10-K 1 alk10-k123116.htm 10-K Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-K
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2016
 
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
 
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $0.01 Par Value
New York Stock Exchange
 Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x   No  ¨ 
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ¨      No   x
 
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 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act: 
Large accelerated filer   x  Accelerated filer  ¨     Non-accelerated filer   ¨  Smaller reporting company   ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x
 
As of February 22, 2017, shares of common stock outstanding totaled 123,468,367. The aggregate market value of the shares of common stock of Alaska Air Group, Inc. held by nonaffiliates on June 30, 2016, was approximately $7.1 billion (based on the closing price of $58.29 per share on the New York Stock Exchange on that date). 

DOCUMENTS INCORPORATED BY REFERENCE
Portions of Definitive Proxy Statement relating to 2017 Annual Meeting of Shareholders are incorporated by reference in Part III.




ALASKA AIR GROUP, INC.
ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2016
 
TABLE OF CONTENTS
 
 
 
 
 
 

 
As used in this Form 10-K, 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,” respectively, and together as our “airlines.”
 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
In addition to historical information, this Form 10-K 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.
 
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 in this Form 10-K, see “Item 1A: Risk Factors.” Please consider our forward-looking statements in light of those risks as you read this report.


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PART I 
ITEM 1. OUR BUSINESS

Air Group operates Alaska, Virgin America and Horizon Air. We completed the acquisition of Virgin America on December 14, 2016, at which time Virgin America became our wholly-owned subsidiary. Together with our regional partner airlines, we fly to 118 destinations with nearly 1,200 daily departures through our expansive network across the United States, Mexico, Canada, Costa Rica and Cuba. With our global airline partners, we can provide our guests with a virtual network of more than 900 destinations worldwide. During 2016, we carried an all-time high 34 million guests and earned adjusted net income of $911 million, which includes operating and financial results for Virgin America for the period December 14, 2016 through December 31, 2016, and excludes pretax special items and merger-related costs of $117 million.

Our acquisition of Virgin America positions us as the fifth largest airline in the U.S., with an unparalleled ability to serve West Coast travelers. Virgin America provides a platform for growth of our low-fare, premium product providing a powerful West Coast network for our guests as well as enhanced international partnerships. Additionally, Virgin America provides an opportunity to grow and improve our loyalty program while gaining access to constrained gates, particularly on the East Coast. The combined company now provides more seats from the West Coast than any other carrier, allowing us to serve our guests better.

Our mission is "creating an airline people love." The "ing" is to recognize we are never donewe are continually working to get better. We believe our success depends on our ability to provide safe air transportation, develop relationships with guests by providing exceptional customer service and low fares, and maintain a low cost structure to compete effectively. It is important to us that we achieve our objective as a socially responsible company that values not just our performance, but also our people, our community and our environment.

While aircraft and technology enable us to provide air transportation, we recognize this is fundamentally a people business. Our employees maintain and strengthen our relationships with guests, and our success depends on our employees working together to successfully execute our strategy. In 2016, Alaska was once again named one of America's Best Employers by Forbes Magazine. We know that engaged employees provide excellent service. In that vein, in 2016, Alaska ranked highest in customer satisfaction among traditional network carriers by J.D. Power and Associates for the ninth year in a row and Virgin America was recognized for excellent service by Conde Nast Traveler and Travel + Leisure magazine also for the ninth year in a row. Customer service matters, and we believe the combination of our airlines will only enhance the experience for our guests.

Operationally, Alaska has held the No. 1 spot in the Wall Street Journal's "Middle Seat" scorecard for U.S. airlines for four consecutive years. We have been the leader in the industry for on-time performance among major airlines for the past seven years. For achieving safety, customer service, operational and financial goals, we rewarded our employees with a record $127 million in incentive pay during 2016. Including incentives earned during the year prior to the acquisition by Virgin America employees, the total is $159 million.

In support of the communities that we serve, we strive to be an industry leader in environmental and community stewardship. In 2016, we improved fuel efficiency by 1.4% from the prior year, as measured by available seat miles flown per gallon. We also flew the first two commercial flights using sustainable alcohol-to-jet biofuel made from U.S. grown corn and alternative jet fuel made from forest residuals, highlighting our commitment to environmental stewardship. Our combined fleet is one of the youngest, most fuel-efficient fleets in North America and we look forward to further enhancements in this area. Air Group donated $13 million to over 1,300 charitable organizations and our employees volunteered more than 27,000 hours of community service. Virgin America has also been active in community service and charitable giving. Our efforts focus on youth and education, medical research and transportation and community outreach. One of our leadership principals is to "give back" and we are proud of the efforts and volunteerism of our employees across the system.

We earned record financial results in 2016, marking our 13th consecutive annual profit on an adjusted basis. We achieved an after-tax return on invested capital of 21.3%, well above our weighted average cost of capital. Although we incurred a significant amount of new debt in 2016 to fund the Virgin America acquisition, our liquidity and capital position still remain strong and are among those of high-quality industrial companies. Due to our strong financial health and outlook, we are one of only three U.S. airlines with investment grade credit ratings. With the cash generated by the continued success we have had in the past decade, we have been able to invest in our business to achieve profitable growth and to enhance the customer experience. Most recently, we launched our Premium Class service on our Boeing 737 aircraft, which includes more legroom, early boarding, free cocktails and premium snacks.


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As we look to the future, we will build on our success by executing our strategic plan in the following areas:

Be Safe and On time
We have an unwavering commitment to run a safe and compliant operation, and we will not compromise this commitment in the pursuit of other initiatives. Alaska and Horizon were the first U.S. major airlines to receive Federal Aviation Administration ("FAA") validation and acceptance of our Safety Management System ("SMS") in the third quarter of 2016. SMS helps identify and manage risk and builds a sustainable culture of safety for Air Group employees. We have an initiative to add Virgin America to the SMS program in 2017. Once again, for 2016, 100% of our Alaska and Horizon aircraft technicians completed the requirements for the FAA's "Diamond Certificate of Excellence" award. This is the 15th consecutive year Alaska Airlines has received the award and the 15th time in the last 17 years for Horizon. We also believe that maintaining safe and compliant operations, through adherence to well defined processes and ensuring every Air Group employee is aware of their individual contribution to our operation, is critical to ensuring on-time performance. The rigor we apply to running a safe and compliant operation has resulted in Alaska being named the No. 1 on-time carrier in North America for the seventh year in a row by FlightStats.
Focus on People
Our success depends on our people. Higher employee engagement drives higher productivity, superior execution and better customer service, which is why we listen to our employees for feedback in shaping our strategy. Employee engagement scores from our annual employee survey are at historical highs. We have designed customer-service workshops and leadership training that cover virtually all employees and do these on an ongoing basis. As we integrate Alaska and Virgin America, in January 2017 we rolled out "Momentum" training for all Virgin America employees to help bridge the two airlines and blend our cultures. For our Horizon employees, we are conducting "QX Factor," a program with the goal of improving culture, engagement and communication.

We understand that aligning our employees' goals with Air Group's goals is important in achieving success. The majority of Air Group employees, including Virgin America employees starting in 2017, participate in our Performance-Based Pay ("PBP") and Operational Performance Rewards ("OPR") programs, which encourage employees to work together to achieve metrics related to safety, profitability, on-time performance, low costs and customer loyalty and satisfaction. Over the last five years, our incentive programs have paid out on average, over 8.7% of annual pay, or more than one month's pay, for most employees.

Build a deep emotional connection for our brand
We want to be recognized as the preferred airline to fly for people living on the West Coast. In January 2016, we introduced a bold new brand expression, including an updated identity, livery, and look and feel for our digital and physical experiences. In January 2017, subsequent to year end, we were the first airline to launch Free Chata feature that allows our guests to text for free in-flight. We believe there is an opportunity to deepen the emotional connection with our guests as we continue to expand and grow. Our updated brand expression draws upon our rich heritage while infusing it with additional warmth and energy to better reflect how guests feel about our brand and the great service that we pride ourselves in delivering.

We continue to invest in a better customer experience. Onboard, guests will continue to enjoy more of what they love with free and premium entertainment direct to their devices, Pacific Northwest-inspired food and beverages, custom leather seats with power outlets at every seat and larger overhead bins for carry-on bags. As mentioned previously, we have also recently launched our new Premium Class section in the main cabin with increased legroom and other amenities and improved our First Class with five additional inches of leg room.

Defend and grow our customer base
The merger with Virgin America provides an amazing opportunity for our new Alaska Air Group. We have a network that provides unparalleled utility and options for our guests living on the West Coast. Competition in our markets is fierce and we know we must defend our customer base as we use our combined network as an opportunity to grow that base. We will be introducing new guests to our award-winning service, Mileage Plan™ program, and affinity credit card as we grow our network. Guests from our airlines already benefit from codeshare and reciprocal frequent flyer benefits, including earning and redeeming rewards on both carriers. Elite members of the Virgin America Elevate® program and Alaska's Mileage Plan™ also receive priority boarding on both carriers. We work hard to ensure our guests have a great experience on our airlines and are provided an exceptional product at a low fare.


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Win with low costs and low fares
We believe that our low-fare model gives us a competitive advantage by providing value to and building trust with our guests. We also know that, in order to provide low fares in our growing network, while returning value to our shareholders, it is imperative for us to maintain a competitive cost structure. In 2016, we lowered our unit costs, excluding fuel, by 0.8% on a consolidated basis, representing the seventh consecutive year of annual reduction. We achieved this through a continued focus on productivity, cost management, and by leveraging capacity growth. We increased employee productivity in 2016 and will continue to focus on that metric as we grow. We also manage fuel costs by flying larger, more fuel-efficient aircraft, which have increased our fuel efficiency as measured by available seat miles flown per gallon by 7.0% over the last five years. As we integrate Virgin America into our operations, we are committed to achieving our stated cost and revenue synergy goals. It is critical that we achieve these goals in order to continue our cost reduction efforts.

During fiscal 2016, we added 17 new markets to the combined network. For 2017, we plan to grow our system-wide capacity approximately 8.5% as compared to the full year 2016 combined capacity of Air Group and Virgin America.

AIR GROUP

Alaska Air Group is a Delaware corporation incorporated in 1985 and the holding company of Alaska, Virgin America, Horizon and other business units. Although Alaska, Virgin America and Horizon operate as airlines, the business plans, competition and economic risks differ substantially for Horizon in comparison to Alaska and Virgin America. Alaska Airlines is an Alaska corporation that was organized in 1932 and incorporated in 1937. Virgin America is a California corporation that was incorporated in 2004 and acquired by Air Group on December 14, 2016. Horizon is a Washington corporation that began service and was incorporated in 1981. It was acquired by Air Group in 1986. Alaska and Virgin America operate fleets of narrowbody passenger jets. Together, the operations of Alaska and Virgin America are referred to as "mainline" operations. Alaska also contracts with Horizon, SkyWest Airlines, Inc. ("SkyWest") and Peninsula Airways, Inc. ("PenAir") for regional capacity such that Alaska receives all passenger revenue from those flights. Horizon currently operates a fleet of turboprop aircraft and sells all of its capacity to Alaska pursuant to a capacity purchase agreement ("CPA"). In 2017, Horizon will begin operating E175 regional jets. The majority of our revenues are generated by transporting passengers. The percentage of revenues by category is as follows:
 
2016(a)
 
2015
 
2014
 
2013
 
2012
Mainline passenger revenue
69
%
 
70
%
 
70
%
 
70
%
 
71
%
Regional passenger revenue
15
%
 
15
%
 
15
%
 
16
%
 
16
%
Other revenue
14
%
 
13
%
 
13
%
 
12
%
 
11
%
Freight and Mail revenue
2
%
 
2
%
 
2
%
 
2
%
 
2
%
Total
100
%
 
100
%
 
100
%
 
100
%

100
%
(a)
Includes information for Virgin America for the period December 14, 2016 through December 31, 2016.

We attempt to deploy aircraft into the network in ways that best optimize our revenues and profitability and reduce our seasonality.

The percentage of our capacity by region is as follows:
 
2016 (a)
 
2015
 
2014
 
2013
 
2012
West Coast
34
%
 
36
%
 
36
%
 
34
%
 
35
%
Transcon/midcon
29
%
 
24
%
 
22
%
 
22
%
 
19
%
Hawaii and Costa Rica
17
%
 
18
%
 
18
%
 
19
%
 
20
%
Alaska
14
%
 
15
%
 
15
%
 
16
%
 
17
%
Mexico
5
%
 
6
%
 
6
%
 
7
%
 
7
%
Canada
1
%
 
1
%
 
3
%
 
2
%
 
2
%
Total
100
%
 
100
%
 
100
%
 
100
%
 
100
%
(a)
Includes information for Virgin America for the period December 14, 2016 through December 31, 2016.


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MAINLINE

The mainline operations include Boeing 737 ("B737") and Airbus family ("A319" and "A320") jet service offered by Alaska and Virgin America. We offer extensive passenger service from the western U.S. throughout the contiguous United States, Alaska, Hawaii, Canada, Mexico, Costa Rica and Cuba. Our largest concentration of departures is in Seattle. We also offer cargo service throughout our network and have dedicated cargo aircraft that operate primarily to and within the state of Alaska.
 
In 2016, we carried 25 million revenue passengers in our mainline operations. At December 31, 2016, our mainline operating fleet consisted of 155 B737 jet aircraft and 63 Airbus A320 family jet aircraft compared to 147 B737 aircraft as of December 31, 2015.

