EL AL ISRAEL AIRLINES LTD.

Transcription

1 EL AL ISRAEL AIRLINES LTD 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 FINANCIAL STATEMENTS

2 Haim Romano CEO Amikam Cohen Chairman of the Board of Directors Greetings, We have pleasure in presenting the financial statements of El Al for El Al s financial statements for 2008 reveal only part of the complex and changing reality that El Al has been forced to deal with during Moreover, many of the dilemmas and the challenges that we faced in the course of 2008 are no longer applicable, and instead we are witnessing the emergence of new and different challenges in the business environment in which El Al operates. There is no doubt that 2008 demanded multi-faceted decision making processes, involving rapid changes of direction. In particular this last year was affected by the steep and unprecedented increase in the price of oil which had already crossed the threshold of $100 a barrel in the first quarter and reached a record $147 a barrel in the third quarter. These changes pushed the whole aviation industry into one of the most serious crises in its history. It was impossible to compensate entirely for the increased price of fuel by raising prices, since the competitive environment and flexibility of consumer demand leave the company little room to maneuver with pricing. The result of the oil price crisis was that many airlines worldwide were forced to close, while others found themselves in serious financial difficulties, and questions arose regarding the feasibility of flights or current capacity to many destinations. Since a considerable slice of our company s activity is based on long haul flights, this reality obliged us to adopt a complex and delicately balanced policy on matters of pricing, capacity and hedging transactions on jet fuel deals. We had to constantly sense the pulse of the market and the competition, and operate in conditions of uncertainty regarding future trends in oil prices. We took steps to maintain El Al s strengths and competitive advantages, we adopted a conservative hedging strategy in the attempt on the one hand, to compensate for the steep rise in fuel prices, while on the other hand to maintain the margins of caution demanded by the uncertainty over future pricing trends. In addition to oil prices, the financial results were also affected by the collapse of the dollar against the shekel, at an average rate of about 13%. The increase of ticket prices in dollar terms, which as I said only partially offset the increase in oil prices, could not also incorporate the erosion in shekel revenues, which led to a rise in the company s shekel expenses, particularly with respect to salary costs in Israel. Over the year we faced a continual growth in competition from other scheduled and charter airlines, which offered over capacity of about 20% more seats compared to previous year. The growing competition forced us to focus differential efforts on the strategic routes where competition was strongest, mainly to England and the United States, while intensifying the ability of our subsidiary Sundor to deal with charter flights and popular tourism. There were other events during the year that led to an increase in security expenses since the Government refuses to recognize its responsibility to help us deal with them. To all these trends, we have to add the global financial crisis that erupted forcefully in the last quarter of the year, leading to a reduction in passenger traffic along with a drastic slump in fuel prices. All these trends indicate, as we said, the highly involved and changeable reality that characterized 2008, a reality that demanded complex decisions and is reflected in the company s financial statements. In 2008 the company s revenues rose to an all time high of $2.1 billion, compared to $1.9 billion the previous year. This growth was mainly the result of increased ticket prices due to the rise in oil prices. But as I said the higher ticket prices did not fully make up for the higher oil prices, which led to a rise of about 45% in the company s expenditure on jet fuel, from $ million in 2007 to $771.2 million in 2008, and this was after receipt of hedging refunds amounting to $6.4 million (these figures include in 2008 a book loss of $41.3 million for the drop in fair value of the jet fuel hedging transactions that are not comply with hedge accounting). Expenditure on jet fuel in 2008 accounted for 36.7% of turnover, compared to 27.6% in Operating costs rose from 78.5% of turnover in 2007 to 84.5% in The sharp rise in operating costs led to a decrease in gross profit of about $90 million, from $414.8 million in 2007 to $325.2 million in At the same time, we

3 managed to maintain a high load factor compared to the global average (82.3%), to reduce sales and distribution costs (mainly by increasing the share of direct sales and cutting commissions), to reduce administrative and general costs as a proportion of turnover, and to increase corporate efficiency. All these measures helped El Al to finish 2008 with an operating loss of only $1.6 million and with a positive cash balance of about $118.9 million (after payment of about $160 million for an investment in the purchase of aircraft and other fixed assets, and settlement of about $65 million in company loans). In the final analysis of this difficult year, El Al recorded a net loss for 2008 of about $38.8 million. These results are also affected by book expenses relating to the fair value of jet fuel and interest hedging transactions which are not comply with hedge accounting amounting to some $60 million, and by an allocation of about $15 million against the background of an arrangement with the US Ministry of Justice regarding an investigation concerning air freight services. In 2008 El Al continued to invest considerable resources in maintaining its leading status in the industry, according to its corporate vision and the El Al 2010 strategic plan. Two new Boeing 777 planes - Sderot and Kiryat Shmona - that were received in the summer of 2007 were integrated into company flights to long distance destinations and were the benchmark for the upgrade of the other 777 planes, based on the high quality specification of the new aircraft, including installation of flat bed seating in prestige classes. During the year we also acquired our fifth Jumbo plane from Singapore Airlines, which is equipped with flat bed seating in prestige classes and with an advanced entertainment system. Towards the end of 2008 we embarked on a project to upgrade the remaining Jumbo aircraft, which is due to be completed in April On its conclusion, El Al will have a fleet of 11 long haul 747 and 777 aircraft, all renovated and upgraded, offering the best flight experience available when compared to any other company. In the summer of 2008 the El Al fleet was joined by two new planes out of five which El Al has either purchased or leased. In addition, in March 2008, the company signed an agreement with Boeing for the purchase of four planes, at a cost of about $540 million, to be supplied during the years In the second quarter of 2008 El Al successfully accomplished the transfer from Carmel, the old distribution system, to Amadeus. This led to considerable improvements in the company s marketing and sales interfaces, both to travel agents and to end consumers in direct sales channels. The El Al website continued its dramatic growth, with an increase of about 132% in sales both in Israel and worldwide. In the course of 2008 we also embarked on a project to develop a corporate resource management system (Back Office) using ERP technology. In the summer of 2008 the code share agreement with American Airlines came into force, considerably extending the range of destinations and flight routes that El Al can offer in flights between Israel and North America. El Al is currently successfully marketing flight tickets with the El Al code to some 25 destinations in North America, on direct flights and flights via Europe. Through 2008 and into 2009 El Al continued to bear the flag of the national carrier and worked with all the necessary responsibility to play its part in national missions. This was the case in the rescue of Israeli citizens and Jews from Georgia during the war there in August 2008, and in the determination to maintain the continuity of flights to Bangkok and Mumbai during riots and terror attacks, and also during Operation Cast Lead ( Oferet Yetsuka ), in which El Al provided assistance for residents of the South and IDF soldiers. There is no doubt that the global financial crisis which erupted towards the end of 2008 demanded and still demands a different type of preparation to what we were familiar with during most of Airline demand is strongly influenced by the economic climate. The crisis has led to a tightening of belts as far as expenditure on leisure and holidays is concerned, as well as a reduction in the volume of business travel. We saw the storm clouds gathering back at the end of the summer, and decided to adopt an aggressive strategy to enlarge El Al s slice of the shrinking airline cake. Since then we have continued to set the marketing agenda, with campaigns, benefits, a range of offers and more. We have expanded and continue to expand our range of products in order to cope with the increasing competition. El Al remains determined to promote its vision: to lead the Israeli aviation market and to be the first choice for air travel to and from Israel. The company s board of directors, headed by the incoming chairman Amikam Cohen, has instructed the company to design a new strategy, El Al 2016, to prepare the company for the challenges of the next decade and provide a response to the situation in the aviation industry in particular, and the financial crisis in general. The plan will be presented for approval in the next few months. We wish to thank our customers for choosing us, in spite of the range of options available to them, and also to thank all El Al employees for their dedication and hard work this year. Haim Romano CEO Amikam Cohen Chairman of the Board of Directors

4 2008 ANNUAL REPORT CHAPTER A OVERVIEW OF THE ENTITY'S BUSINESS

5 El Al Israel Airlines Ltd Annual Report Chapter A Overview of the Entity's Business a-1

6 TABLE OF CONTENTS CHAPTER 1: GENERAL... 5 CHAPTER 2: DESCRIPTION OF THE GENERAL DEVELOPMENT OF THE CORPORATION S BUSINESS The Corporation s Activities and a Description of the Development of its Business General Holdings of the Company Year and Form of Incorporation Changes in the Corporation s Business Fields of Activity Investments in the Corporation s capital Options Shares Held by Company Employees Changes in holdings of Interested Parties Table summarizing data on interested party holdings Distributions of Dividends Financial Data on the Corporation s Fields of Activity Nature of Consolidation Adjustments Explanation of Developments Occurring in the Fields of Activity General Environment and Effect of External Factors with Regard to the Company Traffic in the International Aviation Industry Traffic in the Israeli Aviation Industry Fluctuations in Jet Fuel Prices Foreign Currency Rate Fluctuations Interest Rate Fluctuations CHAPTER 3: DESCRIPTION OF THE CORPORATION S BUSINESS BY FIELD OF ACTIVITY The Field of Passenger Aircraft General Information on the Field of operations Services in the Field of Operations Analysis of revenues and profitability from services a-2

7 7.4 New Services Customers Marketing and distribution Reservations Backlog Competition Seasonality Productive capacity Aircraft Fleet Cargo Aircraft Field General Information on the Field of Operations Services in the Field of Operations Analysis of Service Revenues and Profitability New services Customers, marketing and distribution Reservations Backlog Competition Seasonality Productive capacity Aircraft Fleet Raw materials and suppliers Fixed Assets and Installations Insurance Intangible Assets Human resources Raw Materials and Suppliers Working Capital Investments Financing Taxation Environmental Matters Restrictions and Regulations on the Corporation s Business Material agreements Cooperation agreements a-3

8 9.14 Legal proceedings Goals and Business Strategies Financial Data on Geographic Segments Discussion of Risk Factors a-4

9 CHAPTER 1: GENERAL El Al Israel Airlines Ltd. is pleased to present a description of the Corporation s business for the fiscal year ending December 31, 2008, surveying the Corporation in general and the development of its business, as they occurred during The report was prepared in accordance with the Securities Regulations (Periodic and Immediate Reports) The financial data included in the report is in U.S. dollars, unless stated otherwise. The financial data relating to monetary claims are 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 nearest whole percent, unless stated otherwise. Data appearing in this report are correct as of the report date, unless stated otherwise. Data appearing in this report as correct as of a date close to the approval of the report, have been updated to March 19, 2009, unless stated otherwise. The importance 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 some cases, additional descriptive information is 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, businesses and fields of activity, also includes Forward-Looking Information, as defined in the Securities 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 report date, as well as estimates and forecasts of third parties, which might not be realized or only partially realized. Therefore, actual results, in full 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 Forward-Looking 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. Glossary For convenience purposes, in this Periodic Report, the following capitalized terms will hereinafter have the meaning below: 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, Dollar - U.S. dollar. Stock Exchange - The Tel-Aviv Stock Exchange. The Financial Statements - The consolidated financial statements of the Company for the year ended December 31, 2008, unless 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. a-5

10 The 2003 Prospectus - The prospectus published by the Company on May 30, 2003, as amended on June 3, 2003 and June 4, The Shelf Prospectus - The shelf prospectus published by the Company on May Fifth Freedom - Transport of passengers or cargo between two foreign countries by a carrier from a third country. For example, El Al transports cargo between Liège and New York. 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 the country of that airline in Europe. Companies Law - The Companies Law Government Corporations Law - The Government Corporations Law Securities Law- The Securities Law IATA- The International Air Transport Association. Report Date - December 31, K nafaim - K nafaim- Holdings Ltd. Date Immediately Prior to the approval of the Report - March 19, 2009, unless stated otherwise. Sun D Or - Sun D'Or International Airlines Ltd. Income Tax Ordinance - Income Tax Ordinance (New Version) NIS - New Israeli shekel. Reported Year ASK - Available Seat Kilometer - number of seats offered for sale multiplied by the distance flown. ATK - Available Ton Kilometer - the available capacity for transport 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. FTK - Freight Tone Kilometer the weight in tonnage of cargo (including mail) multiplied by the distance flown. PLF - Passenger Load Factor occupancy rate in passenger flights (percentage of seats occupied) a-6

11 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 7.1.1, 7.1.2, and below for more on this subject and on the term Designated Carrier, and on the Government's decision regarding "Open Skies". The Group is engaged in auxiliary activities to its air transport activity, such as sale of dutyfree products, production and supply of food primarily to its aircraft, and in the leasing of aircraft, providing security services, regular maintenance and overhaul services to aircraft of other airlines at 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 periods of excess capacity. In the area of passenger transport, the Company competes with 2 Israeli airlines (Arkia and Israir), approximately 50 foreign scheduled airlines, and approximately 60 international charter companies, of which 40 operate regular flights. The airlines compete in various areas, principally: fares, frequency and flight times, operational punctuality, equipment type, airplane configuration, passenger service, etc. The competition is with the airlines that 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 to and from BGA, including C.A.L. Cargo Airlines Ltd. Additionally, the Group competes with most of the scheduled airlines that operate passenger airplanes and transport cargo in their holds. See Sections 7.8 and 8.7 for more on competition 1.2 Holdings of the Company In the report year, there were no changes in the Company's holding structure. The following is a chart of the structure of the Company s holdings in investees active as of the date immediately prior to the approval of the report (the percentages listed in the chart express the Company s holdings in the investee companies): a-7

12 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-8

13 1.3 Year and Form of Incorporation El Al Israel Airlines Ltd was incorporated as a limited liability company on November 15, 1948 under the name of El-Al Israel Airlines Ltd. changing its name to its present name on May 16, 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 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. Within the framework of the prospectus, the State also offered shares and options to purchase shares from two series call options (Series A) and call options (Series B). On the prospectus issue date, the State had held approximately 97.25% of the Company s issued share capital. Immediately after issuance of the securities pursuant to the prospectus, the State's holdings in the Company dropped to 85% of the Company's issued share capital (undiluted). 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 under 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 and the State s holdings decreased to approximately 31% of the issued share capital of the Company. On January 6, 2005, the majority of the members of the Board of Directors were replaced when the meeting of the Company s shareholders, convened at the request of K nafaim, decided to appoint new board members. At the same time, the State 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 tenure of the two previous public directors terminated as Company directors. Close to the date of approval of the report, there are 11 members serving on the Company's Board of Directors (including two public directors). As K nafaim holds Company shares at a rate exceeding that held by the State, the special provisions detailed in Section 108 of the Company s Articles of Association ceased to apply. See Section (k) below for additional details. By June 5, 2007, all of the call options (Series B) and most of the options (Series 1) were exercised, as detailed in Section 3.2 below. As a result of the exercise of the call options (Series B), the State ceased being an interested party in the Company as of June 5, The State still holds shares of the Company (which according to the last report the Company has, is at a rate of 1.1% of share capital), and therefore, the Company still has the status of "mixed company". Likewise, the State holds a Special State Share (for information on the Special State Share and its related rights, see Section below). a-9

14 2. Fields of Activity The Group s headquarters functions on an integrated basis in the fields of activity listed below, including financial management, procurement, human resources, legal counsel, information infrastructures, security, maintenance, engineering, marketing and advertising as well as in ground operations and construction. The Group has two fields of activity that are reported as business segments (secondary) in the Company s consolidated financial statements (See also Note 34.B. to the Financial Statements). (A) Air Transport in passenger aircraft In this field, the Group transports passengers as well as cargo (including mail and baggage) in the holds of passenger aircraft, as well as providing auxiliary services, such as sale of duty free products and passenger aircraft leasing. Revenues from this field of operations represented approximately 92% of total Group revenues for (B) Air Transport in cargo aircraft In this area, the Group transport cargo in cargo transport aircraft as well as providing auxiliary services, such as leasing cargo aircraft. The revenues from this field of operations represented approximately 7% of total Group revenues for Other than the fields of activity detailed above, the Group has additional activities that are not included in these fields, which are not material to the Group s operations 1 and with total revenues representing about 1% of total Group revenues for Investments in the Corporation s capital 3.1. General In 2008, no investments were made in the Corporation s capital. In 2007, no investments were made in the Corporation's capital, except for the exercise of options (Series 1) which were issued in the context of the prospectus, into ordinary Company shares, which led to a $31,820 thousand increase in the Company's shareholders' equity. It should be noted that in 2007, the Company's shareholders equity increased by $25,289 thousand, within the capital reserve arising from transactions with a former controlling party (the State), due to deposits by the State in the severance fund of Company employees. See Section for details regarding the State's obligation to cover the deficit in the severance pay fund of Company employees. 3.2 Options The call options (Series A) issued by the State were each exercisable for one ordinary Company share, commencing soon after they were issued and until June 6, 2004, at an 1 The production and supply of meals for flight passengers, providing security services, regular maintenance services and overhaul services to aircraft of other companies at BGA and management of travel agencies abroad. a-10

15 exercise price of NIS 1.30 per option plus linkage to the Consumer Price Index of April Through June 6, 2004, all of the call options (Series A) had been exercised. The call options (Series B) issued by the State were exercisable, commencing December 12, 2004 and until June 5, 2007 (inclusive) for one ordinary Company share each. The exercise price of the call options (Series B) was NIS 1.32 per option (plus linkage to the Consumer Price Index of April 2003) for one ordinary Company share. Through June 5, 2007, all of the call options (Series B) had been exercised, totaling 157,600,000 options. As a result of the exercise of the call options (Series B), on June 5, 2007, the ownership of the State was reduced to approximately 1.1% of the issued share capital of the Company (undiluted). The options (Series 1) issued by the Company were exercisable from December 12, 2004 through June 5, 2007 (inclusive), into one ordinary Company share at an exercise price of NIS 1.34 (plus linkage to the Consumer Price Index of April 2003) per one ordinary Company share. Through June 5, 2007, 99,998,588 options (Series 1) had been exercised out of 100,000,000 options. The balance of the options (Series 1) not exercised by June 5, 2007 (1,412 options) expired and are null and void. 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"). 17,092,129 options were issued to some 50 offerees, of which some 10 were senior executives of the Company and some 40 other Company executives. For more details, see Note 27.i to the Financial Statements. On May 23, 2006, the Company's Board of Directors resolved on the addition of 3,000,000 options to the pool of options for issuance pursuant to the 2006 Options Program. In addition, the Board of Directors appointed the Human Resources and Appointments Committee of the Company's Board of Directors as the Administrator of the 2006 Options Program and authorized the Committee to grant options to executives of the Company in accordance with the guidelines stipulated by the Board of Directors. In addition, the Board of Directors approved the publication of an outline, which was published on May 29, Following that, on December 27, 2006, the Human Resources and Appointments Committee of the Board of Directors of the Company decided to grant 3,072,536 options to nine Company executives (of whom two are officers), which were actually granted on December 31, On November 20, 2007, the Company's Board of Directors resolved to publish an outline (which was published on November 21, 2007) for the granting of options, which returned to the pool of options that can be allotted pursuant to the terms of the 2006 Options Program, from the original quantity as detailed in the outline from February 26, 2006 and as amended on March 15, 2006 and/or from the additional quantity detailed in the outline from May 29, 2006, totaling 3,382,843 options (hereafter: "2007 Options Program"). Likewise, the Board of Directors allotted 2,195,852 options to six offerees (one of whom is an officer), if the requisite approvals are obtained. The said allotment was executed on December 26, As of December 31, 2008, the total options granted under the 2006 and 2007 Options Programs (as described above), equals 16,945,533, after deducting the options returned to the pool for any reason that complied with the program. See Section c. below for further details. During 2008, the Company recorded the value of a benefit against a capital reserve with respect to this options program of $1,316 thousand, according to a calculation of the value of the benefit made by using an economic model. a-11

