UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-K (Mark One) X	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 	1934 [NO FEE REQUIRED] For the fiscal year ended December 31, 1997 		OR 	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] 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 incorporation or organization)	(I.R.S. Employer Identification No.) 19300 Pacific Highway South, Seattle, Washington 98188 (Address of Principal Executive Offices) Registrant's telephone number, including area code: (206) 431-7040 Securities registered pursuant to Section 12(b) of the Act: 	 Title of Each Class	 	Name of Each Exchange on Which Registered Common Stock, $1.00 Par Value	 New York Stock Exchange Rights to Purchase Series A Participating Preferred Stock	 New York Stock Exchange 6-1/2% Convertible Senior Debentures Due 2005	 New York Stock Exchange 6-7/8% Conv. Subordinated Debentures Due 2014	 New York Stock Exchange 	As of December 31, 1997, common shares outstanding totaled 18,282,732. The aggregate market value of the common shares of Alaska Air Group, Inc. held by nonaffiliates, 18,223,488 shares, was approximately $706 million (based on the closing price of these shares, $38.75, on the New York Stock Exchange on such date). 	Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ____ 	Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ( ) DOCUMENTS TO BE INCORPORATED BY REFERENCE 	Title of Document		Part Hereof Into Which Document to be Incorporated Definitive Proxy Statement Relating to 	Part III 1998 Annual Meeting of Shareholders Exhibit Index begins on page 35. PART I ITEM 1.	BUSINESS GENERAL INFORMATION Alaska Air Group, Inc. (Air Group or the Company) is a holding company which was incorporated in Delaware in 1985. Its two principal subsidiaries are Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon). Both subsidiaries operate as airlines, although their business plans, competition and economic risks differ substantially. Alaska is a major airline, operates an all jet fleet, and its average passenger trip length is 846 miles. Horizon is a regional airline, operates jet and turboprop aircraft, and its average passenger trip is 241 miles. Business segment information is reported in the Notes to Consolidated Financial Statements. Air Group's executive offices are located at 19300 Pacific Highway South, Seattle, Washington 98188. The business of the Company is somewhat seasonal, and quarterly operating income tends to peak during the third quarter. Alaska Alaska Airlines is an Alaska corporation that was organized in 1932 and incorporated in 1937. Alaska serves 35 cities in six states (Alaska, Washington, Oregon, California, Nevada and Arizona), one city in Canada, four cities in Mexico and five cities in Russia. In each year since 1973, Alaska has carried more passengers between Alaska and the U.S. mainland than any other airline. In 1997, Alaska carried 12.3 million passengers. Passenger traffic within Alaska and between Alaska and the U.S. mainland accounted for 26% of Alaska's 1997 revenue passenger miles, West Coast traffic accounted for 66%, the Mexico markets 8% and Russia less than 1%. Based on passenger enplanements, Alaska's leading airports are Seattle, Portland, Anchorage and Los Angeles. Based on revenues, its leading nonstop routes are Seattle-Anchorage, Seattle-Los Angeles and Seattle-San Diego. At December 31, 1997, Alaska's operating fleet consisted of 78 jet aircraft. The majority of Alaska flights, and certain Northwest Airlines flights, are dual-designated in airline computer reservation systems as Alaska Airlines and Northwest Airlines in order to facilitate feed traffic between the two airlines. Alaska Airlines also serves three smaller cities in California, three in Washington, and many small communities in Alaska through code share marketing agreements with local carriers. Horizon Horizon, a Washington corporation, began service in 1981 and was acquired by Air Group in 1986. It is the largest regional airline in the Pacific Northwest, and serves 33 cities in five states (Washington, Oregon, Montana, Idaho, and California) and four cities in Canada. In 1997, Horizon carried 3.7 million passengers. Based on passenger enplanements, Horizon's leading airports are Seattle, Portland, Spokane and Boise. Based on revenues, its leading nonstop routes are Seattle- Portland, Seattle-Spokane and Seattle-Boise. At December 31, 1997, Horizon's operating fleet consisted of 15 jet and 47 turboprop aircraft. Horizon flights are listed under the Alaska Airlines designator code in airline computer reservation systems. Most Horizon flights are also dual-designated in these reservation systems as Northwest Airlines and Alaska Airlines. Currently, 32% of Horizon's passengers connect to either Alaska or Northwest. Alaska and Horizon integrate their flight schedules to provide the best possible service between any two points served by their systems. Both airlines distinguish themselves from competitors by providing a higher level of customer service. The airlines' excellent service in the form of advance seat assignments, a first class section, attention to customer needs, high-quality food and beverage service, well-maintained aircraft and other amenities has been recognized by independent studies and surveys of air travelers. Alaska and Horizon offer competitive fares. BUSINESS RISKS The Company's operations and financial results are subject to various uncertainties such as intense competition, volatile fuel prices, a largely unionized labor force, the need to finance large capital expenditures, government regulation, potential aircraft incidents and general economic conditions. Competition Competition in the air transportation industry is intense. Any domestic air carrier deemed fit by the DOT is allowed to operate scheduled passenger service in the United States. Together, Alaska and Horizon carry 2.3% of all U.S. domestic passenger traffic. Alaska and Horizon compete with one or more domestic or foreign airlines on most of their routes. Some of these competitors are substantially larger than Alaska and Horizon, have greater financial resources and have more extensive route systems. Due to its shorthaul markets, Horizon is also subject to competition from surface transportation, particularly the automobile. Most major U.S. carriers have developed, independently or in partnership with others, large computerized reservation systems (CRS). Airlines, including Alaska, and Horizon, are charged industry-set fees to have their flight schedules included in the various CRS displays used by travel agents and airlines. These systems are currently the predominant means of distributing airline tickets. In order to reduce anti- competitive practices, the DOT regulates the display of all airline schedules and fares. Alaska is exploring alternatives to existing distribution methods. Fuel Fuel costs represented 14.5% of the Company's total operating expenses in 1997. Fuel prices, which can be volatile and are largely outside of the Company's control, can have a significant impact on the Company's operating results. Currently, a one cent change in the fuel price per gallon affects annual fuel costs by approximately $3.2 million. The Company has in the past hedged against its exposure to fluctuations in the price of jet fuel, but does not currently do so. The Company evaluates hedging strategies on an ongoing basis. Unionized Labor Force Labor costs represented 33% of the Company's total operating expenses in 1997. Wage rates can have a significant impact on the Company's operating results. At December 31, 1997, labor unions represented 88% of Alaska's and 43% of Horizon's employees. The air transportation industry is regulated under the Railway Labor Act, which vests in the National Mediation Board certain regulatory powers with respect to disputes between airlines and labor unions. The Company cannot predict the outcome of union contract negotiations nor control actions (e.g. work stoppage or slowdown) unions might take to try to influence those negotiations. Leverage and Future Capital Requirements The Company, like many airlines, is highly leveraged, which increases the volatility of its earnings. Due to high fixed costs, including aircraft lease commitments, a decrease in revenues could result in a disproportionately greater decrease in earnings. In addition, the Company has an ongoing need to finance new aircraft deliveries and there is no assurance that such financing will be available in sufficient amounts or on acceptable terms. See Item 7 for management's discussion of liquidity and capital resources. Government Regulation; International Routes The Company, like other airlines, is subject to regulation by the Federal Aviation Administration (FAA) and the United States Department of Transportation (DOT). The FAA, under its mandate to ensure aviation safety, has the authority to ground aircraft and to suspend temporarily or revoke permanently the authority of an air carrier or its licensed personnel for failure to comply with Federal Aviation Regulations and to levy civil penalties for such failure. The DOT has the authority to regulate certain airline economic functions including financial and statistical reporting, consumer protection, computerized reservations systems, essential air transportation and international route authority. The Company is subject to bilateral agreements between the United States and the foreign countries to which the Company provides service. There can be no assurance that existing bilateral agreements between the United States and the foreign governments will continue or that the Company's designation to operate such routes will continue. Risk of Loss and Liability; Weather The Company, like other airlines, is exposed to potential catastrophic losses in the event of aircraft accidents or terrorist incidents. Consistent with industry standards, the Company maintains insurance against such losses. However, any aircraft accident, even if fully insured, could cause a negative public perception of the Company with adverse