southwest airlines

CFA Institute Research Challenge

Hosted by:

CFA Societies Texas, Louisiana, New Mexico and Oklahoma

Local Challenge- Southwest US

University of Central Oklahoma

CFA Institute Research Challenge February 8, 2016

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Company Name Exchange New York Stock Exchange

Sector Services Industry Regional Airlines

Current Price $35.69 Price Target $42.40 (18.8%)

Ticker Symbol LUV

Recommendation BUY

52-Week Range $31.31-$51.34

Flight to Organic Growth An increase in services during turbulent times Investment Theses Highlights:

Ø New services internationally: With recent expansion into the international market, via the new Houston international terminal, LUV now has potential for expanding its earnings organically. We expect a positive reaction once the market receives the initial numbers.

Ø Growth story: Forty-two consecutive years of profitability has been the LUV way. Revenue, free cash flow, dividends, stock repurchases, book value, and earnings, are all set to continue growing.

Ø Commodity tailwind: The plunge in jet fuel has helped LUV increase operating margins.

Ø World-class brand: LUV’s continuous growth in the domestic market and recent international expansion make the brand attractive for partnerships and branded products such as the marketing agreement with Avis Budget Group and the co-branded credit card agreement with Chase. This brand equity justifies, in part, higher multiples and enterprise value compared to industry peers.

Risk: • A drastic rise in jet fuel price;; capacity expansion in a

competitive industry;; pivotal supplier increasing cost or failing to deliver;; acts of domestic terrorism;; and economic recession.

Valuation: We believe that LUV is an industry leader with consistent profitability and a strong balance sheet. Based on our valuations, we issue a BUY recommendation on LUV, with a conservative price target of $42.40 (18.8% upside).

Market Data Market Value $22.8 B Enterprise Value $22.9B Shares Outstanding 650.3MM Average Daily Vol.(3Mo) 6.6MM Dividend Yield .8% Float 98% Institutional 78.7% Top 10 Inst. Holders 40.69% Beta (1Yr) 1.3 P/E 10.93 P/FCF 7.4 P/B 3.1 P/S 1.2 EV/EBITDA 4.42 Source: Morningstar and Bloomberg