16 3.3 Shares Held by Company Employees Pursuant to 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 were purchased by the Eligible Employees are held in trust and were blocked until December 31, 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 has also committed to sell to an employees' association, or to employees as individuals, 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), for a price of NIS 0.39 per share. As of immediately prior to the report approval date, the employees' association holds 31,158,604 ordinary shares, representing 6.29% of the Company's issued share capital (6.08% on a fully-diluted basis), following the exercises from August 2007 through January Sundry restrictions apply to the sale of the shares that are held by the employees association Changes in holdings of Interested Parties As of December 31, 2008, K nafaim owns approximately 39.33% of the issued capital of the Company, on an undiluted basis, and approximately 38.03% of the Company s issued capital on a fully diluted basis. As of March 19, 2009, the holdings of K nafaim in the Company are unchanged 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 the executives' options under the 2006 and 2007 Options Programs (see Section 3.2 for details on the 2006 and 2007 Options Plans). Presented below are details of transactions with respect to interested party holdings that were executed over the past 2 years: As reported by the Company, on September A.L. Aviation Assets (hereinafter: 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-12

17 "A.L. Aviation Assets"), a privately-owned company the issued capital of which is held in equal portions by Lenders' Assets Ltd., a Company controlled by Yehuda (Yudi) Levi, who serves as Deputy Chairman of the Company's Board of Directors, and Miella Venture Partners, a company fully owned by a foreign-based trust the beneficiaries of which are the members of the Effi Arzi family, became an interested party in the Company. A.L. Aviation Assets conducted several purchases and sales of shares (as reported by the Company). As of December , A.L. Aviation Assets held some 0.52% of the Company's issued capital on an undiluted basis and 0.50% of the Company's issued capital on a fully diluted basis. In addition, in February 2008, A.L. Aviation Assets purchased 1,500,000 shares in an off-exchange transaction at a price of NIS per share. As of March , A.L. Aviation Assets holds 4,063,668 shares, which constitute 0.82% of the Company's issued capital on an undiluted basis, and 0.79% of the Company's issued capital on a fully diluted basis. As reported by the Company, on January the Company's CEO Mr. Chaim Romano was added as a Company interested party by virtue of his holdings in the Company. Mr. Romano carried out several stock purchase activities (as reported by the Company). As of March , Mr. Romano held $295,338 shares, which constitute 0.06% of the Company's issued capital on an undiluted basis and 0.06% of the Company's issued capital on a fully diluted basis. On June 4, 2007, the Company was informed that Y. Hillel & Co. Ltd. (a company wholly owned by Mr. Pinchas Ginsburg), together with individuals from the Ginsburg Family (hereinafter together: "the Ginsburg Group") became interested parties in the Company by virtue of their holdings, following the exercise of options. The Ginsburg Group carried out a large number of purchase and sales transactions over the course of 2008, as reported by the Company. As of December 31, 2008, the Ginsburg Group held 8.13% of the Company's issued capital on an undiluted basis and 7.86% of the Company's issued capital on a fully diluted basis. In February 2009, the Ginsburg Group sold 1,500,000 shares in an offexchange transaction at a rate of NIS per share. As of March , the Ginsburg Group held 37,709,267 shares constituting 7.61% of the Company's issued capital on an undiluted basis and 7.36% of the Company's issued capital on a fully diluted basis. On May 6, 2007, the Company was informed that on May 3, 2007, K'nafaim had sold, in an off-exchange transaction, 37,500 thousand options (Series 1) of the Company, at a price of NIS 0.7 per option. Additionally, through June 5, 2007, K'nafaim had exercised all of the options (Series 1) and call options (Series B) it had held to that date. As a result of these transactions, as of December 31, 2007, K'nafaim held 39.33% of the Company's issued share capital on an undiluted basis and 37.91% of the Company's issued share capital on a fully diluted basis. As of March 19, 2009, no change occurred in K'nafaim's holdings in the Company's shares. On June 5, 2007, the State of Israel ceased being an interested party in the Company as a result of the exercise of all the call options (Series B), as described above. The State still holds shares in the Company, which according to the last report the Company has, is 1.1% of the issued and paid-up share capital. In addition, the State owns a Special State Share, which was established under the Company s bylaws and which 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 of the Company s articles prescribes a detailed arrangement on the manner of presenting the request to obtain the authorization to a-13

18 hold Company shares, in a case in which such authorization is required, as mentioned above. See Section below for details regarding the Special State Share. 3.5 Table summarizing data on interested party holdings The following is a table summarizing a number of facts regarding the Company s securities and the holdings of the principal interested parties 3 : Holdings of interested parties Ownership rate of the State in issued capital (undiluted)** Ownership rate of K'nafaim in issued capital (undiluted) Ownership rate of employees' trust holdings in issued capital (undiluted) Ownership rate of Ginsburg Group in issued capital (undiluted) Ownership rate of Mrs. Tamar Borowitz in issued capital (undiluted) Ownership rate of Mrs. A.L. Aviation Assets in issued capital (undiluted) Ownership rate of Chaim Romano in issued capital (undiluted) Company capital Registered share capital in NIS (excluding a Special State Share) Issued share capital in NIS (excluding a Special State Share) Convertible securities March 19, 2009 Special State Share December 31, 2008 Special State Share December 31, 2007 Special State Share 39.33% 39.33% 39.33% 6.29% 6.29% 6.56% 7.61% 8.13% 7.47% 0.07% 0.05% 0.05% 0.82% 0.52% % ,000, ,000, ,000, ,719, ,719, ,788,334 Options (Series 1) (in units) ,932,213 Call options (Series B) (in units) ,422,298 Executive options under 2007 and 16,896,042 16,945,533 20,092, options program 4 ** To the best of the Company's knowledge, the State holds 1.1% of the Company's issued capital of the Company. 3 See Section below regarding the up to date provisions of the Special State Share. 4 After deducting expired options that returned to the pool of options for allotment according to the terms of the program. a-14

19 Breakdown of the holdings of the Company s shares as of : Knafaim 39.3% Ginsburg Group 7.6% Employees Trust 6.3% Others 0.9% Public 45.9% Breakdown of the holdings of the Company s shares as of : Knafaim 39.3% Ginsburg Group 8.1% Employees Trust 6.3% Others 0.6% Public 45.7% 4. Distributions of Dividends On December 28, 2005, the Company's Board of Directors resolved to adopt a dividend distribution policy, whereby the Company will strive to distribute dividends, beginning with the 2006 fiscal year and thereafter, of between 20% to 40% of net after-tax earnings in the prior year 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. The decision also stated that implementation of this policy is subject to the law 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. It was also decided that 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 refrain from a distribution due to the liquidity, operations, business and condition of the Company, which may change from time to time. On November 20, 2007, the Company's Board of Directors resolved to update the dividend policy a-15

20 in the aforementioned manner. Within the scope of the new dividend policy, the Company will periodically distribute dividends, at the discretion of the Board of Directors and subject to the Company's needs. The Company did not distribute dividends in the reported year. The Company did not distribute dividends in the years preceding the reported period, except as follows: On October 7, 2007, the Company's Board of Directors resolved to distribute a dividend of NIS per share, for a total of NIS 37,178,926, 5.98% of the issued and paid-up capital. The dividend was distributed on October 29, On December 30, 2007, the Company's Board of Directors resolved to distribute a dividend totaling NIS 11,571,100 thousand (representing NIS per share), 19.4% of the issued and paid-up share capital. The dividend was actually distributed on January 21, On a related note, on March 28, 2005, K nafaim, the controlling owner of the Company, sent a letter to Bank Leumi stating that considering the present obligo status 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, 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. Concurrent 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 El Al's debt to the bank, conditional upon the terms as detailed in the letter of the bank to the Company, all as detailed in Section c. below. 5. Financial Data on the Corporation s Fields of Activity In the first quarter of 2008, the Company started preparing its financial statements in accordance with International Financial Reporting Standards (IFRS). The transition date to international standards, as defined in Accounting Standard no. 29 by the Israeli Accounting Standards Board, was January 1, As a result of transition to IFRS-based reporting, the Company presented its financial statements for the reported period, as well as comparison figures for the 9-month and 3-month periods ended September 30, 2007 and for the year ended December 31, 2007 in accordance with international standards. The information presented in the Board of Directors' report and comparison figures are presented in accordance with international standards. Information in the Board of Directors' Report and comparison numbers are presented in accordance with International standards. As for overall accounting implications and adjustments required due to transition from reporting based on Israeli GAAP to IFRS-based reporting, see Notes 2b and 38 to the Company's 2008 Financial Statements. Details of the Company's fields of activity in the Financial Statements are given based on the fleets of aircraft - air transport by means of passenger aircraft and air transport by means of cargo aircraft. The breakdown into business segments (as secondary segments) selected by the Company as stated above derives from the following reasons: a-16

21 The Company's economic axis of activity is the route (for instance, Tel Aviv New York Tel Aviv, Tel Aviv Bangkok Tel Aviv), and measurement of operating results and the resulting decision-making is conducted on this basis. Route revenues and expenses include both revenues from passengers and revenues from cargo in passenger aircraft holds as well as route costs, which include both expenses related to passengers and those related to cargo carried in the holds of passenger craft. The revenue-producing unit is the aircraft or the family of aircraft bearing similar flight characteristics and not the cargo they carry. The passenger aircraft is comparable to a car capable of carrying a certain amount of cargo, but primarily intended for carrying passengers, while a cargo aircraft is comparable to a container, capable of transporting cargo only. Everything located in an aircraft is equally affected by the cost generators (pilots, fuel, capital, air passage fees, parking fees etc.). These factors are a function of the airplane and not of what it carries. In addition, the majority of the operating costs of aircraft carrying cargo in their holds are shared by passengers and cargo fuel, depreciation, flight crews, air passage fees, communications, landing and parking fees, tarmac and transportation services, security etc. Therefore, the proper business approach is that of the passenger aircraft sector (the holds of which contain a certain amount of space available for cargo) and the cargo aircraft sector. Note also that even when the Company makes decisions regarding aircraft acquisition, the economic considerations for selecting the type of aircraft purchased takes the volume of cargo transportable by the aircraft on its various routes into account. As stated, cargo transport in the holds of passenger aircraft represents 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 holds 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 based on the above operating segments. Nonetheless, it must be noted that one must look at the profitability of the cargo transport field in a broader context that is derived as well from the cargo transport operations in the holds of passenger aircraft, since the cargo transport field carries out commercial and marketing activities complementary to the activities of the cargo transport activities in the passenger aircraft. The cargo fleet is an independent fleet the economic viability of which is studied separately. For further details see 8.10 below. Note that the aircraft used by the Company for the activity in question are of a relatively advanced age, which leads to high operating costs, as well as the necessity of dealing with noise limitations in various airports that influence their operation. a-17

22 2008: Thousands of Dollars Passenger Aircraft Cargo Aircraft Other and Consolidatio n Adjustments Total Passenger revenues 1,759, ,759,037 Cargo and mail revenues 122, , ,055 Other revenues 48,315 1,162 26,496 75,973 Total revenues 1,929, ,162 26,496 2,101,065 Costs 1,899, ,246 24,062 2,102,695 Operating income (loss) 30,020 ( 34,084) 2,434 ( 1,630) Fixed assets at end of year 1,234,660 31,269 48,253 1,314, : Thousands of Dollars Passenger Aircraft Cargo Aircraft Other and Consolidatio n Adjustments Total Passenger revenues 1,547, ,547,505 Cargo and mail revenues 106, , ,555 Other revenues 38, ,704 62,390 Total revenues 1,692, ,332 22,704 1,932,450 Costs 1,567, ,561 15,779 1,837,777 Operating income (loss) 124,977 ( 37,229 ) 6,925 94,673 Fixed assets at end of year 1,196,057 42,467 47,228 1,285,752 The commission's expenses assignment model for the various routes was updated in 2008 and as a result, commission costs for 2007 were resorted, without this influencing the total expense in this section. a-18

23 5.1 Nature of Consolidation Adjustments The adjustments to consolidate the revenues and costs result from additional activities that are not attributable to the principal fields of operation, primarily maintenance services to other airlines. The consolidation adjustments of the fixed assets relate to the fixed assets not attributed to the Company s aircraft. 5.2 Explanation of Developments Occurring in the Fields of Activity 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 year as compared to previous periods. 6. General Environment and Effect of External Factors with Regard to the Company 6.1 Traffic in the International Aviation Industry The international aviation industry is affected by the economic and security situation and by unusual events, such as the outbreak of epidemics and natural disasters in the world, in general, and in specific areas, in particular. Over recent months the world has been experiencing an unprecedented financial crisis. The crisis, which originated in the U.S., has influenced markets both in Europe and in Asia and has led to the collapse of financial bodies, the nationalization of others and the collapse of stock markets around the world. The crisis has led to a slowdown and even a global recession and to a lack of trust in international economies. This situation originated with the sub-prime crisis, which began in the second half of 2007 and which hurt world banks and financial markets with significant exposure to sub-prime loans via debt instruments backed by these loans. As a result, and particularly starting from the third quarter of 2008, global capital markets suffered from major upheavals, which on the one hand included financial institutions and companies becoming insolvent, and on the other hand saw attempts on behalf of central banks around the world to pump liquidity into banking systems while lowering interest rates in order to curb the effects of the crisis. The global financial crisis has had a significant effect on the airline industry as well. Since the beginning of the crisis, some 25 different airlines have announced major financial difficulties (up to and including liquidation). The main reasons for this are the material increase in fuel expenses, the sharp drop in demand and the diminished willingness of financing bodies to finance members of the airline industry. Note that most airlines terminating their operations have been relatively small. The sharp drops in fuel prices over recent months, the worsening of the crises in the deepening of the global recession has led to a drop in demand and in passenger and even more significantly, to a decrease in the scope of cargo shipping. For further details see and below. a-19

24 6.2 Traffic in the Israeli Aviation Industry According to data from the Central Bureau of Statistics, during 2008, a record number of inbound tourists via air was posted (in BGA and Eilat), with 2.2 inbound tourists listed via air, an overall increase of 22% compared to The previous record was listed in 2000 (the year of the Pope's visit to Israel), when 1.95 tourist entrances via air were listed. In addition, 3.6 million outbound Israelis were listed in 2008, an increase of 3.5% over According to data provided by the Airports Authority, international passenger movement through BGA increased by 10% in 2008 compared to During 2008, a decrease of approximately 4.7% 5 was posted in cargo traffic to and from Israel in comparison to See Section for details. 6.3 Fluctuations in Jet Fuel Prices Jet fuel is a significant component of the Company s expenses. The prices of jet fuel are characterized by extensive and severe fluctuations. The following data refers to jet fuel prices in the Mediterranean Basin region as quoted by 6 Platts 6. During 2008, the trend of sharp increases in jet fuel prices continued until the third quarter, with jet fuel prices decreasing sharply starting from the third quarter. Fuel market prices reached their peak in July 2008, with crude oil prices passing $145 per barrel and dropping to a low of $33 in mid- December In total for 2008, jet fuel market prices rose by an average of approximately 43% as compared to 2007 prices. See Sections and below for details. See Section 7 to the Board of Directors' Report for additional details on the financial effect of jet fuel prices, including hedging activity. 6.4 Foreign Currency Rate Fluctuations The Group s results are affected by a number of currencies, particularly the U.S. dollar. 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, 2008, there was a decrease of approximately 1%, as compared with December 31, 2007 in the exchange rate of the U.S. dollar against the shekel. As of December 31, 2008, there was a decrease of approximately 5.3%, as compared with December 31, 2007 in the exchange rate of the U.S. dollar against the Euro. The weakening of the dollar vs. various currencies in 2008 negatively affected the Group s profitability. See Section below for details. 6.5 Interest Rate Fluctuations The Company took loans in a significant amount at variable interest rates that is based upon LIBOR interest, in order to finance the acquisition of aircraft. A change in the LIBOR interest rate could materially affect the Company s financing expenses. 5 6 The data is based on the Company's estimate, after deducting Sixth Freedom activities of El Al through BGA, and adding mail operations of the Company. To the best of the Company's knowledge, Platts is a company from the McGraw-Hill Group that has provided information on the energy industry for over 75 years. The company provides updated information and analyses among other thing regarding prices and international occurrences in the petroleum, petrochemical, natural gas, electric and nuclear power markets a-20

25 In 2008, the average LIBOR 3-month interest rate decreased by approximately 45%, compared with its average rate during During 2007, there was an increase of about 2% relative to See Section for details. a-21

26 CHAPTER 3: DESCRIPTION OF THE CORPORATION S BUSINESS BY FIELD OF ACTIVITY The following is a description of the business of the Group for each of the fields of operation separately, with the exception of matters applying to the overall operations of the Group, which are described collectively in the framework of Section 9 below. 7. The Field of Passenger Aircraft 7.1 General Information on the Field of operations 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 holds of its passenger aircraft, an activity 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 field of activity, the Company has focused on a description of transport of passengers. Certain matters that relate to the transport of cargo in the holds 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 expected to have a material effect on operating results or on the developments in the field of activity, in the following areas: The Structure of the Field of Activity and Changes Occurring Thereof As mentioned, the Company's main field of activity is air transport in passenger aircraft in scheduled flights to and from Israel. By using passenger aircraft, the Company carries both passengers and cargo in the hold of the passenger aircraft. The flight rights under which the State permits one or more Designated Carriers 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. See Section for details on the Company's status as a "Designated Carrier" and State decisions on this issue, including the State's decision from January Legislative Restrictions, Regulations and Particular Considerations Applicable to the Field a. General The field of activity 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 airline 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 have a a-22

