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Michael Cueva Andrew Dartez

Audrey Guazzone Dylan Mclaughlin

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Table of Contents Executive Summary 4

Industry Analysis 5

Accounting Analysis 6

Financial Analysis, Forecast Financials, and Cost of Capital Estimation 7

Valuations 9

Southwest Airlines and the Airline Industry 10

Company Overview 11

Industry Overview 13

Industry Analysis: five factors model 16

Rivalry amongst existing firms 17

Threat of new Entrants 27

Threat Of Substitutes 30

Bargaining Power of Customers 33

Bargaining Power of Suppliers 37

Value Chain Analysis 40

Firm Competitive Advantage 43

Accounting Analysis 46

Key Accounting Policies 47

Potential Accounting Flexibility 51

Actual Accounting Strategy 55

Quality of Disclosure 57

Qualitative Analysis of Disclosure 60

Potential Red Flags 69

Accounting Distorsions 72

Financial Analysis, Forecasting Financials and Cost of Capital Estimation 73

Financial Analysis 73

Liquidity Ratio Analysis 73

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Profitability Ratio Analysis 79

Capital Structure Analysis 86

Internal Growth Rate and Sustainable Growth Rate Analysis 90

Financial Statement Forecasting 93

Cost of Capital Estimation 104

Intrinsic Valuations 109

Appendices 117

References 127

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Executive Summary Investment Recommendation: Fairly Valued, Hold or Buy (6/1/2008)

SNA-NYSE (6/1/2008) Altman Z-Scores52 Week Range $11.02-$16.96 2003 2004 2005 2006 2007Revenue $10,190 M. Initial 3.01 2.42354 2.05 2.4 1.77Market Capitalization $9,750 M.Shares Oustanding 731.76 M.

Market Price (6/1/2008) $13.06

Book Value Per Share 9.819 Comparable Base Valuations Initial ROE 8.53% Trailing P/E 19.22ROA 4.35% Forward P/E 43.533

P.E.G. 1.3729Cost of Capital P/B 1480Estimated R- Squared Beta KE P/EBITDA 1.109453-Month 0.142768602 0.8382854 0.0091812 P/FCF 0.011256-Month 0.142720361 0.8382393 0.0091977 EV/EBITDA 11.03232-Year 0.14258317 0.8376626 0.00920852 D/P 7405-Year 0.142314764 0.836673 0.0093056510-Year 0.142012366 0.8356908 0.00940268 Intrinsic Valuations

Price Range on Initial Dividends $0.02Alternative Estimate 10.44% (Backdoor Method) Free Cash Flows -Published Beta 0.83828544 Residual Income 8.44Cost of Debt 4.66% L.R. ROE RI 9.45WACC (BT) 7.05% A.E.G. 8.56

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Industry Analysis

Southwest Airlines Company is a major domestic airline that provides point to

point, low fare service. Southwest is headed by Gary C Kelly. It employs a relatively

simple fare structure, featuring low, unrestricted, unlimited, everyday coach fares, as

well as lower fares available on a restricted basis. Southwest currently flies to 64

destinations throughout the United States with more than 3,300 flights a day. The firm

is the primary example of an airline that still uses the point to point transit model.

Currently, however, Southwest Airlines actually uses a hybrid system, flying point to

point routes, but also connecting passenger through several smaller hubs. The company

and its third-party maintenance providers are subject to the jurisdiction of the Federal

Aviation Administration with respect to maintenance and operations.

Southwest was incorporated in Texas in 1967 but obtained the right to fly after a

three year legal battle, which is considered by many to be the beginning of deregulation

in the airline industry. Southwest commenced Customer Service on June 18, 1971, with

three Boeing 737 aircraft serving three cities- Dallas, Houston and San Antonio.

Southwest turned its first annual profit in 1973, and has done so every year since.

Southwest has used financial techniques such as fuel hedging to bolster its profitability

and counteract many of the fiscal disadvantages of operating an airline.

Existing firms compete in an almost cost control industry with a minimal level of

differentiation. The success and profitability of Southwest’s overall cost leadership

strategy led to a common trend being named the Southwest Effect. Indeed, Southwest

entered the airline market, and the market itself changed. The number of customers

augmented significantly. Direct competitors of Southwest Airlines include JetBlue,

American Airlines and Continental.

The airline industry is extremely competitive. Rivalry is intense. The U.S. airline

industry has been in a chaotic state for a number of years. It is now a stagnant industry

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where the concentration is changing according to the recent mergers and alliances.

Companies face increased exposure to the raw oil market every year. This is not a good

sign for the airlines, which are also facing tough competition for US legacy carriers that

have lowered cost through bankruptcy. With the market already over-saturated,

operating limits, and the start up costs being high, the threat of new entrants is low.

However, the threat of substitutes is medium because advantages like speed, service,

and routes provided by planes seem to be considerable compared to substitutes.

However, the relative price performance of trains could be a major threat in a decade

for regional airlines. Buyers’ power is medium/high due to low switching costs, price

sensitivity, standard product, information access, a large number of buyers and low

volume purchases. Finally, suppliers’ power is very high because only Boeing and Airbus

provide planes, and the oil price is increasing.

To be successful, an airline must be effective in three general areas. They need

to attract customers and the ticket price is by far the most significant factor in

attractiveness. Managing its fleet with a cost efficiency control system is essential.

Finally airlines have to be very innovative to try to differentiate themselves from their

competitors.

Accounting Analysis

In order to evaluate a company properly, it is important to look meticulously at

the company’s financial statements. To provide a precise valuation, it is essential to

question how transparent these financials are. The degree of disclosure by the company

is important when evaluating the financial statements. Full disclosure will give a more

accurate picture of the company. Many companies try to hide key information in order

to make the company more appealing to potential investors. There are many ways a

company can manipulate their financials even though they are regulated by the SEC.

This practice makes it complicated for investors or shareholders to have a clear

accurate view of the company. It also makes it difficult for an analyst to have a clear

outlook of the firm in order to make a fair valuation of it.

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Southwest had a high-level of disclosure when it came to their information on

their 10k. They key accounting policies for Southwest Airlines include: revenue

recognition, fuel hedging, capital and operating leases, and retirement and pension

plans. Accounting policies that directly correlate with the identified success factors are

revenue recognition, fuel hedging practices, capital and operating leases, and

retirement and pension plans. Southwest recorded unearned revenue as air traffic

liabilities on the balance sheet before it records it as passenger revenue on the income

statement. It is finally allocated when the passenger is on the plan and the plane has

taken off. Southwest along with many of its competitors practice this accounting when

recording unearned revenue. This accounting practice is in accordance with GAAP, but

can be distorted by managers in order to make their financials look attractive. They

accounted for rising price of fuel in their fuel hedging analysis. They stated their prices

and how they were going to deal with them now and in the future. In the case of

capital and operating leases, it is straight forward; 86 of the 95 planes Southwest leases

are classified as operating leases while the other 9 are classified with capital leases.

The overall accounting strategy for Southwest’s financial statements was fairly

conservative. The accounting had little or no room for any discrepancies leaving no

information out. They explained why they placed line items on their financials.

Financial Analysis, Forecast Financials, and Cost of Capital Estimation

Financial Analysis

When analyzing a firm, potential shareholders look at three main areas to predict

the strength of any given firm. These areas include: a firm’s liquidity, profitability, and

capital structure. With applying useful ratios and trends that can be determined from

past as well as current transactions, the potential shareholder can therefore be able to

make a better and well informed decision on his/her upcoming investment.

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Liquidity

Southwest’s current ratio and quick ratio have been decreasing since 2006. The

impact on liquidity is not favorable. With a current ratio of less than 1 and a quick ratio

of .63 it seems that the company has more difficulty covering its current liabilities from

the cash realized on the current asset account. However, the entire industry is affected

by low current and quick ratios, but Southwest seems to stand alone by having a higher

365/receivables turnover which helps it receive cash realized on credit accounts faster

than its competitors.

Profitability

Like the liquidity ratios, the airline industry all follows the same trends in

profitability ratios. The Net profit margin, gross profit margin, and the operating profit

margin are all very low. However, Southwest seems to always stay on top of the

competition by their superior operating efficiency. The reason they continually best the

other competitors in the industry is due to their primary focus on cost reduction.

Keeping costs down creates the potential for greater profit margins, which is

Southwest’s main competitive advantage.

Capital Structure

The three capital structure ratios that Southwest was evaluated on were the debt to

equity ratio, times interest earned, and the debt service margin. Overall, Southwest

usually tends to follow the industry average when it comes to these ratios as pertaining

too closely relating its financial activities through debt and equity outsourcing. However,

they by far exceed their competition in the debt to equity category by generating large

surpluses of cash (from operations) than needed to cover their liabilities.

Forecast Financials/Cost of Capital Estimation

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To forecast Southwest’s financial accounts for the following ten years ending in

2017, we used our financial ratios, industry averages and trends, and growth rates

within the company pertaining to patterns that we saw fit. Along with these three

forecasting techniques, we used our extensive knowledge of the company’s future

strategies pertaining to cost efficiency tactics and fuel hedging techniques. This

information also played a vital role in our predictions of forecasting growth stunts and

rapid expansions.

To find the cost of equity we used an alternative method which resulted

in10.44% for both before and after taxes. We then calculated the cost of debt to be

4.66% for both before and after taxes. In secession we concluded the weighted

average cost of capital before tax to be 7.05% and after tax to be 5.99%.

Valuations

The purpose of an equity valuation is to value a company’s stock price,

determining if it is under, over, or fairly valued. By using financial ratios, accounting

skills and an exquisite knowledge of the industry to be possibly invested in, potential

stockholders can help better their chances of profitable investments.

After valuing Southwest Airlines through the use of intrinsic valuation models, we

determined there were three particular models that were appropriate for the valuation

of the company. The models used were; the residual income model, the long-term

residual income, and the abnormal earnings growth model. Through the use of these

models we were able to value Southwest’s share price with the respective models as

follows; $8.44, $9.45, and $8.56. Each of Southwest’s share prices was determined

using a cost of equity of 10.44% and a 0% perpetuity growth rate. Comparing the

values of the intrinsic valuations models to the June 1, 2008 share price of $13.06 it can

be concluded that Southwest Airlines is overvalued, and the option is to sell.

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Southwest Airlines and the Airlines Industry

Southwest Airlines (LUV) is a Dallas, Texas based airlines. The airline was

established in 1971by Rollin King and Herb Kelleher with the notion of cheap, no-frills

flights. The airlines had originally three destinations; San Antonio, Houston, and Dallas.

Southwest’s objective market was and still is medium to high frequency business

travelers (grabers.com). Southwest operates in the national category of the Airline

industry, which means it only flies nationally not internationally. Southwest’s home

base is still Dallas, Texas; it has not changed from the 1970’s. Southwest flies to 64

destinations in 32 states and has a fleet of 532 planes, 95 of which are leased.

Competitors of Southwest are American Airlines, Continental, and JetBlue. The

rivalry amongst firms is high for this industry. Firms are competing for brand image

whether it be cheaper flights, state of the art planes, or faster check-in time. The airline

industry has a very high level of competition between existing firms with low or no

switching costs for the customer. Threat of new entrants is low for this industry

because of large economies of scale with low or no exit barriers. Price drives customers

in this industry, this leads to high threat of substitute products. The firms try to create

competitive advantages over one another in order to be number one.

Southwest has had to focus on numerous tactics in order to stay a competitor in

this industry. They looked at their customer base, which is mostly made up of one day

business travelers, and thought what was most important to them. After giving it some

thought, Southwest came to realize that convenience is a very important factor to its

travelers, so they felt it was important to implement that in their airports and on their

website. Now a customer can check-in online so they can avoid the checking lines, pay

a little extra and get seated first on the plane, or even charge their mp3 player while

waiting to board their plane. It also helps that Southwest puts a huge of emphases on

price, which helps them stay ahead of the curve. Southwest is trying to build a

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competitive advantage so it can distinguish itself easily from other firms in the airline

industry.

Company Overview

Southwest Airlines (LUV) is a competitor in the National airline industry. “Based

on the most recent data available from the U.S. Department of Transportation (“DOT”),

Southwest is the largest air carrier in the United States, as measured by the number of

originating passengers boarded and the number of scheduled domestic departures

(Southwest 10K).” Southwest is a Texas-Based airline that was developed in the late

1960’s on the grounds of offering customers discounted flights. Rollin King and Herb

Kelleher founded Southwest Airlines, the airline had originally been named Air

Southwest but changed shortly after in 1970. In the early days, the airline only flew to

and from three cities in Texas; Dallas, Houston, and San Antonio. The airline offered a

no frill, short flight to three destinations, this business approach has helped with the

continuing growth of Southwest. Today, Southwest flies to and from 64 cities in 32

states, with a fleet size of 532. In 2007 Southwest has recommenced service to and

from San Francisco. However, Southwest has recently slowed their growth plan in 2008

because of the rising fuel costs.

(www.wikinvest.com/stock/southwest_airlines)

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The total sales growth of southwest for 2007 was 8.5% (AOL Finance).

(In Thousands) 2002 2003 2004 2005 2006 2007

Assets

8,954.00

9,878.00

11,337.00

14,218.00

13,460.00

16,772.00

Sales

5,522.00

5,937.00

6,530.00

7,584.00

9,086.00

9,816.00

Stock Price

13.90

16.14

16.28

16.43

15.31

12.20

Southwest competes with many other companies in the airline industry. Competitors

with southwest include American Airlines (AMR), Continental (CAL), and JetBlue (JBLU).

Southwest competes more directly with JetBlue because both airlines are more regional

than international. Both are similar when it comes to flight destinations.

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Industry Overview

The airline industry changed the way people traveled the world. The airline industry is

made up of four different types of categories. These categories include

• International - 130+ seat planes that have the ability to take passengers just

about anywhere in the world. Companies in this category typically have annual

revenue of $1 billion or more.

• National - Usually these airlines seat 100-150 people and have revenues

between $100 million and $1 billion.

• Regional - Companies with revenues less than $100 million that focus on short-

haul flights.

• Cargo - These are airlines whose main purpose is to transport goods

This industry exists in a highly competitive market (Investopedia.com). The airline

industry is also affected by other factors. These factors can range from bad weather to

the rising costs of fuel, to government regulations on safety or noise pollution.

Southwest competes for the most part in the national category of the airline industry.

The international category would classify airlines similar to American Airlines and United

Airlines. The regional category would classify airlines similar to JetBlue. The cargo

category would classify companies similar to FedEx and UPS. All of these categories that

classify the airline industry are highly competitive with themselves and with each other.

They each intertwine with each other in way or another.

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The geographic scope and the level of service are two good criteria to represent the

airlines industry.

In the late 1970s, there were more players in the airlines industry. The four main

positions were: international with full service (group 1), national with middle level of

service (group 2), regional with an acceptable level of service (group 3) and regional

with no service (group 4). Rivalry was higher in the third position with nine competitors

than in the other.

In the early 1990s, rivalry is higher since competitors were only in two main positions

on the market: national and international with from a middle level of service to a high

one, and regional with low service quality. Some players like Continental, US air (from

group 3) and American, united and Delta (from group 2) joined the first group by

developing their services and geographic traffic. Consequently Rivalry in the first

Strategic Maps of the United States Airline Industry

Braniff

TWA

EasternUnited

American

Delta

Western RepublicOzark

USAir Piedmont

Frontier AirCal

PSA

South-west

Texas Int’l

United

South-west

AmericaWest

International International

National National

Regional Regional

No Frills No FrillsFull Service Full ServiceQuality of Service Quality of Service

Geo

grap

hic

Scop

e

The Late 1970s The Early 1990s

RenoAir

Continental

PanAm

Northwest

Laker

World American

TWA

Delta

USAir

NorthwestConti-nental

Kiwi

Others

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position became higher with a total of seven players. Some players disappeared from

the 70s to the 90s. Western airlines was purchased by Delta Air Lines in 1986 and after

the merger, Delta released the name Western airlines. Another example is Texas Air

Corporation which had been spilt up with parts sold to Scandinavian Airlines System,

Ross Perot's EDS (Electronic Data Systems), and an Air Canada-led investment group.

New players also, like Kiwi travel international Airlines, came in the industry. Rivalry in

the second group in the 90s became also very strong. Cost leadership was the main

strategy for those firms that provided short air travels. Southwest airlines tried to create

a gap with a more expanded network geographically and a higher level of service than

the group 2 competitors. It was this same strategy that made the firm able to join the

group 2 in the early 90s. In fact, differences in management styles, skills set and

strategic perspectives create advantages and disadvantages. Southwest airlines has

become phenomenally successful and an industry leader. For year q it went virtually

unchallenged. But Southwest costs have crept up, and now start up airlines such as jet

blue are challenging the industry leader with their own low cost strategies. This is

indicative of the competitive dynamic cycle.

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Industry Analysis: Five Forces Model Michael Porter’s five forces are used to analyze the industrial environment. Evaluating a

company’s position relative to the external environment using the five forces allows

analysts to understand the structure of the industry and determine the possible

opportunities and threats that could exist. Each force looks at the industry from a

different perspective, focusing on specific aspects that affect every industry. The Five

Forces Model focuses on five areas; rivalry among existing firms, threat of new

entrants, threat of substitute products, bargaining power of suppliers, and bargaining

power of buyers.

a. Rivalry among existing firms : HIGH Rivalry among existing competitors takes the form of jockeying for position. Firms use

tactics like price competition, advertising battles, product introductions and increased

customer service or warranties. Rivalry occurs when competitors sense the pressure or

act on an opportunity to improve their position. Some forms of competition, such as

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price competition, are typically highly destabilizing and are likely to erode the average

level of profitability in an industry. Rivals easily match price cuts, an action that lowers

profits for all firms. On the other hand, advertising battles expand overall demand or

enhance the level of profit differentiation for the benefit of all firms in the industry.

The US airline industry is a highly competitive and sensitive market. Recently the

merger between Delta and Northwest airlines has heightened the level of

competition in the fight for market share. Competition in the industry has also been

altered by the creation of larger airplanes, a slowing economy and the demand for

cheaper airfare, as well as developing technology, including onboard Wi-Fi internet

access (WSJ 2008). Competitive rivalry is affected by many different factors, these

include: Industry growth, level of concentration, differentiation, switching costs,

economies of scale, fixed and variable costs, excess capacity, and exit barriers.

Industry Growth

The level of industry growth determines whether or not a firm must seek to obtain

market share or not. The airline industry in the United States has grown to become

one of the major modes of transportation for many Americans. According to the

Bureau of Transportation Statistics, there were 735 million passengers on US

domestic flights, up 11.4% from the previous year. With such a large increase in

the number of passengers each year revenues have also increased.

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The chart above shows a constant growth in sales revenues for the past five years.

Each year has been greater than the next, which is a good indicator of growth

within the industry. While the number of flights is increasing, the relative growth in

sales has not increased at such a strong rate.

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

100000

2003 2004 2005 2006 2007

Airline Industry Operating Revenue (millions)

0

2

4

6

8

10

12

2003 2004 2005 2006 2007

Industry Sales Growth (%)

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Industry revenues have increased by an average of 7.67% each year for the last 5

years. While each company’s increase varies from year to year the average rate of

increase has started to slow. However the overall growth rates are still strong and

there has been no sign that sales will start declining. Although revenues increase

over recent years so have expenses.

Expenses across the industry over the past 4 years have increased by an average

9.9% per year. With operating expenses increasing at the same rate as operating

revenues creating increased profits is made difficult. As expenses increase the

industry looks toward cost cutting methods in order to increase profit potential.

With jet fuel prices on the rise expenses for airlines are increasing drastically. Just

this year the price of jet fuel has increased from $850 per metric ton to $1300.

With such a large increase in price jet fuel is the second largest expense for most

airline companies, consisting of an average 34% of all expenses (WSJ 2008).

With high ticket prices and a dismal economy, airliners are looking at alternative

ways to cut cost rather than just making the consumer pay for the difference.

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Recently UAL announced that it will be cutting 70 jetliners from its fleet in lou of

the jet fuel price increase. UAL also announced that it would be cutting routes that

it deemed no longer profitable, a strategy that AMR Corp. already acted upon (WSJ

2008).

With expenses so high, losses in the airline industry are expected to hit $2.3 billion

(Dallas Morning News 2008). Such loses aren’t uncharacteristic in the airline

industry.

In the case of most airlines profits have occurred with similar frequency to losses.

Such an industry could only be described as stagnant. The graph above shows an

income curve that is virtually horizontal, meaning that the level of growth in the

industry is very small. With the exception of Southwest Airlines, every airline

company has reported a loss at year end in a least one of the past 5 years. With

such unstable earnings it makes it hard for an industry to strive. Such factor lead to

price wars, these have been evident in the airline industry for quite some time.

Recent mergers are evidence that the industry is stagnant also, because they

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intend to take market share, the only way to grow in such an industry.

Concentration

Concentration within an industry compares the number of firms in an industry as

well as their relative size to the market. The concentration level in the Domestic

airline industry is reasonably low; market share is divided by many different

companies, neither having any considerable control over the majority. The result is

high price competition because there are a large number of competitors all

competing for the same customers.

The information above reveals that there are four dominant companies in the

industry; Delta and Northwest (after merger), AMR (American), Southwest, and

UAL (United). These four companies only control about 56% of the market, which

only goes to show how fragmented the industry really is. Another indicator of the

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low concentration within the airline industry is the fleet size of each company.

