1. CFA Institute Research Challenge
Hosted by:
CFA Societies Texas, Louisiana, New Mexico and
Oklahoma
Local Challenge- Southwest US
The University of Texas at Dallas
2. 1 | P a g es
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Share Price and Events
S&P 500 Index Southwest Airlines Target Price
S&P Indexed to LUV Share Price
Pilots’ PicketAirTran Integration
Completed
Wright Amendment
Repeal
AirTran Acquisition
Completed
First International
Flight
737-800’s First
Introduction
Market Profile (as of 02/04/2015)
Closing Price: $37.54
52-Week High-Low: $31.36 / $51.34
Diluted Shares Out. : 679.55 M
Average Volume (6M): 8.441 M
Market Cap: $ 22.78 B
LTM Dividend Yield: 0.76%
Short Interest: $ 14.9 M
Beta: 1.11
EV/EBITDAR*: 5.0 x
P/E*: 12.7 x
Institutional Holdings: 82.94%
Insider Holdings: 0.28%
Key Financials FY 2015 FY 2016E FY 2017E
Revenue: 19,647$ 20,460$ 21,009$
Op. Margin*: 4,132 4,300 3,495
Net Margin: 10.2% 11.6% 9.0%
EPS: 3.26$ 3.76$ 3.20$
ROA*: 8.5% 9.5% 7.4%
ROE: 28.4% 31.0% 23.6%
ROIC*: 20.3% 21.4% 16.7%
Valuation Current Comparable Valuation
Method Price Weights
Comps $30.24 50%
DCF $38.81 50%
Target Price $34.53
Upside/Downside -8.03%
BBB+ Upgrade
NYSE: LUV Recommendation: HOLD
Industry: Airline Current Price: $37.54
Sector: Transportation Target Price: $34.53 (8% Downside)
*Denotes Glossary term
# Denotes Appendix reference
We Don’t Believe in LUV at First Sight
Investment Highlights
We initiate our coverage on Southwest Airlines (LUV) with a cautious Hold
recommendation derived from a price target of $34.53, representing potential
downside of 8%. Our recommendation is primarily driven by the following:
Past Maverick Personality Has Been Key to Success. Southwest has proven
profitable over the last 43 years due to its ability to remain a low-cost leader. As
the low cost airline who pioneered the Point-to-Point (P2P) system, Southwest set
the airline industry standards through its low-cost, no-frill approach. In an
industry where customer service has been ranked one of the worst, Southwest’s
unique strategy, combined with a customer-oriented approach, has separated
Southwest from the crowd.
Safety Saves Sadness, Suffering…and Solvency. The conservative operating
philosophy regarding capacity* expansion and capital structure has fared well for
the low-cost leader. By not following in the footsteps of its rivals’ undisciplined
capacity deployment, Southwest has been able to separate themselves from the
cyclical nature shared by the industry. Management’s commitment to maintain a
low degree of financial leverage reduces insolvency risks by providing adequate
liquidity in economic downturns.
However… Good Airlines Copy, Great Airlines Steal. The recent wave of
bankruptcies have allowed competitors to reorganize their cost structures similar
to Southwest’s. The financial success of Southwest attracted new carriers to enter
the industry and adopt aggressive pricing policies. In the long-run, we believe
Southwest’s ability to maintain its low cost advantage will diminish. We see
convergence of interests among carriers to continue pressuring unit revenues,
which will negatively impact margins.
Labor: Southwest’s New Achilles’ Heel. Southwest’s decades of achievement
and the record profits resulting from fuel tailwinds could revert back to the mean
if the pressing labor issue is left unaddressed. The firm’s success has reached a
crossroads in strategy, forcing an uneasy choice between remaining the low-cost
leader or restoring its employee-first attitude. We see the burdensome impacts of
the expected contracts as a shift in management’s attitude, contributing to
declining employees’ morale and mitigating the firm’s excess returns.
*Multiples adjusted for Operating Leases
This report is published for education purposes only
by students competing in the CFA Institute Research
Challenge
3. 2 | P a g e
0 20 40 60 80 100
Industry
Others
SAVE
FRNT
UAL
ALGT
AA
DAL
ALK
LUV
JBLU
Exhibit 1: LUV's high customer service
satisfaction
23.7%
76.3%
Exhibit 2: 2015 Market Share by Traffic
Demand
LUV Domestic
Scorecard Standards
Strategic Initiatives (25%) Metric Wt. Payout Pct
Airtran Integration 5.0% 150.0%
International 5.0% 150.0%
The 737-800's 5.0% 150.0%
Fleet Modernization 5.0% 150.0%
New Reservation System 5.0% 150.0%
Most Loved (16.7%)
Net Promoter Score 8.3% 11.1%
Employee Satisfaction 8.3% 50.0%
Most Flown (8.3%)
Ontime Performance 8.3% 16.5%
Most Profitable (50%)
Total Operating Revenue 16.7% 150.0%
CASM Ex. Fuel & Profitsharing 16.7% 106.5%
15% ROIC 16.7% 150.0%
Total Executive Payout 111.7%
Name Title Tenure
Gary C Kelly Chairman/President/CEO 7.7
Tammy Romo CFO 3.3
"Mike" G Van De Ven COO 7.7
Jeff Lamb Executive VP 0.5
Robert E Jordan Executive VP 4.3
Thomas M Nealon Executive VP 0.1
Source: Company’s Proxy Statement
Source: Bloomberg, Team Research
Source: American Customer Satisfaction Index
Source: Company’s Data
Business Description
Southwest Airlines (LUV) is headquartered in Dallas, Texas at Love Field Airport. The
company operated their first flight on June 18, 1971. With 49,600 employees,
Southwest transports more than 100 million passengers annually to 97 destinations in
40 states and 7 additional countries. As the nation’s largest domestic carrier,
Southwest operates 3,900 flights daily with a uniform fleet of 704 Boeing 737 aircraft.
In 2014, the company fully integrated AirTran Airways into their operations,
providing Southwest access to the Hartsfield-Jackson International Airport in Atlanta
and increasing capacity by 25%. The company offers several products such as Business
Select, Fly by Priority Lanes, and SWABIZ*. Southwest created the Transfarency®*
philosophy, which ensures customers are treated fairly and provided with the lowest
possible fares. Southwest is the only major carrier to offer bags fly free® and no change
fees. The firm has established a leading network that serves 24 of the top 25 U.S metro
areas. The company provides Point-to-Point (P2P) rather than Hub-and-Spoke
service14, allowing the company to offer more short-haul routes and avoid congested
airports. Coupled with fleet efficiencies, Southwest has reduced aircraft turnaround
times and carries 23.7% of all domestic traffic.
Company Strategies
Fleet Modernization - As of 1/21/2015, Southwest announced an accelerated
fleet modernization program to achieve greater range, new markets and fuel
efficiency by adding the Boeing 737 MAX.
2017 New Integrated Reservation System - The Amadeus system provides
Southwest with a single platform to schedule both domestic and international
flights, leading to higher load factors and capacity utilization.
Networks Under Development – LUV is expanding 5 key airports to increase
flight frequencies in demanding markets (Dallas, Fort Lauderdale, Chicago
Midway, Los Angeles, and New Orleans).
Prudent International Expansion - With the crowd domestic market,
Southwest is looking to expand into Latin America, the Caribbean, Central
America, and Mexico to fuel future growth. International networks account
for ~2% of the firm’s total capacity.
Management & Culture
The Southwest Airlines executive council has provided unusual stability for
Southwest within an industry known for its cyclicality. Gary Kelly, the CEO, been
recognized by his peers for numerous Executive of the Year awards. The company has
posted 43 consecutive years of profitability while also never furloughing employees.
With 83% of its employees unionized, a strong relationship with its employees is
essential to maintaining a positive culture. This resonates through all levels of the
organization, with employees rating Southwest
as one of the top companies in America to work
for.
The Corporate Governance structure is
composed of 10 directors that bring experience
from a diverse range of backgrounds. They range from former corporate executives of
Fortune 500 companies to university professors. This creates an experienced board
that is able to guide management effectively and with a purposeful direction. In order
to retain executive talent, management’s pay scales are based on progress made
towards short and long term goals. These are linked to vested equity shares and stock
options that mature over time based on company performance.
“Our vision is to become the
world’s most loved, most flown, and
most profitable airline.”
– CEO Gary Kelly
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0
1
2
3
4
5
Bargaining
Power of
Suppliers
Bargaining
Power of
Buyers
Threat of New
Entrants
Threat of
Substitutes
Industry
Rivalry
Exibit 3: The Airline industry is fiercely competitive
0%
10%
20%
30%
40%
1998 2001 2004 2007 2010 2013
Exhibit 5: Airlines have streamlined its labor
costs
Labor Other Costs
-2
-1
0
1
2
3
4
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Exibit 6: Z scores spell troubles for major
airlines
AAL DAL UAL LUV
0%
5%
10%
15%
$0 B
$20 B
$40 B
$60 B
$80 B
$100 B
1997
1999
2001
2003
2005
2007
2009
2011
2013
Exhibit 7: Operating margins improved due to
restructuring efforts
Revenue Operating Margin
49.5%
56.2%
21.8%
25.8%
28.7%
18.0%
0% 20% 40% 60% 80% 100%
2010
2015
Exhibit 4: The industry has gone through
significant M&A activitity
Legacy LCC Others
Source: FactSet, Team Research
Source: Bloomberg, Team Research
Source: Bloomberg, Team Research
Source: FactSet, Team Research
Source: Team Research
Industry Overview and Competitive Positioning
The Airline Industry
The Domestic Airline Industry consists of three major types of airline carriers: Legacy,
Low Cost (LCC), and Ultra Low Cost (ULCC). Over the last 12 months, the domestic
industry operated approximately 8 million flights. The industry generates $155B in
revenue, with American, Delta, United and Southwest capturing 76.3% of the total
market. Airline revenues are categorized by both passenger and non-passenger
segments. In 2015, passenger* and non-passenger revenues totaled ~$150.35B and
~$4.65B respectively. Since the early 2000s, the industry has seen a major shift in the
way business is conducted. Airline bankruptcies, acquisitions, and heightened
competition have created an industry where distinct competitive advantages are hard
to come by. With more airlines employing the P2P system, we see the significant cost
advantage once held by LCC’s now diminishing.
