
 
Nine Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Fuel expense
$
1,051

 
$
593

 
$
229

 
$
822

 
$
229

 
27.9
%
Non-fuel expenses
3,734

 
2,670

 
804

 
3,474

 
260

 
7.5
%
Special items—merger-related costs
88

 
36

 
8

 
44

 
44

 
100.0
%
Total operating expenses
$
4,873

 
$
3,299

 
$
1,041

 
$
4,340

 
$
533

 
12.3
%

Fuel Expense

Aircraft fuel expense increased $458 million, or 77%, compared to the nine months ended September 30, 2016. On a Combined Comparative basis, aircraft fuel expense increased $229 million, or 28%. The elements of the change are illustrated in the following table: 
 
Nine Months Ended September 30,
 
2017
 
2016 as Reported
 
2016 Combined
(in millions, except for per gallon amounts)
Dollars
 
Cost/Gal
 
Dollars
 
Cost/Gal
 
Dollars
 
Cost/Gal
Raw or "into-plane" fuel cost
$
1,030

 
$
1.74

 
$
590

 
$
1.44

 
$
801

 
$
1.44

Losses on settled hedges
14

 
0.02

 
12

 
0.03

 
32

 
0.06

Consolidated economic fuel expense
1,044

 
1.76

 
602

 
1.47

 
$
833

 
$
1.50

Mark-to-market fuel hedge adjustments
7

 
0.01

 
(9
)
 
(0.02
)
 
(11
)
 
(0.02
)
GAAP fuel expense
$
1,051

 
$
1.77

 
$
593

 
$
1.45

 
$
822

 
$
1.48

Fuel gallons
592

 
 
 
410

 
 
 
554

 
 

On a Combined Comparative basis, the raw fuel price per gallon increased 21% due to higher West Coast jet fuel prices. West Coast jet fuel prices are impacted by both the price of crude oil, as well as refining margins associated with the conversion of crude oil to jet fuel. The increase in raw fuel price per gallon during the first nine months of 2017 was driven by a 19% increase in crude oil prices and a 38% increase in refining margins.
 
We recognized losses of $14 million and $12 million for hedges that settled in the first nine months of 2017 and 2016 as reported. These amounts represent the cash paid for premium expense, offset by cash received from those hedges.

We currently expect our economic fuel price per gallon to be higher in the fourth quarter of 2017 compared to the fourth quarter of 2016 due to our current estimate of higher crude prices and higher refining margins.


35



Non-fuel Expense and Non- special items

The table below provides the reconciliation of the impact of Virgin America on the comparative results for each of our operating expense line items, excluding fuel and special items. Significant operating expense variances from 2016 are more fully described below.
 
Nine Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Wages and benefits
$
1,392

 
$
1,008

 
$
219

 
$
1,227

 
$
165

 
13.4
 %
Variable incentive pay
98

 
95

 
25

 
120

 
(22
)
 
(18.3
)%
Aircraft maintenance
271

 
197

 
51

 
248

 
23

 
9.3
 %
Aircraft rent
204

 
80

 
143

 
223

 
(19
)
 
(8.5
)%
Landing fees and other rentals
338

 
232

 
83

 
315

 
23

 
7.3
 %
Contracted services
234

 
183

 
47

 
230

 
4

 
1.7
 %
Selling expenses
269

 
162

 
96

 
258

 
11

 
4.3
 %
Depreciation and amortization
275

 
281

 
29

 
310

 
(35
)
 
(11.3
)%
Food and beverage service
145

 
93

 
39

 
132

 
13

 
9.8
 %
Third-party regional carrier expense
84

 
72

 

 
72

 
12

 
16.7
 %
Other
424

 
267

 
72

 
339

 
85

 
25.1
 %
Total non-fuel and non-special operating expenses
$
3,734

 
$
2,670

 
804

 
3,474

 
260

 
7.5
 %


36



Wages and Benefits

Wages and benefits increased during the first nine months of 2017 by $384 million, or 38%, compared to 2016. On a Combined Comparative basis, total wages and benefits increased by $165 million or 13%, compared to 2016. The primary components of wages and benefits are shown in the following table:
 
