Translation of the Hebrew Language financial statements
EL AL ISRAEL AIRLINES LTD.
2006 ANNUAL REPORT
MESSAGE FROM THE CEO AND THE CHAIRMAN OF THE BOARD
CHAPTER A - OVERVIEW OF THE ENTITY'S BUSINESS
CHAPTER B - DIRECTORS' REPORT
CHAPTER C - 2006 FINANCIAL STATEMENTS Greetings,
El Al's financial results for 2006 emphasize above all the Company's strength and its ability to overcome obstacles, business wise and market wise, even when all external negative variables join forces and create a negative trend.
2006 has presented El Al with numerous challenges which, each on its own, and without doubt all of them combined together, have an intense effect on the Company's operations. Fuel price increased to new historic records during 2006, adding approximately 136.9 million US dollars, excluding hedging activities, to the company's expenses. Hedging activities performed according to Company's hedging policy saved approximately 52.3 million US dollars in fuel costs during 2006. Unprecedented increase in competition and in the overall capacity, was reflected by an increase of 21% in seat supply offered by schedule Airlines (namely, an increase of seat supply by 840 thousand seats), in light of approximately 6% increase in traffic at Ben-Gurion Airport. Regulatory changes led to unprecedented utilization of the "Sixth Freedom" by foreign carriers, which is basically translated to an increase in number of passengers traveling out of Israel via the foreign carrier's hub to any third destination around the world. Weakening of the US currency in relation to other currencies caused an increase in the company's expenses. And above all, the Second Lebanese War, which occurred during the high season led to cancellation of outgoing flights and to a reduction of incoming tourism to Israel. All of the aforementioned was translated to an annual loss of approximately 44.4 million dollars in 2006.
Throughout the year, El Al has acted skillfully and proactively to dynamically adjust its economic and commercial policy to the developing and changing environment. We implemented a hedging policy in order to minimize the effects of fuel costs, as well as those of interest rate and currency rate, flight capacity offered by the company was adjusted to cope with competitive conditions and thus was reduced in cases where the actual demand for certain destination was negatively affected by the war, marketing efforts were intensified in order to achieve higher demand around the world and in Israel, and restructuring measures were implemented and accelerated in Israel and abroad in an effort to match the company's fixed costs to the changing competitive and geopolitical reality.
Thanks to the strategic decision making and to employees' efforts throughout 2006, and despite the difficult circumstances described herein, El Al's revenues increased by approximately 46 million dollars compared to the previous year, an increase of approximately 3%, totaling approximately 1.7 billion dollars. We succeeded in raising load factor up to 81.3%, reflecting an increase of 2.4% compared to 79.4% last year. This growth is impressive especially in light of the increase in seat available by foreign carriers. These serve as good indicators of the company's strength and its ability to face and overcome challenges.
Parallel to the crises and the timely managerial decisions that were taken, we continued, firmly and consistently, to advance the El Al 2010 vision - to lead the Israeli aviation market and to be the first and preferred choice for air traffic to and from Israel. During the year, we invested approximately 70 million US Dollars in equipping and modernizing the company's fleet. We also invested in additional ground equipment and cutting edge IT enhancement. Revenues from cargo transport amounted to approximately 317.6 million US Dollars in 2006, reflecting an increase of about 8% compared to 2005, a good example of company's implementation of a strategic plan to develop additional profit centers.
El Al's Operational precision reached 84% during 2006, among the highest in Europe, reflecting an improvement of 5% compared to 2005. The company shows impressively low rate of baggage loss compared to other international Airlines. El Al's website underwent a process of accelerated technological upgrading during 2006 that is continuing at a greater pace in 2007 and has consistently led to an increase in online sales. The services provided by the company's website have been expanded, including online check-in service used by over10% of the passengers. Self checking stands have been set up in the terminal for passengers traveling only with hand baggage. Business sections onboard the 737, 757 and 767 fleets have been rearranged, both by installation of new wider and designed seats with greater inclining to offer a spacious and more comfortable experience. The company launched refurnished business lounge in Paris and added new direct flight destinations, such as Los Angeles and Miami, while extending flight operations to the Far East. The company has adjusted its flight schedule to Europe in order to maximize and optimize convenient connectivity for transit passengers continuing on connection flights and has also developed and improved the product for business travelers to various European destinations. The overall focused attention and addressing to the needs of the business traveler has consistently resulted in growth in El Al's share of the premium traffic from Ben-Gurion Airport, which increased this year by approximately 13% compared to 2005.
More than anything, the company's strategic investment in the various service elements has been fruitful, as reflected in passengers' feedback and grading on service parameters, which reached a record high this year compared to the overall grading over the past decade. It is not coincident that El Al was recently chosen, in an annual survey of the newspaper "Yediot Ahronot", as the leading brand name in Israel, as the most outstanding company with regard to quality of service among the airline carriers flying into and out of Israel, and El Al's frequent flyer club was chosen as the best club among Airline companies for international flights flying to and from Israel.*
We are obviously, heading towards the summer of 2007, when two new flagship aircraft of the Company are scheduled to arrive in Israel - advanced 777 Aircraft, which offer El Al's customers a quality product aligned with the best standards in the world.
We are confident that El Al obtains the ability to confront with the challenges while enhancing sales ability and improving its product in order to cope with constant change in the environment including increased competition, in an endless effort to achieve the vision of providing investors yields and to fly together and elevate towards new heights.
We wish to thank all of the company's employees for their devotion and contribution.
Prof. Israel (Izzy) Borovich Haim Romano Chairman of the Board Chief Executive Officer
* The prize was presented subsequent to the date of signing the financial statements and was not known on that date. Translation of the Hebrew Language financial statements
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2006 ANNUAL REPORT
CHAPTER A OVERVIEW OF THE ENTITY'S BUSINESS
Translation of the Hebrew Language financial statements
TABLE OF CONTENTS
Chapter 1: General 3
Chapter 2: Description of the general development of the corporation’s business 4 1. The corporation’s activities and a description of the development of its business 4 1.1 General 4 1.2 Diagram of holdings 5 1.3 Year and form of incorporation 6 1.4 Changes in the corporation’s business 6 2. Operating areas 7 3. Investments in the corporation’s capital 8 3.1 General 8 3.2 Options 9 3.3 Shares held by Company employees 10 3.4 Changes in holdings of interested parties 11 3.5 Table summarizing data on interested party holdings 12 4. Distribution of dividends 14 5. Financial data on the corporation’s operating areas 14 5.1 Nature of consolidation adjustments 16 5.2 Explanation of developments taking place in operating areas 16 6. General environment and effect of external factors with regard to the Company 17 6.1 Traffic in the international aviation Industry 17 6.2 Traffic in the Israeli aviation Industry 18 6.3 Fluctuations in jet fuel prices 18 6.4 Currency rate fluctuations 19 6.5 Interest rate fluctuations 19
Chapter 3: Description of the corporation’s business by operating areas 19 7. Passenger aircraft area 19 7.1 General information on the operating area 19 7.2 Services in the operating area 30 7.3 Analysis of revenues and profitability from services 36 7.4 New services 37 7.5 Customers 37 7.6 Marketing and distribution 37 7.7 Reservations backlog 39
a-1 Translation of the Hebrew Language financial statements
7.8 Competition 40 7.9 Seasonality 41 7.10 Productive capacity 42 7.11aircraft Fleet 44 8. Cargo aircraft area 46 8.1 General information on the operating area 46 8.2 Services in the operating area 51 8.3 Analysis of revenues and profitability from services 53 8.4 New services 53 8.5 Customers, marketing and distribution 54 8.6 Reservations backlog 54 8.7 Competition 54 8.8 Seasonality 58 8.9 Productive capacity 58 8.10aircraft Fleet 59 8.11 Raw materials and suppliers 60 9. Details on the two operating areas 61 9.1 Fixed assets and installations 61 9.2 Insurance 63 9.3 Intangible assets 64 9.4 Human resources 65 9.5 Raw materials and suppliers 79 9.6 Working capital 81 9.7 Investments 82 9.8 Financing 85 9.9 Taxation 88 9.10 Environmental matters 89 9.11 Restrictions and regulation of the corporation’s business 93 9.12 Material agreements 126 9.13 Cooperation agreements 127 9.14 Legal proceedings 127 9.15 Goals and business strategy 134 9.16 Forecasted developments in the coming year 136 9.17 Financial data on geographical segments 137 9.18 Discussion of risk factors 137
a-2 Translation of the Hebrew Language financial statements
CHAPTER 1: GENERAL
El Al Israel Airlines Ltd. is pleased to present the description of the corporation’s business as of December 31, 2006, which surveys the portrayal of the corporation and the development of its business, as they took place during the year 2006. The report was prepared in accordance with the Securities Regulations (Periodic and Immediate Reports)-1970. The financial data included in the report is denominated in U.S. dollars. Monetary claims have been described in financial data expressed in Israeli shekels (“NIS”) as of the date that the claim was filed, unless stated otherwise. The percentages of ownership are presented in numbers rounded out to the closest full percent, unless stated otherwise. The data which appears in this report are as they were as of the date of the report, unless stated otherwise. Data appearing in this report are correct as of a date close to the approval of the report, have been updated as of March 11, 2007, unless stated otherwise. The materiality of the data included in this Periodic Report, including the description of material transactions, has been assessed from the Company’s point of view, while in certain of the cases additional descriptive information are given in order to provide a comprehensive picture of the matter being described. This chapter, which deals with a description of the Group, its development, business and operating areas, and also includes forward-looking information, as defined in the Securities Law,1968 (“the Law”). Forward looking information is information that is uncertain as to the future, based principally on existing Company information at the reporting date and includes estimates, assumptions or intentions of the Company, as of the date of the report, as well as estimates and forecasts of third parties which might not be realized or only partially realized. Therefore, actual results, in whole or in part, could be significantly different, positively or negatively, from the results estimated, derived or implied from this information. In certain cases, sections containing prospective information can be identified by the use of certain words, such as: "estimates", " perceive", "expects", "forecast", etc, but it is possible that this information will also appear with other expressions.
Reading For convenience purposes, in this Periodic Report, the following short expressions will have the meaning recorded alongside: Directors’ report - The report of the Board of directors on the state of affairs of the corporation’s business for the year ended December 31, 2006. Dollar - U.S. dollar. Stock exchange - The Tel-Aviv Stock Exchange Ltd. Financial statements - The consolidated financial statements of the Company for the period ended December 31, 2006, except if stated otherwise. The State - The State of Israel. The Group - The Company and its subsidiaries. The Authority - The Securities Authority. The corporation or the Company or El Al - El Al Israel Airlines Ltd. The prospectus - The prospectus published by the Company on May 30, 2003, as amended on June 3, 2003 and June 4, 2003.
a-3 Translation of the Hebrew Language financial statements
Fifth Freedom - Transport of passengers or cargo between two foreign countries by a carrier from a third country. For example, El Al transports passengers between Toronto and Los Angeles. Sixth Freedom - Transport of passengers or cargo between two foreign countries with a stopover in the country of the air carrier. For example, a flight of a European airline from Israel to the U.S. via an airport in Europe. Companies Law - The Companies Law-1999. Government Corporations Law - The Government Corporations Law-1975. Securities Law- The Securities Law-1968. IATA- The International Air Transport Association. Date of the Report - December 31, 2006. K’nafaim - K’nafaim Arkia - Holdings Ltd. Date close to approval of Report - March 11, 2007, unless stated otherwise. Sun D’Or - Sun D'Or International Airlines Ltd. Income Tax Ordinance - Income Tax Ordinance (New Version)-1961. NIS - New Israeli shekel. Reporting year - The year 2006. ASK - Available Seat Kilometer - number of seats offered for sale multiplied by the distance flown. ATK - Available Ton Kilometer - the available capacity for shipment of passengers (translated into tonnage) and cargo multiplied by the distance flown. RPK - Revenue Passenger Kilometer - number of paying passengers multiplied by the distance flown. RTK - Revenue Ton Kilometer - the weight in tonnage of paying passengers and cargo multiplied by the distance flown.
CHAPTER 2: DESCRIPTION OF THE GENERAL DEVELOPMENT OF THE CORPORATION’S BUSINESS
1. The corporation’s activities and a description of the development of its business
1.1 General The Group is engaged primarily in the air transport of passengers and cargo (including baggage and mail) between Israel and foreign countries, by means of passenger aircraft and cargo aircraft. The passenger aircraft of the Company carry out scheduled flights as well as charter flights. The Company serves as the designated air carrier of the State of Israel on most international routes that operate to and from Israel. See Section 9.11.7.2 below for more on this subject and on the term “designated carrier”. The Group is engaged in auxiliary activities to its air transport activity, such as sale of duty-free products, production and supply of food primarily to its aircraft, and in the leasing of aircraft, providing check-in services, security services, current maintenance and general maintenance services to aircraft of other airlines at the Ben-Gurion airport (“BGA”) and management of travel agencies abroad. The business environment in which the Company operates is the sector of international civil aviation and tourism to and from Israel, which are characterized by seasonal fluctuations and a high level of competition, which becomes more severe during a period of excess capacity.
a-4 Translation of the Hebrew Language financial statements
In the area of passenger transport, the Company competes with 2 Israeli airlines(Arkia and Israir), approximately 41 foreign scheduled airlines and approximately 55 charter companies. The airlines compete in various areas, principally: fares, frequency and dates of flights, operation punctuality, equipment type, airplane configuration, passenger service, etc. The competition is with the airlines which maintain scheduled flights between different destinations, charter flights between those destinations and/or sixth freedom flights (irregular flights via stopover destinations in the mother country of those companies). The Company competes with about seven airlines in the cargo transport area, which operate cargo planes in flights from and to BGA. Additionally, the Group competes with most of the scheduled airlines that operate passenger airplanes and transport cargo in their belly. See Sections 7.8 and 8.7 for more on competition.
1.2 Diagram of holdings The following is a diagram of the structure of the Company’s holdings in affiliated airlines active as of a date close to the approval of the report (The percentages itemized in the diagram express the Company’s holdings in the affiliated companies):
Sun D'or 100%
Tamam 100%
Katit 100%
Superstar Holidays Britain 100%
Bornstein Caterers USA 100%
ACI 50%
Airtour 50%
Sabre 49%
Kavei Chufsha 20% a-5 Translation of the Hebrew Language financial statements
1.3 Year and form of incorporation El Al Israel Airlines Ltd was incorporated as a limited company on November 15, 1948 under the name of El-Al Israel Airlines Ltd. and, on May 16, 1951, changed its name to its present name.
1.4 Changes in the corporation’s business Until June 6, 2004 the Company was a “government corporation” in the process of “privatization” (as these terms are defined in the Government Corporations Law). See Section 9.11.below, “restrictions and regulation of the corporation’s business”, for additional details. In the context of the procedures for privatization of the Company, on May 30, 2003, the Company and the State published a prospectus, by means of which shares of the Company and options exercisable into shares of the Company were issued and sold. On the eve of the issuance of the prospectus, the State had held approximately 97.25% of the Company’s issued share capital. On June 6, 2004, after having purchased shares of the Company and due to the exercise of options by the public, the holdings of the State decreased to below 50%. Therefore, the Company was converted from a “Government Corporation” to a “Mixed Company”, as the meaning of this term is defined in the Government Corporations Law. Following the exercise of further options on December 23, 2004, the holdings of K’nafaim rose to approximately 40% of the issued share capital of the Company (fully diluted: approximately 46.9% of the issued share capital of the Company and approximately 52.8% of voting rights) and the State’s holdings decreased to approximately 31% of the issued share capital of the Company (fully diluted: approximately 1.1%). See Section 3.4 below for additional details on the subject. On January 6, 2005, the majority of the members of the Board of Directors was replaced when the meeting of the Company’s shareholders, convened at the request of K’nafaim, decided to appoint new board members while the State concurrently announced the end of the term of all directors, who were not public directors, who had been serving as of that date on the Company’s Board of Directors. On December 28, 2006, the period of service of two previous public directors terminated as Company directors. On February 28, 2007, the meeting of the Company’s shareholders approved the appointment of two additional public directors to the Company's Board of Directors. Close to the date of approval of the report, there are 10 members serving on the Company's Board of Directors (including two public directors). The transfer of control to K’nafaim did not alter the status of the Company as a “Mixed Company”. However, since K’nafaim holds Company shares at a rate exceeding that held by the State, the special provisions that are detailed in Section 108 of the Company’s articles ceased to apply. See Section 9.11.2. (k) below for additional details.
a-6 Translation of the Hebrew Language financial statements
2. Operating areas
The Group’s headquarters functions on an integrated basis in the operating areas itemized below, including financial management, procurement, human resources, legal counsel, information infrastructures, security, maintenance, engineering, marketing and advertising and also in the ground operations and construction.
The Group has two operating areas which are reported as business segments (secondary) in the Company’s consolidated financial statements (See also Note 24.B. to the financial statements).
(A) Air Transport in passenger aircraft In this area, the Group transports passengers as well as cargo (including mail and baggage) in the belly of the passenger transport aircraft, and also provides auxiliary services, such as: sale of duty free products and leasing passenger aircraft. Revenues from this operating area represented approximately 84% of total Group revenues for the year 2006.
(B) Air Transport in cargo aircraft In this area, the Group transport cargo in cargo transport aircraft and also provides auxiliary services, such as: leasing cargo aircraft. The revenues from this operating area represented approximately 15% of total Group revenues for the year 2006.
Other than the operating areas detailed above, the Group has additional activities which are not included in these areas, which are not material to the Group’s operations1 and with total revenues representing about 1% of total Group revenues for the year 2006.
Breakdown of revenues by operating areas - for the year 2006:
others 1% cargo aircraft 15%
Passenger aircraft 84%
1 The production and supply of meals to flight passengers, providing check-in services, providing security services (see Section 9.11.12 below for details), current and general maintenance services to aircraft of other companies at BGA and management of travel agencies abroad.
a-7 Translation of the Hebrew Language financial statements
3. Investments in the corporation’s capital
3.1. General
In 2006, no investments were made in the corporation’s capital, except for the exercise of options which were issued in the context of the prospectus into ordinary shares of the Company.
It should be noted that in 2006, the shareholders’ equity of the Company increased by the amount of 775 thousand dollars, as the result of a capital reserve arising from transactions with a former controlling interest (the State), this as the result of deposits by the State in the severance fund of company employees. See Section 9.4.8. for details regarding the obligation of the State to cover the deficit in the severance pay fund of Company employees. Additionally, in 2006, the shareholders’ equity of the Company increased by approximately 296 thousand dollars as the result of the exercise of options (Series 1) which the Company had issued within the framework of the prospectus. In June 2003, the Company issued ordinary shares and options to purchase shares by means of a prospectus. In the context of the prospectus, the State also made a tender offer to sell shares and options to purchase shares in two series [purchase options (Series A) and purchase options (Series B)]. At the time that the prospectus was published, the State of Israel owned approximately 97.25% of the issued capital of the Company. Immediately after the securities were issued as per the prospectus, the holdings of the State fell to approximately 85% of the issued capital of the Company (without dilution). On March 23, 2006, the Company's shareholders' meeting approved the increase of the registered share capital of the Company by NIS 54,279,453 to NIS 550,000,001, divided into 550,000,000 ordinary shares of par value NIS 1.00 each, and a Special State Share of NIS 1 par value. (See Section 9.11.9 regarding the Special State Share).
a-8 Translation of the Hebrew Language financial statements
3.2 Options The purchase options (Series A) issued by the State were each exercisable into one ordinary share of the Company, commencing with the date that they were issued and until June 6, 2004, at an exercise price of NIS 1.30 per option plus linkage to the Consumer Price Index of April 2003. Through June 6, 2004, all of the purchase options (Series A) had been exercised, a total of 138,400,000 purchase options. As a result of the exercise of the purchase options (Series A), on June 6, 2004, the ownership of the State was reduced to approximately 49.5% of the issued capital of the Company (without dilution). The purchase options (Series B) issued by the State are exercisable, commencing December 12, 2004 and until June 5, 2007 (inclusive) into one ordinary share of the Company each. The exercise price of the purchase options (Series B) is NIS 1.32 per option (plus linkage to the Consumer Price Index of April 2003) for one ordinary share of the Company. Through December 31, 2006, 79,177,702 of the purchase options (Series B) had been exercised out of 157,600,000 options. Through March 11, 2007, 79,810,971 purchase options (Series B) had been exercised. The options (Series 1) issued by the Company are exercisable from December 12, 2004 through June 5, 2007 (inclusive), into one ordinary share of the Company. The exercise price of the options (Series 1) is NIS 1.34 (plus linkage to the Consumer Price Index of April 2003) per one ordinary share of the Company. Through December 31, 2006, 5,067,787 options (Series 1) had been exercised out of 100,000,000 options. Through March 11, 2007, 5,662,631 options (Series1) had been exercised. On February 26, 2006, the Board of Directors of the Company resolved to adopt a 2006 option plan for employees and executives of the Company (hereafter: "the 2006 options program"). On that date, the Board of Directors confirmed that the quantity of options which would serve as a pool for allotment under the plan would stand at 17,092,129 options, exercisable into 17,092,129 ordinary shares of the Company with par value of NIS 1 each, subject to adjustments. The Board of Directors is permitted, from time to time, to add to this quantity of options At the same time, the Company's Board of Directors approved an allotment of 17,092,129 options to approximately 50 offerees ,of which approximately 10 were senior executives of the Company and approximately 40 other executives of the Company. The allotment of the options to the Company's executives was also ratified by the Audit Committee of the Company on February 26, 2006. The allotment of the options was conditional upon the approval of the General Meeting of the Company for the increase in the Company's registered capital. Such approval was obtained on March 23, 2006 and, on the same day, the allotment was executed. On May 23, 2006, the Company's Board of Directors decided on the addition of 3,000,000 options to the pool of options for issuance pursuant to the 2006 options program. Also, the Board of Directors appointed the Human Resources and Appointments Committee of the Board of Directors of the Company as the Administrator of the 2006 Options Program and authorized the Committee to allot options to executives of the Company in accordance with the guidelines stipulated by the Board of Directors. Also, the Board of Directors approved the publication of an outline, according to which it will be permitted to issue options in accordance with the 2006 Options Program. Following that, on December 27, 2006, the Human Resources and Appointments Committee of the Board of Directors of the Company decided to issue options to Company executives that were actually issued on December 31, 2006. As of December 31, 2006, the total options issued under the 2006 options program
a-9 Translation of the Hebrew Language financial statements stands at 17,809,236, after deducting the options returned to the pool for any reason which complied with the program. See Section 9.4.5 c. below for further details. During 2006, the Company recorded the value of a benefit against a capital reserve with respect to this options program in the amount of 2,582 thousand dollars, according to a calculation of the value of the benefit made by using an economic model.
3.3 Shares held by Company employees Based on the prospectus, the State granted “eligible employees” (as defined in the prospectus) the right to purchase 34,685,642 shares of the Company that had been owned by the State (hereinafter: “the employees’ shares”). The employees’ shares were offered to the eligible employees at a price of NIS 0.91 per share. The employees' shares that will be purchased by the eligible employees are held by a trustee and were blocked until December 31, 2004. According to the rules of the Income Tax Ordinance that apply to an offering to employees under the capital gains alternative, the shares are to be blocked until December 31, 2005. The eligible employees purchased approximately 0.5% of the issued share capital of the Company in the framework of the tender offer (approximately 0.4% fully diluted). The State also became committed to sell the remaining employees’ shares not purchased by eligible employees (“remaining State shares”), at the lower of two prices: 30% of the average closing price of the Company’s shares on the stock exchange during the 90 trading days preceding the exercise date, or NIS 1.30 per share. On February 23, 2005, the employees’ association (Holdings in Trust for El-Al Employees Ltd.) acquired all of the remaining State shares (32,527,216 ordinary shares), representing approximately 8.1% of the issued share capital of the Company (approximately 6.56% fully diluted) for a price of NIS 0.39 per share. Sundry restrictions apply to the sale of the shares that are held by the employees’ 2 association . With the acquisition of the shares by the employees’ Company, the holdings of the State were reduced to approximately 21.7% of the issued share capital of the Company and of its voting rights (1.1% fully diluted). Moreover, the State became obligated at the end of the exercise period of the purchase options (Series B), to sell to the employees’ association, the shares remaining in the hands of the State due to the failure to take advantage of the right to exercise the purchase options
2 The following restrictions apply to the shares held by the employees’ Company (in addition to the provisions of law on tax issues): (A) No transaction or proceeding will be made in the shares and no power of attorney or transfer document will be conferred for a period of 24 months from the date that each purchase was completed; (B) At the end of the aforementioned blockage period, the remaining shares will not be marketable and/or realizable, pledged and/or used as collateral in any manner, except by the employees’ association in the context of the bylaws of the employees’ association and/or after their release to the employee, as specified in the bylaws of the employees’ association. (C) In accordance with the bylaws of the employees’ association, the employees of the Company and the subsidiaries have the right to sell the Company shares held for them by the association at the end of the blockage period, should any of the following occur: (1) with their retirement from work and the termination of the employee-employer relationship between them by their employer, in accordance with the bylaws of the employees’ Company; (2) under other circumstances that are itemized in the bylaws of the employees’ Company, such as a sale between Company employees, or upon the occurrence of exceptional personal circumstances; (3) in each year, beginning from the end of five years, the beginning of which is after the period of blockage within the framework of the prospectus has terminated, up to 20% of the shares held for him by the employees’ Company, in a manner so that by the end of the tenth year, he may sell all of his shares.
a-10 Translation of the Hebrew Language financial statements
(Series B), should any remain, but not to exceed 18,936,027 shares of the Company. This at an exercise price at the lower of 60% of the shares’ average closing price on the stock exchange during the 90 trading days preceding the exercise date, or 60% of NIS 1.30 per share.
3.4 Changes in holdings of interested parties As of December 31, 2006, the holdings of the State of Israel were approximately 20.97% of the Company’s issued capital (undiluted) and about 1.1% (fully diluted). As of March 11, 2006, the State’s holdings stood at approximately 20.78% (undiluted) and about 1.09% (fully diluted). The State also holds a Special State Share (see Section 9.11.9. for details of the Special State Share). The decrease in the State's holdings resulted from the exercise of the purchase options (Series B) and the options (Series 1). As of December 31, 2006, K’nafaim owned approximately 39.49% of the issued capital of the Company, on an undiluted basis, and approximately 45.33% of the Company’s issued capital on a fully diluted basis. As of March 11, 2007, the holdings of K’nafaim in the Company stand at approximately 39.44% of the issued capital of the Company (undiluted). The assumptions for the calculation of the percentages of ownership of capital and voting rights on a fully diluted basis (above and hereafter: “full dilution”) are: exercise of all options (Series 1), purchase options (Series B) and exercise of all of the executives' options under the 2006 options program; exercise of all options held by K’nafaim; and also receipt of all the necessary approvals by K’nafaim and compliance with all legal provisions. See Section 9.11.2 (g) for details regarding the conditions of the Commissioner of Business Restrictions to the merger of K'nafaim and the Company. It should be noted that on March 23, 2006, there was an allotment of 17,092,129 options and on December 31, 2006, an allotment of an additional 3,072,536 options was made, as itemized above in Section 3.2 and below in Section 9.4.5C. On the theoretical assumption of full exercise of the options allotted, the shares to be derived as the result of the exercise of all of these options (hereafter: "the shares from exercise") will be approximately 5.01% of the issued capital and voting rights of the Company (after exercise of the allotted options) and approximately 3.90% of the Company's issued capital and voting rights, fully diluted. It should be emphasized that the quantity of the shares from exercise which will actually be issued at the time that the options are exercised will be determined on the basis of the theoretical profit of the offeree. Therefore, the rate of dilution of the shareholders as the result of the allotment will be lower than the aforementioned.
In addition to ordinary shares, the State owns a Special State Share, which was established under the Company’s bylaws and provides the State with special rights. Among other things, the Special State Share stipulates that transactions in the Company’s shares in certain rates will not procure any right vis-à-vis the Company which is derived from owning and/or acquiring Company shares, without the advance written approval of the holder of the Special State Share (the State, through the ministers determined by the government). Section 8.1.7 of the Company’s articles determines a detailed arrangement on the subject of the manner of presenting the request to obtain the authorization to hold Company shares, in a case in which such authorization is required, as mentioned above. See Section 9.11.9 below as to details regarding the Special State Share.
a-11 Translation of the Hebrew Language financial statements
3.5 Table summarizing data on holdings of interested parties The following is a table which summarizes a number of facts regarding the Company’s securities and the holdings of the principal interested parties3:
March 11, December 31, December 31, December 31, 2007 20064 2005 2004 Holdings of interested parties Ownership rate of the State in issued capital (undiluted) 20.78% 20.97% 21.58% 30.52% Ownership rate of K'nafaim in issued capital (undiluted) 39.44% 39.49% 39.59% 39.76% Ownership rate of employees' trust holdings in issued 8.10% 8.12% 8.14% -- capital (undiluted) Company capital Registered share capital in NIS (excluding a 550,000,000 550,000,000 495,720,547 495,720,547 Special State Share) Issued share capital in NIS (excluding a 401,383,178 400,788,334 399,785,087 398,136,744 Special State Share) Convertible securities Options (Series 1) (in units) 94,337,369 94,932,213 95,935,460 97,583,803 Purchase options (Series B) (in units) 77,789,029 78,422,298 80,671,024 83,344,337 Executive options under 2006 options program5 20,092,129 20,092,129 - -
3 In addition to the shares itemized in the table, the State holds one Special State Share. See Section 9.11.9 below regarding the up to date provisions of the Special State Share. 4On March 23, 2006, the Company's shareholders' meeting approved the increase of the registered share capital of the Company by NIS 54,279,453 to NIS 550,000,001, divided into 550,000,000 ordinary shares of par value NIS 1.00 each, and a Special State Share of NIS 1 par value.
5 Including expired options that were returned to the pool of options for allotment according to the terms of the program.
a-12 Translation of the Hebrew Language financial statements
Breakdown of the holdings of the Company’s shares as of 31.12.2006:
employees' Trust Holdings K'nafaim 8.1% 39.5%
others 31.4% State of Israel 21.0%
Breakdown of the holdings of the Company’s shares as of 11.3.2007:
employees' Trust Holdings K'nafaim 8.1% 39.4%
others 31.7% State of Israel 20.8%
a-13 Translation of the Hebrew Language financial statements
4. Distributions of dividends The Company did not distribute dividends during the years 2003 through 2006. On March 28, 2005, K’nafaim, the controlling owner of the Company, sent a letter to Bank Leumi in which it was stated that “considering the present obligo position of El Al with Bank Leumi, and considering the fact that the Board of Directors of El Al is likely from time to time to formulate policies for distribution of profits of the Company, we state that as long as the balance of the existing principal obligo of El Al to Bank Leumi will not be less than 50 million dollars, we will not support a resolution to distribute earnings at a rate which exceeds 60% of the balance of retained earnings of El Al available for distribution as they will exist from time to time, other than after consultation with the Bank regarding the percentage in excess of 60% as aforementioned”. Concurrently with this letter, El Al received a letter from Bank Leumi on March 28, 2005, according to which the bank will not consider the conversion of K’nafaim into the controlling shareholder of El Al as an event which entitles the bank to immediate payment of the debt of El Al to the bank, conditional upon the terms as itemized in the letter of the bank to the Company, all as detailed in Section 9.8.2.c. below. On December 28, 2005, the Company's Board of Directors decided to adopt a policy for distributing dividends, beginning with the 2006 fiscal year and thereafter, in the context of which the Company will strive to distribute dividends of between 20% to 40% of net after tax earnings in the prior year that were derived from the Company's ordinary operations, excluding one-time earnings not from current operations and capital gains, this on the basis of the consolidated financial statements. Implementation of this policy is subject to all law provisions, and, to the assessment of the Company's Board of Directors concerning the ability of the Company to comply with its existing and anticipated obligations from time to time, and to consideration of the Company's existing liquidity, operations and business plans or those anticipated for the future. Adoption of this policy does not detract in any way from the authority of the Company's Board of Directors to decide, at any time, to change and/or amend and/or revoke the dividends policy which was stipulated in this decision and/or to approve additional distributions within the permitted limitations by law and/or to decide on the reduction of the rate of dividends to actually be distributed, or to evade a distribution due to the liquidity, operations, business and condition of the Company, which may change periodically.
5. Financial data on the corporation’s operating areas Details of the business areas of the Company in the financial statements are given on the basis of the fleets of aircraft- air transport by means of passenger aircraft and air transport by means of cargo aircraft. Cargo Transport in the belly of passenger aircraft represents a part of the operations of passenger aircraft. This activity is auxiliary and a derivative of the operations of transporting passengers in the passenger aircraft and is dependent upon these operations. Thus, for example, the destinations of freight Transport in the belly of passenger aircraft are determined by the flight destinations of the passengers in the passenger aircraft. Additionally, the current operations of the Company’s activities as carried out by Company management, including the decision as to the feasibility of the operation of a route and the actual departure of a flight, are carried out on the basis of this operating area. The convertible aircraft have been attributed to this operating area on the basis of their actual utilization during the entire operating period.
a-14 Translation of the Hebrew Language financial statements
The 2006 year:
Thousands of Passenger Cargo Other and Total dollars aircraft aircraft consolidation adjustments Passenger revenues 1,277,746 - - 1,277,246 Cargo and mail revenues 90,002 241,604 - 331,606 Other revenues 34,426 965 20,703 56,094 Total revenues 1,402,174 242,569 20,703 1,665,446 Costs (1,421,012) (243,385) (18,012) (1,682,409) Operating income (loss) (18,838) (816) 2,691 (16,963) Fixed assets at end of year 1,074,836 24,383 49,170 1,148,389
The 2005 year:
Thousands of Passenger Cargo Other and Total dollars aircraft aircraft consolidation adjustments Passenger revenues 1,259,773 - - 1,259,773 Cargo and mail revenues 92,657 216,463 - 309,120 Other revenues 33,254 839 16,483 50,576 Total revenues 1,385,684 217, 302 16, 483 1,619,469 Costs (1,293,019) (223,112) (14,416) (1,530,547) Operating income (loss) 92,665 (5,810) 2,067 88,922 Fixed assets at end of year 1,080,494 37,674 45,597 1,163,765
a-15 Translation of the Hebrew Language financial statements
The 2004 year:
Thousands of Passenger Cargo Other and Total dollars aircraft aircraft consolidation adjustments Passenger revenues 1,048,513 - - 1,048,513 Cargo and mail revenues 77,731 216,706 - 294,437 Other revenues 25,478 1,011 16,741 43,230 Total revenues 1,151,722 217,717 16,741 1,386,180 Costs (1,098,664) (218,819) (10,840) (1,328, 323) Operating income (loss) 53,058 (1,102) 5,901 57,857 Fixed assets at end of year 1,098,740 42,546 47,623 1,188,909
It should be stated that one must look at the profitability of the cargo transport area in a broader connection that is derived as well from the cargo transport operations in the belly of the passenger aircraft since the cargo transport area carries out commercial and marketing activities complementary to the activities of the cargo Transport activities in the passenger aircraft. The allocation of costs that are not directly related to one of the areas is done according to economic models currently in the Company’s possession. It is possible that in the future, these costs will be allocated on the basis of other economic models which will then be in use by the Company.
5.1 Nature of consolidation adjustments The adjustments to consolidate the revenues and costs result from additional activities which are not attributable to the principal operating areas, primarily maintenance and check-in services to other airlines. The consolidation adjustments of the fixed assets are connected with the fixed assets which are not related to the Company’s aircraft.
5.2 Explanation of occurrences that took place in the operating areas See the clarifications in Section 3.3 of the Directors’ Report regarding the explanation of developments in the Company’s operating results during the reporting period as compared to previous periods.
a-16 Translation of the Hebrew Language financial statements
6. General environment and effect of external factors with regard to the Company
6.1 Rise in traffic in the international aviation industry The international aviation industry is affected by the economic and security situation and from unusual events, such as the outbreak of epidemics and natural disasters in the world, in general, and in specific areas, in particular. During 2006, the trend of improvement in operating results in the worldwide aviation industry was sustained, despite the price rise of jet fuel at an average rate of approximately 15% compared to the year 2005. This improvement resulted, in general, from the positive demand environment and the continued tendency towards growth in passenger traffic, influenced by global economic growth as the result of the accelerated expansion and growth in the markets of the developing economies. Nonetheless, the rate of growth recorded for passenger traffic in the year 2006 was lower than the record levels of the years 2004 (growth rate of approximately 15.3%) and 2005 (growth rate of 7.6%), which reflected significant recovery in passenger traffic after a number of years of decline in the volume of passenger traffic that resulted mainly from the terror attacks on September 11, 2001 and from the outbreak of the SARS epidemic in Eastern Asia. According to IATA forecasts, from the year 2006 through the year 2010, annual average growth of 4.8% in international passenger traffic is anticipated. According to IATA estimates6, during the year 2006, airlines in the industry enjoyed from stability and growth in passenger traffic. International passenger traffic grew at a rate of approximately 5.9%, and the weighted load factor rose to 76.0% against 75.1% during the year 2005. IATA also estimates that operating profit of the world's airlines improved in 2006 as the result of better utilization and also due to efficiency steps and a cutback in expenses other than fuel, instituted by the world airlines. According to IATA data, during the year 2005, world shipments by cargo aircraft (including in the belly of passenger aircraft) grew by approximately 3.6% as compared with the year 2004. IATA forecasts that from the year 2006 through the year 2010, annual growth of approximately 5.3% is anticipated in the volume of shipments on cargo aircraft and in the belly of passenger aircraft, and significant growth is expected in IATA's assessment, in cargo shipments on the routes connected with to the Far East, particularly China and India. In addition, in IATA's estimation, there was an increase of approximately 4.6% as compared to the year 2005, that is the growth rate in the volume of cargo shipments in the year 2006 will be lower than the annual rate of increase anticipated according to IATA's forecast for the years 2006 and 2010. It should be stressed that the IATA forecasts and estimates regarding the global aviation industry (passenger transport) and the volume of world activity in the cargo Transport area as above represent prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). Accordingly, the actual change in the volume of world activity(passenger transport) and in the cargo Transport area may be materially different from that forecast as aforementioned, as the result of a large number of factors, including a change in world economic, security and political conditions in the world, regulatory changes and from the outbreak of epidemics and the actions of other natural forces.
6 Data, estimates, approximations and forecasts of IATA relating to the year 2006 are preliminary. Final data regarding 2006 is expected to be issued by IATA during the month of March 2007 in the framework of World Air Traffic Statistics.
a-17 Translation of the Hebrew Language financial statements
6.2 Rise in traffic in the Israeli aviation industry The year 2006 was, in general, characterized by two different periods. During the months January to June 2006, the security stability continued and an increase was chalked up in passenger traffic to and from Israel in comparison to the same months of the year 2005. On the other hand, during the months of July to December 2006, a decline was recorded in passenger traffic from and to Israel as compared to the parallel months of the year 2005, due to the effect of the war in Lebanon, which began in July and continued until the middle of the month of August, but affected the results of the second half of the year 2006 and also on the operations of the Company in a number of spheres. This effect was reflected principally in a significant decrease in the number of reservations and a material increase in the number of cancellations for flights, particularly among tourists, this along with a slowdown in the quantity of reservations among Israelis. According to data from the Central Bureau of Statistics, during the first half of the year 2006, a rise of approximately 19% was recorded in incoming tourist traffic via air in relation to the same period last year, while in the second half of 2006, a decline of approximately 25% was recorded as compared with the second half of 2005. In total, there was a decrease in the year 2006 of approximately 5.3% in incoming passenger traffic by air to Israel and an increase in outgoing traffic of Israelis leaving Israel by air. As a result, a moderate increase of approximately 3.6% was recorded in international passenger traffic (Israelis and tourists) at BGA during the year 2006 as compared to the year 2005. Additionally, the War in Lebanon led to an increase in the security and operating costs of the Company. The war had substantial consequences to the tourism industry in Israel , which themselves also had an indirect effect on the Company's operations and financial results (see also Sections 9.18.1, 9.18.4, 9.18.7 and 9.18.13 below). The war negatively affected the financial results of the Company for the third and fourth quarters of the year 2006, and this significantly influenced the financial results for the year 2006 as a whole. During the year of 2006, a rise of approximately 4%7 was registered in cargo traffic to and from Israel in comparison to the year 2005. See Section 8.1.3 for details.
6.3 Fluctuations in jet fuel prices Jet fuel for aircraft is a significant component of the Company’s expenses. The prices of jet fuel are characterized by numerous and severe fluctuations. During the year 2006, the trend of sharp increases in jet fuel prices continued and reached their peak in the month of August 2006. Subsequently, the price increase was checked and a significant decrease began which continued until the end of the year 2006, so that in total, jet fuel market prices rose by an average of approximately 15% as compared to 2005 prices. See Sections 9.5.1 and 9.18.2 below for details.
7 The data is based on the Company's estimate, this after deducting Sixth Freedom activities of El Al through BGA, and adding mail operations of the Company. It should be stated that even without deducting these operations, the rate of increase in traffic was approximately 4%.
a-18 Translation of the Hebrew Language financial statements
6.4 Currency rate fluctuations The Group’s results are affected by a number of currencies. Fluctuations in the exchange rate of the dollar vis-à-vis other currencies are likely to cause an improvement or erosion of the Group’s profitability. As of December 31, 2006, there was a decrease of approximately 8.2%, as compared with December 31, 2005 in the exchange rate of the U.S. dollar against the shekel.
As of December 31, 2006, there was a decrease of approximately 10.2%, as compared with December 31, 2005 in the exchange rate of the U.S. dollar against the Euro.
The weakening of the dollar vs. various currencies in the year 2006 negatively affected the Group’s profitability. See Section 9.18.6 below for details.
6.5 Interest rate fluctuations The Company took loans in a significant volume at variable interest that is based upon LIBOR interest, in order to finance the acquisition of aircraft. A change in the LIBOR interest rate might materially affect the Company’s financing expenses. In 2006, an increase of approximately 46% took place in the average LIBOR 3-month interest rate, compared with its average rate during 2005. During 2005, there was an increase of about 120% relative to 2004. See Section 9.18.9 for details.
CHAPTER 3: DESCRIPTION OF THE CORPORATION’S BUSINESS BY OPERATING AREAS
The following is a description of the business of the Group for each of the operating areas separately, with the exception of matters which apply to the overall operations of the Group, which are described collectively in the framework of Section 9 below.
7. Passenger aircraft area 7.1 General information on the operating area The principal activity of the Group in this area is the Transport of passengers on scheduled and charter flights. In addition, the Company carries cargo in the belly of the passenger aircraft, an activity that is auxiliary to the activity of Transport of passengers. Additional auxiliary services are associated with the service in this area, including: sale of duty free products to passengers. Accordingly, in the context of describing this operating area, the Company has focused on a description of Transport of passengers. Certain matters which relate to the Transport of cargo in the belly of passenger aircraft are similar to the service of carrying cargo in cargo aircraft, which are described in Section 8. The following is a description of trends, events and developments in the macroeconomic environment of the Group, which have or are likely to have a material effect on operating results or on the developments in the operating area, this in the following areas:
a-19 Translation of the Hebrew Language financial statements
7.1.1 The structure of the operating area and changes that have taken place As mentioned, the main operating area of the Company is air Transport in passenger aircraft in scheduled flights from and to Israel. By using passenger aircraft, the Company carries both passengers and cargo in the belly of the passenger aircraft. The flight rights under which the State permits a “designated carrier” to carry passengers on international routes are stipulated in international agreements. Each nation determines an air carrier as a “designated carrier” on its behalf to operate the flights and utilize the flight rights. The Company serves as the designated air carrier of the State of Israel for most international routes that operate from and to Israel.
7.1.2 Legislative restrictions, regulations and particular obligations applicable on the area The operating area of carrying passengers and cargo in passenger aircraft is distinguished by international and local regulatory restrictions in various areas. Among other things, authorization is required for operating a flight from one country to another country. In accordance with international agreements, each nation is permitted to grant authorization for the operation of scheduled flights (appointment as a “designated carrier”) to one company or to a limited number of airlines, as stipulated in the agreement. The number of designated carriers that have been appointed between two destinations is likely to materially affect the competition between those destinations. The frequency of the flights and the volume of traffic are also conditional on obtaining consents from the aviation authorities in both countries. Additionally, each flight needs a takeoff or landing slot at the airports to or from which it operates. A commercial and operational license is required in order to operate flights. In the context of these licenses, the State sets various restrictions on the holder of the license. In the framework of international treaties and agreements and local legislation, arrangements have been determined that are connected to implementation of the operating area, which include rules concerning the responsibility of the air carrier for damages caused during the course of international air transport and the responsibility of the air carrier for delays and flight cancellations. Additionally, the Group is committed to operate according to special instructions regarding flight security, which impose additional costs on the Group. Also, the Group is obligated to maintain a minimal fleet of aircraft, in accordance with the Special State Share. In addition to scheduled flights, the Company is also engaged in carrying out charter flights by leasing aircraft capacity to organizers of charter flights at prices agreed on in advance and the sale of blocks of seats to agents. Over recent years, the Ministry of Transport has instituted a relatively liberal policy, which has permitted many airlines to carry out charter flights to and from Israel. See Section 9.11 below for details.
7.1.3 Changes in the volume of operations and profitability of the area (A) International developments According to IATA estimates, in the year 2006, the airlines in the industry enjoyed stability and growth in passenger traffic.. International passenger traffic grew at a rate of approximately 5.9% in 2006, a little lower than the growth rate registered for the year 2005 (7.6%). Concurrent with rising passenger traffic, there was an increase in 2006 in the capacity of passenger flights (the number of seats offered by the airlines), at a rate slightly lower (4.6%)
a-20 Translation of the Hebrew Language financial statements than the rise in traffic. As a result, IATA estimates that the load factor in 2006 was approximately 76% in comparison with about 75.1% in 2005.
In IATA's assessment, the operating profit of the world's airlines for the year 2006 generally improved as the result of enhanced utilization as well as efforts to streamline and a cutback in expenses other than fuel that were undertaken by the airlines. See Section 6.1 above for further information regarding the forecasts and assessments of IATA.
The following table presents the operations of the international airlines (scheduled flights) during the last six years and also the revenues and profitability of the industry during that period.
International operations of the aviation industry and its profitability from the passenger aircraft area8 (scheduled flights) of airlines that are members of IATA
Operational Operating income Year Output revenues 9 (loss) ($ billions) ($ billions) RPK10 Annual RTK11 Annual Before After (in change in (in change interest interest millions) RPK (%) millions) in RTK expenses expenses (%) 200612 2,184,733 6 267,222 5 No data13 10.2 (0.5) 2005 2,063,015 8 255,470 6 210.7 5.1 3.1 2004 1,932,272 16 242,118 16 190.8 4.4 2.5 2003 1,669,449 (2) 209,395 (2) 161.4 (1.2) (4) 2002 1,707,003 1.5 213,343 1 161.4 (1) (3.8) 2001 1,681,776 (4) 210,782 (5) 145.6 (7.8) (10.3)
In the estimation of IATA14, a slight decline is anticipated in the rate of growth of international passenger traffic during the year 2007 and it is expected to reach approximately 5%, this due to the forecast for a minor economic slowdown in the United States and the global economies.
The forecasts, estimates and assumptions of IATA regarding the volume of world activities and operating results in the aviation area as above represent prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). Accordingly, the actual change in the volume and results of world activity in the aviation area may be materially different from that forecast as aforementioned, as the result of a large number of factors, including a change
8 The source of the data regarding 2001-2005: IATA publications (World Air Transport Statistics) (WATS; 50th edition- 2006).
9 Including revenues from cargo aircraft.
10 Revenue Passenger Kilometer - the number of paid passengers multiplied by the distance flown.
11 Revenue Ton Kilometer - the weight in tons of passengers and paid cargo multiplied by the distance flown.
12 Data, estimates, approximations and forecasts of IATA relating to the year 2006 are preliminary. Final data regarding 2006 is expected to be issued by IATA during the month of March 2007 in the framework of World Air Traffic Statistics. 13 As of the date of the report, this data has not yet been published by IATA. 14 IATA forecast taken from IATA publications from: IATA Web Site: Carrier Tracker 12/06. This estimate refers to the aviation industry as a whole, including flights and charter flights of the scheduled companies.
a-21 Translation of the Hebrew Language financial statements in world economic, security and geopolitical conditions, regulatory changes and from the outbreak of epidemics and the actions of other natural forces.
(B) Developments in the Israeli market International passenger traffic to/from BGA during the year 2006 totaled approximately 8.8 million passengers and represents an increase of about 4% compared to 2005. This increase was derived from the continued rise in traffic of Israeli residents (+4.4%). In contrast, due to the War in Lebanon, which began in the month of July 2006 and continued until the middle of August 2006, a severe decrease in demand on the part of tourists wishing to come to Israel was recorded. Despite the moderate growth in international passenger traffic to and from BGA airport, commencing in the year 2006, passenger traffic for 2006 was still lower than passenger traffic in the year 2000, prior to the breakout of the Intifada, the September 11, 2001 crisis, the SARS epidemic, the war in Iraq and the war in Lebanon. The table below presents the development of passenger air traffic to and from Ben-Gurion airport during the last few years:
15 Passenger traffic from and to Israel (from/to BGA)
Year Passenger traffic at BGA (Thousands of Yearly change-increase (decrease) (in %) legs) 2006 8,795 4 2005 8,480 12 2004 7,590 13 2003 6,730 (1) 2002 6,800 (13) 2001 7,845 (15) 2000 9,266 10
The table and the graph below reflect the trends of incoming tourist traffic to Israel and the departing residents in recent years16:
Year Incoming tourism Departing residents (Thousands of Rate of change (Thousands of Rate of change passengers) (in %) passengers) (in %) 2006 1,565 (5.3) 3,145 4.4 2005 1,653 23.5 3,013 5.0 2004 1,339 37.8 2,868 6.7 2003 972 24.8 2,689 (4.9) 2002 779 (26.5) 2,828 (8.3) 2001 1,060 (45.8) 3,085 7.5 * The data in the table is in thousands of passengers.
15 Source: Civil Aviation Administration (including non-paying passengers). In addition to the traffic to BGA, tourists in regular and charter flights arrive in Israel through the Eilat airport in minimal amounts as compared to the traffic at BGA. The term “leg” means a flight section from destination to destination.
16 Data of the Central Bureau of Statistics.
a-22 Translation of the Hebrew Language financial statements
4,000 3,145 3,500 3,085 3,013 2,872 2,828 2,869 2,689 3,000 2,522 2,343 2,214 2,500 2,012 1,847 2,000
1,500 1,827 1,954 1,676 1,610 1,561 1,549 1,653 1,565 1,000 1,339 1,060 972 500 779 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Departing Israelis Incoming tourists
During the year 2006, 1.6 million, and in total , a decrease of approximately 5% in entries by air into Israel by tourists were registered in comparison to 2005. In the Company’s estimation, incoming tourism traffic to Israel during the last five years was affected by the international trends in passenger traffic, but primarily from geopolitical processes in Israel or in the region, which affected the feeling of personal security of tourists visiting our region. In the year 2006, the trend of increase in outgoing tourism also continued (approximately 4%). In total, 3.1 million exits of Israelis by air were recorded, which represents a record number of Israelis going abroad. In the Company’s estimation, the traffic of Israelis was affected principally by the economic situation in Israel. In the estimation of IATA17, in the year 2007, there will be an approximate 5.1% growth in passenger traffic flying to and from Israel as compared with the year 2006. The forecasts and estimates of IATA regarding the volume of passenger traffic to and from Israel as above represent prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). The actual change in the anticipated volume of the number of incoming tourists to Israel and the outgoing tourism from Israel may be materially different from that forecast as aforementioned, as the result of a large number of factors, including a change in economic, security and geopolitical conditions in Israel. This information is supported, inter alia, by the Company’s assessments in light of the trends of change in tourism during recent years and in view of the economic, security and geopolitical situation in Israel during the year 2005. Accordingly, the actual change in the anticipated volume of the number of incoming tourists to Israel and the outgoing tourism from Israel may be materially different from that forecast as aforementioned, as the result of a large number of factors, including a change in economic, security and geopolitical conditions in Israel.
17 Forecast of IATA out of IATA publications from: IATA Passenger Forecast 2006-2010 published by IATA, October 2006.
a-23 Translation of the Hebrew Language financial statements
7.1.4. Developments in the markets of the operating area or changes in the characteristics of its customers In recent years, there has been severe competition in the passenger aircraft transport area between tens of international scheduled and charter airlines. The airlines compete in various areas, principally: fares, frequency and dates of flights on time performance, equipment type, airplane configuration, passenger service. The competition in fares is reflected primarily by offering reduced rates to passengers. The competition is present both with relation to direct scheduled flights between various destinations and with relation to charter flights to the same destinations. Also, in this context, there has been an increase in the activities of the foreign airlines in Israel in the framework of sixth freedom (indirect flights by means of a stopover in the home country of the airlines). For example, a flight of a European airline from Israel to the United States through a European airport. Additionally, during recent years, the aviation world has been penetrated by airlines known as “low cost”18, which maintain low costs expenses and generally offer very competitive prices. The growth in the number of foreign airlines operating out of BGA, in the number of scheduled flights and in the seat capacity of the foreign airlines, on the one hand, against the moderate growth in demand, on the other hand, has caused excess capacity and an exacerbate of competition for part of the routes and to a decrease in the market share of the El Al out of total passenger traffic at BGA and, as a result, has negatively affected the Company's financial results for the year 2006. See Section 7.1.10 below for further details.
7.1.5 Technological changes that could materially affect the operating area From the standpoint of marketing and distribution, in the year 2006, there was a continuation of the trend towards global growth in the use of e-ticketing, in direct marketing of airline tickets by means of the Internet and in carrying out independent check-in and seating. These trends are intended to reduce the distribution and marketing costs of the airlines. The Company is continuously conforming its operations to these trends by the development of means to permit its customers self-service, as in the instance of purchasing tickets and taking care of check-in and seating by means of the Internet, independent check-in and seating by means of terminal locations, etc. • The Company is currently positioned in an advanced stage towards approval of a contract with the Amadeus Company to supply the Company with a reservation system to replace the current "Carmel" system. (See Section 7.6.2 below for further details on the "Carmel" system and replacing it}. • During the year 2006, in the framework of an organizational and technological change, the Company began to activate a unified telephone service center that includes approximately 200 service positions. The new telephone center includes advanced technological solutions in the telephony and computer fields, provides various services to customers in the areas of passenger and cargo flights, and has set the improvement of the level of service as a goal. • During the last quarter of the year 2006, the Company began the process of integrating the "Rotem" system, which is a system for planning the manning of air flight crews
18"Low cost" companies are relatively new airlines with a structure of low expenses deriving mainly from direct marketing by means of the Internet and not through distribution systems and travel agents. Use of secondary airports, minimal service profile during the flight and operations on short range flights, with no cooperation agreements with other companies and high utilization of aircraft.
a-24 Translation of the Hebrew Language financial statements
(pilots and stewards). The integration process is anticipated to end during the 2007 year. The system, shelf software of the LHS Company, is designated to enhance the ability of planning and positioning of the air crews and to permit the Company to have better control over the related expenses • During the year 2005, the Company began a process of outfitting for Internet surfing services, by means of broad band technology, in the framework of the Connexion project, for passengers on its 777 and 747-400 aircraft. At the beginning of July 2006, the Company received a notice from the Connexion Company of Boeing regarding the termination of marketing of the product due to problems at Boeing, and of their intention to consider various possibilities and methods of completing or selling the project. Due to termination of the marketing of the product by Boeing, the service on the Company's aircraft was terminated and, pursuant to the terms of the agreement, Boeing paid compensation to the Company during the month of January 2007. See Note 25 (e) to the financial statements for details. • The Company is acting to execute significant expansion of its commercial capabilities via the Internet, including translation of its Internet site into additional languages, providing the resources to pay and sell abroad, etc • In recent years, the aviation market has geared up to contend with terrorist incidents by means of broadening the use of advanced and other technological means, on land and in the air. In the framework of these preparations, the Company is, inter alia, taking action to scrutinize and install protective measures as described above. • During the third quarter of the year 2006, the Company issued a tender to receive proposals for the implementation of a solution for management of back office systems by means of ERP technology. Currently, the Company is in the stage of surveying the proposals received.
7.1.6 Critical success factors in the operating sector and changes that have taken place in them A number of factors can be pointed to in the operations of the passenger and cargo transport area via passenger aircraft which affect the competitive position in the sector: the economic and security situation in Israel which influences passenger traffic to and from Israel; the image of the Company in the eyes of the customers, including matters of safety and quality of service; the ability to offer flights to popular destinations at competitive prices and development of a network of routes on an independent basis and in cooperation with other airlines; preservation of flight rights; the ability to offer flights at the frequency demanded and with the capacity demanded; a distribution system; risk management by implementing appropriate risk hedging policies.
7.1.7 Changes in the supplier network and the raw materials for the operating area The primary raw material which serves airlines is aircraft fuel (jet fuel) and it represents one of the major expense components of an airline. See Section 9.5.1 below for details relating to fuel.
a-25 Translation of the Hebrew Language financial statements
7.1.8 Main entry and exit barriers of the operating area and changes that have taken place in them One of the most significant entry barriers in the area of the international scheduled flights is obtaining the authorization to carry out scheduled flights from one country to other countries. In accordance with international agreements, each country is permitted to grant the authorization (appointment as “designated carrier”) to carry out flights from that country to other countries to only one company or to a limited number of airlines, as stipulated by agreement. The more liberal the aviation agreement between countries, the lower the entry barriers. According to a Government resolution in May 2003, preference was given to the status of El Al as designated carrier for destinations as to which the Company was designated carrier as of that date, subject to meeting certain conditions. Nevertheless, we must state that, in January 2006, Israir Aviation and Tourism Ltd. was granted the status of an additional Israeli designated carrier for the Tel-Aviv-New York route, although the quantitative conditions stipulated in the May 2003 Government decision had not been complied with. (See Section 9.11.7.2 below for details). In addition to obtaining authorization from the mother country of the airline, consent is generally required from the countries to which the airlines wishes to fly with relation to the number of flights and to the capacity of the flight. Also, each flight is required to have a slot with regard to takeoffs or landings at the airports to or from which it operates. See Section 8.1.8 and Section 9.11.7 below for details. The most important additional entry barrier is the initial relatively large investment which is necessary in order to establish and operate an airline, including acquisition or leasing of aircraft. Under the international aviation agreements, obtaining the appointment as designated carrier is conditional upon the substantial ownership and effective control of the air carrier being in the hands of the state or citizens of the country which has specified that it be the designated carrier. This requirement represents an entry barrier for obtaining the appointment as designated carrier by foreign citizens. With relation to the operation of passenger aircraft in international charter flights-each Israeli carrier must obtain a license to operate charter flights from and to Israel, which is subject to sundry demands at the center of which are: economic competence and ownership or leasing of at least two aircraft. Additionally, each Israeli carrier and foreign carrier must obtain authorizations for charter flights from the Civil Aviation Authority. At present, there exists a more liberal policy of granting authorizations in the area of charter flights, both with relation to Israeli charter airlines as well as with relation to foreign charter companies. Therefore, in the Company’s estimation, there are no material entry barriers in the field of charter flights.
a-26 Translation of the Hebrew Language financial statements
7.1.9 Substitutes for services of the operating area and changes that have taken place in them The substitutes for Transport in passenger aircraft are Transport by other means (ocean and land vehicles and cargo aircraft for cargo in the belly of passenger aircraft). In addition, the Group has competitors that offer alternative Transport in passenger aircraft [by means of regular flights, charter flights and sixth freedom flights (indirect flights with stopovers in the home country of the airlines)]. There were no substantial changes during 2006 in the substitutes for Transport by means of passenger aircraft. In the Company's estimation, the major considerations in preferring a flight over sea and/or land transport are: purpose of travel, time schedule of the traveler, the distance and the nature of the route.
7.1.10 Structure of competition in the operating area and changes that have taken place in it
A) General • There is severe competition in the passenger aircraft Transport area between tens of international scheduled and charter airlines. The airlines compete in various areas, principally: fares, frequency and dates of flights, on-time performance, equipment type, airplane configuration, passenger service, bonuses to frequent travelers, commissions and special incentives to travel agents and supply of computerized ordering and distribution systems to travel agents. Price competition is reflected mainly by offering cheaper fares to passengers or special rates to cargo shippers. The competition is not only with the designated carrier of the country that is located on the other end of the route and with charter airlines that operate on the same route, but also with other airlines, including those not operating flights to Israel (offline airlines), this as the result of the diverse alternatives of the traveler to arrange his own flight schedule, in which a number of airlines participate, and the strengthening of co- operative agreements between airlines (Star, Sky Team, One World) • Also, most of the scheduled airlines which operate flights to and from Israel also carry passengers on sixth freedom flights (indirect flights with a stopover in their mother country). For example, a European company offers a flight from Israel to the United States through a European airport. Because the flight from the home airport (Europe) to the United States is carried out without any connection to the flight from Israel to Europe, the situation sometimes permits the foreign company to lower the total price for the flight from Israel to the United States (through Europe) without impairing the price for which the airline ticket from Europe to the United States is sold. As a matter of fact, sometimes the foreign airlines offer the airline ticket from Israel to the final destination (the United States, for example) at a price lower than the price which they propose for the flight from the stopover destination (Europe, for example) to the final destination. On the other hand, El Al does not presently benefit from similar possibilities to transport passengers between different countries via Israel, primarily because of the current geopolitical situation. A significant portion of the aviation agreements between Israel and other nations state that the offered capacity must be based on the volume of the traffic between Israel and the other nation with which the agreement was signed. Accordingly, the policy of the Ministry of Transport has been to restrict the flight capacity in the context of sixth freedom (indirect flights with a stopover in the mother country of the airlines) of the foreign companies. At the beginning of the year 2006, the Civil Aviation Authority
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approved the applications of a number of foreign airlines to increase their flight capacity to and from Israel, including the applications of Austrian Airlines, Lufthansa, Alitalia, Aerosvit, Turkish Airlines, Royal Guardian and Air Madrid. Also, the commencement of flights to Israel was approved for Delta and "Haphag Lloyd" (a subsidiary of TUI of Germany which, among other things, operates low cost flights). • In view of the aforesaid, a trend is evident towards reducing the limitations imposed by the Ministry of Transport and the Civil Aviation Authority on the flight capacity of the foreign airlines. As a result, beginning from the second quarter of the year 2006, there has been a substantial exasperation of competition at BGA, which has negatively affected the financial results of the Company for the 2006 year. • Additionally, with the breakout of the war in Lebanon in July 2006 and thereafter, foreign scheduled airlines have avoided canceling flights and adjusting the supply of seats despite the decline registered in demand. In total, the supply of seats at BGA (all companies, scheduled and charter) grew by only 6% during the year 2006, this due to the reduction of flight capacity by the El Al Company and the charter companies, in conformance with the drop in demand.
B) "Open skies" Policy • At the beginning of the year 2006, and pursuant to the "open skies" policy led by the Israeli Ministry of Tourism, approvals were given for the addition of capacity and frequency to the foreign airlines operating on routes to and from Israel including: • Air France and Austrian airlines doubled the frequency of their weekly flights from 7 to 14 for each of the companies; • Iberia increased weekly flights from 10 to 14; • Turkish Airlines also increased the frequency of its weekly flights from 15 to 17; • British Airways and Lufthansa received approval to expand their seat capacity without adding flight frequencies, by operating larger aircraft; • Israir began operating scheduled flights on the New York route. • Furthermore, authorizations were given to new airlines to begin to operate on routes to and from Israel, including: • "Haphag Lloyd" which began to operate between Munich and Düsseldorf and between Tel Aviv. • "Air Baltic" began to operate in June 2006 on the Riga-Tel Aviv route. • "Air Madrid" began to operate on the Tel Aviv- Madrid route, but as of the date of the report, it had ceased to operate entirely. • The U.S. "Delta" airline began to operate during the month of March 2006 on the Tel Aviv-Atlanta route. • Due to the open skies policy, there was an increase during the year 2006 of approximately 19% in the flight capacity of the scheduled foreign airlines that fly to and from Israel (increase through additional frequency and/or use of larger aircraft on the route) in comparison to the year 2005. In total, traffic at BGA (scheduled and charter) grew by only approximately 3.6%. (See Section 7.2 (b) below for details as to the changes that took place during the year 2006 in the volume of passenger traffic by destinations). Most of the rise in operations of the foreign airlines is evident on the transatlantic routes, on which the capacity of the scheduled foreign airlines grew by a total of approximately 38% as against the year 2005, and the routes to Western
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Europe on which capacity of the scheduled foreign airlines grew by a total of approximately 20% as against the year 2005. • The increase in the number of foreign airlines operating out of BGA, in the number of scheduled flights and in the seat capacity of the foreign companies, on the one hand, and the decline in demand, on the other, caused excess capacity and severe competition on part of the routes, to a decrease in the market share of the El Al out of total passenger traffic out of BGA and, as a result negatively affected the Company's financial results for the year 2006. See Section 7.1.4 above for additional details . See Section 9.11.2 (b) below for regulatory changes which could change the structure of competition in the operating area.
C) "Open skies " agreement (Europe-United States) In March 2007, the media reported on a draft "open skies" agreement that was agreed to between the U.S. and Europe. The details of the agreement have not yet been officially published. From partial information that were publicized by the world communications media, it appears that the arrangement is intended to initially cancel the national restrictions within the European Union, and permit every airline within the borders of the European Union to fly from every city of the European Union to every city in the U.S.. Furthermore, the European airlines may merge without loosing their flight rights to the U.S. Additionally, the U.S. agreed to ease the restrictions on foreign ownership of American airlines, so that the foreign airlines and foreign private investors will be permitted to own up to 49% of them (but no more than 25% of voting shares). At present, those opposing this agreement are British Airways and Virgin Atlantic airlines, two of the largest transatlantic airlines in Europe, which are expected to be harmed the most from the agreement, since Great Britain holds approximately 40% of the transatlantic market between the European Union and the United States. Should the agreement be approved, it will have a significant impact on operations of Heathrow Airport, from which operations are presently permitted only by the airlines: British Airways, Virgin Atlantic, United Airlines and American Airlines. The European Union Commission has announced that, during the month of March 2007, it will present the draft agreement to the governments of the member nations of the Union, for the purpose of signing the agreement at a summit meeting of the leaders of Europe and the United States to be held in Washington on April 30, 2007. At present, it cannot be estimated whether this agreement will have material implications on the Israeli aviation market.
D) Charter companies In accordance with the policies of the Ministry of Transport and the charter regulations, since the mid-90, the charter airlines enjoy wide freedom from restrictions with regard to routes, fares and frequencies. The competition from the charter airlines is immense and aggressive, in particular as to routes between Israel and Europe to destinations that have intensive Israeli traffic to vacations and recreation in Europe. Recently, the Civil Aviation Authority has given approval to charter airlines to even transport cargo in passenger aircraft which they operate, as the result of which there has only been a minimal increase in the supply of capacity. However, due to the decline in demand from incoming tourism due to the War in Lebanon, the foreign charter airlines have reduced their activities on the
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routes to and from Israel. During the last quarter of the year 2006, the foreign charter airlines reduced their capacity by 23% in comparison to the same period last year. From an annual view, the charter airlines(Israeli and foreign) transported approximately 21% of international passenger traffic at BGA, while a significant trend of decline in the share of the charter airlines in total passenger traffic at BGA (to/from BGA)19 has been evident during recent years, as reflected by the following table:
Year Share of charter airlines out of total passenger traffic at BGA 2006 21% 2005 22% 2004 23% 2003 25% 2002 28% 2001 28%
E) Low cost companies In addition, in recent years, airlines known as low cost have penetrated the world of aviation. These airlines maintain low costs expenses and generally propose very competitive prices, while providing a lower level of service and using alternate, less desirable airports. These airlines have succeeded in growing enormously in the United States, in Canada and in Europe. An stirring in this field has also been felt recently in Asia. The entry of the low cost airlines into certain markets forces the airlines which compete in these markets, which do not have a low cost structure as do the low costs, to become more efficient in order to reduce costs. Until now, the low cost airlines have operated on relatively short flights, and they have not operated on flights to and from Israel. Nevertheless, it should be pointed out that in February 2006, Germany appointed the "Haphag Lloyd" company, a subsidiary of the aviation and tourism giant, TUI, which among other things, which, inter alia, operates low cost flights, as a designated carrier for routes between Munich and Düsseldorf and between Tel-Aviv. See Section 9.18.12 below for further details.
7.2 Services in the operating area A. General The main services which the Company provides in this operating area are air Transport of passengers and cargo to various destinations by using passenger aircraft. As of the date close to the approval of the report, the Group operates flights in passenger aircraft to approximately 40 destinations, in about 30 countries in Europe, North America, the Far East and Central Asia and other destinations. Additionally, during the winter season, the Group operates flights from a number of locations in Europe to Eilat. During the year 2006, the Company began to operate direct flights (non stop) to Miami and Los Angeles. Towards the end of the 2006 year, the Company gave notice of its decision in principle, to cancel the operation of the flights between Tel Aviv and Cairo, due lack of economic feasibility in operating the route
19 Source: Civil Aviation Authority
a-30 Translation of the Hebrew Language financial statements caused by the high security costs borne by the Company, and as part of the Company's actions to reduce expenses. The cancellation of the flights was planned for the month of December 2006, but the Company responded to the request of the Ministry of Transport to continue to operate the route, in light of the announcement of the Managing Director of the Ministry of Transport that the continued operation of the route would take place along with an increase in the State's participation in the security expenses for operating the route to 75% of security costs (as opposed to participation of 50% of security costs on remaining routes. As of a date close to the approval of the report, the mechanism for State participation as aforesaid, has not actually been agreed upon. Also, the Company ceased operating flights on the Larnaca and Istanbul routes beginning from March 2007 due as well to lack of economic feasibility, and even took a decision to cease the flights to Chicago after April 2007. During 2006, the Company operated approximately 200 weekly flights on the average in each direction. In addition to the flights which the Company operates, the Company markets flights in the framework of agreements with other airlines (interline agreements) which make it possible for passengers on regular flights, subject to certain restrictions, to use airline tickets issued by another airline, for flights of the other airlines. The accounting between the airlines is done on a monthly basis, generally by means of IATA's clearing house. The scheduled airlines also operate flights in the context of “code share” .The use of the code share permits the air carrier to market flights of another air carrier as if they were its own flights, so that the passenger orders the flight through one carrier, despite the fact that, in actuality, he flies with another carrier. The code share provides the participating carriers with the possibility of increasing the frequency of the flights that are offered to its customers, accessibility to additional destinations and also marketing advantages, including amplifying the attractiveness of joining the Group’s frequent flyer club. The Company also operates in this field in recent years. As of the date of the report, the Group has activated code share agreements with 12 other airlines. Most of the agreements permit operation of flights by the two companies. See Section 9.11.2 (g) in the chapter on restrictions and supervision over the business of the entity-business restrictions for legislative changes which may materially affect the Company to enter into "code share" agreements. In its scheduled flights, the Group operates four service sections which are distinct one from the other in the type of seat, the space between the seats, the food and beverage menu, the manner of serving, the assortment of convenience and leisure products and the number of flight attendants in relation to the number of passengers. The sections are: first class, improved business section- platinum, business section and tourist section. As part of the charter flights, a service profile is activated which conforms to the charter operations. Not all sections operate in all flights. All scheduled flights contain a system of programs of sound, films, screened magazine and printed magazine and services are provided for the sale of duty free products and catalog sales of electrical products which may be purchased during the flight (without duty exemption) and be received as a shipment to the customer’s home. The Company signed a cooperation agreement during the month of November 2006 with the HOT Company for the upgrading of in-flight entertainment content (video, printed magazines and sound). In 2005, a text message notification system was established, providing the passenger with essential information on various subjects, such as takeoff and landing time and baggage conditions.
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The replacement of seats with electrically-operated seats with enlarged space was completed during the first quarter of 2006 in the prestigious sections on the 767 aircraft and a power electrical plug point for computers was also installed for these seats, to permit working during the course of the flight without being dependent on batteries. Additionally, installation of Iridium satellite telephones in the 767 aircraft is being executed to allow phone conversations at attractive prices during the flight. In addition, the Group has completed the upgrade of all seats in business class on all aircraft in the 737 and 757 fleets, which mainly operate on European routes. The new seats are comfortable hammock seats with innovative design which permit increased inclining and have greater personal space. Furthermore further improvements are planned to the seats in the prestigious sections in the 747-400 and 777 aircraft fleets, commencing from the summer of 2007. See Section 7.11 (c) below for further details. Starting in the month of March 2006, the Company has been operating a unified telephone service center consisting of approximately 200 service positions. The new center includes advanced technological solutions in the telephone and computer areas. In addition to regular flights, the Company is engaged through Sun D’Or, in carrying out charter flights by leasing capacity in aircraft to organizers of charter flights at prices agreed upon in advance, and the sale of blocks of seats to agents. The charter flights are generally undertaken to recreation destinations. The Group’s flights are supported by a system of ground services which administers the processes of boarding passengers and their baggage, their alighting at the destination airport and unloading their baggage, and cargo handling. The ground services exist at BGA and at each of the destinations at which the Group’s aircraft land. At the same time, the Company operates an array of ground security in each of the airports abroad at which the aircraft of Israeli airlines land and a system of air security, which operates during the flights of passengers of Israeli airlines. (The ground security system at BGA is operated by the Airports Authority).
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B. Data regarding the destination groups of the Group The following are data regarding the Group's market share separated into groups of central destinations, with relation to all passenger traffic to or from BGA, broken down into these destination groups:
To/from Number of passengers broken down to Company estimates BGA destinations of direct flights20 (in thousands of market share of of legs) the Company (in %)21 Change 2006 2005 2004 2006 2005 2004 (in %) in 2006 North 9.8 1,426 1,299 1,162 47 49 49 America Europe 2.6 5,486 5,346 4,890 43 44 42 Far East and 17.0 324 277 249 60 60 61 22 Central Asia Other (1.1) 1,303 1,318 1,110 19 23 19 Total 3.6 8,538 8,239 7,412 41.2 42.8 43
C. The routes to North America (to the United States and Canada) During the height of the 2006 summer season, the Company operated approximately 32 weekly flights to North America and during the 2006 winter season, it operated about 26 weekly flights (mostly to New York). Commencing from the end of the month of March 2006, the Company began also to operate 2 direct, non-stop, weekly flights to Miami, and starting from the month of July 2006, the Company also has been operating direct flights 3
20Data of the Civil Aviation Authority relate to the airlines that carry out the flights and not to the destinations of the flights. Therefore, this data represents an estimate of the Group based on analysis of the data of the Civil Aviation Authority, after deducting non paying passengers. This data has been broken down by the direct flight destination and does not make a distinction as to the true destination of the passenger when the subject is sixth freedom flights of foreign companies (flights from Israel to a foreign country with a stopover). 21 This data has been broken down by the passenger’s final flight destination (including the final destination in sixth freedom flights). The Company’s estimate concerning the passenger’s final destination is based upon data from global distribution systems. The Company is unable to assess the level of precision of the data obtained from the distribution systems. This data does not include non paying passengers. It should be noted that the Civil Aviation Authority publishes data which includes non paying passengers and is broken down by the airline companies which carried out the flights (and not by the destinations), so that in cases of a flight of sixth freedom of a European company between Israel and the United States via an airport in Europe-the flight will be attributed to the mother country of the European airline. According to the processing done by the Company of the data of the Civil Aviation Authority (deduction of non paying passengers according to the Company’s estimate and a breakdown of the flights to the mother countries of the airlines, while ignoring sixth freedom flights), the market shares of the Company were: in the North America route: 55.7% in 2006 vs. 63.6% in 2005; in the European routes: 36.2% in 2006 vs. 37.3% in 2005; in the Far East and Central Asia routes 95.1% in 2006 vs. : 97.6% in
2005; in other destinations: 14.4% in 2006 vs. 15.6% in 2005.
22 The Group is unable to assess the level of precision of its estimate of the market share which includes sixth freedom flights in the Far East and Central Asia market, Africa and local destinations (such as Turkey, Greece and Cyprus), this in view of the lack of precision of the information in the Company’s possession regarding the number of passengers of other airlines in this market.
a-33 Translation of the Hebrew Language financial statements times a week on the Tel Aviv-Los Angeles route. Due to lack of economic feasibility, the Company announced its decision to stop its flights on the route to Chicago after April 2007. There is severe competition as to the route between Israel and North America between the airlines that operate on this route (Continental, Delta and Air Canada), which became more pronounced due to the intensive activity of the European airlines which take traffic to the United States and Canada via their home airport (sixth freedom). Additionally, on January 16, 2006, the Minister of Tourism decided to grant the status of an additional designated carrier to Israir Tourism and Aviation Ltd. for the Tel-Aviv-New York route for a period of two years so that commencing from May 2006, Israir began operating scheduled flights on this route. As a whole, there was a sharp increase in activities of the foreign airlines on the transatlantic routes and the capacity of the foreign airlines on these routes grew by about 38% in comparison to the year 2005. This against a rise of approximately 10% in the number of passengers between Israel and North America in relation to the year 2005. Each of the airlines (Israeli and American) on this route has full freedom of action regarding flight fares, number and frequencies, type of aircraft, configuration of aircraft, etc. The Group, as designated carrier to the United States, has the rights to transport passengers, cargo and mail to/ from New York and other points in the United States, in part, solely in the context of “code share”.
