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CFA Institute Research Challenge

Hosted by:
CFA Societies Texas, Louisiana, New Mexico and
Oklahoma
Local Challenge- Southwest US
The University of Texas at Dallas

NYSE: LUV
Industry: Airline
Sector: Transportation

Recommendation: HOLD
Current Price: $37.54
Target Price: $34.53 (8% Downside)

We Dont Believe in LUV at First Sight


This report is published for education purposes only
by students competing in the CFA Institute Research
Challenge

*Denotes Glossary term

Investment Highlights

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%

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:

*Multiples adjusted for Operating Leases

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
Method
Comps
DCF
Target Price
Upside/Downside

Current
Price
Weights
$30.24
50%
$38.81
50%

$34.53
-8.03%

60.00
50.00

AirTran Acquisition
Completed

# Denotes Appendix reference

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, Southwests
unique strategy, combined with a customer-oriented approach, has separated
Southwest from the crowd.
Safety Saves Sadness, Sufferingand 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. Managements 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 Southwests. The financial success of Southwest attracted new carriers to enter
the industry and adopt aggressive pricing policies. In the long-run, we believe
Comparable Valuation
Southwests 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: Southwests New Achilles Heel. Southwests 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 firms 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 managements attitude, contributing to
declining employees morale and mitigating the firms excess returns.

737-800s First
Introduction

AirTran Integration
Completed

Share Price and Events

Pilots Picket

First International
Flight

40.00
30.00
20.00
10.00
0.00
Jan-11

Wright Amendment
Repeal

Jul-11

Jan-12

Jul-12
S&P 500 Index

Jan-13

Jul-13

Jan-14

Southwest Airlines

Jul-14

Jan-15

BBB+ Upgrade

Jul-15

Jan-16

Target Price
S&P Indexed to LUV Share Price

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Exhibit 1: LUV's high customer service


satisfaction

Business Description

JBLU
LUV
ALK
DAL
AA
ALGT
UAL
FRNT
SAVE
Others
Industry
0
20
40
60
80
100
Source: American Customer Satisfaction Index
Exhibit 2: 2015 Market Share by Traffic
Demand

23.7%

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 nations 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.

76.3%
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,

LUV Domestic
Source: Bloomberg, Team Research

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 firms total capacity.

Source: Companys Data


Name
Gary C Kelly
Tammy Romo
"Mike" G Van De Ven
Jeff Lamb
Robert E Jordan
Thomas M Nealon

Title
Chairman/President/CEO
CFO
COO
Executive VP
Executive VP
Executive VP

Tenure
7.7
3.3
7.7
0.5
4.3
0.1

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%

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
Our vision is to become the
as one of the top companies in America to work
worlds most loved, most flown, and
for.
most profitable airline.
The Corporate Governance structure is
CEO Gary Kelly
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, managements 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.

Source: Companys Proxy Statement

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Exibit 3: The Airline industry is fiercely competitive


Bargaining
Power of
Suppliers
5
4
3
Bargaining
Industry
2
Power of
Rivalry
1
Buyers
0

Threat of
Substitutes

Threat of New
Entrants

Source: Team Research


Exhibit 4: The industry has gone through
significant M&A activitity

2015

56.2%

2010

25.8%

49.5%

0%

20%

21.8%

40%

Legacy

28.7%

60%
LCC

18.0%

80%

100%

Others

Source: FactSet, 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 LCCs 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 LCCs and
ULCCs, 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.

Exhibit 5: Airlines have streamlined its labor


costs
40%
30%
20%
10%
0%
1998

2001

2004

2007

Labor

2010

2013

Other Costs

Source: Bloomberg, Team Research


Exibit 6: Z scores spell troubles for major
airlines

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.

4
3
2
1
0
-1
-2
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
AAL

DAL

UAL

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 carriers 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.

LUV

Source: Bloomberg, Team Research


Exhibit 7: Operating margins improved due to
restructuring efforts
$100 B

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.

15%

U.S Economic Performance & Airline Traffic

$80 B
10%

$60 B
$40 B
$20 B

Revenue

2013

2011

2009

2007

2005

2003

2001

1999

1997

$0 B

Operating Margin

Source: FactSet, Team Research

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
5%
down in two types of customers: business and leisure. We analyzed several current
0% 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

3|Page

Exibit 8: Contracting PMI levels are cause for


concern
6%
4%
2%
0%
-2%
-4%
1986 1991 1996 2001 2006 2011 2016
PMI Index

70
60
50
40
30
20
10
0

Capacity

Real GDP YoY

Source: FactSet, Team Research


Exhibit 9: Coporate earnings are indicative of
airline traffic
90,000 B
80,000 B
70,000 B
60,000 B
50,000 B
40,000 B
30,000 B
20,000 B
10,000 B
0B
0B

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.

500B 1,000B 1,500B 2,000B 2,500B


Source: FactSet, Team Research

Exhibit 10: Capacity remains competitive


while CASM Ex-fuel is managable
8.0%
6.0%

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, LCCs and ULCCs 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.

4.0%
2.0%
0.0%
2009

2011

2013

Capacity YoY

2015

2017

CASM Ex-Fuel YoY

Source: Bloomberg, Team Research

Supply-Demand Spread (mbpd)

09/15

06/15

03/15

12/14

09/14

06/14

03/14

12/13

09/13

Exhibit 11: Supply Imbalance has driving down


Crude Oil
$120
3.0 M
2.5 M
$100
2.0 M
$80
1.5 M
$60
1.0 M
0.5 M
$40
0.0 M
$20
-0.5 M
$0
-1.0 M

WTI Spot Price

Oil: A Double-edged Sword?


Over the past year, crude oil prices have fallen from a high of $65 per barrel to a nearrecord low of $31 (as of January 25 th, 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 shortterm 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.

Source: Bloomberg, Team Research

Pricing and Passenger Unit Revenue (PRASM)*


Exhibit 12: Yields have been pushed down as
carriers respond to low jet fuel
20%
15%
10%
5%
0%
-5%
-10%
2010

2011
Legacy

2012

2013

2014

LCC's

ULCC's

Low fuel prices have put downward pressure on yields. Industry supply growth has
been driven mostly by LCCs who have taken advantage of fuel savings. In addition,
legacy carriers have responded by slashing prices to increase domestic traffic and
remain competitive against LCCs and ULCCs. 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
2015 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

Source: FactSet, Team Research

4|Page

Exhibit 13: PRASM has benefited from prudent


capacity expansion

the 2008 recession, Passenger Revenue Available Seat Miles (PRASM) has increased

14.0
16.2% from 10.23 to 11.89 cents as a result of prudent capacity expansion. This year,
12.0
10.0
the industry has experienced a decline in PRASM, largely due to the combination of
8.0
capacity increases and lower fares. Moving forward, we see capacity growth to likely
6.0
4.0
be in line with GDP and in the short term, a stabilized pricing environment.
2.0
0.0
03/06 10/07 05/09 12/10 07/12 02/14 09/15
PRASM

Fuel Cost pASM

Labor Cost pASM

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
Exhibit 14: Labor still remains one of the
costliest expenses for airlines
unit revenues and alleviate insolvency uncertainty. Although all players in the airline
50%
industry are seeing margin expansion, those whose have the highest operating
40%
leverage are benefiting the most. While airlines are experiencing decade-low oil price
30%
levels, labor still represents one of the largest costs for the industry. The passage of
20%
the 1926 Railway Labor Act enabled industry employees to unionize and exert
10%
significant influence in the wage-negotiating process*. All of these factors have forced
0%
03/01 08/03 01/06 06/08 11/10 04/13 09/15 airline companies to allocate a bigger portion of their current profits to their
Wages
Fuel
Other Costs
employees in the form of profit sharing plans and wage hikes.
Source: Company Data, Team Research

Source: Bloomberg, Team Research

2001
AAL/TWA Merger

2001

9/11
Terror Attacks

MetroJet Liquidation

Threats

Opportunites

Exhibit 16: Capacity has been prudently


deployed to match travel demand
40%
30%
20%
10%
0%
08/08

01/11

06/13

ASM YoY Growth

11/15

RPM YoY Growth

Source: Company Data, Team Research


Exhibit 17: Yields have been depressed due to
heightened competition
20%
10%
0%
-10%
12/17

09/15

06/13

03/11

12/08

09/06

06/04

03/02

-20%

Source: Bloomberg, Team Research

2010
UAL/Continental Merger

2011 LUV/AirTran Merger

2016

Investment Summary

Weaknesses
Source: Team Research

-10%
03/06

2008
Financial Crisis

DAL/Northwest Merger

Exhitbit 15: Southwest has faced with outsized


threats from the industry
Strengths
5
4
3
2
1
0

2005 America West


/US Airways Merger

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
Southwests 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 management 29
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.

5|Page

Exhibit 18: Depressed PRASM is expected to


see a distortion before an improvement

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.

20%
15%
10%
5%
0%
-5%
FY06A

FY09A

FY12A

FY15A

FY18E

Investment Grade Balance Sheet - One of Southwests 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 firms 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.

Source: Company Data, Team Research


Exibit 19: Southwest has kept its Debt to
Capital in a managable range
70 %
60 %
50 %
40 %
30 %
20 %
10 %
0%
FY05A FY07A FY09A FY11A FY13A FY15A FY17E
Source: Company Data, Team Research
Exhibit 20: Southwest's pay scale has been
significanly above the industry average
40%
30%
20%
10%

Industry Wages

12/18

12/15

12/12

12/09

12/06

12/03

12/00

12/97

0%

LUV Wages

Source: Bloomberg, Team Research


Exhibit 21: EVA has seen significant gains from
favorable economic conditions
2,000

25%

1,500

20%

1,000

15%

500

10%

5%

(500)

0%

(1,000)
(1,500)

-5%
'05

'07
EVA

'09

'11

'13

'15

WACC

'17

Adjusted ROIC

Source: Team Research

$500
$450
$400
$350
$300
$250
1986

1993

2000

2007

Source: Bloomberg, Team Research

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

Exhibit 23: Fares in real dollar have halved


due to competitive pricing

$200
1979

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.

2014

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

6|Page

Exhibit 22: CASM ex-Fuel: Does LUV really


remain its cost advantage?
10.00

7%

18%
8%

8.00

-53%

-38%

6.00

-11%

-16%

-8%

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

4.00
2.00

Financial Ratios
Profitability Ratios
Return on Assets
Return on Equity
Return on Invested Capital

0.00
12/2009
Legacy

LCC

09/2015
ULCC

LUV

Industry

FY11A

FY12A

FY13A

FY14A

FY15

FY16E

FY17E

FY18E

1.0%
2.7%
6.1%

2.0%
6.1%
4.4%

3.4%
10.5%
8.4%

5.1%
16.1%
14.9%

8.5%
28.4%
20.3%

9.5%
31.0%
21.4%

7.4%
23.6%
16.7%

6.6%
22.0%
15.2%

Efficiency Ratios
Total Asset Turnover
Fixed Asset Turnover

0.9 x
1.2 x

0.8 x
1.1 x

0.8 x
1.1 x

0.8 x
1.1 x

0.8 x
1.1 x

0.8 x
1.1 x

0.8 x
1.1 x

0.8 x
1.0 x

Margin Analysis
Gross Margin
SG&A Margin
EBITDAR Margin
EBIT Margin
Net Income Margin

18.4%
12.0%
13.4%
7.3%
1.1%

16.6%
11.9%
13.4%
5.5%
2.5%

19.4%
12.0%
16.1%
9.1%
4.3%

24.4%
11.9%
21.0%
14.0%
6.1%

31.6%
11.4%
28.9%
21.0%
10.2%

31.3%
12.0%
27.4%
21.0%
11.6%

27.1%
12.0%
23.3%
16.6%
9.0%

25.8%
12.0%
21.6%
14.8%
8.1%

Short Term Liquidity


Current Ratio
Cash Ratio

1.0 x
0.7 x

0.9 x
0.6 x

0.8 x
0.6 x

0.7 x
0.5 x

0.6 x
0.5 x

0.5 x
0.3 x

0.5 x
0.4 x

0.4 x
0.3 x

Coverage Ratios
Total Debt/EBITDAR
EBITDAR/Interest Expense

1.8 x
11.6 x

1.4 x
18.2 x

1.0 x
26.7 x

0.7 x
36.6 x

0.6 x
63.7 x

0.5 x
43.1 x

0.8 x
35.7 x

0.8 x
28.5 x

Leverage Ratios
Total Debt/Equity
Total Debt/Capital
Total Liabilities/Total Assets

79.8%
47.6%
55.9%

103.2%
55.1%
50.7%

79.9%
49.5%
53.1%

78.8%
49.3%
57.9%

93.3%
54.3%
55.8%

70.5%
44.9%
56.8%

82.5%
51.3%
59.0%

79.7%
48.5%
59.7%

Source: Bloomberg, Team Research

Overview
The financial analysis table highlights Southwests 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.

Exhibit 24: Historical EBITDAR


6,000
5,000
4,000
3,000
2,000
1,000

FY15A

FY14A

FY13A

FY12A

FY11A

FY10A

FY09A

FY08A

FY07A

FY06A

FY05A

Source: Company Data, Team Research

Market level
National level

Short-haul
Long-haul
Short-haul
Long-haul

North America
-1.5
-1.4
-0.9
-0.8

Profitability - FASBs 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 Southwests profitability.

Source: International Air Transportation Association

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 firms
ability to deploy seats, manage inventory, and initiate code-sharing*. At the same

7|Page

Exibit 25: Airborne Rates bounced back to


normal levels

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.

100%
80%
60%
40%
20%
0%
2011

2012

2013

Airborne/Block Hours*

2014

2015

On-time Arrival Rate*

Source: Department of Transportation


Exhibit 26: LUV still lags behind the industry in
on-time arrival
14%
12%
10%
8%
6%
4%
2%
0%
2011

2012

2013

Southwest*

2014

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, Southwests aircrafts 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 companys normal business
activities, especially when the market turns for the worst. Southwests 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 companys ability to generate
2015 healthy free cash flow to cover all of its debt obligations and fund its operations.