Nine Months Ended September 30,
 
Change
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Combined
 
% Combined
Wages
$
1,055

 
$
749

 
$
171

 
$
920

 
$
135

 
14.7
%
Pension—Defined benefit plans
24

 
19

 

 
19

 
5

 
26.3
%
Defined contribution plans
73

 
49

 
18

 
67

 
6

 
9.0
%
Medical and other benefits
163

 
135

 
18

 
153

 
10

 
6.5
%
Payroll taxes
77

 
56

 
12

 
68

 
9

 
13.2
%
Total wages and benefits
$
1,392

 
$
1,008

 
$
219

 
$
1,227

 
$
165

 
13.4
%

On a Combined Comparative basis, wages increased $135 million, or 15%, on a 14% increase in FTEs. The increase in FTEs is attributable to the growth of our business and increased staffing during irregular operations, as well as the growth in McGee Air Services which has brought certain airport ground service positions in-house that were previously reflected in our Contracted services expense. The remainder of the increase is driven by higher wage rates for certain labor groups. The first nine months of 2017 also include $9 million of ratification bonus expense in connection with the agreement reached with Horizon's pilots during the second quarter.

For the full year, we expect wages and benefits to increase at a rate greater than capacity growth on a combined comparative basis, due to higher wage rates for certain labor groups and the continued growth of McGee Air Services. Our forecast includes the impact of the pilot arbitration decision which was received subsequent to quarter end, and results in an estimated $24 million of incremental costs in the fourth quarter of 2017.

Variable Incentive Pay

Variable incentive pay expense increased during the first nine months of 2017 by $3 million, or 3% compared to 2016. On a Combined Comparative basis, variable incentive pay decreased $22 million, or 18% due to expectations of lower performance-based pay as compared to the prior year based on how we are tracking in relation to the current year's goals.

For the full year, we expect variable incentive pay expense to be lower than in 2016 on a combined comparative basis, due to lower achievement against performance-based pay metrics than prior year.

Depreciation and Amortization

Depreciation and amortization expense decreased $6 million, or 2% compared to 2016. On a Combined Comparative basis, depreciation and amortization decreased $35 million, or 11%. This decrease was primarily driven by a change in the estimated useful lives of certain B737 operating aircraft and related parts from 20 years to 25 years, which was effective October 1, 2016, partially offset by aircraft additions since September 30, 2016.

For the full year, we expect depreciation and amortization to be 5-6% lower than in 2016 on a combined comparative basis for the same reasons mentioned above.

Food and Beverage Service

Food and beverage service expense increased $52 million, or 56%. On a Combined Comparative basis, food and beverage service expense increased $13 million, or 10% due to increased number of passengers, premium class offerings and enhancements to our onboard menu offerings to provide higher quality food and beverage products.

For the full year, we expect food and beverage expense to be approximately 11-12% higher than in 2016 on a combined comparative basis, in line with the increase in passengers in the current year, and enhancements to our onboard menu offerings.

Third-Party Regional Carrier Expense

Third-party regional carrier expense, which represents payments made to SkyWest and Pen Air under our CPAs, increased $12 million, or 17% compared to 2016. The increase is primarily due to the additional six E175 aircraft operated by SkyWest in the current year.

For the full year, we expect Third-party regional carrier expense to increase due to increased flying by our regional partners.

Other Operating Expenses

Other operating expenses increased by $157 million, or 59%, compared to the first nine months of 2016. On a Combined Comparative basis, other operating expenses increased by $85 million, or 25%. The increase was due to higher costs associated with irregular operations, crew and training costs, higher IT costs, an increase in scrapped parts inventory, and higher property taxes. The first nine months of 2016 also included a benefit of an insurance claim reimbursement we received in the prior year.

For the full year, we expect other expenses to be higher than in 2016 in line with the trends described above.
 
