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
Threat of New Entrants (LOW) High startup costs Limited Hub Access Post 911 environment

Bargaining Power of Buyers (MODERATE) Price Convenience Service

Rivalry Among Existing Firms (HIGH) Route Sharing Hub Competition No Frill Airlines

Bargaining Power of Suppliers (HIGH) Boeing & Airbus Bombardier& Embraer

Threat of Substitutes Short Haul: (MODERATE-HIGH) Long Haul: (LOW- MODERATE)

Airline Model Comparison

National
Long

Regional
Non-stop

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

services Many affiliated with longhaul carriers Low bargaining power Non-unionized no frills airlines Technologically advanced Serve mainly domestic market

short haul

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:

Revenue Earnings Growth Predicted ROE

2001 loss -

2002 8% growth 8.50%

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:

Revenue Earnings Growth Predicted ROE

2002 30% 32% 23%

2003 30% 22% 23%

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:
Revenue Earnings Growth Predicted ROE 2001 loss 2002 increase 13%

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:
Revenue Earnings Growth Predicted ROE 2001 11% 19% 17% 2002 12% 24% 18%

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
Airline A B P/E 7.5 6.8 P/B 0.8 1.2 Your Guess ? ?

C
D

16.8
26.8

3.1
4.9

?
?

Our findings

American ROE P/E P/B Low Low Low

Delta Average Low Low to Average P/B ~ 1

Southwest High High High

Skywest High High High

(ROE<CEC) (P/B<1)

Sustained Growth

Growth ?; P/B >> 1

Valuation Multiples
Airline A
B C D

P/E 7.5
6.8 16.8 26.8

P/B 0.8
1.2 3.1 4.9

Our Guess

Summary

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