27 material effect on 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 made connected to implementation of the field of activity, 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. In addition, the Group is obligated to maintain a minimal fleet of aircraft, in accordance with the Special State Share (also see Section for details). 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. For further details see (c) below. b. Government Resolution no. 535 on Aviation Policy from 2003 Shortly before publication of the 2003 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 2003 Prospectus, subject to the following conditions: (1) The Company will at all times comply with the directives and obligations stipulated for it and which it had assumed vis-à-vis the State of Israel. (2) The Minister of Transport will consider revoking El Al's status 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 El Al scheduled flights 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 one 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 the Company's scheduled flights on a specified route be 30% less than the total number of passengers of the scheduled flights on that same route for a period of one calendar year The positions of the Deputy Attorney General (Economic-Fiscal) and of the Legal Counsel 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 according to the fundamental rules of administrative statutes, it does not contain, anything to restrict his judgment or to prevent him from invoking his authority under any law, including in the matter of a designated carrier on a scheduled air route, also under other appropriate circumstances. a-23

28 It was also stipulated that, without detracting from the authority of the Minister of Transport by law, this policy would be considered if and when the volume of outgoing and incoming air passengers to Israel exceeds 10.7 million passengers annually. c. Government Resolution No from January 2008 On January 27, 2008, the Government passed Resolution No. 3024: "a. (1) To determine the rate of the State's participation in the burden of security expenses of Israeli airlines at the level of 80% of total direct expenses of their operation of existing and future international routes, oriented towards enabling these companies to contend, to the degree possible, in fair and equal competition, opposite foreign airlines and in view of the great importance in the liberalization of the civil aviation field, while recognizing the need for the existing of strong Israeli aviation. (2) To revoke Government Resolution No from b. To determine that the rate of participation mentioned in Par. a. above is a continuation to the resolution of the relevant institutions in "El Al" Israel Airlines Ltd. ("El Al"), which recognizes, to the Company's favor, the importance of raising the percentage of the State's participation in the burden of security expenses of Israeli airlines, and accordingly, to change the Government's aviation policy on the scheduled routes, as provided in Section c. below. c. To amend Government Resolution No. 353(KM/14) dated regarding the aviation policy of the State of Israel on scheduled routes as below: (1) Instead of Section 1(b) of the Resolution will come: (b)"the Minister of Transport and Road Safety, within the scope of his jurisdiction regarding aviation policy, as authorized by all laws, will consider whether to grant rights to an additional Designated Carrier on scheduled air routes, and will consider whether to revoke El Al's status as a Designated Carrier on a specific route". (2) Sections 2-3 of the resolution will be revoked. d. To impose on the Minister of Transport and Road Safety to form an inter-ministerial team with the participation of representatives of the Ministries of Transport and Road Safety, Treasury and the General Security Service, to assess ways to implement the security instructions for Israeli civil aviation. Date of implementation as specified in the Resolution d. Implementation of Government Resolution 3024 Government Resolution 3024 as denoted above (hereinafter in this subparagraph: "Resolution 3024" or "the Government Resolution") regarding the increase in Government 8 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 the Company's operation, both in Section 1 and in Section 2 of that decision, means self-operation by El Al at the rates stipulated and that the aforesaid in no way eliminates the possibility of operating the route by means of a code-share agreement, but then also, the necessary operation is only that carried out by the Company. a-24

29 participation on security expenses of Israeli airlines while amending the 2003 government resolution regarding El Al's status as Designated Carrier mainly consists of two interrelated parts: (a) establishing the State's potion of the airlines' security burden at 80%; (b) amending the aviation policy of the State of Israel for regular routes, as determined in the May 2003 Government resolution, by revoking various threshold demands, which require that the Minister of Transportation and Road Safety ("the Minister of Transportation") consider whether the Company's status as Designated Carrier on a regular route be revoked or a Designated Carrier be added to a certain route in addition to the Company. On February 12 Arkia was appointed as an additional Designated Carrier to Paris. On May the Ministry of Transportation announced that it would be allocating additional routes for regular flights to Arkia, Israir and Sun D'Or as part of the Ministry of Transportation's aviation liberalization policy and as a result of the aforementioned decision. According to the announcement, Israir was appointed Designated Carrier to the London and Rome routes, Arkia to the Barcelona and Madrid routes and Sun D'Or to the Antalya, Bratislava and Zagreb routes. In December 2008 Arkia was appointed as an additional Designated Carrier for the Kiev route, and in February 2009 Sun D'Or received Designated Carrier status to Sochi and Rostov in Russia and Israir was appointed Designated Carrier to Milan. In March 2009 the Ministry of Transportation announced additional appointments of Israeli airlines as Designated Carriers to destinations in Germany: Arkia to Düsseldorf and Munich, Israir to Berlin and Stuttgart, Sun D'Or to Frankfurt and Düsseldorf and C.A.L (cargo transport) to Frankfort and Cologne. As a result of the failure to implement both parts of the decision concurrently, in a manner contrary, according to the Company's arguments, to the letter and spirit of the Government Resolution, and as the Company's queries to the Ministry of Transportation and the Ministry of Finance on the matter of the implementation of both portions of the Government Resolution received no response, the Company filed a petition against the Government of Israel, the Minister of Finance, the Minister of Transportation and other respondents (the Petition) before the Supreme Court, sitting as the High Court of Justice, on May As part of the Petition the Company requested, inter alia, that a temporary injunction be issued against the respondents instructing to give cause as to why the Resolution 3024 has not been implemented immediately and in full. The Company also that a injunction be issued preventing the respondents from implementing and/or from continuing to implement Resolution 3024 in a partial manner only, meaning to avoid implementing only that portion of the Resolution dealing in the appointment of additional Designated Carriers, this until the Petition is resolved. e. Government Resolution 4032 from August 2008 On August 24, 2008, Government Resolution no was passed on the subject of the state's participation in Israeli airline security expenses, as follows: 1. "To revoke Government Resolution no dated January (hereinafter "the Resolution") starting January or on the date on which the scope of passengers entering and exiting Israel by air is greater than 10.7 million passengers per year, whichever is later. a-25

30 2. Section A of the Decision shall be implemented until its cancellation as stated in Section 1 of this decision, only on flight routes for which an additional listed Israeli carrier has been actively appointed, which has started to operate on the flight route. 3. To authorize the Ministries of Finance and Transportation and Road Safety to increase the state's participation rate in security costs for Israeli airlines, pursuant to the signing of a global aviation agreement with the EU in accordance with Government Resolution no. 441 dated September The budgetary expense of Government Resolution 3024, until its cancellation as denoted in Section 1, shall be financed from the Ministry of Transportation's existing budget." On September the State of Israel, the Minister of Finance, the Deputy Prime Minister and the Minister of Transportation and Road Safety field a preliminary response to the aforementioned Petition ("the State's Response"). As stated in the State's Response, in light of the passing of Resolution 4032 ("the Cancellation Decision"), which alters and limits the incidence of Government Resolution 3024 dated January ("the Original Decision"), the Cancellation Decision significantly alters the grounds upon which the Petition is based and therefore the Court is asked to reject it. On September the Company filed a request to amend the petition ("the Petition Amendment Request"), this in light of the State's response, so that in the framework of the Amended Petition, the Company will ask the Court to issue an order to the respondents, according to which they must provide cause as to why the Cancellation Resolution should not be revoked leaving the Original Resolution - the application of which has already begun - in effect, to be applied by the Government in full, and alternately, if the Cancellation Resolution is to remain in effect, why the situation should not be returned to its previous state prior to the original resolution, including the cancellation of the appointment of other Israeli airlines as Designated Carriers, which was made as a result of the original resolution. An amended petition was filed on December , accordingly. f. Government Resolution 4462 from February 2009 On February the Israeli Government passed an updated resolution regarding participation in the security expenses of Israeli airlines (following the resolutions dated January and August ), as follows: " a. To increase the participation rate in security expenses in Israeli airlines to 60% from 2009 onward. Implementation of the resolution shall take place immediately following the Knesset approval of the 2009 budget. b. To instruct the Ministers of Finance and Transportation and Road Safety to increase the State's participation in Israeli airline security costs to 75%, immediately after the signing of a global aviation agreement with the European Union ("Open Skies") in accordance with Government Resolution 441 dated September a-26

31 c. To instruct the Minister of Transportation and Road Safety to report to the Government, six months subsequent to this resolution, on the progress of the negotiations with the European Union regarding the global aviation agreement ("Open Skies"). d. Prior to the approval of the 2009 budget, the Budget Controller at the Ministry of Finance will act to submit a budget addition deriving from this resolution for the Government's approval, for the funding on an increase in the State's participation in civil aviation security costs. e. The airlines will act to conduct "exchange purchases" in Israel, as much as is possible at rates agreed upon with the Industrial Cooperation Authority. The implementation in full of the Government Resolutions and their potential impact on the Company's activities and operating results are Forward-Looking Information as defined in the Securities Law. The manner and degree to which the Government Resolutions are actually implemented, the receipt of security expenses funding at the updated rate and the appointment of additional Israeli airlines as Designated Carriers for regular flights and the operating of said flights by additional Israeli airlines may be conducted differently than as estimated, among other things due to regulatory limitations, economic limitations resulting from the need to purchase equipment needed to operate additional airlines, contractual limitations involved in the alteration of bilateral agreements or other aviation agreements as well as changes in the national security, economic and geopolitical information and their impact on competition Changes in the Volume of Activity and Profitability of the Area (A) International developments According to IATA estimates, international passenger traffic grew at a rate of only 1.6% in 2008, a dramatic drop from the growth rate of 7.4% listed for All in all, a 3.5% increase with listed in the capacity of regular international airlines. As a result of the incompatibility between capacity and demand, the weighted occupancy rate for international passenger flights dropped to 75.9% in 2008 (compared to 77.3% in 2007). According to IATA, 2008 saw a 4% drop in global airline cargo shipping (including in the holds of passenger aircraft). This is a dramatic drop compared to 2007, which had a growth rate of 4.3%. The decrease in cargo volume listed in 2008 is significantly lower than the average yearly growth rate predicted by IATA's 2008 through 2012 projections, estimated at 4.3%. At the same time, the IATA annual growth rate projections were published in October 2008 prior to the full internalization of the implications of the economic crisis. A dramatic 22.6% drop in global air cargo shipping was listed in December 2008, greater than that following the September terror attacks. The drop in global cargo transport in December was evident in all regions: in Asia (- 26.0%), in North America (-22.2%) and in Europe (-21.2%). The sharp drop in cargo volume reflects a 20%-30% drop in imports and exports reported in Asia, North America and Europe, caused by the depending of the global recession. In light of this data, IATA estimates that 2009 will be one of the hardest years ever for the air cargo shipping industry and shall conclude with a drop of at least 5%. a-27

32 By Regional Cross-Section: 2008 versus 2007: Region Passengers Cargo RPK ASK PLF FTK ATK Yearly Change Yearly Change Yearly Change Yearly Change Africa -4.0% -4.2% 70.2% -2.5% -7.4% Asia -1.5% 1.2% 73.9% -6.6% -2.5% Europe 1.8% 3.8% 76.6% -2.8% 2.9% South America 10.2% 9.2% 74.0% -13.5% 5.7% Middle East 7.0% 8.6% 74.9% 6.3% 8.5% North America 2.9% 4.3% 79.8% -1.9% 3.4% Total 1.6% 3.5% 75.9% -4.0% 1.5% According to IATA's updated estimates from March 2009, airlines listed an $8.5 billion loss in This estimate differs from IATA's earlier estimates, according to which the airlines' losses in 2008 were estimated at $5 billion only. According to IATA data, the airlines lost $4 billion over the course of the last quarter of 2008, a greater loss than expected, this as a result of the worsening of the global recession on the one hand, and additional losses borne by the airlines as a result of jet fuel hedging agreements (resulting from a sharp and unexpected drop in jet fuel prices starting Q3 2008). IATA projects losses for the airline industry in 2009, with the drop in fuel prices helping rein in the losses (which might have been higher), but failing to compensate for the drop in flight demand and the resulting drop in income. According to updated IATA projections from March 2009, the scope of the expected loss equals $4.7 billion, this in accordance with IATA guidelines according to which the average cost of fuel is $50 per barrel, a 5.7% drop in passenger volume (and an even greater drop in luxury passenger volume), a 13% drop in cargo volume and a 4.3% decrease in yield. The following table shows the activity of the international aviation industry (regular flights) over the past four years as well as the industry's revenues and earnings throughout the period. a-28

33 International operations of the aviation industry and its profitability from the passenger aircraft area 9 (scheduled flights) of airlines that are members of IATA Year RPK 12 (in Millions) Annual Change in RPK Output RTK 11 (in millions) Annual Change in RTK Operating revenues 10 ($ Billions) Operating Income (Loss) Before Interest Expenses ($ Billions) After Interest Expenses % ,365, % 292, % ,230,135 2,063,015 6% 8% 275, ,470 5% 6% (B) Developments in the Israeli market International passenger traffic to/from BGA during 2008 totaled approximately 11 million passengers and represents an increase of about 10% compared to Passenger Traffic to and from Israel (from/to BGA) 14 Year Passenger traffic at BGA (Millions of Yearly Change Passenger Legs) % % % % The source of the data regarding : IATA publications (World Air Transport Statistics) (WATS; 52 nd edition-2008). Including revenues from cargo aircraft. Revenue Passenger Kilometer - the number of paid pass passengers multiplied by the distance flown. Revenue Ton Kilometer - the weight in tons of passengers and paid cargo multiplied by the distance flown. IATA data, estimates, assessments and projections referring to 2008 are preliminary. Final 2008 data is expected to be published by IATA in June 2009 within the framework of World Air Traffic Statistics 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. a-29

34 The table and the graph below reflect the trends of incoming tourist traffic to Israel and the departing residents in recent years 15 : Year Incoming tourism (Holding Foreign Passports) (Thousands of passengers) Rate of Change Departing Residents (Thousands of passengers) Rate of change , % 3, % , % 3, % ,568 ( 5.1) % 3, % , % 3, % Over the course of 2008, a record 2.2 million tourists entered Israel by air. According to the Company's estimates, the volume of incoming tourism is influenced by a variety of international travel trends, but primarily by geopolitical ;processes in Israel and the surrounding region, which influence the perception of personal safety of tourists visiting the region. In this regard, note that in December 2008 Israel engaged in Operation Cast Lead in Gaza, which lasted 3 weeks. The Company is studying the impact the fighting in Gaza had on incoming tourism and is making preparations for a projected decrease in tourist visits as a result of the public relations crisis Israel is undergoing and as a result of the deepening economic crisis. A moderate 3.5% increase in outgoing tourism was listed in 2008, with a total of 3.6 million departures of Israelis recorded. The December 2008 January 2009 fighting in Gaza, the global economic crisis and the slowdown in passenger travel led to a significant decrease in volume (-16%) on lines to and from Israel in January-February 2008 and most airlines flying to Israel reported significant decreases. The scope of Israeli tourism in Turkey may drop in 2009 as a result of the tension between the two countries as a result of the fighting in Gaza. Passenger volume on Turkish routes dropped 48% in January-February Note in this regard that the Turkish market is the second largest after the U.S. and accounts for 12% of all BGA traffic The forecasts and estimates of IATA regarding the volume of passenger traffic to and from Israel as above represent Forward-Looking Information, as defined in the Securities Law. This information is supported, inter alia, by the Company s assessments in light of the trends of change in tourism during recent years and expected developments, and in view of the economic, security and geopolitical situation in Israel. Accordingly, the actual change in the anticipated volume of incoming tourists to Israel and the outgoing tourism from Israel may be materially different from that forecast as aforementioned, if the Company's assessments are not realized, and because of a large number of factors, including a change in 15 Data of the Central Bureau of Statistics. a-30

35 economic, security and geopolitical conditions in Israel Developments in the markets of the field of activity or changes in the characteristics of its customers In recent years, competition has intensified considerably in the passenger aircraft transport field between dozens of international scheduled and charter airlines. The airlines compete in various areas, principally: fares, frequency and flight times, ontime performance, equipment type, airplane configuration, passenger service. Fare competition 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 charter flights to the same destinations. In addition, in this context, there has been an increase in the activities of the foreign airlines in Israel in the framework of Sixth Freedom. Additionally, during recent years, the aviation world has been penetrated by airlines known as low cost 16, which maintain low expenses and generally offer very competitive prices. 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 airlines, caused considerable intensification in the competition on some of the routes and to a decrease in the Company's market share out of total passenger traffic at BGA. See Section below for further details. For details regarding the implementation of the Ministry of Transportation's liberalization policy and the appointment of Israeli airlines as Designated Carriers see Section above Technological changes that could materially affect the field of operations In April 2008 the Company began using the new AMADEUS reservation system, after replacing the previous system ("Carmel") and adapting the interfacing system. Over the course of the third quarter of 2008, as part of the implementation of Stage B of the transition of AMADEUS, preparation and assimilation of the new DCS model (airport service system) was initiated, to be concluded by March For further details on the Company's agreement with the Amadeus Company regarding the supply of the global reservation system see Section below. The reservation system on the Company's website was upgraded and re-branded as "I Fly", in such a manner so as to allow visitors to select flight destinations and dates in a simple, user-friendly manner, to receive reliable information on cheapest possible rates and to make reservations. In addition, the website allows travelers to upgrade their flights, select seating, perform pre-flight check-in and select meals. This upgrade was made possible thanks to the transition to AMADEUS. An agreement was signed with Lufthansa Systems in Q3 208 for the receipt of optimal flight route planning services, taking fuel costs and tolls into account. The purchased system performs ASP (off-site application) services and calculates optimal flight routes for Company aircraft taking a variety of constraints and limitations into account including fuel consumption, climate influences, tolls as well as arrival and departure routes to and from 16 "Low cost" companies are relatively new airlines with a structure of low expenses deriving mainly from direct marketing through 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 code share agreements with other companies and high utilization of aircraft. a-31