Regulation and Changing Industry Dynamics
After the passage of the 1978 Airline Deregulation Act*, the industry has faced
weakened barriers to entry. The net effect is the creation of numerous LCC’s and
ULCC’s, route liberalization, and laissez faire pricing. However, this has contributed
to intensified competition and substantial capacity growth. At the same time, real
costs to travel one mile has been reduced by half since 1979. These factors have
punched many airlines with excess capacity growth and debt-heavy balance sheets a
one-way ticket to bankruptcy court.
The past two decades have been especially harsh on the industry as a result of
economic recessions, surging costs, and terrorist threats. US airlines revenues
dropped from $130.2B in 2000 to $107.1B in 2002 as a result of the September 11th
attacks. Following the oil price shock of 2008, airlines suffered losses totaling $25.9B,
as jet fuel prices reached as high as $126 per barrel (pb), inflating carrier’s expenses
and sharply reducing operating margins. Large carriers, such as Delta, United, and
American, filed for Chapter 11 bankruptcy protection and merged with other airlines.
As part of reorganization, labor concessions accounted for most of the cost structure
savings.
The Altman Z Score was used as a measure to display the insolvency probability of
major airlines during this period. The EBIT/Total Assets ratio is the primary driver of
the low scores, as operating margins fell and were insufficient for the carriers to
maintain sufficient free cash flows (FCF). Southwest remains the exception with an
average Altman Z score of 1.47, which is well above the .36 industry average.
Numerous events have changed the industry for the better. Airlines have put a
stronger emphasis on ROIC improvement and improving their financial positions.
However, given the positives seen throughout the industry, we note most airlines
have stayed below the 1.81 Z-score threshold, showing their vulnerability to
insolvency still exists. We remain cautious of the capital intensity, heavy operating
leverage, and the highly cyclical nature of the airline industry.
U.S Economic Performance & Airline Traffic
In the airline industry, revenue passenger miles* (RPMs) are used as a leading
indicator to estimate future traffic demand. Demand for airlines can be further broken
down in two types of customers: business and leisure. We analyzed several current
macroeconomic indicators, primarily Consumer Sentiment and Corporate Profits. We
ran a regression on the dependent variable Y (traffic) against one independent
variable X (corporate profits/consumer confidence) to test the correlation between
5. 4 | P a g e
-4%
-2%
0%
2%
4%
6%
1986 1991 1996 2001 2006 2011 2016
0
10
20
30
40
50
60
70
Exibit 8: Contracting PMI levels are cause for
concern
PMI Index Real GDP YoY
$0
$20
$40
$60
$80
$100
$120
-1.0 M
-0.5 M
0.0 M
0.5 M
1.0 M
1.5 M
2.0 M
2.5 M
3.0 M
09/13
12/13
03/14
06/14
09/14
12/14
03/15
06/15
09/15
Exhibit 11: Supply Imbalance has driving down
Crude Oil
Supply-Demand Spread (mbpd) WTI Spot Price
0 B
10,000 B
20,000 B
30,000 B
40,000 B
50,000 B
60,000 B
70,000 B
80,000 B
90,000 B
0B 500B 1,000B 1,500B 2,000B 2,500B
Exhibit 9: Coporate earnings are indicative of
airline traffic
-10%
-5%
0%
5%
10%
15%
20%
2010 2011 2012 2013 2014 2015
Exhibit 12: Yields have been pushed down as
carriers respond to low jet fuel
Legacy LCC's ULCC's
0.0%
2.0%
4.0%
6.0%
8.0%
2009 2011 2013 2015 2017
Exhibit 10: Capacity remains competitive
while CASM Ex-fuel is managable
Capacity YoY CASM Ex-Fuel YoY
Source: FactSet, Team Research
Source: Bloomberg, Team Research
Source: Bloomberg, Team Research
Source: FactSet, Team Research
Source: FactSet, Team Research
those factors. Our results show that traffic levels are strongly correlated with these
factors (~84%). Combined with forecasted real GDP of 2.1%, this leads to our view that
the airline industry will continue to enjoy moderate levels of traffic demand. Given
the PMI Index has been below 50 for the last quarter and has ~80% correlation with
non-manufacturing PMI, this could lead to a plunge in the service sector4. The dip
signals a cause for concern that the U.S. economy is entering another possible
slowdown, which will hurt consumer spending and ultimately airlines’ revenues.
Capacity
Favorable industry conditions, such as lower oil prices and slowly improving
domestic macroeconomic trends, have kept industry-wide Cost per Available Seat
Mile excluding-Fuel* (CASM ex-Fuel) growth under the global inflation rate of 3%
(Appendix 4). This, combined with changing industry dynamics and heighted
competition, has resulted in competitive capacity expansion. Recently, international
capacity growth has been restrained by unstable markets in Latin America and Asia.
In particular, Latin America has experienced weaknesses in core markets such as
Brazil and Argentina. In terms of supply and demand alignment, Europe appears best
positioned due to more effective networks resulting from the three major Alliances32.
In the domestic market, the 2014 Wright Amendment Repeal paved the way for more
freedom to operate non-stop flights not permissible before*. As legal protection to
legacy carriers was repealed, LCC’s and ULCC’s were the beneficiaries of capacity
growth opportunities. Moving forward, we see moderate increases in near-term
capacity of approximately 4% due to the competitive environment and a shifting
strategic approach to capacity deployment.
Oil: A Double-edged Sword?
Over the past year, crude oil prices have fallen from a high of $65 per barrel to a near-
record low of $31 (as of January 25th, 2016). Industry averages for jet fuel price per
gallon have fallen 44% from the previous peak, contributing to industry margin
expansions of 4%. With the supply of oil outpacing demand in the near future, fuel
prices are likely to remain low17. Inventory levels have risen two consecutive years as
a result of elevated production levels including OPEC and the U.S. With weakening
macroeconomic trends and consumption in major economies, oil prices have suffered
from downward pressures. The oil windfall has allowed airlines to increase
shareholder returns and alleviate debt obligations. These decisions reflect improving
confidence in sustaining margins and enhancing free cash flow. The favorable trend
has created ROIC levels above the cost of capital not seen previously. We expect short-
term oil prices to remain near current levels unless substantial cuts in production are
made, or market fundamentals change. Additional information regarding oil can be
found in Appendix 17.
Pricing and Passenger Unit Revenue (PRASM)*
Low fuel prices have put downward pressure on yields. Industry supply growth has
been driven mostly by LCC’s who have taken advantage of fuel savings. In addition,
legacy carriers have responded by slashing prices to increase domestic traffic and
remain competitive against LCC’s and ULCC’s. Fuel tailwinds have allowed carriers
to restore previously unprofitable routes, expand into new markets, and prolong
retirement schedules for older aircraft. Airlines remain cautious about oil prospects
and relative positioning in the current cycle. The focus on disciplined capacity
expansion should help stabilize pricing in the near term but the competitive nature of
the industry will continue to drive prices lower over time, all else held constant. Since
6. 5 | P a g e
2005 America West
/US Airways Merger UAL/Continental Merger
DAL/Northwest Merger 2011 LUV/AirTran Merger
2008
Financial Crisis
20109/11
2001
AAL/TWA Merger
2001
2016
Terror Attacks
MetroJet Liquidation
0
1
2
3
4
5
Strengths
Opportunites
Weaknesses
Threats
Exhitbit 15: Southwest has faced with outsized
threats from the industry
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
03/06 10/07 05/09 12/10 07/12 02/14 09/15
Exhibit 13: PRASM has benefited from prudent
capacity expansion
PRASM Fuel Cost pASM Labor Cost pASM
0%
10%
20%
30%
40%
50%
03/01 08/03 01/06 06/08 11/10 04/13 09/15
Exhibit 14: Labor still remains one of the
costliest expenses for airlines
Wages Fuel Other Costs
-10%
0%
10%
20%
30%
40%
03/06 08/08 01/11 06/13 11/15
Exhibit 16: Capacity has been prudently
deployed to match travel demand
ASM YoY Growth RPM YoY Growth
-20%
-10%
0%
10%
20%
03/02
06/04
09/06
12/08
03/11
06/13
09/15
12/17
Exhibit 17: Yields have been depressed due to
heightened competition
Source: Bloomberg, Team Research
Source: Company Data, Team Research
Source: Team Research
Source: Bloomberg, Team Research
Source: Company Data, Team Research
the 2008 recession, Passenger Revenue Available Seat Miles (PRASM) has increased
16.2% from 10.23 to 11.89 cents as a result of prudent capacity expansion. This year,
the industry has experienced a decline in PRASM, largely due to the combination of
capacity increases and lower fares. Moving forward, we see capacity growth to likely
be in line with GDP and in the short term, a stabilized pricing environment.
Cost Structure Trends
Firms are continuing to shore up balance sheets, taking advantage of current fuel
saving trends. The shifting strategies provide a way for airlines to focus on baseline
unit revenues and alleviate insolvency uncertainty. Although all players in the airline
industry are seeing margin expansion, those whose have the highest operating
leverage are benefiting the most. While airlines are experiencing decade-low oil price
levels, labor still represents one of the largest costs for the industry. The passage of
the 1926 Railway Labor Act enabled industry employees to unionize and exert
significant influence in the wage-negotiating process*. All of these factors have forced
airline companies to allocate a bigger portion of their current profits to their
employees in the form of profit sharing plans and wage hikes.
