UT Dallas CFA IRC Report - 2016 LUV [104644]

CFA Institute Research Challenge

Hosted by:

CFA Societies Texas, Louisiana, New Mexico and Oklahoma

Local Challenge- Southwest US

The University of Texas at Dallas

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Share Price and Events

S&P 500 Index Southwest Airlines Target Price

S&P Indexed to LUV Share Price

Pilots’ Picket AirTran Integration

Completed

Wright Amendment

Repeal

AirTran Acquisition

Completed First International

Flight

737-800’s First

Introduction

Market Profile (as of 02/04/2015)

Closing Price: $37.54

52-Week High-Low: $31.36 / $51.34

Diluted Shares Out. : 679.55 M

Average Volume (6M): 8.441 M

Market Cap: $ 22.78 B

LTM Dividend Yield: 0.76%

Short Interest: $ 14.9 M

Beta: 1.11

EV/EBITDAR*: 5.0 x

P/E*: 12.7 x

Institutional Holdings: 82.94%

Insider Holdings: 0.28%

Key Financials FY 2015 FY 2016E FY 2017E

Revenue: 19,647$ 20,460$ 21,009$

Op. Margin*: 4,132 4,300 3,495

Net Margin: 10.2% 11.6% 9.0%

EPS: 3.26$ 3.76$ 3.20$

ROA*: 8.5% 9.5% 7.4%

ROE: 28.4% 31.0% 23.6%

ROIC*: 20.3% 21.4% 16.7%

Valuation Current Comparable Valuation

Method Price Weights

Comps $30.24 50%

DCF $38.81 50%

Target Price $34.53

Upside/Downside -8.03%

BBB+ Upgrade

NYSE: LUV Recommendation: HOLD

Industry: Airline Current Price: $37.54

Sector: Transportation Target Price: $34.53 (8% Downside)

*Denotes Glossary term

# Denotes Appendix reference

We Don’t Believe in LUV at First Sight

Investment Highlights We initiate our coverage on Southwest Airlines (LUV) with a cautious Hold

recommendation derived from a price target of $34.53, representing potential

downside of 8%. Our recommendation is primarily driven by the following:

Past Maverick Personality Has Been Key to Success. Southwest has proven

profitable over the last 43 years due to its ability to remain a low-cost leader. As

the low cost airline who pioneered the Point-to-Point (P2P) system, Southwest set

the airline industry standards through its low-cost, no-frill approach. In an

industry where customer service has been ranked one of the worst, Southwest’s

unique strategy, combined with a customer-oriented approach, has separated

Southwest from the crowd.

Safety Saves Sadness, Suffering…and Solvency. The conservative operating

philosophy regarding capacity* expansion and capital structure has fared well for

the low-cost leader. By not following in the footsteps of its rivals’ undisciplined

capacity deployment, Southwest has been able to separate themselves from the

cyclical nature shared by the industry. Management’s commitment to maintain a

low degree of financial leverage reduces insolvency risks by providing adequate

liquidity in economic downturns.

However… Good Airlines Copy, Great Airlines Steal. The recent wave of

bankruptcies have allowed competitors to reorganize their cost structures similar

to Southwest’s. The financial success of Southwest attracted new carriers to enter

the industry and adopt aggressive pricing policies. In the long-run, we believe

Southwest’s ability to maintain its low cost advantage will diminish. We see

convergence of interests among carriers to continue pressuring unit revenues,

which will negatively impact margins.

Labor: Southwest’s New Achilles’ Heel. Southwest’s decades of achievement

and the record profits resulting from fuel tailwinds could revert back to the mean

if the pressing labor issue is left unaddressed. The firm’s success has reached a

crossroads in strategy, forcing an uneasy choice between remaining the low-cost

leader or restoring its employee-first attitude. We see the burdensome impacts of

the expected contracts as a shift in management’s attitude, contributing to

declining employees’ morale and mitigating the firm’s excess returns.

*Multiples adjusted for Operating Leases

This report is published for education purposes only

by students competing in the CFA Institute Research

Challenge

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0 20 40 60 80 100

Industry

Others

SAVE

FRNT

UAL

ALGT

AA

DAL

ALK

LUV

JBLU

Exhibit 1: LUV's high customer service satisfaction

23.7%

76.3%

Exhibit 2: 2015 Market Share by Traffic Demand

LUV Domestic

Scorecard Standards

Strategic Initiatives (25%) Metric Wt. Payout Pct

Airtran Integration 5.0% 150.0%

International 5.0% 150.0%

The 737-800's 5.0% 150.0%

Fleet Modernization 5.0% 150.0%

New Reservation System 5.0% 150.0%

Most Loved (16.7%)

Net Promoter Score 8.3% 11.1%

Employee Satisfaction 8.3% 50.0%

Most Flown (8.3%)

Ontime Performance 8.3% 16.5%

Most Profitable (50%)

Total Operating Revenue 16.7% 150.0%

CASM Ex. Fuel & Profitsharing 16.7% 106.5%

15% ROIC 16.7% 150.0%

Total Executive Payout 111.7%

Name Title Tenure

Gary C Kelly Chairman/President/CEO 7.7

Tammy Romo CFO 3.3

"Mike" G Van De Ven COO 7.7

Jeff Lamb Executive VP 0.5

Robert E Jordan Executive VP 4.3

Thomas M Nealon Executive VP 0.1

Source: Company’s Proxy Statement

Source: Bloomberg, Team Research

Source: American Customer Satisfaction Index

Source: Company’s Data

Business Description Southwest Airlines (LUV) is headquartered in Dallas, Texas at Love Field Airport. The

company operated their first flight on June 18, 1971. With 49,600 employees,

Southwest transports more than 100 million passengers annually to 97 destinations in

40 states and 7 additional countries. As the nation’s largest domestic carrier,

Southwest operates 3,900 flights daily with a uniform fleet of 704 Boeing 737 aircraft.

In 2014, the company fully integrated AirTran Airways into their operations,

providing Southwest access to the Hartsfield-Jackson International Airport in Atlanta

and increasing capacity by 25%. The company offers several products such as Business

Select, Fly by Priority Lanes, and SWABIZ*. Southwest created the Transfarency®*

philosophy, which ensures customers are treated fairly and provided with the lowest

possible fares. Southwest is the only major carrier to offer bags fly free® and no change

fees. The firm has established a leading network that serves 24 of the top 25 U.S metro

areas. The company provides Point-to-Point (P2P) rather than Hub-and-Spoke

service14, allowing the company to offer more short-haul routes and avoid congested

airports. Coupled with fleet efficiencies, Southwest has reduced aircraft turnaround

times and carries 23.7% of all domestic traffic.

Company Strategies

Fleet Modernization - As of 1/21/2015, Southwest announced an accelerated

fleet modernization program to achieve greater range, new markets and fuel

efficiency by adding the Boeing 737 MAX.

2017 New Integrated Reservation System - The Amadeus system provides

Southwest with a single platform to schedule both domestic and international

flights, leading to higher load factors and capacity utilization.

Networks Under Development – LUV is expanding 5 key airports to increase

flight frequencies in demanding markets (Dallas, Fort Lauderdale, Chicago

Midway, Los Angeles, and New Orleans).

Prudent International Expansion - With the crowd domestic market,

Southwest is looking to expand into Latin America, the Caribbean, Central

America, and Mexico to fuel future growth. International networks account

for ~2% of the firm’s total capacity.

Management & Culture

The Southwest Airlines executive council has provided unusual stability for

Southwest within an industry known for its cyclicality. Gary Kelly, the CEO, been

recognized by his peers for numerous Executive of the Year awards. The company has

posted 43 consecutive years of profitability while also never furloughing employees.

With 83% of its employees unionized, a strong relationship with its employees is

essential to maintaining a positive culture. This resonates through all levels of the

organization, with employees rating Southwest

as one of the top companies in America to work

for.

The Corporate Governance structure is

composed of 10 directors that bring experience

from a diverse range of backgrounds. They range from former corporate executives of

Fortune 500 companies to university professors. This creates an experienced board

that is able to guide management effectively and with a purposeful direction. In order

to retain executive talent, management’s pay scales are based on progress made

towards short and long term goals. These are linked to vested equity shares and stock

options that mature over time based on company performance.

“Our vision is to become the

world’s most loved, most flown, and

most profitable airline.”

– CEO Gary Kelly

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BargainingPower ofSuppliers

BargainingPower of

Buyers

Threat of NewEntrants

Threat ofSubstitutes

IndustryRivalry

Exibit 3: The Airline industry is fiercely competitive

0%

10%

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40%

1998 2001 2004 2007 2010 2013

Exhibit 5: Airlines have streamlined its labor costs

Labor Other Costs

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Exibit 6: Z scores spell troubles for major airlines

AAL DAL UAL LUV

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Exhibit 7: Operating margins improved due to restructuring efforts

Revenue Operating Margin

49.5%

56.2%

21.8%

25.8%

28.7%

18.0%

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

2010

2015

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

Legacy LCC Others

Source: FactSet, Team Research




Source: Team Research

Industry Overview and Competitive Positioning The Airline Industry

The Domestic Airline Industry consists of three major types of airline carriers: Legacy,

Low Cost (LCC), and Ultra Low Cost (ULCC). Over the last 12 months, the domestic

industry operated approximately 8 million flights. The industry generates $155B in

revenue, with American, Delta, United and Southwest capturing 76.3% of the total

market. Airline revenues are categorized by both passenger and non-passenger

segments. In 2015, passenger* and non-passenger revenues totaled ~$150.35B and

~$4.65B respectively. Since the early 2000s, the industry has seen a major shift in the

way business is conducted. Airline bankruptcies, acquisitions, and heightened

competition have created an industry where distinct competitive advantages are hard

to come by. With more airlines employing the P2P system, we see the significant cost

advantage once held by LCC’s now diminishing.

Regulation and Changing Industry Dynamics

After the passage of the 1978 Airline Deregulation Act*, the industry has faced

weakened barriers to entry. The net effect is the creation of numerous LCC’s and

ULCC’s, route liberalization, and laissez faire pricing. However, this has contributed

to intensified competition and substantial capacity growth. At the same time, real

costs to travel one mile has been reduced by half since 1979. These factors have

punched many airlines with excess capacity growth and debt-heavy balance sheets a

one-way ticket to bankruptcy court.

The past two decades have been especially harsh on the industry as a result of

economic recessions, surging costs, and terrorist threats. US airlines revenues

dropped from $130.2B in 2000 to $107.1B in 2002 as a result of the September 11th

attacks. Following the oil price shock of 2008, airlines suffered losses totaling $25.9B,

as jet fuel prices reached as high as $126 per barrel (pb), inflating carrier’s expenses

and sharply reducing operating margins. Large carriers, such as Delta, United, and

American, filed for Chapter 11 bankruptcy protection and merged with other airlines.

As part of reorganization, labor concessions accounted for most of the cost structure

savings.

The Altman Z Score was used as a measure to display the insolvency probability of

major airlines during this period. The EBIT/Total Assets ratio is the primary driver of

the low scores, as operating margins fell and were insufficient for the carriers to

maintain sufficient free cash flows (FCF). Southwest remains the exception with an

average Altman Z score of 1.47, which is well above the .36 industry average.

Numerous events have changed the industry for the better. Airlines have put a

stronger emphasis on ROIC improvement and improving their financial positions.

However, given the positives seen throughout the industry, we note most airlines

have stayed below the 1.81 Z-score threshold, showing their vulnerability to

insolvency still exists. We remain cautious of the capital intensity, heavy operating

leverage, and the highly cyclical nature of the airline industry.

U.S Economic Performance & Airline Traffic

In the airline industry, revenue passenger miles* (RPMs) are used as a leading

indicator to estimate future traffic demand. Demand for airlines can be further broken

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

macroeconomic indicators, primarily Consumer Sentiment and Corporate Profits. We

ran a regression on the dependent variable Y (traffic) against one independent

variable X (corporate profits/consumer confidence) to test the correlation between

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Exibit 8: Contracting PMI levels are cause for concern

PMI Index Real GDP YoY

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-1.0 M-0.5 M0.0 M0.5 M1.0 M1.5 M2.0 M2.5 M3.0 M

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Exhibit 11: Supply Imbalance has driving down Crude Oil

Supply-Demand Spread (mbpd) WTI Spot Price

0 B

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0B 500B 1,000B 1,500B 2,000B 2,500B

Exhibit 9: Coporate earnings are indicative of airline traffic

-10%

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2010 2011 2012 2013 2014 2015

Exhibit 12: Yields have been pushed down as carriers respond to low jet fuel

Legacy LCC's ULCC's

0.0%

2.0%

4.0%

6.0%

8.0%

2009 2011 2013 2015 2017

Exhibit 10: Capacity remains competitive while CASM Ex-fuel is managable

Capacity YoY CASM Ex-Fuel YoY






those factors. Our results show that traffic levels are strongly correlated with these

factors (~84%). Combined with forecasted real GDP of 2.1%, this leads to our view that

the airline industry will continue to enjoy moderate levels of traffic demand. Given

the PMI Index has been below 50 for the last quarter and has ~80% correlation with

non-manufacturing PMI, this could lead to a plunge in the service sector4. The dip

signals a cause for concern that the U.S. economy is entering another possible

slowdown, which will hurt consumer spending and ultimately airlines’ revenues.

Capacity

Favorable industry conditions, such as lower oil prices and slowly improving

domestic macroeconomic trends, have kept industry-wide Cost per Available Seat

Mile excluding-Fuel* (CASM ex-Fuel) growth under the global inflation rate of 3%

(Appendix 4). This, combined with changing industry dynamics and heighted

competition, has resulted in competitive capacity expansion. Recently, international

capacity growth has been restrained by unstable markets in Latin America and Asia.

In particular, Latin America has experienced weaknesses in core markets such as

Brazil and Argentina. In terms of supply and demand alignment, Europe appears best

positioned due to more effective networks resulting from the three major Alliances32.

In the domestic market, the 2014 Wright Amendment Repeal paved the way for more

freedom to operate non-stop flights not permissible before*. As legal protection to

legacy carriers was repealed, LCC’s and ULCC’s were the beneficiaries of capacity

growth opportunities. Moving forward, we see moderate increases in near-term

capacity of approximately 4% due to the competitive environment and a shifting

strategic approach to capacity deployment.

Oil: A Double-edged Sword?

Over the past year, crude oil prices have fallen from a high of $65 per barrel to a near-

record low of $31 (as of January 25th, 2016). Industry averages for jet fuel price per

gallon have fallen 44% from the previous peak, contributing to industry margin

expansions of 4%. With the supply of oil outpacing demand in the near future, fuel

prices are likely to remain low17. Inventory levels have risen two consecutive years as

a result of elevated production levels including OPEC and the U.S. With weakening

macroeconomic trends and consumption in major economies, oil prices have suffered

from downward pressures. The oil windfall has allowed airlines to increase

shareholder returns and alleviate debt obligations. These decisions reflect improving

confidence in sustaining margins and enhancing free cash flow. The favorable trend

has created ROIC levels above the cost of capital not seen previously. We expect short-

term oil prices to remain near current levels unless substantial cuts in production are

made, or market fundamentals change. Additional information regarding oil can be

found in Appendix 17.

Pricing and Passenger Unit Revenue (PRASM)*

Low fuel prices have put downward pressure on yields. Industry supply growth has

been driven mostly by LCC’s who have taken advantage of fuel savings. In addition,

legacy carriers have responded by slashing prices to increase domestic traffic and

remain competitive against LCC’s and ULCC’s. Fuel tailwinds have allowed carriers

to restore previously unprofitable routes, expand into new markets, and prolong

retirement schedules for older aircraft. Airlines remain cautious about oil prospects

and relative positioning in the current cycle. The focus on disciplined capacity

expansion should help stabilize pricing in the near term but the competitive nature of

the industry will continue to drive prices lower over time, all else held constant. Since

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2005 America West

/US Airways Merger UAL/Continental Merger

DAL/Northwest Merger 2011 LUV/AirTran Merger

2008

Financial Crisis

20109/11

2001

AAL/TWA Merger

2001

2016

Terror Attacks

MetroJet Liquidation

012345

Strengths

Opportunites

Weaknesses

Threats

Exhitbit 15: Southwest has faced with outsized threats from the industry

0.02.04.06.08.0

10.012.014.0

03/06 10/07 05/09 12/10 07/12 02/14 09/15

Exhibit 13: PRASM has benefited from prudent capacity expansion

PRASM Fuel Cost pASM Labor Cost pASM

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50%

03/01 08/03 01/06 06/08 11/10 04/13 09/15

Exhibit 14: Labor still remains one of the costliest expenses for airlines

Wages Fuel Other Costs

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Exhibit 16: Capacity has been prudently deployed to match travel demand

ASM YoY Growth RPM YoY Growth

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/17

Exhibit 17: Yields have been depressed due to heightened competition


Source: Company Data, Team Research




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

16.2% from 10.23 to 11.89 cents as a result of prudent capacity expansion. This year,

the industry has experienced a decline in PRASM, largely due to the combination of

capacity increases and lower fares. Moving forward, we see capacity growth to likely

be in line with GDP and in the short term, a stabilized pricing environment.

Cost Structure Trends

Firms are continuing to shore up balance sheets, taking advantage of current fuel

saving trends. The shifting strategies provide a way for airlines to focus on baseline

unit revenues and alleviate insolvency uncertainty. Although all players in the airline

industry are seeing margin expansion, those whose have the highest operating

leverage are benefiting the most. While airlines are experiencing decade-low oil price

levels, labor still represents one of the largest costs for the industry. The passage of

the 1926 Railway Labor Act enabled industry employees to unionize and exert

significant influence in the wage-negotiating process*. All of these factors have forced

airline companies to allocate a bigger portion of their current profits to their

employees in the form of profit sharing plans and wage hikes.

Investment Summary We initiate our report with a cautious Hold recommendation on Southwest Airlines

with a target price of $34.53. Our price target came from the use of Discounted Cash

Flow Analysis and Relative Valuation. Our recommendation is based upon

Southwest’s competitive advantages, a favorable business environment, and

considerable uncertainties as discussed below.

