Valuation Ratios in the Airline Industry

Valuation Ratios in the Airline Industry John Pagazani Tara Trussell Roisin Byrne

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Objectives We want to determine the following:  – Valuation  –  Valuation ratios to use for the airline industry  – Key  –  Key factors which influence these ratios  – How  –  How to intuitively match a given airline with a set of valuation ratios based on its strategy

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Airline Industry Valuations To start, let’s review the background on the industry and the companies in question...

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Airline Industry Overview

50% fare reduction

  c    i    f    f   a   r    t   e   n    i    l   r    i    A

  s   e   r   a    f   e   n    i    l   r    i    A

1978

1998

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Triple air traffic

Porter’s Five Forces for the Airline Industry Competitive Rivalry Threat of New Entrants Threat of Substitute Products Buyer Power 

Supplier Power 

National-International Carriers

Regional Carriers

6 main players STRONG

Many players STRONG

Hub carrier domination Low cost jet aircraft, WEAK new markets - STRONG  Air travel necessity  Air travel necessity MODERATE MODERATE Price sensitive Price sensitive STRONG STRONG Full pricing control of Full pricing control of most key inputs key inputs - STRONG STRONG

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Overview of the Airlines to be Analyzed

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American Airlines Background • Long haul carrier • Established in the 1920s, American was one of the first U.S. giants in the i ndustry due to >80 acquisitions, and the largest U.S. airline based on revenues in 2000 • Owns two regional airlines and also one of the largest airfreight carriers in the world • Very competitive domestic market with up to nine airlines providing service on competitive routes. Strategy • Pricing decisions largely affected by competition –  some with lower cost structure • Efficient and quiet aircraft • In 2000, American Eagle regional jet fleet was increasingly aggressive • Continued expansion into domestic and international route networks anchored by efficient hubs, enabled American to capitalize on any passenger traffic growth

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Delta Air Lines Background • Long haul carrier • Founded as the world’s first crop-dusting service in 1924. • Established its domestic network via other regional carrier acquisitions –  highly competitive market. • In 1991, Delta entered the international markets. • Largest U.S. airline in terms of aircraft departures and number of passengers served, third largest in terms of operating revenue • Labor issues in 2000 –  unionized workforce Strategy • Variety of services –  Delta Shuttle, Delta Express, Delta Connection, International alliances •  Not a clearly defined strategy except to offer services to everyone

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Sky West Airlines Background • Regional carrier • Founded in 1972, Sky West operates 108 aircraft from 6 hubs • Over 1000 daily departures to 68 destinations • 70% of flights were jointly coded with Delta Air lines and United Airlines flights • Compete with other regional airlines, low-fare carriers and larger airlines. • Strong relationship with non-unionized workforce Strategy • High quality customer service • Joint affiliations which reduced reliance on any single major airline code • Operations are enhanced and stabilized through a combination of Sky West controlled and contract flying. • Committed to acquire 113 additional regional jets with operations on another 119 aircraft –  dependant largely on contracts with Delta and United.

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Southwest Airlines Background • Hybrid carrier • Founded in 1971 with three Boeing 737, Southwest operates 344 aircraft and services 57 destinations • Focused on frequent flights to conveniently located and less congested airports • Wait time at airport gates is less than half the industry average • Operates only one type of aircraft Strategy • Cost leader in the industry • “no frills service” at a low price • High asset utilization and tight control over operating expenses. •  No code-sharing relationships with other airlines • Simple fare structure –  low unrestricted coach fares • Majority owned by its employees - Strong relationships with non-unionized workforce 10

How do we value these airlines?  Now that we have some background on the industry and the airlines, let’s look at the ratios we can use to rank them in terms of value…

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Determinants of Price-Earnings (PE) Ratio PE = f(earnings growth –  cost of equity capital) • A firm with a HIGH PE ratio is expected to exhibit HIGH earnings growth (over and above costs and inflation.) • A firm with a LOW PE ratio will not exhibit earnings above the current level of earnings (approx. = rate of inflation. plus costs)

