UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

~~(Mark One)~~


(X)Mark One)
þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended ~~September 30, 2004.~~March 31, 2005.

o
~~( )~~	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.

(Exact name of registrant as specified in its charter)


Delaware		~~91-1292054~~
(State or other jurisdiction of		~~(I.R.S. Employer~~
incorporation or organization)		91-1292054 (I.R.S. Employer Identification No.)

19300 ~~Pacific Highway South,~~International Boulevard, Seattle, Washington 98188
(Address of principal executive offices)

Registrant’s telephone number, including area code: (206) 392-5040

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (X)þ No ~~( )~~o

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

The registrant has ~~26,886,515~~27,182,608 common shares, par value $1.00, outstanding at ~~September 30, 2004.~~March 31, 2005.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1.

1: Condensed Consolidated Financial Statements

~~Item 2.~~

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

PART II OTHER INFORMATION

~~Item 3.~~

~~Quantitative and Qualitative Disclosures About Market Risk~~

~~Item 4.~~

~~Controls and Procedures~~

~~PART II. OTHER INFORMATION~~

~~Item~~ITEM 1.

Legal Proceedings

~~Item 2.~~

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

~~Item 3.~~

ITEM 3. Default on Senior Securities

~~Item 4.~~

ITEM 4. Submission of Matters to a Vote of Security Holders

ITEM 5. Other Information

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
Item 5.1.		~~Other Information~~Condensed Consolidated Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and
		Results of Operations
Item 3.		Quantitative and Qualitative Disclosures About Market Risk
Item 4.		Controls and Procedures
PART II. OTHER INFORMATION
Item 1.		Legal Proceedings
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.		Default on Senior Securities
Item 4.		Submission of Matters to a Vote of Security Holders
Item 5.		Other Information
Item 6.		Exhibits
Signatures
~~Signatures~~
~~Exhibits~~
~~EXHIBIT 4.1~~
~~EXHIBIT 10.19~~
~~EXHIBIT 31.1~~
~~EXHIBIT 31.2~~
~~EXHIBIT 32.1~~
~~EXHIBIT 32.2~~

Cautionary Note regarding Forward-Looking Statements

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements ~~that relate to future events~~within the meaning of ~~our future financial performance and involve a number of risks and uncertainties. These forward-looking statements are intended to be subject to the safe harbor protection provided by~~ Section 27A of the Securities Act ~~of 1933~~ and Section 21E of the ~~Securities~~ Exchange ~~Act of 1934. In some cases, you~~Act. 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 ~~by terminology such~~ as ~~“forecast,~~statements containing the words “believe,” ~~“may,~~“expect,” “will,” ~~“could,~~“anticipate,” ~~“should,~~“intend,” ~~“expect,~~“estimate,” ~~“plan,~~“project,” ~~“believe,” “potential”~~“assume” or other similar ~~words indicating future events or contingencies.~~expressions, although not all forward-looking statements contain these identifying words. Some of the things that could cause our actual results to differ from our expectations are: changes in our operating costs including ~~fuel;~~fuel, which can be volatile; the competitive environment and other trends in our industry; our ability to meet our cost reduction goals; labor disputes; economic conditions; our reliance on automated systems; actual or threatened terrorist attacks, global instability and potential U.S. military ~~involvement; our ability to meet our cost reduction goals; the outcome of contract talks with the Air Line Pilots Association, whether as a result of negotiations~~actions or ~~binding arbitration; labor disputes;~~activities; changes in laws and regulations; liability and other claims asserted against us; failure to expand our business; interest rates and the availability of financing; our ability to attract and retain qualified personnel; changes in our business plans; our significant indebtedness; downgrades of our credit ratings; and inflation. For a discussion of these and other risk factors, ~~review the information under the caption “Business — Business Risks” in~~see Item 17 of the Company’s Annual Report ~~on Form 10-K/A~~ for the year ended December 31, ~~2003.~~2004 on Form 10-K under the caption “Risk Factors.” All of the forward-looking statements are qualified in their entirety by reference to the risk factors discussed therein. ~~Our forward-looking statements are based on~~These risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. Management cannot predict such new risk factors, nor can it assess the ~~information currently available to us and speak only as~~impact, if any, of ~~the date of this report. You should not place undue reliance~~such new risk factors on our business or events described in any 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.~~statements. We ~~undertake no~~disclaim any obligation to publicly update or revise any forward-looking statements ~~whether as a result of new information, future events or otherwise,~~ after the date of this report to conform them to actual results. 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.

PART I. FINANCIAL INFORMATION

~~ITEM 1.~~Item 1: Condensed Consolidated Financial Statements

~~CONDENSED~~ CONSOLIDATED BALANCE SHEETS (unaudited)
Alaska Air Group, Inc.

ASSETS



	December 31,		September 30,		March 31,		December 31,
(In Millions)	2003		2004		2005		2004

Current Assets
Cash and cash equivalents	$	192.9	$	222.9	$	272.4	$	54.3
Marketable securities		619.4		655.6		491.1		819.6
Receivables - net		120.7		120.5
Inventories and supplies — net		45.8		47.4
Receivables – net						119.6		99.4
Inventories and supplies – net						43.7		42.0
Deferred income taxes		90.6		75.3		80.2		74.7
Fuel hedge contracts						124.4		65.7
Prepaid expenses and other current assets		78.9		169.5		102.7		86.6

Total Current Assets		1,148.3		1,291.2		1,234.1		1,242.3


Property and Equipment
Flight equipment		2,327.6		2,287.0		2,225.0		2,294.3
Other property and equipment		464.2		466.9		467.8		471.8
Deposits for future flight equipment		78.1		61.8		82.5		67.1

		2,869.9		2,815.7		2,775.3		2,833.2
Less accumulated depreciation and amortization		920.7		898.6		951.8		924.9

Total Property and Equipment — Net		1,949.2		1,917.1
Total Property and Equipment – Net						1,823.5		1,908.3


Intangible Assets		45.6		44.6		38.6		38.6


Fuel Hedge Contracts						65.1		30.3


Other Assets		116.1		156.2		139.3		115.5


Total Assets	$	3,259.2	$	3,409.1	$	3,300.6	$	3,335.0

See accompanying notes to condensed consolidated financial statements.

~~CONDENSED~~ CONSOLIDATED BALANCE SHEETS (unaudited)
Alaska Air Group, Inc.

LIABILITIES AND SHAREHOLDERS’ EQUITY


	December 31,			September 30,
(In Millions)	2003			2004
							March 31,			December 31,
(In Millions Except Share Amounts)							2005			2004

Current Liabilities
Accounts payable	$	132.9		$	139.3		$	142.3		$	143.8
Accrued aircraft rent		75.6			71.6			64.3			75.3
Accrued wages, vacation and payroll taxes		92.7			121.5			112.5			133.0
Other accrued liabilities		271.8			290.6			342.7			301.6
Air traffic liability		237.7			279.9			340.3			250.2
Current portion of long-term debt and capital lease obligations		206.7			52.1			54.0			53.4

Total Current Liabilities		1,017.4			955.0			1,056.1			957.3

Long-Term Debt and Capital Lease Obligations		906.9			1,007.6

Long-Term Debt and Capital Lease Obligations, Net of Current								980.4			989.6

Other Liabilities and Credits
Deferred income taxes		192.0			208.3			131.1			173.6
Deferred revenue		252.4			291.2			307.4			304.7
Other liabilities		216.3			233.4			241.1			245.0

		660.7			732.9			679.6			723.3

Commitments and Contingencies

Shareholders’ Equity
Preferred stock, $1 par value								—			—
Authorized: 5,000,000 shares		—			—
Authorized: 5,000,000 shares, none issued or outstanding
Common stock, $1 par value								29.8			29.8
Authorized: 100,000,000 shares
Issued: 2003 - 29,474,919 shares
2004 - 29,593,158 shares		29.5			29.6
Authorized: 100,000,000 shares Issued:
Issued: 2005 - 29,832,756 shares 2004 - 29,777,388 shares
Capital in excess of par value		486.3			488.4			497.5			496.5
Treasury stock, at cost: 2003 - 2,712,979 shares
2004 - 2,706,643 shares		(61.9	)		(61.8	)
Accumulated other comprehensive income (loss)		(79.0	)		(76.7	)
Treasury stock (common), at cost: 2005 - 2,650,148 shares 2004 - 2,651,368 shares								(60.5	)		(60.5	)
2004 - 2,651,368 shares
Deferred stock-based compensation								(3.1	)		(3.4	)
Accumulated other comprehensive loss								(82.7	)		(81.6	)
Retained earnings		299.3			334.1			203.5			284.0

		674.2			713.6			584.5			664.8

Total Liabilities and Shareholders’ Equity	$	3,259.2		$	3,409.1		$	3,300.6		$	3,335.0

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
Alaska Air Group, Inc.


Three Months Ended September 30

Three Months Ended March 31
(In Millions Except Per Share Amounts)	2003			2004			2005			2004
	Revised (See Note 13)
Operating Revenues
Passenger	$	645.8		$	706.0		$	587.0		$	553.3
Freight and mail		22.6			25.5			20.3			18.6
Other — net		33.8			42.3
Other – net								35.2			26.1

Total Operating Revenues		702.2			773.8			642.5			598.0

Operating Expenses
Wages and benefits		237.9			247.0			244.7			241.8
Contracted services		24.4			21.2			30.6			27.5
Aircraft fuel		96.8			148.4			146.7			107.8
Aircraft maintenance		42.4			37.0			61.2			50.8
Aircraft rent		49.2			46.7			46.1			47.8
Food and beverage service		17.6			14.3			11.5			11.6
Other selling expenses and commissions		36.1			37.5			37.4			38.4
Depreciation and amortization		32.7			35.7			34.2			36.1
Loss (gain) on sale of assets		0.1			(2.8	)
Landing fees and other rentals		43.3			48.0			52.2			42.6
Other		45.0			48.1			51.4			49.7
Restructuring charges		—			27.5
Restructuring charges, primarily write-off of Oakland leasehold improvements								7.4			—
Impairment of F-28 aircraft and spare engines								—			2.4

Total Operating Expenses		625.5			708.6			723.4			656.5

Operating Income		76.7			65.2
Operating Loss								(80.9	)		(58.5	)

Nonoperating Income (Expense)
Interest income		5.5			7.9			5.9			4.6
Interest expense		(13.3	)		(13.6	)		(14.1	)		(12.7	)
Interest capitalized		0.4			0.5			0.8			0.3
Other — net		(1.1	)		67.6
Fuel hedging gains								108.2			0.4
Other – net								(2.9	)		(0.3	)

		(8.5	)		62.4			97.9			(7.7	)

Income before income tax		68.2			127.6
Income tax expense		27.5			48.4
Income (loss) before income tax and accounting change								17.0			(66.2	)
Income tax expense (benefit)								7.1			(23.5	)

Net Income	$	40.7		$	79.2
Income (loss) before accounting change								9.9			(42.7	)
Cumulative effect of accounting change, net of tax								(90.4	)		—

Basic Earnings Per Share	$	1.53		$	2.95
Net Loss							$	(80.5	)	$	(42.7	)

Diluted Earnings Per Share	$	1.52		$	2.94
Basic Earnings (Loss) Per Share:
Income (loss) before accounting change							$	0.36		$	(1.59	)
Cumulative effect of accounting change								(3.33	)		—

Net Loss Per Share							$	(2.97	)	$	(1.59	)

Diluted Earnings (Loss) Per Share:
Income (loss) before accounting change							$	0.34		$	(1.59	)
Cumulative effect of accounting change								(2.73	)		—

Net Loss Per Share							$	(2.39	)	$	(1.59	)

Pro Forma Results(assuming change in method of accounting was applied retrospectively):
Pro forma net loss							NA			$	(40.5	)

Pro Forma Basic and Diluted Loss Per Share										$	(1.51	)

Shares used for computation:
Basic		26.660			26.862			27.147			26.778
Diluted		26.796			26.932			33.158			26.778

~~CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)~~
~~Alaska Air Group, Inc.~~

Nine Months Ended September 30
(In Millions Except Per Share Amounts)
2003
2004
Revised (See Note 13)
Operating Revenues

Passenger $ 1,678.2 $ 1,896.7
Freight and mail 63.6 68.3
Other - net 89.7 105.9

Total Operating Revenues
1,831.5 2,070.9

Operating Expenses

Wages and benefits 697.5 733.9
Contracted services 74.5 81.7
Aircraft fuel 270.5 384.8
Aircraft maintenance 140.2 137.9
Aircraft rent 146.1 141.5
Food and beverage service 46.6 39.5
Other selling expenses and commissions 99.1 111.5
Depreciation and amortization 98.2 105.8
Loss (gain) on sale of assets 0.2 (1.4 )
Landing fees and other rentals 120.6 136.2
Other 139.3 146.3
Restructuring charges — 27.5
Impairment of aircraft and spare engines — 39.6

Total Operating Expenses
1,832.8 2,084.8

Operating Loss
(1.3 ) (13.9 )

Nonoperating Income (Expense)

Interest income 11.5 18.6
Interest expense (38.6 ) (38.9 )
Interest capitalized 1.9 1.1
U.S. government compensation 71.4 —
Other — net 8.2 93.8

54.4 74.6

Income before income tax 53.1 60.7
Income tax expense 23.5 25.9

Net Income
$ 29.6 $ 34.8

Basic Earnings Per Share
$ 1.11 $ 1.30

Diluted Earnings Per Share
$ 1.11 $ 1.29

Shares used for computation:
Basic 26.621 26.820
Diluted 26.680 26.922

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (unaudited)
Alaska Air Group, Inc.


													Accumulated
	Common				Capital in		Treasury			Deferred			Other
	Shares		Common		Excess of		Stock,			Stock-Based			Comprehensive			Retained
(In Millions)	Outstanding		Stock		Par Value		at Cost			Compensation			Loss			Earnings			Total

Balances at December 31, 2004		27.126	$	29.8	$	496.5	$	(60.5	)	$	(3.4	)	$	(81.6	)	$	284.0		$	664.8

Net loss for the three months ended March 31, 2005																	(80.5	)		(80.5	)
Other comprehensive income (loss):

Related to marketable securities:
Change in fair value														(0.5	)
Reclassification to earnings														2.5
Income tax effect														(0.7	)

														1.3						1.3


Related to fuel hedges:
Reclassification to earnings														(3.8	)
Income tax effect														1.4

														(2.4	)					(2.4	)

Total comprehensive loss																				(81.6	)

Amortization of deferred stock-based compensation											0.3									0.3
Treasury stock sales		0.001		—		—		—												—
Stock issued for employee stock purchase plan		0.032		—		0.6		—												0.6
Stock issued under stock plans		0.024		—		0.4		—												0.4

Balances at March 31, 2005		27.183	$	29.8	$	497.5	$	(60.5	)	$	(3.1	)	$	(82.7	)	$	203.5		$	584.5

See accompanying notes to condensed consolidated financial statements.

CONDENSED CONSOLIDATED ~~STATEMENT~~STATEMENTS OF ~~SHAREHOLDERS’ EQUITY~~CASH FLOWS (unaudited)
Alaska Air Group, Inc.

Accumulated
Common Capital in Treasury Other
Shares Common Excess of Stock, Comprehensive Retained
(In Millions)
Outstanding
Stock
Par Value
at Cost
Income (Loss)
Earnings
Total
Balances at December 31, 2003: 26.762 $ 29.5 $ 486.3 $ (61.9 ) $ (79.0 ) $ 299.3 $ 674.2

Net income for the nine months ended September 30, 2004 34.8 34.8
Other comprehensive income (loss):
Officers supplemental retirement plan net of $0.4 tax benefit 0.7 0.7
Related to marketable securities:
Change in fair value (3.5 )
Reclassification to earnings 0.5
Income tax effect 1.1

(1.9 ) (1.9 )

Related to fuel hedges:
Change in fair value 18.1
Reclassification to earnings (12.5 )
Income tax effect (2.1 )

3.5 3.5

Total comprehensive loss 37.1
Treasury stock sales 0.007 — — 0.1 0.1
Stock issued for employee stock purchase plan 0.103 0.1 1.8 — 1.9
Stock issued under stock plans 0.015 — 0.3 — 0.3

Balances at September 30, 2004
26.887 $ 29.6 $ 488.4 $ (61.8 ) $ (76.7 ) $ 334.1 $ 713.6



Three Months Ended March 31 (In Millions)	2005			2004

Cash flows from operating activities:
Net loss	$	(80.5	)	$	(42.7	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Cumulative effect of accounting change, net of tax effect		90.4			—
Restructuring charges, primarily write-off of Oakland leasehold improvements		7.4			—
Impairment of F-28 aircraft and spare engines		—			2.4
Depreciation and amortization		34.2			36.1
Amortization of airframe and engine overhauls		—			18.7
Stock-based compensation		0.3			—
Changes in fair values of open fuel hedge contracts		(97.3	)		(0.4	)
(Gain) loss on sale of assets		(0.3	)		0.4
Changes in deferred income taxes		6.3			(22.9	)
Increase in receivables — net		(20.2	)		(22.3	)
Increase in prepaid expenses and other current assets		(17.3	)		(29.6	)
Increase in air traffic liability		90.1			71.9
Increase in other current liabilities		8.7			4.8
Increase (decrease) in deferred revenue and other-net		(25.1	)		5.2

Net cash provided by (used in) operating activities		(3.3	)		21.6

Cash flows from investing activities:
Proceeds from disposition of assets		2.0			4.1
Purchases of marketable securities		(127.0	)		(187.9	)
Sales and maturities of marketable securities		457.4			142.3
Property and equipment additions:
Aircraft purchase deposits		(41.2	)		(3.3	)
Capitalized overhauls		—			(13.6	)
Aircraft		(57.4	)		(40.1	)
Other flight equipment		(1.9	)		(5.9	)
Other property		(11.2	)		(5.4	)
Aircraft deposits returned		7.2			14.0
Restricted deposits and other		1.1			(2.0	)

Net cash provided by (used in) investing activities		229.0			(97.8	)

Cash flows from financing activities:
Proceeds from issuance of long-term debt, net		—			62.6
Long-term debt and capital lease payments		(8.6	)		(15.1	)
Proceeds from issuance of common stock		1.0			0.7

Net cash provided by (used in) financing activities		(7.6	)		48.2

Net change in cash and cash equivalents		218.1			(28.0	)
Cash and cash equivalents at beginning of year		54.3			192.9

Cash and cash equivalents at end of period	$	272.4		$	164.9

Supplemental disclosure of cash paid during the period for:
Interest (net of amount capitalized)	$	9.8		$	9.0
Income taxes		0.7			—
Noncash investing and financing activities:
Assets acquired under capital leases		—			34.2

See accompanying notes to condensed consolidated financial statements.

~~CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)~~
~~Alaska Air Group, Inc.~~

Nine Months Ended September 30 (In Millions)
2003
2004
Cash flows from operating activities:

Net income $ 29.6 $ 34.8
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Impairment of aircraft and spare engines — 39.6
Depreciation and amortization 98.2 105.8
Amortization of airframe and engine overhauls 47.8 48.3
Changes in fair values of fuel hedges 1.8 (80.4 )
Loss (gain) on sale of assets 0.1 (1.4 )
Increase in deferred income taxes 23.6 31.6
(Increase) decrease in receivables - net (16.3 ) 0.2
Increase in prepaid expenses and other current assets (1.6 ) (13.8 )
Increase in air traffic liability 54.2 42.2
Increase in other current liabilities 22.0 50.5
Increase in deferred revenue and other-net 13.1 26.1

Net cash provided by operating activities 272.5 283.5

Cash flows from investing activities:

Proceeds from disposition of assets 3.1 11.1
Purchases of marketable securities (695.2 ) (637.9 )
Sales and maturities of marketable securities 535.3 598.7
Property and equipment additions:
Aircraft purchase deposits (35.3 ) (10.3 )
Capitalized overhauls (56.1 ) (44.1 )
Aircraft (194.4 ) (41.7 )
Other flight equipment (12.1 ) (22.0 )
Other property (22.8 ) (25.7 )
Aircraft deposits returned 1.2 19.2
Restricted deposits and other (32.3 ) (4.5 )

Net cash used in investing activities (508.6 ) (157.2 )

Cash flows from financing activities:

Proceeds from issuance of long-term debt, net 247.0 94.6
Long-term debt and capital lease payments (60.3 ) (193.2 )
Proceeds from issuance of common stock 2.1 2.3

Net cash provided by (used in) financing activities 188.8 (96.3 )

Net change in cash and cash equivalents (47.3 ) 30.0
Cash and cash equivalents at beginning of period 269.0 192.9

Cash and cash equivalents at end of period
$ 221.7 $ 222.9

Supplemental disclosure of cash paid (refunded) during the period for:
Interest (net of amount capitalized) $ 31.1 $ 34.8
Income taxes (0.1 ) (39.6 )
Noncash investing and financing activities:
Assets acquired under long-term debt — 44.7

~~See accompanying notes to condensed consolidated financial statements.~~

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

Alaska Air Group, Inc.

Note 1. Basis of Presentation and Significant Accounting Policies

Organization and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Alaska Air Group, Inc. (Air Group or the Company) include the accounts of the parent company, Alaska Air Group, Inc., and its principal subsidiaries, Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon), through which the Company conducts substantially all of its operations. These interim condensed consolidated financial statements are unaudited and should be read in conjunction with the consolidated financial statements in the Company’s Annual Report on Form ~~10-K/A~~10-K for the year ended December 31, 2003. In the opinion of management, all adjustments have been made which are necessary to present fairly the Company’s financial position as of September 30, 2004, as well as the results of operations for the three and nine months ended September 30, 2003 and 2004. ~~The adjustments made were of a normal recurring nature.~~

The ~~Company’s condensed consolidated~~ financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). In preparing these condensed consolidated financial statements, the Company is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, ~~and~~the disclosure of contingent liabilities, as well as the reported amounts of revenues and expenses. Significant estimates made include assumptions used to record liabilities, expenses and revenues associated with the Company’s Mileage Plan, amounts to be paid to lessors upon aircraft lease ~~return provisions,~~terminations, the fair market value of surplus or impaired aircraft, engines and parts, assumptions used in the ~~calculation~~calculations of pension expense in the Company’s ~~defined benefit plans~~Defined Benefit Plans and the amounts of certain accrued liabilities. Actual results may differ ~~from~~ the Company’s estimates.