Upside: Yield & Capacity - Recently, competitive pressures and acceleration in

quarterly capacity of 8% has driven yields* down by 7%. Though passenger revenues

increased by 3%, this was offset by total increase in traffic of 11%. The change in yield

has fallen into negative territory, and the rest of the industry has suffered as well due

to competitive pricing. Over the last 10 years, Southwest has been able to increase

yields 3% on a CAGR basis. We attribute this increase to better yield management29

and disciplined capacity expansion. Specifically, the effectiveness of seat allocation

among leisure and business customers has supported the firm in minimizing the effect

of empty and oversold seats. The combined effect of improved revenue management

and prudent capacity deployment has resulted in higher load factors over time

without the need to add many additional aircraft. We expect yields to improve in

2016 because of pricing stabilization from the 5% market-under-development

maturity.

Passenger Revenue Available Seat Mile (PRASM) - Over the last year, Southwest

has been faced with significant pricing pressure due to aggressive pricing strategies.

All of their major markets have seen increases in flight frequencies and lower average

yields. In the short-term, we expect prices to be more stable, as domestic capacity

decelerates closer to the rate of GDP. As the AirTran acquisition and Dallas markets

mature, Southwest is favorably positioned due to more stable corporate travels and

close-in bookings. We believe the risk of a potential oil spike will eventually push the

industry to raise their prices to offset constricted margins. Along with the new Chase

deal31, PRASM will see a distortion and then an improvement of 2%, as accounting

changes have allowed for faster revenue recognition.

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(1,500)

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(500)

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'05 '07 '09 '11 '13 '15 '17

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

EVA WACC Adjusted ROIC

$200

$250

$300

$350

$400

$450

$500

1979 1986 1993 2000 2007 2014

Exhibit 23: Fares in real dollar have halved due to competitive pricing

0 %

10 %

20 %

30 %

40 %

50 %

60 %

70 %

FY05A FY07A FY09A FY11A FY13A FY15A FY17E

Exibit 19: Southwest has kept its Debt to Capital in a managable range

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Exhibit 20: Southwest's pay scale has been significanly above the industry average

Industry Wages LUV Wages

-5%

0%

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FY06A FY09A FY12A FY15A FY18E

Exhibit 18: Depressed PRASM is expected to see a distortion before an improvement






Lean Cost Structure - Historically, Southwest has offered P2P service, rather than

Hub-and-Spoke. By choosing this strategy, Southwest has been more cost-effective by

operating one major Dallas headquarters and several key cities similar to traditional

“hubs.” Combined with a single 737 fleet, this business model has supported

Southwest to fly more frequently compared to other industry members. Southwest

has more operational flexibility due to lower maintenance and facility costs. They are

able to pass on these savings to consumers in the form of low fares.

Investment Grade Balance Sheet - One of Southwest’s top priorities has been

maintaining the strength of its balance sheet. Debt to Capital, adjusted for operating

leases, has averaged 50% over the past 10 years27. Southwest is better-positioned to

maintain adequate liquidity that protects them from exposure to the cyclicality of the

industry. The firm’s ability to proactively manage debt levels mitigates pressures

faced by many highly leveraged competitors. Given we are at the later stages of the

macroeconomic cycle, Southwest is better positioned to withstand economic

downturns and avoid insolvency compared to its peers.

Downside: Labor Cost Uncertainty - Ongoing labor negotiations are expected to

result in significant wage hikes. Southwest has been unable to reach conclusive

agreements with major unions representing pilots, flight attendants, and ground

crews. Labor expenses, including profit sharing, have traditionally been 10% higher

than the industry average. Although Southwest typically has had good relations with

their employees in the past, recent failed negotiations have indicated that expectations

are not perfectly aligned5. We see the increasing tension as a pressing issue since the

pilot union has elected a new President and picketed outside of Love Field on

February 3th, 2016. We believe generous pay increases from rival airlines will play a

significant factor in current contract deliberations. With three legacy carriers recently

approving new compensation plans5, Southwest is expected to match these

agreements to maintain their competitive pay scale. Total compensation is expected

to grow by double digits, which will have a net effect of ~370 bps on CASM ex-Fuel in

our Base Case.

Economic Value Added (EVA) - Since 2013, Southwest has experienced a 12.1%

increase in ROIC adjusted for operating leases and net impact from ineffective fuel

derivatives1. Historically, Southwest had a cost of capital that was greater than its

ROIC. The turnaround is largely the result of major one-time events or prevailing

market conditions. Following the repeal of the Wright Amendment, Southwest has

added 60 additional flights to its network at Love Field. The AirTran acquisition

helped Southwest achieve their goal of pre-tax ROIC greater than 15% and also realize

$400M in net synergies. Although EVA has been positive, oil is a significant driver of

the positive returns. We view continued gains in EVA to be unsustainable and could

drop from current levels in the long term. Decline in EVA can be attributed to 1)

heightened industry competition as a result of improving financial positioning and

more aggressive strategies, 2) restraining effects from the increased hedging positions

and 3) material escalation in labor expenses resulting from the unsuccessful on-going

negotiations.

Declining Competitive Advantage - After the 1978 Deregulation Act, airlines have

found it increasingly difficult to maintain a strong competitive position. For

Southwest, deregulation has shown to be a double-edged sword since the industry is

diluted with hundreds of new carriers and transferred pricing control from the

government to carriers. Since 1979, average ticket fares have declined in the industry

by approximately 70.2%. Although Southwest initially disrupted the industry with its

effective use of P2P system, many competitors have mimicked their pricing model and

developed similar P2P networks. Recent restructuring efforts among legacy carriers

have allowed them to reorganize their cost structures, which contributes to higher

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North America

Short-haul -1.5

Long-haul -1.4

Short-haul -0.9

Long-haul -0.8

Market level

National level

18%7%

-8%-16%

-38%-53%

8% -11%

0.00

2.00

4.00

6.00

8.00

10.00

12/2009 09/2015

Exhibit 22: CASM ex-Fuel: Does LUV really remain its cost advantage?

Legacy LCC ULCC LUV Industry

0

1,000

2,000

3,000

4,000

5,000

6,000

FY0

5A

FY0

6A

FY0

7A

FY0

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FY1

0A

FY1

1A

FY1

2A

FY1

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4A

FY1

5A

Exhibit 24: Historical EBITDAR

Source: International Air Transportation Association



levels of industry rivalry. We believe the new favorable operating environment

among legacy carriers and converging market interests of market participants will add

more pressure to the already cutthroat competitive environment.

Financial Analysis

Overview

The financial analysis table highlights Southwest’s strong historical operating

performance and displays our future concerns. The EBITDAR margin has expanded

by 388 bps on average since 2012. The growth is directly related to lower fuel costs

and delayed labor negotiations. Our Base Case forecasts oil prices of $45-$55-$65 per

barrel in the next 3 years as oil inventories continue to remain elevated.

Profitability - FASB’s future accounting standards will change how to record

operating lease treatment, so we adjusted our metrics and capital structure

accordingly12. Wealso made a significant adjustment to add back net operating leases

instead of aircraft rentals given the significance of gates, slots, and terminal lease

expenses12. This effectively raised our operating income, inflates assets, and magnifies

long-term debts, which provides a more accurate ROIC . In the medium to long term,

the supply shortage of skilled labor and rising cost of doing business will remain a

challenge for Southwest. The likely recovery from the dramatic decline of oil and

increased hedging positions also play a limiting effect in future profitability. We note

cuts in SG&A contribute little to profitability given their already low levels.

In general, we see leisure travelers as more price sensitive to price changes than

business travelers, and short-haul routes’ price elasticity are generally higher than

those of long-haul routes, all else constant. Though higher disposable income and

currently low fares have supported air travel demand, the marginal cost of flying has

been reduced, which remains a challenge for Southwest’s profitability.

Efficiency - A multi-year reservation system upgrade allows Southwest to compete

on a more equal basis with other competitors. The net effect will boost the firm’s

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

Financial Ratios FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

Profitability Ratios

Return on Assets 1.0% 2.0% 3.4% 5.1% 8.5% 9.5% 7.4% 6.6%

Return on Equity 2.7% 6.1% 10.5% 16.1% 28.4% 31.0% 23.6% 22.0%

Return on Invested Capital 6.1% 4.4% 8.4% 14.9% 20.3% 21.4% 16.7% 15.2%

Efficiency Ratios

Total Asset Turnover 0.9 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x

Fixed Asset Turnover 1.2 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 x 1.0 x

Margin Analysis

Gross Margin 18.4% 16.6% 19.4% 24.4% 31.6% 31.3% 27.1% 25.8%

SG&A Margin 12.0% 11.9% 12.0% 11.9% 11.4% 12.0% 12.0% 12.0%

EBITDAR Margin 13.4% 13.4% 16.1% 21.0% 28.9% 27.4% 23.3% 21.6%

EBIT Margin 7.3% 5.5% 9.1% 14.0% 21.0% 21.0% 16.6% 14.8%

Net Income Margin 1.1% 2.5% 4.3% 6.1% 10.2% 11.6% 9.0% 8.1%

Short Term Liquidity

Current Ratio 1.0 x 0.9 x 0.8 x 0.7 x 0.6 x 0.5 x 0.5 x 0.4 x

Cash Ratio 0.7 x 0.6 x 0.6 x 0.5 x 0.5 x 0.3 x 0.4 x 0.3 x

Coverage Ratios

Total Debt/EBITDAR 1.8 x 1.4 x 1.0 x 0.7 x 0.6 x 0.5 x 0.8 x 0.8 x

EBITDAR/Interest Expense 11.6 x 18.2 x 26.7 x 36.6 x 63.7 x 43.1 x 35.7 x 28.5 x

Leverage Ratios

Total Debt/Equity 79.8% 103.2% 79.9% 78.8% 93.3% 70.5% 82.5% 79.7%

Total Debt/Capital 47.6% 55.1% 49.5% 49.3% 54.3% 44.9% 51.3% 48.5%

Total Liabilities/Total Assets 55.9% 50.7% 53.1% 57.9% 55.8% 56.8% 59.0% 59.7%

8 | P a g e

0%

20%

40%

60%

80%

100%

2011 2012 2013 2014 2015

Exibit 25: Airborne Rates bounced back to normal levels

Airborne/Block Hours* On-time Arrival Rate*

0%

2%

4%

6%

8%

10%

12%

14%

2011 2012 2013 2014 2015

Exhibit 26: LUV still lags behind the industry in on-time arrival

Southwest* Industry*

Valuation Current Comparable Valuation

Method Price Weights

Comps $30.24 50%

DCF $38.81 50%

Target Price $34.53

Upside/Downside -8.03%

Terminal Value - Perpetuity Growth Method

Implied Terminal EBITDAR Multiple: 6.34 x

Terminal Value: 29,902

Terminal FCF Growth Rate: 2.50%

PV of Terminal Value: 24,333

Present Value of FCFF: 5,751

Implied Enterprise Value: 30,083

Plus: Cash & Cash-Equivalents: 3,050

Less: Total Debt & Capital Leases: (6,866)

Less: Pension: -

Implied Equity Value: 26,268

Diluted Shares Outstanding: 679.55

Base Case Implied Share Price: $38.65

Premium / (Discount) to Current: 2.97%



Source: Department of Transportation, Bloomberg

Source: Department of Transportation

time, Southwest is accelerating its fleet modernization effort by retiring its 129 Classics

by 2018 and exercising their option to add more energy-efficient Next-Generation

aircraft. Acceleration of the retirement program will lead to higher efficiency, simplify

maintenance costs, and result in estimated long-term savings of 6.2%. Newer aircraft

will require less down time and allow aircraft to fly longer hours, which reduces

operational costs and drive passenger unit revenue.

Southwest has Airborne/Block Hours back to normal level of ~85% after the AirTran

acquisition in 2011. Despite having Airborne and On-time Arrival Rates more in-line

with the industry in 2015, Southwest’s aircraft’s Arrival Rate of 8.77% is still 34%

higher than the industry average. These delays, which require additional increases in

fuel, crews, and maintenance, are costly for future growth.

Liquidity - Southwest has established a trusted reputation in the credit markets due

to its conservative balance sheet approach. The ability to service their interest

payments and debt principal has provided Southwest with a privileged revolving line

of credit. Easier access to liquidity has supported the company’s normal business

activities, especially when the market turns for the worst. Southwest’s near-term

liquidity should not be a concern. Nevertheless, given we believe we are in the later

stages of the current cycle, we are concerned with the company’s ability to generate

healthy free cash flow to cover all of its debt obligations and fund its operations.

DuPont Analysis - Southwest achieved a ROE of 28.4% in 2015. This increase was

primarily achieved from profit margin improvements. Looking forward, we forecast

that profit margin gains will not be sustainable based on dwindling impact of the

currently favorable business environment.

Valuation: Is LUV Soaring? At What Price? To value Southwest, we utilized 3 valuation methodologies. We combined both

intrinsic and relative valuation methods, primarily a Discounted Cash Flow Model

and Company Comparable Analysis. The Liquidation Valuation Method also

provides insight into the absolute lower bound liquidation scenario.

DCF Model (50%) - Our valuation model projects FCF for the next 3 years and

assumes terminal growth to be in-line with GDP growth of 2.5%. Given the highly

cyclical nature of the airline industry, we deem a 3-year projection is sufficient before

growth stabilizes. EBIT is adjusted for operating leases due to their debt-like

attributes, which distorts EBIT and in turn intrinsic valuation18.

Our valuation model considers EBITDAR a better proxy for cash flow instead of

EBITDA. We considered the full impact of operating lease expenses rather than just

aircraft rentals, since facility rentals and terminal operation leases are critical to

normal business operations. Given the highly competitive and cyclical nature of the

industry, we see Southwest’s EV/EBITDAR to move closer in-line with the historical

average. In the process of the EV/EBITDAR calculation, we analyzed the last two

business cycles and eliminated abnormal outliers. We reached a terminal multiple of

6.3x that we think is reasonable considering longer-term trading.

Financial Ratios FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

DuPont Analysis

Net Income Margin 1.1% 2.5% 4.3% 6.1% 10.2% 11.6% 9.0% 8.1%

Total Asset Turnover 0.9 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x

Equity Multiplier 2.8 x 3.0 x 3.1 x 3.2 x 3.4 x 3.2 x 3.2 x 3.3 x

ROE 2.7% 6.1% 10.5% 16.1% 28.4% 31.0% 23.6% 22.0%

9 | P a g e

Comparable Valuation

Multiple Turn Price

2016E EBITDAR: 4.4 x $30.47

2017E EBITDAR: 4.5 x $26.64

WACC, Comparable Capital Structure: 6.55%

WACC, Current Capital Structure: 7.68%

Average WACC: 7.11%

WACC, Optimal Capital Structure: 7.60%

Cost of Capital

Risk-free Rate: 2.25%

Market Risk Premium: 5.00%

Beta: 1.33

Cost of Equity: 8.90%

Default Spread: 2.00%

Pre-tax Cost of Debt: 4.25%

Cost of Preferred Stock: 0.00%

Normalized P/E Valuation

Comparable P/E: 24.7 x

Normalized EPS (LUV): 1.37$

Implied Price (LUV): 33.84$

0.0 x

5.0 x

10.0 x

15.0 x

20.0 x

25.0 x

FY0

5A

FY0

6A

FY0

7A

FY0

8A

FY0

9A

FY1

0A

FY1

1A

FY1

2A

FY1

3A

FY1

4A

FY1

5A

FY1

6E

FY1

7E

Exhibit 27: Historical and Projected EV/EBITDAR

Implied Weighted

DCF Case Weight Price Price

Base 60% $38.54 $38.81

Downside 20% $23.72

Upside 20% $54.70

Passenger Revenue per ASM (PRASM)

-3.5% -3.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5%

-2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0%

25.00$ 1.21$ 34.15$ 36.22$ 38.32$ 40.44$ 42.58$ 44.74$ 46.92$ 49.12$ 51.34$

30.00$ 1.30$ 33.11 35.19 37.28 39.40 41.54 43.70 45.88 48.08 50.31

35.00$ 1.39$ 32.07 34.15 36.25 38.37 40.51 42.67 44.85 47.05 49.27

40.00$ 1.48$ 31.03 33.11 35.21 37.33 39.47 41.63 43.81 46.01 48.23

45.00$ 1.57$ 30.00 32.08 34.17 36.29 38.43 40.59 42.77 44.97 47.19

50.00$ 1.66$ 28.96 31.04 33.14 35.25 37.39 39.55 41.73 43.93 46.16

55.00$ 1.75$ 27.92 30.00 32.10 34.22 36.36 38.52 40.70 42.90 45.12

60.00$ 1.84$ 26.89 28.96 31.06 33.18 35.32 37.48 39.66 41.86 44.08

65.00$ 1.93$ 25.85 27.93 30.03 32.14 34.28 36.44 38.62 40.82 43.04

Jet

Fuel




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


Weighted Average Cost of Capital (WACC) - We considered both the near-term and

terminal phases in our calculation for WACC. The cost of equity is estimated using

the CAPM model, which estimated cost of debt by adding BBB+ default spread to the

10-year Treasury bond. We calculated the first-phase WACC by taking the average of

unlevered comparables’ betas and adjust for cash, arriving at our initial period WACC

of 7.11%. In the terminal period, we assume Southwest to move more in-line with the

market, which accounts for our adjustment of Beta to 1. Combined with an adjusted

equity risk premium, this returns a terminal-period WACC of 7.60%.

Relative Valuation (50%) - Our set of comparable companies consists of North

American airlines with market capitalizations and revenues over $1.5B. We eliminated

firms with incompatible business models and market share in key routes. Our relative

valuation emphasizes two valuation multiples:

1) EV/EBITDAR: EV/EBITDAR is a more meaningful multiple as it is adjusts for

industry-specific charges and excludes depreciation, rental and interest expenses. This

provides a more standardized approach for the airline industry.