financial consequences. Unusually adverse weather, as occurred during December 1996 in the Pacific Northwest, can significantly reduce flight operations, resulting in lost revenues and added expenses. OTHER INFORMATION Frequent Flyer Program All major airlines have developed frequent flyer programs as a way of increasing passenger loyalty. Alaska's Mileage Plan allows members to earn mileage by flying on Alaska, Horizon and other participating airlines, and by using the services of non-airline partners, which include a credit card partner, telephone companies, hotels and car rental agencies. Alaska is paid by non-airline partners for the miles it credits to member accounts. Alaska has the ability to change the Mileage Plan terms, conditions, partners, mileage credits and award levels. Mileage can be redeemed for free or discounted travel and for other travel industry awards. Upon accumulating the necessary mileage, members notify Alaska of their award selection Over 70% of the flight awards selected are subject to blackout dates and capacity-controlled seating. Effective in January 1996, miles have no expiration. As of the year end 1996 and 1997, Alaska estimates that 504,000 and 652,000 round trip flight awards could have been redeemed by Mileage Plan members who have mileage credits exceeding the 20,000 mile free round trip domestic ticket award threshold. At December 31, 1997, fewer than 4% of these flight awards were issued and outstanding. For the years 1995, 1996 and 1997, approximately 242,000, 173,000 and 185,000 round trip flight awards were redeemed and flown on Alaska and Horizon. These awards represent approximately 7% for 1995, 4% for 1996, and 3% for 1997, of the total passenger miles flown for each period. Alaska maintains a liability for its Mileage Plan obligation which is based on its total miles outstanding, less an estimate for miles that will never be redeemed. The net miles outstanding are allocated between those credited for travel on Alaska, Horizon or other airline partners and those credited for using the services of non-airline partners. Miles credited for travel on Alaska, Horizon or other airline partners are accrued at Alaska's incremental cost of providing the air travel. The incremental cost includes the cost of meals, fuel, reservations and insurance. The incremental cost does not include a contribution to overhead, aircraft cost or profit. A portion of the proceeds received from non-airline partners is also deferred. At December 31, 1996 and 1997, the total liability for miles outstanding was $17.3 million and $22.3 million, respectively. Employees Alaska had 8,578 active full-time and part-time employees at December 31, 1997. The following is a summary of Alaska's union contracts as of December 31, 1997:	 			Number of 	Union 	Employee Group 	Employees	 Contract Status International	 Mechanic, Rampservice	 1,786 	Amendable 8/31/97 Association of 	and Related Crafts	 		In negotiation Machinists and	 Aerospace Workers	 		Clerical, Office and 	3,094 	Amendable 5/20/99 		Passenger Service Air Line Pilots 	Pilots 	1,085 	Amendable 4/30/03 Association International 	 Association of 	Flight Attendants 	1,491 	Amendable 3/14/99 Flight Attendants Mexico Workers 	Mexico Airport 	61 	Amendable 4/1/98 Association 	Personnel of Air Transport Transport Workers 	Dispatchers 	16 	Amendable 2/9/02 Union of America Horizon had 2,851 active full-time and part-time employees at December 31, 1997. The following is a summary of Horizon's union contracts as of December 31, 1997: 				Number of 	Union	 		Employee Group 	Employees 	Contract Status Transport Workers 	Mechanics and 	403 	Amendable 4/24/98 Union of America	 related classifications		 		Dispatchers 	26 	Amendable 5/10/02 Association of 	Flight Attendants 	281 	Amendable 1/28/03 Flight Attendants			 National Automobile,	 Station personnel 	33	 Amendable 1/17/01 Aerospace, Transportation 	in Canada and General Workers International Brotherhood 	Pilots	 495 	Initial contract of Teamsters		 negotiations in 1998	 Selected Quarterly Consolidated Financial Information (Unaudited) 		1st Quarter 		2nd Quarter 		3rd Quarter	 	4th Quarter 	1996 	1997 	1996 	1997 	1996 	1997 	1996 	1997 				(in millions, except per share) Operating revenues	$351.4	$380.4 	$416.7	$435.0	 $464.9	$501.2	 $359.2	$422.8 Operating income (loss) 	(5.2) 	(5.4) 	39.6 	40.9 	63.0 	76.3 	(8.4) 	27.2 Net income (loss)	 (7.2) 	(5.7) 	18.0 	20.8 	32.8 	42.2 	(5.6) 	15.1 Earnings (loss) per share: 	Basic	 (0.52)	 (0.39) 	1.26 	1.43 	2.27 	2.88 	(0.38) 	0.98 	Diluted 	(0.52)		(0.39) 	0.88 	1.01 	1.53 	1.96 	(0.38) 	0.73 The total of the amounts shown as quarterly earnings per share (EPS) may differ from the amount shown on the Consolidated Statement of Income because the annual computation is made separately and is based upon average number of shares (and equivalent shares for diluted EPS) outstanding for the year. ITEM 2.	PROPERTIES Aircraft The following table describes the aircraft operated and their average age at December 31, 1997. 	Passenger								 Average Age Aircraft Type 	Capacity		Owned	 Leased	 Total	 in Years Alaska Airlines Boeing 737-200C	 111 	7	 1	 8	 17.4 Boeing 737-400 	140	 3	 25	 28	 3.9 McDonnell Douglas MD-80 	140	 16	 26	 42 	8.2 		26 	52	 78 	7.6 Horizon Fairchild Metroliner III 	18 	-- 	11 	11 	10.7 de Havilland Dash 8	 37 	-- 	36 	36 	6.3 Fokker F-28	 62-69 	3 	12 	15 	14.6 			3 	59 	62 	9.0 Part II, Item 7, "Management's Discussion and Analysis of Results of Operations and Financial Condition," discusses future orders and options for additional aircraft. Twelve of the 26 aircraft owned by Alaska as of December 31, 1997 are subject to liens securing long-term debt. Alaska's leased B737-200C, B737-400 and MD-80 aircraft have lease expiration dates in 1999, between 2002 and 2015, and between 1998 and 2013, respectively. Horizon's leased Fairchild Metroliner III, de Havilland Dash 8 and Fokker F-28 aircraft have expiration dates between 1998 and 2000, 1999 and 2013 and 2000 and 2002, respectively. However, as part of its fleet standardization plan, Horizon expects to return to the lessors or otherwise dispose of all of the Metroliners during 1998. Alaska and Horizon have the option to extend most of the leases for additional periods, or the right to purchase the aircraft at the end of the lease term, usually at the then fair market value of the aircraft. For information regarding obligations under capital leases and long-term operating leases, see Notes to Consolidated Financial Statements. Special noise ordinances or agreements restrict the type of aircraft, the timing and the number of flights operated by Alaska and other air carriers at four Los Angeles area airports plus San Diego, Palm Springs, San Francisco and Seattle. At December 31, 1997, all of Alaska's aircraft meet the Stage 3 noise requirements under the Airport Noise and Capacity Act of 1990. Ground Facilities and Services Alaska and Horizon lease ticket counters, gates, cargo and baggage, office space and other support areas at the majority of the airports they serve. Alaska also owns terminal buildings at various Alaska cities. Alaska has centralized operations in several buildings located at or near Seattle-Tacoma International Airport (Sea-Tac) in Seattle, Washington. The owned buildings, including land unless located on leased airport property, include: a three-bay hangar facility with maintenance shops; a flight operations and training center; an air cargo facility; a reservations and office facility; a four-story office building; its corporate headquarters; and two storage warehouses. Alaska also leases a two-bay hangar/office facility at Sea-Tac. Alaska's other major facilities include: a regional headquarters building, an air cargo facility (completed in 1997) and a leased hangar/office facility in Anchorage; a Phoenix reservations center; and a leased two-bay maintenance facility in Oakland. Horizon owns its Seattle corporate headquarters building and leases maintenance facilities at the Portland and Boise airports. A new $17 million operations, training and aircraft maintenance facility is under construction in Portland and is expected to be completed in the second quarter of 1998. ITEM 3.	LEGAL PROCEEDINGS In October 1991, Alaska gave notice of termination of its code sharing and frequent flyer relationship with MarkAir, an airline based in the state of Alaska. Both companies have filed suit against one another in connection with that termination asserting breach of contract and other claims under state law. In June 1992, MarkAir filed for protection under Chapter 11 of the U.S. Bankruptcy Code. In June 1997, MarkAir claimed damages of $57 million (later revised to $70 million) in connection with Alaska's actions. In January 1998, MarkAir's counsel notified the Company that, after application of attorneys' fees and prejudgement interest, its total claim was between $104 and $140 million. If MarkAir were to prevail at the $140 million amount, the after-tax effect would be to reduce shareholders' equity by approximately $82 million or 17%. However, the Company believes that it has valid defenses and is vigorously defending itself against the lawsuit. Trial is scheduled to begin in July 1998. ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of Alaska Air Group, Inc., their positions and their respective ages (as of March 1, 1998) are as follows: 	Name			Position		Age	Officer Since	 John F. Kelly	 Chairman, President and Chief 	53 	1981 			 Executive Officer of Alaska 			 Air Group, Inc. and Chairman and CEO of Alaska Airlines, Inc. Harry G. Lehr	 Senior Vice President/Finance 	57 	1986 			of Alaska Air Group, Inc. 						 and Alaska Airlines, Inc. Steven G. Hamilton	 Vice President/Legal and General 	 58	 1988 			Counsel of Alaska Air Group, Inc. 			and Alaska Airlines, Inc. Keith Loveless 	Corporate Secretary and Associate 	41 	1996 		 	General Counsel of Alaska Air 			Group, Inc. and Alaska Airlines, Inc. The above officers have been employed as officers of Air Group or its subsidiary, Alaska Airlines, for more than five years except for Keith Loveless, who was elected as Corporate Secretary in 1996. Mr. Loveless joined the Alaska Airlines legal department in 1986 and continues to hold his current position as associate general counsel of Alaska Airlines, a post he has held since 1993. ITEM 5.	MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED 	STOCKHOLDER MATTERS As of December 31, 1997, there were 18,282,732 shares of common stock issued and outstanding and 4,876 shareholders of record. The Company also held 2,748,030 treasury shares at a cost of $62.6 million. The Company has not paid dividends on the common stock since 1992. Air Group's common stock is listed on the New York Stock Exchange (symbol: ALK). The following table shows the trading range of Alaska Air Group common stock on the New York Stock Exchange for 1996 and 1997. 		1996		 	1997	 			High	 		Low	 		High 			Low	 	First Quarter 	27-3/4	 15-7/8	 27-5/8	 20-3/4 	Second Quarter 	30-3/4 	24-1/4 26-1/4 	23 	Third Quarter 	28-1/8 	19-1/8 	33-5/16	 25-1/16 	Fourth Quarter	 25-1/8 	20-5/8 40-1/8 	30-3/16 ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA 1993 1994 1995 1996 1997 Consolidated Financial Data: Year Ended December 31 (in millions, except per share amounts): Operating Revenues $1,128.3 $1,315.6 $1,417.5 $1,592.2 $1,739.4 Operating Expenses 1,145.1 1,241.6 1,341.8 1,503.2 1,600.4 Operating Income (Loss) (16.8) 74.0 75.7 89.0 139.0 Nonoperating expense, net (a) (29.0) (33.0) (41.7) (24.7) (15.4) Income (loss) before income tax (45.8) 41.0 34.0 64.3 123.6 Net Income (Loss) $(30.9) $22.5 $17.3 $38.0 $72.4 Average shares outstanding 13.340 13.367 13.485 14.241 14.785 Basic earnings (loss) per share $(2.51) $1.69 $1.28 $2.67 $4.90 Diluted earnings (loss) per share (2.51) 1.62 1.26 2.05 3.53 At End of Period (in millions, except ratio): Total assets $1,135.0 $1,315.8 $1,313.4 $1,311.4 $1,533.1 Long-term debt and capital lease obligations 525.4 589.9 522.4 404.1 401.4 Shareholders' equity 166.8 191.3 212.5 272.5 475.3 Ratio of earnings to fixed charges (b) 1.36 1.28 1.57 2.10 Alaska Airlines Operating Data: Revenue passengers (000) 6,438 8,958 10,140 11,805 12,284 Revenue passenger miles (RPM) (000,000) 5,514 7,587 8,584 9,831 10,386 Available seat miles (ASM) (000,000) 9,426 12,082 13,885 14,904 15,436 Revenue passenger load factor 58.5% 62.8% 61.8% 66.0% 67.3% Yield per passenger mile 14.32c 12.20c 11.59c 11.67c 12.49c Operating revenues per ASM 9.62c 8.79c 8.23c 8.70c 9.38c Operating expenses per ASM 9.88c 8.27c 7.71c 8.10c 8.51c Average full-time equivalent employees 6,191 6,486 6,993 7,652 8,236 Horizon Air Operating Data: Revenue passengers (000) 2,752 3,482 3,796 3,753 3,686 Revenue passenger miles (RPM) (000,000) 560 733 841 867 889 Available seat miles (ASM) (000,000) 986 1,165 1,414 1,462 1,446 Revenue passenger load factor 56.8% 62.9% 59.5% 59.3% 61.5% Yield per passenger mile 37.93c 33.35c 31.48c 33.14c 32.56c Operating revenues per ASM 22.65c 22.06c 19.77c 20.61c 21.00c Operating expenses per ASM 21.76c 20.95c 19.47c 20.60c 20.60c Average full-time equivalent employees 2,267 2,557 2,864 2,891 2,756 c=cents (a) Includes capitalized interest of $.4 million, $.4 million, $.2 million, $1.0 million and $5.3 million for 1993, 1994, 1995, 1996, and 1997, respectively. (b) For 1993, earnings are inadequate to cover fixed charges by $50.0 million. Alaska Airlines Financial and Statistical Data Quarter Ended December 31 Year Ended December 31 Financial Data (in millions): 1996 1997 % Change 1996 1997 % Change Operating Revenues: Passenger $254.8 $313.0 22.8 $1,146.8 $1,297.0 13.1 Freight and mail 19.3 20.7 7.3 82.7 82.9 0.2 Other - net 18.4 16.2 (12.0) 67.8 68.0 0.3 Total Operating Revenues 292.5 349.9 19.6 1,297.3 1,447.9 11.6 Operating Expenses: Wages and benefits 96.8 106.1 9.6 383.6 423.8 10.5 Employee profit sharing (6.7) 2.4 NM 0.9 12.1 NM Contracted services 10.3 11.6 12.6 36.9 42.5 15.2 Aircraft fuel 51.5 49.3 (4.3) 200.5 199.7 (0.4) Aircraft maintenance 16.3 18.6 14.1 57.1 67.4 18.0 Aircraft rent 37.6 38.2 1.6 146.0 148.5 1.7 Food and beverage service 10.6 11.8 11.3 44.2 46.7 5.7 Commissions 19.7 22.9 16.2 88.7 100.8 13.6 Other selling expenses 14.5 11.7 (19.3) 64.3 63.9 (0.6) Depreciation and amortization 13.6 14.9 9.6 55.9 56.9 1.8 Gain on sale of assets (5.7) (0.9) NM (9.3) (1.2) NM Landing fees and other rentals 12.4 12.7 2.4 49.9 53.1 6.4 Other 22.6 26.2 15.9 88.6 99.4 12.2 Total Operating Expenses 293.5 325.5 10.9 1,207.3 1,313.6 8.8 Operating Income (Loss) (1.0) 24.4 NM 90.0 134.3 49.2 Interest income 3.1 3.9 11.5 12.2 Interest expense (6.1) (5.9) (29.7) (25.0) Interest capitalized 0.6 1.1 0.6 3.4 Other - net 1.3 0.1 2.1 2.5 (1.1) (0.8) (15.5) (6.9) Income (Loss) Before Income Tax $(2.1) $23.6 $74.5 $127.4 Operating Statistics: Revenue passengers (000) 2,804 2,958 5.5 11,805 12,284 4.1 RPMs (000,000) 2,307 2,490 7.9 9,831 10,386 5.6 ASMs (000,000) 3,495 3,847 10.1 14,904 15,436 3.6 Passenger load factor 66.0% 64.7% (1.3)pts 66.0% 67.3% 1.3 pts Breakeven load factor 69.3% 60.2% (9.1)pts 62.4% 60.5% (1.9)pts Yield per passenger mile 11.04c 12.57c 13.8 11.67c 12.49c 7.1 Operating revenue per ASM 8.37c 9.10c 8.7 8.70c 9.38c 7.8 Operating expenses per ASM 8.40c 8.46c 0.8 8.10c 8.51c 5.1 Fuel cost per gallon 80.7c 71.7c (11.0) 75.2c 72.6c (3.5) Fuel gallons (000,000) 63.9 68.8 7.7 266.6 275.2 3.2 Average number of employees 7,923 8,223 3.8 7,652 8,236 7.6 Aircraft utilization (block hours) 10.8 11.2 3.7 11.3 11.4 0.9 Operating fleet at period-end 74 78 5.4 74 78 5.4 NM = Not Meaningful c=cents Horizon Air Financial and Statistical Data Quarter Ended December 31 Year Ended December 31 Financial Data (in millions): 1996 1997 % Change 1996 1997 % Change Operating Revenues: Passenger $64.7 $72.7 12.4 $287.3 $289.5 0.8 Freight and mail 2.8 2.7 (3.6) 11.2 11.2 0.0 Other - net 0.7 1.0 42.9 2.8 2.9 3.6 Total Operating Revenues 68.2 76.4 12.0 301.3 303.6 0.8 Operating Expenses: Wages and benefits 23.3 23.9 2.6 92.5 94.4 2.1 Employee profit sharing (0.7) 0.8 NM 0.0 1.4 NM Contracted services 1.6 1.7 6.2 5.8 6.3 8.6 Aircraft fuel 9.3 8.4 (9.7) 33.7 32.8 (2.7) Aircraft maintenance 10.8 8.0 (25.9) 41.7 41.4 (0.7) Aircraft rent 9.0 9.4 4.4 35.3 35.5 0.6 Food and beverage service 0.7 0.5 (28.6) 2.5 1.9 (24.0) Commissions 4.4 4.1 (6.8) 19.2 17.9 (6.8) Other selling expenses 4.3 3.6 (16.3) 17.5 16.5 (5.7) Depreciation and amortization 2.9 2.7 (6.9) 11.4 11.2 (1.8) Loss (gain) on sale of assets (0.6) (0.1) NM 0.2 (0.7) NM Landing fees and other rentals 3.2 3.5 9.4 12.9 13.5 4.7 Other 7.1 6.7 (5.6) 28.5 25.7 (9.8) Total Operating Expenses 75.3 73.2 (2.8) 301.2 297.8 (1.1) Operating Income (Loss) (7.1) 3.2 NM 0.1 5.8 NM Interest income 0.2 0.0 0.3 0.1 Interest expense (0.3) (0.3) (0.9) (1.8) Interest capitalized 0.3 0.6 0.4 1.8 Other - net 0.1 0.1 0.4 0.4 0.3 0.4 0.2 0.5 Income (Loss) Before Income Tax $(6.8) $3.6 $0.3 $6.3 Operating Statistics: Revenue passengers (000) 903 938 3.9 3,753 3,686 (1.8) RPMs (000,000) 211 231 9.6 867 889 2.6 ASMs (000,000) 365 376 2.9 1,462 1,446 (1.1) Passenger load factor 57.8% 61.5% 3.7 pts 59.3% 61.5% 2.2 pts Breakeven load factor 65.4% 58.3% (7.1)pts 59.3% 60.2% 0.9 pts Yield per passenger mile 30.71c 31.48c 2.5 33.14c 32.56c (1.8) Operating revenue per ASM 18.70c 20.32c 8.7 20.61c 21.00c 1.9 Operating expenses per ASM 20.64c 19.47c (5.7) 20.60c 20.60c (0.0) Fuel cost per gallon 84.4c 76.3c (9.6) 78.9c 77.5c (1.7) Fuel gallons (000,000) 11.0 11.0 0.0 42.7 42.4 (0.7) Average number of employees 2,947 2,774 (5.8) 2,891 2,756 (4.7) Aircraft utilization (block hours) 7.3 7.1 (2.7) 7.7 7.1 (7.8) Operating fleet at period-end 62 62 0.0 62 62 0.0 NM = Not Meaningful c=cents ITEM 7.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Industry Conditions During 1997, as part of the Taxpayer Relief Act, the 10% passenger ticket tax was replaced with a new system that combines a percentage tax with a per passenger segment fee. Effective October 1, 1997, the ticket tax is 9% plus $1 per segment. The percentage tax is scheduled to decrease over time and the segment fee is scheduled to increase. The $6 international departure tax has increased to $12 and a new $12 international arrival tax has been added. However, the Act retains the $6 rate for travel between Alaska and the U.S. mainland. This tax and the international taxes will be indexed to the CPI beginning January 1, 1999. The Taxpayer Relief Act also included these items that will affect the Company and the airline industry: (a) a new tax of 7.5% on payments to air carriers for the sale of miles in frequent flyer programs; (b) a phased-in increase from 50% to 80% for the deductible percentage of per diems paid to flight crews; and (c) faster cost recovery for alternative minimum tax purposes of aircraft purchased in 1999 and later years. During 1996, fuel prices increased significantly for the Company and most of its competitors (approximately 20% or 12 cents per gallon over 1995 levels for Alaska Airlines). During 1997, fuel prices decreased approximately 3.5% from 1996 levels. RESULTS OF OPERATIONS 1997 Compared with 1996 Consolidated net income in 1997 was $72.4 million, or $4.90 per share (basic) and $3.53 per share (diluted), compared with net income of $38.0 million, or $2.67 per share (basic) and $2.05 per share (diluted) in 1996. Consolidated operating income was $139.0 million in 1997 compared with $89.0 million in 1996. Of the $50.0 million improvement, $35.6 million occurred in the fourth quarter. Severe winter storms, high fuel prices and matching of competitors' lower fares adversely affected the 1996 fourth quarter. Alaska's annual operating income improved by $44.3 million, while Horizon's improved by $5.7 million. A discussion of operating results for the two airlines follows. Alaska Airlines Operating income increased 49.2% to $134.3 million, resulting in a 9.3% operating margin as compared to a 6.9% margin in 1996. 