Industry*

Source: Department of Transportation, Bloomberg

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.
Financial Ratios
DuPont Analysis
Net Income Margin
Total Asset Turnover
Equity Multiplier
ROE

Valuation
Method
Comps
DCF
Target Price
Upside/Downside

Current
Price
Weights
$30.24
50%
$38.81
50%
$34.53
-8.03%

FY11A
1.1%
0.9 x
2.8 x
2.7%

FY12A
2.5%
0.8 x
3.0 x
6.1%

FY13A
4.3%
0.8 x
3.1 x
10.5%

FY14A
6.1%
0.8 x
3.2 x
16.1%

FY15
10.2%
0.8 x
3.4 x
28.4%

FY16E
11.6%
0.8 x
3.2 x
31.0%

FY17E
9.0%
0.8 x
3.2 x
23.6%

FY18E
8.1%
0.8 x
3.3 x
22.0%

Valuation:Comparable
Is LUVValuation
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.

Source: Team Research

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

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 Southwests 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.

8|Page

Implied
Price
$38.54
$23.72
$54.70

DCF Case Weight


Base
60%
Downside 20%
Upside
20%

Weighted
Price
$38.81

Source: Team Research

Cost of Capital
Risk-free Rate:
Market Risk Premium:
Beta:
Cost of Equity:
Default Spread:
Pre-tax Cost of Debt:
Cost of Preferred Stock:

2.25%
5.00%
1.33
8.90%
2.00%
4.25%
0.00%

WACC, Comparable Capital Structure:


WACC, Current Capital Structure:
Average WACC:

6.55%
7.68%
7.11%

WACC, Optimal Capital Structure:

7.60%

Source: U.S. Treasury, Damodaran, Team Research

Comparable Valuation
Multiple
Turn
Price
2016E EBITDAR:
4.4 x
$30.47
2017E EBITDAR:
4.5 x
$26.64

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 Southwests 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 Southwests ability to generate future free cash flows (FCF), we

Normalized P/E Valuation


Comparable P/E:
24.7 x
Normalized EPS (LUV): $ 1.37
Implied Price (LUV):
$ 33.84

analyzed Southwests 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.

Source: Bloomberg, Team Research


Exhibit 27: Historical and Projected
EV/EBITDAR
25.0 x

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 companys
normal business operations, FCF yield and in turn, intrinsic value.

20.0 x
15.0 x
10.0 x
5.0 x

FY17E

FY16E

FY15A

FY14A

FY13A

FY12A

FY11A

FY10A

FY09A

FY08A

FY07A

Source: Team Research

Jet Fuel

FY06A

FY05A

0.0 x

$
$
$
$
$
$
$
$
$

25.00
30.00
35.00
40.00
45.00
50.00
55.00
60.00
65.00

$
$
$
$
$
$
$
$
$

1.21
1.30
1.39
1.48
1.57
1.66
1.75
1.84
1.93

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.
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%
$ 34.15 $ 36.22 $ 38.32 $ 40.44 $ 42.58 $ 44.74 $ 46.92 $ 49.12 $ 51.34
33.11
35.19
37.28
39.40
41.54
43.70
45.88
48.08
50.31
32.07
34.15
36.25
38.37
40.51
42.67
44.85
47.05
49.27
31.03
33.11
35.21
37.33
39.47
41.63
43.81
46.01
48.23
30.00
32.08
34.17
36.29
38.43
40.59
42.77
44.97
47.19
28.96
31.04
33.14
35.25
37.39
39.55
41.73
43.93
46.16
27.92
30.00
32.10
34.22
36.36
38.52
40.70
42.90
45.12
26.89
28.96
31.06
33.18
35.32
37.48
39.66
41.86
44.08
25.85
27.93
30.03
32.14
34.28
36.44
38.62
40.82
43.04

Source: Team Research

9|Page

Investment Risks
Operational Risks:
Risk

Mitigating Factor
Operational Risk
Balancing Employee
Meaningful labor
Compensation
negotiations
Lower Growth
Opportunities

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, Southwests impressive
earnings and ROIC will be put at risk.

Disciplined capacity
expansion
in-line with travel
Loss of BBB+ Credit
Maintain capital structure
Rating
target
Lower Growth Opportunity for Expansion (OR2): Southwest is faced with limited
Market Risk
Economic Risk
Defensive business tactics domestic growth opportunities. Given low growth opportunities, Southwest will look
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

High
Medium

OR2

MR2

MR3

MR1
OR3

UC

Low

Probability

OR1

Medium
Impact
Source: Team Research

Loss of BBB+ Credit Rating (OR3) A sudden lowering of Southwests credit rating
would increase interest rates required on new loans to finance new projects and signal
that the firms strong historical financial position is weakening.
Market Risks:

Source: Team Research

Low

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.

High

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, Southwests current strategy of unloading
hedging position would prove ineffective. Managements miscalculation of future oil
prices are costly to the firms 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 publics perception of major events hinders the demand for air
travel and can negatively impact the stock and companys performance.

10 | P a g e

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 companys 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 companys stock.

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

Measures one aircraft seat flown one mile,


whether filled or unfilled
Measures the total available seat miles of an
airline, used to indicate supply of seats

One Aircraft Seat x One Mile


Flown

Available Seat Miles (ASMs)


Capacity (Total ASMs)

Chase Credit Card Deal


Block Hour
Cost per Available Seat Mile
(CASM)
CASM ex. Fuel

CASM ex. Fuel & Profit-sharing

Form 41 Data

Load Factor
Passenger Revenue

Used as part of the Rapid Rewards program. This allows customers to obtain
free flights, hotels, and restaurant services
The time from the moment the aircraft door closes at origin city until doors
open at departure city
Measure of unit cost

Operating Expenses / Available


Seat Miles

(Operating Expenses - Fuel


Measures unit costs excluding the cost of fuel
Expenses) / Available Seat
Miles
(Operating Expenses Ex-Fuel &
Measures unit costs excluding the cost of fuel
Profit-sharing) / Available Seat
and profit sharing expenses
Miles
Traffic and employment numbers found in the airline filings from the Bureau
of Transportation Statistics.
Represents the percentage of seats filled on an
aircraft

Revenue Passenger Miles /


Available Seat Miles

Revenue that is generated by the airline from ticket sales

Passenger Revenue per Available


Seat Mile (PRASM)

Measures passenger unit revenue

Passenger Yield

Measure of average fare paid per mile per


passenger

Revenue per Available Seat Mile


(RASM)

Unit revenue

Transfarency

Total Available Seat Miles

Passenger Revenue / Available


Seat Miles
Passenger Revenue / Revenue
Passenger Miles
Total Revenue / Available Seat
Miles

A promise by the company to keep fares low and ensure unbundled packages

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

11 | P a g e

Appendix 1: Range of Implied Shared Prices

Southwest Airlines - Range of Implied Share Prices


Public Company Comparables:
LTM EV / Revenue:
12/31/2016E EV / Revenue:
12/31/2017E EV / Revenue:
LTM EV / EBITDAR:
12/31/2016E EV / EBITDAR:
12/31/2017E EV / EBITDAR:

Discounted Cash Flow Analysis:


6.61% - 7.61% Discount Rate, 2% - 3% Terminal FCF Growth Rate:
6.61% - 7.61% Discount Rate, 5.8 x - 6.8 x Terminal EBITDAR:
$-

$10.00

25th - Mean

$20.00

$30.00

$40.00

$50.00

$60.00

Mean - 75th

Appendix 2: Normalized Earnings for Comparable Companies


Normalized Earnings Per Share
Date
DAL
AAL
LUV
SAVE
JBLU
ALK
UAL
FY 2015
$
4.61 $ 8.94 $ 3.53 $ 4.30 $ 1.98 $ 6.51 $ 11.88
FY 2014
3.27
5.11
2.02
3.08
0.70
4.18
4.52
FY 2013
3.10
8.19
1.12
2.43
0.51
2.69
2.85
FY 2012
0.83
4.06
0.55
1.42
0.37
2.35
1.78
FY 2011
0.41
(4.69)
0.43
1.51
0.29
1.98
3.52
FY 2010
0.70
0.97
1.10
2.65
0.35
1.75
2.92
FY 2009
0.29
(3.18)
0.85
2.70
0.20
0.64
(6.34)
Avg. EPS :
1.89
2.77
1.37
2.59
0.63
2.87
3.02
2015 Price: $
46.08 $ 44.99 $ 40.96 $ 59.93 $ 21.59 $ 71.52 $ 59.77
P/E:
24.4 x
16.2 x
29.9 x
23.2 x
34.4 x
24.9 x
19.8 x
FY 2015
FY 2014
FY 2013
FY 2012
FY 2011
FY 2010
FY 2009

FY 2015
FY 2014
FY 2013
FY 2012
FY 2011
FY 2010
FY 2009

AAL
8.94
5.11
8.19
1.31
(5.33)
(1.26)
(3.85)

LCC

LUV
3.53
2.02
1.12
0.55
0.43
0.73
0.19

AAI

2.75
0.64
2.23
0.67

Merged
$ 8.94
5.11
8.19
4.06
(4.69)
0.97
(3.18)

Merged
$ 3.53
2.02
1.12
0.55
0.43
0.37
1.10
0.66
0.85

FY 2015
FY 2014
FY 2013
FY 2012
FY 2011
FY 2010
FY 2009

FY 2015
FY 2014
FY 2013
FY 2012
FY 2011
FY 2010
FY 2009

UAL
$ 11.88
4.52
2.85
1.78
3.52
2.92
(6.34)

CON

Merged
$ 11.88
4.52
2.85
1.78
3.52
2.92
(6.34)

DAL
4.61
3.27
3.10
0.83
0.41
0.70
0.29

NWA

Merged
$ 4.61
3.27
3.10
0.83
0.41
0.70
0.29

Normalized P/E Valuation


Comparable P/E:
24.7 x
Normalized EPS (LUV): $ 1.37
Implied Price (LUV):
$ 33.84

12 | P a g e

Appendix 3: Management & Governance


EVP of Corporate
Services

EVP/Chief
Commercial
Officer

Jeff Lamb

EVP Strategy &


Innovation

Robert E. Jordan
Thomas M. Nealon

Chairman of the
Board, CEO
Gary C. Kelly
SVP Gen. Counsel,
Corporate
Secretary

EVP/Chief
Financial Officer
Tammy Romo

EVP/Chief
Operating Officer

Mark R. Shaw

Michael G. Van de Ven

Management
Gary Kelly

Position
Chairman/President
/CEO

Background

Served 29 years at Southwest Airlines

Served as Controller, Chief Financial Officer and Vice President Finance,


Executive Vice President
Named twice in D CEO Magazines CEO of the Year

Robert E. Jordan

EVP/Chief
Commercial Officer

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 Presidents Job Council

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 ecommerce platform, and the Rapid Rewards loyalty program.
Jeff Lamb

EVP Corporate
Services

Joined Southwest Airlines in 2004.

Helped establish Southwests Diversity Council, and also serves on the National
Board of Directors for the Make-A-Wish Foundation and Childrens 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

13 | 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) Chinas 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
Chinas Transition
Chinas historic economic growth has been nothing short of astonishing. During the past 35 years, Chinas 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, Chinas slowing Purchasing Managers Index (PMI) has put downward pressure on other
economies and the manufacturing industry alike. The recent decline in manufacturing activity can be observed in Chinas
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
Reserves 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.

14 | 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 Managements Manufacturing Purchasing Managers 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, Chinas 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 NonManufacturing 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.

15 | 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 Unions (EU) decision to continue economic stimulus, current forward volatility is
expected.

16 | P a g e

All Major Currencies Relative to Dollar in 2015


-0.4%

Japanese Yen

-0.8%

Swiss Franc

-3.8%

-5.5%

Taiwanese Dollar
British Pound

-6.3%

South Korean Won

-6.7%

Singapore Dollar

-7.6%

Swedish Krona

-10.3%

Euro

-10.4%

Danish Krone

-11.0%
-12.4%
-14.3%

Autralian Dollar
New Zealand Dollar
Mexican Peso

-15.7%

Norweigian Krone

-16.1%

Canadian Dollar

-25.4%
-32.9%

-35.0% -30.0% -25.0% -20.0% -15.0% -10.0% -5.0%

South African Rand


Brazilian Real
0.0%

Source: Bloomberg

Appendix 5: Labor
30,000 Foot View: A Pilots Perspective
When Herb Kelleher resigned as the former chairman of the board of directors, Southwest lost one of the best CEOs in
America. Under Kellehers 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 airlines labor relations, and contributed to healthy employee and
union relationships over the duration of his leadership. However, since Herb Kellehers 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
nations 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

17 | P a g e

is what competitors are paying, after the recent failed negotiations in November 2015, the two partys appear to still be far
apart. The negotiating process will continue in April as SWAPA regroups under new leadership .