AIRLINE FLEET SIZEAmerican 656Southwest 532United 455Delta 445Continental 367Northwest 366US Airways 360Jet Blue Air Tran

137138

Data as of Dec. 31, 2007

This chart again shows how there are no true dominant company as far as fleet

size is concerned, supporting the position of the industry being fragmented. With

the concentration in the industry being so low it allows smaller airlines to compete

in the areas that larger companies aren’t focused. The current concentration level

could change however; due to recent mergers in the airline industry, it wouldn’t be

unrealistic to expect the concentration level to increase.

Differentiation

Differentiation in the airline industry is reasonably scarce, meaning that there aren’t

many companies offering unique products or services to distinguish themselves

from the rest of the market. This is mainly due to the increased costs in air travel;

costs that have enlarged as a result of high jet fuel prices. Most airlines have

stopped offering free meals and other amenities which were once common place.

Since most airlines are competing on cost, travel routes are about the only thing

that differentiates one airline from another. The exception is in the regional airline

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industry: Many of these airlines provide unique travel routes not offered by some of

the major airlines. Other examples of the differentiation offered by some of these

airlines include: First come first served seating, offered by Southwest, Jet Blue

offers personal entertainment and data systems for every passenger, and Frontier

Airlines goes one step beyond by offering satellite TV. One form of differentiation

which is now almost an industry standard is the offering of rewards for

accumulated miles flown on a certain airline, as well as the purchase of items on a

credit card affiliated by an airline. Overall the airline industry competes in an almost

pure cost control industry with a very minimal level of differentiation.

Switching Costs

Switching cost refers to the degree of ease a company can produce a different

product using the current resources of the company. The cost of one Boeing 737

can range from $50-85 million, making switching costs in the airline industry

incredibly high. Another factor making the switching cost in the airline industry so

high, is that it is almost impossible to use an airplane for anything else than flying

passengers. The only exception would be switching into the cargo freight industry;

however most commercial airlines already transport cargo and is factored into their

operating revenues. Therefore switching costs are barely diminished. This means

that companies within the airline industry are “stuck” with high competitive

pressures.

Economies of Scale

Economies of scale result due to the relative size of a company and its ability to

purchase large amounts of product at cheaper prices, creating an advantage over

smaller companies. Companies with large economies of scale should be able to sell

their commodity at a lower price than any competitor. As discussed in the

concentration section, there isn’t any single dominant market share holder and

therefore it would make it hard for any large economies of scale to exist in the

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industry. Also the fact that there are so many airlines with a large number of

planes, that it doesn’t give any one airline a great advantage in terms of economies

of scale.

The chart above shows total assets held by firms in the airline industry. Although

certain airlines purchase more in assets then others they aren’t necessarily able to

control their costs as tightly as some competitors, resulting in higher prices. Firms such

as Southwest and Jet Blue have much lower total assets and still offer lower prices to

consumers than larger firms. Although economies of scale do exist the fact that those

companies that hold more in assets aren’t able to offer lower prices than certain

competitors results in a reduction in the economies of scale in the industry.

0

5000

10000

15000

20000

25000

30000

35000

2003 2004 2005 2006 2007

Airline Industry Total Assets (millions) 

Southwest

AMR

UAL

Delta

Jet Blue

Continental

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Fixed-Variable Costs

The relation between fixed cost and variable cost defines how a firm goes about pricing

items in relation to competition. The higher the fixed-variable cost ratio, the higher the

level of price competition. Because airlines fixed costs are so great compared to most

other industries, each company must compete at a higher level to gain customers in

order to pay off its sunk costs with the goal of making a profit

The graph above illustrates Southwest’s fixed-variable cost relationship, a ratio which is

quite consistent across the industry. Fixed cost in the airline industry are high mainly

because the costs of owning and/or renting aircrafts are extremely high. Even if the

aircraft is leased, contracts are often for 15 to 20 years, resulting in an expense

whether the planes are flying or not. Recent surges in the cost of jet fuel as well as

increased maintenance costs have led to increasing variable costs. With already high

fixed costs, and ever increasing variable costs, competition between airlines becomes

increasingly important.

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

2003 2004 2005 2006 2007

Axis Title

Southwest's Operating Expenses per ASM (¢)

Variable Costs

Fixed Costs

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Excess Capacity

Excess capacity relates to the rule of supply and demand. With excess capacity, supply

is greater than demand and in order to reach equilibrium, prices must decrease, thus

filling capacity. Excess capacity in the airline industry is a result in high prices charged

by companies battling the increased fuel costs, as well as the inability of airlines to fill

their planes do to high route frequency.

The chart above shows the average capacity load function for each airline over five

years. Capacity load function is equal to the revenue passenger miles (RPM) divided by

available seat miles (ASM); this function provides the average percentage capacity of

operation for each airline. Filling excess capacity is made hard in the airline industry

because each plane is limited to a certain size and number of passengers. The

relatively similar excess capacity that exists across the industry is evident to the high

degree of price competition that exists, in companies both large and small.

71.75 74.57 78 78.85 79.12

28.25 25.43 22 21.15 20.88

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003 2004 2005 2006 2007

Airline Industry Capcity Load Factor (%)

Excess Capacity

Occupancy Load

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Exit Barriers

Exit barriers refer to the degree of difficulty a firm faces when trying to exit an industry.

Barriers are increased when the assets owned by the firm are costly and/or specialized.

Exit barriers in the airline industry are extremely high. Airplanes are highly specialized

pieces of equipment and cannot be sold easily. Due to the tremendous exit barriers of

the airline industry companies are forced to become even more competitive in order to

survive.

Conclusion

The rate of rivalry amongst existing firms in the airline industry is high, creating an

industry that is extremely competitive and sensitive. Most companies with the

exception of only a few share very similar changes in profit. These similarities are due

to a very low growth rate, low concentration, very little differentiation within the

industry, high switching costs, moderate economies of scale, high fixed costs, and high

exit barriers. High rivalry keeps the airlines industry dynamic and creates pressure on all

firms to improve and innovate.

b. Threat of new Entrants: LOW

The threat of new entrants refers to the possibility that the profits of the established

firms in the airline industry may be eroded by new competitors. The extent of the

threats depends upon existing barriers to entry and the combined reactions from

existing competitors. The more new airlines that enter the market, the more saturated

it becomes for everyone.

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Deregulation of the airline industry has eased the establishment of new airlines such as

low cost carriers. The increased use of the internet has made it easier for new

companies to find distribution channels and to sell their tickets over the Internet.

Upstart Jet Blue and Southwest Airlines were among the few to earn a profit in recent

years. However, there are several barriers to potential entrants.

Hubs and landing slots

Hubs and landing slots are a barrier to entry in the airline industry. Researches, from

the General Accounting Office (GAO), show that ticket prices at airports dominated by a

single airline are higher than at more competitive airports. Opportunities for establishing

new service continue to be limited in some airports by restrictive gate leases. These

leases permit an airline exclusive right to use most of an airport’s gates over a long

period of time, commonly 20 years. To gain access to an airport in which most gates

are exclusively leased, a company must sublet gates from the incumbent airlines, often

at none preferred times and at a higher cost than the incumbent. This system leads to a

low threat of new entrants in the airline industry.

Federal restrictions

Federal restrictions prevent foreign ownership of US airlines and block foreign airlines

from offering connecting service between US cities.

Economies of scale

Perhaps the most important barrier to entry is economies of scale. If a firm’s minimum

efficient scale is relatively large compared to industry output, then only a few firms are

needed to satisfy industry demand. To compete with existing airlines companies, a new

entrant must sell enough air tickets to reach a competitive scale of operation.

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The high cost of entry in a competitive industry

The total investment needed to reach the minimum efficient size is gigantic. High start

up costs and established brand names create substantial barriers to entry. The fact that

the new carriers don’t have a well known name and don’t have any long term

relationships with companies which can offer them loyal business consumers could

make it hard for the new actors to grow. The prospect of such losses discourages many

potential entrants.

Another barrier to entry would be the intense competition a starter company would

face. With most potential customers already loyal to their airline of their choice,

whether through lower prices, reward programs, or differentiated quality, it would be

almost impossible for a new company to come in and find a niche that could steal these

customers from the airlines of choice. For example, the biggest airlines fly more

national and international routes, so they offer more opportunities both to accumulate

frequent flyer miles and to use them. Thus, the biggest airlines have the most attractive

programs.

Thus, operating limits in the form of slot controls, scarce hubs and gates, and

restrictions against foreign competition create barriers to entry in the airline industry.

Likewise, several marketing strategies, including special incentives for travel agents and

frequent flyer programs, give an advantage to the established carriers. These strategies

continue to deter new airlines from entering the market. Seven airlines account for

over 80 percent of all passenger service; the threat of new entrants is consequently

low.

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c. Threat Of Substitutes : MEDIUM

All firms within an industry compete with industries producing substitute products and

services. Substitutes limit the potential returns of an industry by placing a ceiling on the

prices that firms in that industry can profitably charge. The more attractive the

price/performance ratio of substitute products, the tighter the lid on an industry’s

profits. The existence of close substitute products increases the propensity of customers

to switch to alternatives in response to price increases (high elasticity of demand).

Substitutes

Travel services, like train and private transportation (cars), are substitutes because they

perform the same function. People who need to travel can choose between those

different travel means. As digital technology has improved and wireless and other forms

of telecommunication have become more efficient, new substitutes have become a

viable substitute for business travel for many executives. Videoconferencing and

groupware allow two or more locations to interact simultaneously via two way video

and audio transmissions. There are consequently two main types of substites,

transportation providers and high technology telecommunication products.

Relative price and performance

Teleconferencing can be a very important threat. It can save both time and money and

affect the number of business travellers. The rate of improvement in the price-

performance relationship of the substitute product is high.

Trains are not a good substitute for airlines because they don’t provide enough routes

in the US to provide a good transportation system. However, with airports and

highways more congested than ever, there are now plenty of plans for next-generation

passenger rail, from upgrading existing lines to building super-high tech tracks. Given

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the expense, the technical challenges and the political complexity of these projects,

trains have the potential to substitute airplanes in at least a decade.

popularmechanics.com

In this map, we can see the proposed North American High Speed Train Project. The

threat to the airlines here yet but it will be soon when it comes to travel over medium

distances. Regional airlines would be the first affected because soon most of the train

routes would provide fast transportation between cities adjoining states very fast,

particularly on the east coast. The threat looks lower when it comes to large distances

in the US. Even if it would be possible to travel by train from Boston to Houston, we

don’t imagine a lot of people doing that. Airplanes will be always more time and money

efficient. Moreover, the major connections between the east and west coasts would be

still via airlines. On the map, we can’t see any routes crossing the entire country.

As for trains in more than a decade, cars are already a reliable substitute for regional

airplanes, when it comes to short distances. In an attempt to provide a long term

perspective in this report, we will assume that the project mapped above will be

implemented and consequently we will compare the time and energy required for all

travel options within a 400 mile trip. A 400 mile trip is appropriate to evaluate the

highest threat of substitutes, which is, as we said before, regional airlines. A 400 mile

trip corresponds to the distance from Boston to Baltimore.

High-Speed Rail Amtrak (Diesel)Travel time: 2 hours, 54 minutes (maglev); 4 hours, 35 minutes (steel-wheel)

Travel time: 7 hours, 5 minutesEnergy used per passenger mile: 2709

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Energy used per passenger mile: 1180 Btu* (maglev); 1200 Btu (steel-wheel) CO2 emissions per passenger mile: 0.47 pounds (maglev); 0.48 pounds (steel-wheel)

Btu CO2 emissions per passenger mile: 0.46 pounds

Airplane CarTravel time: 2 hours, 20 minutes (including 1-hour check-in time) Energy used per passenger mile: 3264 Btu CO2 emissions per passenger mile: 1.06 pounds

Travel time: 7 hours, 6 minutesEnergy used per passenger mile: 3445 Btu CO2 emissions per passenger mile: 0.77 pounds

*Btu stands for British thermal unit. One gal. of gasoline yields about 114,000 Btu.

Trains are a significant threat for airplanes because there is only a 30 minute time

difference between an airplane and a maglev (a train that suspends, guides, and

propels vehicles, using electromagnetic force). The energy used per passenger mile is

lower for trains which represents therefore a lower cost for trains than for airplanes.

Contrary to airplanes or cars, high-speed trains draw power from the electrical grid,

which is fueled primarily by domestically produced energy sources, such as coal.

However, it seems that cars are not a key threat due to the time difference. It is

imperative that airlines take into account the cost of automobile travel in order to fix

their prices and discourage people from driving. Furthermore, with oil cracking $130 a

barrel, driving has become very expensive.

Buyers’ willingness to switch

Air transport is traditionally very reliable for people. But it’s apparent that, in some

areas, this system is reaching capacity. For example, for short distances, air travellers

are spending more time in security lines and waiting on the runway before they ever

get into the air. According to the Department of Transportation, 2007 was the worst

year in the past decade for airport delays, with 25 percent of flights arriving late.

According to these facts, buyers’ propensity to substitute could increase significantly,

particularly with the emergence of reliable train routes. Key criteria for customers are

the amount of money people are willing to spend to travel. As a consequence, such

substitutes are easy to counter by determining airline ticket prices according to the

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equivalent price of the substitute product. For the same amount of money, people

prefer to fly in general. But, since trains will be cheaper and more environmentally

friendly, people may adopt the train instead of the car. They will value the fact that

they don’t need to wait for planes or for luggage, they don’t have to go through the

security or they can still use their cell phones.

However, it seems that customers perceive a higher level of service for airlines and

travel more comfortably in a plane than in a car or a train. Differentiation is also high

when we consider the highest number of routes for airlines.

Currently, the threat of substitutes for airlines is medium. Advantages like speed,

service, and routes provided by planes seem to be considerable compared to

substitutes. However, the relative price performance of trains could be a major threat in

a decade for regional airlines. Airlines need to define themselves as transportation

providers in order to avoid marketing myopia.

d. Bargaining Power of Customers : MEDIUM / HIGH

The power of buyers is the impact that customers have on a producing industry. This is

how much pressure customers can place on business. Customers threaten an industry

by forcing down prices, bargaining for higher quality or more services, and playing

competitors against each other. These actions erode industry profitability.

The largest proportion of revenue is derived from regular and business passengers. For

this reason, it is important that one takes consumer and business confidence into

account on top of the regular factors that one should consider. Main customers in the

airline industry are: Travel Agents, Business Travellers, Federal Government, Pleasure

Travellers, Charter Service, the US military.

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Switching costs.

It’s very easy for customers to switch to another product and company because they

are extremely price sensitive. For example, travelers will choose to drive if they consider

it cheaper than flying. Students, for example almost always adopt this kind of behavior.

Some customers, in general, can do without flying for a period of time if they think that

prices are too high. In times of economic uncertainty or sharp decline in consumer

confidence, one can expect the number of leisure travelers to decline.

Even business travellers become more sensitive to prices, according on the Business

Travel News’ Corporate Travel 100 Report. This year, 22 percent of more than 60

companies that spend a total of more than $44 million in U.S.-booked air travel said

they are seeking air savings by becoming more restrictive in business class policies. Last

year, 28 percent did so. Moreover, these companies don’t have a preference in a

particular airline. They will choose the best price.

However, in some case, consumers value speed more than saving. For example,

Business travellers can’t waste time driving when they can fly. Business travellers are

important to airlines because they are more likely to travel several times throughout the

year and they still tend to purchase the upgraded services that have higher margins for

the airline.

Ticket Price

Also, buyers tend to buy a round trip ticket only, so they can’t negotiate discount for

their purchase volume. Fares are going up and will continue to grow. Average published

airfares next year will rise 6 to 10 percent from 2007 levels, said Bob Brindley, vice

president for the Americas for BCD Travel's consulting subsidiary Advito. However, the

demand should remain at least stable since the airlines tend to give customers some

discounts. Phil Dunphy. director of global travel, said: "If the airlines raise fares 5

percent, they'll give you back 3 percent, but they still net that additional 2

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percent.”(www.btnonline.com) Obviously, discounts may not be sufficient to recover

airline’s previous price but this practice would not decrease demand fundamentally.

Also, airlines product is highly perishable. Once an airplane takes off, the empty seats

lose all value, so airlines need to do what they can to fill them. That means that airlines

companies need to decrease ticket prices daily depending up how full the flights are.

Number of buyers

As American Airlines senior vice president of global sales David Cush said, travel

demand and corporate spending remain robust this year: "I think less about what

people are saying and more about what they're doing. What they're doing is continuing

to travel at a very strong level," he said. "Our July figures for corporate travel show no

decrease in demand there and forward-looking bookings look very strong, so everything

we see points to a robust travel market." It seems that the airlines industry would have

to wait to see "the fallout from some of this financial market turmoil," but international

travel remains strong. Indeed companies have globalized, and they can't just stop

travelling internationally. International demand is going to remain strong. Consequently,

it appears that individual buyers don’t have a lot of power.

Differentiation

Customers appreciate services and airlines companies have to improve them as much

as they can. Indicators that are used in survey such as the “BTN annual airline survey

2007” are flexibility in negotiating pricing; flexibility in negotiating services and

amenities; availability of timely; accurate contract performance data; complaint problem

resolution; quality of airline communication; value of relationships with managers; sales

representatives; quality of customer service; and overall price value. However, it is

quite hard to compete on service. Consumers realize that there is now virtually no

differentiation between airlines in terms of product, even in the upper travel classes. Air

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travel is mostly standard and there is little opportunity for sustainable differentiation. Is

the seat in one airline more comfortable than another? Probably not, unless you are

analyzing a luxury liner like the Concord Jet.

Airlines try to differentiate travel but the problem is that there is simply not enough

product differentiation to go around. Product packages, like air ticket and hotel or car,

used to work; they no longer always do because they can more often be copied or

improved by competitors at an increasing speed. For example, in the mid 1980s, AMR (

American Airlines) introduced AAvantage. This differentiating concept was a great

success until most other competitors realized that they could do likewise. As a

differentiator, the effective life-cycle of frequent flyer miles/points and their

differentiating power were much shorter than the airlines originally anticipated.

Access to information

Another key element of high buyer power is that buyers have access to information.

They can easily compare online hours, prices, connections to decide which flight they

want and therefore the company they want to choose. Tickets can be purchased

through common online venues like Orbitz and Travelocity or are issued directly by

airlines over the phone or through the company’s website. A minority are booked

through travel agents. In the Economist, published June 14th 2007, we find that: “The

web has made it possible for passengers to be their own travel agents by comparing

fares and schedules and booking flights—and at prices much lower than a decade ago.”

The access to information increase buyers’ power.

In conclusion, buyers’ power is medium/high due to low switching costs, price

sensitivity, a standard product, information access, a large number of buyers and low

volume purchases.

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e. Bargaining Power of Suppliers : HIGH The bargaining power of suppliers is how much pressure suppliers can place on a

business. Suppliers can exert bargaining power over participants in an industry by

threatening to raise prices or reduce quality of purchased goods and services. If one

supplier has a large enough impact to affect a company's margins and volumes, then

they hold substantial power.

The airline industry is extremely sensitive to costs such as fuel, labor and borrowing

costs. The airline industry’s main suppliers are aircraft manufacturers, aircraft leasing

companies, labor unions, food service companies, fuel companies, airports, the federal

Aviation Administration (FAA), hotels.

Aircraft makers

The airline supply business is mainly dominated by Boeing and Airbus. For this reason,

there isn't a lot of cutthroat competition among suppliers. As a consequence aircraft

makers are powerful. Even if there is an intensive war between Airbus and Boeing (cf:

graph) gain a higher percentage of the world market, prices are comparable for similar

planes, which allow no breathing space for airlines. Furthermore, aircraft makers’ power

could be higher in the future because they won’t offer identical aircrafts. Indeed,

Boeing’s strategy now is to focus more on small aircrafts for regional lines whereas

Airbus’s strategy is more oriented towards big international planes. The negotiation with

suppliers would be harder to airlines companies. Suppliers’ products are an important

input to the buyers business. Airlines company need to renew their fleet regularly and

Boeing and Airbus are the only providers. Without sufficient planes, an airlines company

loses power. Plane investments are critical and airlines firms don’t have any substitute

products to offer.

The only element that tends to reduce supplier power is that the airlines industry is an

important customer and that the rivalry between Boeing and Airbus is very high.

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Labor supply power (labor unions)

The initial changes in the airline industry created by the Airline Deregulation Act of 1978

seem to have increased union bargaining power. Airline unions have considerable strike

threat power, but are constrained by the financial health of carriers. Since airline

deregulation, compensation has waxed and waned in response to the industry’s

economic environment. Airline workers capture sizable rents following good times and

provide concessions following lean times. Evidence from the CPS for 1995-2006 shows

that wage premiums for airline industry workers remain, particularly for pilots, with

existing premiums almost entirely a union phenomenon. Because unions retain

bargaining power at the major carriers, wages are likely to head upward as carriers’

financial health returns. Such wage levels may or may not be sustainable in the

inevitable next downturn.