D. The routes to Europe The Company has scheduled flights to approximately 30 destinations in Europe, with the central ones being London, Paris, Frankfurt, Rome. Milan, Madrid and Zurich. In general, the Company competes on the routes between Israel and Europe with the national designated carrier of the destination country, and also with other scheduled airlines which take sixth freedom traffic to other countries via their home airport, and with foreign and Israeli charter airlines that operate charter flights to miscellaneous destinations in Europe. In this connection, it should be pointed out that the European scheduled airlines which fly to Israel have an advantage over the Company, since they have the ability to offer continuing flights to destinations to which the Company does not fly. The Group, as designated carrier, has the rights to transport passengers, cargo and mail to/from various destinations in Europe, in part, solely in the context of “code share”. During the year 2006, the competition on these routes became more severe with the granting of authorizations to foreign airlines by the Israeli authorities to increase their capacity. At the beginning of the year 2006, authorizations were also given to new airlines to begin to operate on these routes. (See Section 7.1.4 and Section 7.1.10 above). Most of the growth in capacity was registered on the routes to Western Europe, where the foreign scheduled airlines increased their supply of seats by approximately 20% against the year 2005, and on routes to the nations of the Confederation of Independent States, where growth of approximately 16% was recorded in the capacity of the scheduled foreign airlines. On the other hand, due to the decrease in demand that took place after the War in Lebanon, the charter airlines reduced their activities on the routes to the nations of the Community of Independent States and the routes to Central Europe. In total, an increase of approximately 6% in the supply of seats on this route network (Western Europe, Central and Eastern Europe and the Community of Independent States) in comparison to a rise of only about 3% in passenger traffic on these routes.
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E. The routes to the Far East and Central Asia The Company presently holds a relative advantage as to the routes to the Far East and Central Asia-India (Bombay), Thailand (Bangkok), China (Beijing) and Hong Kong-because it is the only scheduled company which operates scheduled direct flights from Israel to these destinations. Other than the Company, scheduled airlines which operate in Israel operate flights to these destinations in the context of sixth freedom traffic (indirect flights through stopovers in their mother country). Starting from the end of the month of March 2006, the Company started to operate an additional weekly frequency to Beijing (2 weekly frequencies in total), and commencing from November 2006, a fourth weekly frequency was added on the route to Hong Kong. On October 27, 2005, the Company received notification from the Commissioner of Business Restrictions concerning the declaration of the Company as the holder of a monopoly for flying time-sensitive (business passengers) and price-sensitive passengers (holiday passengers) in the civil aviation markets to the destinations: Hong Kong, Bangkok, Bombay and Johannesburg. See Sections 9.11.2 (g). and 9.18.15 (c) below for further details. During the year 2006, a total increase of approximately 6.5% was registered in the supply of seats on this route network as compared with a rise of approximately 17% in passenger traffic on these routes as against the year 2005. Based upon a worldwide trend, there is an expectation for growth in passenger and cargo traffic on the route network to the Far East. Accordingly, the Group is actively attempting to increase its presence in these markets by adding to capacity and flight frequency on existing routes, as well as examining the feasibility of new routes. The data regarding the anticipated growth in passenger and cargo traffic on the route network to the Far East represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). This information is supported, inter alia, by the Company’s assessments in light of the current operational volumes on these routes. Accordingly, the actual change in passenger and cargo traffic on the route network to the Far East, and the Company's arrangements to deal with it may be materially different from that forecast as aforementioned, as the result of a large number of factors, including the outbreak of epidemics, changes in customer preferences, the degree that the market will be opened to additional competition, the success of the Company’s confrontation with competition. See Section 7.8 below concerning competition.
F. Other routes The other routes that the Company operated during the year 2006 were to Turkey, Greece, Cyprus, South Africa and Egypt See Note 24A to the financial statements for details. Towards the end of the 2006 year, the Company gave notice of its decision in principle, to cancel the operation of the route between Tel Aviv and Cairo, due lack of economic feasibility in operating the route caused by the high security costs borne by the Company, and as part of the Company's actions to reduce expenses. The cancellation of the flights was planned for the month of December 2006, but the Company responded to the request of the Ministry of Transport to continue to operate the flight route, in light of the announcement of the Managing Director of the Ministry of Transport that the continued operation of the route would take place along with an increase in the State's participation in the security expenses for operating the route to 75% of security costs (as opposed to participation of 50% of security costs on remaining routes). Also, the Company stopped operating flights on the
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Larnaca and Istanbul routes beginning from March 2007, due as well to lack of economic feasibility As mentioned above, the route to Johannesburg is included in the framework of the declaration of the Company by the Commissioner of Business Restrictions as the holder of a monopoly on 4 routes. See Sections 9.11.2 (g). and 9.18.15 below for further details. In addition, from time to time, the Company operates one time charter flights or short series of charter flights to various destinations. Due to the continuation of the trend of intense competition in the industry, also reflected in the excess capacity existing on the various flight routes, on the one hand, and the Group's policy for optimization of its routes network, on the other, the Group anticipates a decline in its market share during the year 2007, this in particular on the routes on which there is excess capacity. The data regarding the anticipated change in volume of the market share of the Company represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). This information is supported, inter alia, by the Company’s assessments in light of the current operational volumes of the Group and the measure of competition in the markets. Accordingly, the actual change in volume of the market share of the Group may be materially different from that forecast as aforementioned, as the result of a large number of factors, including the degree that the market will be opened to additional competition, the success of the Company’s confrontation with competition and the risk factors that are described in Section 9.18 below. See Section 7.8 below for details with regard to competition.
7.3 Analysis of revenues and profitability from services The following are data concerning the breakdown of the Company’s revenues (consolidated) which are derived from similar service groups in the sector of transport by means of passenger aircraft: (1) Flights from Israel to North America and back; (2) Flights from Israel to Europe and back; (3) Flights from Israel to the Far East and Central Asia and back; (4) Flights from Israel to other destinations and back.
Similar Revenues in thousands of dollars % of total Group revenues service 2006 2005 2004 2006 2005 2004 group North 514,767 519,824 429,777 30.9% 32.1% 31.0% America Europe 638,487 650,217 544,479 38.3% 40.2% 39.3% Far East & 199,331 167,029 141,717 12.0% 10.3% 10.2% Central Asia Other 36,590 34,853 28,233 2.2% 2.2% 2.0% destinations No 12,999 13,761 7,516 0.8% 0.8% 0.5% geographic attribution Total 1,402,174 1,385,684 1,151,722 84.2% 85.6% 83.1%
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The following is the amount of gross profit and the percentage of gross profit for the years 2006, 2005, and 2004 that are derived from the passenger aircraft transport area (excluding segment-wide expenses and revenues not classified):
2006 2005 2004 Amount of gross profit (in 226,753 349,905 279,937 thousands of dollars) Gross profit rate (in %) 16% 25% 24%
7.4 New services From time to time, the Group studies the prospect of increasing the frequency of the flights to existing destinations and the possibility of operating flights to new destinations, according to market demands. During 2006, the Group initially began operating direct (non-stop) flights to Miami and Los Angeles, and the Group also expanded the frequency of flights to a number of destinations. The Group operates charter flights from time to time to popular destinations for short periods, in accordance with demand. The Group is making efforts for added frequency to various destinations and also to expand its destination network by means of "code share" agreements and other agreements with other airlines. See Section 9.11.2. (c) below in the chapter on restrictions and control over the business of the entity-business restrictions, with regard to legislative changes which could materially affect the ability of the Company to enter into agreements of this sort.
7.5 Customers The Group renders its services to passengers who are deemed to be both members of households and of the business sector. The majority of the airline tickets of the Group are sold by means of travel agents and marketers of tourism packages, and directly by the Company to institutions and passengers. The Group does not have a customer in the passenger aircraft sector which is responsible for a volume of revenues that accounts for 10% or more of total Group revenues. See Section 8.5 below for details relating to customers of cargo transport services.
7.6 Marketing and distribution 7.6.1 Travel agents and marketers of tourism packages The great majority of the marketing of airline tickets to passengers is carried out by means of travel agents and marketers of tourism packages. Also, airline tickets are sold by the sales offices of the Group and by direct sale by telephone and the Internet. The Group has 5 sales offices in Israel and approximately 40 sales offices abroad. In addition, the Group sells airline tickets by means of approximately 40 general sales agents (GSA) abroad. Airtour Israel Ltd. (hereinafter- “Airtour”), which is a joint company of the Group and travel agents, is an important marketing channel for the Group in the market in Israel, as a distribution arm to all agents in Israel with respect to sales campaigns, packages and special fares. During the year 2006, approximately 55% of total sales of airline tickets in Israel were executed through Airtour. In the passenger aircraft Transport area, the Group does not have an agent through which sales volume is made which amounts to 10% or more of total Group revenues. The Group estimates that it is not dependent on any single agent in the passenger aircraft Transport area.
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The Group provides support to travel agents and package marketers, inter alia, through the Group’s sales offices. The Company grants commissions and special incentives to travel agents, primarily on the basis of the sales volume of airline tickets. In principle, the consideration to Israeli agents is divided into two parts: a fixed component and a variable commission component, as an incentive. There are various methods in use in the world as regards this matter, in conformity with market needs. During the years 2003 and 2004, the Company changed the commission structure for agents in Israel, so that the fixed component will be lower and the variable component will increase on the basis of production. In recent years, a trend has developed in the world of aviation of a transition to a “net fare” system (fares without commissions) which replaces, in part, the system of sales incentives. The Company sells tickets at a net price in accordance with market demands. The foreign scheduled airlines which operate in Israel have assumed a similar policy to that of the Company. Most of the airlines, including El Al, presently permit agents to deduct the base commission at source, at the time of payment for the tickets sold. The commissions to agents abroad vary from country to country, according to market conditions. See Section 8.5 below for details with respect to commissions in the area of cargo transport.
7.6.2 Computerized reservations system
The reservations for flights are made by means of the “Carmel” computerized order system which also serves both as a cost and as a ticketing system. All sales offices of the Company in Israel and abroad, most of the travel agents in Israel, general agents of the Company and a number of large agents abroad are connected to the Carmel system on an online basis. The Carmel system displays the up to date flight schedule of the Company and of foreign airlines, and permits the users to execute reservations and ticketing on those companies’ flights. The Group also has agreements with certain international distribution systems which allow sale and direct access to the Carmel system by the users of such systems in order to execute reservations for Company flights. The Carmel system is distributed to travel agents in Israel by Sabre Israel Travel Technologies Ltd. jointly owned by the worldwide Sabre (51%) and the Group (49%). See Section 9.7 for additional details regarding Sabre. During the year 2006, various alternatives for replacing the “Carmel” System have been examined and during the year, the Company expects to enter into an agreement with the "Amadeus" Company and to replace the current reservation system. See Section 7.1.5 above for additional details.
7.6.3 Marketing to passengers The Group takes action in order to advertise its services to passengers in the Israeli market and in other large markets. The Group also initiates marketing events, endorsements and joint efforts. The Group sells directly to passengers in an non-substantial volume by means of the reservations department of the Group and its Internet site. The Group additionally operates a business desk which acts to promote sales to business entities, mainly in Israel. In order to bolster the attractiveness of the Group’s flights to passengers who are interested not only in transport to and from Israel, but also in tourism services, the Group markets a variety of ground services for tourists (hotels, tours, car rental) to individual passengers,
a-38 Translation of the Hebrew Language financial statements directly and through agents. For this purpose, the Group markets packages through Airtour. See Section 9.7.2 (b) below. This activity is marketed abroad through the Superstar Holdings (England) company at the Company’s branches abroad by independent direct marketing or through travel agents. The Group also holds shares of marketers of packages operating in Israel: Kavei Chufsha Ltd. (See Section 9.7.2 (c) below for details). See Section 8.5 below for details on marketing and distribution of freight Transport in the bellies of passenger aircraft.
7.6.4 Frequent flyer program As part of the marketing efforts, and in order to fortify the loyalty of the passengers to the Group, the Group offers special benefits to passengers who are members of “frequent flyer” club, which is based upon a recorded data base. The passengers receive credit in points for their flights on all of the Group’s routes. These points enable the passengers to acquire airline tickets at a discount or at no cost, excluding airport fees and fuel increments, and also to upgrade a ticket to a more preferred section and permit entry into the Company’s lounges throughout the world. The Company accrues amounts in its accounts for the redemption of points in the aforementioned frequent flyers club. (See also Notes 2.(l) and 13. to the financial statements.) In recent years, the Group has entered into agreements which allow the redemption of the points with other airlines and/or conversion of points/stars from credit cards and other businesses to the frequent flyers club. The frequent flyers club numbers hundreds of thousands of members and is composed of a number of ranks, according to the level of activity of the members: “regular frequent flyer", “silver”, “gold” and “platinum”. Concurrent with commercial changes made in recent years in the terms of club, including changes in “upgrade” policies, restriction of the use of bonus cards for popular flights, technological improvements were made, including refining the information system by allowing the possibility of executing transactions in their accounts by means of the Internet, enhancing the system for routing the calls at the service center, improving the structure of the statement of account report, etc. Traffic of frequent flyer club members during the year 2006 accounted for about 31% of total passenger traffic for the Company. A program for cultivating and holding onto gold and platinum customers was continued in 2006. The Company is making efforts to broaden the circle of customers to be held on to and to cultivate prestigious customers.
7.7 Reservations backlog In general, a customer is permitted to cancel the reservation, without payment, until the date that the ticket is issued to the customer (“ticketing”).The customer may cancel certain tickets even after ticketing”, at times without payment of cancellation fees and at times with payment of a cancellation fee. There are also tickets which the customer may not cancel at all after “ticketing”. Generally, as the price per ticket is higher, so will there be readiness to allow cancellation of the ticket without cancellation fee or with a cancellation fee in a low amount. See Section 9.11.2 (j) regarding possible legislative changes in the area of consumer protection.
a-39 Translation of the Hebrew Language financial statements
The Company has no financial data as to the volume of forecasted revenues from non cancelable tickets. A portion of these tickets may also be redeemed by the customer over an extended period which does not exceed two years (“open ticket”). The Company has “prepaid income” which is derived from receiving payment in advance for flights which have not yet been carried out. See Note 13 to the financial statements for details of the prepaid income which the Company recorded as of the reporting date.
7.8 Competition 7.8.1 General A. The passenger aircraft Transport area is characterized by severe competition between the airlines which supply transport services between the same destinations or alternative destinations..
B. The Company is the designated carrier of the State of Israel to most of the destinations from which regular flights are operated to and from Ben Gurion airport (BGA). The Group operates flights to most of the destinations which are serviced from BGA.
C. The Group estimates that, as of a date in proximity to approval of the report, the Group competes for flights to and from Israel with approximately 100 airlines, of which approximately 43 airlines operate scheduled flights to approximately 50 destinations in about 35 countries and approximately 57 airlines operate charter flights, including Israeli charter companies: Arkia and Israir. The Company estimates that during the year 2006, the portion of the Group out of all of the traffic from and to BGA stands at approximately 41%. The competition for cargo Transport in the belly of passenger aircraft, which is included in this area, is against airlines that are engaged in transporting cargo by means of cargo aircraft and in the belly of passenger aircraft. See Section 8.7.1 for additional details.
D. See Section 7.1.10 above as regards the structure of the competition in this operating area.
7.8.2 The Group’s market share in the service groups See Section 7.2(b) above regarding the Company’s share in the service groups.
7.8.3 Significant competitors in the passenger aircraft transport sector To the best knowledge of the Group, the significant competitors of the Group in the passenger aircraft Transport area, from the standpoint of market share, are: Continental (U.S.), Lufthansa (Germany), British Airways (Great Britain), Alitalia (Italy) and Swiss (Switzerland). See Section 7.1.10 above for details concerning the severe competition that has taken place in the area beginning from the second quarter of the year 2006.
a-40 Translation of the Hebrew Language financial statements
7.8.4 Major methods for coping with competition The Group acts in a number of venues in order to raise profitability, while conserving and increasing its market share and increasing the load factor, as follows:
A. Conforming the schedule, as much as possible, to the seasonality of traffic and to international events.
B. increasing the frequency of flights to popular destinations and increasing the number of flight destinations by also cooperating with other airlines.
C. Aspiring to constantly improve the service to passengers, including improving seat space, food quality and variety, and flight entertainment, etc. with focus on the business section.
D. Providing benefits to passengers that are counted among the frequent flyers club and to business airlines which are members of the Group’s business desk.
E. Acting through all of the relevant marketing channels.
F. Contact with the traveling public by means of advertising campaigns in Israel and abroad.
The positive factors which affect, or are likely to affect, the Group’s competitive position include the following factors: a broad and varied flight structure; a distribution system spread widely throughout Israel; the existence of an attractive customers’ club; formidable trade name in the local market; high safety and security level; schedule stability and operational precision; conformance of services to the needs of the market and a system of cooperation with other airlines. The negative factors which affect, or are likely to affect, the competitive position of the Group include the following factors: a geopolitical situation which significantly reduces opportunities of the Group to carry out sixth freedom flights (indirect flights via BGA) as opposed to the expansion of sixth freedom flights by foreign airlines; the possibility of sanctioning additional competitors as designated carriers in Israel to destinations to which the Group flies or to destinations nearby; the entry of low cost companies; the reliance of the Group on distribution by means of agents as opposed to the increasing trend towards direct marketing via the Internet; possible worsening of the economic, security and political situation in Israel.
7.9 Seasonality The operations of the Group are seasonal and are concentrated into peak periods. High traffic of Israeli residents abroad occurs principally in the summer seasons and at holiday times, and the greatest traffic of tourists to Israel is principally in the summer season or approaching the Jewish or Christian holidays or vacation time in the home countries. The peak operations of the Group are in the third quarter during which the traffic volume in the years 2006, 2005, and 2004 was approximately 29%, 33% and 34%, respectively, out of the total traffic for the year. Due to the War in Lebanon, which took place during the third quarter of the year 2006 (from July to mid-August), passenger traffic to and from Israel was substantially impaired and it negatively affected the financial results of the Company for that year. The War in Lebanon
a-41 Translation of the Hebrew Language financial statements caused a decline in demand, mostly by tourists who cancelled their arrival to Israel, but a slowdown in demand was also registered among Israelis that was expressed in the cancellation of deferral of flights. During this quarter of the year 2006, passenger traffic of El Al and charter companies went down by approximately 15% and 12%, respectively. The traffic of the foreign scheduled airlines rose by only approximately 4% in comparison with a growth in their seat capacity of approximately 21%, which created excess capacity for those companies, which flew with a lower load factor than accepted for this season of the year. During the other quarters of the year 2006, and especially the winter months, the volume of activities was more condensed in relation to the parallel quarters during previous years. (In the years 2004 through 2006, it fluctuated between 19% to 26% of total annual traffic).
The following are data on the breakdown of the Group’s quarterly revenues from passenger aircraft23:
The quarter (in thousands of dollars) Year January-March April-June July- October- September December 2006 305,513 368,578 389,200 338,883 % of 21.8% 26.3% 27.7% 24.2%% operating sector 2005 258,905 361,773 440,729 324,277 % of 18.7% 26.1% 31.8% 23.4% operating sector 2004 237,913 272,434 364,827 276,548 % of 20.6% 23.7% 31.7% 24.0% operating sector
7.10 Productive capacity The acceptable indices of output in the world of aviation as regards passenger aircraft are 24 25 load factor and ASK . At the peak of demand (the month of August), the productive capacity of the Group reaches near to the full potential output. In August 2006, the ASK was approximately 1,911 million RPK and the load factor for the month of August 2006 was approximately 83%. It should be pointed out that during the month of August 2006, the Company reduced the average capacity due to the decline in demand as the result of the War in Lebanon. Accordingly, the ASK for the month of August 2006 was 15% lower than the parallel data for last year.
23 The period of the Jewish holidays, according to the Gregorian calendar, varies from year to year; this may have an effect in comparing quarterly operations between one year and another. 24 Passenger Load Factor-computed as RPK (number of paying passengers multiplied by distance flown) as a percentage of ASK (number of seats offered for sale multiplied by distance flown).
25 Available Seat Kilometer - number of seats offered for sale multiplied by distance.
a-42 Translation of the Hebrew Language financial statements
The following is a graph that describes the average monthly ASK and the load factor for the quarters of the year 2006: It should be noted that the annual load factor for the leading scheduled airlines in the international aviation industry that is considered to be the most efficient load factor does not generally exceed 80%.
100% 2,500
2,000 90% 1,722 1,779 1,540 1,543 1,500 80% 82.1% 80.5% 80.7% 81.9% 1,000 70% 500
60% 0 Q1 - 2006 Q2 - 2006 Q3 - 2006 Q4 - 2006
ASK in millions - monthly average L.F.
As was mentioned, in accordance with a government resolution in 1982, the Company ceased to operate scheduled flights on the Sabbath and Jewish Holy Days, and, accordingly, does not fully utilize its productive capacity. With the conversion of the Company to a “Mixed Company” on June 6, 2004, this prohibition was removed.
During the month of November 2006, a dispute broke out between the Company and the heads of the Orthodox community on the background of flights that the Company executed on the Sabbath, due to pressures created as the result of a strike at BGA by the employees of the Airports Authority. As a result, after negotiations between representatives of the Committee of Rabbis for Sabbath Observance and Company representatives, it was agreed between the parties that the Company would continue to maintain the status quo which had existed up to then, according to which the Company does not carry out passenger flights of EL Al on the Sabbath and on Jewish Holydays, this pursuant to a 1982 government resolution. In light of the situation that arises from time to time when flights are made on the Sabbath, it was agreed that, prior to executing such flights, the Company would communicate with the Chief Rabbi, Shlomo Amar, to clarify the position of Jewish doctrine. Additionally, the parties formulated understandings concerning the refund of cancellation fees for portions of Kosher meals, in the event that, as the result of the breach of this understanding, the Orthodox customers would be forced to cancel their flights. See Section 9.18.23 below for further details.
a-43 Translation of the Hebrew Language financial statements
7.11 aircraft Fleet 7.11.1 As of a date near the approval of the report, the Company makes use of approximately 32 passenger aircraft26. The fleet of passenger aircraft of the Group was all manufactured by the Boeing Company.
A. The following table itemizes the fleet of passenger aircraft owned by the Group, as of December 31, 2006:
Aircraft type Total Average age Average no. of (in years) seats 747-400 4 11.2 408 757-200 527 15.8 185 737-700 2 7.3 104 737-800 3 7.8 142 767-200 2 23.5 199 767-200ER 4 19.7 192 777-200ER 428 5.6 283 Total 24 12.9 230.2
In addition to the above table, on October 2, 2005, the Company signed an agreement with the Boeing Company for the purchase of two broad hulled, long-range 777-200 ER aircraft, which are anticipated to be received for Company use during the year 2007. The cost of each aircraft will amount to approximately 130 million dollars, according to the volume of accessories and installations to be made to the aircraft in order to conform it to the Company's needs. Self-financing resources are expected to cover approximately 15% of the aircraft price, and the remainder will be financed by means of loans. Acquisition of the aircraft was conditional upon obtaining a pre-commitment from the U.S. Export-Import Encouragement Agency which would permit amenable financing from financial institutions against a guarantee by that Agency. This pre-commitment was obtained in December 2005. See Section 9.8.4 below for further details regarding the purchase of two Boeing 777-200 ER aircraft. In addition, it should be noted that the letter of intent signed by the Company with the Boeing Company for the supply of ten 787 aircraft during the years 2012-2013, never arrived at the signing of a binding agreement, as was reported by the Company in an Immediate Report on November 14, 2006, since understandings on certain subjects were not reached during negotiations with Boeing, and due to the condition of the Company as reflected in the reports that it has issued, the Company decided that it is impossible, within the time framework established by the Boeing Company, to enter into a binding agreement with the Boeing
26 The Company also has 1 convertible aircraft (which can be converted to passenger Transport or to cargo Transport). An additional convertible aircraft was sold during the year 2006. In recent years, the convertible aircraft are operated as cargo aircraft during the winter season (6-9 months) and as passenger aircraft during the summer season. The Company ceased the activation of convertible aircraft as passenger aircraft on scheduled flights beginning from the end of the 2005 summer season. See Section 8.10 below for details.
27 One aircraft was leased to a third party.
28 One aircraft was leased by the Group for 12 years, while the Company has an option to purchase the aircraft at the end of the period for the price of one dollar.
a-44 Translation of the Hebrew Language financial statements
Company for the purchase of the aforementioned aircraft. After this, notification was received from the Boeing Company regarding the expiration of the validity of the offer included in the letter of intent and regarding the refund of the deposit which was paid in by the Company in the framework of the letter of intent. The amount of the deposit was one and one half million dollars. The Company is examining possible alternatives to the supply of the aircraft, manufactured by Boeing or Airbus, in accordance with the Company's needs and in accordance with the business strategy of the Company, "El Al 2010. (see Section 9.15 below).
B. The following table details the fleet of aircraft leased by the Company, as of December 31, 2006: Aircraft type Total Average Date to be returned Average age to lesser no. of seats 757-200 2 18.7 February 2007 219 October 2007 737-800 3 5.7 October 2009 142 October 2010 January 2011 767-300 3 14.0 February 2008 228 May 2011 November 2011 Total 8 12.1 194
C. In the framework of the overall policy of the Company to improve the flying experience and passenger service, actions were also taken during the year 2006 in order to upgrade the product and the maintenance level of the elements in the passenger cabin to which the passenger is exposed: 1) Steps are being taken to improve the quality and maintenance level of the items to which the passenger is exposed during the flight. 2) An agreement was signed with the HOT Company to provide in-flight entertainment services. (3) The use of the convertible 747-200 aircraft as passenger aircraft for scheduled flights was terminated.
In addition, in February 2006, the Board of Directors of the Company approved a project to purchase bed seats (seats which can attain a position of lying down or close to it) at an investment of between 22 and 27 million dollars for the high-status sections in the 747-400 and 777 aircraft. It is anticipated that two prestigious sections will be in operation in these fleets in the framework of the project-a business section which includes new reclining seats and a FLAT business class (in place of first class) to include bed seats that reach a flat and horizontal position. The time schedule for termination of the project is approximately 3 years. The data regarding the forecasted purchase of bed seats represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). This information is supported, inter alia, by the Company’s assessments. The likelihood of purchase and/or the extent and/or the installation and/or the time of execution may be materially different from that forecast as aforementioned, as the result of a large number of factors, including as a result of the risk factors described in Section 9.18 below.
a-45 Translation of the Hebrew Language financial statements
8. Cargo aircraft area 8.1 General information on the operating area The following is a description of trends, events and developments in the macroeconomic environment of the Group, which have, or are likely to have, a material effect on operating results or on the developments in the entire Group or in the cargo aircraft operating area, this as regards the following matters:
8.1.1 Structure of the operating area and changes that have taken place There are four types of competitors in the market of air Transport of cargo: airlines that carry cargo solely by means of cargo aircraft; airlines that carry cargo solely in the belly of passenger aircraft; companies, like El Al, that carry cargo both in cargo aircraft and in the belly of passenger aircraft; courier airlines which, in addition to cargo connected with courier services, also carry other cargo in their aircraft. In recent years, the trend of carrying cargo in the belly of passenger aircraft has become more intense. This trend is reflected, inter alia, in the transition to passenger aircraft with greater cargo carrying capacity. The continuation of this trend is likely to transfer cargo transport operations from the cargo aircraft area to the passenger transport area. The data regarding the possibility of transferring cargo operations from the cargo aircraft area to the passenger transport area represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). This information is supported, inter alia, by current market trends and by the Company’s assessments. These trends may be materially different from the forecast as aforementioned, as the result of a large number of factors, including a change in profitability of the passenger aircraft area and the reduction of activity in it, and the imposition of security restrictions on flying cargo in passenger aircraft that might impair this trend.
8.1.2 Legislative restrictions, regulations and special obligations that apply to the operating area The regulatory restrictions on the cargo carriage of cargo aircraft are similar to those which apply to passenger transport in passenger aircraft. See Section 7.1.2 above for details. Regulatory arrangements have also been set for the cargo area relating to a number of operational aspects, such as: permissible flight capacity, responsibility of the air carrier for damages, safety standards for flights, security and noise. See Sections 9.10.3 and 9.11 below for details. Nevertheless, the policies of the world aviation authorities in granting permits with regard to cargo aircraft have tended to be more lenient than in the passenger aircraft area. The situation especially affects the huge opportunity to carry out flights of cargo aircraft on fifth freedom (flight between two foreign countries without stopover in the home airport of the airlines) and on sixth freedom. During 2004, the Civil Aviation Authority approved the carriage of cargo in the belly of passenger aircraft in charter flights. This decision of the Ministry of Transport led to a marginal increase in capacity supply. The total cargo quantity transported in passenger charter flights during 2006 totaled only about 700 tons, approximately 0.2 % of total cargo 29 flown .
29 Source: Civil Aviation Authority.
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8.1.3 Changes in the volume of activity in the area and in profitability
(A) Volume of world cargo carried According to IATA data, there has been a growth in the weight of cargo flown over the past 20 years (approximately 6% per year on the average). During the year 2005, mainly due to price increases in fuel which directly affected freight rates, a slowdown in growth in the area of world transport of cargo in aircraft (including in the belly of passenger aircraft), and it amounted to only 3.6%. During the year of 2006, cargo flown in the world (including in the belly of passenger aircraft) increased by approximately 4.6%. In IATA's estimation, during the year 2005, cargo flown in the world (including in the belly of passenger aircraft) increased by approximately 3.2%. According to IATA’s approximations, by the year 2010, average annual growth of approximately 5.3% is anticipated in flown cargo in the world (including in the belly of passenger aircraft), with the expectation of markedly greater growth in carrying cargo from the East and within the Far East, and in China and India, in 30 particular .
The following is a table that describes the developments in the volume of activity in cargo air Transport beginning from the year 2001 through the year 2005, on the basis of data of IATA31:
Year Output RTK32 Annual change in (in millions) RTK (%) 2005 118,480 3 2004 115,140 11 2003 103,729 2 2002 101,700 6 2001 95,900 (6)
IATA estimates33 that growth of approximately 5.5% is anticipated in the volume of world cargo aircraft Transport during 2007 as compared with 2006.
The data regarding the IATA estimates of the volume of worldwide cargo Transport in cargo aircraft as above represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). This information is supported in full by IATA estimates. Therefore, the actual change in the volume of worldwide Transport by means of cargo aircraft may be materially different from the forecast as aforementioned, as the result of a large number of factors, including a change in the world economic, security and political situation.
30 IATA’s forecast through the year 2010 relates to the growth in weight of the cargo flown in tonnage, without regard to the distance flown (RTK).
31 2006 data has not been published.
32 Revenue Ton Kilometer - the weight of paid cargo in cargo aircraft in tons multiplied by the distance flown..
33 IATA forecast from IATA publications out of Freight Forecast 2006-2010 published October 2006 by IATA.
a-47 Translation of the Hebrew Language financial statements
B) Volume of cargo Transport carried in aircraft from and to Israel The following are data concerning the traffic of cargo entering and leaving BGA over the past five years (The data includes cargo carried in cargo aircraft and in the belly of passenger aircraft)34:
Cargo traffic at BGA (thousands of tons) for the year ended December 31 2006 Change 2005 Change 2004 Change 2003 Change 2002 from from from from 2005 2004 2003 2002 Export 182 3% 176 (9%) 194 9% 177 9% 162 Import 134 6% 127 (2%) 130 11% 117 (9%) 128 Total 316 4% 303 (6%) 323 10% 294 1% 290
An increase of approximately 4%35 in cargo traffic at BGA was recorded for 2006 as compared with 2005. Among the factors causing the increase in traffic, which took place despite the rise in jet fuel prices and transport rates, are included the significant growth in the volume of international trade and the combined increase in the supply of capacity for cargo by airlines Approximately 65% of the total cargo traffic at BGA was flown in 4,255 cargo flights. The primary airports above serving the airlines that operate cargo flights to and from Israel are: Amsterdam, Liege, Luxembourg, and New York (for El Al cargo flights), Liege and New York (for flights of the C.A.L. Company), Brussels, and Milan (for EAT flights), Frankfurt, Athens, New York and Memphis (for FEDEX flights)and Istanbul (for MNG and Turkish flights)36. This data does not include cargo which the Group flew via BGA in the context of sixth 37 freedom (flight from one foreign country to another via BGA) in a volume of 5 thousand tons, 6 thousand tons, 10 thousand tons and 21 thousand tons during the years 2006, 2005, 2004 and 2003, respectively. The decrease that took place during the years 2003 to 2006 in the volume of cargo flown by means of sixth freedom has resulted, inter alia, from the growth in the volume of cargo flown by means of fifth freedom (flights from one foreign country to another, not through the home airport of the Group). IATA estimates that, in the year 2007, there will be an increase of approximately 3.1% as compared with the year 2006 in cargo traffic to and from Israel. The data regarding the anticipated change in cargo traffic from and to Israel represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). This information is supported by IATA estimates. Therefore, the actual change in the cargo traffic from and to Israel may be materially different from the forecast as aforementioned, as the result of a large number of factors, including a change in the economic, security and geopolitical situation in Israel, and from the outbreak of epidemics and other acts of natural forces, as well as regulatory changes.
34 Source: Civil Aviation Administration and Company estimate.
35 Without deducting the Company's sixth freedom activity by means of BGA, the rate of decrease in 2006 was about 4%.
36 Source: Civil Aviation Authority. 37 The data includes cargo that was carried in cargo aircraft and also cargo carried in the belly of passenger aircraft.
a-48 Translation of the Hebrew Language financial statements
8.1.4 Developments in the operating area’s markets, or changes in its customers’ characteristics The Israeli market in the operating area of cargo shipment by means of cargo aircraft is characterized by high seasonal fluctuations. This, due to the relatively high importance of agricultural exports (carried out primarily in the winter months), out of total exports. See Section 8.5 below for information on the Company's customers. IATA approximates that the market in which the fastest growth is anticipated in 2007 is world shipments from and within the Far East, particularly to China and India38. The IATA forecasts and estimates regarding the growth in the sector cargo shipment, as above, represent prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). Therefore, the actual change in the volume of activity may be materially different from the forecast as aforementioned, as the result of a large number of factors, including a change in the economic, security and political situation in the world, and from the outbreak of epidemics and other acts of natural forces.
8.1.5 Technological changes which could materially affect the operating area During the year 2006, there were no technological changes which could materially affect the cargo aircraft area. It should be stated that the Company is acting to expand and develop advanced computer solutions for the matter of commerce on the Internet and the ability for self- service in order to improve service and reduce Company costs. During the year 2006, the Company commenced the activation of a new system for management of operating area, which includes an Electronic Data Interchange with the agents. Furthermore, in the framework of an organizational and technological change, the service center of the operating area was moved to the Company's telephonic center, as part of the concept that the "unified" center would enhance the level of service provided to agents and customers. See Section 7.1.5 above for further details. Due to the aggravation of the threats to the aviation industry in recent years, the aviation market has prepared itself to confront terrorist events by broadening the use of advanced technological and other means, on the ground and in the air. In the framework of these preparations, the Company is acting, among other things, to scrutinize and install protective devices, as mentioned above. During recent years, a trend has become evident in the world market of airlines which are considering the shift of passenger aircraft to cargo aircraft mostly for economic reasons. The Group is also examining the possibilities of conversion of the 747-400 aircraft from passenger aircraft to cargo aircraft.
8.1.6 Critical success factors in the operating sector and changes that have taken place in them A number of factors can be pointed to in the operations of the cargo transport sector via passenger aircraft which affect the competitive position in the sector: the ability to offer the carriage of cargo to popular destinations at competitive prices and development of a network of routes on an independent basis, including the possibility of carrying out fifth freedom
38 The IATA forecast through the year 2010 relates to the growth in air cargo weight in tons, without considering the distance flown (RTK).
a-49 Translation of the Hebrew Language financial statements flights (flights from one foreign country to another foreign country without a stopover in the home airport of the Group) and sixth freedom flights (flights from one foreign country to another foreign country with a stopover in Israel), both as operations supporting transport to/and from Israel; also in cooperation with other airlines; offering transport at the frequency and quality demanded while meeting time schedules; risk management and risk hedging.
8.1.7 Changes in the supplier network and the raw materials for the operating sector The primary raw material which serves airlines is aircraft fuel (jet fuel) and it represents one of the major expense components of an airline. See Section 9.5.1 below for additional details relating to fuel.
8.1.8 Main entry and exit barriers of the operating sector and changes that have taken place in them The regulatory entry barriers (the need for appointment as designated carrier and the permits as to frequency, capacity, etc.) for regular flights in cargo aircraft are similar in essence to the regulatory entry barriers for regular flights in passenger aircraft. See Section 7.1.8 above and Section 9.11 below for details. The Company estimates that there is a more liberal policy of granting permits to the cargo flight area in some countries. Therefore, in the Company’s assessment, this entry barrier is less significant for part of the countries. An additional important entry barrier is the initial, relatively large investment which is necessary in order to establish and operate an airline, including acquisition of aircraft and other substantial current investments, including the leasing of aircraft. Under the international aviation agreements, obtaining the appointment as designated carrier is conditional upon substantial ownership and effective control of the air carrier being in the hands of the government of the nation or citizens of the country which has specified that it be designated carrier. This requirement represents an entry barrier for obtaining the appointment as designated carrier by foreigners.
8.1.9 Substitutes for services of the operating area and changes that have taken place in them The principal substitutes for air Transport in cargo aircraft are Transport in the belly of passenger aircraft, ocean Transport or a combination of ocean Transport to the nearest destination port and from there, shipment by land vehicle. The Company estimates that the major considerations in selecting air Transport over ocean and/or land Transport are: the nature of the product, the shipping conditions demanded the necessary timing and the cost of shipment. During the year 2006, there were no material changes in the substitutes for Transport by cargo aircraft.
8.1.10 Structure of competition in the operating area and changes that have taken place in it There has been a structural change in the industry in the Israeli market in recent years due to increased sources available to customers with the entry of new airlines with designated cargo aircraft, inter alia, by means of fifth freedom and sixth freedom, upgrade of the passenger aircraft of the foreign airlines to broad hulled aircraft which are capable of carrying more cargo in the belly and also by the entry of an additional Israeli cargo carrier- C.A.L. Cargo Airlines Ltd. (above and below: “CAL”). See Section 8.7 below for further details.
a-50 Translation of the Hebrew Language financial statements
8.2 Services in the operating area In this operating area, the Group offers cargo transport services by means of cargo aircraft from Israel to destinations abroad and from destinations abroad to Israel; cargo carried from one foreign country to another foreign country (fifth freedom), for example from Luxembourg to Shanghai; or cargo carried in the context of sixth freedom (indirect flights via stopovers in the home country of the airlines), for example from Asia to Europe or the United States with a stopover in Israel. The Group differentiates between three main groups of destinations: (1) North America; (2) Europe; (3) the Far East and Central Asia. During the reporting year, the services which the Group offered in this operating area were cargo Transport services to three destinations in Europe, five destinations in the Far East and Central Asia and one destination in North America. Other than that, the Company offers cargo services to many additional destinations by means of the Group’s passenger aircraft or by means of cooperative arrangements with other airlines and also by means of land transport from the airport. The following is a breakdown of the volume of cargo traffic in the Group’s cargo aircraft, by principal destination group, in the years 2003 to 2006:
Cargo Aircraft traffic of the Group, by regions (tons) for the year ended December 31 2006 2005 2004 2003 To and from Europe 63,727 61,802 74,164 67,823
To and from the United 14,445 14,468 21,454 23,969 States To and from the Far 14,997 14,768 15,546 11,529 East and Central Asia Total 93,169 91,038 111,164 103,321
These data do not include cargo which the Group carried by air, other than via BGA in the context of fifth freedom and cargo which the Group carried by air, via BGA, in the context of sixth freedom). The Group carried cargo by air by fifth freedom in a volume of 23 thousand tons, 20 thousand tons, 17 thousand tons and 14 thousand tons in the years 2006, 2005, 2004, and 2003, respectively. The Group carried cargo by air by sixth freedom in a volume of 3 thousand tons, 4 thousand tons, 8 thousand tons and 13 thousand tons in the years 2006. 2005, 2004 and 2003, respectively. The principal markets for cargo Transport services are importers, industrial enterprises and the agricultural sector. For purposes of distributing the shipments from its cargo centers in Europe, the Company, by means of subcontractors, operates a system of truck Transport. Beginning from the month of January 2007, the Group no longer independently operates the cargo terminal in London, but hires cargo terminal services from local handling contractors, similar to the other cargo centers. It should be stated that on October 25, 2005, the Company signed an agreement with Agrexco Agricultural Exports Ltd. (hereafter: "Agrexco"), for air Transport of agricultural export cargo, for the purpose of expanding current activities between the companies. The agreement
a-51 Translation of the Hebrew Language financial statements was for one year, commencing from December 2005, with an option for extension for three additional periods of one year each, so that the agreement will terminate, at the latest, during the month of November 2009. Under the agreement, the Company will place capacity in its aircraft to Europe at the disposal of Agrexco during the winter season at a weekly volume of 1,500 tons, and during the summer season, daily volume to enable shipment of all Agrexco cargo to Europe, at prices stipulated in the agreement. Concurrently, Agrexco became committed to fly 70% of the total quantity of cargo that Agrexco will fly to Europe during the winter and summer seasons, by means of El-Al. In addition, supplementary mechanisms were established for accountings connected with the volume of import cargo from Europe as compared with the growth in export volume. Pursuant to understandings between the Company and Agrexco, the agreement was extended for an additional year commencing on November 30, 2006. Additionally, in those understandings with Agrexco, it was agreed that the volume of capacity to be placed at the disposal of Agrexco in the Company's aircraft to Europe would decrease. Due to the continuing trend of severe of competition in the industry, and the policies of the Group for optimization of its route network, the Group anticipates a reduction of its market share during the 2007 year.
The data concerning the forecast of a change in the market share of the Company represent prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). This data is supported, inter alia, by the Company's assessments due to the current volume of activities of the Group and the extent of competition in the market. Therefore, the actual change in the volume of the Group's market share may be materially different from that forecast as aforementioned, as the result of a large number of factors, including the number of cargo aircraft that will be placed at the Group's disposal, the extent that the market is opened to additional competition, the manner in which the Company deals with competition, and the risk factors described in Section 9.18 below. See Section 8.7 below for details on competition.
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8.3 Analysis of revenues and profitability from services A. The following are data concerning the breakdown of the Company’s revenues (consolidated) which are derived from similar service areas in the area of transport by means of cargo aircraft39:
Destination Revenues in thousands of dollars % of total Group revenues group 2006 2005 2004 2006 2005 2004 North 63,139 46,319 56,582 3.8% 2.9% 4.1% America Europe 64,422 60,048 61,805 3.9% 3.7% 4.5% Far East & 114,169 110,072 97,969 6.9% 6.8% 7.1% Central Asia No 839 863 1,361 0.1% 0.1% 0.1% geographic attribution Total 242,569 217,302 217,717 14.6% 13.4% 15.7%
In the year 2006, there was a rise of approximately 12% in the Group’s revenues from the operating area, in comparison with revenues for the year 2005, while the rate of increase in cargo transport at BGA during 2006 was approximately 6% as against 2005.
B. The following is the amount of gross profit and the percentage of gross profit for the years 2006, 2005 and 2004 that were derived from the cargo aircraft transport area:
2006 2005 2004
Amount of gross profit (in 24,655 17,299 24,601 thousands of dollars) Gross profit rate (in %) 10% 8% 11%
8.4 New services From time to time, the Group studies the prospects of operating flights to new destinations and increasing the frequency of the flights to existing destinations, according to market demands. In the month of September 2006, the Company initiated a cargo service center, in the framework of the unified telephonic service center of the Company. See Section 8.1.5 above for details.
39 The revenues include revenues from flights in the framework of fifth and sixth freedoms; the analysis to destinations was made on the basis of the final destination.
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8.5 Customers, marketing and distribution Most of the sales of the Group in the cargo aircraft Transport area are made by means of cargo agents (approximately 89% for the year 2006). The remaining sales are made directly to customers. Commencing from the beginning of 2006, the Group began to activate a new sales commissions program for Israeli cargo agents. The program is based on a unified hierarchy of sales commissions to all agents for compensation on the basis of cargo quantity, average shipping price and type of route for which the sale is made. The Company does not have a customer from which the Group’s revenues amount to 10% or more of total Group revenues. In the Company’s estimation, it has dependence on one customer, an agent that engages in shipment consolidation, to which the sales represent a material component of the operating sector. In the month of November 2006, the Company was informed that an interested party of the Company who serves as the director acquired ownership of a cargo agent with which the Company has business connections. As the result of this information, the Company formulated a working procedure that includes fixed criteria for purposes of the mode of commitments with this cargo agent, as was approved by the Audit Committee and the Board of Directors of the Company. In addition, the Israeli company for consolidation of cargo (ACI), 50% of the shares of which are held by El Al (without the right of receiving dividends), is engaged in consolidation of air cargo at BGA and their transfer abroad, mainly by El Al. ACI, as other airlines which operate in this sector, consolidates cargo of individual dispatchers into one shipment and, as a dispatcher, transfers it to El Al for shipment, a situation which leads to cheaper air transport costs of consolidated shipments.
8.6 Reservations backlog In general, air shipment of cargo by means of cargo aircraft is carried out in proximity to executing the service reservation. Therefore, the Group did not have a significant volume of reservations backlog during 2006.
8.7 Competition
8.7.1 Competitive conditions in the operating sector
A. The cargo aircraft Transport area is characterized by severe competition between the airlines which supply transport services between the same destinations or alternative destinations. The airlines compete in different areas, the principal ones of which are: rates of Transport cost, time schedule of flights and frequency of flights.
B. In recent years, the Civil Aviation Authority has tended to approve requests of foreign scheduled airlines to increase the frequency of their flights to Israel.
The significant growth in the flight capacity of the foreign scheduled airlines, commencing from the second quarter of the year 2006, as detailed above with regard to the passenger aircraft operating area, led also to substantial growth in the flight capacity for cargo in the belly of passenger aircraft of the foreign scheduled aircraft airlines to and from Israel. Most of the growth is evident in transatlantic routes, particularly since Delta
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began operations. Due to the aforementioned, there is significant exacerbation of competition in the industry, also as regards the cargo transport operating area. Also, in aviation talks between Israel and Jordan which took place in November 2005, the Civil Aviation Authority authorized Royal Jordanian to execute cargo flights without the limitations which had been imposed in the past (cargo shipment was allowed from Israel by sixth freedom). In the context of an additional round of talks between Israel and Jordan, held during the month of December 2006, a decision was taken to increase the cargo flight quota of Royal Jordanian from two to three weekly flights. The Group approximates that the freight transport operations by Royal Jordanian have caused a decrease in the volume of cargo that the Group transported to Europe and the Far East.
C. Until the year 1999, the Company was the sole designated carrier of the State of Israel to most of the destinations to which it operates regular flights of cargo aircraft to and from BGA. Additionally, in recent years, other foreign airlines which operate cargo aircraft have entered into the operating area in Israel. Commencing with the year 1999, CAL was given a full commercial operating license and, over time, it was appointed as designated carrier to a number of destinations. CAL operates two 747-200 cargo aircraft which it owns, and leases additional aircraft as needed. As of the date of the report, CAL operates flights to various destinations in the United States and Europe. The granting of a full commercial operating license to CAL had caused contraction of the cargo operations of the Group in the past. Previously, CAL had requested appointment as designated carrier to additional destinations to which El Al is the only designated carrier, and as to which, under current aviation agreements, no more than one designated carrier may be appointed. During 2005, CAL was not appointed as designated carrier to any destinations. At the start of January 2007, CAL requested to receive an appointment as designated carrier for cargo on the Tel Aviv-Moscow route, a route on which El Al is the sole designated carrier. Through the date this report was issued, CAL has not been appointed as designated carrier to any additional destinations. The Company is unable to estimate whether these requests or any part of them will be approved in the future(with amendment of the international agreements). Should the requests, or part of them, be approved, the matter could negatively affect the Company’s results.
In addition to the aforesaid, it should be pointed out that, during 2002, Arkia was appointed as the Israeli designated carrier to Uzbekistan, in place of the Company, which up to that time, had operated cargo flights to that destination. During the year 2006, after the Company had presented a request to the Civil Aviation Authority, the Company was reappointed as designated carrier to Uzbekistan.
The information concerning the possible implications in the event that the CAL requests are approved, should they be approved, represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). The information is fully supported by the Company’s assessments as of the date of this report. The actual implications may be materially different from the forecast as aforementioned, as the result of a large number of factors, including a change in the volume of operations in the sector, the ability of CAL or another Israeli aviation company to carry out flights to the destinations for which it
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receives (should it receive) the appointment as the designated carrier and the extent of competition with other competitors. The Group competes for cargo transport in cargo aircraft to and from Israel with approximately five airlines, which operate cargo aircraft in flights to and from BGA. In October 2004, DHL began to operate a cargo aircraft for a daily flight on the Tel-Aviv- Bergamo-Brussels route. This activity impaired the quantity of cargo flown by the Group to Europe. Beginning from December 2006, the Korean aviation company started to carry out scheduled cargo flights (one weekly) to Eastern Asia. In addition, the Civil aviation Authority approved the application of the Korean aviation company to execute two weekly flights to Seoul, whereas at this stage, the approval was given for the period between the month of March 2007 and the month of October 2007. This activity could have an effect on the volume of air cargo by the Group to the Far East, due, among other things, if that company obtains a permit for more frequent operation of flights. The information concerning the possible implications of the activities of the Korean company on the volume of air shipments by the Group to the Far East represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). The information is fully supported by the Company’s assessments as of the date of this report. Therefore, the actual implications may be materially different from the forecast as aforementioned, as the result of a large number of factors, including a change in the volume of operations in the sector, the ability of the Korean company to carry out flights to these destinations and the extent of competition with other competitors.
D. The Group competes for cargo transport in cargo with most of the scheduled airlines which operate passenger aircraft and carry cargo in their bellies40. According to statistics of the Civil Aviation Authority, approximately 35% of the air Transport of cargo to and from Israel during the year 2006 was carried out in the belly of passenger aircraft (primarily broad hulled aircraft) in regular flights, while the remaining cargo (approximately 65%) was flown to and from Israel in cargo aircraft. In the Group’s estimation, the share of the group in transporting cargo during the years 2006, 2005 and 2004 stood at approximately 43.1%, 44.7% and 47.8%, respectively, out of the total cargo that is transported by air to and from Israel (including cargo transported in the belly of passenger aircraft, not including sixth freedom and including postal operations).
E. In recent years, the trend of the Group’s fifth freedom has intensified, concurrent with a decrease in the Group's sixth freedom operations. It is the Group's intention to act to expand the use of fifth freedom to additional destinations, subject to obtaining the proper authorizations. The information concerning the intention to act to expand the use of the fifth freedom to additional destinations represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). The information is fully supported by the Company’s intentions and assessments as of the date of this report. Therefore, the actual implications may be materially different from the forecast as aforementioned, as the result of a large number of factors, including obtaining authorizations from the proper regulatory entities and the ability of the Company to make use of fifth freedom as aforesaid.
40 In recent years, there has been intensification of a trend of transporting cargo in the belly of cargo aircraft. This trend is expressed, inter alia, in the transition to passenger aircraft with larger cargo carrying capacity.
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8.7.2 Significant competitors in transport through Cargo Aircraft To the best of the knowledge of the Group, the most significant competitor of the Group through cargo aircraft, from the standpoint of market share, is the CAL company.
8.7.3 Major methods for coping with competition The Group acts in a number of venues in order to raise profitability, while conserving and increasing its market share and also increasing the volume of cargo which it carries as follows:
A. Conforming the schedule, as much as possible, to the seasonality of traffic and conserving the stability of the schedule.
B. Increasing the frequency of flights to popular destinations and increasing the number of flight destinations by cooperating with other companies.
C. Proposing competitive rates.
D. Adding to the frequency of the Company’s cargo flights between two foreign countries (for example between Luxembourg and Shanghai). The positive factors which affect, or are likely to affect, the Group’s competitive position include the following factors: formidable trade name in the local market; high safety level; schedule stability and operational precision. The negative factors which affect, or are likely to affect, the competitive position of the Group include the following factors: the possibility of sanctioning the status of designated carrier in Israel to additional competitors or to additional destinations; regulatory changes that restrict the possibility to enter into agreements with other airlines; the entry of new, foreign competitors; increase in the flight capacity of foreign airlines(including fifth and sixth freedoms);worsening of the economic, security and political situation in Israel.
The information concerning factors that might affect the competitive position of the Group represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). The information is fully supported by the Company’s assessments . The factors that may affect the competitive status of the Group and their actual consequences, may be materially different from the forecast, as the result of a large number of factors, including a change in the economic, security and political situation in the world, regulatory changes, the scale that the market is opened to added competition, the extent that the Company can cope with competition and risk factors as described in Section 9.18 below
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8.8 Seasonality The operating area is characterized by high seasonal fluctuations due to the relatively high influence of agricultural exports out of total exports by means of cargo aircraft. The following are data on the breakdown of the Group’s quarterly revenues from cargo aircraft: The quarter (in thousands of dollars) Year January-March April-June July- October- September December 2006 63,027 55,322 53,010 71,210 % of 26.0% 22.8% 21.9% 29.3% operating sector 2005 57,131 56,673 40,232 63,266 % of 26.3% 26.1% 18.5% 29.1% operating sector 2004 60,087 46,579 44,732 66,319 % of 27.6% 21.4% 20.5% 30.5% operating sector
8.9 Productive capacity The acceptable indices of output for cargo air Transport by means of cargo aircraft are the 41 42 load factor and ATK At the peak of demand (in 2006-the month of November), the productive capacity of the Group reaches near to full potential output. In November 2006, the ATK of the Group was approximately 102,738 ATK (including the convertible aircraft-see Section 8.10 below for details); and the load factor stood at approximately 66.7% It should be emphasized that load factor indicator is computed solely on the basis of cargo weight and does not consider cargo volume.
41 Load Factor - computed as RTK (weight in paid tons multiplied by distance flown) as a percentage of ATK (available cargo capacity multiplied by distance flown).
42 Available Ton Kilometer - available cargo capacity multiplied by distance flown.
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The following is a graph that describes the average monthly load factor and ATK for the quarters of the year 2006:
75% 90 92 100 70% 79 73 80 65% 68.5% 65.0% 60 60% 62.9% 63.1% 55% 40
50% 20
45% 0 Q1 - 2006 Q2 - 2006 Q3 - 2006 Q4 - 2006
ATK in millions - monthly average L.F.
8.10 Aircraft Fleet
A. As of a date near the approval of the report, the Company makes use of 3 cargo aircraft and also a convertible 747-200C aircraft (which can be converted to cargo or to passenger).The fleet of passenger aircraft of the Group was all manufactured by the Boeing Company. It should be pointed out that the Company made use of an additional convertible aircraft through April 2006, and in July 2006, a contract was signed for its sale. The Group recorded capital gain of approximately $ 5.9 million from the sale.
B. The following table itemizes the fleet of cargo aircraft owned by the Group, as of the reporting date:
Aircraft type Total Average age Maximum carrying (in years) capacity 747-200F 2 26.4 127 tons 747-200SF 1 25.9 110 tons 747-200C43 1 27.2 109 tons Total 4 26.5 -
It should be stated that due to negotiations being held for the sale of the convertible 747- 200C aircraft, the Company, in April 2006, contacted the Government Corporations Authority with a request to receive the approval of the holder of the Special State Share for the sale of the fourth cargo aircraft and the reduction of the number of the Company's cargo aircraft to three. In October 2006, the consent of the holder of the Special State Share was obtained for the sale of the additional aircraft, subject to a number of conditions, with the effectiveness of the consent being conditional upon transfer of ownership of the aircraft by December 31, 2006. Since negotiations for the sale of the aircraft and transfer of its ownership could not be finalized by the date stipulated in the
43 Aircraft which can be converted between cargo aircraft to passenger aircraft. Commencing with the 2005 summer season, the activation of the convertible aircraft, then owned by the Company, as passenger aircraft in scheduled flights was terminated. During the year 2006, the Company sold one of the two aircraft.
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consent of the holder of the Special State Share, in November 2006, the Company made a request to the Government Corporations Authority to obtain an extension of the effectiveness of the consent. In the month of January 2007, the approval of the holder of the Special State Share for such sale, and the consent was effective subject to completion of transfer of ownership of the aircraft by June 30, 2007. As of a date close to approval of the report, an agreement for the sale of the above aircraft has not yet been signed.
C. In addition, the Company leases cargo aircraft in “wet leases” (aircraft leased with its crew) as needed.
D. During the coming years, the Company may be required to replace the 747-200 fleet of aircraft, for a number of reasons: considerations of economic feasibility in operating the fleet due to the advanced age of the aircraft and the problem of complying with the maximum permissible engine noise in various airports worldwide (See Section 9.10.3 below for details of noise restrictions).
E. In recent years, there seems to be a trend in the world market of airlines towards examining the conversion of passenger aircraft to cargo aircraft, mostly for economic reasons. The Group is also examining the possibilities of converting the 747-400 aircraft from passenger aircraft to cargo aircraft (the conversion of 747-400 aircraft owned by the Company to cargo configuration or the purchase and conversion of 747-400 aircraft).
8.11 Raw materials and suppliers The principal raw material of the Company is fuel. See Section 9.5.1 for further details. In the cargo aircraft area, the Group, in its various stations throughout the world, engages suppliers which deal in unloading and loading the aircraft, in cargo storage in warehouses and in land Transport of the cargo from the customer to the airport and vice versa. The proportion of expenses related to commitments with these suppliers during the year 2006 stood at approximately 12% of the operating sector’s expenses. In the year 2006, the Group was not dependent on any single supplier.
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9. Details on the two operating areas
9.1 Fixed assets and installations
9.1.1 Real estate A. The Group owns space of approximately 1,560 m2. in the El Al House in Tel-Aviv which serves as the offices of the Israeli branch of the Company. Part of the offices of the Israeli branch were moved to the BGA during the year 2006 in order to save costs. The Group also owns offices in Spain (Madrid) and Argentina (Buenos Aires) with total space of approximately 269 m2.
B. The following is detail of the major real estate properties leased by the Company in Israel:
The property Parties to the agreement Consideration Contract period & extension option The El Al area at License agreement See subsection The contract is BGA with between the Airports (e) below effective until approximately 290 Authority (licensor) and December 31, thousand m2. El Al (licensee) 2010. There is also an extension option for an additional 25 year period. Areas at BGA See subsection (f) below See subsection See subsection (f) Terminal 3 (f) below below Areas at BGA for Agreements between El Al, Annual usage Maman building the Company’s Maman Cargo and Handling fees of 202 until December cargo flight Terminals Ltd. and Ashdod thousand 31, 2006 operations, Bonded Ltd. dollars currently including space in undergoing the Maman renovation). building and space Ashdod building in a building in until December Ashdod (the former 31, 2007. Agrexco building) - total space of 536 m2
C. The Group leases space in various places in Israel for use as offices, shops and warehouses with total space of approximately 1,135 m2 for which the Group pays rent of approximately 200thousand dollars per year.
D. The Group rents various real estate properties all over the world, in the central destinations to which it flies, which serve it to maintain its current operations, of which the major ones are offices in cities and stations in airports. The total expenses for rent abroad during the year 2006 amounted to approximately 5,910 thousand dollars. The
a-61 Translation of the Hebrew Language financial statements
principal properties are in New York (approximately 3,400 m2 for rent of approximately 1,170 thousand dollars per year), in London (approximately 2,860 m2 for rent of approximately 1,300 thousand dollars per year) and in France (approximately 1,350 m2 for rent of approximately 641 thousand dollars per year).
E. Land usage rights at BGA
The Ben- Gurion Airport (BGA) serves as the mother airport and central operational base of the Group. The Group’s headquarters, hangars, aircraft parking areas, workshops, warehouses and other offices and installations of the Group are located at BGA. Most of the offices, hangars and other buildings used at BGA were constructed on land as to which the Group has long-term usage rights.
Under the auspices of this agreement from June 1992 with the Airports Authority (AA), as amended in February 1995, the Company has the user right (permit) to 290 hectares of land at BGA through December 31, 2010. This period may be renewed for an additional 25-year period under the terms of the contract or under other terms as will be agreed upon with the AA. It appears that exercise of the option will be subject to the payment of Purchase Tax.
According to the aforementioned agreement, AA permits the Company to use the property and the access roads to it and also allows the Company to operate on the property and/or use it for services of an aviation company. The agreement gives the AA the right to demand that the Company vacate space and/or a building which it will need for the operations, safety, development or security of the airport.
In 2005, the Company paid licensing fees of 960 thousand dollars for the aforementioned usage rights, and for 2006 and subsequent thereto, the licensing fees will rise by 7.4% per annum until the end of the contract period, but not to exceed 4 million dollars per annum. In accordance with an October 19, 2004 amendment to the agreement, in addition to the payment for the land, the Company will pay annual usage fees to the AA for certain fully depreciated buildings and installations. The annual payment will at a rate which will rise gradually (in accordance with and contingent upon the quantity and type of buildings which become fully depreciated each year), starting with 900 thousand dollars in 2006 and reaching the amount of approximately 4,000 thousand dollars in 2025.
F. Terminal 3 ("BGA 2000")
Within the framework of the “BGA 2000” project, the AA constructed a new passenger terminal at BGA (Terminal 3), aircraft parking spaces and support areas in order to operate the services needed for on-site operations. Terminal 3 operations began in November 2004. The AA shut down Terminal 1 (the terminal which had been in use until Terminal 3 was opened) for international operations. Most of the Company’s installations were situated adjacent to Terminal 1: offices, aircraft parking spaces, hangars, warehouses and various workshops, an area of approximately 75,000 m2. Due to the transfer of the activity to Terminal 3, the Group relocated part of its operations to Terminal 3 and new adjacent areas. The relocation has caused a material
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change in the operating pattern of the Group and to the dispersion of its operations over a broad expanse. The transition to the new terminal increased the current operational costs of the Company, among other reasons, due to the new agreements with the AA, transporting aircraft, shifting and transporting employees, in an amount of approximately 6 million dollars per annum. The agreement to provide a permit for operating a passengers’ lounge (approximately 1,400 m2) was signed on December 11, 2006, even though the Company had been operating the lounge since November 2004.. The agreement will be in effect for 6 years commencing from November 2, 2004 at a total consideration of up to 1,750 thousand dollars per year, including an extension option for another 3 years. The agreements for a permit for the other areas were also signed, and they cover a period of 10 years commencing from November 2, 2004 at a rental of 1,770 thousand dollars per year44.
In the context of the operations of Terminal 3, the Group is considering whether to set up an aircraft maintenance center in stages, adjacent to Terminal 3. In April 2000, the Company signed an agreement in principle with the AA for leasing an area of approximately 20 hectares in order to set up a maintenance center, a hangar and supporting facilities close to Terminal 3. The AA Board of Directors ratified the transaction but it is subject to the signing of a detailed agreement between the parties and the ratification by the Board of Directors of the Company.
9.1.2 Accessories, spare parts and spare engines
The Company keeps accessories, spare parts and spare engines in its warehouses in a total book value of approximately122 million dollars as of December 31, 2006. In recent years, the Company has begun to purchase external logistic support services from designated suppliers abroad as a complement to the spare parts purchased by the Company.
See Note 9 to the financial statements for additional details of fixed assets.
9.2 Insurance The Company’s insurance coverage is mainly related to two aspects: insurance of the different types of Company property and legal liability insurance for property and bodily injury. The airline liability insurance of El Al is limited to a ceiling of 1,500 million dollars for each occurrence. After the attacks in the United States in November 2001, the policy provides an answer to bodily injury of passengers that result from terrorist activities and war within those borders, while third party damages are insured by the same policy to the extent of 150 million dollars. Therefore, the Company purchased additional insurance coverage of 850 million dollars, over and above the first layer of insurance, so that the total insurance protection against third party damages arising from terrorist activities and war stands at 1,000 million dollars. In the Company’s estimation, this coverage is adequate to provide the proper insurance protection for its operations.
44 Including payments for telecommunications.
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The all-risk hull insurance of the aircraft owned by or in the service of the Company, or as regards loss or damage to aircraft for which the Company has agreed to be responsible for insurance, is on the basis of “agreed value” of each and every aircraft and includes deductible levels which are acceptable in the aviation industry. The insurance of the aircraft hulls against dangers of war and similar risks covers, inter alia, acts of war, terror actions, civil war, strikes, riots, malicious damages, hijacks and confiscation.
It should be noted that, at the request of K'nafaim, the Company entered into an agreement with it, according to which mutual application was made to the Company's insurers and three riders for insurance to cover acts related to K'nafaim were added to the Company's insurance policies: • The "contingent stratum" rider for 11 aircraft owned by the Knafaim Group which are leased to various airlines. The insurance is designated to insure the rights of the K'nafaim Company in the event that the lessors or their insurers breach their insurance obligations. • The "ground risks" rider for 3 aircraft owned by the Knafaim Group as it relates to insurance for damage to aircraft on the ground alone. The Company was informed that these aircraft were sold by the K'nafaim Group during the year 2006, and, accordingly, the relevant insurance coverage was cancelled. • The rider for third part liability related to maintenance activities provided by "Knafaim Maintenance" (an entity in the Knafaim Group) to aircraft of the air force. The incremental premium for these three riders amounts to approximately $ 700,000 per year, and, according to the agreement between the Company and K'nafaim, K'nafaim bears this entire incremental premium, and also pays the Company an additional 15% of the incremental premium. Additionally, K'nafaim has made a commitment to be responsible for additional premiums that the Company may be demanded to pay, should such demand be made, in the case of an event related to one of the aforementioned riders. The Company is also covered by various insurance, which in the Company’s assessment is sufficient to provide insurance coverage adequate for the primary risks to which the Company and its employees are exposed. The intention is to policies to insure employers’ liability, insurance of buildings against fire, earthquakes and the like, personal accident insurance for company employees, etc. The policies are renewed annually. Group directors and executives are insured by director and executive liability insurance in the framework of the insurance coverage of K'nafaim, in accordance with an agreement with K'nafaim. (See Section 9.12 below for details). The overall cost to the Company for insurance premiums during the year 2006 was approximately 11.8 million.
9.3 Intangible assets The Group owns the trade name: “El Al”, which is the protected trade mark of the Group. A registered trade mark is valid in Israel for limited periods fixed by law, and may be renewed at the end of every period. In the Group’s assessment, the economic life of the “El Al” trade mark covers a multi-year period, being part of the Company’s name, and due to the many years that this symbol has been used and its dominant market position. See Section 9.11 below and Note 10C to the financial statements for details as to licenses and flight rights given to the Group.
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See Note 10B to the financial statements for details regarding the usage rights of the Company to security equipment.
9.4 Human resources 9.4.1 Organizational structure The establishment of the general policies of the Company and the supervision over the activities of the CEO are within the authority of the Company’s Board of Directors. The everyday management of the Company’s affairs has been assigned to the CEO of the Company, who is assisted for the purpose of fulfilling his duties by the management team, serving as the Company head office, and composed of the VP for finance, the VP for maintenance and engineering, the VP for commerce and aviation relations, the VP for human resources and administration, the VP for service, the VP for operations, the VP for computerization and organization, the General Counsel, and corporate secretary and the Company internal auditor. During the year 2006 and until the approval of this report, the following changes in the Company's head office took place: • In January 2006, a safety and quality division was initiated, subordinate administratively to the CEO and functionally to the VP for operations; • In March 2006, the Israel Station division was initiated, made subordinate to the VP for service; • In July 2006, the training and employee development division was created, made subject to the VP for human resources and administration, and the function of chief of staff of the CEO was created, subordinate to the CEO; • In November 2006, the Company decided on the reduction of positions for senior staff. In the context of this decision of the Company, the changes itemized below were made: • In November 2006, the position of chief of the district division for Africa, Asia and the Mediterranean Ocean was cancelled, and its area or responsibilities was divided among other division heads; • In November 2006, the position of sales director for the Israel branch, who had been subordinate to the Director of the Israel branch (grade of division head) was cancelled; • In December 2006, the title of the Company representative in the United Kingdom and Ireland was changed to "district division head for Northern Europe". Additionally, the title of the division head for international relations, subordinate to the VP for Commercial & Industry affairs, was changed to "division head for Eastern Europe, Asia, Africa and international relations"; • In December 2006, three district divisions heads (district division head for North and Central America, district division head for Western Europe and South America and district division head for Northern Europe), who had been previously subordinate to the CEO- were made subject to the VP for Commercial & Industry affairs; • In December 2006, the position of VP for world sales, and his authority, were transferred to the VP for Commercial & Industry affairs ; • In January 2007, the function of division head for planning and economics was cancelled (who was subordinate to the VP finance);
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• In January 2007, the division for commercial planning and marketing control; was converted to a sub-division (subordinate to the VP for Commercial & Industry affairs; • In March 2007, a new position was added, division head for the business desk, subordinate to the director of the Israel branch.
The following is a diagram that describes the organizational structure of the Company:
Board of Directors Board of Directors ChairmanChairman Board Board of of Directors Directors
President & CEO President & CEO
Company Internal General Counsel Company Internal Chief of staff General Counsel Auditor Chief of staff &Corporate Secretary Auditor &Corporate Secretary
V.P Maintenance V.P Customers V.P IT & V.PV.P Commerce Commerce V.P Maintenance V.P Customers V.P Finance V.P IT & V.P Operations V.PV.P HR HR & & Admin. Admin. & Engineering Service V.P Finance Organization V.P Operations && Industry Industry Affairs Affairs & Engineering Service Organization
Sales & Revenue Ground Operations Information Systems OperationsOperations Control Control HumanHuman Resources Resources Sales & Revenue A/CA/C Maintenance Maintenance Ground Operations AccountsAccounts Div. Div. Information Systems SecuritySecurity Div.* Div.* Div. Div. Div.Div. Div.Div. ManagementManagement Div. Div. Div.Div. Div. Div.
Safety & Quality Schedule & IsraelIsrael Station Station BudgetBudget & & Control Control Projects, Organization Safety & Quality FlightFlight Operations Operations Administration Div. Schedule & A/CA/C Overhaul Overhaul & & Projects, Organization Div.* Administration Div. Distribution Sys. Div. Div.Div. Div.Div. & Methods Div. Div.* Div.Div. Distribution Sys. Div. LogisticsLogistics Div. Div. & Methods Div.
Employee Training ITIT Infrastructure Infrastructure & & Employee Training InflightInflight Services Services CompanyCompany Treasurer Treasurer Cargo Div. PaxPax Marketing Marketing Div. Div. EngineeringEngineering Div. Div. Communications Div Cargo Div. && Development Development Div. Div. Div. Communications Div. Div.
Customers Service IsraelIsrael Branch Branch Quality Control Div. Customers Service Quality Control Div. Div. Div. ChiefChief Executive Executive EastEast Europe, Europe, Asia, Asia, AfricaAfrica &International &International Affairs Div. Affairs Div. ChiefChief Executive Executive WestWest Europe Europe & & South South America America
ChiefChief Executive Executive for for CentralCentral & & North North America America
ChiefChief Executive Executive for for NorthNorth Europe Europe
* Security division & Safety& Quality division are subordinated to the CEO and coordinated by V.P Operations
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9.4.2 Employees in service As of December 31, 2006, the Company employed 3,561 permanent employees, of which 402 employees (including 34 Israelis posted abroad) were in the Company’s branches abroad. In addition, the Company employed an annual average of 2,500 temporary employees during 2005, of which 164 were abroad45. The extreme seasonality in the industry necessitates that manpower be regulated, with a variable number of employees, something which is done in accordance with demand. Personnel employed by the State also work as part of the Group’s security system, and the Company pays one half of their salaries (in accordance with the division of security costs between the Company and the State-see Section 9.11.12 below for details). The following is the breakdown of the permanent employees of the Company in Israel and abroad as of December 31, 2006 and December 31, 2005, according to their fields of employment:
Position December 31, December 31, 2006 2005 Executive employees 42 42 Marketing and sales 457 551 Pilots and flight engineers 524 506 Stewards 297 315 Ground operations, security, control 561 490 operations and service Maintenance, overhaul, engineering and 1,065 1,082 control Auxiliary services 615 594 Total permanent employees46 3,561 3,580
9.4.3 Material dependence on a particular employee The Company is not dependent on any one particular employee.
9.4.4 Investment in instruction and training The Company’s training center has been designated as an “authorizing institute” under the Flight Regulations (Testing Institute, Authorizing Institute and Self Maintenance), 1979. The center prepares workers and holds training courses for most of the professions needed by the Group: pilots, flight engineers, aircraft technicians, stewards, traffic officers, ground stewards, reservations and ticketing personnel, marketing and sales managers, lower level management, etc. In addition, the Company holds courses and study programs for travel agents and cargo agents in Israel and abroad. Other than its activities in the framework of the training center, the Company assists its employees in acquiring technological schooling and higher education. The Company also
45 The breakdown of temporary employees by fields of employment was: air stewards (1,015), ground operations (630), maintenance and engineering (297), marketing and sales (95), overseas (164), remainder in other functions (297).
46 Includes generation A and generation B permanent employees (next generation).
a-67 Translation of the Hebrew Language financial statements sends employees to study programs and professional and management courses abroad and in Israel as well as studies for an academic degree. During 2006, the Company invested approximately 10 million dollars in employee 47 instruction and training .
9.4.5 Employee compensation plans A. See Section 3.3 above for details of the rights of the employees and of the Company to purchase shares from the State.
B. Local employees who are employed abroad by the Group and who, as of the date that the prospectus was published (May 2003) had completed at least six months of employment, are entitled to a bonus from the Government in place of the shares that were granted to Group personnel who were employed in Israel. In December 2005, the State transferred the amount of approximately NIS 2.4 million in order to pay this bonus, and the Company transferred the payment to the eligible employees, after deducting relevant taxes due by every local employee abroad.
C. On February 26, 2006, the Board of Directors of the Company resolved to adopt a 2006 option plan for employees and executives of the Company (in this section: the Program). On that date, the Board of Directors confirmed that the quantity of options which would serve as a pool for allotment under the plan would stand at 17,092,129 options, exercisable into 17,092,129 ordinary shares of the Company with par value of NIS 1 each, subject to adjustments. The Board of Directors is permitted, from time to time, to add to this quantity of options At the same time, the Company's Board of Directors approved an allotment of 17,092,129 options to approximately 50 offerees ,of which approximately 10 were senior executives of the Company and approximately 40 other executives of the Company. The allotment of the options to the Company's executives was also ratified by the Audit Committee of the Company on February 26, 2006. The allotment of the options was described in an outline which the Company published on February 27, 2006, and which was amended on March 15, 2006. The allotment of the options was conditional upon the approval of the General Meeting of the Company for the increase in the Company's registered capital. Such approval was obtained on March 23, 2006 and, on the same day, the allotment was executed. The options were allotted to a trustee in conformity with the capital gains alternative under Section 102 of the Income Tax Ordinance. The options will vest and become exercisable in equal parts over a 4-year period, beginning from January 1, 2007 (each year, one quarter of the options will vest), conditional upon the offerree being employed by the Company, or rendering services to the Company, on the vesting date. The Program also permits the acceleration of vesting under certain circumstances unless they have expired earlier according to the directives of this Program. All options granted but not exercised, will expire and be cancelled at the end of 3 years from the date each option became vested.
47 These costs include the direct training budget, payments for simulator practice, including related expenses, and also the salaries of employees during their training period.
a-68 Translation of the Hebrew Language financial statements
The theoretical exercise price of one option into one share will be 297.33 agorot (85% of the average price for the 30 trading days that preceded the allotment date). The exercise price is the theoretical price not paid by the employee. In the event that the option is exercised, the employee will be eligible for shares in a number equivalent to the difference between the price of the exercise share (the closing price on the Tel-Aviv Stock Exchange of one ordinary share of the Company at the end of the trading day on which the Company received the instruction to exercise) and the theoretical exercise price, multiplied by the number of options for which a notice of exercise was given and divided by the price of the exercise shares. By the date of allotment of the exercise shares, the Company, in its financial statements, will convert the amount of par value of the exercise shares allotted from "capital reserve" to "share capital", in accordance with Section 304 of the AirlinesLaw-1999. In case that this will not be possible, the manager of the Program will determine allotment directives of the exercise shares to the offerees for no consideration, in a manner that the benefit to the offerees will be unaffected. The theoretical exercise price is subject to customary adjustments in the event of dividend distributions and changes in composition of the Company's capital. See Note 19 (H) (1) to the financial statements regarding the accounting implications of this Program.
On May 23, 2006, the Company's Board of Directors decided on the addition of 3,000,000 options to the pool of options for issuance pursuant to the 2006 options program. Also, the Board of Directors appointed the Human Resources and Appointments Committee of the Board of Directors of the Company as the administrator of the 2006 options program and authorized the Committee to allot options to executives of the Company in accordance with the guidelines stipulated by the Board of Directors. Also, the Board of Directors approved the publication of an outline, that was published on May 29, 2006. Following that, on December 27, 2006, the Human Resources and Appointments Committee of the Board of Directors of the Company decided to issue options to Company executives. The allotment of the options was done by the Company on December 31, 2006. The theoretical exercise price of each option out of those allotted on that date into one share stood at 188.94 agorot (85% of the average closing price on the Tel-Aviv Stock Exchange of one ordinary share during the 30 trading days prior to the allotment date). See Note 19 (H)(2) to the financial statements As of December 31, 2006, the total options issued under the 2006 options program stands at 17,809,236, after deducting the options returned to the pool for any reason which complied with the program
D. On May 20, 2004 the Company signed an agreement in principle (special collective labor agreement) with the Histadrut and the employees’ representatives, among other things, in the matter of reducing the stay in North America and operating an air crew base in Toronto, with compensation to employees for savings. The compensation as per the agreement will be according to levels that are conditional upon earnings that were achieved in 2004. In July 2006, a new agreement was signed between the parties as itemized in Section 9.4.7 (H) below.