Special Items—Merger-Related Costs

We recorded special items of $88 million for merger-related costs associated with our acquisition of Virgin America in the first nine months of 2017, compared to $36 million as reported and $44 million on a Combined Comparative basis in the first nine months of 2016. Costs incurred in the first nine months of 2017 consisted primarily of severance and retention and IT integration costs.

We expect to incur merger-related costs for the remainder of 2017, and continuing through 2019.

Nonoperating Income (Expense)


37



During the first nine months of 2017, we had nonoperating expense of $40 million, compared to income of $6 million in the same period in 2016. On a Combined Comparative basis, nonoperating expense increased by $32 million, primarily due to interest expense incurred in the current year on the debt issued in 2016 to finance the acquisition of Virgin America.

Additional Segment Information

Refer to Note 9 of the condensed consolidated financial statements for a detailed description of each segment. Below is a summary of each segment's profitability.

Mainline

Mainline adjusted pretax profit was $1.13 billion in the first nine months of 2017, compared to $1.05 billion in the same period in 2016. On a Combined Comparative basis, Mainline adjusted pretax profit decreased by $111 million. The table below provides the reconciliation of the impact of Virgin America on the comparative results for our Mainline segment, excluding merger-related costs and mark-to-market fuel-hedge accounting charges:
 
Nine Months Ended September 30,
 
 
(in millions)
2017
 
2016 as Reported
 
2016 Virgin America
 
2016 Combined
 
$ Change
Mainline
 
 
 
 
 
 
 
 
 
Operating revenues
$
5,182

 
$
3,661

 
$
1,234

 
$
4,895

 
$
287

Non-fuel, non-special operating expenses
3,101

 
2,107

 
804

 
2,911

 
190

Economic fuel
924

 
512

 
231

 
743

 
181

Operating income
1,157

 
1,042

 
199

 
1,241

 
(84
)
Nonoperating income (expense)
(30
)
 
11

 
(14
)
 
(3
)
 
(27
)
Pretax profit
$
1,127

 
$
1,053

 
$
185

 
$
1,238

 
$
(111
)

The $111 million decrease in Combined Comparative pretax profit was driven by a $181 million increase in Mainline fuel expense, a $190 million increase in Mainline non-fuel operating expenses, and a $27 million increase in nonoperating expense. These increases were offset by a $287 million increase in Mainline passenger revenue. Higher raw fuel prices and an increase in gallons consumed drove the increase in Mainline fuel expense. Non-fuel operating expenses increased due to higher wages to support our growth and higher other operating expenses as described above. Nonoperating expense increased primarily due to increased interest expense. Mainline revenue increased due to higher capacity from the new routes we have added over the past twelve months.

Regional

Our Regional operations contributed a pretax profit of $40 million in the first nine months of 2017, compared to $72 million in the first nine months of 2016. The decrease in pretax profit was attributable to higher non-fuel operating expense, due in large part to increased capacity and higher raw fuel costs, partially offset by a $43 million increase in operating revenues as described in Passenger Revenue—Regional.

Horizon

Horizon incurred a pretax loss of $11 million in the first nine months of 2017, compared to pretax profit of $14 million in the same period in 2016. The change was driven by higher non-fuel expenses and lower CPA Revenues (100% of which are from Alaska and eliminated in consolidation). Non-fuel expenses increased primarily due to higher wage and training expense as a result of the increase in FTE’s, increased costs associated with flight cancellations primarily due to a shortage of pilots necessary to fly the schedule, and a $9 million ratification bonus expense in connection with the agreement with Horizon's pilots.


38



LIQUIDITY AND CAPITAL RESOURCES
 
Our primary sources of liquidity are:
 
Our existing cash and marketable securities balance of $1.7 billion, and our expected cash from operations;

Our 64 unencumbered aircraft in our operating fleet that could be financed, if necessary;

Our combined bank line-of-credit facilities, with no outstanding borrowings, of $400 million. Information about these facilities can be found in Note 5 to the condensed consolidated financial statements.
  
During the nine months ended September 30, 2017, we took free and clear delivery of ten B737-900ER aircraft and ten E175 aircraft. We made debt payments totaling $265 million and paid dividends totaling $111 million.

