An Evaluation of Southwest Airlines

Introduction

Southwest Airlines (Southwest) are a major U.S. airline company headquartered in Dallas, Texas. Established in 1971, they have grown to become the world’s largest low-cost carrier by operating more than 3,600 flights per day to 94 destinations across the U.S. and six additional countries (Southwest.com, 2015). They currently employ over 47,000 people and are listed on the New York Stock Exchange under the symbol ‘LUV’.

The following report analyses Southwest’s equity value based on both the relative and discounted FCF valuation methods, followed by our recommendations for the company to maximize its value by optimizing its capital structure.

Relative Valuation Approach

Under the relative valuation approach, several comparable companies from the airline industry have been used to determine Southwest’s financial worth. They were as follows:

American Airlines; JetBlue Airways; Delta Air Lines; United Continental; and Alaska Airlines

The first multiple chosen to evaluate Southwest was Enterprise Value/Sales. This measure indicates how much it costs to buy Southwest’s sales, and is generally more accurate than other measurements as it takes into account a company’s debt, which needs to be paid back (DePamphilis, 2013).

However, to determine which companies are comparable to Southwest, the average growth rate of sales from the previous 5 years were analyzed. From the table below, both American Airlines and United Continental (UCH) were eliminated due to having significantly different growth rates, 19.72% and 16.09% respectively, to that of Southwest’s 4.79%. The differences in growth of American Airlines and UCH compared to Southwest’s were that the former served much larger regions, served more customers per year, and their expansion rate was more widespread in terms of fleet size and destinations.

Furthermore, the price-to-book value ratio was also analyzed for the purpose of determining whether the comparable companies matched Southwest’s market value, size, and capital structure. As seen from the table below, American Airlines and Delta Air Lines’ price/book value ratio of 18.51 and 13.69 (respectively) were much greater than that of Southwest’s 1.92, and others for that matter, indicating they are much larger airline companies and therefore eliminated from the list. It is important that comparable companies match Southwest’s size and structure in terms of areas/regions served, number of flights per day etc.

To compute the enterprise value (EV), both long-term and short-term debt was added to the firm’s market value of equity, followed by subtracting non-operating cash flow. Subsequently, the multiples were derived from dividing annual sales from enterprise value.

The final multiple, which is used as a benchmark for EV/Sales, is calculated by using the median from the remaining multiples (of JetBlue and Alaska Airlines). Applying the final multiple of 1.53 to Southwest’s annual sales of $18.6bn, we will get an enterprise value of $28.39bn.

Another multiple used to evaluate Southwest was through EV/Size of Fleet. By looking at the remaining comparable companies’ size of fleet that are currently in operation, a multiple of 50.08 is calculated (average of JetBlue and Alaska Airlines). When applied to Southwest Airlines, we will get an enterprise value of $33.7bn.

In conclusion to the relative valuation approach, the value of Southwest Airlines is highly dependent on the companies that are chosen as comparable companies. Not all companies will be similar in size, structure, and credit status etc. but outliers must be eliminated as they could greatly impact a firm’s value. Based on the two different multiples used, Southwest would currently be valued between $28bn to $33bn.

Discounted FCF Valuation Approach

In order to get the true value of Southwest Airlines, we need to assess whether or not they are at their optimal capital structure. That is, the best debt-to-equity ratio that maximizes a firm’s value (Ghosh, 2012). If their current capital structure is at its optimal, then their value can be calculated based on the weighted average cost of capital (WACC) and cash flows. If not, then their optimal capital structure must be found. However, in reality, the capital structure cannot be changed immediately, so the value of the firm needs to be assessed through a progressive change in capital structure over a certain period of time.

Firstly, to determine the value of Southwest at different capital structures, both the cost of equity and cost of debt must be calculated.

To find the cost of equity (Re = rf + MRP * ), the unlevered beta must be βcalculated (at 0% debt). Subsequently, the levered beta formula is used to calculate the beta of equity at the different capital structures shown in the table below.

A market risk premium (MRP) of 6% was used, which could be perceived as high, based on the competitive nature of the airline industry. Meanwhile, the 10-year U.S. treasury bond of 2.5% was used as a close approximation of the risk free (Bloomberg.com, 2015).

Secondly, the current cost of debt is calculated by dividing interest over long-term debt and current portion of long-term debt. As seen from the table above, Southwest’s cost of debt is equal to 4.31%.

At different capital structures, it is important to analyze the interest cover ratio in order to calculate the respective interest rates. The current interest ratio is 12.20, so using the existing table would give Southwest an AAA credit rating, and thus the lowest interest rate available. However, we are aware that Southwest Airlines are currently rated at BBB, meaning the table cannot be applied to establish an accurate interest rate (Jean, 2014).

According to the Airline Analyst, the suggested criteria to rate airline companies are as follows (Theairlineanalyst.com, 2015):

Subsequently, the table below shows the ratings attributed to Southwest based on the above criteria (Ratings.theairlineanalyst.com, 2015):

As a result, the ratings criterion allows us to obtain a final score for Southwest that is used to determine an appropriate interest rate.

The average fleet age, EBITDAR margin, fixed charge cover, and liquidity criteria’s were all kept the same as they are unaffected by changing capital structures. However, the final criteria of leverage (Adjusted Net Debt/EBITDAR) will change depending on the capital structure. But when these changes are computed at the suggested weight (of the criteria) and added to the score of the fixed criteria, though, only minor changes occur to the final score, making changes in capital structure entirely insignificant, as shown below.

