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South west financial note 2011
 

South west financial note 2011

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Southwest Financial note by - Jean Lemercier, Cécilia Cosnard des Closets, Charline Poher, Derek Fleck and Violaine Lièvre. Including risk assessment, peers comparison, internal financial analysis ...

Southwest Financial note by - Jean Lemercier, Cécilia Cosnard des Closets, Charline Poher, Derek Fleck and Violaine Lièvre. Including risk assessment, peers comparison, internal financial analysis and environmental analysis.

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    South west financial note 2011 South west financial note 2011 Document Transcript

    • - 1 -SOUTHWESTAIRLINESFINANCIAL REPORTTicker : LUV Recommendation: BUYPrice: $8.47 (Dec. 5th 2011)HighlightsBusiness mix & market position: Southwest is one of the largest American airlinesin terms of domestic passengers carried, with operating revenue amounting to$12 billion in 2010. The company revenue breakdown in 2010 is the following:Passenger (95% of revenue), freight (1%) and others (4%).Strong effect of the Global Financial Crisis:Southwest Airlines profitability hasbeen seriously affected by the Crisis – its net income went down from $645million by the end of 2007 to $99 Million in 2009 (-84.6%). Nevertheless thisfigure is definitely a good result since other major US based Airlines companiesexperienced huge losses (Delta Airlines: $-1.2 billion in 2009; American Airlines -$1.5 billion).Post-GFC relief:Southwest Airlines recovered quite well from the crisis, with anoverwhelming increase of the net income from $99 million in 2009 to $459 in2010 (+363%) thanks to a 16% growth of the operating revenues to $12,104million. This is a good performance considering that the WTI crude oil barrel pricepassed the $100 mark in March 2010.Consistent profitability & lower volatility than competitors: In 2010, Southwestremained profitable for the 38thconsecutive year which is a major achievement ina fairly cyclical Airline industry. This is mainly due to the fact that SouthwestAirlines is less volatile than the majority of its competition: its volatility (based on3 month historical values fluctuations) is 20% lower than domestic peers.Good medium-term prospects: Analysts forecast both a growth of the revenueand the net profit margin, which result in an increase of the net profit to $844million in 2013 (the figure is made up of 12 estimations). Nevertheless, thoseexpectations are still very dependent on the very volatile fluctuations of oil pricesthat represent a third of the Southwest operating expenses.Earnings/Share June Dec. Year P/E ratio2008A $0.44 $-0.09 $0.20 X35.842009A $0.12 $0.15 $0.19 x85.762010A $0.15 $0.18 $0.62 x21.142011E $0.21 $0.40 X20.53Industry:Airline IndustryTravel servicesDecember 2nd, 2011Jean LemercierCécilia Cosnarddes ClosetsCharline PoherDerek FleckViolaine Lièvre
    • - 2 -Investment SummaryMain risk factors in the Airline industry High volatility of oil prices: fluctuations are very hard to forecast and their increases deeplyaffectthe company’s profitability. Fuel represents an average of 35% of the Airline industryoperating expenses, and this percentage is likely to increase in the next few years.o This aspect has been even more important lately due to the instability in oilexporting countries in the Middle East (Libya, Egypt…) pushing the prices of crude-oilup. Economic slowdown in developed countries and especially in the United States sparked off adecrease in purchasing power; the demand in the Airline industry is hence weaker. Regulations of Greenhouse gases emissions could increase costs. For instance, the EuropeanParliament is planning to add aviation to the European emissions trading scheme, airlinescompanies could therefore be taxed according to their gases emissions. It is a risk for theAirline industry that further regulations take place in the future.Market Profile (Data as of November, 12th2011)Market Capitalization $6.391 BillionOwnership 83% by InstitutionsBeta (1year) 1.2352 week High/Low $13.75/$7.35Daily Average Volume (3 months average) 2,394,896Return on Equity (2010) 7.84%Return on Assets (2010) 3.09%Debt to equity ratio 54,19%
    • - 3 - Airlines companies face the risk of liability in the event of an aircraft accident or a terroristaccident such as the World Trade center attacks. These kinds of incidents could involve costsrelated to the repair of the aircraft, damages and brand image damages.Southwest Key strategic factors: Fuel hedging – Southwest is using a sound strategy using fuel hedge contracts to reduce itsexposure to fluctuations in oil prices. By doing so, the company is able to fix the price of itsfuel and oil expenses for the year, and is not impacted if oil prices rise during the year. This ispositive for investors as it reduces the overall volatility of the company results. However, thecompany loses money when oil prices declines. Low cost model – Southwest top management cuts costs by flying only one aircraft model(Boeing 737), running a streamlined point to point network (domestically) rather than a huband spoke diagram (average aircraft trip length is 653 miles with an average duration of anhour and 55 minutes) and minimizing the time their planes spend languishing in airports. Strategic Acquisitions – Southwest has completed mainly four acquisitions since its creation,in order to increase revenue. Furthermore, the company has been able to enable costsynergies, expand its operations by gaining airport landing slots and aircraft. Corporate culture & Brand Identity: The Company is extremely devoted to its uniquecorporate culture: to make employees, customers feel like they are more than just a business– they are part of a family. In order to do so, the company undertook diverse actions:Southwest extensively invested in its customer service to reduce delays and cancellations, itraised its employee’s wages and provided them with customized training in order to bepromoted, and developed a unique range of commercials based on humor. Consequently,the company has always obtained the lowest complaints ratio per passengers among allmajor U.S. carriers since 1987.Main Challenges: Maintain the quality of its services in recession times: The company is facing a verychallenging business environment,which is why its overall profitability is slumping. Thecompany’s customer policy has always stated it will provide the best experience possible, forinstance not to charge hidden fees for extra bags, fees to take pets onboard, etc. It will geteven more difficult for the company to stick to its policy in recession times, with labor unionclaiming wage increases – jet fuel prices decreasing the profitability and other challenges. Find new ways to differentiate its offer: The airline’s competitive landscape has changedsince the company’s inception: there are more merging companies and that canconsequently focus on low-fare offers, targeting the same market segment than Southwest.The Southwest low cost competitive advantage used to exploit is now questionable. It seemsas though the company will have to broaden its competitive scope in order to gain marketshare.