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E. Following a Board of Directors' resolution in March 2006, an employees' bonus was distributed as compensation to Company employees and executives due to the 2005 business results in an overall cost of approximately eight million dollars.
9.4.6 The applicability of the Budget Fundamentals Law Because the Company was previously a Government Corporation and is presently a Mixed Company, a number of provisions of the Budget Fundamentals Law, 1985 apply to the Company. In accordance with the provisions of Section 29 of the Budget Fundamentals Law, the Company is not permitted to agree to changes in wages, terms of retirement or pensions, or to other financial benefits related to work, and not to institute such changes or benefits, except in accordance with what was agreed or instituted with respect to all State employees or with the consent of the Minister of Finance. The Company’s request for exemption from Section 29 of the Budget Fundamentals Law was approved by the Minister of Finance, and was approved by the Knesset’s Finance Committee on March 17, 2005.
9.4.7 Special collective agreements In addition to labor legislation and Extension Orders, the employment terms of Company personnel employed in Israel, with the exception of the executive employees and other personnel employed under personal agreements, are organized in special collective agreements which are signed from time to time between the Company and the New General Workers Histadrut (above and below-“the Histadrut”) and also by procedures that are occasionally issued by management. The following is a concise description of the main collective agreements, which apply to the Company and its employees.
A. Special collective agreement for permanent Company employees (“Generation A agreement” or “the collective agreement”) The special collective agreement applies to all of the Company’s permanent employees in Israel, including air crews. The agreement does not apply to executive employees (senior and other officers), who have personal employment agreements, nor to temporary employees who have their own special collective agreement. The agreement regulates all of the employment terms of the permanent employees, and stipulates, inter alia, work procedures, basic rights and obligations, productivity incentives48, appointments and stationing abroad, internal tenders, insurance, pension arrangements, dismissal procedures, dealing with disciplinary violations, rights to free and discounted airline tickets and an apparatus for solving disagreements. The agreement forbids having strikes and sanctions, unless the strike has been declared by the Histadrut in compliance with the Law for Settling Work Conflicts, 1957, and subject to the Histadrut constitution, including a secret vote by all employees. According to the agreement, all permanent employees of the Company are ranked on the basis of an enterprise wage ranking, which has no connection to national rankings. There are a number of rankings: ground employee ranking; “veteran” air crew personnel ranking; a separate ranking at lower wages for “new” air crew personnel; “veteran” air steward crew personnel ranking and a separate ranking at lower wages for “new” steward crew personnel.
48 See Note 15 (B) (14) to the financial statements.
a-70 Translation of the Hebrew Language financial statements
The agreement has been amended from time to time and, on May 20, 2004, the effective date of the agreement was extended through December 31, 2005, and up to September 2006, while negotiations regarding the terms of this agreement were being carried on concurrently, the agreement continued to be applicable in light of the fact that a new agreement was not signed/or the existing agreement cancelled. On September 5, 2006, the Company and the New General Workers Histadrut-the Division for Professional Unions and the employees' representatives signed a special collective agreement which extends the effectiveness of the special collective agreement for the permanent company employees ("Generation A Agreement") until December 31, 2007, and on October 5, 2006, the approval of the agreement by the Board of Directors of the Company was received. Concurrently, the employees' representatives took a decision, in view of the economic condition of the Company as reflected by the financial statements, to enter into negotiations with the Company for the purpose of finding joint and agreed solutions to the Company's efficiency, and during the month of October 2006, the holding of actual negotiations was begun. Among the principal subjects which are being discussed in this framework: manpower reductions (temporary and permanent workers), contraction of expenses in the area of wages and ancillaries, including by increasing the rate of participation by the employees in the services provided to them, unification of functions according to Company needs, and various changes in the operations of ground workers and air crews which will contribute to operational flexibility and the reduction of expenses. It should be emphasized that, as of the date of approval of this report, there is no well-founded assessment and/or assurance regarding understandings which will be reached at the end of the negotiations with respect to every one of the subjects itemized above and/or other matters which might arise during the negotiations. In the context of the negotiations on the efficiency program, two special collective agreements were signed on December 7, 2006 in order to extend the effectiveness of availability of employees who were to enter the "permanent employee" track on December 31, 2006. The period of availability was extended for these employees through December 31, 2007.
B. Special collective agreement for the employment of temporary personnel ( “the temporaries agreement”) The employment terms of the temporary employees have been organized by a special collective agreement which, on May 20, 2004 was extended to December 31, 2008. The agreement stipulates the maximum length of employment of temporary employees, in accordance with the type of work and the department in which the worker is employed. The agreement regulates all of the employment terms, including wages, bonuses, provisions for comprehensive pensions, insurance, sick leave, rights to airline tickets, etc.
C. Special collective agreement for the next “permanent” generation The agreement was signed on May 20, 2004 with regard to the administrative, commercial and operational professions, including supervisory and management, air steward and academic positions in administrative professions. This agreement regulates the employment terms of the personnel, which are different than those applying to the generation A employees, with a saving in future costs and achievement of managerial flexibility, including the dismissal of employees due to lack of professional or operational adaptability. This agreement is effective until December 31, 2008.
a-71 Translation of the Hebrew Language financial statements
D. Special collective agreement (ground crew- “intermediate permanent generation”). The agreement was signed on May 20, 2004. It relates to employees who began working prior to January 1, 1999 and is intended to apply different terms to them than those stipulated in the agreement for generation A and than those stipulated for the next generation.
E. Special collective agreement (air steward crew personnel -“interim permanent generation”) The agreement was signed on May 20, 2004. It relates to air steward crew personnel which began employment prior to September 1, 1996 and air steward crew personnel, which commenced employment between January 1, 1996 and December 31, 1997, and is intended to apply different terms to them than those stipulated in the agreement for generation A and for those stipulated for the next generation.
F. Special collective agreement (security) The agreement was signed on May 20, 2004. It obligates the Company to act to create a balance among all personnel whose employment is organized by special collective agreements (generation A, interim generation, next generation) in order to avoid the preference of one segment over another and also regards giving future wage increments to different segments. The agreement stipulates, inter alia, that the number of permanent employees in certain professions may not be less on various dates than those stipulated in the agreement. G. Agreement for the encouragement of economic growth Because it was previously a Government Corporation and is presently a Mixed Company, gradual wage reductions and a deferral of the date of payment of recreation pay apply to the Company’s employees (including executive employees), due to a temporary provision for the period from July 1, 2003 until June 30, 2005. In accordance with authorizations obtained in February 2005, the growth encouragement deduction from the salaries of the Company’s employees ceased, commencing from the salaries for the month of February 2005. See Section 9.11.2 (m) below for details. H. Special collective agreements for ground crews and air steward crews (stay over shortening) In July 2006, a number of special collective agreements relating to ground crews and air steward crews were signed between the Company and the New General Workers Histadrut- the Division for Professional Unions and the employees' representatives for the purpose of improving the Company's operational flexibility by removing existing restrictions on carrying out direct flights without any intermediate stopover and shortening the stay of the crews in North America.
9.4.8 Pension arrangements
Pension agreement Beginning from September 1992, the social rights of part of the Company’s employees are regulated within the context of a pension agreement. An employee joining the comprehensive pension must insure a portion of his salary in the pension plan and the balance can be directed to managers' insurance or to the provident fund of the Company's employees. After the agreement was signed, new employees are required to be insured by the comprehensive pension.
a-72 Translation of the Hebrew Language financial statements
The agreement stipulates that the Company's payments to the pension fund and an approved fund (managers' insurance or provident fund) for an employee joining the pension plan, will come in lieu of its severance pay obligation to that employee, pursuant to Section 14 of the Severance Pay Law, 1963, for that part of the salary and for that period as to which the payments were made. Up to the date of becoming a member, the employee is entitled to receive severance pay on the basis of his last salary. During 2005, amendments were made to the Income Tax Regulations (Rules for Approving and Managing Provident Funds), 1963, which change the rules for deposits and withdrawals of monies in pension insurance plans, inter alia, with regard to the reduction of the maximum amount which may be insured in capital insurance. In June 2005, the Company, the Histadrut-the Federation of Trade Unions and the Employees' Association of El Al Employees signed a special collective agreement which enables the adjustment of the provisions to the new rules, at the employees' option.
Managers’ insurance agreement The agreement between the Company and the Phoenix Israeli Insurance Company Ltd., which became effective on December 1, 1990, was extended until the end of the effective period of the managers’ insurance policies which were issued under its auspices to employees. According to the stipulations of the pension agreement, directing part of the pension salary to managers’ insurance is conditional upon joining comprehensive pension. Managers’ insurance may be considered to be solely a savings plan or a savings plan with specified insurance, including insurance against work disability. The provisions for insurance are at the rate of 18 1/3% of the insured salary, of which 8 1/3% is for severance pay and 5% for provident fund on the employer’s account and 5% for provident fund on the employee’s account.
The deficit in the matter of severance pay and how it was covered Until the pension agreement was signed, the Company personnel employed in Israel, who were covered by the collective agreement, had no pension insurance. According to the provisions of the collective agreement, since January 1983, the Company makes deposits (for employees who are not affiliated with the pension) of 8 1/3% of the current wages of the employees in a provident fund for severance pay in Israeli banks. The deposits are in the Company’s name. Since the Company did not deposit monies for severance pay in a severance pay provident fund through January 1983, and because, from January 1983, severance pay was paid to retired employees from the money accrued in the provident funds for severance pay, a substantial shortage was created in the provident fund for severance pay, as itemized in the table below. (See Note 15.B.4.b to the financial statements on this matter). In addition, the Company’s accounts contain a liability for a grant due to unutilized sick days. The grant is paid according to the provisions of the collective agreement at the time of retirement from working in the Company due to disability or age, or subsequent to a period of service, on the condition that the employee is entitled to severance pay. The liability is in conformity with the eligibility accumulated by the employees, as itemized in the following table, and subject to the maximum ceiling for redemption of sick leave, as detailed in Note 15 (b)(5) to the financial statements.
a-73 Translation of the Hebrew Language financial statements
Also, a liability for cumulative vacation days through 1982 is recorded in the accounts, which, under the agreement with the employees, will be paid at the time that the eligible employees resign.
The following is detail of the Group’s liabilities in connection with the termination of the employee-employer relationship, net (consolidated data):
December 31, December 31, December 31, 2006 2005 2004 Thousands of Thousands of Thousands of dollars dollars dollars Liabilities for severance pay to employees 133,743 125,264 134,731 Less-deposits in severance pay funds (86,752) (80,243) (53,661) Liability for grant due to failure to utilize sick 35,440 31,570 32,781 days and long-term provision for vacation and benefits to retirees Provision for voluntary retirement, net 37,981 45,855 44,684 Less-current installment (837) (1,920) (1,918) Total 119,575 120,526 156,617
In June 2003, an agreement was signed between the State, the Company and the employees’ association, according to which the State and the Company agreed to act in order to cover the deficit between the provisions recorded in the Company’s accounts for severance pay (“the provision”) and the monies actually deposited into the severance pay provident fund (“the fund”) and which is connected to the eligibility of employees who had been employed by the Company at the date that the Official Receiver began to manage in 1982 and who continued to be employed through June 2003 (hereinafter: the eligible employees). On the date of the agreement, the deficit stood at NIS 516,240,000 and it is index linked and bears annual interest of 5.05%, starting June 1, 2003. Under the agreement, the State and the Company transferred the immediate proceeds which they received from the sale of securities in the framework of the prospectus which was published in May 2003 (“the initial offering”), after deducting expenses, to the severance pay fund for the eligible employees. (The balance of the severance pay funds includes the above proceeds.) The State and the Company also became committed under the agreement to transfer to the severance pay fund of the eligible employees, any amount that was raised from the exercise of convertible securities that were issued in the initial offering or from the sale of securities in other offerings which would be executed through the date of the end of the period of the last exercise (June 5, 2007) of securities issued by the Company in the initial offering. Should these amounts, as of June 6, 2007, not cover the entire deficit, the State is obligated to transfer the balance of the deficit to the severance pay fund of the eligible employees. It should be noted that on September 11, 2005, the Company received a letter from the Government Corporations Authority in which the Authority notified the Company, as advised by the Controller General's Division of the Ministry of Finance, that the State of Israel would not object to an interpretation according to which the aforementioned obligation need not
a-74 Translation of the Hebrew Language financial statements apply to the proceeds which the Company is to receive from an offering which only includes non-convertible debentures, subject to the confirmation by the El Al employees' association, which is a signatory to the agreement, that it does not object to this interpretation. Such confirmation from the employees' association has not yet been obtained.
The following is data on deposits made by the State and the Company into the severance pay fund of the eligible employees during the years 2004, 2005 and 2006 and until a date close to the date of approval of the report (in thousands of dollars):
Year State deposits Company Total deposits From January - 189 189 1, 2007 until 11.3.2007 2006 775 296 1,071 2005 25,791 535 26,326 2004 38,396 712 39,108 2003 11,296 4,909 16,205 Total 76,258 6,452 82,710
9.4.9 Legislative amendments relating to retirement age and retirement arrangements Within the framework of legislative amendments in effect from the beginning of 2004 and applying to the entire nation (and not to the Group alone), it was determined as follows:
A. The age at which an employee (both male and female) can be forced to retire due to reasons of age is 67. The male employee is entitled to receive a pension at the age of 67 and the female employee is entitled to retire from work at 62 and to receive a pension (subject to the conditions stipulated by law).
B. Employees (male or female) retiring after the age of 60 but before reaching the age of 67 for a male employee or 62 for a female employee would be entitled to receive a reduced pension.
C. In addition, the pension contribution rates to the veteran deficit pension funds for both employee and employer were gradually increased for 2004-2006.
Employees retiring in the framework of an early pension plan prior to January 1, 2004 The legislative amendments did not deal with the question of the eligibility of employees that retired under early retirement program before January 1, 2004 (during the period when the retirement age for a male employee was 65 and for a female employee-60) for pension from the pension fund between the prior retirement age and the new retirement age. Pursuant to an agreement signed between the Government and the Economic Organizations’ Liaison Bureau on January 5, 2005, it was agreed that the Government would finance the additional cost associated with the raising of the retirement age for employees as aforementioned, in the entire economy.
a-75 Translation of the Hebrew Language financial statements
Pilots who have reached the age of 65 Under regulatory restrictions, an employee may not serve as a pilot on a commercial flight after he has reached the age of 65. Due to the problematic nature of raising the retirement age to 67 for this group, the Company requested the Director of the Ministry of Finance to authorize that pilots’ retirement age remain at 65 years, but this request was not approved. The Company is making efforts to employ pilots who have reached the age of 65 in ground positions. See Section 9.14.10 below as to details of a legal proceeding on the matter of the salaries of these pilots.
It should be noted that, in the context of the aforementioned agreement regarding early retirement prior to January 1, 2004, the Ministry of Finance provided a budget of NIS 600 million for purposes of assistance in providing an answer to real financial difficulties caused by the raising of the retirement age, and a committee of the Economic Organizations’ Liaison Bureau was established in order to contend with the use of this budget.
9.4.10 Eligibility for flight tickets According to IATA regulations, Company employees are entitled, for themselves and for their families, including former employees, to receive service-vacation flight tickets (free or at a discount), the great majority of which are on an empty seat basis. This right is embedded in the labor agreements (and in the personal employment agreements of the senior executives), in the personal retirement agreements, in the Company procedures and in the professional instructions of the human resources division. The quota of free or discounted flight tickets is limited by the provisions of the labor agreement, of personal agreements or retirement agreements and by Company procedures. The Company included a provision in the financial statements as of December 31, 2006 with respect to the anticipated cost to the Company from the utilization of flight tickets by employees after retiring from the Company. See Note 17.A.10.a to the financial statements about the income tax assessment related to this subject.
9.4.11 Employees’ early agreed retirement plans Within the framework of its efficiency and cost-cutting measures, the Company created voluntary early retirement plans. During the years 2006, 2005, 2004 and 2003, 95 employees49, 53 employees 55 employees and 79 employees, respectively, retired in the context of the retirement plans. During the period between January 2003 and through the date of the report, approximately 282 employees have retired within the framework of the early retirement plans. See Note 15 (B) (13) (d) to the financial statements for additional details.
In order to carry out the retirement plans, agreements, agreements were entered into between the employees and the Company, between the employees and financial institutions, and between the Company and financial institutions. In the framework of these agreements, the financial institutions serve as the paying entity which executes the pension payments to the retirees. As security for the Company’s obligations to the retirees, the State provided a guarantee, according to which, inter alia, the Company will make periodic (mostly, annual, in advance) deposits to the financial institutions or will collateralize a deposit in a commercial
49 95 employees endorsed their enrollment in the retirement program for 2006. As of a date in proximity to the approval of this report, most of the signatories had actually retired and the remaining part will retire prior to the beginning of April 2007.
a-76 Translation of the Hebrew Language financial statements bank in an identical amount to the total amounts which the Company must pay as pension to the retirees for the coming year, and the Company’s payments to the retirees will be made from these monies. From time to time, the financial institutions approximate the anticipated costs of the retirement program, and the Company updates its estimates to the extent necessary, according to actual costs and the accumulated experience on the subject. In this context, after receiving the State guarantees as collateral for the Company’s liabilities to the retirees, and in light of the anticipated long term interest rate in the international and Israeli markets, the Company, in 2004, made a change to the estimated interest rate for capitalizing the liability for early retirement of the employees from 2% to 3.8% (the yield on risk-free government debentures).
9.4.12 Local employees in Company branches abroad Most of the Company personnel overseas, other than Israeli employees posted overseas, are employed under collective labor agreements between the Company and the local union in that country, or under agreements with the employees’ association, or under agreements between the employers' organization (foreign airlines) and the umbrella organization of airline employees, or under other agreements. The employment terms of Company employees in the remaining countries are not covered by any collective agreement, but are rather established by the Company, in accordance with acceptable practice in the aviation industry or in the national airlines in those countries. In some branches, the employees are engaged by personal contracts or through a contractor. Some of the branches are committed to pay severance pay in accordance with law or agreement; some of the branches have a pension insurance obligation or a right to pension by agreement. The Company makes regular payments for pension insurance and includes a full provision in its accounts for the liability for severance pay. On February 23, 2007, an understanding was reached with the professional union in the United States for renewal of the collective labor agreement for Company employees in the U.S., this through December 31, 2008, and on March 19, 2007, the consent of the employees' representation in the U.S. to such agreement was obtained.
9.4.13 Israeli employees posted abroad The Company employs abroad, inter alia, permanent workers, Israeli residents, dispatched to fill managerial positions abroad (“posted’). As of December 31, 2006, there were 34 posted, out of total permanent employees (402) abroad. Similar to State emissaries abroad, so are the salaries of those posted during their service abroad (hereinafter “salary abroad”) different from Israeli salaries, since they take into account the standard of living and taxation abroad, and also the fact that the salary is subject to income tax and social taxation, both abroad and in Israel. The salary abroad, including participation in car maintenance, is paid to the posted employee on the basis of “net salary”. (The tax, including social taxation and the grossing-up abroad, are paid by the Company). If the salary abroad or special payments in excess of the tax-exempt ceiling be subject to tax in Israel, the Company assumes the Israeli tax. In addition to the salary abroad, the Company also bears the rental cost of those posted as well as tuition expenses for their children These payments (up to a certain ceiling) are tax-exempt in Israel, but are liable for tax according to the laws of the different countries. The Israeli salary of the posted employee (salary according to rank and position, had he been employed in Israel) serves as the determining salary by the Company for the purpose of
a-77 Translation of the Hebrew Language financial statements making provisions for severance pay, for pensions (or managers’ insurance) and to a professional advancement fund, as is stipulated in the posting letter.
9.4.14 Welfare services and payments In addition to salary, part of the Company’s permanent employees also receive welfare services and payments, which include, among other things: subsidized meals for employees and gross-up of related taxes, medical examinations of employees, participation in medical and health care insurance and dental insurance for employees, clothing, uniforms, and partial participation in higher education. Part of these benefits is also given to temporary employees. Employees may, under certain conditions, receive guarantees for loans for various purposes. The loans are for periods of up to 60 months and are provided by the Company and Bank Yahav on terms which have been approved by the Ministry of Finance. See Note 7.A.3. to the financial statements for details.
9.4.15 Restriction on leasing aircraft in "wet lease" According to a letter by the Company’s CEO dated December 1999 to the Chairman of the Professional Association Division of the Histadrut, the Company is to restrict itself in the future to the lease up to 4 aircraft from Israeli airlines, so that the flight hours that will be executed by the Israeli airlines for the Company will not exceed 10% of the total flight hours of the Company (including flight hours that will be carried out in wet leases by the Israeli airlines, but not including leased aircraft from foreign companies), and they will operate in specified aircraft models in routes from/to Israel to destinations to which the flight range to them from Israel does not exceed 2,400 ocean miles. The Company will continue to plan the employment of its air crews in a volume of 83 monthly flying hours on an annual average, as it has done up to now, and, in the event of a significant change in external circumstances that will create the necessity to change this policy, the CEO will have discussed the matter with the Chairman of the Professional Association Division of the Histadrut, before taking a decision on the subject.
9.4.16 Executives and senior management employees The members of the Company’s Board of Directors are not Company employees. The services of the Chairman of the Board are provided to the Company in the framework of a management agreement between the Company and K'nafaim, the controlling interest in the Company. The directors' compensation (other than the Board Chairman and the public directors) includes compensation for participation in meetings of the Board of Directors and/or its committees, as well as the right to free or discounted flight tickets on El Al fights, subject to the payment of income tax by law by those eligible, and any other payment imposed on Company managers. See the Immediate Report dated May 10, 2005 for additional details regarding the outcome of the shareholders' meeting for approval of a transaction with a controlling interest.
In addition to the CEO, other senior personnel are employed under personal employment agreements. Until the Company was converted to a Mixed Company, the wording of the personal agreements had to be approved by the Government Corporations Authority. The salary of the senior personnel under personal agreement is updated, in a manner that the overall salary is linked to the CPI and updated each and every year, after deduction of the cost-of-living increments that were paid.
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In cases where the personal agreement is silent as to eligibility to augmented severance pay, the Company customarily approves incremental severance pay at the rate of one month per year of work. See also Section 9.4.5.c above regarding a description of an option plan. At a Special Meeting of Company Shareholders on July 14, 2005, a resolution was approved for an addendum to bylaw 158A of the Company's bylaws . The addendum stipulated, inter alia, that the salaries of officers (with the exception of directors not employed by the Company, and excluding the CEO, a controlling shareholder, a relative of a controlling shareholder, and an interested party of a controlling shareholder), where an exceptional transaction is not involved, will be approved by the Human Resources Committee and the appointment of directors.
The following is detail of the number of employees in the group of executives and senior management personnel of the Group during the years 2005 and 2004:
Number of personnel50 December 31, 2006 December 31, 2005 CEO 1 1 Senior management 9 9 Expanded management 32 32 and other senior 51 personnel
9.5 Raw materials and suppliers 9.5.1 Fuel A. The principal raw material that is used by the Company is aircraft fuel (jet fuel). Aircraft fuel (jet fuel) is one of the main expense components of the Company, as it is for every airlines. In the year 2006, jet fuel expenses represented approximately 33% of the Group’s operating expenses (as compared with 31% for 2005).
B. The price of jet fuel materially affects the Company’s profitability. In the Company’s estimation, at the operating level as of the date of the report, every change of 1 cent in the price of a gallon of jet fuel over the year increases the fuel expenses of the Company by 2.6 million dollars.
C. Beginning from the year 2001, the Group takes actions to hedge part of the forecasted consumption of jet fuel. A special committee of the Board of Directors for the management of market risks sets the Company’s policies on the subject of hedging jet fuel prices, the hedge period and the proportion of the hedge out of total jet fuel consumption for that period. The Company requests proposals as to the framework arrangements from a number of financial institutions and fuel companies, with which the Company has contacts, carries out commercial negotiations with them and executes the hedge transactions with them. The
50 Pursuant to the organizational structure (as opposed to salary levels). 51 Not including the CEO and senior management.
a-79 Translation of the Hebrew Language financial statements accounting between the parties is done once each period, and if the average price for the above period in the market is higher than the hedged price, the Company receives a refund in the amount of the price difference in multiples of the quantity for that period, and where the average monthly market price is lower than the hedged price, the Company pays the difference in multiples of the quantity for that period. See the Section 7.2 of the Directors’ Report and Note 20.(A)(1) to the financial statements for details on the Company’s hedge policies.
D. The average market price of jet fuel rose at a rate of approximately 15% in the year 2006 in comparison with the same period last year, before hedging transactions. The effect of this price rise on the operating results of the Company is substantial. The hedging transactions undertaken by the Company have, up to now, mitigated part of the effect of this price increase. The Company also has undertaken a process of conforming the prices of its services in order to moderate the effect of the rise in jet fuel prices on the operating results.
E. The Group purchases fuel in Israel and abroad. In Israel, the Company purchases fuel from two suppliers which were chosen in a tender process, and beginning from July 2004, the Company purchases approximately 65% of its fuel purchases in Israel from one supplier (the Sonol Company).
F. The Group purchases jet fuel abroad from a number of suppliers, including fuel airlines which supply jet fuel to a large number of airports. The foreign contracts are usually for a one year period. Most of the contracts are signed after carrying out commercial negotiations with a number of sources which the Company approaches in order to obtain proposals each and every year, except for those stations where there is only a single supplier or stations at which the Company has found it to be feasible to contract with the supplier for a period exceeding one year. As of the date of presenting the report, the Group has agreements for the purchase of fuel that will be in effect through May 31, 2007.
G. From time to time, the Company evaluates the feasibility of importing jet fuel on its own as opposed to the purchase from local suppliers, and carries out these activities based upon market conditions.
H. The Company purchased approximately 30% of its total fuel purchases (in Israel and abroad) during the year 2006 from one supplier. The Company has seven additional fuel suppliers from which the Company purchased in excess of 5% of its total fuel purchases in that year. The Company does not think that it is dependent on any fuel supplier.
I. During the year 2003, the Company initiated a policy of maintaining an inventory of fuel, which was purchased from local suppliers. As of December 31, 2006, the Company held fuel of about 10.5 million dollars in inventory, which was purchased from suppliers in Israel and abroad.
J. In addition to fuel suppliers, the Group receives fueling services in Israel from other suppliers.
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9.5.2 Aircraft A. All of the aircraft operated by the Company were manufactured by the “Boeing” Company. The Company has substantial dependence on Boeing both with respect to spare parts as well as with respect to engineering support. At the same time, in the estimation of the Company, the likelihood of termination of engineering support is low.
B. See Note 9 to the financial statements with regard to agreements to purchase aircraft.
9.6 Working capital 9.6.1 The Company has an inventory of basic products that include an inventory of jet fuel for consumption, duty-free products to be sold in flight, and also expendable inventory (blankets, cleaning materials, etc.) to take care of the passengers during flight. See Note 6 to the financial statements as to details of the volume of the inventory. Most of the inventory is expendable inventory held for short periods.
9.6.2 Reservation cancellation policies- In general, a customer is permitted to cancel the reservation, without payment, until the date that the ticket is issued to the customer (“ticketing”). The customer may cancel certain tickets even after “ticketing”, at times without payment of cancellation fees and at times with payment of a cancellation fee. There are also tickets which the customer may not cancel at all after “ticketing”. Generally, as the price per ticket is higher, so will there be readiness to allow cancellation of the ticket without cancellation fee or with a cancellation fee in a low amount.
9.6.3 Policies for providing assurance for services - The Group’s responsibility for damages (bodily damages and property damages) which are caused in the course of international air transport are stipulated in international conventions which have been adopted in the Air Transport Law, 1980 and the decrees which have been issued under its auspices. Recently, the Ministry of Transport distributed a legislative memorandum for the purpose of updating the current law, while conforming it to the Montreal Convention of 1999. Additionally, the Group operates in accordance with the directives of IATA on various matters that are connected with responsibility to passengers and their luggage. The Group’s responsibility for denied boarding of passengers from flights due to overbooking is established by the Aviation Services Licensing Regulations, 1985. In addition, with regard to everything that is related to denied boarding of passengers from flights, flight delays and flight cancellations to and from countries that are members of the European Union, Regulation 261/04 of the European Union applies to the Company (see Section 9.11.2 (e) below).
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9.6.4 Credit policies A. Credit to customers: Travel or cargo agents approved by IATA enjoy special payment arrangements in accordance with IATA regulations (a non-IATA agent is obliged to provide guarantees or pay in cash). The Group grants credit to agents in Israel for periods varying between 28 to 45 days. In general, direct sales of air transport to customers are made in cash, other than credit sales to Government ministries and certain commercial customers.
B. Suppliers’ credit: The Group receives credit from its suppliers in Israel for periods varying between 30 to 90 days, in accordance with the type of supplier and the arrangement with him.
C. The following are the average credit volume and credit periods for customers and suppliers of the Group as of December 31, 2006:
The 2006 year Average credit volume Average days of credit in millions of dollars Customers 152 33 Suppliers 145 50
9.6.5 Working capital deficit As of December 31, 2006, the Group had a working capital deficit of approximately 211 million dollars as compared with approximately107 million dollars at the end of the prior year. The current ratio at the end of the year 2006 was approximately 64% as against approximately 81% at the end of the previous year. See Section 2 to the Directors' Report for detail of the factors leading to the rise in the working capital deficit. The overall working capital deficit results from the current liabilities of the Group, which include two material components: deferred revenues from the sale of flight tickets and current installments of long term loans (including a one-time current installment). These elements which are characteristic for current business turnover are included as mentioned in current liabilities and, in effect, explain most of the working capital deficit. The Group estimates that this working capital deficit does not create current cash flow problems for the Group.
9.7 Investments See Note 8 to the financial statements for details of all of the airlines held by the Company.
9.7.1 The following is a concise description of the businesses of the principal subsidiary companies:
A. Sun D’Or International Airlines Ltd. (“Sun D’Or”) The charter operations of the Group, described above and below, are carried out through Sun D’Or (a company wholly owned by El Al). Sun D'Or operates in the field of leasing the capacity of entire aircraft to third parties, or the capacity of part of an aircraft to a number of partners at prices agreed to in advance. Sun D'Or has a commercial operating and operational license for an indefinite period, to transport passenger and cargo on charter flights from and to Israel. The commercial operating license also provides, inter alia, that the flights will be
a-82 Translation of the Hebrew Language financial statements carried out by aircraft which EL Al will lease to it and that BGA will be Sun D’Or’s home- base. Sun D'or approached the Civil Aviation Authority during the reporting year with requests for expansion of its operational license in order to carry out scheduled frights to Zagreb, Anatolia and Reike. As of the date close to the approval of the report, such approval has not yet been received. Sun D’Or’s revenues during the year 2006 were 39,574 thousand dollars. As of the date of the report, Sun D’Or employed 23 persons. See Note 8.B.4. to the financial statements for further details on Sun D’Or.
B. Tamam Aircraft Food Industries (BGA) Ltd. ("Tamam") Tamam (a company wholly owned by El Al) is primarily engaged in the production and supply of Kosher prepared meals for airlines. El Al is the principal customer of Tamam. During 2006, approximately 92% of its sales were to El Al, and the remainder to other airlines and to other customers. Tamam’s revenues for the 2006 year were18,166 thousand dollars. As of the date of the report, Tamam employed 363 workers (not including workers of a contracting company). See Note 8.B.1. to the financial statements for further details.
C. Bornstein Caterers Inc. (USA) - (“Bornstein”) Bornstein (a company wholly owned by El Al), registered in the United States and operating out of New York’s JFK airport, is engaged mostly in the production and delivery of prepared meals for airlines and other institutions. El Al is the major customer of Bornstein (approximately 76% of its sales for the year 2006). Bornstein’s revenues for the year 2006 were10,352 thousand dollars. As of the date of the report, Bornstein employs 102 workers. See Note 8.B.2. to the financial statements for further details about Bornstein.
D. Superstar Holidays Ltd. (Britain) - (“Superstar”) Superstar (a company wholly owned by El Al), is a tourism wholesaler and markets tourism packages to travel agents and individual travelers, and sells airline tickets on El Al routes at reduced prices. In recent years, Superstar has become one of the largest tour operators in Great Britain for tourism to Israel. The Company has operations in a number of additional countries. 52 Superstar’s revenues for the year 2006 were 17,679 thousand dollars .As of the date of the report, Superstar employs 20 workers. See Note 8.B.3. to the financial statements for further details about Superstar.
52 The amount in thousands of dollars has been computed from pounds Sterling at the rate of exchange as of December 31, 2006.
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9.7.2 The following is a concise description of the businesses of the principal airlinesheld, which are not subsidiaries53:
A. Cargo consolidation: Air Consolidators Israel Ltd. ("ACI") ACI (a company 50% owned by El Al) is primarily engaged in the consolidation of air cargo at BGA in order to reduce the price of air shipments The air shipments are made by El Al at special prices and, also, by means of foreign companies. The shares held by El Al entitle it to appoint half of the members of the Board of Directors and also give it the right to participate and vote in general meetings. The shares do not provide El Al with the right to receive dividends or any other benefit distributed by ACI, other than dividends distributed from capital gains. During the year 2006, the Company paid commissions to ACI in the amount of 703 thousand dollars. The revenues of ACI for the year 2006 were 25,088 thousand dollars. As of the date of the report, ACI employs 22 workers. B. Flights marketing: Tour Air (Israel) Ltd. ("Airtour" or "Tour Air") Airtour (a company 50% owned by El Al) markets the flights and special promotions of El Al to all destinations to which it flies. Approximately 55% of the total sales of the Israeli branch during the year 2006 were made through Air Tour. The shares of Air Tour held by the Group grant it the right to participate and vote in shareholders’ meetings and to appoint half of its directors, but do not grant the Group the right to receive dividends or other benefits, other than earnings derived from share capital investments of Airtour. El Al pays Air Tour a commission and also participates in one half of its operating expenses. The few foreign airlines which use the services of Air Tour also pay a commission similar to that paid by El Al. The policy of Air Tour is to transfer the lion’s share of the incentives which it receives to the travel agents, on the basis of their sales revenues at Air Tour, and to distribute the earnings as dividends to the owners of the ordinary shares (the travel agents). The revenues of Air Tour for the year 2006 were 7,619 thousand dollars. As of the date of the report, Air Tour employs 74 workers.
C. Touring and hotels: Kavei Chufsha Ltd. ("Kavei Chufsha") Kavei Chufsha (a company approximately 20% owned by El Al) is engaged in the marketing and sale of tourism services, including as a wholesaler and as an organizer of charter flights from and to Israel. El Al’s investment in the company was made for the purpose of enlarging its marketing channels in the charter flights sector and to expand the share of the Group in the marketing of tourism traffic. The marketing of Kavei Chufsha is done via travel agents and also by the distribution of seats and touring packages to the final consumer.
D. Reservation systems: Sabre Israel Travel Technologies Ltd. (“Sabre Israel”). Sabre Israel is a private company that was incorporated in Israel as a joint venture between El Al (49%) and Sabre Inc. (hereafter: “Sabre”). Sabre Israel supplies reservation services for flights of world airlines to the travel agent sector in Israel and also reservations for a variety
53 The description in this section is to the best of the Company's knowledge, pursuant to data that the companies described submitted.
a-84 Translation of the Hebrew Language financial statements of additional tourism services in the world (hotels, car rental reservations, etc.). Additionally, Sabre Israel supplies support and maintenance services to the agents for the Carmel system. The "Carmel" system serves as a reservation system for flight tickets, costing, ticketing, inventory management and check in services. All of the sales offices of the Company in Israel and abroad, most of the travel agents in Israel, general agents of the Company and a number of large agents abroad are connected on an online basis to the Carmel system. See Section 7.6.2 above for further details on the "Carmel" system and its planned replacement. The revenues of Sabre Israel for the year 2006 were 8,410 thousand dollars. As of the date of the report, Sabre Israel employs 39 workers. There is a cooperation agreement between the Company and Sabre Israel since 31.11.2001. The replacement of the Carmel system might terminate the agreement between the parties and/or change the manner and scope of the agreement between the parties so as to lead to a reduction in the revenues of Sabre Israel from the agreement. The implications of this matter are being examined by the Company. See Note 8.B.7 to the financial statements for further details on Sabre Israel.
9.8 Financing 9.8.1 Loans that are not for exclusive use The Group does not have any loans (whether from banking sources or from non banking sources) which are not for exclusive use, excluding a credit line as mentioned in Section 9.8.3 below.
9.8.2 Credit limitations on the entity
A. Observance of collateral correlation –
In accordance with the stipulations of each and every agreement, the Company is obligated towards the long term loan providers to observe a proper collateral correlation between the unpaid loan balance and the collateral pledged to the bank. In general, the agreements for loans taken by the Company stipulate that the market value of the aircraft pledged should exceed the bank loan balance by 25% and that this should be verified once or twice each year, on the basis of certain, agreed upon, international professional publications. In any case if the value of the collateral falls below that specified in the agreement, the Company is obligated to provide additional security to the lender in a manner that the correlation, as stipulated in the agreement, is maintained. As of the date of the report, the Company has met the restrictions and the financial covenants which were established with the banks.
B. Single borrower and group of borrowers limitation –
The directives of the Supervisor of Banks in Israel include restrictions according to which the debt of a “single borrower” and of a ”group of borrowers” to a bank in Israel shall not exceed a given percentage of that bank’s shareholders’ equity. From time to time, these directives may affect the ability of some of the banks in Israel to grant additional credit to the Company. Due to the change in the holdings in the Company in a manner in which K’nafaim is the controlling shareholder and holds more than 25% of the Company’s issued share capital, the Group is considered to be a part of the K’nafaim group as far as the restriction placed on giving bank credit to a group of borrowers is concerned. Also, in light of the weight of the
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Company’s long-term liabilities to banks in Israel, and due to the volume of loans provided by these banks to the K'nafaim group, the Company may encounter difficulty in raising additional loans in significant amounts from Israeli banks, that it may require for purposes of purchasing new aircraft or other investments.
C. Limitations on transferring control –
The Company has made commitments to the banks according to which, should there be a transfer or change of control of the Company in any manner without the consent of the lenders, the lenders are permitted to demand immediate payment of the loan balances. The following are the obligations of the Company and/or of the controlling shareholders with respect to these limitations: • In proximity to the publication of the prospectus in May 2003, the State made a commitment to Bank Hapoalim Ltd. that the holdings of the State and Company employees would not, at any time, decline below 50.00001% (fully diluted) of the Company’s issued share capital. On September 28, 2004, Bank Hapoalim consented that the transfer of control of the Company to K’nafaim would not be considered by the bank as an event giving it the right to demand immediate repayment of the loans that are the subject of the agreements, or any part of them. • In May 2003, Bank Leumi le’Yisrael Ltd. informed the Company that should control of the Company be changed or transferred in any way without its written consent in advance, Bank Leumi would be entitled to demand immediate repayment of the Company’s debts owed to it. Prior to privatization, Bank Leumi removed its objection to the public offering of the shares. In addition, on March 28, 2005, Bank Leumi notified the Company that it had no objection to the increase by K’nafaim of its holdings in the Company to a level that it would become the controlling interest in the Company, on the condition that the controlling interest in K’nafaim would be the Borovich family (the term “control” for this purpose - as defined in the Banking Law (Authorization), 1981) and that the change in ownership referred to above would take place no later than June 5, 2007. Subject to the above, it was agreed that Bank Leumi would not exercise its right to demand immediate repayment of debts and liabilities solely because of the aforementioned change in control, this without detracting from the other rights of Bank Leumi towards the Company and from the obligations of the Company towards it pursuant to existing agreements. Concurrently, on March 28, 2005, K’nafaim, the holder of control in the Company, sent Bank Leumi a letter as described in Section 4 above. See Note 14. F. 2 to the financial statements for details.
D. Demand for immediate repayment by the bank –
The terms stipulated in certain agreements relating to loans taken by the Company include the right of the bank to demand immediate repayment of the balance of the loans owed to that bank if, in the opinion of the bank, based on reasonable criteria, a change had occurred which adversely affects the Company’s financial position or its operations or its business or its financial ratios, in a manner endangering or potentially endangering the ability to repay the bank loans. See Note 14.E. to the financial statements for details.
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9.8.3 Credit lines The Group has credit lines with banks that totaled 87.5 million dollars as of December 31, 2006, an increase of approximately 35% in relation to the approved framework as of December 31, 2005. The credit lines are for a period of up to one year and at variable interest.
9.8.4 Loans for exclusive use- • The Company has taken loans for the purchase of aircraft, the principal terms of which are itemized in Note 14 to the financial statements. The balance of the bank loans as of December 31, 2006 stood at 667.4 million dollars. • The Company also has a loan received from another company for financing the acquisition of an additional cargo aircraft, the balance of which as of December 31, 2006, is approximately 2 million dollars, as described in Note 16 (B) to the financial statements. • In October 2006, the Company signed an agreement with a foreign bank for the receipt of financing in the amount of approximately 80 million dollars, against a lien on two 747- 400 ELA and ELB aircraft (with an option for an additional 10 million dollars for each aircraft in order to finance the conversion to cargo- should it be decided to convert them to cargo). The proceeds to be received could be used to reschedule part of the existing loans or for other investments, as the Company will see fit at the time that it withdraws the loans. The financing is for a period of 10 years from the first withdrawal, with quarterly repayments of principal plus interest. The Company withdrew approximately 40 million dollars in this framework in November 2006. The Company has the right to withdraw another 40 million dollars by November 2007. • In November 2005, a preliminary commitment was obtained from the Export Import Bank of the United States (EXIM), which will facilitate the financing of two new Boeing 777 aircraft scheduled to arrive during the middle of the year 2007. When the final commitment is received from EXIM, it will serve as security to the financing banks and, as a result, the terms of financing the aircraft will be enhanced. During the month of November 2006, the Board of Directors of the Company approved a commitment with two foreign banks which will jointly act as the financers of a transaction to purchase the two 777 aircraft, and in the month of March 2007, the Company signed a document of intent with the two foreign banks regarding the principles of the financing. The agreement is based upon an EXIM guarantee and is subject to its terms. The financing banks took upon themselves an extension of such financing for a period of up to 15 years. Accordingly, an application was made to the Export Import Bank of the United States to convert the preliminary commitment previously given into a final commitment. The Group estimates that in the coming year, it will not need to raise additional financial resources in order to operate its regular business. This paragraph contains prospective information, as defined in the Securities Law, 1968 (“the Securities Law”), which is based upon existing Company data as of the date of the report, and includes assessments or intentions of the Company as of that date. Accordingly, the actual results may be materially different than the results assessed or implied from this data, as the result of a large number of
a-87 Translation of the Hebrew Language financial statements factors, including exacerbation of competition, liquidity considerations, equipment procurement and changes in interest rates.
9.9 Taxation 9.9.1 Tax laws to which the Company is subject The main subsidiaries of the Company operating in Israel are subject to the Income Tax Law (Inflationary Adjustments), 1985 ("the Adjustments Law") which measures results in real terms. According to the Adjustments Law and the Income Tax Regulations (Rules Concerning the Maintenance of Accounting Records of Airlines with Foreign Investments and of Certain Partnerships and the Determination of their Taxable Income), 1986, the results of the Company and some of its subsidiaries for tax purposes are measured on the basis of adjustment to the exchange rate of the U.S. dollar. The operating results for tax purposes of the other subsidiaries in Israel are measured on the basis of adjustment for changes in the Consumer Price Index. Some of the subsidiaries are assessed jointly with the Company. Pursuant to the Income Tax Regulations (Depreciation), 1941, the Company is entitled to depreciation of aircraft that it owns at an annual rate of 30% of cost and of spare engines that it owns at an annual rate of 40%. In accordance with the Value Added Tax Law, 1975, transactions for the sale of flight tickets to and from Israel, or from one destination abroad to another, as well as cargo Transport by air to and from Israel, have been defined as transactions as to which the VAT rate is zero.
9.9.2 Status of the tax assessments of the corporation
On May 26, 2003, the Company signed an agreement with the Income-Tax Commission, according to which final tax assessments were determined up to, and including, the year 2002. Within this framework, it was established that the balance of tax losses to be carried forward to future years, after the waiver of a debt to the Government, would amount to NIS 2,219 million. The Company and the subsidiaries have received final tax assessments (including self assessments which are regarded as final) for the period through the tax year:
Tax year The Company 2002 Principal direct subsidiaries 2002
9.9.3 Tax laws that apply to significant affiliated companies incorporated abroad The subsidiaries abroad are subject to the tax laws applicable in the countries of residence. Most of the countries in which the Company operates representative offices are signatories to treaties for the prevention of double taxation or mutual arrangements between the nations, which exempt the Company from the payment of income taxes on its operations in those countries.
9.9.4 Reasons for material differences between the effective tax rate and the statutory tax rate See Note 22.B. to the financial statements.
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9.9.5 Cumulative losses for tax purposes The balance of income tax losses as of the end of the 2006 tax year (based on an estimated tax report for 2006) amounted to approximately 558 million dollars.
9.9.6 Income tax- withholding:
See Note 17.A.10 to the financial statements as to the matter of disputes with the tax authorities regarding withholding taxes for employee benefits. See Note 22 to the financial statements for additional details.
9.10 Environmental matters 9.10.1 Significant implications of rules pertaining to environmental matters Many countries including Israel have adopted the conventional international standards regarding engine noise of aircraft and have established additional directives for the conservation of environmental quality. Restrictions exist in various airports in the world as to the times of takeoff or landing of aircraft. The time schedules of the airlines, including those of the Group, are determined in accordance with these restrictions.
9.10.2 Restrictions on night takeoffs at BGA According to a Government decision (PS/15 of July 15, 1997), BGA has halted takeoffs between the hours of 02:00 and 05:30, commencing on October 30, 1998. It was also stipulated in the decision that, as of July 1, 1999, the prohibition of night landings at BGA would be broadened during the hours 01:00 to 05:30. In addition, performing the running of engines during the hours of the night (between 21:00 to 06:00) was prohibited. The Government decision to broaden the restrictions was not carried out, but, in the summer of 2002, the Minister of Transport decided to expand the prohibition on night takeoffs and to set it between 01:30 until 06:00, beginning from October 2002. Some of the foreign airlines in Israel petitioned to the Supreme Court of Justice. The file was closed in a compromise under which the petitioners were permitted at 05:50 to ignite engines and to carry out arrangements that would allow the aircraft to leave. The Ministry of Transport and the Civil Aviation Authority are examining the matter of operating BGA during night hours, subject to the stipulation of restrictions as to noise ceilings created by the aircraft taking off, and there is a proposed law on the matter.
9.10.3 Noise regulations at airports The noise restrictions which are defined by the aviation authorities of the United States are catalogued into 3 levels: Stage 1 to Stage 3. Stage 3 is the most severe level; a Stage 4 is also anticipated for the future. The foremost restriction in most airports in the world is Stage 3. In addition, each airport has the liberty of determining its own permissible noise levels. At the central airports, such as London, Amsterdam, Brussels, Toronto, New York, Paris and BGA, there are even more severe restrictions than Stage 3. As a result, operational restrictions are placed on 747-200 aircraft at those airports (permissible takeoff weight, climb rate after takeoff). All Group aircraft meet the Stage 3 restrictions, and even exceed them, but as to the 747-200 aircraft which take off at maximum weight, this restriction is borderline. Also, according to the decision of the European Union Parliament and Joint Commission of March 2002, the nations which are members in the Union are required to implement policies
a-89 Translation of the Hebrew Language financial statements intended to restrict the operations of aircraft defined as borderline from the standpoint of noise level. The Group has 4 aircraft of the 747-200 type as to which this restriction might apply. This policy is meant to be implemented in the following stages: (a) each nation of the Union will pass the legislation necessary to permit the removal from service of such aircraft; (b) the performance of an environmental survey at the airports of nations of the Union, which includes a cost-benefit analysis regarding the continuation of the operation of borderline aircraft at the airports. The survey is to be performed in consultation with the parties affected by its conclusions; (c) in the event that the results of stage (b) lead to the conclusion that there is justification to impose restrictions on the continued operation of borderline aircraft in any of the airports, the aviation authorities will have the authority to instruct the airlines of a freeze in the number of flights as to which these borderline aircraft will be operated at the subject airport, to an extent which will not deviate from the number of flights over the 6 months which preceded the notice of the freeze; (d) commencing with a date to be determined by the aviation authorities of each nation, and after giving advance notice of 12 months, the activities of the borderline aircraft will be reduced by up to 20% annually in comparison with the maximum volume of activity that will be determined. In mid-2006, the Company received a notice from the authorities at Schiphol airport in Amsterdam regarding their intention to hold a hearing on the matter of noise and regarding the imposition of operational restrictions on noisy aircraft. At this stage, the time schedule and/or the scope of the restrictions to be imposed cannot be evaluated. Other than that, to the best of the Company’s knowledge, as of the date of the report, the stage of consultation with the airlines has not begun in any European country and, in some of the countries, the relevant laws have not even been enacted. On the basis of this information, the Group estimates that the process of restricting the operations of the Group’s 747-200 aircraft will not begin before the second half of 2009. When the restrictions are imposed, operation of the 747-200 type aircraft may gradually become unfeasible economically, and finally impossible from a legal standpoint. The first aircraft, the operation of which is anticipated to become unfeasible, is the convertible aircraft (747-200C), since engines are mounted on them which are older than those mounted on the other cargo aircraft. Should there be any progress in this matter, the Company will, in the future, consider the replacement of the aircraft or their adaptation to the relevant legislation. At present, there is a proposed Government resolution presented by the Ministry of Transport and the Ministry for Environmental Matters on the matter of restrictions on flight operations as regards noise ceilings created by aircraft taking off. The information concerning the date of commencement of the restrictions on operating the 747-200 aircraft as aforementioned represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”), which is supported by the Company’s assessments on the basis of the information in the hands of the Company regarding the progress of the legislative process on the subject and the manner of implementation. Therefore, the actual date of commencement of the restrictions on the operations of the aircraft may vary materially from that forecast as above, as the result of a large number of factors which derive from the conduct of the various authorities in the different European nations.
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9.10.4 Handling of wastes
The Company’s wastes are handled in a plant within the confines of BGA which is operated by the Airports Authority, with the Company participating in 10% of the operating costs. This plant was due to shut down by the beginning of 2005, and in its place, a modern plant will be operating, approved by the Ministry for Environmental Matters. Beginning in 2007, the Company is planning to activate a pre-plant at a cost of 250 thousand dollars. The pre-plant, to be built on the Group’s land, is to treat the wastes and to bring them to the condition which is necessary for their acceptance into the main plant, to be built by the Airports Authority. The Group will pay usage fees to the Airports Authority for the use of the main plant in the amount of approximately 75,000 dollars per year over 22 years. At the same time, the poisonous wastes created by the Company are transported to the Environmental Services Company in Ramat Hovav.
According to the time schedule obtained from the Airports Authority, the closing and conversion of the Airports Authority's central waste treatment installation in the BGA confines, which had been scheduled for the beginning of 2005, was deferred to 2007. The Company will act on the basis of this time schedule. It should be pointed out that the Airports Authority and Tamam-Food Industries (BGA) LTD. (hereafter-Tamam), a subsidiary of the Group, were convicted of the criminal act of pollution of the airport's sewage ditches due to crude oil spillage. A fine of NIS 180 thousand was imposed on Taman and a fine of NIS 250 thousand was imposed on the Airports Authority. In January 2006, the Airports Authority instituted claim against Tamam for the amount of NIS 1.9 million with regard to the cost of cleaning and evacuating the crude oil that caused the pollution.
9.10.5 Fuel All of the El Al fuel tanks were examined during the second half of the year 2002 by an outside consultant who found that all of the tanks are sealed. In addition, an examination was performed by an authorized laboratory in December 2003, and it was found that all of the tanks are in order. The Sonol fuel company also installed viscometers in some of the fuel tanks during the final quarter of the year 2004, pursuant to the regulations of the Ministry for Environmental Matters. The Group carries out specific treatment on a regular basis of land toxic waste, if it exists.
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9.10.6 The material environmental costs and investments for the reporting year and those subsequently anticipated:
2006 2007 (estimated) Material costs 054 Usage fees for the waste treatment plant: up to 75 thousand dollars a year Material investments About 250 thousand dollars55 About 450 annually thousand dollars a year Total About 250 thousand dollars About 525 annually thousand dollars a year
The information concerning the material anticipated environmental costs and investments represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). The information is supported based upon the requirements of the environmental laws presently in effect and on current market prices of the goods and services which the Group must purchase in the framework of the environmental investments. Therefore, the actual costs and investments may vary materially from the forecast as above, as the result of a large number of factors, including legislative changes, requirements of the authorities and changes in the prices of the goods and services which the Group will be required to buy in the framework of the environmental investments.
9.10.7 Restrictions on the level of emissions
Following the strengthening of world awareness to the process of warming of the Planet Earth, governments have become interested in supervising and restricting the level of air pollution caused by engines. During the coming years, laws are expected to be enacted on the matter in different countries all over the world. The Company is examining the possible implications that enacting such laws could have on its operations.
54 Usage fees will be paid to the Airports Authority after the waste treatment plant at BGA is completed. Since according to the plan presented by the Airports Authority, the waste treatment plant will be completed during the year 2007, the Company will not pay for the year 2006 and only pay the relative portion for 2007, and, from the year 2008, it will pay the full sum. 55 For the treatment of asbestos panels, upgrading of coatings workshop and treatment of other environmental nuisances.
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9.11 Restrictions and regulation on the corporation’s business 9.11.1 General Most of the aspects related to the operations of the Company as an air carrier are subject to a system of regulatory arrangements, Israeli and international, which relate, among other things, to flight rights, setting of tariff's, capacity and flight safety standards, security and noise, and are conditional on a commercial operating certificate and an operation certificate. See Section 9.11.2 below as to regulatory arrangements. See Sections 9.11.3 - 9.11.5 below as to business and operational licenses. In addition to operational licenses, the Company’s operations are conditional upon it being an Israeli air carrier (principal ownership and control by the State or its citizens), its appointment as a designated carrier and on the permits of foreign countries allowing it to make use of the flight rights given to it as a designated carrier. See Sections 9.11.6 - 9.11.8 below as to air transport agreements and the civil and international aviation policy of Israel. In addition, there are further restrictions that apply to the Company’s operations deriving from the Special State Share. See Section 9.11.9 as to the restrictions deriving from the Special State Share.
9.11.2 Regulatory arrangements The following are the main regulatory arrangements, Israeli and international, which relate to the Company’s operations as a designated carrier. (See Section 9.11.2(k) below as to specific legislation in the matter of civil aviation security, and Section 9.11.13 below as to operations under emergency circumstances).
(a) Air Law 1927 (hereafter “Air Law"). This law and the regulations issued under its provisions, regulate, inter alia, the following matters: registration and nationality of airplanes, approval of airplanes as being fit for flying, approval of crews and licensing of flight personnel, safety, operation of airplanes and rules of flight, licensing of inspection establishments, self maintenance, etc (See also Order in Council on Air Navigation in the Colonies (Imposition of Laws), 1937 (hereafter-“Order in Council”).
Flight Regulations (Registration, Licensing and Documentation Fees), 1989 These regulations stipulate the amounts of fees to be paid according to the Aviation Services Licensing Law (see below) and according to the Flight Regulations as they relate to operating aircraft, and flying rules, the matter of registering aircraft and their markings, the matter of licenses for flight workers, the matter of procedures for documentation of aircraft and their components, the matter of testing, authorization and self maintenance institutes and the matter of charter flights. It should be noted that in November 2006, an amendment to this regulations became effective which stipulate fees that are at amounts significantly higher than those until then. This proposal is intended to fund the suggested changes in the organizational and budgetary structure of the Civil Aviation Authority, which was established in May, 2005 (see subsection (1) below-The Civil Aviation Authority Law).
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56 (b) Aviation Services Licensing Law, 1963 (hereafter - “Licensing Law”) The following are the principles of the law (as amended)57: (1) The law prohibits operation of aircraft in a commercial flight (passenger or goods transported for reward) or the leasing of aircraft for flight from or to the State or within its territory, except under a license from the Minister of Transport and in accordance with the conditions of the license (Section 2 of the law). (2) The law grants authority to the Minister of Transport, after consultation with the Minister of Tourism and after obtaining the opinion of the professional committee,58 both at the time of issuing the license and at the time of its renewal, to include conditions, inter alia, regarding the operation of aircraft, the proposed services, the fitness and experience of those engaged in operating the aircraft and inspecting them, aviation routes to be operated by the license holder and operational standards by which he should operate, frequency of the services, rates and insurance (Section 3 of the law). (3) The law gives the Minister of Transport the authority to refuse to grant a license, among other reasons, if granting the license might damage the regulation in the aviation market, or in its development or in the security of the State or contrary to its interests or the matter does not comply with an agreement between Israel and a foreign country or if the flight might cause damage to public safety or to the flight itself (Section 5 of the law).
(4) The law gives the Minister of Transport, after consultation with the Minister of Tourism and after obtaining the opinion of the professional committee, the authority to make a license conditional or to revoke it if he discovers one of the following: (a) one of the conditions of the license’s conditions or a directive out of the directives under any law that applies to operating aircraft has not been fulfilled; (b) the aircraft is not operated with safety, efficiency, capability or proper consideration of public need; (c) there is a cause out of the causes that permits the Minister of Transport to refuse to grant a license under this law.
The significance of the amendment to the law is the involvement of the Ministry of Tourism (and, to a certain extent, the Ministry of Finance and the Office of the Prime Minister, as well) in the decisions of the Minister of Transport in the context of his authorities under the law. In view of the published clarifications of the Government decision and trend that seems to be indicated for changing the aviation policies to a policy of "open skies" (inter alia, reduction of the restrictions on the number of air carriers to and from Israel and on the permitted capacity for the different carriers), and the Minister of Tourism's decision during the month of January 2006, to grant "Israir" the status of an additional designated carrier to New York, the structure of competition in the sector of passenger aircraft could be materially changed and impair the business results of the Company. The Company is analyzing the relevant implications of applying the amendment to the Licensing Law on the Group's operations and business results. See Sections 7.1.10, 7.8.4 above and 9.18.3 below with relation to the effect
56A commercial operating license and an operational activation license were granted to El Al under the authority of the law- see Sections 9.11.4-9.11.5
57 The law was amended in the framework of the State Economy Arrangements Law (Law Amendments in Order to Achieve Budget Goals and the Economic Policies for the Fiscal Year 2006). The amendment became effective on 1.7.2006. 58 A committee composed of the managing directors of the Ministries of Transport, Tourism, Prime Minister and Finance and the Civil Aviation Authority, the function of which is to render an opinion to the Minister of Transport on any matter relating to licenses, as to which an opinion is necessary.
a-94 Translation of the Hebrew Language financial statements of the changes on the Company. See Sections 9.11.7.2, 9.11.7.4 and 9.18.5 below with regard to changes in aviation policies in the areas of designated carrier and capacity, and their effect on the Government's decisions in matters of aviation and licensing of the Company as an air carrier. The Company's assessments detailed above, as they regard the practical significance of the amendment to the Aviation Services Licensing Law and its regulations, and the matter of the implications for the future of the Government's decision, represent "prospective information", as defined in the Securities Law, 1968 (“the Securities Law”), and is based upon Company assumptions and forecasts. Prospective information as to the future is information which is uncertain, which is based upon existing information in the Company as of the date of the report, and includes estimations or intentions of the Company as of that date. The actual outcome may be materially different from the outcome which is estimated or which might be deduced from this information.
(c) Licensing regulations The regulations that were issued as empowered by the Licensing Law regulate, inter alia, the aircraft operation and flight rules, operation of flying schools for flying instruction, transfer and endorsement of transport documents on scheduled flights, flying time restrictions for aviation services, overbooking, licenses for operating and leasing aircraft and operations of charter flights (see below).
Aviation Services Licensing Regulations (Charter Flights), 1982 These regulations regulate, inter alia, the granting of authorizations to carry out charter flights, the types of charter flights and the restrictions and conditions for carrying out the different types of charter flights. See Aviation Services Licensing (Charter Flights) (Amendment), 1994 and aviation policies in Section 9.11.7. In February 2007, an amendment to these regulations became effective under which authority was granted to the director of the Civil Aviation Authority to give his consent to allow an air carrier from a country that is not the country of departure or of the destination from or to which the flight is carried out, to also operate charter flights to and from Israel.
(d) Air Transport Law, 1980 This law and the orders and the notices issued there under adopt a number of international conventions which stipulate various rules relating to international air transport, particularly on the matter of the air carrier’s liability for damages (bodily damage and property damage), caused during international air transport. Recently, the Ministry of Transport distributed a legislative memorandum for the purpose of updating existing law, conforming it to the 1999 Montreal convention.
(e) Regulation 261/04 of the European Union-new conditions to compensate "denied boarding passengers" On February 17, 2005, a European Union regulation became effective which stipulates conditions for denied boarding of passengers from flights, flight delays and flight cancellations. This regulation pertains to scheduled and chartered flights which leave from countries that are members of the European Union (including flights to Israel). The regulation stipulates, inter alia, compensation to passengers denied from a flight and to passengers whose flight has been cancelled without giving them advance notice within the times
a-95 Translation of the Hebrew Language financial statements specified in the regulation. Additionally, such passengers are entitled to a substitute flight or to a refund of the payment for the flight ticket, at their choice. The regulation also stipulates the right of passengers registered for a flight as to which there was an extended delay in the time of takeoff, to a refund of the payment for the flight ticket. In Israel, a private law proposal that is in essence based upon this regulation was submitted, but was rejected by the Ministers' Committee on Legislative Matters and did not pass on the first reading.
(f) The Civil Aviation Authority Law, 2005 This law, enacted on January 21, 2005, determines the functions of the Civil Aviation Authority, which was designated to replace the Civil Aviation Administration, which, up to now, operated in the framework of the Ministry of Transport. Among other things, the functions of the Authority are: to determine and assure the existence of internal and international flight regulations according to flight laws; to grant licenses, permits and approves in the area of civil aviation, according to air laws; to supervise the civil aviation sector, including maintaining a proper level of flight safety for Israeli aircraft and for aircraft that are present in Israeli air space. See subsection (a) above for an amendment to the Flight Regulations (Registration, Licensing and Documentation Fees), intended to finance the functioning of the Civil Aviation Authority.
(g) Business restrictions (1) The Business Restrictions Law, 1988 (“Business Restrictions Law”) applies to all of the Company’s operating areas, except for the exemption described below. Until recently, the Business Restrictions Law included an exemption in Section 3(7) to the law which stated that an arrangement would not be considered as a restrictive arrangement if all of its restrictions relate to international Transport by sea or by air, or to integrated international transport by sea, by air or by land, and as to which a relevant notification has been submitted to the Minister of Transport, but only if all of the parties to it are: carriers by sea or by air or carriers as such, as well as an international association of airlines which has been approved for this purpose by the Minister of Transport. The provisions of this exemption did not apply to other activities of the Company. In the context of the Law for Arrangement in the State Economy (Legislative Amendments for Achievement of Budget Goals and Economic Policies for the 2007 Fiscal Year), 2007, approved on January 3, 2007, an amendment to Section 3 (7) to the Business Restrictions Law is included, according to which the application of the exemption included in it will be reduced with regard to limiting arrangements in the area of international transport, as described below. The effective date of the amendment was set for July 1, 2008, although if no class exemption (as defined in Section 15A of the Business Restrictions Law) is determined until that date, with regard to arrangements related to international air transport, the Minister of Finance will defer by order the effective date for additional periods of six months each. The Minister of Finance is permitted to avoid deferring the effective date as above for special reasons and after giving the Israeli air carriers, as well as the air carriers which have operations in Israel, or are the owners of agencies in Israel, the right to make their positions heard. According to the amendment, an arrangement which presently falls within the confines of the exemption will, nevertheless, be considered as a limiting arrangement: (1) if the parties to the arrangement are Israeli air carriers; or (2) if the parties to the arrangement are air carriers of which at least one is Israeli and at least one is not Israeli; or (3) if the parties to the
a-96 Translation of the Hebrew Language financial statements arrangement are non-Israeli air carriers and at least one of them carries on operations, or is the owner of an agency, in Israel and one of the major subjects of the arrangement is air transport to or from Israel and the limitation in the arrangement relates to operations or the prevention of operations in Israel by one of the parties. In addition, according to the amendment, the arrangement in cases (2) and (3) above will not be considered as being limiting if authorized by the Minister of Foreign Affairs and the Minister of Transport, in a well reasoned decision, after consulting the Minister of Finance and obtaining the position of the Commissioner of Restrictions, for reasons of real impairment in the foreign relations of Israel, including its economic-commercial foreign affairs, or in order to insure the continuity of flight rights between Israel and other nations. On January 31, 2007, the Company received a communication from the Commissioner of Business Restrictions that included a call to the Company to present its position with respect to the class exemption as above, including the types of arrangements that should be properly considered in the framework of the class exemption. The Company is engaged in preparing a comprehensive reply to the Commissioner for purposes of the wording of an appropriate class exemption. The final wording of the amendment to the directives of the Law for Business Restrictions, as it will apply, and the date that it becomes effective, represent "prospective information", as defined in the Securities Law, 1968 (“the Securities Law). Prospective information as to the future is information which is uncertain, which is based upon existing information in the Company as of the date of the report, and includes estimations or intentions of the Company as of that date. The actual outcome may be materially different from the outcome which is estimated or which might be deduced from this information. See also Section 9.18.15 B below (Discussion of Risk Factors) as to this subject.
(2) On August 4, 2004, the Commissioner of Business Restrictions (in this Section -“the Commissioner”) authorized K’nafaim to increase its holdings in El Al in excess of 25% of its issued share capital (“merger”, as defined in the Business Restrictions Law), conditional upon certain stipulated conditions (“the merger resolution”). Among the conditions stipulated by the Commissioner in the merger resolution is a condition which obligates K’nafaim, as a shareholder in El Al, to act in order to bring every arrangement between El Al and between another Israeli air carrier, to the consent of the Commissioner of Business Restrictions ("terms of arrangements between carriers"). Another condition stipulated in the merger resolution obliges K’nafaim, as a shareholder in El Al, to do everything necessary to cause a shut down or a transfer of the charter flight activities of El Al or any of its subsidiaries, including all activities connected with the charter flight operations of the Sun D’or company, to an unrelated third party, in every location in which El Al operates scheduled flights (except for deviations) ("Sun D'or conditions"). After the Company submitted an appeal of the conditions set by the Commissioner, the Company and the Commissioner, on March 14, 2005, accepted the proposal of the Business Restrictions Tribunal to conclude the appeal process by accord (hereafter: "the compromise accord"). Pursuant to the compromise accord, the Sun D'or conditions will not become effective before the end of two years from the date of the accord, whereas the terms of arrangements between carriers will not become effective before the end of one year from the date of the accord. The date for purposes of the terms of arrangements between carriers, and only it, will be extended by agreement, as itemized below.
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According to the conditions, the Commissioner may, within 120 days before the termination of each period, again impose the conditions, or one of them, on K’nafaim if, in his opinion, it is justified on such date. Before imposing the conditions, or one of them, the Commissioner will grant El Al the right to a hearing. Should El Al submit an appeal as to any one of the conditions once again imposed by the Commissioner, the conditions will be suspended for a period of six months, during which period the Tribunal will decide as to their validity. No change will take place in the other conditions. On March 14, 2005, K’nafaim signed the compromise accord and on March 20, 2005, the compromise accord between the parties received the validity of a judgment. The merger resolution also includes a condition under which K’nafaim is committed to sell all of its aviation activities as a going concern to an unrelated third party, including its holdings in Arkia Israeli Airlines, Maman- Cargo and Holdings Terminals Ltd., Kishrei T’ufa, Issta Lines and additional companies, but excluding the aircraft leasing operations and a number of additional affiliates. The accord of El Al with the Commissioner did not alter this condition. K’nafaim announced on March 30,2006 that the sale of the holdings of its aviation activities was completed with the sale of its holdings in Arkia and after carrying out additional transactions, including the sale of its holdings in Maman, Kishrei T'ufa and Issta Lines, and thus the condition obligating K'nafaim to sell such holdings was complied with.
It should be noted that on December 29, 2005, the Commissioner notified the Company that he is considering imposing on K'nafaim the terms of arrangements between carriers. In addition, the Commissioner demanded data from the Company concerning agreements, arrangements or understandings between the Company and Arkia and between the Company and Israir, and concerning negotiations carried on between the companies. The Commissioner requested that he receive the above data as well as the Company's position regarding the possibility that the Commissioner will impose this condition on K'nafaim. The Company presented the documents requested to the Commissioner and also stated that it objected to the condition. On March 14, 2006, in response to the Commissioner's notification and at its request, the Company decided to agree to a postponement of one year of the time period allotted to the Commissioner in the accord for imposing the aforementioned condition (that is-two years from March 14, 2005 instead of one year). The other conditions that were set by the accord concerning the manner of imposing the condition, as itemized above, will remain in force during the time of the postponement. See Section 9.14.9 below for further details.
As stated in the compromise accord, the Commissioner was permitted within 120 days prior to the end of two years from March 14, 2005 (that is, March 14, 2007) to reimpose the Sun D'or conditions on K'nafaim, if, in his opinion, there was a basis for same on such date, and subject to granting El Al the right for a hearing. On March 14, 2007, the period ended, while in the course of it- after notification to the Company and giving it the right to a hearing- the Commissioner was permitted to reimpose the Sun D'or conditions on K'nafaim. The Commissioner did not communicate with the Company, did not grant it the right to a hearing and did not reimpose this condition on K'nafaim; therefore, to the best of the Company's understanding and on the basis of legal advice that it obtained, he is no longer permitted to impose this condition according to the March 20, 2005 ruling.
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(3) On October 27, 2005, the Company received notification from the Commissioner of Business Restrictions concerning his pronouncement of the Company as the holder of a monopoly in transporting time sensitive (business passengers) and price sensitive (vacation travelers) in the routes to the destinations of: Johannesburg, Hong Kong, Bangkok and Bombay (hereafter: the Commissioner's decision). It should be pointed out that what is involved are 4 of the 5 routes that were mentioned in the notification of the Commissioner of March 22, 2005 as being routes as to which the Commissioner intends to declare that El Al holds a monopoly. The Beijing route, also mentioned in the Commissioner's March notification, was not included in his notice of pronouncement as a monopoly. It should also be mentioned that, in March 2005, the Commissioner gave notice that he is examining the status of El Al in approximately 19 routes: Brussels, Marseilles, Paris, Berlin, Munich, Moscow, Geneva, New York, Odessa, London, Vilna, Oslo, Palermo, Turin, Crete, Koss, Rhodes, Stockholm and Dublin. The following are the principles of the Commissioner's decision, as they were received in the Company's offices: A. The Commissioner classified and characterized the consumers in the passenger aviation sector into two groups: time sensitive passengers (business passengers) and price sensitive passengers (vacation travelers). B. The Commissioner determined that, as a rule, for the aviation sector in Israel, the geographic market should be defined on the basis of the departure points and the destination points of the flight route (city pairs). C. The Commissioner determined that as to substitutability between charter flights and scheduled flights, since charter flights had not been operated to the destinations included in the pronouncement as of the year 2004, or they had existed on a minimal basis, there is no need for him to reach a decision on this matter, but he did stipulate that, in principle, charter flights are not a substitute for business passengers. D. Regarding the substitutability between scheduled flights, the Commissioner has determined that, for vacation passengers, an indirect flight will, in certain instances, be a substitute for direct flights. However, this will apply mainly for long flights and when the overall flight time is not extended much longer than the direct flight. Regarding business passengers, the Commissioner determined that, as a rule, an indirect flight is not a substitute for a direct flight, except if it is particularly advantageous for them compared to the direct flight, such as being highly frequent. E. The Commissioner stated that for markets to which the pronouncement relates, El Al is the sole company maintaining direct, scheduled flights. He also stated that the Authority approached all of the foreign airlines that it thought were relevant, and an examination of the market shares at the destinations to which the pronouncement relates disclosed that El Al holds the following market shares: The Tel-Aviv- Johannesburg route- A market share in excess of 90%, both for business passengers and for vacation travelers. The Tel-Aviv –Bombay route-a market share in excess of 80% for both business passengers for vacation travelers. The Tel-Aviv –Bangkok route-a market share in excess of 80% for business passengers and in excess of 70% for vacation travelers. The Tel-Aviv-Hong Kong route-a market share in excess of 90%, both for business passengers and for vacation travelers.
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The Commissioner also declared that the examinations that were performed indicated that, even if indirect flights to other destinations in the same countries were included in the analysis of El Al's market share, this would not alter his conclusion.
On March 30,2006, the Company filed an appeal with the Business Restrictions Tribunal regarding the Commissioner's decision The appeal requests the Tribunal to revoke the declaration with regard to the markets which are the subject of the decision, in full or in part. Among the principal allegations upon which the appeal is based: the assertion that the market definition of the Commissioner is erroneous and disregards the characteristics of competition for flights from Israel to long range destinations in the Far East; the assertion that the analysis by the Commissioner, that related to the substitutability of demand alone, is a deficient and erroneous analysis which ignores the current substitutability from the viewpoint of supply despite it being immediate and lacking sunken costs; the assertion that the judgment used by the Commissioner in his decision to activate his authority to declare a monopoly was wrong from the outset and that the Commissioner erred in the manner in which he used his judgment and in the probability of the results of his declaration; the assertion that even according to the definitions of the market which were adopted by the Commissioner, the Company does not transport in excess of 50% of the passengers between Israel and India. In accordance with an understanding during deliberations between the parties, the Commissioner's response to the appeal has not yet been presented. In the context of the appeal, the Company also made a request to provide it with the right to study the documents which served the Commissioner when he declared a monopoly, and which were not submitted to the Company due to the objections of third parties. On December 14, 2006, the Tribunal decided to approve the Company's request to be granted the right of perusal of the documents to the Company's representative, subject to a letter of commitment to observe confidentiality. See 9.18.15 below for more details. (4)It should be stated that, on February 5, 2006, the Commissioner on Business Restrictions approached the Company with a demand to receive data concerning the cooperation agreements of the Company with other airlines, the way that the cooperation agreements affect the operations of the airlines on the routes to which the Commissioner's monopoly pronouncement, described above, applies, and also data regarding the commissions program and the benefits of El Al for the travel agents. At the beginning of March, 2006, the Company transferred the data as per the demand. In addition, the Company received correspondence from the Commissioner with demands for data in relation to the operations of the Company with a cargo agent (which, commencing from November 2006, is owned by an interested party who serves as a director of the Company). The Company transferred all of the data requested to the Commissioner, according to the above demands. As of the date of the report, no additional communications have been received by the Company with respect to this matter. See Section 8.5 above for further details. (5) During the month of February 2006, the Restrictive Practices Division of the U.S. Justice Department ("Restrictive Practices Division") began an open investigation, together with additional competition authorities of other countries, of supposed suspicion of price fixing with respect to certain increments to prices of air cargo transport. A number of cargo transporters announced that they had received Grand Jury injunctions in connection with this investigation. On September 27, 2006, the Company received an injunction from the
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Restrictive Practices Division that had been issued by the Grand Jury, which demands information and documents concerning certain costing and cost increment practices in the area of cargo transport, commencing from the year 1999 and through the date of the injunction. The Restrictive Practices Division notified the Company that the Company is being examined as a suspect in this investigation. The Company is cooperating with the investigation, while performing an internal investigation of its own of the cargo costing practices. At this stage, the Company is unable to assess the outcome of the investigation of the Restrictive Practices Division or to estimate the possible financial effect of the investigation. Nevertheless, it should be pointed out that the consequences could include administrative or civil procedures and/ or a criminal indictment, including penalties and/ or civil charges. It should also be stated that punishments for the violation of competition statutes could be serious, both with regard to criminal charges and also as to civil charges. (6) On December 20, 2006, the Company received a letter from the European Competition Commission ("the Commission") at its head office, which contained a request for information in connection with an investigation being carried out by the Commission in connection with activities which, seemingly, cause damage to competition in the sector of air transport services for cargo. The letter stated that the Commission has information regarding extensive contacts that took place between airlines and other entities with regard to various price increments and other matters such as cargo transport rates. In the context of the letter, the Company was requested to transmit data and documentation regarding the Company and its cargo activities, commencing with the year 1995. The Company is cooperating with the investigation and has transferred its reply as requested by the Commission's letter, while carrying on an internal examination of cargo pricing practices. At this stage, the Company is unable to evaluate the outcome of the investigation of the Commission or to estimate the possible financial effect of the investigation on the Company. Nevertheless, it should be pointed out that the implication might include an administrative proceeding against the Company, include a severe fine which could be imposed on the Company at the end of the proceeding. These financial statements do not include any provision for this investigation. (7) On February 28,2007, the Company received a writ of civil claim that was filed in the United States District Court for the Eastern District of New York in the matter of the prices for cargo air transport services. The Company was included as a defendant in the writ of claim, along with 38 other airlines, with the claim being that the defendants were partners in a conspiracy to conform prices for cargo air transport services, beginning in the year 2000, while violating competition and other laws in Europe and the United States. The claim was filed in the name of entities who purchase air transport services, directly and indirectly, it also includes a request to recognize the claim as a class action. The claim includes a request for compensation in an amount not denominated as well as additional relief. The Company is evaluating the writ of claim that it received and the possible implications and is making preparations to deal with this proceeding. In view of the early stage of the process, the Company is unable to assess the implications or the monetary effect of the proceeding on the Company.
(h) The Airport Authority Law, 1977. This law, the regulations and the rules issued under it, regulate, inter alia, the following matters: aviation fees, transport by import dispatchers, entry into restricted areas, authorization fees and loading and unloading of aircraft.
