JetBlue Airways IPO Valuation

An Analysis of Valuation Processes

FINE 7600 VALUATION AND FINANCIAL ENTERPRISES

October 24, 2012

Authored by: Xian “Sophie” Li, Yu “Charlotte” Pei, Tiancheng “Toby” Sun,
Adrian Townsend, and Yu “Yvonne” Wang
 JETBLUE AIRWAYS IPO VALUATION
An Analysis of Valuation Processes

Contents
JETBLUE TAKES OFF! ................................................................................................ 1
CALCULATING AN APPROPRIATE PRICING POLICY RANGE ..................................................... 1
CORRECT VALUATION LEAVES MONEY ON THE TABLE ......................................................... 2
IS THE I.P.O WORTH THE EXPENSE? .............................................................................. 2
COMPARABLE COMPANIES ANALYSIS .............................................................................. 2
P/E MULTIPLE .................................................................................................2
TOTAL CAPITAL MULTIPLE ................................................................................... 3
EBIT MULTIPLE ................................................................................................ 4
DISCOUNTED CASH FLOW ANALYSIS .............................................................................. 4
ASSUMPTIONS...................................................................................................4
WEIGHTED AVERAGE COST OF CAPITAL ...................................................................5
DISCOUNTED CASH FLOW SHARE PRICE VALUATION .................................................... 6
JETBLUE AIRWAYS IPO VALUATION ............................................................................... 6
WORKS CITED ........................................................................................................ 8

JetBlue Airways IPO Valuation | 10/24/2012

i
 JetBlue Airways IPO Valuation Over the last 50 years,
I.P.O.’s in the United States
An Analysis of Valuation Processes have been underpriced by
16.8 percent on average.
This translates to more
JetBlue Takes Off!
than $125 billion that
JetBlue is an aggressive start-up, which began service in February 2000, and has
grown steadily since its inception. Duplicating Southwest’s simplicity, high companies have left on the

aircraft utilization and low fares, JetBlue offers comfortable, affordable and table in the last 20 years.
convenient point-to-point air travel with some unique amenities (for example,
I.P.O. underpricing is also
leather seats and live-feed TV monitors). It has relied primarily on word of
a worldwide phenomenon.
mouth advertising to execute its strategy. In contrast with most upstart
In China, the underpricing
discount carriers, JetBlue operates a fleet of 31 brand new, highly fuel-efficient
has been severe, averaging
Airbus A320 aircraft and employs a non-unionized FAA certified workforce
(pilots, technicians, dispatchers) The management team has an extensive 137.4 percent from 1990

leadership track record with successful carriers, such as Southwest Airlines. to 2010. This compares
with 16.3 percent in Britain
This report examines the April 2002, decision of JetBlue management to price
from 1959 to 2009. In
the initial public offering of JetBlue, just months after the terrorist attacks of
most other countries, I.P.O.
2001. Although the timing
“The market is never dead for a good company underpricing averages
seemed risky, John Owen,
with real revenues and real earnings” above 20 percent.”
Executive vice president and
chief financial officer of JetBlue (Davidoff, 2011)
Airways stated “the market is never dead for a good company with real
revenues and real earnings”. JetBlue had managed to remain profitable and
grow aggressively despite the challenges facing the airline industry.
JetBlue Airways IPO Valuation | 10/24/2012

Calculating an Appropriate Pricing Policy Range We conclude that the

The lead underwriter for the JetBlue I.P.O. Morgan Stanley had initially
JetBlue offering price
calculated a price per share of $22 to $24. However, with sizeable excess
demand for the 5.5 million shares being offered; they had adjusted the range should be $27 to $29
upwards ($25 to $26).
This report utilized four different share valuation methods: 1) Price/earnings
multiple (comparison pricing); 2) Total capital multiple (comparison pricing);
3) EBIT multiple (comparison pricing); and 4) Discounted free cash flows
(fundamentals pricing). We conclude that the JetBlue offering price should be
$27 to $29.

1
Correct Valuation Leaves Money on the Table
According to economist Kevin Rock (Rock, 1986), because informed investors do not exist in sufficient
number, underwriters re-price I.P.O offerings to bring in uninformed investors and ensure that they
maximize total bidding. This theory has empirical support in papers that have found that when investment
banks can allocate shares in greater measure to informed investors, the underpricing is reduced since the
compensation needed to draw uninformed investors is lower. (Davidoff, 2011). Underpricing has also been
found to be lower when information about the issuer is more freely
available so that uninformed investors are at less of a disadvantage. Underpricing gives uninformed
Underpricing gives uninformed investors normal return. In countries investors normal return.
where share allocation is transparent (Singapore and Finland),
investors receive more shares of overpriced offerings making average profits zero. (Keloharju, 1993).
JetBlue is only offering approximately ten percent of the firm’s outstanding shares; a successful I.P.O. will
help to not only raise short-term capital, but also provide access to future capital. Increasing the share price
aggressively will dampen demand and reduce the publicity buzz surrounding the event and the company. In
line with the benefits of underpricing we agree with a more conservative pricing range as suggested by the
Morgan Stanley underwriters.