The table below presents the major indicators of financial condition and liquidity: 
(in millions)
September 30, 2017
 
December 31, 2016
 
Change
Cash and marketable securities
$
1,740

 
$
1,580

 
10.1 %
Cash, marketable securities, and unused lines of credit as a percentage of trailing twelve months' revenue
29
%
 
31
%
 
(2) pts
Long-term debt, net of current portion
$
2,367

 
$
2,645

 
(10.5)%
Shareholders’ equity
$
3,491

 
$
2,931

 
19.1%
Long-term debt-to-capital including net present value of aircraft operating lease payments(a)
53
%
 
59
%
 
(6) pts
(a)
Calculated using the present value of remaining aircraft lease payments for aircraft in our operating fleet as of the balance sheet date.

The following discussion summarizes the primary drivers of the increase in our cash and marketable securities balance and our expectation of future cash requirements.

ANALYSIS OF OUR CASH FLOWS
 
Cash Provided by Operating Activities
 
For the first nine months of 2017, net cash provided by operating activities was $1.4 billion, compared to $1.2 billion during the same period in 2016. The $151 million increase in our operating cash flows is primarily attributable to increased ticket sales for future travel compared to the prior year resulting from the overall growth in our business and the addition of Virgin America. This was partially offset by a decrease in our net income, which was impacted by higher fuel costs and $88 million of merger-related costs.

We typically generate positive cash flows from operations and expect to use that cash flow to purchase aircraft and capital equipment, make scheduled debt payments, and return capital to shareholders.
 
Cash Used in Investing Activities
 
Cash used in investing activities was $1.1 billion during the first nine months of 2017, compared to $641 million during the same period of 2016. Our capital expenditures were $841 million in the first nine months of 2017, an increase of $332 million compared to the nine months ended September 30, 2016. This is primarily driven by more aircraft purchases and higher spend on other equipment compared to the same period of 2016. Our net purchases of marketable securities increased by $202 million from the prior year, primarily driven by stronger operating cash flows in the first nine months of 2017.

The table below reflects our full-year expectation for capital expenditures and additional expenditures if options are exercised. Options will be exercised only if we believe return on invested capital targets can be met. The table below excludes any associated capitalized interest.

39



(in millions)
2017
 
2018
 
2019
Aircraft and aircraft purchase deposits—firm
$
780

 
$
820

 
$
635

Other flight equipment
100

 
135

 
170

Other property and equipment
170

 
240

 
205

Total property and equipment additions
$
1,050

 
$
1,195

 
$
1,010

Option aircraft and aircraft deposits, if exercised(a)
$

 
$
170

 
$
665

(a)
We have options to acquire 37 B737 aircraft with deliveries from 2020 through 2024, and options to acquire 30 E175 aircraft with deliveries in 2019 to 2021. Amounts above also include payments toward cancelable purchase commitments for 30 A320neo aircraft with deliveries from 2020 through 2022.

Cash Used by Financing Activities
 
Net cash used by financing activities was $399 million during the first nine months of 2017 compared to net cash provided by financing activities of $1.2 billion during the same period in 2016. The change is due to $1.5 billion of debt financing cash inflow in the prior period for the Virgin America acquisition. During the first nine months of 2017 we made debt payments of $265 million, dividend payments totaling $111 million, and had $50 million in common stock repurchases.

CONTRACTUAL OBLIGATIONS AND COMMITMENTS
 
Aircraft Commitments
 
As of September 30, 2017, we have firm orders to purchase or lease 93 aircraft. We also have cancelable purchase commitments for 30 Airbus A320neo with deliveries from 2020 through 2022. We could incur a loss of pre-delivery payments and credits as a cancellation fee. We also have options to acquire 37 B737 aircraft with deliveries from 2020 through 2024 and 30 E175 aircraft with deliveries from 2019 through 2021. In addition to the 21 E175 aircraft currently operated by SkyWest in our regional fleet, we have options in future periods to add regional capacity by having SkyWest operate up to eight more E175 aircraft.