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(i) The Law for Regulation of Goods and Services, 1957. Section 11A of this law grants authority to the Minister of Finance, with the approval of the Government, to instruct by decree, a Government Corporation or Mixed Company, that is engaged in an area in which the State has a vital economic interest, that it continue to operate according to the instructions of the Minister, and the Minister is permitted to appoint a person to manage the company or to supervise its management. No procedures of liquidation, receivership, temporary aid, implementation or enforcement under any law shall be taken against a company to which such decree applies. On May 25, 2003, the Minister of Finance notified the Company that he would not activate his authority under Section 11A of this law, after the shares of the Company had been registered for trading on the Tel Aviv Stock Exchange. See Section 9.11.13 below for details concerning additional authority for action in emergency situations under the Law for Regulation of Goods and Services.
(j) The Consumer Protection Law, 1981. On June 30, 2004, Amendment No. 13 to the Consumer Protection Law was published. The amendment, in essence, revokes the exemption given in the past to services connected with air Transport from the requirement to publicize a comprehensive price. Under the amendment, airlines are required to publicize a price which includes all taxes that apply to the service and which are collected by the airline, and every other supplementary payment, which the consumer has no possibility from a practical standpoint to waive in the framework of the transaction. The amendment did not revoke the exemption that was given to airlines from the necessity to publicize a price in NIS. Under the law, the determining rate for payment is the sale rate for transfers and checks. The amendment also stipulates that for international cargo transport, as to which an arrangement has been established between the air carrier and an international association of airlines, the necessity to state a price in NIS on the basis of the sale rate for transfers and checks will not apply.
Additionally, the law determined that in the case of the sale of a flight ticket by "a sale from afar" (including by mail, telephone, radio, television, electronic communication of any kind, facsimile, advertising in catalogs or notices, etc.), the consumer is permitted, subject to certain commissions, to give notification, in writing, of the cancellation of a transaction and to receive a refund to the extent of a certain rate of the consideration paid, in accordance with the reasons for cancellation of the transaction. It should be noted that the Consumer Protection Law applies to relationships between the business (the Company) and the consumer, and not between the business (the Company) and another business, but to the best of the Company's knowledge, certain persons intend to act in an attempt to change the legislation on this subject, in a manner that the provisions of the law in the matter of cancellation of a transaction from afar will also apply to relations between the Company and travel agents. The possibility of applying the provisions of the Consumer Protection Law on relations between the Company and travel agents, if and to the extent it would apply, represents "prospective information", as defined in the Securities Law, 1968 (“the Securities Law). Prospective information as to the future is information which is uncertain, which is based upon existing information of the Company as of a date close to the report, and includes estimations or intentions of the Company as of the report date. The actual outcome may be
a-102 Translation of the Hebrew Language financial statements materially different from the outcome which is estimated or which might be deduced from this information.
(k) Law provisions that apply to the Company as a “Mixed Company” (1) The Company, until June 6, 2004, was a “Government Corporation” being “privatized”, as defined in the Government Corporations Law. Starting from June 6, 2004, the Company as a “Mixed Company”, as defined in the Government Corporations Law, namely a company which is no longer a Government Corporation, and as to which half or less of the voting rights at its general meetings, or the right to appoint half or less than its directors, are in the hands of the State. As a practical matter, as long as the State owns shares which provide it with voting rights in El Al, the Company will remain as a“Mixed Company”. As a Mixed Company, the Company is subject to part of the provisions of the Government Corporations Law (see Sections 55 and 58 of the law). Among other things, the provisions of the following sections of the Government Corporations Law apply to the Company: Section 14 which deals with the sale of shares held by the Company; Chapter C of the law applies to directors representing the State; Sections 54 (1), 54(7A), 55, 56(b), 58(a)(6) and 58(b), which relate to the powers of the Government Corporations Authority; and also most of Chapter 1G of the law on the subject of privatization.
(2) Bylaw 108 to the Company’s bylaws grants certain rights to the Government Corporations Authority, including the right to have an observer in the Board of Directors; the right to demand the convening of an extraordinary meeting of the Board of Directors upon demand of the Authority; the right of the observer to demand the ratification of certain decisions by the Company’s General Meeting of share holders; the power to approve the appointment of the Chairman Board of the Company and the CEO of the Company. As mentioned above, on December 23, 2004, following the exercise of options held by K’nafaim to acquire shares of the Company, K’nafaim owns Company shares in a proportion exceeding the proportion held by the State. Therefore, the special provisions of Bylaw 108 of the Company bylaws ceased to apply to the Company.
(3) Chapter 2H to the Government Corporations Law empowers the Prime Minister and Minister of Finance, with the consent of the Ministerial Committee for Privatization, and after consultation with the minister who is responsible for the Company’s matters, to determine instructions by decree which are intended to protect the vital interests of the State in connection with the company under privatization. These provisions apply for a stated period, or in general, they might also apply after the company’s privatization, as stipulated in the decree. The definition of vital interests includes various interests, which in part are similar to those which, in order to protect them, led to the issuance of a Special State Share (see below “Special State Share”), and also the avoidance of concentration in the economy, damage to the foreign interests of the State, etc. The position of the Government Corporations Authority is that Chapter 2H to the Government Corporations Law also applies to a Mixed Company. On November 17, 2004, a Government Corporations Decree (Declaration of Vital Interest to the State as to El Al Israel Airlines Ltd.), 2004 (hereafter in this paragraph: “the decree”) was published under the aforementioned Section 2H. The decree stipulates that the State has a vital interest with regard to the Company, in order to make effective use of vital assets during a time of emergency or for security purposes, so as to assure the continued
a-103 Translation of the Hebrew Language financial statements implementation of activities which are vital to the security of the State. The decree also determines that the Company is required to employ, at all times, Israeli air crews, and Israeli ground crews in Israel, which are qualified and licensed as necessary in order to operate the “vital assets” (minimal fleet of aircraft; see “Special State Share”), in the number required for continuous and simultaneous operation of all of the “vital assets” during a time of emergency or for security purposes. The decree adds that it does not intend to make the Company subject to the provisions of Section 59T of the Government Corporations Law (which deals with restrictions on the transfer of control), and that the decree does not intend to detract from the provisions of the Special State Share. See Section 9.11.9 for details of additional restrictions to which the Company is subject as per the Special State Share.
(l) The Budget Fundamentals Law The Company is subject to the provisions of the Budget Fundamentals Law, 1985, according to which a Government Corporation, Government Subsidiary and Mixed Company, according to their meaning in the Government Corporations Law, are included in the definition of a “budgeted entity”. Commencing from the date that the Company was converted into an Mixed Company (June 6, 2004), the Company’s subsidiaries are no longer included in the definition of “budgeted entity”. The Budget Fundamentals Law gives supervisory powers over budgeted entities to the Ministry of Finance and creates a reporting requirement to the Ministry of Finance for the budgeted entity, in order to implement and enforce the Budget Fundamentals Law. In accordance with the provisions of Section 29 of the Budget Fundamentals Law, the Company may not consent to changes in salary, retirement or pension conditions, or other monetary benefits that are related to labor, and may not introduce such changes or benefits, except in accordance with what has been agreed or introduced with regard to all government employees, or with the consent of the Minister of Finance. The law stipulates that any agreement or arrangement that is contrary to Section 29 is null and void. The Minister of Finance is permitted, under certain circumstances and with the consent of the Knesset Finance Committee, to exempt a Mixed Company from the provisions of Section 29. On January 25, 2005, the Company presented a request to the Minister of Finance to exempt the Company from the provisions of Section 29 of the Budget Fundamentals Law, in light of the completion of the process of converting the Company into a privately controlled, rather than a governmental, company. The request was approved by the Minister of Finance. On March 17, 2005, the exemption was also approved by the Knesset Finance Committee.
(m) Wage reduction and freeze pursuant to the Israeli Economy Recovery Program Law As a “budgeted entity”, the Company is subject to Chapter P to the Israeli Economy Recovery Program Law (Law Amendments in order to Achieve Budget Goals and the Economic Policies for the Fiscal Years 2003 and 2004), 2003 (“the Economic Recovery Law”). That chapter orders a gradual wage reduction and a deferral of the date of payment of recreation pay for public sector employees as a Temporary Order for the period from July 1, 2003 through June 30, 2005. The wage reduction conforms to the “Agreement for the Encouragement of Economic Growth”, which was signed between the State and the Histadrut on May 22, 2003. The wage reduction is not to be taken into account in the computation of payments to provident funds and for the matter of payments from provident funds. That
a-104 Translation of the Hebrew Language financial statements chapter does not apply to the Company’s subsidiaries, commencing from the date that the Company was converted into a “Mixed Company” (June 6, 2004). On January 26, 2005, the Company approached the Commissioner of Wages and Labor agreements in the Ministry of Finance and to the director of the Government Corporations Authority with a request to receive their consent to cease the Growth Encouragement Deduction from the Company’s employees. Pursuant to consents received in February 2005, the Growth Encouragement Deduction from the wages of the Company’s employees was stopped, commencing with the February 2005 payroll.
(n) The State Comptroller Law According to Section 9(10) of the State Comptroller Law, the Company will continue to be an audited entity for three years after the State ceased to participate in its management.
(o) Equality of Rights for Persons with Disabilities Regulations (Accessibility Arrangements to Public Transport Services), 2003 Chapter 3 of these regulations (the majority of the provisions of which are in effect) deals with the requirement to arrange assistance in air Transport to persons with disabilities and imposes various obligations on the carriers as a condition of operating aircraft.
(p) Class Action Law, 2006 On 12 March 2006, the class action law was published. The law, inter alia, enables, to file application to approve the suit against a dealer in connection with a matter between him and a client as a class action and this whether they have engaged in a transaction or not. This provision broadens significantly the causes for filing class actions. The provision will be applicable as from the publication of the law also to filings of claims with a request to approve them as class actions that have been filed before the publication of the law and have not been decided. According to the law in pending class actions claimants may request to amend the claim and approve it as a class action (or the statement of appeal if the claim is in the state of appeal) and adding additional causes or extending the existing causes, inter alia, as regards the deceit and abuse in the course of the contractual relations. For details as regards class actions which the company is a part to, see the clause on legal proceedings – article 9.14 hereinafter.
9.11.3 Business licenses and operating certificates Part of the Company’s businesses is required to obtain licenses pursuant to the Business Licensing Law, 1968. During the years 2003 and 2004, the Company filed applications for business licenses for all operations for which licensing is required. The Company is acting in coordination with the Ministry of the Interior and has hired expert consultants for assistance in the process. For this purpose, an outline was created for an organized and authorized operative program in order to complete the process of obtaining the licenses to manage the Company’s business.
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9.11.4 Commercial operating certificate
The Company has a certificate (No. 1/88 dated August 2, 1988) for commercial operation which was granted by the Minister of Transport under the Licensing Law. The following are the main points of the license: (1) The license holder may not operate aircraft operationally, except under an air operation certificate from the head of the Civil Aviation Administration (hereafter-“the Administration”) (See below as to the operational certificate).
(2) The license holder will meticulously fulfill the provisions of every law which applies to the operation of aircraft and all directives which have been established or will be established by the Administration.
(3) The license holder will not operate the aircraft in a manner which might cause damage to national security, public safety and health and flight safety or in a manner which could endanger the public in any other way.
(4) The license holder will notify the Minister of Transport of any demand from a foreign country to transfer a commercial document or commercial information which is found outside of the territorial authority of that nation and will not transmit or supply such document or information without obtaining the Minister’s consent.
(5) The license holder will assure that at least 51% of the share capital of the license holder be owned by Israeli citizens and permanent Israeli residents and that at least two thirds of its directors (Board members), including the Chairman of the Board of Directors and the CEO, will be Israeli citizens and permanent Israeli residents59.
(6) The license holder will submit to the Administration, upon demand, reports, data or information concerning aircraft operation.
(7) The owner of an operations certificate will not operate aircraft, unless he has purchased insurance coverage as itemized in the license.
(8) The license holder will submit for the approval of the Administration, at least 30 days before it becomes effective, a seasonal time schedule of the scheduled flights with detail of aviation routes and frequency of flights on them. A change of a permanent nature in the time schedule requires advance approval of the Administration.
(9) In its scheduled flights under this license, the license holder will convey passengers and transport goods, to the extent possible, in accordance with the fares and travel and
59 On May 26, 2003, Section 8 of the commercial operating license was amended in that the percentage of holdings by Israeli citizens would be reduced from 76% to 51%, so that foreign ownership could reach 49%. Pursuant to the Special State Share, as long as no other decision has been reached by the holder of the Special State Share or the Company’s Board of Directors, the restriction which will apply to the percentage of foreign holdings of the Company’s shares will conform to the commercial operating license of the Company, as it will be at all times. The decision as above on changing the restriction applicable to foreign shareholdings will be reported in an Immediate Report.
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transport conditions that will be set by IATA, or pursuant to other rates, all to be approved in advance by the Administration.
(10) The license holder will convey passengers and transport goods for free or at cheaper rates if requested to do so by the Administration and according to the terms of the license.
(11) The services which the license holder is permitted to propose and to perform are stated in the appendix to the license. The appendix represents an integral part of the license, and the Administration is permitted to change or revoke it.
The following are the main points of the appendix: (a) Conveying passengers and transporting goods on scheduled flights between Israel and points in foreign countries, and between the points themselves. It should be noted that part of the points are not exploited by the Company due to lack of economic feasibility. (b) Conveying passengers and transporting goods on international charter flights in accordance with the official licensing regulations. (c) Special missions conditional upon the Administration’s consent.
The Minister of Transport is empowered to revoke the selection of the Company for a point(s) which are not exploited by the Company or exploited to an extent which is lower than that determined, and to authorize another Israeli carrier. See Section 9.11.7.2 below for details on Government policies with respect to the revocation of the Company’s selection.
(12) The license is valid as long as it has not been revoked or made conditional by the Minister of Transport or the Administration.
9.11.5 Operational operator's certificate
The Company has an operational certificate (No.1/88) which is issued every year. The current license is effective through December 31, 2008. It stipulates, inter alia, that the operator (El Al) is permitted to act as “designated air carrier” of large airplanes (under Chapter 13 of the Flight Regulations- “Operation of Aircraft and Flight Rules”). The operator is permitted to operate international flights and continuing internal commercial flights, conditional upon the operational restrictions and the conditions itemized in the operational specifications which are part of the license.
It is stipulated in the general conditions of the operational specifications that the registered owners of the carrier “holder of the operational certificate” is/will be permanent citizens of the State of Israel with a permanent place of residence in the sovereign territory of the State of Israel. The mother base/bases of the operations certificate holder will be determined by the Civil Aviation Authority in their operational specifications, within the sovereign territory of the State of Israel.
The aircraft recorded in the license will have Israeli registration or foreign registration approved by the Administration, fully owned by the license holder, or will be placed at the disposal of the license holder, with the consent of the Civil Aviation Administration. The
a-107 Translation of the Hebrew Language financial statements operator has the obligation to report every change in the list of aircraft that appears in the operational specifications, such as sale, purchase, lease to another operator and/or lease from any Israeli operator or foreign operator, on the condition that the foreign aircraft is recorded in the Aircraft Registry of a country which is a member of ICAO. The report will be submitted to the operational division and the air fitness department within 10 days of making the change.
9.11.6 International regulatory arrangements The principle of universality dominates in civil aviation, meaning that every country is sovereign over its own air space, and therefore, each commercial flight to or over any country, requires that country's permission. The permission may be in the form of a bilateral agreement (as is customary for scheduled flights) or for a flight(s) on an ad-hoc basis. The international civil aviation sector operates in the context of a system of regulatory arrangements that affect most of the operational aspects of the airlines and, in particular, the subjects of flight rights, permissible capacity, fare setting, air carrier’s responsibility for damages (bodily and property damage) and flight safety standards, security and noise. This system of arrangements is composed of international conventions, laws, regulations and administrative instructions, and also bilateral agreements. The existing basis for the international regulatory arrangement in the matter of international civil aviation is the Chicago Convention of 1944. In the wake of the Convention, the International Civil Aviation Organization (ICAO), an agency of the United Nations, was established. In the framework and under the auspices of ICAO, recommended standards and procedures were determined for various areas of aviation activities. The rights to transport passengers and cargo between countries for compensation, permissible capacity and rate setting are organized in agreements for air transport or aviation agreements (bilateral), which are based on reciprocity and provide fair and equal opportunities to airlines of the two countries.
9.11.7 Air Transport agreements and the Civil and International Aviation Policy of the State of Israel 9.11.7.1 Air Transport agreements- general Most of the traffic rights under which the State of Israel permits a company to carry passengers and cargo on international routes are anchored in air transport agreements between Israel and between foreign countries, and a minority (due to the absence of air transport agreements) by agreements between aviation authorities or commercial agreements between the Company and the air carrier of the other country, which necessitate the approval of the two countries. The principal components in air transport agreements include, inter alia, the traffic rights granted, determination of the designated carrier, the permissible capacity and the methods of determining tariffs. When an air transport agreement is signed, each government determines an air carrier as a “designated carrier” on its behalf that will operate the flights and exploit the traffic rights under the agreement. After the “designated carrier” is selected, it must obtain a permit from the aviation authority of the other country. In order to obtain a permit, the carrier must prove that the substantial ownership and effective control of the air carrier is held by the government of the country or by citizens of the country which selected it as designated carrier, and also that the carrier meets all of the international flight safety standards.
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Most of the air transport agreements that Israel is party to may be terminated or cancelled by advance notice of one year. After such notice, negotiations are generally held between the two governments in order to set an interim arrangement or new conditions before the expiration of the validity of the agreement. In Decision No. 441 of the Government dated September 12, 2006, headed "Encouragement of Competition in the Civil Aviation Area to and from Israel", it was decided that an interministerial steering team would be established to accompany negotiations with the European Union related to the formulation of uniform comprehensive aviation agreement with the nations of the European Union, to replace the existing bilateral agreements between Israel and the European Union. The team is headed by the managing director of the Ministry of Transport and Road Safety, and it will include representatives from the Ministries of Finance, Foreign Affairs and Tourism. The team will appoint representatives for the negotiations with the European Union and will instruct the representatives to include the following principles in the new Air Transport agreement: providing a proper reaction to the interests of the Israeli airlines, including and particularly, the exploitation of the "Freedoms" as well as flight times and frequency; maximum utilization of the possibilities of reaching the State of Israel, including by means of increasing the number of designated carriers in cases in which the current bilateral agreements limit the number to one carrier per country, and the encouragement the entry of low cost airlines to operate in Israel. The Government decision stated that the team would act to formulate the new Air Transport agreement within one year and will report to the Government on the progress of contacts to work out the agreement. At the same time, the Ministry of Transport set up the "Public Committee for Evaluating the Issues of Open Skies" (the Siterman Committee). The committee has recently terminated a hearing on positions of various bodies, including the Company, and is expected to issue its conclusions shortly. See also Section 9.18.5 below as to these matters.
9.11.7.2 Designated carrier (1) Each government grants in the air transport agreement, its counterpart the right to select 60 one of its air carriers as the designated carrier . The designated carrier is granted the right to carry passengers and cargo between the two countries. At times, the designated carrier also receives the right to operate scheduled flights from the second country to a third country (subject to an agreement with the third country). Until the second half of the 1990’s, the Company was the sole designated carrier of Israel in the sector of scheduled flights to carry passengers and cargo to and from Israel, except for Sharm-el- Sheikh. The change in the aforementioned exclusive status of the Company occurred after licenses were given to additional Israeli carriers as “designated carriers” to a number of flight destinations, some of them in place of the Company. As of a date close to the approval of the financial statements, the other Israeli airlines have been appointed as designated carriers to 13 international destinations, including the appointment of Arkia as a designated carrier to Larnaca, beginning from the month of February 2007.
60 The agreements with the United States, Argentina, Singapore, the Philippines, Chile, Korea (under certain conditions), Turkey and Spain permit a large number of designated carriers. The agreements with Great Britain, Germany, the Russian Federation and the Ukraine permit the selection of one carrier from each agreed point (city pair). The agreement with France permits the designation of two carriers from each agreed point (city pair).
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Shortly before publication of the prospectus, the Ministerial Committee for Social and Economic Matters decided (decision No. SE/14 dated May 19, 2003) that:
A. The Company would continue to serve as the designated carrier on all of the routes on which it served as designated carrier immediately prior to publication of the prospectus, subject to the following conditions: (1) The Company will at all times comply with the stipulated directives and obligations and which it had taken upon itself vis-à-vis the State of Israel. (2) The Minister of Transport will consider canceling the status of El Al as the designated carrier for a specific route if the number of passengers that fly with the Company on that route are 20% or less than the number of passengers that fly on the same route on scheduled flights, or if the number of scheduled flights of El Al on that same route are 20% or less than the number of scheduled flights operated by the designated carrier of the destination country, during the period of a calendar year.
B. The Ministerial Committee for Social and Economic Matters also stipulated that the Minister of Transport will consider whether to grant rights to an additional designated carrier for scheduled flights on routes, should the number of passengers flying on scheduled flights of the Company on a specified route be lower by 30% than the total number of passengers of 6162 the scheduled flights on that same route during the period of a calendar year . It was also stipulated that, without detracting from the authority of the Minister of Transport by law, this policy will be considered if and when the volume of outgoing and incoming passengers by air to Israel will exceed 10.7 million passengers annually. (2) On December 21, 2001, a petition was filled with the Supreme Court (Bagatz 10089/01) by Arkia Israel Airlines Ltd. (“Arkia”) against the Company, the Minister of Transport and the Head of the Civilian Aviation Administration, according to which a conditional order would be given ordering the respondents to explain why Arkia should not be permitted to serve as a designated carrier to destinations for which the Company does not maintain scheduled flights, or where it maintains flights at very low regularity, or to destinations for which a designated carrier could be appointed in addition to the Company, or to destinations to which no designated carrier has been appointed as yet. At a later stage, Israir Aviation and Tourism Ltd. joined the petition. Subsequent to Decision HC/14 dated May 19, 2003, the petition was amended so that it made reference to this decision. The Supreme Court rejected the petition on April 1, 2004 and thus approved Decision HC/14 for all practical purposes, so that the Company will continue to act as designated carrier in accordance with the conditions of that decision.
61 The positions of the Deputy Attorney General to the Government (Economic-Fiscal) and of the legal advisor of the Ministry of Transport are that Section 2 of the decision is a clear case in which the Minister of Transport must use his judgment, and it does not contain, according to the fundamental rules of administrative statutes, anything to restrict his judgment or to prevent him from using his authority under any law, including in the matter of a designated carrier on a scheduled air navigation route, under other appropriate circumstances as well.
62 On May 28, 2003, the Director of the Policy Division in the Ministry of Transport made it clear that the determination of the percentages of operation of the Company, both in Section 1 and in Section 2 of that decision, has the significance of “self-operation” by El Al at the rates stipulated and that the aforesaid does not at all eliminate the possibility of operating the route by means of a code-share agreement, but then also the necessary operation is only that which is carried out by the Company.
a-110 Translation of the Hebrew Language financial statements
During recent years, Arkia was appointed as designated carrier, in addition to Sharm-El- Sheikh, for Amman, Copenhagen, Eritrea, Stockholm, Tashkent and Tbilisi In addition, Arkia was appointed as designated carrier to Larnaca in the month of February 2007,in place of the Company which had ceased operations to this destination. It should be clarified that, during the year 2006, following a request by the Company, the Company was appointed as designated carrier to Tahkent, in place of Arkia. “Israir” has been appointed as designated carrier for New York, Izmir, Ankara, Bratislava, Riga, Lisbon and Ljubljana.
(3)In September 2004, Israir made a request to the Minister of Transport to obtain the status of an additional designated carrier for the route to New York. Later, Arkia made a similar request. Due to concerns of conflict of interests, the Government, with approval of the Knesset, transferred the authority for the decision in the requests from the Minister of Transport to the Minister of Tourism. On January 16, 2006, the Minister of Tourism decided to consent to the request of Israir and to appoint it as another designated carrier (in addition to the Company) for the State of Israel on the Tel Aviv-New York route, and to thus broaden Israir's commercial license. The appointment was made for the operation of scheduled flights for a period of 24 months, and in the decision, it was stated that "during this period, the implications of an additional designated carrier would be evaluated on the basis of additional relevant considerations for this route". The Company filed a petition with the High Court for Justice on January 29, 2006 in which it requested the court to order that the Minister of Tourism's decision is baseless from a legal standpoint and it, therefore, is, or should be, annulled. The Company alleged in the petition that the decision of the Minister of Tourism is a violation of a governmental commitment given to the Company, to its employees and to its shareholders in a decision dated May 19, 2003 (HC/14-see above), that the circumstances which would permit a release from the governmental commitment have not transpired and that the reasoning for the Minister of Tourism's decision was erroneous, both factually and economically. Additionally, the petition mentioned allegations regarding official conflict of interest and prejudice and the matter of the date of the decision being in proximity to the upcoming elections, and also additional reasons for annulment of the Minister's decision, including non compliance with the terms of the Law for Licensing Aviation Services and the Flight Regulations, as well as defects in the hearing procedure. On February 23, 2006, the High Court for Justice rejected the Company's petition to annul the decision of the Minister of Tourism. Additional petitions against the Minister of Tourism's decision, which were presented by the Company's employees association (including an employees' organization which purchased Company shares) and K'nafaim, were also rejected. On August 2006, the reasoning of the High Court for Justice was given for the rejection of the Company's petition and additional petitions which were filed by the representatives of the Company's employees and by the Knafaim Company, against the decision of the Minister of Tourism regarding the appointment of the Israir Company as an additional, designated carrier on the route to New York. Following is a summary of the reasons: the considerations which were enumerated in the Government decision dated May 19, 2003 regarding the authority of the minister are not the solitary and comprehensive considerations, but the decision establishes policy courses and guiding principles. The minister is permitted to appoint an additional designated carrier even if the quantitative conditions in the Government decision
a-111 Translation of the Hebrew Language financial statements have not been met, but this only in unusual cases which are in the public interest, as the minister himself directs to consider the interests of El Al and its special status and the tendency to conserve this status. This interpretation of the Government's decision is also expressed in the prospectus of El Al. Therefore, the minister did not deviate from the Government's decision and did not breach a commitment. The minister's decision is located in the realm of reasonableness, especially since it was stipulated that the appointment is for a period of 24 months, during which the implications and additional relevant considerations would be examined.
With regard to the economic influence on the Company as the result of the addition of a designated carrier for the New York, up to the present time, the change in the status of Israir on the New York route from a charter company that operates scheduled flights, has not significantly affected the Company's operations on the New York route. It should be pointed out that Israir gave notice of its intention to purchase or lease Airbus aircraft in order to operate them on the New York route and, in February 2007, it actually leased an Airbus aircraft. If and when should Israir operate additional aircraft on the New York route, its supply of seats will increase and the situation might impair the Company's revenues from this route. It is also possible that there will be a broader effect in view of the fact that the decision of the Minister of Tourism is contrary to a governmental commitment given to the Company, to its employees and to its shareholders on the eve of privatization, including, inter alia, in the Government's decision of May 19, 2003, which was ratified by the Supreme Court sitting as the High Court for Justice, as described in this section (hereafter: the "Government Decision"). In accordance with the decision of the Minister of Tourism, an additional designated carrier for the New York route was appointed, even though there can be no disagreement that the quantitative conditions that were stipulated in the Government Decision for purposes of appointment of an additional carrier have not yet been met. Thus, a situation of uncertainty has been created with regard to the validity and/or manner of implementation of the Government's Decision with relation to other routes, and there is concern that the aforementioned decision could serve as an opening for additional deviations by the Government's Decision, including the appointment of yet another designated carrier, or even one in place of El Al, on any route. At the present stage, there is no possibility of knowing whether and to what extent these concerns will be realized, and it is, therefore, impossible to quantify the effects that will be caused as the result of their realization. It can be said that to the extent that the deviation from the Government's Decision will be greater (such as dependency on the type of route, timing, etc.), the effect of the implication of the Company's financial results will be more material. What has been itemized above regarding the effect of the Minister of Tourism's decision in general, and the operation of additional aircraft on the New York route, in particular, represents prospective information, as defined in the Securities Law, 1968 (“the Securities Law”). The information is supported, inter alia, by the Company's estimations. The actual effect on the Company's performance may vary materially from that forecast, as the result of a large number of factors, including as the result of regulatory changes, changes in economic, geopolitical and security conditions in Israel, the degree that the market is opened to additional competition and the way that the Company copes with the competition..
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(4) At the beginning of the month of October 2006, the Civil Aviation Authority approached the Company and requested its reaction to the allegation that the Company's program to operate five weekly flights on the Tel Aviv–Vienna route during the 2006/07 winter season using Boeing 737 aircraft, whereas Austrian Airlines plans to operate 14 weekly flights on the route, might cause the Company to drop below the 20% threshold during the year of 2006, an occurrence which might lead to the Minister of Transport, as per the Government resolution, to consider the cancellation of the Company's status as a designated carrier on the route. The Company transmitted its reaction, in which it itemized the reasons for not considering the impairment of the rights currently being granted to the Company. (5) In October 2006, the Company was appointed as a designated carrier on the route to Uzbekistan, in place of the Arkia. The appointment was made at the request of the Company in view of its intention to operate cargo flights between Europe and Eastern Asia via Tashkent. (6) There is currently no designated carrier on the route to Istanbul. For the present, the Israeli airlines have announced that they are disinterested in operating this route due to the high costs involved.
9.11.7.3 Ownership and control of an air carrier There is no uniform international arrangement regarding the percentage of the practical ownership and control over an air carrier that must be held by the state or its citizens. The bilateral Air Transport agreements to which Israel is a party include a provision according to which each of the contracting states maintains the right to suspend or to cancel the permit that it gave to the airline of the other state, if the “substantial ownership and effective control” are not held by the contracting state or the citizens of the contracting state. The agreements do not include the definitions of substantial ownership and effective control. The practice in the countries of the Western world is to receive the appointment of an airline as designated carrier as if it included a declaration that the required demand for substantial ownership and effective control is complied with in full, and if it is found that the requirement no longer exists, the state will demand that the situation be rectified. The commercial operating certificate that was given to El Al specifies that at least 51% of the Company’s share capital must be held by Israeli residents and permanent residents in Israel, and that at least two thirds of the directors (Board members), including the Chairman of the Board of Directors and the CEO, are Israeli citizens and permanent Israeli residents (see Section 9.11.4 above-the commercial; operating license). Also, the “Special State Share”, which is embedded in the Company's articles, includes instructions regarding “maintaining the status of the Company as an Israeli company” and “restrictions on the ownership of shares by foreigners”. As long as no other decision has been made by the holder of the Special State Share or by the Board of Directors, the restriction applying to holding shares of the Company by foreigners will remain, in accordance with the Company’s commercial operating license (49% as of the date of the report), and it will remain at all times whereas the Company has given a commitment to file an Immediate Report of a change in this restriction..
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9.11.7.4 Capacity Most of the agreements to which Israel is a party (excluding the agreement between Israel and the United States and Great Britain) contain a limitation on the maximum permissible capacity or frequency that each airline may offer on the agreed routes in order to assure equal opportunities to the air carriers of the two countries that are part to the agreement. A substantial part of the air transport agreements between Israel and other states also state that the capacity must be based on the volume of the traffic between Israel and the other state with which the agreement was signed. Accordingly, the policies of the Ministry of Transport in the past have been to restrict the flight capacity of the foreign airlines to and from Israel. At the beginning of the year 2006, and pursuant to the "open skies" policies led by the Israeli Ministry of Tourism, authorizations have been granted to the foreign airlines which operate on the routes to and from Israel to add capacity and frequency. See Section 7.1.10 for further details.
9.11.7.5 Approval of the Minister of Transport Government Decision No. 161 determined that commercial agreements between designated carriers involving the restriction of competition require pre-approval by the Minister of Transport. See Section 9.11.2 (g) above with regard to legislative changes concerning commercial agreements between air carriers.
9.11.7.6 Flight tariffs The tariffs for flights on international routes are determined within the framework of IATA, the international association of the scheduled airlines. The summations of the conferences are submitted for approval of the aviation authorities in the various countries. These fares relate to the interline feature which allow the passenger to purchase a flight ticket from one company and to utilize it in a flight or flights for other companies. In addition to the fares within the framework of IATA, that are supervised by the aviation authorities, El Al is permitted to set special rates on a one sided basis. The Israeli Ministry of Transport does not generally interfere in setting the rates that are advertised by the Group on a one sided basis, on the condition that the level of these rates is not higher than IATA fares. It should be pointed out that American legislation against restrictive practices prohibits American carriers from equalizing fares with other carriers, except for fare equalization within the framework of IATA’s conferences on traffic. Under the air transport agreement between Israel and the United States, the carriers have freedom to set tariffs, and only if the two governments oppose a proposed rate (a method known as “double disapproval”) due to its being abnormal (exaggerated or within the boundaries of "dumping”), the new tariff will not be approved and it may not be proposed to the public. Despite the arrangements described above regarding tariff setting, most of the flight tickets and cargo capacity are sold at prices lower than those which were agreed upon and approved or at conditions different from those determined for the various fares. The Company behaves as is customary in the industry, while conforming its policies to market conditions and to the actions of the competitors. A substantial part of the Company’s revenues is derived from sales under these conditions. During recent years, a broader variety of flight ticket rates has been created. In all of the service sections of an aircraft (first, business and tourist), there are different types of
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“sections” (or classes of price). There is varied demand and different conditions for each “section” as above during different periods of the year. The charter flight tariffs are set in a different manner than the tariffs for scheduled flights. Every organizer is committed to pay the air carrier for the capacity (number of seats) which he has leased and, on the other hand, he himself sets the price per seat, in general, a package price which includes seats and ground arrangements. The organizer who requests authorization to operate a flight or series of charter flights must state the proposed price to the public and obtain approval to carry out the flights and their prices from the aviation authorities/administrations of the relevant countries. Due to the drastic rise in jet fuel prices in the world, the airlines, including the Company, collect fuel increments as well as security supplement which are paid in the context of the flight ticket prices.
9.11.8 Israel’s international civil aviation policy Over the years, the Government of Israel and ministerial committees (privatization or social and economic) have approved a series of decisions with regard to Israel’s international civil aviation policies, inter alia, MH/83 (dated December 25, 1994), which integrated Decision 2531 (recommendations of the “Sharon Committee”) (dated February 6, 1994), Decision No. 6061 (of August 27, 1995), No. 2465 and 2466 (of August 13, 1997), No.159, No.160 and No.161 (of August 22, 1999), No.649 (of September 2, 2002), No. 2313 (of July 30, 2002), Decision HC/14 (dated May 19, 2003) of the Ministerial Committee for Social and Economic Matters in the matter of "Aviation Policies of the State of Israel on Scheduled Routes" (see Section 9.11.7.2. above “designated carrier”). This decision cancelled prior Government decisions (Decisions No. 160, 649 and 2313), the August 9, 2005 decision on the subject of "Encouragement of Competition in the Area of Civil Aviation to and from Israel", following which the Aviation Services Law was amended (see 9.11.2 B above), Decision 441 (dated September 12, 2006 regarding encouragement of competition in the area of civil aviation to and from Israel, and the decision of the Minister of Transport to establish a public committee to examine "open skies"(see section 9.11.8 H below).
The following are the main decisions which were not cancelled by the decisions HC/14 (dated May 19, 2003):.
(A) The main points of the relevant provisions of Government Decisions MH/83 and 2531 1. Purpose of the policies The purpose of the civil aviation policy is to ensure the goals of Israel in the area of civil aviation, while taking constraints into account the policies are to insure: “a) scheduled air ties of Israel with foreign states, in times of peace and emergencies; b) passenger and cargo air Transport in a reliable and safe manner and at the lowest prices possible; c) encouragement of sound and fair competition to ensure the stability and development of the industry, and efficiency in exploiting the resources of the national economy; d) avoidance of exclusive dependence, to the extent possible, on one aviation resource in the various operating areas of the industry; e) strengthening the variety and level of service to users; f) encouragement of tourism to and from Israel; g) equal opportunities between the Israeli airlines and the foreign airlines on a competitive basis; h) exploitation of the civil aviation industry to assure air transport and vital supplies in times emergency”.
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2. Scheduled international flights The aviation ties of Israel with foreign states is founded, primarily, on scheduled flights, with an aspiration to keep a proper balance between the scheduled flights and the charter flights in accordance with aviation needs and the judgment of the Minister of Transport. El Al, the national carrier, served as the sole Israeli designated carrier in the area of scheduled flights to transport passengers and cargo until the mid-1990. [In Decision MH/29 (dated 8.7.02) in the matter of the privatization of El Al, it is stated in this connection: “Pursuant to the agreements between the State of Israel and foreign states and/or aviation authorities, as of the date of this decision, El Al is the designated carrier of the State of Israel for most of the international routes”].
3. Number of carriers The Sharon Committee recommended entering into a process of controlled and gradual competition in the aviation area, while conserving the status of the El Al, the national carrier, as the sole designated carrier, except for a deviation under which the status of designated carrier will also be granted to other Israeli airlines for regional routes (that is, routes to nearby destinations) or for routes which El Al does not wish to operate. See Section 9.11.7.2 above for details regarding the appointment of an additional designated carrier.
4. Tariffs According to the above decision, as a general rule, Government intervention in setting tariffs to and from Israel will be reduced to the extent possible. The tariffs will be set solely by the designated carriers, in accordance with the bilateral aviation agreements.
63 5. Charter flights
Charter flights are not part of the bilateral arrangement (except with the United States) and are regulated by the directives of the Aviation Services Licensing Law and the regulations issued under it. These regulations differentiate between “charter flights on a route” and “charter flights not on a route” and impose more severe restrictions on flights on a route. The regulations empower the head of the Civil Aviation Administration with wide latitude in granting licenses for the operation of charter flights. In recent years, the Minister of Transport has instituted liberal policies with respect to charter flights, both “outside of the route”, that is to destinations not flown to by El Al, and “on the route”, and also has revoked Regulation 15 of the charter regulations, which, as regards “on route flights” had forbidden the mixing of participants with a departure point in Israel with participants with a departure point outside of Israel. In the context of this liberalization, numerous “on route” destinations were opened to charter flights (destinations to which El Al maintains scheduled flights). The charter airlines also have flights to a large number of “off route” destinations and to recreation destinations. During the month of February 2007, an amendment to the Aviation Services Licensing Regulations (Charter Flights) became effective, according to which authority was granted to the Director of the Civil Aviation Authority to provide authorization to perform charter flights to and from Israel also to an air
63 Charter flights, in opposition to scheduled flights, are characterized by the fact that the organizer or organizers hires the capacity of the aircraft and sells tickets or holiday packages to the public. For scheduled flights, the tickets are sold directly by the air carrier or travel agents.
a-116 Translation of the Hebrew Language financial statements carrier of a country that is not the source country or the destination from which or to which the flight is made.
6. Cargo flights Through the beginning of the year 1999, El Al had served as a charter cargo carrier and as the only cargo carrier on scheduled flights, together with the foreign airlines. CAL had a restricted operating license for air transport of cargo on charter flights since 1976. It was obligated to lease cargo aircraft from El Al. In March 1999, Cal was given a full operating license for carriage of cargo and at the end of that year; it began to operate a 747-200 aircraft that it owned for cargo, and subsequently, 2 more 747-200 aircraft.
(b) Additional designated air carrier for the operation of regional flights (Government decision 6061 from August 27, 1995): “a. To determine an additional Israeli designated air carrier to operate scheduled international routes to destinations in the area of the Mediterranean basin and to other nearby destinations. b. To empower the Minister of Transport to establish……an interministerial team…….which will study and recommend a manner and time schedule to determine the additional carrier…..”.
(c) Additional Israeli charter carriers (Government Decision 2465 from August 13, 1977): “To instruct the Minister of Transport to issue a license to operate charter flights to and from Israel to every Israeli carrier which will fulfill the requirements that will be stipulated, in the framework of Chapter 13 to the Flight Regulations (Operating Flight Equipment and Flight Rules), 1981. The central requirements for the issuance of a license will be these: economic stability - the existence of minimal joint equity of the interested parties in the carrier in an amount of 5 million dollars; the company will have at least two owned or leased aircraft, and also proper equipment for the maintenance and operation of the aircraft. The company also must present an agreement with an authorized entity to handle the matter of maintenance in Israel and stations abroad; the company will have all of the permits and authorizations which are required by the Civil Aviation Administration, as it will publicize as stated below; the company will be demanded to comply with the charter regulations and their requirements.”
(d) Regional aviation (Government Decision 2466 from August 13, 1977): 1. To allow the operation of Israeli air carriers in addition to the current Israeli designated carrier-the El Al company, to nearby existing and new flight destinations, as will be derived from the flight rights in the international aviation conventions to which Israel is party, while observing proper competitive conditions with Israeli airlines as detailed below. 2. Determining additional air carriers to these flight destinations will be carried out by approving them as a designated scheduled air carrier for each specific route as aforesaid, and according to all of the following: a) Flight destinations meeting this definition, will be approved for operation by other Israeli air carrier/s: The existing airline route to a nearby destination, which El Al does not operate (including every destination that appears in the treaties on which the State of Israel is a signatory), or
a-117 Translation of the Hebrew Language financial statements a new aviation route to a central airport in the destination country, which El Al is not interested to operate. b) On routes which meet the definition below, the Israeli designated air carrier will operate in addition to El Al: Existing aviation route to a nearby destination on which the level of service supplied to passengers, for whom Israel is not the point of departure or the destination, is unreasonable, according to the determination made by the Minister of Transport or one who is authorized by him, based upon: 1) Frequency of flights with relation to the number of passengers on the route. 2) Operating hours of the route with relation to its passengers. 3) Price of the flight. 3. …License to operate a route which will be included in one of the categories itemized above will be granted in a competitive process. 4. To empower the Minister of Transport to act, as necessary, to alter the international aviation agreements…in a manner that will allow the determination of additional designated air carriers for each party, and parallel operations of two Israeli carriers on the scheduled routes to the destinations that are defined in those agreements…
(e) Flexibility of the criteria for approving charter flights (Government Decision 159 from August 22, 1999) “In order to intensify the liberalization in the charter flight sector to and from the State of Israel, encouragement of tourism to Israel and improvement in the level of service and reduction of the tariffs in the aviation industry: 1. To instruct the Minister of Transport to amend the charter flight regulations and the definitions that are necessary, in a manner that will expand the charter flights outside of the route. 2. To instruct the head of the Aviation Administration to publish criteria, after consultation with the Ministry of Finance, for the approval of “on route” charter flights no later than December 31, 1999, and charter flights for cargo”.
(f) International aviation agreements-removal of restrictions on competition (Government Decision 161 from August 22, 1999) To instruct the head of the Civil Aviation Administration to establish procedures under which no international aviation agreement or commercial agreement by a designated carrier which involves the restriction of competition (such as: equalizing rates, royalty agreements, “code sharing” - point to point) will be entered into, except with advance approval of the Minister of Transport”.
(g) The aviation policy of the State of Israel on scheduled routes (Decision of the Ministerial Committee for Social and Economic Matters from May 19, 2003 HC/14)* - See 9.11.7.2 above, “designated carrier”.
(h) Changes in aviation policies-following Government Decision 441 dated September 2, 2006, on the matter of "Encouragement of Competition in the Area of Civil Aviation to and from Israel and the public committee to evaluate "open skies", headed by the managing director of the Ministry of Transport (see Section 9.11.7.1 above), the aviation policies may undergo significant changes in the near future. At this stage, due to the lack of information on
a-118 Translation of the Hebrew Language financial statements the recommendations, the effect of the changes on the Company’s operating results cannot be estimated.. The possible changes in the aviation policies of Israel, as described above, represents "prospective information", as defined in the Securities Law, 1968 (“the Securities Law). Prospective information as to the future is information which is uncertain, which is based upon existing information of the Company as of a date close to the report, and includes estimations or intentions of the Company as of the report date. The actual outcome may, therefore, be materially different from the outcome which is estimated or which might be deduced from this information.
9.11.9 Special State Share 9.11.9.1 Close to the publication of the prospectus, the Company issued a “Special State Share” to the State. The rights granted to the holder of the Special Share are itemized in the Company’s articles of association, which also detail the vital interests of the State in the Company, which must be protected by means of the Special State Share. These vital interests are: (A) Protecting the Company as an Israeli company so that it will remain subject to Israeli law, including legislation which permits mobilizing equipment for security purposes and legislation for periods of crisis, and so that the conditions needed to maintain its operating license and traffic rights shall be maintained.
(B) Safeguarding the possibility of ensuring that the operating capability and ability to fly passengers and cargo by the Company will not fall below the capacity detailed in the Company’s articles of association, in order to permit the State to have effective use of vital assets in times of emergency or for security purposes, as will be determined from time to time by those authorized to do so, all as detailed in the Company’s articles of association.
(C) Preventing factions hostile to the State of Israel or persons who could cause damage to the vital interests of the State or to the foreign or security interests of the State or to the aviation ties of Israel with foreign nations, or persons that are found in and/or likely to be found in substantial conflicts of interest which could cause damage in one of the areas itemized above, from being an interested party in the Company or one who can influence its management in any other way.
(D) Fulfilling the security directives and arrangements which apply, or which will apply due to Government decisions or under any law, in the area of security of the flights, passengers, baggage, cargo and mail, in Israel and abroad, including in relation to the Company’s operations abroad and to the cooperation needed from local authorities abroad in these areas; in the area of security classification of employees and suppliers of services to the Company; and in the area of security over classified data and protection of security information.
______* In accordance with Government Decision No. 21 from March 9, 2003 in the matter of the Ministerial Committee for Social and Economic Matters (Social-Economic Cabinet). The decision is agreed to by the Government, and the validity of its decisions is the same as the validity of Government decisions passed during its meetings, this in accordance with the right of the Prime Minister (at his initiative or after a minister’s request to the Prime Minister), to bring matters and decisions which were discussed in the Committee for discussion by the Government, according to Section 37 of the Rules for the Functioning of the Government (“appeal”). If no appeal of the decision is made within two weeks, the decisions of the committee have the same validity as those of the Government.
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(E) The holder of the Special State Share is the State of Israel through a minister or ministers, all as stipulated by the Government or a ministerial committee, from time to time of for a specific purpose.
9.11.9.2 In order to protect these vital interests, instructions were determined by the Special State Share as to the following matters:
(A) Instructions in order to protect the existence of the Company as an Israeli company, including restrictions as to citizenship and security classification of Company executives64;
(B) Instructions in the matter of complying with the security rules and arrangements65;
(C) Instructions in the matter of the Company’s rights to security related data and classified information66;
64 (a) The Company will be a company incorporated and registered in Israel at all times, with everyday management and its business center in Israel and its head office in Israel, being subject to Israeli law, and being subject unqualifiedly to legislation applying to periods of emergency and to mobilizing security equipment. The Company will be permitted to also be registered as a foreign company in a foreign country as long as the aforesaid is effective in the Company at all times, and that the aircraft which are included as vital assets, continue to be registered in the Book of Registry for aircraft of the State of Israel, and after obtaining the advance consent of the holder of the Special State Share; (b) at least two thirds of the members of the Board of Directors of the Company , including the Chairman of the Board of Directors, all outside directors and the CEO, chief business manager, assistant CEO, deputy CEO, other executives answering directly to the CEO, and any other function holder as above in the Company, even if his title is different, will be Israeli citizens and permanent residents and holders of proper security clearance according to the directives of the General Security Law, except if the General Security Services consented in writing and in advance to a deviation from the conditions that will be determined. It should be understood that foreign Company representatives need not be citizens and residents of the State, after advance clearance of the General Security Services has been obtained and under the conditions stipulated. Should the proper security clearance not be given, that person will not be appointed or serve in the Company in a position which requires security clearance in the Company. An entity may not serve as a director in the Company; (c) as a rule, meetings of the Board of Directors shall be held in Israel. The legal quorum for opening a Board of Directors’ meeting and taking decisions by the Board of Directors will be created only if at least one half of the directors present meet the requirements specified in subsection (b) above; (d) no decisions will be approved on liquidation, including voluntary liquidation, or on a change in the corporate structure of the Company or a reorganization of the corporate structure of the Company or on merger, or on a split, including a compromise or arrangement under Sections 350 and 351 of the Companies Law, 1999, and also a decision on taking the powers of the Board of Directors regarding the aforementioned matters, if opposed by the holder of the Special State Share; (e) the Company will provide advance written notice of every decision which it intends to take on the matters described above; the holder of the Special State Share is permitted to give notification of his opposition to the proposed decisions.
65 Without derogating from the relevance of the directives of any law and from the other rights of the Special State Share, the holder of the Special State Share will be permitted to command the Company to comply-and the Company will comply- with the security rules and arrangements that apply or that will apply, under Government decisions or under all laws in the areas of the security of the flights, passengers, baggage, cargo and mail, in Israel and abroad, including in relation to the Company’s operations abroad and to the cooperation needed from local authorities abroad in these areas; in the area of security classification of employees and suppliers of services to the Company; and the area of security over classified data and protection of security information. The holder of the Special State Share will be permitted to command that the Company not operate flights in cases in which, for any reason, the necessary security arrangements cannot be complied with in full. Should the holder of the Special State Share so command as stated herein, the Company will comply with such command and the State will indemnify the Company for the direct expenses which were caused due to executing that command under the terms and at the rates that will be determined in an agreement between the State and the Company. In the event of a dispute regarding the existence of the conditions which created the right to indemnification, the manner of making indemnification, the conditions or the rates of the indemnification, the State and the Company will be permitted to refer to an agreed-upon person in order to conclusively settle the matter under dispute or to appoint another to decide as aforesaid. However, nothing related to the existence of the disputes or actually making indemnification will detract from the obligations of the Company to act in accordance with the instructions of the holder of the Special State Share, as per this subsection. 66 The rights to security related data, including proprietary rights thereto, are the property of the State-General Security Services; the Company or any of its executives or employees will be permitted to make use of the aforementioned security-
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(D) Instructions in the matter of Company deliberations on security matters67;
(E) Instructions in the matter of reviewing Company documents and data68;
(F) Instructions in the matter of observing minimal flight capacity69 - the Company is not permitted to carry out certain transactions relating to its aircraft without approval of the related data for purposes of protecting Israeli aviation in accordance with the directions of the General Security Service and conditional upon observing secrecy arrangements. Every other use of the security-related data will necessitate the advance written approval of the holder of the Special State Share. 67 The Board of Directors of the Company will appoint, from among its members who have been classified according to the General Security Service Law (hereafter: “classified directors”), an authorized organ as per Section 46 of the Companies Law, 1999, to be known as the “Committee for Security Matters”. The Committee will be composed of the Chairman of the Board of Directors and two classified directors, one of whom will be an outside director. The Chairman of the Board of Directors will serve as Chairman of the Committee for Security Matters; matters relating to security will be deliberated, subject to what is written below, in the context of the Committee for Security Matters alone; security matters which the Board of Directors are required to deal with according to the mandatory provisions of the Companies Law, 1999, will be discussed, to the extent that they are to be discussed by the Board of Directors, with the participation of the classified directors alone. The directors who are not classified will not be permitted to participate in this Board of Directors’ meeting and will not be entitled to receive information or to look at documents related to the matters discussed there; a decision which will be made or an action that be taken by the Committee for Security Matters has the same significance as a decision made or an action taken by the Company and it will be discussed by the Board of Directors alone and only if the matter is mandatory under the Companies Law, as mentioned above; discussions and decisions of the Audit Committee on matters related to security will be discussed, to the extent that they must be discussed in the Audit Committee, before a makeup of 3 classified directors out of the members of the Audit Committee, of which two will be outside directors. These directors will only be permitted to invite members of the Committee for Security Matters and the internal auditor to the discussion; these instructions will apply to Board of Directors’ meetings with security matters on the agenda, and only if the quorum at each such meeting includes only classified directors; a director will not serve as an alternate to a classified director unless he has the proper security classification under the General Security Law; security matters will be discussed, subject to the aforesaid, by the Board of Directors, Committee for Security Matters and Audit Committee, after the matter has been cleared and approved by the security official of the Company who has been authorized for that position, as provided by the Law for Security Arrangements in Public Entities; the Company is not permitted to transmit security-related data to a unclassified director, including security information, and the unclassified director may not receive security-related data, including security information, this because transmittal of data on such matter is a violation of a provision of the General Security Service directives, under the authority of the General Security Law, and the Law for Security Arrangements in Public Entities or an offense against the Company’s well being; the classified director shall not transfer or transmit data and documents on security matters, except for the transmittal of data to the Audit Committee as mentioned above; an executive who, as part of his duties and under the bylaw provisions, was to receive data or participate in meetings on security matters and this was denied him because of the aforementioned, will be free of responsibility due to breach of his obligation to the Company for caution, should the obligation for caution have been breached due to his not participating in the meeting or due to not having received the data; the General Meeting will not be entitled to take, to delegate, to transfer or to activate authority which was given to another organ of the Company, on matters of security. 68 The Company is not permitted to transmit classified data or security-related information or to allow the review of classified documents to be found in the Company’s possession, to a shareholder, if the disclosure is contrary to the directives of an authorized officer of the General Security Service under the Law for Security Arrangements in Public Entities. The holder of the Special State Share will have the right to receive from the Company all data and documents which a holder of ordinary shares of the Company is entitled to receive, and in addition, he will have the right to receive, upon demand, all data and documents which a director and/or outside director is entitled to receive, and he will be permitted to make use of the data that he received as aforesaid solely as is necessary in order to protect the vital interests of the State. All data which will be published in advance of the General Meeting and/or will be sent to the members of the Stock Exchange or to the Securities Authority, as well as every notice which a holder of an ordinary share of the Company has the right to receive, will be forwarded to the holder of the Special State Share at the time that it is issued in advance of convening the General Meeting. Each proposal to appoint or select directors will be sent to the holder of the Special State Share before such appointment or selection. The holder of the Special State Share will be permitted to demand that all of the data and documents which are necessary in order to activate his rights under the corporate charter and articles for the purpose of protecting the vital interests of the State will be attached to the proposal. The holder of the Special State Share will make use of this data solely in order to activate his rights under the memorandum of association and the articles of association for the purpose of protecting the vital interests of the State.
a-121 Translation of the Hebrew Language financial statements holder of the Special State Share if, as the result of such transactions, it might reduce flight capacity of the Company below the level that was set by the Special State Share;
(G) The acquisition of influence or status in the Company requires the consent of the State-in accordance with the articles of association of the Company. Transactions in the Company’s
69 (a) Transfer of vital assets will be ineffective as regards the Company, shareholders, and any third party without the advance written consent of the holder of the Special State Share if, as a result, the usable, proper, and ready for- immediate- operation fleet of aircraft will be reduced (including due to any law provision) or the operational flight capability and ability of the Company will be reduced (including due to any law provision) below what is itemized in one of the following sub sections: (1) At least 4 cargo aircraft as to which the minimal cargo transport capability from the United States to Israel is 320 tons daily; (2) At least 3 broad hulled passenger aircraft as to which the overall minimal passenger transport capability from the United States to Israel is 1,000 passengers daily; (3) At least 6 medium and small aircraft as to which the overall minimal passenger transport capability from Europe to Israel is 2,000 passengers daily. (b) Should there be a significant change in the relevant circumstances, the holder of the Special State Share will be permitted, with the Government’s authorization, to adopt a decision on the increase of the number of vital assets and/or to change their quantity and/or the composition of the assets on a permanent basis or for a specific matter, all this for up to half of the number of aircraft owned by the Company at that time. This decision will not be made before the Company is given a fair opportunity to express its position to the Government-the total of the vital assets after increasing the number of vital assets according to this paragraph is limited to up to half of the number of aircraft owned by the Company at the time of the decision. A change in the composition of the vital assets will be made in the framework of the composition of the current fleet of aircraft owned by the Company at the time of the decision. The Company will not be required to acquire new aircraft under this sub-paragraph (b); (c) Despite what appears in sub-paragraph (a) above: (1) An aircraft leased by the Company from an Israeli entity which is properly incorporated and registered in Israel will be considered to be an aircraft owned by the Company, as long as that aircraft is owned by such entity and Israeli law specifically applies to the lease agreement regarding the terms of lease and the aircraft. (2) The holder of the Special State Share will be permitted, at the request of the Company, to approve the lease of an aircraft by the Company from a non-Israeli entity, as long as the vital interests of the State are protected and the agreement contains the proper provision which grants the State the authority to use the aircraft, including mobilizing it at any time under Israeli law, and all to the satisfaction of the holder of the Special State Share. (d) As long as the provisions of sub-paragraph (a) above are not complied with, the Company will not purchase and/or own shares or other means of control, in a proportion which provides it with control, in entities which own, directly or indirectly, including by subsidiaries, aircraft or auxiliary equipment, other than with the consent of the holder of the Special State Share. (e) Without derogating from the above, should a vital asset be transferred in contravention of this section, and the sale cannot be revoked and/or the situation cannot be restored to what it was within a reasonable time, the Company will be obliged, should this occur, to immediately purchase a substitute vital asset and to cover the expenses caused to the State due to the temporary absence of the vital asset. (f) In a case in which the holder of the Special State Share refuses the Company’s request to transfer a vital asset, an arrangement will apply to indemnify the Company for the damages it incurred, the principal one of which is that the State will indemnify the Company by monthly payments to the extent of the leasing fees which the Company would have received, had it leased at the time of the commencement of the monthly indemnification, in the open market to a willing lessee, the vital asset, the transfer of which was refused, as will ultimately be determined by the appraiser(s) appointed by the State and the Company. (g) Should the period over which the holder of the Special State Share refuse the Company’s request to transfer the vital asset, exceed 6 months, or in the judgment of the State, at an earlier date, the State will purchase the hindered asset at the price which the Company would have received, had it sold the hindered asset to a willing purchaser at the time of the purchase, as will ultimately be determined by the appraiser(s) appointed by the State and the Company. (h) Without derogating from the above, should the holder of a specific fixed lien on an aircraft or auxiliary equipment, including the loading equipment that is necessary to protect flight operation capability, wish to realize it (subject to the approval of the lien under the terms which were stipulated), the Company and the holder of the lien will so notify the holder of the Special State Share at least 45 days in advance, and the State will be permitted, at its sole judgment, and after giving advance notice of one week of its intention to do so, to the Company and the holder of the lien, to sustain the charge against which the asset had been pledged as collateral. If the State sustains the charge in accordance with what is contained in this section, it will be permitted, if that right had been had by the holder of the lien, to return to the Company and receive payment from it , including expenses that were connected with sustaining the charge, and the lien will serve it to secure this right. The contents of this section will be included, as an obligation of the parties to the State, in every agreement for the lien of aircraft or auxiliary equipment, including the loading equipment that is necessary to protect flight operation capability, which will be entered into after the Special State Share has been issued, this as a condition of the lien agreement with the Company, its shareholders and any third party.
a-122 Translation of the Hebrew Language financial statements shares in certain proportions will not purchase any right that is derived from holding and/or from purchasing shares in the Company without the advance written approval of the holder of the Special State Share (the State through the ministers determined by the Government)70. The articles of association will stipulate a detailed arrangement on the subject of the manner of submitting the request for obtaining the consent to own shares in the Company, in a case in which such consent is necessary as above.
(H) Instructions in the matter of obtaining approval to vote at the General Meeting- the right to vote at the General Meeting require the approval of the Company71. An approval to vote at the General meeting will not be given when circumstances which require the consent of the holder of the Special State Share exist, and such has not been given.
The articles of association also stipulate instructions in cases when there is reasonable concern that the ownership by foreigners of the Company’s shares might cause damage to the traffic rights of the Company or to its operating license72.
70 (a ) Ownership of 5% or more of the issued share capital of the Company; (b) ownership of 15% of more of the issued share capital of the Company (also if agreement had been received in the past for an ownership percentage below 15%); (c) ownership of 25% or higher of the issued share capital of the Company (also if agreement had been received in the past for an ownership percentage below 25%);(d) ownership of 40% or higher of the issued share capital of the Company (also if agreement had been received in the past for an ownership percentage below 40%); (e) ownership which provides “control” of the Company and even if agreement had been received in the past as to the proportion of ownership (though not agreement as to “control”). For this purpose, control is defined in accordance with the Securities Law .In addition, the largest shareholder, at any time, will be considered as the controlling interest; (f) ownership or acquisition as a result of which “foreigners” will own the proportion of 24% of the issued share capital of the Company, or a higher proportion, which might, in the opinion of the State or in the opinion of the Company’s Board of Directors, cause damage to the Company’s traffic rights and/or to its operating license, which will be given and/or which has been given by the State, in its sole judgment (the commercial operating license given to the Company stipulates that at least 51% of the Company’s share capital must be held by Israeli citizens and permanent Israeli residents of Israel). In any event, the ownership by foreigners of shares of the Company in a proportion which exceeds 49% of the Company’s issued share capital is a proportion which might cause damage to the Company’s traffic rights; (g) every security and/or pledge transaction of the Company’s shares, which, following its realization or activation of underlying rights, the security holder or the pledge holder is likely to own shares out of the Company’s share capital in the proportions mentioned in sub paragraphs (a) to (f).
71 One who is interested in voting at the General Meeting must contact the Company no later than 7 days prior to the convening of the meeting (the Company is permitted to shorten the period until 3 days before the meeting is convened) while declaring whether the shares for which he requests to vote are owned by a foreigner. And so he should declare, if the vote is executed by the grantor of a power of attorney, if the grantor of the power of attorney is a foreigner. Should the person who so requests to vote for shares that are owned by a foreigner, or the person who requests to vote by means of the power of attorney is a foreigner (hereafter: “foreign applicant”), he should detail the citizenship of the foreign shareholder, his residence and/or the citizenship or the place of residence of the grantor of the power of attorney, as the case may be, the dates of purchase of the shares and the number of shares purchased on each date, or other details which will be requested by the Company; with the details of the purchases being verified by the registration company that managed the trading in the shares or the stock exchange member through which the purchases were made. The Company is permitted, where necessary, to also demand details of the hour that the purchase was executed, wherever the matter is required in order to decide on voting rights. Additionally, the vote under the shares owned by the interested party in the Company will be made contingent on the delivery of a written statement, as of the date of the meeting, that his vote in the general meeting is by right of the shares, the ownership of which was approved by the holder of the Special State Share, under the Company’s articles. The Company will have the right to approach, including upon demand of the holder of the Special State Share, any person who has requested to activate any right under the shares that he owns, to receive any data or additional document that are necessary for the owner, in his judgment, to activate his rights according to the Memorandum of Association and the Articles of Association for the purpose of protecting the vital interests of the State. The holder of the Special State Share will be permitted to determine that the additional data be submitted by written statement.
72 The Company shall act to obtain the above information from its shareholders, if there is reasonable concern that due to the foreign ownership, damage may be caused to the traffic rights of the Company and/or its operating license. If the total voting rights of the foreign applicants out of the total voting rights of all of the voting applicants surpasses the permissible rate for foreign ownership (hereafter: “the determining rate”), the secretary of the Company will be permitted to defer the holding of
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9.11.9.3 Every change, including an amendment or cancellation, in the provisions of the Memorandum of Association and articles of Association (incorporation) of the Company which relate to the rights granted and/or ascribed to the Special State Share and to its holder, will be ineffective as regards the Company, its shareholders and any third party, without the written, advance consent of the holder of the Special State Share.
9.11.10 Standardization The Company's maintenance system has been approved by the Israeli Standards Institute under quality standard ISO 9001/2000. In addition, the maintenance system of the Company has been approved as an inspection institute, approved by the Civil Aviation Administration in Israel, the United States Aviation Agency (FAA) and the authorization authority of the European Nations organization (EASA).
9.11.11. Quality control The maintenance system in El Al is supervised by an internal quality control system which operates according to the manufacturer’s specifications and a maintenance program approved by the Civil Aviation Administration. During the month of October 2006, the Group successfully underwent a review performed by the ACS Company (authorized by IATA) for purposes of granting an IOSA Standards seal to the Group. The IOSA Standard is an international standard for operations, safety and quality of an airline and it is a condition for code sharing agreements. In addition, beginning from the year 2008, the standard will be a condition for the airlines in IATA. The Company is the first of the Israeli airlines that has gone through such a review successfully.
the Company’s General Meeting to another date, which is not later than 14 days, but only he has grounds for thinking that by the deferred meeting as above, the rate of foreign ownership that has requested to vote in the General Meeting will not have surpassed the determining rate. Should the secretary not defer the convening of the meeting, the Company will act as follows: (1) the Company secretary shall arrange the voting requests of the foreign applicants in order of the dates that they purchased the shares, as the foreign applicants will establish to his satisfaction; (2) the Company secretary will approve the voting in the General Meeting, with respect to the share ownership of the foreign applicants in the order of their purchase, with each of the earlier ones receiving a consent to vote until the ownership of the foreign voters in the General Meeting reaches the determining rate. In any event, foreign applicants who purchased their shares on the same date, will be permitted to vote in a uniform proportion (pro-rata) of the amount of their shares that were purchased as aforesaid; (3) the remaining shares owned by the foreign applicants (which were purchased at a date subsequent to the shares of the foreign applicant, the vote of whom under their rights was approved as mentioned in sub paragraph (2) above) will not be entitled to a voting right at that General Meeting; (4) if the foreign applicants have not proven the date of purchase of the shares that they own to the satisfaction of the secretary, the date of purchase of the shares will be considered as if they were purchased at a date subsequent to the purchase date that the last foreign applicant verified to the secretary, as described above in sub-paragraph (1).
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9.11.12 Security arrangements The civil aviation industry and, in particular, the routes to and from Israel, have become a target for harassment by various factions, and principally, the terror organizations throughout the world. Recently, there has been a trend towards ruthlessness in the attempts to attack Israeli aircraft. The Company takes extraordinary security measures, under the guidance of the governmental entity which is responsible for this matter. Until the beginning of the 1980’s, the State had covered all of the direct and indirect security costs of the Company. Over the years, the State has instituted a policy of reducing the rate of its participation in security expenses. In accordance with a decision by the Government of Israel, the rate of the Company’s participation in security expenses is 50%, commencing from January 1, 2003. During 2002, the rate of participation was between 30% to 34.14%, while in 2001, it was between 25% to 30%. (See Section 7.2(f) above for additional details concerning the matter of enlarging the State's participation in the costs of security for the Cairo route.) The following is detail of the direct costs for security of the passengers, aircraft and employees of the Group, divided between the portion financed by the Group and the portion financed by the State:
State financing Group portion Total (thousand dollars) 2006 39,967 40,002 79,969 2005 39,027 39,027 78,054 2004 36,220 36,220 72,440
The Company also has indirect security costs which are caused, inter alia, by flying security personnel in the place of paying passengers. Beginning from October 2001, the Company has been allowed to collect a supplement for insurance and security in the amount of 8 dollars per flight leg. The Company also supplies security services to Israeli airlines in consideration for full reimbursement of such expenses of the Company.
9.11.13 Operations during times of emergency and for vital purposes Under existing law, at times of emergency, the Israeli airlines, including the Company, may be operated for purposes of national defense or public security or maintaining supplies or vital services. In addition, there are arrangements between the Company as to flights for the security of the State, or at times of emergency, as well as flights for other extraordinary purposes, including the consideration to be paid for them on a commercial basis. The Law for the Registration and Mobilization of Equipment for the Israel Defense Forces, 1987, empowers the Minister of Defense, if he is convinced that the defense of the State so requires, to declare by decree the need to mobilize equipment (including aircraft). The law relates to equipment that will be owned by the Company during times of emergency. The law obligates the State to pay usage fees for the equipment that was mobilized, and, if damages
a-125 Translation of the Hebrew Language financial statements were caused to the equipment during the period of emergency-also compensation for the damages. The Law for Work Services during Times of Crisis, 1967, empowers the Minister of Labor to approve an enterprise as “a vital enterprise”, and when such declaration has been made, to call up all of its workers for vital work service. El Al has been approved as a “vital enterprise”. The approval is renewed from time to time at the Company’s request. The approval is currently effective through December 31, 2007. The Law for Supervision over Goods and Services, 1957, grants the minister who is so empowered by the Government, the authority to issue an “individual decree” or a “general decree” for the performance, inter alia, of a “vital action” for the defense of the State, for the security of the public, to maintain regular supplies or services. This action includes, among other things, the obligation to activate an enterprise or to perform any service under supervision.
9.12 Material agreements • The Company is party to material agreements with regard to employees and their rights (see Section 9.4 above), an agreement with the State related to covering the deficit in the employees' severance pay fund (see Section 9.4.8 above), agreements for the lease of real estate (see Section 9.1.1 above), agreements for the lease and financing of aircraft (see Sections 7.11 and 8.10 above), loan agreements for designated purpose (see Section9.8.4 above), various agreements with airlines (see Sections 7.2, 9.11.7 and 9.13 above), and insurance agreements (see Section 9.2 above). • On October 2, 2005, the Company signed an agreement with the Boeing Company for the purchase of two wide hulled, long-range 777-200 ER aircraft, which are anticipated to be received for Company use during the year 2007. The cost of each aircraft (in terms of the year 2005) will amount to approximately 130 million dollars, according to the volume of accessories and installations to be made to the aircraft in order to conform it to the Company's needs. Self-financing resources are expected to cover approximately 15% of the aircraft price, and the remainder will be financed by means of loans. During the month of March 2007, the Company signed a commitment agreement with the banks financing the above acquisition and, accordingly, an application was made to the U.S. Bank for the Encouragement of exports and Imports to change the preliminary commitment made in the past into a final commitment. See Note 17 (d) (1) to the financial statements for further details. • The Company also has an obligation to indemnify executives of the Company with respect to activities that were connected with the Company’s privatization and also for performing an act and/or fulfilling an obligation on behalf of the Company under the Securities Law, 1968, for as long as the options that were issued in the framework of the May 2003 prospectus are registered for trading, which includes submitting reports, notifications and approvals that are derived from the Securities Law. The overall amount of indemnification to all of the executives of the Company according to this decision will not exceed 100 million dollars. • In addition, on May10, 2005, the Shareholders' General Meeting approved the following decisions:
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A. To approve granting an advance commitment for indemnification and exemption to executives.(Giving an exemption to executives was not approved). The extent of indemnification according to this decision will be the lower of: 25% of the Company's shareholders' equity according to its consolidated financial statements as of December 31, 2004, or 25% of the Company's shareholders' equity according to its most recent consolidated financial statements as of the date of indemnification. B. To approve transactions in the context of insurance for Company executives (ongoing) and for insurance of executives for a run-off disclosure period. The amount of premium which the Company will pay for its part in the insurance costs for these two types of insurance will not exceed $ 450 thousand per year. During the month of October 2006, the executive insurance that was executed through K'nafaim was renewed for a period of an additional 18 months, as described in an Immediate Report by the Company dated October 4, 2006.
9.13 Cooperation agreements The Company is party to agreements with other airlines (interline agreements) which permit passengers on scheduled flights, subject to certain restrictions, to use flight tickets which were issued by one airlines for the services of another airlines. In addition, the Company is party to “code-share” agreements, which permit an air carrier to market flights of another air carrier, as if they were his own flights. See Section 7.2 above for details. The Company has commercial agreements with part of the airlines which operate in Israel, and also with designated carriers which do not carry on flights to Israel. The commercial agreements relate, inter alia, to conforming flight schedules, the suggested capacity for each company, the division of revenues from the route (pooling agreement) and payments for the utilization of traffic rights. The Company is also party to agreements with airlines with respect to accountings for the use of continuing flights, for matters of recording reservations, for handling (passengers or cargo) and for commercial representation.
9.14 Legal proceedings The following are the most significant contingent actions in which the Company and/or its subsidiaries are being charged:
9.14.1 In October 1998, a lawsuit for NIS 230.4 million (equivalent as of the date of the report to approximately 54.5 million dollars) was filed in the Nazareth District Court against the Company, along with a request to recognize it as a class action. The claim relates to an allegation of the collection of excess flight ticket prices by travel agents which was created, according to the plaintiffs’ allegation, by using improper exchange rates. During the year 2002, the court approved the request for class action recognition in one cause-deception under the Consumer Protection Law and rejected other causes which had been alleged by the plaintiff. The Company filed a petition for the right to appeal with the Supreme Court and, concurrently, an appeal was filed by the plaintiff regarding those causes that had been rejected by the District Court, which primarily were based upon the submission of a class action under Regulation 29 of the Civil Law Arrangement Regulations. The deliberations on the case had been delayed following a request by the court and by agreement between the parties, until a judgment in an additional deliberation in the matter of
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73 A.S.T. , and, after on September 1, 2005, the ruling on the additional deliberation was published, the plaintiff gave notice of its request to expunge the reference to the grounds in the general law from the appeal, and the court ruled that the deliberation on the appeal would take place solely on the basis of grounds from the Consumer Protection Law. In January 2006, the plaintiff filed a request to amend the appeal, in the context of which it requested the addition of additional grounds in accordance with the directives of amendment 18 to the Consumer Protection Law. A judgment has not yet been received. 9.14.2 A lawsuit for NIS 21.7 million (approximately 4.7 million dollars as of the date of the report),was filed in the Tel-Aviv District Court in September 1999 against the Company and against the Airports Authority and Ophir Tours (a travel agency), together with a request for recognition as a class action. The plaintiff alleges that the travel agent collected the travel levy from him at a rate above the legal rate for this purpose, which is the representative exchange rate, and that the Company is also responsible for the acts of agents in this matter. During the year 2002, the court approved the request for recognition of the claim as a class action on one charge-violation of a legislated obligation based on Regulation 29 of the Civil Law Arrangement Regulations. The Company filed a petition for the right to appeal with the Supreme Court. The Court requested and obtained the position of the parties as regards this case in view of the A.S.T. judgment. Following the ruling in an additional deliberation on A.S.T,, the plaintiff gave notice of its request to expunge the reference to the causes in the general law from the appeal, and requested that deliberation on the appeals take place solely on the basis of causes from the Consumer Protection Law. The hearing on the case was set for the month of July 2007. 9.14.3 A lawsuit for 32 million dollars was filed in July 2002 in the Tel-Aviv District Court against the Company and Sun D’or, together with a request for recognition as a class action under the Consumer Protection Law and Regulation 29 of the Civil Law Arrangement Regulations. The plaintiffs claim that the security surcharge of 8 dollars levied for each flight section, which is being collected from every passenger commencing from the beginning of October 2001, was charged following the display of improper presentations and publications, according to which it is intended to fortify the security system after the September 11, 2001 events, while the plaintiffs allege that, in effect, the surcharge was levied in order to ease the load of the security expenses that are imposed on El Al. The plaintiffs have requested that El Al and Sun D’or be required to refund the security surcharge which was collected, to all passengers, and to prohibit the continued collection of the surcharge. On August 9, 2005, the Tel-Aviv District Court handed down a decision which rejects the request of the plaintiffs to recognize their claim as a class action. As a result, the claim was dismissed due to lack of cause. The plaintiffs were charged with payment of attorney's fees. On September 20, 2005, the plaintiffs filed an appeal of the District Court's decision with the Supreme Court. The case is set for deliberation in the month of June 2007. 9.14.4 A lawsuit was filed in July 2004 in the Tel-Aviv District Court against the Company, Sun D’Or, Arkia International, Unitel and Flying Carpet, as well a request for recognition as a class action under the Consumer Protection Law, in an amount that was estimated by the
73 In the matter of A.S.T., the Supreme Court decided that class actions are possible under the specific legislation which include this possibility and, as a practical matter, cancelled the possibility of the use of Regulation 29 of the Civil Law Arrangement Regulations for the purpose of submitting class actions for a cause which is outside of the specific laws as above. As mentioned, on September 1, 2005, the ruling in a further deliberation in the A.S.T case was issued, in which the previous ruling given by the Supreme Court on this matter was ratified and in which it was determined that Regulation 29 could not serve as a source for class actions.
a-128 Translation of the Hebrew Language financial statements plaintiffs as “millions of dollars”. The plaintiffs allege that the purchasers of non-refundable tickets who paid, among other things, various airport taxes and security surcharge, are entitled to a monetary refund of those taxes and levies if they did not utilize their flight tickets, and that the consumers are erroneously led to believe that they are not entitled to a refund of the taxes and levies. The plaintiffs allege that the computation of the refund to all of the consumers for the seven years that preceded the filing of the claim could be complicated or impossible, and in such case, they request that the court rule that the defendants should be obligated to transfer funds in favor of a “public institution”. The Company and Sun D’Or have filed their reaction. A decision has not yet been handed down. 9.14.5 In January 2005, the Company filed an appeal with the Court for Restrictive Trade Practices in Jerusalem against the conditions stipulated by the Commissioner for Restrictive Trade Practices (hereafter: “the Commissioner) in the decision taken on August 5, 2004, concerning the merger between K’nafaim and El Al, as was agreed with K’nafaim. The appeal relates, inter alia, to the conditions which obligate K’nafaim, as a shareholder of the Company, to do everything necessary to cease or transfer the charter flights activity of the Company to an independent third party wherever the Company operates scheduled flights (with exceptions), and to act to present any arrangement between El Al and another Israeli air carrier for the approval of the Commissioner for Restrictive Trade Practices. The Company also appealed the condition according to which K’nafaim is required to sell its aviation operations, including its holdings in Arkia and Maman, to a third party. Concurrently with submitting the appeal, the Company presented an urgent request for an interim injunction for a temporary suspension of the merger conditions, and also a decree which would permit it to review the documents on which the Commissioner had relied in making the merger decision. On March 14, 2005, the Company and the Commissioner for Restrictive Trade Practices accepted the proposal of the Court for Restrictive Trade Practices to conclude the legal proceedings by agreement. Pursuant to this understanding, it was agreed that the stated condition stipulating that K’nafaim, being a shareholder in the Company, would do everything necessary to cease or transfer the charter flights of El Al on routes on which El Al operates scheduled flights, will not go into effect before the end of two years following the date of the understanding. The condition, whereby K’nafaim, being a shareholder in the Company, would act to present any arrangement between El Al and another Israeli air carrier for the approval of the Commissioner, will not go into effect during the year following the date of the understanding. The Commissioner will be able, within 120 days preceding the end of each period referred to above, to act again and impose any or all of the conditions upon K’nafaim, if he believes that a basis exists at the time. Before imposing any or all of the conditions, the Commissioner will grant El Al the right to a hearing. Should El Al file an appeal as to any of the conditions, the conditions will be postponed for a period of six months, and during this period, the court will decide whether they should become effective. The agreement was to go into effect, subject to K’nafaim’s signing the agreement, within three days after being ratified by Knafaim’s Board of Directors. On March 14, 2005, K’nafaim signed the agreement and, on March 20, 2005, the agreement between the parties obtained the effect of a judgment. It should be noted that on December 29, 2005, the Commissioner notified the Company that he is considering imposing on K'nafaim the condition which determines that K'nafaim, as a shareholder of the Company, will act in order to bring any arrangement between the
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Company and another Israeli carrier for consent by the Commissioner. In addition, the Commissioner demanded data from the Company concerning agreements, arrangements or understandings between the Company and Arkia and between the Company and Israir, and concerning negotiations carried on between the companies. The Commissioner requested that he receive the above data as well as the Company's position regarding the possibility that the Commissioner impose this condition on K'nafaim. The Company presented the documents requested to the Commissioner and also stated that it objected to the condition. On March 14, 2006, in response to the Commissioner's notification and at its request, the Company decided to agree to a postponement of a year for the time period allotted to the Commissioner in the accord for imposing the aforementioned condition (that is-two years instead of one year). On January 28, 2007, following a communication from the Commissioner and at his request, the Company decided to a delay of an additional year for the time period that was allotted to the Commissioner in the compromise accord relating to the imposition of such condition (that is- three years in place of two). The other conditions that were set by the compromise accord concerning the manner of imposing the condition, as itemized above, will remain in force during the time of the postponement. 9.14.6 In October 2005, a claim was made in the Supreme Court of Ontario, Canada against the Company and additional defendants by a former employee of the Company for alleged sexual harassment and sexual molestation. The amount of the claim was approximately 2.2 million Canadian dollars (approximately 1.9 million U.S. dollars as of the date of the report). 9.14.7 In June 2006, a suit was filed against the Company and the State of Israel-Ministry of Finance in the Tel-Aviv District Labor Tribunal, by 94 claimants who were employed by the Company and took early retirement between the years 2001-2003. The claimants have appealed to amend their retirement agreements in a manner in which they state that the retiree will receive the early pension stipend, including fringe benefits, until the legal retirement age, instead of until the age of 65. Alternatively, the claimants appealed to revoke the retirement agreements. The Company is in the stages of preliminary deliberations. 9.14.8 During the month of February 2006, the Restrictive Practices Division of the U.S. Justice Department ("Restrictive Practices Division") began an open investigation, together with additional competition authorities of other countries, of supposed suspicion of price fixing with respect to certain increments to prices of air cargo transport. A number of cargo transporters announced that they had received Grand Jury injunctions in connection with this investigation. On September 27, 2006, the Company received an injunction from the Restrictive Practices Division that had been issued by the Grand Jury, which demands information and documents concerning certain costing and cost increment practices in the area of cargo transport, commencing from the year 1999 and through the date of the injunction. The Restrictive Practices Division notified the Company that the Company is being examined as a suspect in this investigation. The Company is cooperating with the investigation, while performing an internal audit of its own of the cargo costing practices. At this stage, the Company is unable to assess the outcome of the investigation of the Restrictive Practices Division or to estimate the possible financial effect of the investigation. Nevertheless, it should be pointed out that the consequences could include administrative or civil procedures and/ or a criminal indictment, including penalties and/ or civil charges. It should also be stated that punishments for the violation of competition statutes could be serious, both with regard to criminal charges and also as to civil charges. 9.14.9 On December 20, 2006, the Company received a letter from the European Competition Commission ("the Commission") at its head office, which contained a request for information in connection with an investigation being carried out by the Commission in connection with activities which, seemingly, cause damage to competition in the sector of air transport
a-130 Translation of the Hebrew Language financial statements services for cargo. The letter stated that the Commission has information regarding extensive contacts that took place between airlines and other entities with regard to various price increments and other matters such as cargo transport rates. In the context of the letter, the Company was requested to transmit data and documentation regarding the Company and its cargo activities, commencing with the year 1995. The Company is cooperating with the investigation and has transferred its reply as requested by the Commission's letter, while carrying on an internal audit of cargo pricing practices. At this stage, the Company is unable to evaluate the outcome of the investigation of the Commission or to estimate the possible financial effect of the investigation on the Company. Nevertheless, it should be pointed out that the implication might include an administrative proceeding against the Company, include a severe fine which could be imposed on the Company at the end of the proceeding. 9.14.10 On February 28,2007, the Company received a writ of civil claim that was filed in the United States District Court for the Eastern District of New York in the matter of the rates for cargo air transport services. The Company was included as a defendant in the writ of claim, along with 38 other airlines, with the claim being that the defendants were partners in a conspiracy to conform prices for cargo air transport services, beginning in the year 2000, while violating competition and other laws in Europe and the United States. The claim was filed in the name of entities who purchase air transport services, directly and indirectly, it also includes a request to recognize the claim as a class action. The claim includes a request for compensation in an amount not denominated as well as additional relief. The Company is evaluating the writ of claim that it received and the possible implications and is making preparations to deal with this proceeding. In view of the early stage of the process, the Company is unable to assess the implications or the monetary effect of the proceeding on the Company. 9.14.11 In January 2007, a suit was filed against the Company in the Jerusalem District Court, to which was attached a request to approve the suit as a class action, in the amount of about NIS 483.4 million (approximately $ 114 million as of the balance sheet date). The plaintiffs allege that the collection of a security levy in the amount of $ 8 per flight leg from passengers on flights not performed by the Company itself, but by other airlines, in the framework of code-sharing agreements with the Company, represents consumer misrepresentation, breach of the agreement with him, absence of integrity, and unlawful gain, since on these flights, according to the allegation of the plaintiffs, no security or protection services were provided which were identical at their level and quality to the security services provided by the Company. The plaintiffs wish to charge the Company to pay $ 8 to each of these passengers as well as compensation in the amount of NIS 500for suffering and aggravation. The Company is studying the claim and preparing its reaction.