The percentage of mainline passenger capacity by region and average stage length is presented below:
 
2016 (a)
 
2015
 
2014
 
2013
 
2012
West Coast
30
%
 
31
%
 
31
%
 
28
%
 
29
%
Transcon/midcon
30
%
 
27
%
 
25
%
 
25
%
 
22
%
Hawaii
19
%
 
20
%
 
20
%
 
21
%
 
22
%
Alaska
15
%
 
16
%
 
16
%
 
18
%
 
18
%
Mexico
6
%
 
6
%
 
7
%
 
7
%
 
8
%
Canada
%
 
%
 
1
%
 
1
%
 
1
%
Total
100
%
 
100
%
 
100
%
 
100
%
 
100
%
 
 
 
 
 
 
 
 
 
 
Average Stage Length
1,225

 
1,195

 
1,182

 
1,177

 
1,161

(a)
Includes information for Virgin America for the period December 14, 2016 through December 31, 2016.

REGIONAL
 
Our regional operations consist of flights operated by Horizon, SkyWest and PenAir. In 2016, our regional operations carried approximately 9 million revenue passengers, primarily in the states of Washington, Oregon, Idaho and California. Horizon is the largest regional airline in the Pacific Northwest and carries about 83% of Air Group's regional revenue passengers.

Based on 2016 passenger enplanements on regional aircraft, our leading airports are Seattle and Portland. At December 31, 2016, Horizon’s operating fleet consisted of 52 Bombardier Q400 turboprop aircraft. The regional fleet operated by SkyWest consisted of 15 E175 aircraft.

The percentage of regional passenger capacity by region and average stage length is presented below:
 
2016
 
2015
 
2014
 
2013
 
2012
West Coast
60
%
 
62
%
 
66
%
 
66
%
 
68
%
Pacific Northwest
16
%
 
19
%
 
19
%
 
21
%
 
20
%
Canada
5
%
 
7
%
 
8
%
 
9
%
 
9
%
Alaska
4
%
 
5
%
 
4
%
 
2
%
 
2
%
Midcon
15
%
 
6
%
 
2
%
 
1
%
 
%
Mexico
%
 
1
%
 
1
%
 
1
%
 
1
%
Total
100
%
 
100
%
 
100
%
 
100
%
 
100
%
 
 
 
 
 
 
 
 
 
 
Average Stage Length
381

 
348

 
339

 
329

 
332


FREQUENT FLYER PROGRAMS

We currently maintain two frequent flyer plans: the Alaska Airlines Mileage Plan™ and the Virgin America Elevate®.

Mileage Plan™ provides a comprehensive suite of frequent flyer benefits. Miles can be earned by flying on Alaska or on one of our 24 airline partners, by using the Alaska Airlines credit card, or through other non-airline partners. Our extensive list of airline partners includes carriers associated with each of the three major global alliances, making it easier for our members to earn miles and reach elite status in our frequent flyer programs and have access to a large network of over 900 worldwide travel

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destinations. Further, members can receive 30,000 bonus miles upon signing up for the Alaska Airlines Visa Signature card and earn triple miles on purchases made on Alaska flights or on alaskaair.com. Alaska Airlines Visa Signature cardholders also receive an annual companion ticket that allows members to purchase an additional ticket for $99 plus taxes, with no restrictions or black-out dates, and a free first checked bag for up to seven people traveling in the same itinerary. Earned miles can be redeemed for flights on our airlines or on any of our partner airlines, or for upgrades to First Class and Premium Class on Alaska Airlines. All of these benefits give our Mileage Plan™ members more value for their travel on Alaska, leading us to receive the highest ranking in customer satisfaction amongst traditional carriers in North America from J.D. Power and Associates for the last nine consecutive years.

Mileage Plan™ revenues represented approximately 12% of Air Group's total revenues in 2016. Mileage Plan™ helps drive revenue growth by attracting new customers and building customer loyalty through the benefits that we provide.

The Elevate® program allows guests to earn points for purchasing travel that are redeemable for travel awards throughout our network and the networks of Virgin America's airline partners. Elevate® members have been introduced to the Mileage Plan™ program and, over time, the two programs will become one. Currently, our guests from both airlines enjoy codeshare and reciprocal frequent flyer benefits, including earning and redeeming rewards on both carriers. Elite members of each frequent flyer program receive priority boarding on both carriers.

AGREEMENTS WITH OTHER AIRLINES

Our agreements fall into three different categories: Frequent Flyer, Codeshare and Interline agreements. Frequent Flyer agreements offer mileage credits and redemptions for our Mileage Plan™ and Elevate® members. Alaska offers one of the most comprehensive frequent flyer programs for our Mileage Plan™ members through our frequent flyer partnerships with 24 domestic and international carriers.

Codeshare agreements allow one or more marketing carriers to sell seats on a single operating carrier that services passengers under multiple flight numbers. The sale of codeshare seats can vary depending on the sale arrangement. For example, in a free-sale arrangement, the marketing carrier sells the operating carrier's inventory without any restriction; whereas in a block space arrangement, a fixed amount of seats is sold to the marketing carrier by the operating carrier. The interchangeability of the flight code between carriers provides a greater selection of flights for customers, along with increased flexibility for mileage accrual and redemption.

Interline agreements allow airlines to jointly offer a competitive, single-fare itinerary to customers traveling via multiple carriers to a final destination. An interline itinerary offered by one airline may not necessarily be offered by the other, and the fares collected from passengers are prorated and distributed to interline partners according to preexisting agreements between the carriers. Frequent flyer, codeshare and interline agreements help increase our traffic and revenue by providing more route choices to our guests.

We have marketing alliances with a number of airlines that provide frequent flyer and codesharing opportunities. Alliances are an important part of our strategy and enhance our revenues by:
 
offering our guests more travel destinations and better mileage credit/redemption opportunities, including elite qualifying miles on all of our major U.S. and international airline partners;

giving our frequent flyer program a competitive advantage because of our partnership with carriers from all three of the major global alliances;
 
giving us access to more connecting traffic from other airlines; and
 
providing members of our alliance partners’ frequent flyer programs an opportunity to travel on Alaska, Virgin America and our regional affiliates while earning mileage credit in our partners’ programs.
 
Most of our codeshare relationships are free-sale codeshares, where the marketing carrier sells seats on the operating carrier’s flights from the operating carrier’s inventory, but takes no inventory risk. Our marketing agreements have various termination dates, and one or more may be in the process of renegotiation at any time.

On December 19, 2016 we announced the termination of our codeshare agreement with Delta Air Lines ("Delta"), effective April 30, 2017. Our interline agreement with Delta will continue. We expect the impact to our guests in 2017 to be minimal due to growth in Alaska's own network, in large part from our acquisition of Virgin America, and our ability to codeshare with other

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partners. We also believe the financial exposure from the termination of our codeshare agreement with Delta will be immaterial to our financial results in 2017.

The comprehensive summary of Alaska, Horizon and SkyWest alliances with other airlines is as follows:
 
 
 
Codeshare
 
Frequent
Flyer
Agreement
 
Alaska Flight # on
Flights Operated by
Other Airline
 
Other Airline Flight #
on Flights Operated by
Alaska / Horizon / SkyWest
Major U.S. or International Airlines
 
 
 
 
 
Aeromexico
Yes
 
No
 
Yes
American Airlines
Yes
 
Yes
 
Yes
Air France
Yes
 
No
 
Yes
British Airways
Yes
 
No
 
Yes
Cathay Pacific Airways
Yes
 
No
 
Yes
Delta Air Lines(b)
Yes(b)
 
Yes(b)
 
Yes(b)
Emirates
Yes
 
No
 
Yes
Icelandair
Yes
 
No
 
Yes
Hainan Airlines
Yes
 
No
 
No
KLM
Yes
 
No
 
Yes
Korean Air
Yes
 
No
 
Yes
LAN S.A.
Yes
 
No
 
Yes
Fiji Airways(a)
Yes
 
No
 
Yes
Qantas
Yes
 
No
 
Yes
Regional Airlines
 
 
 
 
 
Rav'n Alaska
Yes
 
Yes
 
No
PenAir(a)
Yes
 
Yes
 
No
(a)
These airlines do not have their own frequent flyer program. However, Alaska's Mileage PlanTM members can earn and redeem miles on these airlines' route systems.
(b)
Codeshare and frequent flyer agreements with Delta terminate on April 30, 2017.

The comprehensive summary of Virgin America alliances with other airlines is as follows:
 
 
 
Codeshare
 
Frequent
Flyer
Agreement
 
Virgin America Flight # on Flights Operated by
Other Airline
 
Other Airline Flight #
on Flights Operated by
Virgin America
Major U.S. or International Airlines
 
 
 
 
 
China Airlines
No
 
No
 
Yes
China Eastern
No
 
No
 
Yes
China Southern
No
 
No
 
Yes
Emirates
Yes
 
No
 
No
Hawaiian Airlines
Yes(a)
 
No
 
Yes
Singapore Airlines
Yes
 
No
 
Yes
Virgin Australia
Yes
 
No
 
Yes
(a)
Ability to redeem award flights only (no mileage accrual on Hawaiian Airlines flight segments).


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The following is the financial impact of our marketing alliances:
 
2016(a)
 
2015
 
2014
 
2013
 
2012
Air Group Marketed Revenues
92%
 
90%
 
91%
 
90%
 
90%
 
 
 
 
 
 
 
 
 
 
Codeshare Agreements:
 
 
 
 
 
 
 
 
 
American Airlines
3%
 
4%
 
3%
 
2%
 
3%
Delta Air Lines
1%
 
2%
 
2%
 
4%
 
3%
Others
1%
 
1%
 
1%
 
1%
 
1%
 
 
 
 
 
 
 
 
 
 
Interline Agreements:
 
 
 
 
 
 
 
 
 
Domestic Interline
2%
 
2%
 
2%
 
2%
 
2%
International Interline
1%
 
1%
 
1%
 
1%
 
1%
Total Operating Revenue
100%
 
100%
 
100%
 
100%
 
100%
(a)
Includes information for Virgin America for the period December 14, 2016 through December 31, 2016.

OTHER REVENUE

Other revenue consists of freight and mail, certain frequent flyer and ancillary revenue. While some of our product features are included in our base pricing, we have unbundled certain ancillary features that our guests separately value. Major ancillary revenue products include checked bag fees, change fees and lounge memberships. We also promote and sell products in-flight to enhance the guest experience, including our Tom Douglas signature meals, snacks, alcoholic beverages, in-flight entertainment and Wi-Fi. Total other revenue, excluding frequent flyer program revenue, represents about 7% of our total revenues.

GENERAL

The airline industry is highly competitive and subject to various uncertainties, including economic conditions, volatile fuel prices, industry instability, new competition, a largely unionized work force, the need to finance large capital expenditures and the related availability of capital, government regulation—including taxes and fees and potential aircraft incidents. Airlines have high fixed costs, primarily for wages, aircraft fuel, aircraft ownership and facilities rents. Because expenses of a flight do not vary significantly based on the number of passengers carried, a relatively small change in the number of passengers or in pricing has a disproportionate effect on an airline’s operating and financial results. In other words, a minor shortfall in expected revenue levels could cause a disproportionately negative impact on our operating and financial results. Passenger demand and ticket prices are, to a large measure, influenced by the general state of the economy, current global economic and political events, and total available airline seat capacity.

In 2016, the airline industry reported historically high revenues and profits, as the global economy continued to recover and oil prices remained low. As the industry strengthens, airlines are now making significant investments in airports, in new planes and in new services to differentiate their customer service offering. Thus, the level of competition is expected to increase.

FUEL

Our business and financial results are highly affected by the price and the availability of aircraft fuel. The cost of aircraft fuel is volatile and outside of our control, and it can have a significant and immediate impact on our operating results. Over the past five years, aircraft fuel expense ranged from 18% to 35% of operating expenses. Fuel prices are impacted by changes in both the price of crude oil and refining margins and can vary by region in the U.S.
 
The prices we have paid for crude oil on an average annual basis for the past five years have ranged from a low of $43 per barrel in 2016 to a high of $98 in 2013. For us, a $1 per barrel change in the price of oil equates to approximately $18 million of fuel cost annually. Said another way, a one-cent change in our fuel price per gallon will impact our expected annual fuel cost by approximately $7 million per year.

Refining margins, which represent the price of refining crude oil into aircraft fuel, are a smaller portion of the overall price of jet fuel but also contributed to the price volatility in recent years. Average annual refining margin prices have fluctuated between $13 per barrel and $36 per barrel in the last five years, and averaged $13 in 2016.


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Generally, West Coast jet fuel prices are somewhat higher and more volatile than prices in the Gulf Coast or on the East Coast. Our average raw fuel cost per gallon decreased 19% in 2016, 39% in 2015 and 6% in 2014.

The percentages of our aircraft fuel expense by crude oil and refining margins, as well as the percentage of our aircraft fuel expense of operating expenses are as follows:
 
2016 (a)
 
2015
 
2014
 
2013
 
2012
Crude oil
69
%
 
62
%
 
72
%
 
71
%
 
65
%
Refining margins
20
%
 
26
%
 
18
%
 
19
%
 
25
%
Other(b)
11
%
 
12
%
 
10
%
 
10
%
 
10
%
Total
100
%
 
100
%
 
100
%
 
100
%
 
100
%
 
 
 
 
 
 
 
 
 
 
Aircraft fuel expense
18
%
 
22
%
 
32
%
 
34
%
 
35
%
(a)
Includes information for Virgin America for the period December 14, 2016 through December 31, 2016.
(b)
Other includes gains and losses on settled fuel hedges, unrealized mark-to-market fuel hedge gains or losses, taxes and other into-plane costs.