Is the I.P.O Worth the Expense?

A good valuation of the I.P.O. share offering will leave money on the table. In addition to that loss, JetBlue
will have to pay legal, accounting, and underwriting fees associated with public offerings. Is it worth it?
From an operation perspective, the I.P.O. supplies capital to JetBlue which the firm can use to increase
competitiveness and support aggressive growth.
From a financing perspective, JetBlue investors will gain access to a more liquid equity market which will
reduce JetBlue’s cost of capital from the much higher cost of private equity. Additionally, the new equity
will lower the debt to equity ratio. With a lower debt to equity ratio, JetBlue will then have increased
access to the debt market with more favorable terms. The ability to access more debt can then be used to
again decrease the cost of capital by altering the capital structure of JetBlue to take advantage of the tax

JetBlue Airways IPO Valuation | 10/24/2012

advantages provided by debt financing. The tax shield of the debt financing will increase the enterprise
value of the company.

Comparable Companies Analysis

P/E Multiple
Using the leading P/E multiple method of valuation is standard practice in the airline industry (Yale School
of Management, 2002). However, in our analysis (figure 1) the comparison sample size had to be reduced
to include only low-cost airlines with positive earnings which limited the scope of the relative values. Due to
the small sample size, the average P/E ratio was skewed high towards Frontier’s outlying performance.
Therefore we determined that the median P/E ratio of comparable companies provided a more accurate
figure. With predicted earnings per share in 2002 of $1.20, JetBlue’s price per share would be $34.12.

2
 However, using trailing indicators we calculated the current share price to be substantially lower at $28.84.
The wide variance is due to: 1) Increased price earnings ratios in 2002 for low-cost carriers; and 2)
Increased earnings per share for JetBlue. The range is made wider when using the average P/E multiple
from the sample group: $28.46 to $37.28.

Price / Earnings Multiple

Trailing Leading

Earnings/
Airlines positive earnings Price/ Share Share PE Multiple Earnings/ Share PE Multiple
AirTran $6.60 0.26 25.29 0.33 20.00
Frontier $17.00 2.03 8.37 0.37 45.95
Ryanair $32.05 0.73 44.02 0.94 34.10
Southwest $18.48 0.67 27.59 0.65 28.43
WestJet $15.85 0.81 19.57 0.59 26.86
Average 0.90 24.97 0.58 31.07
Median 0.73 25.29 0.59 28.43
JetBlue Tr ailing $28.84 1.14 $25.30 (mult. med.)
JetBlue Leading $34.12 1.20 $28.43 (mult. med.)
(Trailing EPS supplied Exhibit 3; Leading EPS adjusted for increased earnings and newly issued shares)
F IGURE 1

Total Capital Multiple

The total capital multiple company comparison (figure 2) utilized published figures from all low-cost carrier
airlines; the sample size for this comparison was the largest of the comparable companies’ analysis methods.
While the total capital multiple uses trailing indicators, the multiple is the least subject to accounting
practice variances; debt and equity accounting have fewer GAAP methods of calculation.

Total Capital Multiple Trailing

Book Equity/ Total Capital
Price/ Share Share Book Debt/ Share Multiple
AirTran $6.60 0.49 3.96 2.37
Alaska Air $29.10 32.12 33.80 0.95
JetBlue Airways IPO Valuation | 10/24/2012

America West $3.50 12.47 10.20 0.60

ATA $14.95 10.79 32.90 1.10
Frontier $17.00 5.36 0.01 3.17
Ryanair $32.05 5.54 3.33 3.99
Southwest $18.48 5.26 1.79 2.88
WestJet $15.85 2.82 0.97 4.44
Average 2.44
Median 2.62
JetBlue Tr ailing $27.50 5.16 8.59 $2.62 (mult. med.)
F IGURE 2

Again, the median figure was most representative of the sample (as it disregarded unusual outlying high and
low performers), and provided a valuation of $27.50 for JetBlue. This valuation is slightly below the range
of the leading and trailing values generated by the P/E multiple ($28 to $34). The valuation estimate drops
to $24.93 per share when using the average total capital multiple from the sample group. However, the

3
median figure is still conservative as it is below the 2.88 multiple of Southwest. Southwest provides the
closest proxy to JetBlue, because JetBlue duplicated Southwest’s operational practices in the unclaimed
New York hub market.