Reclassifications

Certain reclassifications have been made to conform the prior year’s data to the current format.

Stock Options

The Company has awards outstanding under five long-term incentive equity plans, one of which continues to provide for the grant of stock options to purchase Air Group common stock at market prices on the date of the grant to officers and employees of Air Group and its subsidiaries. The Company applies the intrinsic value method in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations in accounting for stock options. ~~Accordingly, no compensation cost has been recognized for these plans as the exercise price of options equals the fair market value on the date of grant.~~

The following table represents the ~~effect on~~pro forma net income (loss) before accounting change and ~~earnings~~pro forma net loss per share if(EPS) had compensation cost for the ~~Company had applied the fair value based method and recognition provisions~~Company’s stock options been determined in accordance with Statement of ~~Statement on~~ Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based ~~Compensation,~~Compensation.” ~~to its stock-based employee compensation (in millions, except per share amounts):~~In accordance with SFAS No. 123, the fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model and then amortized ratably over the vesting period.

During the fourth quarter of 2004, the Financial Accounting Standards Board issued SFAS 123R, “Share Based Payment: An Amendment of SFAS Nos. 123 and 95”. The new standard requires companies to recognize as expense the fair value of stock options and other equity-based compensation issued to employees as of the grant date. This new standard will apply to both stock options that we grant to employees and our Employee Stock Purchase Plan, which features a look-back provision and allows employees to purchase stock at a 15% discount. Our options are typically granted with graded vesting provisions, and we intend to amortize compensation cost over the service period using the straight line method. Due to a recent decision by the Securities and Exchange Commission, implementation of SFAS 123R will be effective January 1, 2006. We intend to use the “modified prospective method” upon adoption whereby previously awarded but unvested equity awards are accounted for in accordance with SFAS 123R and prospective amounts are recognized in the income statement instead of simply being disclosed. Once adopted, we expect our stock based compensation expense, as measured under SFAS 123R, will be approximately $ 6 to $10 million per year on a pre-tax basis.

Note 2. Change in Accounting Principle

Effective January 1, 2005, the Company changed its method of accounting for major airframe and engine overhauls from the capitalize and amortize method to the direct expense method. Under the former method, these costs were capitalized and amortized to maintenance expense over the shorter of the life of the overhaul or the remaining lease term. Under the direct expense method, overhaul costs are expensed as incurred. The Company believes that the direct expense method is preferable because it eliminates the judgment and estimation needed to determine overhaul versus repair allocations in maintenance activities. Additionally, the Company’s approved maintenance program for the majority of its airframes now focuses more on shorter, but more frequent, maintenance visits that result in a higher portion of the work being repair activity. Management also believes that the direct expense method is the predominant method used in the airline industry. Accordingly, effective January 1, 2005, the Company wrote off the net book value of its previously capitalized airframe and engine overhauls for all aircraft in a charge totaling $144.7 million pre-tax ($90.4 million after tax). The Company does not believe disclosing the effect of adopting the direct expense method on net income for the period ended March 31, 2005 provides meaningful information because of changes in the Company’s maintenance program, including the execution of a “power by the hour” maintenance agreement with a third party in late 2004.

During March 2005, the Company notified the Port of Oakland of its decision to terminate the lease for the Oakland hangar as part of its ongoing restructuring efforts. Accordingly, the Company has recorded an impairment charge for the leasehold improvements that will be abandoned as a result of the lease termination. Additionally, the Company has recorded a charge for for certain costs associated with the lease termination.

The following table displays the activity and balance of the asset impairment and lease termination costs components of the Company’s restructuring reserve as of and for the three months ended March 31, 2005 ($ in millions):

During the third quarter of 2004, ~~the Company~~Alaska announced a management reorganization and the closure of its Oakland heavy maintenance base, contracting out of the Company’s ~~Fleet Service, Ground Equipment~~fleet service and ~~Facility~~ground support equipment and facility maintenance functions, ~~and~~as well as other initiatives. In total, these restructuring activities are expected to result in a reduction of approximately 900 employees when fully implemented in 2005. Severance and related costs associated with this restructuring are estimated at $50-$55 million, of which $27.5 million was recorded during the third quarter of 2004 and $23 to $27 million will be recorded in the fourth quarter. The Company is also currently evaluating any possible asset impairment that may result from the announced initiatives. Any impairment charge would be in addition to the severance estimates above.employees.

The following table displays the activity and ~~balances~~balance of the severance and related costs components of the Company’s restructuring ~~charges~~reserve as of and for the three ~~and nine~~ months ended ~~September 30, 2004.~~March 31, 2005. The restructuring adjustment relates to our change in estimated costs of medical coverage extended to impacted employees. We expect to record similar adjustments in future quarters as actual medical costs become known. There were no restructuring charges during the ~~same period~~first quarter of ~~2003~~2004 ($ in millions):

* The Company ~~expects~~will make the majority of the remaining cash payments ~~will be made~~ during the ~~first and~~ second ~~quarters~~quarter of 2005.

Note ~~3. Impairment of Aircraft and Related Spare Engines~~

~~Impairment of 737-200C Aircraft~~

In June 2004, the Company’s Board approved a plan to accelerate the retirement of its Boeing 737-200C fleet and remove those aircraft from service (by the end of 2007) earlier than initially planned. In July 2004, the Company announced its plan to replace these aircraft by modifying five existing 737-400 aircraft and using other existing 737-400 aircraft for the remaining passenger capacity. Four of the five modified airplanes will be converted into combination passenger/cargo aircraft and one will be converted to an all cargo aircraft. The Company expects to backfill the 737-400s with Boeing 737-800s to be delivered in 2005 and 2006.

The estimated fair value of the Company’s aircraft was derived using third-party appraisals and market data compiled by an independent pricing authority, and adjusted for other factors that management deemed appropriate. In conjunction with the fair value determination, the Company has reassessed the useful lives and residual values of the fleet and related spare equipment and will depreciate the remaining carrying values through 2007 when the last aircraft will be retired.

4. Impairment of F-28 Aircraft and Related Spare Engines

During the first ~~and second quarters~~quarter of 2004, Horizon recorded an impairment ~~charges~~charge of $2.4 million ~~and $0.4 million, respectively,~~ associated with its F-28 aircraft and spare engines to lower the carrying value of these assets to their estimated net realizable value.

Note 5. Derivative Financial Instruments

The Company records all derivative instruments, all of which are currently fuel hedge contracts, on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in earnings or other comprehensive income, depending on the type of hedging instrument and the effectiveness of the hedges.

The Company’s operations are inherently dependent upon the price and availability of aircraft fuel, which accounted for 20.5% and 16.5% of 2005 and 2004 operating expenses (excluding impairment and restructuring charges), respectively. To manage economic risks associated with fluctuations in aircraft fuel prices, the Company enters into swap agreements and call options for crude oil.

Because of variations in the spread between the prices of West Texas Intermediate crude oil and jet fuel since the second quarter of 2004, the Company’s hedge contracts are not “highly correlated” to changes in prices of aircraft fuel, as defined in SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The impacts on the Company’s reported results are as follows:

• All changes in the fair value of fuel hedge contracts that existed as of March 31, 2004 or hedge positions entered into subsequent to March 31, 2004 are reported in other non-operating income (expense).
• Reported fuel expense includes only the effective portion of gains associated with hedge positions that settled during the current period on contracts that existed at March 31, 2004 to the extent that mark-to-market gains were already included in Accumulated Other Comprehensive Loss at March 31, 2004.

The following table summarizes fuel hedging gains and changes in fair value of hedging contracts outstanding as of March 31, 2005 and 2004 (in millions):



	Alaska Airlines						Horizon Air
	Three Months Ended March 31
	2005			2004			2005			2004

Fuel expense before hedge activities (“raw” or “into-plane” fuel cost)	$	131.0		$	96.7		$	19.5		$	14.6
Less: gains on settled hedges included in fuel expense		(3.4	)		(3.1	)		(0.4	)		(0.4	)

GAAP fuel expense	$	127.6		$	93.6		$	19.1		$	14.2

Less: gains on settled hedges included in nonoperating income (expense)		(15.7	)		—			(2.5	)		—

Economic fuel expense	$	111.9		$	93.6		$	16.6		$	14.2


Mark-to-market hedging gains included in nonoperating income (expense)	$	77.7		$	0.4		$	12.3		$	—

Fuel hedge positions entered into by Alaska and Horizon are currently as follows:



	Approximate % of
	Expected Fuel			Gallons Hedged		Approximate Crude
	Requirements			(in millions)		Oil Price per Barrel
Second Quarter 2005		50	%		51.9	$	28.97
Third Quarter 2005		50	%		55.7	$	28.81
Fourth Quarter 2005		50	%		50.4	$	31.85
First Quarter 2006		50	%		50.8	$	35.70
Second Quarter 2006		50	%		53.5	$	39.76
Third Quarter 2006		40	%		45.9	$	41.58
Fourth Quarter 2006		30	%		31.2	$	42.70
First Quarter 2007		20	%		20.9	$	43.09
Second Quarter 2007		15	%		16.5	$	43.86
Third Quarter 2007		15	%		17.7	$	43.50
Fourth Quarter 2007		10	%		10.7	$	47.29
First Quarter 2008		5	%		5.4	$	51.56

The fair values of the Company’s fuel hedge positions for the period ended March 31, 2005 and December 31, 2004 were $189.5 million and $96.0 million, respectively, and are presented as fuel hedge contracts in the consolidated balance sheets.

Note 6. Other Assets

Other assets consisted of the following (in millions):



	March 31, 2005		December 31, 2004

Restricted deposits (primarily restricted investments)	$	85.4	$	84.2
Deferred costs and other		52.4		27.7
Restricted cash for senior convertible notes		1.5		3.6

	$	139.3	$	115.5

Note 7. Mileage Plan

Alaska’s Mileage Plan liabilities are included under the following balance sheet captions (in millions):



	March 31, 2005		December 31, 2004

Current Liabilities:
Other accrued liabilities	$	149.5	$	136.6
Other Liabilities and Credits (non-current):
Deferred revenue		257.9		252.9
Other liabilities		20.1		19.8

	$	427.5	$	409.3

Note ~~4. Derivative Financial Instruments~~

The Company’s operations are inherently dependent upon the price and availability of aircraft fuel, which accounted for 15% and 19% of year-to-date 2003 and 2004 operating expenses (excluding impairment and restructuring charges), respectively. To manage economic risks associated with fluctuations in aircraft fuel prices, the Company enters into swap agreements and call options for crude oil. Prior to the second quarter of 2004, these hedging contracts were “highly correlated” to changes in aircraft fuel prices, and therefore qualified as “cash flow hedges” under SFAS No. 133 whereby the majority of the changes in fair value were deferred in Accumulated Other Comprehensive Income on the Company’s Balance Sheet until these hedge positions were settled at which point they were recognized in earnings.

The Company’s current fuel hedge program includes the same underlying commodities used historically. However, because of variations in the spread between the prices of crude oil and jet fuel since April 1, 2004, the Company’s hedge contracts are no longer “highly correlated” to changes in prices of aircraft fuel, as defined in SFAS No. 133. The impacts on the Company’s reported results are as follows:

• All changes in the fair value of fuel hedge contracts that existed as of March 31, 2004 or hedge positions entered into subsequent to March 31, 2004 (the end of the first quarter of 2004) are reported in other non-operating income (expense).
• Because the Company will be recording fair value changes in its consolidated statement of operations as they occur (in non-operating income (expense)), actual gains or losses realized upon settlement of the hedge contracts entered into subsequent to March 31, 2004 will not be reflected in fuel expense.
• Reported fuel expense will include the effective portion of gains associated with hedge positions that settled during the current period on contracts that existed at March 31, 2004 to the extent that mark-to-market gains were already included in Accumulated Other Comprehensive Income at March 31, 2004.

~~The following table summarizes realized fuel hedging gains and changes in fair value of hedging contracts outstanding as of September 30, 2004 and 2003 (in millions):~~

Three Months Ended Nine Months Ended
September 30, September 30,
2003
2004
2003
2004
Settled hedging gains included in aircraft fuel $ 5.1 $ 4.0 $ 16.5 $ 12.5

Settled hedging gains (losses) included In non-operating income (expense)*** $ (0.8 ) $ 9.7 $ 4.3 $ 13.3
Mark-to-market hedging gains included in non-operating income (expense)** $ — $ 57.2 $ — $ 80.0

Hedging gains included in non-operating income (expense)* $ (0.8 ) $ 66.9 $ 4.3 $ 93.3

* Includes the ineffective portion recorded currently in earnings using “hedge accounting” through the first quarter of 2004.

** Includes changes in fair value since March 31, 2004 resulting from the loss of “hedge accounting”.

*** 2003 includes the ineffective portion of fair market value changes under “hedge accounting”.

~~Fuel hedge positions entered into by Alaska and Horizon are currently as follows:~~

Approximate % of
Expected Fuel Gallons Hedged Approximate Crude
Requirements
(in millions)
Oil Price per Barrel
Fourth Quarter 2004 50 % 49.0 $ 30.39
First Quarter 2005 50 % 49.3 $ 29.86
Second Quarter 2005 50 % 51.9 $ 28.97
Third Quarter 2005 50 % 55.7 $ 28.81
Fourth Quarter 2005 50 % 50.4 $ 31.85
First Quarter 2006 40 % 40.7 $ 33.22
Second Quarter 2006 30 % 32.1 $ 34.41
Third Quarter 2006 20 % 22.9 $ 36.05
Fourth Quarter 2006 10 % 10.4 $ 37.28
First Quarter 2007 5 % 5.2 $ 35.75
Second Quarter 2007 5 % 5.5 $ 35.48
Third Quarter 2007 5 % 5.9 $ 35.23

As of December 31, 2003 and September 30, 2004, the fair values of the Company’s fuel hedge positions were $18.4 million and $117.0 million, respectively, and are presented in the consolidated balance sheets as follows (in millions):

December 31, 2003
September 30, 2004
Prepaid expenses and other current assets $ 12.0 $ 81.6
Other assets 6.4 35.4

$ 18.4 $ 117.0

~~Note 5. Other Assets~~

~~At December 31, 2003 and September 30, 2004, other assets consisted of the following (in millions):~~

December 31, 2003
September 30, 2004
Restricted deposits (primarily restricted investments) $ 70.8 $ 80.8
Derivative financial instruments (fuel hedges) 6.4 35.4
Deferred costs and other 27.7 34.5
Restricted cash for senior convertible notes 11.2 5.5

$ 116.1 $ 156.2

* In connection with the restructuring charge and reduction in force as discussed in Note 2, the Company recorded a curtailment charge pursuant to SFAS No. 88. This charge is estimated at $1.0 million and is included in restructuring charges in the the condensed consolidated financial statements.14

Net periodic benefit cost for the postretirement medical plans for the three ~~and nine~~ months ended ~~September 30~~March 31 included the following ~~components~~components:

SFAS No. 128, “Earnings per Share” requires that companies use income from continuing operations before extraordinary items and the cumulative effect of an accounting change as the “control number” in determining whether potential common shares are dilutive or antidilutive. As the Company reported income before the accounting change in 2005, the potential common shares from the Company’s common stock options and senior convertible notes are included in the calculation for diluted earnings (loss) per share. Therefore, for the three months ended March 31, 2005, the dilutive impact of common stock options and 5.8 million common shares that would have been outstanding upon conversion of the senior convertible notes were included in the calculations. Options to purchase 3.9 million shares and the effect of the senior convertible

notes were excluded from the computation of diluted loss per share in 2004 because the impact would have been antidilutive. Income (loss) per share was calculated as follows (in ~~millions):~~millions except per share amounts).

Three Months Ended Nine Months Ended
September 30, September 30,
2003
2004
2003
2004
Service cost $ 0.9 $ 0.6 $ 2.7 $ 3.0
Interest cost 1.1 0.7 3.3 3.3
Amortization of prior service cost — (0.1 ) — (0.3 )
Actuarial loss 0.4 0.4 1.2 1.8

Net periodic benefit cost $ 2.4 $ 1.6 $ 7.2 $ 7.8



	Three Months Ended
	March 31,
	2005			2004

Basic Earnings (Loss) Per Share
Income (loss) before accounting change	$	9.9		$	(42.7	)
Weighted average shares outstanding		27.147			26.778

Income (loss) per share before accounting change	$	0.36		$	(1.59	)


Cumulative effect of accounting change, net of tax	$	(90.4	)	NA
Weighted average shares outstanding		27.147		NA

Per share cumulative effect of accounting change	$	(3.33	)	NA


Net loss	$	(80.5	)	$	(42.7	)
Weighted average shares outstanding		27.147			26.778

Net loss per share	$	(2.97	)	$	(1.59	)


Diluted Earnings (Loss) Per Share
Income (loss) before accounting change	$	9.9		$	(42.7	)
Interest on convertible notes, net of tax		1.2			—

Diluted income (loss) before accounting change	$	11.1		$	(42.7	)
Weighted average diluted shares outstanding		33.158			26.778

Income (loss) per share before accounting change	$	0.34		$	(1.59	)


Cumulative effect of accounting change, net of tax	$	(90.4	)	NA
Weighted average diluted shares outstanding		33.158		NA

Per share cumulative effect of accounting change	$	(2.73	)	NA


Net loss	$	(80.5	)	$	(42.7	)
Interest on convertible notes, net of tax		1.2			—

Diluted net loss	$	(79.3	)	$	(42.7	)
Weighted average diluted shares outstanding		33.158			26.778

Net loss per share	$	(2.39	)	$	(1.59	)

Note ~~8. Earnings Per Share~~10. Operating Segment Information

~~Earnings per share calculations~~Operating segment information for Alaska and Horizon for the three-month period ended March 31 was as follows (in millions):



	Three Months Ended March 31,
	2005			2004

Operating revenues:
Alaska	$	523.3		$	491.3
Horizon		121.2			110.3
Elimination of intercompany revenues		(2.0	)		(3.6	)

Consolidated	$	642.5		$	598.0

Income (loss) before income tax and accounting change:
Alaska	$	15.4		$	(53.2	)
Horizon		4.6			(10.4	)
Other*		(3.0	)		(2.6	)

Consolidated	$	17.0		$	(66.2	)

Total assets at end of period:
Alaska	$	3,062.0		$	3,185.8
Horizon		342.4			317.0
Other*		760.0			854.7
Elimination of intercompany accounts		(863.8	)		(958.2	)

Consolidated	$	3,300.6		$	3,399.3

* Includes the parent company, Alaska Air Group, Inc., including its investments in Alaska and Horizon, which are eliminated in consolidation.

Note 11. Long-term Debt and Capital Lease Obligations

At March 31, 2005 and December 31, 2004, long-term debt and capital lease obligations were as follows (in millions except per share amounts). Stock options are included in the computation of diluted loss per share unless their impact is antidilutive. For the three months ended September 30, 2003 and 2004, options to purchase 2.4 million shares and 3.3 million shares of common stock, respectively, were excluded from the calculations. For the nine months ended September 30, 2003 and 2004, options to purchase 3.1 million shares and 3.2 million shares of common stock, respectively, were excluded from the calculations.millions):

Three Months Ended Nine Months Ended
September 30, September 30,
2003
2004
2003
2004
Basic

Net income $ 40.7 $ 79.2 $ 29.6 $ 34.8
Weighted average shares outstanding 26.660 26.862 26.621 26.820

Earnings per share $ 1.53 $ 2.95 $ 1.11 $ 1.30



	2005			2004

Fixed rate notes payable due through 2015	$	357.7		$	361.3
Variable rate notes payable due through 2018		526.4			531.2
Senior convertible notes due through 2023		150.0			150.0

Long-term debt		1,034.1			1,042.5
Capital lease obligations		0.3			0.5
Less current portion		(54.0	)		(53.4	)

	$	980.4		$	989.6

1517

Three Months Ended Nine Months Ended
September 30, September 30,
2003
2004
2003
2004
Diluted

Net income $ 40.7 $ 79.2 $ 29.6 $ 34.8
Weighted average shares outstanding 26.660 26.862 26.621 26.820
Assumed exercise of stock options .136 .070 .059 .102

Diluted EPS shares 26.796 26.932 26.680 26.922

Earnings per share $ 1.52 $ 2.94 $ 1.11 $ 1.29

~~Diluted shares also excludes~~During 2004, Alaska repaid its $150 million credit facility and, on December 23, 2004, that facility expired. On March 25, 2005, Alaska Airlines, Inc. finalized a $160 million variable rate credit facility with a syndicate of financial institutions that will expire in March 2008. The interest rate on the ~~shares~~credit facility varies depending on certain financial ratios specified in the agreement with a minimum interest rate of ~~common stock issuable upon conversion~~LIBOR plus 200 basis points. Any borrowings will be secured by either aircraft or cash collateral. This credit facility contains contractual restrictions and requires maintenance of specific levels of net worth, maintenance of certain debt and leases to net worth, leverage and fixed charge coverage ratios, and limits on liens, asset dispositions, dividends, and certain other expenditures. Such provisions restrict Alaska Airlines from distributing any funds to Alaska Air Group in the form of dividends and limit the amount of funds Alaska Airlines can loan to Alaska Air Group. As of March 31, 2005, $300.0 million was available to loan to Alaska Air Group without violating the covenants in the credit facility. As of March 31, 2005, there are no outstanding borrowings on this credit facility.

