Southwest Airlines Valuation

Group 8 5/30/2023 MGMT 231C Final Project Southwest Airlines (LUV) – Valuation Analysis MGMT 231C Final Project Group 8: Eric Topp, Drew Eller, Kyle Mckenzie, Mark Korinek Basic Information Southwest Airlines is headquartered in Dallas, Texas and is a major passenger airline that provides scheduled air transportation to domestic and near-international destinations, primarily within North America, Central America, and the Caribbean. The company commenced operations in 1971, has experienced significant growth through a focus on “friendly, reliable, and low-cost air travel”. In recent years the company has operated over 4,000 flights per day, employed over 60,000 people, and generated over $23bn in revenue. Revenue Southwest generates revenue through 3 major sources, passenger revenue, freight revenue, and other revenue. Passenger revenue made up approximately 90% of total revenues for FY2022 and is driven by passenger purchase of tickets. Passenger ancillary revenue is also included within passenger revenue and includes purchases of EarlyBird Check-In, Upgraded Boarding, and transportation of unaccompanied minors and pets. Freight revenue is a small portion of overall revenue, is generally a byproduct of lower passenger demand, and is not an area of focus for the company. Other revenue is mainly attributed to the company’s co-branded Chase credit cards along with hotel and rental car partners. Target Market Southwest primarily serves budget-conscious consumers who are travelling domestically for leisure. Southwest occupies a middle ground between ultra-low cost domestic carriers (ULCCs) like Spirit, Allegiant, and Frontier, and differentiated international carriers like United, American, and Delta. Unlike ULCCs, Southwest includes free checked bags, carry-ons, complimentary beverages, no fee flight changes, and no expiration travel credits which allows for vertical differentiation and an increase in willingness to pay (WTP). In recent years the company has begun targeting business travelers as well. While Southwest will likely struggle to capture international business travelers due to limited international destinations, it could appeal to cost conscious businesses who primarily travel domestically and are looking for a low-cost, flexible partner. Competitive Advantages and Strategic Position Southwest occupies a niche within the airline industry that allows it to possess a narrow moat in a fiercely competitive industry. Southwest originally pursued a low-cost strategy through an operational ecosystem that allowed for rapid turnaround times. Rapid turnaround times enable more flights per aircraft per day and generate greater utilization of high fixed cost aircraft. The low-cost structure has persisted and is enabled by several points of differentiation including a point-to-point network, usage of a single aircraft type (Boeing 747), free checked bags, and an emphasis on the use of smaller airports in major markets. The use of a point-to-point network enables Southwest to offer more direct flights between pairs of cities than the traditional hub and spoke model which increases consumer WTP. The

Group 8 5/30/2023 MGMT 231C Final Project single aircraft type reduces the cost of maintenance, training, and inventory of spare parts due to economies of scale and greater interchangeability. Free checked bags and the use of smaller airports greatly reduce turn times through quicker loading and reduction of airport congestion, and when combined with efficient processes to onboard customers results in much greater asset utilization in an industry that is famous for its operating leverage. In recent years, new entrant ULCCs have been able to undercut Southwest’s low-cost competitive advantage by taking away frills that lower total cost by more than they lower certain customer segment’s WTP. Southwest’s response to this competitive threat has been to concede this lower-end segment to ULCCs and continue to focus on the segment of budget conscious customers who also value flexibility and customer service. In this transition, Southwest’s brand and reputation for customer service have been critical to differentiate their offering from ULCCs. The Rapid Rewards customer loyalty program has also been a source of competitive advantage to increase switching costs and create a stickier repeat customer. This strategic positioning has allowed Southwest to continue to generate a WTP that is closer to higher-end differentiated airlines but delivered at a total cost that is similar to ULCCs. Strengths and Risks to Competitive Position Southwest’s strengths lie in its full operational ecosystem to minimize total costs, which is difficult for incumbent competitors to replicate, as well as its brand and reputation. Overall Southwest faces far greater risks to its competitive position. As was evidenced in the disruption around Christmas of 2022, the benefits of a point-to-point network also bring significant downsides. When an outage impacts a wide swath of the US, Southwest struggles to place aircraft, pilots, and flight attendants where they’re needed to support flights. This large and ongoing disruption at a time of high demand and high consequences for consumers led to a significant negative reputational impact. For a company that effectively offers the same product as a myriad of competitors, Southwest can ill afford to erode its competitive reputational advantage. In our opinion Southwest took the correct steps to compensate travelers and communicate corrective actions. However, the business impact was material in the short term, the company will incur greater capital expenditures moving forward to prevent similar future challenges, and the company has limited ability to weather additional reputational impacts. In addition to the risks to brand and reputation, the airline industry remains fiercely competitive. Due to limited barriers to entry, high fixed costs and significant operating leverage there is always the potential for irrational economic actors to compete away profits or operate at significant losses while chasing marginal profits in the short run. Due to recent consolidation and bankruptcy the airline industry has become marginally less competitive, but new entrants could quickly reverse that dynamic. Likewise, supplier power is quite high. Southwest is fully reliant on a single supplier (Boeing) to manufacture aircraft and Boeing’s struggles with the Max8 aircraft have impacted Southwest’s COGS as they must continue to operate less fuel efficient, older aircraft. Southwest is also dependent on crude oil producers and refiners to deliver jet fuel which makes up ~20-25% of COGS. Refineries have been closing in the US for the last several decades and the OPEC cartel asserted significant control on oil prices until the shale boom of the 2010s. With more rational investment in shale properties, OPEC will likely regain past market influence and jet fuel prices could be negatively impacted or highly volatile. While Southwest hedges ~50% of their fuel exposure, the market could certainly move against them and reduce profits through increased COGS. Similarly, employees are largely (~83%) represented by organized labor and recent negotiations with pilots, flight attendants, and maintenance personnel have proven contentious.