Carrier Union

Wage Increase

Status

LUV Pilots SWAPA +7.5% by 4/1/16, 17% total by 2019

Rejected 62%

AAL Pilots AAL

+26% 1/1/15, +3% 2016-2019

Ratified 66%

DAL Pilots ALPA

+14% by 1/1/16, 20% total by by 2018 Rejected 65%

ALK Pilots ALPA


UAL Pilots ALPA

Contract not amendable until 2018


13% increase 2016, +3% thereafter

Vote in Progress

Source: SWAPA, ALPA, Pilot Forums

Source: Airline Pilot Central

Appendix 6: Operating Profile


Operating Statistics
(in millions except metrics per ASM)

FY08A

FY09A

Total Revenue:
YoY Growth:

11,023
11.8%

10,350
-6.1%

12,104
16.9%

15,658
29.4%

17,088
9.1%

17,699
3.6%

18,605
5.1%

19,647
5.6%

20,460
4.1%

21,009
2.7%

21,835
3.9%

Total Passenger Revenue:


YoY Growth:

10,549
11.5%

9,892
-6.2%

11,489
16.1%

14,735
28.3%

16,093
9.2%

16,721
3.9%

17,658
5.6%

18,298
3.6%

19,023
4.0%

19,882
4.5%

20,684
4.0%

342
(475)

1,072
263

2,039
1,161

2,104
1,141

2,290
938

2,857
1,610

3,914
2,598

5,674
4,132

5,604
4,300

4,885
3,495

4,717
3,238

3.1%
-4.3%

10.4%
2.5%

16.8%
9.6%

13.4%
7.3%

13.4%
5.5%

16.1%
9.1%

21.0%
14.0%

28.9%
21.0%

27.4%
21.0%

23.3%
16.6%

21.6%
14.8%

10.67
10.21
10.24
6.64

10.56
10.09
10.29
7.19

12.30
11.67
11.29
7.62

14.35

13.29

14.72

12.99
12.22
12.41
7.73
7.65
15.10

13.34
12.56
12.85
8.07
7.98
15.64

13.58
12.83
12.60
8.18
8.00
16.02

14.20
13.48
12.50
8.46
8.19
16.34

13.98
13.02
11.18
8.60
8.16
15.57

13.80
12.83
11.13
8.92
8.45
15.34

13.62
12.89
11.56
9.12
8.77
15.41

13.75
13.02
11.85
9.26
8.97
15.57

Adjusted Earnings
EBITDAR:
EBITR:
EBITDAR Margin %:
EBIT Margin %:
Per ASM Metrics
RASM:
PRASM:
CASM:
CASM Ex-Fuel:
CASM Ex-Fuel & Profitsharing:
Yield:

FY10A

Historical
FY11A

FY12A

FY13A

FY14A

FY15

Projected
FY16E
FY17E

FY18E

18 | P a g e

Appendix 7: Income Statement


Income Statement:
(in millions)

FY08A

FY09A

Revenue:
Passenger:
Freight:
Other Revenue:
Total Revenue:
YoY Revenue Growth:

10,549
145
329
11,023
11.8%

9,892
118
340
10,350
-6.1%

11,489
125
490
12,104
16.9%

14,735
139
784
15,658
29.4%

16,093
160
835
17,088
9.1%

16,721
164
814
17,699
3.6%

17,658
175
772
18,605
5.1%

18,298
179
1,170
19,647
5.6%

19,023
180
1,257
20,460
4.1%

19,882
184
943
21,009
2.7%

20,684
180
971
21,835
3.9%

Operating Expenses:
Salaries, Wages, and Benefits:
Fuel:
Maintenance Materials and Repairs:
Aircraft Rentals:
Landing Fees and Other Rentals:
Depreciation and Amortization:
Acquisition and Integration:
Other Operating Expenses:
Total Operating Expenses as Reported:
Adjusted COGS Including D&A:
Adjusted Operating Expenses:

3,340
3,713
721
154
662
599
1,385
10,574
10,295
11,680

3,468
3,044
719
186
718
616
1,337
10,088
8,933
10,270

3,704
3,620
751
180
807
628
1,426
11,116
9,681
11,107

4,371
5,644
955
308
959
715
134
1,879
14,965
12,776
14,655

4,749
6,120
1,132
355
1,043
844
183
2,039
16,465
14,243
16,282

5,035
5,763
1,080
361
1,103
867
86
2,126
16,421
14,271
16,397

5,434
5,293
978
295
1,111
938
126
2,205
16,380
14,061
16,266

6,384
3,616
1,004
238
1,166
1,015
38
2,243
15,704
13,429
15,666

7,202
3,277
1,027
213
1,238
1,092
2,455
16,504
14,049
16,504

7,782
3,759
1,068
206
1,333
1,158
2,521
17,828
15,307
17,828

8,134
4,108
1,100
213
1,417
1,229
2,620
18,821
16,201
18,821

449
4.1%
(657)
-6.0%

262
2.5%
80
0.8%

988
8.2%
997
8.2%

693
4.4%
1,003
6.4%

623
3.6%
806
4.7%

1,278
7.2%
1,302
7.4%

2,225
12.0%
2,339
12.6%

3,943
20.1%
3,981
20.3%

3,955
19.3%
3,955
19.3%

3,181
15.1%
3,181
15.1%

3,014
13.8%
3,014
13.8%

Other Expenses (Income):


Interest Expense:
Capitalized Interest:
Interest Income:
Other (Gains) Losses, net:
Total Other Expenses:

130
(25)
(26)
92
171

186
(21)
(13)
(54)
98

167
(18)
(12)
106
243

194
(12)
(10)
198
370

147
(21)
(7)
(181)
(62)

131
(24)
(6)
(32)
69

130
(23)
(7)
309
409

120
(31)
(9)
556
636

130
(5)
125

137
(5)
132

165
(5)
160

Profit / (Loss) Before Tax (PBT):


Tax Charge:
Adjusted PBT:

278
100
(828)

164
65
(18)

745
286
754

323
145
633

685
264
868

1,209
455
1,233

1,816
680
1,930

3,307
1,299
3,517

3,831
1,456
3,831

3,049
1,159
3,049

2,853
1,084
2,853

178
36.0%

99
39.6%

459
38.4%

178
44.9%

421
38.5%

754
37.6%

1,136
37.4%

2,008
39.3%

2,375
38.0%

1,890
38.0%

1,769
38.0%

Operating Income:
EBIT Margin:
Adjusted EBIT:
Adjusted EBIT Margin:

Profit / (Loss) for the Period:


Effective Tax Rate:
Basic Earnings / (Loss) per Share (EPS):
Diluted Earnings / (Loss) per Share (EPS):
Basic Shares Outstanding:
Diluted Shares Outstanding:
Cash Dividends per Share:

$
$

Historical
FY11A

FY10A

FY12A

FY13A

FY14A

Projected
FY16E
FY17E

FY15

FY18E

0.24 $
0.24 $

0.13 $
0.13 $

0.62 $
0.61 $

0.23 $
0.23 $

0.56 $
0.56 $

1.06 $
1.05 $

1.65 $
1.64 $

3.30 $
3.26 $

3.81 $
3.76 $

3.24 $
3.20 $

3.25
3.21

735
739

741
741

746
747

774
776

751
753

710
717

687
696

661
669

623
631

583
591

543
551

$ 0.02

$ 0.02

0.02

0.02

0.03

0.13

0.22

0.29

0.30

0.30

0.30

19 | P a g e

Appendix 8: Balance Sheet


Statement of Financial Position:
(in millions)
ASSETS:
Current Assets:
Cash & Cash Equivalents:
Short-term Investments:
Accounts and Other Receivables:
Inventories of Parts and Supplies, at cost:
Prepaid Expenses and Other Current Assets:
Total Current Assets:

FY08A

FY09A

FY10A

Historical
FY11A

FY12A

FY13A

FY14A

FY15

Projected
FY16E
FY17E

FY18E

$ 1,368 $ 1,114 $ 1,261 $


829 $ 1,113
1,355 $ 1,282 $ 1,582 $ 1,080 $ 1,742 $ 1,239
435
1,479
2,277
2,315
1,857
1,797
1,706
1,468
1,428
1,386
1,342
209
169
195
299
332
419
365
474
489
502
522
203
221
243
401
469
467
342
311
346
377
399
313
84
89
238
210
168
232
188
248
267
282
$ 2,528 $ 3,067 $ 4,065 $ 4,082 $ 3,981 $ 4,206 $ 3,927 $ 4,024 $ 3,591 $ 4,275 $ 3,785

Non-Current Assets:
Flight Equipment:
Ground Property and Equipment:
Deposits on Flight Equipment Purchase Contracts:
Assets Constructed for Others:
Total PP&E:
Less allowance for D&A:
Total PP&E, net:
Goodwill:
Other Non-Current Assets:
Total Non-Current Assets:

13,722
1,769
380
15,871
4,831
11,040
375
11,415

13,719
1,922
247
15,888
5,254
10,634
277
10,911

13,991
2,122
230
16,343
5,765
10,578
606
11,184

15,542
2,423
456
18,421
6,294
12,127
970
626
13,723

16,367
2,714
416
19,497
6,731
12,766
970
633
14,369

16,937
2,666
764
453
20,820
7,431
13,389
970
530
14,889

18,473
2,853
566
621
22,513
8,221
14,292
970
534
15,796

15,601
970
717
17,288

16,628
970
818
18,417

17,610
970
840
19,420

18,581
970
873
20,424

Total Assets:

13,943

13,978

15,249

17,805

18,350

19,095

19,723

21,312

22,008

23,695

24,210

668
1,012
963
2,643

746
696
1,044
2,486

739
863
1,198
2,800

1,057
996
1,836
3,889

1,107
1,102
2,170
4,379

1,247
1,229
2,571
5,047

1,203
1,565
2,897
5,665

1,188
2,591
2,990
6,769

1,243
1,981
149
3,961
7,333

1,355
2,139
1,105
4,279
8,878

1,434
2,259
1,105
4,893
9,691

Non-Current Liabilities, Including All Debt and Finance Leases (FL):


Long-term Debt:
3,661
Deferred Income Taxes, net:
1,539
Construction Obligation:
Deferred Gains from Sale and Leaseback of Aircraft:
105
Other Non-Current Liabilities:
1,042
Total Non-Current Liabilities, Incl. All Debt and FL:
6,347

3,515
1,916
102
493
6,026

3,380
2,279
88
465
6,212

3,751
2,303
75
910
7,039

3,154
2,638
63
1,124
6,979

2,820
2,684
437
771
6,712

2,692
2,782
554
1,255
7,283

3,177
2,490
757
760
7,184

2,715
2,490
757
760
6,722

2,747
2,490
757
760
6,754

2,459
2,490
757
760
6,466

Total Liabilities:

8,990

8,512

9,012

10,928

11,358

11,759

12,948

13,953

14,055

15,632

16,157

Shareholders' Equity:
Common Stock & APIC:
Retained Earnings:
Accumulated Other Comprehensive Income (Loss):
Treasury Stock, at cost:
Total Shareholders' Equity:

2,023
4,919
(984)
(1,005)
4,953

2,024
4,983
(578)
(963)
5,466

1,991
5,399
(262)
(891)
6,237

2,182
11,504
(1,051)
(4,682)
7,953

2,182
13,115
(1,051)
(6,182)
8,064

2,182
14,604
(1,051)
(7,682)
8,053

22,008

23,695

24,210

LIABILITIES AND EQUITY:


Current Liabilities, Excluding Debt and Finance Leases:
Accounts Payable:
Accrued Liabilities:
Revolver:
Air Traffic Liability:
Total Current Liabilities, Excl. Debt and Fin. Lease.:

Total Liabilities and Equity:

13,943

13,978

15,249

2,030
5,395
(224)
(324)
6,877
17,805

2,018
5,768
(119)
(675)
6,992
18,350

2,039
6,431
(3)
(1,131)
7,336
19,095

2,123
7,416
(738)
(2,026)
6,775
19,723

2,182
9,409
(1,051)
(3,182)
7,358
21,312

20 | P a g e

Appendix 9: Revenue Projection


Revenue Assumptions
(in millions)

FY08A

FY09A

Baseline Available Seat Kilometers (ASM):


Post-Toggle Available Seat Kilometers (ASM):
Baseline ASM YoY Growth Rate:
Post-Toggle ASM YoY Growth Rate:

103,271
103,271
3.6%
3.6%

98,002
98,002
-5.1%
-5.1%

10,549
11.5%
10.21
7.6%

Passenger Revenue:
YoY Growth Rate:
Passenger Revenue per ASM (PRASM):
YoY Growth Rate:

Historical
FY11A

FY12A

FY13A

FY14A

98,437
98,437
0.4%
0.4%

120,579
120,579
22.5%
22.5%

128,137
128,137
6.3%
6.3%

130,344
130,344
1.7%
1.7%

131,004
131,004
0.5%
0.5%

9,892
-6.2%
10.09
-1.2%

11,489
16.1%
11.67
15.6%

14,735
28.3%
12.22
4.7%

16,093
9.2%
12.56
2.8%

16,721
3.9%
12.83
2.1%

145

118

125

139

160

329
20.1%
0.32
15.8%

340
3.3%
0.35
8.9%

490
44.1%
0.50
43.5%

784
60.0%
0.65
30.6%

11,023
11.8%
10.67
7.8%

10,350
-6.1%
10.56
-1.1%

12,104
16.9%
12.30
16.4%

88.5

86.3
-2.5%
74,457
1.3%

71.2%

Freight:
Other Revenue:
YoY Growth Rate:
Other Revenue per ASM
YoY Growth Rate:
Total Operating Revenue:
YoY Growth Rate:
Operating Revenue per ASM (RASM):
YoY Growth Rate:
Revenue Passengers (mm)
YoY Growth Rate:
Revenue Passenger Mile (RPM):
YoY Growth Rate:

Projected
FY16E
FY17E

FY18E

140,501
140,501
7.2%
7.2%

148,286
148,286
5.5%
5.5%

154,217
154,217
4.0%
4.0%

158,843
158,843
3.0%
3.0%

17,658
5.6%
13.48
5.1%

18,298
3.6%
13.02
-3.4%

19,023
4.0%
12.83
-1.5%

19,882
4.5%
12.89
0.5%

20,684
4.0%
13.02
1.0%

164

175

179

180

184

180

835
6.5%
0.65
0.2%

814
-2.5%
0.62
-4.2%

772
-5.2%
0.59
-5.6%

1,170
51.6%
0.83
41.3%

1,257
7.5%
0.85
1.8%

943
-25.0%
0.61
-27.9%

971
3.0%
0.61
0.0%

15,658
29.4%
12.99
5.6%

17,088
9.1%
13.34
2.7%

17,699
3.6%
13.58
1.8%

18,605
5.1%
14.20
4.6%

19,647
5.6%
13.98
-1.5%

20,460
4.1%
13.80
-1.3%

21,009
2.7%
13.62
-1.3%

21,835
3.9%
13.75
0.9%

88.2
2.2%
78,047
4.8%

104.0
17.9%
97,583
25.0%

109.3
5.2%
102,875
5.4%

108.1
-1.2%
104,348
1.4%

110.5
2.2%
108,035
3.5%

118.2
6.9%
117,500
8.8%

122.9
4.0%
124,033
5.6%

125.9
2.5%
128,994
4.0%

127.8
1.5%
132,864
3.0%

76.0%

79.3%

80.9%

80.3%

80.1%

82.5%

83.6%

83.6%

83.6%

83.6%

830

863
3.9%

885
2.6%

939
6.1%

941
0.2%

966
2.6%

978
1.3%

994
1.7%

1,009
1.5%

1,024
1.5%

1,040
1.5%

14.35
9.8%

13.29
-7.4%

14.72
10.8%

15.10
2.6%

15.64
3.6%

16.02
2.4%

16.34
2.0%

15.57
-4.7%

15.34
-1.5%

15.41
0.5%

15.57
1.0%

73,492

Baseline Load Factor:


Post-Toggle Load Factor:
YoY Growth Rate:
Average Passenger Length of Haul
YoY Growth Rate:
Yield
YoY Growth Rate:

FY10A

FY15

Appendix 10: Fuel Expense Projection


Fuel Expense Assumptions
(in millions)