Holders of the Company’s ~~floating rate~~$150.0 million senior convertible notes due in 2023 (the Notes) issued on March 21, 2003, because the closing prices of Air Group’s common stock during the first, second and third quarters of 2003 and 2004 did not trigger the convertibility feature, their effect would have been antidilutive. Holders(Notes) may ~~not~~elect to surrender the ~~notes~~Notes for conversion into shares of the Company’s common ~~stock (or cash, at the election~~stock. The conversion price of the ~~Company) unless~~Notes is $26.00 through March 2008. Upon a conversion of the ~~closing sale price~~Notes, in lieu of delivering shares of the Company’s common stock, ~~exceeds 110%~~the Company may elect to pay cash or a combination of cash and the Company’s common stock for the Notes surrendered. The Company may also redeem all or a portion of the ~~accreted conversion price under~~Notes in cash or common stock or a combination at any time on or after the ~~Notes for 20 days in the 30 trading-day period ending on the last day~~third anniversary of the ~~fiscal quarter.~~issuance of the Notes. In addition, holders may ~~require the Company to purchase~~redeem all or a portion of their Notes for ~~a purchase price equal to principal plus accrued interest,~~cash on the ~~5th, 10th~~5^th, 10^th and ~~15th~~15^th anniversaries of the issuance of the Notes or upon the occurrence of a change of control or tax ~~event. On September 30, 2004, we entered into the First Supplemental Indenture with respect~~event at principal plus accrued interest.

Subsequent to the ~~Notes~~first quarter, Horizon financed a CRJ-700 that was purchased with cash and delivered during the first quarter. The financing was completed with a $20 million long-term debt arrangement that has a fifteen year term and a fixed interest rate of 6.07%.

Note 12. Contingencies

The Company’s former pilot contract provided that, if a negotiated agreement on the entire contract was not reached by December 15, 2004, ten contract issues plus wage rates would be submitted to ~~rescind the Company’s right to pay for such a repurchase~~an interest arbitrator. The arbitration became effective on May 1, 2005 and resulted in an average pilot wage reduction of ~~the Notes at the option of the holders, in whole or in part, in shares of our common stock. Pursuant~~approximately 26%, various work rule changes, and higher employee health care contributions. No changes were made to the ~~terms of the notes, as amended, any such repurchases shall be paid for in cash.~~pilots’ pension or profit sharing plans.

The Company may redeem all or a portion of the Notes in cash at any time on or after the third anniversary of the issuance of the Notes or if holders of the Notes require the Company to purchase the Notes.

For each $1,000 of original principal amount per Note, the conversion price through March 21, 2008 is equal to the original principal amount of the Notes, divided by 38.4615. At the date of issuance, the conversion price was equal to $26.00 per share and the conversion trigger price was equal to 110% of the conversion price, or $28.60 per share. After March 21, 2008, the conversion price and conversion trigger price increase based on the variable yield of the notes. Once the closing sale price of the Company’s common stock exceeds the conversion trigger price for the requisite period, the notes will be convertible at any time thereafter at the option of the holder, through maturity.

During the third quarter of 2004, the Emerging Issues Task Force (EITF) affirmed its tentative conclusion reached in July of 2004 on EITF Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted EPS” (EITF 04-08). EITF 04-08 requires companies to include certain contingently convertible securities in the calculation of diluted EPS to the extent the inclusion of the shares would be dilutive. Adoption of EITF 04-08 is expected to be required during the fourth quarter of 2004 and will impact periods and comparative periods on a go foward basis. Because the Company’s convertible notes fall under the scope of EITF 04-08, beginning in the fourth quarter of 2004 and for all comparative periods presented, the Company expects to report a lower

1618

~~lower diluted EPS~~The Company is a party to routine commercial and employment litigation incidental to its business and with respect to which no material liability is expected. Management believes the ~~extent~~ultimate disposition of these matters is not likely to materially affect the ~~convertible notes are~~Company’s financial position or results of operations. However, this belief is based on management’s current understanding of the relevant law and facts; it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.

The Company could potentially be responsible for environmental remediation costs primarily related to jet fuel and other petroleum contamination that occurs in the normal course of business at various owned or leased locations in the Company’s system. The Company has established an accrual for estimated remediation costs for known contamination based on information currently available. The accrual was not anti-dilutive. Had EITF 04-08 been required during the third quarter of 2003 and 2004, diluted EPS would include an additional 5.7 million shares and would have resulted in diluted EPS of $1.29 and $2.47 for the three months ended September 30, 2003 and 2004, respectively, and $1.00 and $1.20 per share for the nine months ended September 30, 2003 and 2004, respectively.significant at March 31, 2005.

~~Note 9. Operating Segment Information~~

~~Operating segment information for Alaska and Horizon for the three and nine month periods ended September 30 was as follows (in millions):~~

Three Months Ended Nine Months Ended
September 30, September 30,
2003
2004
2003
2004
Operating revenues:
Alaska $ 585.3 $ 641.2 $ 1,522.9 $ 1,710.1
Horizon 132.7 139.3 342.3 374.3
Elimination of intercompany revenues (15.8 ) (6.7 ) (33.7 ) (13.5 )

Consolidated $ 702.2 $ 773.8 $ 1,831.5 $ 2,070.9

Income (loss) before income tax:
Alaska $ 50.1 $ 106.3 $ 39.1 $ 50.3
Horizon 19.5 24.4 19.9 18.7
Other* (1.4 ) (3.1 ) (5.9 ) (8.3 )

Consolidated $ 68.2 $ 127.6 $ 53.1 $ 60.7

Total assets at end of period:
Alaska $ 3,072.7 $ 3,158.7
Horizon 257.4 304.1
Other* 911.1 887.4
Elimination of intercompany accounts (1,001.8 ) (941.1 )

Consolidated $ 3,239.4 $ 3,409.1

* Includes the parent company, Alaska Air Group, Inc, including Alaska Air Group Leasing and investments in Alaska and Horizon, which are eliminated in consolidation.

1719

Alaska Airlines Financial and Statistical Data (unaudited)


	Three Months Ended March 31
							%
Financial Data (in millions):	2005			2004			Change
Operating Revenues:
Passenger	$	471.3		$	449.3			4.9
Freight and mail		19.3			17.7			9.0
Other — net		32.7			24.3			34.6

Total Operating Revenues		523.3			491.3			6.5


Operating Expenses:
Wages and benefits		199.7			200.8			(0.5	)
Contracted services		27.8			23.1			20.3
Aircraft fuel		127.6			93.6			36.3
Aircraft maintenance		50.1			43.5			15.2
Aircraft rent		28.4			29.5			(3.7	)
Food and beverage service		10.9			11.2			(2.7	)
Other selling expenses and commissions		32.7			33.9			(3.5	)
Depreciation and amortization		30.3			32.8			(7.6	)
Loss on sale of assets		—			0.8		NM
Landing fees and other rentals		40.6			33.2			22.3
Other		38.4			36.9			4.1
Restructuring charges, primarily write-off of Oakland leasehold improvements		7.4			—		NM

Total Operating Expenses		593.9			539.3			10.1


Operating Loss		(70.6	)		(48.0	)	NM


Interest income		6.3			5.3
Interest expense		(11.5	)		(10.8	)
Interest capitalized		0.7			0.1
Fuel hedging gains		93.4			0.4
Other — net		(2.9	)		(0.2	)

		86.0			(5.2	)


Income (Loss) Before Income Tax	$	15.4		$	(53.2	)	NM


Operating Statistics:
Revenue passengers (000)		3,851			3,592			7.2
RPMs (000,000)		3,897			3,580			8.9
ASMs (000,000)		5,370			5,178			3.7
Passenger load factor		72.6	%		69.1	%	3.5 pts
Yield per passenger mile		12.09	¢		12.55	¢		(3.7	)
Operating revenue per ASM		9.74	¢		9.49	¢		2.6
Operating expenses per ASM (a)		11.06	¢		10.42	¢		6.1
Operating expense per ASM excluding fuel and restructuring charges (a)		8.55	¢		8.61	¢		(0.7	)
Raw fuel cost per gallon (a)		155.6	¢		116.6	¢		33.4
GAAP fuel cost per gallon (a)		151.5	¢		112.9	¢		34.2
Economic fuel cost per gallon (a)		132.9	¢		112.9	¢		17.7
Fuel gallons (000,000)		84.2			82.9			1.6
Average number of employees		9,219			9,984			(7.7	)
Aircraft utilization (blk hrs/day)		10.7			10.4			2.9
Operating fleet at period-end		109			108			0.9

NM = Not Meaningful

(a) See Note A on page 22.

Horizon Air Financial and Statistical Data (unaudited)


	Quarter Ended March 31
							%
Financial Data (in millions):	2005			2004			Change
Operating Revenues:
Passenger	$	117.7		$	106.5			10.5
Freight and mail		1.0			0.9			11.1
Other — net		2.5			2.9			(13.8	)

Total Operating Revenues		121.2			110.3			9.9


Operating Expenses:
Wages and benefits		43.2			41.5			4.1
Contracted services		5.5			5.2			5.8
Aircraft fuel		19.1			14.2			34.5
Aircraft maintenance		11.1			7.3			52.1
Aircraft rent		17.7			18.3			(3.3	)
Food and beverage service		0.6			0.4			50.0
Other selling expenses and commissions		6.7			6.5			3.1
Depreciation and amortization		3.6			3.0			20.0
Gain on sale of assets		(0.2	)		(0.4	)	NM
Landing fees and other rentals		11.8			9.9			19.2
Other		11.5			11.5			0.0
Impairment of F-28 aircraft and spare engines		—			2.4		NM
Total Operating Expenses		130.6			119.8			9.0


Operating Income (Loss)		(9.4	)		(9.5	)	NM


Interest income		0.3			—
Interest expense		(1.2	)		(1.3	)
Interest capitalized		0.1			0.2
Fuel hedging gains		14.8			—
Other — net		—			0.2

		14.0			(0.9	)


Income (Loss) Before Income Tax	$	4.6		$	(10.4	)	NM


Operating Statistics:
Revenue passengers (000)		1,475			1,267			16.4
RPMs (000,000)		540			450			20.0
ASMs (000,000)		782			692			13.0
Passenger load factor		69.0	%		65.0	%	4.0 pts
Yield per passenger mile		21.82	¢		23.67	¢		(7.8	)
Operating revenue per ASM		15.50	¢		15.94	¢		(2.8	)
Operating expenses per ASM (a)		16.69	¢		17.30	¢		(3.5	)
Operating expense per ASM excluding fuel and impairment charges (a)		14.25	¢		14.91	¢		(4.4	)
Raw fuel cost per gallon (a)		162.5	¢		121.7	¢		33.5
GAAP fuel cost per gallon (a)		158.5	¢		117.7	¢		34.7
Economic fuel cost per gallon (a)		137.7	¢		117.7	¢		17.0
Fuel gallons (000,000)		12.0			12.0			0.0
Average number of employees		3,363			3,344			0.6
Aircraft utilization (blk hrs/day)		8.4			7.7			9.1
Operating fleet at period-end		66			64			3.1

NM = Not Meaningful

(a) See Note A on page 22.

Note A:

Pursuant to Item 10 of Regulation S-K, we are providing disclosure of the reconciliation of reported non-GAAP financial measures to their most directly comparable financial measures reported on a GAAP basis. The non-GAAP financial measures provide management the ability to measure and monitor performance both with and without the cost of aircraft fuel (including the gains and losses associated with our fuel hedging program where appropriate), restructuring charges, and aircraft impairment charges. Because the cost and availability of aircraft fuel are subject to many economic and political factors beyond our control and we record changes in the fair value of our hedge portfolio in our income statement, it is our view that the measurement and monitoring of performance without fuel is important. In addition, we believe the disclosure of financial performance without impairment and restructuring charges is useful to investors. Finally, these non-GAAP financial measures are also more comparable to financial measures reported to the Department of Transportation by other major network airlines.

The following tables reconcile our non-GAAP financial measures to the most directly comparable GAAP financial measures for both Alaska Airlines, Inc. and Horizon Air Industries, Inc.:

Alaska Airlines, Inc.:
($ in millions)


	Three Months Ended March 31,
	2005			2004
Unit cost reconciliations:

Operating expenses	$	593.9		$	539.3
ASMs (000,000)		5,370			5,178

Operating expenses per ASM		11.06	¢		10.42	¢


Operating expenses	$	593.9		$	539.3
Less: aircraft fuel		(127.6	)		(93.6	)
Less: restructuring charges		(7.4	)		—

Operating expense excluding fuel & restructuring charges	$	458.9		$	445.7
ASMs (000,000)		5,370			5,178

Operating expense per ASM excluding fuel		8.55	¢		8.61	¢


Reconciliation from GAAP pre-tax income (loss):

Pretax income (loss) reported GAAP amounts	$	15.4		$	(53.2	)
Less: mark-to-market hedging gains included in nonoperating income (expense)		(77.7	)		(0.4	)
Add: Restructuring charges		7.4			—


Pretax loss excluding restructuring charges and mark-to-market hedging gains	$	(54.9	)	$	(53.6	)

Aircraft fuel reconciliations:


	Three Months Ended March 31,
	2005						2004
	(in millions)			Cost/Gal			(in millions)			Cost/Gal

Fuel expense before hedge activities (“raw” or “into-plane” fuel cost)	$	131.0		$	1.56		$	96.7		$	1.17
Less: gains on settled hedges included in fuel expense		(3.4	)		(0.04	)		(3.1	)		(0.04	)

GAAP fuel expense	$	127.6		$	1.52		$	93.6		$	1.13
Less: gains on settled hedges included in nonoperating income (expense)		(15.7	)		(0.19	)		—			—

Economic fuel expense	$	111.9		$	1.33		$	93.6		$	1.13

Fuel gallons (000,000)		84.2						82.9


Mark-to-market gains (losses) included in non-operating income related to hedges that settle in future periods	$	77.7					$	0.4

Horizon Air Industries, Inc.
($ in millions)


	Three Months Ended March 31,
Unit cost reconciliations:	2005			2004
Operating expenses	$	130.6		$	119.8
ASMs (000,000)		782			692

Operating expenses per ASM		16.69	¢		17.30	¢


Operating expenses	$	130.6		$	119.8
Less: aircraft fuel		(19.1	)		(14.2	)
Less: impairment of aircraft and spare engines		—			(2.4	)

Operating expenses excluding fuel and impairment charge	$	111.5		$	103.2
ASMs (000,000)		782			692

Operating expenses per ASM excluding fuel and impairment charge		14.25	¢		14.91	¢


Reconciliation from GAAP pre-tax income (loss):
Pretax income (loss) reported GAAP amounts	$	4.6		$	(10.4	)
Less: mark-to-market hedging gains included in nonoperating income (expense)		(12.3	)		—
Add: impairment of aircraft and spare engines		—			2.4


Pretax loss excluding impairment charge and mark-to-market hedging gains	$	(7.7	)	$	(8.0	)

Aircraft fuel reconciliations:


	Three Months Ended March 31,
	2005						2004
	(in millions)			Cost/Gal			(in millions)			Cost/Gal

Fuel expense before hedge activities (“raw” or “into-plane” fuel cost)	$	19.5		$	1.63		$	14.6			$	1.22
Less: gains on settled hedges included in fuel expense		(0.4	)		(0.04	)		(0.4	)			(0.04	)

GAAP fuel expense	$	19.1		$	1.59		$	14.2			$	1.18
Less: gains on settled hedges included in nonoperating income (expense)		(2.5	)		(0.2	)		—				—

Economic fuel expense	$	16.6		$	1.38		$	14.2			$	1.18

Fuel gallons (000,000)		12.0						12.0


Mark-to-market gains included in non-operating income related to hedges that settle in future periods	$	12.3						—

~~Note 10. Long-Term Debt~~ITEM 2. Management’s Discussion and ~~Capital Lease Obligations~~Analysis of Financial Condition and Results of Operations

~~At December 31, 2003,~~The following discussion should be read in conjunction with our condensed consolidated financial statements and ~~September 30, 2004, long-term debt~~the related notes contained elsewhere in this quarterly report on Form 10-Q. All statements in the following discussion that are not reports 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.

Air Group’s filings with the Securities and ~~capital lease obligations were as follows (in millions):~~

December 31, 2003
September 30, 2004
Fixed rate notes payable due through 2015 $ 382.6 $ 368.6
Variable rate notes payable due through 2018 572.5 540.6
Senior convertible notes due through 2023 150.0 150.0

Long-term debt 1,105.1 1,059.2
Capital lease obligations 8.5 0.5
Less current portion (206.7 ) (52.1 )

$ 906.9 $ 1,007.6

Exchange Commission, including its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports are accessible free of charge atwww.alaskaair.com. The information contained on our website is not a part of this quarterly report on Form 10-Q. As used in this Form 10-Q, the terms “Air Group,” “our,” “we” and the “Company” refer to Alaska Air Group, Inc. and its subsidiaries, unless the context indicates otherwise.

~~During~~First Quarter in Review and Current Events

In the first ~~nine months~~quarter of ~~2004,~~2005, revenues continued to improve over the first quarter of last year due to record passenger traffic and load factors at both Alaska ~~issued $94.6 million~~and Horizon. Ticket yields, however, continued to decline year over year, although we began to see some improvement in ticket prices in the latter part of ~~debt secured by flight equipment, having interest rates that vary with LIBOR~~the quarter. Operating expenses remain an area of focus. Operating expenses per available seat mile increased 6.1% at Alaska to 11.06 cents and ~~payment terms ranging from 12~~decreased 3.5% at Horizon to ~~16 years. Debt issuances~~16.69 cents compared to the first quarter of 2004. We continued to show improvement in our unit costs excluding fuel, impairment, and restructuring charges during the ~~period were offset by normal long-term debt payments~~first quarter of ~~$43.2 million~~2005, although the rate of improvement slowed compared to recent quarters. Our cost per available seat mile excluding fuel, impairment, and ~~full repayment~~restructuring charges declined 0.7% at Alaska to 8.55 cents and 4.4% at Horizon to 14.25 cents.

Fuel is a major component of ~~the Company’s credit facility of $150.0 million.~~

~~During~~our operating costs and fuel prices reached record highs in the first ~~nine months~~quarter. Our operational performance, measured by on-time arrivals and departures, declined from the first quarter of ~~2004, Horizon financed three Bombardier Q400s under long-term debt arrangements totaling $44.7 million. These debt arrangements~~2004. In order to improve our operational performance, we have ~~a 15-year term~~recently reduced our capacity throughout the remainder of 2005 from our original expectations.

Accounting Change

Effective January 1, 2005, we changed our method of accounting for major airframe and ~~interest rates that vary with LIBOR. Two~~engine overhauls from thecapitalize and amortizemethod to thedirect expensemethod. Accordingly, effective January 1, 2005, we wrote off the net book value of the aircraft were originally leased in January 2004 and were treated as capital leases at that time. The resulting re-financing transactions did not result in any gain or loss in the consolidated statements of operations.our

~~Note 11. Contingencies~~

The Company is a party to routine litigation incidental to its business and with respect to which no material liability is expected. Management believes the ultimate disposition of these matters is not likely to materially affect the Company’s financial position or results of operations. However, this belief is based on management’s current understanding of the relevant law and facts; it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.

~~Note 12. U.S. Government Compensation~~

On April 16, 2003, the Emergency Wartime Supplemental Appropriations Act (the Act) was signed into legislation. The Act included $2.3 billion of one-time cash payments to air carriers, allocated based on each carrier’s share of security fees remitted and carrier fees paid to the Transportation Security Administration (TSA) since its inception in February 2002. In May 2003, the Company received its share of the one-time cash grant in the amount of $71.4 million ($52.8 million for Alaska and $18.6 million for Horizon).

1824

previously capitalized airframe and engine overhauls for all aircraft in a charge totaling $144.7 million pre-tax ($90.4 million after tax). See Note ~~13. Revision of Previously Issued Financial Statements~~

~~In its previously reported 2003 Form 10-Q’s, the Company recorded unrealized gains and losses related~~2 to ~~the ineffective portion of changes in fair value of~~ our fuel hedge positions as nonoperating income (expense) and then reclassified those gains and losses to fuel expense as those hedges were settled. This practice was not consistent with its stated policy, which is to record the ineffective portion in nonoperating income (expense). The Company has revised its 2003 reported condensed consolidated financial statements for further details.

Restructuring Charges

Asset impairment and rental charges of $8.0 million related to ~~adjust~~our decision to terminate the lease at our Oakland heavy maintenance base were recorded in the first quarter of 2005. During the third quarter of 2004, Alaska announced a management reorganization and the closure of its ~~historical presentation~~Oakland heavy maintenance base, contracting out of ~~such items. Such revisions have~~related heavy maintenance, contracting out of the Company’s fleet service, ground support equipment and facility maintenance functions, maintenance shops and other initiatives. In total, we believe these restructuring activities will result in a reduction of approximately 900 employees when fully implemented through the first half of 2005. Severance and related costs associated with this restructuring were estimated and recorded at $53.4 million in 2004. Cash paid during the first quarter of 2005 was $20.3 million and an adjustment of $0.6 million was recorded to reduce the estimated accrual for related medical benefits. We expect savings from these job-related initiatives to be approximately $35 million per year when fully implemented.

As part of our ongoing cost saving initiatives, we continue to look at all aspects of our business. In the remainder of 2005, we may contract out other activities or initiate other restructuring activities which would result in further restructuring charges.

Labor Costs and Negotiations

Despite ongoing negotiations in late 2003 and much of 2004, we were unable to reach a new agreement with the Air Line Pilots Association (ALPA) and, therefore submitted to binding arbitration, the decision of which became effective on May 1, 2005. The arbitration resulted in ~~reclassification between operating income (loss)~~an average pilot wage reduction of approximately 26%, various work rule changes which should result in productivity improvements, and ~~nonoperating income (expense)~~higher employee health care contributions. No changes were made to the pilots’ pension or profit sharing plans.