Group 8 5/30/2023 MGMT 231C Final Project segment, and consumers in general have fewer funds available for conspicuous consumption following significant and widespread inflation. Lastly, Southwest currently carries a significant amount of cash on the balance sheet following equity and debt raises during the covid pandemic. To appropriately value the cash, we split the cash and short term securities into “required for operations” and “excess” categories. The “required for operations” i s modeled at 73.9% of the air-traffic (AT) liability and grows as revenue and AT liabilities grow over time. We believe this is an appropriate way to model the required cash balances. Southwests receives cash significantly ahead of providing services and must balance their recorded air-traffic liability with available short-term liquid assets. The operating cash portion is considered to be working capital and reduces FCF as the AT liabilities and revenues grow. The remaining short term liquid assets at end of FY2022 are considered “excess” and are added to the value of the operating business when determining firm value and equity value. The DCF valuation ranges from $14.2bn to $50.6bn. This range corresponds to an equity value of $12.3bn to $48.7bn or $19.70/sh to $77.98/sh compared to a current price of $29/sh. The full range of valuations is in the table below. The valuation is particularly sensitive to margin structure and the difference between a 2019 and 2022 cost environment has a large impact on the expected enterprise value. DCF Summary Capex Growth Margin EV ($bn) FV ($bn) Equity Value ($bn) Equity Value ($/sh) Scenario 1 Low Low Average $22.15 $28.35 $20.26 $32.42 Scenario 2 High High Average $24.40 $30.59 $22.51 $36.01 Scenario 3 Low Low High $40.26 $46.46 $38.37 $61.39 Scenario 4 High High High $50.63 $56.83 $48.74 $77.98 Scenario 5 Low Low Low $14.21 $20.40 $12.31 $19.70 Scenario 6 High High Low $18.72 $24.92 $16.83 $26.93 We believe our DCF is relatively conservative and that the most likely case is Scenario 2 (High Growth, Average Margin) which equates to fair value of $36.01/sh. We rate the equity as overweight and believe if Southwest can successfully control costs that the company could wind up being worth significantly more than the fair value calculated in Scenario 2. To note, within the last 12 months Southwest has traded as high as $45/sh and as low as $25/sh and may provide opportunities for intelligent buying and selling for enterprising active investors. Relative Valuation In order to calculate a relative valuation for Southwest Airlines, we decided to identify five key competitors in the airline industry: Jet Blue, United Airlines, American Airlines, Delta Air Lines, and Alaska Airlines. Across the panel, the companies operate in similar capacities and represent the

Group 8 5/30/2023 MGMT 231C Final Project dominant domestic flight operators in the United States. However, there are distinct characteristics to take into consideration, including hub locations and/or regional availability, target customer segment, scale of operations, and breadth of operations (namely, if they operate Internationally or have other sub-brands). The table below outlines some of the comparative factors we considered: Southwest Jet Blue United American Delta Alaska Hub City Dallas New York Chicago Dallas Atlanta Seattle Markets Served 109 94 140 120 143 86 Fleet Size 799 280 800 942 943 289 Passengers 129,938k 24,675k 64,690k 107,138k 101,204k 23,605k Flights (FY’22) 1,112k 221k 484k 778k 784k 203k Domestic Mkt Share 17.5% 5.3% 13.4% 18.6% 16.7% 5.3% Domestic Routes 106 67 238 269 213 107 Int’l Routes 15 41 80 81 91 16 Source: Bureau of Transportation Statistics, for FY ’22; Route info from Airways Mag In terms of size, the revenues and enterprise values of these companies vary, and we clearly needed to factor these considerations in to our comparative analysis. Additionally, the COVID-19 pandemic had a pronounced impact on the airline industry in particular, leading to massive losses in 2020 and 2021. As such, we were almost entirely dependent on 2022 results, as our initial attempts to analyze the airlines over a multi-year period resulted in negative revenues, and very skewed results. Even still, 2022 results may not completely represent recovery for airlines, particularly those that are dependent with International travel routes that may have remained limited into the year. Conversely, some analysts argue that the recovery seen in 2022 is not representative due to the significant refocus on travel by consumers. We feel that 2022 is a representative year for travel going forward, though not all airlines have recovered at the same rate. However, while we believe the market has priced in the recovery and positive trends, our relative valuation analysis is based on hard data around comparable ratios. As exemplified in Exhibit XX, we pulled financial data for the six companies for multiple years, including market cap, enterprise value, net income, and EPS. To evaluate Southwest against its competitors, we calculated several potential ratios that most pertain to the airline industry, and identified EV/EBITDA, EV/EBIT, P/E ratio, and P/S ratio. Across these four ratios, we calculated a minimum, median, and maximum to compare to Southwest’s competitors, and then multiplied these by the relevant Southwest data to see if the airline was being properly priced compared to the competition. Of note, we decided to exclude JetBlue from these calculations, as their Net Income remains negative as of YE 2022, and overall, their values were so low it made JetBlue an outlier altogether. Comparative Analysis Min Median Max SWA PPS at Min SWA PPS at Med SWA PPS at Max P/E 9.85 12.49 30.10 $11.29 $14.32 $34.50 EV / Revenue 0.56 0.80 0.89 $16.75 $25.93 $29.50 EV / EBITDA 3.73 6.19 9.50 $11.35 $21.83 $35.89 P/ S 0.25 1.38 4.20 $6.44 $13.16 $21.63