1997 operating revenue per available seat mile (ASM) increased 7.8% to 9.38 cents while operating expenses per available seat mile increased 5.1% to 8.51 cents. The increase in revenue per ASM was due to a 7.1% increase in system passenger yield combined with a 1.3 point improvement in passenger load factor. Most markets, including the three largest (Pacific Northwest - Southern California, Seattle - Anchorage and Pacific Northwest - Northern California), experienced increases in yields. Most markets also experienced increases in load factor including the Seattle- Anchorage market, which had a 4.9 point improvement. The higher yields and load factors reflect a more stabilized competitive environment in 1997. Freight and mail revenues decreased 3.6% in the first half of 1997 due to more competition and increased 4.1% in the second half due to increased cargo capacity and higher mail rates. Other-net revenues were essentially unchanged because an additional $5 million of proceeds from partners in Alaska's frequent flyer program were offset by a similar increase in the frequent flyer award liability. The table below shows the major operating expense elements on a cost per available seat mile (ASM) basis in 1996 and 1997. Alaska Airlines 	Operating Expenses Per ASM (In Cents) 		1996 	1997 	Change 	% Change Wages and benefits	 2.57 	2.74 	.17 	7 Employee profit sharing	 .01	 .08 	.07 	NM Contracted services	 .25 	.28 	.03 	12 Aircraft fuel 	1.35 	1.29 	(.06) 	(4) Aircraft maintenance 	.38	 .44 	.06 	16 Aircraft rent	 .98 	.96 	(.02) 	(2) Food and beverage service	 .30 	.30 	-- 	-- Commissions	 .59 	.65 	.06 	10 Other selling expenses 	.43 .41 	(.02) 	(5) Depreciation and amortization 	.38 	.37 	(.01) 	(3) Gain on sale of assets 	(.06) 	(.01) 	.05 	NM Landing fees and other rentals 	.33 	.34 	.01 	3 Other 	.59	 .66 	.07 	12 Alaska Airlines Total	 8.10 	8.51 	.41	 5 NM = Not Meaningful Alaska's higher unit costs were primarily due to increased labor costs. Significant unit cost changes are discussed below. Employees increased 7.6% (primarily in reservations and customer service positions) to service the 4.1% increase in passengers and also to improve on-time within 15 minutes flight departure performance, which improved from 77% on-time in 1996 to 82% on-time in 1997. Excluding profit sharing, average wages and benefits per employee were up 2.7%, primarily due to higher pilot wage rates and higher health insurance costs. The net effect was that wages and benefits expense increased more than the ASM growth, resulting in a 7% increase in cost per ASM. Profit sharing expense increased the cost per ASM by .07 cents. Effective for 1997, Alaska changed its profit sharing program so that eligible employees will receive their pro rata share of 10% of Alaska's adjusted pre-tax profits starting with the first dollar of pre-tax profits. Fuel expense per ASM decreased 4%, primarily due to a 3.5% decrease in the price of fuel. Maintenance expense per ASM increased 16% because significantly more engine repair expense was incurred in 1997 and a smaller proportion of airframe maintenance costs were capitalized. Commission expense per ASM increased 10%, less than the 13% increase in passenger revenues because a lower percentage of sales were made by travel agents. In addition, the commission rate paid to travel agents decreased from 10% to 8% for sales made after September 30, 1997. The gain on sale of assets in 1996 is primarily due to the sale of three jet aircraft. Other expense per ASM increased 12%, primarily due to higher costs related to property and other taxes, flight crew hotels, employee hiring and communications. Horizon Air Operating income increased from $0.1 million to $5.8 million, resulting in a 1.9% operating margin as compared to a zero margin in 1996. For 1997, operating revenue per ASM increased 1.9% to 21.00 cents while operating expenses per available seat mile remained even at 20.60 cents. The increase in revenue per ASM was due to a 2.2 point increase in system passenger load factor, partially offset by a 1.8% decrease in passenger yield. The Seattle-to-Canada, Seattle-to-Montana and the Seattle-Boise markets experienced significant increases in load factors. The decrease in yields is believed to be due to a longer average passenger trip length in 1997 and to the presence of the passenger transportation tax for 10 months in 1997 versus 4 months in 1996. The table below shows the major operating expense elements on a cost per ASM basis for Horizon in 1996 and 1997. Horizon Air	 Operating Expenses Per ASM (In Cents) 		 1996 	1997 	Change 	% Change Wages and benefits	 6.33 	6.53 	.20 	3 Employee profit sharing	 -- 	.09 	.09 	NM Contracted services	 .39	 .43	 .04 	10 Aircraft fuel 	2.30 	2.27 	 (.03) 	(1) Aircraft maintenance	 2.85 	2.86 	.01 	-- Aircraft rent	 2.41 	2.45	 .04 	2 Food and beverage service	 .17	 .13 	(.04) 	(24) Commissions	 1.31 	1.24	 (.07) 	(5) Other selling expenses	 1.20 	1.14 	(.06) 	(5) Depreciation and amortization 	.78 	.77 	(.01) 	(1) Loss (gain) on sale of assets	 .01 	(.05) 	(.06) 	NM Landing fees and other rentals 	.88 	.93 	.05 	6 Other 	1.97 	 1.81 	(.16) 	(8) Horizon Air Total	 20.60 	20.60 	--	 -- NM = Not Meaningful Wages and benefits per ASM increased, primarily due to higher wage rates, payroll taxes and more 401(k) plan employer matching costs. Profit sharing expense increased due to profitable operations. Contracted services increased due to higher security screening and hiring costs. Food and beverage decreased due to a conscious effort to reduce costs and improve efficiency. Other expense decreased due to less flight crew training and personnel costs, lower insurance rates and decreased supplies expense. Consolidated Nonoperating Income (Expense) Nonoperating expense decreased $9.3 million to $15.4 million, primarily due to smaller average debt balances, lower interest rates on variable interest rate debt and more interest capitalized. 1996 Compared with 1995 Consolidated net income in 1996 was $38.0 million, or $2.67 per share (basic) and $2.05 per share (diluted), compared with net income of $17.3 million, or $1.28 per share (basic) and $1.26 per share (diluted) in 1995. Consolidated operating income was $89.0 million compared with $75.7 million in 1995. Alaska's operating income improved by $17.7 million, but it was offset by lower operating results at Horizon. Alaska Airlines Operating income increased 24.5% to $90.0 million, resulting in a 6.9% operating margin as compared with a 6.3% margin in 1995. Operating revenue per available seat mile (ASM) increased 5.8% to 8.70 cents while operating expenses per ASM decreased 5.1% to 8.10 cents. The increase in revenue per ASM was primarily due to a 4.2 point improvement in system passenger load factor. Higher unit costs were largely due to higher fuel prices and heavier passenger loads. Horizon Air Operating income decreased 98% to $0.1 million primarily due to the fourth quarter, which was negatively impacted by adverse weather, increased competition, higher than normal maintenance expense and costs associated with transitioning to a simplified fleet. Consolidated Nonoperating Income (Expense) Nonoperating expense decreased from $41.7 million to $24.7 million primarily due to lower interest rates on variable debt and smaller average debt balances. In addition, 1995 included a $2.2 million write-off of capitalized debt issuance costs. LIQUIDITY AND CAPITAL RESOURCES The table below presents the major indicators of financial condition and liquidity. 	 Dec. 31, 1996	 Dec. 31, 1997	 Change 	(In millions, except debt-to-equity and per share amounts) Cash and marketable securities 	 $101.8	 $212.7 	 $110.9 Working capital (deficit)	 	(185.6) 		(48.7)	 	136.9 Long-term debt and capital lease obligations	 	404.1 		401.4	 	(2.7) Shareholders' equity		 272.5	 	475.3	 	202.8 Book value per common share 	 $18.83 	 $26.00	 $7.17 Debt-to-equity	 60%:40% 	46%:54%	 NA 1997 Financial Changes The Company's cash and marketable securities portfolio increased by $111 million during 1997. Operating activities provided $205 million of cash in 1997. Additional cash was provided by the sale and leaseback of four B737-400 aircraft and 13 Dash 8-200 aircraft ($247 million), issuance of common stock ($129 million) and issuance of long-term debt ($28 million). Cash was used for $439 million of capital expenditures including the purchase of two new MD-83 aircraft, three new B737-400 aircraft, a previously leased B737-400 aircraft, 13 new Dash 8-200 aircraft, flight equipment deposits and airframe and engine overhauls, net repayment of short-term borrowings ($47 million) and the repayment of debt ($26 million). Like most airlines, the Company has a working capital deficit. The existence of a working capital deficit has not in the past impaired the Company's ability to meet its obligations as they become due and it is not expected to do so in the future. Shareholders' equity increased by $203 million due to the sale of 3.45 million shares of common stock and net income of $72 million. These factors increased equity to 54% of capital, an improvement of 14 percentage points. Financing Activities During 1997, Alaska sold four B737-400 aircraft and leased them back for 18 years; Horizon sold 13 Dash 8-200 aircraft and leased them back for 15 years. In November 1997, Standard & Poors raised its corporate credit rating on Air Group and Alaska to double B minus from single B plus, citing a stabilized competitive position and improving financial profile. In January 1998, the Company called its 6-7/8% convertible subordinated debentures and, based on recent stock prices, expects that substantially all of them will be converted into 1.608 million shares of common stock. Commitments During 1997, Alaska's lease commitments increased approximately $194 million due to the sale and leaseback of four B737- 400 aircraft. In addition, Alaska ordered 15 Boeing 737 aircraft along with an option to acquire 10 more. The value of the orders is approximately $510 million. Horizon's lease commitments increased approximately $156 million due to the acquisition of 13 new Dash 8-200 aircraft. In addition, Horizon ordered 10 new Dash 8-200 aircraft, valued at approximately $100 million. At December 31, 1997, the Company had firm orders for 46 aircraft with a total cost of approximately $1,015 million as set forth below. In addition, Alaska has options to acquire 22 more B737s and Horizon has options to acquire 25 more Dash 8- 200s. Alaska and Horizon expect to finance the new planes with either leases, long-term debt or internally generated cash.	 	