We continue to pursue the restructuring of our other labor agreements so that they are in line with what we believe to be market. Our objectives as we restructure these agreements are to achieve market labor costs, productivity and employee benefit costs. For example, we recently presented a contract offer to the International Association of Machinists (IAM, representing our ramp workers) and believe that this work group is in the ~~condensed consolidated statements~~process of ~~operations.~~voting on our offer. The ~~revisions have no impact on previously reported pretax income, net income, earnings per share,~~offer, as presented, includes a generous voluntary severance package (similar to that used with our mechanics in Oakland and the ~~condensed consolidated balance sheets, the condensed consolidated statements of shareholders’ equity or the condensed consolidated statements of cash flows for any periods.~~voluntary management reductions), wage reductions, and work

~~The effect of the revisions for 2003 is as follows (in millions):~~

Three Months Ended Nine Months Ended
September 30, 2003
September 30, 2003
Total Aircraft Fuel:
As Previously Reported $ 94.7 $ 265.0
As Revised $ 96.8 $ 270.5
Total Operating Expenses:
As Previously Reported $ 623.4 $ 1,827.3
As Revised $ 625.5 $ 1,832.8
Total Operating Income (Loss):
As Previously Reported $ 78.8 $ 4.2
As Revised $ 76.7 $ (1.3 )
Nonoperating income (expense):
As Previously Reported $ (10.6 ) $ 48.9
As Revised $ (8.5 ) $ 54.4

1925

~~Alaska Airlines Financial~~rule changes. If we are unable to reach an agreement with the IAM, we will consider subcontracting our Seattle ramp operations to a third party in the near future. During the first quarter of 2005, we executed an agreement with a third party that would provide ramp operations in Seattle if we are unable to reach a negotiated agreement. Additionally, Horizon continues to be in negotiations with the American Mechanics Fratnernal Association (AMFA, representing our mechanics and ~~Statistical Data~~

Three Months Ended September 30
Nine Months Ended September 30
% %
Financial Data (in millions):
2003
2004
Change
2003
2004
Change
Operating Revenues:
Passenger $ 532.5 $ 576.6 8.3 % $ 1,380.1 $ 1,545.8 12.0 %
Freight and mail 21.4 24.5 14.5 % 59.8 65.3 9.2 %
Other — net 31.4 40.1 27.7 % 83.0 99.0 19.3 %

Total Operating Revenues 585.3 641.2 9.6 % 1,522.9 1,710.1 12.3 %

Operating Expenses:
Wages and benefits 198.7 207.3 4.3 % 578.7 611.8 5.7 %
Contracted services 20.5 17.8 -13.2 % 60.9 70.3 15.4 %
Aircraft fuel 83.3 130.2 56.3 % 232.2 336.4 44.9 %
Aircraft maintenance 35.2 27.1 -23.0 % 117.7 111.3 -5.4 %
Aircraft rent 31.1 28.1 -9.6 % 92.8 85.5 -7.9 %
Food and beverage service 17.0 13.7 -19.4 % 44.8 37.9 -15.4 %
Other selling expenses and commissions 43.4 35.9 -17.3 % 109.0 101.1 -7.2 %
Depreciation and amortization 29.7 32.0 7.7 % 87.8 95.2 8.4 %
Loss on sale of assets 0.8 (2.5 ) NM 1.3 (0.6 ) NM
Landing fees and other rentals 33.6 37.6 11.9 % 93.5 106.1 13.5 %
Other 34.5 37.1 7.5 % 102.9 111.0 7.9 %
Restructuring charges — 27.5 100.0 % — 27.5 NM
Impairment of aircraft — — 0.0 % — 36.8 NM

Total Operating Expenses 527.8 591.8 12.1 % 1,521.6 1,730.3 13.7 %

Operating Income (Loss) 57.5 49.4 -14.1 % 1.3 (20.2 ) NM

Interest income 4.6 8.4 10.3 20.0
Interest expense (11.2 ) (11.6 ) (33.9 ) (33.1 )
Interest capitalized 0.2 0.4 1.3 0.7
U.S. government compensation — — 52.8 —
Other — net (1.0 ) 59.7 7.3 82.9

(7.4 ) 56.9 37.8 70.5

Income Before Income Tax $ 50.1 $ 106.3 112.2 % $ 39.1 $ 50.3 28.7 %

Operating Statistics:

Revenue passengers (000) 4,280 4,589 7.2 % 11,335 12,296 8.5 %
RPMs (000,000) 4,126 4,571 10.8 % 10,946 12,255 12.0 %
ASMs (000,000) 5,693 6,012 5.6 % 15,611 16,825 7.8 %
Passenger load factor 72.5 % 76.0 % 3.5 pts 70.1 % 72.8 % 2.7 pts
Yield per passenger mile 12.91 ¢ 12.62 ¢ -2.2 % 12.61 ¢ 12.61 ¢ 0.0 %
Operating revenue per ASM 10.28 ¢ 10.66 ¢ 3.7 % 9.76 ¢ 10.16 ¢ 4.1 %
Operating expenses per ASM (a) 9.27 ¢ 9.84 ¢ 6.1 % 9.75 ¢ 10.28 ¢ 5.4 %
Operating expenses per ASM excluding fuel, navigation fee settlement, restructuring and impairment charges (a) 7.81 ¢ 7.35 ¢ -6.0 % 8.26 ¢ 7.95 ¢ -3.9 %
Raw fuel cost per gallon (a) 95.2 ¢ 139.6 ¢ 46.6 % 97.0 ¢ 129.8 ¢ 33.8 %
GAAP fuel cost per gallon (a) 90.5 ¢ 135.9 ¢ 50.2 % 91.5 ¢ 125.7 ¢ 37.4 %
Economic fuel cost per gallon (a) 88.7 ¢ 127.0 ¢ 43.2 % 89.6 ¢ 121.3 ¢ 35.4 %
Fuel gallons (000,000) 92.0 95.8 4.1 % 253.9 267.6 5.4 %
Average number of employees 10,114 10,201 0.9 % 10,079 10,147 0.7 %
Aircraft utilization (blk hrs/day) 11.1 11.8 6.3 % 10.6 11.1 4.7 %
Operating fleet at period-end 109 107 -1.8 % 109 107 -1.8 %

related classifications) using the services of a mediator from the National Mediation Board.

~~NM = Not Meaningful~~Mark-to-Market Fuel Hedging Gains

~~(a) See~~Beginning in the second quarter of 2004, we lost the ability to defer, as a component of comprehensive income, recognition of any unrealized gain or loss on our fuel hedge contracts until the hedged fuel is consumed. We lost this ability because the price correlation between crude oil, the commodity we use to hedge, and West Coast jet fuel fell below required thresholds. For more discussion, see Note A5 to our condensed consolidated financial statements.

The implications of this change are twofold: First, our earnings are more volatile as we mark our entire hedge portfolio to market each quarter-end and report the gain or loss in other non-operating income or expense, even though the actual consumption will take place in a future period. In times of rising fuel prices such as the first quarter of 2005, this will have the effect of increasing our reported net income or decreasing our reported net loss. Our mark-to-market gains recorded in the first quarter of 2005 for contracts that settle in future periods were $90.0 million compared to $0.4 million in the first quarter of 2004. Second, to a large extent, the impact of our fuel hedge program will not be reflected in fuel expense. In the first quarter of 2005, we recorded gains from settled fuel hedges totaling $22.0 million, but only $3.8 million of that gain is reflected as an offset to fuel expense with the balance reported in other non-operating income. In the first quarter of 2004, gains of $3.5 million on ~~Page~~settled hedges were recorded as an offset to fuel expense and there were no gains recorded in non-operating income related to settled hedges.

We have provided information on mark-to-market gains or losses, as well as calculations of our economic fuel cost per gallon on pages 21 and 22.

20We continue to believe that our fuel hedge program is an important part of our strategy to reduce our exposure to volatile fuel prices.

Frontier JetExpress

On January 1, 2004, Horizon began operating regional jet service branded as Frontier JetExpress under a 12-year agreement with Frontier Airlines. Service under this agreement became fully operational during the second quarter of 2004 and Horizon is currently operating nine regional jet aircraft under the Frontier JetExpress brand. Flying under this agreement represented 16.2% of Horizon’s capacity and 7.4% of passenger revenues for the quarter ended March 31, 2004. For

the quarter ended March 31, 2005 (which is more representative of ongoing operations), flying under this agreement represented 23.0% of Horizon’s first quarter capacity and 10.0% of passenger revenue.

The arrangement with Frontier provides for reimbursement of costs plus a base mark-up and certain incentives. However, since Horizon ~~Air~~is not responsible for many of the typical costs of operations such as fuel, landing fees, marketing costs and station labor and rents and combined with longer trip lengths, revenue per available seat mile (ASM), and cost per ASM for this flying is significantly lower than Horizon’s native network flying.

Outlook

For 2005, Alaska and Horizon expect capacity increases of slightly under 2% and approximately 12%, respectively, over 2004 capacity. We have recently reduced the estimated capacity increase for Alaska because of schedule reductions that are being made to improve operational reliability. The expected capacity increase at Alaska is due largely to the annualization of the additional seats added to the B737-400 fleet during the fourth quarter of 2004 and the addition of three B737-800s, two of which were added in the first quarter of 2005, offset by the retirement of two B737-200s in 2004. Horizon’s expected capacity increase is due largely to the annualization of aircraft additions in the first half of 2004, the addition of one new CRJ-700 in the first quarter of 2005, and higher utilization resulting from the annualization of the contract flying for Frontier. In addition, Horizon has completed the addition of a row of seats to the Q400 fleet increasing capacity from 70 to 74 seats. When complete, this will result in an increase of approximately 1.5% in available seat miles on an annualized basis.

During the first quarter of 2005, we announced service to Dallas/Fort Worth beginning in July 2005.

RESULTS OF OPERATIONS

Comparison of Three Months Ended March 31, 2005 to Three Months Ended March 31, 2004

Our consolidated net loss for the first quarter of 2005 was $80.5 million, or $2.39 per diluted share, versus a net loss of $42.7 million, or $1.59 per diluted share, in the first quarter of 2004.

Our consolidated operating loss for the first quarter of 2005 was $80.9 million compared to a loss of $58.5 million during the same period of 2004. Our consolidated pre-tax net income before the accounting change for the quarter was $17.0 million compared to a pre-tax loss of $66.2 million for the first quarter of 2004. The 2005 results include certain significant items that impact the comparability to 2004. These items are discussed in the “First Quarter in Review and Current Events” section beginning on page 23. Financial and ~~Statistical Data~~

Three Months Ended September 30
Nine Months Ended September 30
% %
Financial Data (in millions):
2003
2004
Change
2003
2004
Change
Operating Revenues:
Passenger $ 127.2 $ 134.5 5.7 % $ 326.8 $ 360.4 10.3 %
Freight and mail 1.2 1.0 -16.7 % 3.8 3.0 -20.9 %
Other — net 4.3 3.8 -11.6 % 11.7 10.9 -6.8 %

Total Operating Revenues 132.7 139.3 5.0 % 342.3 374.3 9.3 %

Operating Expenses:
Wages and benefits 39.2 39.7 1.3 % 118.8 122.1 2.8 %
Contracted services 5.7 5.0 -12.3 % 18.4 15.4 -16.3 %
Aircraft fuel 13.5 18.2 34.8 % 38.3 48.4 26.4 %
Aircraft maintenance 7.2 9.9 37.5 % 22.5 26.6 18.2 %
Aircraft rent 18.1 18.6 2.8 % 53.3 56.0 5.1 %
Food and beverage service 0.6 0.6 0.0 % 1.8 1.6 -11.1 %
Other selling expenses and commissions 6.6 6.7 1.5 % 18.8 19.9 5.9 %
Depreciation and amortization 2.7 3.4 25.9 % 9.5 9.7 2.1 %
Gain on sale of assets (0.7 ) (0.3 ) NM (1.1 ) (0.8 ) NM
Landing fees and other rentals 10.3 11.0 6.8 % 28.2 31.2 10.6 %
Other 9.7 9.7 0.0 % 32.6 32.0 -1.8 %
Impairment of aircraft and spare engines — — 0.0 % — 2.8 NM

Total Operating Expenses 112.9 122.5 8.5 % 341.1 364.9 7.0 %

Operating Income 19.8 16.8 -15.2 % 1.2 9.4 NM

Interest income 0.2 0.3 0.5 0.9
Interest expense (0.6 ) (0.9 ) (1.9 ) (3.2 )
Interest capitalized 0.2 0.1 0.6 0.4
Government compensation — — 18.6 —
Other — net (0.1 ) 8.1 0.9 11.2

(0.3 ) 7.6 18.7 9.3

Income Before Income Tax $ 19.5 $ 24.4 25.1 % $ 19.9 $ 18.7 -5.9 %

Operating Statistics:

Revenue passengers (000) 1,376 1,641 19.3 % 3,671 4,362 18.8 %
RPMs (000,000) 466 601 29.0 % 1,224 1,586 29.6 %
ASMs (000,000) 701 830 18.4 % 1,950 2,314 18.7 %
Passenger load factor 66.5 % 72.4 % 5.9 pts 62.8 % 68.5 % 5.7 pts
Yield per passenger mile 27.29 ¢ 22.38 ¢ -18.0 % 26.70 ¢ 22.73 ¢ -14.9 %
Operating revenue per ASM 18.93 ¢ 16.78 ¢ -11.4 % 17.56 ¢ 16.18 ¢ -7.9 %
Operating expenses per ASM (a) 16.11 ¢ 14.76 ¢ -8.4 % 17.49 ¢ 15.77 ¢ -10.0 %
Operating expenses per ASM excluding fuel and impairment charges (a) 14.18 ¢ 12.57 ¢ -11.4 % 15.53 ¢ 13.56 ¢ -12.7 %
Raw fuel cost per gallon (a) 98.6 ¢ 143.8 ¢ 46.0 % 100.2 ¢ 134.1 ¢ 33.8 %
GAAP fuel cost per gallon (a) 93.1 ¢ 140.0 ¢ 50.4 % 94.1 ¢ 130.1 ¢ 38.3 %
Economic fuel cost per gallon (a) 90.3 ¢ 131.2 ¢ 45.2 % 91.9 ¢ 125.8 ¢ 36.8 %
Fuel gallons (000,000) 14.5 13.0 -10.3 % 40.7 37.2 -8.6 %
Average number of employees 3,368 3,439 2.1 % 3,375 3,399 0.7 %
Aircraft utilization (blk hrs/day) 8.2 8.7 6.1 % 7.9 8.3 5.1 %
Operating fleet at period-end 61 65 6.6 % 61 65 6.6 %

~~NM = Not Meaningful~~

~~(a) See Note A~~statistical data comparisons for Alaska and Horizon are shown on ~~Page~~pages 19 and 20, respectively. On pages 21

~~Note A:~~

~~Pursuant to Item 10 of Regulation S-K,~~ and 22, we ~~are providing disclosure of the~~have included a reconciliation of reported non-GAAP financial measures to their most directly comparable financial measures reported on a GAAP basis. The non-GAAP financial measures provide management the ability to measure and monitor performance both with and without the cost of aircraft fuel (including the gains and losses associated with our fuel hedging program where appropriate), restructuring charges, aircraft impairment charges, government compensation in 2003 and a large recovery in 2004 of disputed navigation fees paid in prior years (of which $7.7 million was recorded in operating expenses and $3.3 million was recorded in non-operating income). Because the cost and availability of aircraft fuel are subject to many economic and political factors beyond our control and we record changes in the fair value of our hedge portfolio in our income statement, it is our view that the measurement and monitoring of performance without fuel is important. In addition, we believe the disclosure of financial performance without impairment and restructuring charges, government compensation and the navigation fee recovery in 2004 is useful to investors. Finally, these non-GAAP financial measures are also more comparable to financial measures reported to the Department of Transportation by other major network airlines. The following tables reconcile our non-GAAP financial measures to the most directly comparable GAAP financial ~~measures for both Alaska Airlines, Inc. and Horizon Air Industries, Inc.:~~measures.

~~Alaska Airlines, Inc.:~~

Three Months Ended September 30,
Nine Months Ended September 30,
($ in millions)
2003
2004
2003
2004
Unit cost reconciliations:

Operating expenses $ 527.8 $ 591.8 $ 1,521.6 $ 1,730.3
ASMs (000,000) 5,693 6,012 15,611 16,825

Operating expenses per ASM 9.27 ¢ 9.84 ¢ 9.75 ¢ 10.28 ¢

Operating expenses $ 527.8 $ 591.8 $ 1,521.6 $ 1,730.3
Less: aircraft fuel (83.3 ) (130.2 ) (232.2 ) (336.4 )
Less: impairment of aircraft — — — (36.8 )
Less: restructuring charges — (27.5 ) — (27.5 )
Add: navigation fee settlement — 7.7 — 7.7

Operating expense excluding fuel, navigation fee settlement, impairment and restructuring charges $ 444.5 $ 441.8 $ 1,289.4 $ 1,337.3
ASMs (000,000) 5,693 6,012 15,611 16,825

Operating expense per ASM excluding fuel, navigation fee settlement, impairment and restructuring charges 7.81 ¢ 7.35 ¢ 8.26 ¢ 7.95 ¢

Aircraft fuel reconciliations:

Fuel expense before hedge activities (“raw fuel”) $ 87.6 $ 133.7 $ 246.2 $ 347.4
Fuel gallons (000,000) 92.0 95.8 253.9 267.6

Raw fuel cost per gallon 95.2 ¢ 139.6 ¢ 97.0 ¢ 129.8 ¢

Fuel expense before hedge activities (“raw fuel”) $ 87.6 $ 133.7 $ 246.2 $ 347.4
Less: gains on settled hedges included in fuel expense (4.3 ) (3.5 ) (14.0 ) (11.0 )

GAAP fuel expense $ 83.3 $ 130.2 $ 232.2 $ 336.4

Fuel gallons (000,000) 92.0 95.8 253.9 267.6

GAAP fuel cost per gallon 90.5 ¢ 135.9 ¢ 91.5 ¢ 125.7 ¢

GAAP fuel expense $ 83.3 $ 130.2 $ 232.2 $ 336.4
Less: gains on settled hedges included in nonoperating income (expense) (1.7 ) (8.5 ) (4.6 ) (11.7 )

Adjusted fuel 81.6 121.7 227.6 324.7
Fuel gallons (000,000) 92.0 95.8 253.9 267.6

Economic fuel cost per gallon 88.7 ¢ 127.0 ¢ 89.6 ¢ 121.3 ¢

Mark-to-market gains included in non-operating income related to hedges that settle in future periods — $ 50.3 — $ 70.4

Reconciliation to GAAP pretax income (loss):

Pretax income (loss) excluding impairment and restructuring charges, navigation fee settlement, government compensation and mark-to-market hedging gains $ 50.1 $ 72.5 ($13.7 ) $ 33.2
Less: impairment of aircraft — — — (36.8 )
Less: restructuring charges — (27.5 ) — (27.5 )
Add: government compensation — — 52.8 —
Add: mark-to-market hedging gains included in nonoperating income (expense) — 50.3 — 70.4
Add: navigation fee settlement — 11.0 — 11.0

Pretax income (loss) reported GAAP amounts $ 50.1 $ 106.3 $ 39.1 $ 50.3

2227

~~Horizon Air Industries, Inc.~~

Three Months Ended September 30,
Nine Months Ended September 30,
($ in millions)
2003
2004
2003
2004
Unit cost reconciliations:

Operating expenses $ 112.9 $ 122.5 $ 341.1 $ 364.9
ASMs (000,000) 701 830 1,950 2,314

Operating expenses per ASM 16.11 ¢ 14.76 ¢ 17.49 ¢ 15.77 ¢

Operating expenses $ 112.9 $ 122.5 $ 341.1 $ 364.9
Less: aircraft fuel (13.5 ) (18.2 ) (38.3 ) (48.4 )
Less: impairment of aircraft — — — (2.8 )

Operating expense excluding fuel and impairment charge $ 99.4 $ 104.3 $ 302.8 $ 313.7
ASMs (000,000) 701 830 1,950 2,314

Operating expense per ASM excluding fuel and impairment charge 14.18 ¢ 12.57 ¢ 15.53 ¢ 13.56 ¢

Aircraft fuel reconciliations:

Fuel expense before hedge activities (“raw fuel”) $ 14.3 $ 18.7 $ 40.8 $ 49.9
Fuel gallons (000,000) 14.5 13.0 40.7 37.2

Raw fuel cost per gallon 98.6 ¢ 143.8 ¢ 100.2 ¢ 134.1 ¢

Fuel expense before hedge activities (“raw fuel”) $ 14.3 $ 18.7 $ 40.8 $ 49.9
Less: gains on settled hedges included in fuel expense (0.8 ) (0.5 ) (2.5 ) (1.5 )

GAAP fuel expense $ 13.5 $ 18.2 $ 38.3 $ 48.4
Fuel gallons (000,000) 14.5 13.0 40.7 37.2

GAAP fuel cost per gallon 93.1 ¢ 140.0 ¢ 94.1 ¢ 130.1 ¢

GAAP fuel expense $ 13.5 $ 18.2 $ 38.3 $ 48.4
Less: gains on settled hedges included in nonoperating income (expense) (0.3 ) (1.2 ) (0.8 ) (1.6 )

Adjusted fuel 13.2 17.0 37.5 46.8
Fuel gallons (000,000) 14.5 13.0 40.7 37.2

Economic fuel cost per gallon 90.3 ¢ 131.2 ¢ 91.9 ¢ 125.8 ¢

Mark-to-market gains (losses) included in non-operating income related to hedges that settle in future periods — $ 6.9 — $ 9.6

Reconciliation to GAAP pretax income (loss):

Pretax income (loss) excluding impairment charge, government compensation and mark-to-market hedging gains $ 19.5 $ 17.5 $ 1.3 $ 11.9
Less: impairment of aircraft and related spare parts — — — (2.8 )
Add: government compensation — — 18.6 —
Add: mark-to-market hedging gains included in nonoperating income (expense) — 6.9 — 9.6

Pretax income (loss) reported GAAP amounts $ 19.5 $ 24.4 $ 19.9 $ 18.7

Alaska Airlines Revenues

23Operating revenues increased $32.0 million, or 6.5%, during the first quarter of 2005 as compared to the same period in 2004. The increase in revenues resulted from an 8.9% increase in passenger traffic, offset by a 3.7% decline in ticket yields. For the three months ended March 31, 2005, capacity increased 3.7% as compared to 2004. The capacity increases are primarily due to the annualization of additional seats added to the B737-400 fleet during the fourth quarter of 2004 and the addition of two B737-800s in the first quarter of 2005, partially offset by the retirement of two B737-200s in 2004. The traffic increase of 8.9% outpaced the capacity increase of 3.7%, resulting in an increase in load factor from 69.1% to 72.6%. The decline in yield per passenger mile was a result of continued industry-wide pricing pressure, dropping 3.7% compared to the first quarter of 2004, although yields improved as the quarter progressed. We expect that load factors will continue to be strong and that yields and passenger unit revenues will begin to stabilize or trend slightly higher through the second quarter of 2005.

