continental airlines valuation

Continental Airlines: Valuation Model & Expected Synergies

Zachariah Cheema Irina Surilova Yang Wang

Corporate Finance – FE820 Professor Allen Michel

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Introduction

In May 2010, United and Continental agreed to merge, thereby creating the world’s largest airline both in terms of flights offered and revenue generated. The announcement came on the heels of Delta’s 2008 merger with Midwest-based carrier Northwest Airlines. In an industry with high volatility, heavy capital investments, and extremely price sensitive customers, mergers as a way to improve costs and maximize revenue is certainly not surprising. However, valuating these types of industries comes at a great risk of incorrectly forecasting projected revenue growth compared to long-standing consumer goods firm (General Mills, SC Johnson). The goals of the paper are to:

1) Provide a valuation for Continental through the three principle methodologies: Comparable Company Multiples, Comparable Acquisitions Multiples, and the Discounted Cash Flow Model

2) Assess the valuation models and determine the most appropriate for Continental 3) Discuss the points of variability within the chosen model or a combination of models,

and examine the difficulties of airline ownership that financial models may hide 4) Look at some potential additional benefits from the merger of United and

Continental, both in terms of operational savings from scale and revenue generation through competitive advantages and heightened market power

Comparable Company Multiples

Analysis was performed using civil aviation firms most similar to Continental in terms of operational structure. The selected companies must have a hub-and-spoke system, or at least a system beyond single routes. The firms must have also international routes. Continental’s financial performance is heavily dependent upon global macroeconomic conditions, so the selected companies must also have this same exposure. Continental’s route system, with hubs in Houston and Newark, is less flexible for scaling-back during periods of weak demand. Domestic firms were utilized to take into account the heavy competition faced for US domestic flights vs. European or Latin American intra-nation travel. US Airways, American Airlines, United Airlines, Delta Airlines, and Alaska Airlines represent out selected companies.

The comparable company ratio was derived using Enterprise Value over Earnings before Interest and Tax. Enterprise Value comes from market capitalization (as of 12/31/2009) plus long-term debt less excess cash. We defined the dependent variables as follows:

a) Long-Term Debt: Defined as any interest-bearing obligation. Future aircraft purchases are excluded from the debt calculation, as the terms of these contracts vary and may be amendable, unlike a bank obligation

b) Excess Cash: Due to the heavy debt load within the aviation industry, excess cash is a nonfactor within the valuation model, as no airline will be able to maintain a high cash balance given the need for capital investment

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Our final enterprise value for Continental is set at $-1.67 billion based on comparable company analysis. However, we do not plan to factor the analysis into our final valuation price for the following reasons:

a) Negative EBIT for Continental: The comparable company model works best within industries with consistent positive net income every year. Continental posted negative EBIT in 2009, and thus according to the model, its value would be a multiple of a negative. The model is not dynamic enough to factor in changes year-to-year in profitability.

b) Domestic Recession: As a result of the domestic recession, 2009 was one of the worst performing years since industry deregulation. These numbers cannot be projected moving forward.

c) The Enterprise Value: Puts heavy emphasis on stock market valuation. Market investors are more likely to underinvest in the airline industry because it lacks the ability that other industries (i.e. pharmaceuticals) to grow exponentially based on new products. The industry is already saturated, and thus not a great source of investment.

Comparable Acquisition Analysis

In order to identify the relevant precedent transactions, we used Bloomberg to search for historical M&A transactions in the past five years prior to this acquisition (2005-2009). Because we only obtained data for four companies, we then expanded the time period to the past seven years (2003-2009). We narrowed our research to ensure that sellers and acquirers are all domestic airlines, and further refined for deals of at least $400 million. From the universe, we selected the following firms, and collected data in order to impute multiples as follows:

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We focused on the EV/EBITDA multiple, as we consider it most appropriate for firms in the airline industry sector. Based on the transactions and comparable companies, we do not believe these transaction multiples are appropriate to use. There is no similar transaction multiple, especially EV/EBITDA. The range from 6.64 to 157.07 is too large. Even if we delete the obvious outlier 157.07, the range from 6.64 to 29.06 is still not ideal.

To check the credibility of applying transaction multiples, we use the numbers of sales and EBITDA obtained from the 10-K, and these transaction multiples to calculate the enterprise value for Continental Airlines. Excluding the obvious outlier, the AirTran Holdings Inc. transaction, the enterprise value implied by EV/sales value is in the range of $23 billion to $37 billion, and the enterprise value implied by EV/EBITDA is in the range of $3.4 billion to $15.2 billion. The multiples of each transaction are not relative to each other, resulting in an unreasonably large range of implied enterprise values. There is no overlapping range between calculations based on EV/sales and EV/ EBITDA. Thus, we don’t believe applying transaction multiples can reflect the value of Continental Airlines.

