OVERVIEW

The following Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand the Company, our operations and our present business environment. MD&A is provided as a supplement to - and should be read in conjunction with - our consolidated financial statements and the accompanying notes. All statements in the following discussion that are not statements of historical information or descriptions of current accounting policy are forward-looking statements. Please consider our forward-looking statements in light of the risks referred to in this report's introductory cautionary note and the risks mentioned in Part I, "Item 1A. Risk Factors." This overview summarizes the MD&A, which includes the following sections:

• Year in Review-highlights from 2008 outlining some of the major events that happened during the year and how they affected our financial performance.

• Results of Operations-an in-depth analysis of the results of operations of Alaska and Horizon for the three years presented in our consolidated financial statements. We believe this analysis will help the reader better understand our consolidated statements of operations. Financial and statistical data for Alaska and Horizon are also included here. This section includes forward-looking statements regarding our view of 2009.

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

• Liquidity and Capital Resources-an analysis of cash flows, sources and uses of cash, contractual obligations, commitments and off-balance sheet arrangements, an overview of financial position and the impact of inflation and changing prices.

YEAR IN REVIEW

In 2008, we reported a consolidated net loss of $135.9 million compared to a consolidated net income of $124.3 million in 2007. The largest driver of the decline in results was fuel expense. Our fuel expense increased by $522.1 million over 2007, primarily as a result of the significantly higher average fuel prices in 2008. Oil prices reached record levels during the summer months, but declined sharply in the last few months of 2008. Even with the benefit of $122.7 million of net cash settlements from our fuel hedge program during the year, our "economic" fuel cost (as defined on page 39) increased $277.6 million, or 30%, on a 4.4% decline in fuel gallons consumed. This increase in fuel expense far exceeded the $156.6 million increase in total operating revenues. We also had the following notable items during 2008:

• revenue of $42.3 million associated with the change in Mileage Plan terms to delete accounts that have had no activity for two or more years. Previously, accounts could remain inactive for three years prior to deletion.

• fleet transition costs of $71.2 million compared to $14.1 million in 2007.

• restructuring charges of $12.9 million associated with reductions in work force.

The revenue environment in 2008 was characterized by increased competition in our West Coast market and softer demand in the last half of the year due to the current economic recession. Yield at both companies improved over 2007 as we and other carriers added or increased ancillary fees and raised fares to cover higher fuel costs. Alaska posted slightly higher passenger traffic for the full year and Horizon posted a sharp decline in passenger traffic. All of these factors, along with a one-time $42.3 million benefit from changes in our Mileage Plan program, resulted in an increase in total consolidated operating revenues of $156.6 million.

Our total operating expenses increased by $539.7 million during 2008 compared to 2007, primarily as a result of the significant increase in fuel costs along with an increase in fleet transition costs and restructuring charges. This increase is offset by declines in non-fuel operating costs at both companies as we continued to make progress in our cost reduction efforts. See "Results of Operations" below for further discussion of changes in revenues and operating expenses for both Alaska and Horizon.

Accomplishments and Highlights

Accomplishments and highlights from 2008 include:

• Alaska and Horizon both improved their operational performance in 2008 as measured by on-time arrivals and completion rate. For the full year, Alaska reported an on-time performance and completion rate of 78.3% and 99.2%, respectively, compared to 72.4% and 99.0%, respectively, for 2007. Similarly, Horizon reported a 2008 on-time performance and completion rate of 83.1% and 97.9%, respectively, compared to 80.7% and 97.6% in 2007.

• Alaska received the J.D. Power and Associates "Highest Customer Satisfaction" award in 2008 among North America Airlines in a tie with Continental Airlines.

• Alaska won the 2007 "Program of the Year" Freddie award for our Mileage Plan program in 2008.

• We reached an enhanced long-term agreement with Delta that will benefit our customers as it makes us Delta's preferred partner on the West Coast. Other benefits include enhanced frequent flyer and lounge reciprocity agreements.

• We completed our "Airport of the Future" at Seattle-Tacoma International Airport, reducing customer wait times significantly.

• The cargo business generated over $100 million of consolidated revenue for the first time in 2008.

Alaska Fleet Transition

We completed our transition to an all-B737 fleet in 2008 as our final MD-80 aircraft were removed from service during the year. We now have one of the youngest, most fuel-efficient fleets in the industry.

