Valuation Ratios in the Airline Industry

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

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

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

4. 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

5. 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.

6. 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

7. 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)

8. Airline Model Comparison

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

10. 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

11. 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

12. 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:

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

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

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

16. 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:

17. 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

18. 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:

19. 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

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

21. Valuation Multiples

22. Our findings

23. Valuation Multiples

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