Investment Summary
We initiate our report with a cautious Hold recommendation on Southwest Airlines
with a target price of $34.53. Our price target came from the use of Discounted Cash
Flow Analysis and Relative Valuation. Our recommendation is based upon
Southwest’s competitive advantages, a favorable business environment, and
considerable uncertainties as discussed below.
Upside: Yield & Capacity - Recently, competitive pressures and acceleration in
quarterly capacity of 8% has driven yields* down by 7%. Though passenger revenues
increased by 3%, this was offset by total increase in traffic of 11%. The change in yield
has fallen into negative territory, and the rest of the industry has suffered as well due
to competitive pricing. Over the last 10 years, Southwest has been able to increase
yields 3% on a CAGR basis. We attribute this increase to better yield management29
and disciplined capacity expansion. Specifically, the effectiveness of seat allocation
among leisure and business customers has supported the firm in minimizing the effect
of empty and oversold seats. The combined effect of improved revenue management
and prudent capacity deployment has resulted in higher load factors over time
without the need to add many additional aircraft. We expect yields to improve in
2016 because of pricing stabilization from the 5% market-under-development
maturity.
Passenger Revenue Available Seat Mile (PRASM) - Over the last year, Southwest
has been faced with significant pricing pressure due to aggressive pricing strategies.
All of their major markets have seen increases in flight frequencies and lower average
yields. In the short-term, we expect prices to be more stable, as domestic capacity
decelerates closer to the rate of GDP. As the AirTran acquisition and Dallas markets
mature, Southwest is favorably positioned due to more stable corporate travels and
close-in bookings. We believe the risk of a potential oil spike will eventually push the
industry to raise their prices to offset constricted margins. Along with the new Chase
deal31, PRASM will see a distortion and then an improvement of 2%, as accounting
changes have allowed for faster revenue recognition.
7. 6 | P a g e
-5%
0%
5%
10%
15%
20%
25%
(1,500)
(1,000)
(500)
0
500
1,000
1,500
2,000
'05 '07 '09 '11 '13 '15 '17
Exhibit 21: EVA has seen significant gains from
favorable economic conditions
EVA WACC Adjusted ROIC
$200
$250
$300
$350
$400
$450
$500
1979 1986 1993 2000 2007 2014
Exhibit 23: Fares in real dollar have halved
due to competitive pricing
0 %
10 %
20 %
30 %
40 %
50 %
60 %
70 %
FY05A FY07A FY09A FY11A FY13A FY15A FY17E
Exibit 19: Southwest has kept its Debt to
Capital in a managable range
0%
10%
20%
30%
40%
12/18
12/15
12/12
12/09
12/06
12/03
12/00
12/97
Exhibit 20: Southwest's pay scale has been
significanly above the industry average
Industry Wages LUV Wages
-5%
0%
5%
10%
15%
20%
FY06A FY09A FY12A FY15A FY18E
Exhibit 18: Depressed PRASM is expected to
see a distortion before an improvement
Source: Bloomberg, Team Research
Source: Team Research
Source: Bloomberg, Team Research
Source: Company Data, Team Research
Source: Company Data, Team Research
Lean Cost Structure - Historically, Southwest has offered P2P service, rather than
Hub-and-Spoke. By choosing this strategy, Southwest has been more cost-effective by
operating one major Dallas headquarters and several key cities similar to traditional
“hubs.” Combined with a single 737 fleet, this business model has supported
Southwest to fly more frequently compared to other industry members. Southwest
has more operational flexibility due to lower maintenance and facility costs. They are
able to pass on these savings to consumers in the form of low fares.
Investment Grade Balance Sheet - One of Southwest’s top priorities has been
maintaining the strength of its balance sheet. Debt to Capital, adjusted for operating
leases, has averaged 50% over the past 10 years27. Southwest is better-positioned to
maintain adequate liquidity that protects them from exposure to the cyclicality of the
industry. The firm’s ability to proactively manage debt levels mitigates pressures
faced by many highly leveraged competitors. Given we are at the later stages of the
macroeconomic cycle, Southwest is better positioned to withstand economic
downturns and avoid insolvency compared to its peers.
Downside: Labor Cost Uncertainty - Ongoing labor negotiations are expected to
result in significant wage hikes. Southwest has been unable to reach conclusive
agreements with major unions representing pilots, flight attendants, and ground
crews. Labor expenses, including profit sharing, have traditionally been 10% higher
than the industry average. Although Southwest typically has had good relations with
their employees in the past, recent failed negotiations have indicated that expectations
are not perfectly aligned5. We see the increasing tension as a pressing issue since the
pilot union has elected a new President and picketed outside of Love Field on
February 3th, 2016. We believe generous pay increases from rival airlines will play a
significant factor in current contract deliberations. With three legacy carriers recently
approving new compensation plans5, Southwest is expected to match these
agreements to maintain their competitive pay scale. Total compensation is expected
to grow by double digits, which will have a net effect of ~370 bps on CASM ex-Fuel in
our Base Case.
Economic Value Added (EVA) - Since 2013, Southwest has experienced a 12.1%
increase in ROIC adjusted for operating leases and net impact from ineffective fuel
derivatives1. Historically, Southwest had a cost of capital that was greater than its
ROIC. The turnaround is largely the result of major one-time events or prevailing
market conditions. Following the repeal of the Wright Amendment, Southwest has
added 60 additional flights to its network at Love Field. The AirTran acquisition
helped Southwest achieve their goal of pre-tax ROIC greater than 15% and also realize
$400M in net synergies. Although EVA has been positive, oil is a significant driver of
the positive returns. We view continued gains in EVA to be unsustainable and could
drop from current levels in the long term. Decline in EVA can be attributed to 1)
heightened industry competition as a result of improving financial positioning and
more aggressive strategies, 2) restraining effects from the increased hedging positions
and 3) material escalation in labor expenses resulting from the unsuccessful on-going
negotiations.
Declining Competitive Advantage - After the 1978 Deregulation Act, airlines have
found it increasingly difficult to maintain a strong competitive position. For
Southwest, deregulation has shown to be a double-edged sword since the industry is
diluted with hundreds of new carriers and transferred pricing control from the
government to carriers. Since 1979, average ticket fares have declined in the industry
by approximately 70.2%. Although Southwest initially disrupted the industry with its
effective use of P2P system, many competitors have mimicked their pricing model and
developed similar P2P networks. Recent restructuring efforts among legacy carriers
have allowed them to reorganize their cost structures, which contributes to higher
8. 7 | P a g e
North America
Short-haul -1.5
Long-haul -1.4
Short-haul -0.9
Long-haul -0.8
Market level
National level
18%
7%
-8%
-16%
-38%
-53%
8% -11%
0.00
2.00
4.00
6.00
8.00
10.00
12/2009 09/2015
Exhibit 22: CASM ex-Fuel: Does LUV really
remain its cost advantage?
Legacy LCC ULCC LUV Industry
0
1,000
2,000
3,000
4,000
5,000
6,000
FY05A
FY06A
FY07A
FY08A
FY09A
FY10A
FY11A
FY12A
FY13A
FY14A
FY15A
Exhibit 24: Historical EBITDAR
Source: International Air Transportation Association
Source: Company Data, Team Research
Source: Bloomberg, Team Research
levels of industry rivalry. We believe the new favorable operating environment
among legacy carriers and converging market interests of market participants will add
more pressure to the already cutthroat competitive environment.
Financial Analysis
Overview
The financial analysis table highlights Southwest’s strong historical operating
performance and displays our future concerns. The EBITDAR margin has expanded
by 388 bps on average since 2012. The growth is directly related to lower fuel costs
and delayed labor negotiations. Our Base Case forecasts oil prices of $45-$55-$65 per
barrel in the next 3 years as oil inventories continue to remain elevated.
Profitability - FASB’s future accounting standards will change how to record
operating lease treatment, so we adjusted our metrics and capital structure
accordingly12. Wealso made a significant adjustment to add back net operating leases
instead of aircraft rentals given the significance of gates, slots, and terminal lease
expenses12. This effectively raised our operating income, inflates assets, and magnifies
long-term debts, which provides a more accurate ROIC . In the medium to long term,
the supply shortage of skilled labor and rising cost of doing business will remain a
challenge for Southwest. The likely recovery from the dramatic decline of oil and
increased hedging positions also play a limiting effect in future profitability. We note
cuts in SG&A contribute little to profitability given their already low levels.
In general, we see leisure travelers as more price sensitive to price changes than
business travelers, and short-haul routes’ price elasticity are generally higher than
those of long-haul routes, all else constant. Though higher disposable income and
currently low fares have supported air travel demand, the marginal cost of flying has
been reduced, which remains a challenge for Southwest’s profitability.