Freight and mail revenues increased $1.6 million, or 9.0%, because of a new mail contract we have in the State of Alaska offset by lower freight revenues.

Other-net revenues increased $8.4 million, or 34.6%, due largely to an increase in Mileage Plan revenues, resulting from higher award redemption on our partner airlines and an increase in cash receipts from miles sold, and, to a lesser extent, higher revenues from our contract flying with PenAir which started in January 2004.

Alaska Airlines Expenses

For the three months ended March 31, 2005, total operating expenses increased $54.6 million, or 10.1%, as compared to the same period in 2004. Operating expenses per ASM increased 6.1% from 10.42 cents in the first quarter of 2004 to 11.06 cents in the first quarter of 2005. The increase in operating expenses per ASM is due largely to significant increases in fuel costs, contracted services costs, aircraft maintenance, and landing fees and other rental costs, offset by a decline in depreciation and amortization, aircraft rent, and other selling expenses and commissions. Operating expense per ASM excluding fuel and restructuring charges decreased by 0.7% to 8.55 cents per ASM compared to 8.61 cents per ASM in 2004. Excluding any benefit from labor cost reductions, our estimates of costs per ASM, excluding fuel and restructuring or impairment charges, for the second quarter, third quarter, fourth quarter and full year of 2005 are 7.85 cents, 7.20 cents, 7.80 cents and between 7.80 and 7.85 cents, respectively. We are evaluating the impact of the pilot arbitration results and expect to provide updated cost estimates in May.

Explanations of significant period-over-period changes in the components of operating expenses are as follows:

• Wages and benefits remained relatively flat, decreasing $1.1 million, or 0.5%, during the first quarter of 2005. Wages were favorably impacted by the restructuring initiatives

announced in August and September of 2004, largely offset by an increase in pilot wages, a new performance-based incentive program for all employees, and an increase in medical and pension benefits. During the first quarter of 2005, there were 9,219 full-time equivalents (FTEs), which is down by 765 FTEs from 2004 on a 3.7% increase in capacity.
•   Contracted services increased $4.7 million, or 20.3%, due largely to the contracting out of the Company’s fleet service and ground service equipment and facility maintenance and costs associated with the service to Dutch Harbor, Alaska, which was contracted to PenAir in January 2004 and grew through the first quarter of 2004.
•   Aircraft fuel increased $34.0 million, or 36.3%, due to a 34.2% increase in the GAAP fuel cost per gallon and a 1.6% increase in fuel gallons consumed. The increase in aircraft fuel expense is inclusive of $3.4 million of gains from settled hedges. During the first quarter of 2005, Alaska also realized $15.7 million of hedge gains, which are recorded in other non-operating income. After including all hedge gains recorded during the quarter, our “economic,” or net, fuel expense increased $18.3 million, or 19.6%, over the same period in 2004. Our economic fuel cost per gallon increased 17.7% over the first quarter of 2004 from $1.13 to $1.33.
See page 21 for a table summarizing fuel cost per gallon realized by Alaska (the economic cost per gallon), the cost per gallon on a GAAP basis (including hedging gains recorded in aircraft fuel and non-operating income (expense)) and fuel cost per gallon excluding all hedging activities.
•   Aircraft maintenance increased $6.6 million, or 15.2%, due largely to our power-by-the-hour maintenance agreement, whereby we expense B737-400 engine maintenance on a block-hour basis, regardless of whether the work was actually performed during the period. Other factors causing the increase were the contracting out of related heavy maintenance to third parties, which resulted in a shift of costs from wages and benefits into aircraft maintenance and the change in our accounting policy regarding engine and airframe overhauls (see Note 2 to our condensed consolidated financial statements). Our current expectation is that aircraft maintenance costs will be up approximately $3.0 million in the second quarter, $9.0 million in the third quarter, and $4.0 million in the fourth quarter compared to the prior year periods.
•   Aircraft rent decreased $1.1 million, or 3.7%, due to lower rates on extended leases.

•   Other selling expenses and commissions decreased $1.2 million, or 3.5%, due to a decline in advertising expense, offset by increases in commissions and codeshare fees.
•   Depreciation and amortization decreased $2.5 million, or 7.6%. The first quarter of 2004 included accelerated depreciation on the planned retirement of three Boeing 737-200Cs. In the second quarter of 2004, we recorded an impairment charge of $36.8 million to reduce the carrying value of the Boeing 737-200C fleet, which results in lower depreciation expense in future periods.
•   Landing fees and other rentals increased $7.4 million, or 22.3%. The higher rates primarily reflect higher joint-use fees in Los Angeles and exclusive rental fees at Seattle and Anchorage (including a $1.3 million adjustment in 2005 from the Port of Seattle related to 2004), combined with modest volume growth. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security due to unfunded government mandates.
•   Other expense increased $1.5 million, or 4.1%, primarily reflecting increases in professional services costs, personnel and crew costs, passenger remuneration costs, and supplies costs.

Horizon Air Revenues

For the first quarter of 2005, operating revenues increased $10.9 million, or 9.9% compared to 2004. This increase is due largely to the increased traffic in our native network and our contract flying for Frontier Airlines, which began in January 2004, partially offset by a 7.8% decline in ticket yields.

For the three months ended March 31, 2005, capacity increased 13.0% and traffic was up 20.0%, compared to the same period in 2004. Contract flying with Frontier represented approximately 10.0% of passenger revenues and 23.0% of capacity, during the first quarter of 2005. Passenger load factor increased 4.0 percentage points to 69.0%. Passenger yield decreased 7.8% to 21.82 cents, reflecting the inclusion of the Frontier contract flying, the yield for which is significantly lower than native network flying. Passenger revenues increased by $11.2 million, or 10.5%, due primarily to the increase in traffic resulting from increased harmonization flying with Alaska and the increase in Frontier contract flying.

Horizon Air Expenses

Operating expenses increased $10.8 million, or 9.0%, as compared to the same period in 2004. Operating expenses per ASM decreased 3.5% as compared to 2004 from 17.30 cents in the first quarter of 2004 to 16.69 cents in the first quarter of 2005. Operating expenses per ASM excluding

fuel and impairment charges decreased 4.4% as compared to the same period in 2004. Operating expenses in 2004 include $2.4 million related to an impairment charge on our held-for-sale F-28 aircraft and spare engines to lower the carrying value of these assets to their estimated fair value. Our estimates of costs per ASM, excluding fuel and special charges, for the second quarter, third quarter, fourth quarter and full year of 2005 are 13.2 cents, 12.0 cents, 12.8 cents and 13.0 cents, respectively.

Explanations of other significant period-over-period changes in the components of operating expenses are as follows:

•   Wages and benefits increased $1.7 million, or 4.1%, reflecting a slight increase in the average number of employees, wages per employee, and a new performance-based incentive program for all employees, partially offset by favorable reductions of medical and workers compensation accruals.
•   Aircraft fuel increased $4.9 million, or 34.5%, due to a 34.7% increase in the GAAP fuel cost per gallon from $1.18 in 2004 to $1.59 in 2005. The increase in aircraft fuel expense is inclusive of $0.4 million of gains from settled hedges. During the quarter, Horizon also realized $2.5 million of hedge gains, which are recorded in other non-operating income (expense). After including all hedge gains recorded during the quarter, our “economic,” or net, fuel expense increased $2.4 million, or 16.9%, over 2004. Our economic fuel cost per gallon increased 16.9% from $1.18 in 2004 to $1.38 in 2005.
See page 22 for a table summarizing fuel cost per gallon realized by Horizon (the economic cost per gallon), the cost per gallon on a GAAP basis (including hedging gains recorded in aircraft fuel and non-operating income (expense)) and fuel cost per gallon excluding all hedging activities.
•   Aircraft maintenance expense increased $3.8 million, or 52.1%, primarily due to a higher number of routine maintenance activities and engine overhauls for the Q200 and Q400 fleets and fewer aircraft covered by warranty. These increases are partially offset by the elimination of amortization expense on capitalized airframe and engine overhauls as a result of the accounting change in the first quarter (see Note 2 to our condensed consolidated financial statements).
•   Landing fees and other rentals increased $1.9 million, or 19.2%. Higher landing fees are a result of higher rates associated with modest volume growth, an increase in airport fees and increased costs for security. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security.

Consolidated Nonoperating Income (Expense)

Net nonoperating income was $97.9 million in the first quarter of 2005 compared to net expense of $7.7 million during the same period of 2004. Interest income increased $1.3 million due to a larger average marketable securities portfolio in the first quarter of 2005. Interest expense (net of capitalized interest) increased $0.9 million primarily due to interest rate increases on our variable rate debt.

Fuel hedging gains include $18.2 million in gains from fuel hedging contracts settled in the first quarter of 2005 compared to none in 2004. In addition, fuel hedging gains include net mark-to-market gains on unsettled hedge contracts of $90.0 million in 2005 and $0.4 million in 2004.

Consolidated Income Tax Expense (Benefit)

Accounting standards require us to provide for income taxes each quarter based on either our estimate of the effective tax rate for the full year or the actual year-to-date effective tax rate if it is our best estimate of our annual expectation. The volatility of airfares and fuel prices and the seasonality of our business make it difficult to accurately forecast full-year pretax results. In addition, a relatively small change in pretax results can cause a significant change in the effective tax rate due to the magnitude of nondeductible expenses, such as employee per diem costs, relative to pretax profit or loss. Our effective income tax rate on pre-tax income before the accounting change for the first quarter of 2005 is 41.8%. We applied our estimated 2005 year-to-date composite rate of 37.5% for the cumulative effect of the accounting change. In arriving at these rates, we considered a variety of factors, including year-to-date pretax results, the U.S. federal rate of 35%, estimated year-to-date nondeductible expenses and estimated state income taxes. We evaluate our tax rate each quarter and make adjustments when necessary.

Change in Accounting Policy

Effective January 1, 2005, the Company changed its method of accounting for major airframe and engine overhauls from the capitalize and amortize method to the direct expense method. Under the capitalize and amortize method, these costs were capitalized and amortized to maintenance expense over the shorter of the life of the overhaul or the remaining lease term. Under the direct expense method, overhaul costs are expensed as incurred. The Company believes that the direct expense method is preferable because it eliminates the judgment and estimation needed to determine overhaul versus repair allocations in maintenance activities. Additionally, the Company’s approved maintenance program for the majority of its airframes now focuses more on shorter, but more frequent, maintenance visits that result in a higher portion of the work being repair activity. Management also believes that the direct expense method is the predominant method used in the airline industry. Accordingly, effective January 1, 2005, the Company wrote off the net book value of its previously capitalized airframe and engine overhauls for all aircraft in a charge totaling $144.7 million pre-tax ($90.4 million after tax). The Company does not believe disclosing the effect of adopting the direct expense method on net income for the period ended March 31, 2005 provides meaningful information because of changes in the Company’s maintenance program, including the execution of a “Power by the hour” maintenance agreement with a third party in late 2004.

Critical Accounting Estimates

For information on our critical accounting estimates, see Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2004.

Liquidity and Capital Resources

The table below presents the major indicators of financial condition and liquidity.



	March 31, 2005			December 31, 2004			Change

	(In millions, except per share and debt-to-capital amounts)
Cash and marketable securities	$	763.5		$	873.9		$	(110.4	)
Working capital		178.0			285.0			(107.0	)
Long-term debt and capital lease obligations		980.4			989.6			(9.2	)
Shareholders’ equity		584.5			664.8			(80.3	)
Book value per common share	$	21.50		$	24.51		$	(3.01	)
Long-term debt-to-capital		63%:37	%		60%:40	%	NA
Long-term debt-to-capital assuming aircraft operating leases are capitalized at seven times annualized rent		80%:20	%		78%:22	%	NA

During the three months ended March 31, 2005, our cash and marketable securities decreased $110.4 million to $763.5 million. This decrease reflects cash used for property and equipment additions, net of aircraft deposit returns and proceeds from asset dispositions, of $102.5 million, cash used in financing activities of $7.6 million, and cash used in operating activities of $3.3 million.

Cash Provided by (Used in) Operating Activities

During the first quarter of 2005, net cash used in operating activities was $3.3 million, compared to cash provided by operating activities of $21.6 million during the same period of 2004. The decline was driven by sharp increases in fuel costs offset by higher revenues.

Cash Provided by (Used in) Investing Activities

Cash provided by investing activities was $229.0 million during the first quarter of 2005, compared to cash used in investing activities of $97.8 million during the same period of 2004. We had net sales of marketable securities of $330.4 million and $102.5 million for property and equipment additions, net of aircraft deposit returns and proceeds from asset dispositions. During the three months ended March 31, 2005, our aircraft related capital expenditures, net of aircraft deposit returns and proceeds from asset dispositions, increased $52.3 million as compared to the

same period of 2004, primarily as a result of two new aircraft purchases in 2005. As of January 1, 2005, we no longer have capital expenditures related to overhauls as those maintenance activities are expensed as incurred under our maintenance accounting policy adopted on that date. We expect capital expenditures to be approximately $230.0 million for the full year of 2005.

Cash Provided by (Used in) Financing Activities

Net cash used in financing activities was $7.6 million during the first quarter of 2005 compared to net cash provided by financing activities of $48.2 million during the same period of 2004. There were no new debt issuances in the first quarter of 2005. There were normal long-term debt payments of $8.6 million during 2005.

We plan to meet our capital and operating commitments through cash flow from operations and from cash and marketable securities on hand at March 31, 2005 of $763.5 million. We also have restricted cash of $10.8 million, which is intended to collateralize interest payments due over the next twelve months on our $150 million floating rate senior convertible notes due 2023 issued in 2003.

Bank Line of Credit Facility

During 2004, Alaska repaid its $150 million credit facility and, on December 23, 2004, that facility expired. On March 25, 2005, Alaska Airlines, Inc. finalized a $160 million variable rate credit facility with a syndicate of financial institutions that will expire in March 2008. Any borrowings will be secured by either aircraft or cash collateral. The interest rate on credit facility varies depending on certain financial ratios specified in the agreement with a minimum interest rate of LIBOR plus 200 basis points.

This credit facility contains contractual restrictions and requires maintenance of specific levels of net worth, maintenance of certain debt and leases to net worth, leverage and fixed charge coverage ratios, and limits on liens, asset dispositions, dividends, and certain other expenditures. Such provisions restrict Alaska Airlines from distributing any funds to Alaska Air Group ~~Net Income~~in the form of dividends and ~~EPS Reconciliation:~~limit the amount of funds Alaska Airlines can loan to Alaska Air Group. As of March 31, 2005, $300.0 million was available to loan to Alaska Air Group without violating the covenants in the credit facility. As of March 31, 2005, there are no outstanding borrowings on this credit facility and the Company has no immediate plans to borrow using this credit facility.

Contractual Obligations, Commitments and Off-Balance Sheet Arrangements

Aircraft Purchase Commitments

At March 31, 2005, we had firm orders for 12 aircraft requiring aggregate payments of approximately $318.6 million, as set forth below. In addition, Alaska had options to acquire 23 additional B737’s, and Horizon had options to acquire 12 Q400’s and 21 CRJ 700’s. Alaska and Horizon expect to finance the firm orders and, to the extent exercised, the option aircraft with leases, long-term debt or internally generated cash. We expect to purchase the B737-800 to be delivered in July with cash on hand.

The following table summarizes ~~Alaska Air Group, Inc.’s net income~~aircraft purchase commitments and ~~diluted earnings~~payments by year:


Delivery Period - Firm Orders
	April 1 – December 31,										Beyond
Aircraft	2005		2006		2007		2008		2009		2009		Total

Boeing 737-800		1		3		—		—		—		—		4
Bombardier CRJ700		—		2		2		2		2		—		8

Total		1		5		2		2		2		—		12

Payments (Millions)	$	46.6	$	123.7	$	54.5	$	53.0	$	40.8	$	—	$	318.6

Contractual Obligations

The following table provides a summary of our principal payments under current and long-term debt obligations, operating lease commitments, aircraft purchase commitments and other obligations as of March 31, 2005. This table excludes contributions to our various pension plans, which we expect to be approximately $55 million to $65 million per share during 2003 and 2004 excluding restructuring and impairment charges, navigation fee recovery, the second and third quarter of 2004 hedging mark-to-market gains, government compensation and as reported in accordance with GAAP (in millions except per share amounts):year through 2008.

Three Months Ended September 30,
2003
2004
Dollars
Diluted EPS
Dollars
Diluted EPS
Net income and diluted EPS excluding mark-to-market hedging gains, navigation fee settlement and restructuring charges $ 40.7 $ 1.52 $ 55.9 $ 2.08
Mark-to-market hedging gains, net of tax — — 32.8 1.22
Navigation fee settlement — — 6.3 0.23
Restructuring charge, net of tax — — (15.8 ) (0.59 )

Reported GAAP amounts $ 40.7 $ 1.52 $ 79.2 $ 2.94

Nine Months Ended September 30,
2003
2004
Dollars
Diluted EPS
Dollars
Diluted EPS
Net income (loss) and diluted EPS excluding mark-to-market hedging gains, navigation fee settlement, restructuring charges, government compensation and impairment charge ($ 14.7 ) ($ 0.55 ) $ 24.7 $ 0.92
Government compensation, net of tax 44.3 1.66 — —
Navigation fee settlement — — 6.3 0.23
Mark-to-market hedging gains, net of tax — — 45.9 1.71
Impairment charge, net of tax — — (26.3 ) (0.98 )
Restructuring charge, net of tax — — (15.8 ) (0.59 )

Reported GAAP amounts $ 29.6 $ 1.11 $ 34.8 $ 1.29



	April 1 - December 31,										Beyond
(in millions)	2005		2006		2007		2008		2009		2009^*		Total

Current and long-term debt and capital lease obligations*	$	44.9	$	57.0	$	60.1	$	63.2	$	67.0	$	742.2	$	1,034.4
Operating lease commitments		174.5		284.7		196.0		190.4		174.7		942.1	$	1,962.4
Aircraft purchase commitments		46.6		123.7		54.5		53.0		40.8		—	$	318.6
Interest obligations (1)		43.9		52.4		49.3		47.4		42.3		211.8	$	447.1
Other purchase obligations (2)		21.1		29.1		29.4		29.7		30.0		154.5	$	293.8

Total	$	331.0	$	546.9	$	389.3	$	383.7	$	354.8	$	2,050.6	$	4,056.3

* Includes $150 million related to the Company’s senior convertible notes due in 2023. Holders of these Notes may require the Company to purchase all or a portion of their Notes, for a purchase

price equal to principal plus accrued interest, on the 5^th, 10^th, and 15^th anniversaries of the issuance of the Notes, or upon the occurrence of a change in control or tax event, as defined in the agreement. See Note 11 in the consolidated financial statements.

(1) For variable rate debt, future obligations are shown above using interest rates in effect as of March 31, 2005.

(2) Includes obligations under our long-term power-by-the-hour maintenance agreement.

New Accounting Standards

During the fourth quarter of 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123R, “Share Based Payment: An Amendment of SFAS Nos. 123 and 95”. The new standard requires companies to recognize as expense the fair value of stock options and other equity based compensation issued to employees as of the grant date. This new standard will apply to both stock options that we grant to employees and our Employee Stock Purchase Plan, which features a look-back provision and allows employees to purchase stock at a 15% discount. Our options are typically granted with graded vesting provisions, and we intend to amortize compensation cost over the service period using the straight line method. Due to a recent decision by the Securities and Exchange Commission, implementation of SFAS 123R will be effective January 1, 2006. We intend to use the “modified prospective method” upon adoption whereby previously awarded but unvested equity awards are accounted for in accordance with SFAS 123R and prospective amounts are recognized in the income statement instead of simply being disclosed. Once adopted, we expect our stock based compensation expense, as measured under SFAS 123R, will be approximately $6 to $10 million per year on a pre-tax basis.

In March 2005, the FASB issued Interpretation No. 47 (FIN 47), “Accounting for Conditional Asset
Retirement Obligations — an interpretation of FASB Statement No. 143.” FIN 47 clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. The FIN also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of our fiscal year ending December 31, 2005. FIN 47 is not expected to have a significant impact on our financial position, results of operations or cash flows.

Effect of Inflation- Inflation and price changes other than for aircraft fuel do not have a significant effect on our operating revenues, operating expenses and operating income.

~~ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations~~

The following discussion should be read in conjunction with our condensed consolidated financial statements and the related notes contained elsewhere in this quarterly report on Form 10-Q. All statements in the following discussion that are not reports 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.

Air Group’s filings with the Securities and Exchange Commission, including its annual report on Form 10-K/A, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports are accessible free of charge at www.alaskaair.com. The information contained on our website is not a part of this quarterly report on Form 10-Q. As used in this Form 10-Q, the terms “Air Group,” “our,” “we” and the “Company” refer to Alaska Air Group, Inc. and its subsidiaries, unless the context indicates otherwise.

~~Third Quarter in Review and Current Events~~

We recorded a third quarter 2004 net income of $79.2 million, or $2.94 per diluted share, compared to $40.7 million, or $1.52 per diluted share, in the third quarter of 2003. Third quarter results include a restructuring charge of $27.5 million ($15.8 million net of tax, or $0.59 per share) related to the restructuring initiatives announced in late August and early September. Third quarter results also include mark-to-market fuel hedging gains, reflecting the increase in the fair value of our hedge portfolio during the quarter, of $57.2 million ($32.8 million net of tax, or $1.22 per share). These amounts are net of the gains realized on contracts which settled during the quarter. Finally, third quarter results include the recovery of certain disputed Mexico navigation fees which were originally paid in 2002 and 2003, that amounted to $11.0 million ($6.3 million net of tax, or $0.23 per share). Approximately $7.7 million of this refund was recorded in operating expenses for fees previously remitted and the remaining $3.3 million was recorded in non-operating income for interest accrued on the fees. Without these items in 2004, net income would have been $55.9 million, or $2.08 per share during 2004. Financial and statistical data comparisons for Alaska and Horizon are shown on pages 20 and 21, respectively. A discussion of the three-month data follows. On pages 22 through 24, we have included a reconciliation of reported non-GAAP financial measures to the most directly comparable GAAP financial measures.