Fuel suppliers

Fuel suppliers are very powerful. Indeed, some of the major players in the airline

industry attribute 10-20% of their costs to jet fuel. Fuel prices have been known to

fluctuate 5-10% or more on a monthly basis, so paying close attention to these costs is

crucial. That’s why airlines companies had been interested in reducing the volatility of

oil prices. For example, Southwest Airlines has a long-time program to hedge fuel

prices. It has purchased fuel options years in advance to smooth out fluctuations in fuel

costs. The use of these hedges helped airlines maintain their profitability during oil

shocks like the Iraq War and Hurricane Katrina. However, the rapid increase in fuel

prices this year has a strong impact on airlines profits. Record jet-fuel prices are making

50-seat regional jets unprofitable to fly. For example, with fuel prices at $3.15 a gallon,

the Embraer ERJ-145’s total operating cost has increased 39%, making it, a money-

loser on its routes.

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In those graphs from an article in www.nationalpost.com (April 17, 2008), we can see

the fuel prices increase and their impact on the net income for three main competitors.

Labor costs are also represented. However, there are stable.

In conclusion, Suppliers power is very high. As discussed, only two main aircraft

makers, labor unions are still quite strong, and the increase in fuel makes airlines

companies very weak. Airlines companies need to mitigate rising costs.

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Value Chain Analysis

Competitive strategies-

The airline industry firmly believes that the three main areas of competition is

Cost Control/ Efficiency, frequency and convenience of schedules/routes, and ultimately

fares. With highly competitive price wars, each firm must use its own competitive

advantage to try to increase profitability. Each firm uses its own economies of scale

and cost structures to try to establish the maximum share of the market it can obtain.

Cost Control/Efficiency

Unlike Southwest, the 9/11 aftermath has sent many of the airline firms into

bankruptcy. Recently some of the firms have just climbed out of this negative profit

whole by cutting costs by renegotiating labor, supply, and financial contracts. Through

new deals with labor unions, fuel suppliers, and insurance companies, each firm is

finding new ways to become more cost efficient in day-to-day activities. In addition to

cutting costs through the above stated new venture, many of the other airline

companies are beginning to form new “alliances” to help spread efficiency. Ones such

alliance is Continental’s train-to-plane alliance with Amtrak. (Continental’s 2007 Annual

Report) This alliance allows an easily accessible eight-minute shuttle service for

commuters from Manhattan to Continental’s New York Liberty hub. Other alliances

include SkyTeam, which allows all of its members to share airport lounge

accommodations and helps offer greater destination coverage, as well as an ever

expanding network alliance with various travel agencies to help promote sales of the

individual airline’s ticket sales. These ways are all important in cutting costs to try to

find a competitive advantage in the domestic travels, but as for Southwest’s main

competitors, they have to find additional and alternative strategies to try to help control

cost in their international travels. Along with domestic factors the competitors must face

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additional factors such as currency exchange, war difficulties, and different weather

patterns in international territories.

Frequency and convenience of schedules/routes

Before 9/11 the airline industry seemed to have two main market-share seeking

strategies. One of which was Southwest’s, in seeking the most efficient way of

optimizing domestic route patterns and cost control, and the alternate used by almost

all of Southwest’s competitors, of having a larger fleet to increase route frequency

domestically and internationally, as well as increasing route volume by establishing

codesharing alliances, and obtaining brand recognition. After the terrorist attacks of

9/11, the entire industry had to incur higher fuel prices and a lesser volume of willing

flyers. Southwest continued to maintain its competitive advantage with a smaller and

efficient fleet, but almost all other airlines had to shrink capacity, cut labor, and cease

certain operations.

Fares

All of the airline companies fiercely compete in price competition of lowering their

individual fares. However, each company must face its own factors that deal with the

adjusting of these fares. Besides the main differences of international travel vs domestic

travel and large fleet vs small fleet, each airline must face the same economic and other

conditions that could possibly have them adjust their prices. Some of these conditions

include: fuel prices, union problems, threatened political instability, environmental

issues, changes in consumer preferences, and potential problems in the air traffic

control system. One such factor that had a substantial increase in individual fare prices

were the terrorist attacks of 9/11. This event caused all TSA (Transportation Security

Administration) to increase personnel in all U.S. domicile airports. For example,

Continental’s per enplanement ticket tax went from a $10 per passenger roundtrip cap

to an $18 per passenger roundtrip cap. (Continental’s 2007 Annual Report)

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Along with these factors, the entire airline industry is also faced with competition

from surface transportation, pertaining to shorter travel. In economic regressions, this

form of travel could seem more appropriate.

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Firm Competitive Advantage

Economies of Scale-

Southwest Airlines Co. focuses on targeting a very simplistic market segment. It

focuses principally on customers that are traveling on shorter-route trips that want low-

fares and non-stop frequent flights. These types of customers range from the everyday

traveling businessman to possibly vacationing families. Southwest achieves reaching

these arrays of customers by its efficient cost-structure, differentiated strategies, and

future goal setting techniques.

Cost Efficiency/Control System

Southwest’s main competitive advantage is its superb cost structure. This low

cost-structure is reached through only using one type of aircraft, efficient route

structures, and high moral employees.

By using only one aircraft type, the Boeing 737, Southwest is able to simplify

scheduling, maintenance, flight operations, and training activities. This in turn greatly

reduces costs of having to hire additional workers/trainers that would have to require

additional skill sets.

Southwest’s main low-cost driver would be its efficient route-structure. “Point-to-

point service allows for more direct nonstop routing than the hub and spoke system,

minimizing connections, delays, and total trip time.” (Southwest’s 2007 Annual Report)

As of this year, Southwest now has over 400 nonstop city pairs. Also helping in

Southwest’s efficient routing schedule are conveniently located downtown and

secondary airports. These airports are generally less crowded and congested, which

helps minimize the time the aircraft has to stay on the ground. This asset utilization

helps reduce costs by avoiding flying time in the air waiting too land, and cabbing time

waiting to depart in crowded airports. This reduction in aircraft usage also helps add

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additional routes to increase profitability. Another cost reduction strategy to

compensate for the raising of fuel prices is eliminating shorter less profitable flights to

help utilize the already existing fleet in more profitable ventures. This in turn keeps the

company from expensing additional aircraft and fuel, while increasing its turnover.

Differentiation strategies

-Fare Structure-

“Southwest was the first major airline to introduce a Ticketless travel option,

eliminating the need to print and then process a paper ticket altogether, and the first to

offer Ticketless travel through the Company’s website at www.southwest.com”

(Southwest’s 2007 Annual Report) This innovative strategy helped bring new clientele

that did not want to have to wait in airport terminals to receive their travel vouchers. At

the end of 2007 over 90 % of all Southwest customers chose the ticketless confirmation

method. In addition to this fare distribution channel, Southwest is better trying to reach

the everyday businessman traveler by adding on to its fare distribution web. To help

show available fares in the future, Southwest announced an expansion of its Global

Distribution System to help with corporate travel. Also, to help better compensate these

frequent flyers, Southwest has recently created their rapid rewards frequent flyer

program. This program is based on the number of trips the customer has taken rather

than the mileage flown. For every 16 credits (flights) within 24 months, the flyer will

receive one free round-trip award to any destination on Southwest.

-Enhanced Boarding Method and Updated Gate Design-

To help with efficient boarding, Southwest has created a method that greatly

reduces customer wait time standing in line at the gate. In addition to adding their

“Business Select” class, which basically means frequent flyers that automatically receive

A class status upon arrival at the gate, the new method arranges customers in a fashion

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of A, B, and C boarding groups with assigned numbers. This boarding method allows for

the flyer to have a reserved spot in line, depending on when he/she checked in

electronically or at the terminal, as early as 24 hours in advance. With this new

boarding method, Southwest updated its gate design to have columns with letters and

numbers to help facilitate the order in which to board. Along with these columns, to

help indulge the Southwest experience, they included “(i) a business focused area with

padded seats, tables with power outlets, power stations with stools, and a flat screen

television for news programming; and (ii) a family area with smaller tables and chairs,

“kid friendly” programming on a flat screen television, and power stations for charging

electrical devices.”

Looking into the future

To help become more efficient and to help differentiate itself from its

competitors, Southwest plans to replace its existing Ticketless system and revenue

accounting system with new technology. This new technology will help create easier

data flow, which will in turn increase operational efficiencies and Customer Service

capabilities.

As a member of the low concentration airline industry, Southwest engages in

high price competition with its rivals. With having very closely related rival firms, to

emerge successful a firm must have excellent cost-efficiency strategies. By creating a

superior cost-efficient structure, innovative differentiated strategies, and implementing

useful future goal setting techniques, Southwest seems to be able to sustain its top of

the industry status.

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Accounting Analysis

The purpose of performing an accounting analysis on this firm is to analyze the

firms accounting practices. The analysis will also highlight if the firm, in fact, exercised

acceptable accounting practices that mirror accurate information about the firm. The

degree of financial reporting is regulated in the United States by GAAP, Generally

Accepted Accounting Principles. The Security Exchange commission (SEC) requires

managers of firms to follow GAAP in order to provide a clear picture of the company for

their shareholders and potential investors. GAAP give managers numerous alternative

options in accounting so they can show how their company succeeds or falls short; also

how it competes within its industry. GAAP provides a degree of flexibility to the

managers of the firms rather than using accounting principles that do not represent

accurate conditions of the company and its industry. This accounting flexibility has good

intentions, but accounting can still be manipulated by management.

Structuring an accounting analysis begins with identifying the company’s key

accounting policies that deal directly with its key success factors. Also to look at would

be important information on the financial statements as well. Information like capital

and operating leases, pension plans, and fuel hedging costs should be investigated for

possible manipulation. Assessing the degree of accounting flexibility will help determine

if the firm’s managers distorted the financials in some way to make the company look

financially sound. The accounting strategy phase of the accounting analysis process

allows us to evaluate the accounting policies the company used. From there we need to

compare them with the industry norm and identify if there are any irregularities in our

firm or that of any of the competitors. During the accounting analysis; we will have to

assess the quality of information we are disclosed in the company’s 10K. After

completing the analysis, we will be able to determine how transparent this firm’s

financial statements are. If there are any inconsistencies with reporting, we must

47

identify the potential “Red Flags” or other abnormalities. Lastly, we must then undo any

abnormalities in the firm’s accounting in order to properly value the firm.

Key Accounting Policies

The initial step in Accounting Analysis is to identify the firm’s key accounting

policies. In order to analyze this, Southwest’s key accounting policies must be directly

related to its key success factors. These factors include industry growth, level of

concentration, differentiation, switching costs, economies of scale, fixed and variable

costs, excess capacity, and exit barriers. “The airline industry is highly competitive. The

company believes the principal competitive factors in the industry are, fares, customer

service, costs, frequency and convenience of scheduling, frequent flyer benefits, and

Efficiency and productivity, including effective selection and use of aircraft (Southwest

10K)”. This allows Southwest to help differentiate itself, allowing it to have some

competitive advantage over other airlines in the industry. Every firm wants the

advantage to differ itself from the competition in one way or another to have the upper

hand in the industry. We found in draft one that Southwest’s key success factors are

price competition, differentiated strategies, and future goal setting techniques. The firm

can clearly present these factors, or give their own account of their competitive

advantages.

Southwest also utilizes GAAP when they prepare their financial statements. This

allows Southwest’s management to make assumptions and estimations that affect

amounts stated on their Consolidated Financial Statements. “The Company’s estimates

are based on historical experience and changes in the business environment (Southwest

10K).” Southwest’s assumptions are most important when it comes to the portrayal of

the company’s financial condition; they require the best judgment from managers. The

accounting policies that are directly linked to Southwest’s key success factors are the

following: revenue recognition, fuel hedging, operating leases, and retirement and

pension plans.

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Revenue Recognition

In the airline industry companies like JetBlue, American, Continental, and

Southwest emphasize the importance of price competition, but also have to follow

GAAP’s policies in recording such entries accordingly. The SEC instructs all U.S. based

companies to use GAAP when preparing their financials. Price competition is important

to southwest because it enables them to be the “low cost leader” in the airline industry.

How they maintain low prices in an uncertain economy is a big question. Southwest

achieves this by adjustments made first on the balance sheet, that then affect the

income statement. Southwest like many of its competitors use revenue recognition

when estimating revenue. Southwest initially records all ticket sales to the “Air Traffic

Liability” line of the balance sheet before it allocates the sale to the “Passenger

Revenue” line on the income statement. The air plane has to actually take off before

the sale is adjusted on the Income Statement. An argument can be made that the ticket

sale should be viewed as a revenue not a liability, and have line for doubtful accounts.

Other airlines face the same disadvantage when recording revenues from ticket sales.

Air traffic liability accounted for $931 million in 2007 versus $799 million in 2006.

Fuel Hedging

”Southwest is a pioneer when it comes to the low-cost business model, but high

oil prices are a growing threat (Morningstar.com).” Southwest Airlines has incurred

more costs in 2007 because of rising fuel costs, but those are not the only costs

Southwest has. “Southwest’s business is dependent on the price and availability of

aircraft fuel. Continued periods of high fuel costs and/or significant disruptions in the

supply of fuel could adversely affect the Company’s results of operations (Southwest

10K)”. Fuel cost have risen from $2,119,520 in 2006 to $2,539,600 in 2007, the

average cost per gallon of jet fuel has risen from $1.53 in 2006 to $1.70 in 2007 with

the expected rate to be in the $2.60 to $2.65 range.

49

2007 2006

(In millions)

Mark-to-market impact from fuel contracts settling in future periods — included in

Other (gains) losses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(219) $ 42

Ineffectiveness from fuel hedges settling in future periods —included in Other (gains)

losses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (51) 39

Realized ineffectiveness and mark-to-market (gains) or losses — included in Other

(gains) losses, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (90) 20

Premium cost of fuel contracts included in Other (gains) losses, net . . . . . . . . . . . . . . 58 52

Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 (2)

$(292) $151

(Southwest 10K)

Southwest’s profit for 2007 was $645 million compared to 2006 with $499 million, a

29.3% increase (Southwest 10K). “Jet fuel and oil consumed for fiscal 2007 and 2006

represented approximately 28 percent and 26 percent of Southwest’s operating

expenses, respectively (Southwest 10)”.

Capital and Operating Leases

Southwest believes that having a single type of aircraft, Boeing 737, contributes

to its low cost structure. Some believe that having a single type of aircraft can be

damaging to the firm. The maker of the aircraft may at sometime not be able to provide

adequate assistance to the aircraft. However, Southwest believes that the advantages

outweigh the negative risks when it comes to having a single aircraft strategy

(Southwest 10K). Out of Southwest’s fleet of 520 planes 95 of them are leased, 86 were

under operating leases and 9 were under capital leases (Southwest 10K). The total

50

amount of capital leases for 2007 were $35 million and $45 million for 2006 (Southwest

10K).

2007 2006

(In millions)

Flight equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$168 $168

Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . .(133) (123)

$ 35 $ 45 (Southwest 10K)

Under operating leases not only aircraft was accounted for, terminal operations space

was also accounted for in that section. The operating leases for 2007 were 560 million

and 495 million for 2006. The forecast of operating leases and capital leases are as

follows

Capital Leases Operating Leases

(In millions)

2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$16 $ 400

2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 335

2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 298

2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 235

2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .— 195

After 2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . — 876

Total minimum lease payments . . . . . . . . . . . . .60 $2,339

Less amount representing interest. . . . . . . . . . . 8

Present value of minimum lease payments . . . . .52

Less current portion . . . . . . . . . . . . . . . . . . . . 13

Long-term portion . . . . . . . . . . . . . . . . . . . . . .$39 (Southwest 10K)

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Retirement and Pension Plans

Southwest records retirement and pension plans under the balance sheet. It

records them as other differed liabilities. The company contribution each plan was six

million in 2007. Like any other company Southwest offers a 401K plan and benefits to

their employees. The age for a pilot to retire went from 60 to 65, this allowed a

decrease in the company’s projected future post retirement obligation. The also assume

the health care cost trend to decline to 5% from 7.50% in the next seven years. The

company’s contribution for retirement plans was 279 million in 2007.

Conclusion

A company’s key accounting policies should match their key success factors. If

everything does not match up the analyst should see that as a “red flag”, in that case

the analyst has to go back and correct the company’s mistake. In the case of Southwest

Airlines, we have discovered that their financials are transparent, with a normal level of

company disclosure.

Assess Degree of Potential Accounting Flexibility

Some firms try to distort their financial information by the degree of accounting

flexibility they use. The SEC (Securities Exchange Commission) tries to regulate firm’s

accounting so they are reported to investors as transparent as they can be. GAAP

provides standards and rules that the FASB requires firms to abide by when they are

preparing their financial statements.

Revenue Recognition

When a passenger purchases a ticket for air travel, it is initially deferred as “Air

Traffic liability” (Southwest 10K). When a service is provided (when the flight leaves the

52

ground) passenger revenue is recognized and air traffic liability is reduced. “Air traffic

liability” fluctuates throughout the year; it depends on seasonal travel and fare prices.

“Air traffic liability” balance at December 31, 2007 was $931 million, compared to $799

million as of December 31, 2006 (Southwest 10K).” During this process, estimating how

many tickets will be subject to refunds or forfeits require some degree of bias and

reasoning. It helps when the majority of Southwest’s tickets are sold as non-refundable,

but they do offer the customer use of the ticket up to a year of the purchase if they do

decide to cancel their reservation. The ticket can also be refunded if the ticket was

purchased as “refundable”. Air traffic liability includes all the estimates of future refunds

and exchanges, net forfeited tickets, for all unused tickets once the flight date has

elapsed. The precision of estimation are based on historical information. Southwest and

its competitors have exercised this accounting method to estimate revenue from

forfeited tickets at the date of travel.

Capital & Operating Leases

In Southwest’s case costs would be where they could have some flexibility with

their accounting. When Southwest reports leases they first report them separately

under Capital and Operating leases, under Capital leases they have categorized only

nine planes out of the 95 they lease, and under Operating leases they categorized the

remaining 86 aircraft and also land fees and other rentals, meaning terminal space in

the airport. Out of the 95 lease aircraft, only 86 of them are recognized and affect the

balance sheet. If the Operating leases are not portrayed correctly on the balance sheet,

assets or liabilities can be seriously understated, causing a chain reaction to the rest of

the balance sheet. Net income and retained earnings can be classified as overstated

causing the firm to look more lucrative to investors than it really is.

In the case of the capital lease it is different because it does not affect the

balance sheet. It is categorized as a liability and an asset to the firm, because the

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owner assumes some risk and benefits while owning the lease. Southwest has a lot of

flexibility when it comes to leases.

Fuel Hedging

Accounting flexibility also applies to the hedging Southwest applies towards jet

fuel costs. “Changes in the Company’s overall fuel hedging strategy, the ability of the

commodities used in fuel hedging (principally crude oil, heating oil, and unleaded

gasoline) to qualify for special hedge accounting, and the effectiveness of the

Company’s fuel hedges pursuant to highly complex accounting rules, are all significant

factors impacting the Company’s results of operations (Southwest 10K)”. Southwest has

implemented SFAS 133, Accounting for Derivative Instruments& Hedging Activities, to

address fuel derivatives expiring in forthcoming periods. Southwest’s net income

increase in 2007 from 2006 with gains and losses, its operating income decreased 15.3

% from 2006 due to the rising fuel costs which they were not able to recover with the

year’s revenues. The average jet fuel cost has increased by 2% from 2006 to 2007. The

increase has gone from $1.53 a gallon in 2006 to $1.70 a gallon in 2007. Southwest

expects fuel to rise between $2.60 and $2.65 later in 2008 (non-hedging prices).

“Based on current growth plans, the Company also has fuel derivative contracts in place

for over 55 percent of its expected fuel consumption for 2009 at approximately $51 per

barrel, nearly 30 percent for 2010 at approximately $63 per barrel, over 15 percent for

2011 at $64 per barrel, and over 15 percent in 2012 at $63 per barrel (Southwest

10K)”.

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2007 2006 2005 (In millions) Fuel hedge (gains) included in Fuel and oil expense . . . . . . . . . $(686) $(634) $(892) Mark-to-market impact from fuel contracts settling in future periods —included in Other (gains) losses, net . . . . . . . . . . . . . . (219) 42 (77) Ineffectiveness from fuel hedges settling in future periods — included in Other (gains) losses, net . . . (51) 39 (9) (Southwest

10K)

Retire & Pension Plans

Southwest has incorporated a Profit Sharing Plan as a contribution plan for its

employees. Southwest contribute 15% of its eligible pre-tax profits on an annual basis,

with no employee contributions allowed with the Profit Sharing Plan. Southwest also

offers 401(k) plans that cover almost all of their employees. Their retirement

contributions for 2007 were $279 million compared to $301 million in 2006. The

company provides retirement plans for employees 65 or older.

55

2007 2006

(In millions)

APBO at beginning of period . . . . . . $111 $ 94

Service cost . . . . . . . . . . . . . . . . . 16 15

Interest cost . . . . . . . . . . . . . . . . . 6 5

Benefits paid . . . . . . . . . . . . . . . . (6) (5)

Actuarial (gain) loss . . . . . . . . . . . (39) 2

Plan amendments . . . . . . . . . . . . . — —

APBO at end of period . . . . . . . . . . . $ 88 $111

Conclusion

Accounting flexibility allows firms to manipulate their numbers in order to make

themselves look favorable to outsiders. GAAP tries to enforce guidelines for firms to

follow to make their financials more transparent. In Southwest’s case, their financials

are pretty transparent for the most part. Southwest has used these guidelines to report

their financials to the best of their knowledge.