We use crude oil call options as hedges to decrease our exposure to the volatility of jet fuel prices. Historically, we have had jet fuel refining margin swap contracts, but we discontinued the use of the refining margin swaps in 2014. Call options effectively cap our pricing for crude oil, limiting our exposure to increasing fuel prices for about half of our planned fuel consumption. With call options, we are hedged against spikes in crude oil prices, and during a period of decline in crude oil prices, we only forfeit cash previously paid for hedge premiums. We begin hedging approximately 18 months in advance of crude oil consumption.

We believe that operating fuel-efficient aircraft is the best hedge against high fuel prices. Alaska operates an all-Boeing 737 fleet, Virgin America operates an all-Airbus A320 family fleet, and Horizon currently operates an all-Bombardier Q400 turboprop fleet. Air Group's fuel-efficiency rate expressed in available seat miles flown per gallon ("ASMs/g") improved from 74.5 ASMs/g in 2012 to 79.7 ASMs/g in 2016. These improvements have not only reduced our fuel consumption rate, but also the amount of greenhouse gases and other pollutants that our aircraft emit.

COMPETITION

Competition in the airline industry is intense and unpredictable. Our competitors consist primarily of other airlines and, to a lesser extent, other forms of transportation. Competition can be direct, in the form of another carrier flying the exact non-stop route, or indirect, where a carrier serves the same two cities non-stop from an alternative airport in that city or via an itinerary requiring a connection at another airport. We compete with other domestic airlines and a limited number of international airlines on nearly all of our scheduled routes. Our largest competitor is Delta, who has significantly increased their capacity in Seattle over the past few years. Approximately 61% of our capacity to and from Seattle competes with Delta. Based on schedules filed with the U.S. Department of Transportation, we expect the amount of competitive capacity overlap with all carriers to increase by more than 5% in the first half of 2017, weighted based on our network.

We believe that the following principal competitive factors are important to our guests:
 
Safety record
 
Customer service and reputation

We compete with other airlines in areas of customer service such as on-time performance, guest amenities—including first class and other premium seating, quality of on-board products, aircraft type and comfort. In 2016, Alaska Airlines ranked highest in customer satisfaction among traditional network carriers by J.D. Power and Associates for the ninth year in a row. In 2016 we began installing Boeing Space Bins on our Boeing 737-900ER fleet, providing additional overhead bin space for our guests. In 2017, we are launching a Premium Class of service on our B737 aircraft that will provide extra legroom, early boarding, premium snacks and a complimentary alcoholic beverage. Additionally, in 2017 we are increasing the distance between seats in our first class cabins on the Alaska B737-900 and B737-900ER fleet, providing significantly more space for guests flying in the first class cabin. We expect to fully complete the first class cabin upgrades on the B737-900 and B737-900ER fleet in early 2018.


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Cabins of our Virgin America Airbus A320 family fleet have a distinctive appearance through innovative design and use of technology. Every cabin features special mood lighting, designed to create a calming, low-stress environment for our guests; custom leather seats, tailored to provide comfort, especially on our long-haul flights; inflight wireless internet access; and electrical power outlets adjacent to every seat. All of our guests flying on Virgin America aircraft have access to the Red® inflight entertainment system that allows each guest to customize his or her inflight experience through a host of entertainment options, on-demand food and beverage ordering system and a seat-to-seat chat function.

Our employees are a key element of our product. We have a highly engaged workforce that strives to provide a high degree of service and hospitality to our guests both at the airport and in flight. We heavily emphasize our service standards with our employees through training and education programs and monetary incentives related to operational performance and guest surveys.
 
Fares and ancillary services

The pricing of fares is a significant competitive factor in the airline industry, and the increased availability of fare information on the Internet allows travelers to easily compare fares and identify competitor promotions and discounts. Pricing is driven by a variety of factors including, but not limited to, market-specific capacity, market share per route/geographic area, cost structure, fare vs. ancillary revenue strategies, and demand.

For example, airlines often discount fares to drive traffic in new markets or to stimulate traffic when necessary to improve load factors. In addition, traditional network carriers have been able to reduce their operating costs through bankruptcies and mergers, while low-cost carriers have continued to grow their fleets and expand their networks, potentially enabling them to better control costs per available seat mile (the average cost to fly an aircraft seat one mile), which in turn may enable them to lower their fares. These factors can reduce our pricing power and that of the airline industry as a whole.

Domestic airline capacity is dominated by four large carriers, representing approximately 82% of total seats. Accordingly, if these carriers discount their fares or enter into our core markets, we must match those fares in order to maintain our load factors, often resulting in year-over-year decreases in our yields. We will defend our core markets vigorously and, if necessary, redeploy capacity to better match supply with demand. We believe the restructuring we've completed over the past decade has decreased our costs, enabling us to offer competitive fares while still earning appropriate returns for our shareholders.

Routes served, flight schedules, codesharing and interline relationships, and frequent flyer programs

We also compete with other airlines based on markets served, the frequency of service to those markets and frequent flyer opportunities. Some airlines have more extensive route structures than we do, and they offer significantly more international routes. In order to expand opportunities for our guests, we enter into codesharing and interline relationships with other airlines that provide reciprocal frequent flyer mileage credit and redemption privileges. These relationships allow us to offer our guests access to more destinations than we can on our own, gain exposure in markets we don't serve and allow our guests more opportunities to earn and redeem frequent flyer miles. Our frequent flyer programs offer some of the most comprehensive benefits to our members with the ability to earn and redeem miles on 24 of our partner carriers.

In addition to domestic or foreign airlines that we compete with on most of our routes, we compete with ground transportation in our short-haul markets.  Our airlines, to some extent, also compete with technology such as video conferencing and internet-based meeting tools that have changed the need for, or frequency, of face-to-face business meetings.

TICKET DISTRIBUTION
 
Our tickets are distributed through three primary channels:
 
Direct to customer: It is less expensive for us to sell through our direct channels at alaskaair.com and virginamerica.com. As a result, we continue to take steps to drive more business to our websites. In addition, we believe this channel is preferable from a branding and customer-relationship standpoint in that we can establish ongoing communication with the customer and tailor offers accordingly.
 
Traditional and online travel agencies: Both traditional and online travel agencies typically use Global Distribution Systems (GDS) to obtain their fare and inventory data from airlines. Bookings made through these agencies result in a fee that is charged to the airline. Many of our large corporate customers require us to use these agencies. Some of our competitors do not use this distribution channel and, as a result, have lower ticket distribution costs.

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Reservation call centers: The Alaska call centers are located in Phoenix, AZ, Kent, WA, and Boise, ID. Virgin America uses an outsourced call center. We generally charge a $15 fee for booking reservations through the Alaska call centers and $20 for booking reservations through the Virgin America call centers. We plan on combining the reservations call centers over the next several months as part of our integration efforts.

Our sales by channel are as follows: 
 
2016 (a)
 
2015
 
2014
 
2013
 
2012
Direct to customer
61
%
 
60
%
 
57
%
 
55
%
 
54
%
Traditional agencies
23
%
 
23
%
 
25
%
 
27
%
 
27
%
Online travel agencies
11
%
 
11
%
 
12
%
 
13
%
 
13
%
Reservation call centers
5
%
 
6
%
 
6
%
 
5
%
 
6
%
Total
100
%
 
100
%
 
100
%
 
100
%
 
100
%
(a)
Includes results for Virgin America for the period December 14, 2016 through December 31, 2016.

SEASONALITY AND OTHER FACTORS

Our results of operations for any interim period are not necessarily indicative of those for the entire year because our business is subject to seasonal fluctuations. Our profitability is generally lowest during the first and fourth quarters due principally to fewer departures and passengers. Profitability typically increases in the second quarter and then reaches its highest level during the third quarter as a result of vacation travel, including increased activity in the state of Alaska. However, we have significantly improved the seasonality of our operations by our continued growth from the West Coast to leisure destinations, like Hawaii and Costa Rica, and expanding to leisure and business destinations in the mid-continental and eastern U.S.

In addition to passenger loads, factors that could cause our quarterly operating results to vary include:  

general economic conditions and resulting changes in passenger demand,

•      changes in fuel costs,
 
pricing initiatives by us or our competitors,
 
increases in competition at our primary airports, and
 
increases or decreases in passenger and volume-driven variable costs.
 
Many of the markets we serve experience inclement weather conditions in the winter, causing increased costs associated with deicing aircraft, canceling flights and accommodating displaced passengers. Due to our geographic area of operations, we can be more susceptible to adverse weather conditions, particularly in the state of Alaska and the Pacific Northwest, than some of our competitors, who may be better able to spread weather-related risks over larger route systems. We also are more susceptible to ground delays due to our heavy concentration of departures from San Francisco International Airport.

No material part of our business or that of our subsidiaries is dependent upon a single customer, or upon a few high-volume customers.

EMPLOYEES

Our business is labor intensive. As of December 31, 2016, we employed 19,112 (12,224 at Alaska, 3,252 at Virgin America and 3,636 at Horizon) active full-time and part-time employees. Wages and benefits, including variable incentive pay, represented approximately 40% of our total non-fuel operating expenses in both 2016 and 2015.

Most major airlines, including Alaska and Horizon, have employee groups that are covered by collective bargaining agreements. Airlines with unionized work forces generally have higher labor costs than carriers without unionized work forces, and they may not have the ability to adjust labor costs downward quickly enough to respond to new competition or slowing demand. At December 31, 2016, labor unions represented 84% of Alaska’s and 43% of Horizon’s employees. Inflight teammates, our term for flight attendants at Virgin America, and pilots at Virgin America voted to be represented by unions on

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August 13, 2014 and June 4, 2015, respectively. However, as of December 31, 2016 neither Virgin America work group had completed collective bargaining agreement negotiations.

Our relations with U.S. labor organizations are governed by the Railway Labor Act ("RLA"). Under this act, collective bargaining agreements do not expire but instead become amendable as of a stated date. If either party wishes to modify the terms of any such agreement, it must notify the other party in the manner prescribed by the RLA and/or described in the agreement. After receipt of such notice, the parties must meet for direct negotiations, and if no agreement is reached, either party may request the National Mediation Board ("NMB") to initiate a process including mediation, arbitration, and a potential “cooling off” period that must be followed before either party may engage in self-help.

Alaska’s union contracts at December 31, 2016 were as follows:
Union
 
Employee Group
 
Number of Employees
 
Contract Status
Air Line Pilots Association International (ALPA)
 
Pilots
 
1,834

 
Amendable 03/31/2018
Association of Flight Attendants (AFA)
 
Flight attendants
 
3,921

 
Amendable 12/17/2019
International Association of Machinists and Aerospace Workers (IAM)
 
Ramp service and stock clerks
 
634

 
Amendable 7/19/2018
IAM
 
Clerical, office and passenger service
 
3,032

 
Amendable 1/1/2019
Aircraft Mechanics Fraternal Association (AMFA) (a)
 
Mechanics, inspectors and cleaners
 
684

 
Amendable 10/17/2016
Mexico Workers Association of Air Transport
 
Mexico airport personnel
 
86

 
Amendable 9/29/2016
Transport Workers Union of America (TWU)
 
Dispatchers
 
49

 
Amendable 3/24/2019
(a) On December 12, 2016, Alaska reached a tentative agreement with AMFA on a proposed five-year contract. If ratified the new contract would become amendable in October 2021.

Horizon’s union contracts at December 31, 2016 were as follows:
Union
 
Employee Group
 
Number of Employees
 
Contract Status
International Brotherhood of Teamsters (IBT)
 
Pilots
 
618

 
Amendable 12/14/2024
AFA
 
Flight attendants
 
623

 
Amendable 07/18/2019
IBT
 
Mechanics and related classifications
 
271

 
Amendable 12/16/2020
National Automobile, Aerospace, Transportation and General Workers
 
Station personnel in 
Vancouver and Victoria, BC, Canada
 
38

 
Amendable 2/14/2019
TWU
 
Dispatchers
 
18

 
Amendable 8/26/2018

Virgin America's union contracts at December 31, 2016 were as follows:
Union
 
Employee Group
 
Number of Employees
 
Contract Status
ALPA
 
Pilots
 
714

 
Not completed
TWU
 
Inflight teammates
 
1,068

 
Not completed
 

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EXECUTIVE OFFICERS
 
The executive officers of Air Group. and executive officers of Alaska, Virgin America and Horizon who have significant decision-making responsibilities, their positions and their respective ages are as follows: 
Name
 
Position
 
Age
 
Air Group
or Subsidiary
Officer Since
Bradley D. Tilden
 
Chairman and Chief Executive Officer of Alaska Air Group, Inc., Chairman of Alaska Airlines, Inc., Horizon Air Industries, Inc. and Virgin America Inc.
 
56
 
1994
 
 
 
 
 
 
 
Benito Minicucci
 
President and Chief Operating Officer of Alaska Airlines, Inc. and Chief Executive Officer of Virgin America Inc.
 
50
 
2004
 
 
 
 
 
 
 
Brandon S. Pedersen
 
Executive Vice President/Finance and Chief Financial Officer of Alaska Air Group, Inc. and Alaska Airlines, Inc., and Chief Financial Officer of Virgin America Inc.
 
50
 
2003
 
 
 
 
 
 
 
Andrew R. Harrison
 
Executive Vice President and Chief Commercial Officer of Alaska Airlines, Inc.
 
46
 
2008
 
 
 
 
 
 
 
David L. Campbell
 
President and Chief Executive Officer of Horizon Air Industries, Inc.
 
55
 
2014
 
 
 
 
 
 
 
Kyle B. Levine
 
Vice President Legal and General Counsel of Alaska Air Group, Inc. and Alaska Airlines, Inc. and Chief Ethics and Compliance Officer of Alaska Air Group, Inc.
 