    • - 4 - Thoroughly integrate the company it took over – AirTran Airways: Southwest acquiredAirTran Airwayson May 2, 2011 for a total transaction cost of $3.2 billion. The company willhave to make choices – it is now able to operate internationally (destinations includingMexico, the Caribbean, and Atlantawhether this fits the companys global strategy or not willhave to be discussed. In addition, the company will have to successfully integrate AirTran’sworkforce into its operations.Business descriptionEstablished in 1967 in Dallas, Texas by Herb Kelleher, Southwest Airlines is the most successful low-cost US airline. The company’s strategy of selling low-cost flights combined with high quality service,customer approach (no assigned seats, no additional fees and flights are always on time), high laborcosts and flying “point-to-point” routes to low-cost airports made the company profitable every yearsince its founding, with a $459 Million net income in 2010. Southwest Airlines currently share 2% ofthe world air value share, employs more than 35,000 employees and flies with 548 Boeing 737aircrafts, with a an average of 3,400 daily departures.Southwest’s Business strategiesCompany Ethics“The mission of Southwest Airlines is dedication to the highest quality of Customer Service deliveredwith a sense of warmth, friendliness, individual pride and company spirit” is Southwest’s missionstatement. Gary Kelly, CEO and chairman of the company since 1986, makes sure that the companyconveys an image of a caring and welcoming airline: in fact, Southwest stock are traded on the NewYork Stock Exchange (NYSE) under the ticker “LUV”, in reference to their headquarters based on 2702Love Field Drive in Texas. LUV has since been a shortened motto for the company, indicating theirlove for customers, love for their employees, and love for the company.Southwest’s initial business strategy was to serve low-cost airports in a few cities in the USA (and inthe USA only), targeting the average traveler with a low traveling-budget: it all started betweenDallas, Houston and San Antonio in Texas. As the business grew, their strategy remained the same:Southwest kept attracting people with its famous no baggage-fee, timely departures, low-fare ticketsand friendly service to name but a few. Today Southwest also targets Business travelers and serves72 cities in 37 states.Although the airline’s strategy is to serve its customers with the lowest prices available, Southwest isknown for its high labor-costs: employees earn a relatively high salary in exchange of devotingthemselves to offering the best service and being hard-workers and treating people in an egalitarianway (some of the many required skills and qualities needed to be a Southwest employee). Fuel cost isthe most important expense and hence the biggest issue in keeping the prices low due to theversatility of the raw material. However, in order to level these uncontrollable events, the companymakes money where it could lose some and makes considerable efforts in adapting its ways to keepprices low: in fact, Southwest does not distribute any meals (only snacks), they don’t assign seats,don’t charge for any ticket change; this is seen through its constant positive financial structure (see
    • - 5 -balance sheet and income statement). The airline also started using electric ground power andinstalled blended winglets in order to reduce draft and increase fuel efficiency.Southwest offers three services: air services, car rentals and hotel reservations. Air services are thebiggest activity for the airline, generating 95% revenue for the company. However, Southwest workswith partners such as Marriott, Best Western and Choice hotels as well as Budget, Avis and Hertz carrental companies to allow customers to build the best travel experience and ease their way throughtheir journey, always offering the best deals at the lowest prices. These partnerships generate 5%revenue.Through InternetSouthwest has a strong internet presence: one can only purchase tickets through the company’sinternet website (Southwest does not work as a charter company: absolutely no tour operator cansell Southwest tickets). This decision reflects their strategy to keep the prices at their lowest (nodistribution costs), enhancing buying convenience and drawing customers into the “Southwest Wayof living”. The website also detects and saves passengers’ preferences according to their latesttravels and reservations in order to make it easier for them to book flights, cars and hotels in thefuture, as well as learning about new needs and wants. Southwest’s home page allowed thecompany to generate 84% of total revenue as of December 2010: the best way for the airline tocommunicate promotions and carry out their marketing campaign. InMarch2011, southwest.com was the largest airline site in terms of unique visitors.The airline not only shares information about the company and its culture and financial data, it alsoaims to build a relationship with its customers through blogs and social media. Indeed, Southwestcreated a blog entitled “Nuts about Southwest” (www.blogsouthwest.com), posting articles of dailyevents from employees, videos, pictures and such. Customers and fans can also participate to theelaboration of the blog, give feedback and share articles. Southwest has more than 1,730 millionfollowers on Facebook, and more than 1,195 million followers on Twitter: the company alwaysmakes sure to update the latest information and answer requests and possible disappointments.Customer CareWhat makes Southwest Airlines so different from other airline companies is that the company iscustomer focused and devoted. Southwest always ensures to provide the best customer service to itspassengers, from departing airport to arriving airport. A way of rewarding customers and gainingbrand loyalty Southwest decided to implement is the “Rapid Rewards Frequent Flyer” program,which gives points to passengers every time they purchase a ticket on the home page. Customers canthen collect points and eventually book a flight thanks to the earned points (the more paid for theticket, the greater the reward).Southwest ensures passengers a comfortable flight thanks to spacious seating, leather chairs, WiFi,snacks and a friendly and funny crew. The aim is to give customers the best flight experience andincrease loyalty. Passengers all benefit from the same services: the egalitarian and democratic aspectof customer care only encourages them to come again. Southwest earned many awards and wasranked “#1 friendliest airline” in 2006 by Times.com and “#1 most Reliable Airline for dependability”from the Forbes magazine in 2008.