36 each airport in accordance with weather conditions upon arrival, while making use of the information held in the system for the creating of cost-effective, safe and efficient routes for the Company's aircraft. Over the course of Q the Company began studying technological solutions for the sale of incoming and outgoing tourism services in the framework of its website and direct sales locations. The Company is considering purchasing core software allowing the sale of tourism products at each of the Company's sales locations. The implementation process in Company systems is expected to begin of the course of Q In addition, the characterization stage of the resource management system using the ERP system began in the second quarter of 2008, this after the Company entered into an agreement with IBM in December 2007, for the latter to act as chief integrator for the application of SAP and RAMCO technology (for the field of maintenance and logistics). As part of said characterization stage, gaps were revealed between existing capabilities of RAMCO products and the Company's requirements and over the course of Q the parties are expected to agree on a new version of the system compatible with El Al's requirements and needs. As a result, delays in the project's completion dates are possible. The information on the implementation of the above systems, including project completion dates and their impacts constitute Forward-Looking Information, as defined in the Securities Law. The actual implementation of these projects, their dates, their scopes and their impact on the Company's could be materially different from that forecast, due to reasons including technological, commercial and servicerelated reasons and as a result of the Company's ability to accept the system and the resources allocated for this purpose. From the standpoint of marketing and distribution, in 2008 the airlines constituting IATA, among them the Company, went over to 100% e-ticketing of paying passenger tickets, this as part of the simplification and streamlining process global aviation has been undergoing, In addition, as part of the development and establishment of the Company's direct distribution and marketing channels, the global trend of direct marketing of flight tickets over the internet has continued, in such a manner that the total amount of the Company's online sales amounted to $58 million in 2008 (a 130% increase over online sales in 2007). In addition, the Company' allows online check-ins and seating. These policies are designed to lower airline marketing and distribution costs. The Company has continued adapting its operations to these trends by developing means of providing its customers with the opportunity for self-service, such as online ticket purchasing and check-in and searing, self check-in and seating using airport terminals and so on, The Company is acting to increase its online commercial capabilities significantly, including by translating its websites to additional languages, providing overseas clearing sales capabilities and more. In recent years, the aviation market has geared up to deal with terror events by expanding the use of advanced technological and other means, on land and in the air. Within the scope of these preparations, the Company is working in accordance with the instructions of the General Security Service, inter alia, for evaluating and installing protective measures. For further details on security arrangements see Section below. In early 2009 the Company decided to establish a backup site on the Company's grounds to provide a solution in the event of an IT system failure (DRP). For further details see Section below. a-32

37 7.1.6 Critical Success Factors in the Field of operations and Changes that have occurred 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 field: the economic and security situation in Israel, which influences passenger traffic to and from Israel; the branding 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 - independently and in cooperation with other airlines; preservation of aviation rights; the ability to offer flights at the frequency and the capacity demanded; a distribution system; risk management by implementing appropriate risk hedging policies Changes in the Supplier Network and the Raw Materials for the Field of Operations The primary raw material that serves airlines is jet fuel and it represents one of the major expense components of an airline. See Section below for details relating to fuel Main Entry and Exit Barriers of the Field of operations and Changes Therein 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 another. 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 are 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 for which the Company was the Designated Carrier as of that date, subject to meeting certain conditions (see Section regarding the Government's resolution from May 2003 and developments deriving from this resolution, including further government resolutions). 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. In addition, 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 and Section below for details. The most important additional entry barrier is the initial relatively large investment that 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 that has specified that it be the Designated Carrier. This requirement represents an entry barrier for obtaining the appointment as Designated Carrier by companies whose major ownership and control is held by foreign citizens. However, within the framework of the liberalization of the aviation industry, over the course of the past two years the bilateral agreements between the State of Israel and other nations have been updated in such a manner so as to allow the appointment of a Designated Carrier the principle place of business of which is located in the territory of the a-33

38 side appointing the carrier and that the carrier holds an air operator's certificate issued by the appointing side (as in the agreements with the U.K., France and others). Subsequently, as part of the "horizontal" agreement signed between Israel and the EU in December 2008, it was agreed to grant authorizations to European airlines to fly to Israel from any country in the EU, even if it is not the airline's parent country, with the only limitation being that the number of the flights from the third country be no greater than the sum of the flights allowed from that country in accordance with the aviation agreement between it and Israel. With that, the ownership and control limitation was in effect removed as a condition for receiving the Designated Carrier status. As regards the operation of passenger aircraft in international charter flights, each Israeli carrier must obtain a license to operate charter flights to and from Israel, which is subject to various demands, mainly: economic stability 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, a more liberal policy of granting authorizations in the area of charter flights is in place, 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. In addition to the above, various licenses and permits are required to conduct activity. For further details see Section 9.11 above. The limitations applied to the Company by the holder of the Special State Share in the matter of the reduction of the Company's aircraft fleet, constitutes an exit barrier. For details see Section below Substitutes for Services of the Field of Operations and Changes that have Occurred Therein The alternatives for transport in passenger aircraft are transport by other means (maritime and surface vehicles and cargo aircraft for cargo in the holds of passenger aircraft). Note that Israel has no significant alternative to air passenger transport. In addition, the Group has competitors that offer alternative transport in passenger aircraft in scheduled flights, charter flights, low cost flights and Sixth Freedom Flights. There were no substantial changes during 2008 in the alternative for transport by means of passenger aircraft. In the Company's estimation, the major considerations in preferring a flight to sea and/or land transport are purpose of travel, traveler's timetable, the distance and the nature of the route Structure of Competition in the Field of Operations and Changes that have Occurred Therein A) General There is severe competition in the passenger aircraft transport field between dozens of international scheduled and charter airlines. The airlines compete in various areas, principally: fares, frequency and flight times, on-time performance, equipment type, airplane configuration, passenger service, bonuses to frequent travelers, commissions and special incentives to travel agents and supply of computerized reservation and distribution systems to travel agents. Fare competition is reflected mainly in the offering of 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 a-34

39 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 traveler's diverse alternatives for arranging his own flight schedule, in which a number of airlines participate, and the strengthening of code sharing agreements between airlines (Star, Sky Team, One World) Additionally, most of the scheduled airlines operating flights to and from Israel also carry passengers on Sixth Freedom Flights (indirect flights with a stopover in their mother country). 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 reducing 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 offer 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. In recent years the Ministry of Transportation has began implementing a policy of increasing liberalization in the field of aviation, with the goal of encouraging and increasing the volume of tourism to Israel by increasing competition between airlines. As an application of the liberalization in aviation policy, the Civil Aviation Authority approved requests by many companies to increase the frequency or capacity, while these were not committed in existing bilateral aviation agreements. Many airlines operating scheduled flights to Israel increased their supply of seats, both by adding frequency and by adding capacity by operating flights using larger aircraft. Likewise, over recent years, aviation discussions were held with the civil aviation authorities of several countries and new agreements were signed, in which the liberalization policy in the air transport field was expressed, in such a manner that the agreements established multiple Designated Carriers, enabling an increase in the number of airlines that can operate scheduled flights on the routes to and from Israel as well as increasing their frequency (see below for details on the agreements and resulting developments). B) "Open Skies" Policy (1) Public Commission for Examining the "Open Skies" Issue On April 16, 2007, the report highlights and recommendations of the public commission for evaluating the "Open Skies" issue headed by the Director-General of the Ministry of Transport were published, which were submitted to the Deputy Prime Minister, Minister of Transport and Road Safety, Lieutenant General (retired) Shaul Mofaz. According to the commission's report, the State of Israel is striving to adopt an aviation policy that serves as a springboard for economic growth and increasing tourism to and from Israel, based on the importance of a national aviation industry that will take part in equal and fair competition, based on the global environmental conditions and transforming a-35

40 the State of Israel, from an aviation standpoint, to a more attractive destination that its competitors, in terms of price and in terms of capacity of the airlines over time. The report further states that the opening of the skies will bring with it the entry of new operators, a decrease in fares and an increase in the State of Israel's exposure as a competitive destination and consequently, an increase in the number of tourist arriving via air. At the same time, the policy will also apply to Israeli passengers who will benefit from falling prices and the more diverse range of services and destinations. The following are the commission's key recommendations: Opening the skies to airlines in a gradual and controlled plan, meaning: changing aviation agreements, thereby enabling the entry of new schedules airlines to existing and new destinations. This recommendation is implemented by the State of Israel in various international agreements (such as with Belgium, France and Germany). Encouraging the entry of low cost airlines to Israel, meaning: allowing unlimited activity of low cost companies (including existing and new Israeli companies) from any destination in the world to Israel. Full coverage of security expenses of the Israeli airlines by the State of Israel the commission recommends that Israeli airlines be exempt from security expenses. See the Government resolutions detailed in Section above. Revocation of the Government's 2003 decision regarding its aviation policy on scheduled routes the commission recommends that the Government's May resolution, passed prior to the privatization of El Al, regarding the aviation policy and appointment of a state Designated Carrier on regular routes, be revoked. See the government resolutions detailed in above. Increasing the tourism marketing budget for the Ministry of Tourism. Providing a "safety net" to the airlines in flights from new destinations. To the best of the Company's knowledge, such a safety net has been provided to several airlines operating flights to Israel, including Thomson Fly, Corsair and Jet Air. Establishing differential aviation fees in BGA. Entry into immediate negotiations with the European Union in order to determine policy and new aviation agreements. Such negotiations have already commenced, as detailed in Section above. Development of reasonable infrastructure for the operations of low cost airlines. As of this report no such actions have been taken, but based on various publications it seems as though the Ministry of Transportation intends to assign Terminal 1 to such flights. The commission further recommended immediately opening negotiations with representatives of the European Union in order to institute an Open Sky policy with these countries within three years, on a gradual basis. See Section for details regarding talks with the EU. (2) Implementation of the Open Skies Policy As detailed in previous sections, the Ministry of Transport has begun implementing the report's recommendations through the institution of liberal policy of granting approvals to a-36

41 new foreign airlines to begin operating routes to and from Israel, as well as granting approvals to increase capacity and frequency among existing companies. The following new aviation agreements were signed between Israel and other countries in 2008: South Korea according to the May 2008 agreement, each company will be permitted to appoint two airlines for the Tel Aviv-Seoul route, operating passenger and/or cargo flights, with each of the airlines able to operate three weekly passenger flights and four weekly cargo flights. In addition, it was agreed that the Israeli airlines be allowed to perform flights within the framework of collaboration with companies from third countries, without limits on destinations and beyond Seoul. Italy the June 2008 agreement permits the appointment of to Designated Carriers for each side for each pair of cities. The number of weekly frequencies for each side was increased from 20 to 26 as part of the agreement. In addition, the limitation on the number of weekly flights held by Israeli carriers on the Tel Aviv-Milan route was cancelled. Ukraine the July 2008 agreement allows the appointment of two designated carriers for each side for the Tel Aviv-Kiev line as well as a single designated carrier for the remainder of agreed-upon lines, starting Winter 2008/9. Each side's Tel Aviv-Kiev Designated Carriers may operate (together) up to 9 weekly frequencies in the Winter 2008/9 schedules and 10 frequencies starting summer Starting summer 2010 each nation's Designated Carriers may operate up to 14 weekly frequencies (until now, each country was allowed 7 frequencies in the winter and 8 bin the summer). In the other lines agreed upon (Odessa, Dnipropetrovs'k, Simferopol, Donetsk, Lvov and Kharkiv), each side's Designated Carriers may operate until winter 2011/12 at two weekly frequencies during the winter season and three weekly frequencies in the summer season. Subsequent to this agreement, in December 2008 Arkia was appointed second Designated Carrier, alongside El Al, on the Tel Aviv-Kiev line. Russia an agreement was signed in November 2008 allowing airlines from both countries to operate direct flights between Eilat and Moscow. According to the agreement, each country can operate 6 regular flights per week between Eilat and Moscow. In all, 12 regular flights per week will be held between the countries. Following this agreement, the Ministry of Transportation allowed Arkia and Israir to operate regular direct flights between Eilat and Moscow starting January At this stage, the Russian aviation authority has appointed Aeroflot to the Moscow- Eilat route. At the same time, the Russians will continue to operate charter flights between Moscow and Eilat as they had before. Germany as part of the January 2009 agreement, each country may appoint two regular airlines to operate regular passenger flights to each of the destinations between Israel and Germany. The new agreement allows each country to operate up to 30 regular flights per week, compared to the current 18. In this regard, it is important to note that despite the fact that the quota has been raised to 30 frequencies, the destinations of Frankfurt and Munich have been limited to 21 weekly frequencies for both destinations combined. In addition, the option exists to operate flights from different destinations in Germany as well as, for the first time, to operate regular cargo flights, with 7 weekly cargo flights to be permitted initially. The agreement also allows Israeli and German carriers to operate flights in a code share with a third country. As a result, Lufthansa announced its intention to renew its flights on the Munich-Tel Aviv route, starting a-37

42 summer In March 2009 the Ministry of Transportation announced that it would be making additional appointments of Israeli airlines as Designated Carriers to German destinations: Arkia to Düsseldorf and Munich, Israir to Berlin and Stuttgart, Sun D'Or to Frankfort and Düsseldorf and CAL (cargo shipping) to Frankfort and Cologne. The Netherlands it was agreed in January 2009 to increase the weekly frequency of the Amsterdam route from 8 to 10. As a result, the Company intends to operate 10 weekly frequencies on this route over the course of summer Austria it was agreed in January 2009 to increase the weekly frequency of the Vienna route from 10 to 14, which leaves the current situation unchanged, as Austrian Airlines has operated 14 weekly frequencies on this route for several years. Following the new aviation agreements described above, and following the agreements signed in 2007 with the U.K., France, Belgium, Russia and Slovakia, new airlines began operating regular flights to and from Israel starting in Prominent airlines were: British Midland (BMI), which was appointed as an additional British Designated Carrier for the Tel Aviv-London route, began operating regular daily flights on the route starting March Following BMI's announcement of its intention to operate a second daily flight on the route starting April 2009, on March the Company filed a petition to the High Court of Justice against the Minister of Transportation, the Civil Aviation Authority (hereinafter: "the Respondents") and against BMI. The Company's position is that the Respondents may not increase the frequency of BMI flights from London to Tel Aviv without first arranging landing and takeoff approvals for Heathrow Airport for the Company, as required by the Israel-U.K. aviation agreement. In the petition, the Supreme Court is asked to issue a conditional order requiring the Respondents to explain: (1) why they would not deny approval to BMI to operate additional regular flights until the realization of the aviation agreement between Israel and the U.K and the Company's receipt of landing and takeoff approval at Heathrow Airport on an equal basis (and if such approval has been granted, why it would not be frozen or revoked); (2) why the Supreme Court would not declare that they are required to arrange the Company's landing and takeoff approvals at Heathrow Airport prior to granting BMI any additional rights; and (3) why they would not carry out the test agreed upon in the 2007 agreement between Israel and the U.K regarding the implications and results of the agreement In addition, the Supreme Court was asked to issue an injunction instructing the Respondents to deny BMI approval for additional regular flights to Israel (and if such approval had been granted to postpone it) until the petition is decided. The Supreme Court issued its ruling on March , stating that no injunction would be issued and that the petition would be brought before a panel of judges by the middle of May Jetair Fly, part of the TUI Corporation, began operating 2 regular flights per week between Tel Aviv and Liège. The French airline Corsair, also owned by the TUI Corporation, was appointed as an additional Designated Carrier by France to the Tel Aviv-Paris route and began operating two regular flights per week in April The Spanish airlines Clickair and Air Europa began operating regular flights between a-38

43 Spain and Israel, Clickair (an Iberia subsidiary) began operating 3 regular flights per week on the Barcelona-Tel Aviv route in April 2008 and Air Europe began operating 2 regular flights per week on the Madrid-Tel Aviv Route in June This in accordance with an aviation agreement between Israel and Spain signed in Sky Europe began operating a weekly flight between Tel Aviv and Bratislava (Slovakia) in July Korean Air began operating three regular flights per week between Tel Aviv and Seoul. Eurofly began operating a single weekly flight between Tel Aviv and Milan starting December 2008 after being appointed as an additional Designated Carrier for the Israeli routes by the Italian government. In March 2009, Eurofly increased its number of flights per week to 5 on the Milan-Tel Aviv, Rome-Tel Aviv and Verona-Tel Aviv routes. Following the January 2008 government resolution (no. 3024) (for further details see above), the Ministry of Transportation granted Israeli airlines Arkia, Israir and Sun D'Or Designated Carrier status for a series of destinations as detailed in Section above. In addition to the entry of new carriers, a material increase in capacity was evident on behalf of existing airlines. A large number of foreign airlines increased frequencies and capacity, with the three most prominent in 2008 being Turkish airlines, which increased its weekly frequencies from 18 to 25 (a 23% increase in seat capacity), Delta Airlines, which began operating a daily flight to New York in addition to its Atlanta flights, thus increasing its frequencies from 7 to 14 (a 63% increase in capacity), and the Russian Transaero Airlines, which increased its capacity by 37% compared to In this regard, it must be noted that in late June the Knesset Internal Affairs Committee approved the mutual exemption from entrance visas between Israel and Russia. The cancellation of the need for visas came into effect in September As a result, an increase in Russian tourism is expected in In spite of the above, the high fuel prices in the first nine months of the year, peaking at $147 per barrel in July, and the U.S. financial crisis which depended and expanded to other world markets and led to a significant drop in demand, began to impact the Israeli aviation market: In September 2008, Israir ceased operating regular flights between Tel Aviv and New York. In addition, Israir limited its activity on the routes to Rome, Moscow and London for the winter period. The French airline Corsair froze its flights on the Paris-Tel Aviv route for the winter 2008/9 season, this as a result of the financial crisis and the company's estimates of low demand. As described above, the company began operating regular flights on this route in June Air Europa terminated its activity on the Madrid-Tel Aviv route starting February As mentioned above, Air Europa began operating 2 regular weekly flights on this route starting June The British airline Thomson Fly, which operated flights to London and Manchester, announced that it would be discontinuing its activity on these routes starting May a-39