Efficiency - A multi-year reservation system upgrade allows Southwest to compete
on a more equal basis with other competitors. The net effect will boost the firm’s
ability to deploy seats, manage inventory, and initiate code-sharing*. At the same
Financial Ratios FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E
Profitability Ratios
Return on Assets 1.0% 2.0% 3.4% 5.1% 8.5% 9.5% 7.4% 6.6%
Return on Equity 2.7% 6.1% 10.5% 16.1% 28.4% 31.0% 23.6% 22.0%
Return on Invested Capital 6.1% 4.4% 8.4% 14.9% 20.3% 21.4% 16.7% 15.2%
Efficiency Ratios
Total Asset Turnover 0.9 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x
Fixed Asset Turnover 1.2 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 x 1.0 x
Margin Analysis
Gross Margin 18.4% 16.6% 19.4% 24.4% 31.6% 31.3% 27.1% 25.8%
SG&A Margin 12.0% 11.9% 12.0% 11.9% 11.4% 12.0% 12.0% 12.0%
EBITDAR Margin 13.4% 13.4% 16.1% 21.0% 28.9% 27.4% 23.3% 21.6%
EBIT Margin 7.3% 5.5% 9.1% 14.0% 21.0% 21.0% 16.6% 14.8%
Net Income Margin 1.1% 2.5% 4.3% 6.1% 10.2% 11.6% 9.0% 8.1%
Short Term Liquidity
Current Ratio 1.0 x 0.9 x 0.8 x 0.7 x 0.6 x 0.5 x 0.5 x 0.4 x
Cash Ratio 0.7 x 0.6 x 0.6 x 0.5 x 0.5 x 0.3 x 0.4 x 0.3 x
Coverage Ratios
Total Debt/EBITDAR 1.8 x 1.4 x 1.0 x 0.7 x 0.6 x 0.5 x 0.8 x 0.8 x
EBITDAR/Interest Expense 11.6 x 18.2 x 26.7 x 36.6 x 63.7 x 43.1 x 35.7 x 28.5 x
Leverage Ratios
Total Debt/Equity 79.8% 103.2% 79.9% 78.8% 93.3% 70.5% 82.5% 79.7%
Total Debt/Capital 47.6% 55.1% 49.5% 49.3% 54.3% 44.9% 51.3% 48.5%
Total Liabilities/Total Assets 55.9% 50.7% 53.1% 57.9% 55.8% 56.8% 59.0% 59.7%
9. 8 | P a g e
0%
20%
40%
60%
80%
100%
2011 2012 2013 2014 2015
Exibit 25: Airborne Rates bounced back to
normal levels
Airborne/Block Hours* On-time Arrival Rate*
0%
2%
4%
6%
8%
10%
12%
14%
2011 2012 2013 2014 2015
Exhibit 26: LUV still lags behind the industry in
on-time arrival
Southwest* Industry*
Valuation Current Comparable Valuation
Method Price Weights
Comps $30.24 50%
DCF $38.81 50%
Target Price $34.53
Upside/Downside -8.03%
Terminal Value - Perpetuity Growth Method
Implied Terminal EBITDAR Multiple: 6.34 x
Terminal Value: 29,902
Terminal FCF Growth Rate: 2.50%
PV of Terminal Value: 24,333
Present Value of FCFF: 5,751
Implied Enterprise Value: 30,083
Plus: Cash & Cash-Equivalents: 3,050
Less: Total Debt & Capital Leases: (6,866)
Less: Pension: -
Implied Equity Value: 26,268
Diluted Shares Outstanding: 679.55
Base Case Implied Share Price: $38.65
Premium / (Discount) to Current: 2.97%
Source: Team Research
Source: Team Research
Source: Department of Transportation, Bloomberg
Source: Department of Transportation
time, Southwest is accelerating its fleet modernization effort by retiring its 129 Classics
by 2018 and exercising their option to add more energy-efficient Next-Generation
aircraft. Acceleration of the retirement program will lead to higher efficiency, simplify
maintenance costs, and result in estimated long-term savings of 6.2%. Newer aircraft
will require less down time and allow aircraft to fly longer hours, which reduces
operational costs and drive passenger unit revenue.
Southwest has Airborne/Block Hours back to normal level of ~85% after the AirTran
acquisition in 2011. Despite having Airborne and On-time Arrival Rates more in-line
with the industry in 2015, Southwest’s aircraft’s Arrival Rate of 8.77% is still 34%
higher than the industry average. These delays, which require additional increases in
fuel, crews, and maintenance, are costly for future growth.
Liquidity - Southwest has established a trusted reputation in the credit markets due
to its conservative balance sheet approach. The ability to service their interest
payments and debt principal has provided Southwest with a privileged revolving line
of credit. Easier access to liquidity has supported the company’s normal business
activities, especially when the market turns for the worst. Southwest’s near-term
liquidity should not be a concern. Nevertheless, given we believe we are in the later
stages of the current cycle, we are concerned with the company’s ability to generate
healthy free cash flow to cover all of its debt obligations and fund its operations.
DuPont Analysis - Southwest achieved a ROE of 28.4% in 2015. This increase was
primarily achieved from profit margin improvements. Looking forward, we forecast
that profit margin gains will not be sustainable based on dwindling impact of the
currently favorable business environment.
Valuation: Is LUV Soaring? At What Price?
To value Southwest, we utilized 3 valuation methodologies. We combined both
intrinsic and relative valuation methods, primarily a Discounted Cash Flow Model
and Company Comparable Analysis. The Liquidation Valuation Method also
provides insight into the absolute lower bound liquidation scenario.
DCF Model (50%) - Our valuation model projects FCF for the next 3 years and
assumes terminal growth to be in-line with GDP growth of 2.5%. Given the highly
cyclical nature of the airline industry, we deem a 3-year projection is sufficient before
growth stabilizes. EBIT is adjusted for operating leases due to their debt-like
attributes, which distorts EBIT and in turn intrinsic valuation18.
Our valuation model considers EBITDAR a better proxy for cash flow instead of
EBITDA. We considered the full impact of operating lease expenses rather than just
aircraft rentals, since facility rentals and terminal operation leases are critical to
normal business operations. Given the highly competitive and cyclical nature of the
industry, we see Southwest’s EV/EBITDAR to move closer in-line with the historical
average. In the process of the EV/EBITDAR calculation, we analyzed the last two
business cycles and eliminated abnormal outliers. We reached a terminal multiple of
6.3x that we think is reasonable considering longer-term trading.
Financial Ratios FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E
DuPont Analysis
Net Income Margin 1.1% 2.5% 4.3% 6.1% 10.2% 11.6% 9.0% 8.1%
Total Asset Turnover 0.9 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x
Equity Multiplier 2.8 x 3.0 x 3.1 x 3.2 x 3.4 x 3.2 x 3.2 x 3.3 x
ROE 2.7% 6.1% 10.5% 16.1% 28.4% 31.0% 23.6% 22.0%
10. 9 | P a g e
Comparable Valuation
Multiple Turn Price
2016E EBITDAR: 4.4 x $30.47
2017E EBITDAR: 4.5 x $26.64
WACC, Comparable Capital Structure: 6.55%
WACC, Current Capital Structure: 7.68%
Average WACC: 7.11%
WACC, Optimal Capital Structure: 7.60%
Cost of Capital
Risk-free Rate: 2.25%
Market Risk Premium: 5.00%
Beta: 1.33
Cost of Equity: 8.90%
Default Spread: 2.00%
Pre-tax Cost of Debt: 4.25%
Cost of Preferred Stock: 0.00%
Normalized P/E Valuation
Comparable P/E: 24.7 x
Normalized EPS (LUV): 1.37$
Implied Price (LUV): 33.84$
0.0 x
5.0 x
10.0 x
15.0 x
20.0 x
25.0 x
FY05A
FY06A
FY07A
FY08A
FY09A
FY10A
FY11A
FY12A
FY13A
FY14A
FY15A
FY16E
FY17E
Exhibit 27: Historical and Projected
EV/EBITDAR
Implied Weighted
DCF Case Weight Price Price
Base 60% $38.54 $38.81
Downside 20% $23.72
Upside 20% $54.70
Passenger Revenue per ASM (PRASM)
-3.5% -3.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5%
-2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0%
25.00$ 1.21$ 34.15$ 36.22$ 38.32$ 40.44$ 42.58$ 44.74$ 46.92$ 49.12$ 51.34$
30.00$ 1.30$ 33.11 35.19 37.28 39.40 41.54 43.70 45.88 48.08 50.31
35.00$ 1.39$ 32.07 34.15 36.25 38.37 40.51 42.67 44.85 47.05 49.27
40.00$ 1.48$ 31.03 33.11 35.21 37.33 39.47 41.63 43.81 46.01 48.23
45.00$ 1.57$ 30.00 32.08 34.17 36.29 38.43 40.59 42.77 44.97 47.19
50.00$ 1.66$ 28.96 31.04 33.14 35.25 37.39 39.55 41.73 43.93 46.16
55.00$ 1.75$ 27.92 30.00 32.10 34.22 36.36 38.52 40.70 42.90 45.12
60.00$ 1.84$ 26.89 28.96 31.06 33.18 35.32 37.48 39.66 41.86 44.08
65.00$ 1.93$ 25.85 27.93 30.03 32.14 34.28 36.44 38.62 40.82 43.04
JetFuel
Source: Team Research
Source: Team Research
Source: Bloomberg, Team Research
Source: U.S. Treasury, Damodaran, Team Research
Source: Team Research
Weighted Average Cost of Capital (WACC) - We considered both the near-term and
terminal phases in our calculation for WACC. The cost of equity is estimated using
the CAPM model, which estimated cost of debt by adding BBB+ default spread to the
10-year Treasury bond. We calculated the first-phase WACC by taking the average of
unlevered comparables’ betas and adjust for cash, arriving at our initial period WACC
of 7.11%. In the terminal period, we assume Southwest to move more in-line with the
market, which accounts for our adjustment of Beta to 1. Combined with an adjusted
equity risk premium, this returns a terminal-period WACC of 7.60%.
Relative Valuation (50%) - Our set of comparable companies consists of North
American airlines with market capitalizations and revenues over $1.5B. We eliminated
firms with incompatible business models and market share in key routes. Our relative
valuation emphasizes two valuation multiples:
1) EV/EBITDAR: EV/EBITDAR is a more meaningful multiple as it is adjusts for
industry-specific charges and excludes depreciation, rental and interest expenses. This
provides a more standardized approach for the airline industry.
2) Normalized P/E: We normalized peers’ earnings over the length of the current
business cycle to avoid distortion and more accurately compare market perception.
P/E multiples are normalized by combining earnings for merged carriers and
smoothing earnings over the period for other carriers9. Multiples are then applied
against Southwest’s normalized EPS. Although Southwest has been traded at a
premium, we think it should be traded in-line with the industry given its declining
competitive advantage.