Financials 15 16E 17E Revenue (BB) 19.8 20.9 20.7 Op. Margin % 20.77 24.68 21.03

Net Margin % 11.00 14.81 12.62

EPS $ 3.27 4.92 4.09 Source: Company Financials and Group Estimates

Valuation Performance

Ticker 1Mo 3Mo 1Yr LUV -19.44% -.64% -18.58%

30

35

40

45

50

LUV 52-‐‑WEEKS

$42.40 Target

BEAR $27.05

CURRENT $35.69

TARGET $42.40

BULL $58.39

Source: Morningstar

Source: Morningstar and Group Estimate


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Business Description History of the “fun-LUVing” company LUV was founded March 15, 1967 as Air Southwest Co. (later changing its name to Southwest Airlines Co). Despite many barriers to entry that LUV had to hurdle, Dallas-based LUV flew its inaugural flight on June 18 1971. LUV is a passenger airline operating in the United States and, of recent, internationally. LUV offers scheduled flights with a leading customer-centric mission. Services are delivered to more than 100 million customers annually by more than 48,000 employees. LUV proudly operates a network of 97 destinations across the United States and seven additional countries, expanding monthly, with more than 3,900 departures a day during peak travel season. (See Appendix A) 43 years of profitability LUV is renowned for its tenure of annual profit;; a feature we expect to continue. LUV has also declared 158 consecutive quarterly dividends. This consistency in profits and dividends indicates effective management. Revenue comes from three sources;; passenger fares, freight, and other. Respectively these sources accounted for 92.3%, 0.9%, and 5.8% of LUV’s revenue for FY15 and have been increasing year over year. Along with increasing revenues, net margins have continuously increased. (See Appendix B) Dependency on jet fuel One of the biggest operating costs for airlines is jet fuel. Airlines have never experienced profits as high as we have seen recently, mostly due to drastically lower jet fuel prices. The jet fuel market has played a huge role in helping LUV bring down and/or maintain overall operating expenses while dictating growth. Jet fuel is a variable input and will drastically impact LUV’s bottom line earnings. Comments from management suggest 2016 fuel cost will be at least $500MM lower year over year. Investor can think of the fuel savings as financing LUV’s “Bags Fly Free” program. See Investment Risk for more on the impact of jet fuel. Investment Summary BUY with a $42.40 price target With a current price of $35.69 we issue a BUY recommendation with a conservative price target of $42.40 for LUV. We see growth in earnings over the next 12 months coming from international expansion, low jet fuel prices, increased margins, and higher load factors. We believe completion of the repurchase program and an increase in dividend yield will provide positive impetus for the stock price. We believe a conservative 12-month target upside of 18.8% outweighs the associated risk and justifies a BUY recommendation. International expansion will sustain revenue growth Recent expansion into the international market, will produce revenue growth over the next 12 months. We believe growth in the domestic market over the last 12 months, in the face of volatility, justifies attaching a high probability to future revenue growth. However, the scale of revenue from international operations can only be hypothetically modeled. We have determined that potential revenue could amount to $350MM+ and earnings

Int’l Expansion Low Jet Fuel High Margins

High Load Factor Repurchase-Program

High Jet Fuel Industry Capacity Expansion

Supply Cost Terrorism Economy

-‐‑40.00%

-‐‑35.00%

-‐‑30.00%

-‐‑25.00%

-‐‑20.00%

-‐‑15.00%

-‐‑10.00%

-‐‑5.00%

0.00%

5.00%

10.00%

52-‐‑Week Movement

DAL AAL

UAL LUV

Jet Fuel against Total Expenses

22% 19%

2015

2016 Source: Company Financials


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per share would be approximately $.08 for 2016. When LUV releases its first earnings after the expansion into that market our valuation models will be modified to better incorporate international flights. (See Appendix C) Price stabilization for oil Since June 2014, volatility has accompanied the plunging price of a barrel of oil. LUV stands to benefit if the price of oil stabilizes near current low price levels. Street analysis suggests that oil will remain below $50 during 2016, and can justify the sustained earnings we forecast due to improved margins, especially net margins. The probability of oil rising above $50 within the next 12 months is very low because that move would require an approximately 65% bull run on oil. We have conducted a sensitivity analysis on the stock price of LUV with the price of WTI Crude against fuel consumption. (See Appendix D) Load factor’s impact on earnings per share LUV has been increasing its load factor historically and has room for further improvement. Since airlines are capital intensive and have high fixed costs, increasing the load factor is almost equivalent to obtaining free money because all the airplane’s seats must fly, regardless of the number of tickets sold. A 1% increase in load factor would have a direct impact on earnings per share of approximately $0.06. (See Appendix E) We believe LUV’s load factor will increase due to improved brand equity. Recent marketing strategies such as;; “TransFAREncy” and “Bags Fly Free” help improve this brand equity by driving more customers to LUV. Competitive Positioning and Industry Overview Industry leading strategy In a highly competitive industry with major barriers to entry, LUV has continuously used a contrarian strategy to profitability. From the two major airline business models: “Hub-and-Spoke” or “Point-to-Point,” LUV chose the lesser chosen model. LUV’s, now famous, point-to-point service sets them apart from their peers. Not only do they offer these desired flights, they strive to offer the flights at low-cost. LUV has accomplished many goals and gained awards because of this leading strategy. (See Appendix F) LUV operated 704 Boeing 737s at a load factor of 83.6% at the end of FY15. Overall, LUV’s load factor has increased over the last 10 years. LUV also books 80% of passenger fares through its website www.Southwest.com giving them more control over pricing and selling cost, and thus, better control of margins. Threat of New Entrants: Low High fixed and startup cost are notable barriers to entry into the airline industry. The last two entrants were Virgin America in 2004 and JetBlue in 1998. Planes, airport hubs, experienced pilots and flight crew, and fuel expenses all require a sizable amount of capital to enter the airline industry. The list price for a single Boeing 787 was roughly $194 million in 2012. Pilots with 10 years of experience tend to make a salary in excess of $100,000 and domestic U.S. airlines spend a combined $2 to $5 billion on jet fuel each month.