2) Normalized P/E: We normalized peers’ earnings over the length of the current

business cycle to avoid distortion and more accurately compare market perception.

P/E multiples are normalized by combining earnings for merged carriers and

smoothing earnings over the period for other carriers9. Multiples are then applied

against Southwest’s normalized EPS. Although Southwest has been traded at a

premium, we think it should be traded in-line with the industry given its declining

competitive advantage.

Sensitive Valuation Factors & Other Consideration

Growth - To estimate Southwest’s ability to generate future free cash flows (FCF), we

analyzed Southwest’s historical Reinvestment Rate over the last 10 years. Growth in

EBIT after the impact of reinvestment needs is the key driver of future FCF generation.

Given its capital-intensive nature, we calculate that Southwest has to reinvest 80% of

its EBIT on average to sustain current operating activities. This incorporates growth

assets such as next-generation aircraft and airport facilities. The large level of

reinvestment leads to lower FCF, debt financing, and thus potentially lower value.

Operating Expenses - Southwest operates in an industry that is heavily influenced by

large fluctuations in oil and labor expenses. Although Southwest has generated an

influx of free cash flows due to the windfall provided by lower oil prices, these levels

are not sustainable. The rise of these expenses can prove detrimental to the company’s

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

Liquidation Valuation - We do not put emphasis on the Liquidation Valuation for

our target price. However, given the cyclical nature of the industry and historical

bankruptcies, we take into consideration a liquidation scenario. We consider the low

and high values that shareholders will receive if all assets are liquidated to repay all

liabilities. The method returns a price range of $6.33 - $7.8310.

10 | P a g e

Hig

h

OR1

OR2 MR2

MR3 MR1

OR3 UC

Lo

w

Low Medium High

Impact

Me

diu

m

Pro

ba

bil

ity

Risk Mitigating Factor

Operational Risk

Balancing Employee

Compensation

Meaningful labor

negotiations

Lower Growth

Opportunities

Disciplined capacity

expansion

in-line with travel Loss of BBB+ Credit

Rating

Maintain capital structure

target

Market Risk

Economic Risk Defensive business tactics

Commodity Price

Volatility

Sensible long-term

hedging strategy

Hedging Risk Necessary ongoing

adjustments

Other Considerations

Uncertain Catastrophes Effective contingency

plans

Ability to act swiftly in

catastrophic situations



Investment Risks

Operational Risks:

Balancing Employee Compensation (OR1): Southwest always prides itself in maintaining

excellent employee relations. However, pending labor negotiations and silent

stoppages attributable to poorly-paid compensation are strong indicators that the

employee-first culture is decaying. It is very important that a balance is struck, which

offers a competitive pay scale yet provides enough flexibility to maintain its low cost

structure. If a cost-effective contract is not agreed upon, Southwest’s impressive

earnings and ROIC will be put at risk.

Lower Growth Opportunity for Expansion (OR2): Southwest is faced with limited

domestic growth opportunities. Given low growth opportunities, Southwest will look

towards international expansion, exposing them to outsized risks including foreign

government regulation, exchange rates, and fuel surcharges. LUV will need to follow

a disciplined international capacity strategy to maintain their position as a low cost

provider and ensure the transition from domestic to international carrier is successful.

Loss of BBB+ Credit Rating (OR3) – A sudden lowering of Southwest’s credit rating

would increase interest rates required on new loans to finance new projects and signal

that the firm’s strong historical financial position is weakening.

Market Risks:

Economic Risk (MR1): Southwest operates in an industry that is heavily exposed to

prevailing economic conditions. Tepid global growth constrains revenue by reducing

traffic demand and depressing fares. A high degree of operating leverage and elastic

travel demand magnifies the effects from downward economic pressure.

Commodity Price Volatility (MR2): Southwest is subject to risk associated with large

swings in the price of commodities such as crude and heating oil. As low fuel prices

contribute to margin expansion, the price of commodities plays a key factor in

maintaining profitability. Oil prices are dependent on the alignment of global supply

and demand. We view the following factors contributing to global oil prices:

substantial cut backs in production levels, increased demand for oil, supply-chain

disruptions, dwindling inventory levels, geopolitical tension, and coordinated

production among OPEC and Russia.

Hedging Risks (MR3): Although hedging provides insurance against extreme volatility,

the opportunity costs of these hedging positions are substantial. If the oil price

significantly increases in the near-term, Southwest’s current strategy of unloading

hedging position would prove ineffective. Management’s miscalculation of future oil

prices are costly to the firm’s operations. In the near-term, Southwest is significantly

exposed with a sharp rise in oil prices.

Uncertain Catastrophes (UC):

Southwest is highly susceptible to adverse effects outside of its control: Extreme

weather, disease, terrorism, war, cybersecurity, and environmental regulation can all

impact operations. The public’s perception of major events hinders the demand for air

travel and can negatively impact the stock and company’s performance.

Disclosures:

Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation:Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director:The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making:The author(s) does not act as a market maker in the subject company’s securities. Disclaimer:The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with CFA Societies of Texas, Louisiana, and Oklahoma CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

11 | P a g e

Index Glossary of Terms

Terms Description Equation

Aircraft UtilizationMeasures aircraft productivity, usually

presented as Block Hours per Day

Aircraft Block Hours / Number

of Aircraft Days

Available Seat Miles (ASMs)Measures one aircraft seat flown one mile,

whether filled or unfilled

One Aircraft Seat x One Mile

Flown

Capacity (Total ASMs)Measures the total available seat miles of an

airline, used to indicate supply of seatsTotal Available Seat Miles

Chase Credit Card Deal

Block Hour

Cost per Available Seat Mile

(CASM)Measure of unit cost

Operating Expenses / Available

Seat Miles

CASM ex. Fuel Measures unit costs excluding the cost of fuel

(Operating Expenses - Fuel

Expenses) / Available Seat

Miles

CASM ex. Fuel & Profit-sharingMeasures unit costs excluding the cost of fuel

and profit sharing expenses

(Operating Expenses Ex-Fuel &

Profit-sharing) / Available Seat

Miles

Form 41 Data

Load FactorRepresents the percentage of seats filled on an

aircraft

Revenue Passenger Miles /

Available Seat Miles

Passenger Revenue

Passenger Revenue per Available

Seat Mile (PRASM)Measures passenger unit revenue

Passenger Revenue / Available

Seat Miles

Passenger YieldMeasure of average fare paid per mile per

passenger

Passenger Revenue / Revenue

Passenger Miles

Revenue per Available Seat Mile

(RASM)Unit revenue

Total Revenue / Available Seat

Miles

Transfarency

Traffic/Revenue Passenger Miles

(RPMs)

Basic measure of airline traffic, represents

how many of an airlines available seats were

sold

Passenger Seats Sold x Total

Miles Flown

Revenue per EmployeeA measure to determine an airline's labor

productivity

Total Revenue / Full Time

Employees

Travel Length The average distance that a flight was flownTotal Aircraft Miles / Total

Aircraft Departures

Used as part of the Rapid Rewards program. This allows customers to obtain

free flights, hotels, and restaurant services

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

Traffic and employment numbers found in the airline filings from the Bureau

of Transportation Statistics.

The time from the moment the aircraft door closes at origin city until doors

open at departure city

Revenue that is generated by the airline from ticket sales

12 | P a g e

Appendix 1: Range of Implied Shared Prices

Appendix 2: Normalized Earnings for Comparable Companies

$- $10.00 $20.00 $30.00 $40.00 $50.00 $60.00

6.61% - 7.61% Discount Rate, 5.8 x - 6.8 x Terminal EBITDAR:

6.61% - 7.61% Discount Rate, 2% - 3% Terminal FCF Growth Rate:

12/31/2017E EV / EBITDAR:

12/31/2016E EV / EBITDAR:

LTM EV / EBITDAR:

12/31/2017E EV / Revenue:

12/31/2016E EV / Revenue:

LTM EV / Revenue:

Southwest Airlines - Range of Implied Share Prices

25th - Mean Mean - 75th

Public Company Comparables:

Discounted Cash Flow Analysis:

Normalized Earnings Per Share

Date DAL AAL LUV SAVE JBLU ALK UAL

FY 2015 4.61$ 8.94$ 3.53$ 4.30$ 1.98$ 6.51$ 11.88$

FY 2014 3.27 5.11 2.02 3.08 0.70 4.18 4.52

FY 2013 3.10 8.19 1.12 2.43 0.51 2.69 2.85

FY 2012 0.83 4.06 0.55 1.42 0.37 2.35 1.78

FY 2011 0.41 (4.69) 0.43 1.51 0.29 1.98 3.52

FY 2010 0.70 0.97 1.10 2.65 0.35 1.75 2.92

FY 2009 0.29 (3.18) 0.85 2.70 0.20 0.64 (6.34)

Avg. EPS : 1.89 2.77 1.37 2.59 0.63 2.87 3.02

2015 Price: 46.08$ 44.99$ 40.96$ 59.93$ 21.59$ 71.52$ 59.77$

P/E: 24.4 x 16.2 x 29.9 x 23.2 x 34.4 x 24.9 x 19.8 x

AAL LCC Merged UAL CON Merged

FY 2015 8.94$ 8.94$ FY 2015 11.88$ 11.88$

FY 2014 5.11 5.11 FY 2014 4.52 4.52

FY 2013 8.19 8.19 FY 2013 2.85 2.85

FY 2012 1.31 2.75 4.06 FY 2012 1.78 1.78

FY 2011 (5.33) 0.64 (4.69) FY 2011 3.52 3.52

FY 2010 (1.26) 2.23 0.97 FY 2010 2.92 2.92

FY 2009 (3.85) 0.67 (3.18) FY 2009 (6.34) (6.34)

LUV AAI Merged DAL NWA Merged

FY 2015 3.53$ 3.53$ FY 2015 4.61$ 4.61$

FY 2014 2.02 2.02 FY 2014 3.27 3.27

FY 2013 1.12 1.12 FY 2013 3.10 3.10

FY 2012 0.55 0.55 FY 2012 0.83 0.83

FY 2011 0.43 0.43 FY 2011 0.41 0.41

FY 2010 0.73 0.37 1.10 FY 2010 0.70 0.70

FY 2009 0.19 0.66 0.85 FY 2009 0.29 - 0.29

Normalized P/E Valuation

Comparable P/E: 24.7 x

Normalized EPS (LUV): 1.37$

Implied Price (LUV): 33.84$

13 | P a g e

Appendix 3: Management & Governance

Gary C. Kelly

Chairman of the Board, CEO

Tammy Romo

EVP/Chief Financial Officer

Robert E. Jordan

EVP/Chief Commercial Officer

Michael G. Van de Ven

EVP/Chief Operating Officer

Jeff Lamb

EVP of Corporate Services

Mark R. Shaw

SVP Gen. Counsel, Corporate Secretary

Thomas M. Nealon

EVP Strategy & Innovation

Management Position Background

Gary KellyChairman/President

/CEO Served 29 years at Southwest Airlines

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

Executive Vice President

Named twice in D CEO Magazine’s CEO of the Year

Named as one of the best CEOs in American by Institutional Investor three times

Distinguished Alumunus Award from the University of Texas at Austin

Inducted into the McCombs School of Business Hall of Fame.

Served on the President’s Job Council

Robert E. Jordan EVP/Chief

Commercial Officer Served 27 years at Southwest Airlines

Roles included Director Revenue Accounting, Corporate Controller, Vice

President Prcurement, Vice President Technology, SVP Enterprise Spend

Management, EVP Strategy and Technology

Received his undergraduate degree in Computer and MBA from Texas A&M

University

Led numerous initiatives such as the AirTran acquisition, the southwest.com e-

commerce platform, and the Rapid Rewards loyalty program.

Jeff LambEVP Corporate

Services Joined Southwest Airlines in 2004.

Helped establish Southwest’s Diversity Council, and also serves on the National

Board of Directors for the Make-A-Wish Foundation and Children’s Medical Center

Previously worked at the Staubach Company, Mesa Petroleum, and Belo

Corporation

Completed his undergraduate work at West Texas State University

Tom NealonEVP Strategy &

Innovation Joined Southwest in January 2016

Previously worked as EVP for JCPenny, Partner with the Field Group, and VP/CIO

at Frito-Lay

Received his BSBA from Villanova University and MBA from the University of

Dallas

Tammy RomoEVP & Chief

Financial Officer Served at Southwest Airlines for 24 years

Previous roles included: Senior Vice President Planning, VP Financial Planning,

VP Controller, VP Treasurer, Senior Director Investor Relations

Currently a member of the Accounting Advisory Council at the McCombs School

of Business

Named as an Outstanding CFO for a Public Company by D CEO Magazine

Received undergraduate degree in Accounting from The University of Texas at

Austin

Michael Van de VenEVP & Chief

Operating Officer Joined Southwest Airlines in 1993

Previously served as EVP of Aircraft Operations, SVP of Planning, VP Financial

Planning, Senior Director of Financial Planning and Analysis

Received his undergraduate Accounting degree from the University of Texas at

Austin

14 | P a g e

Appendix 4: 2016 Macro Outlook

In 2015, the U.S economy increased GDP at a tepid 2.4%, while global economies grew at 3.1%. In 2015 global economic

activity remained weak. According to the IMF, growth in emerging and developed economies which accounts for 70% of

total global GDP growth declined for the fifth consecutive year, while modern economies continued to see slow economic

growth. The current macro environment has been impacted by many domestic and global factors that have made growth for

the entire global economy very uncertain. Three key themes are currently driving economic forecasts:

1) China’s transition from an investment and industrial economy, towards a consumer-driven economy

2) Lower energy and commodity prices

3) The tightening of monetary policy from the U.S. and other advanced economies central banks

China’s Transition

China’s historic economic growth has been nothing short of astonishing. During the past 35 years, China’s real gross domestic

product has increased by an average of 10% per year (World Bank). After many years of success, the growth of the Chinese

economy looks to be reverting to the mean. According to the IMF, China has accounted for one-third of global growth since

2010. The Chinese markets are currently transitioning from an export-led model to one that is based more on consumption

and services. During this change, China’s slowing Purchasing Manager’s Index (PMI) has put downward pressure on other

economies and the manufacturing industry alike. The recent decline in manufacturing activity can be observed in China’s

Manufacturing PMI and its decline over the past four months proves manufacturing is contacting. The uncertainty regarding

future Chinese growth is spilling over to other economies through trade channels, and weaker commodity prices.

Manufacturing activity has been weak across the globe which can be most seen in extracting industries and commodities.

Source: Factset and Worldbank

Corporate Profits and Labor

Corporate Profits have fallen to the lowest year-over-year growth levels since the last recession in 2007. This has been a result

of the strong U.S. dollar, weaker commodity prices, and the uncertainty over the long awaited decision by the Federal

Reserve’s to raise interest rates. Although companies that operate internationally are taking the biggest earnings declines,

the health of the domestic economy remains mixed. Unemployment remains at current cycle lows while productivity remains

at cycle highs. We note that the economy is not likely to see additional growth by adding additional employees because

employment is nearing full capacity. Businesses will need to turn to other sources of growth to drive future profits. Although

we see a domestic economy being healthier than it was during the previous down turn, we view the current labor conditions

as a sign the U.S. market has hit full capacity.

15 | P a g e

Source: Factset, Bloomberg

Domestic Service Sector Is Being Pulled Down by Factory Troubles

During the last two months of 2015, the U.S. Institute for Supply Management’s Manufacturing Purchasing Manager’s Index

(PMI) showed readings under 50 which signals contracting manufacturing activity. Current manufacturing activity is

suffering from a wide variety of factors, including weak foreign demand, lower commodity prices, sluggish economic

growth, and a strong dollar. Since the United States is primarily a consumer-based economy, the real question is what impact

the decline in the Manufacturing PMI will have on the Non-Manufacturing PMI. In 2015, global manufacturing was weak

due to lower overall commodity prices. This has been caused firms to slash prices to reflect low input costs, China’s slow

down, and the resulting pressures on emerging economies. Although manufacturing activity has been declining for most of

the past year, domestic services, which accounts for 70% of U.S. total GDP continued to show signs of strength (Federal

Reserve). However, recent manufacturing data from the U.S. Non-Manufacturing Index has recently signaled slowing

growth in services after the index reported its lowest level in nearly two years. The Non-Manufacturing PMI reported a

reading of 53.5, showing consumer spending is starting to feel the side effects of declining manufacturing activity. Although

the Non-Manufacturing Index is still above 50 (the border between expansion and contraction) this marks the lowest level

for the index in 27 months (See Chart Below). In order to understand the effects that Manufacturing PMI has on Non-

Manufacturing activities, we tested the correlation between both indices and found a 77.98% correlation between both

variables. This is significant and proves weakness in the manufacturing industry will eventually spread to the services sector.

With the U.S. GDP composed of 70% services, a decline in manufacturing activity directly impacts the GDP growth and

should sound the alarm on the overall state of the domestic economy.

16 | P a g e

Inflation and Deflationary Fears

Recent inflation both in the United States and abroad has been weak. The chart below shows inflation relative to the 2%

inflation target by the Federal Reserve. Recently the fears of low inflation has sparked fears of a deflationary environment.

Key factors that lead us to believe that we could possibly be entering a deflationary period is the continued pressure in the

Eurozone and Japan

Source: World Bank

Strong Dollar Issues

The recent period in 2015 has been one of the most volatile periods for currencies relative to the dollar. As other economies

in Asia, Europe, and other emerging markets looked to expand monetary policy to stimulate demand, the divergence

between the U.S. dollar and other currencies increased substantially. As the Central Bank of Japan (BOJ) implemented

negative interest rates, and the European Union’s (EU) decision to continue economic stimulus, current forward volatility is

expected.