Sensitive Valuation Factors & Other Consideration
Growth - To estimate Southwest’s ability to generate future free cash flows (FCF), we
analyzed Southwest’s historical Reinvestment Rate over the last 10 years. Growth in
EBIT after the impact of reinvestment needs is the key driver of future FCF generation.
Given its capital-intensive nature, we calculate that Southwest has to reinvest 80% of
its EBIT on average to sustain current operating activities. This incorporates growth
assets such as next-generation aircraft and airport facilities. The large level of
reinvestment leads to lower FCF, debt financing, and thus potentially lower value.
Operating Expenses - Southwest operates in an industry that is heavily influenced by
large fluctuations in oil and labor expenses. Although Southwest has generated an
influx of free cash flows due to the windfall provided by lower oil prices, these levels
are not sustainable. The rise of these expenses can prove detrimental to the company’s
normal business operations, FCF yield and in turn, intrinsic value.
Liquidation Valuation - We do not put emphasis on the Liquidation Valuation for
our target price. However, given the cyclical nature of the industry and historical
bankruptcies, we take into consideration a liquidation scenario. We consider the low
and high values that shareholders will receive if all assets are liquidated to repay all
liabilities. The method returns a price range of $6.33 - $7.8310.
11. 10 | P a g e
High
OR1
OR2 MR2
MR3 MR1
OR3 UC
Low
Low Medium High
Impact
Medium
Probability
Risk Mitigating Factor
Operational Risk
Balancing Employee
Compensation
Meaningful labor
negotiations
Lower Growth
Opportunities
Disciplined capacity
expansion
in-line with travel
Loss of BBB+ Credit
Rating
Maintain capital structure
target
Market Risk
Economic Risk Defensive business tactics
Commodity Price
Volatility
Sensible long-term
hedging strategy
Hedging Risk Necessary ongoing
adjustments
Other Considerations
Uncertain Catastrophes Effective contingency
plans
Ability to act swiftly in
catastrophic situations
Source: Team Research
Source: Team Research
Investment Risks
Operational Risks:
Balancing Employee Compensation (OR1): Southwest always prides itself in maintaining
excellent employee relations. However, pending labor negotiations and silent
stoppages attributable to poorly-paid compensation are strong indicators that the
employee-first culture is decaying. It is very important that a balance is struck, which
offers a competitive pay scale yet provides enough flexibility to maintain its low cost
structure. If a cost-effective contract is not agreed upon, Southwest’s impressive
earnings and ROIC will be put at risk.
Lower Growth Opportunity for Expansion (OR2): Southwest is faced with limited
domestic growth opportunities. Given low growth opportunities, Southwest will look
towards international expansion, exposing them to outsized risks including foreign
government regulation, exchange rates, and fuel surcharges. LUV will need to follow
a disciplined international capacity strategy to maintain their position as a low cost
provider and ensure the transition from domestic to international carrier is successful.
Loss of BBB+ Credit Rating (OR3) – A sudden lowering of Southwest’s credit rating
would increase interest rates required on new loans to finance new projects and signal
that the firm’s strong historical financial position is weakening.
Market Risks:
Economic Risk (MR1): Southwest operates in an industry that is heavily exposed to
prevailing economic conditions. Tepid global growth constrains revenue by reducing
traffic demand and depressing fares. A high degree of operating leverage and elastic
travel demand magnifies the effects from downward economic pressure.
Commodity Price Volatility (MR2): Southwest is subject to risk associated with large
swings in the price of commodities such as crude and heating oil. As low fuel prices
contribute to margin expansion, the price of commodities plays a key factor in
maintaining profitability. Oil prices are dependent on the alignment of global supply
and demand. We view the following factors contributing to global oil prices:
substantial cut backs in production levels, increased demand for oil, supply-chain
disruptions, dwindling inventory levels, geopolitical tension, and coordinated
production among OPEC and Russia.
Hedging Risks (MR3): Although hedging provides insurance against extreme volatility,
the opportunity costs of these hedging positions are substantial. If the oil price
significantly increases in the near-term, Southwest’s current strategy of unloading
hedging position would prove ineffective. Management’s miscalculation of future oil
prices are costly to the firm’s operations. In the near-term, Southwest is significantly
exposed with a sharp rise in oil prices.
Uncertain Catastrophes (UC):
Southwest is highly susceptible to adverse effects outside of its control: Extreme
weather, disease, terrorism, war, cybersecurity, and environmental regulation can all
impact operations. The public’s perception of major events hinders the demand for air
travel and can negatively impact the stock and company’s performance.
12. Disclosures:
Ownership and material conflicts of interest:
The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company.
The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the
content or publication of this report.
Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue.
Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board
member of the subject company.
Market making: The author(s) does not act as a market maker in the subject company’s securities.
Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the
author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or
completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information
does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be
considered to be a recommendation by any individual affiliated with CFA Societies of Texas, Louisiana, and Oklahoma CFA Institute or the
CFA Institute Research Challenge with regard to this company’s stock.
13. 11 | P a g e
Index
Glossary of Terms
Terms Description Equation
Aircraft Utilization
Measures aircraft productivity, usually
presented as Block Hours per Day
Aircraft Block Hours / Number
of Aircraft Days
Available Seat Miles (ASMs)
Measures one aircraft seat flown one mile,
whether filled or unfilled
One Aircraft Seat x One Mile
Flown
Capacity (Total ASMs)
Measures the total available seat miles of an
airline, used to indicate supply of seats
Total Available Seat Miles
Chase Credit Card Deal
Block Hour
Cost per Available Seat Mile
(CASM)
Measure of unit cost
Operating Expenses / Available
Seat Miles
CASM ex. Fuel Measures unit costs excluding the cost of fuel
(Operating Expenses - Fuel
Expenses) / Available Seat
Miles
CASM ex. Fuel & Profit-sharing
Measures unit costs excluding the cost of fuel
and profit sharing expenses
(Operating Expenses Ex-Fuel &
Profit-sharing) / Available Seat
Miles
Form 41 Data
Load Factor
Represents the percentage of seats filled on an
aircraft
Revenue Passenger Miles /
Available Seat Miles
Passenger Revenue
Passenger Revenue per Available
Seat Mile (PRASM)
Measures passenger unit revenue
Passenger Revenue / Available
Seat Miles
Passenger Yield
Measure of average fare paid per mile per
passenger
Passenger Revenue / Revenue
Passenger Miles
Revenue per Available Seat Mile
(RASM)
Unit revenue
Total Revenue / Available Seat
Miles
Transfarency
Traffic/Revenue Passenger Miles
(RPMs)
Basic measure of airline traffic, represents
how many of an airlines available seats were
sold
Passenger Seats Sold x Total
Miles Flown
Revenue per Employee
A measure to determine an airline's labor
productivity
Total Revenue / Full Time
Employees
Travel Length The average distance that a flight was flown
Total Aircraft Miles / Total
Aircraft Departures
Used as part of the Rapid Rewards program. This allows customers to obtain
free flights, hotels, and restaurant services
A promise by the company to keep fares low and ensure unbundled packages
Traffic and employment numbers found in the airline filings from the Bureau
of Transportation Statistics.
The time from the moment the aircraft door closes at origin city until doors
open at departure city
Revenue that is generated by the airline from ticket sales
15. 13 | P a g e
Appendix 3: Management & Governance
Gary C. Kelly
Chairman of the
Board, CEO
Tammy Romo
EVP/Chief
Financial Officer
Robert E. Jordan
EVP/Chief
Commercial
Officer
Michael G. Van deVen
EVP/Chief
Operating Officer
Jeff Lamb
EVP ofCorporate
Services
Mark R. Shaw
SVP Gen. Counsel,
Corporate
Secretary
Thomas M. Nealon
EVP Strategy &
Innovation
Management Position Background
Gary Kelly
Chairman/President
/CEO
Served 29 years at Southwest Airlines
Served as Controller, Chief Financial Officer and Vice President Finance,
Executive Vice President
Named twice in D CEO Magazine’s CEO of the Year
Named as one of the best CEOs in American by Institutional Investor three times
Distinguished Alumunus Award from the University of Texas at Austin
Inducted into the McCombs School of Business Hall of Fame.
Served on the President’s Job Council
Robert E. Jordan
EVP/Chief
Commercial Officer
Served 27 years at Southwest Airlines
Roles included Director Revenue Accounting, Corporate Controller, Vice
President Prcurement, Vice President Technology, SVP Enterprise Spend
Management, EVP Strategy and Technology
Received his undergraduate degree in Computer and MBA from Texas A&M
University
Led numerous initiatives such as the AirTran acquisition, the southwest.com e-
commerce platform, and the Rapid Rewards loyalty program.
Jeff Lamb
EVP Corporate
Services
Joined Southwest Airlines in 2004.