Discounted Cash Flow (DCF)

The Discounted Cash Flow method is utilized to project the future cash flows for Continental Airlines. The financial projections detailed below are based on the previous three years of actual financials from the 2009 10-K statement (2007-2009), economic conditions within the airline Industry, and the market overall at the time of the merger evaluation.

Enterprise Value / Enterprise Value implied byLTM LTM LTM LTM

Acquirer Sales EBITDA Sales EBITDA

US Airways Group Inc 3.25 21.89 37388 11470.36

Delta Air Lines Inc 2 7.39 23008 3872.36

Mesa Air Group Inc 3.11 6.64 35777.44 3479.36

AirTran Holdings Inc 6.56 157.07 75466.24 82304.68

TPG Capital 2.79 29.06 32096.16 15227.44

Mean 3.54x 44.41x 40724.16 23270.84

Median 3.11x 21.89x 35777.44 11470.36

Enterprise Value / LTM Premiums PaidDate Purchase Equity Enterprise LTM LTM EBITDA Prior toAnnounced Acquirer Seller Consideration Value Value Sales EBITDA Margin annouced day

2006/11/15 US Airways Group Inc Delta Air Lines Inc/Old Cash and Stock 10079.1 19351.9104 3.25 21.89 14.80% N/A

2008/4/14 Delta Air Lines Inc Northwest Airlines LLC Stock 2754.82 1212.12 2 7.39 27.06% 20.25%

2003/10/6 Mesa Air Group Inc FLYi Inc Stock 488.74 865.07 3.11 6.64 46.78% 21.98%

2006/12/13 AirTran Holdings Inc Midwest Air Group Inc Cash and Stock 459.9 2110.94 6.56 157.07 4.17% N/A

2007/8/12 TPG Capital Midwest Air Group Inc Cash 441.79 777.55 2.79 29.06 9.61% 21.54%

Mean 3.54x 44.41x 21.26x

Median 3.11x 21.89x 21.54x

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Income Statement

Future revenue forecasts remain the most critical cog in the projection model, but due to the volatility of the industry, in particular 2009’s 19% decline in sales, it is not reliable to forecast simply based on prior year sales. The International Air Transport Association, the industry’s leading entity, forecasted 2010 growth earlier in the year1. Growth was broken down by region of activity, and in order to accurately reflect Continental’s growth, we weighed growth by region of activity. This is an important step because Continental has a large presence in Latin America (14% of revenue), and thus is better shielded from domestic and European slowdown. However, the IATA’s study focuses on regions of growth, whereas Continental breaks down revenue by flight. How can this be reconciled? According to the U.S. Bureau of Transportation Statistics, 47% of international flight passenger revenue came from domestic carriers vs. 53% for international carriers2. Assuming a perfectly competitive market where the consumer decides the carrier purely on price, 47% of Continental’s passengers on international flights will be domestic passengers. For example, when predicting the Latin American revenues, 47% of the growth will

Income Statement for Continental AirlinesUnited States Dollars in Millions, except per share

Historical Year Ending December 31, Projected Year Ending December 31,2007 2008 2009 2010 2011 2012 2013 2014

Operating Revenue $13,448 $14,234 $11,504 $12,274 $12,912 $13,392 $13,890 $14,407Passenger $12,995 $13,737 $11,138Cargo $453 $497 $366

Operating Expenses $11,361 $13,093 $10,318 $10,801 $11,233 $11,517 $11,807 $12,102Aircraft Fuel and related taxes $4,034 $5,919 $3,317wages, salaries, and related costs $3,127 $2,957 $3,137aircraft rantals $994 $976 $934regional capacity purchase, net $1,113 $1,059 $848landing fees and other rentals $790 $853 $841distribution costs $682 $717 $624maintenance, materials and repairs $621 $612 $617Gross Profit $2,087 $1,141 $1,186 $1,473 $1,679 $1,875 $2,084 $2,305

Other operating (income) / expense (3) $987 $1,017 $838 $896 $943 $978 $1,014 $1,052EBITDA $1,100 $124 $348 $577 $736 $897 $1,070 $1,253

Depreciation and Amortization $413 $438 $494 $483 $549 $570 $591 $613EBIT $687 ($314) ($146) $94 $187 $327 $479 $640

Interest expense $393 $376 $367 $373 $373 $373 $373 $373Other, net ($102) $70 ($62) $0 $0 $0 $0 $0Interest (income) ($160) ($65) ($12) $0 $0 $0 $0 $0

Pretax Income $556 ($695) ($439) ($279) ($186) ($45) $106 $267

Income taxes (benefit) $117 ($109) ($157) ($103) ($69) ($17) $39 $99Net Income $439 ($586) ($282) ($176) ($117) ($29) $67 $168