45
 
2016
 
Mr. Tilden joined Alaska Airlines in 1991, became Controller of Alaska Air Group and Alaska Airlines in 1994 and was named Vice President/Finance at Alaska Airlines in January 1999 and at Alaska Air Group in February 2000. He was elected Alaska Airlines Chief Financial Officer in February 2000, Executive Vice President/Finance and Chief Financial Officer of both companies in January 2002 and Executive Vice President/Finance and Planning of Alaska Airlines in April 2007. Mr. Tilden was named, President of Alaska Airlines in December 2008, and in May 2012, he was elected President and CEO of Alaska Air Group and Alaska Airlines and CEO of Horizon Air. He leads Air Group’s Management Executive Committee and was elected to the Air Group Board in 2010 and became Chairman of the Board in January 2014.

Mr. Minicucci joined Alaska Airlines in 2004 as Staff Vice President of Maintenance and Engineering and was promoted to Vice President of Seattle Operations in June 2008. He was elected Executive Vice President/Operations and Chief Operating Officer of Alaska Airlines in December 2008. In May 2016, he was named President of Alaska Airlines and, in December 2016, Chief Executive Officer of Virgin America. He is a member of Air Group’s Management Executive Committee.

Mr. Pedersen joined Alaska Airlines in 2003 as Staff Vice President/Finance and Controller of Alaska Air Group and Alaska Airlines and was elected Vice President/Finance and Controller for both entities in 2006. He was elected Chief Financial Officer of Alaska Air Group and Alaska Airlines in June 2010 and Executive Vice President/Finance and Chief Financial Officer of both entities in 2014. In December 2016, he was named Chief Financial Officer of Virgin America Inc. He is a member of Air Group's Management Executive Committee.

Mr. Harrison joined Alaska Airlines in 2003 as the Managing Director of Internal Audit and was elected Vice President of Planning and Revenue Management in 2008. He was elected Senior Vice President of Planning and Revenue Management in 2014. He was elected Executive Vice President and Chief Revenue Officer in February 2015 and named Executive Vice President and Chief Commercial Officer in August 2015. He is a member of Air Group's Management Executive Committee.

Mr. Campbell joined Horizon Air in 2014 as President and Chief Operating Officer and was named President and Chief Executive Officer in May 2016. Prior to joining Horizon Air, Mr. Campbell served more than 25 years in maintenance and flight operations. Most recently, he served as the Vice President of Maintenance and Engineering at JetBlue Airways from January 2014 to August 2014, and, prior to that, he served as Vice President of Safety and Operational Performance at

15




American Airlines. He joined American in 1988 after serving for four years in the U.S. Air Force and has overseen maintenance, quality, technical operations and safety. He is a member of Air Group's Management Executive Committee.

Mr. Levine was elected Vice President Legal and General Counsel of Alaska Air Group and Alaska Airlines in January 2016 and is a member of Air Group’s Management Executive Committee. He joined Alaska Airlines in February 2006 as a Senior Attorney. He also served as Associate General Counsel and Managing Director Commercial Law and General Litigation from July 2009 to February 2011 and, subsequently, as Deputy General Counsel and Managing Director of Legal at Alaska Airlines from February 2011 to January 2016. He was appointed Assistant Corporate Secretary of Air Group and Alaska Airlines in February 2014.

REGULATION
 
GENERAL
 
The airline industry is highly regulated, most notably by the federal government. The Department of Transportation (DOT), the Federal Aviation Administration (FAA) and the Transportation Security Administration (TSA) exercise significant regulatory authority over air carriers.
 
DOT: In order to provide passenger and cargo air transportation in the U.S., a domestic airline is required to hold a certificate of public convenience and necessity issued by the DOT. Subject to certain individual airport capacity, noise and other restrictions, this certificate permits an air carrier to operate between any two points in the U.S. Certificates do not expire, but may be revoked for failure to comply with federal aviation statutes, regulations, orders or the terms of the certificates. While airlines are permitted to establish their own fares without government regulation, the DOT has jurisdiction over the approval of international codeshare agreements, marketing alliance agreements between major domestic carriers, international and some domestic route authorities, Essential Air Service market subsidies, carrier liability for personal or property damage, and certain airport rates and charges disputes. International treaties may also contain restrictions or requirements for flying outside of the U.S. and impose different carrier liability limits than those applicable to domestic flights. The DOT has been active in implementing a variety of “consumer protection” regulations, covering subjects such as advertising, passenger communications, denied boarding compensation and tarmac delay response. Airlines are subject to enforcement actions that are brought by the DOT from time to time for alleged violations of consumer protection and other economic regulations. We are not aware of any enforcement proceedings that could either materially affect our financial position or impact our authority to operate.

FAA: The FAA, through Federal Aviation Regulations (FARs), generally regulates all aspects of airline operations, including establishing personnel, maintenance and flight operation standards. Domestic airlines are required to hold a valid air carrier operating certificate issued by the FAA. Pursuant to these regulations, we have established, and the FAA has approved, our operations specifications and a maintenance program for each type of aircraft we operate. Each maintenance program provides for the ongoing maintenance of the relevant aircraft type, ranging from frequent routine inspections to major overhauls. From time to time the FAA issues airworthiness directives (ADs) that must be incorporated into our aircraft maintenance program and operations. All airlines are subject to enforcement actions that are brought by the FAA from time to time for alleged violations of FARs or ADs. At this time, we are not aware of any enforcement proceedings that could either materially affect our financial position or impact our authority to operate.

TSA: Airlines serving the U.S. must operate a TSA-approved Aircraft Operator Standard Security Program (AOSSP), and comply with TSA Security Directives (SDs) and regulations. Under TSA authority, we are required to collect a September 11 Security Fee of $5.60 per one-way trip from passengers and remit that sum to the government to fund aviation security measures. Airlines are subject to enforcement actions that are brought by the TSA from time to time for alleged violations of the AOSSP, SDs or security regulations. We are not aware of any enforcement proceedings that could either materially affect our financial position or impact our authority to operate.

The Department of Justice and DOT have jurisdiction over airline antitrust matters. The U.S. Postal Service has jurisdiction over certain aspects of the transportation of mail and related services. Labor relations in the air transportation industry are regulated under the Railway Labor Act. To the extent we continue to fly to foreign countries and pursue alliances with international carriers, we may be subject to certain regulations of foreign agencies and international treaties.


16




ENVIRONMENTAL AND OCCUPATIONAL SAFETY MATTERS
 
We are subject to various laws and government regulations concerning environmental matters and employee safety and health in the U.S. and other countries. U.S. federal laws that have a particular effect on us include the Airport Noise and Capacity Act of 1990, the Clean Air Act, the Resource Conservation and Recovery Act, the Clean Water Act, the Safe Drinking Water Act, and the Comprehensive Environmental Response, Compensation and Liability Act, Superfund Amendments and Reauthorization Act, and the Oil Pollution Control Act. We are also subject to the oversight of the Occupational Safety and Health Administration (OSHA) concerning employee safety and health matters. The U.S. Environmental Protection Agency, OSHA, and other federal agencies have been authorized to create and enforce regulations that have an impact on our operations. In addition to these federal activities, various states have been delegated certain authorities under these federal statutes. Many state and local governments have adopted environmental and employee safety and health laws and regulations. We maintain our safety, health and environmental programs in order to meet or exceed these requirements.

We believe there may be local or federal legislation in the future to reduce carbon and other greenhouse gas emissions. Over the course of several years, we have transitioned to more fuel-efficient aircraft fleets and reduced our emissions with the goal of continuing that trend.

The Airport Noise and Capacity Act recognizes the rights of airport operators with noise problems to implement local noise abatement programs so long as they do not interfere unreasonably with interstate or foreign commerce or the national air transportation system. Authorities in several cities have established aircraft noise reduction programs, including the imposition of nighttime curfews. We believe we have sufficient scheduling flexibility to accommodate local noise restrictions.
 
Although we do not currently anticipate that these regulatory matters, individually or collectively, will have a material effect on our financial condition, results of operations or cash flows, new regulations or compliance issues that we do not currently anticipate could have the potential to harm our financial condition, results of operations or cash flows in future periods.

INSURANCE

We carry insurance of types customary in the airline industry and in amounts deemed adequate to protect our interests and property and to comply both with federal regulations and certain credit and lease agreements. The insurance policies principally provide coverage for Airline Hull, Spares and Comprehensive Legal Liability Insurance, War and Allied Perils, and Workers’ Compensation. In addition, we currently carry a Cyber Liability policy in the event of security breaches from malicious parties.

We believe that our emphasis on safety and our state-of-the-art flight deck safety technology help to control the cost of our insurance.

WHERE YOU CAN FIND MORE INFORMATION
 
Our filings with the Securities and Exchange Commission, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports are available on our website at www.alaskaair.com, free of charge, as soon as reasonably practicable after the electronic filing of these reports with the Securities and Exchange Commission. The information contained on our website is not a part of this annual report on Form 10-K.
 
GLOSSARY OF 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

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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 our fuel-hedging program

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

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 1A. RISK FACTORS
 
If any of the following occurs, our business, financial condition and results of operations could suffer. In such case, the trading price of our common stock could also decline. We operate in a continually changing business environment.  In this environment, new risks may emerge, and already identified risks may vary significantly in terms of impact and likelihood of occurrence. Management cannot predict such developments, nor can it assess the impact, if any, on our business of such new risk factors or of events described in any forward-looking statements.

We have adopted an enterprise wide Risk Analysis and Oversight Program designed to identify the various risks faced by the organization, assign responsibility for managing those risks to individual executives as well as align these risks with Board oversight. These enterprise-level risks have been aligned to the risk factors discussed below.

SAFETY, COMPLIANCE AND OPERATIONAL EXCELLENCE

Our reputation and financial results could be harmed in the event of an airline accident or incident.
 
An accident or incident involving one of our aircraft or an aircraft operated by one of our codeshare partners or CPA carriers could involve a significant loss of life and result in a loss of confidence in our airlines by the flying public and/or aviation authorities. We could experience significant claims from injured passengers, bystanders and surviving relatives as well as costs for the repair or replacement of a damaged aircraft and its consequential temporary or permanent loss from service. We maintain liability insurance in amounts and of the type generally consistent with industry practice, as do our codeshare partners and CPA carriers. However, the amount of such coverage may not be adequate to fully cover all claims, and we may be forced to bear substantial economic losses from such event. Substantial claims resulting from an accident in excess of our related insurance coverage would harm our business and financial results. Moreover, any aircraft accident or incident, even if it is fully insured and does not involve one of our aircraft, could cause a public perception that our airlines or the aircraft we or our partners fly are less safe or reliable than other transportation alternatives. This would harm our business.

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Our operations are often affected by factors beyond our control, including delays, cancellations and other conditions, which could harm our business, financial condition and results of operations.

As is the case for all airlines, our operations often are affected by delays, cancellations and other conditions caused by factors largely beyond our control.

Factors that might impact our operations include:

congestion and/or space constraints at airports or air traffic control problems;

lack of operational approval (e.g. new routes, aircraft deliveries, etc.);

adverse weather conditions;
 
increased security measures or breaches in security;

contagious illness and fear of contagion;
 
changes in international treaties concerning air rights;

international or domestic conflicts or terrorist activity; and

other changes in business conditions.

Due to our concentration of flights in the Pacific Northwest and Alaska, we believe a large portion of our operation is more susceptible to adverse weather conditions. A general reduction in airline passenger traffic as a result of any of the above-mentioned factors could harm our business, financial condition and results of operations.

Changes in government regulation imposing additional requirements and restrictions on our operations could increase our operating costs and result in service delays and disruptions.
 
Airlines are subject to extensive regulatory and legal requirements, both domestically and internationally, that involve significant compliance costs. In the last several years, Congress has passed laws, and the U.S. DOT, the TSA and the FAA have issued regulations that have required significant expenditures relating to maintenance of aircraft, operation of airlines and establishment of consumer protection.

Similarly, there are a number of legislative and regulatory initiatives and reforms at the federal, state and local levels. These initiatives include increasingly stringent laws to protect the environment, minimum wage requirements and health care mandates. They could affect our relationship with our workforce and the vendors that serve our airlines and cause our expenses to increase without an ability to pass through these costs. 

Almost all commercial service airports are owned and/or operated by units of local or state governments. Airlines are largely dependent on these governmental entities to provide adequate airport facilities and capacity at an affordable cost. Many airports have increased their rates and charges to air carriers to reflect higher costs of security, updates to infrastructures and other. Additional laws, regulations, taxes, airport rates and airport charges may be occasionally proposed that could significantly increase the cost of airline operations or reduce the demand for air travel. Although lawmakers may impose these additional fees and view them as “pass-through” costs, we believe that a higher total ticket price will influence consumer purchase and travel decisions and may result in an overall decline in passenger traffic, which would harm our business.

The airline industry continues to face potential security concerns and related costs.

Terrorist attacks, the fear of such attacks or other hostilities involving the U.S. could have a significant negative effect on the airline industry, including us, and could:
 
significantly reduce passenger traffic and yields as a result of a potentially dramatic drop in demand for air travel;
 
significantly increase security and insurance costs;
 

19




make war risk or other insurance unavailable or extremely expensive;
 
increase fuel costs and the volatility of fuel prices;
 
increase costs from airport shutdowns, flight cancellations and delays resulting from security breaches and perceived safety threats; and
 
result in a grounding of commercial air traffic by the FAA.
 
The occurrence of any of these events would harm our business, financial condition and results of operations.
 
We rely on third-party vendors for certain critical activities.
 