17 | P a g e

Source: Bloomberg

Appendix 5: Labor

30,000 Foot View: A Pilot’s Perspective

When Herb Kelleher resigned as the former chairman of the board of directors, Southwest lost one of the best CEO’s in

America. Under Kelleher’s leadership, Southwest applauded out-of-the-box thinking from everyone at the company,

including flight attendants, pilots, and ramp operators. Kelleher and the rest of his management team ensured they always

never shot down ideas because they understood they would never get their employees to voice their opinion ever again. This

open-culture attitude under Kelleher carried over into the airline’s labor relations, and contributed to healthy employee and

union relationships over the duration of his leadership. However, since Herb Kelleher’s resignation in 2008, we see a different

company in terms of size and employment relations. Since the AirTran acquisition in 2011, Southwest has faced the trouble

of integrating two very different cultures.

Before Herb Kelleher retired in 2008, everyone enjoyed working under his guidance. As Southwest has grown to be the

nation’s largest low-cost-carrier, Southwest has deviated from its principles that made Southwest a great company to work

for. The old Southwest believed in the idea that if you took care of your internal customers (employees), then your external

customers (passengers) would always be taken care of. This mindset is not present today, as seen by the Southwest Pilots

Union decision to picket for the first time outside of Dallas Lovefield.

In an effort to keep costs low, the company has not budged on recent negotiations with the Southwest Airlines Pilots Union

Association (SWAPA) and has failed to compensate appropriately. As a pioneer for profit-sharing in the Airline Industry,

Southwest has widely been regarded as one of the highest paying airlines compared to the industry standard. Since the

industry has been through many recent changes regarding restructuring and slow economic growth, firms have cut back on

labor expenses which have lowered the industry average. In the past, the company has justified wage increases during

negotiations based on past performance of the industry; which was when the industry was struggling with bankruptcies and

poor economic conditions. Now that times are improving, management has shown less willingness to talk about the so called

industry standard. The last contract that was turned down represented a 17.6% pay raise, while this may seem high, this

really only represents a 1.5% increase over the life of the entire contract. The tentative agreement initially offered a 3% raise

and then 2% per year. After taking into consideration the cost of living adjustment (COLA), assuming -2-2.9%, the current

wage increases would hardly reflect cost of living increases. Though one of the factors that goes into negotiating pay increases

-32.9%

-25.4%

-16.1%

-15.7%

-14.3%

-12.4%

-11.0%

-10.4%

-10.3%

-7.6%

-6.7%

-6.3%

-5.5%

-3.8%

-0.8%

-0.4%

-35.0% -30.0% -25.0% -20.0% -15.0% -10.0% -5.0% 0.0%

Brazilian Real

South African Rand

Canadian Dollar

Norweigian Krone

Mexican Peso

New Zealand Dollar

Autralian Dollar

Danish Krone

Euro

Swedish Krona

Singapore Dollar

South Korean Won

British Pound

Taiwanese Dollar

Swiss Franc

Japanese Yen

All Major Currencies Relative to Dollar in 2015

18 | P a g e

is what competitors are paying, after the recent failed negotiations in November 2015, the two party’s appear to still be far

apart. The negotiating process will continue in April as SWAPA regroups under new leadership.

Appendix 6: Operating Profile

Operating Statistics Historical Projected

(in millions except metrics per ASM) FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

Total Revenue: 11,023 10,350 12,104 15,658 17,088 17,699 18,605 19,647 20,460 21,009 21,835

YoY Growth: 11.8% -6.1% 16.9% 29.4% 9.1% 3.6% 5.1% 5.6% 4.1% 2.7% 3.9%

Total Passenger Revenue: 10,549 9,892 11,489 14,735 16,093 16,721 17,658 18,298 19,023 19,882 20,684

YoY Growth: 11.5% -6.2% 16.1% 28.3% 9.2% 3.9% 5.6% 3.6% 4.0% 4.5% 4.0%

Adjusted Earnings

EBITDAR: 342 1,072 2,039 2,104 2,290 2,857 3,914 5,674 5,604 4,885 4,717

EBITR: (475) 263 1,161 1,141 938 1,610 2,598 4,132 4,300 3,495 3,238

EBITDAR Margin %: 3.1% 10.4% 16.8% 13.4% 13.4% 16.1% 21.0% 28.9% 27.4% 23.3% 21.6%

EBIT Margin %: -4.3% 2.5% 9.6% 7.3% 5.5% 9.1% 14.0% 21.0% 21.0% 16.6% 14.8%

Per ASM Metrics

RASM: 10.67 10.56 12.30 12.99 13.34 13.58 14.20 13.98 13.80 13.62 13.75

PRASM: 10.21 10.09 11.67 12.22 12.56 12.83 13.48 13.02 12.83 12.89 13.02

CASM: 10.24 10.29 11.29 12.41 12.85 12.60 12.50 11.18 11.13 11.56 11.85

CASM Ex-Fuel: 6.64 7.19 7.62 7.73 8.07 8.18 8.46 8.60 8.92 9.12 9.26

CASM Ex-Fuel & Profitsharing: 7.65 7.98 8.00 8.19 8.16 8.45 8.77 8.97

Yield: 14.35 13.29 14.72 15.10 15.64 16.02 16.34 15.57 15.34 15.41 15.57

Carrier Union Wage Increase Status

LUV Pilots SWAPA +7.5% by 4/1/16, 17% total by 2019 Rejected 62%

AAL Pilots AAL +26% 1/1/15, +3% 2016-2019 Ratified 66%

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

ALK Pilots ALPA Contract not amendable until 2018 -

UAL Pilots ALPA 13% increase 2016, +3% thereafter Vote in Progress

Source: SWAPA, ALPA, Pilot Forums Source: Airline Pilot Central

19 | P a g e

Appendix 7: Income Statement

Income Statement: Historical Projected

(in millions) FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

Revenue:

Passenger: 10,549 9,892 11,489 14,735 16,093 16,721 17,658 18,298 19,023 19,882 20,684

Freight: 145 118 125 139 160 164 175 179 180 184 180

Other Revenue: 329 340 490 784 835 814 772 1,170 1,257 943 971

Total Revenue: 11,023 10,350 12,104 15,658 17,088 17,699 18,605 19,647 20,460 21,009 21,835

YoY Revenue Growth: 11.8% -6.1% 16.9% 29.4% 9.1% 3.6% 5.1% 5.6% 4.1% 2.7% 3.9%

Operating Expenses:

Salaries, Wages, and Benefits: 3,340 3,468 3,704 4,371 4,749 5,035 5,434 6,384 7,202 7,782 8,134

Fuel: 3,713 3,044 3,620 5,644 6,120 5,763 5,293 3,616 3,277 3,759 4,108

Maintenance Materials and Repairs: 721 719 751 955 1,132 1,080 978 1,004 1,027 1,068 1,100

Aircraft Rentals: 154 186 180 308 355 361 295 238 213 206 213

Landing Fees and Other Rentals: 662 718 807 959 1,043 1,103 1,111 1,166 1,238 1,333 1,417

Depreciation and Amortization: 599 616 628 715 844 867 938 1,015 1,092 1,158 1,229

Acquisition and Integration: - - - 134 183 86 126 38 - - -

Other Operating Expenses: 1,385 1,337 1,426 1,879 2,039 2,126 2,205 2,243 2,455 2,521 2,620

Total Operating Expenses as Reported: 10,574 10,088 11,116 14,965 16,465 16,421 16,380 15,704 16,504 17,828 18,821

Adjusted COGS Including D&A: 10,295 8,933 9,681 12,776 14,243 14,271 14,061 13,429 14,049 15,307 16,201

Adjusted Operating Expenses: 11,680 10,270 11,107 14,655 16,282 16,397 16,266 15,666 16,504 17,828 18,821

Operating Income: 449 262 988 693 623 1,278 2,225 3,943 3,955 3,181 3,014

EBIT Margin: 4.1% 2.5% 8.2% 4.4% 3.6% 7.2% 12.0% 20.1% 19.3% 15.1% 13.8%

Adjusted EBIT: (657) 80 997 1,003 806 1,302 2,339 3,981 3,955 3,181 3,014

Adjusted EBIT Margin: -6.0% 0.8% 8.2% 6.4% 4.7% 7.4% 12.6% 20.3% 19.3% 15.1% 13.8%

Other Expenses (Income):

Interest Expense: 130 186 167 194 147 131 130 120 130 137 165

Capitalized Interest: (25) (21) (18) (12) (21) (24) (23) (31) - - -

Interest Income: (26) (13) (12) (10) (7) (6) (7) (9) (5) (5) (5)

Other (Gains) Losses, net: 92 (54) 106 198 (181) (32) 309 556 - - -

Total Other Expenses: 171 98 243 370 (62) 69 409 636 125 132 160

Profit / (Loss) Before Tax (PBT): 278 164 745 323 685 1,209 1,816 3,307 3,831 3,049 2,853

Tax Charge: 100 65 286 145 264 455 680 1,299 1,456 1,159 1,084

Adjusted PBT: (828) (18) 754 633 868 1,233 1,930 3,517 3,831 3,049 2,853

Profit / (Loss) for the Period: 178 99 459 178 421 754 1,136 2,008 2,375 1,890 1,769

Effective Tax Rate: 36.0% 39.6% 38.4% 44.9% 38.5% 37.6% 37.4% 39.3% 38.0% 38.0% 38.0%

Basic Earnings / (Loss) per Share (EPS): 0.24$ 0.13$ 0.62$ 0.23$ 0.56$ 1.06$ 1.65$ 3.30$ 3.81$ 3.24$ 3.25$

Diluted Earnings / (Loss) per Share (EPS): 0.24$ 0.13$ 0.61$ 0.23$ 0.56$ 1.05$ 1.64$ 3.26$ 3.76$ 3.20$ 3.21$

Basic Shares Outstanding: 735 741 746 774 751 710 687 661 623 583 543

Diluted Shares Outstanding: 739 741 747 776 753 717 696 669 631 591 551

Cash Dividends per Share: 0.02$ 0.02$ 0.02$ 0.02$ 0.03$ 0.13$ 0.22$ 0.29$ 0.30$ 0.30$ 0.30$

20 | P a g e

Appendix 8: Balance Sheet

Statement of Financial Position: Historical Projected


ASSETS:

Current Assets:

Cash & Cash Equivalents: 1,368$ 1,114$ 1,261$ 829$ 1,113$ 1,355 1,282$ 1,582$ 1,080$ 1,742$ 1,239$

Short-term Investments: 435 1,479 2,277 2,315 1,857 1,797 1,706 1,468 1,428 1,386 1,342

Accounts and Other Receivables: 209 169 195 299 332 419 365 474 489 502 522

Inventories of Parts and Supplies, at cost: 203 221 243 401 469 467 342 311 346 377 399

Prepaid Expenses and Other Current Assets: 313 84 89 238 210 168 232 188 248 267 282

Total Current Assets: 2,528$ 3,067$ 4,065$ 4,082$ 3,981$ 4,206$ 3,927$ 4,024$ 3,591$ 4,275$ 3,785$

Non-Current Assets:

Flight Equipment: 13,722 13,719 13,991 15,542 16,367 16,937 18,473

Ground Property and Equipment: 1,769 1,922 2,122 2,423 2,714 2,666 2,853

Deposits on Flight Equipment Purchase Contracts: 380 247 230 456 416 764 566

Assets Constructed for Others: - - - - - 453 621

Total PP&E: 15,871 15,888 16,343 18,421 19,497 20,820 22,513

Less allowance for D&A: 4,831 5,254 5,765 6,294 6,731 7,431 8,221

Total PP&E, net: 11,040 10,634 10,578 12,127 12,766 13,389 14,292 15,601 16,628 17,610 18,581

Goodwill: - - - 970 970 970 970 970 970 970 970

Other Non-Current Assets: 375 277 606 626 633 530 534 717 818 840 873

Total Non-Current Assets: 11,415 10,911 11,184 13,723 14,369 14,889 15,796 17,288 18,417 19,420 20,424

Total Assets: 13,943 13,978 15,249 17,805 18,350 19,095 19,723 21,312 22,008 23,695 24,210

LIABILITIES AND EQUITY:

Current Liabilities, Excluding Debt and Finance Leases:

Accounts Payable: 668 746 739 1,057 1,107 1,247 1,203 1,188 1,243 1,355 1,434

Accrued Liabilities: 1,012 696 863 996 1,102 1,229 1,565 2,591 1,981 2,139 2,259

Revolver: - - - - - - - - 149 1,105 1,105

Air Traffic Liability: 963 1,044 1,198 1,836 2,170 2,571 2,897 2,990 3,961 4,279 4,893

Total Current Liabilities, Excl. Debt and Fin. Lease.: 2,643 2,486 2,800 3,889 4,379 5,047 5,665 6,769 7,333 8,878 9,691

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

Long-term Debt: 3,661 3,515 3,380 3,751 3,154 2,820 2,692 3,177 2,715 2,747 2,459

Deferred Income Taxes, net: 1,539 1,916 2,279 2,303 2,638 2,684 2,782 2,490 2,490 2,490 2,490

Construction Obligation: - - - - - - 554 757 757 757 757

Deferred Gains from Sale and Leaseback of Aircraft: 105 102 88 75 63 437 - - - - -

Other Non-Current Liabilities: 1,042 493 465 910 1,124 771 1,255 760 760 760 760

Total Non-Current Liabilities, Incl. All Debt and FL: 6,347 6,026 6,212 7,039 6,979 6,712 7,283 7,184 6,722 6,754 6,466

Total Liabilities: 8,990 8,512 9,012 10,928 11,358 11,759 12,948 13,953 14,055 15,632 16,157

Shareholders' Equity:

Common Stock & APIC: 2,023 2,024 1,991 2,030 2,018 2,039 2,123 2,182 2,182 2,182 2,182

Retained Earnings: 4,919 4,983 5,399 5,395 5,768 6,431 7,416 9,409 11,504 13,115 14,604

Accumulated Other Comprehensive Income (Loss): (984) (578) (262) (224) (119) (3) (738) (1,051) (1,051) (1,051) (1,051)

Treasury Stock, at cost: (1,005) (963) (891) (324) (675) (1,131) (2,026) (3,182) (4,682) (6,182) (7,682)

Total Shareholders' Equity: 4,953 5,466 6,237 6,877 6,992 7,336 6,775 7,358 7,953 8,064 8,053

Total Liabilities and Equity: 13,943 13,978 15,249 17,805 18,350 19,095 19,723 21,312 22,008 23,695 24,210

21 | P a g e

Appendix 9: Revenue Projection

Appendix 10: Fuel Expense Projection

Revenue Assumptions Historical Projected


Baseline Available Seat Kilometers (ASM): 103,271 98,002 98,437 120,579 128,137 130,344 131,004 140,501 148,286 154,217 158,843

Post-Toggle Available Seat Kilometers (ASM): 103,271 98,002 98,437 120,579 128,137 130,344 131,004 140,501 148,286 154,217 158,843

Baseline ASM YoY Growth Rate: 3.6% -5.1% 0.4% 22.5% 6.3% 1.7% 0.5% 7.2% 5.5% 4.0% 3.0%

Post-Toggle ASM YoY Growth Rate: 3.6% -5.1% 0.4% 22.5% 6.3% 1.7% 0.5% 7.2% 5.5% 4.0% 3.0%

Passenger Revenue: 10,549 9,892 11,489 14,735 16,093 16,721 17,658 18,298 19,023 19,882 20,684

YoY Growth Rate: 11.5% -6.2% 16.1% 28.3% 9.2% 3.9% 5.6% 3.6% 4.0% 4.5% 4.0%

Passenger Revenue per ASM (PRASM): 10.21 10.09 11.67 12.22 12.56 12.83 13.48 13.02 12.83 12.89 13.02

YoY Growth Rate: 7.6% -1.2% 15.6% 4.7% 2.8% 2.1% 5.1% -3.4% -1.5% 0.5% 1.0%

Freight: 145 118 125 139 160 164 175 179 180 184 180

Other Revenue: 329 340 490 784 835 814 772 1,170 1,257 943 971

YoY Growth Rate: 20.1% 3.3% 44.1% 60.0% 6.5% -2.5% -5.2% 51.6% 7.5% -25.0% 3.0%

Other Revenue per ASM 0.32 0.35 0.50 0.65 0.65 0.62 0.59 0.83 0.85 0.61 0.61

YoY Growth Rate: 15.8% 8.9% 43.5% 30.6% 0.2% -4.2% -5.6% 41.3% 1.8% -27.9% 0.0%

Total Operating Revenue: 11,023 10,350 12,104 15,658 17,088 17,699 18,605 19,647 20,460 21,009 21,835

YoY Growth Rate: 11.8% -6.1% 16.9% 29.4% 9.1% 3.6% 5.1% 5.6% 4.1% 2.7% 3.9%

Operating Revenue per ASM (RASM): 10.67 10.56 12.30 12.99 13.34 13.58 14.20 13.98 13.80 13.62 13.75

YoY Growth Rate: 7.8% -1.1% 16.4% 5.6% 2.7% 1.8% 4.6% -1.5% -1.3% -1.3% 0.9%

Revenue Passengers (mm) 88.5 86.3 88.2 104.0 109.3 108.1 110.5 118.2 122.9 125.9 127.8

YoY Growth Rate: -2.5% 2.2% 17.9% 5.2% -1.2% 2.2% 6.9% 4.0% 2.5% 1.5%

Revenue Passenger Mile (RPM): 73,492 74,457 78,047 97,583 102,875 104,348 108,035 117,500 124,033 128,994 132,864

YoY Growth Rate: 1.3% 4.8% 25.0% 5.4% 1.4% 3.5% 8.8% 5.6% 4.0% 3.0%

Baseline Load Factor:

Post-Toggle Load Factor: 71.2% 76.0% 79.3% 80.9% 80.3% 80.1% 82.5% 83.6% 83.6% 83.6% 83.6%

YoY Growth Rate:

Average Passenger Length of Haul 830 863 885 939 941 966 978 994 1,009 1,024 1,040