We have four MD-80 aircraft under long-term lease arrangements that were retired prior to the end of their lease terms and placed in temporary storage at an aircraft storage facility. As a result of their grounding, we recorded a $47.5 million charge during 2008 associated with these aircraft representing the remaining obligation under the existing lease contracts.

Horizon Fleet Transition

Horizon is in the process of transitioning to an all-Q400 fleet and expects to complete the transition as soon as the CRJ-700 fleet is successfully remarketed. At the beginning of 2008, we had 17 Q200s in the fleet, of which we were able to remarket all but six through sublease agreements or arranged sales of the aircraft to third parties. The total charge during 2008 related to the removal of these aircraft from operation was $10.2 million, which represents the estimated sublease loss for five aircraft delivered under the sublease arrangement and the loss on the termination of the underlying leases of six additional aircraft. Although we removed all remaining Q200 aircraft from scheduled operations as of the end of 2008, six of the aircraft were used as spares through the end of January 2009. We are actively remarketing these remaining aircraft. We do not currently know the timing or amount of any associated charge.

In the first quarter of 2008, our Board of Directors approved the plan to remove our CRJ-700 fleet from operations, in addition to the Q200 transition described above. As a result of the decision, the Company determined that its two owned CRJ-700s were impaired and recorded an impairment charge on the aircraft and their related spare parts of $5.5 million in 2008 to reduce the carrying value of these assets to their estimated fair value. Additionally, during 2008, we recorded severance charges of $1.3 million

related to this fleet transition. We are currently evaluating various alternatives to dispose of our CRJ-700 aircraft in the most economically feasible way. Two of our 18 leased aircraft were subleased to a third party during the fourth quarter, resulting in an estimated sublease loss of $6.7 million. The current economic conditions are hindering the remarketing effort and could result in further delays of the timeline to transition completely to an all-Q400 fleet. As such, the nature, timing or amount of any potential gain or loss associated with transactions on the remaining aircraft cannot be reasonably estimated at this time.

Fuel Hedging

We utilize primarily crude oil call options to decrease our exposure to the volatility of jet fuel prices, although we do have some collar structures that are scheduled to settle in 2009. The total outstanding liability for the collar contracts at December 31, 2008 is approximately $24 million, and we currently do not have any collateral on deposit with counterparties to these agreements. With call option contracts, we benefit from the decline in crude oil prices, as there is no future cash exposure above the premiums that we pay to enter into the contracts.

In the fourth quarter of 2008, we restructured our hedge portfolio to take advantage of lower fuel prices. We were able to reduce our 2009 average strike price from $103 per barrel at the end of the third quarter of 2008 to $76 per barrel for 50% of the planned 2009 consumption. As part of this restructuring effort, we terminated some of the previously held contracts. We realized losses on the termination of these contracts of $41.5 million and $8.5 million at Alaska and Horizon, respectively, representing the difference between the original premiums paid to purchase those contracts and the cash received from the counterparty upon termination. We believe that restructuring the hedge portfolio was a wise use of our resources and consistent with our stated objective of managing volatility.

Operational Performance

Our core promise to our customers is to get them and their bags to their destinations safely and on time. Operational performance was a top initiative in 2008 and we believe we made significant progress during the year. For 2008, Alaska and Horizon both exceeded their prior-year performance in on-time arrivals and in schedule completion rates. As a result of the current-year performance, our employees received higher payouts under our Operational Performance Rewards program.

Fees and Mileage Plan Changes

Like many of our competitors, we have increased existing fees or implemented new fees in an effort to increase our revenues. Examples include:

• increasing the charge for booking through reservations and airport sales agents from $10 to $15,

• raising the fee for overweight baggage from $25 to $50,

• increasing the charge for transporting pets in the cabin from $75 to $100 one-way, and

• raising the unaccompanied minor fee from $30 to $75 for one-way nonstop flights and from $60 to $75 for connecting flights.

The increases above were effective May 21, 2008. We also began charging $25 for a second checked bag effective July 1, 2008. First class and top-tier Mileage Plan members and customers on flights within the state of Alaska are exempt from the new fee.

On July 24, 2008 we announced a $25 fee for booking Mileage Plan award travel on partner airlines. We also announced that our domestic round-trip "Coach Saver" award will increase to 25,000 miles from 20,000 miles, and we have expanded our 15,000-mile "Intra-Alaska" award levels in coach to an "Intra-State" award. This award offers travel wholly within one state for 15,000 award miles. Other changes include an increase in the award miles needed for "Peak" awards and the introduction of a three-tier award level structure. All of these changes are effective for awards redeemed on or after November 19, 2008.