The following table summarizes expected fleet activity by year as of September 30, 2017:
 
Actual Fleet
 
Expected Fleet Activity
Aircraft
September 30, 2017
 
Q4 2017 Additions
 
Q4 2017 Removals
 
December 31, 2017
 
2018-2019 Changes
 
December 31, 2019
B737 Freighters & Combis(a)
5

 
2

 
(3
)
 
4

 
(1
)
 
3

B737 Passenger Aircraft
148

 
4

 
(1
)
 
151

 
19

 
170

Airbus Passenger Aircraft
65

 
3

 

 
68

 
4

 
72

Total Mainline Fleet
218

 
9

 
(4
)
 
223

 
22

 
245

Q400 operated by Horizon
52

 

 

 
52

 
(15
)
 
37

E175 operated by Horizon(b)
10

 

 

 
10

 
23

 
33

E175 operated by third party(c)
21

 
2

 

 
23

 
12

 
35

Total Regional Fleet
83

 
2

 

 
85

 
20

 
105

Total
301

 
11

 
(4
)
 
308

 
42

 
350

(a) 
Remaining 2017 changes reflect retirement of three combis and the reintroduction of two B737-700 aircraft as freighters.
(b) 
Reflects recent deferral of three aircraft from 2017 to 2018.
(c) 
Reflects third-quarter addition of ten aircraft flown by SkyWest under our CPA to be delivered in 2017 and 2018.

For future firm orders, and if we exercise our options for additional deliveries, we may finance the aircraft through internally generated cash, long-term debt or lease arrangements.


40



Fuel Hedge Positions

All of our current oil positions are call options, which are designed to effectively cap the cost of the crude oil component of our jet fuel purchases. With call options, we benefit from a decline in crude oil prices, as there is no cash outlay other than the premiums we pay to enter into the contracts. Our crude oil positions are as follows:
 
Approximate % of Expected Fuel Requirements
 
Weighted-Average Crude Oil Price per Barrel
 
Average Premium Cost per Barrel
Fourth Quarter 2017
50
%
 
$
61

 
$
2

First Quarter 2018
50
%
 
62

 
2

Second Quarter 2018
40
%
 
$
61

 
$
2

Third Quarter 2018
30
%
 
60

 
2

Fourth Quarter 2018
20
%
 
60

 
2

Full Year 2018
35
%
 
61

 
2

First Quarter 2019
10
%
 
62

 
2

Total 2019
2
%
 
$
62

 
$
2


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 September 30, 2017.
(in millions)
Remainder of 2017
 
2018
 
2019
 
2020
 
2021
 
Beyond 2021
 
Total
Current and long-term debt obligations
$
55

 
$
350

 
$
422

 
$
449

 
$
422

 
$
1,016

 
$
2,714

Operating lease commitments (a)
111

 
415

 
409

 
380

 
335

 
1,467

 
3,117

Aircraft maintenance deposits (b)
15

 
61

 
65

 
68

 
63

 
90

 
362

Aircraft purchase commitments (c)
168

 
956

 
806

 
352

 
273

 
355

 
2,910

Interest obligations (d)
18

 
89

 
77

 
63

 
48

 
108

 
403

Aircraft maintenance and parts management (e)
8

 
32

 
35

 
37

 
40

 

 
152

Other obligations (f)
22

 
125

 
158

 
165

 
172

 
1,277

 
1,919

Total
$
397

 
$
2,028

 
$
1,972

 
$
1,514

 
$
1,353

 
$
4,313

 
$
11,577

(a)
Operating lease commitments generally include aircraft operating leases, airport property and hangar leases, office space, and other equipment leases. Included here are E175 aircraft that are operated by SkyWest under capacity purchase agreements.
(b)
Aircraft maintenance deposits relate to leased Airbus aircraft.
(c)
Represents non-cancelable contractual commitments for aircraft and engines.
(d)
For variable-rate debt, future obligations are shown above using interest rates in effect as of September 30, 2017.
(e)
Includes minimum obligations under engine and parts management and maintenance agreements with third-party vendors. Subsequent to September 30, 2017, the Company signed a parts management and maintenance agreement which includes minimum obligations of approximately $459 million over a nine-year period, not included in the table above.
(f)
Includes minimum obligations associated with the SkyWest third-party CPA.