44 Other airlines to discontinue their activity in Israel in the third quarter of 2008: XL from Britain, which operated charter flights to Israel from France and England and entered bankruptcy in September 2008; the Kazakh airline (Sayakath); Air Lithuanian, which operated flights between Vilnius and Tel Aviv. Overall, in 2008 the capacity of foreign companies (including regular Arkia and Israir flights) increased by 20% and passengers increased by 19% compared to In all, the Group increased its seat capacity by 5% and listed a 2% increase in passenger volume compared to During the winter 2008/2009 season, the Company announced that it would be increasing its supply of seats on direct flights to business destinations by adding 11 weekly frequencies to European destinations. Starting late October 2008 the Company added two weekly flights to Barcelona, Milan, Rome, Prague and Bucharest as well as an additional weekly flight to Sofia. In addition, the Company began operating a Boeing 777 on its Mumbai route starting November 2008 and for the winter period, for the benefit of business travelers. A 10% increase was listed in passenger volume at BGA in 2008, with a 10% increase occurring in regular passenger travel (including the Company) and a 9% in charter flights compared to last year. Overall, charter traffic (including Sun D'Or flights) through BGA constituted 22% of all traffic, as in The increase in the number of foreign airlines operating in BGA, in the number of regular flights and in the seat capacity of foreign airlines led to increased competition in some of the routes and a decrease in the Company's share of total BAG passenger traffic. Passenger traffic through BGA in 2008 was distributed as follows: the Group: 35.7%; other regular airlines 45.6%; charter airlines (not including Sun D'Or) 18.7%. An escalation in competition levels is expected in 2009 ad a result of the entry of additional airlines announcing their intention to operate regular flights to Israel and as a result of further activity of airlines that began operating regular flights throughout 2008 and the increased capacity of these airlines (including expanding destinations such as Lufthansa's flights from Munich) as well as the continued liberalization in international aviation agreements, as described above. A new factor that may contribute to the competition is the entrance of Arkia and Israir as Designated Carriers on regular flights to new destinations. At the same time, a slowdown in passenger traffic is expected as a result of the economic crisis and the fighting in Gaza. The Company's estimates regarding increased competition in 2009 and its possible impact on the Company are Forward-Looking Information as defined in the Securities Law based on the influence of the Open Skies policy, including the increase in the number of foreign airlines operating in BGA, and the increase in the capacity of foreign airlines operating today. The actual level of the increase and its impact on the Company are influenced, inter alia, by economic, security and geopolitical factors and by trends in the airline industry. For further details see above. For regulatory changes that may alter the structure of competition in the field of activity see Section below. (3) The Open Skies Agreement with the European Union In accordance with the aforementioned commission recommendations, talks began in November 2007 between Israel and the European Union, the objective of which is to a-40

45 eliminate the need for separate agreements with each European country, and the execution of one general agreement with the Union's executive, in order to create aviation liberalization that will increase competition and freedom of movement between the airlines. In February 2008, Israel and the European Union Commission signed a preliminary memorandum of understanding, toward the signing of a uniform global aviation agreement between European countries and Israel. In December 2008, a new aviation agreement ("Horizontal Agreement") was signed between Israel and the EU. The Horizontal Agreement updates the sections of the bilateral aviation agreements between Israel and the EU members referring to the ownership and control of Designated Carriers (without changing the aviation rights established in the bilateral agreements) and allows airlines controlled and owned in one of the EU members to operated regular flights from any other country in the EU, subject to the bilateral agreement (for example: Sky Europe Airlines, which is owned by Austrian citizens, may operate regular flights between Slovakia and Israel, subject to the aviation agreement between Israel and Slovakia). The Horizontal Agreement does not influence the aviation rights determined as part of the bilateral agreements, These rights include, inter alia, the right to operate regular flights on agreed-upon routes, the number of companies on each side entitled to operate flights on these routes (Designated Carriers) and the weekly frequency quota granted Designated Carriers. At the same time, the Horizontal Agreement may in the future allow the realization of aviation rights not realized to date on the lines between Israel and the EU and pave the way for a global aviation agreement with the EU (for further details see below). In addition, the parties agreed to establish the framework and content of the negotiations for the global aviation agreement and negotiations have begun for a global aviation agreement. The first round of talks between Israel and the EU regarding the global agreement ("the Vertical Agreement"), which is designed to replaces all of Israel's bilateral agreements with EU members and to contain no limitations on the number of carriers, frequencies, capacity and type of aircraft, took place in December Aviation talks are expected to continue throughout (4) "Open Skies" Agreement (Europe U.S.) On April 30, 2007, representatives of the European Union and of the U.S. signed an "Open Skies" agreement, published May 25, This agreement is based on the willingness of the parties to develop and to encourage an international aviation system based on competition between airlines in the European Union countries and in the U.S., with minimal government involvement, and to enable the expansion of international opportunities, inter alia, through the development of broad communication systems for the convenience of passengers and those sending air cargo, through which the airlines in the said companies can offer to transport passengers and/or cargo at a range of prices and services in the "open market". The agreement came into effect on March Among other things, the agreement stipulated that if, by 2010, the demand of European Union companies from the American Government, to allow larger European investment in American airlines (which is limited to just 25%), is not met, every state in the European Union will have the right to suspend the agreement. As of the date of this report, it is still a-41

46 not possible to assess whether this agreement will have material implications for the Israeli aviation market. C) 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. For several years, the Civil Aviation Authority has granted approval to charter airlines to transport cargo in passenger aircraft that they operate, as the result of which there has only been a minimal increase in the supply of capacity. Starting July 2008 the Israeli charter airlines, including Sun D'Or, renewed their activity on routes to Turkey, this after the Israeli companies discontinued their activity on these routes in March 2007 as a result of high security costs. In this regard, note that Sun D'Or received Designated Carrier status fro the Antalya route in May 2008 All in all 2008 saw a 9% increase in charter company activity and the portion charter airlines (Israeli and foreign) held of total BGA passenger traffic (to/from BGA) 17 reached 22% in 2008 similar to 2007, as detailed in the table below: Year Share of Charter Airlines out of Total Passenger Traffic at BGA % % % % % E) Low cost companies In recent years, airlines known as low cost have penetrated the world of aviation. These airlines maintain low costs and generally offer very competitive prices, while providing a low 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. A stirring in this field has also been felt recently in Asia. The entry of the low cost airlines into certain markets forces the airlines competing in these markets, which do not have a low cost structure like the low cost airlines, to become more efficient in order to reduce costs. Until now, the low cost airlines have operated on short flights, and have not operated on flights to and from Israel. Starting 2006, several subsidiaries of the German aviation and tourism giant TUI, began operating as Designated Carrier on routes from various European countries to Israel (such as Thomson Fly, which operated regular flights from London and Manchester). Note that the appointment of these airlines was made possible 17 Source: Civil Aviation Authority a-42

47 Airline as a result of changes in the bilateral agreements with these countries and in light of the provisions of the Horizontal Agreements signed with the European Union described above. The following table specifies the Marley portion of TUI airlines at BGA in 2006, 2007 and 2008: Hapag Fly Thomson Fly Jet Air Corsair Passenger Traffic through BGA , ,922 21,018 39, ,624 20,128 1, , ,307 Market Share at BGA % 1.0% 0.2% 0.4% % 0.2% 0.0% 0.0% % 1.0% 0.2% 0.4% The above table indicates that 2008 saw a significant increase in the activity of low cost airlines belonging to the TUI corporation, the aggregate 2008 market share amounted to 2.7% of all traffic at BGA, compared to a mere 1% in This increase derived from the expansion of the activity of Hapag Fly Airlines, which operates flights between Germany and Israel, as well as the operation of flights from other European destinations using the other TUI airlines. As noted above, Thomson Fly operates flights from Luton (west London) and from Manchester to Tel Aviv, Jet Air operates in the Liège -Tel Aviv route and Corsair operates on the Paris-Tel Aviv route. As described above, Corsair suspended its activities for the winter 2008/9 season and Thomson Fly announced that it would be discontinuing activities on routes to Israel starting May 2009 following reorganization and merger with a British travel company. Thomson Fly is expected to be replaced by British low cost airline Jet2.com, which will operate a weekly flight between Manchester and Tel Aviv starting May 2009, and EasyJet, Europe's largest low cost airline, which is expected to operate flights out of Luton Airport in London starting September The entrance of these and additional companies to the Israeli market may have a negative impact on the Company's operating results as a result of the added capacity offered by these companies at reduced costs. The Company's estimates regarding the entrance of these companies may be different or incorrect an in such a case the scopes of activity of these companies may differ from the Company's estimates. The Company's estimates regarding the scopes of activity of the low cost companies and the future development of this activity in Israel is Forward-Looking Information as defined in the Securities Act. This estimate is based on the fact that this activity involves operating difficulties that might arise such as: a shortage in a critical amount of passengers, which this activity requires, difficulty in quick flight turnaround (ground time of no more than an hour) and more. a-43

48 7.2 Services in the Field of Operations A. General The main services provided by the Company in this field of operations 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 35 destinations in 25 countries in Europe, North America, 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 2008, the Company halted flights to Miami, because of lack of economic feasibility and also altered its operations on the route to Minsk, with the Company flying passengers to this destination through a code share agreement with Belavia Airlines starting December For details see 7.4 below. In 2008, the Company operated an average of 207 weekly flights on in each direction. In addition to the flights it operates, the Company markets flights in the framework of interline agreements with other airlines, which make it possible for passengers on scheduled flights, subject to certain restrictions, to use airline tickets issued by another airline, for flights of the other airlines. The company whose flights are used by the passenger submits the bill for payment to the company that issued the flight ticket. The accounting between the airlines is done on a monthly basis, generally through IATA's clearinghouse. 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 operated by 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 practice, his flight is with another carrier. The code share provides the participating carriers with the possibility of increasing the frequency of the flights 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 has also operated in this area in recent years. As of the date of the report, the Group has active code share agreements with 12 other airlines, most of which permit operation of flights by the two companies. A code share agreement signed with American Airlines in December 2007 came into effect in July A code share agreement signed with Belavia in October 2008 came into effect in October 2008 (for details regarding legislative changes in the antitrust field see Section (i) below). In its scheduled flights, the Group operates four service sections that 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 class - platinum, business class and economy class. The charter flights operate a service profile suitable for charter operations. Not all classes operate in all flights. All scheduled flights contain a system of programs of audio, films, screened magazine and printed magazine and services are provided for the sale of duty free products. In March 2008, the Company entered into a collaboration agreement with Keshet Broadcasting Company Ltd. and Channel 2 News Company to broadcast the entertainment programs of "Keshet" and the daily news edition on its flights. 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 that administers the a-44

49 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 overseas airports 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). B. Data Regarding the Destination Groups of the Group The following are data regarding the Group's market share separated into groups of key destinations, relative to all passenger traffic to or from BGA, broken down into these destination groups: To/from BGA Number of passengers broken down to destinations of direct flights 18 (in thousands of legs) Change (in %) in 2008 Company estimates of market Company share (in %) North America 0.8 1,568 1,555 1, Europe ,082 6,369 5, East and Central Asia 20 ( 7.1) Other ,012 1,749 1, Total ,030 10,069 8, 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, which includes paying passengers only. 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 parent country of the European airline. According to the Company's processing of the Civil Aviation Authority data (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: 50.3% in 2008 vs. 54.7% in 2007; in the European routes: 36.3% in 2008 vs. 38.3% in 2007; in the East and Central Asia routes 97% in 2008 vs. 96.6% in 2007; in other destinations: 10.8% in 2008 vs. 10.8% in Data 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 a Group estimate based on analysis of the Civil Aviation Authority data, 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). The Group is unable to assess the level of precision of its estimate of the market share which includes Sixth Freedom flights in the East and Central Asia market, Africa and regional 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 these markets. a-45

50 C. The routes to North America (to the United States and Canada) During the height of the 2008 summer season, the Company operated 34 weekly flights to North America and during the 2008 winter season, it operated some 26 weekly flights (mostly to New York). In light of financial feasibility considerations and in the framework of the Company's strategy to streamline its flight array, the Company discontinued its activity on the route to Miami starting September The Company's code share agreement with American Airlines came into effect in July 2008 for flights beginning September 2008 (for further details see 7.4 below). There is severe competition between the airlines that operate on the route between Israel and North America (Continental, Delta and Air Canada), which was intensified due to the heightened activity Delta Airlines, which starting March 2008 has began operating a daily flight between Tel Aviv and New York, in addition to its Tel Aviv-Atlanta flights, thus doubling its weekly frequencies from 7 to 14 (a 61% increase in seat capacity). In addition, intensive activity by European airlines taking traffic to the United States and Canada via their home airport (Sixth Freedom) continues. Overall, in 2008, there was no material change in the activities of foreign airlines on the transatlantic routes (1%+) compared to The Company decreased its capacity on these routes by 6%, and the Company's passenger traffic decreased by 7% on these routes. The Company's estimates regarding the changes in capacity and frequency of other airlines and the intensifying of competition is Forward-Looking Information as defined in the Securities Act. This information is based, inter alia, on the Company's estimates in light of the Group's current scopes of activity and the level of market competition that may not be realized in whole or in part, or which may be realized in a significantly different manner. The actual situation may be different from projections among other reasons due to the opening of the market to additional competition, regulatory changes, the manner in which the Company deals with competition and the risk factors listed in Section 9.18 below as well as economic, security and geopolitical changes. D. Routes to Europe The Company has scheduled flights to 25 destinations in Europe, with the key destinations 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 Carriers of the destination country, as well as with other scheduled airlines that take Sixth Freedom traffic to other countries via their home airport, and with foreign and Israeli charter airlines that operate charter flights to various destinations in Europe. In this regard, it should be pointed out that European scheduled airlines flying 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. In 2008, the liberalization of the Israeli aviation industry continued, with the signing of new aviation agreements with several European countries and approvals granted by Israeli authorities to increase capacity for foreign airlines (See Sections 7.1.1, 7.1.4, and for details). Most of the growth in capacity was on the routes to the Confederation of Independent a-46

51 States (former Soviet Union), where the scheduled airlines increased the capacity they offer by 38% and the number of their passengers increased by 31%. Trans Euro increased its seats offered by 37%. Impressive growth was also evident in other airlines from Confederation nations including KD Avia, which operates flights between Kaliningrad and Tel Aviv, which doubled its weekly frequencies from 3 to 6, Belavia, which operates flights between Minsk and Tel Aviv, which increased its capacity by 42% and Air Baltic, which operates flights on the Riga-Tel Aviv route (+67%). On routes to Western Europe, Competition intensified, with the entrance of additional Designated Carriers on routes to France, the U.K., Spain and Belgium (See Sections 7.1.1, 7.1.4, and for details). Likewise, in light of the Government's decision from January 2008, Israir, Arkia and Sun D'Or were appointed Designated Carrier to various destinations. For further details on the Designated Carrier appointments for other airlines see (d) above. Note that in spite of the above, Arkia, Israir and Sun D'Or still operate charter flights on some of the aforementioned routes. The Company estimates that Arkia, Israir and Dun D'Or will be appointed designated carriers to additional destinations in 2009, in accordance with new aviation agreements signed in 2008 and which will be signed in In all, a 16% increase occurred in the capacity of regular airlines in Western Europe routes. Note that Western European routes also saw an increase in foreign charter airline activity, with these airlines increase seat capacity by 33%, with the number of their passengers increasing accordingly. Note also that Sun D'Or (the El Al subsidiary) listed a significant increase in its activity in Eastern and Western European routes, increasing its activity on these routes by a total of 37%. Overall, passenger traffic to Europe (East, West and Central) increased by some 11%, with the Group listing a 6% increase in its passenger traffic to these destinations. Aviation agreements signed in 2008 and those expected to be signed in the near future and the Government's decision regarding a change in the Open Skies policy will lead to the operation of scheduled flights to and from Israel by other airlines, and to an increase in the capacity and frequency among the existing airlines. For instance, Lufthansa Airlines has announced its intentions to renew its flights to Munich starting Spring/Summer 2009 and BMI announced that it would be operating a second daily flight from London starting April For details regarding the petition the Company filed before the High Court of Justice on this issue see Section above). Therefore, in 2009, a further increase is expected in the competition for traffic on these routes. The Company's estimation regarding the increased capacity and frequency among the other airlines and the intensifying competition are Forward-Looking Information as defined in the Securities Law. This information relies, inter alia, on the Company's estimates in view of the volume of the Group's current activity and the degree of competition in the markets may not be realized in full or part or be realized in a significantly different manner. The actual situation could be different than that forecast, for reasons including the degree to which the market is opened to additional competition, regulatory changes, how the Company deals with the competition and the risk factors described in Section 9.18, as well as economic, security and geopolitical changes. a-47

52 E. The Routes to East and Central Asia On the routes to the Far East and Central Asia - India (Mumbai), Thailand (Bangkok), China (Beijing) and Hong Kong the Company presently has an advantage because it is the only scheduled company that operates scheduled direct flights from Israel to these destinations. In September 2008 Korean Air began operating three regular passenger flights per week on the Tel Aviv-Seoul route. Other than the Company, scheduled airlines that operate in Israel operate flights to these destinations in the context of Sixth Freedom traffic. In all, no significant change occurred in 2008 (-1%) in the supply of seats in these routes compared to 2007 and the number of passengers on these routes decreased by 7%. F. Other routes The other routes that the Company operated during 2007 were Greece, South Africa and Egypt. As mentioned, due to a lack of economic feasibility the Israeli airlines, including the Group, discontinued their flights to Turkey starting March Therefore, Turkish Airlines significantly increased its capacity on these routes (23%), with Turkish charter airlines increasing activity on these routes by 13%. The Group renewed its activity on the Turkish routes in July 2008 via Sun D'Or flights, currently operating as charter flights. Arkia and Israir as well have begun operating flights to Turkey, albeit at insignificant levels. In all, passenger traffic on regional routes and on African routes increased by some 15%. The number of Group passenger also increased at a similar rate. The Group's share of these destinations equaled some 10% in As mentioned above, the route to Johannesburg is included in the framework of the Commissioner of Business Restrictions' declaration of the Company as the holder of a monopoly on four routes. See Sections (i) and 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. 7.3 Analysis of revenues and profitability from services The following are data concerning the breakdown of the Company s revenues (consolidated) deriving from similar service groups in the passenger aircraft transport field: (1) Flights from Israel to North America and back; (2) Flights from Israel to Europe and back; (3) Flights from Israel to East and Central Asia and back; (4) Flights from Israel to other destinations and back. Similar Service Group North America Europe Far East & Central Asia Other destinations No geographic attribution Total North America Revenues in Thousands of Dollars , , ,566 46,758 20,809 1,929, , , ,561 42,061 14,464 1,692,414 % of Total Group Revenues % 31.4% 44.6% 40.0% 13.3% 13.3% 2.2% 2.2% 1.0% 0.7% 91.8% 87.6% a-48