Diluted weighted average shares (in millions) 114 106 129 132 134 136 138 140

Earnings Per Share 4.05 ($5.54) ($2.18) ($1.33) ($0.88) ($0.21) $0.48 $1.20

Ratios & Assumptions 2007 2008 2009 2010 2011 2012 2013 2014Operating Revenue growth rate 5.8% (19.2%) 6.7% 5.2% 3.7% 3.7% 3.7%Gross Profit 15.5% 8.0% 10.3% 12.0% 13.0% 14.0% 15.0% 16.0%Other (as a % of operating revenue) 7.3% 7.1% 7.3% 7.3% 7.3% 7.3% 7.3% 7.3%Effective tax rate 21.0% 15.7% 35.8% 37.0% 37.0% 37.0% 37.0% 37.0%

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be based on US travel growth rate, and 53% will be based on Latin American travel growth rate. Other and Cargo also utilize solely the United States growth rate. In aggregate, the growth rate comes to 6.7% for 2010.

For operating revenue forecast for years 2011-2014, we looked at Airbus Inc.’s business report at the time of the merger. Airbus predicted twenty-year growth by region, with an aggregate traffic growth of 4.8%3. Once weights are applied based upon Continental’s travel destinations, we achieve a 3.7% growth rate to be applied from 2012 to 2014. 2011 serves as a bridge year between 2010’s rebound and the long-term traffic growth, so 5.2% was applied in 2011 to achieve a linear decline.

Future gross profit is calculated as a percentage of operating revenue. Starting in 2009, there has been a renewed pressure to bring up this metric at Continental Airlines, as detailed in the 10-K. Steps the company is taking in order to increase the gross profit percentage include adding fees for checked baggage and curbing in-flight amenities. The gross profit percentage has gone up in the past year, from 2008 to 2009, and we are projecting the increase to continue in the next five years at 1% a year. Operating Expenses are calculated as the remaining percentage of revenue (100%-gross profit % of operating revenue). Other expenses are kept constant at the rate calculated for 2009, since it has remained consistent over the last three years. Effective tax rate is assumed at the statutory tax rate of 35.0% (Federal) plus 2.0% (State) to serve as both a tax shield in years of losses and tax rate in years of profitability. These assumptions result in the projected Income Statement above.

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Balance Sheet

The Balance Sheet above was calculated mainly to forecast working capital for the cash flows and depreciation. Below are the assumptions used for working capital ratios. Continental has seen significant variation in its accounts receivable over the last three years, going from 14.6 days in 2007, to 11.6 days in 2008, and back up to 15.7 days in 2009. Our analysis keeps 15.7 days constant in the forecast model because we have no concrete basis to prove change in Continental’s collection time. However, it is possible, but not proven, that Continental will begin to lower its collection time based on technology upgrades and efficiencies within the system.

Inventory of spare parts and supplies and other current percentage assets are both kept at previous year levels, since there is no indication of a change in strategy. The short-term investments days available has been decreasing over the last three years, and thus we are projecting it to be lower in 2010 than in 2009, and constant for the four years following. Accounts payable days outstanding, accrued liabilities and air traffic and frequent flyer liability as a percentage of operating expenses have been left at previous year levels. Other current liabilities as a percentage of operating expenses is assumed at 5% over the next five years, about average rate from the last three years of actuals. These assumptions are applied to 2009 levels of working capital, and carried through the next five years of assumptions.

Balance Sheet for Continental AirlinesUnited States Dollars in Millions, except per share


Cash 2,128$ 2,165$ 2,546$ 1,981$ 2,058$ 2,193$ 2,426$ 2,764$ Short-term investments 675$ 478$ 310$ 303$ 318$ 330$ 343$ 355$ Accounts receivables, net 606$ 453$ 494$ 527$ 554$ 575$ 596$ 619$ Spare parts and supplies, net 271$ 235$ 254$ 271$ 285$ 296$ 307$ 318$ Restricted cash and st investments 179$ 190$ 164$ Deferred income taxes 259$ 216$ 203$ Other current assets 443$ 610$ 402$ 820$ 863$ 895$ 929$ 963$

Total Current Assets: 4,561$ 4,347$ 4,373$ 3,903$ 4,079$ 4,289$ 4,600$ 5,019$

PP&E, net 6,558$ 7,327$ 7,420$ 7,357$ 7,285$ 7,211$ 7,134$ 7,054$ Investment in other companies 775$ 804$ 778$ 778$ 778$ 778$ 778$ 778$ Other assets, net 211$ 208$ 210$ 210$ 210$ 210$ 210$ 210$

Total Assets: 12,105$ 12,686$ 12,781$ 12,248$ 12,352$ 12,488$ 12,722$ 13,061$

Accounts payable 1,013$ 1,021$ 924$ 967$ 1,006$ 1,031$ 1,057$ 1,084$ Accrued liabilities 817$ 1,053$ 635$ 665$ 691$ 709$ 727$ 745$ Air traffic and frequent flyer liability 1,967$ 1,881$ 1,855$ 1,942$ 2,020$ 2,071$ 2,123$ 2,176$ Other current liabilities 652$ 519$ 975$ 614$ 646$ 670$ 695$ 720$

