Southwest Airlines

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Memorandum From: To: Brandon Mills, Executive Director of the DD Investment Fund Date: 12th December 2012 Subject: Southwest Airlines-Analysis and Valuation The current memo outlines the analysis and valuation of Southwest Airlines along with sectoral trends in the US airline industry, its prospects for growth in the near future

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Overvie w of the US Airlines Industry and Growth Prospects In the last 20 years, capacity in the US airline industry has grown at a CAGR of 1.4 % to ~ 1,012 billion available seat miles while passenger traffic has grown at a CAGR of 2.7% to 826 billion revenue passenger miles. Thus capacity utilisation has steadily increased from 63% in the year 1990 to 82% in the year 2011. The mean capacity utilisation of the airline industry is 72% while the median stands at 71%. The historical trends over the last 20 years have been outlined in Annexure 1. Industry Revenue has grown @ 2.92% CAGR to ~104 bn $. The industry is only marginally profitable with average returns (Industry Operating Profit/Industry Assets) of merely 0.7% across the last 20 years. The trends in returns in outlined in Annexure 2. ROIC below WACC translates to loss of investor wealth. The Annexure 3 depicts the trend between Passenger Revenue and GDP (Source : MIT Airline Data Project) Annual U.S Domestic Average Itinerary Fare has grown at a CAGR of merely 1.38% from $292 to $ 364. However it registered healthy growth rates of 8.4% and 8.2% in 2010 and 2011. The market share of key players is set out in Anne xure 4 and 5. It may be seen that the top 5 players after the mergers - Delta Air Lines Inc., American Airlines Inc., United Air Lines + Continental, Southwest +Airtan and US Airways Inc. control 80% of the market. This shows signs of consolidation in the US industry. The factors that are at play in the current scenario are as follows: a) Economic trends are weak

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b) Consumer confidence is well below optimum levels c) Manufacturing activity showing little to no expansion d) Premium travel trends are exhibiting little growth The recent change in the ability of legacy airlines to generate revenues represents a structural change and cannot be considered cyclic. Whereas revenue per available seat mile (RASM) has become a most important industry benchmark, as load factors continue to increase, focus on yield, or revenue per revenue passenger mile, will be the critical metric to watch to signal a carrier’s success. In most cases, today’s fares are equal to fares charged in the mid 1990s. And the premiums that carriers could charge in markets where they had a significant market position have dissipated largely as the result of increased competition. The key to growth and profitability has been to diversify the route portfolio as has been adopted by the major airlines. (Annexure 5) There is a common view that the U.S. airline industry is likely to remain profitable over the next two decades given the improving worldwide trends in air travel. International traffic is expected to grow 4.2% per year, in contrast to US domestic trave l that will growth at a more modest clip of 2.7% annually. This projection assumes a steady economic recovery with no major calamities like a large rise in oil price, swings in macroeconomic policy or further financial meltdowns However, growth may be held back until 2015 because of the rising fuel costs and the aftereffects of the financial crisis in the in the U.S. and Europe. While macro economic factors and volatile energy prices are factors that are beyond the control of airlines, the key issue will be capacity cutting/discipline

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Southwest’s Business Model America's largest discount carrier has been a subject of interest for business travellers since its launch in 1971....
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