Evaluate Actual Accounting Strategy

Some firms give very little disclosure when they are creating their financial

statements in accordance to GAAP. Even though GAAP has requirements that must be

stated, it manages to give managers flexibility. They have the power to alter lines of

revenues and expenses in order to make the firm more attractive to investors or

potential investors. Firms also mix the way their accounting appears, aggressive and/

or conservative. Firms can be giving a potential investor a good evaluation of their

company or the total opposite. In Southwest’s case we have come to the consensus

that this firm is conservative when it comes to accounting. Southwest is also a high

disclosure company. The accounting strategies that affect Southwest are revenue

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recognition, fuel hedging, operating and capital leases, and retirement and pension

plans.

Revenue Recognition

Costs have a lot to do with Southwest’s reporting’s for the year. Revenue

recognition helps Southwest keep revenues because it is not stated as un-earned

revenue but as an air traffic liability until the plane has left the runway. Many other

competitors in the industry also record these unearned revenues as “liabilities” also.

Southwest explains why they record them as liabilities first in the 10K.

Operating and Capital Leases

Leases are a big part of Southwest’s cost. They incorporate both capital and

operating costs when they allocate leases. When we analyzed the balance sheet, they

have everything in order even though capital leases are not included on the balance

sheet. Southwest combined 86 of the 95 leased aircraft with the majority of the

company’s terminal operations space to operating leases in December of 2007, the 9

remaining aircraft were put under capital leases. They also have a purchasing option at

the end of the lease date.

Fuel Hedging

Fuel costs were difficult because of the hedging that has to be incorporated with

it. After reading the SFAS 133 amendment section of Southwest’s 10K and reading how

they are expected to deal with the rising fuel costs. We also analyzed from year to year

the operating expenses and saw how much of it was allocated to rising fuel costs and it

all balanced out.

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Retirement and Pension Plans

Southwest does offer a 401k plan like all of its major competitors. The U.S.

congress increased the retirement age for pilots from 60 to 65, which decreased the

company’s projected future retirement obligation. Southwest expects healthcare cost to

decrease from 7.50% in 2008 to 5% in 2014 and remain at the rate thereafter.

Conclusion

Firms can be flaky when it comes to disclosures and make their accounting really

aggressive where everything looks great on the outside but is really crumbling on the

inside. Southwest’s financials have been transparent enough to understand what is

going on in the firm. Their accounting is conservative and their disclosure is high.

Qualitative Analysis

A qualitative analysis involves the examination of financial statements in order to

understand, in essence, the business of a particular company. The information is

analyzed within the company’s audited annual report, in which all the consolidated

financial statements are held, as well as in the management’s discussion and analysis;

which together makes up a 10-K.

The quality of disclosure within Southwest’s 10-K is quite good, especially when

compared to that of its competitors. Information disclosed within the 10-K is straight

forward, the airline describes the overall nature of its market risk and then in the notes

addresses in detail the risk of its business strategy including key accounting policies and

assumptions. The description of southwest’s lease information is an example of the

level of disclosure provided by Southwest Airlines. Within the disclosure of risk

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Southwest presents the number of airplanes that are under operating and capital leases

which is 95. Within the notes Southwest then provides the number of airplanes under

both capital leases (9) and operating leases (86). Southwest also provides the exact

amount paid on capital and operating leases as well as offering future minimum lease

payments and expected future payments for the next five years and beyond. Included

in the lease information are the possible lease renewal options which can come into

effect toward the end of the lease term.

Within the footnotes the accounting assumptions are revealed with great detail.

Each of the notes seems to clarify any discrepancies that may exist in the market risk

disclosures. The only risk that could be apparent and unaccounted for are two different

interest rates swaps for $350 and $385 million in unsecured notes. The two different

notes are paid at the London InterBank Offered Rate (LIBOR). Recently the validity of

the LIBOR has been under question; a study performed by the Wall Street Journal casts

doubt on the key rate, stating that it is much lower than it should be because banks

have been reporting lower than actual borrowing costs. If these rates are understated

Southwest could be vulnerable to a large increase in the amount of interest owed. It is

understandable that these risks would not have been addressed on the 2007 balance

sheet because only recently has the LIBOR been under question for understated rates.

The firm gives interesting information about its geographic segments. Indeed, in the

10k, Southwest gives a system map where we can see all the cities where Southwest is

present. The company also provides the top ten airports classified by the number of

daily departures. Outsiders can easily quantify the company’s activity and localize where

the key airports are. Moreover, pie graph on the report shows Southwest’s capacity by

region. This is very useful for outsiders to identify market geographic segments.

However, the firm doesn’t share disaggregated performance data with the public. For

example, outsiders have no clue about firm improvements in those geographic

segments during the last years and the objective in that area. The firm does not explain

the intensity of competition in some large cities and consequently, we think that some

59

markets must not be cost effective for Southwest. Southwest just emphasizes the fact

that it returned to San Francisco International Airport and mentions its improving

position in California. The firm’s quality geographic segment disclosure reinforces the

company’s good position in its key areas but is not sufficient to explain its lack of

network or its geographic goals. The main reason must be that it is risky to disclose its

strategic goals to competitors.

Southwest management is very optimistic and likes challenges. In the report, the

firm always shows effective and preventing measures that Southwest took to limit the

extent of the bad news… Southwest is very proud of its 35th consecutive year of

profitability. The firm adopts a very realistic approach by providing the industry specific

data: increase in the unit cost by 3.3 percent, rise of jet fuel for the last five years,

$100 a barrel by fourth quarter 2007, higher fares… But the report shows that the

firm’s performance was not affected “our performance was among the best in the

industry and as good as the year before”. It is a way to emphasize its success against

competitors, and make outsiders see the company as a leader in the industry. It looks

reasonable because the report gives measures that enabled and will enable the firm to

maintain its position. The hedge for 2007 and 2008 with approximately 70 percent of its

fuel needs protected at $51 barrel, the changes in the flight schedule, and the brand

capacity to offer low fares are relevant. The firm provides an Excellent Customer

Service and shows its interest in keeping improving this area with customer research as

she did in 2007 by creating a new way to board. Finally, Southwest offers a concrete

strategy which is to drive more revenue per flight by maintaining its low fare brand. The

firm adopts a very innovative customer focus and anticipating approach to face bad

times. Its long-term outlook is enthusiastic and restores confidence for outsider readers.

The quality of disclosure is very transparent compared to Southwest’s main

competitors. The information was made very clear and provides sufficient decision

useful data that satisfies the needs of financial analysis.

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Quantitative Analysis

The Generally Accepted Accounting Principle (GAAP) allows some flexibility for

managers responsible for producing the financial statements. As a result, managers can

determine how the information is disclosed and how much information is disclosed in

the financial statements. The purpose of the Quantitative Analysis is to question the

depth and the quality of a firm’s disclosure to evaluate the degree to which a firm’s

accounting captures the underlying business reality. Revenue and Expense diagnostic

screening ratios can inform investors if the company is manipulating the numbers to

make them look better off than they really are and provide a distorted view of actual

revenues or expanses. We will compare the ratios to Southwest competitors’ ratios over

a five year span to determine trends, accounting strategies, and investigate

discrepancies in the airline industry. The following graphs incorporate the diagnostic

ratios for Southwest, AMR, Continental, and Jet Blue. We will analyse first Sales

Manipulation Diagnostic and then Expense Manipulation diagnostics.

Sales Manipulation Diagnostics

These diagnostics involve the affect of several factors on net sales. By dividing net sales

by different line items, we will determine their affects on a firm. By comparing ratios of

Southwest to a sample of the industry, we can see if patterns occur and whether or not

there are immediate differences in industry patterns. Ratio analysis would be useful to

decide if the company has manipulated these numbers to appear more productive. We

will examine three ratios (Net Sales/Cash from sales, Net Sales/Net Accounts

Receivable, and Net Sales/Inventory) to explain the sales fluctuations and help analysts

to attempt to find discrepancies. These ratios will add value to the overall accounting

research and will give a visual indication of “red flags” if they occur.

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Net Sales/Cash from Sales

This ratio is used to determine if the cash from sales is equal to the sales we had, less

increase in account receivable or plus decrease in account receivable. This is a very

important ratio because it reveals whether management is manipulating sales. Very

often, managers have an incentive to overstate or understate their sales, which is

totally against any business ethics. The idea of the “big bath theory” for example, is to

understate sales when a company has good performance in order to transport those

unreported earnings to another year corresponding to a bad performance year for the

company. The ideal situation for any company would be a ratio around 1.1, thus

indicating that increasing and decreasing sales are supported by cash collected on

sales.

Having a ratio above 1 means that there are more sales than there is cash being

collected for those sales, with the leftover portion of sales remaining on accounts

receivable. Southwest is consistent in their relation to amount of cash from sales as

well as their relation to the industry as a whole. Southwest’s percentage of sales

receipts from cash over the last five years have been higher than most competitors

0.99

1

1.01

1.02

1.03

1.04

1.05

1.06

1.07

2003 2004 2005 2006 2007

Sales/Cash from Sales

Southwest

AMR

Continental

Jet Blue

62

which could lead to an assumption that they are overstating cash from sales. However

the fluctuations in their ratio have been consistent with the industry which could

conclude that Southwest is just more efficient at converting their receivables quickly.

Net Sales/ Net Accounts Receivable

The information in the graph above is similar to that of the previous graph, in which it

interprets how quickly receivables are collected. Having lower sales/accounts receivable

ratio means that more sales are paid using credit and less paid in cash. This could

prove to be to a greater liability and therefore is a less desired outcome. With a high

ratio, cash is made more readily available reducing the amount of risk faced by a

company. Provided by the information above it can be distinguished that Southwest on

average has a lower amount of accounts receivable than the majority of the industry.

While this high number could be suspicious as far as its financial disclosure is

concerned, its relative similarity to Jet Blue a rival low cost provider diminishes this

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concern as far as quality of disclosure.

Net Sales/Inventory

This ratio shows how many times a company’s inventory is sold and replaced over a

period. A low turnover implies poor sales and, therefore, excess inventory. A high ratio

implies either strong sales or ineffective buying.

The chart above shows that the inventory turnover ratio in the airline industry is quite

high. This is due to the fact that the amount inventory relative to the rest of the airline

business is quite low, consisting largely of jet fuel and maintenance equipment.

Southwest’s amount of sales relative to inventory is reasonably consistent with the rest

of the industry with the exception of Jet Blue. The comparative similarities demonstrate

Southwest’s high quality of disclosure, and may point out some aggressive accounting

64

policies used by Jet Blue, as its level of net sales to inventory are drastically higher than

its competitors.

Expense Manipulation Diagnostics

Expense Diagnostics Ratios also help to uncover discrepancies from the financial

statements. These ratios will help to verify if the company has unexplained increase or

decrease in its reported expenses by comparing Southwest Airlines to that of its

competitors within the industry. If this is the case, we would raise a potential red flag in

the accounting policies chosen by the management. Red flags could affect the overall

value of the company. There will be three ratios used in the expense manipulation

diagnostics: Asset turnover, Changes in CFFO/OI and Total Accruals/Sales.

65

Asset Turnover (Net Sales/ Total Assets)

Asset turnover can be used in determining whether a firm is depreciating its assets

properly according to FASB. It also indicates pricing strategy. Companies with low profit

margins tend to have high asset turnover, while those with high profit margins have low

asset turnover.

The ratio of Southwest is under the average of the industry. This financial ratio is

correctly related to Southwest pricing strategy which is to be profitable with low prices.

From one year to another, Southwest’s ratio variation is alternatively negative and

positive. While the fluctuations aren’t significant, remaining close to the overall trend of

the company, it could be a sign of Southwest’s want to either overstate or understate

either sales or assets. In 2005 Southwest’s assets didn’t grow much in comparison to

2004 because there was a very small increase in aircraft lease payments, which were

outweighed by the increase in sales. The reason for the decline from 2006 to 2007 was

due partially to the fact that fuel derivative contracts rose 190%. This is consistent

66

with the dramatic increase in fuel prices for the year, and probably explains why the

industry as a whole experienced reduction in turnover for the year. Consequently, the

ratio, the strategy and the information disclosure in the 10K are related adequately. No

discrepancies are detected.

CFFO / OI (Cash Flow from Operations / Operating Income)

This ratio is highly valuable in determining if a company had any discrepancies within its

operating expenses. When the ratio increases it usually means that are expenses are

increasing, thus making operating income smaller. Operating income is calculated by

subtracting operating expense from gross profit, therefore operating income and

operating expenses have an inverse relationship. CFFO is a measure of the cash

generated by the operating activities. This is an important ratio for the purposes of

expense diagnostics because it communicates how a firm is controlling expenses in

relation to the rest of the industry.

67

Contrary to American airlines and continental tremendous ratios’ variations, Southwest’s

ratio is stable. The ratio reflects the company’s ability to generate its income in the form

of cash. The rise in 2005 is a result of reasonably stable operating expenses and a 92%

increase of cash flow from operations. The drastic increase is due mostly impart to a

decrease in net income between 2003 and 2004, that increased back to its expected

growth rate. This is the result of a constant cost anticipation and proactive financial

management of cash in a changing environment. The close relationship between

Southwest and Jet Blue enforces Southwest’s high level of disclosure, because the two

airlines are very similar in strategy.

Total Accruals/ Sales

Total Accruals represent expenses and revenue that have not been accounted for.

Relating accruals to sales can be used to determine whether a company is either under

or overstating its expense. In general accrued expense on the balance sheet should be

much lower than recorded sales on the income statement.

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

2003 2004 2005 2006 2007

Total Accruals / Sales

Southwest

AMR

Continental

Jet Blue

68

The graph above illustrates with the exception of Southwest Airlines how much lower

total accruals are in relation to sales in the airline industry. The drastic changes in

numbers shown by Southwest look suspicious and could be the result of a low level of

disclosure, especially when compared to the rest of the industry. Conversely, in the

notes of the in financial it is explained that fuel contracts cause the drastic hike in

Southwest’s ratio. As already discussed fuel prices are quite high and have a large

effect on expenses. The comparative flat lines shown by AMR, Continental and Jet Blue

would appear proper in most industries, however understanding the sensitive nature of

the airline industry these numbers seem quite skeptical as far as the level of disclosure

is concerned. Therefore it would be reasonable to conclude that Southwest doesn’t

have any accounting discrepancies, and that the large fluctuations are a result of the

sensitive nature of the airline industry.

Conclusion

After the analysis of both qualitative and quantitative of the quality of disclosure, we

are able to determine the integrity and accuracy of the figures in the financial

statements produced by the firm’s management. We don’t really notice any major

discrepancy. The quality of disclosure is elevated in general and in comparison to most

of the firms in the airlines industry.

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Potential Red Flags

In accounting analysis, red flags are areas in which the analyst can determine

questionable areas of accounting quality. These potential disaster areas could help lead

the reader as to the quality of the disclosure principles of the company’s management.

Southwest seems to be a very efficiently ran firm with very little potential problem

sectors in their financials. However there were a few areas of concern that led us to

believe of a few quantitative discrepancies in their balance sheet report.

Changes in accounting

As of September 2006, the FASB introduced a new type of accounting disclosure.

Statement No. 157, “Fair Value measurements”, defines a new framework of accurately

judging an entity’s value measurements. This statement plans to be enacted on Jan 1st

2008. As far as South west is concerned, this statement will not have a large impact on

its financial condition. The FASB also introduced statement No. 159, “The Fair Value

Option for Financial Assets and Financial Liabilities.” This new accounting disclosure

principle also appears to have little effect on Southwest’s financials. They believe that

their financial instruments are updated frequently to fair market value.

Conservatism approach

Southwest applies the Conservatism type of policy to a couple different issues.

Revenues are usually greatly understated due to Southwest’s initial ticket sales being

classified as an “air traffic liability.” These fair amounts that could be purchased as far

as months ahead of time are places into the company’s liability portion of the balance

sheet. These funds are not transferred to the sales revenue side of the balance sheet

until the physical act of transportation takes place. However, even though initially

recorded as a liability Southwest is reassured that these revenues will be recognized at

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a later date due to their “non-refundable” ticket policy. Another policy that greatly

understates Southwest’s Balance sheet is their allowance by the flexibility principle to

not disclose and obligations associated with the company’s 95 leased aircraft. Even

though Southwest does include an expense account that is responsible for the aircraft’s

maintenance, insurance, and operating costs, there is no recording of any asset

addition to the tangible fleet section, except for 2 aircraft for 2007. These leased

aircraft also shows an type of conservatism in Southwest’s accounting policy.

Hedging techniques as well as Derivative and Financial Instruments

The airline industry today is focused on keeping their airline fuel costs as low as

possible. In the year 2007 these fuel costs represented approximately 28 percent of

Southwest’s operating costs alone. With the ever rising fuel and oil/gas prices changing

every day, each airline entity is approaching this dilemma with their own respected cost

efficient approach. We found that an enormous difference in assets was recorded from

the fiscal year or 2006 to 2007. Southwest went from spending 630 million dollars in

2006 to 1,318,000,000 in 2007 on noncurrent fuel contracts. This amount of dollar

increase definitely posed to be a bold move on Southwest’s behalf and definitely posed

to be an accounting red flag.

Operating Expenses with regards to Operating Leases

Surprisingly enough, we believe that there were no potential red flags in

accounting with regards to Southwest’s operating leased aircraft. As for 2007,

Southwest added 39 aircraft, of which only 2 were leased. This helped to increase

revenue capacity by 7.5%, but was slightly outweighed by a cumulative operating cost

increase of 11.3%. (Southwest’s 2007 Annual report) This outweighing operating cost

was not due to the increase expenses of leased and owned aircraft, but was due to the

substantial increase in gas and oil. On Southwest’s per-ASM dollar basis, their fuel and

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oil expense increased a staggering 46.2% from 2006 t0 2007. (Southwest’s 2007

Annual Report)

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Undoing Accounting Disclosures

As far as the new accounting policies that were enacted as of this year, and

Southwest’s somewhat form of conservatism in recognizing revenues and recordings of

leased aircraft, these red flags are very minute in the overall financial picture. We

believe that Southwest’s way of disclosing this information is very efficient pertaining to

the specific time periods that they are recorded as well as the costs that are estimated

with these activities.

With regards to their hedging/derivative techniques we believe that there could

be some discrepancies in their estimated costs for future contracts. Along with their

estimated 1,318,000,000 dollars in spending on noncurrent fuel contracts, they have

also recorded spending 1,069,000,000 on jet fuel contracts. The main difficulty that we

see with these numbers are that even with their closer to perfect information than we

can obtain, there will still be estimation errors with any hedging/derivative technique.

Due to “dirty hedging” for jet fuels Southwest cannot guarantee a long term contract to

keep their purchases of jet fuel low. Therefore they use the “clean” hedging technique

to invest in non jet fuel assets such as crude oil, heating oil, and unleaded gasoline. To

suffice for the ever rising fuel costs, Southwest hopes that this return on investment will

be able to keep their jet fuel prices at around $63 a barrel. The problem that we have

with this “fair swap” of money, is that there will always be estimation errors in these

contractual agreements due to spikes in demand, as well as other economic forces.

As per the balance sheet change from 2006-2007, there was actually a .01%

decrease in operating leased aircraft, and no change in the Depreciation and

amortization, as well as the Other line accounts. This helps us believe that there is no

distortion in Southwest’s conservative approach to recording its operating leased

aircraft accounts.

73

Financial Ratio Analysis

Financial ratio analysis assesses past and present data in order to help determine a

firm’s financial performance. The ratios used help analyze a firm’s value in three

different areas: Liquidity, profitability, and capital structure. Ratio analysis is an easy

way to compare different firms, as well as benchmarking a particular firm against the

industry as a whole. The comparison of a firm against the rest of the industry helps in

determining both positive and negative characteristics of a particular firm; these

characteristics can be made obvious when they vary from the results of the industry.

The ratios used can illustrate a change in a particular firm’s strategy, as well as the

systematic effects of an industry. These ratios also allow for the forecasting of future

performance of both a particular firm and the industry.

Liquidity Analysis

Liquidity refers to the cash equivalence of assets and the firm’s ability to maintain

sufficient near-cash resources to meet its current obligations in a timely manner. In

general, if a company’s ratio value is high, it will have a larger margin of safety to cover

short-term debt. Five ratios will be used in the calculation of liquidity, which include:

Current ratio, quick ratio, receivables turnover, days sales outstanding, and working

capital turnover. The ability of a company to convert short-term liabilities in to cash is

particularly important to companies seeking debt financing because it shows a

company’s ability to payoff its debt.

74

Current ratio: current assets/ current liabilities

The current ratios the sum of a firm’s short term liquidity, since both current assets and

current liabilities have comparable duration.

Southwest’s current ratio has been decreasing between 2003 and 2006. The impact on

liquidity is not favorable. With a current ratio under 1 since 2004, it seems that the

company has more difficulty to cover its current liabilities from the cash realized from

its current assets. However, the all industry is affected by low current ratio. Southwest

is consequently following the trend.

Quick Ratio: Quick Assets/Current Liabilities

The quick ratio captures the firm’s ability to cover its current liabilities from liquid

assets. This ratio compared to the current ratio gives a better picture in terms of a

firm’s ability to payoff debt with liquid assets. This is because the ratio only uses the

most liquid of the current assets, which are; cash and cash equivalents, accounts

receivable, and marketable securities.

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

2003 2004 2005 2006 2007

Current Ratio

Southwest

AMR

Continental

Jet Blue

Industry Avg.