9.14.12 In the month of February 2007, a claim was filed against the Company and other parties in the New York State Supreme Court by an employee of the Company for allegations of sexual harassment by another Company employee in the U.S. The Company is studying the claim and is preparing to present its reaction. 9.14.13 On March 18, 2007, a claim against the Company was made to the Tel-Aviv District Court, to which was attached a request for approval as a class action. The claimant alleges that the charge to customers who purchase airline tickets directly (and not through a travel agent) by means of credit cards in foreign currency instead of Israeli currency, with payment
a-131 Translation of the Hebrew Language financial statements of a conversion commission of 2% of the price of the flight ticket (for conversion of the payment in foreign currency into a payment in Israeli currency) to the credit airlines represents a violation of the Consumer Protection Law- 1981, a violation of the necessity for integrity and unjust enrichment. It was also alleged that this was a breach of the requirement to publish an "overall price", and that it is the Company that must bear these conversion charges. In addition, the claimant alleged that charging customers in foreign currency and not in shekels represents of itself, a violation of The Consumer Protection Law. The claimant has requested that the Company be charged to pay compensation to each of the members of the group to the extent of all of the amounts of the conversion fees collected unlawfully, and to refund to each the amounts of the conversion fees unlawfully collected, as alleged by the claimant. The claimant also has requested that an order be given to the Company which stipulates that the collection of the payments in foreign currency and the charging of the relevant conversion commissions were done unlawfully and to prohibit the Company to continue to collect payments in foreign currency and to pass on the conversion fee charges for foreign currency payments to its customers. The Company is studying the claim and is preparing to file its response.
The following are major claims in which the Company and/or the subsidiaries were defendants, and which terminated during the year 2006 and until a date close to the approval of the report:
9.14.14 A lawsuit was filed against the Company with the Tel Aviv Regional Labor Court in July 2004 by the National Pilots Association of Israel and others, to desist from making a change in the wage structure of pilots who were grounded after they reached the age of 65. Under the Retirement Age Law, 2004, the retirement age for a male is to be gradually raised to 67. Under regulatory restrictions, a pilot is forbidden to fly after he has reached the age of 65 years. The plaintiffs are pilots who have reached the age of 65, and the Company offered to employ them on ground jobs, at wages that are significantly lower than the salary of a pilot. The plaintiffs are requesting that their salary not be reduced following the transfer to ground jobs. In May 2006, a ruling in the case was handed down according to which the claim was expunged at the court's initiative due to inaction by the plaintiffs.
9.14.15 In January 2002, 72 flight captains, some retired and some still active, filed a claim against the Company. The claim alleges that the Company does not comply with a provision of the collective labor agreement stating that the retirement age for a permanent employee is 65 years and three months. In their claim, the plaintiffs requested the court to declare that they are entitled to continue to work until that age. On April 17, 2005, the Tel-Aviv District Labor Court made a ruling rejecting the claim against the Company. 58 out of the plaintiff pilots filed an appeal of the ruling with the National Labor Tribunal. On July 23, 2006, the National Labor Tribunal handed down a judgment ratifying the ruling of the District Labor Court and rejected the appeal of the plaintiff flight captains.
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9.14.16 On May 31, 2005, the Company filed a petition with the High Court of Justice with regard to the examination by the Commissioner of Business Restrictions of the status of El Al in different aviation markets. The respondents to the petition are the Commissioner of Business Restrictions, the head of the Civil Aviation Authority and eighteen airlines which operate flights to and from Israel. The Company's approaching the High Court of Justice was intended to prevent a situation of inequitable arrangements and enforcement in the aviation sector and to prevent inequity and discrimination against the Company, which might place the Company in an inferior commercial and business position relative to its competitors. The Company alleges that if, under the Commissioner's specification, it holds a monopoly in certain routes, so are many of its competitors the holders of a monopoly, each for the routes relevant to it, and the Commissioner should, therefore, also examine the status of other airlines in the relevant aviation markets, parallel to his examination of El Al. On August 3, 2006, the High Court of Justice ruled, at the Company's request to expunge the appeal while conserving the right to reinstate it without having a claim of delay alleged against it.
9.14.17 During the month of August 2000, a claim was filed against the Company and other defendants by a bankrupt travel agency which still owed money to the Company, in the Supreme Court in Ontario, Canada, alleging conspiracy, breach of contract, slander, hindering economic relations, and punitive indemnification. The total amount of the claim is approximately 50 million Canadian dollars (approximately 43 million U.S. dollars as of the date of the report). A ruling rejecting all aspects of the claim and not imposing any debt on the Company was given on February 26, 2006.
9.14.18 In January 2006, the Company filed a petition with the High Court of Justice against the decision of the Minister of Tourism to appoint Israir as an additional designated carrier on the New York route. The Company alleged in the petition that the decision of the Minister of Tourism is a violation of a governmental commitment given to the Company, to its employees and to its shareholders in a decision dated May 19, 2003 (see Section 9.11.7.2 above for further details), that the circumstances which would permit a release from the governmental commitment have not transpired and that the reasoning for the Minister of Tourism's decision was erroneous, both factually and economically. Additionally, the petition mentioned allegations regarding official conflict of interest and prejudice and the matter of the date of the decision being in proximity to the upcoming elections, and also additional reasons for annulment of the Minister's decision, including non compliance with the terms of the Law for Licensing Aviation Services and the Flight Regulations, as well as defects in the hearing procedure. On February 23, 2006, the High Court for Justice rejected the Company's petition, stating that its viewpoint will be given separately and in the month of August 2006, the reasoning of the High Court of Justice for rejecting the appeal and the additional appeals filed by the employees' representation of El Al and K'nafaim. (see Section 9.11.7.2 above for details).
9.14.19 In September 2005, a claim against the Company, as well as a request to recognize it as a class action, was filed in the Tel- Aviv Magistrates’ Court, in the amount of NIS 2.1 million (approximately 453 thousand dollars as of the date of the report). The plaintiffs claim that, due to a mishap during a flight of the Company to New York, the aircraft was returned to BGA and the incident caused them expenses and non-monetary damages, so that they
a-133 Translation of the Hebrew Language financial statements request that compensation of NIS 4,000 each be ruled for each of the passengers on the aircraft The Company has presented its reaction. The Court rejected the plaintiffs' claim out of hand, and in the month of October 2006, the plaintiffs presented an appeal to the Tel Aviv District Court. The parties reached a compromise in the context of which the appeal was expunged. In February 2007, the effectiveness of a judgment was given to the compromise agreement.
9.15 Goals and business strategy On September 20, 2005, the Company's Board of Directors approved the strategic program of the Company for the five coming years and the principles of implementing it, under the heading "El Al 2010", the major points of which are:
1. The overall goals of the strategic program include a substantial improvement in the business results by the year 2010 by means of an increase in revenues and an improvement in profitability. 2. The goals of the program include: (a) significant improvement in treatment of the customer by means of an improvement in the customer's experience in all activities of the Company according to the needs of specific segments, focusing on the business customer and dealing with his special needs, emphasis on developing customer loyalty, improving the handling of the incoming tourist and establishing an integrated service center; (b) cultivation of operational excellence, both in the processes for dealing with customers and other processes, as well as through aspiring to reduce the level of fixed assets in relation to revenues and investment in systems and processes for the management of the organization's resources in the optimum manner; (c) business innovation and initiative, including initiatives for developing traffic to and from Israel, development of additional revenue sources in the areas of maintenance, tourist services and ground services, development of BGA as a transit airport for ongoing flights and conversion into a global company, advancement of cooperation with aviation wholesalers and development of the Internet as a distribution channel; (d) outfitting, including investment in modern equipment for long range routes, gradual rejuvenation of the fleet of aircraft in accordance with financing terms, repayment ability and market development, and weighing continued outfitting based upon market developments; (e) improvements in the areas of cargo and maintenance, through continued growth in cargo operations while, at the same time, monitoring the operational structure, strengthening the ability to sell maintenance services and examining the development of maintenance as a profit center for the Company, and investigating cooperative arrangements with Israeli and international airlines for expansion of the ranges and areas of activities; (f) cultivation of human resources by means of updating labor agreements, developing and updating training systems, employee compensation and incentives, and embedding the culture of a private entity that is involved in a competitive market.
3. In accordance with these goals and the assumption of the basis of the strategic program by which the average annual rate of growth in passenger traffic at BGA will be 5%, the principles of the operational plan regarding aircraft outfitting was set down in the strategic planning, which includes the acquisition of two broad hulled, long range aircraft to provide the solution for certain routes, conforming capacity to anticipated
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growth in demand for the various destinations, short term solutions and improvements to the cargo aircraft fleet. In addition, the principles of the operational plan relating to improvement in profitability and primary activity directions were set down in the program.
4. During the year 2006, the Group continued to implement the strategic program in its operations while conforming it to developments that took place in the security, political and economic situation, including the Second War in Lebanon and its effect on passenger traffic, the continuing trend of jet fuel price rises and the intensification of competition. The Company is examining its operations in order to bring about optimization of the route network, while adjusting means of production in accordance with the demand environment and the profitability of routes by increasing or decreasing capacity, or reducing operations to unprofitable destinations.
5. The business strategy that is presented above is “prospective information” and is based upon the Group’s assumptions, assessments and forecasts as to the environment of its business activities, which could change, from time to time, and thus affect the way it is actually implemented by the Group and the achievement of the program's goals. Prospective information is uncertain information concerning the future, which is based upon data at the Company as of a date close to the approval of the report, and includes estimates by the Company or its intentions as of the date of the report. Accordingly, actual results, wholly or partially, may not be realized as above, to be realized in part or to be significantly different than the results which are approximated, derived or implied from this information, inter alia, for the reasons itemized below. Applying the strategy may be affected by regulatory changes (including changes in business restraints laws, as described in Section 9.11.2 (g) above) and the manner of implementation and/or changes in the aviation policy of the State of Israel and in the manner of its implementation, including civil aviation policy relating to designated carriers for the network of routes and permissible capacity for foreign airlines (in light of the changes and trends itemized in Sections 9.11.7.1 and 9.11.7.2 above). Among other things, this business strategy is based upon the assumption that the status of the Company as designated carrier in the network of routes in which it operates will remain substantially unchanged. Any change in this situation will necessitate a change, inter alia, in the route network and aircraft fleet. In addition, the Company currently sustains exceptional costs of security, in relation to competing airlines, which are not under its control, and an increase in these expenses due to circumstances or with respect to a governmental decision might necessarily cause damage to the Company’s profitability. The implementation of the strategy is also subject to the possible implications on the volume of the Company’s operations, which might be caused by economic and/or security changes in the world in general, and in Israel, in particular. These changes could place a threat on the Company which results from inflexibility in the ability to make changes in part of the expense components (such as flight equipment and salaries) and to make implementation of the processes of adjustment of the Company’s expenses more difficult. Additionally, the implementation of the strategy in the matter of equipping with aircraft is subject to the measure of deterioration which might take place in the permissible pollution-noise conditions at the airports, which could force the airlines to take steps to silence the aircraft or to replace them with more quiet and
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“clean” aircraft. The exacerbation of competition due to any reason and/or factor and, in particular, conditions to which the Company may find it difficult to respond also might affect the competitive position of the Company and the possibility of implementing the business strategy. The exacerbation of competition might also be caused, inter alia, by: changes in the aviation policy of the State of Israel and/or the manner of its implementation; from the expansion of operations of “network” airlines(which represent a part of a global pact) into the Israeli market, in a manner which might make it difficult for the Company to join such a pact, and cause injury to its market share; the entry of the low cost airlines into the market and the extent of the influence which that will have on worsening competition in the industry, the reduction in prices and the necessity to carry out a process of adjustment in the Company’s costs; the creation of a European Aviation Bloc or approval of an aviation pact ("open skies") between the European Union and the United States which might fundamentally change the structure of traffic rights in the countries of the EU, to expand the number of airlinesand the capacity being offered between Israel and the members of the market in an unchecked manner, and to place a threat on the price level of the flights and the Company’s share in these routes. Also, implementation of the strategy could be affected by fluctuations in prices of jet fuel, which is a substantial part of the Company's expenses, and also from the level of cooperation of the workers' associations with regard to updating the labor agreements and maintaining "industrial peace".
The Group makes it a practice, from time to time, to evaluate the conformance of the strategic program and its goals to developments in the environment of the Group's business operations.
9.16 Forecasted developments in the coming year
The Group intends to continue implementation of the strategic program described above, while evaluating the trends and developments created in the business activities environment of the Company and the world aviation industry on a current basis. Managing the goals of the strategic program will be done by being attentive, inter alia, to the strengthening of the ability of the Group for coping with and preparing for severe competition, and striving to improve the business results for the 2007 year by enhancing the mix of revenues, improving yields, implementing organizational efficiency steps and reducing expenses.
The Group is also examining the execution of various technological enhancements, including assessing the replacement of the Company's reservation system to a global system, developing marketing and service tools by means of the Internet and evaluating solutions for a comprehensive resources management system (ERP). The information concerning the forecast of developments during the coming year represents prospective information, as defined in the Securities Law, 1968. The information is supported, inter alia, by the Company’s estimates or intentions as of the date of the report. The actual developments during the coming year may, in whole or in part, vary materially from the developments estimated, derived or implied from this data, as the result of a large number of factors, including those itemized in section 9.15 above and the risk factors described in Section 9.18 below.
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9.17 Financial data on geographic segments See Note 24A. to the financial statements for data concerning the geographical segments. See Note 3.5 (a) of the Directors’ Report for explanations as to developments in these segments.
9.18 Discussion of risk factors The information concerning the effect of the risk factors below on the Group represents prospective information, as defined in the Securities Law, 1968. The information is supported, inter alia, by the Company’s estimates as of the date of the report. The actual effect on the Company’s performance may vary materially from that forecast, as the result of a large number of factors, including as the result of changes in the economic, geopolitical and security conditions in Israel. In similarity to other airlines, the operations of the Company are affected by a number of external and internal factors which could lead to material changes in its profitability (positive or negative). The risk factors may be divided according to macro factors, industry risks and risks that are unique to the Group. The major risk factors are:
9.18.1 Political or security events or terrorist acts Political or security occurrences or terrorist acts in the world or in the region have an immediate, negative effect on the demand for passenger and cargo Transport and influence the Company’s economic condition. So that, after the outbreak of the Intifada in the fourth quarter of the year 2000, there was a decrease in the quantity of travelers to the region. During the years 2004-2005, there was a relative recovery but the dimensions of tourism still have not reached the levels of the years prior to the crisis. During the year 2006, the War in Lebanon caused a decline in demand and negatively affected, in a material way, the Company's financial results. (see Section 6.2 above).
9.18.2 Jet fuel prices Jet fuel is a significant component of the operating expenses of an air carrier. During the years 2004-2006, the price of jet fuel rose at a substantial rate. Jet fuel prices are subject to severe fluctuations. The Company has used hedge activities for part of the forecasted jet fuel consumption. This policy could change according to circumstances. Due to the great weight of jet fuel in the operating expenses of the Company, every increase in jet fuel prices negatively affects the operating expenses and business results of the Company, see Section 9.5.1 above. See Section 7.3 to the Directors’ Report for details of actions which the Company has taken to protect against changes in fuel prices.
9.18.3 Changes in competition The aviation industry is characterized by a high level of competition, which becomes more acute during periods of excess capacity. The entry of additional charter airlinesinto the market, the entry of additional foreign, scheduled carriers into the Israeli market or an increase in capacity of existing foreign carriers, the entry of additional Israeli carriers into the market and the appointment of additional Israeli carriers as designated carriers, the granting of operating licenses to additional Israeli airlines in the passenger and cargo areas will necessarily cause a sharpening of competition in the Israeli aviation industry, a situation which might reduce the Company’s share in the operations of the industry, create excess capacity, lower the level of passenger and cargo transport prices and cause damage to the
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Company’s business results. This trend of exacerbation of competition intensified during the year 2006 with the entry of foreign airlines and the increased capacity of these companies, that even maintained the excess means of production during the period of the War in Lebanon. In addition, efficiency steps of competing airlines, including as the result of organizational changes and/or changes in capital structure, and also government support or subsidizing of foreign airlines, might place the Company in an inferior position as compared with competitors. Changes in international agreements, including commencement of the aviation agreement between the European market and the United States, could negatively affect the operations of the Company in the industry due to the exacerbation of competition and the expansion of carriers and capacity. See Sections 7.1.10, 7.8 and 8.7 above.
9.18.4 Seasonal influences The operations of the Company are seasonal by nature and are focused during peak periods (see Section 7.9 above). Tourism traffic, mostly during the summer season and at holidays (Jewish and Christian), is greater than the annual average. Also, the area of cargo transport is characterized by high seasonal fluctuations due to the large relative weight of agricultural exports. (See Section 8.8 above for more details.) Since the component of the capital and fixed expenses out of the total Company expenses is significant, an impairment of operations during the peak seasonal season (due, for example, to political and security occurrences, such as the War in Lebanon that occurred during the summer of 2006) or the lack of probability of obtaining replacement aircraft, even if concentrated over a short period, can have a substantial negative effect on the business results of that year.
9.18.5 Government decisions on aviation and the Company’s licensing as an air carrier (A) A change in the Government’s policy with respect to the Company’s status as a designated carrier with regard to all or part of the routes on which the Company serves as designated carrier could materially impact the Company’s financial results, according to the type of route.(See Section 9.11.7.2 above as to the Government’s policy with respect to determining a designated carrier, and on the January 2006 decision to appoint Israir as an additional designated carrier on the New York route.). Furthermore, the Government resolution or the recommendation of the public committee headed by the managing director of the Ministry of Transport for evaluating the subject of "open skies", could change the status of the Company and negatively affect its financial results. (See Section 9.11.7.1 above for details with respect to the Government's decision and the public committee for assessment of the subject of open skies.) (B) The Company’s operating licenses as an air carrier and its rights as a designated carrier are conditional upon the principal ownership and the effective control being in the hands of Israelis. The ability of the company to know at all times the extent of ownership by foreigners of its shares is restricted to the records that it administers, and, accordingly, it is possible that there will be a situation in which the foreign ownership of the shares who have not reported their holdings to the Company (purchase or sale) and have not been recorded in the registry of shareholders will exceed the permissible proportion or will be less than the proportion that is recorded in the shareholders’ registry, without the Company being aware of it. If the Company will be aware if the ownership of foreigners exceeds the permissible percentage, then it will be able to act in conjunction with the Special State Share to reduce the ownership percentage of foreigners. Should it be unable to do so and the holdings of foreigners in the Company’s shares exceed the permissible proportion, the Company is liable to lose its status
a-138 Translation of the Hebrew Language financial statements as a designated carrier. At the same time, whenever the holder of the Special State Share and/or the Minister of Transport believe that the actual control and the ability to direct the Company’s operations remains in the hands of the Board of Directors of which two thirds of its members, including the Chairman, and also the CEO and Company executives, are Israeli citizens and permanent residents of Israel, the risk is minimal that the Company will lose its status as designated carrier just because of the rate of ownership in the Company’s shares in the hands of foreigners.
9.18.6 Exposure to currency risks The Company’s revenues and expenses are mostly in, or linked to, foreign currency (mainly the US dollar). The Company is exposed to a rise in value of the shekel in relation to the dollar with respect to current wage expenses and other liabilities denominated in shekels in the Company's balance sheet, principally with respect to termination of employee employer relationships. The revaluation of the shekel vis-à-vis the dollar increases the current expenses of the Company and also enlarges in dollar terms (without affecting cash flows) the Company's obligations related to termination of employee employer relations. In addition, the policy of the Company to reduce exposure to the risks of the principal foreign currencies (Sterling, Euro, Rand, etc ) is executed by matching payments and receipts in each and every branch. In years when the volume of the receipts was not significantly different from the volume of payments in European currencies, the mixture served as internal protection against currency exposure vis-à-vis the dollar, whereas in years in which there is an excess of payments over receipts, the Company has exposure to those currencies, and mainly against the Euro. From time to time, the Company examines the necessity of an investment in derivative financial instruments in order to reduce the exposure to foreign currency risks. See the Section 7.5 to the Directors’ Report, as well as Note 20.(a) (1) to the financial statements for details with regard to the actions taken by the Company for hedging the exposure to currency risks.
9.18.7 Changes in economic activities The aviation and tourism industries are sensitive to changes in economic activities which affect the demand for passenger and cargo Transport. The expense structure of the aviation industry, which includes a high component of fixed expenses, makes the implementation of procedures to adjust the supply of the Company to changes in demand in the short-term very difficult. When, during periods of a slowdown in economic activities, the demand for air Transport is reduced for different reasons, an excess of capacity and labor and flight equipment, which are not fully utilized, is created. The result is of necessity deterioration in the Company’s economic condition which is reflected in its business results.
9.18.8 Outburst of epidemics and natural disasters Outbursts of epidemics (such as the SARS epidemic) and natural disasters (such as the Tsunami disaster) have a negative effect on passenger traffic to the disaster areas and on the business results of the Company.
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9.18.9 Exposure to variable interest rates The Company finances part of its investments by means of loans from banking institutions. The Company’s loans and most of its deposits are in dollars and bear interest. Most of the loans bear variable interest rates and, accordingly, any change in interest rates might materially affect the Company’s financing expenses. See Section 7.2 of the Directors' Report as to policies for hedging interest risks which have been established by the Company. From time to time, the Company examines the necessity of hedging exchange rates and interest and the extent of the hedge. See Section 7.4 to the Directors’ Report for details with regard to the actions taken by the Company for hedging the exposure to variable interest rates.
9.18.10 Operations in an industry with a high structure of fixed expenses The Company operates in the aviation industry which has a structure of fixed costs which are relatively high and profit margins which are relatively low. Therefore, small changes in the level of revenues or expenses could have a direct effect on whether there will be profit or loss.
9.18.11 Noise and environmental restrictions on flight operations Every change in restrictions on night operations at BGA or other airports from/to which the Group flies and each additional restriction or prohibition on the operation of aircraft due to air pollution, noise, etc. might have a material effect on the business results of the Company. A number of alternatives are presently being examined as to a change in the hours of operation at BGA and the permissible noise levels, which, if they are carried out, could materially affect the Company’s business results. (See Sections 9.10.2 and 9.10.3 above for further details.)
9.18.12 Effect of operations of low cost airlines on the market in Israel Airlines, with a low production cost structure (low cost carriers) have increased their market share to a substantial extent in the past two years, principally in the United States and in Europe. This growth has negatively affected the veteran airlines with higher production cost structures, and has caused a decrease in their market share and a drop in their yield due to fare reductions as the result of competition. Most of the airlines in the low cost class specialize in short flight sections. It should be stated that in an agreement between representatives of the Israeli and the German aviation authorities in February 2006, Germany appointed the Haphag Lloyd company as a designated carrier for routes between Munich and Düsseldorf and between Tel-Aviv, as from the beginning of the summer season of 2006. Haphag Lloyd is a subsidiary of the aviation and tourism giant, TUI, which among other things, operates low cost flights. If such airlines do enter the Israeli market in the future, it might have a negative effect on the business results of the Company, due to increased capacity offered by these airlines at reduced prices. See Section 7.1.10 above for additional details.
9.18.13 Costs of maintaining flight security Since the Company is required to maintain security arrangements which are determined by a governmental body and it bears security expenses over which it has no control, most of which do not apply to foreign, competing airlines, this situation causes damage to its profitability, to its competitive ability, and to the development of a route network. In recent years, the State budget for security of civil aviation in Israel has been reduced, including the
a-140 Translation of the Hebrew Language financial statements budget for security of the Group, and the proportion which the Group must bear has increased (see Section 9.11.12 above). If the proportion of the State’s participation in the flight security expenses of the Group should be reduced and/or if changes will be caused due to a worsening caused by attempts to attack the Company’s aircraft and its passengers and/or additional means of security will become necessary and/or if the Company is forced to cease its flights to a destination or additional destinations for reasons of security, it might have a material effect on the business results of the Company. It should be pointed out that the Company ceased flights to a number of destinations during the year 2006, because of high security costs and operational limitations in matters of security.
9.18.14 Restrictions in Israel on the receipt of credit and/or additional loans in the future The directives of the Supervisor of Banks in Israel include restrictions according to which the debt of a “single borrower” and of a ”group of borrowers” to a bank in Israel shall not exceed a given percentage of that bank’s shareholders’ equity. From time to time, these directives may affect the ability of some of the banks in Israel to grant additional credit to the Company. Due to the change in the holdings in the Company in a manner in which K’nafaim is the controlling shareholder and holds more than 25% of the Company’s issued share capital, the Group is considered to be a part of the K’nafaim group, as far as the restriction placed on giving bank credit to a group of borrowers is concerned. Also, in light of the weight of the Company’s long-term liabilities to banks in Israel, and due to the volume of loans provided by these banks to Israeli airlines, the Company may encounter difficulty in receiving significant amounts of additional credit in Israel that may be required for purposes of purchasing new aircraft or other investments.
9.18.15 Business restrictions (A) The Commissioner for Restrictive Trade Practices (in this Section-“the Commissioner“) set conditions which obligate K’nafaim, as a shareholder in El Al, as itemized in Section 9.11.2 (g) above. The Commissioner will be able, within 120 days preceding the end of each period, to act to again impose any or all of the conditions upon K’nafaim, if he believes that a basis exists at the time. Before imposing any or all of the conditions, the Commissioner will grant El Al the right to a hearing. Should El Al file an appeal as to any of the conditions, the conditions will be postponed for a period of six months, and during this period, the court will decide whether they should become effective. These conditions, if they should become effective, might have a negative effect on the business results of the Company. There is no assurance that the Commissioner will decide to impose these conditions, and even if he should so decide- there is no assurance that the Company will operate according to such decision, which is not directed towards it, but towards K’nafaim. See Section 9.11.2.g. above for more details. (B) In the context of the Law for Arrangement in the State Economy for the year 2007, an amendment to Section 3 (7) to the Business Restrictions Law was included, according to which the application of the exemption included in it will be reduced with regard to restrictive arrangements in the area of international transport (see Section 9.11.2 (g) above for details). The effective date of the amendment was deferred and it is contingent upon the issuance of a class exemption by the Commissioner. The amendment to the Business Restrictions Act, and the resultant contraction of the exemption for arrangements related to aviation, could cause damage to the competitive ability of the Israeli carriers, including the
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Group, and it could have a negative effect on the Group's business results due to the regulatory restrictions on compliance with international agreements in the operating areas of the Group and the failure to ratify these agreements by the Business Restrictions Authority.
(C) On October 27, 2005, the Commissioner of Business Restrictions declared that the Company is the holder of a monopoly for flying time-sensitive (business passengers) and price-sensitive passengers (holiday passengers) in the civil aviation markets to the destinations: Johannesburg, Hong Kong, Bangkok and Bombay. On March 30, 2006, the Company filed an appeal to the Tribunal for Business Restrictions with respect to this determination (See Section 9.11.2 (g) for details of the appeal). A determination by an authorized body that the Company is a monopoly in any relevant market could limit the freedom of action of the Company, as will be described below: The owner of a monopoly is not permitted to refuse to sell a product as to which it is the owner of a monopoly, unless the refusal is "reasonable" (that is, there is legitimate business rationale); The owner of a monopoly may not sell the product as to which it is the owner of a monopoly at unfair prices and, in particular, it may not sell the product as to which it is the owner of a monopoly at loss prices, for the purpose of driving away competitors from the market ("predatory prices"); The owner of a monopoly is forbidden to decrease or increase the quantity of the monopoly product which it supplies to the market with the intention of exploiting its power as the owner of a monopoly to increase the price of a product, or in an attempt to drive a competitor out of the market or prevent his entry into it; The owner of a monopoly is forbidden to determine varying prices or terms of sale for a product as to which it is the owner of a monopoly, to customers or suppliers in parallel or similar transactions, if this discrimination provides part of the customers or suppliers with an unfair advantage as compared with other customers or suppliers; The owner of a monopoly is forbidden to make the sale of the monopoly product conditional on another product which it supplies, including giving an economic benefit which is conditional upon purchasing the monopoly product or certain quantities of the monopoly product. The owner of a monopoly is forbidden to adversely use his status in the market in a manner which might lessen business competition or cause damage to the public in any other way. In addition, under Section 30 of the Business Restrictions Law, 1988, the Commissioner of Business Restrictions is permitted to approach the Business Restrictions Tribunal with a request to give an order to the owner of a monopoly if he feels that, due to the existence of a monopoly, damage is caused to business competition or to the public. Moreover, the declaration of someone as the owner of a monopoly is one of the grounds for price control, under Section 6(a)(1) of the Law for Control over Prices of Goods and Services, 1996. From the date of declaration, and for as long as the declaration has not been cancelled by the Business Restrictions Tribunal, there is a supposition that El Al is the owner of a monopoly , both with regard to the definition of the relevant market and also as regards the fact that it is the owner of a share of in excess of half of the market, for as long as the declaration has not been revoked by the Business Restrictions Tribunal. Under Sections 26(a) and 43(e) of the Business Restrictions Law, 1988, the declaration allegedly serves as prima fascia evidence of
a-142 Translation of the Hebrew Language financial statements its accuracy in any legal proceeding, and is likely to facilitate the activation of sundry statutory tools in order to supervise the owners of a monopoly, among them public enforcement (conferring orders on the owner of the monopoly, breaking up a monopoly, etc.), and private enforcement (ordinary civil suits by competitors or consumers who were injured by acts of the monopoly, including class actions). The rejection of the appeal filed by the Company, as well as an additional declaration of the Commissioner as to the status of El Al as a monopoly on additional flight routes could have a negative effect on El Al's status, its ability to compete and its business results. (D) During the month of February 2006, the Restrictive Practices Division of the U.S. Justice Department ("Restrictive Practices Division") began an open investigation, together with additional competition authorities of other countries, of supposed suspicion of price fixing with respect to certain increments to prices of air cargo transport. A number of cargo transporters announced that they had received Grand Jury injunctions in connection with this investigation. On September 27, 2006, the Company received an injunction from the Restrictive Practices Division that had been issued by the Grand Jury, which demands information and documents concerning certain costing and cost increment practices in the area of cargo transport, commencing from the year 1999 and through the date of the injunction. The Restrictive Practices Division notified the Company that the Company is being examined as a suspect in this investigation. The Company is cooperating with the investigation, while performing an internal audit of its own of the cargo costing practices. At this stage, the Company is unable to assess the outcome of the investigation of the Restrictive Practices Division or to estimate the possible financial effect of the investigation. Nevertheless, it should be pointed out that the consequences could include administrative or civil procedures and/ or a criminal indictment, including penalties and/ or civil charges. It should also be stated that punishments for the violation of competition statutes could be serious, both with regard to criminal charges and also as to civil charges. See also Section 9.11.2 (g) (4).
(E) On December 20, 2006, the Company received a letter from the European Competition Commission ("the Commission") at its head office, which contained a request for information in connection with an investigation being carried out by the Commission in connection with activities which, seemingly, cause damage to competition in the sector of air transport services for cargo. The letter stated that the Commission has information regarding extensive contacts that took place between airlines and other entities with regard to various price increments and other matters such as cargo transport rates. In the context of the letter, the Company was requested to transmit data and documentation regarding the Company and its cargo activities, commencing with the year 1995. The Company is cooperating with the investigation and has transferred its reply as requested by the Commission's letter, while carrying on an internal audit of cargo pricing practices. At this stage, the Company is unable to evaluate the outcome of the investigation of the Commission or to estimate the possible financial effect of the investigation on the Company. Nevertheless, it should be pointed out that the implication might include an administrative proceeding against the Company, include a severe fine which could be imposed on the Company at the end of the proceeding. See Section 9.11.2 (g)(5) above for details. (F) On February 28,2007, the Company received a writ of civil claim that was filed in the United States District Court for the Eastern District of New York in the matter of the prices for cargo air transport services. The Company was included as a defendant in the writ of claim, along with 38 other airlines, with the claim being that the defendants were partners in a conspiracy to conform prices for cargo air transport services, beginning in the year 2000, while violating competition and other laws in Europe and the United States. The claim was filed in the name of entities who purchase air transport services, directly and indirectly, it also
a-143 Translation of the Hebrew Language financial statements includes a request to recognize the claim as a class action. The claim includes a request for compensation in an amount not denominated as well as additional relief. The Company is evaluating the writ of claim that it received and the possible implications and is making preparations to deal with this proceeding. In view of the early stage of the process, the Company is unable to assess the implications or the monetary effect of the proceeding on the Company.
9.18.16 Immediate repayment of loans for the purchase of aircraft and complying with financial criteria The Company is obligated towards the long-term loan providers to observe a proper collateral correlation between the unpaid loan balance and the collateral pledged to the bank, this as stipulated by each agreement. In any case that the value of the collateral falls below that specified in the agreement, the Company is obligated to provide additional security to the lender in a manner that the correlation, as stipulated in the agreement, is maintained. In addition, the terms stipulated in certain agreements relating to loans taken by the Company include the right of the bank to demand immediate repayment of the balance of the loans owed to that bank if, in the opinion of the bank, based on reasonable criteria, a change had occurred which adversely affects the Company’s financial position or its operations or its business or its financial ratios, in a manner endangering or potentially endangering the ability to repay the bank loans. Additionally, the Company has made commitments to the banks according to which, should there be a transfer or change of control of the Company in any manner without the consent of the lenders, the lenders is permitted to demand immediate payment of the loan balances. For this purpose, a public offering will not be considered as a transfer of control of the Company, unless, as a result, the control of the Company changed. See Section 9.8.2 above and Note 14(f) to the financial statements for more information. The failure of the Company to comply with financial criteria which were stipulated in the loan agreements, including with regard to the decrease in market value of the collateral, and/or the demand for immediate repayment of Company loans by the banks, might have a negative effect on the business results of the Company.
9.8.17 The municipal status of BGA From time to time, the addition of BGA to the jurisdiction of the city of Lod is considered. If the transfer of BGA to the jurisdiction of any local authority should become a reality, the expenses of the Company might rise (due to the payment of municipal taxes which up to now have not been paid), and the matter will negatively affect its business results.
9.18.18 Labor relations Every interruption of operations of an air carrier due to sanctions or a strike causes a non- recoverable loss and damage to customer confidence. The situation in the industry and the increasing competition in the industry necessitate continuing efforts to increase Company efficiency and to improve service to the customer public. These are conditional upon stability in labor relations in the Company, in the employees identification with the Company and in readiness to cooperate and in an understanding with management.
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Although the “industrial calm” in the Company has been preserved since 1983, excluding a small number of breakdowns, the efficiency that is expressed in structural changes, in the reduction in the number of personnel (with the emphasis on permanent employees), and the reduction of labor costs could cause a tremor, even for a short period, in the delicate texture of labor relations in the Company. The incident could cause damage in the immediate term and injury in the Company’s goodwill over the longer term, and it might have a negative effect on the business results of the Company for that year and thereafter. Negotiations are currently being held between the Company and the employees’ association in connection with an efficiency agreement which Company management requests be formulated, as well as changing the terms of the special collective agreement for the permanent employees of the Company, effective through December 31, 2007 ("Generation A agreement"-see Section 9.4.7 A. above). As of a date in proximity to the date of the report, the negotiations between the parties has not yet been completed.
Agreement or lack of agreement regarding the Company's efficiency program and collective labor agreements could have a material effect on the financial results of the Company and on its ability to maintain operations regularly.
9.18.19 Legal proceedings The Company is a party to legal proceedings, including a number of lawsuits which the courts have been requested to recognize as class actions (and two of them have actually been recognized as such), which might cause it to be charged with material amounts, which cannot be estimated, and as to the majority of which, no provision has been made in the Company’s financial statements, (See Section 9.14 above for a description of the principal claims). In addition, during the year 2006 and at the beginning of the year 2007, legal proceedings were begun in the United States and Europe to which the Company is party, that are connected to investigations by competition authorities in the U.S and Europe in connection with price increments collected for cargo transport. These proceedings could have a substantial effect on the Company because of the penalties that these authorities are permitted to impose, which could be exceedingly high. (See Section 9.11.2.(g) above for details regarding these proceedings; see Section 9.14 above for a description of the main claims.)
9.19.20 Restrictions due to certain provisions of the Special State Share The restrictions relating to preserving a minimal flight capacity, especially for cargo aircraft, and the prospect of the State demanding to increase the minimal flight capacity with which the Company must comply, diminishes operational flexibility and imposes burdensome obligations (assurance of fitness). The indemnification in these cases does not cover the Company’s expenses. In addition, the Government Corporations Law gives the authority, to the Company, to set instructions that are intended to protect the vital interests of the State with respect to the Company, this according to decrees under Chapter 2H of the Government Corporations Law. Such a decree was published on November 17, 2004. See Section 9.11.2 (j) above for more details. Such decrees might restrict the business judgment of the Company and, as a result, could cause damage to its financial results. See Section 8.10 above for information concerning the approval received by the Company from the holder of the Special State Share with respect to the reduction of the fleet of cargo aircraft in its ownership.
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9.18.21 Dependence on aircraft manufacturer All of the aircraft in the service of the Company are products of the “Boeing” Company. The discontinuation of the operations of Boeing could cause temporary operational difficulties for the Company. The Company is materially dependent on Boeing, both with respect to parts and with respect to engineering support. At the same time, the Company estimates that the likelihood of the termination of this support is low.
9.18.22 Dependence on normal operations at the home airport (BGA) Most of the Company’s operations are carried out at the home airport, BGA. Therefore, an interruption or breakdown in the normal operations of BGA and/or changes in the policies of giving out takeoff and landing authorizations (slots) at the central airports in which the Company operates might have a material negative effect on the Company’s operations.
9.18.23 Flights on the Sabbath and Jewish holydays The Company continues to operate pursuant to a 1982 Government resolution and does not carry out passenger flights on the Sabbath and on Jewish Holydays, this. During the month of November 2006, as the result of a dispute which broke out between the Company and representatives of the Committee of Rabbis for Sabbath Observance on the background of a flight that the Company executed on the Sabbath, an agreement was reached between the parties. (See Section 7.10 above for details of the understanding). The failure to comply with the understandings regarding flights on the Sabbath and Jewish Holydays, or a change of the Company's policies with respect to this subject, could cause a dispute with this segment of customers, which could have an effect on the Company's results due to a boycott by consumers.
9.18.24 Impairment of flight safety or flight security In order to preserve flight security, the Company maintains security arrangements in accordance with the instructions of the authorized governmental agency. In order to conserve flight safety, the Company maintains the instructions and provisions stipulated by the relevant entities, including the instructions of the manufacturer and the Civil Aviation Authority. Damage to the Company's flights and/or its customers and/or its installations and/or its employees, due to an event connected with flight security and/or flight safety is liable to have a material negative effect on the Company's operations.
9.18.25 Information systems and information security The current operations of the Company, the business activities and the services which it provides are based upon information systems and data bases. An extended failure of critical information systems and/or damage to information security of the Company could have a major negative effect on the Company's operations.
The following table presents the risk factors that are described above according to their nature (macro risks, industry risks and risks particular to the Group), which have been ranked, as estimated by the Group’s management, according to their effect on the Group’s business as a whole-large, moderate and small effect. The Company’s approximations as to the ranking of the risks was determined in consideration of the likelihood of the occurrence of the event and the measure of damage which might be caused to the Group, should the event take place.
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Measure of the effect of the risk on the Company Large effect Moderate effect Small effect Macro risks Political or security events or terrorist actions √ Exposure to currency risks √ Changes in the economic situation √ Natural forces and epidemic outbreaks √ Exposure to variable interest risks √ Industry risks Jet fuel prices √ Changes in competition √ Seasonal influence √ Governmental decisions on aviation matters and √ licensing of the Company as an air carrier Operations in an industry with a high fixed cost √ structure Noise restrictions and environmental matters √ Effect of low cost airlines operation on the Israeli √ market Impairment of flight safety or flight security √ Risks particular to the Company Costs of maintaining flight security √ Restrictions on receipt of credit and/or additional √ future loans Business restrictions √ Immediate repayment of loans for the acquisition √ of aircraft Municipal status of BGA √ Labor relations √ Legal proceedings √ Restrictions due to provisions of Special State √ Share Dependence on aircraft manufacturer √ Dependence on regular operations at home √ airport (BGA) Saturday and religious holiday flights √ Information systems and information security √
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2006 ANNUAL REPORT
CHAPTER B DIRECTORS' REPORT
Translation of the Hebrew Language financial statements
EL AL ISRAEL AIRLINES LTD. REPORT OF THE BOARD OF DIRECTORS CONCERNING THE COMPANY’S AFFAIRS DURING THE YEAR ENDED DECEMBER 31, 2006
We are pleased to submit herewith the directors’ report on the state of the Company’s affairs as of December 31, 2006 and for Net income(loss), by year: the year then ended. (in millions US dollars)
80 The EL AL company ended the 2006 year with a loss of $ 44.6 64.1 60 million ("m"). The consolidated sales revenues of the Company 33.1 40 during the year 2006 rose by approximately 3% in relation to the
6.4 20 year 2005 and totaled approximately 1,665m dollars. 0 During the year 2006, the Group flew 3.6m traveler legs and -6.4 -20 transported 162 thousand tons of cargo. -40 -44.4 -60 Net cash derived from current operations amounted to 2002 2003 2004 2005 2006 approximately $ 73.4m and the balance of cash, cash equivalents and short-term investments as of December 31, 2006 totaled
approximately $ 150.8m.
The total shareholders' equity as of December 31, 2006 amounted
to $ 230.3m.
The year 2006 was characterized by a number of factors that negatively affected the operating results of the Group:
A. The "open skies" policy of the Israeli government exacerbated competition in the aviation market by increasing the supply of seats
of the competing scheduled airline companies in a volume of
approximately 21%, while the total traffic of the scheduled airlines at BGA grew by only about 6%.
B. The Second Lebanon War, occurring during the third quarter
(from July through the middle of August) materially impaired passenger traffic to and from Israel, principally with respect to
tourists who cancelled their arrival to Israel, but a slowdown in demand was also recorded among the Israelis. During this quarter,
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passenger traffic at BGA diminished by about 7% as compared to the third quarter of the year 2005. Since this quarter is the most significant one of the year as regards incoming and outgoing
tourism traffic, it affected the year as a whole.
C. The rise in jet fuel prices also continued during the 2006 year and
despite that there were decreases in the prices of jet fuel towards the end of the year, on the average, jet fuel market prices were
higher during the year 2006 by approximately 15% from 2005 prices.
D. Weakness of the dollar in relation to the shekel and in relation to
the Euro, and the continued rise in the LIBOR interest rate also impaired the Company's business results.
The Company succeeded in moderating the annual loss by means
of transactions to hedge the prices of jet fuel, interest rates and currency rates, which yielded refunds to the Company's treasury
during the year 2006 of approximately $ 57m (during the 2005 year, returns in total of about $ 66m).
During the year 2006, the Group continued with the implementation of the “EL AL 2010” strategic program, with adjustment for developments in the security, political and economic situation in
Israel, including the Second Lebanon War and its effect on passenger traffic, the continued trend of jet fuel price rises and amplified competition. The Group scrutinizes its operations in order to cause optimization of the network of the routes, while adjusting
the means of production in accordance with the demand environment and profitability of the routes by increasing or
decreasing capacity, or reducing operations to non-profitable destinations.
1. General
The Company serves as Israel’s designated carrier on most international routes to and from Israel.
The principal activity of the Company and its subsidiaries is
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the transport of passengers and cargo, including baggage and mail, by means of scheduled flights and, as far as
transport of passengers is concerned, also chartered flights
between Israel and foreign countries. The Company is also engaged in the leasing of flight equipment, in rendering
materials-handling and maintenance services at its home airport, in the sale of duty-free products and - through its
investees - in related activities, the main ones of which are supplying passenger meals and managing several travel
agencies in Israel and abroad.
The business environment in which the Company operates is the international civil aviation industry and tourism to and from
Israel, characterized by seasonal factors and a high level of competition, which intensifies in periods of excess capacity. EL
AL competes with 43 scheduled airlines which operate in the market on the basis of aviation agreements signed between the
State of Israel and other countries as well as 57 charter airlines which operate based upon charter regulations established by the Ministry of Transport. The Group has two areas of activity reported as business segments (secondary) in the Company’s
consolidated financial statements:
a) Air transport in passenger aircraft - this area of the Group consists of the transport of passengers, as well as cargo (including baggage and mail) in the belly of aircraft for transporting passengers, plus the
rendering of related services, such as: the sale of duty-free products and the leasing of passenger aircraft. This operating segment provided approximately 84% of the Group’s total revenues
during the year 2006.
b) Air transport in cargo aircraft - this area of the
Group constitutes the conveyance of cargo in cargo- transport aircraft and the providing of related services. The revenues of this area of operations
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constituted approximately 15% of the Group’s total
revenues for the year 2006. Shareholdings in Company The Group has additional income, unrelated to its main areas of at December 31, 2006: activity, constituting approximately 1% of total revenues.
employees’ As of December 31, 2006, the holdings in the Company were : Trus t State of K’nafaim Holdings Ltd. (K'nafaim)- 39.5%; the State of Israel - Holdings Israel 8.1% 21.0% 21.0%; a corporation of the Company's employees called "Trust Holdings of El Al employees" (employees' corporation) - 8.1%; others - 31.4%.
Others K'nafaim Additional information pertaining to the Company’s privatization 31.4% 39.5% is provided in Note 1.b to the financial statements.
2. Financial position (Consolidated data)
31.12.2006 31.12.2005 change in Shareholders’ equity in thousands in thousands thousands US dollars US dollars US dollars % at December 31: Assets Cash and short-term investments 150,840 206,763 (55,923) (27%) (in millions US dollars) Trade accounts receivable 131,027 126,699 4,328 3% Other receivables 47,342 45,831 1,511 3% Deferred income taxes 30,645 46,698 (16,053) (34%) 400 Inventory 17,190 22,445 (5,255) (23%) 271.0 Investments 5,945 5,846 99 2% 230.3 300 Fixed assets 1,148,389 1,163,765 (15,376) (1%) 182.8 Other assets 3,455 4,671 (1,216) (26%) 200 110.6 1,534,833 1,622,718 (87,885) (5%) 100 Equity & liabilities Short-term bank borrowings 105,100 75,713 29,387 39% 0 Trade accounts payable 143,473 155,046 (11,573) (7%) Payables and other current liabilities 339,287 324,546 14,741 5% -100 Long-term loans from financial institutions 566,104 627,363 (61,259) (10%) Accrued severance pay, net 119,575 120,526 (951) (1%) -200 Deferred income taxes 30,268 46,300 (16,032) (35%) -212.7 Other long-term liabilities 730 2,215 (1,485) (67%) -300 Shareholders’ equity 230,296 271,009 (40,713) (15%) 2002 2003 2004 2005 2006 1,534,833 1,622,718 (87,885) (5%)
The major changes in the items of assets, liabilities and shareholders' equity as of December 31, 2006 as compared
with December 31, 2005 were:
• A decrease in the balances of cash and cash
equivalents and short-term investments, derived mainly from investments in fixed assets of approximately $ 104m and repayment of loans in the
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Translation of the Hebrew Language financial statements
amount of approximately $ 70m which were partially Cash and short-term offset by positive cash flow from operating activities investments at December 31: during the reporting period and from the receipt of a (in millions US dollars) loan from a banking institution of $ 40m. An increase in the balance of trade accounts 250 • 206.8 receivable, mainly due to higher passenger and 200 151.3 150.8 cargo revenues. 150 • A decrease in short-term deferred taxes receivable 98.1 93.1 100 and a parallel decrease in long-term deferred tax
50 liabilities resulted from the classification during the reporting year of a tax asset receivable from short- 0 2002 2003 2004 2005 2006 term to long-term.
• A decrease in inventory resulted mainly from the fact that, as of December 31,2005, the inventory included
independent imports of jet fuel that were fully consumed at the beginning of the 2006 year.
• A reduction in fixed assets derived mainly from
annual depreciation charges and consumption of spare parts, net of purchases of fixed assets, spare parts and accessories in a total amount for the reporting year of approximately $ 104m.
• The decrease in other assets is explained by the
change in classification of the expenses of obtaining
loans from other assets to a reduction of long-term loans in accordance with Accounting Standard Number 22.
• The increase in short-term credit and current maturities resulted primarily from the classification of
a bank loan payable in the year 2007 from long-term liabilities to current maturities.
• A decrease in trade accounts payable due, among
other things, to an expenditure deferred from the year 2005 of a payment to the IATA clearing house
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and from a decrease in the balances for jet-fuel and for engine overhauls.
• A rise in payables and other current liabilities, mainly due to higher deferred income following an increase
in sale of tickets not yet utilized, as well as an increase in the liability with respect to the programs
for frequent flyer clubs.
• The balance of long-term liabilities (including current maturities) declined due to current repayments of
long-term loans, partially offset by a loan received from a foreign banking institution.
• The decrease in shareholders’ equity resulted mainly from the net loss for the reporting period. This decrease was offset by the following factors:
deposits made by the Government of Israel in the severance-pay fund, which increased the capital reserve from transactions with a former controlling party, the exercise of options into shares and the
recording of a benefit with relation to an employee
option plan to a capital reserve.
As of December 31, 2006 ,the Company had a working-capital deficiency of approximately $ 210.8m as compared to approximately $ 106.9m as of December 31, 2005.
The rise in the working-capital deficit derives mostly from
decreases in cash and short-term investments balances of
approximately $ 56m (see Section 5 below), from the classification of a tax asset receivable during the reporting year from short-term
to long-term, from an increase in the short-term credit due mainly the classification of a loan from a banking institution due to be
repaid during the year 2007, from long-term liabilities to current maturities. The current ratio of the Company as of December 31,
2006 stood at 64.1% as against 80.8% as of December 31, 2005.
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Translation of the Hebrew Language financial statements
The working-capital deficiency is the result of the current liabilities of the Company which include two material
components: deferred income from the sale of passenger flight
tickets and current maturities of long-term loans (including a one time current maturity as explained above). These
components which are characterized by the regular business cycle in fact explain most of the working-capital deficit.
Passenger traffic at BGA 3. Analysis of business activities of EL AL Incoming tourists & Departing Israelis, by year: (In thousands) 3.1 Market data Passenger and cargo 2006 2005 change traffic at BGA in thousands in thousands in thousands % Incoming tourists * 1,565 1,653 (88) (5%) Departing Israelis * 3,145 3,013 132 4% Cargo import - tons ** 134 127 7 6% 3,000 Cargo export - tons ** 182 176 6 3% 3,013 3,145 2,828 2,869 2,689 2,000 (*) Source: The Central Bureau of Statistics. (**) Excluding cargo in transit. 1,653 1,565 1,339 1,000 972 779 3.2 Operating data - Company 0 2002 2003 2004 2005 2006 Jan - Dec Jan - Dec change Incoming tourists 2006 2005 Departing Israelis Passenger leg (scheduled and chartered) - in
thousands 3,569 3,593 (1%) RPK (scheduled) - in millions 16,055 16,141 (1%) ASK (scheduled) - in millions 19,750 20,324 (3%) Load factor (scheduled) 81.3% 79.4% 2% Operating data, by year: The Company's market share (scheduled and (in millions) chartered) 41.7% 43.2% (3%) Cargo, in thousand tons 162 159 2% 25,000 RTK - in millions 885 871 2% Weighted flying hours (including leased 20,32419,750 95% 20,000 18,665 equipment) - in thousands * 172 172 (0%) 16,254 16,035 positions at the end of the year (El AL only): ** 15,000 16,141 16,055 85% Permanent 3,561 3,580 (1%) 14,347 Temporary 2,336 2,430 (4%) 10,000 11,92912,139 Total 5,897 6,010 (2%) 81.3% 79.4% 75% 76.9% 5,000 75.7% Aircraft in operation - end of period - 73.4% number of units 35 34 1 0 65% Average age of owned fleet at the end of the 2002 2003 2004 2005 2006 period - in years 14.8 14.2 0.6 ASK RPK L. F.
** Number of employees (permanent and temporary) per average man years-
amounted to 6,185 for the year 2006 and 5,943 for the year 2005.
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Reading: Passenger Leg - Flight coupon in one direction.
RPK - Revenue Passenger Kilometer - number of paying passengers X distance flown. ASK - Available Seat Kilometer - number of seats offered for sale X distance flown. RTK - Revenue Ton Kilometer - cargo weight in ton X distance flown.
Passenger Load factor - Revenue Passenger Kilometer, expressed as percentage of Available Seat Kilometer.
*Aircraft weighted block hours in terms of Boeing 767/757: Boeing 767/757 = 1.0; Boeing 747=2.0; Boeing 777 =1.6; Boeing 737=0.6. These values have been determined on the basis of an estimate of total expenses incurred for each type of aircraft and are used consistently for computing weighted flight hours as an indicator of the volume of aviation activity.
3.3 Profit and loss Year ended December 31, 2006 (consolidated):
Jan - Dec Jan - Dec change Operating revenues, by year: 2006 2005 in % of in % of in (in millions US dollars) thousands operating thousands operating thousands US dollars revenues US dollars revenues US dollars % 2,000 Operating revenues 1,665,446 100% 1,619,469 100% 45,977 3% 1,665 Operating expenses (1,402,652) (84.2%) (1,243,198) (76.8%) (159,454) 13% 1,619 Gross profit 262,794 15.8% 376,271 23.2% (113,477) (30%) 1,386 1,500 Selling expenses (187,805) (11.3%) (198,591) (12.3%) 10,786 (5%) 1,100 1,168 General and administrative expenses (91,952) (5.5%) (88,758) (5.5%) (3,194) 4% Operating income (loss) before financing (16,963) (1.0%) 88,922 5.5% (105,885) 1,000 Financing expenses, net (29,492) (1.8%) (20,606) (1.3%) (8,886) 43% Other income (expenses), net 1,806 0.1% (4,519) (0.3%) 6,325 Income taxes (134) (0.0%) (304) (0.0%) 170 (56%) 500 Income (loss) after taxes (44,783) (2.7%) 63,493 3.9% (108,276) Company’s equity in results of affiliates, net 417 0.0% 633 0.0% (216) (34%) Net Income (loss) for the year (44,366) (2.7%) 64,126 4.0% (108,492) 0 2002 2003 2004 2005 2006 Major factors affecting the business results during the year ended December 31, 2006 as compared with the parallel period last year are:
• The higher operating revenues were derived mainly from an increase in passenger revenues due to a rise in average revenue per passenger/km, and from increased cargo revenue as a result of a rise in
ton/km flown and from higher average cargo income per ton/km flown by the Company. Additionally, there
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Translation of the Hebrew Language financial statements
was an increase in other operational revenues, mainly from rendering maintenance services to other Distribution of Operating expenses - 2006: aviation companies and from leasing aircrafts.
Maintenance Wages and • Operating expenses rose mainly due to higher jet-fuel of aircraft 8% social Jet fuel 33% Meals 3% benefits 19% prices, an increase in wages, as detailed below, and higher aircraft and flight-equipment maintenance and aircraft leasing expenses. • The Company's average jet-fuel price, net of hedging refunds, rose approximately 22% during the year
Air navigation & Other Ai r p o r t f e e s Depreciation communication 2006 as compared with the 2005 year. The expenses 12% & service 12% 7% 6% Company’s jet-fuel expenses increased by
approximately 20% from approximately $ 388.0m for the year 2005 to about $ 465.9m during the year 2006, this after the receipt of hedging refunds in the amount of about $ 52m (as compared with
approximately $ 65m in the 2005 year).
• Current wages rose, among other reasons, due to a revaluation of the shekel and the Euro vis-à-vis the dollar, from an increase in the average workforce Selling expenses & General and administrative expenses during the year, from recording an expense with as % of operating revenues, respect to an option plan for Company employees by year: and officers, from recording a severance pay liability 20% in the branches and from a decrease in earnings of 12.7%12.3% 15% 11.3% the severance pay funds for the year 2006 as 10% compared with last year. As for the effect of the 5.9% 5.5% 5.5% 5% changes in the shekel’s exchange rate against the dollar on the Company’s provisions, see item 3.4 0% % Selling % Ge ne r al and below. expenses administrative expenses • Aircraft and flight-equipment maintenance expenses 2004 2005 2006 rose, primarily due to fluctuations in timing of engine
overhauls, from increased costs in the spare parts market and from the commencement of expenditures
for an additional fleet of engines as to which the warranty period terminated.
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• During the year 2006, there was an increase in
aircraft and flight equipment leasing expenses of approximately $ 15.8m in relation to the 2005 year,
deriving principally from the addition of a 737-800 aircraft and two 767-300 aircraft. (A 747-400 aircraft
was returned to the leasing company in the year 2006).
• Selling expenses declined due mainly to the decrease in distribution expenses as the result of the reduction in their rate to sales revenue. • There was a rise in administrative and general
expenses in relation to the same period last year due mostly from the revaluation of the dollar in relation to the shekel and the Euro, and from recording an expense with respect to an option plan for Company
employees and officers. At the same time, their ratio
to sales volume in the year 2006 remained unchanged from the year 2005.
• Higher LIBOR interest rates led to an increase in financing expenses, which were offset by a reduction
in the Company's loan position, higher financing income on bank deposits arising from increased
interest rates, and income from transactions to hedge interest and foreign currency. Also, the revaluation of
the shekel and the Euro in relation to the dollar caused the recording of exchange rate expense due
to the revaluation of balance sheet balances as compared with income from this item recorded during
the year 2005. • During the year, the Company recorded a capital gain in the amount of approximately $ 5.9m from the sale of a cargo aircraft. In the year 2005, a capital
gain in the amount of approximately $ 8.3m from the sale of holdings in the Maman and Unitel companies
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Translation of the Hebrew Language financial statements
had been recorded and, on the other hand, an expense was recorded in the amount of
approximately $16m for a provision for early
retirement programs.
The principal factors which impacted the business results for the three-month period ended December 31, 2006 as compared
with the parallel period last year:
In the fourth quarter of the year 2006, the Company recorded a
loss of approximately $ 18.6m as compared with earnings of approximately $ 0.6m. Operating revenues for this quarter,
both from passenger flights and from cargo flights, grew during this quarter, as did other operating revenues. Nonetheless,
operating expenses rose at a higher rate, mainly due to the increase in fuel expenses, wages and aircraft leasing fees.
The average price of jet fuel for the Company, net of hedging refunds, for the fourth quarter of the year 2006 rose by approximately 11% in relation to the fourth quarter of the year 2005. The Company's expenses for jet fuel increased by
approximately 17% from about $ 102.5m during the year 2005
to about $ 119.4m for the year 2006.
Selling expenses for the fourth quarter of the year 2006
increased in comparison to the same quarter last year, but their proportion to sales volume did not change materially.
Administrative and general expenses grew primarily as the result of the effect of the revaluation of the dollar in relation to the shekel as well as from the recording of an expense with relation to the options program for Company employees and officers.
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3.4 Effect of exchange-rate changes on the Company's obligations for the termination of employee-employer Changes in US dollar relationships (including early retirement programs), and exchange rate: on the provision for sick leave and vacation pay 4.7 (hereafter: "the effect of changes in the exchange rate 4.665 4.603 4.5 on the Company's provisions") During the year ended December 31, 2006, the shekel was 4.440 4.3 revalued by 8.2% against the dollar, as compared with a 4.302 devaluation of 6.8% in 2005. 4.225
31.12.05 31.03.06 30.06.06 30.09.06 31.12.06 4.1 On December 31, 2006, the Company had liabilities totaling $ 155m for severance pay, retirement programs, sick-leave and vacation pay. Since most of these liabilities are denominated in shekels while the Company’s functional currency is the US dollar, the
translation of the liabilities into dollars creates exchange-rate
differences resulting from changes in the exchange rate of the shekel vis-à-vis the dollar. Such changes in exchange rates are not one -dimensional and create income or expenses in the
Company's financial statements which neither affect cash flows
nor short-term operating expenses of the Company. In order to be able to compare business results over time, it is necessary to neutralize these income and expense items. This impact declines along with the State’s deposits into the severance-pay fund. During the year ended December 31, 2006, expenses were increased due to this component by $ 10.2m as opposed to the parallel period last year when expenses decreased due to this component by $ 9.1m. The following presents details of business results, with the effect of changes in the exchange-rate on accrued severance pay having been neutralized:
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Translation of the Hebrew Language financial statements
Before After neutralizing the exchange-rate effect Year ended on the accrued severance pay December 31, 2006 2005 2006 2005 (in thousands US dollars) Operating expenses 1,402,652 1,243,198 1,396,250 1,248,457 Gross profit 262,794 376,271 269,196 371,012 Gross profit rate 15.8% 23.2% 16.2% 22.9% Selling, general and administrative expenses 279,757 287,349 278,509 288,414 Operating income (loos) before financing expenses (16,963) 88,922 (9,313) 82,598 Operating income (loos) rate before financing (1.0%) 5.5% (0.6%) 5.1% Other income (expenses), net 1,806 (4,519) 4,355 (7,290) Net income (loss) for the period (44,366) 64,126 (34,167) 55,031 Net income (loss) for the period rate (2.7%) 4.0% (2.1%) 3.4%
In the fourth quarter of 2006, there was a revaluation in the exchange rate of the shekel against the dollar at the rate of 1.8% compared with a devaluation of 0.1% during the same
quarter last year.
During the fourth quarter of 2006, the Company had expenses
of $ 2.3 m from changes in dollar/shekel exchange rates, as
compared a reduction of $ 0.2m in expenses from this component in the same quarter in 2005.
Operating revenues attributed to 3.5 Reporting by segments (consolidated) geographical segments - 2006: a. The following is a summery by geographical segments - Rest of Nor th consolidated - primary reporting: the America world 36% Asia Central Asia Rest of 2% 19% North America Europe & Far East the world (in millions US dollars) 2006 operating revenues * 580.4 702.9 313.5 36.6 Operating income ** 11.2 81.2 37.8 7.8 % of operating revenues 1.9% 11.6% 12.1% 21.4%
2005 operating revenues * 568.3 710.3 277.1 34.9 Operating income ** 58.5 166.4 33.8 11.6 Eu r o p e % of operating revenues 10.3% 23.4% 12.2% 33.2% 43% 2004 operating revenues * 488.0 606.3 239.7 28.2 Operating income ** 42.2 113.9 51.6 8.2 % of operating revenues 8.7% 18.8% 21.5% 29.1%
(*) Revenues attributed to geographical segments based on flight destination. (**) Excluding unclassified segment expenses (see Note 24a to the financial statements).
During the year ended December 31, 2006, all segments enjoyed higher revenues over the previous year, except for the
European segment. The rates of operating income fell during
2006 in all segments, due mainly to the rise in prices of jet fuel
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for the Company which were higher by 22%, from increased wage expenses, from higher aircraft and flight equipment
maintenance expenses and from greater aircraft leasing
expenses.
There was a rise in occupancy rates in the Central Asia- Far East segment, in the number of flight legs and in air cargo
tonnage. Therefore, only a slight decline was recorded in the rate of operating income in that segment. Operating revenues by business-activity segments - b. The following is a summary by business activity 2006: segments - consolidated - secondary reporting:
Others cargo passenger aircraft cargo aircraft others Total 1% aircraft (in millions US dollars) 15% 2006 Passengers 1,277.7 - - 1,277.7 Cargo and mail 90.0 241.6 - 331.6 Other revenues 34.4 1.0 20.7 56.1 Total revenues 1,402.2 242.6 20.7 1,665.4 Distribution - in % 84% 15% 1% 100%
2005 Passengers 1,259.8 - - 1,259.8 passenger Cargo and mail 92.7 216.5 - 309.2 Other revenues 33.2 0.8 16.5 50.5 aircraft Total revenues 1,385.7 217.3 16.5 1,619.5 84% Distribution - in % 86% 13% 1% 100%
2004 Passengers 1,048.5 - - 1,048.5 Cargo and mail 77.7 216.7 - 294.4 Other revenues 25.5 1.0 16.7 43.2 Total revenues 1,151.7 217.7 16.7 1,386.2 Distribution - in % 83% 16% 1% 100%
During the year 2006, passenger aircraft revenues increased Distribution of Operating by only 1% over 2005, constituting resulting in a decrease in revenues by quarters - 2006: their share of the Group’s total revenues from 86% in 2005 to (in millions US dollars) 84% in 2006. 50% 500 447.0 Cargo revenues increased by 12% in relation to 2005, with their 429.2 416.7 40% 400 372.5 share in Group total revenues rising from 13% in 2005 to 15% 300 in 2006. 30% 200 27% 4. Seasonal factors 26% 25% 20% 100 22% The passenger traffic at BGA is characterized by strong 0 10% seasonality, with the primary activity taking place during the Q1-06 Q2-06 Q3-06 Q4-06 revenues % of revenues summer months, (peaking in July-September). The winter
months (January-March) are characterized by slow passenger
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Translation of the Hebrew Language financial statements
traffic, on the one hand, with higher export cargo of agricultural produce to Europe during those months, on the other hand.
It should be pointed out that the Second Lebanese War that
went on during the months of July and August 2006 caused a
decline at the rate of approximately 7% in passenger traffic at Ben Gurion Airport during the third quarter as compared with
the parallel quarter last year.
5. Liquidity and financing sources
Cash flows from operating Jan - Dec Jan - Dec change activities for years: 2006 2005 in thousands in thousands in thousands (in millions US dollars) US dollars US dollars US dollars Cash flows from operating activities 73,436 183,619 (110,183) 250 Cash flows from (used) for investing activities 10,146 (95,655) 105,801 Cash flows used for financing activities (31,353) (58,682) 27,329 Net increase in cash 52,229 29,282 22,947 176.3 183.6 200
150 The change in cash flows from operating activities in 2006 as
90.0 84.3 compared to last year resulted mainly from the loss this year as c 73.4 100 compared with net income in 2005. 50 During the reporting period, the Company used $ 104.2 million 0 for the acquisition of fixed assets, spare parts and accessories 2002 2003 2004 2005 2006 (last year- $ 82.8m) while withdrawing a net amount of $ 107.9m from short-term deposits as compared with net deposits of $ 26.4m in the same period last year. During 2006, the
Company received proceeds of $ 7.0m from the sale of fixed
assets, primarily a cargo aircraft, whereas in the year 2005, the Company received $ 13.7m from realizing investments in
investees. In total, the Company used $ 10.1m for investment activities as compared with $95.7m in the same period last
year.
During 2006, the Company used $ 70m to repay long-term loans compared with $ 79.2m last year. On the other hand, in
2006, the Company received a loan of $ 40m from a financial institution abroad, after having obtaining a loan of $ 14.2m
during 2005 to acquire a spare engine.
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In total, the Company used $ 31.4m for financing activities during the reporting year as compared with $ 58.7m in the
same period last year.
Total cash and cash equivalents and short term investments on
December 31, 2006 amounted to $ 150.8m as compared with $ 206.8m on December 31, 2005.
During the reporting year, the State deposited $ 0.8m to the
severance-pay fund for Company employees, in accordance with the terms of the prospectus and the Company also
received $ 0.3m from the exercise of options (Series 1) which were also deposited to the severance-pay fund.
The average outstanding volume of long-term bank loans
(including current maturities), supplier credit and credit granted to customers during the year 2006 amounted to $ 676m,
$ 145m and $ 152m, respectively.
6. Disclosure of critical accounting estimates
The application of accounting principles by management in the preparation of financial statements involves at times the use of
assessments, assumptions and estimates affecting the
business results reported in the financial statements. Part of these assessments, assumptions and estimates are critical to
the financial position and results of the operations reflected in the Group’s financial statements, due to the materiality of the
topic, complexity of the computations or probability for materialization of the uncertain topics.
The following is an outline of critical accounting estimates:
Accounting Standards 15 (“Impairment in the Value of
Assets”), published by the Israeli Accounting Standards Board, states that an entity must ensure that its assets are not presented in amounts exceeding their “recoverable amount”. An asset’s “recoverable amount” equals the higher between net
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Translation of the Hebrew Language financial statements
selling price and the present value of estimated future cash flows. The Company has a fleet of 747-200 aircraft with
depreciated book value that exceeds the listed prices of the
fleet. The appendix attached to the Directors' Report contains an appraisal which calculates the recoverable value of this
fleet. The conclusion of the appraisal is that the recoverable value of this fleet of aircraft exceeds depreciated cost. In
determining the present value of estimated future cash flows from the use of its various fleets of aircraft, the Company relied
on forecasts pertaining, inter alia, to expected operating volume, prices of airline tickets and cargo airway bills,
operating costs and future interest rates. Material changes in these estimates or part thereof may adversely affect the
recoverable amounts of these assets and, consequently affect the Company’s results of operations.
See Note 2X to the financial statements for details.
The fleet of 767-200 aircraft, which was included in the
appraisal in previous periods, is no longer included since its depreciated book value as of December 31, 2006 is no longer higher than its market value.
Pending lawsuits - the Company records a provision for lawsuits filed against it both in Israel and abroad, including
class actions based on the level of risk for each claim determined on the basis of the opinion of the Company's legal counsel. The Company has not recorded a provision for pending lawsuits (including class actions) where the exposure
of the Company cannot be estimated by the Company's legal
counsel. The Court's ruling may, naturally, differ from the Company’s estimates and thus adversely affect the Company's results of operations.
As for details - see Note 17a to the financial statements as well
as Notes 25C and D with regard to claims filed against the
Company subsequent to the balance sheet date.
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7. Quality reporting concerning exposure to
market risks and methods used for
managing them
7.1 Exposure to market risks
The following is an outline of the market risks to which the Company is exposed:
Changes in jet-fuel prices - this is a significant component in operating expenses of the Company, materially affecting
profitability of the Company. It is estimated by management
that a US 1 cent rise in the price of a gallon over the course of a year increases annual expenses by $ 2.6m. The Company has carried out hedging transactions in order to reduce
exposure, as detailed in item 7.3.
Currency fluctuations - the Company’s revenues and expenses
are mostly denominated in foreign currency (mainly the US dollar), other than a number of expenses paid in shekels,
primarily wages paid in Israel. Therefore, a change in the dollar/shekel exchange rate affects the Company's shekel-
denominated expenses. In the Company's estimation, at the current level of operations, each 1% of Shekel revaluation over
the course of a year increases annual expenses of the Company by $ 3m, while a Euro devaluation against the dollar,
when there is an excess of Euro-denominated receipts over payments, results in lower Company revenues. The Company has taken defensive actions in order to reduce exposure, as itemized in section 7.5.
Changes in interest rates - most of the Company’s long-term
loans bear variable interest rates and, accordingly, any additional rise in interest rates might materially affect the Company's profitability. The Company has carried out hedging transactions in order to reduce exposure, as detailed in item
7.4.
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Translation of the Hebrew Language financial statements
Exposure in the context of long-term loan agreements - according to the terms of these loan agreements, the Company
is required to maintain a minimal security ratio of market value
of aircraft to total outstanding loans used to finance the acquisition of the aircraft. Moreover, the Company is obliged to
fulfill several conditions (also due to the transfer of control in the Company), failure of which may lead to demands for
immediate repayment of the loans. The Company’s exposure to market risks in this area derives from the changes taking place
in the global market value of aircraft following unusual security events as well as overcapacity of seats in airline companies
worldwide. Therefore, due to the weight of the long-term liabilities owed by the Company to Israeli banks and in
consideration of the volume of loans provided by these banks to companies in the K'nafaim group, the Company may face
difficulties in obtaining additional substantial loans from Israeli banks that could be necessary for future aircraft equipping and for other investments. 7.2 EL AL’s policy for managing market risks,
the responsibility for managing them, means
of supervision and policy implementation
The Company has a Committee of the Board of Directors for
Market Risk Management, headed by the chairman of the Finance and Budget Committee, which is responsible for establishing policies designed to cover existing risks. The CFO is responsible for carrying out policies and for
reporting to the Committee for Market Risk Management. The Committee for the Management of Market Risks determines the volume of hedging of future consumption of jet fuel. The significance of the financial hedging of jet fuel prices is to insure
the range of purchase prices of jet fuel. In the event of a decrease in the insured jet fuel prices in excess of that range, the Company pays the difference. In the event of a rise in jet fuel prices, the Company receives the difference from the insuring company
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(mostly foreign banks). The aim of the hedging of jet fuel prices is to protect against the exposure of the company to changes in
world jet fuel prices.