    • - 6 -Results from the strategySouthwest’s strategy paid-off in the short and long term, as these following facts and events showbellow.Southwest acquired AirTran Holdings Inc. in September 2010 for $3.2 Billion, allowing the companyto expand its route network throughout the USA (new airports include Atlanta, Logan Airport inBoston and Ronald Reagan in Washington DC) and introduces international routes towards Mexicoand the Caribbean, thus a new strategy for the airline. This acquisition has many positive aspects: it will progressively eliminate some of the East Coast competition giving Southwest morevisibility, access to customers and pricing power; AirTran provides Southwest with expertise on the international environment, 138 newaircrafts and 37 new cities to serve; Attract more business travelers thanks to the newly acquired international airports.Southwest has decided to maintain the “no baggage fee” strategy, as it has been its majorcompetitive advantage, and AirTran will progressively adopt and adapt to the Southwest Culture(Southwest plans on painting the aircrafts and train new employees). The acquisition is expected togenerate $400 million net annual sales through the synergies of the two companies by 2013;however, the total cost of integration in the long-term will cost the company $300 to $500 million.Together, AirTran and Southwest combine and hope to serve more than 125 million customers andplan on reaching $13 billion sales.ShareholdersAs of October 2011, the airline issued 747,434,272 outstanding shares, one share valued at $7.94 onNovember 30th2011. Southwest accounts 4 major investors, namely Capital Research GlobalInvestors (11.5%), Manning and Napier Advisors, Inc. (5.1%), PRIMECAP Management Company(10.5%) and T. Rowe Price Associates, Inc. (9.1%). Over the past few years, Southwest has beenincreasing its stockholder’s equity from 35% in 2008 to 44% in 2010, meaning that the companycontinuously attaches great importance to its shareholders.In conclusion, we can say that Southwest is an outstanding company that passengers andshareholders trust: Southwest was able to increase sales by 17% from 2009 to 2010 in a time ofeconomic crisis and low traveling expenses. The company’s strategy combined with its culture andfinancial structure makes the airline a successful company listed on the Fortune 500 ranking in 2011.
    • - 7 -Porters Five ForcesThe Porter’s five forces model will now be described in order to analyze the profitability of theindustry, hence to estimate the interest for investors to buy company stocks:First of all, it is essential to clearly identify in which market Southwest is operating. SouthwestAirlines is classified by the “North American Industrial Classification System” as a Scheduled AirTransportation company.Threat of New Entrants: (3/5)The threat of New Entrants is quite low owing to various factors: the centralization of the industry,high startup costs, post market entry competition and relatively low earnings of companies in theindustry. Most of the new carriers have failed to succeed in the industry historically, and stoppedoperations: from 2003 to 2006 companies such as Southeast Airlines, Midway Airlines and AlohaAirlines have halted operations. However, although strong barriers to entry are present in the airlineindustry, some airlines have successfully invested in the airline business. For example, JetBlue, whobegan operations in 2000, has become quickly profitable due to a low cost position and high loadfactors.In conclusion, there is a possibility that new competitors could arise in the airline industry, but it isquite unlikely since becoming viable would take years for a new airline.
    • - 8 -Rivalry among competitors (5/5)The rivalry among airline companies is overwhelming, mainly due to the fact that the industry ismade of numerous competitors offering almost undifferentiated services. This intense competition,resulting in a real price war, pushes down the profitability prospects of the industry. As a result,many airline companies have experienced huge losses and some of them even had to facebankruptcy (United Airlines, ATA Airlines). Even though some companies tried to differentiate theirservice (High quality, more comfortable flights, etc.) most of them failed, because the pricesensitivity of customers is so strong that the price war seems inevitable.Many of the currently operating airlines will have to trim their margins in order to gain market shareand remain competitive on the market. In conclusion, the rivalry among competitors is so that theoverall profitability of the industry is very low.Buyer Power (5/5)As explained earlier, the price sensitivity and low differentiation of airline companies are giving thebuyers tremendous power. Moreover, the relatively high number of airline companies and the lowgrowth in customers due to bad business environment reinforce the buyer power. In addition,booking platforms and fare comparators are increasing the amount of pressure on airline ticketsprices, helping increase the buyer power.In conclusion, the buyer power is high due to significant price sensitivity and low brand loyalty,leaving little room for Southwest and other airline companies to maneuver.Supplier Power (4/5)The airline industry is greatly exposed to supplier power, which we have to breakdown into twoparts: fuel and airplanes. Jet-fuel suppliers are constantly pushing up prices or at least maintainingthem, by cutting off production whenever demand for fuel is decreasing. Besides, even when oilprices fall, the jet fuel prices do not systematically decrease as well. Jet fuel suppliers’ power istherefore soaring.On the other hand, current economic conditions have lessened the supplier powerof airframe manufacturers. Airbus and Boeing are highly dependent on airline companies buyingtheir planes and the recent downturn in sales is increasing this dependency.In conclusion, if jet fuel and airframe suppliers’ power is quite high, the decrease in airframes salesand fuel hedging alternatives for airlines are pushing it down.Threat of Substitutes (1/5)Substitutes to flights in the US include bus, car and train transportation. Because of an extensivehighway system in the U.S, travelling by car is possible virtually anywhere in the country. However onlong distance trips, people tend to prefer traveling by plane as the time needed is shorter. Trains alsooffer long distance trips, and have the advantageof being cheaper than flights. However, the slowtravel rate for trains, the limited number of stations and the relative longer trip duration are thereason why train transportation only attracts a small percentage of customers in the US.In conclusion the threat of substitutes is very low and is not likely to increase over the next few years.