2013 2014 2015

$98 $60 $37

60

65

70

75

80

85

1/1/94

1/1/97

1/1/00

1/1/03

1/1/06

1/1/09

1/1/12

1/1/15

LOAD FACTOR %

Hub-and-Spoke

Point-to-Point

Source: EIA.gov

Source: Company Financials


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Threat of Substitute Products: Low Air travel stands out among modes of transportation. Trains and cars both provide an alternative option in travel and can be quite useful over short distances, but both lack the speed that air travel provides when traveling moderate to long distances. Boats can allow a means of travel overseas, but take considerably more time than a plane would and at a much higher cost. There are currently no other means of transportation that can match the amenities and speed of air travel when traveling overseas or even considerable distances over land. Bargaining Power of Customers: Low Customers have very little to no power over the prices they pay at airlines. The large number of travelers vying for a limited number of flights results in travelers being price takers. Some consumers may be willing to pay more for brand recognition or more luxurious amenities, but have little influence in the fluctuation in fare prices. Bargaining Power of Suppliers: Moderate Suppliers in the airline industry hold a moderate amount of power over commercial airlines. With Boeing and Airbus dominating the supply market of planes and jets, there is little to no explicit competition among suppliers to drive down the costs of aircraft. Even though there is little explicit competition, aircraft manufactures like to keep their customers happy and tend to offer rather steep discounts. Hence, there is a tacit competition among plane manufacturers. The Wall Street Journal reports that LUV, one of Boeing’s best customers, received around a 64% discount on their orders of Boeing 737 Max jetliners. Competitive Rivalry within the Industry: Intense There are many regional airline companies in the United States competing for short range customers. Additionally, there are major airlines competing for long range customers. These companies, such as Delta, American and United control the international industry due to their numerous airport hubs and routes. Even though there is a high level of competition amongst the regional airlines for shorter flights that result in lower fares, there is a much more concentrated scale of competition for longer flights with higher fares among the major airlines. LUV is at a stage where it is both retaining its competitive advantage among regional airlines and expanding services internationally in competition with the major airlines.

Threat of New Entrants Competitive

Rivalry in the Industry

Bargaining Power of Suppliers

Bargaining Power of

Customers

Threat of Substitute Products

Source: Group Estimates


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Share Price (P/E) Forecast 2016 2017

Bear $27.48 $22.86 Base $46.40 $38.60 Bull $65.69 $55.65

Share Price (P/S) Forecast 2016 2017

Bear $26.61 $27.55 Base $28.40 $29.41 Bull $31.74 $32.87

Share Price (P/B) Forecast 2016 2017

Bear $27.95 $28.71 Base $28.17 $28.94 Bull $29.11 $29.90

Share Price (P/FCF) Forecast 2016 2017

Bear $16.73 $13.92 Base $19.00 $15.81 Bull $22.88 $19.04 Share Price (DDM) Forecast 2016 2017

Bear $30.00 $30.00 Base $30.00 $30.00 Bull $30.00 $30.00

Weighted Stock Price

Forecast

2016 2017

Bear $27.05 $23.30

Base $42.40 $36.09

Bull $58.39 $50.26

Valuations Earnings per share With many variables that could potentially impact earnings over the next 12 months, there is a $2 range from our bear to bull case in earnings for 2016. We see at minimum that earnings per share will be $3.53 if LUV sustains current margin levels. With an expansion in capacity, load factor, and margins for 2016 (suggested by LUV), we believe earnings will be $4.92. In addition to the three previous factors, international expansion, stock repurchases, and baggage opportunity cost (See Appendix G) all make up our bull case. If LUV successfully implements all these initiatives, we would see earnings amount up to $5.53 per share.