The average price of jet fuel in the market during the year of 2006 rose in relation to the year 2005 at the rate of approximately 15%.
(During the three months ended December 31, 2006, it rose by approximately 0.4% as compared to the fourth quarter last year.)
The effect of this price rise on the financial results of the Company is material.
The hedging activities undertaken by the Company have moderated part of the effect of the aforementioned price increase.
Furthermore, the Company has embarked on a process of adjusting flight ticket prices for the purpose of limiting the effect of
jet fuel price increases on the business results.
Accordingly, the hedging policies are: hedging jet-fuel quantities for up to 24 months in advance so that a minimal hedging rate is
established for each period for total expected consumption, with a maximum hedging rate of the total expected consumption in a graduated, declining manner. Accordingly, the maximum hedging rate at the beginning of the period amounted to 80% while the
minimal hedging rate at the end of the period was 20%.
The Company examines its need for investment in financial derivatives from time to time in an effort to reduce exposure to interest risks and currency risks. The Company’s interest-rate policies are as follows: half of its
credit portfolio will be at variable interest rates and half will be at
fixed interest, by means of financial instruments for converting variable interest into fixed rates over a five-year period. For this purpose the Company carried out several financial transactions.
For additional details regarding actual implementation of these
policies -see Sections 7.3, 7.4 and 7.5 below.
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Translation of the Hebrew Language financial statements
7.3 Hedging jet-fuel prices
The Company carries out financial transactions for securing jet- Total Jet-fuel expenses and % fuel prices. As of December 31, 2006, it had executed a of operating revenues number of contracts in order to hedge jet fuel prices in a (in millions US dollars) volume estimated at 52% and 20% of estimated consumption 40% 465.9 for 2007 and 2008, respectively. 450 388.0 30% The following table presents data on the fair value of jet-fuel 281.1 300 28.0% price hedge transactions (recognized for accounting purposes) 191.7 165.2 24.0% 20% outstanding as of December 31, 2006 150 20.3% Type of Transaction’s Fair value 16.4% 15.0% transaction Period currency in thousand US dollars 0 10% HJFP Financial instruments Up to One year US dollar (3,001) 2002 2003 2004 2005 2006 Jet-fuel expenses HJFP Financial instruments Over One year US dollar (1,843) % of operating revenues Total US dollar (4,844)
For more details see Note 20.b.1 to the financial statements.
7.4 Hedging loan interest rates
During 2005 and 2006, the Company entered into several transactions with Israeli banks for hedging the existing
exposure to changes in interest rates in the long-term credit portfolio of the Company. Part of these financial instruments are not recognized for accounting purposes. The fair value of the above financial instruments as of December 31, 2006 was $
2.9m, presented in the balance sheet as other current assets. Other agreements are recognized as hedge transactions for accounting purposes. Following these transactions, about 70% of the Company's outstanding loans as of December 31, 2006
were at fixed interest for horizon of up to five years forward.
It should be noted that part of the above hedging transactions as of December 31, 2006, were ineffective since the interest rate had passed the exit point established in agreements with
the banks as of that date.
For additional details see Note 20a.4 to the financial statements.
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7.5 Hedging exchange rates
During the year 2006, the Company entered into several financial transactions, in an effort to hedge against a decline in the dollar exchange rate against the shekel. These transactions
were not recognized for accounting purposes.
The Company had no currency rate hedging contracts as of December 31, 2006.
As for currency risks and linked balances - see Note 20 to the financial statements.
7.6 Report on sensitivity analysis
The following is a sensitivity analysis of the financial
instruments which are sensitive to possible changes in the risk factors to which they are exposed.
The sensitivity analyses are performed with regard to the fair
value of the financial instruments as of December 31, 2006, unless otherwise stated.
The following is a description of the models for examining the
sensitivity of the fair value of the various financial instruments:
1. Sensitivity to changes in interest rates on long-term liabilities at fixed interest- The fair value is based upon a
computation of the present value of cash flows at the accepted interest rate for a similar loan with similar characteristics (6.3% as of balance sheet date).
2. Hedging of interest- Interest hedge transactions executed by the Company are done by means of financial instruments
with Israeli banks.
The asset basis for these transactions is LIBOR (London Inter Bank Offered Rate) interest for various periods (3 months , 6 months, year),as is accessible on "Reuter" screens, according to which the refund of interest on the Company's loans at
variable interest is determined (plus a margin).
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Translation of the Hebrew Language financial statements
Interest hedge transactions are carried out "back-to-back" in order to avoid additional exposure due to timing differences
between the expiration of the transaction and actual payment
against existing loans, so that the settlement dates conform to the repayment dates of the loans. On the repayment dates of
the loans, the amount of the settlement is calculated for the coming period, on the basis of the interest that was effective
on the market during the two prior business days and pursuant to the predetermined structure of the transaction.
The current interest hedge transactions include options and
future interest rate securing (IRS).
The calculation of fair value of interest hedge transactions is done according to forecasted LIBOR interest. For interest
hedge transactions in which interest securing is carried out , fair value is determined on the basis of the difference between
the interest forecasted and published periodically by the leading banks in the world and the interest denominated for
the transaction, multiplied by the volume of hedging for each period.
In hedging transactions that include options, fair value is determined in reliance on mathematical formulae for pricing options under recognized models.
As of the date of issuance of the report, the banks were not in a position to provide sensitivity analysis and, as a result, the Company was assisted by external entities, included among leaders in their field in Israel and in the world.
3. Jet fuel hedges-jet fuel hedging transactions executed by the Company are carried out by means of trading in financial instruments vis-à-vis world financial and banking leaders active in this market (Morgan Stanley, Goldman Sachs, Merill Lynch, BP, Mitsui, JP Morgan, Societe Generale, Citibank).
The base asset for these transactions is jet fuel in the various markets that serve as the basis for setting the price of jet fuel
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actually paid by the Company, principally jet fuel prices in the Mediterranean Ocean Basin - Jet aviation FOB Med. In addition to this market, the Company purchases jet fuel according to its price in other markets, mainly US Gulf Coast, North West Europe, Singapore.
Jet fuel is a vital raw material for the Company's operations- the Company is obligated to purchase the raw material for purposes of flying the aircraft and there is no substitute or ability to maneuver between costs of this raw material and other raw materials.
The price of jet fuel fluctuates greatly.
As can be seen from the graph, the volatility of the prices of petroleum and jet fuel fluctuates in ranges of 20-70% during certain periods during recent years. During the year 2006, the average volatility for jet fuel prices that was measured was 28%.
The price is set based on a number of parameters, among them:
World oil prices, which include the expectations of the market and supply and demand. The pace of demand for oil and its products has risen during recent years due to global growth
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Translation of the Hebrew Language financial statements
(especially the growth rate of China). The supply of oil and its products is limited by physical and structural factors (oil reserves, production infrastructure, distillation, storage, transport, etc.), as well as by geopolitical and monopolistic factors and effects connected with the large oil producers (OPEC nations).
Price volatility-due to the proximity between limited supply and mounting demand over recent years, each change, or anticipated change, in one of these factors draws immense price volatility (such as: wars and terrorist incidents, shutdowns and breakdowns in the world's large oil refineries, US-Venezuelan relations, etc.)
Seasonal demand- the various refined oil products , including jet fuel, (during the winter, there is high demand for heating fuel, during the summer, there is high demand for gasoline for automobiles. Also, transport costs vary depending upon seasonal risks with respect to ocean transport).
Production costs and infrastructure limitations- the refining prices vary according to the various stresses in the oil refining industry, refining infrastructures, storage and transport of oil and its products have limitations, the cost of developing them is very high and their expansion takes many years (construction of an oil refinery covers about 5-7 years).
In addition, the future prices for oil and its derivatives (including jet fuel) are greatly affected as well by the power of the financial demands of institutional and speculative investment bodies which include these products in their investment portfolios.
b-25 Translation of the Hebrew Language financial statements
From the diagram, one can see that the volume of the market share in futures transactions on these financial entities during the year 2005 was approximately 25%.
In recent years, for different reasons (including the reasons mentioned above), the risk entrenched in the markets and the price fluctuations have been very high. A very high standard deviation of between approximately 20-30% has been derived in latest price quotes received by the Company.
In light of the behavior of the markets, the leading investment houses and analysts in the world have found difficulty in accurately and consistently estimating the trends of price changes. For example, in April 2005, the Goldman Sachs investment firm published a forecast of the probability of soaring crude oil prices in the world to a level of $ 105 per barrel. In June 2005, the chief economist of the Morgan Stanley investment house in Asia issued a projection according to which the price is expected to go down to a level of $ 40-45 for a barrel. It is superfluous to state that both of these forecasts have not been realized up to now and prices have fluctuated during this period in a range of $ 50-75 per barrel.
The forecasting ability of the various investment houses and
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Translation of the Hebrew Language financial statements
analysts presents, at best, the immediate present assessment of the macro economic effects which were in place at the time of the assessment. Additionally, these estimates are calculated according to the different economic analyses of each analyst and investment house. The curve structure of the forwards are unable to predict and, at most, they represent a forecast and the level of risk ingrained in the markets. One of the clear substantiations of this is the transition of the markets from a position of Backwardation to a position of Contango from time to time.
According to the structure of the Company's hedging transactions, on the actual settlement date with the financial entity with which the hedging transactions were contracted (expiration date of the transaction), a computation was made of the price of the strike price of the transaction as compared with the average monthly price of the basis asset (Asiatic options) (published by The Platts Company Division of McGraw Hill Companies which is the authorized and leading international factor for providing information services on the energy market) and represents the accepted attribution point in the area of trading oil and its derivatives. The payment or receipt related to the transaction is executed pursuant to the structure of the transaction as determined in advance.
b-27 Translation of the Hebrew Language financial statements
The financial instruments in which the Company trades (and particularly jet fuel options) are traded "Over the Counter" between the Company and the financial entities with whom the transaction is executed and are not contracts traded directly on the various stock exchanges.
The futures price for jet fuel, as traded in these instruments, are structured from three major components: the price of crude oil, the gas oil crack and the jet differential.
Each of these 3 components is, in practice, traded separately (between the different financial institutions and brokers) and is separately priced.
The pricing of each of the components is influenced by different factors, including the current price, the length of time, the price fluctuation, demand and supply, seasonality, storage costs, transport, etc. and is affected differently by the change in the overall jet fuel price.
This costing is done by every financial entity in a different manner pursuant to the models and algorithms they have developed (based on models such as Black and Scholes, Monte Carlo and others) and against the investment portfolio of that entity.
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Translation of the Hebrew Language financial statements
As is customary in this field by airlines in the world, the companies obtain their estimates of fair value from investment houses with which they execute transactions. These investment houses have macro economic models which take into account the individual behavior of each of the components, the relative mix between the components in the formula, the particular volatility of each component, the interlocking effect between the prices and the volatility between the demand and the supply (flexibility of supply and demand), development in the future of the capabilities for production, distillation, storage and transport (tankers and pipes), world geopolitical predictions and behavior of the cartels, macroeconomic models of growth rates and global demand for energy sources, forecasts of changes in interest and currency rates, projection of creation of alternative energy sources to those being discussed, conduct of the financial markets with relation to trading in securities, relevant derivatives and other factor. All of these elements are processed pursuant to the economic models developed and owned by the various investment houses. These models are capable of generating estimates and forecasts with the qualification that they are accurate the moment that they are generated. Part of the investment houses apply a simulation model, "Monte Carlo", to these estimates in order to foresee the price/value expectancy in the future.
In this report, we are relying on the computations that were made by the various financial entities with whom the transactions were executed (Morgan Stanley, Goldman Sachs, Societe Generale) and transmitted to us. Due to the fact that it was not possible to request the computations in advance from the investment houses, the calculation made by them is a calculation in proximity to the date of issuance of the reports (16.3.2007) and not the balance sheet dates.
b-29 Translation of the Hebrew Language financial statements
The sensitivity analysis of fair value was carried out under the assumption of a uniform change in the final jet fuel price over the entire future price curve at margins of 5%, 10%, upwards and downwards.
Platts formula to calculate the base asset was changed during the year 2001 and, accordingly, the change before that time could not be examined. Beginning from 2001, we did not find that a daily change had taken place that was lower or higher than 10% of the jet fuel prices.
Jet fuel is the most material component of the Company's expenses.
Sensitivity to changes in the NIS/Dollar exchange rates-in thousands U.S Dollars
Gain (loss) from changes Gain (loss) from changes Increase Increase Decrease Decrease 10% 5% Fair value 5% 10% 4.648 4.436 4.225 4.014 3.803 NIS/$ NIS/$ NIS/$ NIS/$ NIS/$ Cash and cash equivalent (1,366) (714) 15,011 789 1,666 Short-term investments (62) (32) 682 36 76 Trade accounts receivable (10) (5) 109 6 12 Receivables (476) (249) 5,227 275 580 Long-term bank deposits (167) (87) 1,836 97 204 Total financial Assets (2,081) (1,088) 22,865 1,202 2,537 Short-term bank borrowings 11 6 (126) (7) (14) Trade accounts payable 2,090 1,092 (22,964) (1,207) (2,548) Payables and other current liabilities 8,770 4,583 (96,361) (5,065) (10,693) Total financial liabilities 10,871 5,682 (119,451) (6,279) (13,255) Exposure in linkage balance sheet due to surplus financial liabilities over financial assets* 8,790 4,594 (96,586) (5,077) (10,718)
* Excluding exposure due to effect of changes in exchange rate on accrued severance pay, net, as described in Section 3.4
b-30
Translation of the Hebrew Language financial statements
Sensitivity to changes in Euro/$ exchange rates- in thousands U.S Dollars:
Gain (loss) from changes Gain (loss) from changes Increase Increase Decrease Decrease 10% 5% Fair value 5% 10% 0.835 0.797 0.759 0.721 0.683 Euro/$ Euro/$ Euro/$ Euro/$ Euro/$ Cash and cash equivalent (48) (25) 530 28 59 Trade accounts receivable (1,080) (565) 11,872 624 1,317 Receivables (78) (41) 857 45 95 Total financial Assets (1,207) (631) 13,259 697 1,471 Short-term bank borrowings 54 28 (595) (31) (66) Trade accounts payable 2,105 1,100 (23,126) (1,216) (2,566) Payables and other current liabilities 258 135 (2,830) (149) (314) Total financial liabilities 2,416 1,263 (26,551) (1,396) (2,946) Exposure in linkage balance sheet due to surplus financial liabilities over financial assets* 1,210 632 (13,292) (699) (1,475)
* Excluding exposure due to effect of changes in exchange rate on accrued severance pay, net, as described in Section 3.4.
Sensitivity to changes in jet fuel prices on inventory ($/gallon)- in thousands U.S dollars:
רווח מהשינויים הפסד מהשינויים סוג המכשיר עלייה ב10%- עלייה ב5%- שווי הוגן ירידה ב5%- ירידה ב10%- 1.641 1.732 1.823 1.914 2.005 $/גלון $/גלון $/גלון $/גלון $/גלון
מלאי דלק סילוני 1,048 524 10,484 (524) (1,048)
Sensitivity to changes in interest rates on the company's liabilities - in thousands U.S dollars:
רווח מהשינויים הפסד מהשינויים סוג המכשיר עלייה ב10%- עלייה ב5%- ירידה ב5%- ירידה ב10%- בשער הריבית בשער הריבית שווי הוגן בשער הריבית בשער הריבית 5.67% 5.99% 6.3% 6.62% 6.93% התחייבויות לזמן ארוך בריבית קבועה 13 6 (3,003) (7) (14)
Note: since most of the loans of the Company are at variable interest, the Company is almost never exposed to a change in fair value of financial obligations due to a change in the market interest rate.
b-31 Translation of the Hebrew Language financial statements
Sensitivity of jet fuel hedges to changes in jet fuel prices – in millions of U.S. dollars- as of 16.03.07
According to the principles of the model, a grouping was made of jet fuel hedging instruments which react similarly to market factors, since there was no loss of material data as a result of the grouping that is needed for purposes of understanding the exposure of the Company to market risks.
Gain from changes Loss from changes Type of Increase Increase Decrease Decrease instrument 10% 5% Fair value 5% 10% 1.938 1.850 1.762 1.674 1.586 $/gallon $/gallon $/gallon $/gallon $/gallon 3 WAY - transactions 10.0 5.4 (2.9) (5.9) (11.1)
The 3-way option instrument is a combination of 3 options with a zero cost cumulative premium.
The structure of the instrument for the Company, which is interested in protection against jet fuel price increases, includes the purchase of a call option with a strike=x and the sale of a put option with a strike>x and a call option with a strike Option Call Put Call Company Buys Sells Sells buys/sells Strike Price X Y The instrument's protection operates in the following manner: When the market price on expiration date is lower than Y, the put option sold by the Company is activated and it pays the difference between the actual market price and Y multiplied by the quantity of fuel hedged in the transaction. b-32 Translation of the Hebrew Language financial statements When the market price upon expiration date is between X and Y, neither of the parties either pays or receives money. When the market price on expiration date is higher than X but lower than Z, the call option purchased by the Company is activated and it receives the difference between the actual market price and Y, multiplied by the quantity of fuel hedged in the transaction. When the market price on expiration date is higher than Z, both the call option (with the X strike) purchased by the Company and the call option (with the Z strike) sold by the Company are activated and, therefore, the Company receives the difference between Z and X only multiplied by the quantity of fuel hedged in the transaction. The structure of the transaction allows the Company to benefit to a certain extent from a decrease in market price, on account of a partial waiver by the Company of protection against price increases. Sensitivity of interest hedges to changes in market interest rates- in thousands of U.S dollars: According to the principles of the model, a grouping was made of interest hedging instruments that react similarly to market factors (SWAP transactions that are not recognized for accounting purposes, IRS transactions recognized for accounting purposes and cylinder transactions recognized for accounting purposes), since there was no loss of material data as a result of the grouping that is needed for purposes of understanding the exposure of the Company to market risks. b-33 Translation of the Hebrew Language financial statements Gain (Loss) from changes Gain (Loss) from changes Type of instrument Increase Increase Decrease Decrease 10% 5% 5% 10% in interest in interest in interest in interest rate rate Fair value rate rate SWAP transactions with KNOCK OUT- not recognized accounting wise (1,231) (870) 2,904 (182) (53) IRS transactions- recognized accounting wise 1,879 1,046 5,534 (965) (1,898) Cylinder transactions- recognized accounting wise 1,293 470 704 (670) (1,002) Total 1,941 646 9,142 (1,817) (2,953) * The fair value was calculated according to market LIBOR interest as of the balance sheet date at the following rates: 3 month LIBOR: 5.36%, 6 month LIBOR: 5.37%, and 12 month LIBOR-5.33%, all according to the subject and to the relevant transaction. 8. Explanation regarding issues to which the independent auditors drew attention in their opinion on the financial statements In their opinion on the Company’s financial statements, the independent auditors drew attention to Note 17a to the financial statements concerning its exposure to lawsuits approved as class actions and to Note 17b, regarding additional legal proceedings against the Company. Although these matters to which the independent auditors drew attention do not affect a change in the uniform wording of the independent auditors, drawing attention is required due to their potential material impact on the Company. 9. Executive compensation See Note 23 q with reference to the compensation agreement with the CEO. As for the options program approved by the Board of Directors, see Note 19h to the financial statements. 10. Policies regarding distribution of dividends The Board of Directors of the Company, meeting on December 28, 2005, adopted a dividends-distribution policy, within the b-34 Translation of the Hebrew Language financial statements framework of which the Company would make an effort, starting in 2006 and forward, to distribute dividends to its shareholders of 20%-40% of its net income (after tax) from the preceding year that was derived from ordinary activities, other than one- time non-operating items and capital gains. Implementation of this policy is contingent upon any applicable statutory laws and the board’s assessment of the Company’s ability to meet its existing and future obligations from time to time, after having taken into account its present and future liquidity, activity and business plans. The adoption of this policy does not diminish the board’s authority to decide, at any time, on changing and/or abolishing this dividend policy and/or approve additional distributions within the limits of the law and/or resolve to reduce the amount to be distributed or avoid any distribution altogether in face of liquidity, activities and changing position of the Company from time to time. 11. Donations EL AL attaches great importance to granting donations and assistance to the needy and the community. The donations for the year 2006 totaled approximately $ 95 thousand. 12. Use of proceeds from securities Based on the commitment made by the Company and the State of Israel, as reflected in the prospectus published in 2003, all proceeds from the issuance of securities by the Company and under the State’s offer of sale, have been deposited in recognized severance-pay funds in order to secure payments to the employees (see Note 15b.4.b to the financial statements). 13. Directors possessing accounting and financial skills a. Pursuant to the Companies Law, 1999, and its related regulations in regard to the reporting of directors possessing accounting and financial skills, the Board of Directors resolved that the minimal number of directors with accounting and b-35 Translation of the Hebrew Language financial statements financial skills would equal one third of the total number of directors serving at any time. As of the date of approval of the financial statements, the board consisted of 10 members and, therefore, that minimal number of directors possessing accounting and financial skills was established at four directors. In light of the volume and complexity of the Company’s activities, it is the opinion of the Board of Directors that this number of directors possessing accounting and financial skills will enable the board to fulfill its obligations, especially as it pertains to the Company’s financial position and preparation and approval of the financial statements. b. The following are details of the directors possessing accounting and financial skills, with an indication of why they should be viewed as such directors: Prof. Israel (Izzy) Borovich - chairman of the board since January 2005. A professor of computers and information technology and currently serves as Deputy Chairman of K’nafaim Holdings Ltd. Mr. Nadav Palti, CPA. - a director since January 2005; currently acts as chairman of MPL Telecommunications Ltd. and CEO of Dori Media Group Ltd. Mr. Eyal Rozner - a director since February 2005. He served as CEO of BMG (Borovich Mozes Group) Ltd. He has attained experience as an economic adviser, investment banker and business analyst. Mr. Simon Katznelson - an external director since December 2003 until December 2006. In February 2007 his position was approved for another period. He holds Master degrees in electrical engineering and public administration and served for five years as assistant and deputy mayor of Ashdod, responsible for financial management and engineering. Since b-36 Translation of the Hebrew Language financial statements June 2003 he has served as chairman of Mif’al Hapais. He has extensive experience in money management. Mr Yair Rabinovich - an external director of the Company since February 2007. A certified public accountant since 1970, owner of a firm dealing in taxation and finances and previously managing partner of a large auditing firm. Also served in the past as commissioner of income and property taxes, as a member of the Advisory Committee on Banking Matters to the Bank of Israel, as a member of the presidium of the Institute of Certified Public Accountants in Israel and as a lecturer in institutions of higher education. 14. Disclosure pertaining to the internal auditor of the Reporting Company The following is an outline pertaining to the internal auditor of the entity: 1. Details of the internal auditor 1.1. The internal auditor’s name is Mr. Ely Reich, CPA. 1.2 The internal auditor began to serve in this position on December 15, 1989. 1.3 The internal auditor meets all of the qualification requirements stipulated by Section 3(a) of the Internal Audit Law. 1.4 The internal auditor complies with the directives of Section 146(b) of the Companies Law and the provisions of Section 8 of the Internal Auditors Law. 1.5 The internal auditor holds options granted to executives of the Company in the context of a 2006 options program. In addition, the internal auditor holds shares granted to all Company employees, by means of a Company employees entity in the framework of privatization of the Company. Over and above this, the internal auditor has no holdings in the securities of the Company or holdings in another entity related b-37 Translation of the Hebrew Language financial statements to it. 1.6 The internal auditor does not have, nor did he ever have, any business connections with the audited entity or any other entity related to it. 1.7 The internal auditor is a full-time Company employee. 2. Method of appointment of the internal auditor The internal auditor was appointed on December 15, 1989 by the person serving at that time as temporary liquidator of the Company, on the basis of his skills (certified public accountant by education and holder of a bachelor's degree in psychology from Tel Aviv University), and in reliance on his experience in the management of corporations with substantial sales volume. The auditor accepted obligations and, accordingly, was granted authority to manage the internal audit of the Company, the directives of which are based upon the laws of the State of Israel. In this framework, an obligation was imposed on the auditor to propose a work program, to perform in accordance with the Company's audit program and to distribute written reports that include findings, conclusions and recommendations. 3. Identity of the superior of the internal auditor The internal auditor is subordinate to the Company’s chairman of the board and the CEO, as provided by the Company's by- laws. 4. Work program A. The work program of the internal auditor is an annual one. B. The work program of the internal auditor is determined according to the following criteria; • The risk to the Company's operations and profitability included in a topic. • The existence of proper controls, applications and b-38 Translation of the Hebrew Language financial statements effectiveness in the audited area. • Suggestions of deputy general managers and division heads. • Previous audit findings and the pace of implementing the recommendations made. • The effect of the matter on passenger service. C. The Chairman of the board, members of the Audit Committee of the Board of Directors and the Company CEO are involved in determining the work program. D. The Chairman of the board, members of the Audit Committee of the Board of Directors and the Company CEO receive the proposed work program each year. They all approve the proposal pursuant to Section 149 of the Companies Law. E. The work program leaves the judgment of whether to deviate from the program in the hands of the internal auditor. F. In the context of his work, the internal auditor also examines material transactions and the procedures to approve them. 5. Audit abroad or of investees The Company auditor also serves as the internal auditor of all of the active subsidiaries, and the work program therefore brings these companies into account. The internal auditor's work program also includes the performance of examinations of Company operations abroad. 6. Extent of employment The internal auditor is employed by the Company on a full time basis and has five full time internal auditors that are subordinate to him. During the year 2006, the work hours of the audit invested in the Company and subsidiaries in Israel and abroad were as itemized below: b-39 Translation of the Hebrew Language financial statements Work hours in regard Work hours in regard Work hours in Total to the Company in to operations aboard* regard to the Israel subsidiaries ** 9,600 1,400 1,000 12,000 * Approximately 50% of the work hours with regard to foreign operations were performed in Israel. ** An audit was performed in three subsidiaries, of which 250 hours were invested with respect to operations outside of Israel. 7. Performance of the audit The Company's internal auditor performs his work pursuant to the Companies Law-1999, the Internal Auditors Law -1992 and the professional standards of the Institute of Internal Auditors in Israel. The chairman of the board holds a wide ranging monthly discussion with the internal auditor regarding his work and the professional standards according to which the auditor works. The Audit Committee holds meetings in which it discusses the work of the internal auditor and the audit standards. Prior to approving the proposed annual audit program, the chairman of the board discusses with the internal auditor, the standards according to which the proposed audit program was formulated and after that, the Audit Committee discusses the proposed audit program and the standards according to which the proposal was formulated, and approves it. 8. Access to information The internal auditor has free, constant and unlimited access to every document and all data in the Company's possession or in the possession of any one of its employees, as well as access to the entire compilation of regular and computerized data, to the full data base and to every automatic data processing system of the Company, including financial data, as mentioned in Section 9 of the Internal Audit Law. b-40 Translation of the Hebrew Language financial statements 9. Internal auditor's report A. The internal auditor's reports are presented in writing. B. During the year 2006, the internal auditor produced three to four reports monthly. A total of 41 reports were presented during the year. The audit reports were presented to the chairman of the board, to the members of the Audit Committee and to the CEO of the Company. C. During 2006, the Audit Committee convened five times to discuss the internal auditor's reports. 10. Evaluation of the internal auditor's activities by the Board of Directors In the opinion of the board of Directors, the range, character and consecutively of the activities of the internal auditor and his work program are reasonable in the circumstances and they are able to achieve the purposes of the internal audit of the entity since they relate to all of the central and significant operations of the Company. 11. Compensation The total salary cost of the internal auditor amounted to approximately NIS 1,398,643. The amount includes the obligation for payments undertaken by the Company for the reporting year, including for purposes of retirement conditions, as well as the value of the benefit with respect to options granted to the internal auditor in the framework of the executive options program during the year 2006, as detailed above. In the opinion of the Company's Board of Directors, the amount of compensation and additional components given to the internal auditor do not impair the ability of the internal auditor to apply independent judgment in carrying out his duties, inter alia, in light of the fact that the audit work is performed by a number of internal auditors. The right to options and shares of the Company was given to the internal auditor in the framework b-41 Translation of the Hebrew Language financial statements of an executive options program and the privatization of the Company under objective criteria, and in the opinion of the Company, does not detract from the independence or judgment of the internal auditor. 15. Disclosure concerning the fees of the independent auditor On November 30, 2005, the Securities Authority published a guideline pursuant to Section 36a(b) of the Securities Law, 1968, concerning disclosure of the independent auditor’s fees for audit and tax services as well as any related services. The following are the fees of Brightman Almagor & Co., certified public accountants, for the year 2006: Fees for audit and audit related services and tax services: $ 359 thousand (2005-$ 361 thousand) for 6,952 working hours. Fees for other services: $ 8 thousand (2005- $ 7 thousand) for 390 working hours 16. Disclosure pertaining to consent for peer review On July 28, 2005, the Securities Authority published a guideline in accordance with Section 36a of the Securities Law, 1968, concerning disclosure of consent to conduct a peer review, aimed, pursuant to the abovementioned guideline, to trigger a procedure of control over the work of independent auditing firms and to examine the compliance with the procedures required during the audit work that they perform, for the purpose of maintaining an advanced capital market. On March 29, 2006, the Board of Directors of the Company approved giving consent to performing the review. b-42 Translation of the Hebrew Language financial statements 17. Disclosure pertaining adoption of international Financial reporting standards (IFRS): In July 2006, the Israel Accounting Standards Board published Accounting Standard No. 29 - "Adoption of International Financial Reporting Standards (IFRS)" (hereafter-"the Standard"). The Standard determines that, from the reporting period commencing on January 1, 2008, financial statements of entities which are subject to the Securities Law and are required to report in accordance with regulations issued in conformance with this law, must be prepared in conformity with International Financial Reporting Standards. The Standard permits early adoption commencing from financial statements that are issued after July 31, 2006. For purposes of the transition, the initial adoption of IFRS will be carried out in accordance with the provisions of IFRS 1, "Initial Adoption of IFRS". Pursuant to the Standard, the Company must include in a note to the financial statements as of December 31, 2007, the balance sheet data as of that date and the data from the statement of operations for the year ended on that date, after the recognition, measurement and presentation rules of IFRS standards have been applied to them. Company management is examining the implications of the transition to IFRS standards, but is unable at this stage to assess the effect on the financial statements of the adoption of the standards. In the context of the Company's preparations for the process of adopting financial reporting pursuant to IFRS standards, the Company has established a team headed by the deputy CEO- finances of the Company. b-43 Translation of the Hebrew Language financial statements The following is the process as determined by the appointed team: • Studying the IFRS standards and charting the IFRS standards that are relevant to the Company and that require an intensive examination of their implications for the financial statements. • Detect and identify initial disparities between generally accepted accounting principles in Israel currently implemented by the Company and the IFRS standards relevant to the Company. • Examination of the possible alternatives under IFRS for the accounting principles selected by the Company. • Selection and formulation of the Company's accounting policies, including investees, under IFRS standards. • Qualitative examination of the principal effects anticipated to be derived by the Company as the result of adopting the IFRS standards. • Examination of the effect on the financial statements as of the transition date (January 1, 2007) as the result of adopting IFRS 1, including checking the various relieves and prohibitions stipulated by IFRS 1. • Quantitative examination of the primary accounting implications anticipated to be derived by the Company as the result of adopting the IFRS standards, on the basis of the accounting policies chosen and the relieves which it was decided to adopt. • Preparation of balance sheet and statement of operations as of December 31, 2007 in accordance with IFRS standards. Until these financial statements are issued, the Company began to study the IFRS standards, to detect and chart the initial discrepancies between generally accepted accounting principles in Israel and the IFRS, as is relevant for the Company, examination of relieves that will be adopted as permitted by IFRS 1 and examination of accounting policies, including the performance of a qualitative test of the effects that are anticipated to result from the adoption of the IFRS policies. b-44 Translation of the Hebrew Language financial statements In the context of the transition to reporting according to IFRS standards, the Company will consider, as it is called for, the incorporation of external experts into the process. The following is a description of the subjects with the most significant consequences that are to be expected from the transition to reporting according to IFRS, as they have been identified at this stage, on the Company's consolidated financial statements, including changes that might take place in the accounting policies of the Company as a result of this transition: Fixed assets: effective January 1,2007, Accounting Standard Number 27 will apply in Israel which precedes the implementation of IAS 16 on which it is based. See Note 2.Z.2 to the financial statements for details on the standard and its implications for the Company. Obligations for the termination of employee-employer relationships: In accordance with generally accepted accounting principles in Israel, obligations for termination of employee-employer relationships are recognized on the basis of the full liability, on the assumption that all of the employees terminated employment on the balance sheet date under conditions entitling them to full severance pay, without considering discount rates, rates of forthcoming wage increases and retirements in the future. According to IAS 19, post-retirement benefits that relate to defined benefit plans are to be measured, inter alia, on the basis of actuarial estimations and discounted amounts. Contingent liabilities and recognition of provisions: in accordance with IFRS, a provision should be recognized when it is more likely than not that the Company will be need economic resources in order to settle an obligation as stipulated by IAS 37. The amount of the provision will be b-45 Translation of the Hebrew Language financial statements determined by the Company on the basis of its estimate of the value of settling the claim. Additionally, the provision is to be measured according to its present value when the effect of the passage of time is material. Under generally accepted accounting principles in Israel, the Company recognizes a provision if it is probable that economic resources will be used in order to settle an obligation. The provision is also measured at full value and not at present value. Financial instruments-recognition and measurement-Standard IAS 39 deals with a wide range of subjects, including the measurement and timing of recognition of financial assets and liabilities. New, stringent conditions have been defined that are required for purposes of accounting recognition of financial instruments designated for hedging. All of the various hedging devices will be presented in the balance sheet at their fair value, the changes in fair value will be recorded to operations (for speculative instruments not meeting the conditions required in order to recognize them as hedging devices), or to shareholders' equity (for instruments that are designated for hedging forecasted cash flows and which comply with the conditions necessary for hedging devices). Furthermore, the standard deals with the treatment of derivatives, including embedded derivatives, and the treatment of early repayment and refinancing (including changes in the terms of loans). The Company completed the needed allocation and documentation by the transition date (1.1.07) in order to allow its hedging instruments to be recognized for accounting purposes from that date onwards, if the Company will be so interested. b-46 Translation of the Hebrew Language financial statements At this stage, the Company is deliberating the effect that IAS 39 will have on its financial statements that will be prepared according to IFRS standards. Financial instruments-disclosure and presentation: the Company issued options (Series 1) with an exercise increment denominated in NIS, linked to the index. According to Standard IAS 32, at the time of initial transition to the international standards, it will be necessary to present liabilities with respect to these options against retained earnings, in accordance with their overall market value on that date, and as of every cut-off date through the expiration date of the options or their conversion (June 2007), it will be necessary to update the liability against operations pursuant to market value. 18. Subsequent events As for events subsequent to the balance-sheet date - see Note 25 to the financial statements. The Board of Directors thanks the Company’s management and employees for their devoted labors and their efforts for the development of the Company and the advancement of its business. Haim Romano Prof. Israel (Izzy) Borovich Chief Executive Officer Chairman of the Board March 21, 2007 b-47 Translation of the Hebrew Language financial statements Appendix to the Directors' report on the Company’s 2006 business affairs Minimal disclosure required in and in relation to valuations and rules pertaining to their inclusion with reports required by the guideline of the Securities Authority pursuant to Section 36a of the Securities Law, 1968 Valuation of the 747-400 fleet of aircraft a. Preface Accounting Standard No.15 (“Asset Impairment”) was approved by the professional committee of the Israeli Accounting Standards Board. The standard is based on International Accounting Standard No.36, which establishes rules for the required accounting treatment, presentation and disclosure in the event of impairment in the value of assets. The standard’s objective is to establish rules to be followed by a company in order to ensure that its assets are not presented in amounts exceeding their recoverable values. An asset that is presented in the financial statements at an amount above its recoverable value and its book value exceeds the amount to be received from the use of the asset or its realization indicates that impairment in its value has occurred and, accordingly, based on Standard No.15, the company must recognize a loss from impairment. The following document presents the highlights of a valuation carried out by management of EL AL Israel Airlines Ltd. (hereafter "EL AL or "the Company") in order to ascertain whether it is necessary to recognize any impairment in the value of its 747-400 fleet of aircraft (“the Fleet”), under Standard No. 15 and in accordance with the guideline of the Securities Authority. This document has been prepared in accordance with the guideline of the Securities Authority, based on paragraph 36A of the Securities Law, 1968 concerning the minimal disclosure required in and in connection with valuations as well as to the rules pertaining to their inclusion in reporting pursuant to the Securities Law, 1968. b. Details and Identification of the assets group The group of assets for which a valuation was performed includes the 4 aircraft of the 747-400 fleet owned by the company. b-48 Translation of the Hebrew Language financial statements c. Effective date of the opinion March 2007. The valuation is based on the 2006 financial data plus financial forecasts for future years. d. Appraiser The valuation was carried out by EL AL management. e. Circumstances giving rise to performing a valuation according to Standard 15 The Fleet’s book value is higher than market value, as it appears in pricelists published by AVAC - the Aircraft Value Analysis Company. It should be noted that the use of market value for aircraft based on pricelists published by AVAC is common and acceptable by airlines around the globe as well as financing banks and it also serves EL AL in its various agreements with banks. As noted, Standard No.15 states that a company should record a provision for impairment in the value of its assets whenever book value exceeds recoverable amount. The recoverable amount is the higher between net selling price or value in use. Net selling price is the amount received from the sale of the asset in a transaction executed in good faith at arm’s length. The asset’s value in use equals the present value of future cash flows expected from the continued use of the asset and its realization at the end of the period of use. The Company considers the assets’ market value (as determined by AVAC) as representing net selling price. As of the date of this valuation, the Company has examined the value in use of its owned aircraft currently in use and whose net book value in the Company’s balance sheet at December 31, 2006 exceeds their selling price. As of the date of this valuation, the selling price of the aircraft (see item b above) amounts to $ 262m as compared to net book value for the same aircraft of $ 275m as of December 31, 2006. f. Valuation method The valuation was carried out by the cash-flow-capitalization method, according to which estimates of expected future cash flows from the use of the Fleet were capitalized. The following major assumptions were used in the computations: • Useful life - 9 years of activity (and aircraft realization at net selling price after a nine-year period). • Expected cash flows from operating activities - management estimated that the cash b-49 Translation of the Hebrew Language financial statements flows from operating the Fleet during 2006 amounted to $ 59m. This computation was based on the Fleet’s revenues net of commissions and variable expenses attributed to the Fleet and net of fixed cash outlays, such as security and maintenance which may be allocated in proportion to the Fleet’s operating cost. • Disposal value at the end of useful life (i.e., nine years), which has been computed based on the AVAC forecasts, amounts to $ 83m (non-discounted values). • Growth rates: due to considerations of conservatism, real future growth in the activities of Company from this Fleet has not been taken into account (actual 2006 results were taken into account in this forecast for the 9 future years). • Discount rate: assumed at 8%, which - in management’s opinion -adequately reflects the Company’s capital cost. • Fleet’s future Load Factor was set at a fixed rate, similar to 2006. • Company’s effective tax rate during the next 9 years - zero. • The Company assumes that during the next 9 years, the Fleet will be used as passenger aircraft. • The Company assumes that there is no need for unexpected investments for those aircraft in order to be able to continue to use them. g. Value determined based on cash-flow capitalization 2007 2008 2009 2010 2011 2012 2013 2014 2015 Total in millions $ Total capitalized 57 52 48 45 42 38 36 33 30 381 cash flows Total capitalized ------42 42 disposal value (at the end of nine years) Total Fleet’s value based on the cash-flow capitalization approach - $423m b-50 Translation of the Hebrew Language financial statements The following is an a sensitivity analysis to the Fleet’s value in case of a change in the discount price, a change in the price of jet fuel and a change in the cash contribution, which - in the Company's opinion - constitute key factors that may alter the useful- value forecasts. Capitalization rate / annual contribution 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% (in thousands US dollars) 30,000 259,358 253,302 247,464 241,834 236,404 231,164 226,107 221,224 40,000 329,386 321,992 314,858 307,972 301,323 294,902 288,699 282,705 45,000 364,400 356,338 348,555 341,041 333,783 326,771 319,995 313,445 50,000 399,413 390,683 382,252 374,110 366,243 358,640 351,291 344,185 58,743 460,639 450,739 441,175 431,934 423,002 414,367 406,016 397,937 60,000 469,441 459,373 449,646 440,248 431,163 422,379 413,883 405,665 65,000 504,455 493,718 483,344 473,316 463,622 454,248 445,180 436,405 Sensitivity analysis pertaining to jet-fuel price and asset utilization over nine years Jet-fuel price annual NPV Net book The surplus contribution value of NPV over net book value (cent per Gallon) in millions $ 165 60 434 275 159 174 60 428 275 154 183 59 423 275 148 192 58 418 275 143 201 57 412 275 138 b-51 Translation of the Hebrew Language financial statements h. Summary The following table presents a summary of the computation as of March 2007: Computation of recoverable amount: Net selling price Company’s value Company’s recoverable in use amount - the higher of the two in millions $ 262 423 423 Should a provision for impairment be recorded? Fleet’s net book Fleet’s recoverable Should a provision value - amount to EL AL - for impairment be December 31, 2006 December 31, 2006 recorded? in millions $ 275 423 NO This valuation is effective as of the date it was prepared and is based on the 2006 financial data as well as income and expense estimates for the coming 9 years. Any change in the assumptions outlined above may change this valuation and, consequently, require the Company to record a provision for impairment of value. b-52 Translation of the Hebrew Language financial statements ______ 2006 ANNUAL REPORT CHAPTER C 2006 FINANCIAL STATEMENTS Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. FINANCIAL STATEMENTS AS OF DECEMBER 31, 2006 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD FINANCIAL STATEMENTS AS OF DECEMBER 31, 2006 C o n t e n t s Page Independent auditors' reports C-1 – C-2 Balance sheets C-3 – C-4 Statements of operations C-5 Statement of changes in shareholders' equity C-6 Statements of cash flows C-7 – C-9 Notes to the financial statements C-10 – C-104 Appendix A - List of Principal Investees C-105 -=-=-=-=-=- Translation of the Hebrew Language financial statements Brightman Almagor 1 Azrieli Center Tel Aviv 67021 P.O.B. 16593, Tel Aviv 61164 Israel Tel: +972 (3) 608 5555 Fax: +972 (3) 609 4022 [email protected] www.deloitte.com INDEPENDENT AUDITORS' REPORT TO THE SHAREHOLDERS OF EL AL ISRAEL AIRLINES LTD. We have audited the attached balance sheets of El Al Israel Airlines Ltd. ("the Company") as of December 31, 2006 and 2005 and the consolidated balance sheets as of those dates, and the statements of operations, changes in shareholders' equity and cash flows - of the Company and on a consolidated basis - for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s Board of Directors and management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of subsidiaries, whose assets included in consolidation constitute 0.9% and 0.8% of total consolidated assets as of December 31, 2006 and 2005, respectively, and whose revenues constitute 0.4% of total consolidated revenues for each of the three years ended December 31, 2006, respectively. The financial statements of those subsidiaries were audited by other auditors, and our opinion, insofar as it relates to the amounts included in respect thereof, is based on the reports of those other auditors. We conducted our audits in accordance with generally accepted auditing standards, including those prescribed by the Israeli Auditors’ Regulations (Mode of Performance), 1973. 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 the board of directors and 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, based on our audits and the reports of other auditors as noted above, the financial statements referred to above present fairly, in all material respects, the financial position - of the Company and on a consolidated basis – as of December 31, 2006 and 2005, and the results of operations, changes in shareholders’ equity and cash flows- of the Company and on a consolidated basis - for each of the three years in the period ended December 31, 2006, in conformity with generally accepted accounting principles. In addition, it is our opinion that the financial statements referred to above are prepared in accordance with the Israeli Securities Regulations (Preparation of Annual Financial Statements), 1993. C-1 Translation of the Hebrew Language financial statements As explained in Note 2b, the financial statements referred to above are presented in U.S. dollars, in accordance with accounting standards of the Israeli Accounting Standards Board. Without qualifying our above opinion, we draw attention to the contents of Note 17a to the financial statements with regard to the Company’s exposure to lawsuits approved as class actions, the contents of Note 17b to the financial statements-regarding additional legal proceedings against the Company and the contents of Note 25a to the financial statements concerning claims filed against the Company subsequent to the balance sheet date. The accompanying financial statements are a translation of the original Hebrew-language audited financial statements. Brightman Almagor & Co Certified Public Accountants A member firm of Deloitte Touche Tohmatsu Tel Aviv, March 21, 2007 C-2 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. BALANCE SHEETS Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 Note (in thousand US dollars) Current assets Cash and cash equivalents 146,158 93,929 139,408 86,615 Short-term investments 3 4,682 112,834 4,000 111,740 Trade accounts receivable 4 131,027 (*)126,700 127,483 (*)124,305 Receivables and other current assets 5 47,342 (*)45,830 49,394 (*)46,409 Deferred income taxes 22.d 30,645 46,698 30,171 46,173 Inventory 6 17,190 22,445 16,464 21,833 377,044 448,436 366,920 437,075 Investments Long-term bank deposits 7a 1,836 1,779 1,836 1,779 Investment in another company 7b 1,829 1,878 1,829 1,878 Investees 8 2,280 2,189 11,275 11,870 5,945 5,846 14,940 15,527 Fixed assets 9 1,148,389 1,163,765 1,146,216 1,161,500 Other assets 10 3,455 4,671 3,455 4,671 1,534,833 1,622,718 1,531,531 1,618,773 (*) Reclassified The accompanying notes are an integral part of the financial statements. C-3 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. BALANCE SHEETS Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 Note (in thousand US dollars) Current liabilities Short-term borrowings and current maturities 11 105,100 75,713 105,100 75,713 Trade accounts payable 12 143,473 155,046 143,924 155,647 Payables and other current liabilities 13 339,287 324,546 335,578 320,039 587,860 555,305 584,602 551,399 Long-term liabilities Long-term loans from financial institutions 14 566,104 627,363 566,104 627,363 Accrued severance pay, net 15 119,575 120,526 119,816 120,837 Deferred income taxes 22.d 30,268 46,300 30,171 46,173 Other long-term liabilities 16 730 2,215 542 1,992 716,677 796,404 716,633 796,365 Total liabilities 1,304,537 1,351,709 1,301,235 1,347,764 Contingent liabilities, guarantees, commitments and liens 17,18 Shareholders' equity Share capital 19 131,536 131,318 131,536 131,318 Premium on shares 904 826 904 826 Capital reserve from transactions with a former controlling party 299,894 299,119 299,894 299,119 Capital reserve from employees' option program 2,582 - 2,582 - Accumulated deficit (204,620) (160,254) (204,620) (160,254) 230,296 271,009 230,296 271,009 1,534,833 1,622,718 1,531,531 1,618,773 Prof. Israel (Izzy) Borovich Haim Romano Nissim Malki Chairman of the Board Chief Executive Officer Chief Financial Officer Approval date of financial statements – March 21, 2007. The accompanying notes are an integral part of the financial statements. C-4 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. STATEMENTS OF OPERATIONS Consolidated Company Year ended December 31, Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 2 0 0 6 2 0 0 5 2 0 0 4 Note (in thousand US dollars) Operating revenues 21a 1,665,446 1,619,469 1,386,180 1,654,373 1,608,447 1,375,351 Operating expenses 21b 1,402,652 1,243,198 1,071,027 1,397,494 1,238,864 1,067,190 Gross profit 262,794 376,271 315,153 256,879 369,583 308,161 Selling expenses 21d 187,805 198,591 175,517 187,371 197,945 174,496 General and administrative expenses 21e 91,952 88,758 81,779 86,335 83,349 76,339 279,757 287,349 257,296 273,706 281,294 250,835 Operating income (loss) before net financing expenses (16,963) 88,922 57,857 (16,827) 88,289 57,326 Net financing expenses 21f 29,492 20,606 17,469 29,732 20,727 17,536 Operating income (loss) after net financing expenses (46,455) 68,316 40,388 (46,559) 67,562 39,790 Other income (expenses), net 21g 1,806 (4,519) (8,685) 1,824 (4,628) (8,710) Pre-tax income (loss) (44,649) 63,797 31,703 (44,735) 62,934 31,080 Income taxes 22 134 304 88 - - - Income (loss) after income taxes (44,783) 63,493 31,615 (44,735) 62,934 31,080 Company's equity in earnings of affiliates, net 21h 417 633 1,484 369 1,192 2,019 Net income (loss) for the year (44,366) 64,126 33,099 (44,366) 64,126 33,099 Basic earnings (loss) per share of NIS 1.00 par value (in US dollars): 2u (0.11) (*) 0.16 (*) 0.08 Number of shares used in computation (in thousands)-basic 400,680 399,633 395,757 Diluted earnings (loss) per share of NIS 1.00 par value (in US dollars): 2u (0.11) 0.13 0.07 Number of shares used in computation (in thousands)- diluted 400,680 495,721 495,721 (*) Restated-see Note 2u The accompanying notes are an integral part of the financial statements. C-5 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY Capital reserve Differences from Capital reserve from transactions from translation with a former employees' of investees’ Share Premium controlling option financial Accumulated capital on shares party program statements Deficit Total ( I N T H O U S A N D U S D O L L A R S ) Balance - January 1, 2004 130,385 691 234,932 - 2,058 (257,479) 110,587 Differences from the translation of investees’ financial statements - - - - 174 - 174 Reduction in the participation of the Government of Israel in issuance expenses - (181) - - - - (181) Receipts on account of debt owed by the Government of Israel (3) - - 38,396 - - - 38,396 Exercise of options into shares 555 189 - - - - 744 Net income for the year - - - - - 33,099 33,099 Balance - December 31, 2004 130,940 699 273,328 - 2,232 (224,380) 182,819 Differences from the translation of investees’ financial statements - - - - (104) - (104) Realization of investment in an investee - - - - (2,128) - (2,128) Receipts on account of debt owed by the Government of Israel (3) - - 25,791 - - - 25,791 Exercise of options into shares 378 127 - - - - 505 Net income for the year - - - - - 64,126 64,126 Balance - December 31, 2005 131,318 826 299,119 - - (160,254) 271,009 Receipts on account of debt owed by the Government of Israel (3) - - 775 - - - 775 Exercise of options into shares (2) 218 78 - - - - 296 Value of benefit of employee's option program (1) - - - 2,582 - - 2,582 Loss for the year - - - - - (44,366) (44,366) Balance - December 31, 2006 131,536 904 299,894 2,582 - (204,620) 230,296 (1) See Note 19h (2) See Note 19c. (3) See Note 15b.4 The accompanying notes are an integral part of the financial statements. C-6 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. STATEMENTS OF CASH FLOWS Consolidated Company Year ended December 31, Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) for the year (44,366) 64,126 33,099 (44,366) 64,126 33,099 Adjustments required to present net cash flows provided by operating activities - Appendix A 117,802 119,493 143,204 117,715 118,055 142,596 Net cash provided by operating activities (*) 73,436 183,619 176,303 73,349 182,181 175,695 CASH FLOWS FOR INVESTING ACTIVITIES Investment in other assets (1,188) (1,485) (1,743) (1,188) (1,485) (1,743) Additions to fixed assets (including payments on account of aircrafts) (104,194) (82,822) (48,638) (103,759) (82,427) (48,170) Proceeds from disposition of fixed assets 6,965 954 557 6,955 883 555 Decrease (increase) in short-term deposits, net 107,912 (26,428) (79,727) 107,500 (26,000) (80,500) Investment in suppliers’ deposits (82) (121) (41) (82) (121) (41) Repayment of suppliers’ deposits 73 130 82 73 130 82 Redemption of long-term deposits 560 678 790 560 678 790 Investment in long-term deposits (226) (368) (245) (226) (368) (245) Proceeds from realization of investments in investees - 13,656 - - 13,656 - Decrease (increase) in investments and loans to investees, net 326 151 446 964 227 (229) Net cash provided by (used in) investing activities 10,146 (95,655) (128,519) 10,797 (94,827) (129,501) CASH FLOWS FOR FINANCING ACTIVITIES Proceeds from exercise of options into shares 296 505 744 296 505 744 Receipt of long-term loans from financial institutions 40,000 14,169 - 40,000 14,169 - Repayment of long-term loans from financial institutions (67,745) (77,160) (76,219) (67,745) (77,160) (76,219) Receipt of other long-term loans 1,014 - 6,258 1,014 - 6,258 Repayment of other long-term loans (2,248) (2,017) (191) (2,248) (2,010) (164) Loans arrangement fees (1,080) - - (1,080) - - Increase (decrease) in short-term borrowings, net (1,590) 5,821 56 (1,590) 5,821 56 Net cash used in financing activities (31,353) (58,682) (69,352) (31,353) (58,675) (69,325) Increase (decrease) in cash and cash equivalents 52,229 29,282 (21,568) 52,793 28,679 (23,131) Cash and cash equivalents at the beginning of the year 93,929 64,647 86,215 86,615 57,936 81,067 Cash and cash equivalents at the end of the year 146,158 93,929 64,647 139,408 86,615 57,936 (*) et cash provided by operating activities, without the deposit of the issuance proceeds in the severance-pay fund for covering past liabilities (see Note 15b.4.b), follow: 73,732 184,154 177,015 73,645 182,716 176,407 The accompanying notes are an integral part of the financial statements. C-7 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. STATEMENTS OF CASH FLOWS Appendix A – Adjustment to present cash flows provided by operating activities Consolidated Company Year ended December 31, Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Income and expenses not involving cash flows: Depreciation and amortization (including disposals of accessories and components no longer in use and consumption of disposable equipment) 117,943 108,269 111,108 117,443 107,684 110,534 Adjustment in the value of long-term deposits (151) 108 (5) (151) 108 (5) Equity in earnings of investees, less dividend received, net (**) (417) (273) (562) (369) (832) (1,097) Deferred taxes 21 (77) (574) - - - Decrease in accrued severance-pay, net (1,259) (10,298) (4,326) (1,329) (10,250) (4,249) Capital gains from disposition of fixed assets, net (6,212) (590) (247) (6,229) (585) (245) Capital gain from realization of investment in investees - (8,297) - - (8,297) - Adjustment in value of suppliers’ deposits 58 (51) (68) 58 (51) (68) Increase in capital reserve from employees option program 2,582 - - 2,582 - - Changes in assets and liabilities: Increase in trade accounts receivable (4,327) *(15,521) (19,789) (3,178) *(16,067) (20,688) Decrease (increase) in payables and other current assets 93 *(13,233) (1,780) (1,380) *(12,827) (1,937) Decrease (increase) in inventory 5,255 (12,970) 5,585 5,369 (12,941) 5,672 Increase (decrease) in trade accounts payable (11,573) 18,920 26,149 (11,723) 18,248 27,438 Decrease in other current liabilities 15,824 53,566 27,777 16,622 53,865 27,241 Decrease in other long-term liabilities (35) (60) (64) - - - 117,802 119,493 143,204 117,715 118,055 142,596 (*) Reclassified. (**) Dividends received - 360 922 - 360 922 The accompanying notes are an integral part of the financial statements. C-8 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. STATEMENTS OF CASH FLOWS Appendix B – Non- cash transactions Consolidated Company Year ended December 31, Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Deposits made by the Government of Israel in an employees’ severance-pay fund (Note 15b.4.b) 775 25,791 38,396 775 25,791 38,396 Refunds due from the Government of Israel in respect of issuance expenses - - (181) - - (181) The accompanying notes are an integral part of the financial statements. C-9 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 1 - GENERAL a. Operations EL AL Israel Airlines Ltd (hereafter-"the Company") was incorporated on November 15, 1948 as a public company. The Company is the Israeli designated carrier on most routes to and from Israel, other than a number of routes on which other Israeli carriers were granted the status of designated carriers (see Notes 10c). An additional Israeli carrier was also granted certificate as a cargo carrier. The Company is primarily engaged in the transport of passengers and cargo, including luggage and mail, on scheduled flights and charter flights between Israel and foreign countries. Passenger transport on charter flights is carried out mainly by Sun D'Or International Airlines Ltd (hereafter: "Sun D'Or"), a wholly owned subsidiary of the Company. The Company is also engaged in leasing flight equipment, providing luggage-handling and maintenance services at its home airport, sale of duty-free products and - through investees - related activities, mainly production and supply of meals for aircraft and management of several travel agencies in Israel and abroad. The financial statements of the Company have been prepared in accordance with the Securities Regulations (Preparation of Annual Financial Statements), 1993. b. Privatization 1. Starting June 6, 2004 EL AL is defined as a “mixed company” pursuant to the Government Corporations Law, 1975, which defines “mixed company” as one that is not a government corporation, with half or less of the voting rights in its General Meetings or the right to appoint half or less than its directors in the hands of the State. As of December 31, 2006, the State held 20.97% of the ownership and voting rights in the Company, in addition to the rights derived from the Special State Share. 2. On June 2, 2004, following the exercise of options that it held into shares of the Company, K’nafaim Holdings Ltd. (“K’nafaim”) became an interested party in the Company. In January, 2005, the Company’s Board of Directors appointed Prof. Israel (Izzy) Borovich as its chairman and Mrs. Tamar Mozes Borovitz as deputy chairman of the board. In addition, new directors were appointed, replacing all the former ones (except for public directors) who were terminated at that time. Accordingly, starting at that time, K’nafaim became the Company’s controlling party. As of December 31, 2006, K'nafaim held 39.49% of the ownership and voting rights in the Company. 3. A company established by the Company’s employees called “Holdings in Trust of EL AL Employees Ltd. (hereafter-"the Employees Corporation") acquired on February 23, 2005 from the Government of Israel a total of 32,527,216 ordinary shares, pursuant to an undertaking document granted by the State to the employees’ representatives. Thus the Employees Corporation became an interested party in the Company. As of December 31, 2006, the Employees Corporation held 8.12% of the Company’s issued and outstanding share capital. C-10 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 1 - GENERAL (Cont.) b. Privatization (cont.) 4. On August 5, 2004 the Company was informed by the Commissioner for Restrictive Trade Practices (“the Commissioner”) of his decision concerning the merger between K’nafaim and EL AL. Accordingly, K’nafaim would be allowed to increase its holdings of Company shares above 25%, subject to the terms stipulated in the decision, which also stated that since K’nafaim is a shareholder in the Company, it would present any arrangement between EL AL and another Israeli carrier to the approval of the Commissioner. In addition, being a shareholder, K’nafaim would do everything necessary to cease or transfer the charter flights of the Company or any of its subsidiaries, including any activity related to the charter operations of Sun D’Or, to an independent third party wherever the Company operates scheduled flights, other than places where another Israeli carrier also operates scheduled flights. On January 5, 2005 the Company appealed the Commissioner's decision with the Court for Restrictive Trade Practices while also asking the court for an interim injunction in regard to the conditions stipulated in the Commissioner’s decision. On March 14, 2005, the Company and the Commissioner accepted the court’s proposal for a voluntary conclusion of the appeal against the Commissioner’s stated conditions. Pursuant to this understanding, it was agreed that the stated condition stipulating that K’nafaim, being a shareholder in the Company, would do everything necessary to cease or transfer the charter flights of the Company wherever the Company operates schedules flights, will not go into effect prior to two years subsequent to March 14, 2005. The condition whereby K’nafaim, being a shareholder in the Company, would present any arrangement between the Company and another Israeli carrier to the approval of the Commissioner will not go into effect prior to the end of the year following March 14, 2005. The Commissioner would be able within, 120 days preceding the end of the period referred to above, to reimpose any or all of the conditions upon K’nafaim if he believes that a basis for it exists at the time. Before imposing the conditions, the Commissioner will grant the Company the right to a hearing and if the Company appeals the conditions, they will be postponed for a period of six months during which the court will decide on their effect. The parties’ agreement was approved by a consent judgment of the Court. On December 29, 2005, the Commissioner informed the Company that it was considering the imposition on K’nafaim of the condition which states that, being a shareholder in the Company, it would act to submit any arrangement between the Company and another Israeli carrier for the approval of the Commissioner. In addition, the Commissioner required that the Company provide information pertaining to any agreements, arrangements or understandings between the Company and Arkia as well as between the Company and Israir, and on negotiations being carried on between the companies. On March 14, 2006, following the Commissioner’s request, the Company decided to consent to a one-year postponement in the period of time allotted to the Commissioner in the compromise arrangement for the imposition of the abovementioned condition (i.e., two years instead of one). The remaining conditions stipulated in the compromise agreement regarding the manner of imposing the condition, as described above, would remain in effect during the period of the deferral. Following a request by the Commissioner, on January 28, 2007, the Company decided to agree to a deferral for an additional year of the time period allotted by the Commissioner for imposing such condition (that is, three years instead of two). C-11 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES a. Definitions for these financial statements: 1. Subsidiary – a company controlled by the Company in excess of 50%, the financial statements of which are, directly or indirectly, fully consolidated with the Company’s financial statements. 2. Affiliate – a company, other than a subsidiary, in which the Company exercises material influence and the Company’s investment therein, is accounted for by the equity method. 3. Investees - subsidiaries and affiliates. 4. The Group - the Company and its investees. 5. Another company – a company in which the Company's investment does not grant the Company material influence over the other company’s financial and operating policies. 6. Related parties - as defined in Opinion No.29 of the Institute of Certified Public Accountants in Israel 7. Interested parties - as defined in the Securities Regulations (Preparation of Annual Financial Statements), 1993. 8. Dollar – the U.S. dollar. 9. Controlling party - as defined in the Securities Regulations (Presentation of Transactions between the Company and Its Controlling Party in the Financial Statements), 1996. 10. Former controlling party - on the approval date of these financial statements - the State of Israel. 11. “Date near the approval date of the financial statements” - March 11, 2007, unless otherwise indicated. b. Financial statements in U.S. dollars 1. General The financial statements are presented under the historical cost convention in U.S. dollars. The Group companies operating in Israel maintain their accounts, on a current basis, in nominal shekels and dollars. The Company’s overseas branches and the main foreign investees maintain their accounts in foreign currency (mainly dollars). The Group's transactions are mostly carried out in foreign currency, mainly in dollars, with Group revenues received primarily in foreign currency or linked thereto and its principal fixed assets mainly paid for in dollars. Accordingly, the dollar is the currency of the economic environment in which the Group operates ("functional currency") and thus the currency of measurement in these financial statements. The term "cost" in these financial statements refers to the cost in dollars, unless otherwise stated. Appendix B to the financial statements is a translation in Hebrew of the financial statements, and this according to Regulation 4 of the Israely Securities Regulations (Preparation of Annual Financial Statements), 1993. C-12 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES Cont.) b. Financial statements in U.S. dollars (Cont.) 2. Balance sheet Balances in other currencies have been translated into dollars, as follows: Non-monetary items have been translated at the exchange rate of the dollar ("the rate") in effect at acquisition (or origination). Monetary items (items reflecting current or realizable value) have been translated at the rate in effect at the financial statements date. The values of non-monetary assets do not necessarily represent realization value or economic value in real terms and, therefore, these amounts should not be construed as either representing dollars receivable or payable or convertible into dollars. 3. Statement of operations Sales revenues and expenses, other than financing and expenses arising from non-monetary items, have been translated at the rate in effect on the transaction date. Expenses deriving from non-monetary items and components relating to balance-sheet accruals have been translated concurrently with the translation of the corresponding balance- sheet item. Exchange-rate differences relating to monetary assets and liabilities have been allocated to operations in the financing section, except for those relating to obligations for the termination of employee-employer relationships, which were recorded to wage expense. 4. Translation of investees’ financial statements The financial statements of part of the branches abroad and part of the investees, the operations of which are not autonomous are prepared in local currency and translated in accordance with what is described in items b2 and b3 above. Differences resulting from such financial statement translation differences are, accordingly, included in the statement of operations in the financing section. c. Consolidation financial statements The consolidated financial statements include the financial statements of the Company and all of its (over 50%) controlled companies. Material inter-company balances and transactions have been eliminated. A list of the main active investees is presented appendix A to the financial statements. d. Cash and cash equivalents Cash and cash equivalents include bank demand deposits as well as unrestricted time deposits with original maturities not exceeding three months. C-13 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) e. Allowance for doubtful debts The allowance is computed for specific outstanding amounts, the collection of which – in management’s opinion – is doubtful. Doubtful debts having no apparent chance of being collected are written off, based on management’s decision. f. Inventory Inventory is stated at the lower of cost or market, with cost determined by the weighted moving average method. See Note 2.z.3 regarding the effective date of the new accounting standard, Number 26-Inventory. g. Investment in another company An investment in another company has been included at cost, which – in management’s assessment – does not exceed its fair value. h. Investments in investees Investments in investees have been accounted for by the equity method. i. Fixed assets Fixed assets are stated at cost, net of accumulated depreciation. The cost of accessories and spare parts has been determined by the moving weighted-average method. The cost of assets (mainly, aircraft) includes absorption and financing expense with respect to specific loans used to finance the purchase of the assets during their pre-operational period. Maintenance expenses of various aviation accessories are allocated to operations as incurred. Depreciation is computed by the straight-line method at equal annual rates of cost, net of disposition value of aircraft and spare engines, over the estimated useful lives. Accessories and spare parts attributed to a specific fleet are depreciated over the remaining average useful life of that fleet. Accessories and replacement parts which are not attributed to a specific fleet are depreciated at a fixed annual rate. Obsolete and slow-moving accessories and spare parts are included at their written down value, based on management’s estimate. As for annual depreciation rates – see Note 9. See Note 2x as to the implementation of Accounting Standard Number 15. See Note 2z2 with relation to the issuance of Accounting Standard Number 27- Fixed Assets. C-14 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) j. Other assets Through December 31, 2005, deferred expenses associated with the attainment of long-term loans were presented with other assets at cost less accumulated amortization. Such expenses related to the attainment of loans were amortized over the repayment period of the loans in proportion to their outstanding balance. Commencing from January 1, 2006, when Accounting Standard Number 22, "Financial Instruments: Disclosure and Presentation", became effective, the cost of raising loans is offset from the balance of the liability related to such loans. Rights to use security-related equipment are stated at their cost to the Company and amortized over the estimated economic life. k. Obligations for frequent flyer programs The provision has been computed for passengers accumulating minimum points in relation to an estimate of the plans’ effective cost to the Company arising from the utilization of the benefits granted under those plans. The effective cost is based on management’s assessment of the anticipated relative weight of the marginal expenses likely to be incurred by the Company and of the loss of alternative revenues attributable to rejection of a paying passenger upon the utilization of those benefits. l. Obligation for termination of employee-employer relationships, net The obligation for termination of employee-employer relationships covers all obligations to employees required by law, agreement, practice and management expectations. The monies received from the Government of Israel to cover the deficit in the severance-pay fund are included in the financial statements on the cash basis upon their placement in the severance-pay fund by the Government of Israel-see Note 15b.4.b. C-15 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) m. Basis for revenue recognition and allocation of commissions to agents Revenues from passenger-ticket sales are included as deferred income with current liabilities until the earlier of the date of the service provided or two years from date of sale. Revenues from the carriage of passenger include income for service provided by the Company in cases in which the sale of flight tickets has been made by other airlines. Additionally, revenues from the carriage of passenger also include income derived from Code Share Agreements with other airlines. In such case, the service is rendered by other airlines while the sale is made by the Company, with the income being presented at a net amount. Revenues from carriage of cargo are recorded as income in the statement of operations upon rendering the service. Agent commissions attributed to unrecognized revenues are included in the financial statements in “other current assets-prepaid expenses” and charged to the statement of operations as selling expenses concurrent with the recognition of revenue. n. Maintenance and engine overhaul expenses Maintenance and engine overhaul expenses are charged to the statement of operations upon actual performance of the maintenance or engine overhaul. In cases in which the Company entered into warranty contracts, the Company records expenses as defined in the warranty agreement, and the cost of the overhaul is borne by the warrantor. o. Security expenses for Company services The Company's participation in the government’s expenses for providing security for the Company's services is allocated to operations as incurred. p. Jet-fuel hedging transactions The outcome of financial transactions to hedge jet-fuel prices designed to secure the price of fuel against changes in world prices are allocated to operating expenses in the statement of operations concurrently with the recording of the results of fuel purchase transactions. C-16 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) q. Hedging interest and foreign exchange rates Part of the financial instruments used by the Company to replace the variable-interest component with a fixed interest component are designed to hedge, but are not recognized for accounting purposes. These financial instruments are presented in the financial statements based on their fair value with other current assets. Changes in fair value are allocated to the financing section in the statement of operations for each period. The fair value of the derivative financial instruments referred to above is determined by market prices. Another part of the financial instruments used by the Company to replace the variable interest component in the fixed interest component is recognized for accounting purposes as hedging transactions. The outcome of these financial instruments is charged to financing expenses in the statement of operations, concurrently with recording the financing expenses on the loans to which the financial instruments relate. The financial instruments used by the Company to hedge against changes in foreign-exchange rates are not recognized for accounting purposes. These financial instruments are presented in the financial statements at their fair value, determined based upon data received from the banks with which the Company has entered into agreements related to these transactions. r. Deferred income taxes The Company and subsidiaries allocate taxes with respect to temporary difference between the value of assets and liabilities in the financial statements and their tax basis, and with respect to tax losses whose realization is anticipated. The deferred income taxes are computed at the tax rates expected upon realization, as known as of the balance-sheet date (between 25%-29%). s. Use of estimates in the preparation of financial statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions which affect the amounts of the assets and liabilities included in the financial statements, disclosure of contingent assets and liabilities as of the date of the financial statements and amounts of revenues and expenses in the reporting periods. Actual results may differ from these estimates. C-17 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) t. Linked balances Balances in, or linked to, foreign currency are included in the financial statements on the basis of the representative exchange rate in effect on the balance- sheet date. Following is data on the Consumer Price Index ("CPI") in Israel and the exchange rates of foreign currencies in relation to the U.S. dollar: December 31 2 0 0 6 2 0 0 5 2 0 0 4 CPI - in points 184.9 185.1 180.7 NIS/$ 4.225 4.603 4.308 $/€ 0.759 0.845 0.733 $/₤ 0.510 0.580 0.519 Rate of change - in %: Year ended December 31 2 0 0 6 2 0 0 5 2 0 0 4 CPI (0.1%) 2.4% 1.2% $ against NIS (8.2%) 6.8% (1.6%) $ against € (10.2%) 15.3% (7.3%) $ against ₤ (12.1%) 11.7% (7.1%) u. Earnings (loss) per share Until December 31, 2005, the Company implemented Opinion Number 55 of the Institute of Certified Public Accountants in Israel. Effective from January 1, 2006, the Company applies Accounting Standard No. 21 of the Israel Accounting Standards Board (“Earnings per Share”), which became effective on that date concurrently with the cancellation of the aforementioned Opinion No. 55. In accordance with the new standard, the Company computes the amounts of basic earnings per share by dividing earnings or loss attributable to ordinary shareholders of the Company (numerator), by the weighted average of the outstanding ordinary shares (denominator) during the reporting period. In its computation of diluted earnings per share, the Company adjusts earnings or loss attributable to the ordinary shareholders of the reporting entity and the weighted average of the outstanding shares for the effects of all the dilutive potential ordinary shares. As mentioned above, the new standard will apply to financial statements for reporting periods starting January 1, 2006 and thereafter. The standard further establishes that comparative figures for earnings per share that relate to prior periods are to be adjusted in order to reflect the directives of the standard in their calculation. Pursuant to the transitional rules of the standard, the Company has restated the comparative figures regarding earnings per share for prior years, and the basic earnings per share of the Company increased by 0.03 dollars and by 0.01 dollars for the years 2005 and 2004, respectively. C-18 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) v. Share-based payments Commencing January 1, 2006, the Company applies Accounting Standard No. 24 of the IASB, “Share-Based Payments” (hereafter- the standard). Pursuant to the directives of the standard, the Company recognizes share-based payment transactions in the financial statements, including transactions with employees or other parties that are settled by means of equity instruments of the Company or in cash. For share-based payment transactions that are settled in cash, the Company measures the goods or services acquired and the liabilities incurred according to the fair value of the liability. Until the liability is settled, the Company remeasures the fair value of the liability at each reporting date, and at the date of settlement, with any changes in fair value being recognized in earnings or loss for the period. With respect to share-based payment transactions with employees (including others who supply similar services), the Company, on the day of grant, measures the fair value of the equity instruments granted. If the equity instruments have not vested until those employees have completed a defined period of service, the Company then recognizes the service in the financial statements over the vesting period. w. Transactions with a former controlling party According to the Securities Regulations (Presentation of Transactions between a Company and its Controlling Party in the Financial Statements), 1996, the Government’s waiver of a Company obligation to the Government of Israel executed in the year 2003, has been allocated to a capital reserve from transactions with a former controlling party. Moreover, amounts received from the Government of Israel to cover the deficit in the pension fund are allocated, upon deposit, to the capital reserve from transactions with a former controlling party. C-19 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) x. Impairment of assets On February 27, 2003, the Israeli Accounting Standards Board published accounting Standard No.15 (“Impairment of Assets”), which addresses the issue of asset impairment. Standard 15 sets forth, for the first time in Israel, the accounting treatment and presentation of asset impairment and establishes procedures to be implemented by an entity in order to insure that assets are not presented in amounts exceeding their recoverable amount. The recoverable amount of an asset is defined as the higher between the net selling price of the asset and the present value of estimated future cash flows expected to be derived from the use and realization of the asset. The standard also stipulates the rules for presentation and disclosure of impaired assets. This standard applies to financial statements covering the periods starting January 1, 2003 and thereafter. The Company management believes that the recoverable amounts of the aircraft should be examined in relation to their net book value on the basis of grouping the fleets and that it is incorrect to examine the recoverable value of each plane separately in relation to its net book value. Following the grouping conducted by the Company for its fleets of aircraft, it became evident that the recoverable value for each group of aircraft exceeds the net book value of that group of aircraft at that time. Accordingly, no provision for impairment has been included in these financial statements for impairment of the value of these aircrafts. y. Change in estimate During 2004, the State completed the grant of guarantees to the Company for securing the Company's obligations to Mivtachim - Institution for Workers’ Social Insurance Ltd., pertaining to employees’ early retirement from the Company, for which it had made a provision in its accounts (see Note 15b.13). Accordingly, and due to the expected long-term interest rate, the Company, in 2004, changed its estimate of the discount rate required to capitalize the liability with respect to the early retirement of the employees, from 2% to 3.8% (the yield on a risk-free government debenture). It is the opinion of the management that the new discount rate more accurately reflects future periods’ financing cost resulting from the Company’s liability in regard to the early retirement of the employees. The statement of operations for the year ended December 31, 2004 includes income of $ 3,170 thousand together with other income, with respect to that increase in the discount rate against a corresponding reduction in accrued severance pay, net. The effect on earnings per share for the year ended December 31, 2004 was an increase of $0.008 per share. C-20 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) z. Effect of new accounting standards during the period prior to implementation 1. Accounting Standard Number 29-Adoption of International Financial Reporting Standards In July 2006, the Israel Accounting Standards Board published Accounting Standard No. 29 – "Adoption of International Financial Reporting Standards (IFRS)" (hereafter-"the Standard"). The Standard determines that, from the reporting period commencing on January 1, 2008, financial statements of entities which are subject to the Securities Law and are required to report in accordance with regulations issued in conformance with this law, excluding foreign entities as they are defined in the Securities Law, must be prepared in conformity with International Financial Reporting Standards -the IFRS and their clarifications, which are issued by the International Accounting Standards Board (hereafter- "the IASB"). An entity which will apply IFRS beginning from January 1, 2008, and which will elect to report on comparative figures in accordance with IFRS solely for the year 2007 will be required to prepare an opening balance sheet as of January 1, 2007 in accordance with IFRS (hereafter- "the Opening Balance Sheet"). The transition to reporting as per IFRS will be carried out in accordance with the provisions of IFRS 1, "Initial Adoption of IFRS". IFRS 1 sets rules as to how an entity should execute the transition from previous financial reporting on the basis of local accounting principles to financial reporting on the basis of the international accounting standards. IFRS 1 takes precedence over all transitional provisions which were stipulated by other IFRS's (including transitional provisions determined in previous local accounting standards) and states that IFRS should be adopted retroactively in the opening balance sheet. Nevertheless, IFRS 1 grants relief in certain instances by not requiring the application of retroactive implementation. In addition, IFRS 1 specifies a number of exceptions in the matter of retroactive application of certain aspects of other IFRS. The Company management intends to examine the effects of the transition to IFRS, but it is unable at this stage to assess the overall anticipated effects on the financial statements as a result of the adoption of the International Financial Reporting Standards. 