Credit Card Agreements
 
We have agreements with a number of credit card companies to process the sale of tickets and other services. Under these agreements, there are material adverse change clauses that, if triggered, could result in the credit card companies holding back a reserve from our credit card receivables. Under one such agreement, we could be required to maintain a reserve if our credit rating is downgraded below the contractually-specified level, or if our cash and marketable securities balance falls below $500 million. Under another such agreement, we could be required to maintain a reserve if our cash and marketable securities balance falls below $500 million. We are not currently required to maintain any reserve under these agreements, but if we were, our financial position and liquidity could be materially harmed.


41



Deferred Income Taxes

For federal income tax purposes, the majority of our assets are fully depreciated over a seven-year life using an accelerated depreciation method or bonus depreciation, if available. For financial reporting purposes, the majority of our assets are depreciated over 15 to 25 years to an estimated salvage value using the straight-line basis. This difference has created a significant deferred tax liability. At some point in the future the depreciation basis will reverse, potentially resulting in an increase in income taxes paid.

While it is possible that we could have material cash obligations for this deferred liability at some point in the future, we cannot estimate the timing of long-term cash flows with reasonable accuracy. Taxable income and cash taxes payable in the short term are impacted by many items, including the amount of book income generated (which can be volatile depending on revenue and fuel prices), usage of net operating losses, whether "bonus depreciation" provisions are available, pending tax reform efforts at the federal level, as well as other legislative changes that are beyond our control. We believe that we have the liquidity to make our future tax payments.

CRITICAL ACCOUNTING ESTIMATES

There have been no material changes to our critical accounting estimates for the three months ended September 30, 2017. For information on our critical accounting estimates, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the year ended December 31, 2016.

GLOSSARY OF AIRLINE TERMS

Aircraft Utilization - block hours per day; this represents the average number of hours per day our aircraft are in transit

Aircraft Stage Length - represents the average miles flown per aircraft departure

ASMs - available seat miles, or “capacity” represents total seats available across the fleet multiplied by the number of miles flown

CASM - operating costs per ASM, or "unit cost" represents all operating expenses including fuel and special items

CASMex - operating costs excluding fuel and special items per ASM; this metric is used to help track progress toward reduction of non-fuel operating costs since fuel is largely out of our control

Debt-to-capitalization ratio - represents adjusted debt (long-term debt plus the present value of future operating lease payments) divided by total equity plus adjusted debt

Diluted Earnings per Share - represents earnings per share ("EPS") using fully diluted shares outstanding

Diluted Shares - represents the total number of shares that would be outstanding if all possible sources of conversion, such as stock options, were exercised

Economic Fuel - best estimate of the cash cost of fuel, net of the impact of settled fuel-hedging contracts in the period

Free Cash Flow - total operating cash flow generated less cash paid for capital expenditures

Load Factor - RPMs as a percentage of ASMs; represents the number of available seats that were filled with paying passengers

Mainline - represents flying Boeing 737 and Airbus 320 family jets and all associated revenues and costs

PRASM - passenger revenue per ASM; commonly called “passenger unit revenue”

Productivity - number of revenue passengers per full-time equivalent employee

RASM - operating revenue per ASMs, or "unit revenue" operating revenue includes all passenger revenue, freight & mail, Mileage Plan and other ancillary revenue; represents the average total revenue for flying one seat one mile

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Regional - represents capacity purchased by Alaska from Horizon, SkyWest and PenAir. In this segment, Regional records actual on-board passenger revenue, less costs such as fuel, distribution costs, and payments made to Horizon, SkyWest and PenAir under the respective capacity purchased arrangement (CPAs). Additionally, Regional includes an allocation of corporate overhead such as IT, finance, other administrative costs incurred by Alaska and on behalf of Horizon.

