luv final presentation

1

The University of Texas at DallasJames, Tyler, Trevor

We Don’t Believe in LUV at First Sight

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Close Price Current Price Target Price

Executive Summary

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Market Profile (as of 02/04/2016)

Closing Price: $37.54

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

Diluted Shares Out. : 679.55 M

Average Volume (6M): 8.44 M

Market Cap: $ 22.78 B

LTM Dividend Yield: 0.76%

Short Interest (%) Float: 3.77%

Beta: 1.11

EV/EBITDAR*: 5.0 x

P/E*: 12.7 x

Institutional Holders: 82.94%

Insider Holdings: 0.28%

NYSE: LUV Recommendation: HOLD

Industry: Airlines Current Price: $37.54

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

LUV $34.53

LUV $37.54

Investment Themes:

Low Cost, No Frill Approach

Conservative Operating Philosophy

Declining Competitive Advantage

Strained Employee Relations

*Multiples adjusted for Operating Leases

Investment Highlights Company Overview Industry Analysis Financial Analysis Valuation Risk Analysis Conclusion

3

Employee Relations

Cost Structure

A B

C D

E F FC

E

D

B G

A

Low Cost Structure

Point to Point

Each route serves a single city-pair

Higher aircraft utilization and

turnaround times

Hub and Spoke

Hub connections significantly

increase CASM

Routes are interdependent for connecting

passengers

Vs.


Historical Competitive Advantage

The Southwest Effect

Traffic Demand In New Markets

Average Fares in New Markets

Low Fares Brand Image

4

Executive Council * denotes company tenure

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

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12

0

24

28

11

15

*


“Your people come first, and if you treat them right, they’ll treat the customers right.”

- Herb Kelleher, Founder of Southwest Airlines

Major Markets, Pre-AirTran Acquisition (2011)

5


Major Markets, After AirTran Acquisition (2014)

6

ATLANTA

PARADISE ISLAND

BERMUDA

CHARLOTTE

MEMPHIS

BRANSON

WICHITA

GRAND RAPIDS

FLINT

RICHMOND

ROCHESTER

PENSACOLA

PORTLAND

CABO SAN LUCAS

MEXICO CITY

CANCÚN

MONTEGO BAY

ARUBA

PUNTA CANASAN JUAN


Major Markets, After Wright Amendment Repeal (2014)