FY08A

FY09A

FY10A

Historical
FY11A

FY12A

FY13A

FY14A

Projected
FY16E
FY17E

FY15

FY18E

Fuel Expense:
Fuel Consumed (gallons):
YoY Growth Rate:

3,713
1,511
1.5%

3,044
1,428
-5.5%

3,620
1,437
0.6%

5,644
1,764
22.8%

6,120
1,847
4.7%

5,763
1,818
-1.6%

5,293
1,801
-0.9%

3,616
1,901
5.6%

3,277
1,986
4.5%

3,759
2,035
2.4%

4,108
2,085
2.5%

Fuel as % of Operating Expense:

35.1%

30.2%

32.6%

37.7%

37.2%

35.1%

32.3%

23.0%

19.9%

21.1%

21.8%

Fuel Cost per ASM:

0.036

0.031

0.037

0.186

0.191

0.177

0.162

0.103

0.088

0.097

0.103

Baseline Gallons of Fuel per 1000 ASM:


Post-Toggle Gallons of Fuel per 1000 ASM:
Baseline YoY Growth Rate:
Post-Toggle YoY Growth Rate:
ASMs per Gallon:
YoY Growth Rate:

14.63
14.63

14.57
14.57

14.60
14.60

14.63
14.63

14.41
14.41

13.95
13.95

13.75
13.75

13.53
13.53

13.40
13.40

13.19
13.19

13.13
13.13

-2.1%
68.3
2.1%

-0.4%
68.6
0.4%

0.2%
68.5
-0.2%

0.2%
68.4
-0.2%

-1.5%
69.4
1.5%

-3.2%
71.7
3.3%

-1.4%
72.7
1.5%

-1.6%
73.9
1.6%

-1.0%
74.7
1.0%

-1.5%
75.8
1.5%

-0.5%
76.2
0.5%

Economic Cost per Gallon:

1.73

2.20

2.50

Cost per Gallon:

1.65

1.90

2.10

Jet Fuel Market Price :


Baseline:
Fuel Tax and Other Costs:

1.39 $
1.21
0.18

1.75 $
1.39
0.18

1.90
1.56
0.18

Hedged Fuel %:

20.0%

65.0%

35.0%

21 | P a g e

Appendix 11: Non-Fuel Expense Projection


Non-Fuel Expense Assumptions
(in million)
Salaries, Wages, and Benefits:
YoY Growth Rate:

FY08A

FY09A
3,468
3.8%

3,704
6.8%

FY12A

FY13A

FY14A

FY15

Projected
FY16E
FY17E

FY18E

4,371
18.0%

4,749
8.6%

5,035
6.0%

5,434
7.9%

6,384
17.5%

7,202
12.8%

7,782
8.1%

8,134
4.5%

Profit-sharing Program:
% of Profit before Tax, excl. Gain/Loss from Hedges:

93
14.7%

121
13.9%

228
18.5%

355
18.4%

620
17.6%

690
18.0%

549
18.0%

457
16.0%

Salaries Ex-Profitsharing:
YoY Growth Rate:
Salaries Ex-Profitsharing per ASM:
YoY Growth Rate:

4,278

4,628
8.2%
3.61
1.8%

4,807
3.9%
3.69
2.1%

5,079
5.7%
3.88
5.1%

5,764
13.5%
4.10
5.8%

6,512
13.0%
4.39
7.1%

7,233
11.1%
4.69
6.8%

7,677
6.1%
4.83
3.0%

End-of-period Employees:
Average Employees:
YoY Growth Rate:
Average Employees per Aircraft:
YoY Growth Rate:
Salaries per Avg. Employee:
YoY Growth Rate:

3,340
4.0%

Historical
FY11A

FY10A

3.55

35,499
34,726
34,901
45,392
45,861
44,831
46,278
49,583
51,361
53,022
54,804
34,939
35,113
34,814
39,934
46,124
45,146
45,051
47,689
50,609
52,467
54,595
4.3%
0.5%
-0.9%
14.7%
15.5%
-2.1%
-0.2%
5.9%
6.1%
3.7%
4.1%
66.1
65.4
64.2
64.1
66.3
65.7
67.0
69.7
71.1
72.1
73.6
-1.3%
-1.1%
-1.9%
-0.1%
3.4%
-0.8%
1.9%
4.0%
2.0%
1.5%
2.0%
$ 95,597 $ 98,768 $ 106,396 $ 107,126 $ 100,339 $ 106,477 $ 112,738 $ 120,862 $ 128,678 $ 137,865 $ 140,622
-0.3%
3.3%
7.7%
0.7%
-6.3%
6.1%
5.9%
7.2%
6.5%
7.1%
2.0%

Maintenance Materials and Repairs:


Maintenance Materials and Repairs per ASM:
YoY Growth Rate:

721
6.98

719
7.34

751
7.63

955
38.97

1,132
35.99

1,080
32.41

978
31.25

1,004
32.78

1,027
30.90

1,068
32.28

1,100
35.26

Aircraft Rentals:

154

186

180

308

355

361

295

238

213

206

213

Landing Fees and Other Rentals:


Landing Fees and Other Rentals per ASM:
YoY Growth Rate:

662
6.41

718
7.33

807
8.20

959
39.13

1,043
33.16

1,103
33.11

1,111
35.50

1,166
38.06

1,238
37.25

1,333
40.28

1,417
45.44

134

183

86

126

38

1,385
12.6%

1,337
12.9%

1,426
11.8%

1,879
12.0%

2,039
11.9%

2,126
12.0%

2,205
11.9%

2,243
11.4%

2,455
12.0%

2,521
12.0%

2,620
12.0%

3,340
721
154
662
599
1,385
6,861
10,574
10.24
6.64
1.3%

3,468
719
186
718
616
1,337
7,044
10,088
10.29
7.19
8.2%

3,704
751
180
807
628
1,426
7,496
11,116
11.29
7.62
5.9%

4,371
955
308
959
715
134
1,879
9,321
14,965
12.41
7.73
1.5%
7.65

4,749
1,132
355
1,043
844
183
2,039
10,345
16,465
12.85
8.07
4.4%
7.98

5,035
1,080
361
1,103
867
86
2,126
10,658
16,421
12.60
8.18
1.3%
8.00

5,434
978
295
1,111
938
126
2,205
11,087
16,380
12.50
8.46
3.5%
8.19

6,384
1,004
238
1,166
1,015
38
2,243
12,087
15,704
11.18
8.60
1.7%
8.16

7,202
1,027
213
1,238
1,092
2,455
13,227
16,504
11.13
8.92
3.7%
8.45

7,782
1,068
206
1,333
1,158
2,521
14,068
17,828
11.56
9.12
2.3%
8.77

8,134
1,100
213
1,417
1,229
2,620
14,713
18,821
11.85
9.26
1.5%
8.97

Acquisition and Integration:


Acquisition and Integration per ASM:
Other Operating Expenses:
% of Revenue:
Post-Toggle Expense Totals:
Salaries, Wages, and Benefits:
Maintenance Materials and Repairs:
Aircraft Rentals:
Landing Fees and Other Rentals:
Depreciation and Amortization:
Acquisition and Integration:
Other Operating Expenses:
Total Non-Fuel Expense:
Total Operating Expense:
Total Operating Expense per ASM:
Total OpEx per ASM, excl. Fuel:
CASM ex-Fuel YoY Growth:
Total OpEx per ASM, excl. Fuel & Profitsharing:

22 | P a g e

Appendix 12: Fleet and Capital Expenditure Projection


Fleet, CapEx, and Leasing Assumptions:
(in millions except aircraft-related metrics)

FY08A

FY09A

FY10A

Historical
FY11A

FY12A

FY13A

FY14A

FY15

Projected
FY16E
FY17E

FY18E

717-200 Owned
717-200 Leased
737-300 Owned
737-300 Leased
737-500 Owned
737-500 Leased
737-700 Owned
737-700 Leased
737-800 Owned
737-800 Leased
737-Max Owned
737-Max Leased

8
58
76
46
9
6
378
47
45
7
-

76
44
10
3
389
58
78
7
-

73
44
9
3
404
68
96
7
-

65
35
432
77
101
10
-

38
32
444
88
109
10
7
6

24
17
457
97
118
10
16
9

Total Aircraft:
Growth Aircraft
ASM per Aircraft:

680
191.68

665
-2.2%
197.00

704
5.9%
199.58

720
2.3%
205.86

734
2.0%
209.97

750
2.1%
211.89

516
164
680
687

553
112
665
673

582
122
704
685

598
122
720
712

599
136
734
727

616
133
750
742

24.1%

16.8%

17.3%

17.0%

18.5%

17.8%

37

29

16

17

139.7
1,447
8.2%
166.9%

227.4
1,748
9.4%
186.4%

426.4
2,105
10.7%
207.5%

370.0
1,497
7.3%
137.1%

1,480.0
1,417
6.7%
122.3%

460.0
1,974
9.0%
160.6%

503

683

226

Total Aircraft - Owned or Finance Lease


Total Aircraft - Operating Lease
Total Aircraft - Owned or Leased
Average Total Aircraft:
YoY Growth

537
529

537
537

548
543

% Operating Lease:

# of New Owned or Finance Leased Aircraft:


CapEx per New Owned/Finance Leased Aircraft:
Post-Toggle CapEx per Aircraft:
Total CapEx:
CapEx % Revenue:
CapEx % Depreciation:

698
623

694
696

Facility CapEx:
Depreciation per Owned/Finance Leased Aircraft:
Total Depreciation:
Depreciation per ASM
YoY Growth

1.68
867.0
0.67
N/A

1.70
938.0
0.72
7.6%

1.74
1,014.7
0.72
0.9%

1.83
1,092.1
0.74
2.0%

1.93
1,158.5
0.75
2.0%

1.99
1,229.0
0.77
3.0%

Aircraft Rental per Operating Leased Aircraft:


Total Aircraft Rental
Aircraft Rental per ASM
YoY Growth

2.20
361.0
0.28
N/A

2.63
295.0
0.23
-18.7%

1.95
237.9
0.17
-24.8%

1.74
213.4
0.14
-15.0%

1.52
206.4
0.13
-7.0%

1.59
212.6
0.13
0.0%

313
0.6

561
1.0

213
0.4

354
0.6

359
0.6

366
0.6

Proceeds from Finance Leases:


Repayment of Finance Leases:
Repayment of Finance Leases per Aircraft:

Appendix 13: Major Shareholders

Major Shareholders
Primecamp Management
FMY LLC
BlackRock
Vanguard Group
State Street Corp
Egerton Capital
Others
Total Shares Outstanding

Numbers of Shares Percentage


74,401,158
11.7%
45,146,705
7.1%
41,882,226
6.6%
37,538,498
5.9%
22,403,927
3.5%
16,820,941
2.6%
399,876,577
62.7%
638,070,032
100.0%

23 | 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.

24 | P a g e

Appendix 15: Porters 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.

Industry
Rivalry

Bargaining
Power of
Suppliers
5
4
3
2
1
0

Threat of
Substitutes

Bargaining
Power of
Buyers

Threat of New
Entrants

Threat Hierarchy:
0 None
1 Slight
2 Low
3 Moderate
4 Substantial
5 High

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:

25 | 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 inflight 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 Southwests 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.

26 | P a g e

Appendix 16: SWOT Analysis

Strengths
Strong balance sheet
Uniform fleet
Recognizable brand
High aircraft utilization

Weaknesses
Minimal ancillary revenue opportunities
No segmented seating

SWOT Analysis

Opportunities

Threats

International expansion
Advanced aircraft
Capture additional domestic share
Airline alliances/codesharing

Legacy & ULCC


Rising costs
Reduced traffic demand
Volatile fuel prices
Terrorism
Regulation

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.

27 | P a g e

Price Decline as Excess Capacity Dwindles

Baker Hughes Rig Count


4500
4000
3500
3000
2500
2000
1500
1000
500
0
Mar-11

160

450,000
400,000
350,000
300,000
250,000
200,000
150,000
100,000
50,000
-

140
120
100
80
60
40
20
Mar-12

Mar-13

Mar-14

World Rig Count

0
2004

Mar-15

2006

2008

2010

2012

Open Interest

US Rig Count

2014

Last Price

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&Ps in the United States
6

US Crude Oil Imports

E&P Debt Troubles

120

100

80

8000

60

6000

40

4000

20

2000

12000
10000

0
Total Debt / EBITDA (X) 5.04

0
2004

2006

2008

2010

2012

2014

Net Interest Expense (Million) 96.21

Looking forward, the price of oil will continue to fluctuate until a new equilibrium is reached in the marketplace. Growth
in the worlds 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%.

28 | P a g e

Production in the United States

US Oil Barrels Per Rig

Oil Production in the United States


12000

500

10000

400

8000

300

6000

200

4000
2000
0
3/1/2009

100
3/1/2011

3/1/2013

3/1/2015

CROMUS Index : United States 9,318.00

0
Jun-13

Dec-13

Jun-14

Dec-14

Jun-15

Dec-15

Source: Bloomberg
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.