~~Restructuring Charges~~

During the third quarter of 2004, the Company announced a management reorganization and the closure of its Oakland maintenance base, contracting out of the Company’s Fleet Service, Ground Equipment and Facility maintenance functions and other initiatives. In total, these restructuring activities are expected to result in a reduction of approximately 900 employees when fully implemented in 2005. Severance and related costs associated with this restructuring are estimated at $50-$55 million, of which $27.5 million was recorded during the third quarter of 2004 and $23-$27 million will be recorded in the fourth quarter. The Company is also currently evaluating any possible asset impairment that may result from the announced initiatives. Any impairment charge would be in addition to the severance estimates above. We expect savings from these job-related initiatives to be approximately $35 million per year when fully implemented.

~~Labor Costs and Negotiations~~

Alaska Airlines continues to pursue the restructuring of its labor agreements so that they are in line with the market. Our objectives as we restructure these agreements are to achieve market labor costs, productivity and employee benefit costs. Based on these three objectives, in 2003 Alaska targeted $112 million per year of labor savings. As a result of increases in our wage rates since that time combined with labor cost decreases achieved by our competitors, we believe that our wages and benefits are now above market by more than $112 million. Alaska believes that its pilot labor costs represent the majority of this amount. Alaska is currently in negotiations with the Air Line Pilots Association (ALPA) on the pilot collective bargaining agreement. If we do not reach an agreement, the parties will submit the contract to binding arbitration, the decision of which will be effective in May 2005. The arbitration will cover wages plus five issues submitted by each of the Company and ALPA. The pilot labor contract contains market related standards for wages and benefits. Nevertheless, we cannot predict the outcome of this proceeding, particularly whether the arbitrator’s award will reflect cost savings in wage rates, productivity and benefits equal to what the we consider to be the current excess over market.

~~Mark-to-Market Fuel Hedging Gains~~

Beginning in the second quarter of 2004, we lost the ability to defer, as a component of comprehensive income, recognition of any unrealized gain or loss on our fuel hedge contracts until the hedged fuel is consumed. We lost this ability because the correlation between crude oil, the commodity we use to hedge, and West Coast jet fuel fell below required thresholds. For more discussion, see Note 4 to our condensed consolidated financial statements.

The implications of this change in the current period and on a go-forward basis are twofold: First, we will have more volatile earnings as we mark our entire hedge portfolio to market each quarter-end and report the gain or loss in other non-operating income or expense. Second, to an increasing extent, the impact of our fuel hedge program will not be reflected in fuel expense. We had unrealized gains on our balance sheet of $26.5 million at March 31, 2004 when we last qualified for hedge accounting. These unrealized gains will be recognized in fuel expense as the hedged fuel is consumed, which will occur through the second quarter of 2006. Subsequent gains or losses resulting from changes in the fair value of our current hedge positions will be recorded in other non-operating income or expense until correlation returns and the positions are redesignated.

~~We have provided information on mark-to-market gains or losses, as well as calculations of our economic fuel cost per gallon on pages 22 through 24.~~

~~We continue to believe that our fuel hedge program is an important part of our strategy to reduce our exposure to volatile fuel prices.~~

~~Impairment of 737-200C Aircraft~~

~~be converted to an all cargo aircraft. The Company expects to backfill the 737-400s with Boeing 737-800 aircraft in 2005 and 2006.~~

As a result of this decision, the Company evaluated impairment as required by SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” and concluded that the carrying value of the 737-200C fleet was no longer recoverable when compared to the estimated remaining future cash flows. Accordingly, during the second quarter of 2004, the Company recorded an impairment charge totaling $36.8 million (pretax) to write down the fleet to its estimated fair market value. In addition, we revised our estimates of the useful lives and residual values of the fleet and related spare equipment and will depreciate the remaining carrying values through 2007, when the last aircraft will be retired.

~~Other Events~~

In October 2004, Alaska entered into a 10 year outsourcing “power-by-the-hour�� engine maintenance agreement with a third party. Under terms of this arrangement, the third party will provide routine and major overhaul maintenance services on certain engines in our 737-400 fleet at an agreed upon rate per hour flown.

On January 1, 2004, Horizon began operating regional jet service branded as Frontier JetExpress under a 12-year agreement with Frontier Airlines. Service under this agreement became fully operational during the second quarter of 2004 and Horizon is currently operating nine regional jet aircraft under the Frontier JetExpress brand. Flying under this agreement represented 23.1% of Horizon’s third quarter capacity and 9.2% of passenger revenues.

The arrangement with Frontier provides for reimbursement of expected costs plus a base mark up and certain incentives. However, since Horizon is not responsible for many of the typical costs of operations such as fuel, landing fees, marketing costs and station labor and rents, revenue per ASM, cost per ASM and cost per ASM excluding fuel for this flying is significantly lower than Horizon’s native network flying.

For 2004, Alaska and Horizon expect capacity increases of approximately 7% and 20%, respectively. The expected capacity increase at Alaska is due largely to the annualization of the additional aircraft added in 2003 combined with increases in utilization. Horizon’s expected capacity increase is due largely to the annualization of aircraft additions in late 2003, the addition of two aircraft in the first half of 2004, the arrival of a third aircraft in early July 2004 and higher utilization resulting from the new contract flying for Frontier.

Alaska is currently in the process of adding a row of seats to its 737-400 fleet. When complete, this will result in an increase of approximately 2.3% in available seat miles on an annualized basis. We expect this change will represent a significant portion of our capacity growth in 2005.

In 2005, Horizon will be adding a row of seats to the Q400 fleet increasing capacity from 70 to 74 seats. When complete, this will result in an increase of approximately 1.5% in available seat miles on an annualized basis.

~~Results of Operations~~

~~Comparison of Three Months Ended September 30, 2004 to Three Months Ended September 30, 2003~~

During the third quarter of 2004, we recorded consolidated operating and pre-tax income of $65.2 million and $127.6 million, respectively, versus $76.7 million and $68.2 million, respectively, in the third quarter of 2003.

~~Alaska Airlines Revenues~~

Operating revenues increased $55.9 million, or 9.6%, during 2004 as compared to 2003. For the quarter, available seat miles (ASMs or capacity) increased 5.6% and revenue passenger miles (RPMs or traffic) increased 10.8%. The majority of our 2004 ASM growth came from expansion in our Trans-Continental markets. We also experienced slight increases in capacity in Nevada, Mexico and Anchorage/Fairbanks-Lower 48, partially offset by decreases in service to Northern Alaska, Canada, Arizona, the Bay Area and the Pacific Northwest. Traffic increases primarily reflect increases in traffic in the Trans Continental, Denver, Southern California, Mexico, Arizona, Nevada and Anchorage/Fairbanks-Lower 48 markets, partially offset by decreases in traffic in Northern Alaska, the Bay Area and Canada.

Passenger revenues increased by 8.3% as a result of a 10.8% increase in traffic partially offset by a 2.2% decrease in yield per passenger mile. Load factors were up year over year in all of our regions.

Freight and mail revenues increased by $3.1 million, or 14.5%, compared to the same period in 2003 as a result of a new mail contract we have in the State of Alaska and due to revenues associated with an agreement with PenAir to provide flight services to Dutch Harbor that began in January of 2004. These increases are partially offset by lower contract maintenance revenue.

~~Other-net revenues increased $8.7 million, or 27.7%, due largely to higher cash receipts (and through higher revenue) from the Mileage Plan credit card.~~

~~Alaska Airlines Expenses~~

For the quarter, total operating expenses increased $64.0 million, or 12.1%, as compared to the same period in 2003. Operating expenses per ASM increased 6.1% in 2004 as compared to 2003. These increases are due largely to the restructuring charge, significant increases in fuel costs and higher wages and benefit costs. Operating expense per ASM excluding fuel, the navigation fee recovery and the restructuring charge decreased 6.0% as compared to the same period in 2003. Explanations of significant period-over-period changes in the components of operating expenses are as follows:

• Wages and benefits increased $8.6 million, or 4.3%, during the third quarter. Approximately $1.5 million of this increase reflects higher benefit costs, resulting from increases in pension, medical and health insurance costs. The remaining $7.1 million increase primarily reflects scale and step increases.
~~In May 2004, under terms of our union contract, our pilots received a 4% wage rate increase, which represented 50.7% of the total increase in wages.~~
• Contracted services decreased $2.7 million, or 13.2%, due largely to the recovery in 2004 of disputed Mexico navigation fees paid in 2002 and 2003, partially offset by expenses associated with an agreement with PenAir to provide flight services to Dutch Harbor that began in January of 2004 and costs associated with a temporary charter contract we had for our new mail contract in Alaska, and higher security costs.
• Aircraft fuel increased $46.9 million, or 56.3%, due to a 50.2% increase in the GAAP fuel cost per gallon and a 4.1% increase in fuel gallons consumed. Our economic cost per gallon (the raw price paid less all benefits from settled hedges) was $1.27 per gallon, a 43.2% increase over the prior year. Fuel prices remain at very high levels and continue to be volatile. At September 30, 2004, we have fuel hedge contracts in place to hedge 50% of our anticipated fuel consumption for the remainder of 2004 and 2005 and 25% of our anticipated fuel consumption in 2006 at prices ranging from $28.81 to $37.28 per crude oil barrel.

The following table summarizes fuel cost per gallon realized by Alaska (the economic cost per gallon), the cost per gallon on a GAAP basis (including hedging gains recorded in aircraft fuel and non-operating income (expense)) and fuel cost per gallon excluding all hedging activities:

Three Months Ended Nine Months Ended
September 30,
September 30,
2003
2004
2003
2004
Fuel expense before hedge activities (“raw fuel”) $ 87.6 $ 133.7 $ 246.2 $ 347.4
Fuel gallons (000,000) 92.0 95.8 253.9 267.6

Raw fuel cost per gallon 95.2 ¢ 139.6 ¢ 97.0 ¢ 129.8 ¢

Fuel expense before hedge activities (“raw fuel”) $ 87.6 $ 133.7 $ 246.2 $ 347.4
Less: gains on settled hedges included in fuel expense (4.3 ) (3.5 ) (14.0 ) (11.0 )

GAAP fuel expense $ 83.3 $ 130.2 $ 232.2 $ 336.4
Fuel gallons (000,000) 92.0 95.8 253.9 267.6

GAAP fuel cost per gallon 90.5 ¢ 135.9 ¢ 91.5 ¢ 125.7 ¢

GAAP fuel expense $ 83.3 $ 130.2 $ 232.2 $ 336.4
Less: gains on settled hedges included in nonoperating income (expense) (1.7 ) (8.5 ) (4.6 ) (11.7 )

Adjusted fuel $ 81.6 $ 121.7 $ 227.6 $ 324.7
Fuel gallons (000,000) 92.0 95.8 253.9 267.6

Economic fuel cost per gallon 88.7 ¢ 127.0 ¢ 89.6 ¢ 121.3 ¢

Mark-to-market gains included in nonoperating income related to hedges that settle in future periods (in millions) — $ 50.3 — $ 70.4

• ~~Aircraft maintenance decreased $8.1 million, or 23.0%, due largely to fewer engine overhauls and a change in the mix of heavy maintenance versus routine maintenance.~~
For the remainder of the year we anticipate that aircraft maintenance will be somewhat higher than in 2003 as outsourcing of all base maintenance work takes effect. The anticipated savings from contracting out will be reflected through lower wages and benefits in future periods.
• ~~Aircraft rent decreased $3.0 million, or 9.6%, due to lower rates on extended leases.~~
• Other selling expenses and commissions decreased $7.5 million, or 17.3%. This decrease is due largely to a decrease in incentive payments made to Horizon. Incentive payments to Horizon are eliminated in consolidation at the Air Group level.

Landing fees and other rentals increased $4.0 million, or 11.9%. The higher rates primarily reflect higher joint-use rental fees at Seattle, Portland and Los Angeles, combined with modest volume growth. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security due to unfunded government mandates.

~~Horizon Air Revenues~~

For the quarter, operating revenues increased $6.6 million, or 5.0% as compared to 2003. This increase is due largely to $12.4 million in revenue from contract flying for Frontier Airlines, which began January 1, 2004, partially offset by a 4.4% decrease in revenue associated with the Horizon brand (“native network”) flying resulting from a decrease in incentive payments made from Alaska to Horizon.

For the three months ending September 30, 2004, capacity increased 18.4% and traffic was up 29.0%, compared to the same period in 2003. Contract flying with Frontier represented approximately 23.1% of capacity and 9.2% of passenger revenues during the third quarter of 2004. Passenger load factor increased 5.9 percentage points to 72.4%. Passenger yield decreased 18.0% to 22.38 cents, reflecting the inclusion of the Frontier contract flying, the yield for which is significantly lower than native network flying, and a slight decrease in yield from native network flying. Contract revenue and increases in traffic, combined with lower native network yields and a decrease in incentive payments from Alaska to Horizon resulted in an increase in passenger revenue of $7.3 million, or 5.7%.

~~Horizon Air Expenses~~

Operating expenses increased $9.6 million, or 8.5%, as compared to the same period in 2003. Total operating expenses per ASM decreased 8.4% as compared to 2003. Operating expenses per ASM excluding fuel decreased 11.4% as compared to the same period in 2003. Explanations of other significant period-over-period changes in the components of operating expenses are as follows:

• Wages and benefits increased $0.5 million, or 1.3%, due primarily to a 2.1% increase in the average number of employees partially offset by a $2.0 million accrual reduction for estimated medical costs.
• Aircraft fuel increased $4.7 million, or 34.8%, due to a 50.4% increase in the GAAP fuel cost per gallon, partially offset by a 10.3% decrease in gallons consumed, reflecting the addition of four aircraft as compared to the same period in 2003, offset by a reduction in fuel consumption for the capacity flown in the Frontier JetExpress operation. Horizon’s fuel hedge contracts are consistent with those at Alaska.

The following table summarizes fuel cost per gallon realized by Horizon (the economic cost per gallon), on a GAAP basis (including hedging gains recorded in aircraft fuel and non-operating income (expense)) and fuel cost per gallon excluding all hedging activities:

Three Months Ended Nine Months Ended
September 30,
September 30,
2003
2004
2003
2004
Fuel expense before hedge activities (“raw fuel”) $ 14.3 $ 18.7 $ 40.8 $ 49.9
Fuel gallons (000,000) 14.5 13.0 40.7 37.2

Raw fuel cost per gallon 98.6 ¢ 143.8 ¢ 100.2 ¢ 134.1 ¢

Fuel expense before hedge activities (“raw fuel”) $ 14.3 $ 18.7 $ 40.8 $ 49.9
Less: gains on settled hedges included in fuel expense (0.8 ) (0.5 ) (2.5 ) (1.5 )

GAAP fuel expense $ 13.5 $ 18.2 $ 38.3 $ 48.4
Fuel gallons (000,000) 14.5 13.0 40.7 37.2

GAAP fuel cost per gallon 93.1 ¢ 140.0 ¢ 94.1 ¢ 130.1 ¢

GAAP fuel expense $ 13.5 $ 18.2 $ 38.3 $ 48.4
Less: gains on settled hedges included in nonoperating income (expense) (0.3 ) (1.2 ) (0.8 ) (1.6 )

Adjusted fuel $ 13.2 $ 17.0 $ 37.5 $ 46.8
Fuel gallons (000,000) 14.5 13.0 40.7 37.2

Economic fuel cost per gallon 90.3 ¢ 131.2 ¢ 91.9 ¢ 125.8 ¢

Mark-to-market gains included in nonoperating income related to hedges that settle in future periods (in millions) — $ 6.9 — $ 9.6

• ~~Aircraft maintenance expense increased $2.7 million, or 37.5%, primarily due to an increase in block hours, fewer aircraft covered by warranty and higher routine maintenance costs for the Q400 fleet.~~
• Landing fees and other rentals increased $0.7 million, or 6.8%. Higher landing fees are a result of higher rates and increased costs for capital improvement, debt service and security. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security.

~~Consolidated Nonoperating Income (Expense~~)

~~Net nonoperating income was $62.4 million in 2004 compared to net nonoperating expense of $8.5 million in 2003.~~

Other-net includes $2.0 million and $9.7 million in gains resulting from settled fuel hedge contracts in 2003 and 2004, respectively. In addition, other-net includes mark-to-market hedging gains of $57.2 million in 2004 as previously discussed.

~~Comparison of Nine Months Ended September 30, 2004 to Nine Months Ended September 30, 2003~~

During the nine months ended September 30, 2004, we recorded net income of $34.8 million, or $1.29 per diluted share, compared to net income of $29.6 million, or $1.11 per diluted share, during the same period of 2003. Our 2003 consolidated net income includes $71.4 million ($52.8 million for Alaska and $18.6 million for Horizon) received in connection with government assistance received under the Emergency Wartime Supplemental Appropriations Act. The 2004 results include four unusual items. First, we recorded a restructuring charge of $27.5 million ($15.8 million net of tax, or $0.59 per share) related to the restructuring initiatives announced in late August and early September. Second, like last quarter, this quarter’s results include mark-to-market fuel hedging gains, which reflect the increase in the fair value of our hedge portfolio during the quarter, of $80.0 million ($45.9 million net of tax, or $1.71 per share). These amounts exclude gains realized on contracts which settled during the quarter. Third, 2004 results also include impairment charges of $39.6 million ($26.3 million net of tax, or $0.98 per share), substantially all of which was associated with a decision to accelerate the retirement of the Company’s Boeing 737-200C fleet. Finally, this quarter’s results include the recovery of certain disputed Mexico navigation fees which were originally paid in 2002 and 2003, that amounted to $11.0 million ($6.3 million net of tax, or $0.23 per share). Without these items in 2004 and excluding the government compensation received in 2003, net income would have been $24.7 million, or $0.92 per share during 2004, compared to a net loss of $14.7 million, or $0.55 per share, in 2003. Financial and statistical data comparisons for Alaska and Horizon are shown on pages 20 and 21, respectively. A discussion of the nine-month data follows. On pages 22 through 24, we have included a reconciliation of reported non-GAAP financial measures to the most directly comparable GAAP financial measures.

~~Alaska Airlines Revenues~~

~~Operating revenues increased $187.2 million, or 12.3%, during 2004 as compared to 2003. For the first nine months of 2004, ASM’s increased 7.8% and RPM’s increased 12.0%.~~

Yield per passenger mile remained flat at 12.61 cents and passenger load factor increased 2.7 points during the first nine months of 2004 as compared to the same period in 2003. Increases in traffic and yield resulted in a 12.0% increase in passenger revenues in 2004.

~~Freight and mail revenues increased $5.5 million, or 9.2%, compared to the same period in 2003 because of a new mail contract we have in the State of Alaska.~~

Other-net revenues increased $16.0 million, or 19.3%, due largely to revenues received from an agreement with PenAir to provide flight services to Dutch Harbor that began in January of 2004 and higher Mileage Plan revenues.

~~Alaska Airlines Expenses~~

For the nine months ended September 30, 2004, total operating expenses increased $208.7 million, or 13.7%, as compared to the same period in 2003. Operating expenses per ASM increased 5.4% in 2004 as compared to 2003. These increases are due largely to the 7.8% increase in capacity combined with a significant increase in fuel costs, higher wages and benefits, landing fees and other rental costs, restructuring charges and an impairment charge related to our Boeing 737-200 fleet. Operating expense per ASM excluding fuel, navigation fee recovery, restructuring and impairment charges decreased 3.9% as compared to the same period in 2003. Explanations of significant period-over-period changes in the components of operating expenses are as follows:

• Wages and benefits increased $33.1 million, or 5.7%, during the first nine months of 2004. Approximately $12.5 million of this increase reflects higher benefit costs, resulting from increases in pension, medical and health insurance costs. The remaining $20.6 million increase primarily reflects scale and step increases.
~~In May of 2004, under terms of our union contract, our pilots received a 4% wage rate increase, which represented approximately 51.0% of the total increase in wages.~~
• Contracted services increased $9.4 million, or 15.4%, due largely to expenses associated with an agreement with PenAir to provide flight services to Dutch Harbor that began in January of 2004, costs associated with a temporary charter contract we have for our new mail contract in Alaska and higher security costs, partially offset by the recovery in 2004 of disputed Mexico navigation fees paid in 2002 and 2003.
• Aircraft fuel increased $104.2 million, or 44.9%, due to a 37.4% increase in the GAAP fuel cost per gallon and a 5.4% increase in fuel gallons consumed. Air Group’s fuel hedging program resulted in Alaska recognizing a $11.0 million reduction in aircraft fuel expense for hedging gains realized on hedge positions settled during the first half of 2004.
• ~~Aircraft maintenance decreased $6.4 million, or 5.4%, due largely to fewer engine overhauls during the first nine months and a change in the mix of heavy maintenance versus routine maintenance.~~
• Aircraft rent decreased $7.3 million, or 7.9%, due to lower rates on extended leases and MD-80 returns, offset by one new 737-700 aircraft and one new 737-900 aircraft since the end of the third quarter of 2003.
• Depreciation and amortization increased $7.4 million, or 8.4%, reflecting accelerated depreciation on the planned retirement of three Boeing 737-200C’s and an increase in depreciation resulting from two aircraft purchased in the last twelve months.
• Landing fees and other rentals increased $12.6 million, or 13.5%. The higher rates primarily reflect higher joint-use rental fees at Seattle, Portland, Los Angeles and Oakland, combined with modest volume growth. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security due to unfunded government mandates.

~~Other expense increased $8.1 million, or 7.9%, primarily reflecting a $6.4 million increase in professional services and a $1.1 million increase in property taxes.~~

~~Horizon Air Revenues~~

For the first nine months of 2004, operating revenues increased $32.0 million, or 9.3% as compared to 2003. This increase is due largely to a 0.1% increase in revenue associated with the native network flying combined with $31.8 million in revenue from contract flying for Frontier Airlines, which began January 1, 2004.