EBIT Multiple
The EBIT multiples (figure 3) provide a useful comparison with low-cost airline carriers with different
capital structures. However, the EBIT multiple had the widest range between trailing and leading
estimates; and the widest range between the EBIT multiple average and median. For these calculations, the
average of the sample represented JetBlue most closely.

EBIT Multiple
Trailing Leading
Book Debt/
Airlines positive earnings Price/ Share Share EBIT/ Share EBIT multiple EBIT/ Share EBIT multiple
AirTran $6.60 3.96 0.81 13.04 0.76 13.89
Frontier $17.00 0.01 2.99 5.69 0.64 26.58
Ryanair $32.05 3.33 0.92 38.45 1.17 30.26
Southwest $18.48 1.79 1.09 18.60 1.42 14.27
WestJet $15.85 0.97 1.32 12.74 1.59 10.58
Average 1.43 17.70 1.12 19.12
Median 1.09 13.04 1.17 14.27
JetBlue Tr ailing $16.48 8.59 1.42 $17.70 (mult. ave.)
JetBlue Leading $29.08 1.97 $19.12 (mult. ave.)
(Trailing EBIT 18% greater than net income, Exhibit 3; Leading EBIT $80M / 40.6M shares, Exhibit 13)
F IGURE 3

Similar to the P/E multiple, the large gap between the trailing and leading estimate is mainly due to
JetBlue’s large jump in EBIT for 2002 (over 100 percent). JetBlue’s increase in EBIT is magnified by the
sample’s increase in the EBIT multiple. The trailing multiple valuation provides a conservative $16.48 per
share ($9.87 per share when using sample median multiple). However, the leading valuation is in line with
the other multiples at $29.08 per share ($19.54 per share when using the median multiple).

JetBlue Airways IPO Valuation | 10/24/2012

Discounted Cash Flow Analysis
Assumptions
We have used the following assumptions supplied by the JetBlue management forecast and the case-writer
analysis provided in Exhibit 13 (Bruner, Eades, & Schill, 2010):
1. The Revenue per aircraft will commence at $17 million per aircraft and increase by 4 percent per
year (inflation) going forward from 2003-2009 since the airline is at the height of the industry in
terms of load factors. This estimate will drive the revenue growth rates in the DCF model.
2. Operating expenses are projected as a percentage of revenues.
3. Capital expenditures estimates are based on information presented in JetBlue’s I.P.O. prospectus
and adjusted upwards for inflation of 5 percent per year.
4. The debt-to-equity ratio is estimated using the Total Capital Multiple estimate (figure 2).

4
 5. The risk-free rate and market premium are as of April 2002
6. Corporate income tax rate remains flat at the 2002 level of 34 percent.
7. A terminal growth rate of 4.5 percent, which is a reasonable estimate of GDP growth, based on
official estimates. (Bureau of Labor Statistics projection for GDP by 2005 plus inflation)
8. The levered beta for the Airline Industry is 1.08 (Yale School of Management, 2002); however we
chose the higher levered beta of Southwest (1.10) as the best representation of low-cost carriers’
levered beta (figure 4).

Southwest Capital Structure

Market Value Equity 16,071,992 (776.8M shares * $20.69, ex hibit 5)
Market Value Debt 1,842,000 (Exhibit 5)
Enterprise Value 17,913,992
Southwest D/E Ratio 0.11
JetBlue Beta
SW Levered Beta 1.10 (Ex hibit 5)
SW Unlevered Beta 1.02
Southwest Tax Rate 31% (Ex hibit 5)
JetBlue Tax Rate 34% (Ex hibit 13)
Jet Blue D/E Ratio 0.31 Estimate using median total capital multiple (ex hibit 7)
JetBlue Levered Beta 1.23 F IGURE 4

Weighted Average Cost of Capital

Using the market value capital structure estimate from the total capital multiple (figure 2), we calculated
the weighted average cost of capital for JetBlue to be 9.22 percent (figure 5).

JetBlue - Cost of Capital

Pretax cost of debt
Tax rate
After-tax cost of debt
JetBlue Airways IPO Valuation | 10/24/2012
K d =Yield to maturity of Southwest Airlines 5 y r debenture
7.91% (Ex hibit 6) + 0.5% premium for new company w/ 10y r debt
34%
5.22% K d (1-t)

Dividends of Preferred Stock 16,970 ( Ex hibit 3)