YoY Growth Rate: 3.9% 2.6% 6.1% 0.2% 2.6% 1.3% 1.7% 1.5% 1.5% 1.5%

Yield 14.35 13.29 14.72 15.10 15.64 16.02 16.34 15.57 15.34 15.41 15.57

YoY Growth Rate: 9.8% -7.4% 10.8% 2.6% 3.6% 2.4% 2.0% -4.7% -1.5% 0.5% 1.0%

Fuel Expense Assumptions Historical Projected


Fuel Expense: 3,713 3,044 3,620 5,644 6,120 5,763 5,293 3,616 3,277 3,759 4,108

Fuel Consumed (gallons): 1,511 1,428 1,437 1,764 1,847 1,818 1,801 1,901 1,986 2,035 2,085

YoY Growth Rate: 1.5% -5.5% 0.6% 22.8% 4.7% -1.6% -0.9% 5.6% 4.5% 2.4% 2.5%

Fuel as % of Operating Expense: 35.1% 30.2% 32.6% 37.7% 37.2% 35.1% 32.3% 23.0% 19.9% 21.1% 21.8%

Fuel Cost per ASM: 0.036 0.031 0.037 0.186 0.191 0.177 0.162 0.103 0.088 0.097 0.103

Baseline Gallons of Fuel per 1000 ASM: 14.63 14.57 14.60 14.63 14.41 13.95 13.75 13.53 13.40 13.19 13.13

Post-Toggle Gallons of Fuel per 1000 ASM: 14.63 14.57 14.60 14.63 14.41 13.95 13.75 13.53 13.40 13.19 13.13

Baseline YoY Growth Rate:

Post-Toggle YoY Growth Rate: -2.1% -0.4% 0.2% 0.2% -1.5% -3.2% -1.4% -1.6% -1.0% -1.5% -0.5%

ASMs per Gallon: 68.3 68.6 68.5 68.4 69.4 71.7 72.7 73.9 74.7 75.8 76.2

YoY Growth Rate: 2.1% 0.4% -0.2% -0.2% 1.5% 3.3% 1.5% 1.6% 1.0% 1.5% 0.5%

Economic Cost per Gallon: 1.73$ 2.20$ 2.50$

Cost per Gallon: 1.65$ 1.90$ 2.10$

Jet Fuel Market Price : 1.39$ 1.75$ 1.90$

Baseline: 1.21 1.39 1.56

Fuel Tax and Other Costs: 0.18 0.18 0.18

Hedged Fuel %: 20.0% 65.0% 35.0%

22 | P a g e

Appendix 11: Non-Fuel Expense Projection

Non-Fuel Expense Assumptions Historical Projected

(in million) FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E


YoY Growth Rate: 4.0% 3.8% 6.8% 18.0% 8.6% 6.0% 7.9% 17.5% 12.8% 8.1% 4.5%

Profit-sharing Program: 93 121 228 355 620 690 549 457

% of Profit before Tax, excl. Gain/Loss from Hedges: 14.7% 13.9% 18.5% 18.4% 17.6% 18.0% 18.0% 16.0%

Salaries Ex-Profitsharing: 4,278 4,628 4,807 5,079 5,764 6,512 7,233 7,677

YoY Growth Rate: 8.2% 3.9% 5.7% 13.5% 13.0% 11.1% 6.1%

Salaries Ex-Profitsharing per ASM: 3.55 3.61 3.69 3.88 4.10 4.39 4.69 4.83

YoY Growth Rate: 1.8% 2.1% 5.1% 5.8% 7.1% 6.8% 3.0%

End-of-period Employees: 35,499 34,726 34,901 45,392 45,861 44,831 46,278 49,583 51,361 53,022 54,804

Average Employees: 34,939 35,113 34,814 39,934 46,124 45,146 45,051 47,689 50,609 52,467 54,595

YoY Growth Rate: 4.3% 0.5% -0.9% 14.7% 15.5% -2.1% -0.2% 5.9% 6.1% 3.7% 4.1%

Average Employees per Aircraft: 66.1 65.4 64.2 64.1 66.3 65.7 67.0 69.7 71.1 72.1 73.6

YoY Growth Rate: -1.3% -1.1% -1.9% -0.1% 3.4% -0.8% 1.9% 4.0% 2.0% 1.5% 2.0%

Salaries per Avg. Employee: 95,597$ 98,768$ 106,396$ 107,126$ 100,339$ 106,477$ 112,738$ 120,862$ 128,678$ 137,865$ 140,622$

YoY Growth Rate: -0.3% 3.3% 7.7% 0.7% -6.3% 6.1% 5.9% 7.2% 6.5% 7.1% 2.0%


Maintenance Materials and Repairs per ASM: 6.98 7.34 7.63 38.97 35.99 32.41 31.25 32.78 30.90 32.28 35.26

YoY Growth Rate:



Landing Fees and Other Rentals per ASM: 6.41 7.33 8.20 39.13 33.16 33.11 35.50 38.06 37.25 40.28 45.44

YoY Growth Rate:


Acquisition and Integration per ASM:


% of Revenue: 12.6% 12.9% 11.8% 12.0% 11.9% 12.0% 11.9% 11.4% 12.0% 12.0% 12.0%

Post-Toggle Expense Totals:





Depreciation and Amortization: 599 616 628 715 844 867 938 1,015 1,092 1,158 1,229



Total Non-Fuel Expense: 6,861 7,044 7,496 9,321 10,345 10,658 11,087 12,087 13,227 14,068 14,713

Total Operating Expense: 10,574 10,088 11,116 14,965 16,465 16,421 16,380 15,704 16,504 17,828 18,821

Total Operating Expense per ASM: 10.24 10.29 11.29 12.41 12.85 12.60 12.50 11.18 11.13 11.56 11.85

Total OpEx per ASM, excl. Fuel: 6.64 7.19 7.62 7.73 8.07 8.18 8.46 8.60 8.92 9.12 9.26

CASM ex-Fuel YoY Growth: 1.3% 8.2% 5.9% 1.5% 4.4% 1.3% 3.5% 1.7% 3.7% 2.3% 1.5%

Total OpEx per ASM, excl. Fuel & Profitsharing: 7.65 7.98 8.00 8.19 8.16 8.45 8.77 8.97

23 | P a g e

Appendix 12: Fleet and Capital Expenditure Projection

Appendix 13: Major Shareholders

Fleet, CapEx, and Leasing Assumptions: Historical Projected

(in millions except aircraft-related metrics) FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

717-200 Owned 8 - - - - -

717-200 Leased 58 - - - - -

737-300 Owned 76 76 73 65 38 24

737-300 Leased 46 44 44 35 32 17

737-500 Owned 9 10 9 - - -

737-500 Leased 6 3 3 - - -

737-700 Owned 378 389 404 432 444 457

737-700 Leased 47 58 68 77 88 97

737-800 Owned 45 78 96 101 109 118

737-800 Leased 7 7 7 10 10 10

737-Max Owned - - - - 7 16

737-Max Leased - - - - 6 9

Total Aircraft: 680 665 704 720 734 750

Growth Aircraft -2.2% 5.9% 2.3% 2.0% 2.1%

ASM per Aircraft: 191.68 197.00 199.58 205.86 209.97 211.89

Total Aircraft - Owned or Finance Lease 516 553 582 598 599 616

Total Aircraft - Operating Lease 164 112 122 122 136 133

Total Aircraft - Owned or Leased 537 537 548 698 694 680 665 704 720 734 750

Average Total Aircraft: 529 537 543 623 696 687 673 685 712 727 742

YoY Growth

% Operating Lease: 24.1% 16.8% 17.3% 17.0% 18.5% 17.8%

# of New Owned or Finance Leased Aircraft: 9 37 29 16 2 17

CapEx per New Owned/Finance Leased Aircraft:

Post-Toggle CapEx per Aircraft: 139.7 227.4 426.4 370.0 1,480.0 460.0

Total CapEx: 1,447 1,748 2,105 1,497 1,417 1,974

CapEx % Revenue: 8.2% 9.4% 10.7% 7.3% 6.7% 9.0%

CapEx % Depreciation: 166.9% 186.4% 207.5% 137.1% 122.3% 160.6%

Facility CapEx: 503 683 226

Depreciation per Owned/Finance Leased Aircraft: 1.68 1.70 1.74 1.83 1.93 1.99

Total Depreciation: 867.0 938.0 1,014.7 1,092.1 1,158.5 1,229.0

Depreciation per ASM 0.67 0.72 0.72 0.74 0.75 0.77

YoY Growth N/A 7.6% 0.9% 2.0% 2.0% 3.0%

Aircraft Rental per Operating Leased Aircraft: 2.20 2.63 1.95 1.74 1.52 1.59

Total Aircraft Rental 361.0 295.0 237.9 213.4 206.4 212.6

Aircraft Rental per ASM 0.28 0.23 0.17 0.14 0.13 0.13

YoY Growth N/A -18.7% -24.8% -15.0% -7.0% 0.0%

Proceeds from Finance Leases: - - - - - -

Repayment of Finance Leases: 313 561 213 354 359 366

Repayment of Finance Leases per Aircraft: 0.6 1.0 0.4 0.6 0.6 0.6

Major Shareholders Numbers of Shares Percentage

Primecamp Management 74,401,158 11.7%

FMY LLC 45,146,705 7.1%

BlackRock 41,882,226 6.6%

Vanguard Group 37,538,498 5.9%

State Street Corp 22,403,927 3.5%

Egerton Capital 16,820,941 2.6%

Others 399,876,577 62.7%

Total Shares Outstanding 638,070,032 100.0%

24 | P a g e

Appendix 14: Hub-and-Spoke v. Point-to-Point

The airline industry is composed of two different types of transportation networks: the Hub-and-Spoke (H&S) system, and

the Point to Point (P2P) system. Each system offers different advantages over the other as airlines have realized gains from

each. The larger legacy carriers primarily use the H&S system while low cost carriers utilize the P2P system.

Hub-and-Spoke System

In an H&S system, airlines fly passengers from sets of “spoke” cities to a central “hub” where they then change planes and

fly to their final destination. Advantages of the H&S system include:

• Fewer routes are needed to serve the entire network. This is because flights are run through a central hub which

connects directly to most destinations on the network.

• Airlines can operate flights with higher load factors since fewer flights are flown on each route.

• Economies of scale are created when a centralized approach is taken. This reduces the labor associated with managing

operations and staffing requirements.

The H&S network also has disadvantages that include:

• Congestion of hub airports. This is because the airlines are operating on very tight schedules that have many

incoming/outbound flights simultaneously.

• Passengers are also inconvenienced by switching flights. This will also increase the probability of lost baggage claims

and missed connection flights.

• Hubs are both labor- and capital- intensive, rendering them costly to operate. Additionally, weather delays may

systematically delay the entire network, which results in flight delays and high associated costs.

Point-to-Point System

Point to Point systems are used primarily by low cost carriers who wish to reduce the costs associated from maintain formal

hub centers. Advantages include:

• Eliminating the need for connection flights.

• Improved baggage arrival times and reduced lost baggage claims

• Reducing the operational constraints associated with delayed flights.

• Improved turnaround times. This results from avoiding delays that is a result of hub congestion.

This network style has disadvantages that include:

• Higher fares. While this may not necessarily be the case for Southwest, many carriers charge for a convenience

premium.

• Cities that may not be on the network. This is largely the case with smaller cities that cannot generate enough demand

for airlines to profitably operate the route.

25 | P a g e

0

1

2

3

4

5

BargainingPower ofSuppliers

BargainingPower of

Buyers

Threat of NewEntrants

Threat ofSubstitutes

IndustryRivalry

Threat Hierarchy:

0 – None

1 – Slight

2 – Low

3 – Moderate

4 – Substantial

5 – High

Appendix 15: Porter’s Five Forces Analysis

Unlike other competitors, Southwest created their competitive advantage by offering frequent flights at a cost that was well

below the competition. The airline industry is structurally unattractive as a result of the intense competition, but Southwest

was able to operate in a niche that had previously been unfilled. This enabled the airline to avoid the intense competition

faced by the rest of the industry and cement itself in the low cost-market segment.

Threat of New Entrants – High:

Barriers to entry are low. This results from the recent liberalization of the markets. In the past 40 years, nearly 1300

new airlines were established.

There are many regulations that airlines must comply with. The FAA and foreign governments and require airline

operators to obtain certificates for flying.

There are high capital requirements, but the low interest rate environment has allowed more competitors to enter the

market at a lower cost. There are also many leasing options available that allow the airlines to offset the initial investments

needed to start a new operation.

There is very little differentiation among the operators, allowing new competitors to easily enter the market and offer

the same service.

There are very low switching costs for consumers. Airlines have attempted to combat this by offering frequent flyer

programs which incentivize the customers to fly with a specific airline.

Historically, the industry has been very unprofitable. This has changed recently with the depressed fuel prices and

debt restructurings.

Industry Rivalry- High:

It is hard to sustain a competitive advantage without innovation. The only way airlines can do this is through customer

service improvements, aircraft upgrades, or operational efficiencies.

There are low switching costs between the carriers. This has caused the airlines to undercut each other in an attempt

to stimulate traffic demand. As a result,

Firms are adopting similar strategies across the industry. They are able to offset the costs associated with this because

of the current fuel environment.

Bargaining Power of Suppliers – Moderate:

26 | P a g e

Airlines are usually locked into long term contracts, creating high switching costs for the airline companies who wish

to use a different manufacturer.

There is little differentiation between airplane manufacturers. This means that the suppliers must also be competitive

in terms of price with the airline companies and now they can

There is no opportunity for the manufacturers to forward integrate. Suppliers are dependent on the health of the airline

industry to continue doing business.

The labor force is highly unionized. As a result, the supply of labor has a high degree of leverage within the airline

industry. If labor unions strike, this will cause massive disruptions in the airlines ability to generate revenue, as they are

only able to do so when the planes are in the air.

Bargaining Power of Buyers – High:

There are very low switching costs for the buyers as most of the airlines are competing against each other while offering

the same service.

There is a lot of availability of the lowest fares with the advent of the internet and booking sites that provide instant

data.

Buyers are very sensitive to price, as flights are often seen as a discretionary expense. Airlines are not able to pass on a

high portion of the variable costs because of the number of similar competitors.

They are able to force down the prices of the airlines as a result of the airline industry currently experiencing intense

competition.

There is very little differentiation between airline operators, especially in the low cost segment.

Threat of Substitutes – Moderate:

Buyers have a high propensity to substitute in times of economic downturns.

Since there are very little switching costs, buyers are able to substitute alternate forms of travel.

Alternate forms of transportation are usually not as fast as airline travel, but they provide a cheaper form of travel for

those who can afford it.

Airlines are able to be the dominant form of transportation for international travel, as other methods are usually not

time efficient.

Unlike other competitors, Southwest created their competitive advantage by offering frequent flights at a cost that was well

below the competition. The airline industry is structurally unattractive as a result of the intense competition, but Southwest

was able to operate in a niche that had previously been unfilled. This enabled the airline to avoid the intense competition

faced by the rest of the industry and cement itself in the low cost-market segment.

Southwest based their business model upon keeping costs low, stimulating traffic demand, and operating on less

competitive routes. While Southwest faces the same fixed costs as the rest of the carriers, high aircraft utilization ensures

that planes are in the air generating revenue. Southwest accomplishes this by only operating the Boeing 737, avoiding in-

flight meals, and no reserved seats. This reduces variable costs associated with each flight, contributing to higher profits

and lower fares. Underpinning the whole operation were employees that were paid better than anywhere in the industry,

reinforcing the operational excellence that created strong brand sentiment. These reinforcing cycles reinforced enabled the

carrier to dominate the low-cost niche for the past 40 years.

Future Outlook

We believe that the current industry competition has diminished Southwest’s competitive advantage. They are unable to

consistently offer the lowest fares anymore, and new companies are beginning to gain market share in the low-cost segment.

The current profits are unsustainable and are heavily influenced by the fuel tailwinds. Structurally, this industry is

unattractive because of the cyclicality and destabilizing effects of economic recessions.

27 | P a g e

Appendix 16: SWOT Analysis

Appendix 17: OIL

Commodity Prices Decline

Commodity prices declined markedly over the second half of 2015. Strong production output from members of OPEC, the

United States, and Russia are expected to continue into 2016. Supply capacity investments that were made during times of

high oil prices have finally matured as companies are now utilizing the increased capacity ability. This has created

downward pricing pressures, causing many oil exporting countries to search for ways to survive during the glut. Oil

markets will take time to restructure as marginal cost producers attempt to survive during the current environment. This

will only prolong the supply and demand imbalance that is allowing inventory levels to climb and suppress prices as

marginal players continue to pump oil to maintain interest payments

Oil Rigs

Oil rigs in the United States have fallen to ~500, as shrinking revenues have forced drillers to produce more efficiently. The

past year has seen the total drop from 1400 rigs, but this has been offset by increased efficiency from each available rigs.

Since 2004, our dependency on foreign oil has significantly been reduced by 37%. Looking forward, a sharp drop in rig

counts is cause for concern in the event of major worldwide supply disruptions.

Strengths

•Strong balance sheet

•Uniform fleet

•Recognizable brand

•High aircraft utilization

Weaknesses

•Minimal ancillary revenue opportunities

•No segmented seating

Opportunities

•International expansion

•Advanced aircraft

•Capture additional domestic share

•Airline alliances/codesharing

Threats

•Legacy & ULCC

•Rising costs

•Reduced traffic demand

•Volatile fuel prices

•Terrorism

•Regulation

SWOT Analysis

28 | P a g e

OPEC & Russia

Historically, OPEC has been the driving force behind the pricing of oil. They have created a cartel by controlling

approximately 38% of the world's oil supply, giving them control over the world oil price. This also creates geopolitical

pressures on countries who do not support the OPEC cartel, as they have restrained supply in the past and created price

shocks. According to some sources, Saudi Arabia may have a marginal cost of production as low as $10-15 range, meaning

that they can continue to sustain their current level output to regain market share that they lost during the oil supply

expansion of other countries. Russia has also returned production back to post-Soviet highs, and now produce nearly 10.8

mbpd of oil. Russia has now surpassed OPEC as the largest supplier of crude oil to China, providing nearly 1.3 mbpd.