For the nine months ended September 30, 2004, capacity increased 18.7% and traffic was up 29.6%, compared to the same period in 2003. Contract flying with Frontier represented approximately 8.8% of passenger revenues and 20.8% of capacity, during the first nine months of 2004. Passenger load factor increased 5.7 percentage points to 68.5%. Passenger yield decreased 14.9% to 22.73 cents, reflecting the inclusion of the Frontier contract flying, the yield for which is significantly lower than native network flying. Contract revenue and higher yields in Horizon’s native network combined with the increases in traffic, resulted in an increase in passenger revenue of $33.6 million, or 10.3%.

~~Horizon Air Expenses~~

Operating expenses increased $23.8 million, or 7.0%, as compared to the same period in 2003. Operating expenses per ASM including fuel and the impairment charge decreased 10.0% as compared to 2003. Operating expenses per ASM excluding fuel and the impairment charge decreased 12.7% as compared to the same period in 2003. Operating expenses include $2.8 million related to an impairment charge on our held-for-sale F-28 aircraft and spare engines to lower the carrying value of these assets to their estimated fair value. Explanations of other significant period-over-period changes in the components of operating expenses are as follows:

• Wages and benefits increased $3.3 million, or 2.8%, reflecting an increase in the average number of employees and in average wages and payroll taxes, partially offset by an accrual reduction for medical costs resulting from a downward trend in claims activity.
• Aircraft fuel increased $10.1 million, or 26.4%, due to a 38.3% increase in the GAAP fuel cost per gallon, partially offset by an 8.6% decrease in gallons consumed, reflecting the addition of four aircraft as compared to the same period in 2003, offset by the reduction in fuel consumption for the capacity flown in the Frontier JetExpress operation. Air Group’s fuel hedging program resulted in Horizon recognizing a $1.5 million reduction in aircraft fuel expense for hedging gains realized on hedge positions settled during the first nine months of 2004.
• Aircraft maintenance expense increased $4.1 million, or 18.2%, primarily due to an increase in block hours, a higher number of routine maintenance activities and engine overhauls for the Q200 fleet and less aircraft covered by warranty.
• ~~Aircraft rent increased $2.7 million, or 5.1%, reflecting the addition of one CRJ and the addition of spare engines in 2004 as compared to the same period in 2003.~~

Landing fees and other rentals increased $3.0 million, or 10.6%. Higher landing fees are a result of higher rates associated with modest volume growth, an increase in airport fees and increased costs for security. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security.

~~Consolidated Nonoperating Income (Expense~~)

Net nonoperating income was $74.6 million in 2004 compared to $54.4 million in 2003. Interest income increased $7.1 million due to a larger marketable securities portfolio in 2004 combined with a negative adjustment of premium and discount amortization on our marketable securities portfolio in 2003. Interest expense (net of capitalized interest) increased $1.1 million due to increases in debt balances as compared to 2003.

The 2003 results include $71.4 million ($52.8 million for Alaska and $18.6 million for Horizon) received in connection with the government reimbursement of security fees remitted and carrier fees paid under the Emergency Wartime Supplemental Appropriations Act.

Other-net includes $5.4 million and $13.3 million in gains from settled fuel hedging contracts in 2003 and 2004, respectively. In addition, other-net includes mark-to-market gains on unsettled hedge contracts of $80.0 million in 2004.

~~Consolidated Income Tax Benefit~~

Accounting standards require us to provide for income taxes each quarter based on either our estimate of the effective tax rate for the full year or the actual year-to-date effective tax rate if it is our best estimate of our annual expectation. The volatility of airfares and fuel prices and the seasonality of our business make it difficult to accurately forecast full-year pretax results. In addition, a relatively small change in pretax results can cause a significant change in the effective tax rate due to the magnitude of nondeductible expenses, such as employee per diem costs, relative to pretax profit or loss. We used our actual 2004 year-to-date effective rate of 42.7%. In arriving at this rate, we considered a variety of factors, including year-to-date pretax results, the U.S. federal rate of 35%, estimated year-to-date nondeductible expenses and estimate state income taxes. We evaluate this rate each quarter and make adjustments when necessary.

~~Critical Accounting Policies~~

~~For information on our critical accounting policies, see Item 7 of our Annual Report on Form 10-K/A for the year ended December 31, 2003.~~

~~Liquidity and Capital Resources~~

~~The table below presents the major indicators of financial condition and liquidity.~~

December 31, 2003
September 30, 2004
Change
(In millions, except per share and debt-to-capital amounts)
Cash and marketable securities $ 812.3 $ 878.5 $ 66.2
Working capital 130.9 336.2 205.3
Long-term debt and capital lease obligations 906.9 1,007.6 100.7
Shareholders’ equity 674.2 713.6 39.4
Book value per common share $ 25.19 $ 26.54 $ 1.35
Long-term debt-to-capital 57%:43 % 59%:41 % NA
Long-term debt-to-capital assuming aircraft operating leases are capitalized at seven times annualized rent 77%:23 % 77%:23 % NA

During the nine months ended September 30, 2004, our cash and marketable securities increased $66.2 million to $878.5 million at September 30, 2004. This increase reflects cash provided by operating activities of $283.5 million, partially offset by cash used in financing activities of $96.3 million and cash used for the purchase of property and equipment of $113.5 million.

~~Cash Provided by Operating Activities~~

During the first nine months of 2004, net cash provided by operating activities was $283.5 million (including $42.7 million of cash received from a tax refund during the second quarter of 2004), versus $272.5 million during the first nine months of 2003.

~~Cash Used in Investing Activities~~

Cash used in investing activities was $157.2 million during the first nine months of 2004, compared to $508.6 million in 2003. We had net purchases of $39.2 million of marketable securities and $113.5 million for property and equipment. During the first nine months of 2004, our aircraft related capital expenditures decreased $197.8 million as compared to 2003, primarily reflecting a reduction in spending for new aircraft and capitalized overhauls.

~~Cash Provided by (Used in) Financing Activities~~

Net cash used in financing activities was $96.3 million during the first nine months of 2004 compared to net cash provided by financing activities of $188.8 million during the same period in 2003. Debt issuances during the first nine months of 2004 of $94.6 million were secured by flight equipment. These debt issuances have interest rates that vary with the London Interbank Offered Rate (LIBOR) and payment terms ranging from 12 to 16 years. Debt issuances during the period were offset by normal long-term debt payments of $43.2 million and full repayment of our credit facility of $150 million.

We plan to meet our capital and operating commitments through internally generated funds from operations and cash and marketable securities on hand at September 30, 2004 totaling $878.5 million. We also have restricted cash of $14.2 million, which is intended to collateralize interest payments due in the next two years on our $150 million floating rate senior convertible notes due 2023 issued in 2003.

In 2003, we completed the private placement of $150.0 million of floating rate senior convertible notes due in 2023 pursuant to Rule 144A of the Securities Act of 1933, as amended. Net proceeds from the offering were $144.9 million, of which $22.3 million was used to acquire U.S. government securities to fund the first three years of interest payments. In 2003, we made a capital contribution to Alaska Airlines of the remaining net proceeds from the sale of the notes. Alaska Airlines has used the remaining proceeds from the notes for working capital requirements and expects in the future to continue to use these remaining proceeds for working capital requirements as well as other general corporate purposes. Although we have not yet determined how each payment of principal or interest due will be funded in the future, we anticipate that these payments will be funded either by dividends, distributions, loans, advances or other payments from our subsidiaries or through new borrowings or financings by Alaska Air Group. Any such payments by our subsidiaries to us could be subject to statutory or contractual restrictions. Currently, the only contractual restrictions are contained in Alaska Airlines’ $150 million credit facility, which expires in December 2004 and requires maintenance of specific levels of net worth, maintenance of certain debt and leases to net worth, leverage and fixed charge coverage ratios, and limits on investments, lease obligations, sales of assets, and additional indebtedness. Such provisions limit the amount of funds Alaska Airlines can distribute via dividend to Alaska Air Group. As of September 30, 2004, $195.3 million was available to distribute to Alaska Air Group via dividend without violating the covenants in Alaska Airlines’ credit facility. The notes do not restrict the ability of our subsidiaries to enter into additional agreements limiting or prohibiting the distribution of earnings, loans or other payments to Alaska Air Group. We are considering various alternatives including renewing or replacing the credit facility, although there can be no assurance that this can be accomplished on acceptable terms to us.

The holders of the $150.0 million of floating rate senior convertible notes due in 2023 may elect to have the Company redeem all or a portion of the notes on the 5th, 10th and 15th anniversaries of the date of issuance. On September 30, 2004, we entered into the First Supplemental Indenture with respect to the Notes to rescind the Company’s right to pay for such a repurchase of the Notes at the option of the holders, in whole or in part, in shares of our common stock. Pursuant to the terms of the notes, as amended, any such repurchases shall be paid for in cash.

~~Supplemental Disclosure of Noncash Investing and Financing Activities~~

During the first nine months of 2004, Horizon financed three Bombardier Q400s under long-term debt arrangements totaling $44.7 million. These debt arrangements have a 15-year term and interest rates that vary with LIBOR. Two of the aircraft were originally leased in January 2004 and were treated as capital leases at that time. The resulting re-financing transactions did not result in any gain or loss in the consolidated statements of operations.

~~Contractual Obligations, Commitments and Off-Balance Sheet Arrangements~~

At September 30, 2004, we had firm orders for 12 aircraft requiring aggregate payments of approximately $284.4 million, as set forth below. In addition, Alaska has options to acquire 26 additional B737’s, and Horizon has options to acquire 15 Q400’s and 25 CRJ 700’s. Alaska and Horizon expect to finance the firm orders and to the extent exercised, the option aircraft with leases, long-term debt or internally generated cash. During the first quarter of 2004, Alaska converted two 737-900 aircraft it had on firm order with Boeing for two 737-800s. The planes are due for delivery in February and July of 2005.

~~The following table summarizes aircraft commitments and payments by year:~~

Delivery Period - Firm Orders
October 1-December 31, Beyond
Aircraft
2004
2005
2006
2007
2008
2008
Total
Boeing 737-800 — 3 — — — — 3
Bombardier CRJ700 — 1 2 2 2 2 9

Total — 4 2 2 2 2 12

Payments (Millions) $ 12.9 $ 82.4 $ 52.5 $ 49.5 $ 49.6 $ 37.5 $ 284.4

~~The table above does not include our planned acquisition of three Boeing 737-800’s in 2006 to replace the Boeing 737-400’s being converted since we do not have firm commitments at this time.~~

The following table provides a summary of our principal payments under current and long-term debt obligations, capital lease obligations, operating lease commitments and aircraft purchase commitments as of September 30, 2004. This table excludes other obligations that we may have, such as pension obligations and routine purchase obligations entered into in the normal course of business.

October 1-December 31, Beyond
(in millions)
2004
2005
2006
2007
2008
2008*
Total
Current and long-term debt and capital lease obligations $ 16.7 $ 53.5 $ 57.1 $ 60.2 $ 63.3 $ 808.9 $ 1,059.7
Operating lease commitments 82.2 278.0 223.3 195.9 189.5 1,136.1 2,105.0
Aircraft purchase commitments 12.9 82.4 52.5 49.5 49.6 37.5 284.4

Total $ 111.8 $ 413.9 $ 332.9 $ 305.6 $ 302.4 $ 1,982.5 $ 3,449.1

^* Includes $150 million related to the Company’s senior convertible notes due in 2023. Holders of these Notes may require the Company to purchase all or a portion of their Notes, for a purchase price equal to principal plus accrued interest, on the 5th, 10th, and 15th anniversaries of the issuance of the Notes, or upon the occurance of a change in control or tax event. See Note 8 in the condensed consolidated financial statements.

~~New Accounting Standards~~

Fuel Hedging

We purchase jet fuel at prevailing market prices, and seek to manage the risk of price fluctuations through execution of a documented hedging strategy. We utilize derivative financial instruments as hedges to decrease our exposure to the volatility of jet fuel prices. We believe there is risk in not hedging against the possibility of fuel price increases. At ~~September 30, 2004,~~March 31, 2005, we had fuel hedge contracts in place to hedge ~~49.0~~158.0 million gallons of our expected jet fuel usage during the remainder of ~~2004, 207.3 million gallons in~~ 2005, ~~106.1~~181.4 million gallons in 2006, ~~and 16.6~~65.8 million gallons in ~~2007.~~2007, and 5.4 million gallons in 2008. This represents 50%, 42%, 15%, and 1% of our anticipated fuel consumption in ~~2004~~2005, 2006, 2007, and ~~2005 and 25% and 4% of our anticipated fuel consumption in 2006 and 2007,~~2008, respectively. Prices of these agreements range from $28.81 to ~~$37.28~~$51.56 per crude oil barrel. We estimate that a 10% increase or decrease in crude oil prices as of ~~September 30, 2004~~March 31, 2005 would impact ~~hedging positions~~the fair value of our hedge portfolio by approximately ~~$6.0 million.~~$54.1 million and $51.3 million, respectively.

As of March 31, 2005 and December 31, ~~2003 and September 30,~~ 2004, the fair values of our fuel hedge positions were ~~$18.4~~$189.5 million and ~~$117.0~~$96.0 million, respectively. Of these amounts, ~~$12.0~~$124.4 million of the ~~2003~~2005 fair value amounts and ~~$81.6~~$65.7 million of the 2004 fair value amounts were included in ~~prepaid and other~~ current assets in the condensed consolidated balance ~~sheets.~~sheets based on settlement dates for the underlying contracts. The remaining ~~$6.4~~$65.1 million ~~2003~~2005 fair value and ~~$35.4~~$30.3 million 2004 fair value is reflected ~~in other assets~~as a non-current asset in the condensed consolidated balance sheets.

~~The following table summarizes Air Group’s realized~~Please refer to pages 21 and 22, as well as to Note 5 in the condensed consolidated financial statements, for company specific data on the results of our fuel hedging ~~gains and changes in fair value of hedging contracts outstanding as of September 30, 2004 and 2003 (in millions):~~

Three Months Ended Nine Months Ended
September 30,
September 30,
2003
2004
2003
2004
Settled hedging gains included in aircraft fuel $ 5.1 $ 4.0 $ 16.5 $ 12.5

Settled hedging gains (losses) included In non-operating income (expense)*** $ (0.8 ) $ 9.7 $ 4.3 $ 13.3
Mark-to-market hedging gains included in non-operating income (expense)** $ — $ 57.2 $ — $ 80.0

Hedging gains included in non-operating income (expense)* $ (0.8 ) $ 66.9 $ 4.3 $ 93.3

program.

		^* ~~Includes the ineffective portion recorded currently in earnings using “hedge accounting” through the first three months of 2004.~~

		^** ~~Includes changes in fair value since March 31, 2004 resulting from the loss of “hedge accounting”.~~

		^*** ~~2003 includes the ineffective portion of fair market value changes under “hedge accounting”.~~

~~Financial Market Risk~~

~~During the first nine months of 2004, we issued $94.6 million of debt secured by flight equipment, having interest rates that vary with LIBOR and payment terms ranging from 12 to 16 years.~~

ITEM 4. Controls and Procedures

As of ~~September 30, 2004,~~March 31, 2005, an evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer (collectively, our “certifying officers”), of the effectiveness of the design and operation of our disclosure controls and procedures. These disclosure controls and procedures are designed to ensure that the information required to be disclosed by us in our periodic reports filed with the Securities and Exchange Commission (the SEC) is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms, and that the information is communicated to our certifying officers on a timely basis.

Our certifying officers concluded, based on their evaluation, that disclosure controls and procedures were effective.

We made no changes in our internal controls over financial reporting during the fiscal quarter ended ~~September 30, 2004,~~March 31, 2005, that our certifying officers concluded materially affected, or are reasonably likely to materially ~~affect,~~effect, our internal control over financial reporting.

We intend to regularly review and evaluate the design and effectiveness of our disclosure controls and procedures and internal controls over financial reporting on an ongoing basis and to improve these controls and procedures over time and to correct any deficiencies that we may discover in the future. While we believe the present design of our disclosure controls and procedures and internal controls over financial reporting are effective, future events affecting our business may cause us to modify our ~~these~~ controls and procedures in the future.

PART ~~II.~~II OTHER INFORMATION

ITEM 1. Legal Proceedings

Our pilot contract provided that, if a negotiated agreement on the entire contract could not be reached by December 15, 2004, ten contract issues plus wage rates would be submitted to an interest arbitrator. The parties did not reach an agreement, and each party submitted five issues to binding arbitration, resulting in a decision that became effective on May 1, 2005. The arbitration resulted in an average pilot wage decrease of approximately 26%, various work rule changes resulting in productivity improvements and higher employee health care contributions. No changes were made to the pilots’ pension or profit sharing plans.

We are a party to ~~ordinary~~ routine litigation incidental to our business and with respect to which no material liability is expected. Management believes the ultimate disposition of these matters is not likely to materially affect our financial position or results of operations. This forward-looking statement is based on management’s current understanding of the relevant law and facts; it is subject to various contingencies, including the potential costs and risks associated with litigation and the actions of judges and juries.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

~~None~~None.

ITEM 3. Default on Senior Securities

~~None~~None.

ITEM 4. Submission of Matters to a Vote of Security Holders

~~None~~None.

4138

EXHIBIT INDEX

Pursuant to Item 601(a)(2) of Regulation S-K, this Exhibit Index immediately precedes the exhibits.

The following exhibits are numbered in accordance with Item 601 of Regulation S-K.


Exhibit No.		Description
4.1*10.1 (1)		~~Indenture~~Credit Agreement dated as of March ~~31, 2003 between~~25, 2005 among Alaska ~~Air Group,~~Airlines, Inc. ~~and~~, as borrower, Bank of America, N.A. as administrative agent, Citicorp USA, Inc. as syndication agent, U.S. Bank National Association as ~~Trustee,~~documentation agent, and ~~First Supplemental Indenture dated September 30, 2004 between Alaska Air Group, Inc. and U.S. Bank National Association as Trustee, relating to senior convertible notes due 2023.~~other lenders.

10.19*18.1 (1)		2004 Alaska Air Group performance based pay plan***Letter from KPMG LLP regarding change in accounting principle

31.1*31.1 (1)		Section 302 Certification of Chief Executive Officer Pursuant to 1518 U.S.C. Section ~~7241~~1350

31.2*31.2 (1)		Section 302 Certification of Chief Financial Officer Pursuant to 1518 U.S.C. Section ~~7241~~1350

32.1*32.1 (1)		Section 906 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350

32.2*31.2 (1)		Section ~~906~~302 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350

(1) Filed herewith.

*** Indicates management contract or compensatory plan or arrangement.

4441



Asset Impairment and Lease Termination Costs

Balance at December 31, 2004	$	0.0
Asset impairment charge		7.7
Write-off of impaired assets		(7.7	)
Lease termination costs		0.3
Cash payments		(0.1	)

Balance at March 31, 2005	$	0.2



Severance and Related Costs

Balance at December 31, 2004	$	38.7
Restructuring adjustment		(0.6	)
Cash payments		(20.3	)

Balance at March 31, 2005	$	17.8


Nine Months Ended September 30
(In Millions Except Per Share Amounts)	2003			2004
	Revised (See Note 13)
Operating Revenues
Passenger	$	1,678.2		$	1,896.7
Freight and mail		63.6			68.3
Other - net		89.7			105.9

Total Operating Revenues		1,831.5			2,070.9

Operating Expenses
Wages and benefits		697.5			733.9
Contracted services		74.5			81.7
Aircraft fuel		270.5			384.8
Aircraft maintenance		140.2			137.9
Aircraft rent		146.1			141.5
Food and beverage service		46.6			39.5
Other selling expenses and commissions		99.1			111.5
Depreciation and amortization		98.2			105.8
Loss (gain) on sale of assets		0.2			(1.4	)
Landing fees and other rentals		120.6			136.2
Other		139.3			146.3
Restructuring charges		—			27.5
Impairment of aircraft and spare engines		—			39.6

Total Operating Expenses		1,832.8			2,084.8

Operating Loss		(1.3	)		(13.9	)

Nonoperating Income (Expense)
Interest income		11.5			18.6
Interest expense		(38.6	)		(38.9	)
Interest capitalized		1.9			1.1
U.S. government compensation		71.4			—
Other — net		8.2			93.8

		54.4			74.6

Income before income tax		53.1			60.7
Income tax expense		23.5			25.9

Net Income	$	29.6		$	34.8

Basic Earnings Per Share	$	1.11		$	1.30

Diluted Earnings Per Share	$	1.11		$	1.29

Shares used for computation:
Basic		26.621			26.820
Diluted		26.680			26.922


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2003			2004			2003			2004
Net income:
As reported	$	40.7		$	79.2		$	29.6		$	34.8
Deduct: Total stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects		(1.4	)		(1.1	)		(4.6	)		(3.4	)

Pro forma net income	$	39.3		$	78.1		$	25.0		$	31.4

Basic earnings per share:
As reported	$	1.53		$	2.95		$	1.11		$	1.30
Pro forma		1.47			2.91			0.94			1.17
Diluted earnings per share:
As reported	$	1.52		$	2.94		$	1.11		$	1.29
Pro forma		1.47			2.90			0.94			1.17


Severance and Related Costs
Balance at December 31, 2003	$	—
Restructuring charges		27.5
Cash payments*		(1.2	)

Balance at September 30, 2004	$	26.3

	•	All changes in the fair value of fuel hedge contracts that existed as of March 31, 2004 or hedge positions entered into subsequent to March 31, 2004 are reported in other non-operating income (expense).

	•	Reported fuel expense includes only the effective portion of gains associated with hedge positions that settled during the current period on contracts that existed at March 31, 2004 to the extent that mark-to-market gains were already included in Accumulated Other Comprehensive Loss at March 31, 2004.

	•		All changes in the fair value of fuel hedge contracts that existed as of March 31, 2004 or hedge positions entered into subsequent to March 31, 2004 (the end of the first quarter of 2004) are reported in other non-operating income (expense).