53 The following is the amount of gross profit and the gross margin for the years 2008 and 2007 deriving from the passenger aircraft transport field (excluding field-wide expenses and unclassified revenues): Amount of gross profit (in thousands of dollars) Gross margin ,126 17% ,357 25% 7.4 New Services The Company has continued upgrading and renewing its long distance aircraft fleet, completing a seat upgrading project for the first class seating in all of its Boeing 777 aircraft in April 2008, in which all luxury-class seats were replaced: first and business class to advanced recliner seats. In addition, improvements were made to the appearance of the interior of the aircraft in all service classes, with the seat covers being replaced by a more modern design in economy class. In addition, entertainment systems were improved to advanced digital systems to improve in-flight entertainment with laptop sockets installed in coach. The Company is performing a similar upgrade to its Boeing fleet, which is expected to be completed by April As part of its attempt to improve service for Company customers, in February 2009 the Company launched a new advance duty free product ordering service on the Company's website. This service is designed to make things easier for passengers and to provide a solution for passengers interested in ensuring the availability of duty free items on their flights. Payment is made upon receipt of the items on the flights. The Company launched a new service in August 2008 granting passengers flying economy class the option of premium seating, this in return for additional payment and/or frequent flier points. Premium seating is a seat with improved legroom, adjacent to exits or partitions. The Company began charging service fee for changes in flight tickets and the sale of flight tickets using avenues of sales not via travel agents. The Company launched a new service allowing economy class passengers not entitled to lounge services to use the high-class King David lounge prior to their flights, in return for payment. This service is offered upon checking in. In February 2008, the Company signed an agreement with DFASS Distribution LLC, to manage and operate the sale of duty-free products on the Group's flights. DFASS specializes in the sale of duty-free items with large purchasing power. The agreement is for a 5-year period, during which the Group will purchase all of the duty-free products from DFASS, except for Israeli products. DFASS will also provide a ground and air computer system, including terminals, in order to expand and streamline duty-free sales, to provide an array of possibilities for campaigns and to enable optimal inventory management. Following the new pre-flight check-in service from home or office launched by the Company in 2007, together with Home Check In of the Shachar Group, the service was expanded to passengers on Sun D'Or flights and tourists leaving Israel in June In a-49

54 addition, an expanded service as offered with includes personal ground transportation to the airport, private security checks and passport control and direct access to the aircraft and the lounge. From time to time, the Group assesses the possibility of increasing the frequency to existing destinations and the possibility of operating flights to new destinations, meeting market demand, inter alia, through other code sharing agreements with other airlines. In 2008, the Group increased the frequency of flights to several destinations. Following earlier reports from the Company the code share agreement the Company signed with American Airlines in December 2007 came into effect in July The agreement allows Company passengers to enjoy a broad network of major North American destinations, accessed using an El Al ticket via a code sharing agreement. The Agreement provides Company passengers with maximum flexibility in selecting flight routes and dates, while leaning on the Company's direct destination network in North America and Europe. At the same time, in light of the FAA's declaration from December 2008 that it would be lowering the State of Israel's flight safety rating, starting that date American Airlines removed its code from the Company's flights and at this stage the agreement is being implemented unilaterally, with the Company entitled to sell flight tickets using the Company's code on American Airlines flights, but American Airlines not selling flight tickets with American Airlines codes on the Company's flights (for further details see Section below). For new legislation that may influence the Company's ability to enter code share agreements see Section (i) below. In October 2008 the Company signed a code share agreement with Belavia-Belarusian Airlines (hereinafter: "Belavia"). According to the agreement, which is a "soft block" type agreement, El Al shall receive a seat allotment on flights operated by Belavia, which shall operate between 2 and 5 weekly flights on the Tel Aviv-Minsk line, based on the seasonality of traffic. The flights shall operate in an economy class-only configuration. This agreement went into effect on November In February 2009 the Company was appointed Designated Carrier for the route to Brazil, this in preparation for the planned operation of regular flights on the Tel Aviv- Sao Paulo route. The Company is preparing to launch direct flights on this route starting May 2009, subject to the receipt of approvals from the necessary authorities. The Company will also be able to offer, through this route, connecting flights to a broad variety of South American destinations. 7.5 Customers The Group renders its services to passengers who are 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 individuals. See Section 7.6 for additional details. For information on the frequent flier program see Section below. The Group does not have a customer in the passenger aircraft field from which the revenues account for 10% or more of total Group revenues. See Section 8.5 below for details relating to customers of cargo transport services. a-50

55 7.6 Marketing and distribution Travel agents and marketers of tourism packages Most travel agents are IATA members and sell flight tickets for a various airlines. There are no agreements between airlines and agents and the agents may sell flight tickets for any number of airlines, unless a certain airline decides to block their ability to ticket their tickets. Upon making the sale, the agents are entitled to commissions from the airlines at rates determined by them an in accordance with IATA directives 21. Agents may occasionally be entitled to additional commissions, including sales incentives, as decided by the airlines. The great majority of the marketing of airline tickets to passengers is carried out by means of travel agents and marketers of tourism packages. In addition, airline tickets are sold by the sales offices of the Group and by direct sale over the telephone and the Internet. The Group has 5 sales offices in Israel and approximately 30 sales offices abroad. In addition, the Group sells airline tickets by means of approximately 16 general sales agents (GSA) abroad. Airtour Israel Ltd. (hereinafter- Airtour ), which is a jointly-owned company of the Group and travel agents, is an important marketing channel for the Group in the Israeli market, as a distribution arm to all agents in Israel with respect to sales campaigns, packages and special fares to all agents in Israel. During 2008, approximately 10% of total sales of airline tickets in Israel were executed through Airtour. Airtour's work methods have been altered and adapted to work with global ordering systems instead of the Company's previous ordering system "Carmel". In the passenger aircraft transport field, the Group does not have an agent through which sales volume 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 field. 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 based on the sales volume of airline tickets. In principle, the consideration to Israeli agents is divided in two: a fixed component (a basic 7% IATA commission) and a variable commission component, as an incentive. There are various methods in use globally regarding this matter, conforming to market needs. In recent years, a trend has developed in the aviation world of a transition to a reduced commission system, reaching a net fare system (fares without commissions) in such a manner that the agents' base commissions are cancelled and service fees collected by the agents (as well as by the airlines in direct sales) are added. The foreign scheduled airlines operating in Israel have instituted a similar policy to that of the Company, although in 2008, Lufthansa, Swissair, British Airways, Air France, KLM and Alitalia, which operate in Israel, announced that they intend to eliminate agents' commissions and make the transition to the "net price" method practiced in other foreign markets starting January To the best of the Company's knowledge, these airlines began operating according to the above format. 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. 21 For details regarding IATA directives see a-51

56 7.6.2 Computerized reservations system Until 2008, reservations for flights were made by means of the Carmel computerized booking system that also served both as a pricing and as a ticketing system, to which all of the Company's sales offices in Israel and abroad, most travel agents in Israel, general agents of the Company and a number of large agents abroad were linked. A computerized reservation system displays the up-to-date flight schedule of the Company and of foreign airlines, and enables the users to book reservations and ticket on those companies flights. The Group also has agreements with certain international distribution systems that allow sale and direct access to the Carmel system by the users of such systems in order to book reservations for Company flights. The Carmel system was 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 for additional details regarding Sabre. For further details on a lawsuit filed against the Company by Sabre International see below. In August 2007, the Company signed an agreement with "Amadeus" for a comprehensive technology system for reservations and inventory management, as well as an in-airport service system (DCS). The Company made the transition to the new Amadeus system in April 2008, which including the replacement of the system and the adaptation of interfacing systems. The transition from Carmel to Amadeus is a complicated process, which affects all of the Company's passenger flight sales processes involving sales, commercial and service bodies, the Company's branches and stations in Israel and abroad. As part of the implementation of Stage B of the transition to Amadeus, in Q the Company began its preparations for the implementation of the new DCS model (airport service model), which is expected to include the subject of check-in, weight and balance. The Company is preparing a graded work plan for the transition to the new system, which is expected to be completed by March In May 2008 the Company signed a full content agreement with Travelport International LLC (formerly Worldspan and Galileo), expanding distribution and data access options in the Company's Israeli reservation system (including existing inventory and rates), for distribution to agents. Note that the Company expanded the aforementioned distribution options by entering into a full content agreement with Amadeus, according to which the Company will provide Amadeus with access to the majority of data existing in the Company's reservation system (including existing inventory and rates). The Company's estimation regarding the possible results of the transition to the Amadeus system is Forward-Looking Information as defined in the Securities Law, based on the Company's assessments and forecasts as of the date of this report regarding the success of the transition to Amadeus. These assessments may not be realized, in full or in part, or may be realized in a materially different manner, with the main influencing factors being technological factors, the Company's ability to complete integration of the new system and its actual implementation, and changes in the volume of the Company's activity, deriving, inter alia, from the competition and a change in the economic, security and geopolitical situation. a-52

57 7.6.3 Marketing and Sales 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, sponsorships and joint efforts. In 2008, there has been continuation of the trend of global growth in e-ticketing, direct marketing of flight tickets through the Internet, and passenger's self check-in and seat selection. These trends are intended to reduce airlines' marketing and distribution costs. The Company continues to conform its operations to these trends, by developing means that enable self-service for customers, such as ticket purchasing, check-in and seat selection by Internet, check-in and seat selection through counters in the terminal, etc. The Group sells directly to passengers through the Group's reservations department and website. The Group also operates a business desk to promote sales to business entities, mainly in Israel. In order to increase the attractiveness of the Group's flights for passengers interested not only in transport services 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, directly and through agents. For this purpose, the Group markets packages through Airtour. See Section (f) below for details. This activity is marketed abroad through Superstar Holdings (England) at the Company s branches abroad by independent direct marketing or through travel agents. See Section 9.7.1(d) for details. The Group also holds shares in the marketers of packages operating in Israel: Kavei Chufsha Ltd. (See Section 9.7.2(g) below for details). See Section 8.5 below for details on marketing and distribution of freight transport in the bellies of passenger aircraft 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 the frequent flyer club, which is based upon a recorded database. 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, payment of added cash which includes airport fees and various increments (including fuel increments), and also to upgrade a ticket to a preferred section and permit entry into the Company s lounges throughout the world. The Company accrues amounts for the redemption of points in the aforementioned frequent flyers club. Staring January the Company shall issue reports regarding program liabilities in its Financial Statements according to the IFRIC-13 international accounting regulations, This clarification states that flight ticket sales agreements in which the Company grants its customers frequent flyer points exercisable in the future as flight tickets will be treated as multi-component transactions, and the payment received from the customers will be allocated between its various components based on the fair value of the bonus credits. The proceeds attributed to the bonus will be recognized as income when the bonus credits are repaid and the Company's obligation to provide the bonuses is upheld (see Note 2y(c) to the Financial Statements) In recent years, the Group has entered into agreements that allow the accrual and redemption of points in other airlines and/or conversion of points/stars from credit cards a-53

58 and other businesses to the frequent flyers club as cooperation agreements allowing the accrual of points as a result of purchases made from various businesses. In addition, agreements have been made with various non-profit organizations working for social, ethical and humanitarian causes, for the contribution of points to said organizations by club members. The frequent flyers club has hundreds of thousands of members and is composed of a number of ranks according to the activity level of their members: Regular Frequent Flyer", Silver, Gold, Platinum and "Top-Platinum". Concurrent with commercial changes made in recent years in the club's terms, including changes in upgrading policies, restriction of the use of bonus tickets for popular flights, and requirements for cash supplements (including for fuel increment) for bonus tickets, technological improvements were made, including upgrading the information system by allowing club members to execute transactions in their accounts through the website, improving the system for routing calls at the service center, improving the format of the customer account statement, etc. Traffic of frequent flyer club members during 2008 accounted for about 31% of the Company's total passenger traffic compared to 32% in A program for cultivating and retaining prestigious customers was continued in The Company is making efforts to broaden the circle of customers to be retained and to cultivate prestigious customers. 7.7 Reservations Backlog The Company has no financial data as to the volume of forecasted revenues from noncancelable tickets. A portion of these tickets may also be redeemed by the customer over an extended period that does not exceed two years ( open ticket ). The Company has prepaid income which is derived from advance payments received for flights that have not yet flown. 7.8 Competition General A. The passenger aircraft transport field is characterized by strong competition between the airlines providing transport services between the same 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 serviced from BGA. For further details regarding government resolutions pertaining to aviation policy see Section above. C. The Group estimates that, as of a date close to report approval, the Group competes for flights to and from Israel with approximately 100 airlines, including Israeli airlines Arkia and Israir (operating both charter flights and regular flights to certain destinations), some 50 foreign airlines operating scheduled flights to 61 destinations in 38 countries and more than 60 airlines operate charter flights (of which 40 operated throughout the year and the rest operated individual flights). The competition for cargo transport in the holds of passenger aircraft, which is included in this field, is against a-54

59 airlines that transport cargo in cargo aircraft and in the holds of passenger aircraft. See Section for additional details. D. See Section above for details on the competitive structure of this field of operations The Group s Market Share in the Service Categories According to the Company's estimates, in 2008 the Group's portion of all traffic to and from BGA amounted to 35.7%, compared to 38.3% in For the Company's market share of service groups see Section 7.2.(b) above Significant Competitors in the Field of Passenger Aircraft Transport To the best of the Group's knowledge, the Group's major competitors in the passenger aircraft transport field, from the standpoint of market share, are Continental (U.S.), Delta (U.S.), Lufthansa (Germany), British Airways (UK), British Midlands BMI (UK) Alitalia (Italy), Air France KLM (France and Holland), Swissair (Switzerland), Trans Euro (Russia), and Aerosvit (Ukraine). See Section above for details on the significant intensification of competition that occurred in the field in 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. Striving to constantly improve the service to passengers, including improving seat comfort, food quality and variety, and flight entertainment, etc. with focus on business class. D. Providing benefits to frequent flyers club members and to businesses that are members of the Group s business desk. E. Operating through all of the relevant marketing channels. F. Approaching the traveling public by means of advertising campaigns in Israel and abroad. The positive factors that affect, or are likely to affect the Group s competitive position include the following: a broad and varied flight structure; a distribution system dispersed widely throughout Israel; the existence of an attractive frequent flyers club; formidable brand in the local market; high level of safety and security; schedule stability and on-time performance; conforming services to market needs and code share agreements with other airlines. The negative factors that affect, or are likely to affect, the Group's competitive position include the following: a geopolitical situation that significantly reduces the Group's a-55

60 opportunities 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 appointing additional competitors as Designated Carriers in Israel to destinations to which the Group flies or to nearby destinations, especially in view of the Government's aforementioned 2008 decision; the declaration made by the U.S. FAA to lower the State of Israel's flight safety rating to Category 2 and the fear of limitations placed by European aviation authorities (for further details see Section (h) below); the entry of low cost companies; excess capacity of competitors; the Group's reliance on distribution by means of agents as opposed to the growing trend of direct marketing via the Internet; the Company's not flying on the Sabbath or Jewish holidays and possible worsening of the economic, security and political situation in Israel. 7.9 Seasonality The Group's operations are seasonal and are concentrated in 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 their countries of origin. The Group's peak operations are in the third quarter, when passenger volume in 2008 and 2007 was approximately 28%, and 30%, respectively, of total annual passenger traffic. The following are data on the breakdown of the Group s quarterly revenues from passenger aircraft 22 : The Quarter (in Thousands of Dollars) Year January-March April-June July- September October- December , , , ,909 % of operating sector 21.5% 26.6% 29.5% 22.4% , , , ,447 % of operating sector 19.7% 23.6% 30.0% 26.7% 7.10 Productive capacity The accepted indices of output in the world of aviation as regards passenger aircraft are load factor 23 and ASK 24. At peak demand (the month of August), the productive capacity of the Group approximates full potential output. In August 2008 the ASK was approximately 1,934 million RPK and the load factor for the month of August 2008 was approximately 86%. Note that the yearly load rate considered most efficient by leading regular international The period of the Jewish holidays, according to the Gregorian calendar, varies from year to year; this may have an effect on comparing quarterly operations between one year and another. 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). Available Seat Kilometer - number of seats offered for sale multiplied by distance. a-56

61 airlines is generally no greater than 80%. 100% 2,500 90% 80% 70% 1, % 1, % 1, % 1, % 1, % 2,000 1,500 1, % ASK in millions - monthly average L.F. In accordance with a 1982 government resolution, the Company ceased operating scheduled flights on the Sabbath and Jewish holidays, 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. Pursuant to an agreement reached in January 2007 between representatives of the Rabbinic Committee for Sabbath Observance and Company representatives, the parties agreed 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 holidays, pursuant to the 1982 government resolution. In light of the situation that arises from time to time when flights are carried out on the Sabbath, it was agreed that, prior to 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 ultra-orthodox customers would be forced to cancel their flights. See Section below for further details Aircraft Fleet As of a date near the approval of the report, the Company makes use of 34 passenger aircraft (of which 26 are owned by the Group and 8 are leased by the Group). The fleet of passenger aircraft of the Group was all manufactured by the Boeing Company. As a result, El Al is dependent upon the Boeing aircraft manufacturer for everything related to the supply of aircraft parts, in the event of failures and findings occurring during regular maintenance (as a result of it being the aircraft's manufacturer) and engineering consulting. a-57

62 Type of Aircraft Total Average Age (in Years) Average No. of Seats Maximum Flight Range (Nautical Miles) 26 Cargo Capacity , , , , ER(CD) , ER(EF) , , , Total A. The following table itemizes the fleet of passenger aircraft owned by the Group, as of December 31, 2008: Type of Aircraft Price of Transactio n (in Millions of Dollars) Amount of Aircraft in the Transactio n Self Financing % Loans/ Credit (in Millions of Dollars) Fleet Joining Date Further Details % 36 December 2008 See subsection (1) below % 110 April, May and June 2009 See subsection (2) below ER % , 2013 See subsection (3) below The following are purchasing transactions of Company aircraft carried out in the reported period up to immediately prior to the approval of this report: The range is for a plane full of passengers and without cargo Cargo capacity of a aircraft full of passengers for a range where the required amount of fuel does not come at the expenses of useful cargo 27 Three of the 777s were purchased using EXIM guarantees and therefore the legal formula states that the aircraft were first leased by the Company, with the Company retaining the right to purchase the aircraft at the end of the period in return for $1. a-58

