Global Air Lines

David MartiSandy SchatzRoshan Mann

Eric Yung

Agenda

• Industry Introduction• Singapore Airlines

– Introduction– Financials– Hedging Strategy

• Southwest Airlines– Introduction– Financials– Hedging Strategy

Goals

• Find out what risks the airlines currently have

• Find how these risks are hedged• Find out if the hedges are successful

– What is successful?

Air Lines

•The worlds first airline was in 1909 (Deutsche Luftschiffahrts-Aktiengesellschaft)•Airlines provide air transportation for cargo and for passengers•The cumulative net profit of all airlines put together since 1909 is negative

• Positive externalities •Airlines are highly leveraged

Air Line Alliances

• Star Alliance, Sky Team, Americas and Oneworld

• Cost Reduction– Sales offices, maintenance facilities

• Traveler benefits– More departure times – Optimizes transfers

• Traveler disadvantages– Less competition

How do airlines become profitable?

•Revenues are from ticket sales and shipping •Costs

• Fuel Costs • Labour• Fleet Management• Financing Costs

•Profitability is cyclical and follows the economy

Airline Owners

•Public-Southwest, WestJet, Delta

•Private- Indo China Airlines

•Government owned- Aerolineas Argentinas, Czech Airlines and Air India.

PROFITS

Risk For Airlines

•Strategic risk– Business design choices

•Financial risk – Variability of revenue and costs

•Operational risk – Tactical aspects of running the business

•Hazard risk– Safety of physical assets

Company IntroductionFinancials

Risks and Hedging Strategies

Singapore Airline

General Information

• Founded in 1947 as Malaysian Airlines• SIA’s passenger network covers 61 cities in

34 countries• Own parts of

– Singapore Airlines Cargo (100%)– SIA Engineering Company (SIAEC) (81.9%)– Singapore Airport Terminal Services (81.9%)– SilkAir (100%)– Singapore Flying College ( 100%)– Virgin Atlantic Airways Limited (49%)

SIA Facts

• Founded in 1972• Provide world-class customer service• Most modern and comfortable aircraft• SIA Group employs 28,343 staffs• SIA’s passenger network covers 64 cities

in 35 countries• SIA Cargo offers a network linking 68 cities

in 36 countries, making it the 2nd largest international cargo airline

Marketing and Branding

• Company slogan “A great way to fly” • Singapore emphasis their staff

– Singapore Girls

Awards

• Singapore airlines claims to be “Worlds Most Awarded Airline”

• Zagat Survey– Placed first in premium and economy classes

for comfort, service and food• Fortune

– Was ranked 33rd World’s Most Admired Companies rankings in 2009 by Fortunes

Financials

Net Profit and Operating Profit Margin

Earnings

Revenue Composition 07/08

29%

19%22%

18%

12%

Sales

East AsiaAmericasEuropeSouth West PacificWest Asia and Africa

Revenue Composition 08/09

Expenditures

Balance Sheet

Cash Flow

Cash Flow statement

Cash Flow Statement cont

SIA Hedging Philosophy

• The Group operates globally and generates revenue in various currencies. The Group’s airline operations carry certain financial and commodity risks, including the effects of changes in jet fuel prices, foreign currency exchange rates, interest rates and the market value of its investments.

• The Group’s overall risk management approach is to moderate the effects of such volatility on its financial performance. The Group’s policy is to use derivatives to hedge specific exposures.

• As derivative are used for the purpose of risk management, they don’t expose the Group to market risk because gains and losses on the derivatives offset losses and gain on the matching asset, liability, revenue or costs being hedged.

Accounting Principles of Financial Instruments• Financial assets are recognized on the balance sheet

when, and only when, the Group becomes a party to the contractual provisions of the financial instrument.

• When financial assets are recognized initially, they are measured at fair value, plus, in the case of financial assets not at fair value through profit and loss, directly attributable transaction costs.

• A financial asset is derecognized when the contractual right to receive cash flows from the asset has expired.

• All regular way purchases and sales of financial assets are recognized or derecognized on the trade date, i.e., the date that the Group commits to purchase or sell the asset.

Accounting Principles of Financial Instruments

There are two sub-categories: • 1. Financial Assets as fair value through profit or

loss at inception. A financial asset is classified in this category if acquired principally for the purpose of selling in the short term. Derivatives are also classified under this category unless they are designated as hedging derivatives

• 2. Financial assets held for trading. Assets in this category are classified as current assets if they are either held for trading or are expected to be realized within 12 months after the balance sheet date.

Accounting Principles of Financial Instruments

• Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market are classified as loans and receivables. Such assets are carried at amortised cost using the effective interest method. Gains and losses are recognised in the profit and loss account when the loans and receivables are derecognised or impaired, as well as through the amortisation process.

SIA Derivative Instruments And Hedging Activity The Group uses derivative financial instruments such as

forward contracts, interest rate swap contracts, jet fuel options and jet fuel swap contracts to hedge its risks associate with foreign currency, interest rate and jet fuel price fluctuations.