Delivery Period - Firm Orders Aircraft	 1998 	1999	 2000	 2001	 2002 	2003-05 	 Total Boeing B737-400 	9 	2	 -- 	-- 	-- 	-- 	 11 Boeing B737-700 	-- 	3 	-- 	-- 	--	 --	 3 Boeing B737-900 	-- 	-- 	-- 	5	 5 	-- 	 10 de Havilland Dash 8-200 	11 	1 	3	 --	 -- 	 7 	22 Total 	20 	6	 3	 5 	5	 7	 46 Cost (Millions) 	$398 	$167 	$30 	$175 	$175 	$70 	$1,015 The Company accrues the costs associated with returning leased aircraft over the lease period. As leased aircraft are retired, the costs are charged against the established reserve. At December 31, 1997, $43 million was reserved for leased aircraft returns. Deferred Taxes At December 31, 1997, net deferred tax liabilities were $62 million, which includes $112 million of net temporary differences offset by $50 million of Alternative Minimum Tax (AMT) credits. The Company believes that all of its deferred tax assets, including its AMT credits, will be realized through profitable operations. Year 2000 Computer Issue During the past eight years, the Company has been engaged in a number of projects to improve its information technology infrastructure. The Company expects to complete these projects during 1998 and 1999 at an estimated cost of $5 to $10 million. As a result of these activities, the Company's systems will be Year 2000 compliant. The direct cost of projects solely intended to correct Year 2000 problems is expected to be less than $1 million. 1996 Financial Changes The Company's cash and marketable securities portfolio decreased by $33 million during 1996. Operating activities provided $223 million of cash in 1996. Additional cash was provided by the sale and leaseback of three B737-400 aircraft ($86 million), the sale of three MD-80 aircraft ($52 million) and proceeds received from the issuance of common stock ($21 million). Cash was used for the purchase of two new MD-83 aircraft, two used B737-400 aircraft, two previously leased B737-200Cs, airframe and engine overhauls and other capital expenditures ($209 million), and aircraft purchase deposits ($61 million). Cash was also used to repay net short-term borrowings ($19 million), and $134 million of long-term debt (including $100 million repaid early). During 1996, Alaska replaced its $75 million credit facility with a $125 million credit facility with substantially the same terms and conditions. 1995 Financial Changes The Company's cash and marketable securities portfolio increased by $30 million during 1995. Operating activities provided $126 million of cash in 1995. Additional cash was provided by flight equipment deposits returned ($11 million), net short-term borrowings ($41 million), the sale and leaseback of two B737-400 aircraft ($56 million) and new long-term debt proceeds ($129 million). Cash was used for the purchase of one previously leased B737-400 aircraft, airframe and engine overhauls and other capital expenditures ($103 million) and the repayment of debt and capital lease obligations ($237 million). Included in the above numbers are the June 1995 issuance of $132.3 million of 6-1/2% convertible senior debentures due 2005, and the August 1995 redemption of the 7-1/4% zero coupon, convertible subordinated notes for $127.7 million EFFECT OF INFLATION Inflation and specific price changes do not have a significant effect on the Company's operating revenues, operating expenses and operating income, because such revenues and expenses generally reflect current price levels. ITEM 8.	CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14. ITEM 9.	DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See "Election of Directors," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 20, 1997. See "Executive Officers of the Registrant" in Part I following Item 4 for information relating to executive officers. ITEM 11.	EXECUTIVE COMPENSATION See "Executive Compensation," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 20, 1997. ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Security Ownership of Certain Beneficial Owners and Management," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 19, 1997. ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Transactions with Management and Others," incorporated herein by reference from the definitive Proxy Statement for Air Group's Annual Meeting of Shareholders to be held on May 20, 1997. PART IV ITEM 14.	EXHIBITS, CONSOLIDATED FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Consolidated Financial Statements:	 Page(s) Selected Quarterly Consolidated Financial Information (Unaudited)	 5 Consolidated Balance Sheet as of December 31, 1996 and 1997	 20-21 Consolidated Statement of Income for the years ended December 31, 1995, 1996 and 1997	 22 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1995, 1996 and 1997	 23 Consolidated Statement of Cash Flows for the years ended December 31, 1995, 1996 and 1997	 24 Notes to Consolidated Financial Statements	 25-32 Report of Independent Public Accountants	 33 Consolidated Financial Statement Schedule II, Valuation and Qualifying Accounts, for the years ended December 31, 1995, 1996 and 1997 						 34 See Exhibit Index on page 35. (b)	A report on Form 8-K announcing orders for 15 Boeing 737 series aircraft was filed on November 20, 1997 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALASKA AIR GROUP, INC. By:	 /s/ John F. Kelly							Date: February 10, 1998 	John F. Kelly, Chairman, Chief Executive Officer and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on February 10, 1998 on behalf of the registrant and in the capacities indicated. 	 /s/ John F. Kelly			Chairman, Chief Executive Officer, President and Director 		John F. Kelly		 	 /s/ Harry G. Lehr			Senior Vice President/Finance 		Harry G. Lehr 		(Principal Financial Officer) 				 	 /s/ Bradley D. Tilden		Controller 		Bradley D. Tilden	 	(Principal Accounting Officer) 				 	 /s/ Ronald F. Cosgrave		Director 		Ronald F. Cosgrave 	 /s/ Mary Jane Fate		Director 		Mary Jane Fate 	 /s/ Bruce R. Kennedy		Director 		Bruce R. Kennedy 	 /s/ R. Marc Langland		Director 		R. Marc Langland 	 /s/ Byron I. Mallott		Director 		Byron I. Mallott 	 /s/ Robert L. Parker, Jr.		Director 		Robert L. Parker, Jr. 	 /s/ John V. Rindlaub.		Director 		John V. Rindlaub. 	 /s/ Richard A. Wien		Director 		Richard A. Wien CONSOLIDATED BALANCE SHEET Alaska Air Group, Inc. ASSETS As of December 31 (In Millions) 1996 1997 Current Assets Cash and cash equivalents $49.4 $102.6 Marketable securities 52.4 110.1 Receivables - less allowance for doubtful accounts (1996 - $1.3; 1997 - $1.2) 69.7 72.6 Inventories and supplies 47.8 47.2 Prepaid expenses and other assets 80.9 92.1 Total Current Assets 300.2 424.6 Property and Equipment Flight equipment 851.6 950.1 Other property and equipment 234.8 258.5 Deposits for future flight equipment 84.4 108.9 1,170.8 1,317.5 Less accumulated depreciation and amortization 326.3 373.8 844.5 943.7 Capital leases: Flight and other equipment 44.4 44.4 Less accumulated amortization 25.5 27.5 18.9 16.9 Total Property and Equipment - Net 863.4 960.6 Intangible Assets - Subsidiaries 61.6 59.6 Other Assets 86.2 88.3 Total Assets $1,311.4 $1,533.1 See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEET Alaska Air Group, Inc. LIABILITIES AND SHAREHOLDERS' EQUITY As of December 31 (In Millions) 1996 1997 Current Liabilities Accounts payable $65.4 $73.9 Accrued aircraft rent 52.8 60.7 Accrued wages, vacation and payroll taxes 51.5 70.1 Other accrued liabilities 82.0 73.5 Short-term borrowings (Interest rate: 1996 - 5.6%) 47.0 - Air traffic liability 163.0 166.4 Current portion of long-term debt and capital lease obligations 24.1 28.7 Total Current Liabilities 485.8 473.3 Long-Term Debt and Capital Lease Obligations 404.1 401.4 Other Liabilities and Credits Deferred income taxes 49.5 72.3 Deferred income 18.1 19.5 Other liabilities 81.4 91.3 149.0 183.1 Commitments Shareholders' Equity Preferred stock, $1 par value Authorized: 5,000,000 shares - - Common stock, $1 par value Authorized: 50,000,000 shares Issued: 1996 - 17,223,281 shares 1997 - 21,030,762 shares 17.2 21.0 Capital in excess of par value 166.8 292.5 Treasury stock, at cost: 1996 - 2,748,550 shares 1997 - 2,748,030 shares (62.6) (62.6) Deferred compensation (2.7) (1.8) Retained earnings 153.8 226.2 272.5 475.3 Total Liabilities and Shareholders' Equity $1,311.4 $1,533.1 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF INCOME Alaska Air Group, Inc. Year Ended December 31 (In Millions Except Per Share Amounts) 1995 1996 1997 Operating Revenues Passenger $1,258.2 $1,427.7 $1,574.5 Freight and mail 95.2 93.9 94.1 Other - net 64.1 70.6 70.8 Total Operating Revenues 1,417.5 1,592.2 1,739.4 Operating Expenses Wages and benefits 427.8 477.0 531.7 Contracted services 36.8 42.7 48.8 Aircraft fuel 181.2 234.2 232.6 Aircraft maintenance 79.2 98.7 108.7 Aircraft rent 172.1 181.2 183.9 Food and beverage service 44.7 46.6 48.5 Commissions 93.1 101.5 106.6 Other selling expenses 72.8 81.8 80.4 Depreciation and amortization 68.3 67.5 68.3 Loss (gain) on sale of assets 0.2 (9.1) (1.9) Landing fees and other rentals 57.7 62.4 66.2 Other 107.9 118.7 126.6 Total Operating Expenses 1,341.8 1,503.2 1,600.4 Operating Income 75.7 89.0 139.0 Nonoperating Income (Expense) Interest income 10.4 11.1 10.6 Interest expense (51.5) (38.4) (33.6) Interest capitalized 0.2 1.0 5.3 Other - net (0.8) 1.6 2.3 (41.7) (24.7) (15.4) Income before income tax 34.0 64.3 123.6 Income tax expense 16.7 26.3 51.2 Net Income $17.3 $38.0 $72.4 Basic Earnings Per Share $1.28 $2.67 $4.90 Diluted Earnings Per Share $1.26 $2.05 $3.53 Shares used for computation: Basic 13.471 14.241 14.785 Diluted 20.765 22.458 22.689 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY Alaska Air Group, Inc. Capital in Treasury Deferred Common Excess of Stock Compen- Retained (In Millions) Stock Par Value at