63 (1) On January 10, 2008, an agreement was signed to purchase a Boeing aircraft, which was received by the Company in October The plane, manufactured in 1994 and containing 395 seats, was integrated in the Company's flight schedule for long-range flights. The payment for the purchase of the plane and the investments needed to place it in service, and the cost of the additions and installations that will be made in the plane to conform it to the Company's needs, amounts to $50 million. The payment was made upon receipt of the plane. The independent financing means total $14 million, with the balance financed by loans, according to a long-term credit agreement with a foreign bank. (2) On April 10, 2008, the Company signed an agreement with a Spanish airline, for the purchase of 3 new aircraft ("the Agreement"). According to the Agreement, the aircraft are expected to enter Company service in 2009, which each plane containing 160 seats in the Company's service. Total investment for acquisition of these three aircraft, including expected cost for putting them into service for the Company, subject to the scope of additions and installations to be performed on the aircraft to adapt them to Company needs, is estimated at $148 million. Self-financing is expected to amount to 26% of aircraft cost, with the balance financed by loans. (3) In March 2008, the Company signed an agreement with the aircraft manufacturer Boeing for the purchase of four wide-body model long-range aircraft. This agreement was approved by the Company's Board of Directors on April These planes, which will be equipped with "Rolls Royce" engines, are expected to join the Company's passenger fleets for intermediate and long-range flights, and will have a configuration of 279 seats. Delivery of the planes is expected in January 2012, April 2012, November 2012 and January The total purchase cost of the four planes, including spare parts and installations necessary for them to conform to the Company's needs, is $576 million. In accordance with to the agreement with Boeing, the payments for each plane will be made only two years before the plane is delivered to the Company. Therefore, at this stage, the Company has not made a final decision as to how the transaction will be financed, and the Company is evaluating various possibilities. Under the terms of the agreement, the Company was granted an option to convert the purchase of the new ER planes (which will be equipped with General Electric engines), with a configuration of 348 seats. The Company will decide whether to exercise the option by December 31, 2008, subject to the fact that Boeing will not be required to provide the aircraft on the delivery dates in question. Additionally, the agreement contains an additional option that was granted to the Company to purchase two additional planes of this model, which will be delivered to the Company in the years 2014 and 2015, pursuant to the terms stipulated in the agreement. The following are sales transactions of Company aircraft carried out in the reported period up to immediately prior to the approval of this report: (1) On February 23 the sale of Boeing possessed by the Company, manufactured in 1987 was sold and leased back to the Group. The plane was purchased by a Panamanian leasing company. The Company received $9 million in return for the aircraft. According to the agreement, the Group shall lease the aircraft under market conditions for a 22 month period, with the option to extend the lease for an additional 12 months, as well as a monthly credit for engine maintenance calculation. (2) On July the Company signed an agreement for the sale of two Boeing airplanes, manufactured in 1983, owned by the Company. One plane was supposed to be purchased by a Philippine airline and the other by a Singapore-based investment firm. The Company was supposed to receive $6.5 million per aircraft. The delivery of one to the Philippine airline was completed on October , this after the entire proceeds for a-59

64 this aircraft, a total of $6.5 million U.S., had been paid to the Company prior to the signing of the agreement. As regards the sale of the second , the intended purchaser, a Singapore investment company, informed the Company that it would be unable to meet payments for the aircraft due to difficulties in securing bank financing and therefore would be unable to purchase it, leaving the $325 thousand advance payment in the Company's possession. (3) On January 27, 2008, the Company filed a claim with Tel Aviv District Court against Legend International LLC ("Legend") and Babcock & Brown Aircraft ("Babcock") for issuance of a declaratory order stating that a binding agreement was signed between the Company and Legend, through Babcock, whereby Legend committed to sell to the Company a Boeing aircraft for a sum of $50 million. In February 2008, a settlement was signed between the Company and Legend & Babcock, whereby the Company waived its demand for enforcement and fulfillment of the purchase agreement for the plane, in consideration for receipt of a financial sum that is immaterial relative to the Company's operating results. To the best of the Company's knowledge, the average age of passenger aircraft in Europe is 11 years, with the average being higher in the U.S. In Asia, on the other hand, the average aircraft age is lower than in the rest of the world due to high turnover rates. These transactions have been conducted in accordance with the Company's El Al 2010 business strategy, as detailed in Section 9.15 below, which was adopted in 205. The Company continues with the implementation of the plan in question while making adjustments to general market trends and as of this report, the Company has yet to approve any other equipping plan. B. The following table details the fleet of aircraft leased by the Company, as of December 31, 2007: Aircraft type Total Average age Date to be returned to lesser October 2010 January 2011 October 2015* August 2016** December 2016** ER May 2011 November 2011 April 2013 Total Average no. of seats Further Details 142 * See (1) below ** See (2) Below 228 *** See (3) Below Leasing fees for all Company aircraft in this field of activity in 2008 amounted to $37 million compared to $39 million in 2007 and $36 million in In accordance with a resolution of the Board of Directors regarding the replacement of the Boeing fleet with the aforementioned aircraft, provided below are additional updates regarding the aircraft fleet: (1) A dry lease agreement for a aircraft from GECAS or a GECAS subsidiary was a-60

65 extended in March 2008 for an additional 72 month period ending October (2) In December 2007 the Company signed an agreement for the lease of two aircraft from ACG Aviation Capital Group, for an 8 year lease each, starting from the receipt of each aircraft by the Company. The first plane was received by the Company in August 2008 and the second was received in December The planes are fresh off the production line and will include 142 seats each in the Company's service. (3) A dry lease agreement of a ER for Celestial Aviation Trading 36 was extended in March 2008 for an additional 61 months. C. In the fourth quarter of 2008 the Company entered into two agreements for the sale of two engines: an engine sales agreement for a Boeing at $900,000 as well as an agreement to sell a Boeing 757 engine for $1.7 million, The Company listed capital gains of $2.3 million in the fourth quarter. D. In November 2007 an agreement was signed with Boeing according to which Boeing will provide maintenance and restoration work for the landing gear of 4 Boeing 777 aircraft. The agreement will be first activated in In addition, in January 2009 an agreement was signed with Nepal Airlines Corporation for the provision of maintenance services for Nepal Airlines' fleet of aircraft, including periodic checkups, failure maintenance services, instruction and administrative assistance. The services shall be granted by the Company starting March E. In the framework of the overall policy of the Company to improve the flying experience and passenger service, actions were also taken during 2008 in order to improve the product and the maintenance level of the elements inside and outside the passenger cabin to which the passenger is exposed. In 2008, the luxury-class seats in all of the craft in the 777 fleet were upgraded (in such a manner that the seats installed were identical to existing seats in the new aircraft received by the Company in 2007) as well as in the fleet. The Company intends to complete upgrading the seats in the luxury classes in the entire fleet by April For further details see 7.4 above. a-61

66 8. Cargo Aircraft Field 8.1 General Information on the Field of Operations The following is a description of trends, events and developments in the Group's macroeconomic environment, 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-field of operations, regarding the following matters: Structure of the Fields of Operation and Changes that have Occurred Thereof There are four types of competitors in the cargo air transport market: airlines that carry cargo solely in cargo aircraft; airlines that carry cargo solely in the holds of passenger aircraft; companies, like El Al, that carry cargo both in cargo aircraft and in the holds of passenger aircraft; courier airlines which, in addition to cargo related to courier services, also carry other cargo in their aircraft. In recent years, a trend has increased among airlines studying the possibility of converting passenger craft to cargo craft primarily for economic reasons. The cargo craft in the Company's service are Boeing of a relatively advanced age compared to the aircraft fleet in general, and various limitations have been placed on their activity that harm their economic feasibility. In addition, there is a relatively low global supply of designated cargo craft, and therefore the aviation market has come up with the solution of converting passenger planes to cargo craft. This trend is reflected, inter alia, in the transition to passenger aircraft with greater cargo carrying capacity. Continuation of this trend could transfer cargo transport operations from the cargo aircraft field to the passenger transport field. Based on the reasons presented above, the Company is considering such conversion possibilities as well. The data regarding the possibility of transferring cargo operations from the cargo aircraft field to the passenger transport field represents Forward-Looking Information, as defined in the Securities Law. This information is supported by current market trends and by the Company s assessments on anticipated market trends. Therefore, these trends may be materially different from the forecast as aforementioned, as the result of many factors, including a change in profitability of the passenger aircraft field and the reduction of its activity and the imposition of security restrictions on flying cargo in passenger aircraft that might impair this trend. According to the Company's estimates, the Group's portion of the cargo shipping market in 2008, 2007 and 2006 has been assessed at 33.0%, 38.0% and 43.1% respectively, out of all cargo transported to and from Israel (including cargo shipped in the holds of cargo craft. Not including Sixth Freedom and including mail activity) Legislative Restrictions, Regulations and Special Obligations that Apply to the Field of operations The regulatory restrictions on cargo transport in cargo aircraft are similar to those that apply to passenger transport in passenger aircraft. See Section above for details. Regulatory arrangements have also been set for the cargo field relating to a number of operational aspects, such as permissible flight capacity, responsibility of the air carrier for damages, flight safety standards, security and noise. See Sections and 9.11 below for details. Nevertheless, the policies of the global aviation authorities in granting permits a-62

67 for cargo aircraft have tended to be more lenient than in the passenger aircraft field. The situation especially affects the huge opportunity to carry out flights of cargo aircraft on Fifth Freedom and on Sixth Freedom. In 2004, the Civil Aviation Authority approved the shipping of cargo in the holds of passenger aircraft in charter flights. This Ministry of Transport decision led to a marginal increase in capacity offered Changes in the Volume of Activity and Profitability of the Field (A) Volume of global cargo transported According to IATA data, there has been a growth in the cargo transport field over the past 20 years (an annual average of approximately 6%). During 2007, due mainly to rising fuel prices, which have a direct impact on transport prices, there was a slowdown in global air transport of cargo (including in the holds of passenger aircraft) to a rate of 4.3%. In IATA's estimation, during 2008, global air cargo transport (including in the holds of passenger aircraft) decreased by approximately 4.0%. In October 2008 IATA published its estimates according to which by 2012 an average annual growth of approximately 4.5% is anticipated in global cargo air transport (including in the holds of passenger aircraft) 28. A dramatic 22.6% decrease in global airborne cargo shipping was listed in December 2008, greater than that following the September terror attacks, the largest monthly drop in the past 30 years. The drop in global cargo transport in December was evident in all regions: in Asia (-26.0%), in North America (- 22.2%) and in Europe (-21.2%). In light of this data, IATA estimates that 2009 will be one of the worst years for international airborne cargo shipping recorded, with a decrease of at least 5%. The following table describes the development of airborne cargo shipping activity between 2004 and 2008, based on IATA data 29 : Year Output RTK 30 (in millions) Annual change in RTK (%) 2008 No data No data , , , , The IATA projection for 2012 refers to increases in the weight of cargo shipped in tons, without taking the distance flown (RTK) into account 2008 data has not yet been published. Revenue Ton Kilometer - the weight in tons of paid cargo in cargo aircraft multiplied by the distance flown. a-63

68 B) Volume of cargo air transport carried in aircraft from and to Israel The following are data on cargo traffic to and from BGA over the past five years (The data includes cargo carried in cargo aircraft and in the holds of passenger aircraft) 31 : Cargo Traffic through BGA (Thousands of Tons) for the Year Ending December 31 Export Import Total Change from 2007 (9%) 1% (5%) Change from % 3% 6% Change from % 6% 4% Change from 2004 (9%) (2%) (6%) A decrease of approximately 4.7% 32 in cargo traffic at BGA was posted in 2008 as compared with The main cause for the drop in traffic was the global financial crisis, which was evident in reduced activity in cargo traffic starting May 2008, with a sharp decrease of up to 25% compared to the previous year occurring during the last quarter of In addition to the Israeli cargo airline CAL, the cargo capacity of foreign airlines includes cargo capacity on passenger flights and capacity on cargo flights of six companies: FedEx (U.S.), MNG and Turkish Airlines (Turkey), EAT (Belgium), Royal Jordanian (Jordan) and Korean Air (Korea). Likewise, unscheduled cargo flights were flown through foreign companies, on an ad hoc basis. The significant growth in the total number of cargo and passenger flights operated by foreign airlines, led to growth in the cumulative capacity they offer in the cargo field and to 9% growth in the aggregate quantity of cargo they have flown. Some 60% of the cargo traffic through BGA was flown on cargo aircraft and the remainder (40%) was flown in the holds of passenger aircraft (primarily wide-body planes). This data does not include cargo that the Group flew via BGA in the context of Sixth Freedom (flight from one foreign country to another via BGA) to the amount of 33 2 thousand tons, 7 thousand tons, 5 thousand tons and 6 thousand tons in the years 2008, 2007, 2006 and 2005, respectively. The decrease that began between 2005 and 2008 in the volume of cargo flown by means of Sixth Freedom is the result, inter alia, of the growth in the volume of cargo flown by means of Fifth Freedom and in the discontinuation of El Al cargo craft activity to East Asia in Developments in the Field of Operations' Markets, or Changes in its Customers Characteristics The Israeli market in the field of operations of cargo transport by cargo aircraft is characterized by high seasonal fluctuations, 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 in the field of cargo aircraft Source: Civil Aviation Administration and Company estimate, which includes the deduction of Sixth Freedom activity by El Al through BGA and the addition of El Al mail activity. Without deducting the Company's Sixth Freedom activity by means of BGA, the rate of increase in traffic in 2008 was about 5.3%. The data includes cargo that was carried in cargo aircraft and also cargo carried in the holds of passenger aircraft. a-64

69 shipping Technological Changes that could Materially Affect the Field of operations The Company is working to expand and develop advanced IT solutions in the field of airborne cargo, in the field of online trade and in self service abilities with the goal of improving service and reducing the Company's costs. Due to the aggravation of the threats to the aviation industry in recent years, the aviation market is preparing itself to confront terror events by expanding the use of advanced technological and other means, on the ground and in the air. Among the actions taken as part of these preparations, the Company is evaluating and installing protective devices, as mentioned above. Starting February 2009 the U.S. TSA has required that all airlines shipping cargo from the U.S. on passenger aircraft perform security tests while employing advanced methods and technological means that have been used by the Company for some time. A project is currently reaching conclusion for the management of cargo transaction using a mechanized operational system. The project is expected to lead to improvements in commercial processes including in the areas of pricing and work with price frameworks, supporting various levels of salespersons, improving availability of land shipping price lists and additional shipping segments performed by foreign airlines, limitation of the amount of transactions, consolidating transactions by subsidiaries, consolidating transactions with adjacent airports, simplification of the transaction approval process, greater precision in attaching transactions to bills of lading, greater precision in customer billing and improvements in service. In addition, completion of the project will lead to work with a centralized operation system, improvement in the quality of information and improvement in the transparency of information on the network. The information regarding possible implications of the completion of the cargo transaction management via mechanized operational system project and the expected improvements in the company's commercial processes represents Forward-Looking Information, as defined in the Securities Law. The information is based in its entirety on the Company's estimates as of this report. Therefore, the actual implications may be materially different from those forecast, as the result of many factors, including technological factors, the Company's ability to implement the new system and its actual implementations as well as changes in cargo aircraft activity levels Critical Success Factors and Changes that have occurred in the Field of operations A number of factors can be pointed to in the operations of the cargo transport sector via passenger aircraft that affect the field's competitive position: the ability to offer the transport of cargo to popular destinations at competitive prices; development of a network of routes on an independent basis, including the possibility of carrying out Fifth Freedom Flights and Sixth Freedom Flights, both as operations supporting transport to and from Israel; cooperation with other airlines; offering transport at the frequency and quality demanded while meeting time schedules; risk management and risk hedging Changes in the Supplier Network and the Raw Materials for the Field of Operations The primary raw material used by airlines is jet fuel and it represents one of the major a-65

70 expense components of an airline. See Section below for additional details relating to fuel. In addition, as the Company's entire passenger plane fleet was manufactured by the Boeing Corporation, the Company is dependent upon this manufacturer for everything connected to regular maintenance of its aircraft, as regards parts and repairs Main entry and exit barriers of the field of operations and changes that have occurred 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 scheduled flights in passenger aircraft. See Section above and Section 9.11 below for details. The Company assesses that some countries have a more liberal policy of granting permits in the filed of cargo transports. Therefore, in the Company s assessment, this entry barrier is less significant for some countries in the cargo field. Another important entry barrier in the industry is the initial, relatively large investment that 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 international aviation agreements, obtaining appointment as a Designated Carrier is conditional upon substantial ownership and effective control of the air carrier being held by the government or citizens of the country that has specified that it be a Designated Carrier. This requirement represents an entry barrier for obtaining the appointment as Designated Carrier by foreigners. See Section above for details on changes in this condition under the terms of aviation agreements of the State of Israel. The limitations of the holder of the Special Government Share in the matter of the reduction of the Company's cargo fleet constitute an exit barrier. See Section below for further details Substitutes for Services of the Field of Operations and Changes that have Occurred in them The principal substitutes for air transport in cargo aircraft are transport in the holds of passenger aircraft, maritime shipping or a combination of maritime shipping to the nearest destination port and from there, shipment overland. The Company estimates that the major considerations in selecting air transport over ocean and/or land transport are the nature of the product, the requisite shipping conditions, the necessary time frame and the transport costs. In 2008, no material changes occurred in the substitutes for transport by cargo aircraft Competitive Structure of the Field of Operations and Changes that have Occurred 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 cargo aircraft, inter alia, by means of the fifth and Sixth Freedoms, upgrade of the passenger aircraft of the foreign airlines to broad-body planes capable of carrying more cargo in their holds 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-66

71 8.2 Services in the Field of Operations In this field of operations, the Group offers cargo transport services in cargo aircraft from Israel to destinations to and from Israel; cargo transported from one foreign country to another foreign country (Fifth Freedom), for example from Liège to New York; or cargo transported 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 U.S. with a stopover in Israel. The Group differentiates between three main groups of destinations: (1) North America; (2) Europe; (3) East and Central Asia. During the reporting year, the services offered by the Group in this field of operations were cargo transport services to three destinations in Europe, three destinations in the East and Central Asia (up to April 2008) and one destination in North America. Moreover, 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. Note that the Company's Fifth and Sixth Freedom activity exist in the field of cargo shipping only. Starting May 2008 the Company ceased operating cargo flights to East Asia. Air cargo shipping to East Asia and from it to a broad variety of destinations is currently carried out by shipping cargo in the holds of passenger planes as well as by collaborations with foreign airlines. A process was completed on October in which European cargo activity was concentrated at Liège Airport, Belgium, which constitutes a single central airport as an alterative to cargo activity in three airports in the Benelux region. The key advantages of the move to Liège Airport are: The absence of noise restrictions allowing stable and appropriate timetables and greater flexibility. A central European location and accessibility to a broad ground transport network. Logistically designated for cargo shipping. The airport offers 24/7 veterinary customs services for the agricultural sector. Flight time from Tel Aviv is 40 minutes shorter than to Amsterdam, where most cargo activity was concentrated in the past. Note that Amsterdam station remains a center of activity and collection point even after the move to Liège. The shipping services provider providing storage and expansion services as well as customer services for El Al is a new shipping company operating our of Liège Liège Handling Services S.A. The following is a breakdown of the volume of cargo traffic in the Group s cargo aircraft, by principal destination category, in the years 2005 to 2008: a-67