Total Current Liabilities: 4,449$ 4,474$ 4,389$ 4,187$ 4,362$ 4,480$ 4,601$ 4,725$

Accrued Retiree Medical Benefits 769$ 1,651$ 1,464$ 1,464$ 1,464$ 1,464$ 1,464$ 1,464$ Defered Income Tax 359$ 216$ 203$ -$ -$ -$ -$ -$

Long-Term Debt and Capital Leases 4,366$ 5,353$ 5,291$ 5,291$ 5,291$ 5,291$ 5,291$ 5,291$ Other long-term liabilities 612$ 869$ 844$ 844$ 844$ 844$ 844$ 844$

Total Liabilities: 10,555$ 12,563$ 12,191$ 11,786$ 11,961$ 12,079$ 12,200$ 12,324$

Total equity 1,550$ 123$ 590$ 461$ 391$ 409$ 522$ 738$

Total Liabilities and Equity: 12,105$ 12,686$ 12,781$ 12,248$ 12,352$ 12,488$ 12,722$ 13,061$

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Forecasted capital expenditures are based on the percentage capital expenditures were of operating revenue over the last three years. The trend had been for capital expenditures as a percentage of operating revenue to go up. In 2009, this percentage increased by a disproportionally high rate due to operating revenue being smaller, so the future increase in capital expenditures rate is mostly based on the 2007 and 2008 numbers. The rate is also based on information in the 10-K that states capital expenditures for future years to be in line with previous years, including planned plane purchases at the same planned rates. From this information, we increased the rate slightly for 2010 and left it at a sustainable 3.7% for the next four years.

Depreciation expense is calculated as a percentage of capital expenditures. In the previous three years, the depreciation has exceeded capital expenditures, which is not a great sign of growth in the infrastructure of the company. However, Continental Airlines has been able to utilize its capital to drive more revenue, such as having planes that are increasingly closer to capacity. With slightly increased capital expenditures, we are lowering the depreciation as a percent of CapEx slightly to keep with the general trend, but still having it larger than capital expenditures. Projected PP&E is the result of the projected capital expenditure and depreciation numbers, assuming no asset sales and write-offs.

Ratios and Assumptions 2007 2008 2009 2010 2011 2012 2013 2014Accounts receivables, net (collection period in days) 16.4 11.6 15.7 15.7 15.7 15.7 15.7 15.7Spare parts and supplies, net (days outstanding) 7.4 6.0 8.1 8.1 8.1 8.1 8.1 8.1Short-term investments (days outstanding) 18.3 12.3 9.8 9.0 9.0 9.0 9.0 9.0Other current assets (as % of op. rev.) 6.6% 7.1% 6.7% 6.7% 6.7% 6.7% 6.7% 6.7%

Accounts payable (days outstanding) 32.5 28.5 32.7 32.7 32.7 32.7 32.7 32.7Accrued liabilities (as % of op. exp.) 7.2% 8.0% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2%Air traffic and frequent flyer liability (as % of op. exp.) 17.3% 14.4% 18.0% 18.0% 18.0% 18.0% 18.0% 18.0%Other current liabilities (as % of op. exp.) 4.8% 3.6% 8.5% 5.0% 5.0% 5.0% 5.0% 5.0%


Operating Revenues 13,448$ 14,234$ 11,504$ 12,274$ 12,912$ 13,392$ 13,890$ 14,407$ Operating Expenses 11,361$ 13,093$ 10,318$ 10,801$ 11,233$ 11,517$ 11,807$ 12,102$

Working Capital BalancesAccounts receivables, net 606$ 453$ 494$ 527$ 554$ 575$ 596$ 619$ Spare parts and supplies, net 271$ 235$ 254$ 271$ 285$ 296$ 307$ 318$ Short-term investments 675$ 478$ 310$ 303$ 318$ 330$ 343$ 355$ Other current assets 881$ 1,016$ 769$ 820$ 863$ 895$ 929$ 963$

Total Non-Cash Current Assets: 2,433$ 2,182$ 1,827$ 1,921$ 2,021$ 2,096$ 2,174$ 2,255$

Accounts payable 1,013$ 1,021$ 924$ 967$ 1,006$ 1,031$ 1,057$ 1,084$ Accrued liabilities 817$ 1,053$ 635$ 665$ 691$ 709$ 727$ 745$ Air traffic and frequent flyer liability 1,967$ 1,881$ 1,855$ 1,942$ 2,020$ 2,071$ 2,123$ 2,176$ Other current liabilities 652$ 519$ 975$ 614$ 646$ 670$ 695$ 720$

Total Non-Debt Current Liabilities: 4,449$ 4,474$ 4,389$ 4,187$ 4,362$ 4,480$ 4,601$ 4,725$

NET WORKING CAPITAL / (DEFICIT) (2,016)$ (2,292)$ (2,562)$ (2,266)$ (2,341)$ (2,384)$ (2,427)$ (2,470)$

(Increase)/Decrease in Working Capital 276$ 270$ (296)$ 75$ 43$ 43$ 43$

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Equity is projected to complete the projected balance sheet, and is using information from the 10-K report, keeping accounts involved constant at the 2009 level.