Additionally, beginning in August 2008, we reduced from three years to two years the length of time that a Mileage Plan account could be inactive before the account is deleted. As a result of this change in terms, our Mileage Plan liability was reduced by $42.3 million. This benefit is recorded separately in operating revenues as "Change in Mileage Plan terms."

Update on Labor Negotiations

Alaska is currently in negotiations with its pilots and has been since early 2007. The contract with Alaska's pilots became amendable on May 1, 2007. The Air Line Pilots Association (ALPA) at Alaska has requested mediation from the National Mediation Board (NMB) in order to assist with contract negotiations. We have begun meeting with the NMB and hope to reach a negotiated contract that recognizes the important contributions that our pilots make while not harming our competitive position. Factoring in pay rates, productivity measures, pension, and post-retirement medical benefits, we believe our pilot unit costs are among the highest in the industry for the size of aircraft operated.

Alaska and the Association of Flight Attendants have reached a tentative agreement to extend the current contract with Alaska's flight attendants by two years. The current agreement becomes amendable on May 1, 2010. Horizon is currently in negotiations with the following work groups - pilots, flight attendants, technicians and dispatchers.

We do not know what the final outcome of these negotiations will be or when agreements will be reached. However, uncertainty around open contracts could distract some employees, reduce employee engagement in our business, and prevent us from achieving the operational goals (such as on-time and completion-rate targets) that we have set.

Common Stock Repurchase

In September 2007, our Board of Directors authorized the Company to repurchase up to $100 million of our common stock over a twelve-month period. We completed the repurchase in February 2008 buying back 4.1 million shares of our outstanding common stock, or 10% of the outstanding stock at the start of the program, at an average price of $24.31 per share. During the first quarter of 2008, we repurchased 1.5 million shares for approximately $37.2 million. On March 13, 2008, we announced a new $50 million common stock repurchase program. Through April 24, 2008, we had repurchased 605,700 shares of our common stock for approximately $11.7 million under this new program. The repurchased shares have been recorded as treasury shares in our condensed consolidated balance sheets.

We temporarily stopped further repurchases under this program given the uncertainty in the economic environment and currently do not expect to repurchase any more shares prior to the expiration date in March 2009.

Line of Credit Modification

Alaska has a $185 million variable-rate credit facility that expires in March 2010. In the fourth quarter we borrowed $75 million from this facility and that amount was outstanding at December 31, 2008. On September 24, 2008, we entered into the Fourth Amendment to our $185 million variable-rate credit facility that eliminated all previous financial covenants and replaced them with a requirement to maintain a minimum unrestricted cash and marketable securities balance of $500 million.

Outlook

As we look forward to 2009, the two primary uncertainties are the demand environment and fuel prices. Although fuel prices have declined significantly since their record high in July 2008, the global financial instability and economic recession have put downward pressure on demand for air travel.

Traffic was down by 4.4% and 22.4% at Alaska and Horizon, respectively, in the fourth quarter as the economic recession began to take its toll on travel behaviors of our customers. In anticipation of this decline in demand, the Alaska and Horizon reduced capacity by 7.1% and 21.1%, respectively, in the fourth quarter. We currently anticipate further capacity

reductions of 8% at Alaska and 9% at Horizon in 2009 compared with 2008. We believe the actions we are taking to reduce capacity are necessary and appropriate given the uncertainty in the demand outlook, although we do have the flexibility to adjust our capacity throughout the year to stay aligned with demand.

Oil prices have declined from a record $147 per barrel in July to approximately $40 to $45 per barrel recently. That translates to a significant reduction in fuel cost for Air Group, although prices are still above historical levels. In July 2008, our average raw, unhedged price of jet fuel per gallon was $4.19 and is currently around $1.60 per gallon. Oil prices continue to be volatile, however, and prices could rise again. We continue to execute our hedging strategy to help remove some of the impact of that volatility on our financial results.