75

The quick ratio tends to be the same for all the firms in the industry. We explain this

trend by the high part of inventory in the current liabilities which decreases the ratio

and increases the similarity between airlines firms. We notice with this ratio the

decreasing degree of differentiation in the industry and the limited number of strategy

in this competitive industry. Southwest has the lowest quick ratio but it does not mean

anything particular.

Receivables Turnover: Sales/Accounts Receivable

This ratio measures the number of times, on average; receivables are collected during

the period. The ability to collect receivables relates to how efficient a company is in

using its assets. The higher a company’s turnover, the quicker it collects cash. With

more cash on had the quicker a company can cover its debts and increase its liquidity.

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2003 2004 2005 2006 2007

Quick Ratio

Southwest

AMR

Continental

Jet Blue

Industry Avg.

76

The decrease in receivables turnover is the most negative factor in the liquidity

evaluation. It will not cause a major liquidity problem unless the firm must use short

term debt as a source of cash to sustain operations in the next period. The graph

shows that Southwest collects its receivables much faster than that of the industry, and

outperforms every firm for the past three years. One reason for Southwest’s high

receivables turnover rate could be due to the fact that its customers can respond to

credit payments quicker because of Southwest’s more affordable ticket prices.

Southwest’s ability to collect cash quicker than its competitors gives it an advantage in

terms of reinvesting in assets before others can.

Days Sales Outstanding: 365/Receivables turnover

Days sales outstanding calculates the number of days in a year it takes a firm to collect

on its credit sales. The quicker a firm collects on its receivables, the quicker it can

invest, taking advantage of the time value of money.

0

10

20

30

40

50

60

70

2003 2004 2005 2006 2007

Receivables Turnover

Southwest

AMR

Continental

Jet Blue

Industry Avg.

77

Southwest has the shortest collection period in the industry. It takes the firm ten days

to collect receivables. In contrast, the average period for the industry is 15 days. This

difference of 5 days is significant and shows clearly one of the main aspects of

Southwest performance. As previously mentioned, Southwest’s capability to collect its

accounts quickly leads to a competitive advantage in terms of liquidity and investing.

Working capital Turnover: Sales/working capital

This ratio indicates how many dollars of sales a firm is able to generate for each dollar

invested in working capital. Working capital is a measure of current assets less current

liabilities. This ratio shows how efficient a firm uses its working capital to create sales.

0

5

10

15

20

25

2003 2004 2005 2006 2007

Days Supply of Receivables

Southwest

AMR

Continental

Jet Blue

Industry Avg.

78

This ratio is very low compared to the industry average. Southwest doesn’t seem to

use its working capital effectively to generate sales. Southwest previously outperformed

the industry before 2005 in which it dropped below that of the industry. While

Southwest’s turnover is negative it doesn’t mean that the amount of sales have gone

down, in fact Southwest’s sales have gone up each year consecutively. The negative

ratio demonstrates a liquidity risk in terms of paying back debt. This is a negative

aspect of Southwest, however most of the industry either has or have had negative

turnovers, thus making Southwest’s performance close to that of the industry where it

is not alone.

Conclusion

Southwest liquidity performance is generally better than the average industry.

Southwest’s ability to obtain enough liquidity contributes towards the firm’s position as

a main player in the industry, even if the ratios are usually low compared to other

industries with a lowest degree of competition and pressure. Southwest’s higher than

average performance may be some of the contributing factors to its ability to keep costs

so low and hedge fuel better than its competitors.

‐75

‐25

25

75

125

175

225

275

325

375

425

2003 2004 2005 2006 2007

Working Capital Turnover

Southwest

AMR

Continental

Jet Blue

Industry Avg.

79

Profitability Analysis

The principal objectives of this part are to evaluate four critical factors related to

profits: operating efficiency, asset productivity, rate of return on assets, and rate of

return on equity. Each factor looks at different areas of a firm’s financials and relates

them to the overall profitability of that firm. The profitability analysis will also compare

different firms in the industry in order to ascertain where a particular firm sits in relation

to other firms.

Operating efficiency

By relating all income statement items to sales, the analysis permits comparison of

expense levels and profit measures on a relative basis. We can easily see areas of

improvement or deterioration in profitability.

80

Gross profit margin: gross profit/sales

This ratio is an indication of the extent to which revenues exceed direct costs

associated with sales. It Gross profit margin serves as the source for paying additional

expenses and future savings

The graph above demonstrates the low procurement rate that exists in the airline

industry. This is because the cost of flying is increasingly more expensive for airlines.

The largest factors being affecting the high cost of revenue (cost of goods sold) are jet

fuel and aircraft maintenance, both of which have risen dramatically in price.

Southwest’s gross profit margin is low, but when compared within the airline industry

Southwest’s margin is higher than its competitors. Southwest’s success in comparison

to its competitors could be attributed to its excellent fuel hedging strategy, their ability

to fill seats on planes, and of course their low cost strategy.

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

2003 2004 2005 2006 2007

Gross Profit Margin

Southwest

AMR

Continental

Jet Blue

Industry Avg.

81

Operating Profit Margin: Operative income/Sales

Operating margin is a measurement of what proportion of a company's revenue is left

over after paying for variable costs of production such as wages, raw materials, etc. It

gives an idea of how much a company makes on each dollar of sales. If a company’s

margin is increasing, it is earning more per dollar of sales.

Like that of gross profit margin, operating profit margin in the airline industry is also

very low. This is due to all of the additional costs attributed to the industry. After cost

of revenue a firm must take into account operating expenses, for Southwest these

include; salaries, wages, and benefits, as well as depreciation and amortization costs.

While Southwest’s operating profit margin isn’t very high it is once again greater than

that of its competitors. This may be attributed to Southwest’s low employee turnover

rate and its ability to buy planes cheaper because of the company’s moderate

economies of scale and the fact that it only buys one model of plane, the Boeing 737.

‐10.00%

‐5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

2003 2004 2005 2006 2007

Operating Profit Margin

Southwest

AMR

Continental

Jet Blue

Industry Avg.

82

Net Profit Margin: Net income/Sales

It measures how much out of every dollar of sales a company actually keeps in

earnings. A higher profit margin indicates a more profitable company that has better

control over its costs compared to its competitors.

The chart above illustrates how efficient at cutting costs Southwest is in contrast with

the rest of the industry. Southwest is the only firm that has not had a negative net

profit margin in the past five years, making it the most profitable airline in terms

collecting on sales. Another positive aspect that can be observed by this graph is

Southwest’s relatively constant net profit margin; over the last five years Southwest has

stayed around a 6% margin with only one slight drop which was common within the

entire industry.

‐8.00%

‐6.00%

‐4.00%

‐2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

2003 2004 2005 2006 2007

Net Profit Margin

Southwest

AMR

Continental

Jet Blue

Industry Avg.

83

Conclusion

Southwest’s operating efficiency is well above that of the industry. The reason is

probably due to the fact that Southwest’s primary focus is on cost reduction. Keeping

costs down creates the potential for greater profit margins, which is something

Southwest obviously takes advantage of. Southwest is able to gain more net income

because it is consistent in keeping other expenses down, consistency that is less

evident with other companies, which is the reason for both positive and negative

profits.

Asset productivity

Asset Turnover: sales/total assets

This ratio measures the revenue productivity of resources employed by a company. The

revenue productivity of total resources is an important factor in evaluating profitability.

The ratio measures the amount of sales dollars that were generated for every dollars

worth in assets.

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

2003 2004 2005 2006 2007

Asset Turnover

Southwest

AMR

Continental

Jet Blue

Industry Avg.

84

The asset turnover ratio is low in the airlines industry because airplanes are very

expensive. Southwest owns the majority of its planes whereas its competitors lease the

majority of their planes. Southwest’s total assets are consequently very high, which

explains why Southwest has a low asset turnover. Southwest situation is not alarming

and follows the general trend of the industry.

Return on Assets: Net Income/Total Assets

This is a comprehensive measure of profitability that considers both profits and

resources employed to earn profits. The ratio measures how efficient a firm is at

converting its assets into profit. The higher the ratio, the better the firms is at earning

money on its investment.

Southwest’s ROA is above the average of the industry. This ratio tells that Southwest is

able to generate more profit than its competitors for each dollar of assets invested. We

already know that Southwest has more assets than its competitors, but this ratio

permits to assert now that Southwest investment strategy in assets is working and is

participating actively in profit creation. Southwest is also following the general trend of

‐6.00%

‐4.00%

‐2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

2003 2004 2005 2006 2007

Return on Asset

Southwest

AMR

Continental

Jet Blue

Industry Avg.

85

the industry making its efficiency look sustainable rather than just something sporadic

and unattainable in the long-run.

Return on Equity: Net Income/ Equity

ROE measures the profitability of the owners’ interest in total assets. ROE is a

comprehensive indicator of a firm’s performance because it provides an indication of

how well managers are employing the funds invested by the firm’s shareholders to

generate returns.

2003 2004 2005 2006 2007Southwest 0.1 0.043 0.088 0.075 0.1AMR -1.28 -16.3 1.47 -0.16 -0.832Continental 0.037 -0.560 -0.439 1.518 1.323Jet Blue 0.251 0.069 -0.03 0 0.019

Southwest ROE is similar to JetBlue ROE but differs heavily from other competitors with

respect to ROE fluctuations. Southwest shows less volatility than the industry but is

‐16.3‐200.00%

‐150.00%

‐100.00%

‐50.00%

0.00%

50.00%

100.00%

150.00%

2003 2004 2005 2006 2007

Return on Equity

Southwest

AMR

Continental

Jet Blue

Industry Avg.

86

consistent with the overall linear trend of the industry. The consistency will allow

managers to better predict the amount of equity financing they will have to work with,

which could prove to be beneficial in the long-run. Southwest has a low ROE because it

is much more equity financed than the majority of its competitors.

Conclusion

Southwest’s performance in utilizing its assets is good. While it has a large amount of

assets and isn’t able to gain as much revenue as all of its competitors, it is efficient in

turning its assets into net income, which is what really matters. While Southwest

doesn’t outperform its competitors in each area, it is always in line with the industry

trend.

Capital Structure Analysis

The capital structure of a company refers to the sources of financing used to acquire

assets. In analyzing capital structure, there are two main concerns: The amount of

debt relative to the owners’ equity; the ability to service the principal and interest

requirements on debt.

Debt to Equity ratio: Total liabilities/Owners’ equity

This ratio is an indicator of the credit risk to which a company is exposed. It indicates

what proportion of equity and debt the company is using to finance its assets. The

higher the ratio, the more a company is financed in debt compared to equity.

87

Southwest Airlines has a low debt to equity ratio. This is positive because it means that

Southwest uses both sources of financing. It is a good way to deal with the advantages

and disadvantages of each king of financing. For example, the existence of debt

financing shows that Southwest is a reliable company because it is able to pay interests.

Equity financing can be important for generating high returns for example but dilutes

ownership. Overall, Southwest follows the general trend of the industry, and in 2007

each company appears to have approximately the same debt equity ratio, leaving no

outliers.

Times interest earned: NIBIT/ Interest expense

This ratio indicates the adequacy of income from operations to cover required interest

charges. In this case companies would prefer to have a high ratio because it would

mean that a company’s interest expenses are relatively lower, allowing for a greater net

income after interest expense is paid.

636.6

‐60

‐40

‐20

0

20

40

60

80

2003 2004 2005 2006 2007

Debt to Equity ratio

Southwest

AMR

Continental

JetBlue

Industry Avg.

88

Southwest Airlines has a ratio more elevated than its industry. This means that

Southwest is able to cover required interest charges better than its competitors.

Therefore, Southwest is able to keep a higher part of its NIBIT than its competitors to

finance activities unrelated to interest charges. This ratio associated with the debt to

equity ratio indicates that Southwest appeals to debt financing in adequate proportions

to be able to cover the interest expense successfully.

Debt service margin: CFFO/ CLTD

This ratio measure the adequacy of cash provided by operations to cover required

annual payments on the principal amount of long term liabilities. A margin equal to or

greater than 1.0 allows firms to pay off current long-term debt payments. The higher

the ratio, the more cash a firm has available for other business operations.

‐20

‐10

0

10

20

30

40

50

60

70

80

2003 2004 2005 2006 2007

Times interest earned

Southwest

AMR

Continental

JetBlue

Industry Avg.

89

There is a huge variation for the Southwest debt service margin. It can illustrate the

change in cash every year provided by operations to cover long term liabilities. The

ratio is always positive and above the industry level which means that Southwest

provides enough cash every year to cover liabilities. The high ratio in 2005 and 2007

illustrates the firm’s performance and capacity to generate more cash (from operations)

than needed to cover liabilities.

Credit Risk Analysis

The Altman Z-Score is used in order to determine bankruptcy risk of a particular firm.

Edward Altman’s Z-Score determines a company’s financial health by forecasting its risk

and measuring its score. There are two important numbers in the Z-Score: 1.81 and

2.67, these numbers are used to differ between high and low risk of bankruptcy. If a

firm’s value is below 1.81 its risk of bankruptcy is high. If a firm’s value is above 2.67

then its risk of bankruptcy is considerably low. Between these numbers is referred to

as the grey area, in this region a firms bankruptcy risk is unclear.

0

5

10

15

20

25

2003 2004 2005 2006 2007

Debt service Margin

Southwest

AMR

Continental

JetBlue

Industry Avg.

90

It isn’t any secret that companies in the airline industry are highly susceptible to

bankruptcy, in fact most airlines in the US have filed for bankruptcy at least once. With

that in mind the Z-Score results were anything but a surprise. The only score that was

reasonable when compared to that of the industry was Southwest’s. While the score is

less than desirable the positive note is that it is consistently above its competitors and it

barely dips below the bankruptcy in an industry that averages very high bankruptcy

risk.

Internal Growth Rate: ROA[1-(Div./NI)]

Internal growth rate is the maximum amount a firm can grow without the use of any

external financing. The growth rate measured is dependent on the amount of earnings

a firm can retain. The internal growth rate is a function of return on assets and

retained earnings.

0

0.5

1

1.5

2

2.5

3

3.5

2003 2004 2005 2006 2007

Z‐Score

Southwest

AMR

Continental

Jet Blue

Industry Avg.

2.67

1.81

91

Southwest’s internal growth rate is higher and more consistent than its competitors.

This shows the strength of Southwest’s capital structure, that if the industry was no

longer able to receive outside funding, Southwest would grow at the fastest rate. The

negative rate in the industry can be explained by the negative net income that is

prevalent in the airline industry.

Sustainable Growth Rate: IGR[1+(D/E)]

Sustainable growth rate is the maximum amount a firm can grow without having to

borrow more money. This ratio calculates the growth in firm assets with both internal

and external financing.

‐0.06

‐0.04

‐0.02

0

0.02

0.04

0.06

0.08

0.1

2003 2004 2005 2006 2007

Internal Growth Rate

Southwest

AMR

Continental

Jet Blue

Industry Avg.

92

The two low-cost competitors Southwest and Jet Blue have reasonably similar and

consistent growth rates of around zero. The low to almost non-existent growth rate

found must mean that both of these firms must rely on leverage in order to increase

their capital structure. The rest of the firms, like the results found from the internal

growth rate analysis fluctuate between negative and positive.

Conclusion

Southwest’s capital structure is quite efficient when compared to the industry average

as well as individual firms. Southwest either outperforms the industry or is along the

same trend, in which most cases the company is less volatile than the average firm.

‐16

‐3.5

‐3

‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

1

1.5

2

2003 2004 2005 2006 2007

Sustainable Growth Rate

Southwest

AMR

Continental

Jet Blue

Industry Avg.

93

Financial Statement Forecasting

By analyzing a company’s income, balance, and cash-flow statements, a financial

analyst can better determine a company’s future well being. The documents report to

the analyst historical data, as well as up to date information to help better his/her

decision. First off the analyst must contract important data into a common-size

statement in terms of percentages. Here he/she can use different ratios, growth rates,

and averages to help better forecast the performance of the chosen company. Our

choice was to forecast the next ten years of these financial statements to help give us a

better view of the future cash flows to come.

94

Income Statement

The income statement is the first set of financials that we used in order to help

us forecast a more accurate valuation of later revenues and expenses. To further assist

our predictions, we used the last six years of historic income financials of Southwest.

The spread of years selected were 2002-2007. Along with computing average

percentage growth/deteriating rates, we also used current/future economic factors as

well as enabling new future strategies to help us in our future forecasts. With this

approach our selected forecastable items were: Total Revenue, Total Cost of Revenue,

Gross Profit, Depreciation/Amortization, Total Operating Expenses, and Net Income

Before Extra. Items.

The first line item in our forecastable approach was Total Revenue. We first

decided to take the percent average of which the Total Revenue was increasing from

year to year. In the first 5 years, Southwest’s Total Revenue was growing at an average

of almost 14% each year. However recently, their Total Revenue growth rate has

slightly declined back down to 8.5%. This is largely affected by the raise in jet fuel

prices, which has greatly increased our expense account. Even though Southwest has

major strategic plans of acquiring additional planes for its fleet in 2009, we believe that

with the economy raising fuel prices and the somewhat inefficient short-term hedging

strategies of acquiring cheaper fuel for longer periods of time, to go with a 10.5%

growth rate to Total Revenue each additional year.

The next line item that we forecasted was the Cost of Total Revenue. These

numbers almost followed a uniform increasing percent increase with regards to the

increasing Total Revenue. However, there were some years that did not follow this

pattern, so we believed that the best approach to predicting this growth rate would be

to go with the average percent of Total Revenue. This approach deems acceptable to

us due to the range of the percentiles no more differentiating from each other than

95

more than 3%. Our final conclusion came to 69.2%. In immediate succession to this

conclusion, we concurred that it would deem fit to have our Gross Profit equate to the

remaining 30.8%, seeing that the Cost of Revenue and Gross Profit must equal 100%

of the Total Revenue. This Gross Profit percentage also fit to set with our estimates by

closely correlating with the 6 year GPavg of 28.36%

Our fourth item line to forecast is the Depreciation/Amortization line. These

expenses have been increasing year to year at a very steady rate. This is due to

Southwest’s slight addition each year to their fleet to compensate for older planes,

along with the continuing form of straight-line depreciation that they keep constant with

their accounting policies. This policy allows for each plane to have a useful life of 25

years with a 15% salvage value that helps pay for new additional inventory. However,

Southwest has us suspect to believe that their will be a greater addition to the fleet in

2009, “The largest low-fare airline may keep as many as 10 older planes set to be retired in 2008

and then add 14 new jets in 2009,” (Mary Schlangenstein, Bloomberg.com) As for 2008, we

have decided that the best estimate will be to continue with the continuing trend of

decrease to 5.5% and then to slightly increase this series percent to 5.9% in 2009 to

compensate for additional depreciation cost.

Another trend series that we picked to forecast was the Total Operating Expense.

This will be our greatest differentiation from the norm avg. percent of Total Revenue.

For the first five years of our financials, 2002-2006, Southwest has shown their

competitive advantage in showing on a constant basis of lowering their Total Operating

Expense percentage of Total Revenue. However, for the 2007 annual report the

increase in these total expenses is helpful in foreshadowing our beliefs on what is to

come. We believe that with Southwest’s short term derivative hedging strategies, the

inevitability of raising fuel prices, and the soon to come acquisition of additional aircraft,

will all greatly increase their Total Operating Expenses. Therefore, with this knowledge

of future events we believe that this series percentage of Total Revenue will forever

96

increase at some nominal rate. With our ability of limited information, we therefore will

have this series trend increase to 93.5% of Total Revenue.

Even with this great discrepancy in raising Total Operating Expenses, we decided

to analyze Southwest’s Net Income Before Extra. Items with a conservative approach.

We realize that with these forever increasing Operating Costs that this account series

should be forecasted to be lower. However with Southwest’s strong knowledge of the

industry, and their ability to always have a profitable competitive advantage over their

competing firms in multiple areas, (see Firm Competitive Advantage section for further

details) we believe that the Net Income Before Extra. Items will stay stable over time.

Therefore we used the 6 year average of 5.58% to further continue our forecasted

estimation for the company’s future 10 years of operation.