Effects on Oil E&P’s in the United States

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

in the world’s supply of crude has exceeded demand, which has led to sharp reductions in prices and earnings for the energy

sector.

The impact of cheap crude oil can be seen not only in the form of lower energy prices, but on oil explorers and producers.

The oil and gas sector currently has $200b in high yield debt that financed the shale oil boom. In the current market, nearly

all of the free cash flow generated is used to reduce or service debt. This has affected the credit quality of the sector, with 19

companies defaulting on their loans in 2015 and 15 filing for bankruptcy. 77% of the E&P firms have ratings below BB+,

which indicates that most of the sector bonds are considered junk for financing. This can be seen in the U.S. distressed ratio,

which climbed to its highest level since September 2009 at 20.1%. Oil and Gas has the largest proportion of distressed issuers

by count at 37% of total distressed debt, and the second highest sector distress ratio at 50.4%.

0

2000

4000

6000

8000

10000

12000

2004 2006 2008 2010 2012 2014

US Crude Oil Imports

0

20

40

60

80

100

120

0

1

2

3

4

5

6 E&P Debt Troubles

Total Debt / EBITDA (X) 5.04

Net Interest Expense (Million) 96.21

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Mar-11 Mar-12 Mar-13 Mar-14 Mar-15

Baker Hughes Rig Count

World Rig Count US Rig Count

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

0

20

40

60

80

100

120

140

160

2004 2006 2008 2010 2012 2014

Price Decline as Excess Capacity Dwindles

Open Interest Last Price

29 | P a g e

Source: Bloomberg

Production in the United States

Crude oil production in the United States has sharply risen in the past 6 years by 78%. This can be attributed to the explosion

of the shale industry, as drilling companies have found new ways in which to extract oil from the rock. Horizontal drilling,

which is known as “fracking”, enables companies to extract oil from rock underground using pressurized drills. Contained

within the drills are a combination of water and 600 various chemicals that then break the rock down even further. In the

current environment, producers have had to increase the efficiency of each shale play to maximize the returns on capital

invested. Break-even models of shale plays have indicated that some producers can survive in the $20-22 per barrel range

of crude. Not only does this mean that OPEC producers would have to flood the market even further, but

Forward Outlook

We believe that going forward a bounce to historical levels of 100+ oil is unlikely. We believe this is driven by 1) Lowered

marginal costs, 2) Unprecedented supply glut and 3) Changing industry dynamics.

1- It is clear that the marginal cost of oil has dropped. As oil companies have tightened their budgets and cut costs, they

have learned to become more productive with rigs, while lowering operational costs. The result is that this lowers the overall

cost curve. Additionally lower marginal cost players will increase market share, further lowering the price.

2- The current supply glut is unprecedented as the cost of storage has increased to all time highs. We have seen supply

increase each month in Cushing, and there seems to be little production decreases to stop this supply glut. As long as this

remains there will be continued downward pressures.

3- Some recent changes have been the lift on the ban of exporting oil from the United States, aggressive Saudi Pricing,

and the recent rise of alternative energy. It is clear that Saudi Arabia is more willing to stay the course than intially expected,

and multiple years of supply glut would create a longer than expected price period. Additionally the rising cost

competitiveness of alternative could display traditional oil. All these uncertainites are possible reasons for a prolonged and

lower price of oil.

With these key factors, we believe that the forward oil curve is extremely reasonable if not generous estimate for our forward

outlook for oil prices.

0

100

200

300

400

500

Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15

US Oil Barrels Per Rig

0

2000

4000

6000

8000

10000

12000

3/1/2009 3/1/2011 3/1/2013 3/1/2015

Oil Production in the United States

CROMUS Index : United States 9,318.00

30 | P a g e

Appendix 18: Cost of Capital

Appendix 19: Discounted Cash Flow Analysis

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

Cost of Capital

Risk-free Rate: 2.25%

Market Risk Premium: 5.00%

Beta: 1.32

Cost of Equity: 8.84%

Default Spread: 2.00%

Pre-tax Cost of Debt: 4.25%

Cost of Preferred Stock: 0.00%

Comparable Companies - Unlevered Beta

Levered Preferred Equity Unlevered

Ticker Beta Debt % Debt Stock % Preferred Value % Equity Tax Rate Beta Cash Firm Value

American Airlines Group AAL 1.25 30,048$ 54.0% - - 25,584$ 46.0% 37.0% 0.87 (9,583) 53,947

Delta Airlines DAL 1.32 16,889 32.3% - - 35,320 67.7% 37.0% 1.11 (5,424) 62,105

JetBlue JBLU 1.27 3,385 33.0% - - 6,882 67.0% 37.0% 1.12 (1,132) 8,276

Alaska Air Group ALK 1.21 1,473 14.1% - - 8,973 85.9% 37.0% 1.27 (1,258) 9,402

United Continental UAL 1.20 24,905 57.8% - - 18,217 42.2% 37.0% 0.75 (5,755) 41,520

Spirit Airlines SAVE 1.17 1,765 37.0% - - 3,007 63.0% 37.0% 1.05 (749) 4,023

Virgin America VA 1.09 1,213 40.9% - - 1,755 59.1% 37.0% 0.96 (512) 2,456

Median: 1.21 3,385$ 37.0% -$ - 8,973$ 63.0% 37.0% 1.05

Southwest Airlines Co LUV 1.11

The Southwest Airlines Co. - Levered Beta and WACC Calculation

Unlevered Preferred Levered

Beta Debt % Debt Stock % Preferred Equity % Equity Tax Rate Beta

Comparable Capital Structure: LUV 1.05 11,649 37.0% - - 19,839 63.0% 37.0% 1.44

Current Capital Structure: LUV 1.05 5,923 18.8% - - 25,565 81.2% 38.0% 1.20

Optimal Capital Structure: LUV 1.00 6,298 20.0% - - 25,190 80.0% 38.0% 1.16

WACC, Comparable Capital Structure: 6.55%

WACC, Current Capital Structure: 7.68%

Average WACC: 7.11%

WACC, Optimal Capital Structure: 7.60%

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

Historical Historical Projected

Annual Unlevered FCF Projection FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

Operating Leases (Book Value): 343 332 360 400 376 414 386 640 688 637 684 557 545 474

Discounted Operating Leases: 523 436

Pre-tax Cost of Debt: 6.89% 7.28% 7.65% 6.53% 5.62% 6.38% 6.11% 4.62% 4.78% 5.47% 4.50% 4.25%

PV of Operating Lease Expenses: 1,689 1,621 1,510 1,523 1,349 1,748 1,734 4,064 3,042 2,643 3,689 2,746 2,801 2,857

Revenue: 7,584$ 9,086$ 9,861$ 11,023$ 10,350$ 12,104$ 15,658$ 17,088$ 17,699$ 18,605$ 19,647$ 20,460$ 21,009$ 21,835$

EBITDA: 399 815 660 (58) 696 1,625 1,718 1,650 2,169 3,277 4,990 5,047 4,340 4,243

EBIT: (70) 300 105 (657) 80 997 1,003 806 1,302 2,339 3,975 3,955 3,181 3,014

Operating Lease Expense in Current Year: 343 332 360 400 376 414 386 640 688 637 684 557 545 474

Depreciation on leased asset: 188 203 189 218 193 250 248 508 380 378 527 213 231 250

Adjusted After-tax EBIT: 53 266 171 (294) 163 720 708 582 998 1,611 2,562 2,666 2,167 2,008

Non-cash Adjustments: 820 1,092 1,158 1,229

Changes in NOWC: 366 205 502 723

CapEx: (2,041) (1,057) (2,155) (2,256)

FCFF: 1,707 2,905 1,672 1,704

FCFF, remaining periods:

Present Value of FCFF: 2,807 1,509 1,435

Sum of PV of FCFF: 5,751

Normal Discount Period: 1.00 2.00 3.00

Mid-year Discount Period: 0.50 1.50 2.50

Annual FCFF Growth: N/A 70.2% -42.4% 1.9%

31 | P a g e

Terminal Value - Multiple Method Terminal Value - Perpetuity Growth Method

Terminal EBITDA Multiple: 6.30 x Implied Terminal EBITDAR Multiple: 6.34 x

Terminal Value: 29,715 Terminal Value: 29,902

Implied Terminal FCF Growth Rate: 2.47% Terminal FCF Growth Rate: 2.50%

PV of Terminal Value: 24,181 PV of Terminal Value: 24,333

Present Value of FCFF: 5,751 Present Value of FCFF: 5,751

Implied Enterprise Value: 29,932 Implied Enterprise Value: 30,083

Plus: Cash & Cash-Equivalents: 3,050 Plus: Cash & Cash-Equivalents: 3,050

Less: Total Debt & Capital Leases: (6,866) Less: Total Debt & Capital Leases: (6,866)

Less: Pension: - Less: Pension: -

Implied Equity Value: 26,116 Implied Equity Value: 26,268

Diluted Shares Outstanding: 679.55 Diluted Shares Outstanding: 679.55

Implied Share Price from DCF: $38.43 Implied Share Price from DCF: $38.65

Premium / (Discount) to Current: 2.37% Premium / (Discount) to Current: 2.97%

Implied Weighted

DCF Case Weight Price Price

Base 60% $38.54 $38.81

Downside 20% $23.72

Upside 20% $54.70

32 | P a g e

Appendix 20: Sensitivity Analysis – Base Case Scenario

Sensitivity - Terminal FCF Growth Rate vs. WACC and Implied Share Price from DCF Analysis:

Terminal FCF Growth Rate Capacity Expansion (ASM)

3865.5% 1.5% 1.8% 2.0% 2.3% 2.5% 2.8% 3.0% 3.3% 3.5%

6.1% 34.17$ 35.58$ 37.12$ 38.81$ 40.65$ 42.69$ 44.96$ 47.48$ 50.30$

6.4% 33.74 35.14 36.66 38.32 40.14 42.16 44.39 46.88 49.67

6.6% 33.32 34.70 36.20 37.84 39.64 41.63 43.83 46.29 49.04

6.9% 32.91 34.27 35.75 37.37 39.15 41.11 43.28 45.71 48.43

7.1% 32.50 33.84 35.30 36.90 38.66 40.59 42.74 45.14 47.82

7.4% 32.10 33.42 34.86 36.44 38.18 40.09 42.21 44.57 47.22

7.6% 31.70 33.01 34.43 35.99 37.70 39.59 41.68 44.02 46.63

7.9% 31.31 32.60 34.01 35.55 37.24 39.10 41.17 43.47 46.05

8.1% 30.92 32.20 33.59 35.11 36.78 38.62 40.66 42.93 45.48

Dis

cou

nt

Rat

e

(WA

CC

)

Sensitivity - Terminal EBITDAR vs. WACC and Implied Share Price from DCF Analysis:

Terminal FCF Growth Rate

3843.1% 5.3 x 5.6 x 5.8 x 6.1 x 6.3 x 6.6 x 6.8 x 7.1 x 7.3 x

6.1% 33.74$ 35.19$ 36.64$ 38.10$ 39.55$ 41.00$ 42.45$ 43.91$ 45.36$

6.4% 33.50 34.94 36.38 37.82 39.27 40.71 42.15 43.59 45.04

6.6% 33.26 34.69 36.12 37.55 38.99 40.42 41.85 43.28 44.71

6.9% 33.02 34.44 35.86 37.29 38.71 40.13 41.55 42.97 44.40

7.1% 32.78 34.20 35.61 37.02 38.43 39.85 41.26 42.67 44.08

7.4% 32.55 33.95 35.36 36.76 38.16 39.56 40.96 42.37 43.77

7.6% 32.32 33.71 35.10 36.50 37.89 39.28 40.67 42.07 43.46

7.9% 32.09 33.47 34.86 36.24 37.62 39.00 40.39 41.77 43.15

8.1% 31.86 33.24 34.61 35.98 37.36 38.73 40.10 41.48 42.85

Dis

cou

nt

Rat

e

(WA

CC

)

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

Capacity Expansion (ASM)

1.5% 2.5% 3.5% 4.5% 5.5% 6.5% 7.5% 8.5% 9.5%

-4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0%

25.00$ 1.21$ 37.46$ 38.74$ 40.02$ 41.30$ 42.58$ 43.86$ 45.14$ 46.42$ 47.71$

30.00$ 1.30$ 36.45 37.72 39.00 40.27 41.54 42.82 44.09 45.36 46.64

35.00$ 1.39$ 35.45 36.71 37.98 39.24 40.51 41.77 43.04 44.30 45.57

40.00$ 1.48$ 34.44 35.70 36.95 38.21 39.47 40.73 41.98 43.24 44.50

45.00$ 1.57$ 33.43 34.68 35.93 37.18 38.43 39.68 40.93 42.18 43.43

50.00$ 1.66$ 32.43 33.67 34.91 36.15 37.39 38.64 39.88 41.12 42.36

55.00$ 1.75$ 31.42 32.65 33.89 35.12 36.36 37.59 38.83 40.06 41.30

60.00$ 1.84$ 30.42 31.64 32.87 34.09 35.32 36.55 37.77 39.00 40.23

65.00$ 1.93$ 29.41 30.63 31.84 33.06 34.28 35.50 36.72 37.94 39.16

Jet

Fuel

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

Passenger Revenue per ASM (PRASM)

-3.5% -3.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.0% 0.5%

-2.0% -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0%

25.00$ 1.21$ 34.15$ 36.22$ 38.32$ 40.44$ 42.58$ 44.74$ 46.92$ 49.12$ 51.34$

30.00$ 1.30$ 33.11 35.19 37.28 39.40 41.54 43.70 45.88 48.08 50.31

35.00$ 1.39$ 32.07 34.15 36.25 38.37 40.51 42.67 44.85 47.05 49.27

40.00$ 1.48$ 31.03 33.11 35.21 37.33 39.47 41.63 43.81 46.01 48.23

45.00$ 1.57$ 30.00 32.08 34.17 36.29 38.43 40.59 42.77 44.97 47.19

50.00$ 1.66$ 28.96 31.04 33.14 35.25 37.39 39.55 41.73 43.93 46.16

55.00$ 1.75$ 27.92 30.00 32.10 34.22 36.36 38.52 40.70 42.90 45.12

60.00$ 1.84$ 26.89 28.96 31.06 33.18 35.32 37.48 39.66 41.86 44.08

65.00$ 1.93$ 25.85 27.93 30.03 32.14 34.28 36.44 38.62 40.82 43.04

Jet

Fuel

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

Fuel Efficiency

-5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0%

$120,862 -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0%

$123,884 2.5% 45.89$ 45.57$ 45.25$ 44.92$ 44.60$ 44.28$ 43.96$ 43.63$ 43.31$

$125,092 3.5% 44.39 44.07 43.75 43.42 43.10 42.78 42.46 42.13 41.81

$126,301 4.5% 42.86 42.54 42.22 41.90 41.57 41.25 40.93 40.60 40.28

$127,510 5.5% 41.31 40.99 40.66 40.34 40.02 39.69 39.37 39.05 38.72

$128,718 6.5% 39.72 39.40 39.08 38.75 38.43 38.11 37.79 37.46 37.14

$129,927 7.5% 38.11 37.79 37.46 37.14 36.82 36.49 36.17 35.85 35.53

$131,136 8.5% 36.47 36.14 35.82 35.50 35.17 34.85 34.53 34.21 33.88

$132,344 9.5% 34.79 34.47 34.15 33.83 33.50 33.18 32.86 32.53 32.21

$133,553 10.5% 33.09 32.77 32.45 32.12 31.80 31.48 31.16 30.83 30.51

Ave

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Per

-em

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yee

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ense

33 | P a g e

Appendix 21: Adjusted Total Capital Calculation

Appendix 22: EVA & EBITDAR Calculation

Adjusted Total Capital Calculation FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

PV of Long-term Capital Leases Obligations: 334

Capitalized Leases: 3,689 2,746 2,801 2,857

Change in Capitalized Leases: (943) 55 56

YoY Growth 2.0% 2.0%

Debt Outstanding: 1,995 1,689 2,091 3,661 3,515 3,380 3,751 3,154 2,820 2,692 3,177 2,863 3,852 3,564

Cash: 2,280 1,390 2,213 1,368 1,114 1,261 829 1,113 1,355 1,282 1,582 1,080 1,742 1,239

Adjusted Debt Outstanding: 3,684 3,310 3,601 5,184 4,864 5,128 5,485 7,218 5,862 5,335 6,866 5,609 6,653 6,421

Equity Value: 6,675 6,449 6,941 4,953 5,466 6,237 6,877 6,992 7,336 6,775 7,358 7,953 8,064 8,053

Total Capital: 8,079 8,369 8,329 8,769 9,216 10,104 11,533 13,097 11,843 10,828 12,642 12,482 12,974 13,234

Reported ROIC: 5.6% 7.0% 5.6% 3.3% 1.8% 6.5% 4.5% 4.8% 8.4% 15.0% 24.2% 23.0% 17.4% 15.9%

Normalized ROIC: -0.5% 2.3% 0.7% -4.8% 0.5% 6.6% 5.5% 4.8% 8.0% 14.9% 24.1% 23.0% 17.4% 15.9%

WACC: 7.6% 7.6% 7.6% 7.6% 7.6% 7.6% 7.6% 7.6% 7.6% 7.6% 7.1% 7.1% 7.1% 7.1%

Adjusted ROIC: 0.7% 3.2% 2.1% -3.4% 1.8% 7.1% 6.1% 4.4% 8.4% 14.9% 20.3% 21.4% 16.7% 15.2%

Spread: -7.0% -4.4% -5.6% -11.0% -5.8% -0.5% -1.5% -3.2% 0.8% 7.3% 13.2% 14.2% 9.6% 8.1%

Historical Enterprise Value & EVA FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

Enterprise Value: 12,524 12,032 8,074 6,854 9,353 8,951 8,298 8,763 14,209 29,603

Adjusted EBIT: 85 429 276 (475) 263 1,161 1,141 938 1,610 2,598 4,132 4,300 3,495 3,238