29 | P a g e

Appendix 18: Cost of Capital


WACC - Southwest Airlines Co.
($ in Millions Except Per Share and Per Unit Data)

Cost of Capital
Risk-free Rate:
Market Risk Premium:
Beta:
Cost of Equity:
Default Spread:
Pre-tax Cost of Debt:
Cost of Preferred Stock:

2.25%
5.00%
1.32
8.84%
2.00%
4.25%
0.00%

Comparable Companies - Unlevered Beta

American Airlines Group


Delta Airlines
JetBlue
Alaska Air Group
United Continental
Spirit Airlines
Virgin America

Ticker
AAL
DAL
JBLU
ALK
UAL
SAVE
VA

Levered
Beta
Debt
1.25 $ 30,048
1.32
16,889
1.27
3,385
1.21
1,473
1.20
24,905
1.17
1,765
1.09
1,213

Median:
Southwest Airlines Co

1.21
LUV

3,385

% Debt
54.0%
32.3%
33.0%
14.1%
57.8%
37.0%
40.9%

Preferred
Equity
Stock % Preferred Value
$ 25,584
35,320
6,882
8,973
18,217
3,007
1,755

37.0% $

$ 8,973

% Equity Tax Rate


46.0%
37.0%
67.7%
37.0%
67.0%
37.0%
85.9%
37.0%
42.2%
37.0%
63.0%
37.0%
59.1%
37.0%
63.0%

Unlevered
Beta
0.87
1.11
1.12
1.27
0.75
1.05
0.96

37.0%

Cash
Firm Value
(9,583)
53,947
(5,424)
62,105
(1,132)
8,276
(1,258)
9,402
(5,755)
41,520
(749)
4,023
(512)
2,456

1.05

1.11

The Southwest Airlines Co. - Levered Beta and WACC Calculation


Unlevered
Beta
Debt
Comparable Capital Structure:
LUV
1.05
11,649
Current Capital Structure:
LUV
1.05
5,923
Optimal Capital Structure:
LUV
1.00
6,298

% Debt
37.0%
18.8%
20.0%

Preferred
Stock % Preferred
-

Equity
19,839
25,565
25,190

% Equity Tax Rate


63.0%
37.0%
81.2%
38.0%
80.0%
38.0%

Levered
Beta
1.44
1.20
1.16

WACC, Comparable Capital Structure:


WACC, Current Capital Structure:
Average WACC:

6.55%
7.68%
7.11%

WACC, Optimal Capital Structure:

7.60%

Appendix 19: Discounted Cash Flow Analysis


DCF - Operating Lease Adjustment
($ in Millions Except Per Share and Per Unit Data)
Annual Unlevered FCF Projection

FY05A

Operating Leases (Book Value):


Discounted Operating Leases:
Pre-tax Cost of Debt:
PV of Operating Lease Expenses:
Revenue:
EBITDA:
EBIT:
Operating Lease Expense in Current Year:
Depreciation on leased asset:
Adjusted After-tax EBIT:
Non-cash Adjustments:
Changes in NOWC:
CapEx:
FCFF:
FCFF, remaining periods:
Present Value of FCFF:
Sum of PV of FCFF:

Historical
FY06A

FY07A

FY08A

FY09A

FY10A

Historical
FY11A
FY12A

FY13A

FY14A

FY15

Projected
FY17E

FY18E

343

332

360

400

376

414

386

640

688

637

684

557

6.89%
1,689

7.28%
1,621

7.65%
1,510

6.53%
1,523

5.62%
1,349

6.38%
1,748

6.11%
1,734

4.62%
4,064

4.78%
3,042

5.47%
2,643

4.50%
3,689

4.25%
2,746

7,584 $
399
(70)
343
188
53

9,086 $
815
300
332
203
266

9,861 $ 11,023 $ 10,350 $ 12,104 $ 15,658 $ 17,088 $ 17,699 $ 18,605 $ 19,647 $ 20,460 $ 21,009 $ 21,835
660
(58)
696
1,625
1,718
1,650
2,169
3,277
4,990
5,047
4,340
4,243
105
(657)
80
997
1,003
806
1,302
2,339
3,975
3,955
3,181
3,014
360
400
376
414
386
640
688
637
684
557
545
474
189
218
193
250
248
508
380
378
527
213
231
250
171
(294)
163
720
708
582
998
1,611
2,562
2,666
2,167
2,008
820
1,092
1,158
1,229
366
205
502
723
(2,041)
(1,057)
(2,155)
(2,256)
1,707
2,905
1,672
1,704

545
523

474
436

2,801

2,857

2,807

1,509

1,435

1.00
0.50

2.00
1.50

3.00
2.50

70.2%

-42.4%

1.9%

5,751

Normal Discount Period:


Mid-year Discount Period:
Annual FCFF Growth:

FY16E

N/A

30 | P a g e

Terminal Value - Multiple Method


Terminal EBITDA Multiple:
Terminal Value:
Implied Terminal FCF Growth Rate:

6.30 x
29,715
2.47%

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:
Present Value of FCFF:
Implied Enterprise Value:

24,181
5,751
29,932

PV of Terminal Value:
Present Value of FCFF:
Implied Enterprise Value:

24,333
5,751
30,083

Plus: Cash & Cash-Equivalents:


Less: Total Debt & Capital Leases:
Less: Pension:
Implied Equity Value:

3,050
(6,866)
26,116

Plus: Cash & Cash-Equivalents:


Less: Total Debt & Capital Leases:
Less: Pension:
Implied Equity Value:

3,050
(6,866)
26,268

Diluted Shares Outstanding:

679.55

Diluted Shares Outstanding:

679.55

Implied Share Price from DCF:


Premium / (Discount) to Current:

$38.43
2.37%

Implied Share Price from DCF:


Premium / (Discount) to Current:

$38.65
2.97%

DCF Case
Base
Downside
Upside

Weight
60%
20%
20%

Implied Weighted
Price
Price
$38.54
$38.81
$23.72
$54.70

31 | P a g e

Appendix 20: Sensitivity Analysis Base Case Scenario

Discount Rate
(WACC)

Sensitivity - Terminal FCF Growth Rate vs. WACC and Implied Share Price from DCF Analysis:
Terminal FCF Growth Rate
3865.5% 1.5%
1.8%
2.0%
2.3%
2.5%
2.8%
3.0%
3.3%
3.5%
6.1%
$ 34.17 $ 35.58 $ 37.12 $ 38.81 $ 40.65 $ 42.69 $ 44.96 $ 47.48 $ 50.30
6.4%
33.74
35.14
36.66
38.32
40.14
42.16
44.39
46.88
49.67
6.6%
33.32
34.70
36.20
37.84
39.64
41.63
43.83
46.29
49.04
6.9%
32.91
34.27
35.75
37.37
39.15
41.11
43.28
45.71
48.43
7.1%
32.50
33.84
35.30
36.90
38.66
40.59
42.74
45.14
47.82
7.4%
32.10
33.42
34.86
36.44
38.18
40.09
42.21
44.57
47.22
7.6%
31.70
33.01
34.43
35.99
37.70
39.59
41.68
44.02
46.63
7.9%
31.31
32.60
34.01
35.55
37.24
39.10
41.17
43.47
46.05
8.1%
30.92
32.20
33.59
35.11
36.78
38.62
40.66
42.93
45.48

Discount Rate
(WACC)

Sensitivity - Terminal EBITDAR vs. WACC and Implied Share Price from DCF Analysis:
Terminal FCF Growth Rate
3843.1% 5.3 x
5.6 x
5.8 x
6.1 x
6.3 x
6.6 x
6.8 x
7.1 x
7.3 x
6.1%
$ 33.74 $ 35.19 $ 36.64 $ 38.10 $ 39.55 $ 41.00 $ 42.45 $ 43.91 $ 45.36
6.4%
33.50
34.94
36.38
37.82
39.27
40.71
42.15
43.59
45.04
6.6%
33.26
34.69
36.12
37.55
38.99
40.42
41.85
43.28
44.71
6.9%
33.02
34.44
35.86
37.29
38.71
40.13
41.55
42.97
44.40
7.1%
32.78
34.20
35.61
37.02
38.43
39.85
41.26
42.67
44.08
7.4%
32.55
33.95
35.36
36.76
38.16
39.56
40.96
42.37
43.77
7.6%
32.32
33.71
35.10
36.50
37.89
39.28
40.67
42.07
43.46
7.9%
32.09
33.47
34.86
36.24
37.62
39.00
40.39
41.77
43.15
8.1%
31.86
33.24
34.61
35.98
37.36
38.73
40.10
41.48
42.85

Jet Fuel

Sensitivity - ASM vs. Price per Gallon and Implied Share Price from DCF Analysis:

$
$
$
$
$
$
$
$
$

25.00
30.00
35.00
40.00
45.00
50.00
55.00
60.00
65.00

$
$
$
$
$
$
$
$
$

1.21
1.30
1.39
1.48
1.57
1.66
1.75
1.84
1.93

Capacity Expansion (ASM)


1.5%
2.5%
3.5%
4.5%
5.5%
6.5%
7.5%
8.5%
9.5%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
$ 37.46 $ 38.74 $ 40.02 $ 41.30 $ 42.58 $ 43.86 $ 45.14 $ 46.42 $ 47.71
36.45
37.72
39.00
40.27
41.54
42.82
44.09
45.36
46.64
35.45
36.71
37.98
39.24
40.51
41.77
43.04
44.30
45.57
34.44
35.70
36.95
38.21
39.47
40.73
41.98
43.24
44.50
33.43
34.68
35.93
37.18
38.43
39.68
40.93
42.18
43.43
32.43
33.67
34.91
36.15
37.39
38.64
39.88
41.12
42.36
31.42
32.65
33.89
35.12
36.36
37.59
38.83
40.06
41.30
30.42
31.64
32.87
34.09
35.32
36.55
37.77
39.00
40.23
29.41
30.63
31.84
33.06
34.28
35.50
36.72
37.94
39.16

Jet Fuel

Sensitivity - PRASM vs. Price per Gallon and Implied Share Price from DCF Analysis:

$
$
$
$
$
$
$
$
$

25.00
30.00
35.00
40.00
45.00
50.00
55.00
60.00
65.00

$
$
$
$
$
$
$
$
$

1.21
1.30
1.39
1.48
1.57
1.66
1.75
1.84
1.93

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%
$ 34.15 $ 36.22 $ 38.32 $ 40.44 $ 42.58 $ 44.74 $ 46.92 $ 49.12 $ 51.34
33.11
35.19
37.28
39.40
41.54
43.70
45.88
48.08
50.31
32.07
34.15
36.25
38.37
40.51
42.67
44.85
47.05
49.27
31.03
33.11
35.21
37.33
39.47
41.63
43.81
46.01
48.23
30.00
32.08
34.17
36.29
38.43
40.59
42.77
44.97
47.19
28.96
31.04
33.14
35.25
37.39
39.55
41.73
43.93
46.16
27.92
30.00
32.10
34.22
36.36
38.52
40.70
42.90
45.12
26.89
28.96
31.06
33.18
35.32
37.48
39.66
41.86
44.08
25.85
27.93
30.03
32.14
34.28
36.44
38.62
40.82
43.04

Average Per-employee
Expense

Sensitivity - Load Factor vs. Per-Employee Expense and Implied Share Price from DCF Analysis:

$120,862
$123,884
$125,092
$126,301
$127,510
$128,718
$129,927
$131,136
$132,344
$133,553

2.5%
3.5%
4.5%
5.5%
6.5%
7.5%
8.5%
9.5%
10.5%

Fuel Efficiency
-5.0%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
$ 45.89 $ 45.57 $ 45.25 $ 44.92 $ 44.60 $ 44.28 $ 43.96 $ 43.63 $ 43.31
44.39
44.07
43.75
43.42
43.10
42.78
42.46
42.13
41.81
42.86
42.54
42.22
41.90
41.57
41.25
40.93
40.60
40.28
41.31
40.99
40.66
40.34
40.02
39.69
39.37
39.05
38.72
39.72
39.40
39.08
38.75
38.43
38.11
37.79
37.46
37.14
38.11
37.79
37.46
37.14
36.82
36.49
36.17
35.85
35.53
36.47
36.14
35.82
35.50
35.17
34.85
34.53
34.21
33.88
34.79
34.47
34.15
33.83
33.50
33.18
32.86
32.53
32.21
33.09
32.77
32.45
32.12
31.80
31.48
31.16
30.83
30.51

32 | P a g e

Appendix 21: Adjusted Total Capital Calculation


Adjusted Total Capital Calculation

FY05A

FY06A

FY07A

FY08A

FY09A

FY10A

FY11A

FY12A

FY13A

FY14A

PV of Long-term Capital Leases Obligations:


Capitalized Leases:
Change in Capitalized Leases:
YoY Growth

FY15
334
3,689

FY16E

FY17E

FY18E

2,746
(943)

2,801
55
2.0%

2,857
56
2.0%

Debt Outstanding:

1,995

1,689

2,091

3,661

3,515

3,380

3,751

3,154

2,820

2,692

3,177

2,863

3,852

3,564

Cash:
Adjusted Debt Outstanding:
Equity Value:
Total Capital:

2,280
3,684
6,675
8,079

1,390
3,310
6,449
8,369

2,213
3,601
6,941
8,329

1,368
5,184
4,953
8,769

1,114
4,864
5,466
9,216

1,261
5,128
6,237
10,104

829
5,485
6,877
11,533

1,113
7,218
6,992
13,097

1,355
5,862
7,336
11,843

1,282
5,335
6,775
10,828

1,582
6,866
7,358
12,642

1,080
5,609
7,953
12,482

1,742
6,653
8,064
12,974

1,239
6,421
8,053
13,234

Reported ROIC:
Normalized ROIC:
WACC:
Adjusted ROIC:
Spread:

5.6%
-0.5%
7.6%
0.7%
-7.0%

7.0%
2.3%
7.6%
3.2%
-4.4%

5.6%
0.7%
7.6%
2.1%
-5.6%

3.3%
-4.8%
7.6%
-3.4%
-11.0%

1.8%
0.5%
7.6%
1.8%
-5.8%

6.5%
6.6%
7.6%
7.1%
-0.5%

4.5%
5.5%
7.6%
6.1%
-1.5%

4.8%
4.8%
7.6%
4.4%
-3.2%

8.4%
8.0%
7.6%
8.4%
0.8%

15.0%
14.9%
7.6%
14.9%
7.3%

24.2%
24.1%
7.1%
20.3%
13.2%

23.0%
23.0%
7.1%
21.4%
14.2%

17.4%
17.4%
7.1%
16.7%
9.6%

15.9%
15.9%
7.1%
15.2%
8.1%

Appendix 22: EVA & EBITDAR Calculation


Historical Enterprise Value & EVA
Enterprise Value:

FY05A

FY06A

FY07A

FY08A

FY09A

FY10A

FY11A

FY12A

FY13A

FY14A

12,524

12,032

8,074

6,854

9,353

8,951

8,298

8,763

14,209

29,603

FY15

Adjusted EBIT:
YoY Growth Rate
Depreciation:
Depreciation on leased asset:
EBITDAR:
EBITDAR Margin:

85

429

276

(475)

263

1,161

1,141

938

1,610

2,598

4,132

469
188
742
9.8%

515
203
1,147
12.6%

555
189
1,020
10.3%

599
218
342
3.1%

616
193
1,072
10.4%

628
250
2,039
16.8%

715
248
2,104
13.4%

844
508
2,290
13.4%

867
380
2,857
16.1%

938
378
3,914
21.0%

EV/EBITDAR:
Average EBITDAR Ex-Outlier:

16.9 x
7.6 x

10.5 x

7.9 x

20.0 x

8.7 x

4.4 x
--

3.9 x

3.8 x

5.0 x

7.6 x
5.6 x

Economic Value Added:

(562)

(371)

(463)

(962)

(538)

(49)