Any gains or losses arising from changes in fair value on derivatives that do not qualify for hedge accounting are taken directly to the profit and loss account.

The fair value of forward currency contracts is determined by reference to current forward contracts with similar maturity profiles. The fair value of interest rate contracts is calculated using rates assuming these contracts are liquidated at balance sheet date. The fair value of jet fuel swap contracts is determined by the reference to available market information and option valuation methodology.

SIA Financial Risks

• Main Risks– Jet Fuel– Foreign Currency– Interest Rate

• Other Risks– Market Price Risk– Liquidity Risk– Credit Risk

Jet Fuel Price Risk

Jet Fuel Price Risk

Risk Exposure: The Group’s earning are

affected by changes in the price of jet fuel.

Strategy: Provide the Group with protection against sudden and significant increase in the jet fuel price.

Derivative Instruments: The group manages this fuel price risk by using jet fuel swap and option contracts and hedging up to 18 months, as well as gasoil swap hedging up to 24 month.

Jet Fuel Price Risk

Jet Fuel Price Risk

Foreign Currency Risk

Risk Exposure: The Group is exposed to the effects of foreign exchange rate fluctuations because of its foreign currency denominated operating revenues and expenses.

Strategy: The Group manages its foreign exchange exposure by a policy of matching, as far as possible, receipts and payments in each individual currency.

Derivative Instruments: Surpluses of convertible currencies are sold, as soon as practicable, for USD and SGD. The Group also uses forward foreign currency contracts and foreign currency option contracts to hedge a portion of its future foreign exchange exposure. Such contracts provide for the Group to sell currencies at predetermined forward rates, buying either USD or SGD depending on forecast requirements, with settlement dates that range from one month up to one year.

Foreign Currency Risk

Foreign Currency Risk

Interest Rate RiskRisk Exposure: The Group’s earning can also be

affected by changes in interest rates as they have expenses from short term deposits and other interest bearing financial assets that are at a variable rate. Also, they earn variable rates on some financial investments.

Strategy: The majority of the Group’s interest-bearing financial liabilities over a year are either offset by financial investments or have been initiated at a fixed rate.

Derivative Instruments: Interest rate swaps and interest rate cap contracts are used when liabilities are not at a fixed rate or offset.

Interest Rate Derivatives

• Interest Rate Cap– Have a strike price of 6.5% and mature in 7-

10 years • Interest Rate Swap

– Exchanged for fixed at 3%-4.95% maturity march 2014-2016

Market risk Sensitivity analysis

• Sensitivity report looking at increase or decrease of .01% on market interest rates

Interest Rate Swap Contracts

Finance Charges –Interest Rates

Market Price Risk

Credit Risk

Credit Risk

SIA Stock Options

SIA Share Option Plan• The Singapore Airlines Limited

Employee Share Option Plan, which comprises the Senior Executive Share Option Scheme and the Employee Share Option Scheme for senior executives and all other employees respectively, was adopted in 2000.

SIA Stock Options Cont.

Restrictions on Stock Options• No options have been granted to controlling

shareholders or their associates, or parent group employees.

• No employee has received 5% or more of the total number of options available under the Plan.

• The options granted by the Company do not entitle the holders of the options, by virtue of such holding, to any rights to participate in any share issue of any other company.

SIA Stock Options Cont.

All Stock Options Have a term no longer than 10 years from the date of grant

Exercise price will be the average of the closing prices of the Company’s ordinary shares on the SGX-ST for the five market days immediately preceding the date of grant

Options will vest• For employee – two years after the date of grant• For senior executive

- one year after the date of grant for 25% of the ordinary shares subject to the options.

- two years after the date of grant for an additional 25% of the ordinary shares subject to the options

- three years after the date of grant for an additional 25% of the ordinary shares subject to the options

- four years after the date of grant for the remaining 25% of the ordinary shares subject to the options

The Restricted Share Plan (“RSP”) and Performance Share Plan (“PSP”), share-based incentive plans for senior executives and key senior management

SIA Stock Options Cont.

SIA Stock Options Cont. (Singapore Airport Service Terminal)

SIA Stock Options Cont. (SIA Engineering Company)

South West Airlines

Company Profile

• Founded in 1967 with headquartered in Love Field, Dallas, Texas ( NYSE: LUV )

• As of December 31, 2009, the company operated 537 Boeing 737 aircrafts and provided service to 68 cities in 35 states

• Had 37 consecutive years of profitability

Operating Strategy

• Point-to-point, rather than hub-and-spoke (Cheaper and more Efficient)

• Frequent, conveniently timed flights– Decreased labour force to control CASM (cost

per available seat mile) not related to passengers

• Low fares

Route Map

Competitors

• AMR corporation• Continental Airline• JetBlue Airways

South West AirlineMarket Share

• Despite only operating in the United States, Southwest still remains a top controlling company

Stock Performance

Stock Performance

• Last Trade: 13.00• Change: 0.03 (0.23%) • Prev Close: 13.03 Open: 13.03• Day's Range: 12.84 – 13.10• 52wk Range: 5.92 – 13.34• Volume: 5,795,819• Avg Vol (3m): 9,669,430• Market Cap: 9.66B• P/E (ttm): 97.01• EPS (ttm): 0.13 Div & Yield: 0.02 (0.10%)

Financials

Income Statement

Cash Flow Statement

Cash Flow Statement Cont

Risk Factor

Risk Factor

• From company’s Annual Report:

• Southwest's business is labor-intensive

• Southwest relies on technology to operate its business and any failure of these system could harm the Company’s business

• Insurance cost increases, or reductions in insurance coverage may adversely impact the Company’s operation and financial results.