97

Income Statement

Income Statement

In Millions of (except for per share items)12/31/2002 12/31/2003 12/31/2004 12/31/2005 12/31/2006 12/31/2007 12/31/2008 12/31/2009 12/31/2010 12/31/2011 12/31/2012 12/31/2013 12/31/2014 12/31/2015 12/31/2016 12/31/2017

Total Revenue   5,521.77   5,937.00  6,530.00   7,584.00   9,086.00  9861.00 10896.405 12040.52753 13304.78292 14701.78512 16245.47256 17951.24718 19836.12813 21918.92159 24220.40835 26763.55123Cost of Revenue, Total   3,731.12  4,087.00   4,637.00   5,186.00   6,311.00  7081 7540.31226 8332.045047 9206.909777 10173.6353 11241.86701 12422.26305 13726.60067 15167.89374 16760.52258 18520.37745Gross Profit   1,694.91   1,748.00   1,760.00   2,226.00   2,573.00  2506 3356.09274 3708.482478 4097.873138 4528.149817 5003.605548 5528.984131 6109.527464 6751.027848 7459.885772 8243.173778Selling/General/Admin. Expenses, Total  ‐ ‐ ‐ ‐ ‐ ‐Research & Development  ‐ ‐ ‐ ‐ ‐ ‐Depreciation/Amortization   356.30  384.00   431.00   469.00   515.00  555 599.302275 710.391124 784.982192 867.4053222 958.482881 1059.123583 1170.33156 1293.216374 1429.004093 1579.049522Interest Expense(Income) ‐ Net Operating  ‐ ‐ ‐ ‐ ‐ ‐Unusual Expense (Income)  ‐ ‐ ‐ ‐ ‐ ‐Other Operating Expenses, Total   1,017.01  983.00  1,058.00   1,204.00   1,326.00   1,434.00 Total Operating Expense   5,104.43   5,454.00   6,126.00   6,859.00   8,152.00  9070 10188.13868 11257.89324 12439.97203 13746.16909 15189.51684 16784.41611 18546.7798 20494.19168 22646.08181 25023.9204Operating Income   417.34   483.00   404.00   725.00   934.00   791.00 Interest Income(Expense), Net Non‐Operating  ‐52.34   ‐34.00  ‐28.00  ‐36.00  7.00  ‐25.00 Gain (Loss) on Sale of Assets  ‐ ‐ ‐ ‐ ‐ ‐Other, Net   27.68   259.00  ‐37.00   90.00  ‐151.00  292.00 Income Before Tax   392.68   708.00   339.00   779.00   790.00   1,058.00 Income After Tax   240.97   442.00   215.00   484.00   499.00   645.00 Minority Interest  ‐ ‐ ‐ ‐ ‐ ‐Equity In Affiliates  ‐ ‐ ‐ ‐ ‐ ‐Net Income Before Extra. Items   240.97   442.00   215.00   484.00   499.00   645.00 Accounting Change  ‐ ‐ ‐ ‐ ‐ ‐Discontinued Operations  ‐ ‐ ‐ ‐ ‐ ‐Extraordinary Item  ‐ ‐ ‐ ‐ ‐ ‐Net Income Before Extra. Items   240.97   442.00   215.00   484.00   499.00  645 608.019399 671.8614359 742.4068867 820.3596098 906.4973688 1001.679593 1106.85595 1223.075824 1351.498786 1493.406159

In Millions of (except for per share items)12/31/2002 12/31/2003 12/31/2004 12/31/2005 12/31/2006 12/31/2007 12/31/2008 12/31/2009 12/31/2010 12/31/2011 12/31/2012 12/31/2013 12/31/2014 12/31/2015 12/31/2016 12/31/2017

Total Revenue  100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%Cost of Revenue, Total  67.57 68.84 71.01 68.38 69.46 71.81 69.2 69.2 69.2 69.2 69.2 69.2 69.2 69.2 69.2 69.2Gross Profit  30.7 29.44 26.95 29.35 28.32 25.41 30.8 30.8 30.8 30.8 30.8 30.8 30.8 30.8 30.8 30.8Selling/General/Admin. Expenses, Total  ‐ ‐ ‐ ‐ ‐ ‐Research & Development  ‐ ‐ ‐ ‐ ‐ ‐Depreciation/Amortization  6.45 6.47 6.6 6.18 5.67 5.63 5.5 5.9 5.9 5.9 5.9 5.9 5.9 5.9 5.9 5.9Interest Expense(Income) ‐ Net Operating  ‐ ‐ ‐ ‐ ‐ ‐Unusual Expense (Income)  ‐ ‐ ‐ ‐ ‐ ‐Other Operating Expenses, Total  18.42 16.56 16.2 15.88 14.59 14.54Total Operating Expense  92.44 91.86 93.81 90.44 89.72 91.98 93.5 93.5 93.5 93.5 93.5 93.5 93.5 93.5 93.5 93.5Operating Income  7.56 8.14 6.19 9.56 10.28 8.02Interest Income(Expense), Net Non‐Operating  ‐0.95 ‐0.57 ‐0.43 ‐0.47 0.08 ‐.25Gain (Loss) on Sale of Assets  ‐ ‐ ‐ ‐ ‐ ‐Other, Net  0.5 4.36 ‐0.57 1.19 ‐1.66 2.96Income Before Tax  7.11 11.93 5.19 10.27 8.69 10.73Income After Tax  4.36 7.44 3.29 6.38 5.49 6.54Minority Interest  ‐ ‐ ‐ ‐ ‐ ‐Equity In Affiliates  ‐ ‐ ‐ ‐ ‐ ‐Net Income Before Extra. Items  4.36 7.44 3.29 6.38 5.49 6.54Accounting Change  ‐ ‐ ‐ ‐ ‐ ‐Discontinued Operations  ‐ ‐ ‐ ‐ ‐ ‐Extraordinary Item  ‐ ‐ ‐ ‐ ‐ ‐Net Income Before Extra. Items  4.36 7.44 3.29 6.38 5.49 6.54 5.58 5.58 5.58 5.58 5.58 5.58 5.58 5.58 5.58 5.58

98

Balance Sheet Forecasting

In order to forecast the balance sheet we first need to complete forecasting the income statement. By linking

important key information from the income statement and adding specific financial ratios derived from the financial

statements, we believe to be able to forecast a fairly accurate common sized balance sheet.

We looked at the ratios we had for Southwest and thought it would be the best fit to link assets first. We did that

by incorporating the asset turnover ratio. The six year average of the ATO ratio was 73%. After we calculated the asset

turnover ratio, we divided the ratio by net sales to find the total amount of assets for the next ten years. With this new

basis of forecasted assets, we can now easily determine the rest of the asset section as well as liabilities.

To forecast our current asset section, we used an average trend, along with internal information to help forecast

our growth rate. We determined that an average growth rate of 23% would suffice to help forecast future years. The only

discrepancy with this estimate is the initial reduction of current assets in the year of 2008. We did expect a 10-15%

reduction in the first place due to Southwest releasing some of its sub-leased contracts, but not to this extent. However,

at the end of 2008 to the beginning of 2009, Southwest plans to add on 19 additional aircraft. This counteracts the quick

drop off to bring our forecast back to accuracy of additional growth of 23% a year. As for out inventory and accounts

receivable accounts, we decided to use the corresponding ratios appropriate. For our inventory account we used our

inventory ratio of 27 and for our accounts receivable account we used the accounts receivable ratio of 35.

99

In addition to the asset account, we believed that the flight equipment, along with the ground and property

equipment would move smoothly along as a percentage of Total assets. For the flight equipment account, seeing that this

is a majority of our total assets, we used a percentage of 93% of Total assets. As per the ground equipment account, we

followed the trend of assuming 10% of the recorded Total assets.

After the asset portion of the balance sheet, Retained Earnings must fist be calculated to determine Total

Stockholder’s equity. Retained earnings were calculated by taking the forecasted current year Net Income plus the

retained earnings from the previous year minus dividends paid. The dividends were an easy account to forecast, seeing

that Southwest has always paid out the same amount of dividends each year of 14 million. Therefore we decided this

would be an accurate amount to carry out for the next 10 years.

The only measurable variable to base any judgment of forecasted Total Stockholder’s equity was the retained

earnings line account. The difference between 2007’s and 2008’s retained earnings plus the previous year’s stockholders

equity equated to the new forecasted stockholders equity. This translates to the stockholders equity line account changes

directly with regards to retained earnings. In addition to this section, we decided to forecast the total current liabilities

line account by dividing it by the current ratio of .92.

We were able to forecast the balance sheet through using ratios pre-determined from our financials, as well as

determining certain growth trends. The balance sheet is a good representation of the company by showing the different

allocations of their assets and how they are financed through different forms of debt and equity.

100

Balance Sheet

SOUTHWEST AIRLINES CO.(In Millions, Except Share Data) CONSOLIDATED BALANCE SHEET

ASSETS 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Current assets:Cash and cash equivalents $1,815 $1,865 $1,048 $2,280 $1,390 $2,213Short-term investments N/A N/A 257 251 369 566Accounts and other receivables 175 132 248 258 241 279 311.326 344.015 380.137 420.051 464.156 512.893 566.747 626.255 692.012 764.673Inventories of parts and supplies, at cost 86 93 137 150 181 259 279.271 308.594 340.997 376.801 416.365 460.084 508.393 561.774 620.76 685.94Fuel derivative contracts 113 164 428 641 369 1069Prepaid expenses and other current assets 43 59 54 40 51 57Total current assets 2232 2313 2172 3620 2601 4443 3433.11 3793.59 4191.92 4632.07 5118.44 5655.87 6249.74 6905.96 7631.09 8432.35Property and equipment, at cost:Flight equipment 8025 8646 10037 10999 11769 13019 12239.8 13525 14945.1 16514.3 18248.3 20164.4 22281.7 24621.3 27206.5 30063.2Ground property and equipment 1042 1117 1202 1256 1356 1515 1492.66 1649.39 1822.57 2013.94 2225.41 2459.07 2717.28 3002.59 3317.86 3666.24Deposits on flight equipment purchase contracts 389 787 682 660 734 626

9456 10550 11921 12915 13859 15160Less allowance for depreciation and amortization 2810 3107 3198 3488 3765 4286

6646 7443 8723 9427 10094 10874 10150.1 11215.8 12393.5 13694.8 15132.8 16721.7 18477.5 20417.6 22561.5 24930.4Other assets 76 122 442 1171 765 1455Total Assets 8954 9878 11337 14218 13460 16772 14926.6 16493.9 18225.7 20139.4 22254.1 24590.7 27172.8 30025.9 33178.6 36662.4

LIABILITIES AND STOCKHOLDERS’ EQUITYCurrent liabilities:Accounts payable 362 405 420 524 643 759Accrued liabilities 529 650 1047 2074 1323 3107Air traffic liability 412 462 529 649 799 931Current maturities of long-term debt 131 206 146 601 122 41Total current liabilities 1434 1723 2142 3848 2887 4838 5258.7 5715.97 6213.01 6753.28 7340.52 7978.82 8672.64 9426.78 10246.5 11137.5Long-term debt less current maturities 1553 1332 1700 1394 1567 2050Deferred income taxes 1227 1420 1610 1896 2104 2535Deferred gains from sale and leaseback of aircraft 184 168 152 136 120 106Other deferred liabilities 134 183 209 269 333 302Commitments and contingenciesStockholders’ equity:Common stock, $1.00 par value: 2,000,000,000 shares authorized; 807,611,634 sharesissued in 2007 and 2006 777 789 790 802 808 808Capital in excess of par value 136 258 299 424 1142 1207Retained earnings 3455 3883 4089 4557 4307 4788 5419 6013.02 6670.88 7399.29 8205.65 9098.14 10085.8 11178.7 12387.8 13725.3Accumulated other comprehensive income 54 122 417 892 582 1241Treasury stock, at cost,respectively N/A N/A -71 0 -390 -1103Total stockholders’ equity. 4422 5052 5524 6675 6449 6941

8954 9878 11337 14218 13460 16772 17403 17997 18654.9 19383.3 20189.6 21082.1 22069.8 23162.7 24371.8 25709.3

101

Balance Sheet

SOUTHWEST AIRLINES CO.(In Millions, Except Share Data) CONSOLIDATED BALANCE SHEET

ASSETS 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Current assets:Cash and cash equivalents $1,815 $1,865 $1,048 $2,280 $1,390 $2,213Short-term investments N/A N/A 257 251 369 566Accounts and other receivables 175 132 248 258 241 279Inventories of parts and supplies, at cost 86 93 137 150 181 259Fuel derivative contracts 113 164 428 641 369 1069Prepaid expenses and other current assets 43 59 54 40 51 57Total current assets 2232 2313 2172 3620 2601 4443 23% 23% 23% 23% 23% 23% 23% 23% 23% 23%Property and equipment, at cost:Flight equipment 8025 8646 10037 10999 11769 13019 82% 82% 82% 82% 82% 82% 82% 82% 82% 82%Ground property and equipment 1042 1117 1202 1256 1356 1515 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%Deposits on flight equipment purchase contracts 389 787 682 660 734 626

9456 10550 11921 12915 13859 15160Less allowance for depreciation and amortization 2810 3107 3198 3488 3765 4286

6646 7443 8723 9427 10094 10874 68% 68% 68% 68% 68% 68% 68% 68% 68% 68%Other assets 76 122 442 1171 765 1455Total Assets 8954 9878 11337 14218 13460 16772 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

LIABILITIES AND STOCKHOLDERS’ EQUITYCurrent liabilities:Accounts payable 362 405 420 524 643 759Accrued liabilities 529 650 1047 2074 1323 3107Air traffic liability 412 462 529 649 799 931Current maturities of long-term debt 131 206 146 601 122 41Total current liabilities 1434 1723 2142 3848 2887 4838Long-term debt less current maturities 1553 1332 1700 1394 1567 2050Deferred income taxes 1227 1420 1610 1896 2104 2535Deferred gains from sale and leaseback of aircraft 184 168 152 136 120 106Other deferred liabilities 134 183 209 269 333 302Commitments and contingenciesStockholders’ equity:Common stock, $1.00 par value: 2,000,000,000 shares authorized; 807,611,634 sharesissued in 2007 and 2006 777 789 790 802 808 808Capital in excess of par value 136 258 299 424 1142 1207Retained earnings 3455 3883 4089 4557 4307 4788Accumulated other comprehensive income 54 122 417 892 582 1241Treasury stock, at cost,respectively N/A N/A -71 0 -390 -1103Total stockholders’ equity. 4422 5052 5524 6675 6449 6941

8954 9878 11337 14218 13460 16772

102

Cash Flow Statement

The Cash Flow Statement is one of the most important financial reports a

company has. It shows investors how much the company has profited or lost during the

fiscal year. It is also one of the most difficult an analyst can forecast. The cash flow

statement is separated in to thee sections; Income from Operations, Income from

Investments, and Income from financing.

We used three ratios to perform our forecast of the cash flow statement,

CFFO/OI, CFFO/Sales, and CFFO/NI. They seemed to be the most consistent ratios for

the cash flow statement. For CFFO/OI we calculated a five year average of 3.6. When

we calculated CFFO/Sales we arrived at a five year average of 29%. Thirdly, when we

calculated CFFO/NI we arrived at a five year average of 4.41.

As per our cash pertaining to investing activities, we decided to go with a 15%

growth rate. This was a very difficult account to forecast seeing that there was

absolutely no trend to follow. However, in the airline industry, investing activities are

usually fully concentrated in fuel hedging. So even though some years have only

increased by a couple percent in growth, we believe that with the information of

Southwest about to increase its fuel hedging strategies by over 50%, that this growth

rate will deem sufficient for future years.

Finally for our dividends account, the growth seemed inevitably to same the

same. Southwest has consistently paid the same amount of dividends annually, so we

deemed it fit to continue this pattern of 14 million a year in the future years to com

103

Cash Flow Statement

SOUTHWEST AIRLINES CO.(In Millions except per chare amounts)

CONSOLIDATED STATEMENT OF CASH FLOWS2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

CASH FLOWS FROM OPERATING ACTIVITIES:Net income 241 442 313 484 499 645Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization 356 384 431 469 515 555Deferred income taxes 170 183 184 291 277 328Amortization of deferred gains on sale and leaseback of aircraft ‐15 ‐16 ‐16 ‐16 ‐16 ‐14Share‐based compensation expense 46 49 52 80 80 37Excess tax benefits from share‐based compensation arrangements 38 41 35 ‐47 ‐60 ‐28Changes in certain assets and liabilities:Accounts and other receivables ‐103 43 ‐75 ‐9 ‐5 ‐38Other current assets ‐10 ‐19 ‐44 ‐59 87 ‐229Accounts payable and accrued liabilities ‐149 129 231 ‐855 ‐223 1609Air traffic liability ‐38 50 68 120 150 131Other, net ‐16 50 ‐22 ‐50 102 ‐151Net cash provided by operating activities 520 1336 1157 2118 1406 2845 2947 3054 3163 3277 3395 3518 3644 3775 3911 4052CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property and equipment, net ‐603 1238 ‐1775 ‐1146 ‐1399 ‐1331Purchases of short‐term investments N/A  N/A N/A ‐1804 ‐4509 ‐5086Proceeds from sales of short‐term investments N/A N/A N/A 1810 4392 4888Payment for assets of ATA Airlines, Inc 0 0 ‐34 ‐6 0 0Debtor in possession loan to ATA Airlines, Inc 0 0 ‐40 0 20 0Other, net 0 0 ‐1 0 1 0Net cash used in investing activities ‐603 ‐1238 ‐1850 ‐1146 ‐1495 ‐1529 ‐1758 ‐2022 ‐2325 ‐2674 ‐3075 ‐3537 ‐4067 ‐4677 ‐5379 ‐6186CASH FLOWS FROM FINANCING ACTIVITIES:Issuance of long‐term debt 385 0 520 300 300 500Proceeds from Employee stock plans 57 93 88 132 260 139Payments of long‐term debt and capital lease obligations ‐65 130 ‐207 ‐149 ‐607 ‐122Payments of cash dividends ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14 ‐14Repurchase of common stock 0 0 ‐246 ‐55 ‐800 ‐1001Excess tax benefits from share‐based compensation arrangements 0 0 0 47 60 28Other, net ‐4 3 ‐8 ‐1 0 ‐23Net cash provided by (used in) financing activities ‐382 ‐48 133 260 ‐801 ‐493 ‐494 ‐496 ‐497 ‐499 ‐500 ‐502 ‐503 ‐505 ‐506 ‐507NET INCREASE (DECREASE) IN CASHAND CASH EQUIVALENTS ‐465 50 ‐560 1232 ‐890 823CASH AND CASH EQUIVALENTS ATBEGINNING OF PERIOD. 2280 1815 1865 1048 2280 1390CASH AND CASH EQUIVALENTS AT END OF PERIOD 1815 1865 1305 2280 1390 2213 2222 2231 2240 2250 2259 2268 2277 2287 2296 2305SUPPLEMENTAL DISCLOSURESCash payments for:Interest, net of amount capitalized. 80 62 38 71 78 63Income taxes 3 51 2 8 15 94Noncash rights to airport gates acquired through reduction in debtor in possession loan toATA Airlines, Inc. 0 0 0 20 0 0

104

Cost of Capital Estimation

Cost of Equity

The Cost of Equity is the rate of return in which an investor will receive when

buying a firm’s share of stock. One way of estimating the Cost of Equity is through

the CAPM model (Capital Asset Pricing Model). The CAPM model includes such

variables as: the Risk Free Rate, which is concluded from the rate of return of a

treasury bill, the Beta, which is the systematic risk specific to the firm, and the MRP

(Market Risk Premium), which is the difference between the S&P 500 market return

and the Risk Free Rate.

To start the CAPM model we first started with finding the monthly stock prices

of Southwest for the past seven years. Then we retrieved the market returns from

the S&P 500. Lastly we found different treasury constant maturity rates that included

the 3 month, 6 month, 2 year, 5 year, and 10 year rates. We then used 72, 60, 48,

36, and 24 month investment periods to try to estimate a Beta. Before trying to pick

a reasonable Beta, we tried to find the highest adjusted R², which infers the highest

explanatory power of Beta. We encountered the problem of having (-) R²s, for every

investment period but one, on every different Treasury bill rate. With this low to no

explanatory power, we could not find a suitable Beta to further our completion of the

CAPM model. Therefore, we decided that we would try to see if the Backdoor

Method cost of equity would better estimate Southwest’s cost of equity.

105

3 Month Rate REGRESSION ANALYSIS Month Beta Adj. R² t Stat

24 -0.201482433 -0.032925135 -0.516585523

36 -0.104047997 -0.026988266 -0.283255317

48 0.218960463 -0.013784637 0.600775649

60 0.13344328 -0.014473265 0.397819202

72 0.83828544 0.142768602 3.58116988

6 Month Rate

Month Beta Adj. R² t Stat

24 -0.201720638 -0.032910327 -0.516894417

36 -0.105358605 -0.026929295 -0.286689068

48 0.218264539 -0.013839407 0.598687606

60 0.132551476 -0.014510033 0.39516115

72 0.838239274 0.142720361 3.580519091

2 Year Rate

Month Beta Adj. R² t Stat

24 -0.206825795 -0.032293112 -0.529616405

36 -0.110377892 -0.026692631 -0.300078223

48 0.215155628 -0.014074167 0.589656511

60 0.130498294 -0.014605385 0.388184024

72 0.837662635 0.14258317 3.578668092

5 Year Rate

Month Beta Adj. R² t Stat

24 -0.207870413 -0.032088792 -0.533764317

36 -0.110822354 -0.026658754 -0.301946728

48 0.213339894 -0.014178258 0.58560898

60 0.12991139 -0.014634768 0.386008843

72 0.836672961 0.142314764 3.575045673

10 Year Rate

Month Beta Adj. R² t Stat

24 -0.207202436 -0.032093679 -0.533665458

36 -0.10967587 -0.026702048 -0.299556796

48 0.212860544 -0.014186462 0.585288802

60 0.129917387 -0.014634598 0.386021492

72 0.835690757 0.142012366 3.570962815

106

Alternative Cost of Equity Estimate (Back Door Method)

The back door method is an alternative way to calculate cost of equity. Its use is

particularly suitable in the case of Southwest, who’s CAPM is not very reliable

because of little explanatory power and a ineffective beta. The alternative method

uses the price to book ratio, return on equity, and sales growth ratios to calculate

cost of equity. Southwest’s price to book ratio according to finance.yahoo.com is

equal to 8.43, the long-term return on equity ratio equals 10%, and we calculated

the sales growth rate of 10.5%. Using the back door formulation method, we

computed a cost of equity equal to 10.44%.