Helped establish Southwest’s Diversity Council, and also serves on the National
Board of Directors for the Make-A-Wish Foundation and Children’s Medical Center
Previously worked at the Staubach Company, Mesa Petroleum, and Belo
Corporation
Completed his undergraduate work at West Texas State University
Tom Nealon
EVP Strategy &
Innovation
Joined Southwest in January 2016
Previously worked as EVP for JCPenny, Partner with the Field Group, and VP/CIO
at Frito-Lay
Received his BSBA from Villanova University and MBA from the University of
Dallas
Tammy Romo
EVP & Chief
Financial Officer
Served at Southwest Airlines for 24 years
Previous roles included: Senior Vice President Planning, VP Financial Planning,
VP Controller, VP Treasurer, Senior Director Investor Relations
Currently a member of the Accounting Advisory Council at the McCombs School
of Business
Named as an Outstanding CFO for a Public Company by D CEO Magazine
Received undergraduate degree in Accounting from The University of Texas at
Austin
Michael Van de Ven
EVP & Chief
Operating Officer
Joined Southwest Airlines in 1993
Previously served as EVP of Aircraft Operations, SVP of Planning, VP Financial
Planning, Senior Director of Financial Planning and Analysis
Received his undergraduate Accounting degree from the University of Texas at
Austin
16. 14 | P a g e
Appendix 4: 2016 Macro Outlook
In 2015, the U.S economy increased GDP at a tepid 2.4%, while global economies grew at 3.1%. In 2015 global economic
activity remained weak. According to the IMF, growth in emerging and developed economies which accounts for 70% of
total global GDP growth declined for the fifth consecutive year, while modern economies continued to see slow economic
growth. The current macro environment has been impacted by many domestic and global factors that have made growth for
the entire global economy very uncertain. Three key themes are currently driving economic forecasts:
1) China’s transition from an investment and industrial economy, towards a consumer-driven economy
2) Lower energy and commodity prices
3) The tightening of monetary policy from the U.S. and other advanced economies central banks
China’s Transition
China’s historic economic growth has been nothing short of astonishing. During the past 35 years, China’s real gross domestic
product has increased by an average of 10% per year (World Bank). After many years of success, the growth of the Chinese
economy looks to be reverting to the mean. According to the IMF, China has accounted for one-third of global growth since
2010. The Chinese markets are currently transitioning from an export-led model to one that is based more on consumption
and services. During this change, China’s slowing Purchasing Manager’s Index (PMI) has put downward pressure on other
economies and the manufacturing industry alike. The recent decline in manufacturing activity can be observed in China’s
Manufacturing PMI and its decline over the past four months proves manufacturing is contacting. The uncertainty regarding
future Chinese growth is spilling over to other economies through trade channels, and weaker commodity prices.
Manufacturing activity has been weak across the globe which can be most seen in extracting industries and commodities.
Source: Factset and Worldbank
Corporate Profits and Labor
Corporate Profits have fallen to the lowest year-over-year growth levels since the last recession in 2007. This has been a result
of the strong U.S. dollar, weaker commodity prices, and the uncertainty over the long awaited decision by the Federal
Reserve’s to raise interest rates. Although companies that operate internationally are taking the biggest earnings declines,
the health of the domestic economy remains mixed. Unemployment remains at current cycle lows while productivity remains
at cycle highs. We note that the economy is not likely to see additional growth by adding additional employees because
employment is nearing full capacity. Businesses will need to turn to other sources of growth to drive future profits. Although
we see a domestic economy being healthier than it was during the previous down turn, we view the current labor conditions
as a sign the U.S. market has hit full capacity.
17. 15 | P a g e
Source: Factset, Bloomberg
Domestic Service Sector Is Being Pulled Down by Factory Troubles
During the last two months of 2015, the U.S. Institute for Supply Management’s Manufacturing Purchasing Manager’s Index
(PMI) showed readings under 50 which signals contracting manufacturing activity. Current manufacturing activity is
suffering from a wide variety of factors, including weak foreign demand, lower commodity prices, sluggish economic
growth, and a strong dollar. Since the United States is primarily a consumer-based economy, the real question is what impact
the decline in the Manufacturing PMI will have on the Non-Manufacturing PMI. In 2015, global manufacturing was weak
due to lower overall commodity prices. This has been caused firms to slash prices to reflect low input costs, China’s slow
down, and the resulting pressures on emerging economies. Although manufacturing activity has been declining for most of
the past year, domestic services, which accounts for 70% of U.S. total GDP continued to show signs of strength (Federal
Reserve). However, recent manufacturing data from the U.S. Non-Manufacturing Index has recently signaled slowing
growth in services after the index reported its lowest level in nearly two years. The Non-Manufacturing PMI reported a
reading of 53.5, showing consumer spending is starting to feel the side effects of declining manufacturing activity. Although
the Non-Manufacturing Index is still above 50 (the border between expansion and contraction) this marks the lowest level
for the index in 27 months (See Chart Below). In order to understand the effects that Manufacturing PMI has on Non-
Manufacturing activities, we tested the correlation between both indices and found a 77.98% correlation between both
variables. This is significant and proves weakness in the manufacturing industry will eventually spread to the services sector.
With the U.S. GDP composed of 70% services, a decline in manufacturing activity directly impacts the GDP growth and
should sound the alarm on the overall state of the domestic economy.
18. 16 | P a g e
Inflation and Deflationary Fears
Recent inflation both in the United States and abroad has been weak. The chart below shows inflation relative to the 2%
inflation target by the Federal Reserve. Recently the fears of low inflation has sparked fears of a deflationary environment.
Key factors that lead us to believe that we could possibly be entering a deflationary period is the continued pressure in the
Eurozone and Japan
Source: World Bank
Strong Dollar Issues
The recent period in 2015 has been one of the most volatile periods for currencies relative to the dollar. As other economies
in Asia, Europe, and other emerging markets looked to expand monetary policy to stimulate demand, the divergence
between the U.S. dollar and other currencies increased substantially. As the Central Bank of Japan (BOJ) implemented
negative interest rates, and the European Union’s (EU) decision to continue economic stimulus, current forward volatility is
expected.
19. 17 | P a g e
Source: Bloomberg
Appendix 5: Labor
30,000 Foot View: A Pilot’s Perspective
When Herb Kelleher resigned as the former chairman of the board of directors, Southwest lost one of the best CEO’s in
America. Under Kelleher’s leadership, Southwest applauded out-of-the-box thinking from everyone at the company,
including flight attendants, pilots, and ramp operators. Kelleher and the rest of his management team ensured they always
never shot down ideas because they understood they would never get their employees to voice their opinion ever again. This
open-culture attitude under Kelleher carried over into the airline’s labor relations, and contributed to healthy employee and
union relationships over the duration of his leadership. However, since Herb Kelleher’s resignation in 2008, we see a different
company in terms of size and employment relations. Since the AirTran acquisition in 2011, Southwest has faced the trouble
of integrating two very different cultures.
Before Herb Kelleher retired in 2008, everyone enjoyed working under his guidance. As Southwest has grown to be the
nation’s largest low-cost-carrier, Southwest has deviated from its principles that made Southwest a great company to work
for. The old Southwest believed in the idea that if you took care of your internal customers (employees), then your external
customers (passengers) would always be taken care of. This mindset is not present today, as seen by the Southwest Pilots
Union decision to picket for the first time outside of Dallas Lovefield.
In an effort to keep costs low, the company has not budged on recent negotiations with the Southwest Airlines Pilots Union
Association (SWAPA) and has failed to compensate appropriately. As a pioneer for profit-sharing in the Airline Industry,
Southwest has widely been regarded as one of the highest paying airlines compared to the industry standard. Since the
industry has been through many recent changes regarding restructuring and slow economic growth, firms have cut back on
labor expenses which have lowered the industry average. In the past, the company has justified wage increases during
negotiations based on past performance of the industry; which was when the industry was struggling with bankruptcies and
poor economic conditions. Now that times are improving, management has shown less willingness to talk about the so called
industry standard. The last contract that was turned down represented a 17.6% pay raise, while this may seem high, this
really only represents a 1.5% increase over the life of the entire contract. The tentative agreement initially offered a 3% raise
and then 2% per year. After taking into consideration the cost of living adjustment (COLA), assuming -2-2.9%, the current
wage increases would hardly reflect cost of living increases. Though one of the factors that goes into negotiating pay increases
-32.9%
-25.4%
-16.1%
-15.7%
-14.3%
-12.4%
-11.0%
-10.4%
-10.3%
-7.6%
-6.7%
-6.3%
-5.5%
-3.8%
-0.8%
-0.4%
-35.0% -30.0% -25.0% -20.0% -15.0% -10.0% -5.0% 0.0%
Brazilian Real
South African Rand
Canadian Dollar
Norweigian Krone
Mexican Peso
New Zealand Dollar
Autralian Dollar
Danish Krone
Euro
Swedish Krona
Singapore Dollar
South Korean Won
British Pound
Taiwanese Dollar
Swiss Franc
Japanese Yen
All Major Currencies Relative to Dollar in 2015
20. 18 | P a g e
is what competitors are paying, after the recent failed negotiations in November 2015, the two party’s appear to still be far
apart. The negotiating process will continue in April as SWAPA regroups under new leadership.
Appendix 6: Operating Profile
Operating Statistics Historical Projected
(in millions except metrics per ASM) FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E
Total Revenue: 11,023 10,350 12,104 15,658 17,088 17,699 18,605 19,647 20,460 21,009 21,835
YoY Growth: 11.8% -6.1% 16.9% 29.4% 9.1% 3.6% 5.1% 5.6% 4.1% 2.7% 3.9%
Total Passenger Revenue: 10,549 9,892 11,489 14,735 16,093 16,721 17,658 18,298 19,023 19,882 20,684
YoY Growth: 11.5% -6.2% 16.1% 28.3% 9.2% 3.9% 5.6% 3.6% 4.0% 4.5% 4.0%
Adjusted Earnings
EBITDAR: 342 1,072 2,039 2,104 2,290 2,857 3,914 5,674 5,604 4,885 4,717
EBITR: (475) 263 1,161 1,141 938 1,610 2,598 4,132 4,300 3,495 3,238
EBITDAR Margin %: 3.1% 10.4% 16.8% 13.4% 13.4% 16.1% 21.0% 28.9% 27.4% 23.3% 21.6%
EBIT Margin %: -4.3% 2.5% 9.6% 7.3% 5.5% 9.1% 14.0% 21.0% 21.0% 16.6% 14.8%
Per ASM Metrics
RASM: 10.67 10.56 12.30 12.99 13.34 13.58 14.20 13.98 13.80 13.62 13.75
PRASM: 10.21 10.09 11.67 12.22 12.56 12.83 13.48 13.02 12.83 12.89 13.02
CASM: 10.24 10.29 11.29 12.41 12.85 12.60 12.50 11.18 11.13 11.56 11.85
CASM Ex-Fuel: 6.64 7.19 7.62 7.73 8.07 8.18 8.46 8.60 8.92 9.12 9.26
CASM Ex-Fuel & Profitsharing: 7.65 7.98 8.00 8.19 8.16 8.45 8.77 8.97
Yield: 14.35 13.29 14.72 15.10 15.64 16.02 16.34 15.57 15.34 15.41 15.57
Carrier Union WageIncrease Status
LUVPilots SWAPA +7.5%by 4/1/16,17%total by 2019 Rejected 62%
AALPilots AAL +26%1/1/15,+3%2016-2019 Ratified 66%
DALPilots ALPA +14%by 1/1/16,20%total by by 2018 Rejected 65%
ALK Pilots ALPA Contractnotamendableuntil 2018 -
UALPilots ALPA 13%increase2016,+3%thereafter Votein Progress
Source: SWAPA, ALPA, Pilot Forums Source: Airline Pilot Central
26. 24 | P a g e
Appendix 14: Hub-and-Spoke v. Point-to-Point
The airline industry is composed of two different types of transportation networks: the Hub-and-Spoke (H&S) system, and
the Point to Point (P2P) system. Each system offers different advantages over the other as airlines have realized gains from
each. The larger legacy carriers primarily use the H&S system while low cost carriers utilize the P2P system.