Therefore, according to Standard & Poor’s, the following key ratios are considered the best indicators of financial leverage of airlines (Csimarket.com, 2015):

Debt/Capital; Debt/EBITDA; and Debt/Revenues

Using these ratios, an average score could be computed and then assigned to a range of scores that will determine suitable interest rates, described in the table below:

After calculating both the cost of equity and cost of debt, the value of Southwest can be measured based on different capital structures, given the consideration of the following assumptions:

EBIT was adjusted by calculating the year-on-year change in growth rate of annual sales (over the past 5-years) for Southwest, followed by applying the same growth (per year) to the respective EBIT. Then, after adjusting the EBIT of the previous years, taking the average. This was done once there were significant fluctuations of the EBIT on the previous years, while sales growth was constant. After an analysis of their financial statements we could see that there important fluctuations on the COGS, mainly due to changes on depreciation&amortization that caused this EBIT fluctuation.

Growth rate equal to 4% consistent, which was consistent with annual revenue growth; and

Free cash flow (FCF) was retrieved from FactSet database.

As seen from the table above, the optimal capital structure is debt at 45%, with a minimum WACC of 7.91% (re = 11.91% & rd = 4.81%), and where the firm value is at its maximum.

To better assess the value of Southwest Airlines, the following scenarios need to be calculated:

1. The value without changing its capital structure;2. The value by immediately changing its capital structure; and3. The value by changing the capital structure in progressive manner over 5-

years.

1. Value with no change in capital structure

To value Southwest without changing its capital structure, the WACC needs to be calculated. As seen from the table below, the WACC stands at 8.26%.

Then after, the FCF’s of the next 5 years will be discounted at the WACC shown above, assuming the following:

EBITDA estimations were retrieved from FactSet for the following three years where growth was constant until 2020. These were chosen instead of the the current sales growth once for this forecast, un understanding of the industry trend and environment is highly important to compute the forecasts.

Depreciation was based on Southwest’s 2014 Income Statement, and assumed to remain the same for the next 5 years;

Current assets and current liabilities estimations were obtained from FactSet for the next 2 years, and assumed constant growth until 2020; and

Net fixed assets = Plant, property, and equipment. Retrieved from Income Statement and assumed to remain the same for the forecasted years. (Finance.yahoo.com, 2015)

Discounting the FCF from the calculated WACC, the present value of the Southwest is $24,593bn.

2. Value by immediately changing capital structure

The same forecasted FCF’s have to be discounted using the WACC that corresponds to Southwest’s optimal capital structure. To calculate this WACC, the cost of debt and cost of equity must be found at the targeted capital structure.

The table below shows equity beta (relevered) equal to 1.57, giving a cost of equity of 11.9%. By taking the cost of debt from the interest rate table, a WACC of 7.91% is obtained.

Therefore, discounting the FCF at a WACC of 7.91% gives Southwest a present value of $26,420bn, as seen from the table below:

3. Value by progressively changing capital structure

In reality, it is difficult for a firm to immediately change its capital structure, meaning it has to be done progressively. For Southwest, we assume the capital structure can be progressively modified in 5 years (from 28% 30% 35% 40% 43% to 45%), given a 0.10% increment along each year.

For each of the 5 years, the WACC has been calculated at different capital structures, and therefore different cost of capitals. When the FCF’s are discounted at the different WACC’s, the final value of Southwest is equal to $26,061bn.

Conclusion

As shown above, Southwest Airlines value, can achieve $26,061bn, higher than the $24,593bn. This can be achived by shifting the capital structure to its optimal (45% debt). However one has to take into account the possible necessity of financial flexibility. Depending on the internal strategy and structure of the company this might be extremely fundamental and hence force the company to position itself on the left of the optimal capital structure (therefore with less debt%). Moreover, one should also remember of the cost of crossing over the optimal capital structure, meaning that there are very small financial improvements before reaching the OCS, however there are huge costs just after overtaking the OCS. Thus, a couchin should be left to avoid these costs.

When compared, there is a difference between the relative valuation and the Discounted FCF valuation. This is logical, once it is extremely difficult to recreate the same conditions of the companies used for the comparison and also of the economical environment from where the numbers come from. Nontheless it could also be justified by a overvaluation from the market on this industry. This would also be proven by the fact that according to the equity value achieved at its optimal capital structure the price per share would be $29, lower than the current $35.

References

Bloomberg.com, (2015). United States Government Bonds. [online] Available at: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us.

Csimarket.com, (2015). Airline Industry financial strength, leverage, interest, debt coverage and quick ratios. [online] Available at: http://csimarket.com/Industry/industry_Financial_Strength_Ratios.php?ind=1102.

DePamphilis, D. (2013). Mergers, Acquisitions, and Other Restructuring Activities. 7th ed. Academic Press.

Finance.yahoo.com, (2015). LUV Income Statement | Southwest Airlines Company Comm Stock - Yahoo! Finance. [online] Available at: http://finance.yahoo.com/q/is?s=LUV+Income+Statement&annual.

Ghosh, A. (2012). Capital Structure and Firm Performance. Transaction Publishers.

Jean, S. (2014). S&P upgrades Southwest Airlines’ credit rating to BBB on improving financial conditions. The Dallas Morning News. [online] Available at: http://aviationblog.dallasnews.com/2014/10/sp-upgrades-southwest-airlines-credit-rating-to-bbb-on-improving-financial-conditions.html/.

Ratings.theairlineanalyst.com, (2015). Ratings criteria and process. [online] Available at: http://ratings.theairlineanalyst.com/RatingsCriteriaAndProcess.

Southwest.com, (2015). About Southwest - Southwest Airlines. [online] Available at: https://www.southwest.com/html/about-southwest/index.html?clk=GFOOTER-ABOUT-ABOUT.

Theairlineanalyst.com, (2015). Using the service | The Airline Analyst. [online] Available at: http://www.theairlineanalyst.com/FinancialRatings.aspx.