Cost of Debt

The cost of debt is the effective rate a company pays on all of its liabilities. Debt is

in general less risky to debt holders than equity, therefore making the effective rate

or cost of capital for a company less than the cost of equity. Firms often prefer debt

financing rather than equity financing for a number of reasons: Debt financing is

easier, it shows a firms ability to pay off its debt, it doesn’t give up ownership to

others, and interest expenses are tax deductible.

For accounts payable, accrued liabilities, air traffic liabilities, and other deferred

liabilities the interest rate used is the short-term 3-month AA nonfinancial

commercial paper rate. This rate was obtained from the Federal Reserve Bank of St.

Louis (http://research.stlouisfed.org/fred2/categories/120). The interest rate for

current maturities of long-term debt was determined using the weighted average

rate of all long-term debt. For Long-term liabilities all of the interest rates were

found in the notes as stated below. The interest rate for French credit agreements

due 2012 were determined by finding the LIBOR rate minus 45 basis points. French

credit agreements due 2017 were determined by finding the LIBOR rate minus 67

basis points. After calculating the weighted average of all debt and multiplying it by

each interest rate the weighted average cost of debt was determined to be 4.66%

107

Cost of Debt Current Liabilities:  Debt  Interest Rate  Weight  WACD 

Accounts Payable  759,000,000  0.0411  0.0647  0.0027 

Accrued Liabilities:  3,107,000,000  0.0750  0.2650  0.0199 

Air Traffic Liabilities  931,000,000  0.0370  0.0794  0.0029 

Current Maturities of Long‐term Debt  41,000,000  0.0477  0.0035  0.0002 

Total Current Liabilities  4,838,000,000  0.4126 

Long‐term Debt less current maturities:  2,050,000,000  0.1748 

       French Credit Agreements due 2012  32,000,000  0.0323  0.0027  0.0001 

       6 1/2% Notes due 2012  386,000,000  0.0650  0.0329  0.0021 

       5 1/4% Notes due 2014  352,000,000  0.0525  0.0300  0.0016 

       5 3/4% Notes due 2016  300,000,000  0.0575  0.0256  0.0015 

       5 1/8% Notes due 2017  311,000,000  0.0512  0.0265  0.0014 

       French Credit Agreements due 2017  94,000,000  0.0361  0.0080  0.0003 

       Pass Through Certificates  480,000,000  0.0185  0.0409  0.0008 

       7 3/8% Debentures   103,000,000  0.0738  0.0088  0.0006 

       Capital Leases  52,000,000  0.0588  0.00443  0.0003 

Total Liabilities  11,726,000,000  1  0.0342           Cost of Capital =  3.42%

108

Cost of Capital

Weighted average cost of capital is the total of all capital costs with respect to cost

of debt and cost of equity. WACC represents the overall return required by the

company. Assets for the most part are either financed using debt or equity; WACC

is the average of both debt and equity. Two types of WACC exist, before tax WACC

and after tax WACC. WACC is calculated by multiplying the cost of equity and debt

by their respective firm value ratio. We derived WACC before taxes to be 7.05%

and WACC after taxes to be 5.99%.

Weighted Average Cost of Capital

Cost of

Debt D/D+ETax Rate

Cost of Equity E/D+E WACC

WACC Bt 4.66% 0.5862 0 10.44% 0.4138445 7.05%

WACC At 4.66% 0.5862 0.39 10.44% 0.4138445 5.99%

109

Intrinsic Valuation

Intrinsic valuation models use forecasts to value a particular firm’s assets or equity.

These models are very useful for analysts who want to create a picture of the firm’s

risk as it pertains to lending. Stock holders also benefit from intrinsic valuations

because they are more accurate in terms of valuing a company in contrast to a

comparables valuation. There will be five different models used in the intrinsic

valuation of Southwest Airlines: The discounted dividends model, the free cash

flows model, the residual income model, the abnormal earnings growth model, and

the long-run return on equity residual income model. Each of these models values a

specific area of the company by creating an implied share price that is weighted

against the actual market price.

Discounted Dividends Model

The discounted dividends model values a company based on the net present value

of all forecasted dividends. Due to the fact that this model expects the company has

an indefinite life and indefinite dividend growth rate the present value of all future

dividends must be determined through the use of a growing perpetuity. In order to

calculate the implied share price, all future dividends must be discounted to the

present value.

To find the implied share price of Southwest we forecasted 10 years of dividend

payments, growing at a rate of 0%. The forecast was determined by past dividend

payments of the company. All dividends for the forecasted 10 years were

discounted to the present time of June 1, 2008 in order to determine their present

value. The same was done to the value of the perpetuity to convert it to June 1,

2008 prices. All dividends were discounted at the cost of equity, which was

determined previously to equal 10.44%. Southwest’s implied share price was then

determined by adding the present values of forecasted dividends and the perpetuity,

equaling $.20.

The observed share price for Southwest on June 1, 2008 was $13.06. Obviously the

2 share prices are not very comparable to one another. The reason for such a

110

difference in the two prices is because Southwest only pays dividends at miniscule

amounts in order to claim that they actually pay dividends and not to add any real

shareholder value. As a result, the discounted dividend valuation model is not a very

accurate way to value Southwest Airlines, the inaccuracies of which can be observed

in the sensitivity analysis below.

The sensitivity analysis measures how sensitive the share prices are to fluctuations

in both the cost of equity and the growth rate of the perpetuity. The sensitivity

analysis for Southwest demonstrates how insensitive the airline’s share prices are to

the dividend growth. An example of the insensitivity of Southwest’s share prices

related to dividends can be shown by holding the growth rate at 0 and decreasing

the cost of equity form 10.44% to 4% the implied share price increased from $.20 to

$.51, increasing only $.51. This chart shows that Southwest is highly overvalued in

relationship to dividends.

Discounted Free Cash Flow Model

The free cash flow model is used to calculate a company’s intrinsic value of equity.

This valuation method is derived from the discounted dividends valuation model.

Firm value is calculated by discounting all forecasted future cash flows to their

present value. Since the model expects companies to have an indefinite life, a

growing perpetuity is also discounted back to their present value. Free cash flows

used in the model are derived by calculating the difference between cash flow from

0.00% 3.00% 6.50% 7.00% 7.50% 8.00% 8.50%4.00% $0.51 $1.54 ‐ ‐ ‐ ‐ ‐6.00% $0.34 $0.53 ‐ ‐ ‐ ‐ ‐8.00% $0.26 $0.33 $0.78 $1.10 $2.05 ‐ ‐

10.44% $0.20 $0.23 $0.32 $0.35 $0.39 $0.44 $0.5212.00% $0.17 $0.19 $0.24 $0.25 $0.27 $0.29 $0.3114.00% $0.15 $0.16 $0.19 $0.19 $0.20 $0.21 $0.2116.00% $0.13 $0.14 $0.15 $0.16 $0.16 $0.16 $0.17

PPS as of June 1, 2008 Undervalued Greater than $15.02$13.06 Overvalued Less than $11.10

Fairly Valued Between $15.02-$11.10within 15%

Cost

of

Equi

ty

Perpetuity Growth Rate (g)

111

operating activities (CFFO) and cash flow from investing activities (CFFI). Both CFFI

and CFFO are stated as after tax values, therefore the discount rate used is the

before tax weighted average cost of capital (WACC). Once all future cash flows is

discounted to present time values they are subtracted by the book value of liabilities

and divided into shares to determine the implied share value.

To determine implied share value for Southwest Airlines, net cash flow was

forecasted out 10 years along with a growing perpetuity use to forecast the infinite

long-term growth of the company. These values were discounted back to their

present time value of June 1, 2008 using a WACC equal to 7.05%. The sum of all

discounted future cash flows is negative $15.771 billion. Cash flows are then

subtracted by the book value of liabilities totaling $16.772 billion which equates the

market value of equity to be negative $31.836. Market value of equity divided by 2

billion authorized shares gives an implied share value of negative $44.76.

The sensitivity analysis shows that with a current weighted average cost of capital

of 7.05% Southwest would require a perpetuity growth rate of at least 8% to create

positive share prices. With a WACC of 7.05% and a growth rate of 10% the

company would be fairly valued. The same could be concluded if Southwest’s WACC

dropped to 5% and the growth rate was 8%. We assume that any price within 15%

of the current stock price is fairly valued. With a current implied share price less

than zero and fairly valued share prices only available at higher growth rates, it is

reasonable to conclude that Southwest is overvalued in relation to its free cash

flows.

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%4.00% ‐ ‐ ‐ $80.03 $28.47 $11.28 $2.695.00% ‐ ‐ ‐ $165.28 $39.02 $14.74 $3.996.00% ‐ ‐ ‐ ‐ $63.18 $20.23 $5.917.05% ‐ ‐ ‐ ‐ $141.97 $30.41 $9.008.00% ‐ ‐ ‐ ‐ ‐ $49.34 $13.439.00% ‐ ‐ ‐ ‐ ‐ $109.11 $21.45

10.00% ‐ ‐ ‐ ‐ ‐ ‐ $37.92

PPS as of June 1, 2008 Undervalued Greater than $15.02$13.06 Overvalued Less than $11.10

Fairly Valued Between $15.02-$11.10

WAC

C (B

T)

Perpetuity Growth Rate (g)

112

Residual Income Model

The residual income evaluation uses forecasted earning to compute the implied

share price rather than that of perpetuity. Residual income valuation is particularly

useful because it has a low sensitivity to changes in growth rates. The reason for

less sensitivity is that the less reliability on the present value of perpetuities and

more emphasis on the forecasted residual income as well as the book value of

equity.

Residual income is calculated by subtracting the “Benchmark” earnings by the

forecasted net income. The “Benchmark” earnings rate is calculated by multiplying

the previous year’s book value of equity and multiplying it by the cost of equity.

Positive residual income implies that a firm is creating value and a negative residual

income implies that a firm’s value is being destroyed. In order to determine the

market value of equity we must calculate the total present value of all residual

income as of June 1, 2008 and add it to the initial book value of equity. Implied

share price can then be calculated by dividing the market value of equity by the

number of shares.

Southwest’s book value of equity was found in their financial statements to be

$6,941 million. The book value multiplied by the cost of equity (10.44%) gave a

“benchmark” value of $725 million. When subtracted from the forecasted net

income for 2008 of $608 million it left a positive value for residual income of

negative $116 million, meaning that Southwest destroyed value for the year.

Southwest was able to maintain a positive RI for every year it was forecasted.

The model below uses negative growth rates because the present value of the

terminal perpetuity gets smaller as it approaches zero, this occurs because the

growth rates and residual income are inversely related.

113

The present value of the terminal perpetuity gets smaller as it approaches

zero, so we decided to use negative growth rates. The fair-valued amounts range

from $16.63 with a cost of equity of 7% and a 0% growth rate to $6.91 with a cost

of equity of 13% and a -60% growth rate. In general, the sensitivity analysis

demonstrates that the valuation model does vary in stock prices, ranging from

$23.57 to $5.59. This model shows that Southwest is more than likely overvalued

with an implied share price of $8.44.

Abnormal Earnings Growth (AEG) Model

The abnormal earnings growth model uses present values of forecasted

earnings with the current book value of equity to determine an implied share price.

A firm’s abnormal earnings are their earnings for the year created by reinvesting

dividends after “normal earnings”. These “normal earnings” are calculated by

increasing the previous year’s forecasted net income at a rate equal to the estimated

cost of equity. Dividend are grown the same way to calculate what is known as DRIP

Income, which is previous years dividend payments increased at a rate equal to the

cost of equity. AEG is calculated by subtracting “normal earnings” by the cumulative

income of both net income and DRIP income. The estimated market value of equity

is equal to the total present value of AEG for both the 10 years of forecasts and the

perpetuity as of June 1, 2008. Dividing the market value of equity by the number of

shares generates the implied share price of a firm.

0.00% -10.00% -20.00% -30.00% -40.00% -50.00% -60.00%7.00% $16.63 $13.97 $13.28 $12.96 $12.78 $12.66 $12.588.00% $13.40 $12.11 $11.74 $11.57 $11.46 $11.40 $11.359.00% $10.98 $10.54 $10.41 $10.34 $10.30 $10.27 $10.26

10.44% $8.44 $8.69 $8.78 $8.82 $8.85 $8.87 $8.8811.00% $7.66 $8.08 $8.22 $8.30 $8.35 $8.38 $8.4012.00% $6.49 $7.10 $7.33 $7.45 $7.53 $7.58 $7.6113.00% $5.54 $6.27 $6.55 $6.70 $6.80 $6.86 $6.91

PPS at June 1, 2008 Undervalued Greater than $15.02$13.06 Overvalued Less than $11.10

Fairly Valued Between $15.02-$11.10

Cost

of

Equi

ty

Negative Growth Rate

114

Southwest’s forecasted dividend payments are constant over 10 years,

therefore the DRIP income is determined to be a flat income each year for the

company. Since net income each year is growing a faster rate than the “normal

income,” AEG also increases at a growing rate each year.

The AEG growth rate allows us to check the accuracy of our calculations by

comparing it to the residual income growth rate. These two rates are interrelated

due to the fact that both models use earnings benchmarks, net income, and

dividends to equate either income or earnings. The chart below illustrates the

correlation of the two growth rates, verifying the accuracy of our calculation.

  2 3 4 5 6 7 8 9 10 Annual AEG 

1.83   1.86   1.91   1.95   2.01   2.06   2.13   2.20   2.27  

Change in RI 

1.83   1.86   1.91   1.95  2.01  2.06  2.13  2.20  2.27 

We used negative growth rates in order to get directly linked to the residual

income valuation model. The cost of equity we used stretched from 7% to 13% and

growth rates varied from 0% to -60%. The company had a stock price of $13.06 and

a change of 13%; these determined the over and undervalued amounts. Southwest

had fairly priced stocks when the cost of equity was at 9% and had a growth rate of

0%. As indicated in the above table Southwest is primarily overvalued the largest

part of the time.

0.00% -10.00% -20.00% -30.00% -40.00% -50.00% -60.00%7.00% $23.57 $19.22 $18.10 $17.58 $17.28 $17.09 $16.958.00% $16.86 $14.79 $14.19 $13.91 $13.75 $13.64 $13.569.00% $12.51 $11.63 $11.36 $11.22 $11.15 $11.09 $11.06

10.44% $8.56 $8.50 $8.48 $8.47 $8.47 $8.46 $8.4611.00% $7.49 $7.59 $7.63 $7.65 $7.66 $7.67 $7.6812.00% $9.71 $6.28 $6.39 $6.44 $6.48 $6.50 $6.5213.00% $4.90 $5.26 $5.41 $5.48 $5.53 $5.56 $5.59

PPS at June 1, 2008 Undervalued Greater than $15.02$13.06 Overvalued Less than $11.10

Fairly Valued Between $15.02-$11.10

Cost

of

Equi

ty

Negative Growth Rate

115

Long-Run Residual Income Model

The long-run residual income model is a valuation of the perpetuity of the

residual model. In order to determine the implied share price, long-run return on

equity, long-run growth rate on equity, cost of equity, and market capitalization

must be estimated. We assigned a long-run return on equity of 10% as determined

in the forecasted financial statements. It was also determined in the forecasting of

financial statements that the long-run growth rate on equity is equal to 0.65%. Cost

of equity was calculated using the alternative estimate of cost of capital equaling

10.44%. Computing the data into the long-run residual income model formula we

found the estimated MCAP to be $6.629 billion. Dividing the MCAP by the number

shares (731M) we estimated Southwest’s share price to be $9.45.

Long Run Return Growth Rate in Equity

long

run

ret

urn

on

equi

ty

0.00% 1.00% 2.00% 3.00% 4.00%6.00% $5.69 $5.24 $4.69 $3.99 $3.07 7.00% $6.64 $6.29 $5.86 $5.32 $4.61 8.00% $7.58 $7.34 $7.04 $6.65 $6.15 9.00% $8.53 $8.39 $8.21 $7.98 $7.68

10.00% $9.48 $9.44 $9.38 $9.31 $9.22 11.00% $10.43 $10.48 $10.55 $10.64 $10.76 12.00% $11.38 $11.53 $11.73 $11.97 $12.29

(Holding Ke constant at 10.44%) Undervalued Greater than $15.02 Overvalued Less than $11.10 Fairly Valued Between $15.02-$11.10

7.00% 8.00% 9.00% 10.00% 11.00%7.00% $9.77 $11.30 $12.84 $14.38 $15.928.00% $8.47 $9.80 $11.14 $12.47 $13.819.00% $7.48 $8.66 $9.84 $11.02 $12.20

10.44% $6.42 $7.43 $8.44 $9.45 $10.4611.00% $6.08 $7.04 $8.00 $8.96 $9.9212.00% $5.57 $6.45 $7.32 $8.20 $9.0813.00% $5.14 $5.95 $6.76 $7.56 $8.37

Undervalued Greater than $15.02Overvalued Less than $11.10Fairly Valued Between $15.02-$11.1

Long Run Return on Equity

Cost

of

Equi

ty

(Holding g constant at .65%)

116

9.00% 10.44% 12.00% 13.00% 14.00%0.00% $10.94 $9.48 $8.30 $7.69 $7.161.00% $11.07 $9.44 $8.40 $7.49 $6.942.00% $11.25 $9.38 $7.96 $7.27 $6.693.00% $11.48 $9.31 $7.74 $6.99 $6.384.00% $11.81 $9.22 $7.47 $6.66 $6.025.00% $12.30 $9.10 $7.11 $6.24 $5.576.00% $13.12 $8.92 $6.64 $5.71 $5.01

(Holding LR ROE constant at 10%)Undervalued Greater than $15.02Overvalued Less than $11.10Fairly Valued Between $15.02-$11.1

Cost of Equity

Long

Run

Gro

wth

Rat

e

117

Appendices Liquidity Ratios Current Ratio 2003 2004 2005 2006 2007 Southwest 1.34 1.014 0.94 0.9 0.92 Continental 0.9 0.9 1 1.05 1.03 AMR 0.71 0.71 0.75 0.81 0.85 JetBlue 1.75 1.05 0.94 1.09 0.89 Quick Asset Ratio 2003 2004 2005 2006 2007 Southwest 1.16 0.73 0.72 0.69 0.63 Continental 0.16 0.64 0.73 0.78 0.77 AMR 0.52 0.54 0.58 0.67 0.66 JetBlue 1.7 1 0.86 0.91 0.74 Account Receivable Turnover 2003 2004 2005 2006 2007 Southwest 45 26 29 38 35 Continental 19 18 21 22.5 23 AMR 21.9 22 21 23 22 JetBlue 59.7 34.2 18.1 30.7 30.9 Days sales Outstanding 2003 2004 2005 2006 2007 Southwest 8 14 12.4 9.7 10 Continental 19 20 17 16 15.5 AMR 16.7 16.4 17.5 16 16.3 JetBlue 6 10.7 20 12 12 Working Capital Turnover 2003 2004 2005 2006 2007 Southwest 10 218 -33 -32 -25 Continental -32 -33 400 67 127 AMR -9 -9 -10 -14 -18 JetBlue 4 49 -41 32 -20

118

Profitability Ratios Gross Profit Margin 2003 2004 2005 2006 2007 Southwest 0.29 0.27 0.29 0.28 0.25 Continental 0.18 0.09 0.09 0.11 0.12 AMR 0.17 0.19 0.19 0.22 0.22 JetBlue 0.4 0.33 0.27 0.24 0.23 Operating Profit Ratio 2003 2004 2005 2006 2007 Southwest 0.081 0.062 0.096 0.103 0.08 Continental 0.021 -0.024 -0.004 0.036 0.048 AMR -0.05 -0.007 -0.004 0.047 0.042 JetBlue 0.169 0.088 0.028 0.054 0.059 Net Profit Margin 2003 2004 2005 2006 2007 Southwest 0.074 0.033 0.064 0.055 0.065 Continental 0.003 -0.041 -0.006 0.026 0.032 AMR -0.07 -0.04 -0.04 0.01 0.022 JetBlue 0.104 0.037 -0.012 -0.0004 0.006 Asset Turnover 2003 2004 2005 2006 2007 Southwest 0,66 0.66 0.67 0.65 0.73 Continental 0.85 0.93 1.07 1.25 1.26 AMR 0.58 0.64 0.72 0.76 0.81 JetBlue 0.72 0.58 0.61 0.61 0.59 Return on assets 2003 2004 2005 2006 2007 Southwest 0.049 0.022 0.043 0.036 0.048 Continental 0.003 -0.039 -0.0065 0.033 0.041 AMR -0.041 -0.026 -0.03 -0.008 0.018 JetBlue 0.075 0.021 -0.007 -0.0003 0.004 Return on Equity 2003 2004 2005 2006 2007 Southwest 0.1 0.043 0.088 0.075 0.1Continental 0.037 -0.560 -0.439 1.518 1.323AMR -1.28 -16.3 1.47 -0.16 -0.832JetBlue 0.251 0.069 -0.03 0 0.019