We rely on outside vendors for a variety of services and functions critical to our business, including airframe and engine maintenance, ground handling, fueling, computer reservation system hosting, telecommunication systems and information technology infrastructure and services.
 
Even though we strive to formalize agreements with these vendors that define expected service levels, our use of outside vendors increases our exposure to several risks. In the event that one or more vendors go into bankruptcy, ceases operation or fails to perform as promised, replacement services may not be readily available at competitive rates, or at all. If one of our vendors fails to perform adequately, we may experience increased costs, delays, maintenance issues, safety issues or negative public perception of our airline. Vendor bankruptcies, unionization, regulatory compliance issues or significant changes in the competitive marketplace among suppliers could adversely affect vendor services or force us to renegotiate existing agreements on less favorable terms. These events could result in disruptions in our operations or increases in our cost structure.

STRATEGY

The airline industry is highly competitive and susceptible to price discounting and changes in capacity, which could have a material adverse effect on our business. If we cannot successfully compete in the marketplace, our business, financial condition and operating results will be materially adversely affected.

The U.S. airline industry is characterized by substantial price competition. In recent years, the market share held by low-cost carriers and ultra low-cost carriers has increased significantly and is expected to continue to increase. Airlines also compete for market share by increasing or decreasing their capacity, route systems and the number of markets served. Several of our competitors have increased their capacity in markets we serve, particularly on the West Coast and in our Seattle hub, resulting in increased competition for those destinations. Increased competition in both domestic and international markets may have a material adverse effect on our results of operations, financial condition or liquidity.

We continue to strive toward aggressive cost-reduction goals that are an important part of our business strategy of offering the best value to our guests through competitive fares while achieving acceptable profit margins and return on capital. If we are unable to reduce our costs over the long-term and achieve sustained targeted returns on invested capital, we will likely not be able to grow our business in the future or weather industry downturns. Therefore, our financial results may suffer.

The airline industry may undergo further restructuring, consolidation, or the creation or modification of alliances or joint ventures, any of which could have a material adverse effect on our business, financial condition and results of operations.

We continue to face strong competition from other carriers due to restructuring, consolidation, and the creation and modification of alliances and joint ventures. Since deregulation, both the U.S. and international airline industries have experienced consolidation through a number of mergers and acquisitions. Carriers may also improve their competitive positions through airline alliances, slot swaps/acquisitions and/or joint ventures. Certain airline joint ventures further competition by allowing airlines to coordinate routes, pool revenues and costs, and enjoy other mutual benefits, achieving many of the benefits of consolidation.

We depend on a few key markets to be successful.
 
Our strategy includes being the premier carrier for people living on the West Coast. This results in a high concentration of our business in key West Coast markets. A significant portion of our flights occur to and from our Seattle hub. In 2016, passengers to and from Seattle accounted for 61% of our total guests. We expect this to become more diversified in the future as a result of the recent acquisition of Virgin America, whose primary hubs are San Francisco and Los Angeles.

20





We believe that concentrating our service offerings in this way allows us to maximize our investment in personnel, aircraft and ground facilities, as well as to gain greater advantage from sales and marketing efforts in those regions. As a result, we remain highly dependent on our key markets. Our business could be harmed by any circumstances causing a reduction in demand for air transportation in our key markets. An increase in competition in our key markets could also cause us to reduce fares or take other competitive measures that, if sustained, could harm our business, financial condition and results of operations.

Economic uncertainty or another recession would likely impact demand for our product and could harm our financial condition and results of operations.
 
The airline industry, which is subject to relatively high fixed costs and highly variable and unpredictable demand, is particularly sensitive to changes in economic conditions. We are also highly dependent on U.S. consumer confidence and the health of the U.S. economy. Unfavorable U.S. economic conditions have historically driven changes in travel patterns and have resulted in reduced spending for both leisure and business travel. For some consumers, leisure travel is a discretionary expense, and shorter distance travelers, in particular, have the option to replace air travel with surface travel. Businesses are able to forgo air travel by using communication alternatives such as videoconferencing or may be more likely to purchase less expensive tickets to reduce costs, which can result in a decrease in average revenue per seat. Unfavorable economic conditions also hamper the ability of airlines to raise fares to counteract increased fuel, labor and other costs. Unfavorable or even uncertain economic conditions could negatively affect our financial condition and results of operations.

We are dependent on a limited number of suppliers for aircraft and parts.
 
Alaska is dependent on Boeing as its sole supplier for aircraft and many aircraft parts. Virgin America is similarly dependent on Airbus, and Horizon is dependent on Bombardier and soon Embraer. Additionally, each carrier is dependent on sole suppliers for aircraft engines for each aircraft type. As a result, we are more vulnerable to issues associated with the supply of those aircraft and parts, including design defects, mechanical problems, contractual performance by the manufacturers or adverse perception by the public that would result in customer avoidance or in actions by the FAA resulting in an inability to operate our aircraft or instability in the foreign countries, in which the aircraft and its parts are manufactured.

We rely on partner airlines for codeshare and frequent flyer marketing arrangements.
 
Our airlines are parties to marketing agreements with a number of domestic and international air carriers, or “partners." These agreements provide that certain flight segments operated by us are held out as partner “codeshare” flights and that certain partner flights are held out for sale as Alaska or Virgin America codeshare flights. In addition, the agreements generally provide that members of Alaska’s Mileage Plan™ program, or Virgin America's Elevate® program, can earn credit on or redeem credit for partner flights and vice versa. We receive revenue from flights sold under codeshare and from interline arrangements. In addition, we believe that the frequent flyer arrangements are an important part of our frequent flyer programs. The loss of a significant partner through bankruptcy, consolidation, or otherwise, could have a negative effect on our revenues or the attractiveness of our Mileage Plan™ and Elevate® programs, which we believe is a source of competitive advantage.

We routinely engage in analysis and discussions regarding our own strategic position, including alliances, codeshare arrangements, interline arrangements and frequent flyer program enhancements, and may have future discussions with other airlines regarding similar activities. If other airlines participate in consolidation or reorganization, those airlines may significantly improve their cost structures or revenue generation capabilities, thereby potentially making them stronger competitors of ours and potentially impairing our ability to realize expected benefits from our own strategic relationships.


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INFORMATION TECHNOLOGY

We rely heavily on automated systems to operate our business, and a failure to invest in new technology or a disruption of our current systems or their operators could harm our business.
 
We depend on automated systems to operate our business, including our airline reservation system, our telecommunication systems, our website, our maintenance systems, our check-in kiosks, mobile devices and other systems. Substantially all of our tickets are issued to our guests as electronic tickets, and the majority of our customers check in using our website, airport kiosks, or our mobile application. We depend on our reservation system to be able to issue, track and accept these electronic tickets. In order for our operations to work efficiently, we must continue to invest in new technology to ensure that our website, reservation system and check-in systems are able to accommodate a high volume of traffic, maintain information security and deliver important flight information. Substantial or repeated website, reservations system or telecommunication systems failures or service disruptions could reduce the attractiveness of our services and cause our guests to do business with another airline. In addition, we rely on other automated systems for crew scheduling, flight dispatch and other operational needs. In 2017, subsequent to year end, we migrated to a new crew management system. We also plan to move our primary data center location. Disruptions, failed migration, untimely recovery, or a breach of these systems or the data center could result in the loss of important data, an increase of our expenses, an impact on our operational performance or a possible temporary cessation of our operations.

If we do not maintain the privacy and security of our information, we could damage our reputation and incur substantial legal and regulatory costs.

We accept, store and transmit information about our guests, our employees, our business partners and our business.  In addition, we frequently rely on third-party hosting sites and data processors, including cloud providers. Our sensitive information relies on secure transmission over public and private networks.  A compromise of our systems, the security of our infrastructure or those of other business partners that result in our information being accessed or stolen by unauthorized persons could adversely affect our operations and our reputation.

FINANCIAL CONDITION AND FINANCIAL MARKETS

Our business, financial condition and results of operations are substantially exposed to the volatility of jet fuel prices. Significant increases in jet fuel costs would harm our business.
 
Fuel costs constitute a significant portion of our total operating expenses. Future increases in the price of jet fuel may harm our business, financial condition and results of operations unless we are able to increase fares and fees or add additional ancillary services to attempt to recover increasing fuel costs.

Our indebtedness and other fixed obligations could increase the volatility of earnings and otherwise restrict our activities and potentially lead to liquidity constraints.

We incurred a significant amount of new debt to finance our acquisition of Virgin America. We now have and will continue to have for the foreseeable future a substantial amount of debt. Due to our high fixed costs, including aircraft lease commitments and debt service, a decrease in revenues would result in a disproportionately greater decrease in earnings.

Our outstanding long-term debt and other fixed obligations could have important consequences. For example, they could limit our ability to obtain additional financing to fund our future capital expenditures, acquisitions, working capital or other purposes; require us to dedicate a material portion of our operating cash flow to fund lease payments and interest payments on indebtedness, thereby reducing funds available for other purposes; or limit our ability to withstand competitive pressures and reduce our flexibility in responding to changing business and economic conditions.

Although we have historically been able to generate sufficient cash flow from our operations to pay our debt and other fixed obligations when they become due, we cannot ensure we will be able to do so in the future. If we fail to do so, our business could be harmed.

See "Liquidity and Capital Resources" within Item 7 of this filing for more detailed information about our obligations and commitments.

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Certain of our financing agreements have covenants that impose operating and financial restrictions on us.

Certain of our credit facilities and indentures governing our secured borrowings impose certain operating and financial covenants on us. Such covenants require us to maintain, depending on the particular agreement, minimum liquidity and/or minimum collateral coverage ratios and other negative covenants customary for such financings. A decline in the value of collateral could result in a situation where we may not be able to maintain the required collateral coverage ratio.

Our ability to comply with these covenants may be affected by events beyond our control, including the overall industry revenue environment and the level of fuel costs, and we may be required to seek waivers or amendments of covenants, repay all or a portion of the debt or find alternative sources of financing.

Our maintenance costs will increase as our fleet ages, and we will periodically incur substantial maintenance costs due to the maintenance schedules of our aircraft fleet.

As of December 31, 2016, the average age of our NextGen aircraft (B737-800, -900, -900ERs) was approximately 7.3 years, the average age of our Q400 aircraft was approximately 10 years, and the average age of our A319 and A320 aircraft was approximately 6.8 years. Our relatively new aircraft currently require less maintenance than they will in the future. Any significant increase in maintenance expenses could have a material adverse effect on our results of operations.

BRAND AND REPUTATION

As we evolve our brand to appeal to a changing demographic and grow into new markets, we will engage in strategic initiatives that may not be favorably received by all our guests.
 
We continue to focus on strategic initiatives designed to increase our brand appeal to a diverse and evolving demographic of airline travelers. These efforts could include significant enhancements to our in-airport and on-board environments, increasing our direct customer relationships through improvements to our purchasing portals (digital and mobile) and optimization of our customer loyalty programs.

In pursuit of these efforts we may negatively affect our reputation with some of our existing customer base.
 
LABOR RELATIONS AND LABOR STRATEGY

A significant increase in labor costs, unsuccessful attempts to strengthen our relationships with union employees or loss of key personnel could adversely affect our business and results of operations.
  
Labor costs are a significant component of our total expenses. Each of Alaska and Horizon's represented employee groups has a separate collective bargaining agreement. Through negotiations or transition agreements in the Virgin America integration, each group could make demands that would increase our operating expenses and adversely affect our financial performance if we agree to them. The same result could apply if we experience a significant increase in vendor labor costs, including wage rate increases, which could ultimately flow through to us under the applicable services agreement.

As of December 31, 2016, labor unions represented approximately 84% of Alaska’s and 43% of Horizon’s employees. Although Virgin America employees are not currently covered under collective bargaining agreements, pilots and inflight teammates have elected to be represented and will, through negotiations, ultimately enter into joint collective bargaining agreements with Alaska's represented workforce. Although we have been successful in fostering communications, negotiating approaches and developing other strategies to enhance workforce engagement in our long-term vision, future uncertainty around open contractsincluding the joint collective bargaining negotiations for the integration of Alaska's and Virgin America's represented work groupscould be a distraction, affecting employee focus on our business and diverting management’s attention from other projects and issues.

We compete against the major U.S. airlines and other businesses for labor in many highly skilled positions. If we are unable to hire, train and retain qualified employees at a reasonable cost, sustain employee engagement in our strategic vision, or if we are unsuccessful at implementing succession plans for our key staff, we may be unable to grow or sustain our business. In recent years, there have been pilot shortages in hiring in the regional market, and there is an anticipated pilot shortage in hiring in the mainline markets in the next two to three years. Attrition beyond normal levels could negatively impact our operating results, and our business prospects could be harmed.


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Employees could also engage in job actions such as slow-downs, work-to-rule campaigns, sick-outs or other actions designed to disrupt our normal operations in an attempt to pressure us to acquiesce to wage or other demands during Section 6 negotiations or transition agreement discussions. Although the Railway Labor Act makes such “self-help” unlawful until the National Mediation Board releases the parties following lengthy mediation attempts, and we could seek injunctive relief or other remedies against premature self-help, such actions could cause significant harm even if we were ultimately to be successful.

ACQUISITION AND INTEGRATION OF VIRGIN AMERICA

We may be unable to effectively integrate Virgin America’s business and realize the anticipated benefits of the acquisition. In addition, delays in integration could cause anticipated synergies to take longer to realize than currently anticipated.