    • - 9 -Conclusion (18/25)The industry analysis by Porter’s Five Forces reveals that the airline industry is poorly profitable dueto a remarkable competitive rivalry and the strong supplier power. Nevertheless, the airline marketdemand is quite high and if one steps up and beats the competition, profits could be very high.Therefore investors have to know that investing in an Airline company such as Southwest is quite riskybut potential rewards are significant as well.Industry overviewIndustry Overview and Competitive Positioning:There are many competing companies in the airline industry. We can notice that the four best airlinecompanies are Asian ones, and their capitalization ranges between 13 Billion € and 7 Billion €.However, Southwest is well defending its place by being classified 8th best capitalized company onthe NYSE with 6.29 Billion €.Strengths: Southwest has invested a lot and capitalized on its competitive strengths: the service isalways on time and the airline is a business-friendly company. There is also a positiveorganizational culture which leads to a very high-quality service: some of these factorsinclude a good crew who cares a lot about their customers, a great teamwork and the overallefficiency of the airline. These elements convey a good image to the customer and makethem feel confident about the brand.Strengths Strong position in themarket Many acquisitions High number of passengersWeaknesses Only operating on thedomestic market Dependence on producer Limited offerThreats Fuel-Prices are increasing Strong competition More legal restrictions Terrorism fearOpportunities Many market opportunities Growing market Advancement oftechnology
    • - 10 - Southwest has a strong position as a low-cost carrier in the North American airline market; asa result, customer loyalty is high and the risk of losing customers is low. Southwest accounts an average of 3 400 flights a day and is one of the most profitablecompanies in the US: the consecutive profitability has always been increasing since 2009; thisallows a good and constant inflow and involves fewer risks for the company. The company was the first to launch the ticketless travelling and discounts for senior people.The leadership in this domain reinforces the company’s positive image toward customers.Moreover, there are no additional feesto shift reservation, which enables customers to feelmore confident about their buying power and will purchase tickets more easily. Southwest previously acquired many airlines: Muse Air, Morris Air, ATA airlines and the lastone AirTran, increases Southwest’s capital and helps improving its image and visibilitytowards customers and shareholders. These acquisitions represent an improved access tobusiness travelers and international routes. This is another way for Southwest to boost itsmarket shares. Southwest is listed 8th best capitalized company on the NYSE (New York Stock Exchange),with 6.29 Billion €, another proof of its reliability.Weaknesses: Until recently, Southwest only relied on its domestic market: apart from recent flying routesto Mexico and the Caribbean, there are no direct flights away from the USA. Consequently,the company is missing out on potential customers as it narrows its flights offer, and isexposed to US market risks, risks that could be outweighed if the company had moreinternational presence. The company highly depends on fuel expenses and fluctuations. As the company iscontinuously doing its best to offer low-cost fares,it can never predict future oil price raisesand Southwest has to therefore constantly adapt its way to save money on other expenses. Southwest does not offer many morning flights (before 7 AM) and this can easily discourageearly birds/business passengers from traveling with Southwest. Those elements could lead tocustomer’s dissatisfaction and a loss of market share. Southwest has a single aircraft supplier as it only uses Boeing 737 aircrafts. This can create adependence effect towards the supplier, which increases his power, and can possiblyincrease prices. Since Southwest does not sell its tickets on online booking agencies, it reduces its visibilityand purchasing possibilities.
    • - 11 - Southwest features very good strengths which ensures its strong position in the market;however, Southwest encounters weaknesses which can easily beconverted into strengths bybringing some modifications to its strategy, especially in their offer range.Opportunities: Since the company is targeting business travelers more aggressively, this should boostcoming sales and increase inflows as the US total population is composed of a large activework force. Many national and international markets and airports are still not tapped, which means thatSouthwest can possibly expand to them. Southwest is slowly starting to internationalize itsflying routes, so this opportunity can be approached in the long term run. Industrial technologies have developed and improved, representing new opportunities forthe airline industry; Southwest could take advantage of them to solve current problems andincrease their aircraft technology and efficiency. Traveler traffic should rise from 2011 to 2014; moreover, globalization leads to an increase ininternational tourism and in longer flights. These points give the company good salesperspectives for the coming years. The US airline industry is competent, technologically superior with financial potency andaccess to global market. Southwest can take advantage of it to correct its defects. American Airlines, the third biggest airline on the US market recently declared that it wasgoing in bankrupt: a falling competitor is an opportunity for Southwest.Threats: The American airline market is an intense competitive market due to the expansion of lowcost carriers, and reorganization of competitors. Despite its strong position in the market,Southwest has to compete with all the new entrances which could lead to a loss of marketshare. There are more limitations regarding the terms and legal obligations nowadays therefore thecompany restricted in what it want to do. Terrorism impacts customer trust and can reduce considerably the number of travelersacross the world. This element has to be taken into account in case of internationalization. Many opportunities should make Southwest’s market shares increase easily and someothers can be profitable for the company if it decides to convert its weaknesses. On thecontrary, price of basic expenditures are increasing, consequently making fare-prices forcustomers higher. As globalization is significantly gaining power and the company isclassified as a low cost company, these forces should not have a major impact.