YoY Growth Rate 4.1% -18.7% -7.4%

Depreciation: 469 515 555 599 616 628 715 844 867 938 1,015 1,092 1,158 1,229

Depreciation on leased asset: 188 203 189 218 193 250 248 508 380 378 527 213 231 250

EBITDAR: 742 1,147 1,020 342 1,072 2,039 2,104 2,290 2,857 3,914 5,674 5,604 4,885 4,717

EBITDAR Margin: 9.8% 12.6% 10.3% 3.1% 10.4% 16.8% 13.4% 13.4% 16.1% 21.0% 28.9% 27.4% 23.3% 21.6%

EV/EBITDAR: 16.9 x 10.5 x 7.9 x 20.0 x 8.7 x 4.4 x 3.9 x 3.8 x 5.0 x 7.6 x

Average EBITDAR Ex-Outlier: 7.6 x -- 5.6 x

Economic Value Added: (562) (371) (463) (962) (538) (49) (170) (415) 97 787 1,663 1,778 1,244 1,066

34 | P a g e

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35 | P a g e

Appendix 24: Comparable Comps Analysis

AAL DAL JBLU ALK

American Airlines Group Delta Airlines JetBlue Alaska Air Group

FY 15 FY 15 FY 15 FY 15

Revenue: 40,990.0$ 40,704.0$ 6,416.0$ 5,598.0$

Cost of Sales:

Gross Profit:

Operating Expenses:

Operating Income (EBIT): 7,161.0 8,688.0 1,203.0 1,330.0

Interest and Other Income:

Pre-Tax Income: 6,172.0 8,184.0 1,082.0 1,344.0

Taxes:

Other Items:

Reported Net Income: 6,269.0 3,709.0 677.0 842.0

D&A from the CFS:

Rental Expenses: 1,391.0 157.0 235.0 206.0

Non-Recurring Charges:

Tax Rate: 37.0% 37.0% 37.0% 37.0%

EBITDA: 8,647 8,371 1,571 1,650

EBITDAR: 10,038 8,528 1,806 1,856

Balance Sheet Data Balance Sheet Data Balance Sheet Data Balance Sheet Data Balance Sheet Data

Less: Cash & Cash Equivalents: (9,583) (5,424) (1,132) (1,258)

Less: Equity Investments: - - - -

Less: Other Non-Core Assets, Net: - - (413) -

Less: Net Operating Losses: - (46) (446) -

Plus: Debt 20,561 8,329 2,458 710

Plus: Preferred Stock: - - - -

Plus: Noncontrolling Interests: - 360 - -

Plus: Unfunded Pension Obligations: 7,898 15,006 - 214

Plus: Capitalized Leases: 9,487 8,560 927 763

Plus: Other Liabilities: - - - -

Equity Research Projections Equity Research Projections Equity Research Projections Equity Research Projections Equity Research Projections

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

Bank: Fact Set Fact Set Fact Set Fact Set

Date:

Revenue: 40,990$ 40,930$ 42,733$ 40,704$ 40,804$ 42,031$ 6,416$ 6,930$ 7,539$ 5,598$ 5,862$ 6,250$

EBITDAR: 10,757 11,530 10,850 10,078 12,052 11,696 1,796 2,129 2,152 1,856 2,060 2,061

EBITDA: 8,647 9,613 9,041 8,371 10,559 10,373 1,561 1,959 2,012 1,650 1,865 1,900

Reported Net Income: 6,269 4,378 4,046 3,709 5,233 5,126 677 897 911 842 942 948

Diluted Shares Calculation Diluted Shares Calculation Diluted Shares Calculation Diluted Shares Calculation Diluted Shares Calculation

Share Price as of the Valuation Date: 38.99$ 44.29$ 21.31$ 70.40$

Common Shares Outstanding: 630.33 786.47 315.06 126.13

Options and Warrants:

Total Strike Dilution Total Strike Dilution Total Strike Dilution Total Strike Dilution

7.006 13.90$ 4.508 7.954 10.99$ 5.981 5.977 12.38$ 2.505 1.920 21.57$ 1.332

0.000 0.000 2.552 8.04$ 1.589 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

Convertible Bonds: $ Amount Par Value Conv. Price Dilution $ Amount Par Value Conv. Price Dilution $ Amount Par Value Conv. Price Dilution $ Amount Par Value Conv. Price Dilution

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

# RSUs Dilution # RSUs Dilution # RSUs Dilution # RSUs Dilution

Restricted Stock Units (RSUs): 21.342 21.342 5.010 5.010 3.785 3.785 0.000 0.000

Total Diluted Shares: 656.18 797.46 322.94 127.46

Valuation Metrics Valuation Metrics Valuation Metrics Valuation Metrics Valuation Metrics

Equity Value: 25,584.3$ 35,319.7$ 6,881.8$ 8,973.2$

Enterprise Value: 53,947.3$ 62,105.2$ 8,275.5$ 9,401.7$

Beta: 1.25 1.32 1.27 1.21

Valuation Multiples Valuation Multiples Valuation Multiples Valuation Multiples Valuation Multiples

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

EV / Revenue: 1.0 x 1.0 x 1.0 x 1.1 x 1.0 x 1.9 x 1.4 x 1.2 x 1.1 x 1.6 x 1.5 x 1.4 x

EV / EBITDAR: 5.0 x 4.7 x 5.0 x 6.2 x 5.2 x 5.3 x 4.6 x 3.9 x 3.8 x 5.1 x 4.6 x 4.6 x

EV / EBITDA: 5.0 x 4.3 x 4.6 x 5.3 x 3.7 x 3.5 x 5.7 x 4.2 x 3.9 x 5.5 x 4.8 x 4.6 x

P / E: 4.6 x 5.6 x 5.8 x 11.0 x 6.4 x 6.1 x 11.4 x 8.1 x 8.0 x 12.4 x 9.2 x 9.0 x

Lookup Variables Lookup Variables Lookup Variables Lookup Variables Lookup Variables

12/31/2015 Revenue: 40,990.0$ 40,704.0$ 6,416.0$ 5,598.0$

12/31/2015 EBITDAR: 10,757.0 10,078.0 1,796.0 1,856.0

12/31/2015 EBITDA: 8,647.0 8,371.0 1,561.0 1,650.0

12/31/2015 Reported Net Income: 6,269.0 3,709.0 677.0 842.0

12/31/2016 Revenue: 40,930.0$ 40,804.0$ 6,930.0$ 5,862.0$

12/31/2016 EBITDAR: 11,530.0 12,052.0 2,129.0 2,060.0

12/31/2016 EBITDA: 9,613.0 10,559.0 1,959.0 1,865.0


12/31/2017 Revenue: 42,733.0$ 42,031.0$ 7,539.0$ 6,250.0$

12/31/2017 EBITDAR: 10,850.0 11,696.0 2,152.0 2,061.0

12/31/2017 EBITDA: 9,041.0 10,373.0 2,012.0 1,900.0


FY 15 EV / Revenue: 1.0 x 1.1 x 1.4 x 1.6 x

FY 15 EV / EBITDAR: 5.0 x 6.2 x 4.6 x 5.1 x

FY 15 EV / EBITDA: 5.0 x 5.3 x 5.7 x 5.5 x

FY 15 P / E: 4.6 x 11.0 x 11.4 x 12.4 x

12/31/2016 EV / Revenue: 1.0 x 1.0 x 1.2 x 1.5 x

12/31/2016 EV / EBITDAR: 4.7 x 5.2 x 3.9 x 4.6 x

12/31/2016 EV / EBITDA: 4.3 x 3.7 x 4.2 x 4.8 x

12/31/2016 P / E: 5.6 x 6.4 x 8.1 x 9.2 x

12/31/2017 EV / Revenue: 1.0 x 1.9 x 1.1 x 1.4 x

12/31/2017 EV / EBITDAR: 5.0 x 5.3 x 3.8 x 4.6 x

12/31/2017 EV / EBITDA: 4.6 x 3.5 x 3.9 x 4.6 x

12/31/2017 P / E: 5.8 x 6.1 x 8.0 x 9.0 x

Adjusted D/E: 1053.5% 215.7% 149.7% 115.5%

36 | P a g e

UAL SAVE VA LUV

United Continental Spirit Airlines Virgin America Southwest Airlines Co.

FY 15 FY 15 FY 15 FY 15

37,864.0$ 2,139.0$ 1,534.0$ 19,647$

5,492.0 479.0 220.0 3,981

4,498.0 488.0 210.0

4,478.0 310.0 209.0 2,008

3,566.0 243.9 217.0

37.0% 37.0% 37.0% 38.0%

7,311 569 237 4,990

10,877 813 454 5,674

Balance Sheet Data Balance Sheet Data Balance Sheet Data Balance Sheet Data

(5,755) (749) (512) (3,050.30)

- - - -

- - - -

(82) - (3)

12,121 538 215 3,177

- - - -

- - - -

4,236 - - -

12,784 1,228 998 2,746

- - - -

Equity Research Projections Equity Research Projections Equity Research Projections Equity Research Projections

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

Fact Set Fact Set Fact Set

37,864$ 37,324$ 38,657$ 2,139$ 2,362$ 2,870$ 1,534$ 1,697$ 1,884$ 19,647$ 20,460$ 21,009$

10,040 10,026 9,625 813 920 897 794 809 879 5,674 5,604 4,885

7,311 7,656 7,389 569 592 675 237 310 304

4,478 3,118 3,023 310 293 321 209 230 193 2,008 2,375 1,890

Diluted Shares Calculation Diluted Shares Calculation Diluted Shares Calculation Diluted Shares Calculation

48.28$ 41.80$ 38.85$ 37.62$

372.81 71.54 43.91 675.99

Total Strike Dilution Total Strike Dilution Total Strike Dilution Total Strike Dilution

0.000 0.032 8.32$ 0.025 0.135 15.95$ 0.079 2.477 15.17$ 1.478

0.000 0.000 0.913 15.95$ 0.538 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

$ Amount Par Value Conv. Price Dilution $ Amount Par Value Conv. Price Dilution $ Amount Par Value Conv. Price Dilution $ Amount Par Value Conv. Price Dilution

0.000 0.000 0.000 0.000

0.000 0.000 0.000 0.000

# RSUs Dilution # RSUs Dilution # RSUs Dilution # RSUs Dilution

4.500 4.500 0.364 0.364 0.636 0.636 2.077 2.077

377.31 71.93 45.16 679.55

Valuation Metrics Valuation Metrics Valuation Metrics Valuation Metrics

18,216.5$ 3,006.6$ 1,754.5$ 25,564.6$

41,520.4$ 4,023.1$ 2,455.9$ 28,434.7$

1.20 1.17 1.09 1.11

Valuation Multiples Valuation Multiples Valuation Multiples Valuation Multiples

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

1.8 x 1.7 x 1.6 x 1.5 x 1.6 x 1.5 x 1.9 x 1.8 x 1.9 x 1.4 x 1.4 x 1.4 x

4.1 x 4.1 x 4.3 x 4.9 x 4.4 x 4.5 x 3.1 x 3.0 x 2.8 x 5.0 x 5.1 x 5.8 x

3.9 x 3.2 x 3.1 x 5.6 x 6.3 x 6.1 x 6.0 x 4.2 x 4.3 x 5.0 x 5.1 x 5.8 x

4.8 x 5.3 x 5.3 x 9.2 x 10.0 x 9.3 x 7.7 x 6.4 x 6.3 x 12.7 x 10.8 x 13.5 x

Lookup Variables Lookup Variables Lookup Variables Lookup Variables

37,864.0$ 2,139.0$ 1,534.0$ 19,646.9$

10,040.0 813.0 794.1 5,673.7

7,311.0 569.0 237.0 -

4,478.0 310.0 209.0 2,008.2

37,324.0$ 2,362.0$ 1,697.0$ 20,459.8$

10,026.0 919.6 809.0 5,604.5

7,656.0 592.0 310.0 -

3,118.0 293.0 230.0 2,375.0

38,657.0$ 2,870.0$ 1,884.0$ 21,008.9$

9,625.0 896.6 878.8 4,884.6

7,389.0 675.0 304.0 -

3,023.0 321.0 193.0 1,890.5

1.8 x 1.5 x 1.9 x 1.4 x

4.1 x 4.9 x 3.1 x 5.0 x

3.9 x 5.6 x 6.0 x 5.0 x

4.8 x 9.2 x 7.7 x 12.7 x

1.7 x 1.6 x 1.8 x 1.4 x

4.1 x 4.4 x 3.0 x 5.1 x

3.2 x 6.3 x 4.2 x 5.1 x

5.3 x 10.0 x 6.4 x 10.8 x

1.6 x 1.5 x 1.9 x 1.4 x

4.3 x 4.5 x 2.8 x 5.8 x

3.1 x 6.1 x 4.3 x 5.8 x

5.3 x 9.3 x 6.3 x 13.5 x

358.4% 218.9% 274.7% 70.5%

37 | P a g e

Appendix 25:

Appendix 26: Reinvestment Need Calculation

Liquidation Valuation - Southwest Airlines Co.Condensed Consolidated Balance Sheet as of December 31, 2015

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

Southwest Airlines Co. - Liquidation Valuation Based on 12/31/2015 Balance Sheet

Assumed Recovery Liquidation Value

FY 2015 Low - High Low - High

Assets

Current Assets:

Cash and Cash Equivalents: 1,582$ 95.0% 100.0% $1,503 $1,582

Short-Term Investments: 1,468$ 90.0% 95.0% $1,322 $1,395

Accounts and other receivables: 474$ 95.0% 100.0% $450 $474

Inventories of parts and supplies, at cost: 311$ 90.0% 95.0% $280 $295

Prepaid Expenses & Other Current Assets: 188$ 90.0% 95.0% $170 $179

Total Current Assets: 4,024$ $3,724 $3,925

Flight equipment 19,462$

Ground property and equipment: 3,219$

Deposits on flight equipment purchase contracts: 1,089$

Assets constructed for others: 915$

24,685$

Less allowance for depreciation and amortization: 9,084$

Net PP&E: 15,601$ 90.0% 95.0% $14,040 $14,821

Goodwill: 970$ 0.0% 0.0% $0 $0

Other Long-Term Assets: 717$ 68.4% 73.6% $491 $528

Total Assets: 21,312$ 18,255$ 19,274$

Liabilities

Current Liabilities:

Accounts Payable: 1,188$ 1,188 $1,188

Accrued Liabilities: 2,591$ $2,591 $2,591

Air Traffic Liability: 2,990$ 2,990$ 2,990$

Total Current Liabilities, ex. Current Debt: 6,769$ 6,769 $6,769

Long-term debt: 3,177$ $3,177 $3,177

Deferred income taxes, net: 2,490$ $2,490 $2,490

Construction obligation 757$ $757 $757

Deferred gains from sale and leaseback of aircraft -$ $0 $0

Other non-current liabilities 760$ $760 $760

Total Liabilities: 13,953$ $13,953 $13,953

Value Available to Shareholders: 4,302$ 5,320$

Per Share Value: 6.33$ 7.83$

Reinvestment Rate and Payout Ratio Calculation FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

CapEx: 1,146 1,399 1,331 923 585 493 1,218 1,598 1,697 1,998 2,041 2,000 2,100 2,200

Depreciation: 657 718 744 817 809 878 963 1,352 1,247 1,316 1,542 1,305 1,390 1,479

Change in NOWC: 857 111 1,322 (2,360) 184 216 292 749 811 48 366 205 502 723

Reinvestment: 1,346 792 1,909 (2,254) (40) (169) 547 995 1,261 730 866 900 1,212 1,445

After-tax Adjusted EBIT

Reported: 546 659 597 391 276 714 515 468 983 1,540 2,542 2,666 2,167 2,008

Normalized: 53 266 171 (294) 163 720 708 582 998 1,611 2,562 2,666 2,167 2,008

Annual Reinvestment Rate: 2544.5% 297.7% 1114.7% 765.9% -24.4% -23.4% 77.3% 171.1% 126.3% 45.3%

Average Reinvestment Rate: 102.8% 79.4%

38 | P a g e

Appendix 27: Comprehensive Ratio Analysis

Appendix 28: Fuel Hedging

Over the past 15 years, Southwest has been able to maintain effective hedging positions. In 2015, jet fuel and oil accounted

for approximately 23% percent of the company’s operating expenses. While the price of oil and jet fuel dropped significantly

in the second half of the year, changes in oil prices still represent still represent a significant risk for the company’s

profitability. Fuel derivative contracts--which are based on heating oil, Brent, and WTI—are used to offset the change in jet

fuel prices. Due to the high degree of volatility that can occur in a relatively short amount of time, the company utilizes a

variety of instruments in order to effectively hedge risk. These instruments are varied in terms of the price points in which

they protect against, which may result in the company not realizing adequate protection if the price swings are large. When

this occurs, Southwest may also have to post cash collateral to its counterparties which may impact liquidity and financial

position.

Southwest uses what they call an “economic” hedge, which is the net effect of all fuel derivative contracts purchased. Call

options, collar structures, call spreads, put spreads, and fixed price swap agreements are all instruments that they use to

effectively hedge against price fluctuations. Last year, Southwest hedged 15 percent of its fuel consumption and posted

hedging losses of $544m last year. This was primarily due to the unforeseen oil price drop, as their hedge positions locked

the company in at higher, forcing them to post cash collateral to their counterparties accounts.

Looking forward, Southwest is hedged approximately for ~20% of their fuel consumption in 2016, 65% in 2017, and 35% in

2018. These are likely to change as the contract settlement dates approach because Southwest continuously monitors its

hedge positions and accounts for the current fuel prices that they expect to see. These hedge positions will also affect

earnings as they change in fair value over time, shifting the derivatives into either asset or liability positions.