RESULTS OF OPERATIONS

2008 COMPARED WITH 2007

Our consolidated net loss for 2008 was $135.9 million, or $3.74 per share, compared to net income of $124.3 million, or $3.07 per diluted share, in 2007. Both periods include gains and losses arising from fuel-hedging activities. In 2008, there were several other items, as noted below, that affect the comparability between the two years:

• restructuring charges of $12.9 million ($8.1 million after tax, or $0.22 per share) related to the reduction in work force at Alaska;

• fleet transition charges of $61.0 million ($38.2 million after tax, or $1.05 per share) related to the ongoing transitions out of the MD-80 and CRJ-700 fleets; and

• a $42.3 million benefit ($26.5 million after tax, or $0.73 per share) related to a change in the terms of our Mileage Plan program.

We believe disclosure of the impact of these individual charges is useful information to investors because:

• it is useful to monitor performance without these items as it improves a reader's ability to compare our results to other airlines;

• our results excluding these adjustments related to fuel hedge accounting and other items serve as the basis for our various employee incentive plans, thus the information allows investors to better understand the changes in variable incentive pay expense in our consolidated statements of operations;

• our results excluding these items are most often used in internal management and board reporting and decision-making; and

• we believe it is the basis by which we are evaluated by industry analysts.

Our consolidated results are primarily driven by the results of our two operating carriers. Alaska and Horizon reported pretax losses of $153.3 million and $55.8 million, respectively, in 2008. Financial and statistical data for Alaska and Horizon are shown on pages 34 and 35, respectively. An in-depth discussion of the results of Alaska and Horizon begins on page 36.

                 ALASKA AIRLINES FINANCIAL AND STATISTICAL DATA



                                         Three Months Ended December 31                                    Year Ended December 31
                                                                       %                                             %                             %
                                        2008            2007         Change            2008           2007         Change           2006         Change
Financial Data (in millions):
Operating Revenues:
Passenger                            $    602.5       $  612.8          (1.7 )       $ 2,643.7      $ 2,547.2         3.8         $ 2,453.1         3.8
Freight and mail                           22.2           21.3           4.2              99.3           94.2         5.4              93.4         0.9
Other-net                                  34.0           41.3         (17.7 )           135.2          147.1        (8.1 )           129.6        13.5
Change in Mileage Plan terms                 -              -             NM              42.3             -           NM                -           NM

Total mainline operating revenues         658.7          675.4          (2.5 )         2,920.5        2,788.5         4.7           2,676.1         4.2
Passenger-purchased capacity               66.9           71.9          (7.0 )           300.8          281.4         6.9              16.4          NM

Total Operating Revenues                  725.6          747.3          (2.9 )         3,221.3        3,069.9         4.9           2,692.5        14.0

Operating Expenses:
Wages and benefits                        183.8          191.0          (3.8 )           742.7          753.9        (1.5 )           745.8         1.1
Variable incentive pay                      5.0            2.3         117.4              15.8           13.5        17.0              27.7       (51.3 )
Aircraft fuel, including hedging
gains and losses                          298.4          182.2          63.8           1,162.4          737.5        57.6             757.0        (2.6 )
Aircraft maintenance                       38.5           42.0          (8.3 )           150.6          149.8         0.5             156.8        (4.5 )
Aircraft rent                              23.8           29.5         (19.3 )           106.2          112.8        (5.9 )           110.9         1.7
Landing fees and other rentals             40.8           42.8          (4.7 )           167.7          170.1        (1.4 )           158.2         7.5
Contracted services                        29.7           32.9          (9.7 )           130.2          124.1         4.9             117.5         5.6
Selling expenses                           20.4           30.0         (32.0 )           116.0          129.3       (10.3 )           141.5        (8.6 )
Depreciation and amortization              42.7           36.2          18.0             165.9          142.3        16.6             137.8         3.3
Food and beverage service                  11.2           12.1          (7.4 )            48.3           46.9         3.0              48.3        (2.9 )
Other                                      40.1           48.1         (16.6 )           170.3          173.1        (1.6 )           161.1         7.4
Restructuring charges and
adjustments                                 9.2             -             NM              12.9             -           NM              24.8          NM
Fleet transition costs-MD-80                 -              -             NM              47.5             -           NM             189.5          NM

Total mainline operating expenses         743.6          649.1          14.6           3,036.5        2,553.3        18.9           2,776.9        (8.1 )
Purchased capacity costs                   66.9           80.7         (17.1 )           313.7          302.8         3.6              14.3          NM

Total Operating Expenses                  810.5          729.8          11.1           3,350.2        2,856.1        17.3           2,791.2         2.3