We must devote significant management attention and resources to integrating the business practices and operations of Virgin America. Potential difficulties we may encounter as part of the integration process include the following:

the inability to successfully combine the Virgin America business with that of Alaska's in a manner that permits us to achieve anticipated net synergies and other anticipated benefits of the acquisition;

the inability to successfully attract and retain Virgin America guests upon integration with Alaska;

the challenges associated with operating aircraft types new to our operations, specifically the Airbus A319 and A320;

the challenges associated with an expanded or new presence in more congested airports and markets;

the challenges associated with integrating complex systems, technology, aircraft fleets, networks, facilities and other assets in a seamless manner that minimizes any adverse impact on guests, suppliers, employees and other constituents;

the challenges associated with integrating Virgin America employees into Alaska's workforce while maintaining our focus on providing consistent, high quality customer service, including seniority list integration, negotiation of transition process agreements and, in the case of the pilot workgroups, negotiation of a joint collective bargaining agreement; and

potential unknown liabilities, liabilities that are significantly larger than we currently anticipate, and unforeseen increased expenses or delays, including costs to integrate Virgin America’s business that may exceed our current estimates.

Any of the foregoing factors could adversely affect our ability to maintain relationships with guests, suppliers, employees and other constituencies or our ability to achieve the anticipated benefits of the acquisition on a timely basis, or at all. These factors could also reduce our earnings or otherwise adversely affect our business and financial results. In addition, integration requirements have caused, and may continue to cause, a delay of other strategic initiatives.

The Virgin brand is not under our control, and negative publicity related to the Virgin brand name could materially adversely affect our business.

Virgin America licenses rights to the Virgin brand from certain entities affiliated with the Virgin Group on a non-exclusive basis. The Virgin brand is also licensed to and used by a number of other companies, including two airlines, Virgin Atlantic Airways and Virgin Australia Airlines, operating in other geographies. We rely on the general goodwill of consumers and our employees towards the Virgin brand. Consequently, any adverse publicity in relation to the Virgin brand name, its principals, particularly Sir Richard Branson who is closely associated with the brand, or another Virgin-branded company over which we have no control or influence could have a material adverse effect on our business.

We obtain our rights to use the Virgin brand under agreements with certain entities affiliated with the Virgin Group, and we would lose those rights if these agreements are terminated or not renewed.

Virgin America is a party to license agreements with certain entities affiliated with the Virgin Group pursuant to which we obtain rights to use the Virgin brand. The licensor may terminate the agreements upon the occurrence of a number of specified events including if Virgin America commits a material breach of our obligations under the agreements that is uncured for more than 10 business days or if we materially damage the Virgin brand. If we lose our rights to use the Virgin brand, we would lose the goodwill associated with the brand name, which would likely require substantial expenditures, and our business and financial condition would likely be materially adversely affected.


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The need to integrate Virgin America’s workforce into joint collective bargaining agreements with Alaska's workforce presents the potential for delay in achieving expected synergies and other benefits or labor disputes that could adversely affect our operations and costs.

The successful integration of Virgin America and achievement of the anticipated benefits of the acquisition depend significantly on integrating Virgin America’s employees into Alaska and on maintaining productive employee relations. Failure to do so presents the potential for delays in achieving expected synergies and other benefits of integration or labor disputes that could adversely affect our operations and costs. The process for integrating labor groups in an airline merger is governed by a combination of the Railway Labor Act, the McCaskill-Bond Act, and where applicable, the existing provisions of our collective bargaining agreements (“CBAs”) and internal union policies.

Under the Railway Labor Act, the National Mediation Board has exclusive authority to resolve representation disputes arising out of airline mergers. The disputes that the National Mediation Board has authority to resolve include (i) whether the carriers, through the merger, have integrated operations to the point of creating a “single transportation system” for representation purposes; (ii) determination of the appropriate “craft or class” for representational purposes, including a determination of which positions are to be included within a particular craft or class; and (iii) certification of the system-wide representative organization, if any, for each of our craft or class following the merger. Failure to resolve these disputes could result in delays in achieving expected synergies and other benefits of integration as well as adversely impact our operations and costs.

Pending operational integration of Virgin America with Alaska, it will be necessary to maintain a “fence” between Alaska and Virgin America employee groups that are represented by unions. During this time, we will keep the employee groups separate, each applying the terms of its own existing employment agreements unless other terms have been negotiated. Achievement of expected synergies and other benefits will be delayed until the time that operational integration is obtained.

We are expected to incur substantial expenses related to the acquisition and the integration of Virgin America’s business.

We are expected to incur substantial integration and transition expenses in connection with the acquisition of Virgin America, including the necessary costs associated with integrating the operations of Alaska and Virgin America. There are a large number of processes, policies, procedures, operations, technologies and systems that must be integrated, including reservations, frequent flyer, ticketing/distribution, maintenance and flight operations. While we have assumed that a certain level of expenses will be incurred, there are many factors beyond our control that could affect the total amount or the timing of the integration expenses. Moreover, many of the expenses that will be incurred are, by their nature, difficult to estimate accurately. These expenses could, particularly in the near term, exceed the financial benefits we expect to achieve from the acquisition, including the elimination of duplicative expenses and the realization of economies of scale and cost savings. These integration expenses likely will continue to result in us taking significant charges against earnings in future periods, and the amount and timing of such charges are uncertain at present.

We acquired Virgin America’s indebtedness upon closing of the acquisition, which additional indebtedness may limit our financial and operating flexibility.

Upon closing of the acquisition, we acquired Virgin America’s outstanding indebtedness and became subject to the operating restrictions under the debt instruments governing such indebtedness. Virgin America has significant debt and lease obligations related to existing purchased and leased aircraft. Our increased indebtedness following the acquisition may:

require a substantial portion of cash flows from operations for debt service payments and operating lease payments, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, acquisitions and other general corporate purposes; and

limit our flexibility in planning for, or reacting to, changes in its business and the airline industry and, consequently, negatively affect our competitive position.

We will need to launch certain branding or rebranding initiatives in connection with the acquisition that may take a significant amount of time and involve substantial costs and that may not be favorably received by our guests.

We may incur substantial costs if we decide to rebrand any of Virgin America’s products and services and may not be able to achieve or maintain brand name recognition or status that is comparable to the recognition and status previously enjoyed by Virgin America in any of Virgin America’s markets. The failure of any such rebranding initiatives could adversely affect our ability to attract and retain guests, which could cause us not to realize some or all of the anticipated benefits contemplated to result from the acquisition.

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Our ability to use Virgin America’s net operating loss carryforwards to offset future taxable income for U.S. federal and state income tax purposes may be limited as a result of the previous ownership changes, this acquisition or taxable income if it does not reach sufficient levels.

As of the acquisition closing date, Virgin America had federal net operating loss carryforwards (“NOLs”) of approximately $773 million available to offset future taxable income, expiring between 2028 and 2036, and state NOLs of approximately $344 million that expire beginning in 2027 and continuing through 2035.

Virgin America has experienced multiple “ownership changes” as defined in Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), the most recent being its acquisition by us. Section 382 of the Code imposes an annual limitation on the amount of pre-ownership change NOLs of the corporation that experiences ownership change. The limitation imposed by Section 382 of the Code for any post-ownership change year generally would be determined by multiplying the value of such corporation’s stock immediately before the ownership change by the applicable long-term tax-exempt rate. Any unused annual limitation may, subject to certain limits, be carried over to later years, and the limitation may, under certain circumstances, be increased by built-in gains or reduced by built-in losses in the assets held by such corporation at the time of the ownership change. Our use of NOLs generated after the date of an ownership change would not be limited unless we were to experience a subsequent ownership change.

Our ability to use the NOLs will also depend on the amount of taxable income generated in future periods. The NOLs may expire before we can generate sufficient taxable income to utilize the NOLs.

The application of the acquisition method of accounting resulted in us recording a significant amount of goodwill, which could result in significant future impairment charges and negatively affect our financial results.

In accordance with applicable acquisition accounting rules, we recorded goodwill on our consolidated balance sheet to the extent the Virgin America acquisition purchase price exceeded the net fair value of Virgin America’s tangible and identifiable intangible assets and liabilities as of the acquisition date. Goodwill is not amortized, but is tested for impairment at least annually. We could record impairment charges in our results of operations as a result of, among other items, extreme fuel price volatility, a significant decline in the fair value of certain tangible or intangible assets, unfavorable trends in forecasted results of operations and cash flows, uncertain economic environment and other uncertainties. We can provide no assurance that a significant impairment charge will not occur in one or more future periods. Any such charges may materially negatively affect our financial results.

ITEM 1B.     UNRESOLVED STAFF COMMENTS

 None

ITEM 2.      PROPERTIES

26





AIRCRAFT
 
The following table describes the aircraft we operate and their average age at December 31, 2016:
Aircraft Type
Seats
 
Owned
 
Leased
 
Total
 
Average
Age in
Years
B737 Freighter & Combis
0/72
 
6

 

 
6

 
23.2

B737-400
144
 
3

 
7

 
10

 
20.9

B737 NextGen
124-181
 
129

 
10

 
139

 
7.3

A319
119
 

 
10

 
10

 
9.2

A320
146-149
 
10

 
43

 
53

 
6.3

Total Mainline Fleet
 
 
148

 
70

 
218

 
8.2

Q400
76
 
37

 
15

 
52

 
10.0

E175
76
 

 
15

 
15

 
0.8

Total Regional Fleet
 
 
37

 
30

 
67

 
7.9

Total
 
 
185

 
100

 
285

 
8.2


“Management’s Discussion and Analysis of Financial Condition and Results of Operations" discusses future orders and options for additional aircraft. “Liquidity and Capital Resources" provides more information about aircraft that are used to secure long-term debt arrangements or collateralize credit facilities.

Alaska’s leased B737 aircraft have lease expiration dates between 2017 and 2023. Virgin America's leased A319 and A320 aircraft have expiration dates between 2019 and 2025. Horizon’s leased Q400 aircraft have expiration dates in 2018. The leased E175 aircraft are through our capacity purchase agreement with SkyWest. Alaska, Virgin America and Horizon have the option to extend some of the leases for additional periods, or the right to purchase the aircraft at the end of the lease term, usually at the then-fair-market value of the aircraft. Air Group also owns two non-operating CRJ-700 aircraft classified as held-for-sale as of December 31, 2016.

GROUND FACILITIES AND SERVICES
 
We own terminal buildings in various cities in the state of Alaska and several buildings located at or near Seattle-Tacoma International Airport (Sea-Tac) near Seattle, WA. These include a multi-bay hangar and shops complex (used primarily for line maintenance), a flight operations and training center, an air cargo facility, an information technology office and data center, and various other commercial office buildings.

We lease ticket counters, gates, cargo and baggage space, ground equipment, office space and other support areas at the majority of the airports we serve. Airport leases contain provisions for periodic adjustments of lease rates. We are typically responsible for maintenance, insurance and other facility-related expenses and services under these agreements. We also lease operations, training, data center, and administrative facilities in Burlingame, CA; Portland, OR; Quincy, WA; and Spokane, WA as well as line maintenance stations in Boise, ID; Bellingham, WA; Eugene, OR; San Jose, CA; Medford, OR; Redmond, OR; Seattle, WA; and Spokane, WA. Further, we lease call center facilities in Phoenix, AZ, and Boise, ID.

ITEM 3.  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 through, among other

27




strategies, filing a motion for reconsideration of the Court’s certification decision and denial of summary judgment and, if necessary, a motion for certification of interlocutory appeal to the U.S. Court of Appeals for the Ninth Circuit.

ITEM 4.       MINE SAFETY DISCLOSURES
 
Not applicable.


PART II
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
 
As of December 31, 2016, there were 129,189,634 shares of common stock of Alaska Air Group, Inc. issued and 123,328,051 shares outstanding and 2,277 shareholders of record. In 2016, we paid quarterly dividends of $0.275 per share in March, June, September and December. Our common stock is listed on the New York Stock Exchange (symbol: ALK). The following table shows the trading range of Alaska Air Group, Inc. common stock on the New York Stock Exchange: 
 
2016
 
2015
 
High
 
Low
 
High
 
Low
First Quarter
$
83.05

 
$
61.58

 
$
70.83

 
$
57.73

Second Quarter
83.09

 
54.53

 
68.68

 
58.15

Third Quarter
71.57

 
56.47

 
82.75

 
62.59

Fourth Quarter
91.88

 
65.60

 
87.16

 
73.00


SALES OF NON-REGISTERED SECURITIES
 
None.

PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

None during the quarter ended December 31, 2016.

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PERFORMANCE GRAPH
 
The following graph compares our cumulative total stockholder return since December 31, 2011 with the S&P 500 Index and the Dow Jones U.S. Airlines Index. The graph assumes that the value of the investment in our common stock and each index (including reinvestment of dividends) was $100 on December 31, 2011.

alk10-k123_chartx57832.jpg


29




ITEM 6. SELECTED FINANCIAL AND OPERATING DATA

Virgin America became a wholly-owned subsidiary of Air Group on December 14, 2016. Operating results, financial position and operating statistics presented below include Virgin America data for the period December 14, 2016 through December 31, 2016, and the impact of purchase accounting as of December 14, 2016 in the "consolidated" and "mainline" results. Refer to "Critical Accounting Estimates" section of Item 7 for further information regarding purchase accounting.