Financial Ratios FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15 FY16E FY17E FY18E

Profitability Ratios

Return on Assets N/A 3.2% 3.9% 1.1% 0.6% 2.8% 1.0% 2.0% 3.4% 5.1% 8.5% 9.5% 7.4% 6.6%

Return on Equity 9.0% 7.6% 9.6% 3.0% 1.9% 7.8% 2.7% 6.1% 10.5% 16.1% 28.4% 31.0% 23.6% 22.0%

Return on Invested Capital 0.7% 3.2% 2.1% -3.4% 1.8% 7.1% 6.1% 4.4% 8.4% 14.9% 20.3% 21.4% 16.7% 15.2%

Efficiency Ratios

Total Asset Turnover 0.5 x 0.6 x 0.6 x 0.7 x 0.7 x 0.7 x 0.9 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x 0.8 x

Fixed Asset Turnover 0.8 x 0.8 x 0.8 x 0.9 x 0.8 x 1.0 x 1.2 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 x 1.1 x 1.0 x

Accounts Receivable Turnover 30.0 x 36.4 x 37.9 x 45.2 x 54.8 x 66.5 x 63.4 x 54.2 x 47.1 x 47.5 x 46.8 x 42.5 x 42.4 x 42.6 x

DSO 12.2 10.0 9.6 8.1 6.7 5.5 5.8 6.7 7.7 7.7 7.8 8.6 8.6 8.6

Inventory Turnover 45.6 x 45.1 x 37.8 x 44.6 x 42.1 x 41.7 x 39.7 x 32.7 x 30.5 x 34.8 x 41.1 x 42.8 x 42.3 x 41.7 x

DIO 8.0 8.1 9.6 8.2 8.7 8.7 9.2 11.1 12.0 10.5 8.9 8.5 8.6 8.8

Accounts Payable Turnover 13.9 x 12.8 x 11.9 x 14.4 x 12.6 x 13.0 x 14.4 x 13.2 x 12.1 x 20.3 x 11.2 x 11.6 x 11.8 x 11.6 x

DPO 26.3 28.5 30.7 25.3 28.9 28.0 25.3 27.6 30.1 17.9 32.5 31.6 31.0 31.4

CCC (6.1) (10.4) (11.5) (9.0) (13.6) (13.8) (10.4) (9.7) (10.4) 0.2 (15.8) (14.5) (13.7) (14.1)

Margin Analysis

Gross Margin 13.7% 17.9% 15.6% 6.6% 13.7% 20.0% 18.4% 16.6% 19.4% 24.4% 31.6% 31.3% 27.1% 25.8%

SG&A Margin 15.9% 14.6% 14.5% 12.6% 12.9% 11.8% 12.0% 11.9% 12.0% 11.9% 11.4% 12.0% 12.0% 12.0%

EBITDAR Margin 9.8% 12.6% 10.3% 3.1% 10.4% 16.8% 13.4% 13.4% 16.1% 21.0% 28.9% 27.4% 23.3% 21.6%

EBIT Margin 1.1% 4.7% 2.8% (4.3%) 2.5% 9.6% 7.3% 5.5% 9.1% 14.0% 21.0% 21.0% 16.6% 14.8%

Net Income Margin 6.4% 5.5% 6.5% 1.6% 1.0% 3.8% 1.1% 2.5% 4.3% 6.1% 10.2% 11.6% 9.0% 8.1%

Short Term Liquidity

Current Ratio 0.9 x 0.9 x 0.9 x 1.0 x 1.3 x 1.3 x 1.0 x 0.9 x 0.8 x 0.7 x 0.6 x 0.5 x 0.5 x 0.4 x

Quick Ratio 0.9 x 0.8 x 0.9 x 1.0 x 1.2 x 1.2 x 0.9 x 0.8 x 0.7 x 0.7 x 0.5 x 0.4 x 0.4 x 0.3 x

Cash Ratio 0.8 x 0.7 x 0.8 x 0.7 x 1.0 x 1.1 x 0.7 x 0.6 x 0.6 x 0.5 x 0.5 x 0.3 x 0.4 x 0.3 x

Coverage Ratios

Total Debt/EBITDAR 2.7 x 1.5 x 2.1 x 10.7 x 3.3 x 1.7 x 1.8 x 1.4 x 1.0 x 0.7 x 0.6 x 0.5 x 0.8 x 0.8 x

Net Debt/EBITDAR NM NM NM 5.4 x 0.9 x NM 0.3 x 0.1 x NM NM 0.0 x 0.1 x 0.1 x 0.2 x

EBITDAR/Interest Expense 8.9 x 14.9 x 14.8 x 3.3 x 6.5 x 13.7 x 11.6 x 18.2 x 26.7 x 36.6 x 63.7 x 43.1 x 35.7 x 28.5 x

EBIT/Interest Expense 1.0 x 5.6 x 4.0 x NM 1.6 x 7.8 x 6.3 x 7.4 x 15.0 x 24.3 x 46.4 x 33.1 x 25.6 x 19.6 x

Leverage Ratios

Total Debt/Equity 55.2% 51.3% 51.9% 104.7% 89.0% 82.2% 79.8% 103.2% 79.9% 78.8% 93.3% 70.5% 82.5% 79.7%

Total Debt/Capital 45.6% 39.6% 43.2% 59.1% 52.8% 50.8% 47.6% 55.1% 49.5% 49.3% 54.3% 44.9% 51.3% 48.5%

Total Liabilities/Total Assets 46.7% 46.5% 53.8% 58.1% 55.5% 53.0% 55.9% 50.7% 53.1% 57.9% 55.8% 56.8% 59.0% 59.7%

39 | P a g e

Appendix 29: Yield Management System

Southwest Airlines uses a yield management system to optimize capacity and route expansions by making adjustments to

its flight schedules. Using the profitability tools, the company adjusts frequencies in existing markets and ensures that

aircraft which underutilized be redeployed to other markets.

Appendix 30: Route Analysis

0 50 100 150

Chicago, IL

Las Vegas, NV

Baltimore, MD

Denver, CO

Phoenix, AZ

Other

Top Domestic Markets By Millions of Passenger's 2013-14

2014-2015 2013-2014

40 | P a g e

Appendix 31: Chase Credit Card Deal

Southwest's co-branded Chase credit card is integral to the expansion of their Rapid Rewards program. The credit card

allows consumers to earn points which they can then use towards free flights, hotels, and restaurant services who are

partners with the company.

Appendix 32: Airlines Alliance

Since the turn of new century, Airlines have worked closely with one another in the form of Alliances. An airlines alliance

is an agreement between carriers to coordinate networks, schedules, and sometimes operations. Currently there are three

major alliances; Oneworld, SkyTeam, and Star Alliance. These global alliances benefit travelers by lowering costs, including

more destinations, and enhanced frequent flier programs. Star Alliance is the largest alliance with 27 participating carriers,

followed by Oneworld with 16, and SkyTeam with 14. Star Alliance is the oldest alliance, serving over 192 countries. The

group has a large presence in North America (United Airlines), Europe (Lufthansa), and Asia (Air China). Sky Team, with

only 14 current members, serves just as many countries at 187. It has regional presence in North America (Delta), Europe (Air

France), and China (China Southern). This alliance was founded in 2000 making it the oldest alliance out of the three.

Oneworld was founded in 1999 and is the smallest alliance as measured by revenue, which totals 141.4 b. Its major airlines

include American Airlines, British Airways, and Japan Airlines.

Appendix 33: Airline Deregulation Act

In 1978, the Airline Deregulation Act shifted control of the airline industry from the government back to the market. The

objective of this law was to remove government control over fares, routes, and market entries from commercial aviation.

Deregulation effectively opened up the airline industry to competition which provided new opportunities for new and

existing players while also lowering fares for consumers. The Civil Aeronautics Board (CAB), the agency whom previously

regulated the industry, was phased out in 1984.

Appendix 34: Wright Amendment

The Wright Amendment of 1979 was a federal mandate that limited the amount of flying that could be done out of Dallas

Love Field. This federal law, limited non-stop flights from Love Field to destinations within Texas and neighboring states, to

promote the larger Dallas-Fort Worth International Airport (DFW). In 1997 and 2005 the government repealed some of the

restrictions, before voting to repeal the entire bill in 2006. Although the bill was repealed in 2006, some restrictions were left

in place until October 13, 2014.

0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%80.00%90.00%

100.00%

Southwest ExpressJet Virgin America Delta Other

Dallas Love Field Market Share Oct. 2013-Oct. 2014

2013-2014 2014-2015

41 | P a g e

Appendix 35: Channel Check & Other Relevant Materials

Southwest Airline Pilot Association (SWAPA) Channel Check

We reached out to a member of SWAPA to get a better understanding about the current labor situation at Southwest. We

informed him of our intended use and made it clear to only share information that was available to the public. He permitted

us to use the conversation below but wished to remind anonymous. The details per our email conversation are below.

UTD CFA Team

1. “Will the election of the new union president slow down the current negotiations? Does he have a different view than the

previous president about what kind of deal should be reached?”

2 “.I saw that 60% of the pilots rejected a 17.6% increase. How far apart are the pilots and management in regards to reaching

an agreement that accommodates both sides?”

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

forward?”

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

5. “How strong do you foresee demand to be for new pilots as Southwest continues to grow? Please let me know if you need

any clarification and look forward to hearing from you. Best Regards, James”

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

SWAPA Pilot: James, Great subject to choose and certainly good timing. Years ago, i did my Undergraduate Thesis on

Southwest Airlines. Boy have things changed. I am going to answer your questions right now. In order to give you a more

detailed understanding, I want to start off with a 30,000 foot view and then fine tune the rest of the discussion with details.

James, first and foremost, if you ever had the chance to read the book, NUTS, it is a fantastic book. It truly offers insights on

the way Southwest used to be. Everyone loved Herb and he was an amazing leader. Southwest has fallen victim to Corporate

Greed and has disregarded many of the principles that made Southwest a great company to work for. Why this is important

will be revealed shortly. For now, just know that this is the first time in Southwest's history that the pilot group has gone this

long without a contract based on true value. Yes, Southwest is a great company to work for and i am proud to be here. The

original leaders at Southwest believed that if you take care of the Internal Customers (the employees), then the External

customers (passengers) will always be taken care of. For us here, it’s more about how we are treated. Now, in an effort to

keep cost low, the company maintains a "flattish contract" mentality and refuses to acknowledge all the sacrifices we made

over the last several years. We don't begrudge Southwest for being successful, we just feel that it is only fair to compensate

us accordingly for all of our hard work and contributions towards that success. Unfortunately, the last contract offer was

extremely inadequate. You don't get what you deserve, you only get what you negotiate. That is why we turned the last

contract down and why we replaced the negotiating committee and the President. After September 11th, ALL of the airlines

suffered financially except a rare few. Southwest was one of them. They did well because they had a dedicated employee

group willing to do whatever it took to keep the airline flying. Unfortunately for the others, their contracts were gutted. As

you start to understand the big picture, let me say this. Southwest is my 5th airline and again, i am proud and happy to be

here. The company has never furloughed employees, especially pilots and has always been profitable. Our compensation

package is more than just about money. Its retirement, Medical, travel benefits etc. After almost 4 years of negotiating, under

the best of economic times and unprecedented profits, it is truly unfortunate that we dont have an agreement that represents

a significant gain in all of those areas. Our last agreement was grossly inadequate and we were asked to give up a lot for very

42 | P a g e

little gain. It is Management's job to keep costs low and its our job to reestablish our profession by seeking what we are truly

worth. We are often looked at as greedy pilots who work very little and get paid a lot. This perception has been around

forever. This is an entirely different discussion. I may offer some insight on that too later but its important to understand that

the Management Employee relationship is no different here than anywhere else in Corporate America. There is a huge

difference between Leadership and Management too, which again, is important to understand but I will save that for later.

SWAPA Pilot: To answer your questions....

SWAPA Pilot: 1. The new President of SWAPA, Jon Weaks, used to be our Union President back in 2000. He is a good man

and the perfect person for the job. He's already demonstrated great leadership, as evidenced by our informational picketing

yesterday in Dallas, where over 300 pilots silently, and professionally displayed our displeasure with stalled negotiations.

The process has to take its course due to not only a new President but an entirely new negotiations committee. However, we

ramped up rather quickly and are ready to get back to negotiating a new agreement, beginning in March. Even though we

could meet with the company sooner, we are bound by the process set forth by our Mediator. That is ok too because by the

time negotiations begin again, the other Airlines, ie Delta, American and United will have or already have new agreements

in place which compensate their pilots well. Jon does indeed have a different view and has cleared up much of the

dysfunction from our previous group. Our last group did their best but did things on a regular basis that was not consistent

with the pilot group's wishes. The contract that got voted down should have NEVER made it to the pilot group. They sent it

out in my opinion, out of frustration and lack of progress, to allow the group to vote on it. The President felt it was the best

we could get, despite the fact that a majority of the Board of Directors disapproved of it

2. Management and the pilot group were engaged in standard negotiations. They low ball us and we are looking for justifiable

improvements, based on what we call, " Industry Standard". In the past, the Company mentioned Industry Standard and

wanted to discuss compensation a few years ago based on this. Of course this is when the other airlines had horribly gutted

contracts because of bankruptcies and less than stellar economic conditions. Now, times are good, profits are soaring and the

other airlines have negotiated great contracts. Now, our Management is not willing to discuss Industry Standard. Go figure.

By the way, it seems like a massive pay raise. 17.6 percent raise in reality was barely a 1.5 percent increase over the life of the

contract. So by no means were we turning down a massive pay raise. Media always finds a way to spin the truth. In addition,

there was little to no gain in most of the contract but a lot of items we were asked to give up, such as International code

sharing and reduced flexibility in the way we create our schedules. A contract is only as good as the language in it. Poor

language makes it hard to enforce. Our retirement is grossly inadequate and not in line with Industry Standard. There were

many things that were inadequate so to answer your question, we are now pretty far apart in what we are seeking and what

the company has offered. In short, we are not asking for anything that is going to break the bank either. We simply want

what we should have, an industry leading contract that compensates us and allows us to share the success we helped create.

Yes, we get profit sharing and that is awesome but in terms of compensation, we are far apart for now I'm afraid. As i said,

you only get what you negotiate, not what you deserve.

3. James, there is very little cost associated with training pilots to fly International. Whatever costs the company pays to fly

International may be a lot, but just like our compensation package, it’s the cost of doing business. The pilot group has been

trained at minimal expense to fly International. It’s really not a factor on our end.

4. As i mentioned earlier, a compensation package has many components. The sad reality is that Insurance costs have

skyrocketed and the employees have taken a massive hit and have absorbed the costs. Inflation has hit all of us hard. Without

even a COLA, which was barely addressed in the last contract, everything costs more. So in many ways, our tentative contract

was concessionary. Profit sharing is not a guarantee and again, it’s nice to have but that money does not get touched until

retirement. Bottom line, we were not asking for anything unreasonable and so to answer your question, our negotiations

include the compensation package as a whole.

43 | P a g e

5. Southwest will continue to grow for the foreseeable future. That growth is driven by Domestic and International expansion.

For the pilot group, growth and hiring is always a good thing. I’ve been at 2 other companies where they shrunk the airline

and furloughed thousands of pilots. Our growth is driven my retirements (age 65) and expansion. The demand is strong.

This year they plan on hiring 650 pilots and probably close to that for the next few years. As we continue to grow, the demand

will continue. It’s a good time to be a pilot if you are interested :)

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

1. “You mentioned that the “17.6 percent raise in reality was barely a 1.5 percent increase over the life of the contract. I was

wondering if you could elaborate on the 1.5 percent a bit more? My general understanding is that it is 17% increase over 8

years. Is the union trying to match AA’s recent contract of 30% increase or maybe just the industry average of ~23% increase,

immediately effective next year instead of 8 years?”

2. “You talked about the growth driven by retirements and growth. I see that the U.S. will experience massive retirements as

the Baby Boomers age. Regarding Southwest, do you see the need for more pilots deriving more from aging pilots or from

growth? I appreciate your time and any thought on the issue you could share without the conflict of interest. And yes, I

would be happy to send you a copy of my work when I finish it! Thanks again, Best regards, James Nguyen”

SWAPA Pilot: “James, There were a few articles that led the public to believe that we turned down a massive pay raise. In

reality, we have been without a contract for 4 years plus the life of a new contract is 4 years. I won’t even mention that it takes

a long time to negotiate a new contract so what ever we agree to will be what we live with for between 4 and 7 years from

now. Now, the Tentative agreement initially offered a 3% raise then like 2% a year. Considering this is over 8 years and COLA

is approximately -2 - 2.9 %, those raises are barely cost of living increases. It may have been acceptable if other areas in the

agreement were better but even when those new rates, we still would not be making industry standard rates, especially after

American, United and Soon to be Deltas new rates are in place. So yes, we are looking very closely at the other airlines now.

The dynamics of how much the company will be willing to pay is is complex. One of the factors is our competition's pay rates

so in effect, when the company delayed or stalled negotiations, it only made it harder for them to justify not offering us

higher pay. New they are making Billions under decent economic times and it's time to settle this. The culture is gone here

outside Head Quarters. All of the employee groups have seen the culture that Southwest always prided themselves on, go

down hill. As far as retirement go, timing is everything in life and especially in the airline business. Believe it or not, we have

a fairly young pilot group. We do have retirements but not as many as the other airlines have so growth is more of a factor

in how many they hire. Of course, unless they change the retirement age again, that's the only thing we can count on.

Southwest could easily shut hiring down if the economy tanked. For now they are growing based on expansion and

retirements but for now, mostly due to growth. As time goes on, we will begin to feel the effect of mass retirements.”

“One final thing. The airline industry has been dumbed down so much since September 11th. The amount of compensation

the average pilot made was shameful. Get on board a Regional Her and I bet you that most people don't realize what the

copilot is making, which is poverty wages. Southwest pilots are The Most productive pilots in the industry and that has to

be factored in. I just read some of the ignorant comments people made in response to our informational picketing. Truly sad.

No one questions what a doctor or lawyer makes or even to an extreme, what actors or sports figures make. The bottom line

is, for what we had to go thru to get here and what we endure every day to maintain our employment, we are grossly

underpaid in my opinion. Ask yourself what The Captain who landed in the Hudson was worth that day... Anyway, hope

this helps. Again, feel free to ask any other questions.”

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