72 Cargo Traffic in Group's Aircraft, by Region (Tons) for the Year Ending December To and from Israel and Europe To and from Israel and the U.S. To and from Israel and East and Central Asia 41,281 55,129 63,727 61,802 13,364 15,170 14,445 14,468 3,451 13,292 14,997 14,768 Total 58,096 83,591 93,169 91,038 These data do not include cargo which the Group flew 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 flew cargo by Fifth Freedom to the amount of 8 thousand tons, 21 thousand tons, 23 thousand tons and 20 thousand tons in 2008, 2007, 2006 and 2005, respectively. The Group flew cargo by Sixth Freedom to the amount of 1 thousand tons, 5 thousand tons, 3 thousand tons and 4 thousand tons in 2008, 2007, 2006 and 2005, respectively. The principal markets for cargo transport services are importers, industrial enterprises and the agricultural sector. For purposes of distributing cargo from its cargo centers, the Company, by means of subcontractors, operates a truck transport system. As of immediately prior to the approval of this report,, the Group no longer independently operates cargo terminals and hires cargo terminal services from local handling contractors in various countries. Note that the Group ceased operating its London terminal in January Despite the intensifying competition on the industry, the Company expects to preserve its market share in The data concerning the forecast of a change in the market Company share represent Forward-Looking Information, as defined in the Securities Law. This data is supported, inter alia, by the Company's assessments in light of the Group's current volume of activity and the extent of competition in the market. Therefore, the actual change in the volume is due to many factors, including the number of cargo aircraft available to the Group, 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. a-68

73 8.3 Analysis of Service Revenues and Profitability A. The following are data concerning the breakdown of the Company s revenues into key destination categories (consolidated) in the field of transport by means of cargo aircraft 34 : Destination group North America Europe Far East & Central Asia No geographic attribution Total Revenues in Thousands of Dollars ,662 60,721 17,699 1, , ,076 50,028 99, ,332 % of Total Group Revenues % 2.9% 0.8% 0.1% 6.9% % 2.6% 5.1% 0.1% 11.2% 2008 saw a 33% decrease in the Group s revenues from the field of operations compared to 2007, while the rate of increase in cargo traffic in BGA during 2008 was some 5% compared to B. The following is the gross profit and the gross profit margin from the cargo aircraft transport field in 2008 and 2007: Gross profit (in thousands of dollars) ( 13,362) (13,120) Gross profit margin (in %) ( 9% ) (6%) 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, in accordance with market demands. In August 2007, the Minister of Transport appointed the Company the Designated Carrier on the route to Japan, also for cargo transport. As of the reporting date, the Company has not yet begun to operate direct flights to this destination. 8.5 Customers, marketing and distribution Most of the Group's sales in the cargo aircraft transport field are effected through cargo agents (approximately 88% f in 2008). The remaining sales are made directly to customers. 34 The revenues include revenues from flights in the framework of fifth and Sixth Freedoms; the analysis to destinations was made based on the final destination. a-69

74 Starting early 2006, the Group instituted 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 based on cargo quantity, average shipping price and type of route for which the sale is made. In the transport through cargo planes field, the Company does not have any 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 whom the sales represent a material component of the field of operations. In addition, the Israeli company for cargo consolidation (ACI), 50% of the shares of which are held by El Al (without the right to receive dividends), is engaged in consolidation of air cargo at BGA and its transfer abroad, mainly by El Al. ACI, like other airlines which operate in this field, consolidates the cargo of individual dispatchers into one shipment and, as a dispatcher, transfers it to El Al for shipment. In this way, it avoids interaction with a large number of dispatchers and cargo recipients, leading to cheaper air transport costs of consolidated shipments. On August 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 activities between the companies. The agreement was for one year, commencing from December 2005, with an option for its extension for three additional periods of one year each, so that the agreement will terminate, at the latest, in November 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 formulas were established for accountings connected with the volume of import cargo from Europe against growth in export volume. Pursuant to understandings between the Company and Agrexco, the agreement was extended for an additional year commencing on November 30, 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. The agreement will remain in effect until November The Company is considering refining its pricing principles as regards fuel surcharges the Company adds on short-range routes, in such a manner that the fuel surcharges shall be derived from fuel receipts as a function of flight hours and prices shall be adjusted to the global purchase price of a gallon a fuel accordingly. This change should not influence he general price but only make a "technical" correction reflecting the ratio between the fuel surcharge and the shipping fees. This change in pricing methods is designed to create greater transparency and clarity in the calculation of the fuel element vis-à-vis the customers, this following changes in fuel prices and the global economic crisis. Information regarding the possible redefinition of the Company's pricing principles is Forward-Looking Information as defined in the Securities Law. This information relies, inter alia, on the Company's goals and estimates in light of the existing pricing model and the possibility of implementing a new model. Therefore, the actual change in pricing principles and its impact on the Company may differ materially from projections, as a result of a large number of factors, including changes in jet fuel prices and the Company's handling of competition and risk factors described in 9.18 below. a-70

75 8.6 Reservations Backlog In general, air transport of cargo in 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 Competition Competitive Conditions in the Field of Operations A. The cargo aircraft transport field is characterized by strong competition between the airlines that supply transport services between the same destinations or alternative destinations. The airlines compete in different areas, mainly: transport rates, 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. As a result, an increase has been apparent in the capacity of cargo shipping in the holds of passenger aircraft of foreign airlines. This increase has led to intensifying competition in cargo shipping as well. C. The significant increase in the flight capacity of regular foreign airlines referring to the passenger aircraft field of activity also led to a significant increase in cargo shipping capacity in the holds of passenger aircraft operated by regular foreign airlines to and from Israel. In light of the above, competition in the industry has intensified in the field of cargo aircraft activity. According to the Company's estimates, this trend of intensifying competition will become even more prominent in 2009, in light of the intention of several airlines to increase frequencies as well as integrate wider aircraft in their flights (capable of carrying larger amounts of cargo). For further details on increased competition see above. D. Until 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. In recent years, other foreign airlines that operate cargo aircraft have entered the field of operations in Israel. Starting 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 cargo aircraft that 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 led to a reduction in the Group's cargo operations. Previously, CAL had requested appointment as Designated Carrier to additional destinations to which El Al is the sole Designated Carrier, and as to which, under current aviation agreements, no more than one Designated Carrier may be appointed. In aviation talks held between Israel and Russia, it was agreed that for the Tel Aviv-Moscow route, each country would be able to appoint an additional Designated Carrier for passengers and/or cargo, as a temporary arrangement. To the best of the Company's knowledge, CAL has requested to be appointed Israel's second Designated Carrier for operation of cargo flights. If all or some of these requests will be approved, it could have a negative effect on the volume of the Company's activity on these routes. E. The Group competes for cargo transport in cargo aircraft to and from Israel with a-71

76 approximately seven airlines, which operate cargo aircraft in flights to and from BGA. Starting December 2006, a Korean airline began flying scheduled cargo flights to Eastern Asia. Over the course of 2008, the Korean airline operated 2 weekly cargo flights to Seoul. F. An agreement was reached between Israel and Germany in January 2009 for 7 cargo frequencies per week for each side's Designated Carriers (compared to three frequencies to date). Following this, in March 2009 the Ministry of Transportation announced that CAL would be appointed Designated Carrier for cargo flights to Frankfurt and Cologne in Germany. The Company estimates that the above changes may affect the amount of cargo transported by the Group to Europe. The information regarding possible implications of such agreement regarding the scope of the Company's cargo shipping activity to Europe is Forward-Looking Information as defined in the Securities Law. The information is entirely based upon the Company's estimates as of this date. Therefore, the actual implication may be materially different from projections as a result of a large number of variables, including changes in the scope of activity in the field, realization of the agreement by the Designated Carriers for the Germany route to carry out flights to these destinations and the level of competition with other competitors. The Group competes with most of the scheduled airlines that operate passenger aircraft and carry cargo in their holds 35. According to statistics of the Civil Aviation Authority, approximately 40% of the air transport of cargo to and from Israel during 2008 was carried out in the holds of passenger aircraft (primarily wide-body aircraft) in scheduled flights, while the remaining cargo (approximately 60%) was flown to and from Israel in cargo aircraft Major competitors in transport through cargo aircraft To the best of the Group's knowledge, its most significant competitor in transport through cargo aircraft, from the standpoint of market share, is the CAL Company Key methods for coping with competition The Group acts on a number of planes in order to raise its profitability, while retaining and increasing its market share and also increasing the volume of the cargo its transports as follows: A. Conforming their timetable, as much as is possible, to the seasonality of traffic and maintaining the timetable's stability. B. Increasing the frequency of flights to popular destinations and increasing the number of flight destinations by cooperating with other companies. C. Proposing competitive prices. D. Adding to the frequency of the Company s cargo flights between two foreign countries. Positive factors that affect, or are likely to affect, the Group s competitive position include: a strong brand name in the local market; a high standard of service, high safety levels; timetable stability and on-time performance. 35 In recent years, there has been intensification of a trend of transporting cargo in the holds of cargo aircraft. This trend is expressed, inter alia, in the transition to passenger aircraft with larger cargo carrying capacity. a-72

77 Negative factors which affect, or are likely to affect, the competitive position of the Group include: the possibility of appointing in Israel additional competitors as Designated Carrier or to additional destinations; regulatory changes that restrict the possibility to enter into agreements with other airlines or prevent the utilization of flight rights; the entry of new, foreign competitors; increases in the flight capacity of foreign airlines (including fifth and Sixth Freedoms); worsening in the economic, security and political situation in Israel. 8.8 Seasonality The field of operations is characterized by high seasonal fluctuations due to the relatively strong 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: Year January-March Quarter (in Thousands of Dollars) April-June July- September October- December ,853 37,023 30,488 26,797 % of operating sector 35.0% 25.5% 21.0% 18.5% ,468 49,833 52,294 64,737 % of operating sector 23.2% 22.9% 24.1% 29.8% 8.9 Productive capacity The accepted indices of output for cargo air transport in cargo aircraft are the load factor 36 and ATK 37. During peak demand (in March), the Group's productive capacity Group comes close to its full potential output. In March 2008, the Group's ATK was 60,488 ATK (including the convertible aircraft) and the load factor stood at 75.1% It should be emphasized that load factor indicator is computed solely based on cargo weight and does not take cargo volume into consideration. The following graph describes the average monthly load factor and ATK per quarter in 2008: [ATK in millions - monthly average] 8.10 Aircraft Fleet A. As of immediately prior to the approval of report, the Company makes use of two Boeing cargo aircraft The above is in accordance with the approval granted by the Company Board of Directors to remove two additional cargo aircraft which have served the Company in 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). Available Ton Kilometer - available cargo capacity multiplied by distance flown. a-73

78 the past (one of them being the convertible C cargo plane) from service. The Company received the approval of the holder of the Special Government Share, in accordance with the provisions in the Company's articles pertaining to the reduction of the Company's cargo fleet to two. B. The following table itemizes the fleet of cargo aircraft owned by the Group, as of December 31, 2008: Type of Aircraft F SF* C* Total Total Average Age (in Years) Maximum Carrying Capacity 127 Tons 110 Tons 109 Tons * As stated above, a SF and a C listed in the table above are no longer used for cargo flights. C. In addition, the Company leases cargo aircraft in wet leases (aircraft leased with its crew) as needed. D. Over the coming years, the Company may be required to replace all or part of its fleet, 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 restrictions in various airports worldwide (See Section below for details of noise restrictions). E. Total leasing costs borne by the Company in this field of operations amounted to $660,000 in The Company did not lease cargo aircraft in 2007 and Raw materials and suppliers The principal raw material of the Company is fuel. See Section for further details. In the cargo aircraft field, 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 2008 accounted for some 11% of the operating sector s expenses. The Group was not dependent on any single supplier in Aircraft that 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 2006, the Company sold one of the two aircraft a-74

79 9. Details on the Two Fields of Operations 9.1 Fixed Assets and Installations Real Estate A. The Group owns an area of approximately 1,560 square meters in El Al House in Tel- Aviv, which serves as the offices of the Company's Israeli branch. The Group also owns offices in Spain (Madrid) and Argentina (Buenos Aires) with total space of approximately 269 square meters. B. The following is a list of the major real estate properties leased by the Company in Israel: The El Al area at BGA with an area of approximately 290 thousand square meters. Parties to the Agreement License agreement between the Airports Authority (licensor) and El Al (licensee) Consideration See subsection (e) below Contract Period & Extension Option The contract is in effect until December 31, There is also an extension option for an additional 25-year period. Warehouse in BGA with an area of 4,380 square meters. Areas at BGA Terminal 3 Areas at BGA for the Company s Cargo flight operations, including space in the Maman building amounting to 275 square meters License agreement between the Airports Authority (licensor) and El Al (licensee) See subsection (f) below Agreements between El Al, Maman Cargo and Handling Terminals Ltd. Annual usage fees of $480 thousand See subsection (f) below Annual usage fees of $140 thousand Agreement effective until December 31, 2009 See subsection (f) below Until December 31, C. The Group leases space in various places in Israel for use as offices, shops and warehouses with total space of approximately 1,135 square meters for which the Group pays annual rental fees of approximately $200 thousand. D. The Group rents various real estate properties all over the world, in the key destinations to which it flies, used to maintain its current operations, mainly offices in cities and stations in airports. The total expenses for rent abroad during 2008 totaled $5,910 thousand. The principal properties are in New York (approximately 3,400 square meters with annual rental fees of approximately $1,170 thousand), in London (approximately 2,860 square meters with annual rent fees of approximately $1,300 thousand) and in France (approximately 1,350 square meters with annual rental fees of approximately $641 thousand). E. Land usage rights at Ben Gurion Airport (BGA) The Ben- Gurion Airport (BGA) serves as the Group's home port and central base of a-75

80 operations. The Group s headquarters, hangars, aircraft parking areas, workshops, warehouses and other offices and installations are located at BGA. Most of the offices, hangars and other buildings used at BGA were constructed on land for 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 usage right (permit) to 29 hectares of land at BGA through December 31, This period may be extended 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. For the purpose of the investment reduction period for BGA rental properties, the Company did not take the option to extend the rental period with the AA into account and neither was the purchase tax taken into account. 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 that it will need for the operations, safety, development or security of the airport. In 2005, the Company paid $960 thousand in licensing fees for the aforementioned usage rights, and starting 2006 and thereafter, the licensing fees will rise by 7.4% per annum until the end of the contract period, not to exceed $4 million 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 be at a rate that 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 in 2006 and reaching approximately $4,000 thousand in 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 The AA shut down Terminal 1 (the terminal that 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 square meters. 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 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 Company's current operational costs, due to reasons resulting from the new agreements with the AA, including transporting aircraft, shifting and transporting employees, by approximately $6 million per annum. The agreement to provide a permit for operating a passengers lounge (approximately 1,500 square meters) was signed on December 11, 2006, even though the Company had been operating the lounge since November The agreement will be in effect for 6 years starting November 2, 2004 at total consideration of up to $1,750 thousand per year, including an extension option for another 3 years. Agreements for a permit for the other areas were also signed, covering a period of 10 years starting November 2, 2004 at of a-76

81 $1,770 thousand per year 39. In the context of the operations of Terminal 3, the Group is considering whether to set up an aircraft maintenance center adjacent to Terminal 3, in stages. For this purpose and in preparation for the move to Terminal 3, in April 2000 the Company signed an agreement in principle with the AA to lease approximately 2 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 Company's Board of Directors. As of this report, no detailed agreement has yet been signed between the parties. Note that the Company pays a yearly retention fee for the areas in question of an insignificant sum Accessories, Spare Parts and Spare Engines The Company keeps accessories, spare parts and spare engines in its warehouses, having total book value of approximately $104 million as of December 31, In recent years, the Company has begun to purchase external logistic support services from designated suppliers abroad to complement the spare parts purchased by the Company. See Note 14 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. El Al's airline liability insurance is limited to a ceiling of $1,500 million for each occurrence. After the September 11 attacks in the United States, the policy provides a response to bodily injuries of passengers that resulting from acts of terror and war within these boundaries, while third party damages are insured by the same policy to the extent of $150 million. Therefore, the Company purchased additional insurance coverage of $850 million, above and beyond the first layer of insurance, so that the total insurance protection against third party damages arising from acts of terror and war amounts to $1,000 million. According to the Company's estimates, this coverage suffices to provide the proper insurance protection for its operations. The hull all-risk 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 based on agreed value of each aircraft and includes deductible levels that 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's controlling party, the Company entered into an agreement with it, according to which joint application was made to the Company's insurers. As of the report date, two riders for insurance to cover acts 39 Including payments for telecommunications. a-77

82 related to K'nafaim were added to the Company's insurance policies: The "contingent stratum" rider for 11 aircraft owned by the K'nafaim Group leased to various airlines. The insurance is designed to insure the rights of the K'nafaim Company in the event that the lessors or their insurers breach their insurance obligations. The rider for third party liability related to maintenance activities provided by "K'nafaim Maintenance" (an entity in the K'nafaim Group) to Israeli Air Force aircraft. The incremental premium for these two riders amounts to approximately $ 65,000 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 undertook to be responsible for additional premiums that the Company may be required to pay, should such demand be made, if required The Company is also covered by various insurance policies, which Company assesses are sufficient to provide insurance coverage adequate for the primary risks to which the Company and its employees are exposed. These refer 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 officers' liability insurance in the framework of the insurance coverage prepared by K'nafaim, in accordance with an agreement with K'nafaim. See Section 29a of Chapter D (further details on the Corporation's activities) for details. The overall cost to the Company for insurance premiums during 2008 was approximately $7 million. 9.3 Intangible Assets The Group owns the trademark: El Al, which is the protected trademark of the Group. A registered trademark is valid in Israel for limited periods fixed by law, and may be renewed at the end of each period. In addition, the Company owns the trademark for "El Al" in the U.S. as well. In the Group s assessment, the economic lifespan of the El Al trademark 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 details as to licenses and flight rights given to the Group. See Note 15b to the Financial Statements for details regarding the usage rights of the Company regarding security equipment. 9.4 Human resources Organizational structure The prescribing of the Company's general policies and supervision over the activities of the CEO is within the authority of the Company s Board of Directors. The day-to-day 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 CFO, the Maintenance and Engineering VP, the Commerce and Aviation Relations VP, the Human Resources and Administration a-78

83 VP, the Service VP, VP of Operations, the IT and Organization VP, the Cargo VP, the General Counsel and Corporate Secretary, the CEO's Chief of Staff and the Company Internal Auditor. For details regarding the CEO's terms of employment see Section below. During 2008 and until the approval of this report, the following changes took place in the Company's head office: (a) The Purchasing and Commitments Branch was created in August 2008, subject to the Vice President of Human Resources and Administration. This branch shall concentrate the Company's purchasing activity. (b) In February 2009, sales bodies in Israel and abroad (including the Israel branch and the regional sectors responsible for foreign activity) were transferred from the trade division to the service division, which from that date became the Service Division (for further details see the organizational chart in this Section below). The following is a flowchart depicting the Group's organizational structure: a-79

84 * Security Division Head and Safety and Quality Division Head report to the CEO and coordinate with the VP of Operations. * Company Security Officer reports to the CEO and coordinates with VP of Human Resources and Administration. a-80