(170)

(415)

97

787

FY16E

FY17E

FY18E

1,015
527
5,674
28.9%

4,300
4.1%
1,092
213
5,604
27.4%

3,495
-18.7%
1,158
231
4,885
23.3%

3,238
-7.4%
1,229
250
4,717
21.6%

1,663

1,778

1,244

1,066

33 | P a g e

34 | P a g e

Southwest

LUV

Ticker
AAL
DAL
JBLU
ALK
UAL
SAVE
VA

37.62

70.40
46.29
41.80
38.92
21.31

37.62

70.40
46.29
41.80
38.92
21.31

Share
Price
$ 38.99
44.29
21.31
70.40
48.28
41.80
38.85

Maximum
75th Percentile
Median
25th Percentile
Minimum

Company Name
American Airlines Group
Delta Airlines
JetBlue
Alaska Air Group
United Continental
Spirit Airlines
Virgin America

Valuation Statistics

Southwest

LUV

Ticker
AAL
DAL
JBLU
ALK
UAL
SAVE
VA

Share
Price
$ 38.99
44.29
21.31
70.40
48.28
41.80
38.85

Maximum
75th Percentile
Median
25th Percentile
Minimum

Company Name
American Airlines Group
Delta Airlines
JetBlue
Alaska Air Group
United Continental
Spirit Airlines
Virgin America

Operating Statistics

($ in Millions Except Per Share and Per Unit Data)

$ 28,435

$ 62,105
47,734
9,402
6,149
2,456

$ 25,565

$ 35,320
21,900
8,973
4,944
1,755
$ 28,435

$ 62,105
47,734
9,402
6,149
2,456

Capitalization
Equity
Enterprise
Value
Value
$ 25,584 $ 53,947
35,320
62,105
6,882
8,276
8,973
9,402
18,217
41,520
3,007
4,023
1,755
2,456

$ 25,565

$ 35,320
21,900
8,973
4,944
1,755
20,460

$ 40,930
39,064
6,930
4,112
1,697

Revenue
2016E
$ 40,930
40,804
6,930
5,862
37,324
2,362
1,697

21,009

$ 42,733
40,344
7,539
4,560
1,884

2017E
$ 42,733
42,031
7,539
6,250
38,657
2,870
1,884

1.4 x

1.9 x
1.7 x
1.5 x
1.3 x
1.0 x
1.4 x

1.8 x
1.7 x
1.5 x
1.1 x
1.0 x
1.4 x

1.9 x
1.8 x
1.5 x
1.3 x
1.0 x

Enterprise Value /
Revenue
2015
2016E
2017E
1.0 x
1.0 x
1.0 x
1.1 x
1.0 x
1.9 x
1.4 x
1.2 x
1.1 x
1.6 x
1.5 x
1.4 x
1.8 x
1.7 x
1.6 x
1.5 x
1.6 x
1.5 x
1.9 x
1.8 x
1.9 x

19,647

$ 40,990
39,284
6,416
3,869
1,534

Capitalization
Equity
Enterprise
Value
Value
2015
$ 25,584 $ 53,947 $ 40,990
35,320
62,105
40,704
6,882
8,276
6,416
8,973
9,402
5,598
18,217
41,520
37,864
3,007
4,023
2,139
1,755
2,456
1,534

Comparable Companies - Airlines Companies, with Revenue More than 1B

5,604

$ 12,052
10,778
2,129
1,490
809
4,885

$ 11,696
10,238
2,152
1,479
879

2017E
$ 10,850
11,696
2,152
2,061
9,625
897
879

5.0 x

6.2 x
5.0 x
4.9 x
4.4 x
3.1 x
5.1 x

5.2 x
4.6 x
4.4 x
4.0 x
3.0 x
5.8 x

5.3 x
4.8 x
4.5 x
4.1 x
2.8 x

Enterprise Value /
EV/EBITDAR
2015
2016E
2017E
5.0 x
4.7 x
5.0 x
6.2 x
5.2 x
5.3 x
4.6 x
3.9 x
3.8 x
5.1 x
4.6 x
4.6 x
4.1 x
4.1 x
4.3 x
4.9 x
4.4 x
4.5 x
3.1 x
3.0 x
2.8 x

5,674

$ 10,757
10,059
1,856
1,304
794

2015
$ 10,757
10,078
1,796
1,856
10,040
813
794

EBITDAR
2016E
$ 11,530
12,052
2,129
2,060
10,026
920
809
$

2,375

5,233
3,748
942
595
230

12.7 x

12.4 x
11.2 x
9.2 x
6.3 x
4.6 x

10.8 x

10.0 x
8.7 x
6.4 x
6.0 x
5.3 x

P / E Multiple
2015
2016E
4.6 x
5.6 x
11.0 x
6.4 x
11.4 x
8.1 x
12.4 x
9.2 x
4.8 x
5.3 x
9.2 x
10.0 x
7.7 x
6.4 x

2,008

6,269
4,094
842
494
209

13.5 x

9.3 x
8.5 x
6.3 x
6.0 x
5.3 x

2017E
5.8 x
6.1 x
8.0 x
9.0 x
5.3 x
9.3 x
6.3 x

1,890

5,126
3,535
948
616
193

Reported Net Income


2015
2016E
2017E
$ 6,269 $ 4,378 $ 4,046
3,709
5,233
5,126
677
897
911
842
942
948
4,478
3,118
3,023
310
293
321
209
230
193

2.7%

21.5%
9.9%
6.6%
4.0%
3.0%
(12.8%)

8.6%
0.6%
-2.5%
-3.5%
-5.9%

(20.4%)

9.6%
1.1%
-2.0%
-5.3%
-16.1%

Projected Projected Projected


Revenue
EBITDAR
NI
Growth
Growth
Growth
4.4%
(5.9%)
(7.6%)
3.0%
(3.0%)
(2.0%)
8.8%
1.1%
1.6%
6.6%
0.0%
0.6%
3.6%
(4.0%)
(3.0%)
21.5%
(2.5%)
9.6%
11.0%
8.6%
(16.1%)

28.9%

51.8%
35.6%
28.0%
26.4%
24.8%

27.4%

47.7%
37.0%
30.7%
28.9%
26.9%

23.3%

46.6%
32.1%
28.5%
26.6%
24.9%

EBITDAR Margin
2015
2016E
2017E
26.2%
28.2%
25.4%
24.8%
29.5%
27.8%
28.0%
30.7%
28.5%
33.2%
35.1%
33.0%
26.5%
26.9%
24.9%
38.0%
38.9%
31.2%
51.8%
47.7%
46.6%

Appendix 24: Comparable Comps Analysis


AAL
American Airlines Group

Revenue:
Cost of Sales:
Gross Profit:
Operating Expenses:
Operating Income (EBIT):
Interest and Other Income:
Pre-Tax Income:
Taxes:
Other Items:
Reported Net Income:
D&A from the CFS:
Rental Expenses:
Non-Recurring Charges:
Tax Rate:
EBITDA:
EBITDAR:

DAL
Delta Airlines

JBLU
JetBlue

FY 15
$ 40,990.0

FY 15
$ 40,704.0

FY 15
$ 6,416.0

7,161.0

8,688.0

1,203.0

1,330.0

6,172.0

8,184.0

1,082.0

1,344.0

6,269.0

3,709.0

677.0

842.0

1,391.0

157.0

235.0

206.0

37.0%
8,647
10,038

37.0%
8,371
8,528

37.0%
1,571
1,806

37.0%
1,650
1,856

Balance Sheet Data

Balance Sheet Data

Less: Cash & Cash Equivalents:


Less: Equity Investments:
Less: Other Non-Core Assets, Net:
Less: Net Operating Losses:
Plus: Debt
Plus: Preferred Stock:
Plus: Noncontrolling Interests:
Plus: Unfunded Pension Obligations:
Plus: Capitalized Leases:
Plus: Other Liabilities:

Equity Research Projections


12/31/2015 12/31/2016 12/31/2017

40,990 $
10,757
8,647
6,269

40,930 $
11,530
9,613
4,378

42,733
10,850
9,041
4,046

40,704 $
10,078
8,371
3,709

Diluted Shares Calculation


Share Price as of the Valuation Date:
Common Shares Outstanding:
Options and Warrants:

Convertible Bonds:

Restricted Stock Units (RSUs):

$ Amount

Par Value

Conv. Price

# RSUs
21.342

Total Diluted Shares:

40,804 $
12,052
10,559
5,233

42,031
11,696
10,373
5,126

38.99
630.33

Dilution
0.000
0.000
Dilution
21.342

Total
Strike
7.954 $
10.99

$ Amount

Par Value

Conv. Price

# RSUs
5.010

656.18

Equity Value:
Enterprise Value:
Beta:

6,416 $
1,796
1,561
677

6,930 $
2,129
1,959
897

Equity Research Projections


12/31/2015 12/31/2016 12/31/2017

7,539
2,152
2,012
911

Fact Set
$

5,598 $
1,856
1,650
842

Diluted Shares Calculation


44.29
786.47

Dilution
0.000
0.000
Dilution
5.010

Total
Strike
5.977 $
12.38
2.552 $
8.04

$ Amount

Par Value

Conv. Price

Dilution
0.000
0.000

# RSUs
3.785

Dilution
3.785

Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.0 x
1.0 x
1.0 x
5.0 x
4.7 x
5.0 x
5.0 x
4.3 x
4.6 x
4.6 x
5.6 x
5.8 x

Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.1 x
1.0 x
1.9 x
6.2 x
5.2 x
5.3 x
5.3 x
3.7 x
3.5 x
11.0 x
6.4 x
6.1 x
Lookup Variables

Total
Strike
1.920 $
21.57

$ Amount

Par Value

70.40
126.13
Dilution
1.332
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

Conv. Price

Dilution
0.000
0.000

# RSUs
0.000

Dilution
0.000

322.94
Valuation Metrics

$ 35,319.7
$ 62,105.2
1.32

6,250
2,061
1,900
948

21.31
315.06
Dilution
2.505
1.589
0.000
0.000
0.000
0.000
0.000
0.000
0.000

797.46

$ 25,584.3
$ 53,947.3
1.25

5,862 $
2,060
1,865
942

Diluted Shares Calculation


$

Dilution
5.981
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

Valuation Metrics

Lookup Variables

(1,258)
710
214
763
-

Fact Set
$

Dilution
4.508
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

Valuation Metrics

EV / Revenue:
EV / EBITDAR:
EV / EBITDA:
P / E:

Equity Research Projections


12/31/2015 12/31/2016 12/31/2017

Diluted Shares Calculation


$

Total
Strike
7.006 $
13.90

(1,132)
(413)
(446)
2,458
927
-

Fact Set
$

FY 15
5,598.0

Balance Sheet Data

(5,424)
(46)
8,329
360
15,006
8,560
-

Fact Set
$

Balance Sheet Data

(9,583)
20,561
7,898
9,487
Equity Research Projections
12/31/2015 12/31/2016 12/31/2017

Bank:
Date:
Revenue:
EBITDAR:
EBITDA:
Reported Net Income:

ALK
Alaska Air Group

127.46
Valuation Metrics

$
$

6,881.8
8,275.5
1.27

Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.4 x
1.2 x
1.1 x
4.6 x
3.9 x
3.8 x
5.7 x
4.2 x
3.9 x
11.4 x
8.1 x
8.0 x
Lookup Variables

$
$

8,973.2
9,401.7
1.21

Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.6 x
1.5 x
1.4 x
5.1 x
4.6 x
4.6 x
5.5 x
4.8 x
4.6 x
12.4 x
9.2 x
9.0 x
Lookup Variables

12/31/2015 Revenue:
12/31/2015 EBITDAR:
12/31/2015 EBITDA:
12/31/2015 Reported Net Income:

$ 40,990.0
10,757.0
8,647.0
6,269.0

$ 40,704.0
10,078.0
8,371.0
3,709.0

6,416.0
1,796.0
1,561.0
677.0

5,598.0
1,856.0
1,650.0
842.0

12/31/2016 Revenue:
12/31/2016 EBITDAR:
12/31/2016 EBITDA:
12/31/2016 Reported Net Income:

$ 40,930.0
11,530.0
9,613.0
4,378.0

$ 40,804.0
12,052.0
10,559.0
5,233.0

6,930.0
2,129.0
1,959.0
897.0

5,862.0
2,060.0
1,865.0
942.0

12/31/2017 Revenue:
12/31/2017 EBITDAR:
12/31/2017 EBITDA:
12/31/2017 Reported Net Income:

$ 42,733.0
10,850.0
9,041.0
4,046.0

$ 42,031.0
11,696.0
10,373.0
5,126.0

7,539.0
2,152.0
2,012.0
911.0

6,250.0
2,061.0
1,900.0
948.0

FY 15 EV / Revenue:
FY 15 EV / EBITDAR:
FY 15 EV / EBITDA:
FY 15 P / E:

1.0 x
5.0 x
5.0 x
4.6 x

1.1 x
6.2 x
5.3 x
11.0 x

1.4 x
4.6 x
5.7 x
11.4 x

1.6 x
5.1 x
5.5 x
12.4 x

12/31/2016 EV / Revenue:
12/31/2016 EV / EBITDAR:
12/31/2016 EV / EBITDA:
12/31/2016 P / E:

1.0 x
4.7 x
4.3 x
5.6 x

1.0 x
5.2 x
3.7 x
6.4 x

1.2 x
3.9 x
4.2 x
8.1 x

1.5 x
4.6 x
4.8 x
9.2 x

12/31/2017 EV / Revenue:
12/31/2017 EV / EBITDAR:
12/31/2017 EV / EBITDA:
12/31/2017 P / E:

1.0 x
5.0 x
4.6 x
5.8 x

1.9 x
5.3 x
3.5 x
6.1 x

1.1 x
3.8 x
3.9 x
8.0 x

1.4 x
4.6 x
4.6 x
9.0 x

1053.5%

215.7%

149.7%

115.5%

Adjusted D/E:

35 | P a g e

UAL
United Continental

SAVE
Spirit Airlines

VA
Virgin America

FY 15
$ 37,864.0

FY 15
$ 2,139.0

FY 15
$ 1,534.0

5,492.0

479.0

220.0

4,498.0

488.0

210.0

4,478.0

310.0

209.0

3,566.0

243.9

217.0

37.0%
7,311
10,877

37.0%
569
813

37.0%
237
454

Balance Sheet Data

Balance Sheet Data

Equity Research Projections


12/31/2015 12/31/2016 12/31/2017

37,864 $
10,040
7,311
4,478

37,324 $
10,026
7,656
3,118

38,657
9,625
7,389
3,023

2,139 $
813
569
310

Diluted Shares Calculation

Equity Research Projections


12/31/2015 12/31/2016 12/31/2017

Total

Strike

Dilution
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

Par Value

Conv. Price

Dilution
0.000
0.000

# RSUs
4.500

2,870
897
675
321

48.28
372.81

Dilution
4.500

1,534 $
794
237
209

Conv. Price

Dilution
0.000
0.000

# RSUs
0.364

Dilution
0.364

Valuation Metrics

Lookup Variables

Equity Research Projections


12/31/2015 12/31/2016 12/31/2017

1,884
879
304
193

19,647 $
5,674
2,008

Total
Strike
0.135 $
15.95
0.913 $
15.95

$ Amount

Par Value

Lookup Variables

1,890

Dilution
0.079
0.538
0.000
0.000
0.000
0.000
0.000
0.000
0.000

Conv. Price

Dilution
0.000
0.000

# RSUs
0.636

Dilution
0.636

Total
Strike
2.477 $
15.17

$ Amount

Par Value

Conv. Price

# RSUs
2.077

45.16

3,006.6
4,023.1
1.17

Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.5 x
1.6 x
1.5 x
4.9 x
4.4 x
4.5 x
5.6 x
6.3 x
6.1 x
9.2 x
10.0 x
9.3 x

2,375

21,009
4,885

38.85
43.91

Valuation Metrics
$
$

20,460 $
5,604

Diluted Shares Calculation

71.93

$ 18,216.5
$ 41,520.4
1.20
Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.8 x
1.7 x
1.6 x
4.1 x
4.1 x
4.3 x
3.9 x
3.2 x
3.1 x
4.8 x
5.3 x
5.3 x

1,697 $
809
310
230

41.80
71.54
Dilution
0.025
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000

377.31
Valuation Metrics

(3,050.30)
(3)
3,177
2,746
-

Diluted Shares Calculation

Total
Strike
0.032 $
8.32

Par Value

38.0%
4,990
5,674

Fact Set
$

$ Amount

2,008

215
998
-

Diluted Shares Calculation


$

$ Amount

2,362 $
920
592
293

3,981

(512)
-

Fact Set
$

FY 15
19,647

Balance Sheet Data

(749)
538
1,228
-

Fact Set
$

Balance Sheet Data

(5,755)
(82)
12,121
4,236
12,784
Equity Research Projections
12/31/2015 12/31/2016 12/31/2017

LUV
Southwest Airlines Co.

37.62
675.99
Dilution
1.478
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
Dilution
0.000
0.000
Dilution
2.077
679.55

Valuation Metrics
$
$

1,754.5
2,455.9
1.09

$ 25,564.6
$ 28,434.7
1.11

Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.9 x
1.8 x
1.9 x
3.1 x
3.0 x
2.8 x
6.0 x
4.2 x
4.3 x
7.7 x
6.4 x
6.3 x

Valuation Multiples
12/31/2015 12/31/2016 12/31/2017
1.4 x
1.4 x
1.4 x
5.0 x
5.1 x
5.8 x
5.0 x
5.1 x
5.8 x
12.7 x
10.8 x
13.5 x

Lookup Variables

Lookup Variables

$ 37,864.0
10,040.0
7,311.0
4,478.0

2,139.0
813.0
569.0
310.0

1,534.0
794.1
237.0
209.0

$ 19,646.9
5,673.7
2,008.2

$ 37,324.0
10,026.0
7,656.0
3,118.0

2,362.0
919.6
592.0
293.0

1,697.0
809.0
310.0
230.0

$ 20,459.8
5,604.5
2,375.0

$ 38,657.0
9,625.0
7,389.0
3,023.0

2,870.0
896.6
675.0
321.0

1,884.0
878.8
304.0
193.0

$ 21,008.9
4,884.6
1,890.5

1.8 x
4.1 x
3.9 x
4.8 x

1.5 x
4.9 x
5.6 x
9.2 x

1.9 x
3.1 x
6.0 x
7.7 x

1.4 x
5.0 x
5.0 x
12.7 x

1.7 x
4.1 x
3.2 x
5.3 x

1.6 x
4.4 x
6.3 x
10.0 x

1.8 x
3.0 x
4.2 x
6.4 x

1.4 x
5.1 x
5.1 x
10.8 x

1.6 x
4.3 x
3.1 x
5.3 x

1.5 x
4.5 x
6.1 x
9.3 x

1.9 x
2.8 x
4.3 x
6.3 x

1.4 x
5.8 x
5.8 x
13.5 x

358.4%

218.9%

274.7%

70.5%

36 | P a g e

Appendix 25:

Liquidation Valuation - Southwest Airlines Co.


Condensed Consolidated Balance Sheet as of December 31, 2015
($ in Millions Except Per Share and Per Unit Data)
Southwest Airlines Co. - Liquidation Valuation Based on 12/31/2015 Balance Sheet
Assumed Recovery

FY 2015
Assets
Current Assets:
Cash and Cash Equivalents:
Short-Term Investments:
Accounts and other receivables:
Inventories of parts and supplies, at cost:
Prepaid Expenses & Other Current Assets:
Total Current Assets:

Low

$
$
$
$
$
$

1,582
1,468
474
311
188
4,024

Less allowance for depreciation and amortization:


Net PP&E:
Goodwill:
Other Long-Term Assets:
Total Assets:

$
$
$
$
$
$
$
$
$
$

19,462
3,219
1,089
915
24,685
9,084
15,601
970
717
21,312

Liabilities
Current Liabilities:
Accounts Payable:
Accrued Liabilities:
Air Traffic Liability:
Total Current Liabilities, ex. Current Debt:
Long-term debt:
Deferred income taxes, net:
Construction obligation
Deferred gains from sale and leaseback of aircraft
Other non-current liabilities
Total Liabilities:

$ 1,188
$ 2,591
$ 2,990
$ 6,769
$ 3,177
$ 2,490
$
757
$
$
760
$ 13,953

Flight equipment
Ground property and equipment:
Deposits on flight equipment purchase contracts:
Assets constructed for others:

Liquidation Value

High

Low

95.0%
90.0%
95.0%
90.0%
90.0%

100.0%
95.0%
100.0%
95.0%
95.0%

$1,503
$1,322
$450
$280
$170
$3,724

$1,582
$1,395
$474
$295
$179
$3,925

90.0%
0.0%
68.4%

95.0%
0.0%
73.6%

$14,040
$0
$491
$ 18,255

$14,821
$0
$528
$ 19,274

1,188
$2,591
$ 2,990
6,769
$3,177
$2,490
$757
$0
$760
$13,953

$1,188
$2,591
$ 2,990
$6,769
$3,177
$2,490
$757
$0
$760
$13,953

$ 4,302
$ 6.33

$ 5,320
$ 7.83

Value Available to Shareholders:


Per Share Value:

High

Appendix 26: Reinvestment Need Calculation


Reinvestment Rate and Payout Ratio Calculation

FY05A

FY06A

FY07A

FY08A

FY09A

FY10A

FY11A

FY12A

FY13A

FY14A

FY15

FY16E

FY17E

FY18E

CapEx:
Depreciation:
Change in NOWC:

1,146
657
857

1,399
718
111

1,331
744
1,322

923
817
(2,360)

585
809
184

493
878
216

1,218
963
292

1,598
1,352
749

1,697
1,247
811

1,998
1,316
48

2,041
1,542
366

2,000
1,305
205

2,100
1,390
502

2,200
1,479
723

Reinvestment:

1,346

792

1,909

(2,254)

(40)

(169)

547

995

1,261

730

866

900

1,212

1,445

546
53

659
266

597
171

391
(294)

276
163

714
720

515
708

468
582

983
998

1,540
1,611

2,542
2,562

2,666
2,666

2,167
2,167

2,008
2,008

2544.5%
102.8%

297.7%
79.4%

1114.7%

765.9%

-24.4%

-23.4%

77.3%

171.1%

126.3%

45.3%

After-tax Adjusted EBIT


Reported:
Normalized:
Annual Reinvestment Rate:
Average Reinvestment Rate:

37 | P a g e

Appendix 27: Comprehensive Ratio Analysis


Financial Ratios
Profitability Ratios
Return on Assets
Return on Equity
Return on Invested Capital

FY05A

FY06A

FY07A

FY08A

FY09A

FY10A

FY11A

FY12A

FY13A

FY14A

FY15

FY16E

FY17E

FY18E

N/A
9.0%
0.7%

3.2%
7.6%
3.2%

3.9%
9.6%
2.1%

1.1%
3.0%
-3.4%

0.6%
1.9%
1.8%

2.8%
7.8%
7.1%

1.0%
2.7%
6.1%

2.0%
6.1%
4.4%

3.4%
10.5%
8.4%

5.1%
16.1%
14.9%

8.5%
28.4%
20.3%

9.5%
31.0%
21.4%

7.4%
23.6%
16.7%

6.6%
22.0%
15.2%

Efficiency Ratios
Total Asset Turnover
Fixed Asset Turnover
Accounts Receivable Turnover
DSO
Inventory Turnover
DIO
Accounts Payable Turnover
DPO
CCC

0.5 x
0.8 x
30.0 x
12.2
45.6 x
8.0
13.9 x
26.3
(6.1)

0.6 x
0.8 x
36.4 x
10.0
45.1 x
8.1
12.8 x
28.5
(10.4)

0.6 x
0.8 x
37.9 x
9.6
37.8 x
9.6
11.9 x
30.7
(11.5)

0.7 x
0.9 x
45.2 x
8.1
44.6 x
8.2
14.4 x
25.3
(9.0)

0.7 x
0.8 x
54.8 x
6.7
42.1 x
8.7
12.6 x
28.9
(13.6)

0.7 x
1.0 x
66.5 x
5.5
41.7 x
8.7
13.0 x
28.0
(13.8)

0.9 x
1.2 x
63.4 x
5.8
39.7 x
9.2
14.4 x
25.3
(10.4)

0.8 x
1.1 x
54.2 x
6.7
32.7 x
11.1
13.2 x
27.6
(9.7)

0.8 x
1.1 x
47.1 x
7.7
30.5 x
12.0
12.1 x
30.1
(10.4)

0.8 x
1.1 x
47.5 x
7.7
34.8 x
10.5
20.3 x
17.9
0.2

0.8 x
1.1 x
46.8 x
7.8
41.1 x
8.9
11.2 x
32.5
(15.8)

0.8 x
1.1 x
42.5 x
8.6
42.8 x
8.5
11.6 x
31.6
(14.5)

0.8 x
1.1 x
42.4 x
8.6
42.3 x
8.6
11.8 x
31.0
(13.7)

0.8 x
1.0 x
42.6 x
8.6
41.7 x
8.8
11.6 x
31.4
(14.1)

Margin Analysis
Gross Margin
SG&A Margin
EBITDAR Margin
EBIT Margin
Net Income Margin

13.7%
15.9%
9.8%
1.1%
6.4%

17.9%
14.6%
12.6%
4.7%
5.5%

15.6%
14.5%
10.3%
2.8%
6.5%

6.6%
12.6%
3.1%
(4.3%)
1.6%

13.7%
12.9%
10.4%
2.5%
1.0%

20.0%
11.8%
16.8%
9.6%
3.8%

18.4%
12.0%
13.4%
7.3%
1.1%

16.6%
11.9%
13.4%
5.5%
2.5%

19.4%
12.0%
16.1%
9.1%
4.3%

24.4%
11.9%
21.0%
14.0%
6.1%

31.6%
11.4%
28.9%
21.0%
10.2%

31.3%
12.0%
27.4%
21.0%
11.6%

27.1%
12.0%
23.3%
16.6%
9.0%

25.8%
12.0%
21.6%
14.8%
8.1%

Short Term Liquidity


Current Ratio
Quick Ratio
Cash Ratio

0.9 x
0.9 x
0.8 x

0.9 x
0.8 x
0.7 x

0.9 x
0.9 x
0.8 x

1.0 x
1.0 x
0.7 x

1.3 x
1.2 x
1.0 x

1.3 x
1.2 x
1.1 x

1.0 x
0.9 x
0.7 x

0.9 x
0.8 x
0.6 x

0.8 x
0.7 x
0.6 x

0.7 x
0.7 x
0.5 x

0.6 x
0.5 x
0.5 x

0.5 x
0.4 x
0.3 x

0.5 x
0.4 x
0.4 x

0.4 x
0.3 x
0.3 x

Coverage Ratios
Total Debt/EBITDAR
Net Debt/EBITDAR
EBITDAR/Interest Expense
EBIT/Interest Expense

2.7 x
NM
8.9 x
1.0 x

1.5 x
NM
14.9 x
5.6 x

2.1 x
NM
14.8 x
4.0 x

10.7 x
5.4 x
3.3 x
NM

3.3 x
0.9 x
6.5 x
1.6 x

1.7 x
NM
13.7 x
7.8 x

1.8 x
0.3 x
11.6 x
6.3 x

1.4 x
0.1 x
18.2 x
7.4 x

1.0 x
NM
26.7 x
15.0 x

0.7 x
NM
36.6 x
24.3 x

0.6 x
0.0 x
63.7 x
46.4 x

0.5 x
0.1 x
43.1 x
33.1 x

0.8 x
0.1 x
35.7 x
25.6 x

0.8 x
0.2 x
28.5 x
19.6 x

55.2%
45.6%
46.7%

51.3%
39.6%
46.5%

51.9%
43.2%
53.8%

104.7%
59.1%
58.1%

89.0%
52.8%
55.5%

82.2%
50.8%
53.0%

79.8%
47.6%
55.9%

103.2%
55.1%
50.7%

79.9%
49.5%
53.1%

78.8%
49.3%
57.9%

93.3%
54.3%
55.8%

70.5%
44.9%
56.8%

82.5%
51.3%
59.0%

79.7%
48.5%
59.7%

Leverage Ratios
Total Debt/Equity
Total Debt/Capital
Total Liabilities/Total Assets

Appendix 28: Fuel Hedging


Over the past 15 years, Southwest has been able to maintain effective hedging positions. In 2015, jet fuel and oil accounted
for approximately 23% percent of the companys operating expenses. While the price of oil and jet fuel dropped significantly
in the second half of the year, changes in oil prices still represent still represent a significant risk for the companys
profitability. Fuel derivative contracts--which are based on heating oil, Brent, and WTIare used to offset the change in jet
fuel prices. Due to the high degree of volatility that can occur in a relatively short amount of time, the company utilizes a
variety of instruments in order to effectively hedge risk. These instruments are varied in terms of the price points in which
they protect against, which may result in the company not realizing adequate protection if the price swings are large. When
this occurs, Southwest may also have to post cash collateral to its counterparties which may impact liquidity and financial
position.
Southwest uses what they call an economic hedge, which is the net effect of all fuel derivative contracts purchased. Call
options, collar structures, call spreads, put spreads, and fixed price swap agreements are all instruments that they use to
effectively hedge against price fluctuations. Last year, Southwest hedged 15 percent of its fuel consumption and posted
hedging losses of $544m last year. This was primarily due to the unforeseen oil price drop, as their hedge positions locked
the company in at higher, forcing them to post cash collateral to their counterparties accounts.
Looking forward, Southwest is hedged approximately for ~20% of their fuel consumption in 2016, 65% in 2017, and 35% in
2018. These are likely to change as the contract settlement dates approach because Southwest continuously monitors its
hedge positions and accounts for the current fuel prices that they expect to see. These hedge positions will also affect
earnings as they change in fair value over time, shifting the derivatives into either asset or liability positions.