    • - 12 -Competition is getting more intense, as a result, Southwest has to improve its offer andfocus on its competitive advantages to remain profitable.General conclusionIn both conclusions above, we can notice that the positive parts (opportunities and strengths) arealways stronger. Opportunities can be easily profitable for the company and threats can be beaten byusing well-thinking strategies. To conclude, the Southwest SWOT is really positive and forecasts agood future for the company.Financial Analysis2007/2008: 11.78% growth revenue (2007/2010): 18.53%2008/2009: -6.10%2009/2010: 16.95%Analysis of income statement’s performance:Revenues:2007/2008: The revenues grew by 11.78%, with a contribution of 95.8% from passenger, 1.32% fromfreight and 2.88% from other.020004000600080001000012000140002007 2008 2009 2010RevenuesRevenues
    • - 13 -2008/2009: The revenues dropped by -6.10% with a contribution of 95.63% from passenger, 1.23%from freight, and 3.13% from other.2009/2010: The revenues grew by 14.49% with a contribution of 95.23% from passenger, 1.07% fromfreight and 3.64% from other.What we can conclude from these numbers:First, we can say that when the subprime crisis started in 2008, the revenues of the companyimmediately decreased. The inflation has obviously had a great impact on the company’s level ofoperation. But another important fact to take in consideration is that through these four years, thecontribution to the revenue of other factors is growing progressively, while the contribution ofpassengers (the main source of revenues) is declining softly. The conclusion that we can get from thisfact and from the report is that the prices of seats are falling but the number of passengers is still thesame. The company gets its money from other partnerships, such as hotels, car renting, banks…etc. Itemphasizes the change in the company’s strategy. Over the 2007, 2008, 2009, and 2010 fiscal years,South West’s revenues grew by 18.53%.Cost of goods sold:(Salaries, wages and benefits, Fuel and oil, Maintenance materials and repairs,Aircraft rentals, Landing fees & other rentals)2007 2008 2009 2010Cost of goods sold $ 7 081,00 $8 590,00 $8 135,00 $9 062,002007/2008/2009/2010: 21.86%Sales were enhanced followed by an increase of costs of goods sold over the four fiscal years (from2007 to 2010).EBIT:2007 2008 2009 2010EBIT $791,00 $449,00 $262,00 $988,00Growth EBIT 20%EBIT (Earnings before Interest and Taxes) is an indicator of the company’s profitability excludingtaxes and interests and shows the cash flow generated by the operating process. EBIT grew by 20%,roughly in line with revenues (that grew by 18.53%)As we can notice, in South West’s case the EBIT growth is 20% while the revenue growth represents18.53%. We can thus say that interests and taxes change the profitability of the company.Operating margin:The operating margin stands for the margin that the firm earns after all the operating expenses.Thanks to the ratios (excel sheet), this margin shrank by 5.49% from 2007 until 2009, but then roseby 5.63% between 2009 and 2010. Compared to other airlines’ margins, such as United continental
    • - 14 -(for example for 2007/2008: decrease of 19.57%), South West’s one is fairly stable. This fact is a keypoint to take into account as a potential investor.Net profit margin:This margin is meaningful for investors, since it helps to predict the future earnings per share,hencethe expected return. The Net profit margin had the same tendency than the operating margin;it decreased moderately over the first three years (from 2007 till 2009) and then amplified in 2010.Yet again, compared to other companies, the net profit margin fluctuations are quite modest.Therefore the conclusion remains the same for the operating margin: Southwest is a healthycompany for possible investors.Thanks to the operating margin and the net profit margin, Southwest managed to catch up its pre-crisis’s activity levelwithout being as profitable as it used to be.Conclusion for the income statement: Basically, we learnt from the income statement’s analysisthat, even if the company sometimes generates less cash than other competitors, it is overall morebalanced because the variations of its operating margin and of its revenues are narrower aside toother airline companies. A stable company is more attractive for prospective investors.Balance sheet:Accounts receivable days:This amount symbolizes the number of days clients have to pay the company back. Southwest had anaverage account receivable of 7.17 days over the four past fiscal years.Compared toother airline companies, Southwest’s average accounts receivable days is low. Bymaintaining accounts receivable days, firms are indirectly “allowing”clients to benefit from interest-free loans. A low ratio implies that the company should re-assess its credit policies in order to ensurethe timely collection of imparted credit - that is not earning interest for the firm.Indeed, a high ratioimplies that a company operates on a cash basis or that its extension of credit and collection ofaccounts receivable is very efficient. The higher the ratio, the quickerwill a business collect itsreceivables and the more cash will the company have on hand. However, an unusual high ratio couldindicate that the company’s credit terms are tighter than its competitors and that it is running therisk of losing customers.Accounts payable days:APD is an accounting entry that corresponds to an entitys obligation to pay off a short-term debtto its creditors. Just as the Accounts Receivable ratio is used to evaluate a company’s incoming cashsituation, this figure can demonstrate how a business handles its outgoing payments.Southwest has an average of 24.24 days accounts payable over the four fiscal years. Compared to itsmain competitors, this number is low. It usually means that the company is slow in paying itssuppliers. But sometimes, it could be a strategic choice from the company. Indeed high accountspayable ratio is not always in the best interest of a company. Many companies extend the period ofcredit turnover, getting extra liquidity.