Long-Term Debt and Capital Leases repayment schedules for the next five years are included in the 10-K, and are taken as given in our calculations. The key assumption for long-term debt is that the amount issued each year is set equal to the amount planned to be repaid for that year. The general trend seen on the historical cash flow statement is that the cash for repayment of long-term debt is close in number to the cash proceeds from long-term debt issued. Lacking further insight into future debt plans, we are keeping long-term debt constant in the next five years. Same logic applies to Accrued Retiree and Medical Benefits. Minimum cash balance required is assumed to be zero because of the debt-heavy industry structure that does not generally have excess cash on hand.


Operating Revenue 13,448$ 14,234$ 11,504$ 12,274$ 12,912$ 13,392$ 13,890$ 14,407$ Capital expenditures 329$ 373$ 381$ 420$ 478$ 496$ 514$ 533$ Capital expenditures as % of sales 2.4% 2.6% 3.3% 3.4% 3.7% 3.7% 3.7% 3.7%

Depreciation expense 413.0$ 438.0$ 494.0$ 483.0$ 549.4$ 569.8$ 591.0$ 613.0$ Depreciation as % of CapEx 125.5% 117.4% 129.7% 115.0% 115.0% 115.0% 115.0% 115.0%Depreciation as % of PP&E, net 6.3% 6.0% 6.7% 6.6% 7.5% 7.9% 8.3% 8.7%

Beginning Net PP&E 7,420$ 7,357$ 7,285$ 7,211$ 7,134$ Capital expenditures 420$ 478$ 496$ 514$ 533$ (Depreciation expense) (483)$ (549)$ (570)$ (591)$ (613)$ (Asset sales and write-offs) -$ -$ -$ -$ -$

Ending Net PP&E 6,558$ 7,327$ 7,420$ 7,357$ 7,285$ 7,211$ 7,134$ 7,054$

Projected Year Ending December 31,2010 2011 2012 2013 2014

Total equityBeginning balance 590$ 461$ 391$ 409$ 522$ Net income (176)$ (117)$ (29)$ 67$ 168$ Stock-based compensation expense 16$ 16$ 16$ 16$ 16$ Repurchase of equity -$ -$ -$ -$ -$ Dividends -$ -$ -$ -$ -$ Option proceeds 31$ 31$ 31$ 31$ 31$ Ending balance 461$ 391$ 409$ 522$ 738$

New shares from exercised optionsNew shares issued from options - millions 2.000 2.000 2.000 2.000 2.000Average strike price 15.45$ 15.45$ 15.45$ 15.45$ 15.45$ Option proceeds 31$ 31$ 31$ 31$ 31$

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The long-term debt and capital leases interest rate is the weighted average interest rate on the current long-term debt and capital leases detailed in the 10-K statement. Accrued Retiree Medical Benefits interest rate is also described in the 10-K, and the deferred income tax interest rate is assumed to be zero.


Cash Flow Available for Financing Activities (393)$ 45$ 104$ 202$ 307$ Repurchase of equity -$ -$ -$ -$ -$ Dividends -$ -$ -$ -$ -$ Option proceeds 31$ 31$ 31$ 31$ 31$ Plus: Beginning cash balance 2,546$ 1,981$ 2,058$ 2,193$ 2,426$ Less: Minimum cash balance -$ -$ -$ -$ -$

Cash Available for Debt Repayment 2,184$ 2,058$ 2,193$ 2,426$ 2,764$ Long-term debt issuance 972$ 1,142$ 584$ 650$ 332$ Long-term debt (repayments) (972)$ (1,142)$ (584)$ (650)$ (332)$

Excess Cash Available for Revolver 2,184$ 2,058$ 2,193$ 2,426$ 2,764$

Defered Income TaxBeginning balance 203$ -$ -$ -$ -$ Issuance / (repayment) of revolver (203)$ -$ -$ -$ -$ Ending balance -$ -$ -$ -$ -$

Long-Term Debt and Capital LeasesBeginning Balance 5,291$ 5,291$ 5,291$ 5,291$ 5,291$ Issuance 972$ 1,142$ 584$ 650$ 332$ (Repayment / Amortization) (972)$ (1,142)$ (584)$ (650)$ (332)$ Ending Balance 5,291$ 5,291$ 5,291$ 5,291$ 5,291$