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Determinants of Return on Equity (ROE) ROE = f(Dupont relationships) = f(NI/Sales X Sales/Assets X Assets/SE) = f(Profit margin + asset turnover + leverage) = Earnings/equity

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Determinants of Price-to-Book (PB) Ratio PB = f[future abnormal ROE + growth in equity(book value) –  cost of equity capital] • A firm with a HIGH PB ratio is expected to grow and expand its asset base over and above the CEC • A firm with a LOW PB ratio is not expected to grow  beyond the rate of inflation

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Relationship between the Ratios Once we determine one of the ratios, the others can be solved because they are linked  by return on stockholders’ equity (ROE): PE (price/earnings) x ROE (earnings/equity) = PB (price/equity)

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Interpretation of the Ratios PE

"Rising" 

"Recovering" 

"Falling" 

Takeover or "bankruptcy" 

H

H

L

L

PB

H

L

H

L

ROE

Interpretation

H

- Expectations of high earnings growth relative to recent earnings (high P/E) - Earnings growth will increase the asset base (high P/B) - Both will contribute to rising ROE

L

- The firm will recover from recently lower earnings (high P/E) - Will not exhibit growth in asset base (low P/B) - Will not exhibit high returns (low ROE)

H

- The firm will not grow earnings beyong current levels (low P/E) - High earnings expected on current investments (high P/B & high ROE) - New investment returns at lower levels (low ROE)

L

- The firm will experience earnings growth (high P/E) - Will not exhibit growth in asset base (low P/B) - Below average returns are expected (low ROE)

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The Four Airlines  Now, let’s take our knowledge of how the ratios work and apply them to what we know about the airlines…

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Summary of the Airlines Industry

Delta

American

Skywest

Southwest

12%

17%

12%

18%

21%

12.50%

12.5%

12.5%

12.5%

12.5%

6%

5%

9%

11%

Asset growth (5 yr)

12.4%

6%

20.1%

15.4%

Revenue growth (5 yr)

6.1%

3%

16.1%

14.5%

ROE ROE trend Cost of equity capital  Net operating margin    l   a   c    i   r   o    t   s    i

   1    0    0    2

 Net operating margin trend

2.0

Price / book  Price / book trend

   H

- ' ve

Price / earnings Price / earnings trend    )   r   y    (    5

Industry 2001   s   n   o    i    t   c    i    d   e   r   p    t   s   y    l   a   n    A

  y   r    t   s   u    d   n    I

  s   e   n    i    l   r    i    A

Air traffic growth

 

2002

Delta 2001

American 2002

2001

Skywest

Southwest

2002

2002

2003

2001

2002

8%

> 30%

> 30%

11%

12%

profit

32%

22%

19%

24%

8.5%

~ 23%

~ 23%

17%

17.5%

3.5%

Air traffic growth trend Yield (avg revenue per passenger)

4%

Revenue growth Earnings growth ROE

 

loss

 

moderate increase

8.0%

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loss

Exercise: Identify the Airlines • We do not have adequate information to  precisely CALCULATE the ratios, so we want to use our intuition to gauge which airline best fits each description below: Airline A=? B=? C=? D=?

Price/Earnings (PE) 7.5 6.8 16.8 26.8

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Price/Book Value (PB) 0.8 1.2 3.1 4.9

Possible Results and Discussion • • • •

American = High competition for routes, low historical ROE, low PE as earnings growth not over CEC, PB CEC, so PB >1, low PE Southwest = flexible, non-union labour, low cost strategy sustainable, high PB, high PE due to presumably sustainable long-term earnings growth Skywest = Serves larger air carriers who can also compete directly, depends on Delta/United for business ~ maybe earnings not as sustainable, high ROE, ROE > CEC = PB much greater than one, PE is high also, but limited sustainability

A= B= C= D=

Airline American Delta Skywest? Southwest?

Price/Earnings (PE) 7.5 6.8 16.8 26.8

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Price/Book Value (PB) 0.8 1.2 3.1 4.9

Summary We have seen that by a) reviewing the strategies and b) estimating the direction and magnitude of earnings and asset base growth, we can intuitively rank airline companies using our PE and PB valuation multiples.

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