RPMs - revenue passenger miles, or "traffic" represents the number of seats that were filled with paying passengers; one passenger traveling one mile is one RPM

Yield - passenger revenue per RPM; represents the average revenue for flying one passenger one mile

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
There have been no material changes in market risk from the information provided in Item 7A. “Quantitative and Qualitative Disclosure About Market Risk” in our Annual Report on Form 10-K for the year ended December 31, 2016.
 
ITEM 4. CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures

As of September 30, 2017, 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 or submitted to the Securities and Exchange Commission (the SEC) is recorded, processed, summarized and reported within the time periods specified by the SEC's rules and forms, and includes, without limitation, controls and procedures designed to ensure that such information is accumulated and communicated to our management, including our certifying officers, as appropriate, to allow timely decisions regarding required disclosure. Our certifying officers concluded, based on their evaluation, that disclosure controls and procedures were effective as of September 30, 2017.
 
Changes in Internal Control over Financial Reporting
 
Except as noted below, there have been no changes in our internal control over financial reporting during the quarter ended September 30, 2017, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In the fourth quarter of 2016, we acquired Virgin America (see Note 2). As permitted by Securities and Exchange Commission Staff interpretive guidance for newly acquired businesses, management excluded Virgin America from its annual evaluation of internal control over financial reporting as of December 31, 2016. We are implementing internal controls over significant processes specific to the acquisition that we believe are appropriate in consideration of related integration of operations, systems, control activities, and accounting for the merger and merger-related transactions. As of the date of this Quarterly Report on Form 10-Q, we are in the process of further integrating the acquired Virgin America operations into our overall internal controls over financial reporting.



43



PART II

ITEM 1. LEGAL PROCEEDINGS
 
We are a party to routine litigation matters incidental to our business. 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, and it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.

In 2015, three flight attendants filed a class action lawsuit seeking to represent all Virgin America flight attendants for damages based on alleged violations of California and City of San Francisco wage and hour laws. Plaintiffs received class certification in November 2016. Virgin America filed a motion for summary judgment seeking to dismiss all claims on various federal preemption grounds. In January 2017, the Court denied in part and granted in part Virgin America’s motion. Virgin America believes the claims in this case are without factual and legal merit and intends to defend this lawsuit.

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors affecting our business, financial condition or future results from those set forth in Item 1A."Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

This table provides certain information with respect to our purchases of shares of our common stock during the third quarter of 2017.
 
Total Number of
Shares Purchased
 
Average Price
Paid per Share
 
Maximum remaining
dollar value of shares
that can be purchased
under the plan
(in millions)
July 1, 2017 - July 31, 2017
5,770

 
$
84.37

 
 
August 1, 2017 - August 31, 2017
349,645

 
78.52

 
 
September 1, 2017 - September 30, 2017

 

 
 
Total
355,415

 
$
78.61

 
$
637


The shares were purchased pursuant to a $1 billion repurchase plan authorized by the Board of Directors in August 2015.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

None.

ITEM 5. OTHER INFORMATION
 
None.


44



ITEM 6. EXHIBITS
 
The following documents are filed as part of this report:

1.
Exhibits: See Exhibit Index.

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
ALASKA AIR GROUP, INC.
 
 
 
/s/ CHRISTOPHER M. BERRY
 
Christopher M. Berry
 
Vice President Finance and Controller
 
 
 
November 2, 2017
 
 

45



EXHIBIT INDEX
Exhibit
Number
Exhibit
Description
Form
Date of First Filing
Exhibit Number
3.1
10-Q
August 3, 2017
3.1
10.1*
10-Q
May 5, 2017
10.1
10.2*
10-Q
May 5, 2017
10.2
31.1†
10-Q
 
 
31.2†
10-Q
 
 
32.1†
10-Q
 
 
32.2†
10-Q
 
 
101.INS†
 
 
 
101.SCH†
 
 
 
101.CAL†
 
 
 
101.DEF†
 
 
 
101.LAB†
 
 
 
101.PRE†
 
 
 
 
 
 
 
 
Filed herewith
 
 
 
*
Indicates management contract or compensatory plan arrangement
 
 
 


46