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8

Industry

Rivalry

Threat of

Substitutes

Threat of

New

Entrants

Power of

Buyers

Power of

Suppliers

Porter’s Five Forces


Changing Dynamics

9

$200

$250

$300

$350

$400

$450

$500

1979 1986 1993 2000 2007 2014

Average Fares

Deregulation

Weakened

Barriers

Laissez-faire

PricingBankruptcy


Converging Interests

LCC’s ULCC’s

Legacy

Legacy

Before 1978 2016

Industry Timeline

10

AAL/TWA

Merger

MetroJet

Liquidation

9/11 Terror

Attacks

American West/US

Airways Merger

DAL/Northwest

Merger

Financial

Crisis

UAL/Continental

Merger

LUV/AirTran

Merger

2001 2005 2008 2010 2011

AAL/US Airways

Merger

2013

-2

-1

0

1

2

3

4

1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Strengthening Z scores

AAL DAL UAL LUV


0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

$0 B

$50 B

$100 B

$150 B

$200 B

2007 2008 2009 2010 2011 2012 2013 2014 2015

Improving Operating Margin

Revenue Operating Margin

Evolving Structures

11

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

2001 2003 2005 2007 2009 2011 2013 2015

Operating Cost Structure

Wages Fuel Other Costs

The industry dynamics have changed substantially since the Deregulation Act


0%

5%

10%

15%

20%

25%

30%

35%

40%

1998 2000 2002 2004 2006 2008 2010 2012 2014

Streamlined Labor Costs % of Revenue

Labor Other Costs

Current Dynamics

12


$0

$20

$40

$60

$80

$100

$120

-1.0 M

-0.5 M

0.0 M

0.5 M

1.0 M

1.5 M

2.0 M

2.5 M

3.0 M

Supply-Demand Spread (mbpd) WTI Spot Price

Supply Imbalance vs Crude Oil

Fuel tailwinds have created ROIC levels above WACC

44% Jet fuel price per gallon

Oil Supply Surplus

Global energy demand

Alleviate debt obligations

Increase shareholder returns

Macroeconomic Drivers

13

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

1986 1991 1996 2001 2006 2011 2016

0

10

20

30

40

50

60

70

Contracting PMI levels

PMI Index Real GDP YoY

0 B

10,000 B

20,000 B

30,000 B

40,000 B

50,000 B

60,000 B

70,000 B

80,000 B

90,000 B

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

Corporate Earnings vs Airline Traffic

Correlation = 84%


PMI Non-PMI Corp. Earnings Traffic*78% *84%*80%

* Denotes correlation

Industry Drivers

14

-10%

-5%

0%

5%

10%

15%

20%

2010 2011 2012 2013 2014 2015

Yield

Legacy LCC's ULCC's

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

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

Passenger Revenue per Available Seat Mile

PRASM Fuel Cost pASM Labor Cost pASM


Short-term industry yields are expected to stabilize

Yield = Passenger Revenue/Revenue Passenger Mile

Revenue Analysis

15

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

2006 2008 2010 2012 2014 2016

Capacity Expansion vs Traffic

ASM YoY Growth RPM YoY Growth

-15%

-10%

-5%

0%

5%

10%

15%

20%

2002 2005 2008 2011 2014 2017

Historical Yield


Growth Opportunity

16

4%

Domestic

2%

Inter-

national

6%

Capacity

Expansion


Cost – Efficiency Analysis

17

0%

5%

10%

15%

20%

25%

30%

35%

40%

20182015201220092006200320001997

Significantly Above-average Labor Costs

Industry Wages LUV Wages

∆ = 10%


-60% -40% -20% 0% 20% 40%

Legacy

LCC's

ULCC's

Industry

Industry's CASM Ex-fuel compared to LUV

09/2015 12/2009

∆ = -19%

∆ = -15%

∆ = -8%

∆ = -11%

Cost – Efficiency Analysis

18


0%

2%

4%

6%

8%

10%

12%

14%

2011 2012 2013 2014 2015

Late Arrival Ratio

Southwest* Industry*

∆ = 34%

-60% -40% -20% 0% 20% 40%

Legacy

LCC's

ULCC's

Industry

Industry's CASM Ex-fuel compared to LUV

09/2015 12/2009

∆ = -19%

∆ = -15%

∆ = -8%

∆ = -11%

“Not only has the world changed, but our relative position within the industry on costs has changed.”

- Gary Kelly, CEO of Southwest Airlines

19

5 Union Work Groups

Current Negotiations:

Employees

Representing

55.8%

43%57%

Labor Costs % Operating Expenses

Labor Expenses Other Expenses

83%

17%

Percent of Workers Unionized

Unionized Non-Unionized

Labor Cost Uncertainty


Fading Competitive Advantage

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LUV no longer remains a low cost leader

LUV

Other

LCC’s

Legacy

Cost

Qu

ality

of S

ervic

e

Other

LCC’s

LUV

Legacy

Cost

Qu

ality

of S

ervic

eULCC’sULCC’s

Cost

This graph is illustrative purposes

Profitability Analysis

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FASB Operating Leases Adjustment

Add back Aircraft & Other Rentals

-5%

0%

5%

10%

15%

20%

25%

30%ROIC

Reported ROIC Adjusted ROIC

0

1,000

2,000

3,000

4,000

5,000

6,000

Historical EBITDAR


Before Adjustment

27.4% EBITDAR

24.1% ROIC

After Adjustment

28.9% EBITDAR

20.3% ROIC

+2.7B Debt

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Capital Structure Analysis

NM

2.0 x

4.0 x

6.0 x

8.0 x

10.0 x

12.0 x

Total Debt/EBITDAR


Conservative Operating Philosophy

0 %

10 %

20 %

30 %

40 %

50 %

60 %

70 %

FY05A FY07A FY09A FY11A FY13A FY15A FY17E

Historical Debt to Capital

As reported Adjusted

23

Terminal EV/EBITDAR

Adj. for Operating Leases

DCF Analysis

Price: $38.81

Relative Valuation

Price: $30.24

LUV $34.53

(50%) (50%)