Cost sation Earnings Total Balances at December 31, 1994 $16.6 $152.8 $(71.8) $(4.8) $98.5 $191.3 1995 net income 17.3 17.3 Stock issued under stock plans 0.1 2.6 2.7 Treasury stock purchase Employee Stock Ownership Plan shares allocated 1.2 1.2 Balances at December 31, 1995 16.7 155.4 (71.8) (3.6) 115.8 212.5 1996 net income 38.0 38.0 Stock issued under stock plans 0.5 9.7 10.2 Treasury stock activity: Purchase (4,466 shares) (0.1) (0.1) Sale (409,524 shares) 1.7 9.3 11.0 Employee Stock Ownership Plan shares allocated 0.9 0.9 Balances at December 31, 1996 17.2 166.8 (62.6) (2.7) 153.8 272.5 1997 net income 72.4 72.4 Issuance of 3,450,000 shares of common stock 3.5 118.4 121.9 Stock issued under stock plans 0.3 7.1 7.4 Stock issued for convertible subordinated debentures 0.0 0.2 0.2 Treasury stock activity: Purchase (2,094 shares) (0.1) (0.1) Sale (2,614 shares) 0.1 0.1 Employee Stock Ownership Plan 0.0 shares allocated 0.9 0.9 Balances at December 31, 1997 $21.0 $292.5 $(62.6) $(1.8) $226.2 $475.3 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF CASH FLOWS Alaska Air Group, Inc. Year Ended December 31 (In Millions) 1995 1996 1997 Cash flows from operating activities: Net income $17.3 $38.0 $72.4 Adjustments to reconcile net income to cash: Depreciation and amortization 68.3 67.5 68.3 Amortization of airframe and engine overhau 24.3 34.6 35.1 Loss (gain) on disposition of assets and de 1.9 (9.1) (1.9) Increase in deferred income taxes 12.4 8.5 22.8 Decrease (increase) in accounts receivable (18.5) 18.8 (2.9) Increase in other current assets (17.2) (13.9) (10.6) Increase in air traffic liability 1.0 38.6 3.4 Increase in other current liabilities 15.5 36.9 26.5 Other-net 20.5 3.0 (7.9) Net cash provided by operating activities 125.5 222.9 205.2 Cash flows from investing activities: Proceeds from disposition of assets 3.8 58.1 6.9 Purchases of marketable securities (169.4) (53.5) (443.6) Sales and maturities of marketable securities 153.5 110.4 385.9 Flight equipment deposits returned 10.8 1.1 8.7 Additions to flight equipment deposits (0.5) (60.5) (68.4) Additions to property and equipment (102.8) (209.3) (370.6) Restricted deposits and other 3.9 0.5 (2.0) Net cash used in investing activities (100.7) (153.2) (483.1) Cash flows from financing activities: Proceeds from short-term borrowings 69.9 47.0 56.4 Repayment of short-term borrowings (29.0) (65.9) (103.4) Proceeds from sale and leaseback transactions 56.0 85.6 246.7 Proceeds from issuance of long-term debt 128.8 - 28.0 Long-term debt and capital lease payments (237.4) (133.9) (25.9) Proceeds from issuance of common stock 2.8 10.2 129.3 Proceeds from sale of treasury stock - 10.9 - Gain (loss) on debt retirement (1.7) - - Net cash provided by (used in) financing activities (10.6) (46.1) 331.1 Net increase in cash and cash equivalents 14.2 23.6 53.2 Cash and cash equivalents at beginning of year 11.6 25.8 49.4 Cash and cash equivalents at end of year $25.8 $49.4 $102.6 Supplemental disclosure of cash paid during the year for: Interest (net of amount capitalized) $52.6 $43.5 $28.7 Income taxes 5.0 20.6 22.1 Noncash investing and financing activities: None None None See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Alaska Air Group, Inc. December 31, 1997 Note 1.	Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of Alaska Air Group, Inc. (Company or Air Group) and its subsidiaries, the principal subsidiaries being Alaska Airlines, Inc. (Alaska) and Horizon Air Industries, Inc. (Horizon). All significant intercompany transactions are eliminated. Preparation of financial statements requires the use of management's estimates. Actual results could differ from those estimates. Certain reclassifications have been made in prior years' financial statements to conform to the 1997 presentation. Alaska and Horizon operate as airlines. However, their business plans, competition and economic risks differ substantially. Alaska is a major airline serving Alaska, the West Coast, Mexico and Eastern Russia. It operates an all jet fleet and its average passenger trip is 846 miles. Horizon is a regional airline serving the Pacific Northwest, Northern California and Western Canada. It operates both jet and turboprop aircraft, and its average passenger trip is 241 miles. Substantially all of Alaska's and Horizon's sales occur in the United States. See Note 11 for operating segment information. Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with original maturities of three months or less. They are carried at cost, which approximates market. The Company reduces its cash balance when checks are disbursed. Due to the time delay in checks clearing the banks, the Company normally maintains a negative cash balance on its books which is reported as a current liability. The amount of the negative cash balance was $12.5 million and $10.1 million at December 31, 1996 and 1997, respectively. Inventories and Supplies Expendable and repairable aircraft parts, as well as other materials and supplies, are stated at average cost. An allowance for obsolescence is accrued on a straight-line basis over the estimated useful lives of the aircraft. Inventories related to the retired B727 fleet and other surplus items are carried at their net realizable value. The allowance at December 31, 1996 and 1997 for all inventories was $16.1 million and $18.0 million, respectively. Property, Equipment and Depreciation Property and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives, which are as follows: Aircraft and other 	flight equipment	 8-20 years Buildings 	10-30 years Capitalized leases and 	leasehold improvements 	Term of lease Other equipment 	3-15 years Assets and related obligations for items financed under capital leases are initially recorded at an amount equal to the present value of the future minimum lease payments. The cost of major airframe overhauls, engine overhauls, and other modifications which extend the life or improve the usefulness of aircraft are capitalized and amortized over their estimated period of use. Other repair and maintenance costs are expensed when incurred. The Company periodically reviews long-lived assets for impairment. Capitalized Interest Interest is capitalized on flight equipment purchase deposits and ground facilities progress payments as a cost of the related asset and is depreciated over the estimated useful life of the asset. Intangible Assets-Subsidiaries The excess of the purchase price over the fair value of net assets acquired is recorded as an intangible asset and is amortized over 40 years. Accumulated amortization at December 31, 1996 and 1997 was $21.1 million and $23.1 million, respectively. Deferred Income Deferred income results from the sale and leaseback of aircraft, the receipt of manufacturer or vendor credits, and from the sale of foreign tax benefits. This income is recognized over the term of the applicable agreements. Frequent Flyer Awards Alaska operates a frequent flyer award program that provides travel awards to members based on accumulated mileage. The estimated incremental cost of providing free travel is recognized as an expense and accrued as a liability as miles are accumulated. Alaska also defers recognition of income on a portion of the payments it receives from travel partners associated with its frequent flyer program. The frequent flyer award liability is relieved as travel awards are issued. Passenger Revenues Passenger revenues are considered earned at the time service is provided. Tickets sold but not yet used are reported as air traffic liability. Contracted Services Contracted services includes the expenses for aircraft ground handling, security, temporary employees and other similar services. Other Selling Expenses Other selling expenses includes credit card commissions, computerized reservations systems (CRS) charges, advertising and promotional costs. The costs of advertising are expensed the first time the advertising takes place. Advertising expense was $15.2 million, $15.6 million, and $11.0 million, respectively, in 1995, 1996 and 1997. Income Taxes Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Stock Options The Company applies APB Opinion No. 25 and related Interpretations in accounting for stock options. See Note 6 for more information. Derivative Financial Instruments The Company periodically enters into interest rate swap agreements to hedge interest rate risk. The differential to be paid or received from these agreements is accrued as interest rates change and is recognized currently in the income statement. The Company periodically enters into hedge agreements to reduce its exposure to fluctuations in the price of jet fuel. A gain or loss is recorded quarterly if the fuel index average exceeds the ceiling price or falls below the floor price. Note 2.	Marketable Securities Marketable securities are investments that are readily convertible to cash and have original maturities that exceed three months. They are classified as available for sale and consisted of the following at December 31 (in millions): 	1996 	1997 Cost: U.S. government securities 	$48.4	 $75.1 Asset backed obligations 	4.0 	35.0 		$52.4 	$110.1 Fair value: U.S. government securities 	$48.2 	$75.2 Asset backed obligations	 4.0 	35.0 		$52.2 $110.2 There were no material unrealized holding gains or losses at December 31, 1996 or 1997. Of the marketable securities on hand at December 31, 1997, 54% will mature during 1998 and the remainder will mature during 1999. Based on specific identification of securities sold, the following occurred in 1996 and 1997 (in millions): 	1996 	1997 Proceeds from sales	 	$110.4 	$385.9 Gross realized gains	 	0.3 	0.1 Gross realized losses 		0.1 	0.1 Realized gains and losses are reported as a component of interest income. Note 3.	Other Assets Other assets consisted of the following at December 31 (in millions): 	1996	1997 Restricted deposits 		 $64.6	 $67.5 Leasehold rights	 	8.4 	5.5 Deferred costs and other		 13.2 	15.3 		$86.2 	$88.3 Leasehold rights and deferred costs are amortized over the term of the related lease or contract. Note 4.	