38 | P a g e

Appendix 29: Yield Management System


Southwest Airlines uses a yield management system to optimize capacity and route expansions by making adjustments to
its flight schedules. Using the profitability tools, the company adjusts frequencies in existing markets and ensures that
aircraft which underutilized be redeployed to other markets.

Appendix 30: Route Analysis


Top Domestic Markets By Millions of
Passenger's 2013-14
Other
Phoenix, AZ
Denver, CO
Baltimore, MD
Las Vegas, NV
Chicago, IL
0

50
2014-2015

100

150

2013-2014

39 | P a g e

Dallas Love Field Market Share


Oct. 2013-Oct. 2014
100.00%
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Southwest

ExpressJet

Virgin America

2013-2014

Delta

Other

2014-2015

Appendix 31: Chase Credit Card Deal


Southwest's co-branded Chase credit card is integral to the expansion of their Rapid Rewards program. The credit card
allows consumers to earn points which they can then use towards free flights, hotels, and restaurant services who are
partners with the company.
Appendix 32: Airlines Alliance
Since the turn of new century, Airlines have worked closely with one another in the form of Alliances. An airlines alliance
is an agreement between carriers to coordinate networks, schedules, and sometimes operations. Currently there are three
major alliances; Oneworld, SkyTeam, and Star Alliance. These global alliances benefit travelers by lowering costs, including
more destinations, and enhanced frequent flier programs. Star Alliance is the largest alliance with 27 participating carriers,
followed by Oneworld with 16, and SkyTeam with 14. Star Alliance is the oldest alliance, serving over 192 countries. The
group has a large presence in North America (United Airlines), Europe (Lufthansa), and Asia (Air China). Sky Team, with
only 14 current members, serves just as many countries at 187. It has regional presence in North America (Delta), Europe (Air
France), and China (China Southern). This alliance was founded in 2000 making it the oldest alliance out of the three.
Oneworld was founded in 1999 and is the smallest alliance as measured by revenue, which totals 141.4 b. Its major airlines
include American Airlines, British Airways, and Japan Airlines.
Appendix 33: Airline Deregulation Act
In 1978, the Airline Deregulation Act shifted control of the airline industry from the government back to the market. The
objective of this law was to remove government control over fares, routes, and market entries from commercial aviation.
Deregulation effectively opened up the airline industry to competition which provided new opportunities for new and
existing players while also lowering fares for consumers. The Civil Aeronautics Board (CAB), the agency whom previously
regulated the industry, was phased out in 1984.
Appendix 34: Wright Amendment
The Wright Amendment of 1979 was a federal mandate that limited the amount of flying that could be done out of Dallas
Love Field. This federal law, limited non-stop flights from Love Field to destinations within Texas and neighboring states, to
promote the larger Dallas-Fort Worth International Airport (DFW). In 1997 and 2005 the government repealed some of the
restrictions, before voting to repeal the entire bill in 2006. Although the bill was repealed in 2006, some restrictions were left
in place until October 13, 2014.

40 | P a g e

Appendix 35: Channel Check & Other Relevant Materials


Southwest Airline Pilot Association (SWAPA) Channel Check
We reached out to a member of SWAPA to get a better understanding about the current labor situation at Southwest. We
informed him of our intended use and made it clear to only share information that was available to the public. He permitted
us to use the conversation below but wished to remind anonymous. The details per our email conversation are below.
UTD CFA Team

1. Will the election of the new union president slow down the current negotiations? Does he have a different view than the
previous president about what kind of deal should be reached?

2 .I saw that 60% of the pilots rejected a 17.6% increase. How far apart are the pilots and management in regards to reaching
an agreement that accommodates both sides?

3. With all of the international expansion occurring, what additional resources/training costs will the pilots need moving
forward?

4. Are you looking for benefits other than profit sharing increases to be included in the negotiation deal?

5. How strong do you foresee demand to be for new pilots as Southwest continues to grow? Please let me know if you need
any clarification and look forward to hearing from you. Best Regards, James

SWAPA Pilot: great questions. I'll get back to you asap

SWAPA Pilot: James, Great subject to choose and certainly good timing. Years ago, i did my Undergraduate Thesis on
Southwest Airlines. Boy have things changed. I am going to answer your questions right now. In order to give you a more
detailed understanding, I want to start off with a 30,000 foot view and then fine tune the rest of the discussion with details.
James, first and foremost, if you ever had the chance to read the book, NUTS, it is a fantastic book. It truly offers insights on
the way Southwest used to be. Everyone loved Herb and he was an amazing leader. Southwest has fallen victim to Corporate
Greed and has disregarded many of the principles that made Southwest a great company to work for. Why this is important
will be revealed shortly. For now, just know that this is the first time in Southwest's history that the pilot group has gone this
long without a contract based on true value. Yes, Southwest is a great company to work for and i am proud to be here. The
original leaders at Southwest believed that if you take care of the Internal Customers (the employees), then the External
customers (passengers) will always be taken care of. For us here, its more about how we are treated. Now, in an effort to
keep cost low, the company maintains a "flattish contract" mentality and refuses to acknowledge all the sacrifices we made
over the last several years. We don't begrudge Southwest for being successful, we just feel that it is only fair to compensate
us accordingly for all of our hard work and contributions towards that success. Unfortunately, the last contract offer was
extremely inadequate. You don't get what you deserve, you only get what you negotiate. That is why we turned the last
contract down and why we replaced the negotiating committee and the President. After September 11th, ALL of the airlines
suffered financially except a rare few. Southwest was one of them. They did well because they had a dedicated employee
group willing to do whatever it took to keep the airline flying. Unfortunately for the others, their contracts were gutted. As
you start to understand the big picture, let me say this. Southwest is my 5th airline and again, i am proud and happy to be
here. The company has never furloughed employees, especially pilots and has always been profitable. Our compensation
package is more than just about money. Its retirement, Medical, travel benefits etc. After almost 4 years of negotiating, under
the best of economic times and unprecedented profits, it is truly unfortunate that we dont have an agreement that represents
a significant gain in all of those areas. Our last agreement was grossly inadequate and we were asked to give up a lot for very

41 | P a g e

little gain. It is Management's job to keep costs low and its our job to reestablish our profession by seeking what we are truly
worth. We are often looked at as greedy pilots who work very little and get paid a lot. This perception has been around
forever. This is an entirely different discussion. I may offer some insight on that too later but its important to understand that
the Management Employee relationship is no different here than anywhere else in Corporate America. There is a huge
difference between Leadership and Management too, which again, is important to understand but I will save that for later.

SWAPA Pilot: To answer your questions....

SWAPA Pilot: 1. The new President of SWAPA, Jon Weaks, used to be our Union President back in 2000. He is a good man
and the perfect person for the job. He's already demonstrated great leadership, as evidenced by our informational picketing
yesterday in Dallas, where over 300 pilots silently, and professionally displayed our displeasure with stalled negotiations.
The process has to take its course due to not only a new President but an entirely new negotiations committee. However, we
ramped up rather quickly and are ready to get back to negotiating a new agreement, beginning in March. Even though we
could meet with the company sooner, we are bound by the process set forth by our Mediator. That is ok too because by the
time negotiations begin again, the other Airlines, ie Delta, American and United will have or already have new agreements
in place which compensate their pilots well. Jon does indeed have a different view and has cleared up much of the
dysfunction from our previous group. Our last group did their best but did things on a regular basis that was not consistent
with the pilot group's wishes. The contract that got voted down should have NEVER made it to the pilot group. They sent it
out in my opinion, out of frustration and lack of progress, to allow the group to vote on it. The President felt it was the best
we could get, despite the fact that a majority of the Board of Directors disapproved of it

2. Management and the pilot group were engaged in standard negotiations. They low ball us and we are looking for justifiable
improvements, based on what we call, " Industry Standard". In the past, the Company mentioned Industry Standard and
wanted to discuss compensation a few years ago based on this. Of course this is when the other airlines had horribly gutted
contracts because of bankruptcies and less than stellar economic conditions. Now, times are good, profits are soaring and the
other airlines have negotiated great contracts. Now, our Management is not willing to discuss Industry Standard. Go figure.
By the way, it seems like a massive pay raise. 17.6 percent raise in reality was barely a 1.5 percent increase over the life of the
contract. So by no means were we turning down a massive pay raise. Media always finds a way to spin the truth. In addition,
there was little to no gain in most of the contract but a lot of items we were asked to give up, such as International code
sharing and reduced flexibility in the way we create our schedules. A contract is only as good as the language in it. Poor
language makes it hard to enforce. Our retirement is grossly inadequate and not in line with Industry Standard. There were
many things that were inadequate so to answer your question, we are now pretty far apart in what we are seeking and what
the company has offered. In short, we are not asking for anything that is going to break the bank either. We simply want
what we should have, an industry leading contract that compensates us and allows us to share the success we helped create.
Yes, we get profit sharing and that is awesome but in terms of compensation, we are far apart for now I'm afraid. As i said,
you only get what you negotiate, not what you deserve.

3. James, there is very little cost associated with training pilots to fly International. Whatever costs the company pays to fly
International may be a lot, but just like our compensation package, its the cost of doing business. The pilot group has been
trained at minimal expense to fly International. Its really not a factor on our end.

4. As i mentioned earlier, a compensation package has many components. The sad reality is that Insurance costs have
skyrocketed and the employees have taken a massive hit and have absorbed the costs. Inflation has hit all of us hard. Without
even a COLA, which was barely addressed in the last contract, everything costs more. So in many ways, our tentative contract
was concessionary. Profit sharing is not a guarantee and again, its nice to have but that money does not get touched until
retirement. Bottom line, we were not asking for anything unreasonable and so to answer your question, our negotiations
include the compensation package as a whole.

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5. Southwest will continue to grow for the foreseeable future. That growth is driven by Domestic and International expansion.
For the pilot group, growth and hiring is always a good thing. Ive been at 2 other companies where they shrunk the airline
and furloughed thousands of pilots. Our growth is driven my retirements (age 65) and expansion. The demand is strong.
This year they plan on hiring 650 pilots and probably close to that for the next few years. As we continue to grow, the demand
will continue. Its a good time to be a pilot if you are interested :)

UTD CFA Team: Thank you for your extensive response. I have quick follow-ups, if I may:

1. You mentioned that the 17.6 percent raise in reality was barely a 1.5 percent increase over the life of the contract. I was
wondering if you could elaborate on the 1.5 percent a bit more? My general understanding is that it is 17% increase over 8
years. Is the union trying to match AAs recent contract of 30% increase or maybe just the industry average of ~23% increase,
immediately effective next year instead of 8 years?

2. You talked about the growth driven by retirements and growth. I see that the U.S. will experience massive retirements as
the Baby Boomers age. Regarding Southwest, do you see the need for more pilots deriving more from aging pilots or from
growth? I appreciate your time and any thought on the issue you could share without the conflict of interest. And yes, I
would be happy to send you a copy of my work when I finish it! Thanks again, Best regards, James Nguyen

SWAPA Pilot: James, There were a few articles that led the public to believe that we turned down a massive pay raise. In
reality, we have been without a contract for 4 years plus the life of a new contract is 4 years. I wont even mention that it takes
a long time to negotiate a new contract so what ever we agree to will be what we live with for between 4 and 7 years from
now. Now, the Tentative agreement initially offered a 3% raise then like 2% a year. Considering this is over 8 years and COLA
is approximately -2 - 2.9 %, those raises are barely cost of living increases. It may have been acceptable if other areas in the
agreement were better but even when those new rates, we still would not be making industry standard rates, especially after
American, United and Soon to be Deltas new rates are in place. So yes, we are looking very closely at the other airlines now.
The dynamics of how much the company will be willing to pay is is complex. One of the factors is our competition's pay rates
so in effect, when the company delayed or stalled negotiations, it only made it harder for them to justify not offering us
higher pay. New they are making Billions under decent economic times and it's time to settle this. The culture is gone here
outside Head Quarters. All of the employee groups have seen the culture that Southwest always prided themselves on, go
down hill. As far as retirement go, timing is everything in life and especially in the airline business. Believe it or not, we have
a fairly young pilot group. We do have retirements but not as many as the other airlines have so growth is more of a factor
in how many they hire. Of course, unless they change the retirement age again, that's the only thing we can count on.
Southwest could easily shut hiring down if the economy tanked. For now they are growing based on expansion and
retirements but for now, mostly due to growth. As time goes on, we will begin to feel the effect of mass retirements.

One final thing. The airline industry has been dumbed down so much since September 11th. The amount of compensation
the average pilot made was shameful. Get on board a Regional Her and I bet you that most people don't realize what the
copilot is making, which is poverty wages. Southwest pilots are The Most productive pilots in the industry and that has to
be factored in. I just read some of the ignorant comments people made in response to our informational picketing. Truly sad.
No one questions what a doctor or lawyer makes or even to an extreme, what actors or sports figures make. The bottom line
is, for what we had to go thru to get here and what we endure every day to maintain our employment, we are grossly
underpaid in my opinion. Ask yourself what The Captain who landed in the Hudson was worth that day... Anyway, hope
this helps. Again, feel free to ask any other questions.

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