Operating Income (Loss)                   (84.9 )         17.5            NM            (128.9 )        213.8          NM             (98.7 )        NM

Interest income                            13.1           15.1                            51.3           64.8                          56.3
Interest expense                          (25.0 )        (21.3 )                         (92.5 )        (86.2 )                       (73.3 )
Interest capitalized                        4.1            6.6                            20.2           25.7                          21.5
Other-net                                  (0.7 )         (2.7 )                          (3.4 )         (3.1 )                        (0.5 )

                                           (8.5 )         (2.3 )                         (24.4 )          1.2                           4.0

Income (Loss) Before Income Tax      $    (93.4 )     $   15.2            NM         $  (153.3 )    $   215.0          NM         $   (94.7 )        NM

Mainline Operating Statistics:
Revenue passengers (000)                  3,772          4,191         (10.0 )          16,809         17,558        (4.3 )          17,165         2.3
RPMs (000,000) "traffic"                  4,302          4,498          (4.4 )          18,712         18,451         1.4            17,822         3.5
ASMs (000,000) "capacity"                 5,590          6,020          (7.1 )          24,218         24,208         0.0            23,278         4.0
Passenger load factor                      77.0 %         74.7 %         2.3 pts          77.3 %         76.2 %       1.1 pts          76.6 %      (0.4 )pts
Yield per passenger mile                  14.01 ¢        13.62 ¢         2.8             14.13 ¢        13.81 ¢       2.3             13.76 ¢       0.3
Operating revenues per ASM "RASM"         11.78 ¢        11.22 ¢         5.0             12.06 ¢        11.52 ¢       4.7             11.50 ¢       0.2
Impact of change in Mileage Plan
terms per ASM                                -              -             NM              0.17 ¢           -           NM                -           NM
Passenger revenue per ASM                 10.78 ¢        10.18 ¢         5.9             10.92 ¢        10.52 ¢       3.7             10.54 ¢      (0.2 )
Operating expenses per ASM                13.30 ¢        10.78 ¢        23.4             12.54 ¢        10.55 ¢      18.9             11.93 ¢     (11.6 )
Aircraft fuel cost per ASM                 5.34 ¢         3.02 ¢        76.4              4.80 ¢         3.05 ¢      57.4              3.25 ¢      (6.2 )
Restructuring charges per ASM              0.16 ¢           -             NM              0.05 ¢           -           NM              0.11 ¢        NM
Fleet transition costs per ASM               -              -             NM              0.20 ¢           -           NM              0.81 ¢        NM
Aircraft fuel cost per gallon        $     3.95       $   2.09          89.0         $    3.48      $    2.08        67.3         $    2.14        (2.8 )
Economic fuel cost per gallon        $     2.52       $   2.48           1.6         $    3.00      $    2.20        36.4         $    1.92        14.6
Fuel gallons (000,000)                     75.5           87.2         (13.4 )           333.8          354.3        (5.8 )           354.3         0.0
Average number of full-time
equivalent employees                      9,156          9,672          (5.3 )           9,628          9,679        (0.5 )           9,322         3.8
Aircraft utilization (blk
hrs/day)                                   10.0           10.7          (6.5 )            10.6           10.9        (2.8 )            11.0        (0.9 )
Average aircraft stage length
(miles)                                     995            946           5.2               979            926         5.7               919         0.8
Operating fleet at period-end               110            115            (5 )a/c          110            115          (5 )a/c          114           1 a/c
Purchased Capacity Operating
Statistics:
RPMs (000,000)                              227            287         (20.9 )           1,100          1,099         0.1                41          NM
ASMs (000,000)                              316            386         (18.1 )           1,469          1,453         1.1                67          NM
Passenger load factor                      71.8 %         74.4 %        (2.6 )pts         74.9 %         75.6 %      (0.7 )pts         61.2 %        NM
Yield per passenger mile                  29.47 ¢        25.05 ¢        17.6             27.35 ¢        25.61 ¢       6.8             40.00 ¢        NM
Operating revenue per ASM                 21.17 ¢        18.63 ¢        13.7             20.48 ¢        19.37 ¢       5.7             24.48 ¢        NM
Operating expenses per ASM                21.17 ¢        20.91 ¢         1.3             21.35 ¢        20.84 ¢       2.5             21.34 ¢        NM

NM = Not Meaningful