Long-term Debt and Capital Lease Obligations At December 31, 1996 and 1997, long-term debt and capital lease obligations were as follows (in millions): 	1996 	1997 8.7%* fixed rate notes payable 	due through 2004	 $115.5 	$103.5 6.4%* variable rate notes payable 	due through 2009 	98.6 	114.9 6-1/2% convertible senior 	debentures due 2005	 132.3	 132.1 6-7/8% convertible subordinated 	debentures due 2004-2014 	54.0	 54.0 Long-term debt	 400.4 	404.5 Capital lease obligations	 27.8 	25.6 Less current portion	 (24.1)	 (28.7) 	$404.1 $401.4 * weighted average for 1997 At December 31, 1997, borrowings of $218.4 million are secured by flight equipment and real property. The 6-1/2% and 6-7/8% debentures are convertible into common stock at $21.50 and $33.60 per share, respectively, subject to adjustments in certain events. The 6-1/2% debentures are redeemable at the Company's option on or after June 15, 1998, initially at a redemption price of 104.33% of the principal amount, declining ratably to 100% over six years. The 6-7/8% debentures are redeemable at the Company's option at a redemption price of 101.38% of the principal amount at December 31, 1997, declining ratably to 100% on June 15, 1999. At December 31, 1997, Alaska had a $125 million credit facility with commercial banks. Advances under this facility may be for up to a maximum maturity of four years. Borrowings may be used for aircraft acquisitions or other corporate purposes, and they bear interest at a rate which varies based on LIBOR. At December 31, 1997, no borrowings were outstanding under this credit facility. Certain Alaska loan agreements contain provisions that require maintenance of specific levels of net worth, leverage and fixed charge coverage, and limit investments, lease obligations, sales of assets and additional indebtedness. At December 31, 1997, the Company was in compliance with all loan provisions, and under the most restrictive loan provisions, Alaska had $140 million of net worth above the minimum. At December 31, 1997, long-term debt principal payments for the next five years were (in millions): 1998		$26.3 1999		$26.3 2000		$57.3 2001		$47.6 2002		$14.5 Note 5.	Commitments Lease Commitments Lease contracts for 113 aircraft have remaining lease terms of one to 18 years. The majority of airport and terminal facilities are also leased. Total rent expense was $201.9 million, $214.7 million and $218.7 million, in 1995, 1996 and 1997, respectively. Future minimum lease payments under long-term operating leases and capital leases as of December 31, 1997 are shown below (in millions): 		Operating Leases 	Capital 		 Aircraft 	Facilities	 Leases 1998	 $178.2	 $16.9	 $ 4.1 1999	 165.6	 16.7 	4.1 2000 	156.3	 14.9 	4.1 2001	 140.3	 9.8	 4.1 2002	 137.5	 5.2	 4.1 Thereafter 	804.9	 71.0 	6.8 Total lease payments		$1,582.8	 $134.5 	27.3 Less amount representing interest		 (1.7) Present value of capital lease payments	 $25.6 Aircraft Commitments The Company has firm orders for 24 Boeing 737 series aircraft to be delivered between 1998 and 2002 and 22 Dash 8-200s to be delivered between 1998 and 2005. The total amount of these commitments is approximately $1.015 billion. As of December 31, 1997, deposits related to the future equipment deliveries were $100.6 million. In addition to the ordered aircraft, the Company holds purchase options on 22 Boeing 737s and 25 Dash 8-200s. Note 6.	Stock Plans Air Group has three stock option plans, which provide for the purchase of Air Group common stock at a stipulated price on the date of grant by certain officers and key employees of Air Group and its subsidiaries. Under the 1988 Plan, options for 1,720,700 shares were granted. Under the 1996 and 1997 Plans, options for 519,900 shares have been granted and, at December 31, 1997, 401,975 shares were available for grant. Under all plans, the incentive and nonqualified stock options granted have terms of up to approximately ten years. Grantees are 25% vested after one year, 50% after two years, 75% after three years and 100% after four years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in 1995, 1996 and 1997, respectively: dividend yield of 0%, 0% and 0%; volatility of 37%, 36% and 34%; risk- free interest rates of 6.46%, 6.33% and 5.69%; and expected lives of 5, 5 and 5 years. Using these assumptions, the weighted average fair value of options granted was $6.69, $9.58 and $14.04 in 1995, 1996 and 1997, respectively. Air Group follows APB Opinion 25 and related Interpretations in accounting for stock options. Accordingly, no compensation cost has been recognized for these plans. Had compensation cost for the Company's stock options been determined in accordance with Financial Accounting Standard 123, net income and earnings per share (EPS) would have been reduced to the pro forma amounts indicated below. The reductions in future years are likely to be larger than shown below because options vest over four years and new grants are typically made each year. 	1995 	1996 	1997 Net income (in millions): As reported 	$17.3 	$38.0 	$72.4 Pro forma	 17.1 	37.4 	71.4 Basic EPS: As reported 	$1.28 	$2.67 	$4.90 Pro forma	 1.27 	2.63 	4.83 Diluted EPS: As reported 	$1.26 $2.05 	$3.53 Pro forma	 1.25	 2.03 	3.48 Changes in the number of shares subject to option, with their weighted average exercise prices, are summarized below: 	Shares 	Price Outstanding, Dec. 31, 1994		1,044,143	 $17.15 Granted		 425,500	 15.37 Exercised		 (165,005) 	16.11 Canceled		 (143,050) 	17.80 Outstanding, Dec. 31, 1995		1,161,588 	$16.56 Granted		 379,900 	22.51 Exercised		 (504,138)	 17.05 Canceled	 	(45,525) 	17.13 Outstanding, Dec. 31, 1996		 991,825 	$18.57 Granted		 245,800 	35.25 Exercised	 	(349,575) 	17.36 Canceled	 	(8,125) 	17.03 Outstanding, Dec. 31, 1997		 879,925 	$23.72 At December 31, 1997, 245,800 of the outstanding options (none of which are currently exercisable) had an exercise price of $35.25 and a remaining contractual life of 10.0 years. The other 634,125 outstanding options had a weighted average exercise price of $19.24 (ranging from $15.00 to $24.00), and a weighted average remaining contractual life of 7.9 years. The number of shares exercisable at year-end with their weighted average exercise prices, are summarized below: 	 Shares 	Price December 31, 1995	 	596,338	 $17.24 December 31, 1996		 243,675	 16.70 December 31, 1997		 161,775	 19.08 Note 7.	Employee Benefit Plans Pension Plans Four defined benefit and five defined contribution retirement plans cover various employee groups of Alaska and Horizon. The defined benefit plans provide benefits based on an employee's term of service and average compensation for a specified period of time before retirement. Pension plans are funded as required by the Employee Retirement Income Security Act of 1974 (ERISA). The defined benefit plan assets are primarily common stocks and fixed income securities. Plan assets exceeded the accumulated benefit obligation at December 31, 1996 and 1997. The following table sets forth the funded status of the plans at December 31, 1996 and 1997 (in millions): 	1996 	1997 Benefit obligation - Vested	 $180.9 	$211.5 	Nonvested	 22.1 	38.4 Accumulated benefit obligation		 $203.0 	$249.9 Plan assets at fair value	 $223.7 	$289.2 Projected benefit obligation 		230.7 	307.4 Plan assets less projected benefit obligation	 (7.0) 	(18.2) Unrecognized transition asset		 (0.8)		 (0.5) Unrecognized prior service cost 		2.6	 	60.1 Unrecognized loss		 	32.6 		(0.8) Prepaid pension cost		 $ 27.4	 	$ 40.6 The weighted average discount rate used to determine the projected benefit obligation was 7.5% and 7.25% as of December 31, 1996 and 1997, respectively. The calculation assumed a weighted average rate of increase for future compensation levels of 5.1% and 3.2% for 1996 and 1997, respectively. The expected long-term rate of return on plan assets used in 1996 and 1997 was 10%. Net pension expense for the defined benefit plans included the following components for 1995, 1996 and 1997 (in millions):	 		1995 	1996 	1997 Service cost (benefits earned during the period)	 $	11.4	 $	15.9	 $	17.3 Interest cost on projected benefit obligation	 12.9 	15.4 	17.3 Actual return on assets	 (37.0) 	(23.6) 	(47.6) Net amortization 	and deferral 	23.3 	6.5 	26.4 Net pension expense	 $	10.6	 $	14.2	 $	13.4 The defined contribution plans are deferred compensation plans under section 401(k) of the Internal Revenue Code. Some of these plans require Company matching contributions based on a percentage of participants' contributions. One plan has an Employee Stock Ownership Plan (ESOP) feature. The ESOP owns Air Group common shares which are held in trust for eligible employees. The Company has recorded deferred compensation to reflect the value of the shares not yet allocated to eligible employees' accounts. As these shares are allocated to employees, compensation expense is recorded and deferred compensation is reduced. Alaska and Horizon also maintain an unfunded, noncontributory benefit plan for certain elected officers. The present value of unfunded benefits for this plan was accrued as of December 31, 1996 and 1997. Total expense for all pension plans was $22.2 million, $26.5 million and $29.0 million, respectively, in 1995, 1996 and 1997. Profit Sharing Plans Alaska and Horizon have employee profit sharing plans. Profit sharing expense for 1995, 1996 and 1997 was $-0-, $0.9 million and $13.5 million, respectively. Other Postretirement Benefits The Company allows retirees to continue their medical, dental and vision benefits by paying all or a portion of the active employee plan premium until eligible for Medicare, currently age 65. This results in a subsidy to retirees because the premiums received by the Company are less than the actual cost of the retirees' claims. The accumulated postretirement benefit obligation (APBO) for this subsidy at December 31, 1996 and 1997 was $13.5 million and $15.7 million, respectively. The APBO is unfunded and is included with other liabilities on the Balance Sheet. Annual expense related to this subsidy is not considered material to disclose. Note 8.	