Valuation Ratios in the Airline Industry Hari Stirbet Tammy Cheung Shelly Khindri Parmjit Marway

Agenda Industry Overview Financial Theory American Airlines Skywest Delta Southwest Class Exercise Summary

Industry - Overview 1978: deregulation of US Airline Industry Mid-2001 industry dominated by long-haul small carriers Many non-stop regional & commuter carriers

Industry – Financial State First cyclical downturn in 2001 Air travel demand declined & prices softened ROE had declined to 12% v.s. 25% P/B ratio declined to 2% v.s. 2.8% P/E ratio was negative

What does this all mean?  To maintain long term competitiveness and sustainability, an airline needs to have both global scale, strong presence and a cost efficient strategy.

Future Trends? Passenger traffic on a steady increase since 2002 Airlines operating under cost cutting strategies A trend towards globalization Increased influence of alliances: Star, SkyTeam and One World

Industry Analysis Rivalry Among Existing Firms (HIGH) Route Sharing Hub Competition ‘No Frill’ Airlines Threat of New Entrants (LOW) High startup costs Limited Hub Access Post 911 environment Bargaining Power of Buyers (MODERATE) Price Convenience Service Threat of Substitutes Short Haul: (MODERATE-HIGH) Long Haul: (LOW- MODERATE) Bargaining Power of Suppliers (HIGH) Boeing & Airbus Bombardier& Embraer

Airline Model Comparison NationalRegional  Long haul domestic & international services  Economies of scale (long flights)  ‘Hub-and-spoke’ networks  High fixed costs  Low marginal costs  Use alliances to strengthen international presence  Non-stop short haul services  Many affiliated with long- haul carriers  Low bargaining power  Non-unionized  ‘no frills’ airlines  Technologically advanced  Serve mainly domestic market

Company Strategy & Current Performance Company strategy drives Earnings growth Growth in ROE Growth in equity

Financial Theory P/E increases as Earnings grow P/E decreases as CEC increases ROE is based on Dupont (Earnings/Equity) If ROE < CEC then P/B decreases

American Airlines Very competitive domestic market Competition in long-haul, regional & cargo service Many other airlines on same routes Relatively new aircraft Unionized labour force

American Airlines – Strategy Impacts ROE: 12% - (declining from 21%) Earnings Growth: Loss – (slow growth) Assets Growth: 6 % Net Operating Profit Margin : 5% - (declining from 8%) Forecast:

Skywest Airlines Founded in 1972 Relationship with Delta Airlines & United Airlines – LT revenue High competition with regional airlines, low fare carriers & major airlines

Skywest – Strategy Impacts ROE: 18% Earnings Growth: High (Long term Sustainability??) Assets Growth: 20.1% Net Operating Profit Margin: 9% (declining) Forecast:

Delta Airlines Founded in 1924 Highly competitive in domestic market; growing competition Low switching costs Unionized labour force Average asset growth

Delta Airlines – Strategy Impacts ROE: Fluctuates between 17% - 30% Most recent 8% Assets Growth: 12.4 % Net Operating Profit Margin : 6% (declined from 9%) Forecast:

Southwest Airlines Flexible non-unionized workforce Use of same aircraft across routes Low cost airports No lock-in to standard banking services ROE> CEC (21% vs. 12.5%) => P/B > 1

Southwest Airlines – Strategy Impacts ROW: 21% Earnings Growth: Very High Assets Growth: 15.4 % Net Operating Profit Margin : 11% - stable (highest in the market) Forecast:

Recall: Financial Theory P/E increases as Earnings grow P/E decreases as CEC increases ROE is based on Dupont (Earnings/Equity) If ROE < CEC then P/B decreases Assumption: CEC = 12.5% industry wide

Other Things to Consider Company Strategy Operating Model Growth Plans Access to Capital Company & Industry Trends

Valuation Multiples AirlineP/EP/BYour Guess A7.50.8? B6.81.2? C ? D ?

Our findings AmericanDeltaSouthwestSkywest ROELowAverageHigh P/ELow High P/BLow Low to AverageHigh (ROE<CEC) (P/B<1)P/B ~ 1 Sustained Growth Growth ?; P/B >> 1

Valuation Multiples AirlineP/EP/BOur Guess A B C D

Summary Difference in performance/strategy can affect the valuation multiples Rank companies based on strategy analysis Value of the company is NOT only numbers