	•		Because the Company will be recording fair value changes in its consolidated statement of operations as they occur (in non-operating income (expense)), actual gains or losses realized upon settlement of the hedge contracts entered into subsequent to March 31, 2004 will not be reflected in fuel expense.

	•		Reported fuel expense will include the effective portion of gains associated with hedge positions that settled during the current period on contracts that existed at March 31, 2004 to the extent that mark-to-market gains were already included in Accumulated Other Comprehensive Income at March 31, 2004.


	December 31, 2003		September 30, 2004
Prepaid expenses and other current assets	$	12.0	$	81.6
Other assets		6.4		35.4

	$	18.4	$	117.0


	December 31, 2003		September 30, 2004
Current Liabilities:
Other accrued liabilities	$	112.9	$	121.1
Other Liabilities and Credits (non-current):
Deferred revenue		204.5		238.4
Other liabilities		18.6		19.7

Total	$	336.0	$	379.2



	March 31, 2005			March 31, 2004

Service cost		$1.0			$1.2
Interest cost		1.1			1.3
Amortization of prior service cost		(0.1	)		(0.1	)
Actuarial gain		0.5			0.7

Net periodic benefit cost		$2.5			$3.1


	Three Months Ended			Nine Months Ended
	September 30, 2003			September 30, 2003
Total Aircraft Fuel:
As Previously Reported	$	94.7		$	265.0
As Revised	$	96.8		$	270.5
Total Operating Expenses:
As Previously Reported	$	623.4		$	1,827.3
As Revised	$	625.5		$	1,832.8
Total Operating Income (Loss):
As Previously Reported	$	78.8		$	4.2
As Revised	$	76.7		$	(1.3	)
Nonoperating income (expense):
As Previously Reported	$	(10.6	)	$	48.9
As Revised	$	(8.5	)	$	54.4


	Three Months Ended September 30									Nine Months Ended September 30
							%									%
Financial Data (in millions):	2003			2004			Change			2003			2004			Change
Operating Revenues:
Passenger	$	532.5		$	576.6			8.3	%	$	1,380.1		$	1,545.8			12.0	%
Freight and mail		21.4			24.5			14.5	%		59.8			65.3			9.2	%
Other — net		31.4			40.1			27.7	%		83.0			99.0			19.3	%

Total Operating Revenues		585.3			641.2			9.6	%		1,522.9			1,710.1			12.3	%

Operating Expenses:
Wages and benefits		198.7			207.3			4.3	%		578.7			611.8			5.7	%
Contracted services		20.5			17.8			-13.2	%		60.9			70.3			15.4	%
Aircraft fuel		83.3			130.2			56.3	%		232.2			336.4			44.9	%
Aircraft maintenance		35.2			27.1			-23.0	%		117.7			111.3			-5.4	%
Aircraft rent		31.1			28.1			-9.6	%		92.8			85.5			-7.9	%
Food and beverage service		17.0			13.7			-19.4	%		44.8			37.9			-15.4	%
Other selling expenses and commissions		43.4			35.9			-17.3	%		109.0			101.1			-7.2	%
Depreciation and amortization		29.7			32.0			7.7	%		87.8			95.2			8.4	%
Loss on sale of assets		0.8			(2.5	)	NM				1.3			(0.6	)	NM
Landing fees and other rentals		33.6			37.6			11.9	%		93.5			106.1			13.5	%
Other		34.5			37.1			7.5	%		102.9			111.0			7.9	%
Restructuring charges		—			27.5			100.0	%		—			27.5		NM
Impairment of aircraft		—			—			0.0	%		—			36.8		NM

Total Operating Expenses		527.8			591.8			12.1	%		1,521.6			1,730.3			13.7	%

Operating Income (Loss)		57.5			49.4			-14.1	%		1.3			(20.2	)	NM

Interest income		4.6			8.4						10.3			20.0
Interest expense		(11.2	)		(11.6	)					(33.9	)		(33.1	)
Interest capitalized		0.2			0.4						1.3			0.7
U.S. government compensation		—			—						52.8			—
Other — net		(1.0	)		59.7						7.3			82.9

		(7.4	)		56.9						37.8			70.5

Income Before Income Tax	$	50.1		$	106.3			112.2	%	$	39.1		$	50.3			28.7	%

Operating Statistics:
Revenue passengers (000)		4,280			4,589			7.2	%		11,335			12,296			8.5	%
RPMs (000,000)		4,126			4,571			10.8	%		10,946			12,255			12.0	%
ASMs (000,000)		5,693			6,012			5.6	%		15,611			16,825			7.8	%
Passenger load factor		72.5	%		76.0	%		3.5	pts		70.1	%		72.8	%		2.7	pts
Yield per passenger mile		12.91	¢		12.62	¢		-2.2	%		12.61	¢		12.61	¢		0.0	%
Operating revenue per ASM		10.28	¢		10.66	¢		3.7	%		9.76	¢		10.16	¢		4.1	%
Operating expenses per ASM (a)		9.27	¢		9.84	¢		6.1	%		9.75	¢		10.28	¢		5.4	%
Operating expenses per ASM excluding fuel, navigation fee settlement, restructuring and impairment charges (a)		7.81	¢		7.35	¢		-6.0	%		8.26	¢		7.95	¢		-3.9	%
Raw fuel cost per gallon (a)		95.2	¢		139.6	¢		46.6	%		97.0	¢		129.8	¢		33.8	%
GAAP fuel cost per gallon (a)		90.5	¢		135.9	¢		50.2	%		91.5	¢		125.7	¢		37.4	%
Economic fuel cost per gallon (a)		88.7	¢		127.0	¢		43.2	%		89.6	¢		121.3	¢		35.4	%
Fuel gallons (000,000)		92.0			95.8			4.1	%		253.9			267.6			5.4	%
Average number of employees		10,114			10,201			0.9	%		10,079			10,147			0.7	%
Aircraft utilization (blk hrs/day)		11.1			11.8			6.3	%		10.6			11.1			4.7	%
Operating fleet at period-end		109			107			-1.8	%		109			107			-1.8	%


	Three Months Ended September 30,						Nine Months Ended September 30,
($ in millions)	2003			2004			2003			2004
Unit cost reconciliations:
Operating expenses	$	527.8		$	591.8		$	1,521.6		$	1,730.3
ASMs (000,000)		5,693			6,012			15,611			16,825

Operating expenses per ASM		9.27	¢		9.84	¢		9.75	¢		10.28	¢

Operating expenses	$	527.8		$	591.8		$	1,521.6		$	1,730.3
Less: aircraft fuel		(83.3	)		(130.2	)		(232.2	)		(336.4	)
Less: impairment of aircraft		—			—			—			(36.8	)
Less: restructuring charges		—			(27.5	)		—			(27.5	)
Add: navigation fee settlement		—			7.7			—			7.7

Operating expense excluding fuel, navigation fee settlement, impairment and restructuring charges	$	444.5		$	441.8		$	1,289.4		$	1,337.3
ASMs (000,000)		5,693			6,012			15,611			16,825

Operating expense per ASM excluding fuel, navigation fee settlement, impairment and restructuring charges		7.81	¢		7.35	¢		8.26	¢		7.95	¢

Aircraft fuel reconciliations:
Fuel expense before hedge activities (“raw fuel”)	$	87.6		$	133.7		$	246.2		$	347.4
Fuel gallons (000,000)		92.0			95.8			253.9			267.6

Raw fuel cost per gallon		95.2	¢		139.6	¢		97.0	¢		129.8	¢

Fuel expense before hedge activities (“raw fuel”)	$	87.6		$	133.7		$	246.2		$	347.4
Less: gains on settled hedges included in fuel expense		(4.3	)		(3.5	)		(14.0	)		(11.0	)

GAAP fuel expense	$	83.3		$	130.2		$	232.2		$	336.4

Fuel gallons (000,000)		92.0			95.8			253.9			267.6

GAAP fuel cost per gallon		90.5	¢		135.9	¢		91.5	¢		125.7	¢

GAAP fuel expense	$	83.3		$	130.2		$	232.2		$	336.4
Less: gains on settled hedges included in nonoperating income (expense)		(1.7	)		(8.5	)		(4.6	)		(11.7	)

Adjusted fuel		81.6			121.7			227.6			324.7
Fuel gallons (000,000)		92.0			95.8			253.9			267.6

Economic fuel cost per gallon		88.7	¢		127.0	¢		89.6	¢		121.3	¢

Mark-to-market gains included in non-operating income related to hedges that settle in future periods		—		$	50.3			—		$	70.4

Reconciliation to GAAP pretax income (loss):
Pretax income (loss) excluding impairment and restructuring charges, navigation fee settlement, government compensation and mark-to-market hedging gains	$	50.1		$	72.5			($13.7	)	$	33.2
Less: impairment of aircraft		—			—			—			(36.8	)
Less: restructuring charges		—			(27.5	)		—			(27.5	)
Add: government compensation		—			—			52.8			—
Add: mark-to-market hedging gains included in nonoperating income (expense)		—			50.3			—			70.4
Add: navigation fee settlement		—			11.0			—			11.0

Pretax income (loss) reported GAAP amounts	$	50.1		$	106.3		$	39.1		$	50.3

		announced in August and September of 2004, largely offset by an increase in pilot wages, a new performance-based incentive program for all employees, and an increase in medical and pension benefits. During the first quarter of 2005, there were 9,219 full-time equivalents (FTEs), which is down by 765 FTEs from 2004 on a 3.7% increase in capacity.

	•	Contracted services increased $4.7 million, or 20.3%, due largely to the contracting out of the Company’s fleet service and ground service equipment and facility maintenance and costs associated with the service to Dutch Harbor, Alaska, which was contracted to PenAir in January 2004 and grew through the first quarter of 2004.

	•	Aircraft fuel increased $34.0 million, or 36.3%, due to a 34.2% increase in the GAAP fuel cost per gallon and a 1.6% increase in fuel gallons consumed. The increase in aircraft fuel expense is inclusive of $3.4 million of gains from settled hedges. During the first quarter of 2005, Alaska also realized $15.7 million of hedge gains, which are recorded in other non-operating income. After including all hedge gains recorded during the quarter, our “economic,” or net, fuel expense increased $18.3 million, or 19.6%, over the same period in 2004. Our economic fuel cost per gallon increased 17.7% over the first quarter of 2004 from $1.13 to $1.33.

		See page 21 for a table summarizing fuel cost per gallon realized by Alaska (the economic cost per gallon), the cost per gallon on a GAAP basis (including hedging gains recorded in aircraft fuel and non-operating income (expense)) and fuel cost per gallon excluding all hedging activities.

	•	Aircraft maintenance increased $6.6 million, or 15.2%, due largely to our power-by-the-hour maintenance agreement, whereby we expense B737-400 engine maintenance on a block-hour basis, regardless of whether the work was actually performed during the period. Other factors causing the increase were the contracting out of related heavy maintenance to third parties, which resulted in a shift of costs from wages and benefits into aircraft maintenance and the change in our accounting policy regarding engine and airframe overhauls (see Note 2 to our condensed consolidated financial statements). Our current expectation is that aircraft maintenance costs will be up approximately $3.0 million in the second quarter, $9.0 million in the third quarter, and $4.0 million in the fourth quarter compared to the prior year periods.

	•	Aircraft rent decreased $1.1 million, or 3.7%, due to lower rates on extended leases.

	•	Other selling expenses and commissions decreased $1.2 million, or 3.5%, due to a decline in advertising expense, offset by increases in commissions and codeshare fees.

	•	Depreciation and amortization decreased $2.5 million, or 7.6%. The first quarter of 2004 included accelerated depreciation on the planned retirement of three Boeing 737-200Cs. In the second quarter of 2004, we recorded an impairment charge of $36.8 million to reduce the carrying value of the Boeing 737-200C fleet, which results in lower depreciation expense in future periods.

	•	Landing fees and other rentals increased $7.4 million, or 22.3%. The higher rates primarily reflect higher joint-use fees in Los Angeles and exclusive rental fees at Seattle and Anchorage (including a $1.3 million adjustment in 2005 from the Port of Seattle related to 2004), combined with modest volume growth. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security due to unfunded government mandates.

	•	Other expense increased $1.5 million, or 4.1%, primarily reflecting increases in professional services costs, personnel and crew costs, passenger remuneration costs, and supplies costs.

	•	Wages and benefits increased $1.7 million, or 4.1%, reflecting a slight increase in the average number of employees, wages per employee, and a new performance-based incentive program for all employees, partially offset by favorable reductions of medical and workers compensation accruals.

	•	Aircraft fuel increased $4.9 million, or 34.5%, due to a 34.7% increase in the GAAP fuel cost per gallon from $1.18 in 2004 to $1.59 in 2005. The increase in aircraft fuel expense is inclusive of $0.4 million of gains from settled hedges. During the quarter, Horizon also realized $2.5 million of hedge gains, which are recorded in other non-operating income (expense). After including all hedge gains recorded during the quarter, our “economic,” or net, fuel expense increased $2.4 million, or 16.9%, over 2004. Our economic fuel cost per gallon increased 16.9% from $1.18 in 2004 to $1.38 in 2005.

		See page 22 for a table summarizing fuel cost per gallon realized by Horizon (the economic cost per gallon), the cost per gallon on a GAAP basis (including hedging gains recorded in aircraft fuel and non-operating income (expense)) and fuel cost per gallon excluding all hedging activities.

	•	Aircraft maintenance expense increased $3.8 million, or 52.1%, primarily due to a higher number of routine maintenance activities and engine overhauls for the Q200 and Q400 fleets and fewer aircraft covered by warranty. These increases are partially offset by the elimination of amortization expense on capitalized airframe and engine overhauls as a result of the accounting change in the first quarter (see Note 2 to our condensed consolidated financial statements).

	•	Landing fees and other rentals increased $1.9 million, or 19.2%. Higher landing fees are a result of higher rates associated with modest volume growth, an increase in airport fees and increased costs for security. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security.

	•		Wages and benefits increased $8.6 million, or 4.3%, during the third quarter. Approximately $1.5 million of this increase reflects higher benefit costs, resulting from increases in pension, medical and health insurance costs. The remaining $7.1 million increase primarily reflects scale and step increases.

			~~In May 2004, under terms of our union contract, our pilots received a 4% wage rate increase, which represented 50.7% of the total increase in wages.~~

	•		Contracted services decreased $2.7 million, or 13.2%, due largely to the recovery in 2004 of disputed Mexico navigation fees paid in 2002 and 2003, partially offset by expenses associated with an agreement with PenAir to provide flight services to Dutch Harbor that began in January of 2004 and costs associated with a temporary charter contract we had for our new mail contract in Alaska, and higher security costs.

	•		Aircraft fuel increased $46.9 million, or 56.3%, due to a 50.2% increase in the GAAP fuel cost per gallon and a 4.1% increase in fuel gallons consumed. Our economic cost per gallon (the raw price paid less all benefits from settled hedges) was $1.27 per gallon, a 43.2% increase over the prior year. Fuel prices remain at very high levels and continue to be volatile. At September 30, 2004, we have fuel hedge contracts in place to hedge 50% of our anticipated fuel consumption for the remainder of 2004 and 2005 and 25% of our anticipated fuel consumption in 2006 at prices ranging from $28.81 to $37.28 per crude oil barrel.


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2003			2004			2003			2004
Fuel expense before hedge activities (“raw fuel”)	$	87.6		$	133.7		$	246.2		$	347.4
Fuel gallons (000,000)		92.0			95.8			253.9			267.6

Raw fuel cost per gallon		95.2	¢		139.6	¢		97.0	¢		129.8	¢

Fuel expense before hedge activities (“raw fuel”)	$	87.6		$	133.7		$	246.2		$	347.4
Less: gains on settled hedges included in fuel expense		(4.3	)		(3.5	)		(14.0	)		(11.0	)

GAAP fuel expense	$	83.3		$	130.2		$	232.2		$	336.4
Fuel gallons (000,000)		92.0			95.8			253.9			267.6

GAAP fuel cost per gallon		90.5	¢		135.9	¢		91.5	¢		125.7	¢

GAAP fuel expense	$	83.3		$	130.2		$	232.2		$	336.4
Less: gains on settled hedges included in nonoperating income (expense)		(1.7	)		(8.5	)		(4.6	)		(11.7	)

Adjusted fuel	$	81.6		$	121.7		$	227.6		$	324.7
Fuel gallons (000,000)		92.0			95.8			253.9			267.6

Economic fuel cost per gallon		88.7	¢		127.0	¢		89.6	¢		121.3	¢

Mark-to-market gains included in nonoperating income related to hedges that settle in future periods (in millions)		—		$	50.3			—		$	70.4

	•		~~Aircraft maintenance decreased $8.1 million, or 23.0%, due largely to fewer engine overhauls and a change in the mix of heavy maintenance versus routine maintenance.~~

			For the remainder of the year we anticipate that aircraft maintenance will be somewhat higher than in 2003 as outsourcing of all base maintenance work takes effect. The anticipated savings from contracting out will be reflected through lower wages and benefits in future periods.

	•		~~Aircraft rent decreased $3.0 million, or 9.6%, due to lower rates on extended leases.~~

	•		Other selling expenses and commissions decreased $7.5 million, or 17.3%. This decrease is due largely to a decrease in incentive payments made to Horizon. Incentive payments to Horizon are eliminated in consolidation at the Air Group level.

	•		Wages and benefits increased $0.5 million, or 1.3%, due primarily to a 2.1% increase in the average number of employees partially offset by a $2.0 million accrual reduction for estimated medical costs.

	•		Aircraft fuel increased $4.7 million, or 34.8%, due to a 50.4% increase in the GAAP fuel cost per gallon, partially offset by a 10.3% decrease in gallons consumed, reflecting the addition of four aircraft as compared to the same period in 2003, offset by a reduction in fuel consumption for the capacity flown in the Frontier JetExpress operation. Horizon’s fuel hedge contracts are consistent with those at Alaska.

	•		~~Aircraft maintenance expense increased $2.7 million, or 37.5%, primarily due to an increase in block hours, fewer aircraft covered by warranty and higher routine maintenance costs for the Q400 fleet.~~

	•		Landing fees and other rentals increased $0.7 million, or 6.8%. Higher landing fees are a result of higher rates and increased costs for capital improvement, debt service and security. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security.

	•		Wages and benefits increased $33.1 million, or 5.7%, during the first nine months of 2004. Approximately $12.5 million of this increase reflects higher benefit costs, resulting from increases in pension, medical and health insurance costs. The remaining $20.6 million increase primarily reflects scale and step increases.

			~~In May of 2004, under terms of our union contract, our pilots received a 4% wage rate increase, which represented approximately 51.0% of the total increase in wages.~~

	•		Contracted services increased $9.4 million, or 15.4%, due largely to expenses associated with an agreement with PenAir to provide flight services to Dutch Harbor that began in January of 2004, costs associated with a temporary charter contract we have for our new mail contract in Alaska and higher security costs, partially offset by the recovery in 2004 of disputed Mexico navigation fees paid in 2002 and 2003.

	•		Aircraft fuel increased $104.2 million, or 44.9%, due to a 37.4% increase in the GAAP fuel cost per gallon and a 5.4% increase in fuel gallons consumed. Air Group’s fuel hedging program resulted in Alaska recognizing a $11.0 million reduction in aircraft fuel expense for hedging gains realized on hedge positions settled during the first half of 2004.

	•		~~Aircraft maintenance decreased $6.4 million, or 5.4%, due largely to fewer engine overhauls during the first nine months and a change in the mix of heavy maintenance versus routine maintenance.~~

	•		Aircraft rent decreased $7.3 million, or 7.9%, due to lower rates on extended leases and MD-80 returns, offset by one new 737-700 aircraft and one new 737-900 aircraft since the end of the third quarter of 2003.

	•		Depreciation and amortization increased $7.4 million, or 8.4%, reflecting accelerated depreciation on the planned retirement of three Boeing 737-200C’s and an increase in depreciation resulting from two aircraft purchased in the last twelve months.

	•		Landing fees and other rentals increased $12.6 million, or 13.5%. The higher rates primarily reflect higher joint-use rental fees at Seattle, Portland, Los Angeles and Oakland, combined with modest volume growth. We expect landing fees and other rentals to continue to increase as a result of airport facility expansions and increased costs for security due to unfunded government mandates.

	•		Wages and benefits increased $3.3 million, or 2.8%, reflecting an increase in the average number of employees and in average wages and payroll taxes, partially offset by an accrual reduction for medical costs resulting from a downward trend in claims activity.

	•		Aircraft fuel increased $10.1 million, or 26.4%, due to a 38.3% increase in the GAAP fuel cost per gallon, partially offset by an 8.6% decrease in gallons consumed, reflecting the addition of four aircraft as compared to the same period in 2003, offset by the reduction in fuel consumption for the capacity flown in the Frontier JetExpress operation. Air Group’s fuel hedging program resulted in Horizon recognizing a $1.5 million reduction in aircraft fuel expense for hedging gains realized on hedge positions settled during the first nine months of 2004.

	•		Aircraft maintenance expense increased $4.1 million, or 18.2%, primarily due to an increase in block hours, a higher number of routine maintenance activities and engine overhauls for the Q200 fleet and less aircraft covered by warranty.

	•		~~Aircraft rent increased $2.7 million, or 5.1%, reflecting the addition of one CRJ and the addition of spare engines in 2004 as compared to the same period in 2003.~~


	Delivery Period - Firm Orders
October 1-December 31,											Beyond
Aircraft	2004		2005		2006		2007		2008		2008		Total
Boeing 737-800		—		3		—		—		—		—		3
Bombardier CRJ700		—		1		2		2		2		2		9

Total		—		4		2		2		2		2		12

Payments (Millions)	$	12.9	$	82.4	$	52.5	$	49.5	$	49.6	$	37.5	$	284.4


		ALASKA AIR GROUP, INC.

~~Registrant~~

~~Date: November 9, 2004~~Registrant


By:		/s/ Brandon S. Pedersen

Brandon S. Pedersen
Staff Vice President/Finance and Controller


By:			/s/ Bradley D. Tilden

Bradley D. Tilden
Executive Vice President/Finance and Chief Financial Officer