Accrued Retiree Medical BenefitsBeginning Balance 1,464$ 1,464$ 1,464$ 1,464$ 1,464$ Issuance -$ -$ -$ -$ -$ (Repayment / Amortization) -$ -$ -$ -$ -$ Ending Balance 1,464$ 1,464$ 1,464$ 1,464$ 1,464$

2010 2011 2012 2013 2014Defered Income Tax Average Balance 102$ -$ -$ -$ -$

Interest Rate 0.00% 0.00% 0.00% 0.00% 0.00%Interest Expense -$ -$ -$ -$ -$

Long-Term Debt and Capital Leases Average Balance 5,291$ 5,291$ 5,291$ 5,291$ 5,291$ Interest Rate 5.38% 5.38% 5.38% 5.38% 5.38%Interest Expense 285$ 285$ 285$ 285$ 285$

Accrued Retiree Medical Benefits Average Balance 1,464$ 1,464$ 1,464$ 1,464$ 1,464$ Interest Rate 6.03% 6.03% 6.03% 6.03% 6.03%Interest Expense 88$ 88$ 88$ 88$ 88$

Total Interest Expense 373$ 373$ 373$ 373$ 373$

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Projected Cash Flow Statement

Projected income statement and balance sheet information culminates into the projected cash flow statement below. Cash Flows from operating activities grow significantly from 2010 to 2011 due to lower losses and eventual profitability we are forecasting, and changed working capital situation after 2010. Overall ending cash balance is growing each year, making Continental Airlines more attractive as a target under this scenario.

Discounted Cash Flow Calculation

Having projected all relevant financial data, discounted cash flow analysis is done below:

Projected Cash Flow Statement for Continental AirlinesUnited States Dollars in Millions, except per share


Operating ActivitiesNet Income (176)$ (117)$ (29)$ 67$ 168$ Stock-based compensation expense 16$ 16$ 16$ 16$ 16$ Depreciation 483$ 549$ 570$ 591$ 613$ (Increase)/decrease in working capital (296)$ 75$ 43$ 43$ 43$

Cash Flow from Operating Activities: 27$ 523$ 600$ 716$ 840$

Investing ActivitiesCapital expenditures (420)$ (478)$ (496)$ (514)$ (533)$

Cash Flow from Investing Activities: (420)$ (478)$ (496)$ (514)$ (533)$

CASH FLOW AVAILABLE FOR FINANCING ACTIVITIES (393)$ 45$ 104$ 202$ 307$

Financing ActivitiesIssuance / (repayment) of revolver (203)$ -$ -$ -$ -$ Issuance of long-term debt 972$ 1,142$ 584$ 650$ 332$ (Repayment) of long-term debt (972)$ (1,142)$ (584)$ (650)$ (332)$ Repurchase of equity -$ -$ -$ -$ -$ Dividends -$ -$ -$ -$ -$ Option proceeds 31$ 31$ 31$ 31$ 31$

Cash Flow from Financing Activities: (172)$ 31$ 31$ 31$ 31$

Net Change in Cash (565)$ 76$ 135$ 233$ 338$ Beginning cash balance 2,546$ 1,981$ 2,058$ 2,193$ 2,426$ Ending cash balance 1,981$ 2,058$ 2,193$ 2,426$ 2,764$

Discounted Cash Flow Analysis for Continental AirlinesUnited States Dollars in Millions, except per share


Operating Revenues 13,448$ 14,234$ 11,504$ 12,274$ 12,912$ 13,392$ 13,890$ 14,407$

EBITDA 1,100$ 124$ 348$ 577$ 736$ 897$ 1,070$ 1,253$ Less: Depreciation (413)$ (438)$ (494)$ (483)$ (549)$ (570)$ (591)$ (613)$ EBIT 687$ (314)$ (146)$ 94$ 187$ 327$ 479$ 640$ Less: Taxes @ 37.0% (254)$ 116$ 54$ (35)$ (69)$ (121)$ (177)$ (237)$ Tax-effected EBIT 433$ (198)$ (92)$ 59$ 118$ 206$ 301$ 403$

Plus: Depreciation 483$ 549$ 570$ 591$ 613$ Less: Capital expenditures (420)$ (478)$ (496)$ (514)$ (533)$ + / - Changes in working capital (296)$ 75$ 43$ 43$ 43$

Unlevered Free Cash Flow (174)$ 264$ 323$ 421$ 526$

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After completing discounted cash flow calculations, we utilize the Perpetuity Growth Method to calculate the enterprise value of the company, and the value of its equity. The reason for the Perpetuity Growth Method instead of the alternative method of EBITDA Multiple is because there are no great comparable companies. In the absence of appropriate compatibles, the Perpetuity Method is more accurate.

In order to calculate weighted average cost of capital, the following variables were sought:

1) Debt-Equity Ratio: Interest bearing debt was taken from the 2009 Annual Report, while equity was determined from market capitalization as of 12/31/20094. The firm is financed by 68.8% debt and 31.2% equity, which is pretty consistent with the debt-heavy nature of the industry.