EV/EBITDAR

Normalized P/E

8% Potential Downside


Valuation Overview

Assumption Breakdown FY16E FY17E FY18E

YoY Capacity Growth: 5.5% 4.0% 3.0%

Load Factor: 83.6% 83.6% 83.6%

Change in Yield: -1.5% 0.5% 1.0%

Passenger Revenue: 19,023 19,882 20,684

Freight: 180 184 180

Other Revenue: 1,257 943 971

Total Operating Revenue: 20,460 21,009 21,835

YoY Growth Rate: 4.1% 2.7% 3.9%

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Revenue Assumptions

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

0 B

5 B

10 B

15 B

20 B

25 B

FY09A FY10A FY11A FY12A FY13A FY14A FY15A FY16E FY17E FY18E

Revenue Projection

-3 B

-2 B

-1 B

0 B

1 B

2 B

3 B

FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15A

Historical Earnings vs Reinvesment Need

Reinvestment Need After-tax Adjusted EBIT

~82%Average Annual

Reinvestment Need


25

Cost of Equity 2016-2019 Terminal

Risk-free Rate*: 2.25% 3.00%

Risk Premium: 5.00% 5.00%

Adjusted Beta: 1.32 1.16

Cost of Equity: 8.84% 8.78%

Cost of Debt 2016-2019 Terminal

Risk-free Rate*: 2.25% 3.00%

BBB+ Default Spread: 2.00% 2.00%

Cost of Debt: 4.25% 5.00%

*Expected 10-Y U.S. Treasury

2016-2019 Terminal

WACC: 7.11% 7.60%

WACC Assumptions


DCF Outputs

26

SPE = Salaries per Employee


$55 - $65 - $75 Brent

+7.6% SPE

$55 - $65 - $75 Brent

+5.1% SPE

$45 - $55 - $65 Brent

+6.5% SPE

Base$38.54 $45 - $55 - $65 Brent

+ 650 bps SPE FY 2016

$45 - $55 - $65 Brent

+6.5% SPE

Bull$54.70 $35 - $45 - $55 Brent

+ 510 bps SPE FY 2016

$45 - $55 - $65 Brent

+6.5% SPE

Bear$23.72 $55 - $65 - $75 Brent

+ 760 bps SPE FY 2016

DCF

Target Price

$38.81

Jet Fuel Expense

25.00$ 30.00$ 35.00$ 40.00$ 45.00$ 50.00$ 55.00$ 60.00$ 65.00$

$120,862 1.21$ 1.30$ 1.39$ 1.48$ 1.57$ 1.66$ 1.75$ 1.84$ 1.93$

$123,884 2.5% 48.75$ 47.71$ 46.68$ 45.64$ 44.60$ 43.56$ 42.53$ 41.49$ 40.45$

$125,092 3.5% 47.25 46.21 45.18 44.14 43.10 42.06 41.03 39.99 38.95

$126,301 4.5% 45.72 44.68 43.65 42.61 41.57 40.54 39.50 38.46 37.42

$127,510 5.5% 44.17 43.13 42.09 41.05 40.02 38.98 37.94 36.90 35.87

$128,718 6.5% 42.58 41.54 40.51 39.47 38.43 37.39 36.36 35.32 34.28

$129,927 7.5% 40.97 39.93 38.89 37.85 36.82 35.78 34.74 33.71 32.67

$131,136 8.5% 39.32 38.29 37.25 36.21 35.17 34.14 33.10 32.06 31.03

$132,344 9.5% 37.65 36.61 35.58 34.54 33.50 32.47 31.43 30.39 29.35

$133,553 10.5% 35.95 34.91 33.88 32.84 31.80 30.76 29.73 28.69 27.65

Ave

rage

Per

-em

plo

yee

Exp

ense

Sensitivity Analysis

27


28

Relative Valuation

North AmericanAirlines

Market Cap >1.5B

Revenue >1.5B

Screening

Criteria

Comparable Valuation

Multiple Turn Price

2016E EBITDAR: 4.4 x $30.47

2017E EBITDAR: 4.5 x $26.64

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

Historical LUV EV/EBITDAR


Valuation Summary

29

$45 - $55 - $65 Brent

+6.5% SPE

$55 - $65 - $75 Brent

+7.6% SPE

Consensus Team Analysis

Adjust for Operating Leases (BOTH

LUV and Peers)

Add back full Operating Lease

Expenses (Aircraft + Facility + Others)

Integrate the impacts of labor contracts

Cycle-average EV/EBITDAR, normalized

P/E

(Some) Adjust for Operating Leases

Add back only Aircraft Rentals

Wait for new contract releases and

then revise investment thesis

DCF Analysis

$38.81(50%)

Relative Valuation

$30.24(50%)

Target Price

$34.53(8% Downside)


30

High

OR1

OR2 MR2

MR3 MR1

OR3 UCLow

Low Medium High

Impact

Medium

Probability

Legend

OR1: Operational Risk – MR1: Market Risk – Economic Uncertainty

Balancing Employee Compensation MR2: Market Risk – Commodity Price Volatility

UC: Uncertain Catastrophes

Risk Analysis


31

Market Risk

30

35

40

45

50

55

60

65

Manufacturing PMI vs Non-Manufacturing PMI

NAPMPMI Index NAPMNMI Index


$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

$3.5

2000 2003 2006 2009 2012 2015

Economic Fuel Price vs Market Price

Carrier 2015 2016 Comments

Southwest 40% 20% Most heavily hedged (65% through 2017)

Delta 40% 5% Owns refinary to offset flucuations

American 0% 0% Does not hedge

United 22% 35% Opportunity to gain philosophy

Alaskan 42% 33% Uses call options as insurance

JetBlue 17% 0% Opportunity to gain philosophy

Virgin 27% 0% Hedged 31% H1' 16

Spirit 35% 0% No hedging target

Allegiant Air 0% 0% Does not hedge

ZikaHezbollah

Tornado

32

Hurri-

caneMERS

-CoV

TB

Impact

Fre

quency

Ebola

H7N9H1N1

Vol-

canoes

Thunder-

storm

ISIS

Al-Qaeda

Cybersecurity

War

Geopolitical

Tension

Regulation

Uncertain Catastrophes


Investment Summary

33


Tenuous Pricing Power

Strained Labor Relations

Air travel Commoditization

Cyclicality

Customer Service

Low-cost Structure

HOLD

Conservative Operating

Philosophy Target Price

$34.53

(8% Downside)

luv final presentation

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