    • - 15 -This strategy can be confirmed by examining the quick ratio. Indeed, this ratio indicates whether ornot the company has enough liquidity to cover its short term liabilities. For Southwest, during mostyears, this ratio is inferior to 1. (For instance: year 1: quick ratio=0.63) It means that the companydoes not have enough cash to pay its short term liabilities. This is why it is adjusting its strategy to getmore liquidity.Debt-asset ratio:Indicates what proportion of the company’s assets are being financed through debt. In this case, theratio isalwayskept under 1. This suggests that a majority of its assets are financed by equity ratherthan by debt.Southwest is thus, a very attractive company for potential investors, as it is financing its assets withequity: the risk is therefore lower for investors. A high debt-to-equity ratio will imply significantinterest payments.Enterprise value:It measures the company’s value and also straightforward market capitalization. In Southwest’s case,this value is steadily increasing over the four fiscal years, when competitors’ enterprise value is highlyvolatile: it is very stable and attractive to investors.Price-earnings ratio:This ratio is a key element to investors: it is a valuation of a company’s current share price comparedto its per-share earnings. By relating share prices to actual profits, the P/E ratio highlights theconnection between the price and recent company performance. If prices and profits increase, theratio stays the same. The ratio only fluctuates as price and profits become disconnected.Concerning Southwest, this amount is increasing drastically during the 3 first years and thendecreases during the fourth year: recent profit levels seem to be no longer the main factor in stockpricing. This might be because change is occurring - investors are expecting a much better or worseperformance the next year - or because impressionsare now the dominant factor.Statement of cash flows:Total cash flow has increased from $1.10B in 2009 to $1.24B in 2010. This increase displaysSouthwest’s ability to be self-sufficient with regards to financing. Furthermore, this increase shows ahealthy similarity to the increase in sales growth around 15-20%. In addition, cash flows fromoperating activities have grown steadily from -$1.52B in 2008 to $1.56B in 2010. This can beexplained by the easing of the financial crisis on the airline industry since its severe drop in 2008.Even when comparing with fiscal year 2009, operating activities have increased by 158% in 2010.However, cash flows from investing activities have not experienced a similar rebound. While thisnumber did increase slightly in 2010 to -$1.26B, Southwest’s purchases in this area are continuouslygreater than the sales from the proceeds of short-term investments. While investment cash flowsare often negative for companies of this size, it would be important for future investors to keep an
    • - 16 -eye on this information. This rise in investment spending is largely due to some of Southwest’srecent acquisitions, most notably the purchase of AirTran Airways.In 2010, cash flows from financing activities were also negative. Decreasing from $1.65B in 2008 to -$149M in 2010, Southwest can mainly attribute this decrease to a lack of issuance of long-term debt.Because no further details were given, it is difficult to understand why this occurred.At the end of fiscal year 2010, Southwest saw a positive net change in cash and cash equivalents forthe first time in three years. When this is paired with an increase and a positive total cash flow, it isclear that Southwest is doing a sufficient job in financing activities with its own resources.It is finally important to note the stable increase of the free cash flow margin of Southwest, whichseems to have recovered since the 2008 financial crisis. When compared to other airlines and theindustry median, we see once again that Southwest is outperforming the competition.South west Performance compared to peersIntroductionA good way to assess a company’s performance is to compare it to the industry average and its maincompetitors. “Taking the pulse” of an investment by doing so helps to pick stock. Regardless ofcurrent news, and announcement that have a great influence on stock prices, the company’shistorical profitability and overall performance related to its industry is a good way to estimate itsfuture stock price fluctuation (Rise, straight line or fall).Main CompetitorsUnited Continental Holdings :This Chicago based company is the result of a 2010 merger combining United Airlines andContinental Airlines. In 2010, United Continental had revenue of $23.4 billion. The company fliesextensively in the United States and throughout the world as well. When the merger is finallycomplete, United will have become the world’s largest airline based on revenue passenger miles.JetBlue :Founded in 1999, this airline company appeals to middle and upper class flyers. It has achieved thehighest rankings of any commercial American airline and is the country’s only 4-star airline.However, JetBlue flies to fewer destinations, both domestically and internationally, in comparisonthe other main American competitors.AMR Corporation :Originally known simply as American Airlines, AMR has expanded to include TWA Airlines, AmericanEagle Airlines and Executive Airlines. A traditional American airline with services focused on thedomestic market, American Airlines has experienced significant financial trouble lately and filed forbankruptcy in November 2011.
    • - 17 -ProfitabilitySouthwest has been one of the only airlines to maintain profitability over the last four years despite achallenging business environment (GFC, jet-fuel prices rising). Its four years average profitabilityindicators (Operating, net profit and free cash flow margins, in reference to the excel sheet) are allpositives while most of competitor’s 4 years average indicators are negatives (Avg Net profit margin:-3,4%). In the heart of the crisis, Southwest has definitely outperformed the market – with a netprofit margin of 1,61% (2008) when competitors experienced large losses (12,5% average peer’s netprofit margin). Additionally, its capacity to turn profit into cash is outstandingly greater than its peers(Southwest’s average FCF: 3,46% - Peers average FCF -1,27%).Likewise, the company has a better return on investment than its peers (2,2% and -3,09% for itspeers) meaning that Southwest resources are used efficiently. On the other hand, Southwest’s returnon equity has been lower over the last few years than it’s peers’ (5,52% and 7,72% for the peers) dueto a greater market capitalization. Overall, Southwest’s superior profitability makes it moreinteresting to invest in than its competitors. The fact that Southwest’s profitability is greater than itscompetition is exceptional taking in consideration the fact that it is a bigger company in terms ofmarket capitalization and operations on the US market.Financial LiquidityFirst of all, it is necessary to understand that airline companies tend to have lower levels of liquiditythan other industries due to the high level of capital needed to enter this market. Thus the peer’s 4year average current ratio is below 100% (88,70%), meaning that Southwest’s competitors weretechnically unable to pay off their short term obligations if they had come due at that point. Quitesurprisingly, Southwest has been able to maintain a good current ratio for the airline industry (4yrsaverage : 110) : the company is