Hub-and-Spoke System
In an H&S system, airlines fly passengers from sets of “spoke” cities to a central “hub” where they then change planes and
fly to their final destination. Advantages of the H&S system include:
• Fewer routes are needed to serve the entire network. This is because flights are run through a central hub which
connects directly to most destinations on the network.
• Airlines can operate flights with higher load factors since fewer flights are flown on each route.
• Economies of scale are created when a centralized approach is taken. This reduces the labor associated with managing
operations and staffing requirements.
The H&S network also has disadvantages that include:
• Congestion of hub airports. This is because the airlines are operating on very tight schedules that have many
incoming/outbound flights simultaneously.
• Passengers are also inconvenienced by switching flights. This will also increase the probability of lost baggage claims
and missed connection flights.
• Hubs are both labor- and capital- intensive, rendering them costly to operate. Additionally, weather delays may
systematically delay the entire network, which results in flight delays and high associated costs.
Point-to-Point System
Point to Point systems are used primarily by low cost carriers who wish to reduce the costs associated from maintain formal
hub centers. Advantages include:
• Eliminating the need for connection flights.
• Improved baggage arrival times and reduced lost baggage claims
• Reducing the operational constraints associated with delayed flights.
• Improved turnaround times. This results from avoiding delays that is a result of hub congestion.
This network style has disadvantages that include:
• Higher fares. While this may not necessarily be the case for Southwest, many carriers charge for a convenience
premium.
• Cities that may not be on the network. This is largely the case with smaller cities that cannot generate enough demand
for airlines to profitably operate the route.
27. 25 | P a g e
0
1
2
3
4
5
Bargaining
Power of
Suppliers
Bargaining
Power of
Buyers
Threat of New
Entrants
Threat of
Substitutes
Industry
Rivalry
Threat Hierarchy:
0 – None
1 – Slight
2 – Low
3 – Moderate
4 – Substantial
5 – High
Appendix 15: Porter’s Five Forces Analysis
Unlike other competitors, Southwest created their competitive advantage by offering frequent flights at a cost that was well
below the competition. The airline industry is structurally unattractive as a result of the intense competition, but Southwest
was able to operate in a niche that had previously been unfilled. This enabled the airline to avoid the intense competition
faced by the rest of the industry and cement itself in the low cost-market segment.
Threat of New Entrants – High:
Barriers to entry are low. This results from the recent liberalization of the markets. In the past 40 years, nearly 1300
new airlines were established.
There are many regulations that airlines must comply with. The FAA and foreign governments and require airline
operators to obtain certificates for flying.
There are high capital requirements, but the low interest rate environment has allowed more competitors to enter the
market at a lower cost. There are also many leasing options available that allow the airlines to offset the initial investments
needed to start a new operation.
There is very little differentiation among the operators, allowing new competitors to easily enter the market and offer
the same service.
There are very low switching costs for consumers. Airlines have attempted to combat this by offering frequent flyer
programs which incentivize the customers to fly with a specific airline.
Historically, the industry has been very unprofitable. This has changed recently with the depressed fuel prices and
debt restructurings.
Industry Rivalry- High:
It is hard to sustain a competitive advantage without innovation. The only way airlines can do this is through customer
service improvements, aircraft upgrades, or operational efficiencies.
There are low switching costs between the carriers. This has caused the airlines to undercut each other in an attempt
to stimulate traffic demand. As a result,
Firms are adopting similar strategies across the industry. They are able to offset the costs associated with this because
of the current fuel environment.
Bargaining Power of Suppliers – Moderate:
28. 26 | P a g e
Airlines are usually locked into long term contracts, creating high switching costs for the airline companies who wish
to use a different manufacturer.
There is little differentiation between airplane manufacturers. This means that the suppliers must also be competitive
in terms of price with the airline companies and now they can
There is no opportunity for the manufacturers to forward integrate. Suppliers are dependent on the health of the airline
industry to continue doing business.
The labor force is highly unionized. As a result, the supply of labor has a high degree of leverage within the airline
industry. If labor unions strike, this will cause massive disruptions in the airlines ability to generate revenue, as they are
only able to do so when the planes are in the air.
Bargaining Power of Buyers – High:
There are very low switching costs for the buyers as most of the airlines are competing against each other while offering
the same service.
There is a lot of availability of the lowest fares with the advent of the internet and booking sites that provide instant
data.
Buyers are very sensitive to price, as flights are often seen as a discretionary expense. Airlines are not able to pass on a
high portion of the variable costs because of the number of similar competitors.
They are able to force down the prices of the airlines as a result of the airline industry currently experiencing intense
competition.
There is very little differentiation between airline operators, especially in the low cost segment.
Threat of Substitutes – Moderate:
Buyers have a high propensity to substitute in times of economic downturns.
Since there are very little switching costs, buyers are able to substitute alternate forms of travel.
Alternate forms of transportation are usually not as fast as airline travel, but they provide a cheaper form of travel for
those who can afford it.
Airlines are able to be the dominant form of transportation for international travel, as other methods are usually not
time efficient.
Unlike other competitors, Southwest created their competitive advantage by offering frequent flights at a cost that was well
below the competition. The airline industry is structurally unattractive as a result of the intense competition, but Southwest
was able to operate in a niche that had previously been unfilled. This enabled the airline to avoid the intense competition
faced by the rest of the industry and cement itself in the low cost-market segment.
Southwest based their business model upon keeping costs low, stimulating traffic demand, and operating on less
competitive routes. While Southwest faces the same fixed costs as the rest of the carriers, high aircraft utilization ensures
that planes are in the air generating revenue. Southwest accomplishes this by only operating the Boeing 737, avoiding in-
flight meals, and no reserved seats. This reduces variable costs associated with each flight, contributing to higher profits
and lower fares. Underpinning the whole operation were employees that were paid better than anywhere in the industry,
reinforcing the operational excellence that created strong brand sentiment. These reinforcing cycles reinforced enabled the
carrier to dominate the low-cost niche for the past 40 years.
Future Outlook
We believe that the current industry competition has diminished Southwest’s competitive advantage. They are unable to
consistently offer the lowest fares anymore, and new companies are beginning to gain market share in the low-cost segment.
The current profits are unsustainable and are heavily influenced by the fuel tailwinds. Structurally, this industry is
unattractive because of the cyclicality and destabilizing effects of economic recessions.
29. 27 | P a g e
Appendix 16: SWOT Analysis
Appendix 17: OIL
Commodity Prices Decline
Commodity prices declined markedly over the second half of 2015. Strong production output from members of OPEC, the
United States, and Russia are expected to continue into 2016. Supply capacity investments that were made during times of
high oil prices have finally matured as companies are now utilizing the increased capacity ability. This has created
downward pricing pressures, causing many oil exporting countries to search for ways to survive during the glut. Oil
markets will take time to restructure as marginal cost producers attempt to survive during the current environment. This
will only prolong the supply and demand imbalance that is allowing inventory levels to climb and suppress prices as
marginal players continue to pump oil to maintain interest payments
Oil Rigs
Oil rigs in the United States have fallen to ~500, as shrinking revenues have forced drillers to produce more efficiently. The
past year has seen the total drop from 1400 rigs, but this has been offset by increased efficiency from each available rigs.
Since 2004, our dependency on foreign oil has significantly been reduced by 37%. Looking forward, a sharp drop in rig
counts is cause for concern in the event of major worldwide supply disruptions.
Strengths
•Strong balance sheet
•Uniform fleet
•Recognizable brand
•High aircraft utilization
Weaknesses
•Minimal ancillary revenue opportunities
•No segmented seating
Opportunities
•International expansion
•Advanced aircraft
•Capture additional domestic share
•Airline alliances/codesharing
Threats
•Legacy & ULCC
•Rising costs
•Reduced traffic demand
•Volatile fuel prices
•Terrorism
•Regulation
SWOT Analysis
30. 28 | P a g e
OPEC & Russia
Historically, OPEC has been the driving force behind the pricing of oil. They have created a cartel by controlling
approximately 38% of the world's oil supply, giving them control over the world oil price. This also creates geopolitical
pressures on countries who do not support the OPEC cartel, as they have restrained supply in the past and created price
shocks. According to some sources, Saudi Arabia may have a marginal cost of production as low as $10-15 range, meaning
that they can continue to sustain their current level output to regain market share that they lost during the oil supply
expansion of other countries. Russia has also returned production back to post-Soviet highs, and now produce nearly 10.8
mbpd of oil. Russia has now surpassed OPEC as the largest supplier of crude oil to China, providing nearly 1.3 mbpd.