2) Cost of Capital: The cost of funding will vary depending on market conditions, but since the weighted average cost of capital reflects current market conditions, only Continental’s interest rates from 2009 were applied. Continental’s weighted interest rate was 8.14% from the year’s aircraft investments5.

3) Cost of Equity: Since excess cash is nonexistent in the industry, Continental does not pay out dividends. Therefore, the capital asset pricing model was applied to determine cost of equity, which we have at 11.99%

a. Beta: Continental’s beta is 1.56 based on weekly stock data from 2009, a less volatile value than for United (2.03) or Delta (1.83)6

b. Risk Free Interest Rate: 3.73%, based on 10-year Treasury yield on January 1, 20107.

c. Return on Market: Too volatile to calculate during the time period in which the acquisition took place. Instead, we found the market risk premium used by companies and analysts during that time based on a detailed market study, which was 5.3%8. This would mean that the return on market is 9.03%.

Perpetuity Growth Method

Weighted average cost of capital: 7.27%Net present value of free cash flow 1,018$

Growth rate of FCF after 2014 2.59%Terminal value 11,531$ Present value of the terminal value 8,118$

Enterprise Value 9,137$ LESS: Net Debt (5,098)$ Equity Value 4,039$

Diluted shares: 129.000Equity Value Per Share 31.31$

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Cost of Equity = Risk Free Rate + (Beta * (Return on Market – Risk Free Rate)) = 3.73% + (1.558 * (5.3%)) = 11.99%

WACC = (11.99% * 31.2%) + (8.14% * (1-.37) * 68.8%) = 7.27% Applying the rates weighted against the debt-equity ratio, WACC of 7.27% is determined for Continental Airlines.

Terminal growth rate is calculated at 2.59%, which is the average monthly inflation rate between 2005 and 20109. We are using only the inflation rate because we believe that real growth within the airline industry for non-low-cost carriers would halt to a stop. Growth in air traffic and increased fees charged would be off-set by a declining trend in ticket prices driven by low-cost carriers.

Enterprise Value is the sum of present values of the future cash flows for the next five years and the present value of the terminal value for the company. When we deduct total long-term debt (net of capital leases) at the end of 2009, we get equity value of $4.039 billion for Continental Airline under this base scenario. This valuation equates to $31.31 per share of the company.

Sensitivity Analysis

To get a better degree of comfort in the equity value of Continental Airlines, we conducted a simple sensitivity analysis. We varied the terminal growth rate and the average yearly operating revenue growth for the next five years within what we consider reasonable parameters of possibility. The values in grey are the scenarios that result in lower than base values. The highest value swings come from changing the terminal growth rate. We feel that our base scenario is putting forth the most reasonable terminal growth rate that we are able to get to today, but considering the impact of a lower terminal growth rate would also be product.

Valuation Determination

The Discounted Cash Flow model will be assigned 100% of the weight for the valuation of Continental. Within Comparable Company analysis, too much variation exists within the ratio of Enterprise Value to EBIT to apply to Continental. The model treats annual earnings as a constant, and is unfit for volatile industries. On the flipside, many of the acquisitions in the Company Acquisition Multiple analysis occurred during more profitable times for the industry, and thus could potentially overvalue the target. The DCF model, which looks at current financial

In Million USD 2% 3% 4%1% 703$ 2,001$ 4,092$ 2% 1,385$ 2,820$ 5,133$ 3% 2,104$ 3,686$ 6,234$ 4% 2,863$ 4,600$ 7,398$ 5% 3,664$ 5,564$ 8,627$

Terminal Growth Rate

Avg. Yearly Operating Revenue Growth

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projections, as well as a long-term forecast of where the company will eventually land, takes into account enough to provide comfortable value estimation.

Dangers within the Financial Model

While the DCF analysis provides the closest approximation of firm value, it does not fully take into account the inherent riskiness of the industry. While revenues are projected for the first five years, a terminal value is assigned to project long-term growth. While the terminal value may be accurate, it does not take into account variability, and its impact on financial health. The airline industry historically has limited cash and a high debt structure. If a global recession creates three years of net losses, it will be difficult for Continental to absorb this impact. The terminal value trends to 2.59% over time, but can the Continental survive through the bad years?

In our estimation, United Airlines is aware of the inherent riskiness of both valuing another carrier, and ensuring the acquisition can weather through periods of declining revenue. The true value proposition for United comes from both the increased market power and scale savings from the integration.