able to pay off its short term debt by selling off its assets and istherefore less risky than its peers. In addition, Southwest liquidity has improved, the current ratiowent up from 91,84% in 2007 (competitors avg :83,5%) to 110% (competitors avg 88%). Likewise,Southwest 4yrs avg quick ratios, cash ratios and operating ratios are all better than its competition(respectively 88%, 43% and 22% compared to 70%, 30% and 19%). Thus it is apparent that Southwestis more liquid hence less risky than most of its competitors. Moreover, the competitors have anegative 4 yrs avg net working capital ($-1134 M) when Southwest’s 4yrs avg net working capital ispositive ($ 272M) – meaning that Southwest has had extra current asset (ex : cash) that have helpedthe company’s growth when competitors had to finance the negative net working capital by eitherextra debt or equity.From the analysis of the leverage ratios, we can say that Southwest has been more liquid, generatedmore cash from its operations and held more cash compared to its short term liabilities than itscompetitors did over the last 4 years on average. This means that Southwest is less risky, detainsmore cash from its operations and is therefore able to invest more without using debt/equityfinancing compared to its competitors.Financial leverage ratiosIt is very important to look at financial leverage ratios to understand how companies are financed(debt/equity) and the relative importance of assets and earning to the company’s leverage. However
    • - 18 -it has been difficult to take conclusion from the analysis of financial leverage ratios for many reasons:Southwest’s competitors have had very low share prices, making their shareholders equity fall andartificially increase their financial leverage ratio. Using a same reasoning process, their retainedearnings to total assets over the last 4 years is negative due to negative earnings. However, it isimportant to see that Southwest’s financial leverage ratio is quite low (55% over the last 4 years) andits 4 years retained earnings to total assets (33%) indicate that a third of the company’s growth isfinanced by profit, which is a good result. Besides, Southwest 4 yrs avg debt to assets is lower than itspeers (61% compared to 96%) signifying that southwest is less leveraged than its competitors andagain, less risky.We can surely say after a deep analysis of the financial leverage ratios that Southwest is relativelysafer than its competitors due to lower level of debts to equity and a greater value of its assetscompared to its debt. In other words South west is less leveraged than its competitors so it is safer toinvest in the company.Efficiency ratiosEfficiency ratios give a grasp of how efficiently a business uses and controls its assets and how wellthe company manages its suppliers and customers payments. The most significant findings after aprofound analysis are the following: Southwest got paid two times quicker by its customers than itscompetitors over the last four years (days in account receivable: higher level of available cash andtherefore better future prospects. On the other hand, Southwest competitors had lower level ofinventory (Peers 4 yr avg days in inventory: 5 compared to 7,75) revealing a weakness onSouthwest’s inventory management. Efforts will have to be made by Southwest’s management onthis point, but when looking at the global efficiency of the company the outcome is positivecompared to competition.Southwest is having better operating process than its competition, implying that sales will be turnedinto cash more easily through Southwest’s operations than its peers’ operations.Growth RatesGrowth rates give an indication of the future development of a business. However, comparingSouthwest growth rates to its peers is quite delicate due to the fact that most of them had lowoperations level during the GFC (Global Financial Crisis) so they had gigantic growth rates after theend of the GFC. Yet, it is interesting to see that Southwest net income growth has been 3 timesgreater than its peers after the GFC (respectively 360 and 91%). Similarly, Southwest’s free cash flowgrowth has been two times higher than its peers over the last 4 years (167% and 90,7%).Southwest future developments are potentially greater than the majority of its peers (Jet Blue, AMRand United Continental).ConclusionBased on a financial comparison to peers, Southwest is without a doubt a company we advise toinvest in. It has clearly outperformed its main competitors in terms of operating efficiency andprofitability, and at the same time it has been able to keep a low level of risk/leverage. It seems asthough Southwest shows better growth prospects than its competition, and is clearly less risky.
    • - 19 -Investment RisksMarket RisksLike any airline around the world, Southwest’s economic results are heavily influenced by oil prices.When prices of jet fuel increase, airlines either take a hit to their profit margin, or are forced tocharge customers extra for the fuel. The aeronautical industry and the raw materials it supplies toSouthwest are also variable, meaning that prices for these necessary parts could change at any time.Economic Risks:Within the past five years, the United States has suffered due to the economic crisis. This situationmeans that travelers take fewer vacations requiring flights and businesses have cut back on thenumber of flights for meetings and conferences. In addition, almost all of Southwest’s operations aredomestic, meaning if the American economy continues to suffer, so will their business.Business Risks:Southwest distinguishes itself from competitors by offering cheaper flights and friendly customerservice. If the company is unable to maintain this reputation, customers are likely to quickly lookelsewhere. Because Southwest is not providing a unique service, its economic vitality will depend onits efforts to continue its successful business plan and culture. Furthermore, with its recentacquisition of AirTran Airways, Southwest’s future depends on its ability to successfully managethese new operations, particularly in Mexico and the Caribbean.International/Translation Risks:The international risks are limited because of Southwest’s heavy concentration on the Americanmarket. No foreign currencies appear in any of the financial statements. This, in turn, means thatSouthwest has not diversified its services in order to protect against negative domesticcircumstances.General conclusionGoing through this Financial Report, we can say that Southwest is definitely a successful companyproven by the many financial, investment and background. Not only is it listed on the Fortune 500ranking in 2011, Southwest is also classified 8th best capitalized company on the NYSE; two strongreasons for shareholders to trust the airline. During the last few years, Southwest was able to face allkinds of challenges the economy and market have to offer: from the crisis to the rising prices in rawmaterials; in the end, Southwest continuously succeeded in increasing its sales. Moreover, forecastsshow that this tendency will keep on rising for the next years to come. It is true that investing in anairline company can be risky; however, Southwest has already demonstrated its value and itsstrengths by its strong strategy, culture, financial structure and stability. Finally, it seems as thoughSouthwest shows better growth prospects than its competition, and is clearly less risky: this is whywe highly recommend shareholders to invest in this company.