• Disruptions to operations due to factors beyond Southwest’s control could adversely affect the Company.

• Southwest’s low cost structure is one of its primary competitive advantages and many factors could affect the Company’s ability to control its costs.

Risk Factor

• Jet Fuel– Unpredictable price movement – Unable to increase fares when fuel price rise– Changes in hedging strategy and the

effectiveness of hedging arrangement have significant impact on operating results

Risk Factor: Jet Fuel

• Uncertainty about future jet fuel prices – Not as strong hedge position from 2009 to 2013– Created a table to show what current hedged

positions would yield based on oil prices

Purpose of Hedging

• Airline operators are inherently dependent upon jet fuel to operate, and therefore, impacted by change in jet fuel prices– Jet fuel and oil consumed in 2009 and 2008

30 and 35% of operating expenses respectively

• Southwest expects to consume 1.4 billion gallons of fuel in 2010

Fuel and oil expense = $1.4 billion X ±$.01 = ±$14 million

Hedging Strategy - Jet Fuel

• Hedging Commodities:– Primarily crude oil– Heating oil– Unleaded gas

• Components of hedging positions:– Call options– Collar structures– Fixed price swap agreements

Hedging Strategy: Jet Fuel

• Hedge ratio:– 55% for 2009 at $51/barrel– 25% for 2010 at $63/barrel– 15% for 2011 at $64/barrel– 15% for 2012 at $63/barrel

• Near term hedge positions are in the form of option contracts– Limit the cost of rising fuel price and benefit

the company of declining fuel price

Value of Hedge Contracts

• As of December 31, 2009, the company had $1.02 billion derivative instruments

• $347 million of that was classified as “Fuel hedge contracts”– Fair value is determined by the use of present

value methods or standard option value model with assumptions about the commodity prices based on those observed in underlying markets

Balance Sheet - Assets

Performance of Hedging

• Gains from hedging:– $406 million gain, as of December 31, 2009– Of that amount, $378 million came from fuel

hedged derivatives and $28 million from changes in fair values of derivatives

Balance Sheet – Liability & SW’s Equity

Cost Structure

Cost Control

• Reduced Hedge positions• Freedom 09• Reduce Capital Spending• Winglets

Risk Factor #2

• 82% of employees are represented by Unions

Employee Stock Option

ESO - Options grated at or above FMV of the common stock- 6-12 year terms- Neither Executive officer nor members of the board of directors are allow to participate

Other Employee plans- Options granted at the money- 10 year terms- Fully exercisable over 3, 5 or 10 years of continued employment

Employee Stock Option

Employee Stock Option

An option’s exercise price may be paid

(i) in cash, (ii) in shares of Common Stock, (iii) through a cashless exercise, or (iv) in any other manner permitted by the committee.

Interest Rate Risk

- Interest rate risk (Debt)• Fluctuations of interest rate affect firm’s interest obligation,

therefore have impact on the firm’s liquidity position• May result in insolvency and bankruptcy

- Southwest Strategy• Prepayment, redemption or termination for floating-rate debt• Interest Swap

Interest Rate Hedging

Interest Rate Swaps

Debt Instrument $ (million) Fixed rate Average Floating rate 2009

2012 385 6.5% 3.18%

2014 350 5.25% 2.72%

2016 300 5.75% 3.16%

2017 300 5.125% 0.39%

2027 100 7.375% 2.48%

-Take advantage of short term rate vs LT fixed rate in 2009- Reduce Volatility

Credit risk

• The Company does not expect any of the counterparties to fail to meet their obligations

• To manage credit risk:– selects and periodically reviews counterparties based on credit ratings – limits its exposure to a single counterparty– and monitors the market position of the program and its relative market

position with each counterparty• The Company had agreements with several counterparties

containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount or credit ratings fall below certain levels.– held $478 million in fuel hedge related cash collateral deposits under

these bilateral collateral provisions– decrease, but not totally eliminate, the credit risk associated with the

Company's hedging program

Insurance

• Purpose of Insurance:– protect the Company and its property – comply both with federal regulations and the Company’s

credit and lease agreements. • General Coverage:

– public and passenger liability, property damage, cargo and baggage liability, loss or damage to aircraft, engines, and spare parts, and workers’ compensation.

• Increasing insurance cost after 9-11

Conclusion

It is important to hedge and hedge appropriately

THE END

Any questions or comments are welcomed!