2. Accounting Standard Number 27-Fixed Assets During the month of September 2006, the Israeli Accounting Standards Board published Accounting Standard Number 27, "Fixed Assets" (hereafter- "the Standard"), which stipulates the accounting treatment of fixed assets, including the recognition of assets, determining their value in the accounts and the depreciation expenses and losses from impairment of value which will be recognized with respect to them. Additionally, the Standard states the disclosure that is necessary in the financial statements in connection with the fixed assets of an entity. Among other things, the Standard stipulates the following: C-21 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) z. Effect of new accounting standards during the period prior to implementation (cont.) 2. Accounting Standard Number 27-Fixed Assets (cont.) An item of fixed assets will be measured at the time of initial recognition at cost which includes, in addition to the purchase price of the asset, all of the costs which can be directly attributed to bringing that item to the location and condition that are necessary in order to enable it to operate in the manner intended by management. In addition, the cost is composed of the initial estimate of the costs to dismantle and remove the item and to restore the location of the item as to which the entity had an obligation when the item was acquired, or as the result of using it over a specific period other than for the purpose of producing inventory during that same period. The Standard stipulates that upon purchasing fixed assets in exchange for a non- monetary asset or non- monetary assets or in consideration of a combination of monetary assets and non- monetary assets, the cost will be measured according to fair value, except if (a) the exchange transaction has no commercial substance or (b) the fair value of the asset received and the asset conferred cannot be reliably measured. Should the asset purchased not have been measured on the basis of fair value, its cost will be set according to the book value of the asset conferred. After the initial recognition, the Standard permits the entity to select whether to implement measurement of fixed assets as part of its accounting policies either by the cost method or the revaluation method, as long as this policy is implemented for all items of fixed assets from the same group. Under the cost method, an item of fixed assets is presented at its cost, less accumulated depreciation and less cumulative losses from impairment of value. Under the revaluation method, an item of fixed assets, the fair value of which can be determined in a reliable manner, will be presented at a revalued amount, which is equivalent to its fair value on the date of the revaluation, less depreciation accumulated thereafter, and less cumulative losses from impairment of value. Revaluations will be carried out on a regular basis which is sufficient to assure that book value is not materially different from the value which would have been determined at fair value as of the balance sheet date. If an item of fixed assets is revalued, the entire group of fixed assets to which the asset pertains must be revalued. Should the book value of an asset increase as the result of a revaluation, the increase is to be recorded directly to shareholders' equity, under the heading of Revaluation Surplus. At the same time, the increase will be recognized in operating results up to the amount by which it cancels a decrease which resulted from a revaluation of that same asset which had previously been recognized in operating results. If the book value of the asset decreases as the result of a revaluation, the decrease will be recognized in operating results. Nevertheless, the decrease will be recorded directly to shareholders' equity under the heading of Revaluation Surplus up to the amount as to which any credit balance with relation to such asset exists in Revaluation Surplus. C-22 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) z. Effect of new accounting standards during the period prior to implementation (cont.) 2. Accounting Standard Number 27-Fixed Assets (cont.) Each part of a fixed asset that has a cost which is significant in relation to the total cost of the item should be depreciated separately. The cost of an overall renovation ("overhaul") of the engine of an aircraft will be charged as an asset in the balance sheet and will be depreciated over the period of economic benefit derived from this renovation. The accounting policy currently being followed is to record the cost of the renovation as an expense at the time that the renovation is performed. The projected useful length of life of an asset and the salvage value determined for the asset should, at a minimum, be reviewed as of the end of each fiscal year and, should a substantial change have taken place in the pattern of utilization of the anticipated future economic benefits incorporated in the asset, the useful length of life and/or the salvage value should be changed in order to reflect theses changes. Such change should be treated as a change in accounting estimate. In accordance with the provisions of the Standard, this Standard will apply to financial statements which relate to periods which commence on January 1, 2007 and thereafter, and will be applied in the manner of retroactive implementation, except for an entity which, as of January 1, 2007, selects the revaluation method as its accounting policy with respect to a group of fixed assets, so that the difference between the revalued book value of the asset as of that date and its cost, represents the Revaluation Surplus on that date. During the month of January 2007, the Israeli Accounting Standards Board published a proposal for Accounting Standard Number 28, an amendment of the transitional provisions in Accounting Standard Number 27, "Fixed Assets" (hereafter-"Proposed Standard 28"). For purposes of the transition to implementation of Standard 27, the Proposed Standard permits the entity which intends to adopt one or more of the relieves stipulated by International Financial Reporting Standard Number 1 as it applies to fixed assets, in the financial statements for periods commencing on January 1, 2008, to implement them on January 1, 2007. According to these relieves, the entity is permitted to present items of fixed assets on the transition date at their fair value as an alternative to their cost ("deemed cost"). Additionally, it was stipulated that an entity which selects fair value as deemed cost, will not restate comparative information but will disclose this fact, as well as the fair value as of January 1, 2007 of each item which was so treated. The Company is assessing Standard 27, including the choice between the cost method and the revaluation method, as well as the Proposed Standard 28 for measuring part of the items of its fixed assets at fair value as deemed cost. At this stage, the Company is unable to evaluate the effect of implementation of the Standard and Proposed Standard 28, on its financial condition and results of operations. C-23 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) z. Effect of new accounting standards during the period prior to implementation (cont.) 3. Accounting Standard No. 26 – Inventory During the month of August 2006, the Israeli Accounting Standards Board published Accounting Standard Number 26, "Inventory" (hereafter- "the Standard"), which stipulates the accounting treatment of inventory. The Standard applies to all types of inventory, with the exception of the inventory of buildings for sale, to which Accounting Standard Number 2 applies, the construction of buildings for sale, the inventory of work in process deriving from performance contracts, to which Accounting Standard Number 4 applies, works in accordance with a performance contract, financial instruments and biological assets which are related to agricultural operations and to agricultural production during harvest. The Standard states, among other things, that inventory will be measured at the lower of cost or net realizable value. The cost of the inventory will be determined according to the first- in, first- out (FIFO) method or by means of a weighted average of cost, with consistent use of the same cost formula for all inventory with the same characteristics and uses. In certain cases, the Standard requires that the cost of the inventory be determined by specific identification of its costs. The cost of the inventory includes all purchase costs, production costs and other costs which were incurred in bringing the inventory to its current location and condition. In instances in which the inventory was purchased under credit terms, when the arrangement includes a financing component, the inventory will be presented at cost which is equivalent to the purchase cost in cash and the financing element will be recognized as financing expenses over the credit period. The amount of any decline in value of inventory to its net realizable value and all losses related to inventory are recognized in operating results for the period in which they take place. The amount of the cancellation of any decline in value of inventory, which results from a rise in net realizable value, is recognized in the results of operations for the period in which the cancellation takes place. In accordance with the provisions of the Standard, this Standard will apply to financial statements which relate to periods commencing on January 1, 2007 or thereafter, and it will be applied in the manner of retroactive implementation. In the estimation of the Company's management, the Standard will have no effect on the financial condition, results of operations and cash flows of the Company. C-24 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES (Cont.) z. Effect of new accounting standards during the period prior to implementation (cont.) 4. Accounting Standard No. 23 “Accounting Treatment of Transactions between an Entity and its Controlling Shareholder" In December 2006, the Israel Accounting Standards Board published Accounting Standard No. 23 "Accounting Treatment of Transactions between an Entity and its Controlling Shareholder" (hereafter-"the Standard"). The Standard is mandatory for entities which are subject to the Securities Law, 1968. The Standard prescribes the accounting treatment for transactions between an entity and its controlling shareholder that involve the transfer of an asset, the acceptance of a liability, indemnification and waiver, and also loans. The Standard does not apply to the combination of businesses under common control. The Standard prescribes that the basis for valuation for transactions between an entity and its controlling shareholder is fair value; undertakings with the characteristic of shareholders' investments or a distribution to shareholders are to be incorporated into shareholders' equity and are not to be included in the results of the controlled entity; the differences between the consideration determined in transactions of an entity and its controlling shareholder and the fair value of such transactions will be recorded to shareholders' equity. Current taxes and deferred taxes relating to items recorded to shareholders' equity with respect to transactions with controlling shareholders should also be recorded directly to shareholders' equity. The Standard applies to transactions that will be executed between an entity and its controlling shareholder after January 1, 2007 and on to a loan given or received from a controlling shareholder before this Standard takes effect, beginning the date of the Standard. In the estimation of Company's management, the Standard will not materially affect the financial condition, operating results of cash flows of the Company. NOTE 3 - SHORT-TERM INVESTMENTS Consolidated Company December 31, December 31, a. Composition 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) Short-term bank deposits 4,682 112,594 4,000 111,500 Current maturities of long-term deposits and investments - 240 - 240 4,682 112,834 4,000 111,740 b. The short-term bank deposits as of December 31, 2006 bear annual interest at a rate of 5.3%. C-25 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 4 - TRADE ACCOUNTS RECEIVABLE Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 a. Composition (in thousand US dollars) Outstanding accounts 117,714 *108,448 114,100 *106,018 Less: allowance for doubtful accounts (2,086) (1,576) (2,016) (1,541) 115,628 *106,872 112,084 *104,477 Airlines (see b. below) 15,399 19,828 15,399 19,828 131,027 *126,700 127,483 *124,305 b. The accounting settlement among the airlines is mostly arranged through IATA’s clearing system. * Reclassified NOTE 5 - RECEIVABLES AND OTHER CURRENT ASSETS Consolidated Company December 31, December 31, Composition 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) Prepaid expenses 24,960 21,733 24,684 21,509 VAT authorities 4,138 3,468 3,982 3,329 Fair value of financial instruments 2,904 2,627 2,904 2,627 Loans and advances to employees 289 444 282 315 Subsidiaries - - 2,621 1,516 Interest receivable 473 2,046 473 2,046 Other receivables 14,578 *15,512 14,448 *15,067 47,342 *45,830 49,394 *46,409 * Reclassified NOTE 6 - INVENTORY Consolidated Company December 31, December 31, Composition 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) Jet fuel for consumption 10,484 15,977 10,484 15,977 Other (mainly chemicals, consumable equipment, duty-free products and meals) 6,706 6,468 5,980 5,856 17,190 22,445 16,464 21,833 C-26 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 7 - LONG-TERM BANK DEPOSITS AND INVESTMENT IN ANOTHER COMPANY Consolidated and Interest rates on Company December 31, December 31, 2 0 0 6 2 0 0 6 2 0 0 5 % (in thousand US dollars) a. Long-term bank deposits: 1. Composition Bank deposits - In unlinked NIS (see 2 below) 2.43-2.95 1,836 1,779 Debentures in dollars, issued by a US trust - 240 1,836 2,019 Less: current maturities - (240) 1,836 1,779 2. The unlinked NIS bank deposits as of December 31, 2006 include $1,829 thousand used as security for the repayment of bank loans received by Company employees. (As of December 31, 2005-$ 1,737 thousand). The deposits have no predetermined redemption date. b. Investments in another company - An investment of $1,829 thousand in Societe Internationale de Telecommunications – Aeronautiques-Sita (“SITA”) - a non-profit cooperative society of airlines and related entities, whose objective is mainly to provide international telecommunication services to airlines and others. As of December 31, 2006, the Company held 36 shares of €5 par value each, constituting 0.5% of SITA’s share capital. C-27 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 8 - INVESTEES a. Composition: December 31, 2006 December 31, 2005 Company's Company's Loans and equity in Loans and equity in inter- retained inter- retained Shares, company earnings Shares, company earnings at cost balances (deficits) Total at cost balances (deficits) Total ( I n t h o u s a n d U S d o l l a r s) 1. Consolidated: Affiliates (1): Sabre Israel (2) - 1,228 771 1,999 - 1,554 573 2,127 Air Tour 13 - - 13 13 - - 13 ACI and Kavei Chufsha 44 - 224 268 44 - 5 49 57 1,228 995 2,280 57 1,554 578 2,189 2. Company: Subsidiaries: Superstar 349 - (150) 199 349 638 267 1,254 Tamam 1 - 4,862 4,863 1 - 4,655 4,656 Borenstein 1 - 3,929 3,930 1 - 3,767 3,768 Sun D'Or 3 - - 3 3 - - 3 354 - 8,641 8,995 354 638 8,689 9,681 Affiliates - Sabre Israel (2) - 1,228 771 1,999 - 1,554 573 2,127 Air Tour 13 - - 13 13 - - 13 ACI and Kavei Chufsha 44 - 224 268 44 - 5 49 57 1,228 995 2,280 57 1,554 578 2,189 411 1,228 9,636 11,275 411 2,192 9,267 11,870 1. Includes Airtour and ACI which are presented at cost – see note 8b.5 and 8b.6. 2. The loan to Sabre is denominated in US dollars and bears interest of Libor + 1.5%. C-28 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 8 - INVESTEES (Cont.) b. Additional information pertaining to the investments and activity in main investees: 1. Tamam Aircraft Food Industries (BGA) Ltd. ("Tamam") Tamam is primarily engaged in the production and supply of prepared meals for airlines, with most of its sales made to the Company and a small fraction to other airlines and customers. Tamam supplies the Company with catering and food services on its aircraft at prices specified by agreements, the last of which expired on December 31, 2006. By the approval date of these financial statements the Company had not yet signed a new agreement with Tamam. Tamam's plant is located at BGA and it has an agreement with the Airports Authority ("AA"), according to which it may use the area owned by AA in exchange for agreed-upon authorization fees until December 31, 2006. This agreement may be extended with the consent of the two parties. On December 12, 2006, AA gave notice of its decision to extend the authorization period of Tama through December 31, 2007. Following the opening of BGA 2000, Tamam estimates that it will have to relocate its plant from its present location and move to a new location in 2010. As for transactions carried out by the Company with Tamam – see Note 23. 2. Borenstein Caterers Inc. (USA) – (“Borenstein”) Borenstein, a wholly owned subsidiary, is a USA corporation operating out of New York’s JFK, and is mostly engaged in the production and delivery of kosher meals for airlines and other institutions, with the Company being its major customer. As for transactions carried out between the Company and Borenstein – see Note 23. 3. Superstar Holidays Ltd. (England) – (“Superstar”) Superstar is registered in England and Wales and is wholly owned by the Company. It is engaged in the marketing of wholesale tourism packages to travel agents and individual travelers, as well as airline tickets. Superstar has a branch in Israel, as well as branches in several cities abroad. As for transactions carried out between the Company and Superstar – see Note 23. C-29 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 8 - INVESTEES (Cont.) b. Additional information on investments and activity in main investees: (Cont.) 4. Sun D'Or International Airlines Ltd. ("Sun D'Or") Sun D'Or operates charter flights within the framework of a commercial policy coordinated with the Company, by means of aircraft leased from the Company, or through the Company. In addition, Sun D’Or sells seat packages on EL AL flights to agents in exchange for a commission. Sun D'Or has a commercial operation certificate, valid for an indefinite period, to transport passengers and cargo on charter flights to and from Israel. The license provides, inter alia, that the operation of aircraft requires Civil Aviation Authority (CAA) approval that flights will be carried out by planes owned by the Company or Arkia Israel Airlines Ltd. or aircraft leased by the Company, with BGA being Sun D’Or’s home-base. In addition, Sun D’Or operates charter flights under an independent code (“7L”). It has an air operation certificate, which is based on two aircraft leased from the Company, subject to requirements set by the CAA which pertain mainly to the receipt of maintenance services from an authorized inspection institute and to the employment of substitute workers in certain functions. According to the method used by the two companies to settle their accounts, Sun D’Or ends each year at a breakeven point. As for an understanding reached between the Company and the Commissioner for Business Restrictions and the Company’s appeal – see Note 1.b.4. As for transactions between the Company and Sun D’Or – see Note 23. 5. Tour Air (Israel) Ltd. ("Air Tour ") Air Tour, which was founded by Israeli travel agents (50%) and the Company (50%), acts as a reduced-price ticket provider for individuals, almost exclusively for the Company, and also markets the Company’s flights and special promotions of the Company to all of its flight destinations. The shares held by the Company grant it the right to participate and vote in Air Tour’s General Meetings with 50% voting rights and to appoint half of its directors, but do not grant it the right to receive dividends or profits, other than profits derived from investing in Air Tour’s share capital. The investment in Air Tour is stated at cost. As for transactions between the Company and Air Tour – see Note 23. C-30 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 8 - INVESTEES (Cont.) b. Additional information on investments and activity in main investees: (Cont.) 6. Air Consolidators Israel Ltd. ("ACI") ACI is primarily engaged in the consolidation of air cargo at BGA to facilitate reduction in price of air shipments. Air transport is carried out by the Company, at special prices, and by foreign companies. The shares held by the Company entitle it to participate and vote in the General Meetings of ACI to the extent of 50% and to appoint half of its board members, without the right to receive earnings by way of a dividend distribution or any other benefit, other than earnings and dividends derived from capital gains. The investment is presented at cost. As for transactions between the Company and ACI – see Note 23. 7. Sabre Israel Travel Technologies Ltd. (“Sabre Israel”) Sabre Israel was established within the framework of an agreement signed in 2001 for the set up of a joint venture between the Company and Sabre Inc. The Company’s share in Sabre Israel is 49% while the share of Sabre Inc. is 51%. Sabre Israel commenced its activities in December 2001 and it provides the travel agents segment in Israel with flight- order services for the airlines of the world, as well as orders for a wide range of additional tourism services worldwide. Those services are provided to travel agents, which acquire a license for using an integrated system that includes the use of the “Carmel” system owned by the Company as well as the use of Sabre system and technology. In addition, Sabre Israel provides support and maintenance services to travel agents in Israel. According to the agreement, the Company and Sabre Inc. pay marketing fees to Sabre Israel, as well as additional marketing fees, which complement Sabre Israel’s pre-tax operating income to cost plus 7%. The investment is presented on the equity basis. As for mutual transactions between the Company and Sabre Israel– see Note 23. C-31 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 9 - FIXED ASSETS a. Composition: Consolidated Buildings Aircraft Payments and and flight on account Machinery Computers Vehicles installations equipment of aircraft and ground and office and hanger (1) (2) & engines(3) equipment furniture equipment Total (in thousand US dollars) Cost Balance - January 1, 2006 91,238 2,145,243 26,763 53,425 108,159 9,291 2,434,119 Additions 5,668 28,840 59,429 2,306 7,546 405 104,194 Disposals (71) (106,088) (3,473) (1,045) (88) (1,157) (111,922) Balance - December 31, 2006 96,835 2,067,995 82,719 54,686 115,617 8,539 2,426,391 Accumulated depreciation Balance - January 1, 2006 64,613 1,053,838 - 47,242 97,242 7,419 1,270,354 Annual depreciation 2,391 83,445 - 2,365 6,479 399 95,079 Disposals (49) (85,788) - (624) (86) (884) (87,431) Balance - December 31, 2006 66,955 1,051, 495 - 48,983 103,635 6,934 1,278,002 Net book value: December 31, 2006 29,880 1,016,500 82,719 5,703 11,982 1,605 1,148,389 December 31, 2005 26,625 1,091,405 26,763 6,183 10,917 1,872 1,163,765 Annual depreciation See b rate 4%-10% below - 5%-20% 5%-33% 5%-15% (mainly 10%) (mainly 33%) (mainly 15%) (1) See f. below. (2) See b. below. (3) See c. below. C-32 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 9 - FIXED ASSETS (Cont.) a. Composition: (Cont.) Company Buildings Aircraft Payments and and flight on account Machinery Computers Vehicles installations equipment of aircraft and ground and office and hanger (1) (2) & engines(3) equipment furniture equipment Total (in thousand US dollars) Cost Balance - January 1, 2006 87,357 2,145,243 26,763 47,238 106,112 7,972 2,420,685 Additions 5,594 28,840 59,429 2,005 7,506 385 103,759 Disposals - (106,088) (3,473) (1,025) - (1,157) (111,743) Balance - December 31, 2006 92,951 2,067,995 82,719 48,218 113,618 7,200 2,412,701 Accumulated depreciation Balance - January 1, 2006 61,376 1,053,838 - 42,424 95,283 6,264 1,259,185 Annual depreciation 2,300 83,445 - 2,009 6,448 380 94,582 Disposals - (85,788) - (610) - (884) (87,282) Balance - December 31, 2006 63,676 1,051,495 - 43,823 101,731 5,760 1,266,485 Net book value: December 31, 2006 29,275 1,016,500 82,719 4,395 11,887 1,440 1,146,216 December 31, 2005 25,981 1,091,405 26,763 4,814 10,829 1,708 1,161,500 Annual depreciation See b rate 4%-10% below - 5%-20% 5%-33% 5%-15% (mainly 10%) (mainly 33%) (mainly 15%) (1) See f. below. (2) See b. below. (3) See c. below. C-33 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 9 - FIXED ASSETS (Cont.) b. Boeing aircraft and flight equipment 1. Composition Consolidated and Company December 31, 2 0 0 6 2 0 0 5 Annual Accumulated Net book Net book depreciation Cost depreciation value value rate (1) (in thousand US dollars) Quantity Type of aircraft (31.12.05) 747-400 4% 4 458B (passenger) 491,247 217,116 274,131 293,968 Spare engines 20,850 11,106 9,744 10,366 512,097 228,222 283,875 304,334 747-200 5% (5) 3 245F (cargo) 108,882 91,996 16,886 23,869 1 258C (convertible) (6) 44,748 44,748 - - Spare engines 16,771 16,433 338 1,197 170,401 153,177 17,224 25,066 757 4% 5 258B (passenger) (4) 209,339 141,872 67,467 72,570 Spare engines 13,546 10,034 3,512 3,685 222,885 151,906 70,979 76,255 737 4% 5 700/800 (passenger) 168,935 50,746 118,189 124,958 Spare engines 10,872 3,139 7,733 8,168 179,807 53,885 125,922 133,126 2 767 4%-6 /3 % 2 200 (passenger) 90,121 82,946 7,175 11,038 4 200ER (passenger) 183,043 131,522 51,521 61,068 Spare engines 7,002 7,002 - - 280,166 221,470 58,696 72,106 777-258 ER(2) 4% 4 Passenger 459,003 99,697 359,306 377,866 Spare engines 30,733 4,403 26,330 27,693 28 489,736 104,100 385,636 405,559 1,855,092 912,760 942,332 1,016,446 Accessories and spare parts - general (3) 212,903 138,735 74,168 74,959 2,067,995 1,051,495 1,016,500 1,091,405 Including capitalized financing costs 5,859 2,026 3,833 4,068 (1) The annual depreciation rate takes into account, for most planes, a disposition value of 20% - see Note 9i. (2) Includes one aircraft on a financing lease – see Note 9e. (3) Accessories and parts allocated to a specific fleet are depreciated over that fleet’s average useful life, while those not so allocated are depreciated at an annual rate of 10%. (4) Includes one aircraft leased to Israir Aviation and Tourism Services Ltd. (5) The entire 747-200 fleet has reached its disposition value (20%) and since then it is depreciated over a four-year period. Until then, these planes were depreciated at 8% per annum, except for one used cargo aircraft purchased in 2004, which is depreciated at 20% per annum. (6) Following a decision of Company management, in September 2005 the Company decided to stop operating two convertible aircrafts for scheduled passenger flights. C-34 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 9 - FIXED ASSETS (Cont.) b. Boeing aircraft and flight equipment (Cont.) 2. Fully depreciated assets in use On December 31, 2006, the Company had in use two fully depreciated Boeing 747-200 aircraft as well as engines for the 747-200 and 767 fleet, costing $63.3m. c. Payments on account of aircraft and flight equipment - composition Consolidated and Company December 31 2 0 0 6 2 0 0 5 (in thousand US dollars) Advance for the purchase of two 777-200 aircraft (see Note 17d.1) 82,108 21,899 Advance for the installation of equipments in the aircrafts - 1,518 Others 611 3,346 82,719 26,763 d. Acquisition of aircraft from the State and settlement of the Company’s liabilities for use of aircraft - 1. Overview- On May 5, 2003, prior to privatization, the Company signed an agreement with the Government of Israel to arrange the repayment of Company liabilities to the Government of Israel for the Company's use, since 1983, of four Boeing 767 aircraft (two of the ER model) and two 737-200 aircraft (sold in 1999) as well as related equipment. Within the framework of this agreement, which was approved by the Knesset’s Finance Committee on May 5, 2003, the acquisition of four 767 aircraft from the State and an allotment of share capital to the Government of Israel were arranged. The effect of this agreement on the Company’s financial statements was reflected in the financial statements for the year ended December 31, 2003. 2. Agreement highlights - The Company’s liabilities to the Government of Israel as of the end of 2002 amounted to approximately $ 274.5 million, of which, a total of $ 226.3 million was waived by the government while the Company waived an identical amount of carry-forward business tax losses to future years. The market value of the four planes on May 5, 2003 amounted to approximately $ 41 million. The net book value of the four aircraft which had been owned by the State as of May 5, 2003, had the Government of Israel included them in financial statements prepared in conformity with generally accepted accounting principles, would have been $ 41.1 million. The planes were recorded in the Company’s accounts at this net book value. In exchange for the purchase of the four planes from the government and the amounts previously received for the sale of two 737 aircraft on account of share capital (including the settlement of payments made in previous years on account of the aircraft) and to settle the remaining debt owed to the Government of Israel, the Company allotted ordinary shares amounting to $ 84 million to the Government of Israel in May, 2003. C-35 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 9 - FIXED ASSETS (Cont.) d. Acquisition of aircraft from the State and settlement of the Company’s liabilities in respect of aircraft use (Cont.) 3. In accordance with the Securities Regulations (Presentation of Transactions between a Company and a Controlling Party in the Financial Statements), 1996, the difference between the market value and the net book value as above, was recorded to a capital reserve from transactions with a former controlling party. In addition the net waiver by the Government of Israel in the amount of approximately $ 223.6 million (net of an amount of $ 2.7 million representing additional consideration to the Government of Israel for the State- owned aircraft sold by the Company in 2000) was recorded to a capital reserve from transactions with a former controlling party. e. Fourth 777-200 aircraft In June 2002 the Company received and operated a fourth 777-200 aircraft (hereafter-"the fourth aircraft). City Bank financed most of the cost of the fourth aircraft by means of a loan, and,, for that purpose, a new foreign company, Zipporah Leasing Ltd. (hereafter: "the foreign company"), was established in the Cayman Islands. The Exim Bank provided City Bank with a guarantee while City Bank, the foreign company, Exim Bank and the Company appointed Wells Fargo as trustee of the collateral (hereafter: " trustee of the collateral"). The shares of the foreign company were pledged in favor of the trustee of the collateral, which also appoints the directors of the foreign company. The fourth aircraft, which is leased by the foreign company from Boeing, is subleased to the Company for 12 years in exchange for leasing fees identical in amount to the repayment of the principal and interest amounts payable to City Bank. The Company has an option to acquire this plane at the end of the loan-repayment period for $1.00. The fourth aircraft, which is included in the financial statements within the Company’s fixed assets, is depreciated over the expected period of economic benefit (20 years, with a salvage value of 20%), against an entry to long-term loans for the loan received from City Bank to finance most of the plane’s cost. As for credit terms – see Note 14.c.9. C-36 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 9 - FIXED ASSETS (Cont.) f. Buildings and installations December 31, 2 0 0 6 2 0 0 5 Accumulated Net book Net book Cost depreciation value value (in thousand US dollars) Consolidated Buildings, hangars, warehouses, workshops and offices at BGA 62,555 40,070 22,485 19,088 Leasehold improvements of rented offices 19,934 13,507 6,427 6,491 Owned offices 2,822 1,860 962 1,031 Passenger and cargo terminals 11,524 11,518 6 15 96,835 66,955 29,880 26,625 Company Buildings, hangars, warehouses, workshops and offices at BGA 62,483 40,016 22,467 19,070 Leasehold improvements in rented offices 16,122 10,282 5,840 5,865 Owned offices 2,822 1,860 962 1,031 Passenger and cargo terminals 11,524 11,518 6 15 92,951 63,676 29,275 25,981 As for the contract with the Airports Authority – see Note 17.d. 3. g. Acquisition of equipment under financing lease During the reporting year, the Company acquired computer and other equipment under a financing lease. Upon their receipt, the assets were recorded in the Company's accounts at an overall cost $ 1,014 thousand, against a long-term liability (see Note 16). i. Salvage value Salvage value of 20% of cost was established on the basis of management’s estimate, taking into account the Company’s aircraft maintenance standards. When the net book value reaches salvage value, the Company reestimates the fleet’s useful life. Company management has decided to continue and depreciate the salvage value of its 747-200 and 767 fleets. See Note 2 z.2 regarding the effective date of January 1, 2007 of Accounting Standard 27 of the Israeli Accounting Standards Board. j. Liens – see Note 18. C-37 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 10 - OTHER ASSETS a. Composition – consolidated and Company Loan Rights to use arrangement security expenses equipment Total (in thousand US dollars) Cost - Balance – January 1, 2006 9,523 2,780 12,303 Classification as offset from loan balances-see Note 2.j. (9,523) - (9,523) Current additions - 1,188 1,188 Balance – December 31, 2006 - 3,968 3,968 Accumulated depreciation - Balance – January 1, 2006 7,400 232 7,632 Classification as offset from loan balances-see Note 2.j. (7,400) - (7,400) Amortization for the year - 281 281 Balance – December 31, 2006 - 513 513 Net book value - December 31, 2006 - 3,455 3,455 December 31, 2005 2,123 2,548 4,671 Annual amortization rate 5%-10% b. Rights to use security equipment As explained in Note 21c, the Company bears 50% of the security costs of the Government of Israel pertaining to safeguarding the Company passengers and aircraft from acts of terror. Accordingly, the Company recorded the payments made for its share in financing the protective systems and security inspection equipment in other assets. The Company has an arrangement with the Ministry of Defense, according to which this equipment will be exclusively used by the Company over its anticipated useful economic life. Part of the security equipment had not yet been put into operation as of December 31, 2006. c. Traffic rights The Company operates in a regulatory environment, under government supervision, in addition to its being an integrated company, according to licenses and permits held by the Company by law. These characteristics restrict the Company which operates in competitive international markets. Until the mid 90’s the Company had been the sole air carrier in the area of scheduled flights ("designated carrier") of passengers and cargo to and from Israel, except for one regional destination. This exclusive status was changed following the granting of licenses to additional Israeli carriers as "designated carriers" to several destinations, partially replacing EL AL as the designated carrier of the State of Israel, granting a full operating license to KAL as a cargo carrier, and licenses for international charter flights granted to additional Israeli carriers. C-38 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 10 - OTHER ASSETS (Cont.) c. Traffic rights (cont.) Prior to the privatization, on May 19, 2003, the Ministerial Committee for Social and Economic Affairs resolved as follows: “The Government of Israel assigns prime importance to EL AL’s continued activities as designated carrier of the State of Israel in light of its imposed as well as voluntarily assumed obligations. Accordingly, the Government of Israel ratified the Minister’s of Transport's policy, according to which: a. EL AL will continue to serve as a designated carrier on all routes that it served as a designated carrier prior to the publication of the prospectus, subject to the following conditions: 1. EL AL fulfils, at all times, its imposed as well as voluntarily assumed obligations towards the State of Israel. 2. The Minister of Transport will consider the cancellation of EL AL’s status as a designated carrier on a given route if the number of passengers flying with EL Al is 20% or lower than the number of passengers flying on that route on scheduled flights, or if the number of EL AL's scheduled flights is 20% or less than the scheduled flights operated by the designated carrier of the country of destination during the period of a calendar year. b. Within the framework of his aviation-policy considerations, and under his legal authority, the Minister of Transport will determine whether to grant rights to an additional carrier on scheduled routes if the number of passengers flying on EL AL’s scheduled flights is lower than 30% of the total number of passengers using scheduled flights on that route during a period of a calendar year. c. Without derogating from the authority of the Minister of Transport, this policy will be reconsidered if, and when, the volume of exiting and arriving airline passengers to Israel exceeds 10.7 million per annum. d. This decision supersedes Government Resolutions No’s.160, 649 and 2313 of August 22, 1999, September 2, 2001 and July 3, 2002, respectively. e. This resolution will go into effect upon the registration of the Company’s shares on the Tel Aviv Stock Exchange." On April 1, 2004 the High Court of Justice rejected the petitions filed by Arkia and Israir against the Minister of Transport and the Company in regard to the aviation policy of the State of Israel for scheduled routes. On January 16, 2006, the Minister of Tourism announced that he had decided to accede to the request of Israir Aviation and Tourism Ltd (hereafter: "Israir") and to appoint it as an additional designated carrier on behalf of the State of Israel on the Tel Aviv-New York route, and accordingly, to expand Israir's commercial operating certificate. The selection was given for the operation of scheduled flights for a period of 24 months, and it was stated in the resolution that "during this period, the implications of the addition of a designated carrier would be examined, as well as additional relevant considerations regarding this route." C-39 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 10 - OTHER ASSETS (Cont.) c. Traffic rights (cont.) The management of the Company believes that the Minister of Tourism's decision represents a breach of a governmental commitment lawfully adopted in a governmental resolution, approved by the Supreme Court acting as the High Court of Justice, and given to the Company on the eve of privatization. Therefore, there is no legal and/or economic justification for a variance of that governmental decision. On January 29, 2006, the Company filed a petition to the High Court of Justice in which it requested the court that as the decision of the Minister of Tourism is without any legal basis, therefore it is annulled or should be revoked. On February 23, 2006, the High Court of Justice rejected the Company's petition. NOTE 11 - SHORT-TERM BORROWINGS AND CURRENT MATURITIES a. Composition: Consolidated and company As of December 31 2 0 0 6 2 0 0 5 (in thousand US dollars) Current maturities of long-term loans from financial institutions 98,505 67,744 Current maturities of other loans (see Note 16) 2,308 2,092 Bank overdrafts 4,287 5,877 105,100 75,713 b. As for liens and security – see Note 18. NOTE 12 - TRADE ACCOUNTS PAYABLE Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) a. Composition: Open accounts 131,141 *133,321 126,968 *129,799 Airlines (see b) 12,332 *21,725 12,332 *21,725 Subsidiaries - - 4,624 4,123 143,473 155,046 143,924 155,647 b. Most of the liabilities to other airlines are secured – see Note 4b. * Reclassified C-40 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 13 – PAYABLES AND OTHER CURRENT LIABILITIES Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) Deferred income (mainly from sale of flight tickets) 142,345 135,574 141,853 135,574 Employees and wage-related liabilities (1) 122,888 124,909 121,172 123,222 Accrued expenses 18,604 14,151 17,381 13,213 Accrued interest on long-term loans 9,311 8,550 9,311 8,550 Accrual for frequent-flier programs 19,863 15,862 19,863 15,862 Current maturities of a voluntary retirement plan (see note 15.b.13) 837 1,920 837 1,920 Affiliate companies - - 5 - Other creditors 25,439 23,580 25,156 21,698 339,287 324,546 335,578 320,039 (1) Includes: accrued vacation pay 36,231 32,142 35,480 31,276 NOTE 14 - LONG-TERM LOANS FROM FINANCIAL INSTITUTIONS Interest rates - Consolidated and Company December 31, December 31, a. Composition: 2 0 0 6 2 0 0 6 2 0 0 5 % (in thousand US dollars) Loans in, or linked to, U.S. dollars: Bank loans - bearing interest of Libor plus a margin from a trust 5.35-6.5 667,362 683,693 at a fixed interest rate (see c1 below) - 11,414 667,362 695,107 Less: current maturities (98,505) (67,744) 568,857 627,363 Less: balance of loan arrangement expenses (see Note 2.j.) (2,753) - 566,104 627,363 b. Repayment schedule: December 31, 2006 (in thousand US dollars) First year 98,505 Second year 52,542 Third year 54,040 Fourth year 53,684 Fifth year and thereafter 408,591 667,362 Less: current maturities (98,505) 568,857 C-41 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 14 - LONG-TERM LOANS FROM FINANCIAL INSTITUTIONS (Cont.) c. Additional information: 1. For financing the acquisition of two 747-400 aircraft (ELA and ELB) and spare engines received in 1994, the Company obtained a loan, secured by a promissory note from a trust established by Citicorp Securities Inc. in the US, for which debentures totaling $ 274 million were issued in the US. The 12-year loan bears a fixed interest rate of 7.39% and is repayable in 24 semi-annual installments starting in November 1994. EXIM Bank guaranteed the Company’s repayment of the loan against a parallel guarantee by the State of Israel, for which the Company pays the State annual guarantee fees equaling 0.25% of the loan’s outstanding balance. See Note 18.b.10. The Company is required to insure the planes at 115% of the outstanding loan balance and also to insure itself by means of liability insurance for an amount not lower than $ 800 million per incident. During the reporting year, the repayments of this loan ended and the loan was paid in full. 2. In October 2006, the Company signed an agreement with a foreign bank for the receipt of financing in the amount of approximately 80 million dollars, against a lien on two 747- 400 ELA and ELB aircraft (with an option for an additional 10 million dollars for each aircraft in order to finance the conversion to cargo- should it be decided to convert them to cargo). The proceeds to be received could be used to reschedule part of the existing loans or for other investments, as the Company will see fit at the time that it withdraws the loans. The financing bears variable interest at the rate of Libor plus a margin and was given for a period of 10 years from the first withdrawal, with semi-annual repayments of principal plus interest. The Company withdrew approximately 40 million dollars in this framework in November 2006. The Company has the right to withdraw another 40 million dollars through November 2007. 3. For financing three 777-200 aircraft (marked ECA, ECB and ECC), the Company signed a contract with Bank Hapoalim Ltd. on July 27, 2001 to receive loans totaling approximately $ 300 million over a 12-year period, bearing a variable interest rate of Libor plus a margin. 4. For financing a third 747-400 aircraft (ELC), the Company received a loan of $102 million on May 31, 1995 from Bank Leumi Ltd. ("BLL") for a period of 12 years, repayable in 24 semi-annual installments at variable interest of Libor plus a margin. 5. In order to finance a fourth 747-400 aircraft (ELD), the Company received a loan of $ 150 million on May 20, 1999 from BLL for a period of 12 years, with a variable rate of interest of Libor plus a margin, repayable in 24 semi-annual installments. During 2004 the bank agreed to split the loan balance into two separate loans, each with a designated semi-annual repayment date. The loan agreement stipulated that a sale of more than 25% of the Company’s ownership rights to a single purchaser is subject to the bank’s consent, lack of which would constitute a cause for immediate loan repayment. As for the Company's approach to BLL following the transfer of control of the Company in December 2004, see note 14f.2.b. C-42 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 14 - LONG-TERM LOANS FROM FINANCIAL INSTITUTIONS (Cont.) c. Additional information: (Cont.) 6. The Company received a loan of $ 70 million on April 15, 1999 from Israel Discount Bank Ltd. in order to finance the purchase of two second-hand 767-200 aircraft (EAE and EAF), for a period of 12 years, repayable in 24 semi-annual installments at variable interest of Libor plus a margin. 7. For the financing of five 737 aircraft (EKA, EKB, EKC, EKD, EKE), the Company received a loan of $ 190 million from Bank Hapoalim Ltd. on January 13, 2000 for a period of 12 years, repayable in 24 semi-annual installments with variable interest of Libor plus a margin. During 2004, the bank agreed to split the loan balance into two separate loans, each with a designated annual repayment date. 8. In order to finance the acquisition of a 757-200 aircraft (EBU), the Company received a loan of $ 40 million from Bank Hapoalim Ltd. on March 31, 1998 for a period of 10 years, repayable in semi-annual installments with variable interest of Libor plus a margin. During 2004 the bank agreed to split the loan balance into two separate loans, each with a designated annual repayment date. 9. The Company received a loan of approximately $ 102 million in June 2002 from City Bank for financing the acquisition of a fourth 777-200 aircraft (ECD) (by means of the subleasing referred to in Note 9.e above), for a period of 12 years, with variable interest of Libor plus a margin 10. As financing for a first spare engine for the 777-200 aircraft fleet, the Company received a loan of $ 12 million from Bank Leumi Leasing Ltd. on December 14, 2000 for a period of 10 years, repayable in quarterly installments with variable interest of Libor plus a margin. 11. For the financing of most of the acquisition cost of another spare engine for the 777-200 fleet, the Company obtained a loan of approximately $ 14 million on December 29, 2005 from the BNP Paribas bank. This 12-year loan will be repaid in semi-annual installments, at a Libor variable interest rate plus a margin. The Bank for the Encouragement of Industry in England (ECGD) provided the Company with a loan repayment guarantee for which the Company paid a one-time premium to ECGD. 12. See Note 17.d.1 regarding a commitment to obtain financing for the acquisition of two 777- 200 aircraft to be received in the year 2007. d. As for transactions to hedge interest rates – see Note 20.a.4. e. Early repayment: All existing loans as of December 31, 2006 may be repaid early by the Company. Moreover, in accordance with the terms stipulated in certain agreements, it was determined that if, in the opinion of the bank, based on reasonable criteria, an event had occurred which adversely affects the Company’s financial position or its business or its financial ratios in a manner endangering or potentially endangering the ability to repay any bank loans, then the bank may demand immediate repayment of the outstanding loans owed to it. C-43 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 14 - LONG-TERM LOANS FROM FINANCIAL INSTITUTIONS (Cont.) f. Restrictions and financial covenants of long-term loans: 1. Ratio between loan balances and collateral- All of the loan agreements described in items c.3-c-8 above stipulate that the market value of the pledged aircraft should exceed the bank-loan balance by 25% and that an examination of this nature should be carried out once a year (in some agreements – twice a year) based on certain, stipulated, international professional publications. The Company also agreed to provide additional security, or repay its bank loans earlier, should the actual ratio be lower than the above ratio. As of the financial statements date, the Company has complied with the restrictions and financial covenants established with the banks. 2. Arrangement with banks following privatization – a. During April - May 2003, the Company received letters from Bank Hapoalim Ltd. (“the Bank”), claiming that, based on the loan agreements the Bank is entitled to demand immediate repayment of all outstanding loans in the event of a change in the Company’s status as a “government corporation” under the Government Corporations Law. After privatization, the Bank removed its objection to carrying out the offering of shares to the public, and the State concurrently undertook that, starting from the date of the share offering and share sales proposal and through December 2004, the State and employee holdings in the Company would not, at any time, decline below 50.00001% of the Company’s outstanding share capital (fully diluted). Within the framework of the abovementioned agreement, the Bank agreed to rescind its demand for early repayment. On September 28, 2004, the Bank notified the Company that it consents to the transfer of control to K’nafaim (see Note 1.b.2) in any manner, and this would not be considered by the Bank as an event constituting a breach event in the context of the agreements and would not give the Bank the right to demand immediate repayment of any outstanding loans, in whole or in part. b. In May 2003 Bank Leumi Ltd. (BLL) informed the Company that, should control in the Company be changed or transferred in any way, without its written consent in advance, BLL would be entitled to demand immediate repayment of all outstanding loans. Upon privatization, BLL removed its objection to carrying out the offering of shares to the public. During the year 2004, management requested that BLL to agree that the transfer of control to K’nafaim would not give the BLL the right to demand immediate repayment. In this connection, BLL informed the Company that it had no objection to the change of control in the Company whereby K’nafaim would increase its holdings in the Company in a manner that would cause it to be the controlling interest in the Company. C-44 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 14 - LONG-TERM LOANS FROM FINANCIAL INSTITUTIONS (Cont.) f. Restrictions and financial covenants of long-term loans (cont.): 2. Arrangement with banks following privatization (cont.) – b. (Cont.) BLL’s consent is contingent upon the fulfillment of the following conditions: 1. The controlling parties in K’nafaim would be the Borovich family. The term “control” for this purpose – as defined in the Banking Law (Authorization), 1981. 2. The change in ownership referred to above would take place no later than June 5, 2007. Subject to the above, it was agreed that BLL would not exercise its right to demand immediate repayment of outstanding debts and liabilities of the Company solely as the result of the abovementioned change in control. Moreover, within this framework, K’nafaim informed BLL that, in light of the Company’s present outstanding debt to BLL, and due to the fact that the Company’s Board of Directors will, from time to time, formulate a profit-distribution policy for the Company, then as long as the open principal balance of the outstanding debt of the Company to BLL is not less than $ 50 million, K’nafaim will not support a resolution for profit-distribution at a rate exceeding 60% of distributable retained earnings of the Company from time to time, unless it will consult with BLL regarding any amount in excess of 60% (as for the dividend distribution policy – see Note 19g). 3. Obtaining additional loans in Israel - The rules of the Israeli Supervisor of Banks include restrictions according to which the debt of a "single borrower" or "a group of borrowers" to a bank in Israel shall not exceed a certain percentage of that bank’s shareholders’ equity. These instructions may, from time to time, affect the ability of some of the banks in Israel to grant the Company additional credit. Due to the change in the holdings in the Company, following which K’nafaim holds more than 25% of the Company’s issued and outstanding share capital, the Company is deemed to be a part of the K’nafaim Group as far as the restriction of bank credit is concerned. In light of the weight placed on its outstanding long-term loans from banks in Israel, and due to the volume of loans provided by these banks to the companies in the K'nafaim group, the Company may encounter difficulty in raising additional loans in considerable amounts from banking institutions in Israel that may be required for purchasing new aircraft and for other investments. g. Liens – see Note 18. C-45 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET a. Composition: Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) Liability for severance pay 133,743 125,264 132,116 123,872 Less: amounts funded (86,752) (80,243) (84,865) (78,521) 46,991 45,021 47,251 45,351 Liability for grant due to unutilized sick leave (see Note 15b.5), accrued vacation pay and benefits to retirees 35,440 31,570 35,421 31,551 Liability for a agreed retirement program, net 37,981 45,855 37,981 45,855 Less: current maturity (see Note 15b.13) (837) (1,920) (837) (1,920) 37,144 43,935 37,144 43,935 119,575 120,526 119,816 120,837 b. Additional information 1. General The liabilities of the Company and its subsidiaries for the termination of employee- employer relationships included in these financial statements represent those not covered by current deposits to recognized pension and severance-pay funds, provident funds and insurance companies. The amounts accumulated in the aforementioned pension funds, provident funds and insurance companies are not under the custody or management of the companies of the Group and, therefore, the related liabilities are not reflected in the financial statements. Against part of the above liabilities not otherwise covered, the Company maintains accounts in recognized severance-pay funds into which it deposits amounts in its name and in the name of its subsidiaries. These amounts, which include accrued income, may be withdrawn only after fulfilling the conditions stipulated in the Severance Pay Law. C-46 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 2. Collective labor agreements On May 20, 2004 the Company signed several collective labor agreements with the Histadrut and the employees’ representatives, as follows: a. The special collective agreement for Company employees was extended to December 31, 2005. b. At the same time, a collective labor agreement for the next generation in administrative, operative and air-steward professions was signed. This agreement, which will remain in effect until December 31, 2008, will enable the Company to hire trained temporary workers, will prevent the loss of professional know-how, will enable the Company to achieve efficient improvement in the wage area during the coming years for the Company and will allow it to acquire administrative flexibility. c. The effective date of the special collective labor agreement concerning the hiring of temporary workers was extended to December 31, 2008. On September 5, 2006, the Company, the Histadrut and employee representatives signed a special collective agreement that extends the effective date of the special collective with respect to the permanent Company employees (Generation A Agreement") through December 31, 2007. On October 5, 2006, the Board of Directors of the Company ratified this agreement. Concurrently, due to the Company's economic condition, the Company management entered into negotiations with the employees' representatives for purposes of finding joint and agreed solutions for introducing efficiency steps in the Company, and changing the terms of the above special collective agreement. Management believes that the financial statements contain adequate provisions to cover the liabilities deriving from the above labor agreements. 3. Pension agreement The social benefits of some of the Company employees have been formalized in a pension agreement signed in September 1, 1992 between the Company, the Histadrut, representatives of employees and the Mivtachim pension fund, based on the industrial pension agreement that was adapted for the particular structure of the population of Company employees. Membership in the comprehensive pension plan was previously voluntary for veteran employees and mandatory for new employees to whom the collective labor agreement applied and who were able to accumulate the qualification period for entitlement to a pension. (Veteran employees with an age exceeding 55 for men and 50 for women could, under certain conditions, join a comprehensive pension plan and receive a pension even without having completed 10 years of membership.) An employee joining the comprehensive pension must insure part of his salary by pension (ground worker - 50%, air- crew personnel - 25%) and the balance can be covered by managers' insurance or the provident fund for Company employees. C-47 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 3. Pension agreement (cont.) The agreement provided that the Company's payments to the pension fund and an approved fund (managers' insurance or provident fund) for an employee joining the pension plan, will, for all intensive purposes, come in lieu of its severance-pay obligation for that employee, pursuant to Section 14 of the Severance Pay Law for that part of the salary and for that period as to which the payments were made. The employees joining the pension plan are eligible for severance pay and provident fund pay upon retirement from work, for the period beginning with commencement of employment through the date of joining the pension fund and, subsequently, to the rights accrued to their credit in the pension fund. Starting January 1, 1995, new employees are insured for pensions with the Mivtachim comprehensive pension plan, according to the pension rules to new members. The retirement age was raised effective 2004. For the effect of this change on the early retirement programs – see Note 15.b.13.e below. The amendments to the Income Tax Ordinance (Rules for Approving and Managing Pension Funds) (Amendment), 2004, which were enacted in 2005, change the rules pertaining to deposits in, and withdrawals from, pension plans, also in regard to the reduction of the ceiling of the amount insured as equity insurance. In June 2005, the Company signed a special collective labor agreement with the New Histadrut Labor Union-the Professional Union Branch and the Joint Representatives for EL AL employees, enabling to adapt the existing provisions to the new rules, at the employee's preference. 4. Severance pay a. Overview – Employees who received permanent status through the month of September 1992 are entitled to severance pay for their employment until then, computed on the basis of one month for each year of employment. With regard to the employment period thereafter, the abovementioned employees are entitled to severance pay if they have not joined a pension plan, or a combined plan of pension, managers' insurance and savings in a provident fund (at their personal election) according to the rules prescribed in the collective labor agreement. Employees who received permanent status in the Company subsequently were then obligated to join the pension plan by selecting the appropriate pension combination but are not entitled to severance pay. By the privatization date the Company had concluded arrangements with the employees for assuring severance pay and with the State of Israel to assure financing sources. See item b below. C-48 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 4. Severance pay (cont.) b. Arrangements with the employees for assuring severance pay and with the State of Israel to assure financing sources 1. Covering the deficit in the obligation for termination of employee-employer relationships- On June 3, 2003 the Company reached an agreement with the employees' representatives for covering the deficit of NIS 516,240 thousand (“the Deficit”) in the obligation for termination of employee-employer relationships, with this amount linked to the CPI and bearing annual interest of 5.05% starting June 1, 2003, net of the amounts transferred to a recognized pension fund, from time to time. The Company and the State agreed to cover the Deficit by assuring the raising of capital, as outlined below: a. Any immediate as well as future proceeds from the initial offering and any proceeds from future offerings of shares or other securities received by June 5, 2007 ("immediate and future proceeds") up to the amount of the Deficit will be transferred to the severance-pay fund as soon as it is received, with the Deficit reduced accordingly; b. Should the Company’s immediate and future proceeds not be sufficient to cover the balance of the Deficit at that given point in time, the State would then transfer the amount required to fully cover that Deficit. As soon as this agreement goes into effect, and subject to its execution, the employees’ union waived, on behalf of each and every Company employee, any claim against the State with respect to the Deficit or financing it. Moreover, the Company and the employees’ representatives undertook to refrain from making any claim, allegation or demand against the State concerning this matter. This understanding went into effect upon the registration of the Company’s shares for trade on the Tel Aviv Stock Exchange. On June 2, 2003 the Knesset’s Finance Committee resolved to approve a commitment with respect to this arrangement for purposes of providing a safety net of NIS 628,689 thousand for the employees’ severance-pay fund. On June 3, 2003 the Company’s Board of Directors ratified the above agreement. C-49 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 4. Severance pay (cont.) b. Arrangements with the employees for assuring severance pay and with the State of Israel to assure financing sources (cont.) 1. Covering the deficit in the obligation for termination of employee-employer relationships (cont)- The following table presents the amounts originating from the proceeds of exercise of purchase options and options exercisable into shares that have been deposited to the employees’ severance-pay fund: Year ended December 31 Amounts deposited by - the State the Company Total (in thousand US dollars) 2003 11,296 4,909 16,205 2004 38,396 712 39,108 2005 25,791 535 26,326 2006 775 296 1,071 76,258 6,452 82,710 Subsequent to the balance- sheet date and near the approval date of the financial statements - 189 189 The balance of the Deficit to be covered by the State amounted, as of December 31, 2006, to $ 47.6 million (including interest and linkage as above). On September 11, 2005 the Company received a letter from the Government Corporations Authority, in which the Authority notified the Company that, in agreement with the Accountant General of the Ministry of Finance, the State of Israel would not object to the interpretation according to which the State’s obligation would not be diminished due to the proceeds receivable by the Company from an offering which includes only non-convertible debentures, so long as the employees' representatives of the Company, which is a signatory to the agreement, consents to that interpretation. The consent of the employees' representatives has not yet been received. 2. The Company and the employees’ representatives agreed to cooperate in the implementation of an agreed-upon retirement program of 50 employees per annum over a four-year period (total: 200 employees) so long as the identity of the retiring employees is jointly determined by the Company and the employees’ representatives. During the years 2003-2006 a total of 200 employees retired within that framework (for additional details – see Note 15b.13). C-50 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 5. Redemption of sick leave Pursuant to the collective labor agreement, employees are eligible for full payment of up to 30 days' illness per annum (other than new employees who have limited accumulation), which may be accrued throughout all years of employment. Upon retirement from the Company, mandatory or having retired after reaching the age of 45, permanent employees (other than executives, beginning from their transition to personal employment contracts) are eligible, if they retired under terms entitling them to severance pay, to a grant for unutilized sick days, at a rate of up to 26.6% of the value of the unused days. The liability for this grant was determined on the basis of the rights accrued for those eligible employees who reached the age of 45 as of the date of the financial statements and is presented in the financial statements at its full, non-discounted value. 6. Temporary employees Pursuant to the labor agreement signed by the Company and the temporary employees, these employees have joined the comprehensive pension plan, and the Company deposits monthly amounts for them on a current basis. These deposits cover the Company’s obligations for the termination of employee-employer relationships for its temporary employees. As for the temporary employees who commenced work before the requirement to join the pension plan took effect, the Company records an adequate provision in its accounts. As regards the extension of the special collective labor agreement pertaining to the employment of temporary staff (collective labor agreement for the continuing generation) – see Note 15b.2 above. In November 2002 the New Histadrut Labor Union (hereafter: "Histadrut") filed a motion to become a party to a collective dispute with regard to the temporary air and ground stewards on the following topics: Non-payment of minimum wage and social benefits during the training course, non- payment of minimum wage and overtime during advanced studies, non-payment of wages to air stewards for ground hours, breach of the collective labor agreement on the issue of new assignment and breach of the collective labor agreement on the subject of vacation and sick-leave. The legal aid requested by the Histadrut were declaratory and relates to future entitlements of stewards who will undergo training as well as entitlements of stewards who were trained in the past (subject to the statue of limitation). The Tel Aviv District Labor Court handed down its judgment on March 15, 2005. The principal operative rulings in the judgment were that an employer-employee relationship does exist during the training period and, accordingly, the trainee is entitled to compensation that is not less than minimum wage plus social benefits. As for stewards who took the course in the past, the court stated that each steward is entitled to file a personal claim, as to which the Company would be allowed to assert the statue of limitations and the rate of benefits and payments. The court also ruled that the temporary stewards are entitled to minimum wage plus overtime pay during the training period and are also entitled to vacation days based on years of employment and have the right to pay differentials for the past with respect to these two components. C-51 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 6. Temporary employees (cont.) The court rejected the claim for ground hours for temporary stewards and rejected the claim for new assignment and the computation of sick-leave compensation for the ground stewards. On July 27, 2005 the Company signed a special collective labor agreement constituting a compromise agreement between the Company, the Histadrut and the employees’ representatives, that went into effect at the beginning of September 2005. This followed the signed consent to the contents of the agreement by the currently employed 1,250 stewards who are entitled to file a claim under the court judgment. This compromise agreement detailed the payments and the rules based on which the Company’s obligations to the employees would be fully discharged in accordance with the court judgment. 7. Air-crew personnel Air-crew personnel are entitled, according to an agreement, to receive the higher of severance pay for their period of employment through December 1979, computed on the basis of their last salary, or their salary for the month of December 1979 (net of the part of the salary as to which severance pay had been paid in the past - 20%), linked to the Israeli CPI. As for the period subsequent to December 1979, the Company's liability for severance pay is computed on the basis of their last salary. As for the Company’s communication regarding the retirement age of the pilots – see Note 15b.13.e below. 8. Company executives Company executives are employed under personal employment agreements. These employees are entitled to receive additional severance pay for the period of their employment of 100%, in excess of the balances accumulated in the pension-funds and/or insurance-companies.. 9. Employees posted abroad The Company employs abroad, inter alia, permanent workers who are Israeli residents, relocated to fulfill managerial positions abroad, usually for periods ranging from four to six years ("agent"). Salaries of the posted employees while serving abroad ("compensation abroad") are different than Israeli wages, and take into account the local standard of living and taxation, and the fact that the salary is subject to tax and social-insurance deductions both abroad and in Israel. In addition to the salaries of the posted employees, the Company bears the cost of their housing and tuition fees for the agents' children. Payment of salaries plus rent and tuition is carried out by the Company under the Israeli income tax regulations. As for the claim of the income tax authorities-deductions–see Note 17.a.10.b. below. The obligations for termination of employee-employer relationships for those employees are determined on the basis of wages paid to employees at their level who are employed in Israel. C-52 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 10. Local employees in Company branches abroad Most of Company employees abroad, other than the Israeli posted employees, are engaged under collective labor agreements between the Company and the union in that country, or under employment agreements with the employees’ representatives, with a few under agreements between the employers' organization (foreign airlines) and the umbrella organization of airline employees, or under other agreements. The employment terms of Company personnel in certain countries are not covered by a collective agreement but rather established by the Company, in accordance with the acceptable practice in the airline industry or the national airlines in those countries. In some branches, the employees are engaged under personal contracts or through a contractor. Some of the branches are committed to pay severance pay according to law or agreement while other are obliged to adhere to national or other pension insurance. The Company transfers ongoing payments for the pension insurance while providing in its accounts for the obligation for severance pay. Some of the local employees of the Company who are residents of the US and Britain, respectively, benefit from pension plans ("the plans"), with the pension cost of the branch employees being paid for by the Company. The cost of the pension is computed as a multiple of "years of eligibility" for the pension multiplied by the rate of salary determined as entitled to pension. Retirement commencing at the age of 65 ordinarily entitles the employee to full benefits. The pension-plan assets, which are invested mainly in marketable securities, are not owned by the Company. The Company is obliged to cover any deficit that would be created in the value of the funds’ assets relative to any actuarial obligation, should such deficit be created. The Company adequately provided in its financial statements as of December 31, 2006 for the difference between the actuarial liability for the employees in the US and Britain, who were included in the pension plans, and the amount of the pension plans. 11. Security personnel Payments to discharge obligations for termination of employee-employer relationships related to personnel employed by the Company or by a governmental entity to defend the Company's services are made out of the State budget for aviation security. There is no employee-employer relationship with the Company for most of these employees and, accordingly, no provision was included in these financial statements to cover such payments. With regard to the Company's participation in the Government's expenses for defending the Company’s services (including participation in the above expenses) - see Note 21c. 12. Employees of subsidiaries Employment terms of the Company's main subsidiaries in Israel are regulated by labor agreements, pursuant to which the obligation for termination of employee-employer relationships is computed on the basis of their last salary and of pension arrangements, as applicable. The employment terms of the main foreign subsidiaries are regulated by collective labor agreements in those countries and in accordance with local laws and practices. C-53 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 13. Consensual early retirement programs a. General - Within the framework of the Company's cost cutting and efficiency improvement measures, the Company has, since 2000, been implementing a retirement plan pertaining mainly to veteran employees. In this context, the Company has signed agreements with Mivtachim – Institution of Social Insurance for the Employees Ltd. (“Mivtachim”) and in the current year and with Clal Pension and Provident Services Ltd ("Clal"), guaranteed by the State of Israel and by a bank guarantee. b. Highlights of the agreement with the retiring employees and with Mivtachim and Clal: 1. Receipt of an annuity from date of retirement until the age of 65, and for part of the employees until retirement age according to law (men and women) up to 70% of pension-base gross salary. The payment of the annuity shall not exceed 10 years; 2. Mivtachim or Clal will pay the pension directly to the employee; 3. The retirement arrangements have been formalized in a series of agreements between the Company and the employee, the employee and Mivtachim or Clal and the Company and Mivtachim or Clal. Pursuant to these agreements, Mivtachim and Clal undertake to guarantee the pension payments against a back-to-back guarantee to be given to it; 4. All employee-employer relationships between the Company and the employee are terminated upon retirement. c. Highlights of the agreement with the State of Israel, as approved by the Knesset Finance Committee: In an effort to assist the Company in implementing the above retirement programs, the Company signed an understanding with the Accountant General, representing the State, on April 4, 2002 to arrange the commitment made by the State at the time of privatization to finance the deficit in the provision for severance pay for those personnel continuously employed by the Company up to the end of the year 1982. In the context of the accord, the following was agreed, irrespective of privatization: 1. The State will provide a guarantee to Mivtachim – Institution of Social Insurance for the Employees Ltd. or other financial institutions, including banks, in connection with the financing of the deficit in provision related to the employee retirement program. The extent of the State guarantee will be $ 80 million. 2. Following the State’s discharge of its obligation to provide that guarantee, the Company would have no further demands of any kind against the State in connection with the historical accounting regarding those employed by the Company until the end of the year 1982. 3. In the event of privatization, the Company’s new owners would be required to provide guarantees in lieu of the State’s guarantee. This requirement was abolished by the Knesset’s Finance Committee on June 2, 2003, after the privatization date. C-54 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 13. Consensual early retirement programs (cont.) d. Additional information - During the years 2000 through 2006, the Company's management adopted resolutions relating to early retirement programs for 602 employees, as to which provisions were recorded in the Company's accounts. As of December 31, 2006, 530 employees had concluded their actual retirement from the Company within the framework of the abovementioned programs. The financial statements as of December 31, 2006 include the balance of an accrual in a total amount of $ 57,724 thousand for financing the retirement of approximately 437 employees, (after a group of employees included in the original retirement programs reached retirement age through December 31, 2006 with a provision no longer recorded for them in the financial statements). Within that framework the Company deposited funds for assuring early retirement pension payments to employees, the balance of which as of December 31, 2006 amounted to $ 19,743 thousand. The balance of the State’s guarantees in favor of Mivtachim and Clal with respect to the retirement programs amounted as of December 31, 2006 to approximately $ 46 million. As the Company formulates and decides upon consensual retirement programs in the future, subject to the cooperation of the employees’ representatives, as explained in Note 15b.4.b.2, the Company will not be entitled to receive additional guarantees from the State of Israel. Additional retirement programs will be executed with Company guarantees. e. Change in retirement age Within the context of the Law for Economic Recovery of the Israeli Economy and Retirement Age Law, 2004 it was determined, among other things, effective from the year 2004, that: 1. The age at which employees (both men and women) may be forced to retire from their jobs will be 67 (“Mandatory Retirement Age”). Mandatory retirement age will apply to every employee whether insured by managers’ insurance, or not insured by any insurance. 2. Employees who are insured by pension plans may be forced to retire at the ages of 67 (male) and 62 (female) (Pension Fund Retirement Age”). Employees (male or female) retiring after the age of 60 but before reaching retirement age will be entitled to receive reduced early pension during this period. 3. Starting January 1, 2004, the pension contribution rates (for both employee and employer) were raised (gradually over the years 2004-2006, up to an additional rate of 1.5% for the employee and 1.5% for the employer). C-55 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 15 - OBLIGATIONS FOR THE TERMINATION OF EMPLOYEE-EMPLOYER RELATIONSHIPS, NET (Cont.) b. Additional information (cont.) 13. Consensual early retirement programs (cont.) e. Change in retirement age (cont.) The effect of the above change on the early retirement programs: a. The raising of the retirement age and the increase in pension contributions has increased the Company’s liability with respect to the consensual retirement programs by an approximate $ 2.5 million (including the additional pension contribution that the Company will be required to transfer to the pension fund until retirement age), which was recorded to other expenses for the year ended December 31, 2004 and for which is fully provided for in these financial statements. b. In addition, there is a group of veteran employees that retired within the framework of an early retirement program before the date of the change in retirement age (“the Veteran Employees”). Pursuant to an agreement signed between the Government and the Economic Organizations’ Liaison Bureau on January 5, 2005 to amend the package agreement signed by the parties, it was agreed that the Government would finance the additional cost associated with the raising of the retirement age for employees leaving under early retirement programs by December 31, 2003. c. Furthermore, the Company asked the Director of the Finance Ministry to leave the retirement age of pilots (as stipulated in the flight regulations) unchanged (65 years) but this request was rejected. Other than for this, the change in retirement age and the increase in pension contributions do not materially affect the Company’s current expenses. As for a lawsuit filed against the Company in this matter – see Note 17a.8 below. 14. Productivity incentives Within the framework of the collective labor agreement, the Company pays its ground personnel productivity incentives for efficiency and workforce reduction (measured in payable hours) per unit of output (hereafter: "the productivity") in accordance with the "improve and win" method. The "improve and win" method is based on equal distribution among the parties (Company and employees) of the saving achieved by the Company by efficiency and reduction in manpower input per unit of output. The productivity incentives are paid monthly and limited to a ceiling of 20% of wages. Productivity surpluses (should there be any) are retained in a “bank” for future utilization. On the basis of indices taken into account in the determination of the “overall productivity rate” and on the basis of management’s estimate, a provision of $11,400 thousand was included in the financial statements as of December 31, 2006 (as of 31.12.05: $ 11,400 thousand). C-56 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 16 - OTHER LONG-TERM LIABILITIES Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 a. Composition: (in thousand US dollars) Loans to finance the purchase of a cargo plane (see b) 1,992 4,084 1,992 4,084 Capital leases 1,046 223 858 - 3,038 4,307 2,850 4,084 Less: current maturities (2,308) (2,092) (2,308) (2,092) 730 2,215 542 1,992 b. The Company received a loan during the year 2004 in the amount of approximately $ 6.3 million in order to finance the acquisition of a cargo aircraft, repayable in 36 monthly installments. The loan bears a fixed interest rate. As for liens - see Note 18b.5. c. During the reporting year, the company entered into two capital lease agreements for the acquisition of computer and other equipment in a total original amount of $ 1,014 thousand. This equipment is included in the framework of the Company's fixed assets (see Note 9.g.) NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES a. Lawsuits and other claims As of December 31, 2006, legal claims in a total amount of approximately $ 99.4 million had been filed against the Company with respect to which the Company had recorded provisions in the financial statements, based on legal counsel of the Company, in approximately a total of $ 4.4 million. Legal claims non-quantified in monetary amounts have also been filed against the Company. The above provision in the financial statements also includes provisions for non-quantified claims, as estimated by Company management. The above amounts exclude various claims against the Company which, in management’s opinion, are covered by adequate insurance policies and handled by the insurance companies on their responsibility. The aforementioned amounts of claims and provisions do not include income tax-withholding tax assessments and income tax demands (see Note 17.a.10 below). In the assessment of Company management, based upon the opinions of its legal counsel, it is not anticipated that the Company will be exposed to an additional loss with respect to the abovementioned claims in excess of the above provisions recorded in the financial statements, except for certain legal claims-mostly claims approved as class actions, for which no provision has been made in the financial statements since the Company's legal counsel has difficulty in assessing their financial outcome. C-57 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) a. Lawsuits and other claims (Cont.) The following is a detailed summary of material legal and financial claims: 1. In October 1998, a lawsuit for NIS 230.4 million (approximately $54.5 million as of the balance sheet date) was filed in the Nazareth District Court against the Company, along with a request to recognize it as class action. The claim relates to excess collections of airline ticket prices by travel agents derived, allegedly, by using improper exchange rates. During the year 2002, the court approved the request for class-action recognition under the Consumer Protection Law. The Company filed an appeal with the Supreme Court. Based on the opinion of its legal counsel, Company management believes, at this stage, the results of the hearings against the judgment to consider the claim as a class action cannot be assessed and that that the outcome of the claim itself should the Company's appeal not be accepted. Accordingly, no provision for this claim has been included in the financial statements. 2. A lawsuit for NIS 21.7 million (approximately $ 5.1 million), was filed in September 1999 in the Tel-Aviv District Court against the Company, the Aviation Authority and Ophir Tours (a travel agency), together with a request for recognition as a class action. The plaintiff alleges that the travel agent charged it travel tax at a rate above the legal limit, which is the representative exchange rate, and that the Company is responsible as well for the actions of the agents in this matter. During the year 2002, the court approved the request to recognize the claim as a class action for purposes of a breach of a legal obligation on the basis of Regulation 29 of the Legal Order Regulations. The Company filed a request for permission to appeal to the Supreme Court. In October 2005, judgment was handed down in the matter of Eshet, in which the Supreme Court ruled that class actions are possible strictly on the basis of specific laws which include that possibility but not in accordance with Regulation 29of the Civil Legal Order Regulations. Consequently, the parties were requested to submit their position to the court in connection with the continuance of the proceedings. The plaintiff gave notice that it planned to continue the proceedings on the basis of the Consumer Protection Law, and this was not approved by the District Court. The court has not yet decided on that issue. Based on the opinion of its legal counsel, the Company believes that neither the result of the appeals nor the outcome of lawsuit itself can be estimated at this stage. No provision for this claim has been compiled in the financial statements. 3. A lawsuit for $32 million was filed in July 2002 against the Company and Sun D’Or, pertaining to the insurance and security surcharge collected by the Company. The plaintiffs asked the court to order the Company to reimburse them for the surcharge paid and order the Company to refrain from continuing to collect it, this since the plaintiffs allege that the surcharge is not used by the Company for improving its security system. The plaintiff also requested the court to approve this claim as class action. In August 2005 the District Court rejected the request for approval as a class-action and the plaintiffs filed an appeal with the Supreme Court. The Company’s legal counsel believes that the appeal’s prospects are not significant and, accordingly, the Company has not compiled any provision in this matter. C-58 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) a. Lawsuits and other claims (Cont.) 4. A lawsuit was filed in July 2004 against the Company, Sun D’Or, Arkia and two travel agents. The plaintiffs requested the court to approve their claim as a class action under the Consumer Protection Law. The plaintiffs allege that the purchasers of non-refundable airline tickets are falsely led to believe that they are not entitled to receive a refund of the airport tax and various surcharges. The plaintiffs requested to represent all the purchasers of tickets from the defendants who had neither used their airline tickets nor received a refund of the taxes and surcharges during the seven years preceding the filing of the lawsuit. The Company and Sun D’Or have filed their defense motion. A court-hearing date has not yet been established. Based on the opinion of legal counsel, Company management believes that it is impossible to assess the outcome of this lawsuit. No provision has been compiled in the financial statements for this claim. 5. A claim was filed against the Company by passengers who allege that, during an El AL flight to New York on July 24, 2003, one of the aircraft's tires exploded, which caused a mishap and the return of the aircraft to BGA. The plaintiffs claim that the event caused them expenses as well as non monetary damages (anguish, anxiety, etc.). The plaintiffs requested that their claim be recognized as a class action and asked that they be allowed to represent all of the aircrafts passengers (approximately 550) and to rule on compensation to each of NIS 4,000 and in total, NIS 2.1 million (approximately $ 0.5 million as of the balance sheet date). The court expunged the plaintiffs' claim outright. An appeal was filed on October 23, 2006. Subsequent to the balance sheet, the parties reached a compromise in the context of which the appeal was withdrawn. 6. In October 2005, a claim was made in the Supreme Court of Ontario, Canada against the Company and additional defendants by a former employee of the Company for alleged sexual harassment and sexual molestation. The amount of the claim was approximately 2.2 million Canadian dollars (approximately 1.9 million U.S. dollars as of the date of the report). In the Company's estimation, based on its legal counsel, the prospects for the claim are not significant. 7. A claim was filed against the Company by a former employee of a subsidiary in relation of discharge, which he alleges was due to harassment by the Company. The amount of the claim is approximately NIS 6.1 million (about $ 1.4 million as of the balance sheet date). In the Company's estimation, based on its legal counsel, the prospects for the claim are not significant. C-59 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) a. Lawsuits and other claims (Cont.) 8. In June 2006, a suit was filed against the Company and the State of Israel-Ministry of Finance by 94 claimants who were employed by the Company and took early retirement between the years 2001-2003. The claimants in their suit have appealed for declaratory relief/order of performance to amend their retirement agreements in a manner in which the retiree will receive the early pension stipend, including fringe benefits, until the legal retirement age, instead of until the age of 65; alternatively, the claimants appealed for declaratory relief/order of performance to revoke the retirement agreements. The principal relief claimed is to "amend" the retirement agreement so that the claimants will be eligible to receive budgetary pension through the age of 67, in parallel to which they will be entitled to have the Company continue to deposit provisions for them until that time to the pension funds. The claim was not quantified and therefore it means the continuation of such payments for an additional period for each claimant of two years. A writ of defense was filed in which it was alleged that the claim should be rejected out of hand, both for the reason that all of the claimants left their employment under early retirement and signed retirement agreements which included a section stating absence of claims, and also due to lack of quantification of the claim. It was also alleged that the claimants who had elected not to join the pension fund had, over the years, did not pay the employee's share of pension contributions to the pension fund, this in contrast to the employees who joined the pension fund, and unlike the employees who joined the pension fund, the claimants chose not to do so and received full severance pay for the entire period of their service upon termination of their employment. In addition, the Company presented additional defense claims. The claim is in the stage of preliminary proceedings. 9. In January 2002, 72 pilots, some who had terminated their service and some who were still active, filed a lawsuit against the Company. The plaintiffs alleged that the collective labor agreement stipulates the retirement age for a permanent employee as being 65 plus three months and that the Company does not comply with this agreement. The plaintiffs, in their lawsuit, requested the court to declare that they are entitled to keep on working in the Company up to that age. In April 2005, the Tel Aviv Regional Labor Court handed down a judgment rejecting the lawsuit. Following this, 58 of the plaintiffs filed an appeal. During the reporting year, the court recommended to the parties to reach a compromise arrangement and, accordingly, the Company compiled an adequate provision in its books. C-60 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) a. Lawsuits and other claims (Cont.) 10. Income tax – withholding tax The Company received agreed assessments for withholding tax through the 2002 tax-year. As for the topics remaining in dispute the Company received assessments for the years 1998- 2002, followed by demands, amounting to approximately $ 22 million, including interest and linkage (not including fines). The Company appealed the demands to the Tel Aviv District Court, and, the Company intends to file an appeal to the courts with regard to the demand for the years 2001-2002, received in the month of March 2007. The following issues remain in dispute: a. Computation of benefit-in-kind to employees for flight tickets –according to Company procedures, the Company charges a benefit in kind to employees for airline tickets granted to them on the basis of seats available at a rate of 22.5% of the average price to the public at large for a flight ticket in the most common tourist section, and at value of 50% of airline tickets on the basis of a positive seat. The tax authorities demand that this computation be based on economic value, whereas the Company claims that the economic benefit does not exceed the amount that it charges. b. Company employees posted abroad –a demand to pay tax in Israel for Company employees posted abroad in excess of four years, when their occupation abroad is identical to that in Israel and, as to employees in the US, the disallowance of city, state and social-security taxes paid by the Company. The financial statements as of December 31, 2006 include an adequate provision, which, in management’s opinion, based on the advice of legal counsel, covers the anticipated liability with respect to the above withholding tax assessments and tax demands, including the additional period up to, and including, the year 2006. 11. See Note 25.a. regarding claims filed against the Company subsequent to the balance sheet date. C-61 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) b. Legal proceedings abroad in the area of business restrictions 1. In February 2006, the Restrictive Practices Division of the U.S. Justice Department ("Restrictive Practices Division ") began an open investigation, together with additional competition authorities of other countries, of supposed suspicion of price fixing with respect to certain increments to prices of air cargo transport. A number of cargo transporters announced that they had received Grand Jury injunctions in connection with this investigation. On September 27, 2006, the Company received an injunction from the Restrictive Practices Division that had been issued by the Grand Jury, which demands information and documents concerning certain costing and cost increment practices in the area of cargo transport, commencing from the year 1999 and through the date of the injunction. The Restrictive Practices Division notified the Company that the Company is being examined as a suspect in this investigation. The Company is cooperating with the investigation, while performing an internal audit of its own of the cargo costing practices. At this stage, the Company is unable to assess the outcome of the investigation of the Restrictive Practices Division or to estimate the possible financial effect of the investigation. Nevertheless, it should be pointed out that the consequences could include administrative or civil procedures and/ or a criminal indictment, including penalties and/ or civil charges. It should also be stated that punishments for the violation of competition statutes could be serious, both with regard to criminal charges and also as to civil charges. No provision in connection with this investigation has been included in the financial statements. 