    • - 20 -APPENDICISSouthwest Stock Price
    • - 21 -In million $Year ended31/12/2010Revenues:Passenger $ 11 489,00Freight $ 125,00Other $ 490,00Total Operating revenue $12 104,00Cost and expenses:Salaries , wages and benefits $3 704,00Fuel and oil $3 620,00Maintenance materials and repairs $751,00Aircraft rentals $180,00Landing fees & other rentals $807,00Depreciation & Amortization $628,00Other operating expenses $1 426,00Total operating expenses $11 116,00Operating income $988,00Other expenses (Income)Interest expense $167,00Capitalized interest ($18,00)Interest income ($12,00)Other (gains) losses,net $106,00Total other expenses $243,00Income from continuing operation before income taxes $745,00Provision for income taxes $286,00Net income $459,00Basic net income per common share $0,62Diluted net income per common share: $0,61Southwest Income Statement 2010Impact of Fuel Cost on Southwest Airlines Co Operations
    • - 22 -Cash flows from operating activities 2010Net Income $459Adjustements to reconcile net income to cash provided by operating activities :Depreciation and amortization 628Unrealized loss on fuel derivative instruments 139Share based compensation expenseExcess tax benefits from share based compensation arrangementsDeferred income taxes 133Amortization of deferred gains on sale and leaseback of aircraft -14Changes in certain assets and liabilities :Accounts and other receivables -26Other current assets -8Accounts payable and accrued liabilities 193Air traffic liability 153Cash collateral received from (provided to) fuel derivative counterparties 265Other, net -361Net cash provided (used) by operating activities $1 561Cash flows from investing activitiesPurchases of property and equipment,net ($493)Purchases of short-term investments -5 624Proceeds from sales of short-term investments 4 852Other, netNet cash provided (used) by investing activities ($1 265)Cash flows from financing activitiesIssuance of long-term debtProceeds from (payments of) Revolving credit facilityExcess tax benefits from share based compensation arrangementsProceeds from sale and leaseback transactionsProceeds from Employee stock plans 55Payments of long-term debt and capital lease obligations -155Proceeds from (payment of) credit line borrowing -44Payment of cash dividends ($13)Repurchase of common stockOther, net 8Net cash provided by (used in) financing activities ($149)NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS $116CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 1 096CASH AND CASH EQUIVALENTS AT END OF PERIOD $1 212Southwest Cashflow Statement
    • - 23 -Southwest Stock price variation (in %) and (W&T Offshore.inc – an oil price indicator, in %)
    • - 24 -W&T Offshore.inc stock price (Indicator of oil prices)Data from INFINANCIALS
    • - 25 -
    • - 26 -Profitability 2007 2008 2009 2010Operating margin - Operating Income/Revenue 8,02% 4,07% 2,53% 8,16%Net Profit Margin - Net profit/Revenue 6,54% 1,61% 0,96% 3,79%Free Cash Flow margin : FCF/Revenue 15,35% -22,34% 3,86% 16,97%Return on Assets - Net profit/Total Assets 3,85% 1,27% 0,69% 2,97%Return on Equity - Net profit/Shareholders Equity 9,29% 3,59% 1,82% 7,36%Liquidity RatiosCurrent ratio - Current Assets/Current liabilities 91,84% 94,55% 124,60% 129,47%Net Working capital -Current Assets - Current liabilities (millions) -395 -153 663 974Quick ratio - (Cash + ST investments + AR)/CL 63,21% 71,70% 102,49% 112,95%Cash ratio - (Cash + Cash equivalents)/ CL 45,74% 48,75% 41,34% 38,15%Operating CF ratio - (Cash Flow from operations)/ CurrentLiabilities58,81% -54,85% 36,55% 47,23%Financial leverage RatiosFinancial leverage ratios - Total financial debt/Equity 30,13% 73,91% 64,45% 54,19%Retained Earnings to Total Assets - Earning/total assets 28,55% 34,97% 34,84% 34,92%Debt to Assets ratio -(Total liabilities/Total Assets) 58,62% 64,79% 61,78% 59,67%Efficiency RatiosSales to total Assets - Sales/Total Assets 0,59 0,78 0,73 0,78Days in Account payable - (360*AP)/Sales 27,71 24,62 31,58 37,24Days in Account receivable - (360*AR)/Sales 10,19 6,83 5,88 5,80Days in Inventory- (Inventory*360)/Sales 9,46 6,63 7,69 7,23Growth RatesGrowth of Sales- (2010 Sales - 2009)/2009 8,53% 11,78% -6,11% 16,95%Growth of Net income (2010 Net Income - 2009)/2009 29,26% -72,40% -44,38% 363,64%Growth of Free Cash Flow(2010 FCF - 2009)/2009 Non meaningful Non meaningful Non meaningful 167,00%Valuation RatiosMarket Capitalization (12 months avrg,infinancials) - in Million 8965 6379 8490 9702Enterprise value (MC + Net debt) 8277 8237 9412 9544Price to earnings ratio Market capitalization/net income 13,89922481 35,83707865 85,75757576 21,1372549Enterprise value to Sales-EV/Sales 0,83531082 0,747255738 0,909371981 0,78849967Price/Book RatioMarket capitalization/Shareholder Equity 1,291600634 1,287906319 1,556655666 1,555555556Southwest Ratios
    • - 27 -0%5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100%2007 2008 2009 2010OthersFreightPassenger