30




Year Ended December 31 (in millions, except per-share amounts):
2016
 
2015
 
2014
 
2013
 
2012
CONSOLIDATED OPERATING RESULTS (audited)
 
 
 
 
 
 
 
 
 
Operating Revenues
$
5,931

 
$
5,598

 
$
5,368

 
$
5,156

 
$
4,657

Operating Expenses
4,582

 
4,300

 
4,406

 
4,318

 
4,125

Operating Income
1,349

 
1,298

 
962

 
838

 
532

Nonoperating income (expense), net of interest capitalized(a)
(4
)
 
14

 
13

 
(22
)
 
(18
)
Income before income tax
1,345

 
1,312

 
975

 
816

 
514

Net Income
$
814

 
$
848

 
$
605

 
$
508

 
$
316

Average basic shares outstanding
123.557

 
128.373

 
135.445

 
139.910

 
141.416

Average diluted shares outstanding
124.389

 
129.372

 
136.801

 
141.878

 
143.568

Basic earnings per share
$
6.59

 
$
6.61

 
$
4.47

 
$
3.63

 
$
2.23

Diluted earnings per share
$
6.54

 
$
6.56

 
$
4.42

 
$
3.58

 
$
2.20

Cash dividends declared per share
$
1.10

 
$
0.80

 
$
0.50

 
$
0.20

 

CONSOLIDATED FINANCIAL POSITION (audited)
 

 
 

 
 

 
 

 
 

At End of Period (in millions):
 

 
 

 
 

 
 

 
 

Total assets(b)
$
9,962

 
$
6,530

 
$
6,059

 
$
5,719

 
$
5,350

Long-term debt, including current portion(b)
$
2,964

 
$
683

 
$
798

 
$
865

 
$
1,025

Shareholders' equity
$
2,931

 
$
2,411

 
$
2,127

 
$
2,029

 
$
1,421

OPERATING STATISTICS (unaudited)(e)
 

 
 

 
 

 
 

 
 

Consolidated:(c)
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
34,289
 
31,883
 
29,278
 
27,414
 
25,896
RPMs (000,000) "traffic"
37,209
 
33,578
 
30,718
 
28,833
 
27,007
ASMs (000,000) "capacity"
44,135
 
39,914
 
36,078
 
33,672
 
31,428
Load factor
84.3%
 
84.1%
 
85.1%
 
85.6%
 
85.9%
Yield
13.45¢
 
14.27¢
 
14.91¢
 
14.80¢
 
14.92¢
PRASM
11.34¢
 
12.01¢
 
12.69¢
 
12.67¢
 
12.82¢
RASM
13.44¢
 
14.03¢
 
14.88¢
 
14.74¢
 
14.82¢
CASMex(d)
8.23¢
 
8.30¢
 
8.36¢
 
8.47¢
 
8.48¢
Mainline:
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
24,838
 
22,869
 
20,972
 
19,737
 
18,526
RPMs (000,000) "traffic"
33,489
 
30,340
 
27,778
 
26,172
 
24,417
ASMs (000,000) "capacity"
39,473
 
35,912
 
32,430
 
30,411
 
28,180
Load factor
84.8%
 
84.5%
 
85.7%
 
86.1%
 
86.6%
Yield
12.24¢
 
12.98¢
 
13.58¢
 
13.33¢
 
13.45¢
PRASM
10.38¢
 
10.97¢
 
11.64¢
 
11.48¢
 
11.65¢
CASMex(d)
7.30¢
 
7.39¢
 
7.45¢
 
7.54¢
 
7.56¢
Regional (c):
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
9,452
 
9,015
 
8,306
 
7,677
 
7,371
RPMs (000,000) "traffic"
3,720
 
3,238
 
2,940
 
2,661
 
2,590
ASMs (000,000) "capacity"
4,662
 
4,002
 
3,648
 
3,261
 
3,247
Load factor
79.8%
 
80.9%
 
80.6%
 
81.6%
 
79.8%
Yield
24.42¢
 
26.37¢
 
27.40¢
 
29.20¢
 
28.81¢
PRASM
19.49¢
 
21.34¢
 
22.08¢
 
23.83¢
 
22.98¢
(a)
Capitalized interest was $25 million, $34 million, $20 million, $21 million and $18 million for 2016, 2015, 2014, 2013 and 2012.
(b)
In the first quarter of 2016, we retrospectively adopted Accounting Standards Update 2015-03 "Simplifying the Presentation of Debt Issuance Costs." Prior year amounts have been adjusted to reflect a reclassification of debt issuance costs.
(c)
Includes flights under Capacity Purchase Agreements operated by SkyWest and PenAir.
(d)
See reconciliation to the most directly related Generally Accepted Accounting Principles ("GAAP") measure in the "Results of Operations" section.
(e)
See "Glossary of Terms" for definitions of the abbreviated terms.

31




ITEM 7.     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, our operations and our 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 Part I, “Item 1A. Risk Factors.” This overview summarizes the MD&A, which includes the following sections:
 
Year in Review—highlights from 2016 outlining some of the major events that happened during the year 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 years presented in our consolidated financial statements. 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. This section includes forward-looking statements regarding our view of 2017. When providing forward-looking statements on future expectations, we will provide the impact of Virgin America as a separate component of expected changes from 2016. Virgin America was acquired on December 14, 2016 and plays a significant role in the year-over-year change. Further information about the acquisition of Virgin America can be found in Note 2 to the consolidated financial statements.
  
Liquidity and Capital Resources—an overview of our financial position, analysis of cash flows, sources and uses of cash, contractual obligations and commitments and off-balance sheet arrangements.

Critical Accounting Estimates—a discussion of our accounting estimates that involve significant judgment and uncertainties.

YEAR IN REVIEW

On December 14, 2016 we completed our acquisition of Virgin America, becoming the fifth largest U.S. airline. The combined company now offers nearly 1,200 daily flights to 118 destinations across the United States, Mexico, Canada, Costa Rica and Cuba, with more nonstop destinations from the West Coast than any other airline. By combining loyalty programs and networks, along with our award-winning customer service and the expansion of our international partner portfolio, we believe we will provide greater benefits for our guests and become known as the premier airline for people on the West Coast.

In 2016, we posted our thirteenth consecutive annual profit on an adjusted basis, which is a testament to the hard work of our people and the successful execution of our strategic initiatives. Our 2016 pretax income as reported was $1.3 billion, an increase of 3% over 2015. Our 2016 pretax income on an adjusted basis (a non-GAAP financial measure) was $1.4 billion, an increase of 8% over 2015. The adjusted pretax income reflects the exclusion of $117 million of merger-related costs associated with our acquisition of Virgin America and $13 million of mark-to-market fuel hedge adjustments.

The improvement in adjusted pretax income was driven by an increase of $333 million in revenues and a decrease of $123 million in fuel costs. These benefits were partially offset by an increase in operating expenses, excluding fuel and special items, of $320 million, or 10%, to support the increased capacity of 11%. This increase reflects the addition of Virgin America capacity from the acquisition date through December 31, 2016.

The growth in revenues of $333 million was driven by the growth in our business and the inclusion of Virgin America in our results for the period from December 14, 2016 through December 31, 2016. On a combined basis, we launched 17 new markets in 2016 and, in January 2017, we launched historic flights to Havana, Cuba from Los Angeles. On the regional side of our business, we anticipate the delivery of Horizon's Embraer E175 regional jet this spring—the first of an order of 33 placed in early 2016. Our network is rapidly expanding with these regional aircraft and the recent acquisition of Virgin America. We believe we have a strong future ahead of us and look forward to the many new opportunities our combined networks will bring our company.


32




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.

Accomplishments and Highlights

Acquisition of Virgin America Inc.

Air Group completed its acquisition of Virgin America Inc. ("Virgin America") on December 14, 2016.
Results for 2016 include the results of operations and cash flows for Virgin America from December 14, 2016 through December 31, 2016, including the impact of purchase accounting. Periods presented prior to the acquisition date do not include Virgin America's results.

Dividend Increase

Announced a 9% increase in the quarterly dividend, from $0.275 per share to $0.30 per share in February 2017. This is the fourth time we have raised the dividend since initiating the quarterly dividend in July 2013, with a cumulative increase of 200% since that time.

Financial Highlights

Reported full-year net income under Generally Accepted Accounting Principles ("GAAP") of $814 million, or $6.54 per diluted share. These results compared to full year 2015 net income of $848 million, or $6.56 per diluted share.
Reported full-year 2016 net income, excluding special items, of $911 million, an 8% increase from 2015, and adjusted diluted earnings per share of $7.32, a 12% increase from 2015.
Paid $0.275 per-share quarterly cash dividend in the fourth quarter, bringing total dividend payments in 2016 to $136 million.
Generated approximately $1.4 billion of operating cash flow and $708 million of free cash flow in 2016.
Grew passenger revenues by 4% compared to full-year 2015.
Generated full-year adjusted pretax margin of 24% in 2016, in line with 2015.
Lowered consolidated unit costs, excluding fuel and special items, for the seventh consecutive year, to the lowest level ever. Mainline unit costs excluding fuel and special items have declined 14 of the last 15 years.
Held $1.6 billion in unrestricted cash and marketable securities as of December 31, 2016.

Recognition and Awards—Alaska

Became the first major U.S. airline to receive approval from the Federal Aviation Administration for its Safety Management System.
Ranked best airline in the U.S. by the Wall Street Journal's "2016 Airline Scorecard" for the fourth year in a row.
Ranked highest in customer satisfaction among traditional carriers in North America in 2016 by J.D. Power and Associates for the ninth year in a row.
Ranked highest in customer satisfaction with airline loyalty rewards programs in 2016 by J.D. Power and Associates for the third consecutive year.
Ranked first in the U.S. News & World Report's list of Best Airline Rewards Programs for the second consecutive year.
Ranked among Forbes' 2016 "America's Best Employers."
Named No. 1 on-time carrier in North America for the seventh year in a row by FlightStats in January 2017.
Received the Department of Defense 2016 Freedom Award, the highest recognition given to employers by the U.S. government for their support of National Guard and Reserve members.
Received 15th Diamond Award of Excellence from the Federal Aviation Administration, recognizing both Alaska and Horizon's aircraft technicians for their commitment to training.
Ranked first in the commercial aviation division and first place overall at the 2016 Annual International Aerospace Maintenance Competition, surpassing over 50 teams from around the world.
Named the No. 1 cargo carrier by Logistics Management magazine as part of its annual Quest for Quality awards.
Joined Standard and Poor's 500 Index. Companies included in the S&P 500 are chosen by the S&P Index Committee based on their size, earnings history and liquidity, among other factors.
Ranked among the Fortune 500 for the third year in a row.
Ranked among the top "green companies" in the United States by Newsweek.
Ranked among the top 100 socially just companies in the United States by Forbes.
Received the Seattle-Tacoma International Airport Green Gateway Environmental Excellence Award for the second year in a row, as a result of efforts in reducing emissions, recycling and waste reduction and lowered energy consumption.

33





Recognition and Awards—Virgin America

Rated Best U.S. Airline by Conde Nast Traveler in their "Annual Readers' Choice Awards" for nine years in a row.
Ranked Best Domestic Airline in Travel + Leisure "World's Best Awards" for nine years in a row.
Rated the number one carrier in the 2016 Airline Quality Report for the fourth consecutive year, an annual analysis of airline performance metrics conducted by Wichita State University and Embry-Riddle Aeronautical University.
Rated "Best Airline in North America" for the second year in a row and "Best Low-Cost Airline in the U.S." for the seventh year in a row by Skytrax World Airline Awards.

Our People

Awarded a record $159 million in incentive pay to employees for 2016, including $32 million earned by Virgin America employees in 2016 prior to the acquisition.
Reached a tentative agreement with Alaska's aircraft technicians on a new collective bargaining agreement.
Alaska received a perfect score of 100% for workplace equality on the 2017 Corporate Equality Index ("CEI"). Virgin America received a score of 95%.

Our Guests and Product

Announced enhanced benefits to the Alaska Airlines Visa Signature credit card and the Alaska Airlines Visa Business credit card including the elimination of foreign transaction fees and increased bonus miles.
Announced a new codeshare agreement and frequent flyer partnership with Japan Airlines, providing Alaska guests seamless travel and mileage earning opportunities.
Launched premium class service on Alaska, including more legroom, complimentary alcoholic beverages and premium snacks.
Flew the first three commercial flights using sustainable alcohol-to-jet biofuel made from U.S. grown corn and alternative jet fuel made from forest residuals, continuing Alaska's commitment to reduce its carbon emissions.
Placed order for 33 firm Embraer 175 ("E175") regional jets and 30 options, to be flown by subsidiary Horizon Air, with first delivery scheduled in 2017.
Added 19 Boeing 737-900ERs aircraft to the operating fleet in 2016, bringing the total fleet to 155 Boeing aircraft.
Added 5 Airbus A320 aircraft to Virgin America's fleet in 2016, bringing the total fleet to 63 Airbus aircraft.
Added 17 new markets in 2016 across the Alaska Air Group and Virgin America networks.
Increased fuel efficiency (as measured by seat-miles per gallon) by 1.4% over 2015.

Our Communities

Donated nearly $13 million to support nonprofits in our local communities, focusing on youth & education, medical (research/transportation) and community outreach.

Shareholder Return

In 2016, we paid cash dividends of $136 million and repurchased approximately 3 million shares of our common stock for $193 million under the $1 billion share repurchase program authorized by our Board of Directors. In the second quarter of 2016, we paused our share repurchases in advance of the acquisition of Virgin America. Since 2007, we have repurchased 59 million shares of common stock for $1.5 billion for an average price of approximately $25.90 per share. In 2016, we increased our quarterly dividend 38% from $0.20 per share to $0.275 per share, and, subsequent to December 31, 2016, we announced a 9% increase to $0.30 per share. Overall, we returned $329 million to shareholders during 2016. We expect to continue to return capital to shareholders in 2017, primarily in the form of dividends.

Outlook
 
We completed the acquisition of Virgin America on December 14, 2016, positioning us as the fifth largest airline in the U.S., with an unparalleled 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.