Benefits of Integration

At the time the announcement of the United Continental merger, analysts noted the $2 billion potential benefit in operational efficiencies and revenue generation10. While United CEO Glenn Tilton was adamant that price would not increase with the merger11, it is largely evident that lowering the competitive threshold provides heightened price leverage, at least in certain markets. Below is the breakdown of expected synergies from the merger:

Revenue Generation

Average Ticket Price: Projected to Increase

Domestic Flights: The merger should help reduce the probability of price wars. Continental and United have hubs in different regions of the United States, the integration of the two can work together to help respond strategically to outside competition. For example, flights from Minneapolis to Cleveland are served by two carriers: Delta and Continental. If Delta decides to lower its fare as a way of obtaining a higher route share, the new United has more opportunities to cut prices on competing routes, such as Houston to Atlanta.

Probability of Achievement: Low. Airline prices have continued to decline despite previous mergers and bankruptcies. Carriers such as Southwest and JetBlue have a lower cost structure and have significant pricing power regardless of merger.

International Flights: International routes constituted 34% of United’s revenue stream in 200912, and due to fewer competitors and high barriers to entry, price increases become

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easier to acquire. For example, Continental serves many of the same cities in Central America as Taca Airlines, United’s Star Alliance partner13. The acquisition of Continental both frees up price competition in the region, and helps create value generation within the alliance.

Probability of Achievement: Medium. Fewer competitors, and thus pricing gains are easier to achieve.

Volume Travel: Potential to Increase

Coastal Hub: Newark International Airport, one of Continental’s hubs, is about 20 minutes from New York and serves the largest metropolitan area in the United States. The airport also faces stiff competition from geographically closer (albeit by not much) airports such as LaGuardia and JFK International. If United feels they have the business savvy, loyalty strength, and marketing prowess to lure business travelers to Newark, NJ, it can stand to significantly increase passenger volume on both domestic and international travel.

Probability of Achievement: Low. According to 2009 passenger traffic data, Newark already has a high penetration rate with 33.4 million annual passengers vs. 22 million for LaGuardia and 45.9 million for JFK14. However, if Newark was able to steal 30% market share from its airport competitors, it would become the fifth largest airport in the United States by passenger count.

Expense Savings: Potential for operational efficiency through scale savings, elimination of slack, and integrated capital and technologies. Potential savings are broken down based on the two largest variables within expenses.

Fuel Savings: 21% of United’s 2009 Operating Expenses. Gains come from negotiating more favorable fuel deals as a larger company, acquiring more efficient aircrafts, and leveraging the increased personnel from the merger to develop solutions to save on fuel

Probability of Achievement: Low. New systems and fuel efficiencies can save significant money for a carrier, but this is not something that requires an acquisition per se. New aircrafts can also be purchased in lieu of purchasing an entire company.

Labor Costs: 23% of United’s 2009 Operating Expenses. Integration increases the organization’s leverage for future labor deals.

Probability of Achievement: Low. Most of the employees are unionized15, making employee concessions and layoffs harder to materialize. In addition, information systems, a critical piece of the airline system, needs integration post-merger16.

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This will put additional burden on the labor force to reconcile these issues, as well as require additional technology consulting resources to help in the integration.

Takeaways from Airline Valuation

When looking into acquiring Continental Airlines, United runs significant risk in selecting the right valuation analysis, making the correct assumptions about revenue and terminal rate, and projecting the likelihood of value-generating synergies. All those pose significant variation, and certainly no third party investment firm would look into making such a high-risk, low-reward purchase. What does United stand to gain? By not making the acquisition, United runs the risk of seeing a competitor acquire Continental, leaving the firm with less market power. In the long-run, the synergies may prove to be insignificant, and the real value lies in sustaining the firm as long as possible before another trip to Chapter 11.

1 IATA cuts airline industry 2010 loss forecast by half. Structural shift in premium yields? March 12 2010. 2 Research and Innovative Technology Administration. http://www.bts.gov/press_releases/2010/bts015_10/html/bts015_10.html 3 Leahy, John. Airbus Global Market Forecast: 2010-2029, December 13, 2009. 4 Information take from http://finance.yahoo.com/ and 2009 Annual Report to Shareholders – Continental Airlines 5 2009 Annual Report to Shareholders – Continental Airlines 6 Information taken from Bloomberg 7 http://www.usinflationcalculator.com/inflation/current-‐inflation-‐rates/ 8 Campo, Javier & Pablo Fernandez. Market Risk Premium Used in 2010 by Analysts and Companies: A Survey of 2,400 Answers. IESE Business School, 2011. 9 http://www.usinflationcalculator.com/inflation/current-‐inflation-‐rates/ 10 Mouawad, Jad. United and Continental Said To Agree to Merge. NYTimes.com. May 2, 2010. 11 Airline CEOs: Merger won't raise prices. August 31, 2010. 12 United Airlines 10-K SEC Filings, 2009. 13 Information taken from Continental and United route maps pre-merger 14 Airport Traffic Reports. Airports Council International – North America. 2009 Data. 15 Reed, Ted. United/Continental Unions Could Battle. The Street. May 6, 2010. 16 Thompson, Ben. Will United’s merger fly? Business Management Magazine, Issue 20. November 8, 2010.

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