119

Capital Structure Ratio Debt to Equity Ratio 2003 2004 2005 2006 2007 Southwest 0.960 1.050 1.100 1.090 1.420Continental 13.610 66.810 45.590 31.590 6.810AMR 636.600 -50.520 -21.630 -49.090 9.750JetBlue 28.620 6.330 9.077 -4.470 6.987 Times Interest Earned 2003 2004 2005 2006 2007 Southwest 7.78 3.85 6.39 6.17 8.89 Continental 13.61 66.81 45.59 31.59 6.81 AMR 1.75 0.86 0.9 -0.22 -0.55 JetBlue -8.35 -2.59 -0.22 0.05 0.18 Debt Service Margin 2003 2004 2005 2006 2007 Southwest 10.2 5.17 14.5 2.34 23.32 Continental 0.24 0.88 0.68 1.94 1.97 AMR 0.84 1.19 1.55 1.8 1.55 JetBlue 5.64 2.96 1.61 1.73 2.05

120

Sales Diagnostics Net Sales/Cash from Sales 2003 2004 2005 2006 2007 Southwest 19.152 -197.88 33.558 35.217 26.943 Continental -20.36 -10.29 -18.649 -54.929 -96.82 AMR -8.617 -11.75 -11.23 -29.81 -43.853 JetBlue 11.452 137.01 -14.92 -30.29 -38.41 Net Sales / Account receivable 2003 2004 2005 2006 2007 Southwest 44.977 26.331 29.395 37.701 35.344 Continental 19.151 17.901 21.081 22.5567 23.485 AMR 21.91 22.303 20.09 22.837 22.332 JetBlue 59.71 34.178 18.096 30.688 30.891 Net Sales/ Inventory 2003 2004 2005 2006 2007 Southwest 63.839 47.664 50.56 50.199 38.073 Continental 47.126 46.257 55.7612 60.4977 52.517 AMR 33.798 38.207 40.217 44.591 38.161 JetBlue 120.43 126.46 81 87.519 109.31 Expense Diagnostics CFFO/OI 2003 2004 2005 2006 2007 Southwest 2.766 2.6386 2.9214 1.5054 3.5967 Continental 0.6223 -1567 -11.718 2.26068 1.6492 AMR -0.712 -5.351 -11.23 -29,81 -43.853JetBlue 1.696 1.7893 3.5417 2.1575 2.1183 Total Accruals/ Change in sales 2003 2004 2005 2006 2007 Southwest 1.5654 1.7656 1.9677 0.8808 4.0090 Continental 1.31184 0.5924 0.40642 0.36979 0.74 AMR 99.45 1.6813 1.1321 1.2431 6.0941 JetBlue 0.23386 0.353 0.2543 0.2477 0.480

121

Methods of Comparables Company EPS BPS DPS EBITDA CFFO CFFI FCF PPS

Southwest 0.77 0.01 0.02 13.34 2845.00-

1529.00 1316.00 14.8Continental 2.98 0.015 0 6.68 1133.00 -760.00 373.00 15.59AMR 0.1 0.01 0 7.55 1935.00 -234.00 1701.00 6.31JetBlue 0.18 0.005 0 12.49 358.00 -734.00 -376.00 4.3

Company Trailing P/E

Forward P/E P/B D/P

P/EBITDA P/FCF PEG

EV/EBITDA

Southwest 19.220

8 43.533

3 1480 740 1.10944

50.0112

5 1.3729 11.0323Continental

5.23154

-5.9306

1039.3 N/A

2.333832 0.0418

0.24912 4.78

AMR 63.1 -

1.3943 631 N/A 0.835760.0037

1 0 4.11656

JetBlue 23.889 -16.08 860 N/A 0.34427

5-

0.0114 0 15.13922 Industry Avg.

30.7401 -7.801

843,44 N/A 1.17129

0.01136

0.24912 8.013403

results2007

24.2847

-2.3405

8,4344 N/A

15.62501

14.9452

2.68553 14.54405

Z-score Southwest 2003 2004 2005 2006 2007 Working Cap/Total Assets 0.071674 0.003175 0 -0.0255 -0.02826 Retained Earn/Total Assets 0.550334 0.504948 0.401714 0.447979 0.399666 EBIT/Total Assets 0.161359 0.117597 0.170856 0.22899 0.155634 MV Equity/BV of Liablities 1.6256 1.221829 0.95537 1.073492 0.655017 Sales/Total Assets 0.601033 0.57599 0.541598 0.675037 0.587944 z score 3.01 2.42354 2.05 2.4 1.77

Z-SCORE 2003 2004 2005 2006 2007 Southwest 3.01 2.42354 2.05 2.4 1.77 Continental 1.04 0.94 1.18 1.47 1.61 AMR 0.43 0.52 0.55 0.88 0.94 JetBlue 3.29 1.82 1.2 0.96 0.86

122

REGRESSION ANALYSIS 3 month-

SUMMARY OUTPUT 72

Regression StatisticsMultiple R 0.39350004R Square 0.15484228Adjusted R Square 0.1427686Standard Error 0.0682514Observations 72

ANOVAdf SS MS F Significance F

Regression 1 0.059741071 0.059741 12.824778 0.000627152Residual 70 0.326077773 0.004658Total 71 0.385818844

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.0026203 0.008058053 ‐0.32517 0.7460196 ‐0.018691546 0.013451014 ‐0.01869155 0.013451014X Variable 1 0.83828544 0.234081451 3.58117 0.0006272 0.371424714 1.305146167 0.371424714 1.305146167

SUMMARY OUTPUT 60

Regression StatisticsMultiple R 0.0521651R Square 0.0027212Adjusted R Square ‐0.0144733Standard Error 0.06343466Observations 60

ANOVAdf SS MS F Significance F

Regression 1 0.000636832 0.000637 0.1582601 0.692223936Residual 58 0.233389447 0.004024Total 59 0.234026279

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.0019117 0.008298775 ‐0.23035 0.8186273 ‐0.018523458 0.014700147 ‐0.01852346 0.014700147X Variable 1 0.13344328 0.335437001 0.397819 0.6922239 ‐0.538006824 0.804893384 ‐0.53800682 0.804893384

SUMMARY OUTPUT 48

Regression StatisticsMultiple R 0.08823406R Square 0.00778525Adjusted R Square ‐0.0137846Standard Error 0.06219827Observations 48

ANOVAdf SS MS F Significance F

Regression 1 0.001396308 0.001396 0.3609314 0.55093831Residual 46 0.177956732 0.003869Total 47 0.17935304

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.0020159 0.009006457 ‐0.22383 0.8238795 ‐0.020144987 0.016113127 ‐0.02014499 0.016113127X Variable 1 0.21896046 0.364462947 0.600776 0.5509383 ‐0.514665387 0.952586314 ‐0.51466539 0.952586314

SUMMARY OUTPUT 36

Regression StatisticsMultiple R 0.04852067R Square 0.00235426Adjusted R Square ‐0.0269883Standard Error 0.0550195Observations 36

ANOVAdf SS MS F Significance F

Regression 1 0.000242879 0.000243 0.0802336 0.778698715Residual 34 0.102922927 0.003027Total 35 0.103165806

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.0012892 0.009184906 ‐0.14036 0.8892051 ‐0.019955153 0.017376797 ‐0.01995515 0.017376797X Variable 1 ‐0.104048 0.36732937 ‐0.28326 0.7786987 ‐0.850551087 0.642455093 ‐0.85055109 0.642455093

SUMMARY OUTPUT 24

Regression StatisticsMultiple R 0.10947444R Square 0.01198465Adjusted R Square ‐0.0329251Standard Error 0.05211306Observations 24

ANOVAdf SS MS F Significance F

Regression 1 0.000724732 0.000725 0.2668606 0.610599682Residual 22 0.059746962 0.002716Total 23 0.060471694

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.0070703 0.010645429 ‐0.66416 0.5134877 ‐0.029147563 0.015006974 ‐0.02914756 0.015006974X Variable 1 ‐0.2014824 0.390027253 ‐0.51659 0.6105997 ‐1.010349445 0.60738458 ‐1.01034945 0.60738458

123

6 month-

SUMMARY OUTPUT 72

Regression StatisticsMultiple R 0.393439604R Square 0.154794722Adjusted R Square 0.142720361Standard Error 0.068253323Observations 72

ANOVAdf SS MS F Significance F

Regression 1 0.059723 0.059723 12.82012 0.000628472Residual 70 0.326096 0.004659Total 71 0.385819

Coefficients tandard Erro t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.002516652 0.008057 ‐0.31237 0.755687 ‐0.018585029 0.013551726 ‐0.018585029 0.013551726X Variable 1 0.838239274 0.234111 3.580519 0.000628 0.371319408 1.30515914 0.371319408 1.30515914

SUMMARY OUTPUT 60

Regression StatisticsMultiple R 0.051817494R Square 0.002685053Adjusted R Square ‐0.014510033Standard Error 0.063435809Observations 60

ANOVAdf SS MS F Significance F

Regression 1 0.000628 0.000628 0.156152 0.694173572Residual 58 0.233398 0.004024Total 59 0.234026

Coefficients tandard Erro t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001888957 0.008291 ‐0.22783 0.820583 ‐0.018485647 0.014707733 ‐0.018485647 0.014707733X Variable 1 0.132551476 0.335437 0.395161 0.694174 ‐0.538897639 0.80400059 ‐0.538897639 0.80400059

SUMMARY OUTPUT 48

Regression StatisticsMultiple R 0.087929767R Square 0.007731644Adjusted R Square ‐0.013839407Standard Error 0.062199949Observations 48

ANOVAdf SS MS F Significance F

Regression 1 0.001387 0.001387 0.358427 0.552318149Residual 46 0.177966 0.003869Total 47 0.179353

Coefficients tandard Erro t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001979464 0.009002 ‐0.21989 0.826933 ‐0.020099976 0.016141048 ‐0.020099976 0.016141048X Variable 1 0.218264539 0.364572 0.598688 0.552318 ‐0.515580155 0.952109232 ‐0.515580155 0.952109232

SUMMARY OUTPUT 36

Regression StatisticsMultiple R 0.04910745R Square 0.002411542Adjusted R Square ‐0.026929295Standard Error 0.055017916Observations 36

ANOVAdf SS MS F Significance F

Regression 1 0.000249 0.000249 0.082191 0.776090254Residual 34 0.102917 0.003027Total 35 0.103166

Coefficients tandard Erro t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001301672 0.009182 ‐0.14176 0.888103 ‐0.0199616 0.017358257 ‐0.0199616 0.017358257X Variable 1 ‐0.105358605 0.367501 ‐0.28669 0.77609 ‐0.852211096 0.641493886 ‐0.852211096 0.641493886

SUMMARY OUTPUT 24

Regression StatisticsMultiple R 0.109539116R Square 0.011998818Adjusted R Square ‐0.032910327Standard Error 0.052112686Observations 24

ANOVAdf SS MS F Significance F

Regression 1 0.000726 0.000726 0.26718 0.610387572Residual 22 0.059746 0.002716Total 23 0.060472

Coefficients tandard Erro t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.007091687 0.010644 ‐0.66627 0.512164 ‐0.029165641 0.014982268 ‐0.029165641 0.014982268X Variable 1 ‐0.201720638 0.390255 ‐0.51689 0.610388 ‐1.011060001 0.607618724 ‐1.011060001 0.607618724

124

2 year-

SUMMARY OUTPUT 72

Regression StatisticsMultiple R 0.393267673R Square 0.154659463Adjusted R Square 0.14258317Standard Error 0.068258784Observations 72

ANOVAdf SS MS F Significance F

Regression 1 0.059670535 0.059671 12.80687 0.000632241Residual 70 0.326148309 0.004659Total 71 0.385818844

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.00231901 0.008054321 ‐0.28792 0.774258 ‐0.018382846 0.013744827 ‐0.018382846 0.013744827X Variable 1 0.837662635 0.23407106 3.578668 0.000632 0.370822631 1.304502639 0.370822631 1.304502639

SUMMARY OUTPUT 60

Regression StatisticsMultiple R 0.050904976R Square 0.002591317Adjusted R Square ‐0.014605385Standard Error 0.06343879Observations 60

ANOVAdf SS MS F Significance F

Regression 1 0.000606436 0.000606 0.150687 0.699301034Residual 58 0.233419843 0.004024Total 59 0.234026279

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001856003 0.008282207 ‐0.2241 0.823471 ‐0.018434641 0.014722636 ‐0.018434641 0.014722636X Variable 1 0.130498294 0.336176366 0.388184 0.699301 ‐0.54243181 0.803428399 ‐0.54243181 0.803428399

SUMMARY OUTPUT 48

Regression StatisticsMultiple R 0.086613388R Square 0.007501879Adjusted R Square ‐0.014074167Standard Error 0.06220715Observations 48

ANOVAdf SS MS F Significance F

Regression 1 0.001345485 0.001345 0.347695 0.558306265Residual 46 0.178007556 0.00387Total 47 0.17935304

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001955958 0.00900111 ‐0.2173 0.828934 ‐0.020074253 0.016162337 ‐0.020074253 0.016162337X Variable 1 0.215155628 0.364882985 0.589657 0.558306 ‐0.519315715 0.949626971 ‐0.519315715 0.949626971

SUMMARY OUTPUT 36

Regression StatisticsMultiple R 0.051394978R Square 0.002641444Adjusted R Square ‐0.026692631Standard Error 0.055011576Observations 36

ANOVAdf SS MS F Significance F

Regression 1 0.000272507 0.000273 0.090047 0.765944573Residual 34 0.102893299 0.003026Total 35 0.103165806

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001287753 0.009182213 ‐0.14024 0.889294 ‐0.019948255 0.017372749 ‐0.019948255 0.017372749X Variable 1 ‐0.110377892 0.367830397 ‐0.30008 0.765945 ‐0.857899192 0.637143408 ‐0.857899192 0.637143408

SUMMARY OUTPUT 24

Regression StatisticsMultiple R 0.112201594R Square 0.012589198Adjusted R Square ‐0.032293112Standard Error 0.052097114Observations 24

ANOVAdf SS MS F Significance F

Regression 1 0.00076129 0.000761 0.280494 0.601682216Residual 22 0.059710404 0.002714Total 23 0.060471694

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.007056563 0.010642799 ‐0.66304 0.514195 ‐0.029128376 0.01501525 ‐0.029128376 0.01501525X Variable 1 ‐0.206825795 0.390519993 ‐0.52962 0.601682 ‐1.016714688 0.603063098 ‐1.016714688 0.603063098

125

5 year-

SUMMARY OUTPUT 72

Regression StatisticsMultiple R 0.392931085R Square 0.154394838Adjusted R Square 0.142314764Standard Error 0.068269467Observations 72

ANOVAdf SS MS F Significance F

Regression 1 0.059568438 0.059568 12.78095 0.000639678Residual 70 0.326250406 0.004661Total 71 0.385818844

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.00190818 0.008050703 ‐0.23702 0.813333 ‐0.017964801 0.014148439 ‐0.017964801 0.014148439X Variable 1 0.836672961 0.234031405 3.575046 0.00064 0.369912048 1.303433873 0.369912048 1.303433873

SUMMARY OUTPUT 60

Regression StatisticsMultiple R 0.050620464R Square 0.002562431Adjusted R Square ‐0.01463477Standard Error 0.063439708Observations 60

ANOVAdf SS MS F Significance F

Regression 1 0.000599676 0.0006 0.149003 0.70090246Residual 58 0.233426603 0.004025Total 59 0.234026279

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.00180308 0.008263949 ‐0.21819 0.82805 ‐0.018345168 0.014739015 ‐0.018345168 0.014739015X Variable 1 0.12991139 0.336550296 0.386009 0.700902 ‐0.543767216 0.803589996 ‐0.543767216 0.803589996

SUMMARY OUTPUT 48

Regression StatisticsMultiple R 0.08602327R Square 0.007400003Adjusted R Square ‐0.01417826Standard Error 0.062210342Observations 48

ANOVAdf SS MS F Significance F

Regression 1 0.001327213 0.001327 0.342938 0.561000543Residual 46 0.178025827 0.00387Total 47 0.17935304

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.00190829 0.008996482 ‐0.21211 0.832954 ‐0.020017267 0.01620069 ‐0.020017267 0.01620069X Variable 1 0.213339894 0.364304341 0.585609 0.561001 ‐0.519966699 0.946646487 ‐0.519966699 0.946646487

SUMMARY OUTPUT 36

Regression StatisticsMultiple R 0.051714147R Square 0.002674353Adjusted R Square ‐0.02665875Standard Error 0.055010668Observations 36

ANOVAdf SS MS F Significance F

Regression 1 0.000275902 0.000276 0.091172 0.76453199Residual 34 0.102889904 0.003026Total 35 0.103165806

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.00129764 0.00918018 ‐0.14135 0.888426 ‐0.019954013 0.01735873 ‐0.019954013 0.01735873X Variable 1 ‐0.11082235 0.367026181 ‐0.30195 0.764532 ‐0.856709291 0.635064583 ‐0.856709291 0.635064583

SUMMARY OUTPUT 24

Regression StatisticsMultiple R 0.113069156R Square 0.012784634Adjusted R Square ‐0.03208879Standard Error 0.052091958Observations 24

ANOVAdf SS MS F Significance F

Regression 1 0.000773108 0.000773 0.284904 0.598856893Residual 22 0.059698586 0.002714Total 23 0.060471694

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.00708249 0.010639797 ‐0.66566 0.512548 ‐0.02914808 0.014983098 ‐0.02914808 0.014983098X Variable 1 ‐0.20787041 0.389442317 ‐0.53376 0.598857 ‐1.015524342 0.599783517 ‐1.015524342 0.599783517

126

10 year-

SUMMARY OUTPUT 72

Regression StatisticsMultiple R 0.392551524R Square 0.154096699Adjusted R  0.142012366Standard Er 0.068281501Observatio 72

ANOVAdf SS MS F Significance F

Regression 1 0.05945341 0.059453 12.75178 0.000648161Residual 70 0.326365434 0.004662Total 71 0.385818844

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001525601 0.008049039 ‐0.18954 0.850219 ‐0.017578903 0.0145277 ‐0.017578903 0.0145277X Variable 1 0.835690757 0.234023932 3.570963 0.000648 0.368944749 1.302436766 0.368944749 1.302436766

SUMMARY OUTPUT 60

Regression StatisticsMultiple R 0.050622118R Square 0.002562599Adjusted R  ‐0.014634598Standard Er 0.063439703Observatio 60

ANOVAdf SS MS F Significance F

Regression 1 0.000599715 0.0006 0.149013 0.700893143Residual 58 0.233426563 0.004025Total 59 0.234026279

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001752843 0.008247586 ‐0.21253 0.83244 ‐0.018262181 0.014756495 ‐0.018262181 0.014756495X Variable 1 0.129917387 0.336554802 0.386021 0.700893 ‐0.543770239 0.803605013 ‐0.543770239 0.803605013

SUMMARY OUTPUT 48

Regression StatisticsMultiple R 0.085976585R Square 0.007391973Adjusted R  ‐0.014186462Standard Er 0.062210594Observatio 48

ANOVAdf SS MS F Significance F

Regression 1 0.001325773 0.001326 0.342563 0.561213949Residual 46 0.178027268 0.00387Total 47 0.17935304

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001850314 0.008990956 ‐0.2058 0.837857 ‐0.01994817 0.016247542 ‐0.01994817 0.016247542X Variable 1 0.212860544 0.363684634 0.585289 0.561214 ‐0.519198644 0.944919732 ‐0.519198644 0.944919732

SUMMARY OUTPUT 36

Regression StatisticsMultiple R 0.051305907R Square 0.002632296Adjusted R  ‐0.026702048Standard Er 0.055011828Observatio 36

ANOVAdf SS MS F Significance F

Regression 1 0.000271563 0.000272 0.089734 0.766338916Residual 34 0.102894243 0.003026Total 35 0.103165806

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.001320392 0.009177005 ‐0.14388 0.886444 ‐0.01997031 0.017329527 ‐0.01997031 0.017329527X Variable 1 ‐0.10967587 0.36612713 ‐0.29956 0.766339 ‐0.853735717 0.634383976 ‐0.853735717 0.634383976

SUMMARY OUTPUT 24

Regression StatisticsMultiple R 0.113048482R Square 0.012779959Adjusted R  ‐0.032093679Standard Er 0.052092081Observatio 24

ANOVAdf SS MS F Significance F

Regression 1 0.000772826 0.000773 0.284799 0.598924155Residual 22 0.059698868 0.002714Total 23 0.060471694

Coefficients Standard Error t Stat P‐value Lower 95% Upper 95% Lower 95.0% Upper 95.0%Intercept ‐0.007133925 0.010636874 ‐0.67068 0.509406 ‐0.029193451 0.0149256 ‐0.029193451 0.0149256X Variable 1 ‐0.207202436 0.388262783 ‐0.53367 0.598924 ‐1.01241016 0.598005289 ‐1.01241016 0.598005289

127

References

• Southwest’s Website: www.southwest.com

2007 Annual Report

2003 10K- 2008 10K

• Continental’s Website www.continental.com

2007 Annual Report

2003 10K- 2008 10K

• AMR (American Airlines) Website: www.aa.com

2007 Annual Report

2003 10K- 2008 10K

• JetBlue’s Website www.jetblue.com

2007 Annual Report

2003 10K- 2008 10K

• Google Finance: www.finance.google.com

• Investopedia: www.investopedia.com

• Wall Street Journal: http://online.wsj.com

• Yahoo Finance: www.finance.yahoo.com

• The US Department of Transportation: www.dot.gov

• The federal Aviation Administration: www.faa.gov

• Business Travel news Magazine: www.btnonline.com

• Popularmechanics: www.Popularmechanics.com

• The economist: www.economist.com