Income Taxes Deferred income taxes result from temporary differences in the timing of recognition of revenue and expense for tax and financial reporting purposes. Deferred tax assets and liabilities comprise the following at December 31 (in millions): 	1996 	1997 Excess of tax over book depreciation	 $146.7 	$161.8 Training expense	 0.8 	0.2 Other - net	 1.2	 1.1 Gross deferred tax liabilities	 148.7	 163.1 Loss carryforward	 (17.8) 	(0.5) Alternative minimum tax	 (44.1) 	(50.1) Capital leases	 (4.5) 	(4.5) Ticket pricing adjustments	 (1.0) 	(1.2) Frequent flyer program	 (6.6) 	(8.5) Employee benefits	 (10.2) 	(7.8) Aircraft return provisions	 (13.9) 	(16.0) Deferred gains	 (3.1) 	(4.8) Capitalized interest	 (1.5) 	(1.4) Inventory obsolescence	 (7.1) 	(6.5) Gross deferred tax assets 	(109.8) 	(101.3) Net deferred tax liabilities 	$ 38.9 	$ 61.8 Current deferred tax asset	 $ (10.6)	 $ (10.5) Noncurrent deferred tax liability	 49.5	 72.3 Net deferred tax liabilities 	$ 38.9	 $ 61.8 After consideration of temporary differences, taxable income for 1997 was approximately $99 million, which was partially offset by net operating losses generated in prior years. At December 31, 1997, no federal loss carryforwards remain. The components of income tax expense were as follows (in millions): 		1995	 1996 	1997 Current tax expense: 	Federal	 $ 5.0 	$17.5	 $ 26.4 	State	 0.3 	0.9 	1.9 Total current	 5.3 	18.4	 28.3 Deferred tax expense: 	Federal	 9.2 	6.7 	18.5 	State	 2.2 	1.2 	4.4 Total deferred 11.4 	7.9 	22.9 Total tax expense 	$16.7 	$26.3	 $51.2 Income tax expense reconciles to the amount computed by applying the U.S. federal rate of 35% to income before taxes as follows (in millions):	 	1995 	1996	 1997 Income before income tax 	$34.0 	$64.3 	$123.6 Expected tax expense	 $11.9	 $22.5	 $43.3 Nondeductible expenses 	 3.0 	2.8 	2.9 State income tax	 1.8 	1.0 	4.1 Other - net 	-- 	--	 0.9 Actual tax expense	 $16.7 $26.3 	$51.2 Effective tax rate 	49.1% 	40.9% 	41.4% Note 9.	Earnings per Share Statement of Financial Accounting Standards No. 128, Earnings per Share (EPS) was adopted for 1997 calendar year reporting. FAS 128 replaces "primary" and "fully-diluted" EPS with "basic" and "diluted" EPS. Basic EPS is calculated by dividing net income by the average number of common shares outstanding. Diluted EPS is calculated by dividing net income plus the after-tax interest expense on convertible debt by the average common shares outstanding plus additional common shares that would have been outstanding if conversion of the convertible debt and exercise of in-the-money stock options is assumed. EPS calculations were as follows (in millions except per share amounts): 	1995 	1996 	1997 Net income	 $17.3 	$38.0 	$72.4 Avg. shares outstanding	 13.471 	14.241 	14.785 Basic earnings per share	 $1.28 	$2.67 	$4.90 Net income	 $17.3 	$38.0 	$72.4 After-tax interest on: 6-1/2% debentures	 2.7 	5.3 	5.3 6-7/8% debentures	 2.3 	2.3	 2.3 7-3/4% debentures	 0.6	 0.5 	-- 7-1/4% notes 	3.3	 -- 	-- Diluted EPS income	 $26.2 	$46.1 	$80.0 Avg. shares outstanding 	13.471 	14.241 	14.785 Assumed conversion of: 6-1/2% debentures	 3.151 	6.151 	6.151 6-7/8% debentures 	1.608 	1.608 	1.608 7-3/4% debentures	 0.468 	0.361 	-- 7-1/4% notes	 2.053 	-- 	-- Assumed exercise of stock options 	0.014 	0.097 	0.145 Diluted EPS shares	 20.765 	22.458 	22.689 Diluted earnings per share 	$1.26 	$2.05 	$3.53 Note 10.	 Financial Instruments The estimated fair values of the Company's financial instruments were as follows (in millions): December 31, 1996 	Carrying	 Fair 	Amount 	Value Cash and cash equivalents	 $ 49.4	 $ 49.4 Marketable securities	 52.4 	52.2 Restricted deposits	 64.6 	64.6 Long-term debt	 400.4	 421.7 			December 31, 1997 	Carrying	 Fair 	Amount 	Value Cash and cash equivalents 	$102.6	 $102.6 Marketable securities	 110.1	 110.1 Restricted deposits	 67.5	 67.5 Long-term debt	 404.5 	521.7 The fair value of cash equivalents approximates carrying value due to the short maturity of these instruments. The fair value of marketable securities is based on quoted market prices. The fair value of restricted deposits approximates the carrying amount. The fair value of publicly traded long-term debt is based on quoted market prices, and the fair value of other debt approximates carrying value. Note 11.	Operating Segment Information Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information, was adopted for 1997 calendar year reporting. Financial information for Alaska and Horizon follows (in millions): 	1995 	1996 	1997 Operating revenues: 	Alaska 	$1,142.3 	 $1,297.3 	$1,447.9 	Horizon	 279.5 	301.3 	303.6 	Elimination of intercompany 	 revenues	 (4.3) 	(6.4) 	(12.1) 	Consolidated	 1,417.5 	1,592.2	 1,739.4 Depreciation and amortization expense: 		Alaska			 58.2 	55.9	 56.9 		Horizon		 9.9 	11.4 	11.2 Interest income: 		Alaska			 10.3 	11.5 	12.2 		Horizon	 	0.4 	0.3 	0.1 Interest expense: 		Alaska			 40.3 	29.7 	25.0 		Horizon		 0.6 	0.9 	1.8 Pretax income: 	Alaska		 43.9 	74.5 	127.4 	Horizon	 4.2 	0.3 	6.3 	Air Group	 (14.1)	 (10.5) 	(10.1) 	Consolidated	 34.0 	64.3 123.6 Total assets: 	Alaska		 1,266.5 	1,247.9 	1,370.7 	Horizon 	154.9 	173.3 	158.0 	Air Group	 521.1 	524.3 	668.0 	Elimination of intercompany 	 accounts	 (629.1)	 (634.1) 	(663.6) 	Consolidated	 1,313.4 	1,311.4 	1,533.1 Capital expenditures: 		Alaska			 87.9 	229.9 	293.0 		Horizon		 15.4	 39.9	 145.9 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of Alaska Air Group, Inc.: We have audited the accompanying consolidated balance sheet of Alaska Air Group, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Alaska Air Group, Inc. and subsidiaries as of December 31, 1997and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in Item 14(a) is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. 												 /s/ Arthur Andersen LLP 												ARTHUR ANDERSEN LLP Seattle, Washington January 26, 1998 VALUATION AND QUALIFYING ACCOUNTS Alaska Air Group, Inc. Schedule II Additions Beginning Charged (A) Ending (In Millions) Balance to Expense Deductions Balance Year Ended December 31, 1995 (a) Reserve deducted from asset to which it applies: Allowance for doubtful accounts $2.3 $0.6 $(1.3) $1.6 Obsolescence allowance for flight equipment spare parts $12.1 $2.7 $(1.3) $13.5 (b) Reserve recorded as other long-term liabilities: Leased aircraft return provision $25.6 $7.5 $(0.6) $32.5 Year Ended December 31, 1996 (a) Reserve deducted from asset to which it applies: Allowance for doubtful accounts $1.6 $0.7 $(1.0) $1.3 Obsolescence allowance for flight equipment spare parts $13.5 $3.5 $(0.9) $16.1 (b) Reserve recorded as other long-term liabilities: Leased aircraft return provision $32.5 $9.4 $(3.3) $38.6 Year Ended December 31, 1997 (a) Reserve deducted from asset to which it applies: Allowance for doubtful accounts $1.3 $1.0 $(1.1) $1.2 Obsolescence allowance for flight equipment spare parts $16.1 $3.4 $(1.5) $18.0 (b) Reserve recorded as other long-term liabilities: Leased aircraft return provision $38.6 $11.4 $(6.8) $43.2 (A) Deduction from reserve for purpose for which reserve was created. EXHIBIT INDEX Certain of the following exhibits have heretofore been filed with the Commission and are incorporated herein by reference from the document described in parenthesis. Certain others are filed herewith. 	3.(i)	Articles of Incorporation of Alaska Air Group, Inc. as amended through May 21, 1996 	3.(ii)	Bylaws of Alaska Air Group, Inc., as amended through Feb. 8, 1996 (Exhibit 3.(ii) to 1995 10-K) 	4.1	Amended and Restated Rights Agreement dated 8/7/96 between Alaska Air Group, Inc. and The First National Bank of Boston, as Rights Agent (Exhibit 2.1 to Form 8A-A filed 8/8/96) 	10.1	Lease Agreement dated Feb. 1, 1979 between Alaska Airlines, Inc. and the Alaska Industrial Development Authority (AIDA) (Exhibit 10-15 to Registration Statement No. 2-70742) 	10.2	Lease Agreement dated April 1, 1978 between Alaska Airlines, Inc. and the AIDA (Exhibit 10-16 to Registration Statement No. 2-70742) 	10.3	Management Incentive Plan (1992 Proxy Statement) 	10.4	Loan Agreement dated as of December 1, 1984, between Alaska Airlines, Inc. and the Industrial Development Corporation of the Port of Seattle (Exhibit 10-38 to 1984 10-K) 	10.5	Alaska Air Group, Inc. 1984 Stock Option Plan, as amended through May 7, 1992 (Registration Statement No. 33-22358) 	10.6	Alaska Air Group, Inc. 1988 Stock Option Plan, as amended through May 19, 1992 (Registration Statement No. 33-52242) 	#10.7	Lease Agreement dated January 22, 1990 between International Lease Finance Corporation and Alaska Airlines, Inc. for the lease of a B737- 400 aircraft, summaries of 19 substantially identical lease agreements and Letter Agreement #1 dated January 22, 1990 (Exhibit 10-14 to 1990 10-K) 	#10.8	Agreement dated September 18, 1996 between Alaska Airlines, Inc. and Boeing for the purchase of 12 Boeing 737-400 aircraft (Exhibit 10.1 to Third Quarter 1996 10-Q) 	#10.9	Agreement dated August 28, 1996 between Horizon Air Industries, Inc. and Bombardier for the purchase of 25 de Havilland Dash 8-200 aircraft (Exhibit 10.2 to Third Quarter 1996 10-Q) 	10.10	Supplemental retirement plan arrangement between Horizon Air Industries, Inc. and George D. Bagley (1996 Proxy Statement) 	10.11	Alaska Air Group, Inc. 1996 Long-Term Incentive Equity Plan (Registration Statement 333-09547) 	10.12	Alaska Air Group, Inc. Non Employee Director Stock Plan (Registration Statement 333-33727) 	10.13	Alaska Air Group, Inc. Profit Sharing Stock Purchase Plan (Registration Statement 333-39889) 	10.14	Alaska Air Group, Inc. 1997 Non Officer Long-Term Incentive Equity Plan (Registration Statement 333-39899) 	*10.15	Alaska Air Group, Inc. Supplementary Retirement Plan for Elected Officers 	*10.16	1995 Elected Officers Supplementary Retirement Plan 	*12	Calculation of Ratio of Earnings to Fixed Charges 	21	Subsidiaries of the Registrant (Exhibit 22-01 to 1987 10-K) 	*23	Consent of Arthur Andersen LLP 	*27	Financial Data Schedule * Filed herewith. # Confidential treatment was granted as to a portion of this document.