34




In 2017 and beyond, we are focused on the successful integration of Virgin America with Alaska Air Group, while continuing to work towards obtaining a Single Operating Certificate ("SOC"). We currently expect to receive an SOC in early 2018. Our priority throughout the integration process is to run two great airlines and maintain a safe and compliant operation, while providing a great experience for our guests. Additionally, we are particularly focused on merging the cultures and brands that have made Alaska and Virgin America respected and trusted over the years by our guests. We intend to minimize any disruption to our guests during our 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 new Alaska Air Group. We plan to bring our teams together through workshops and trainings delivered throughout 2017. Additionally, we will remain focused on capturing the value and synergies created by combining these two great companies.

In addition to our integration with Virgin America, one of our biggest initiatives is the launch of our new "Premium Class" service on our B737 aircraft, which provides greater leg room, priority boarding and complimentary cocktails, among other benefits. Premium Class was rolled out in early January 2017 and, so far, the results are exceeding our expectations in both guest response and revenue generation.

Currently, we expect to grow our combined network capacity in 2017 by approximately 8.5%. The growth rate compares 2017 system-wide capacity with historical Air Group and Virgin America combined capacity in 2016. This compares to a 10.2% combined growth in 2016 on the same basis. Current schedules indicate competitive capacity will be 5 points higher in the first quarter of 2017. We believe that our product, our operation, our engaged employees, our award-winning service, and our competitive Mileage Plan™ and Elevate® programs, combined with our strong balance sheet, give us the ability to compete vigorously in our markets.



35




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 eliminating fuel expense and certain special items (including merger-related costs) from our unit metrics, we believe that we have better visibility into the results of operations and our non-fuel cost-reduction 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 the basis by which they compare our airlines to others in the industry. The measure is also the subject of frequent questions from investors.

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.

2016 COMPARED WITH 2015

Our consolidated net income for 2016 was $814 million, or $6.54 per diluted share, compared to net income of $848 million, or $6.56 per diluted share, in 2015. Our financial results include results of Virgin America for the period from December 14, 2016 through December 31, 2016 and the impact of purchase accounting as of December 14, 2016. Refer to the "Critical Accounting Estimates" section for further information regarding purchase accounting.

Excluding the impact of merger-related costs, mark-to-market fuel hedge adjustments and other special items, our adjusted consolidated net income for 2016 was $911 million, or $7.32 per diluted share, compared to an adjusted consolidated net income of $842 million, or $6.51 per share, in 2015. The following tables reconcile our adjusted net income and earnings per diluted share ("EPS") during the full year 2016 and 2015 to amounts as reported in accordance with GAAP.

36




 
Twelve Months Ended December 31,
 
2016
 
2015
(in millions, except per-share amounts)
Dollars
 
Diluted EPS
 
Dollars
 
Diluted EPS
Reported GAAP net income and diluted EPS
$
814

 
$
6.54

 
$
848

 
$
6.56

Mark-to-market fuel hedge adjustments
(13
)
 
(0.11
)
 

 

Special items—merger-related costs and other(a)
117

 
0.94

 
32

 
0.25

Income tax effect on special items(b)
(24
)
 
(0.19
)
 
(12
)
 
(0.10
)
Special tax (benefit)/expense(c)
17

 
0.14

 
(26
)
 
(0.20
)
Non-GAAP adjusted net income and diluted EPS
$
911

 
$
7.32

 
$
842

 
$
6.51

(a)
Refer to Note 11 to the consolidated financial statement for the description of special items.
(b)
Certain merger-related costs are non-deductible for tax purposes, resulting in a smaller income tax effect for current year adjusting items.
(c)
Special tax (benefit)/expense represents the discrete impacts of adjustments to our position on income sourcing in various states.

CASM is summarized below:
 
Twelve Months Ended December 31,
 
2016
 
2015
 
% Change
Consolidated:
 
 
 
 
 
Total CASM

10.38
¢
 

10.77
¢
 
(3.6
)
Less the following components:
 
 
 

 
 

Aircraft fuel, including hedging gains and losses
1.88

 
2.39

 
(21.3
)
Special items—merger-related costs and other(a)
0.27

 
0.08

 
237.5

CASM, excluding fuel and special items

8.23
¢
 

8.30
¢
 
(0.8
)
 


 
 
 
 
Mainline:
 
 
 
 
 
Total CASM

9.39
¢
 

9.77
¢
 
(3.9
)
Less the following components:
 
 
 

 
 

Aircraft fuel, including hedging gains and losses
1.79

 
2.29

 
(21.8
)
Special items—merger-related costs and other(a)
0.30

 
0.09

 
233.3

CASM, excluding fuel and special items

7.30
¢
 

7.39
¢
 
(1.2
)
(a)
Refer to Note 11 to the consolidated financial statement for the description of special items.



37




OPERATING STATISTICS SUMMARY (unaudited)
Alaska Air Group, Inc.

Below are operating statistics we use to measure performance. Consolidated and Mainline amounts presented below include Virgin America data for the period December 14, 2016 through December 31, 2016. We often refer to unit revenues and adjusted unit costs, which is a non-GAAP measure.
 
Twelve Months Ended December 31,
 
2016
 
2015
 
Change
 
2014
 
Change
Consolidated Operating Statistics:(a)
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
34,289
 
31,883
 
7.5%
 
29,278
 
8.9%
RPMs (000,000) "traffic"
37,209
 
33,578
 
10.8%
 
30,718
 
9.3%
ASMs (000,000) "capacity"
44,135
 
39,914
 
10.6%
 
36,078
 
10.6%
Load factor
84.3%
 
84.1%
 
0.2 pts
 
85.1%
 
(1.0) pts
Yield
13.45¢
 
14.27¢
 
(5.7)%
 
14.91¢
 
(4.3)%
PRASM
11.34¢
 
12.01¢
 
(5.6)%
 
12.69¢
 
(5.4)%
RASM
13.44¢
 
14.03¢
 
(4.2)%
 
14.88¢
 
(5.7)%
CASM excluding fuel and special items(b)
8.23¢
 
8.30¢
 
(0.8)%
 
8.36¢
 
(0.7)%
Economic fuel cost per gallon(b)
$1.52
 
$1.88
 
(19.1)%
 
$3.08
 
(39.0)%
Fuel gallons (000,000)
554
 
508
 
9.1%
 
469
 
8.3%
ASM's per gallon
79.7
 
78.6
 
1.4%
 
76.9
 
2.2%
Average number of full-time equivalent employees (FTEs)
14,760
 
13,858
 
6.5%
 
12,739
 
8.8%
 
 
 
 
 
 
 
 
 
 
Mainline Operating Statistics:
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
24,838
 
22,869
 
8.6%
 
20,972
 
9.0%
RPMs (000,000) "traffic"
33,489
 
30,340
 
10.4%
 
27,778
 
9.2%
ASMs (000,000) "capacity"
39,473
 
35,912
 
9.9%
 
32,430
 
10.7%
Load factor
84.8%
 
84.5%
 
0.3 pts
 
85.7%
 
(1.2) pts
Yield
12.24¢
 
12.98¢
 
(5.7)%
 
13.58¢
 
(4.4)%
PRASM
10.38¢
 
10.97¢
 
(5.4)%
 
11.64¢
 
(5.8)%
CASM excluding fuel and special items(b)
7.30¢
 
7.39¢
 
(1.2)%
 
7.45¢
 
(0.8)%
Economic fuel cost per gallon(b)
$1.52
 
$1.87
 
(18.7)%
 
$3.07
 
(39.1)%
Fuel gallons (000,000)
474
 
439
 
8.0%
 
407
 
7.9%
ASM's per gallon
83.3
 
81.8
 
1.8%
 
79.7
 
2.6%
Average number of FTEs
11,447
 
10,750
 
6.5%
 
9,910
 
8.5%
Aircraft utilization
10.5
 
10.8
 
(2.8)%
 
10.5
 
2.9%
Average aircraft stage length
1,225
 
1,195
 
2.5%
 
1,182
 
1.1%
Mainline operating fleet at period-end
218 a/c
 
147 a/c
 
71 a/c
 
137 a/c
 
10 a/c
 
 
 
 
 
 
 
 
 
 
Regional Operating Statistics:(c)
 
 
 
 
 
 
 
 
 
Revenue passengers (000)
9,452
 
9,015
 
4.8%
 
8,306
 
8.5%
RPMs (000,000) "traffic"
3,720
 
3,238
 
14.9%
 
2,940
 
10.1%
ASMs (000,000) "capacity"
4,662
 
4,002
 
16.5%
 
3,648
 
9.7%
Load factor
79.8%
 
80.9%
 
(1.1) pts
 
80.6%
 
0.3 pts
Yield
24.42¢
 
26.37¢
 
(7.4)%
 
27.40¢
 
(3.8)%
PRASM
19.49¢
 
21.34¢
 
(8.7)%
 
22.08¢
 
(3.4)%
(a)
Except for FTEs, data includes information related to regional CPA flying with Horizon, SkyWest and PenAir.
(b)
See reconciliation of this measure to the most directly related GAAP measure in the "Results of Operations" section.
(c)
Data presented includes information related to regional CPAs.

38




OPERATING REVENUES

Total operating revenues increased $333 million, or 6%, during 2016 compared to the same period in 2015.  The changes are summarized in the following table:
 
Twelve Months Ended December 31,
(in millions)
2016
 
2015
 
% Change
Passenger
 
 
 
 
 
Mainline
$
4,098

 
$
3,939

 
4
Regional
908

 
854

 
6
Total passenger revenue
$
5,006

 
$
4,793

 
4
Freight and mail
108

 
108

 
Other—net
817

 
697

 
17
Total operating revenues
$
5,931

 
$
5,598

 
6

Passenger RevenueMainline

Mainline passenger revenue for 2016 increased by 4% due to a 9.9% increase in capacity, partially offset by a 5.4% decrease in PRASM compared to 2015. The increase in capacity was driven by new routes and growth in our operating fleet. Virgin America capacity from the acquisition date through December 31, 2016 represented approximately 2 points of capacity increase from 2015. The decrease in PRASM was driven by a decrease of 5.7% in ticket yield due to competitive pressures and our own growth, offset by a slight increase in load factor. Furthermore, the decline in fuel prices over the last year has contributed to lower ticket prices.

We expect competitive pressures on unit revenues to continue into 2017. However, given our projected capacity growth, we expect total passenger revenue will increase from 2016 on a combined comparative basis that includes full 2016 capacity of Virgin America.
 
Passenger RevenueRegional

Regional passenger revenue increased by $54 million, or 6%, compared to 2015 due to a 16.5% increase in capacity, partially offset by an 8.7% decrease in PRASM compared to 2015. The increase in capacity is due to an increase in departures from new E175 deliveries, an increase in average aircraft stage length and the annualization of new routes introduced over the past twelve months. The decrease in PRASM was due to a 7.4% decrease in ticket yield, as well as a decrease in load factor of 1.1 points. The decrease in yield was due to an increase in competitive capacity in our regional markets and our own growth as we strengthen our network utility in the Pacific Northwest, as well as an increase in the average trip length of our regional flights.

We expect Regional passenger revenue to increase in 2017, primarily due to the delivery and placement into service of 18 E175s and the annualization of new routes introduced in 2016.

OtherNet

Other—net revenue increased $120 million, or 17%, from 2015, primarily due to increases in Mileage Plan™ revenue. Mileage Plan™ revenue increased $100 million or 30%, due to increased miles sold and improved compensation terms with our Mileage Plan™ affinity credit card partner as a result of a contract extension which became effective January 1, 2016. Additionally, Mileage Plan™ revenue earned from our partner airlines increased as compared to the prior year.

We expect our Other—net revenue to experience an increase, on a year over year basis, at a pace higher than the expected increase in passengers in 2017, due to growth in the Mileage Plan™ program as we introduce Virgin America Elevate® members to the program, as well as continued organic growth amongst new and existing customers.



39





OPERATING EXPENSES

Total operating expenses increased $282 million, or 7%, compared to 2015, primarily as a result of higher wages and benefits and $117 million of merger-related costs, partially offset by lower fuel costs. 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:
 
Twelve Months Ended December 31,
(in millions)
2016
 
2015
 
% Change
Fuel expense
$
831

 
$
954

 
(13
)
Non-fuel expenses
3,634

 
3,314

 
10

Special items—merger-related costs and other
117

 
32

 
266

Total Operating Expenses
$
4,582

 
$
4,300

 
7


Significant operating expense variances from 2015 are more fully described below.

Wages and Benefits

Wages and benefits increased during 2016 by $128 million, or 10%, compared to 2015. The primary components of wages and benefits are shown in the following table:
 
Twelve Months Ended December 31,
(in millions)
2016
 
2015
 
% Change
Wages
$
1,022

 
$
945

 
8

Medical and other benefits
192

 
153

 
25

Defined contribution plans
67

 
60

 
12

Pension—Defined benefit plans
25

 
28

 
(11
)
Payroll taxes
76

 
68

 
12

Total wages and benefits
$
1,382

 
$
1,254

 
10


Wages increased 8% on a 6.5% increase in FTEs. The increase in wages was primarily attributable to FTE growth to support expansion of our business and an increase in the average wages per employee.

Medical and other benefits increased 25% compared to the prior year. The increase is primarily due to an increase in the number of employees and high-cost medical claims.

Defined contribution plans increased 12% due to FTE growth and increased participation throughout all labor groups.

Pension expense decreased 11%, compared to the same period in the prior year. The decrease is due to a change in several assumptions used at December 31, 2015, including a higher discount rate, updated retirement age assumptions, future salary increase assumptions and others that resulted in lower expense recognition in 2016.

We expect wages and benefits to be 30% to 35% higher in 2017