Effects on Oil E&P’s in the United States
Looking forward, the price of oil will continue to fluctuate until a new equilibrium is reached in the marketplace. Growth
in the world’s supply of crude has exceeded demand, which has led to sharp reductions in prices and earnings for the energy
sector.
The impact of cheap crude oil can be seen not only in the form of lower energy prices, but on oil explorers and producers.
The oil and gas sector currently has $200b in high yield debt that financed the shale oil boom. In the current market, nearly
all of the free cash flow generated is used to reduce or service debt. This has affected the credit quality of the sector, with 19
companies defaulting on their loans in 2015 and 15 filing for bankruptcy. 77% of the E&P firms have ratings below BB+,
which indicates that most of the sector bonds are considered junk for financing. This can be seen in the U.S. distressed ratio,
which climbed to its highest level since September 2009 at 20.1%. Oil and Gas has the largest proportion of distressed issuers
by count at 37% of total distressed debt, and the second highest sector distress ratio at 50.4%.
0
2000
4000
6000
8000
10000
12000
2004 2006 2008 2010 2012 2014
US Crude Oil Imports
0
20
40
60
80
100
120
0
1
2
3
4
5
6 E&P Debt Troubles
Total Debt / EBITDA (X) 5.04
Net Interest Expense (Million) 96.21
0
500
1000
1500
2000
2500
3000
3500
4000
4500
Mar-11 Mar-12 Mar-13 Mar-14 Mar-15
Baker Hughes Rig Count
World Rig Count US Rig Count
-
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
0
20
40
60
80
100
120
140
160
2004 2006 2008 2010 2012 2014
Price Decline as Excess Capacity Dwindles
Open Interest Last Price
31. 29 | P a g e
Source: Bloomberg
Production in the United States
Crude oil production in the United States has sharply risen in the past 6 years by 78%. This can be attributed to the explosion
of the shale industry, as drilling companies have found new ways in which to extract oil from the rock. Horizontal drilling,
which is known as “fracking”, enables companies to extract oil from rock underground using pressurized drills. Contained
within the drills are a combination of water and 600 various chemicals that then break the rock down even further. In the
current environment, producers have had to increase the efficiency of each shale play to maximize the returns on capital
invested. Break-even models of shale plays have indicated that some producers can survive in the $20-22 per barrel range
of crude. Not only does this mean that OPEC producers would have to flood the market even further, but
Forward Outlook
We believe that going forward a bounce to historical levels of 100+ oil is unlikely. We believe this is driven by 1) Lowered
marginal costs, 2) Unprecedented supply glut and 3) Changing industry dynamics.
1- It is clear that the marginal cost of oil has dropped. As oil companies have tightened their budgets and cut costs, they
have learned to become more productive with rigs, while lowering operational costs. The result is that this lowers the overall
cost curve. Additionally lower marginal cost players will increase market share, further lowering the price.
2- The current supply glut is unprecedented as the cost of storage has increased to all time highs. We have seen supply
increase each month in Cushing, and there seems to be little production decreases to stop this supply glut. As long as this
remains there will be continued downward pressures.
3- Some recent changes have been the lift on the ban of exporting oil from the United States, aggressive Saudi Pricing,
and the recent rise of alternative energy. It is clear that Saudi Arabia is more willing to stay the course than intially expected,
and multiple years of supply glut would create a longer than expected price period. Additionally the rising cost
competitiveness of alternative could display traditional oil. All these uncertainites are possible reasons for a prolonged and
lower price of oil.
With these key factors, we believe that the forward oil curve is extremely reasonable if not generous estimate for our forward
outlook for oil prices.
0
100
200
300
400
500
Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15
US Oil Barrels Per Rig
0
2000
4000
6000
8000
10000
12000
3/1/2009 3/1/2011 3/1/2013 3/1/2015
Oil Production in the United States
CROMUS Index : United States 9,318.00
32. 30 | P a g e
Appendix 18: Cost of Capital
Appendix 19: Discounted Cash Flow Analysis
WACC - Southwest Airlines Co.
($ in Millions Except Per Share and Per Unit Data)
Cost of Capital
Risk-free Rate: 2.25%
Market Risk Premium: 5.00%
Beta: 1.32
Cost of Equity: 8.84%
Default Spread: 2.00%
Pre-tax Cost of Debt: 4.25%
Cost of Preferred Stock: 0.00%
Comparable Companies - Unlevered Beta
Levered Preferred Equity Unlevered
Ticker Beta Debt % Debt Stock % Preferred Value % Equity Tax Rate Beta Cash Firm Value
American Airlines Group AAL 1.25 30,048$ 54.0% - - 25,584$ 46.0% 37.0% 0.87 (9,583) 53,947
Delta Airlines DAL 1.32 16,889 32.3% - - 35,320 67.7% 37.0% 1.11 (5,424) 62,105
JetBlue JBLU 1.27 3,385 33.0% - - 6,882 67.0% 37.0% 1.12 (1,132) 8,276
Alaska Air Group ALK 1.21 1,473 14.1% - - 8,973 85.9% 37.0% 1.27 (1,258) 9,402
United Continental UAL 1.20 24,905 57.8% - - 18,217 42.2% 37.0% 0.75 (5,755) 41,520
Spirit Airlines SAVE 1.17 1,765 37.0% - - 3,007 63.0% 37.0% 1.05 (749) 4,023
Virgin America VA 1.09 1,213 40.9% - - 1,755 59.1% 37.0% 0.96 (512) 2,456
Median: 1.21 3,385$ 37.0% -$ - 8,973$ 63.0% 37.0% 1.05
Southwest Airlines Co LUV 1.11
The Southwest Airlines Co. - Levered Beta and WACC Calculation
Unlevered Preferred Levered
Beta Debt % Debt Stock % Preferred Equity % Equity Tax Rate Beta
Comparable Capital Structure: LUV 1.05 11,649 37.0% - - 19,839 63.0% 37.0% 1.44
Current Capital Structure: LUV 1.05 5,923 18.8% - - 25,565 81.2% 38.0% 1.20
Optimal Capital Structure: LUV 1.00 6,298 20.0% - - 25,190 80.0% 38.0% 1.16
WACC, Comparable Capital Structure: 6.55%
WACC, Current Capital Structure: 7.68%
Average WACC: 7.11%
WACC, Optimal Capital Structure: 7.60%
DCF - Operating Lease Adjustment
($ in Millions Except Per Share and Per Unit Data)
Historical Historical Projected
Annual Unlevered FCF Projection FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E
Operating Leases (Book Value): 343 332 360 400 376 414 386 640 688 637 684 557 545 474
Discounted Operating Leases: 523 436
Pre-tax Cost of Debt: 6.89% 7.28% 7.65% 6.53% 5.62% 6.38% 6.11% 4.62% 4.78% 5.47% 4.50% 4.25%
PV of Operating Lease Expenses: 1,689 1,621 1,510 1,523 1,349 1,748 1,734 4,064 3,042 2,643 3,689 2,746 2,801 2,857
Revenue: 7,584$ 9,086$ 9,861$ 11,023$ 10,350$ 12,104$ 15,658$ 17,088$ 17,699$ 18,605$ 19,647$ 20,460$ 21,009$ 21,835$
EBITDA: 399 815 660 (58) 696 1,625 1,718 1,650 2,169 3,277 4,990 5,047 4,340 4,243
EBIT: (70) 300 105 (657) 80 997 1,003 806 1,302 2,339 3,975 3,955 3,181 3,014
Operating Lease Expense in Current Year: 343 332 360 400 376 414 386 640 688 637 684 557 545 474
Depreciation on leased asset: 188 203 189 218 193 250 248 508 380 378 527 213 231 250
Adjusted After-tax EBIT: 53 266 171 (294) 163 720 708 582 998 1,611 2,562 2,666 2,167 2,008
Non-cash Adjustments: 820 1,092 1,158 1,229
Changes in NOWC: 366 205 502 723
CapEx: (2,041) (1,057) (2,155) (2,256)
FCFF: 1,707 2,905 1,672 1,704
FCFF, remaining periods:
Present Value of FCFF: 2,807 1,509 1,435
Sum of PV of FCFF: 5,751
Normal Discount Period: 1.00 2.00 3.00
Mid-year Discount Period: 0.50 1.50 2.50
Annual FCFF Growth: N/A 70.2% -42.4% 1.9%
33. 31 | P a g e
Terminal Value - Multiple Method Terminal Value - Perpetuity Growth Method
Terminal EBITDA Multiple: 6.30 x Implied Terminal EBITDAR Multiple: 6.34 x
Terminal Value: 29,715 Terminal Value: 29,902
Implied Terminal FCF Growth Rate: 2.47% Terminal FCF Growth Rate: 2.50%
PV of Terminal Value: 24,181 PV of Terminal Value: 24,333
Present Value of FCFF: 5,751 Present Value of FCFF: 5,751
Implied Enterprise Value: 29,932 Implied Enterprise Value: 30,083
Plus: Cash & Cash-Equivalents: 3,050 Plus: Cash & Cash-Equivalents: 3,050
Less: Total Debt & Capital Leases: (6,866) Less: Total Debt & Capital Leases: (6,866)
Less: Pension: - Less: Pension: -
Implied Equity Value: 26,116 Implied Equity Value: 26,268
Diluted Shares Outstanding: 679.55 Diluted Shares Outstanding: 679.55
Implied Share Price from DCF: $38.43 Implied Share Price from DCF: $38.65
Premium / (Discount) to Current: 2.37% Premium / (Discount) to Current: 2.97%
Implied Weighted
DCF Case Weight Price Price
Base 60% $38.54 $38.81
Downside 20% $23.72
Upside 20% $54.70