Convertible Preferred Stock 210,441 ( Ex hibit 2)
Cost of preferred stock 8.06% K p = Dp / P p
Equity beta 1.23
Rf 5.00% April 2002 long-term U.S. Treasuries
RM-Rf 5.00% Market risk premium giv en at 5%
Cost of common stock 11.15% K e = Rf + b*(Rm-Rf)
Debt-to-Cap 23.80% Estimate using median total capital multiple (ex hibit 7)
Preferred-to-Cap 16.62% Estimate using median total capital multiple (ex hibit 7)
Common-to-Cap 59.58% Estimate using median total capital multiple (ex hibit 7)
WACC 9.22% WACC = K d (1-t) * Wd + K p *Wp + K e * We
F IGURE 5

5
Discounted Cash Flow Share Price Valuation
The resulting share price from the discounted cash flow analysis (figures 6 and 7) is $29.89. This figure is
within the P/E multiple valuation range (the industry’s standard practice for valuation) of $28 to $34. The
discounted cash flow analysis price per share is slightly higher than the total capital and EBIT multiples. We
subjected the DCF price per share to a sensitivity analysis (figure 8) to calculate the effect of a change in
growth and a change in the weighted average cost of capital. An adjustment of 0.5 percent to either the
WACC or the terminal growth rate resulted in changes to the share price estimate of 20 to 30 percent. The
effect of the WACC rate on JetBlue’s share price highlights the value of the I.P.O. to JetBlue. The I.P.O.
will reduce the cost of equity (by introducing liquidity to private equity holders); additionally the improved
debt-to-equity ratio will provide JetBlue with increased access to the debt markets. With a carefully
calculated capital adjustment, JetBlue can further decrease its weighted cost of capital by using the tax
shield benefits of capital debt and the lower cost of debt.

Year 2002E 2003E 2004E 2005E 2006E 2007E 2008E 2009E 2010E Terminal
NOPAT 52.64 88.67 119.57 148.99 180.77 215.06 247.44 270.28 292.16
Growth (NOPAT) 196% 68% 35% 25% 21% 19% 15% 9% 8%
Depreciation 17.71 26.25 35.60 44.62 54.45 65.15 75.38 82.82 90.04
Capital expenditure 290.37 328.34 344.76 310.29 325.80 342.09 299.33 157.15 132.00
Net working capital 63.47 93.54 126.14 157.18 190.71 226.88 261.03 285.13 308.22
∆ Net working capital 29.56 30.08 32.60 31.04 33.53 36.17 34.15 24.10 23.08
Free Cash Flows (249.58) (243.50) (222.19) (147.71) (124.10) (98.05) (10.66) 171.85 227.11 5024.17
Discounted FCF (228.51) (204.11) (170.52) (103.79) (79.84) (57.75) (5.75) 84.84 102.66 2270.95
F IGURE 6

Terminal Growth 4.50%

WACC 9.22%
NPV 1,608
Less: Preferred Shares (210)
Less: Long Term Debt (301) Sensitivity Analysis

JetBlue Airways IPO Valuation | 10/24/2012

Add: Cash 117 Price/Share Terminal Growth Rate
Equity Value $ 1,213 4.0% 4.5% 5.0%
Shares (millions) 40.60 8.72% 31.88 39.06 48.17
WACC

9.22% 24.29 29.89 36.81

Share Price $ 29.89 9.72% 18.13 22.58 27.98 F IGURE 7
F IGURE 8

JetBlue Airways IPO Valuation

From the analysis of the company comparison multiples and the discounted cash flows, we conclude that the
JetBlue Airways I.P.O. should have a share price within the range of $27 to $29. This range is below the
price per share of all leading multiples estimates and is below the DCF estimate. The range captures the
more conservative trailing estimate of the Total Capital multiple estimate. To accommodate the benefits of

6
 underpricing (access to future capital; generating goodwill and publicity; enticing uninformed investors),
we therefore suggest the conservative range of $27 to $29. The current suggested price of $25 to $26
unnecessarily leaves too much money on the table.
JetBlue Airways IPO Valuation | 10/24/2012

7
Works Cited
Bruner, R., Eades, K., & Schill, M. (2010). Case 28 JetBlue Airways IPO Valuation. In R. Bruner, K.
Eades, & M. Schill, Case Studies in Finance (pp. 381-399). McGraw-Hill.
Davidoff, S. M. (2011, May). Why I.P.O.'s Get Underpriced. Retrieved from New York Times:
http://dealbook.nytimes.com/2011/05/27/why-i-p-o-s-get-underpriced/
Keloharju, M. (1993). THe Winner's Curse. Journal of Financial Economics, 254-277.
Rock, K. F. (1986). Why New Issues are Underpriced. Journal of Financial Economics, 187-212.
Yale School of Management. (2002, October 9). JetBlue. Retrieved from
http://analystreports.som.yale.edu/reports/JetBlue.pdf

JetBlue Airways IPO Valuation | 10/24/2012