2. During the month of December 2006, the Company received a letter from the European Competition Commission ("the Commission"), which was transmitted to the Company's offices in Germany and contained a request for information in connection with an investigation being carried out by the Commission. The letter stated that the demand for information is in the context of an investigation being carried out by the Commission in connection with activities which, seemingly, cause damage to competition in the sector of air transport services for cargo, and that the Commission has information regarding extensive contacts that took place between airlines companies with regard to various price increments and other matters such as cargo transport rates. 3. The proceedings described above that are connected to investigations of business restriction authorities could have a material effect on the Company, due to the especially severe penalties which such entities are permitted to possibly impose. In the context of the letter, the Company was requested to transmit data and documentation regarding the Company and its cargo activities, commencing with the year 1995. The Company is cooperating with the investigation and transferred its reply as requested by the Commission's letter, while carrying on an internal audit of cargo pricing practices. At this stage, the Company is unable to evaluate the outcome of the investigation of the Commission or to estimate the possible financial effect of the investigation on the Company. Nevertheless, it should be pointed out that the implication might include an administrative proceeding against the Company, include a severe fine which could be imposed on the Company at the end of the proceeding. These financial statements do not include any provision for this investigation. 4. See Note 25.a.2 regarding a claim against the Company subsequent to the balance sheet date on the matter of business restrictions. C-62 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) c. Guarantees Composition of guarantees provided by the Company to third parties: December 31, 2006 (in thousand US dollars) To secure employee retirement programs 3,011 To secure employee loans 473 To secure subsidiaries’ liabilities 2,229 To airport authorities, customs authorities and other third parties 7,540 13,253 d. Commitments 1. Commitment to purchase two 777-200 aircraft On October 2, 2005, the Company signed an agreement with The Boeing Company for the purchase of two wide-body, long-range Boeing 777-200 ER aircraft, due to be delivered for Company use during the months of July and August 2007. The cost of each plane will amount to approximately $ 130 million, depending on the volume of accessories and installations made to the aircraft in order to adapt it to Company requirements. Financing from independent sources will stand at approximately 15% of the price of the aircraft, with the balance financed by loans. In November 2005, a preliminary commitment was obtained from the Authority for Encouragement of Exports and Imports of the United States (EXIM), which will enable receipt of adequate financing from financial institutions against the guarantee of that authority. Through December 31, 2006, the Company paid the Boeing Company the amount of approximately $ 82.1 million on account of the purchase of the two abovementioned aircrafts, of which about $ 60.2 million during the reporting year. As an additional and final payment after the balance sheet date on account of the advances required for the acquisition of the aircraft- see Note 25.b.1. During the month of November 2006, the Board of Directors of the Company approved a commitment with two foreign banks which will jointly act as the financiers of a transaction to purchase two 777 aircraft. In this context, the Company signed a document of intent with the two foreign banks regarding the principles of the financing. The agreement is based upon an EXIM guarantee and is subject to its terms. The financing banks took upon themselves an extension of such financing for a period of up to 15 years. See Note 25.b.2 regarding a commitment subsequent to the balance sheet date to receive the above financing. C-63 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) d. Commitments (Cont.) 2. Leasing and rental fees a. The Company leases planes under operating leases, generally in consideration of monthly leasing fees plus a payment for reserves for maintenance, based on actual flight hours. Most of the agreements include options for renewing and shortening the leasing contracts. b. The following is detail of the minimal leasing fees for the fixed components (but excluding the payment for the maintenance reserves) payable for the leased aircraft: Aircraft operating leases Year (in thousand US dollars) 2007 27,066 2008 22,763 2009 21,585 2010 18,365 2011 6,740 Total 96,519 c. In addition, the Company has agreements for leasing aircraft, generally on payment of monthly leasing fees plus a payment for maintenance reserves. d. The Company has lease commitments for land and buildings in Israel and abroad, including in various airports, as well as offices used by its branches. C-64 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) d. Commitments (Cont.) 3. Commitments with the Airports Authority (AA) a. The Company has a use-right (permit) to 290 hectares of land at BGA until December 31, 2010 (with an option to renew it for an additional 25-year period). Following privatization, on May 19, 2003, the Company and the AA, with the approval of the Ministerial Committee for Social and Economic Affairs, reached an understanding concerning new permit fees for which the Company will be obligated to the AA. Under this agreement, the annual payment for the areas referred to above will be $ 960 thousand in 2005, rising by 7.4% per annum up to a maximum of $ 4 million per annum. b. On October 19, 2004, this agreement was amended, to include, in addition for the payment for the land, annual usage fees for certain fully depreciated buildings and installations. The payment will rise gradually, starting with $ 900 thousand for the year 2006 and up to a maximum amount of $ 4 million in 2025. c. The Company is obliged to pay flight fees, airport taxes and permit fees to the AA. The Company enjoys the maximum reduced rate due to the volume of its activity at BGA. d. In November 2004, within the framework of Ben Gurion 2000, the AA opened Terminal 3. The project includes a new passenger terminal-Terminal 3, an aircraft parking space and service-support areas to activate the services required to operate the location. The AA shut down the present Terminal 1 and will designate it for internal flights. Until Terminal 3 was opened, all of the Company’s installations were adjacent to Terminal 1: offices, aircraft parking spaces, hangars, warehouses and various workshops. Following the transfer of the activity to Terminal 3, the Company was forced to relocate part of its activity to Terminal 3 and its new adjacent areas. The agreements between the Company and the AA arranging the passenger lounge in Terminal 3 and the authorization of additional areas were signed during the month of December 2006. In April 2000, the Company signed a new agreement-in-principle for leasing 20 hectares in order to set up a maintenance center, a hangar and supporting facilities within the framework of Ben Gurion 2000. The AA council ratified the transaction but it is subject to the signing of a detailed agreement between the parties as well as the ratification by the Company’s Board of Directors. 4. Commitments for maintenance of engines and aircraft The Company has several agreements with various entities for maintenance services to engines and planes. The agreements are long-term (up to 20 years). Some of the agreements are based on Time & Material while others are based on cost per hour flown. As for actual engine and aircraft maintenance expenses – see Note 21.b. C-65 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 17 - COMMITMENTS, GUARANTEES AND CONTINGENT LIABILITIES (Cont.) c. Commitments (Cont.) 5. Commitments to perform work to insure air worthiness The 747-200 aircraft owned by the Company are ageing aircraft. They require relatively higher maintenance cost than newer planes in order to assure air worthiness. This cost may significantly change from period to period in accordance with the flight proficiency requirements (AD'S), which mandate for unplanned repair or maintenance work or the performance of special inspections. The Company is committed to take the abovementioned actions in order to assure air worthiness, as stipulated by the engineering and quality control division of the Company, in consideration of the manufacturer’s guidelines and requirements as well as the regulations of various aviation authorities worldwide. This maintenance work is planned for execution within the framework of a multi-year program based on the guidelines and requirements referred to above. NOTE 18 - LIENS a. The following is detail of Company’s liabilities that are secured by liens: December 31, 2006 (in thousand US dollars) Accrued interest 10,390 Short-term bank borrowings (excluding current maturities) 4,287 Long-term bank loans (including current maturities) 667,362 Long-term loan from another company (including current maturities) 1,992 684,031 Of which: Banks in Israel 557,225 Banks abroad 124,814 A company abroad 1,992 684,031 C-66 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 18 - LIENS (Cont.) b. Details of assets pledged as security for the liabilities referred to above as of December 31, 2006: 1. Perpetual and specific first-tier pledge and lien in favor of banks in Israel on two 747-400 aircraft (ELC and ELD), three 777-200 aircraft (ECA, ECB and ECC) and the entire fleet of 737 aircraft, on the entire fleet of 767 aircraft, other than one aircraft (EAA) and the entire 757 fleet of aircraft, other than one 757-200 (EBM) aircraft. The pledges and liens cover all the engines, rights deriving from leasing or use of aircraft, or from contracts or insurance policies and also on rights for compensation or indemnification in connection with those aircraft. In addition, a first-tier floating lien was registered on all the engines and auxiliary equipment installed on the abovementioned aircraft from time to time, as well as the insurance rights with respect to them. No additional lien may be registered on those assets or the assets may not be transferred without the bank’s advance, written consent. 2. Perpetual and specific first-tier pledge and lien in favor of a trustee for collateral (see Note 9.e) on all of the Company’s rights in a fourth 777-200 aircraft (ECD). The pledge and lien include all the rights deriving from contracts connected to the plane, rights to indemnification or insurance proceeds for of the aircraft or any part of it and all rights under from the lease agreement for the aircraft. In addition, the Company assigned by way of a pledge in favor of a foreign company (see Note 9e) all of the existing and/or future rights arising from insurance policies for the fourth aircraft. 3. A pledge in favor of a bank in Israel on two spare engines serving the 767 and 747-400 aircraft fleets. 4. In order to secure a long-term loan received from Leumi Leasing Ltd. for the purchase of an engine for the 777-200 fleet, the Company registered a first-tier lien on the engine, unlimited in amount (including the rights deriving from insurance as well as rights of compensation or indemnification). 5. A pledge in favor of a third party on a 747-200 cargo aircraft (AXM) acquired in 2004 from that same third party. The lien includes the four engines installed on the aircraft, as well as any insurance proceeds with respect to the aircraft. C-67 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 18 - LIENS (Cont.) b. Details of assets pledged as security for the liabilities referred to above as of December 31, 2006 (cont.): 6. In order to obtain financing from a foreign banking institution during the reporting year, as described in Note 14.c.2, the Company pledged all of the Company's rights in a 747-400 (ELA) aircraft in favor of that bank in a fixed first-tier lien, including 4 engines and all other components installed in the aircraft (including any engine of other part which will be installed in the aircraft from time to time), and assigned all of the existing and future insurance and compensatory rights with respect to the aircraft by means of a first tier lien. No additional lien may be registered on those assets or the assets may not be transferred without the bank’s advance, written consent. This aircraft and its engines were released during the reporting period from a prior lien in favor of an Israeli bank. Additionally, the Company was obligated to pledge an additional 747-400 aircraft (ELB), when additional financing will be received during the year 2007 from that same foreign bank, as mentioned in Note 14.c.2. 7. In order to secure the Company’s liabilities for the utilization of credit lines provided to it by two banks in Israel (including the provision of bank guarantees), the Company pledged its revenues from three specific travel agencies in Israel by way of mortgaging and registering first-tier floating and perpetual liens and by way of assignment of rights in the form of a pledge. 8. A lien in favor of an Israeli bank on funds deposited or to be deposited from time to time, including income thereon, in the Company's accounts in the London branch of such bank. 9. A lien in favor of the Bank for the Encouragement of Industry in England-ECGD on a spare engine for the 777-200 fleet which had been acquired with a loan obtained from a foreign bank (as explained in Note 14c.10) to which ECGD had provided a guarantee. This pledge includes insurance, compensation and indemnification rights. 10. The EXIM bank, in whose favor the Company previously registered a negative lien on two 747-400 aircraft (ELA and ELB), agreed to remove that negative lien, contingent upon the consent of the State of Israel to continue serving as a guarantor towards the EXIM bank on the Company’s outstanding loan balance deriving from the acquisition of these two planes. Consequently, the State of Israel announced its consent to continue to guarantee the outstanding loan, as noted. C-68 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 19 - SHARE CAPITAL Following the publication of a prospectus in May 2003 (and amendments to the prospectus dated June 3 and 4, 2003) (hereafter: “the Prospectus”) for the issuance of shares and options to the public, together with a tender offer made by the Government, the Company’s securities were registered for trading on the Tel Aviv Stock Exchange in June 2003. a. Tender offer and Prospectus 1. Based on the Prospectus, the Company issued to the public 17,000,000 ordinary shares of NIS 1.00 par value each (“OS”) registered in name, with total par-value of NIS 17,000,000, together with 100,000,000 options (Series 1) registered in name, with each option exercisable into one OS of NIS 1.00 par value at a cash exercise price of NIS 1.34 per option; starting December 12, 2004 and until June 5, 2007, together with a tender offer of 32,000,000 OS of NIS 1.00 par value registered in name, made by the State of Israel, with total par-value amount of NIS 32,000,000, together with 138,400,000 purchase options registered in name (Series A), with each option exercisable into one OS of NIS 1.00 par value, at a cash exercise price of NIS 1.30 per option, by June 5, 2004, and together with 157,600,000 purchase options registered in name (Series B), with each option exercisable into one OS of NIS 1.00 par value at a cash exercise price of NIS 1.32 per option, starting December 12, 2004 and through June 5, 2007. Any option not exercised by the date stipulated will become null and void. The cash exercise increment of the options is linked to the CPI of April 2003. 2. Based on the Prospectus, the State of Israel offered eligible employees to purchase up to 34,685,642 OS of NIS 1.00 par value by way of a tender offer made by the State, at a discount of 30% from the share’s par value in alternative A of the issuance tender (NIS 0.91 per share). The shares were offered in trust and they will be blocked until December 31, 2004. The employees will bear any tax resulting from the exercise of the proposal. The offer to the employees included a tender offer of 32,222 shares to former interested parties who were employed by the Company, at a discount and on the same terms granted to the other eligible employees, as defined in the offer to employees. Following the response by part of the eligible employees for the acquisition of 2,158,426 OS of NIS 1.00 par value, the Government allotted them the above number of shares in exchange for approximately $ 445 thousand. In December 2005, the Company’s local employees working abroad received a grant from the Israeli government equaling 30% of the value of the shares to which a local employee working in Israel would have been entitled. C-69 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 19 - SHARE CAPITAL (Cont.) a. Tender offer (cont.) 3. On June 3, 2003, the State approved a written undertaking towards the employees’ representatives, according to which: a proposal to eligible employees without full response would enable the entity established on behalf of the employees to acquire the offered shares up to 34,685,642 OS of NIS 1.00 par value each (“the Remaining Shares”) at the end of one and one-half years from the date of publication of the prospectus, at an exercise price equaling 30% of the shares’ average closing price on the stock exchange during the 90 trading days preceding the exercise date or NIS 1.3 per share – the lower of the two. Moreover, the State approved a written undertaking directed towards the employees’ representatives, enabling the entity to be established by the employees to purchase, at the end of a four-year period ending June 5, 2007, additional shares remaining in the hands of the State due to the non-exercise of the right to realize purchase options of Series B, not to exceed 18,936,027 Company shares (hereafter- "Additional Shares"), at an exercise price equaling 60% of the shares’ average market closing price during the 90 trading days preceding the exercise date, or NIS 1.3 per share – the lower of the two. The purchasers of the Remaining and Additional Shares undertook to refrain from any transaction or action in the Remaining and Additional Shares during a 24-month period following the closing date. The ownership and control structure, as well as the articles of incorporation of the employees' entity, are subject to approval of the Government Corporations Authority. The Securities Authority informed the Company and the State that the execution of future sales could require the publication of a prospectus or abstract by the State, subject to the provisions of the Securities Law as well as any other relevant law prevailing at the time, while the employees’ entity (if established) may be required to publish a prospectus, subject to the directives of the Securities Law as well as any other relevant law prevailing at the time. 4. On February 23, 2005, the employees established an entity (“Holdings in Trust of EL AL Employees Ltd.), which acquired the Remaining Shares, as noted in item 3 above, from the State i.e., 32,527,216 ordinary shares in accordance with the written undertaking granted by the State to the employees’ representatives, thus converting the employees’ entity into an interested party of the Company. As of December 31, 2006, the employees' entity holds 8.12% of the Company's issued and outstanding share capital. b. Share capital of the Company as of December 31, 2006: Authorized Issued and outstanding Special Ordinary Special Ordinary share shares share shares NIS 1.00 par value NIS Balance – January 1, 2006 1 495,720,547 1 399,785,087 Exercise of options (Series 1) (see c below) - - - 1,003,247 Increase of authorized capital of Company (see d below) - 54,279,453 - - Balance – December 31, 2006 1 550,000,000 1 400,788,334 C-70 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 19 - SHARE CAPITAL (Cont.) c. During 2006, the Company received approximately $ 296 thousand for the exercise by the public of 1,003,247 options (Series 1) into an identical number of OS of NIS 1 par value each, which were deposited in the severance pay fund of the eligible employees options (Series 1) d. On March 23, 2006, the General Meeting of the Company approved the increase of the Company’s authorized share capital by NIS 54,279,453, bringing the total to NIS 550,000,001 after such increase, divided into the State’s special share of NIS 1.00 par value and 550,000,000 ordinary shares registered in name of NIS 1.00 par value each. e. Options and purchase options The following table presents the activity in options and purchase options: Options Purchase options Purchase options (Series 1) (Series A) (Series B) (in thousand units) Issued in June 2003 100,000 138,400 157,600 Exercised in 2003 - (6,134) - Balance – December 31, 2003 100,000 132,266 157,600 Exercised in 2004 (2,416) (132,266) (74,256) Balance – December 31, 2004 97,584 - 83,344 Exercised in 2005 (1,649) - (2,673) - Balance – December 31, 2005 95,935 - 80,671 Exercised in 2006 (1,003) - (2,249) - Balance – December 31, 2006 94,932 - 78,422 The proceeds from the exercise of the purchase options (Series A and B) were received by the Government of Israel. f. The rights accompanying the special State share – On May 18, 2003 the Company allotted the government a special, non-sellable, non-transferable share designed to protect the State’s vital interests, in accordance with the following Government resolutions: • Maintaining the Company as an Israeli company, subject to Israeli law; • Maintaining the operating capability and the flight capability of carrying passengers, and cargo, to not fall below a minimum established level; • Preventing any hostile interests to take over the Company; • Maintaining security and safety arrangements as determined by state bodies on behalf of the State. C-71 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 19 - SHARE CAPITAL (Cont.) f. The rights accompanying the special State share (cont.) In addition, on October 12, 2004, the Knesset’s Finance Committee approved a directive under the Government Corporations Act whereby the Company would be obliged to employ, at any time, Israeli crew members, and – in Israel – Israeli ground personnel, in a number not lower than that required for continuous and simultaneous operations in an emergency of all the aircraft fleets constituting the minimal flying capacity which the Company is required to maintain as stipulated by directives of the State’s special share. As of the approval date of the financial statements, the provisions of this directive did not obligate the Company to make any changes in its method of operations or composition of employees. g. Dividend-distribution policy - In December 2005, the Company’s Board of Directors adopted a dividend-distribution policy, within the framework of which the Company would strive to distribute dividends to its shareholders of 20%-40% of its after-tax annual net earnings for the preceding year, resulting from the Company’s ordinary activities, excluding one-time profits not generated by operating activities and capital gains. Implementation of this policy is subject to any relevant law provisions as well as the assessment of the Company's Board of Directors of the Company’s ability to meet its present as well as forecasted liabilities and taking into account its liquidity, and present as well as future business plans and activities. The adoption of this policy does not diminish the authority of the Board of Directors of the Company to decide upon a change, amendment and/or abolishment of the currently established dividend policy and/or to approve any additional distributions that comply with the law nor to decide on a reduction of actual distributions or to preclude them altogether should it be warranted by changes from time to time in the Company’s liquidity, operations and conditions. h. Executive option program 1. On February 26, 2006, the Board of Directors of the Company resolved to adopt an option plan for employees and executives of the Company (hereafter: the 2006 options program). On that date, the Board of Directors of the Company confirmed that the quantity of options which would serve as a pool for allotment under the plan would stand at 17,092,129 options, exercisable into 17,092,129 ordinary shares of the Company with par value of NIS 1 each, subject to adjustments. The Board of Directors is permitted, from time to time, to add to this quantity of options. At the same time, the Company's Board of Directors approved an allotment of 17,092,129 options to approximately 50 offerees, of which approximately 10 were senior executives of the Company and approximately 40 other executives of the Company. The allotment of the options to the Company's executives was also ratified by the Audit Committee of the Company on February 26, 2006. The allotment of the options was conditional upon the approval of the General Meeting of the Company for the increase in the Company's registered capital. Such approval was obtained on March 23, 2006 and, on the same day, the allotment was executed. Such options will not be registered for trading on the stock exchange, although the shares that will be derived from the exercise of the options will be registered for trading on the stock exchange C-72 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 19 - SHARE CAPITAL (Cont.) h. Executive option program (cont.) 1. (Cont.) The options were allotted to a trustee in conformity with the capital gains alternative under Section 102 of the Income Tax Ordinance. The options will vest and become exercisable in equal parts over a 4-year period, beginning from January 1, 2007 (each year, one quarter of the options will vest), conditional upon the offeree being employed by the Company, or rendering services to the Company, on the vesting date. All options granted but not exercised, will expire and be cancelled at the end of 3 years from the date that each option became vested. The theoretical exercise price of one option into one share will be 297.33 agorot. The exercise price is the theoretical price not paid by the employee. In the event that the option is exercised, the employee will be eligible for shares in a number equivalent to the difference between the price of the exercise share (the closing price on the Tel-Aviv Stock Exchange of one ordinary share of the Company at the end of the trading day on which the Company received the instruction to exercise) and the theoretical exercise price, multiplied by the number of options in his possession. The theoretical exercise price is subject to customary adjustments in the event of dividend distributions and changes in composition of the Company's capital According to the provisions of Accounting Standard No.24 (Stock-Based Payment) of the Israeli Accounting Standards Board, the Company records expenses pertaining to the options grant based on their economic value. The computation is made on the date of the grant, for each batch separately, based on the Black & Scholes model. The expense is recorded over the vesting period of each batch, with the extent of the expense being a function of the quantity of options granted and the economic value of each option. The option’s value will be computed based on the program’s terms and subject to the following assumptions: • The price of a share for computation purposes equals the Company’s closing share price on the stock exchange on March 23, 2006 (NIS 3.837). • The exercise price equals 85% of the share price on February 26, 2006-NIS 2.973. • The expected life for the exercise of each batch has been computed by the average between the vesting period of each batch and the expiration date. • The standard deviation has been computed based on the daily yield of the price of the share on the stock exchange during a period equaling the expected period for exercise of each batch (as outlined above). The maximum standard deviation has been taken from the date of issuance of the Company for trading (while neutralizing the first trading day) for batches whose expected period for exercise is longer than the period during which the Company’s shares are traded on the stock exchange. • Discount rate–the rate of yield of unlinked debentures (“Shahar”) which conforms to the expected period of exercise of each batch. C-73 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 19 - SHARE CAPITAL (Cont.) h. Executive option program (cont.) 1. (Cont.) After the retirement of a number of employees during the reporting period, and the expiration of part of the options granted to them, 14,736,700 options remained within the framework of the program. Based on the above assumptions, the Company’s expenses with respect to the program, after expiration of part of the aforementioned options, would total NIS 25,774 thousand (approximately $ 6.1 million as of the balance sheet date), reflecting an average option value of NIS 1.75 based on the Black & Scholes model. The Company charged salary expenses of $ 2,582 thousand for the year 2006 with respect to the program, recorded against a capital reserve. 2. On May 23, 2006, the Board of Directors of the Company resolved to increase the quantity of options in the options pool for allotment pursuant to the options program for compensating Company executives and other employees by another 3,000,000 options. Such options will not be marketable and they will exercisable into up to 3,000,000 ordinary shares of the Company with par value of NIS 1. The Board of Directors appointed the Human Resources and Appointments Committee to manage the options program and authorized the Committee to allot these options to Company executives, in accordance with the criteria stipulated by the Board of Directors. The theoretical exercise price of each option will be 85% of the average closing price on the Tel-Aviv Stock Exchange of one ordinary share of the Company during the 30 trading days that preceded the decision of the manager of the program to make an allotment to each offeree, except for an offeree who served in the position of vice-president or division head in the Company on March 23, 2006, and who had not received options according to the allotment decision during the month of March 2006, as to which the theoretical exercise price was set at 297.33 agorot.. After the Human Resources and Appointments Committee decided on December 27, 2006 to allot options, an allotment of 3,072,536 options was executed on December 31, 2006 to 9 senior employees, out of which 72,536 options were derived from a quantity of options which had been allotted by the Company from the outset, as described in Note 19.h.1 above, and which had expired and were returned to the pool of options for allotment, in accordance with the terms of the Company's options. Such options will not be registered for trading on the stock exchange, although the shares that will be derived from the exercise of the options will be registered for trading on the stock exchange The options were allotted to a trustee in conformity with the capital gains alternative under Section 102 of the Income Tax Ordinance. The options will be divided into four equal batches which will vest over 3.5 years as follows: one quarter will vest on June 30 of each one of the years 2007 through 2010. C-74 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 19 - SHARE CAPITAL (Cont.) h. Executive option program (cont.) 2. (Cont.) The theoretical exercise price of one option into one share will be 188.94 agorot. The exercise price is the theoretical price not paid by the employee. In the event that the option is exercised, the employee will be eligible for shares in a number equivalent to the difference between the price of the exercise share (the closing price on the Tel-Aviv Stock Exchange of one ordinary share of the Company at the end of the trading day on which the Company received the instruction to exercise) and the theoretical exercise price, multiplied by the number of options in his possession. The theoretical exercise price is subject to customary adjustments in the event of dividend distributions and changes in composition of the Company's capital According to the provisions of Accounting Standard No.24 (Stock-Based Payment) of the Israeli Accounting Standards Board, the Company records expenses pertaining to the options grant based on their economic value. The computation is made on the date of the grant, for each batch separately, based on the Black & Scholes model. The expense is recorded over the vesting period of each batch, with the extent of the expense being a function of the quantity of options granted and the economic value of each option. The option’s value will be computed based on the program’s terms and subject to the following assumptions: • The price of a share for computation purposes equals the Company’s closing share price on the stock exchange on December 31, 2006 (NIS 2.08). • The exercise price equals 85% of the average closing price during the 30 trading days that preceded the decision of the Board of Directors on December 27, 2006- NIS 1.89. • The expected life for the exercise of each batch has been computed by the average between the vesting period of each batch and the expiration date. • The standard deviation has been computed based on the daily yield of the price of the share on the stock exchange during a period equaling the expected period for exercise of each batch (as outlined above). The maximum standard deviation has been taken from the date of issuance of the Company for trading (while neutralizing the first trading day) for batches whose expected period for exercise is longer than the period during which the Company’s shares are traded on the stock exchange. • Discount rate–the rate of yield of unlinked debentures (“Shahar”) which conforms to the expected period of exercise of each batch. Based on the above assumptions, the Company’s expenses with respect to this program would total NIS 2,318 thousand ($ 549 thousand as of the balance sheet date), reflecting an average option value of NIS 0.75 based on the Black & Scholes model. C-75 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS a. Risk management goals and policies The Company's operations expose it to risks connected with various financial instruments, principally: market risks (including currency risk, credit risk, liquidity risk and cash flow risk due to interest rates. The overall risk management program focuses on actions intended to reduce the possible negative effects on the Company's financial performance to a minimum. The Company uses derivative financial instruments to hedge certain exposures to risks. The Company has a Risk Management Committee headed by the Chairman of the Financial, Budgetary and Balance Sheet Committee, which has the responsibility for determining the policies to cover existing exposures. The Deputy CEO-Finances is responsible to execute the policies and to report to the Risk Management Committee. Following is information connected to financial instruments to which the Company is exposed is given hereinafter: 1. Market risks: Price risk The Risk Management Committee determines the extent of hedging future consumption of jet fuel. The significance of the financial hedging of jet fuel prices to assure the price range for purchasing jet fuel. In the event of a decrease in jet fuel prices which are assured past the range, the Company pays the difference. In the case of an increase in jet fuel prices, the Company receives the difference from the insuring entity (mostly foreign banks). The goal of hedging jet fuel prices is to defend the Company's exposure to changes in world jet fuel prices. Accordingly, the hedging policies are: hedging jet fuel quantities up to 24 months ahead, so that for each quarter in that period, a minimum rate for hedging is determined for the entire forecasted consumption, and a maximum rate for hedging the entire forecasted consumption in a graduated and decreasing manner. Accordingly, the maximum hedging rate as of the beginning of the year 2007 was 80% and the minimum hedging rate as of the end of the year 2008 is 20%. The Company has exposure due to a change in the fair value of these financial instruments as a result of changes in their market prices. C-76 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) a. Risk management goals and policies (cont.) 1. Market risks (cont.): Currency risk Most of the Company's revenues and expenses are in foreign currency (mainly the dollar), other than a number of expenses in NIS, primarily most salary expenses paid in Israel which are in NIS. Accordingly, a change in the dollar rate in relation to the NIS affects the NIS expenses of the Company. In addition, in the case of a devaluation of the Euro in relation to the dollar, the excess of receipts over payments in Euro reduces the Company's revenues. The Company also has balance sheet exposure to a devaluation of the dollar vis-à-vis the NIS due to the excess of financial liabilities over financial assets denominated in a currency other than the dollar (mostly, the NIS). From time to time, the Company examines the need to invest in derivative financial instruments to reduce exposure to currency risks. When the Company holds a derivative financial instrument, the Company is exposed to changes in the fair value of these financial instruments as the result of changes in their market value. Fair value risk due to interest rates The Group companies have investments in financial instruments bearing fixed interest, and therefore, there is exposure to changes in the fair value of these financial instruments as the result of changes in the interest rate. Since nearly all of the Company's loans are at variable interest, it is rare for the Company not to be exposed to changes in the fair value of financial liabilities, such as due to a change in the market interest rate. The Company's policy regarding interest is-approximately half of the Company's credit portfolio is at variable interest and about half is protected by means of financial instruments that convert variable interest into fixed interest over a period of 5 years. For this purpose, the Company carries out a number of financial transactions. The Company is exposed due to changes in the fair value of these financial instruments as the result of changes in the interest rate. C-77 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) a. Risk management goals and policies (cont.) 2. Credit risk: a. The Company and its subsidiaries have cash, cash equivalents and long and short- term investments deposited mainly with large, highly rated financial institutions. The Company and its subsidiaries do not anticipate any losses resulting from credit risk. b. Most of the revenues earned by the Company and its subsidiaries are derived from a large number of customers (mainly travel and cargo agents), characterized by their distribution throughout several countries. Exposure to risk from the extension of credit to customers is limited because of their relatively large number and distribution, as mentioned above. In Israel, there is insurance on credit (limited in amount) granted to travel and cargo agents. Overseas agents are covered by collateral to the extent that it is accepted in that country. The Company regularly examines customer compliance with credit terms and includes in its financial statements an appropriate allowance for doubtful accounts. 3. Liquidity risk: The Company has no difficulty in obtaining credit in order to meet its obligations that relate to financial liabilities and long-term loans. Also, the Company has no liquidity risk which could arise as the result of the lack of its ability to quickly sell investments in financial assets at a consideration that approximates their fair value. 4. Cash flow risk due to interest rates Most of the long-term loans of the Company are at variable interest. The loans, which bear variable interest rates, expose the Company to cash flow risk due to changes in interest rates. As protection and in order to reduce the Company's exposure to future changes in the interest rate, the Company entered into a number of agreements with banks in Israel for hedging transactions so that the Libor variable interest rate component on the Company's loans was replaced by a fixed rate component, running parallel to the repayment schedules for these loans. In one agreement signed with two banks in Israel the Libor was fixed for a five-year period, commencing in January 2004 with respect to an opening principal amount of approximately $ 270 million, at graduated interest rates, which proceeds to decline in accordance with the repayment schedule of the loan. The agreement was extended by an additional year, until January 27, 2010. In another agreement signed with a bank in Israel at a premium, the Libor was fixed for five years, starting September 2004, with respect to an opening principal amount of approximately $ 87 million, at graduated interest rates, which proceeds to decline in accordance with the repayment schedule of the loan. C-78 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) a. Risk management goals and policies (cont.) 4. Cash flow risk due to interest rates (cont.) The above financial instruments are not recognized as a hedge for accounting purposes. The fair value of these instruments amounted to $ 2,904 thousand as of December 31, 2006 ($2,627 thousand as of December 31, 2005) (see Note 2q). In two additional agreements recognized for accounting purposes as hedging transactions, carried out with banks in Israel, the Libor variable interest rate was replaced by a maximum fixed interest rate which hedges against a rise in the variable interest rate beyond that rate while establishing a minimum rate so that should the variable interest rate decline below the minimum level the Company would waive the gain. These transactions were carried out as follows: the first with respect to an opening principal amount of approximately $ 244 million, gradually declining based on a repayment schedule for the loan over a two-year period starting January 27, 2006; and the second, in accordance with a hedging policy for five years in the future, on the balance of that same loan, the balance of which will stand at an opening principal amount of approximately $ 183 million, gradually declining based on a repayment schedule over a two-year year period starting January 27, 2010. In two additional agreements recognized for accounting purposes as hedging transactions, carried out with banks in Israel, the Libor variable interest rate was replaced by a fixed rate. These transactions were carried out as follows: the first with respect to an opening principal amount of approximately $ 138 million, gradually declining based on a repayment schedule for the loan over a period of five years and three months, gradually declining based on a repayment schedule over a period of five years and three months starting July 18, 2005; and the second, on an opening principal amount of approximately $ 40 million, gradually declining based on a repayment schedule over a five-and-a-half year period starting October 17, 2005. C-79 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) a. Risk management goals and policies (cont.) 5. Cash flow risk due to interest rates The table below presents the book value of groups of financial instruments that are exposed to fair value risk and/or cash flow risk due to interest rates, in accordance with their contractual repayment dates: As of December 31, 2006 Consolidated Sixth Effective Up to one Second Third Fourth Fifth year & interest Note year year year year year after Total rate-% Financial assets Cash and cash equivalents (*) 146,158 - - - - - 146,158 4.9-5.4 Short-term investments (*) 3 4,682 - - - - - 4,682 5.3 Long-term bank deposits (**) 7A - - - - - 1,836 1,836 2.4-3 Financial liabilities Short-term bank credit (**) 11 (4,287) - - - - - (4,287) 5.3-6.3 Dollar bank loans (**) 14 (98,505) (52,542) (54,040) (53,684) (121,127) (287,464) (667,362) 5.4-6.5 Other dollar loan (*) 16 (1,992) - - - - - (1,992) 4 Obligations for capital leases (*) 16 (316) (326) (404) - - - (1,046) 4.9-5.6 45,740 (52,868) (54,444) (53,684) (121,127) (285,628) (522,011) (*) These assets/liabilities carry a fixed interest rate. (**) These assets/liabilities carry a variable interest rate. b. Fair value Fair value of financial instruments The financial instruments of the Company constitute primarily cash and cash equivalents, deposits, trade accounts receivable, other current assets, short-term bank loans, trade accounts payable, other current liabilities and long-term financial obligations. Due to the nature of the financial instruments, their fair value is usually identical to the value at which they are stated in the financial statements. The fair value of the long-term loans is ordinarily based on the present value of future payments in accordance with the interest rates payable by the Company, as of the balance-sheet date, on loans with similar terms, and it is not materially different from their financial statement value. The fair value of derivative financial instruments is determined according to quotes from financial entities with which those transactions were executed. The fair value of marketable financial instruments was calculated according to quoted closing prices as of December 31, 2006. C-80 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) b. Fair value (cont.) Fair value of financial instruments (cont.) The fair value of non-marketable financial instruments is estimated by using accepted costing models such as present value of future cash flows that are capitalized at discount interest rates which, in the Company's estimation, reflect the risk level incorporated in the financial instrument. The estimate of fair value is computed by means of an assessment of future cash flows and determination of a discount interest rate on the basis of rates in proximity to the balance sheet date, among other things, are based on assumptions of Company management, and, therefore, for most of the financial instruments, the estimate of fair value is not necessarily an indication of realization value of the financial instrument as of the balance sheet date. The assessment of the fair value was carried out as aforementioned according to discount rates close to the balance sheet date and did not take into account the variability of interest rates from the date of the calculation through the date that this report was issued. Under the assumption of other discount rates, fair values would be obtained which could be materially different from those estimated by the Company, principally in relation to financial instruments with fixed interest. In addition, in determining fair value, commissions which might be payable at the time the instrument is redeemed were not brought into account. The gap between the balances in the December 31, 2006 balance sheet and the balances of fair value as estimated by the Company will not necessarily be realized, especially as regards a financial instrument held to maturity. The following table itemizes the book value and the fair value of groups of financial instruments that are presented in the financial statements at other than fair value: As of December 31, 2006 Book value Fair value (in thousand US dollars) Financial assets Derivative financial instruments to hedge interest (recognized for accounting purposes as hedging instruments) (1) - 6,238 Financial liabilities Long-term liabilities at fixed interest (2) (3,038) (3,003) Derivative financial instruments to hedge jet fuel (recognized for accounting purposes as hedging instruments) (1) - (4,844) (3,038) (1,609) (1) Fair value is based upon quoted prices in an active market as of the balance sheet date. (2) The fair value of long-term loans bearing fixed interest is based on the calculation of the present value of cash flows according to the accepted rate of interest for a similar loan with similar characteristics (6.3% as of December 31, 2006) C-81 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) c. Linkage balance sheet 1. Linked balances – consolidated balance sheet – December 31, 2006 In, or In, or linked linked to, In, or to, other Non- the U.S. In linked to, foreign monetary dollars NIS the euro currency items Total (in thousand US dollars) Assets Cash and cash equivalents 127,167 15,011 530 3,450 - 146,158 Short-term investments 4,000 682 - - - 4,682 Trade accounts receivable 100,535 109 11,872 18,511 - 131,027 Other current assets 13,431 5,227 857 2,867 24,960 47,342 Deferred taxes - - - - 30,645 30,645 Inventory - - - - 17,190 17,190 Long-term bank deposits - 1,836 - - - 1,836 Investment in another company 1,829 - - - - 1,829 Investees 1,228 - - - 1,052 2,280 Fixed assets - - - - 1,148,389 1,148,389 Other assets - - - - 3,455 3,455 248,190 22,865 13,259 24,828 1,225,691 1,534,833 Liabilities Short-term bank borrowings and current maturities (104,359) (126) (595) (20) - (105,100) Trade accounts payable (85,005) (22,964) (23,126) (12,378) - (143,473) Other current liabilities (93,308) (96,361) (2,830) (4,443) (142,345) (339,287) Long-term loans from financial institutions (566,104) - - - - (566,104) Obligations for termination of employee-employer relationships, net (15,305) (96,010) (6,420) (1,840) - (119,575) Deferred taxes - - - - (30,268) (30,268) Other long-term liabilities (730) - - - - (730) Shareholders’ equity - - - - (230,296) (230,296) (864,811) (215,461) (32,971) (18,681) (402,909) (1,534,833) Monetary assets, net of monetary liabilities (monetary liabilities net of monetary assets) (616,621) (192,596) (19,712) 6,147 822,782 - C-82 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) c. Linkage balance sheet (cont.) 2. Linked balances – company balance sheet – December 31, 2006 In, or In, or linked linked to, In, or to, other Non- the U.S. In linked to, foreign monetary dollars NIS the Euro currency items Total (in thousand US dollars) Assets Cash and cash equivalents 122,070 14,213 530 2,595 - 139,408 Short-term investments 4,000 - - - - 4,000 Trade accounts receivable 97,184 40 11,872 18,387 - 127,483 Other current assets 15,612 5,064 857 3,177 24,684 49,394 Deferred taxes - - - - 30,171 30,171 Inventory - - - - 16,464 16,464 Long-term bank deposits - 1,836 - - - 1,836 Investment in another company 1,879 - - - - 1,829 Investees 1,228 - - - 10,047 11,275 Fixed assets - - - - 1,146,216 1,146,216 Other assets - - - - 3,455 3,455 241,923 21,153 13,259 24,159 1,231,037 1,531,531 Liabilities Short-term bank borrowings and current maturities (104,359) (126) (595) (20) - (105,100) Trade accounts payable (87,816) (21,229) (23,126) (11,753) - (143,924) Other current liabilities (92,280) (94,226) (2,830) (4,389) (141,853) (335,578) Long-term loans from financial institutions (566,104) - - - - (566,104) Obligations for termination of employee-employer relationships, net (15,431) (96,125) (6,420) (1,840) - (119,816) Deferred taxes - - - - (30,171) (30,171) Other long-term liabilities (542) - - - - (542) Shareholders’ equity - - - - (230,296) (230,296) (866,532) (211,706) (32,971) (18,002) (402,320) (1,531,531) Monetary assets, net of monetary liabilities (monetary liabilities net of monetary assets) (624,609) (190,553) (19,712) 6,157 828,717 - C-83 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) c. Linkage balance sheet (cont.) 3. Linked balances – Consolidated balance sheet - December 31, 2005 In, or In, or linked linked to, In, or to, other Non- the U.S. In linked to, foreign monetary dollars NIS the Euro currency items Total (in thousand US dollars) Assets Cash and cash equivalents 78,279 11,345 1,503 2,802 - 93,929 Short-term investments 111,841 993 - - - 112,834 Trade accounts receivable (*)102,731 45 10,331 13,593 - (*)126,700 Other current assets (*)16,738 6,085 232 1,042 21,733 (*)45,830 Deferred taxes - - - - 46,698 46,698 Inventory - - - - 22,445 22,445 Long-term bank deposits - 1,779 - - - 1,779 Investment in another company 1,878 - - - - 1,878 Investees 1,554 - - - 635 2,189 Fixed assets - - - - 1,163,765 1,163,765 Other assets - - - - 4,671 4,671 313,021 20,247 12,066 17,437 1,259,947 1,622,718 Liabilities Short-term bank borrowings and current maturities (75,713) - - - - (75,713 ) Trade accounts payable ()95,380) ()28,412 ()21,398 (9,856 - (155,046) Other current liabilities ()103,547) ()84,357 ()10 (1,058 (135,574) (324,546) Long-term loans from financial institutions (627,363) - - - - (627,363 ) Obligations for termination of employee-employer relationships, net ()29,332) ()84,762 ()5,058 (1,374 - (120,526) Deferred taxes - - - - (46,300 ) (46,300) Other long-term liabilities (2,215) - - - - (2,215 ) Shareholders’ equity - - - - (271,009) (271,009) (933,550) (197,531) (26,466) (12,288) (452,883) (1,622,718) Monetary assets, net of monetary liabilities (monetary liabilities net of monetary assets) (620,529) (177,284) (14,400) 5,149 807,064 - (*) Reclassified C-84 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 20 - FINANCIAL INSTRUMENTS (Cont.) c. Linkage balance sheet (cont.) 4. Linked balances – Company balance sheet - December 31, 2005 In, or In, or linked linked to, In, or to, other Non- the U.S. In linked to, foreign monetary dollars NIS the Euro currency items Total (in thousand US dollars) Assets Cash and cash equivalents 72,846 11,086 1,378 1,305 - 86,615 Short-term investments 111,740 - - - - 111,740 Trade accounts receivable (*)100,450 -10,331 13,524 - (*)124,305 Other current assets (*)17,750 6,081 232 837 21,509 (*)46,409 Deferred taxes - - - - 46,173 46,173 Inventory - - - - 21,833 21,833 Long-term bank deposits - 1,779 - - - 1,779 Investment in another company 1,878 - - - - 1,878 Investees 1,554 - - 638 9,678 11,870 Fixed assets - - - - 1,161,500 1,161,500 Other assets - - - - 4,671 4,671 306,218 18,946 11,941 16,304 1,265,364 1,618,773 Liabilities Short-term bank borrowings and current maturities (75,713) --- - (75,713) Trade accounts payable ()98,366) ()26,388 ()21,398 (9,495 - (155,647) Other current liabilities ()101,395) (-)82,276 (794 (135,574) (320,039) Long-term loans from financial institutions (627,363) --- - (627,363) Obligations for termination of employee-employer relationships, net ()29,461) ()84,944 ()5,058 (1,374 - (120,837) Deferred taxes - --- (46,173) (46,173) Other long-term liabilities (1,992) --- - (1,992) Shareholders’ equity - - - - (271,009) (271,009) (934,290) (193,608) (26,456) (11,663) (452,756) (1,618,773) Monetary assets, net of monetary liabilities (monetary liabilities net of monetary assets) (628,072) (174,662) (14,515) 4,641 812,608 - (*) Reclassified C-85 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 21 - STATEMENT-OF-OPERATIONS DETAILS a. Operating revenues Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 Composition - (in thousand US dollars) Consolidated: Passengers 1,317,259 1,292,941 1,070,708 Less: discounts (39,513) (33,168) (22,195) 1,277,746 1,259,773 1,048,513 Cargo and mail 331,606 309,120 294,437 1,609,352 1,568,893 1,342,950 Aircraft leasing 5,073 5,154 4,595 Other 51,021 45,422 38,635 1,665,446 1,619,469 1,386,180 Company: Passengers 1,275,038 1,253,704 1,029,118 Less: discounts (39,513) (33,168) (22,195) 1,235,525 1,220,536 1,006,923 Cargo and mail 331,606 309,120 294,437 1,567,131 1,529,656 1,301,360 Aircraft leasing 40,307 37,797 36,401 Other 46,935 40,994 37,590 1,654,373 1,608,447 1,375,351 C-86 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 21 - STATEMENT-OF-OPERATIONS DETAILS (Cont.) b. Operating expenses Year ended December 31 Composition - 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Consolidated: Wages and social benefits 262,599 229,278 215,378 Fuel 465,912 388,028 281,083 Airport fees and services 169,717 175,009 164,705 Maintenance of aircraft , flight and ground equipment 107,724 85,338 63,617 Air navigation and flight communication 89,851 85,872 85,235 Depreciation 94,877 92,834 93,169 Insurance 9,909 11,680 10,782 Aircraft leasing fees 38,540 22,729 23,035 Meals and supplies 39,733 38,217 33,292 Air-crew expenses 45,811 40,755 34,636 Participation in security expenses (see 21c) 40,002 39,027 36,220 Cost of duty-free products 8,840 8,091 7,864 Other expenses 29,137 26,340 22,011 1,402,652 1,243,198 1,071,027 Company Wages and social benefits 252,361 219,057 205,900 Fuel 465,912 388,028 281,083 Airport fees and services 169,717 175,009 164,705 Maintenance of aircraft , flight and ground equipment 107,724 85,338 63,617 Air navigation and flight communication 89,851 85,872 85,235 Depreciation 94,582 92,461 92,795 Insurance 9,909 11,680 10,782 Aircraft leasing fees 38,540 22,729 23,035 Meals and supplies 54,298 52,673 47,117 Air-crew expenses 45,811 40,755 34,636 Participation in security expenses (see 21c) 40,002 39,027 36,220 Cost of duty-free products 8,840 8,091 7,864 Other expenses 19,947 18,144 14,201 1,397,494 1,238,864 1,067,190 c. Security expenses The Company is obliged to maintain security arrangements which are determined by a State agency, and the Company has no control over these expenses. The Company bears part of the government expenses incurred in defending Company passengers, aircraft, employees, offices and other installations against acts of terror. Following a government resolution, the Company’s participation rate in these expenses increased on January 1, 2003 to 50%. In addition to these expenses, the Company bears other, indirect security costs which also cause a loss of revenue due to in-flight security personnel. These additional costs are included in various operating items in the statement of operations. C-87 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 21 - SUPPLEMENTAL STATEMENT-OF-OPERATIONS DETAILS (Cont.) d. Selling expenses Composition: Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Consolidated: Wages and social benefits 45,700 45,862 44,089 Commissions 116,232 125,793 109,176 Advertising and public relations 9,907 9,734 7,142 Others 15,966 17,202 15,110 187,805 198,591 175,517 Company: Wages and social benefits 45,700 45,862 44,089 Commissions 116,232 125,714 109,026 Advertising and public relations 9,473 9,505 6,860 Others 15,966 16,864 14,521 187,371 197,945 174,496 e. General and administrative expenses Composition - Consolidated: Wages and social benefits 60,626 59,192 54,608 Professional consultation 4,807 4,403 3,818 Telecommunication 5,062 5,331 5,592 Office rental and maintenance 9,445 7,200 6,287 Insurance 2,113 2,252 2,279 Other expenses 9,899 10,380 9,195 91,952 88,758 81,779 Company: Wages and social benefits 56,366 55,234 50,578 Professional consultation 4,446 4,227 3,581 Telecommunication 4,974 5,291 5,545 Office rental and maintenance 9,027 6,957 6,068 Insurance 1,929 2,088 2,121 Other expenses 9,593 9,552 8,446 86,335 83,349 76,339 C-88 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 21 - SUPPLEMENTAL STATEMENT-OF-OPERATIONS DETAILS (Cont.) f. Financing expenses (income), net Year ended December 31, Composition - 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Consolidated: Financing expenses on long-term loans 38,673 31,069 20,990 Interest income on short-term deposits (6,872) (6,024) (1,743) Gain on marketable securities, net (9) (44) (79) Interest income on long-term deposits (55) (77) (36) Other financing expenses (income), net (including erosion of monetary items, net) (2,245) (4,318) (1,663) 29,492 20,606 17,469 Company: Financing expenses on long-term loans 38,673 31,069 20,990 Interest income on short-term deposits (6,872) (6,024) (1,743) Gain from marketable securities, net (9) (44) (79) Interest income on long-term deposits (55) (77) (36) Other financing expenses (income), net (including erosion of monetary items, net) (2.005) (4,197) (1,596) 29,732 20,727 17,536 g. Other expenses (income), net 1. Composition: Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Consolidated: Expenses pertaining to retirement plans, net (see Note 15b.13) (2) 4,405 13,510 8,008 Expenses pertaining to pension plans abroad, (see note 15b.10) - - 1,317 Gain from realizing investments in investees (3) - (8,297) - Gain from disposition of fixed assets (4) (6,211) (590) (246) Other capital gains, net - (104) (394) (1,806) 4,519 8,685 Company: Expenses pertaining to retirement plans, net (see Note 15b.13) (2) 4,405 13,510 8,008 Expenses pertaining to pension plans abroad, (see note 15b.10) - - 1,317 Gain from realizing investment in investees (3) - (8,297) - Gain from disposition of fixed assets (4) (6,229) (585) (245) Other capital gains, net - - (370) (1,824) 4,628 8,710 C-89 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 21 - SUPPLEMENTAL STATEMENT-OF-OPERATION DETAILS (Cont.) g. Other expenses (income), net (cont.) 2. Expenses for retirement plans, net The expenses for employee retirement plans during the reporting year mainly include expenses for reappraisal of liabilities pertaining to early retirement programs following the revaluation of Israeli currency vis-à-vis the dollar. The expenses for employee retirement plans for the year ended December 31, 2005 mainly include expenses for two new retirement programs which jointly pertain to 100 employees, most of whom retired during the year 2006 and for which the Company recorded provisions totaling $ 16 million. The expenses for employee retirement plans for the year ended December 31, 2004 mainly pertain to an additional retirement program for 37 employees and expenses due to an increase in the retirement age for employees as to which an additional liability was created for the Company (see Note 15b.13.e), net of income arising from a change in the estimated capitalization interest rate ( see Note 2 Y). 3. Gain from realization of investments in investees - a. In April 2005, the Company signed agreements for the sale of its entire holding in Maman - Cargo and Handling Terminals Ltd (hereafter: "Maman"), which constituted 26% of the share capital of Maman, to two other Israeli companies, for a price of $ 12.8 million. Consequently, the Company recorded a pre-tax capital gain of approximately $ 8 million during the year 2005 (including $2 million derived from translation differences with respect to investees). b. In November 2005, the Company concluded an agreement with another Israeli company for the sale of its entire holding in Unitel Tourism and Aviation Ltd. (“Unitel”), which constituted 13.7% of Unitel’s issued share capital, in exchange for approximately $ 856 thousand; Consequently, the Company recorded a pre-tax capital gain of approximately $ 294 thousand during the year 2005. 4. In July 2006, the Company sold a 747-200 cargo aircraft which was owned by it. Consequently, the Company recorded in 2006 equity gain of approximately $5.9 million. C-90 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 21 - SUPPLEMENTAL STATEMENT-OF-OPERATION DETAILS (Cont.) h. Company's equity in earnings of investees, net Year ended December 31, Composition - 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Consolidated: Maman - 306 1,213 Other companies 417 327 271 417 633 1,484 Company: Maman - 306 1,213 Superstar (417) 170 266 Tamam 207 108 151 Borenstein 162 281 118 Other companies 417 327 271 369 1,192 2,019 NOTE 22 - INCOME TAXES a. Tax laws applicable to the Group companies The Company’s main subsidiaries operating in Israel are subject to the Income Tax Law (Inflationary Adjustments), 1985 ("the Adjustments Law") which measures results in real terms. According to the Adjustments Law and the Income Tax Regulations (Rules Concerning the Maintenance of Accounting Records of Companies in Foreign Investments and of Certain Partnerships and the Determination of their Taxable Income), 1986, the results of the Company and some of its subsidiaries for tax purposes are measured on the basis of changes in the exchange rate of the U.S. dollar. The operating results for tax purposes of the other subsidiaries in Israel are measured on the basis of adjustment for changes in the CPI. Some subsidiaries are assessed jointly with the Company. The Company is deemed an industrial company under the Law for the Encouragement of Industry (Taxes), 1969 and, accordingly, is entitled to accelerated depreciation rates on aircraft and equipment as well as amortization of costs incurred in connection with the registration of shares for trading on a stock exchange. Pursuant to the Income Tax Regulations - Depreciation, 1941, the Company is entitled to depreciate the cost of owned aircraft and spare engines at an annual rate of 30% and 40% of cost, respectively. The foreign subsidiaries are subject to the tax laws applicable in the countries of residence. Most of the countries in which the Company operates representative offices are signatories to treaties or mutual arrangements for the prevention of double taxation, which exempt the Company from income taxes in these countries. C-91 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 22 - INCOME TAXES (Cont.) b. Effective tax rate Reconciliation between the taxes computed on the pre-tax income at ordinary rates ("theoretical tax") and the provision included in the statement of operations is as follows: Year ended December 31, 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Consolidated: Statutory tax rate (in %) 31% 34% 35% Pre-tax income - per statement of operations (44,649) 63,797 31,703 Theoretical tax (13,841) 21,691 11,096 Change in tax burden in respect of: Deferred taxes not provided for losses and timing differences (utilization of losses), net 13,765 (21,647) (11,464) Other differences, net (*) 210 260 456 134 304 88 Company: Statutory tax rate (%) 31% 34% 35% Pre-tax income - per statement of operations (44,735) 62,934 31,080 Theoretical tax (13,867) 21,397 10,878 Change in tax burden in respect of: deferred taxes not provided for losses and timing differences, net 13,657 (21,652) (11,405) Other differences, net (*) 210 255 527 - - - (*) Mainly disallowed expenses. c. On July 25, 2005, the Israeli Knesset passed, in second and third reading, the Law for Amending the Income Tax Ordinance (No.147) 2005, according to which the 34% corporate-tax rate is to be reduced gradually to 31% for the 2006 tax-year and eventually, to 25% for the 2010 tax-year. C-92 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 22 - INCOME TAXES (Cont.) d. Deferred income taxes Timing Carry- Depreciation differences- forward differences expenses losses Total (in thousand US dollars) 1. Consolidated: Balance – January 1, 2006 (205,963) 60,326 146,035 398 Deferred income taxes - (21) - (21) Current activity 23,332 (8,261) (15,071) - Balance – December 31, 2006 (182,631) 52,044 130,964 377 2. Company: Balance - January 1, 2006 (205,836) 59,801 146,035 - Current activity 23,205 (8,134) (15,071) - Balance - December 31, 2006 (182,631) 51,667 130,964 - 3. Balance-sheet presentation: Consolidated Company December 31 December 31 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) In current assets 30,645 46,698 30,171 46,173 In current liabilities (30,268) (46,300) (30,171) (46,173) 377 398 - - e. Provision for income taxes – consolidated Year ended December 31 2 0 0 6 2 0 0 5 2 0 0 4 (in thousand US dollars) Current-tax expenses 113 381 662 Deferred tax expense (income) 21 (77) (574) 134 304 88 Total tax expense f. Final tax assessments On May 26, 2003, the Company signed an agreement with the income-tax authorities, according to which it received final tax assessments up to, and including, the 2002 tax-year. Within this framework, it was established that the balance of the carry-forward tax losses to the year 2003, after the waiver of government debt (explained in Note 9d.2 above) would amount to NIS 2,219 million (based on the exchange rate in effect on December 31, 2006-$ 525 million). The balance of the Company’s tax losses at the end of the 2006 tax-year (based on an estimated tax report for the year 2006) amounted to approximately $ 558 million. C-93 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 23 - RELATED AND INTERESTED PARTIES a. Balance-sheet items pertaining to related and interested parties: Consolidated Company December 31, December 31, 2 0 0 6 2 0 0 5 2 0 0 6 2 0 0 5 (in thousand US dollars) Trade accounts receivable - 805 - (*) 202 The highest balance during the year - 822 - 264 Other current assets - - 2,621 1,516 The highest balance during the year - - 6,428 4,888 Loans granted to investees 1,228 1,554 1,228 2,192 The highest balance during the year 1,554 1,704 2,192 2,418 Trade accounts payable 13,582 (*)21,045 18,148 (*) 25,114 Other current liabilities 1,627 2,764 1,600 2,461 Bank loan 35,454 40,094 35,454 40,094 (*) Reclassified b. Transactions with related and interested parties: Consolidated Company Year ended December 31 Year ended December 31 2006 2005 2004 2006 2005 2004 (in thousand US dollars) Operating income 72,572 97,221 41,642 121,160 145,885 80,372 Operating expenses 280,784 249,697 100,356 305,109 273,964 124,867 Selling expenses 10,965 13,192 10,331 10,965 13,192 10,331 G & A expenses 1,751 3,637 540 1,751 3,637 540 Financing expenses 2,113 1,654 - 2,154 1,696 62 Other income - - - - - 345 C-94 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 23 - RELATED AND INTERESTED PARTIES c. Benefits to interested parties: 2006 2005 2004 (in (in (in No. of thousand No. of thousand No. of thousand people dollars) people dollars) people dollars) Employed directors (*) - - - - 1 54 Non-employed directors (*) 9 66 9 68 8 52 Employed interested parties (**) 1 770 2 2,570 1 434 (*) The number of directors constitutes a yearly average. (**) The new CEO assumed his post in March 2005. As for his employment terms - see Note 23Q below. d. The Government of Israel and related institutions As of December 31, 2006, the Government owned 20.97% of the Company’s shares. During the course of its business, the Company carries passengers and cargo for the State of Israel and its many agencies, including government ministries, companies that it owns, institutions and authorities. These transactions are carried out during the ordinary course of business activities under commercial terms, with each individual transaction, on its own, not being material from the Company’s point of view. Concurrently, in the course of its business, the Company acquires services from the State of Israel and its agencies, including government ministries, companies that it owns, institutions, authorities and, in particular, services at BGA, and the payment of usage fees for a complex on which Company installations are located and where it performs aircraft repair and maintenance work, etc. The Company also is provided services by government corporations in the ordinary course of business (such as electricity, telecom, etc). As for the State of Israel being an interested party in the Company – before the publication of the Securities Regulations (Preparation of Annual Financial Statements) (Amendment), 2005 (hereafter- "the Regulations"), the Company received an exemption from describing transactions with government institutions due to the difficulties that it would have involved (as it entails many and diversified ministries, authorities and companies). This exemption was granted for transactions carried out in the ordinary course of business with entities included, or which could be included in the definition of “related parties”, including banks, since they are related to the Government of Israel. Accordingly, this note does not include a description of transactions carried out in the year 2004 and the amounts itemized therein do not include them. C-95 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 23 - RELATED AND INTERESTED PARTIES d. The Government of Israel and related institutions (cont.) Following the amendment to the Regulations, the Company, in the year 2005 and thereafter, provides a general description of the transactions, their nature and volume, in accordance with Regulation 64(3) (d) (2), as follows: - Operating revenues includes revenues from sale of tickets to various government entities during the year 2006 in a total amount (Company and consolidated) of approximately $ 25.9 million (about $ 25.6 million in the year 2005), revenues from carrying cargo for various government entities in a total (Company and consolidated) of approximately $ 38.4 million (about $ 18.9 million for the year 2005) and revenues from rendering maintenance services (Company and consolidated) totaling approximately $ 4 million (about $ 2.3 million for the year 2005). - Operating expenses during the year 2006 include those incurred by purchasing services from various government entities in a total amount of approximately $ 127.3 million, consolidated, and about $ 124.8 million, Company, (for the year 2005: approximately $ 105.3 million, consolidated, and about $ 102.6 million, Company). Most of these expenses pertain to various fees and space rental from the AA, the government’s participation in security expenses (see Note 21c) and engine maintenance and repairs carried out by a government corporation. Operating expenses also include those incurred with related parties, electricity, telecom, infrastructure for gasoline delivery and ground transportation through government corporations. Financing expenses for the year 2006 include net financing expenses of approximately $ 2.2 million (Company and consolidated) paid to a bank in which the Government of Israel is an interested party (about $ 1.7 million for the year 2005). e. K’nafaim Holdings Ltd. and interested parties therein - In June 2004, K’nafaim Holdings Ltd ("K'nafaim") became an interested party in the Company and in January 2005 it became the controlling party therein. As of December 31, 2006, K'nafaim holds approximately 39.49% of the Company's shares. With regard to transactions with related and interested parties during the year 2004, as noted above, the Company applied to the Securities Authority in the context of Section 64 of the Securities' Regulations (Preparation of Annual Financial Statements), 1993 and obtained an exemption from describing transactions with its interested parties, other than irregular transactions, as defined in item 1 of the Companies Law, 1999, including transaction’s not carried out at arm’s length. This exemption included casual transactions related to the rendering of flight services with the K’nafaim Group, casual transactions for purchasing products and services carried out by the Company during the ordinary course of business with the K’nafaim Group, as well as with other companies related to this Group, the activity of which entails the sale of products or services. C-96 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 23 - RELATED AND INTERESTED PARTIES e. K’nafaim Holdings Ltd. and interested parties therein (cont.) - Commencing from the year 2005, following the abovementioned amendment to the Regulations, a general description of the transactions, their nature and volume, in accordance with Regulation 64(3) (d) (2), is provided as follows: - Operating revenues for the year 2006 include revenues from companies in the K’nafaim Group and its controlling parties in a total amount of approximately $ 3.4 million, consolidated, and about $ 1.6 million, Company (the 2005 year: approximately $ 49 million, consolidated, and about $ 48.3 million, Company), most of such revenues derived from the sale of flight tickets to the Group’s travel agencies, and with a small part coming from the rendering of maintenance, loading and cargo transport services. - Operating expenses for the year 2006 include transactions carried out the K’nafaim Group and its controlling parties, amounting to approximately $153.5 million (the year 2005: about $ 143.3 million) (Company and consolidated) and pertaining almost entirely to the purchase of jet fuel from a related company, with a small part incurred for borrowing crews and leasing. - Selling expenses include agent commissions of approximately $ 15 thousand (2005-about $2.3 million) paid to the K’nafaim Group and its controlling shareholders (Company and consolidated). - General and administrative expenses include approximately $ 0.9 million for management fees paid to K’nafaim and directors’ insurance (the year 2005: about $ 1 million. (As for the management agreement and the group insurance agreement – see Notes 23.o and 23.r.2, respectively). - Other than the items detailed above, the other transactions with the K’nafaim Group and its controlling parties are negligible and they relate to the purchase of cleaning materials, lounge services for hosting airline passengers of foreign airlines, transportation to BGA, magazines for prestigious sections and entertainment brochures on flights, meals served in terminal 3 for delayed-flight passengers, children's accessories, hotel accommodation for outstanding employees and holiday vouchers. C-97 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 23 - RELATED AND INTERESTED PARTIES f. Transactions with additional related parties: Operating revenues of the Company include revenue of $ approximately $ 51.2 million (the 2005 year: about $ 50.9 million) from investees for aircraft leasing to Sun D’Or and sale of flight tickets to Superstar and management fees from Borenstein. These items have been eliminated in the consolidated financial statements. It also includes (Company and consolidated) income from Sabre Israel, an investee, for software use. Operating expenses of the Company include approximately $ 26.8 million (2005 year: about $ 28 million) of expenses incurred by investees for buying passenger meals from Tamam, Borenstein and Katit as well as materials-handling services from Maman up to April 2005 (when it was sold by the Company). The consolidated amount includes $ 1.2 million in the year 2005 for the purchase of material-handling services from Maman . Selling expenses include approximately $ 11 million (the year 2005: about $ 10.9 million) (Company and consolidated) for commissions and marketing fees paid to investees (Airtour, ACI and Sabre). General and administrative expenses include approximately $ 0.8 million (year 2005: about $ 2.6 million) (Company and consolidated) for directors’ fees and benefits to employed interested parties. g. Privatization of the Company- see Note 1b. h. Issuance of a special share – see Note 19f. i. State of Israel guarantees provided to fulfill Company obligations - see Notes 14c.1 and 15b.13. j. Agreement with the Government of Israel to acquire State-owned aircraft and arranging Company debt for the use of aircraft - see Note 9d. k. Financing the acquisition of aircraft by banks in which the State of Israel owns more than 25% - see Notes 14 and 18. l. Commitments with the AA – see Note 17d.3. m. Arrangement with the State of Israel to assure the raising of capital - see Note 15b.4.b. n. Sole supplier – Boeing Inc. is the Company’s sole supplier of aircraft – see Note 9b. o. Management fees: The Company’s General Meeting of Shareholders, which was held on May 10, 2005, approved a management agreement with the controlling party in the Company according to which the controlling party, through, Prof. Israel (Izzy) Borovich and a personal assistant would render services as active Chairman of the Board to the Company, for which the controlling party would receive monthly management fees of $60 thousand, in effect from January 9, 2005, over a three- year period. In addition, the Chairman of the Board and his family members will be entitled to receive free or discounted flight tickets. C-98 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 23 - RELATED AND INTERESTED PARTIES (Cont.) p. Directors’ fees: The Company’s General Meeting of Shareholders, which was held on May 10, 2005, approved each director’s fee as compensation for participation in meetings of the Board of Directors and/or any of its committees, as well as entitlement to receive, as a benefit, free or discounted flight tickets for each director and members of his family. q. Agreement with CEO of the Company: 1. In February 2005, the Board of Directors appointed Mr. Haim Romano as the Company’s new CEO, based on an employment contract according to which he would be employed, commencing from March 1, 2005. The agreement entitles the CEO, inter alia, to: - Severance pay upon termination of employment equaling two monthly salaries for every year of employment with the Company; - An adaptation grant equaling six monthly salaries (18 months in case of dismissal); - An annual grant computed on the basis of the Company’s net income (as defined in the agreement and which includes adjustments of the income for various expenses), ranging between 0.7% and 1% of net income after adjustments. The annual grant is not entitled to any social benefits; - Options program ("phantom") for a vesting period of up to three years, according to which the CEO will be entitled to a monetary grant computed on the basis of 3,258,210 ordinary ("phantom") shares at an exercise price of NIS 2.2098 per share. The gross value of the benefit of the options program upon commencement of employment, based on the computation rules of the Tel Aviv Stock Exchange, is estimated at approximately $ 1.5 million, with any tax liability on the value of the benefit payable by the CEO. The value of this benefit will be allocated over the above period and subject to the period of employment of the CEO. During the month of October 2006, an understanding in principle was formulated between the Chairman of the Board of the Company and the CEO according to which the CEO would waive the balance of the phantom options that were granted to him under his employment contract, as aforementioned. The CEO announced this waiver to the Company's Board of Directors on March 21, 2007. 2. Pursuant to the request of the Company CEO, on March 29, 2006 the Company amended his employment contract so that $ 1.2 million of the grant to which he is eligible for the year 2005, based on the terms of the agreement described in item 1 above, would be postponed and payable in three equal installments in January 2007, January 2008 and January 2009. The entitlement to receive each installment is contingent upon continued employment of the CEO in that position at the time each installment is to be paid. On December 31, 2006, the Board of Directors of the Company decided on an amendment to the agreement with the CEO so that the date of payment of the second installment in the amount of $ 0.4 million would be advanced and paid together with the first installment during the month of January 2007. The advance payment would be contingent upon the commitment of the CEO that, in the event that the CEO would not be serving in his position in the month of January 2008, he would refund the amount paid of the second installment to the Company, unless the Company would decide otherwise. 3. On August 16, 2006, the Audit Committee and the Board of Directors of the Company approved an amendment to the employment agreement between the CEO and the Company extending the term of employment of the CEO until December 31, 2010. C-99 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 23 - RELATED AND INTERESTED PARTIES (Cont.) r. Directors’ and officers’ insurance and indemnification: The General Meeting of Shareholders of the Company, held on May 10, 2005 approved the following matters: 1. Making an advance commitment to indemnify present as well as future directors, and executives who are not directors, serving from time to time in the Company as long as control over the Company is not transferred from the present controlling parties. The amount of the indemnification will include any financial obligation imposed as well as reasonable legal expenses not exceeding the lesser of 25% of the Company’s shareholders’ equity at December 31, 2004 or 25% of its shareholders’ equity reported in the last financial statements just prior to the actual payment of the indemnification, in addition to any indemnification amounts received, if received, from the Company’s officers’ insurance policy. The indemnification certificate also entitles the officers to receive interim financing until the legal proceedings are concluded. 2. Acquiring professional-liability insurance for officers, according to which the officers, the Company and the controlling party in the Company will receive insurance coverage within the framework of group insurance obtained with an Israeli and/or foreign insurer, or, alternatively, self-insurance by the Company. The ceiling of joint liability would be a maximum of $ 100 million plus 20% for legal defense expenses. The Company’s share in the group insurance fees amounts to 65% of the group insurance cost and, in any event, will not exceed $ 450 thousand per annum, with the addition of the run-off premiums as below. In the event of self-insurance –the liability ceiling will not exceed $ 100 million per incident and, in total for any annual insurance period, plus 20% for legal defense expenses. The annual premium that will be paid by the Company for self insurance plus the premiums for run off insurance will not exceed $ 450 thousand. In addition, the General Meeting resolved to adopt a framework resolution for purchasing a run-off policy for officers acting within the framework of their duties until January 5, 2005. Liability will be limited to $ 30 million plus 20% for legal defense expenses. The premium-as itemized above. s. Salaries of officers who are not directors of the CEO A Special Meeting of Shareholders of the Company, taking place on July 14, 2005, resolved to add Regulation 158a to the Company’s bylaws. The regulation added states, among other things, that the salaries of officers (not including directors who are not Company employees, other than the CEO, a controlling party, a relative of a controlling party and an interested party in a controlling party), when the issue does not entail an irregular transaction, will be approved by the Human Resources and Appointments Committee of the Board of Directors. t. Government of Israel participation in issuance expenses: The Government of Israel participated in the underwriting, management, distribution and legal expenses in proportion to the proceeds from the sales offer, with the remaining expenses divided between the Company and the Government of Israel. In 2004, following its account settlement with the Company, the Government of Israel reduced its participation in the issuance expenses by $ 181 thousand. C-100 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 24 - OPERATING SEGMENTS a. Prime reporting - geographical segments The Company’s activity is organized by flight routes, traffic rights and branches across the globe and, accordingly, the Company reports on geographical segments in a primary format. Most of the Company’s assets and liabilities are attributed to its various fleets of aircraft, which – by designation – are mobile by designation and thus are not identified with any given geographical segment. The following is the reporting of geographical segments on a consolidated basis – Far East & North Central Other America Europe Asia countries Total (in thousand US dollars) 2006: Revenues - Segment revenues 580,399 702,909 313,500 36,590 1,633,398 Non-segment revenues 32,048 Total consolidated revenues 1,665,446 Operating income - Operating income by segment 11,186 81,234 37,837 7,830 138,087 Overall segment expenses, net (155,050) Operating loss, before financing expenses - consolidated (16,963) 2005: Revenues - Segment revenues 568,289 710,265 277,101 34,853 1,590,508 Non-segment revenues 28,961 Total consolidated revenues 1,619,469 Operating income - Operating income by segment 58,501 166,379 33,765 11,555 270,200 Overall segment expenses, net (181,278) Operating income, before financing expenses - consolidated 88,922 2004: Revenues - Segment revenues 488,018 606,284 239,686 28,233 1,362,221 Non-segment revenues 23,959 Total consolidated revenues 1,386,180 Operating income - Operating income by segment 42,239 113,851 51,565 8,213 215,868 Overall segment expenses, net (158,011) Operating income, before financing expenses - consolidated 57,857 C-101 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 24 - OPERATING SEGMENTS (Cont.) b. Secondary reporting – business segments The Company’s activity is organized by fleets of aircrafts. Accordingly, the Company reports in a secondary format on its business segments, on the basis of a division by passenger and cargo aircraft. The following is the reporting by business segments on a consolidated basis – Other and Passenger Cargo consolidated aircraft aircraft adjustments Total (in thousand US dollars) 2006: Revenues from : Passengers 1,277,746 - - 1,277,746 Cargo and mail 90,002 241,604 - 331,606 Other income 34,426 965 20,703 56,094 Total revenues 1,402,174 242,569 20,703 1,665,446 Net book value of fixed assets 1,074,836 24,383 49,170 1,148,389 2005: Revenues from : Passengers 1,259,773 - - 1,259,773 Cargo and mail 92,657 216,463 - 309,120 Other income 33,254 839 16,483 50,576 Total revenues 1,385,684 217,302 16,483 1,619,469 Net book value of fixed assets 1,080,494 37,674 45,597 1,163,765 2004: Revenues from : Passengers 1,048,513 - - 1,048,513 Cargo and mail 77,731 216,706 - 294,437 Other income 25,478 1,011 16,741 43,230 Total revenues 1,151,722 217,717 16,741 1,386,180 Net book value of fixed assets 1,098,740 42,546 47,623 1,188,909 C-102 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 25 - EVENTS SUBSEQUENT TO THE BALANCE SHEET DATE a. Contingent claims 1. On January 22, 2007, a suit was filed against the Company in the Jerusalem District Court, to which was attached a request to approve the suit as a class action, in the amount of about NIS 483.4 million (approximately $ 114 million as of the balance sheet date). The plaintiffs allege that the collection of a security levy in the amount of $ 8 per flight leg from passengers on flights not performed by the Company itself, but by other airlines, in the framework of code sharing agreements with the Company, represents consumer misrepresentation, breach of the agreement with him, absence of integrity, and unlawful gain, since on these flights, according to the allegation of the plaintiffs, no security or protection services were provided which were identical at their level and quality to the security services provided by the Company. The plaintiffs wish to charge the Company to pay $ 8 to each of these passengers as well as compensation for suffering and aggravation. At this stage, the legal advisors of the Company are unable to evaluate the probability of the lawsuit and the request to recognize it as a class action.. No provision for this suit was recorded in these financial statements. 2. At the end of the month of February 2007, the Company received a writ of civil claim that was filed in the court in New York in the matter of the prices of cargo air transport services. The Company was included in the writ of claim which was filed as aforesaid, along with 38 other airlines, with the claim being that the defendants were partners in a conspiracy to conform prices for cargo air transport services, directly and indirectly, in Europe and the United States; it also includes a request to recognize the claim as a class action. The claim includes a request for compensation in an amount not denominated as well as additional relief. The Company is evaluating the writ of claim that it received and the possible implications and is making preparations to deal with this proceeding. In view of the early stage of the process, the Company is unable to assess the implications or the monetary effect of the proceeding on the Company and has, therefore, not made any provision for this claim in these financial statements. C-103 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. NOTES TO THE FINANCIAL STATEMENTS NOTE 25 - EVENTS SUBSEQUENT TO THE BALANCE SHEET DATE (Cont.) a. Contingent claims (cont.) 3. On March 18, 2007, a claim against the Company was made in the Tel-Aviv District Court, to which was attached a request for approval as a class action. The claimant alleges that the charge to customers who purchase airline tickets directly (and not through a travel agent) by means of credit cards in foreign currency instead of Israeli currency, with payment of a conversion commission of 2% of the price of the flight ticket (for conversion of the payment in foreign currency into a payment in Israeli currency) to the credit companies represents a violation of the Consumer Protection Law- 1981, a violation of the necessity for integrity and unjust enrichment. It was also alleged that this was a breach of the requirement to publish an "overall price", and that it is the Company that must bear these conversion charges. In addition, the claimant alleged that charging customers in foreign currency and not in shekels represents of itself, a violation of The Consumer Protection Law. The claimant has requested that the Company be charged to pay compensation to each of the members of the group to the extent of all of the amounts of the conversion fees collected unlawfully, and to refund to each the amounts of the conversion fees unlawfully collected, as alleged by the claimant. The claimant also has requested that an order be given to the Company which stipulates that the collection of the payments in foreign currency and the charging of the relevant conversion commissions were done unlawfully and to prohibit the Company to continue to collect payments in foreign currency and to pass on the conversion fee charges for foreign currency payments to its customers. The Company is studying the claim and is preparing to file its response. b. Other events 1. After the balance sheet date, the Company paid an additional amount of approximately $ 5.5 million to the Boeing Company as the final payment for its independent financing on account of two ordered 777-200 aircraft, as described in Note 17, d.1. 2. At the beginning of the month of March 2007, the Company signed a contractual agreement with the financing banks for purposes of the purchase transaction for the two 777-200 aircraft mentioned in Note 17.d.1, and concurrently, the Company filed a request to convert the preliminary obligation with a final obligation to the EXIM bank for purposes of obtaining an EXIM guarantee for financing the transaction. 3. Following the termination of a company related to Boeing with which the Company had an agreement in the past for purposes of operating Internet systems in a part of its aircraft, this service was ceased by the Company. In the month of January 2007, an agreement was signed between the Company and Boeing according to which the Company received compensation from Boeing for its investments in the Internet system and the additional damage caused to it due to the cessation of the operation of the system. For this compensation, the Company will record a capital gain of approximately $ 4.4 million during the first quarter of the year 2007. C-104 Translation of the Hebrew Language financial statements EL AL ISRAEL AIRLINES LTD. APPENDIX A TO THE FINANCIAL STATEMENTS DETAILS CONCERNING MAJOR ACTIVE INVESTEES AS OF DECEMBER 31, 2006 Control and ownership as of the balance-sheet date Company Business activity (%) Subsidiaries Bornstein Caterers Inc. (USA) Production and supply of airline meals 100.0 Tamam Aircraft Food Industries (Ben-Gurion Airport) Ltd. Production and supply of airline meals 100.0 Sun D'Or International Airlines Ltd. Operation of charter flights 100.0 Superstar Holidays Ltd.(Britain) Marketing of tour packages 100.0 Katit Ltd. Supplying meals to employees 100.0 Affiliates Sabre Israel Travel Technologies Ltd. Management of flight ticket orders 49.0 Kavei Chufsha. Ltd. Marketing of tourism services 20.0 Other investees Airtour Israel Ltd. Grouping flight tickets - (1) Air Consolitours Israel Ltd. (ACI) Grouping cargo - (2) Notes: (1) The shares held by the Company grant it the right to participate and vote in its company's General Meetings (at the rate of 50%) and appoint half of the directors, without the right to receive any profits. (2) The ordinary shares held by the Company grant it the right to participate and vote in the company’s General Meetings and appoint half of the directors, without the right to receive any profits. C-105