Earnings Per Share Breakdown Historical Forecast

2015 2016 2017 2018 2019 Bear -‐ $3.53 $2.93 $2.86 $2.52 Base $3.27 $4.92 $4.09 $3.99 $3.52 Bull -‐ $5.53 $4.68 $4.57 $4.10

Weighted valuation models LUV has a historic track record of higher multiples compared to industry peers. However, with the recent move into international flights, we expect these multiples to change. We have created proprietary Weighted Valuation Models (WVM) that take into account LUV’s move into competing more directly with the major airlines. Our forecasts reflect the weighted average (60% on majors and 40% on regionals) as the base case, the major airlines average as the bear case, and the regional airlines average as the bull case. (See Appendix H) After determining five individual weighted valuations, we assign a weighting to each of those values. Compiling our final weighted values gave us one last bear, base, and bull forecast for the weighted stock price. We subscribe to the base case, from the weighted stock price model, as our target price for LUV. This final stock price is made up of 80% of the (P/E) share price, 5% of the (P/S) (P/B) (P/FCF) share prices, and 5% of the share price from our DDM.






Source: Company Financials and Group Estimates



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Financial Analysis Industry leading financials LUV is a highly profitable and effectively leveraged airline that leads them to having one of the highest credit ratings amongst peers. LUV Industry Average

Profitability Sales Growth (%) 6.53 1.99

Net Profit Margin 11.89 7.25 Return on Invested Capital 22.91 16.02 Return on Assets 11.35 6.80 Return on Equity 33.34 23.80

Leverage Capex/Sales (%) 10.30 14.33

Net Debt/EBITDA (x) 0.03 1.26 Total Debt/EBITDA (x) 0.64 2.57 Net Debt/Equity (%) 1.73 91.24 Total Debt/Total Assets (%) 14.91 32.58

LUV Credit Ratings

S&P Rating BBB Moody's Rating Baa1 Fitch Rating BBB+

Investment Risks Impact of volatile fuel prices Fuel prices accounted for approximately 37% of total operating expenses in 2012 and has dropped to 23% in 2015. Although this is highly beneficial, a slight change in the market for fuel prices could have an extraordinary impact on LUV’s profit. Low fuel prices have always rebounded. As always, the question is when and how much? Once oil breached the $50 per barrel level in a bearish manner, a positive correlation between airline stock prices on oil prices developed, impacting the stock price of LUV in a bearish manner. This recent correlation is unwarranted, based on history. We forecast oil to stabilize within the $30-$50 range, with periodic spikes, over a period of 12 months. LUV is slightly hedged against moves in jet fuel prices during 2016. (See Appendix I) With an extremely bullish move in jet fuel prices over $50, we would revise our models. Low-cost business structure The major advantage of LUV over their competitors is its ability to maintain its fares below the industry average. It does this by controlling its expenses. The recent decline in fuel prices has helped LUV maintain their low fares. However, LUV has unionized employees and are pressured to increase pay up to 20 percent over the next five years. This will add over $1.2B in yearly expenses by 2020. This has an effect on salaries in 2016 that we have modeled in the operating expenses. (See Appendix J)

Source: Bloomberg

Source: Bloomberg


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Dependency on information systems The airline industry is increasingly dependent on information systems to properly operate. LUV is continually upgrading their information systems to ensure smooth daily operations as they did in 2014 when they upgraded to the Amadeus’ Altea reservations solution. Today’s complex information systems present challenges that affect costs and the development of internal controls. Any information system is always going to be at risk of operational failure and present a security risk. Any failure with a system would be serious for LUV and could have a major impact on its profit. Dependence on single aircraft and engine suppliers LUV is dependent on Boeing for all of its aircraft and most of the parts. This limitation would have adverse effects if Boeing could not get all of the needed parts or planes delivered on time or if Boeing did not produce the model needed by LUV. Additionally, if mechanical or regulatory problems with LUV’s most popular jet, the Boeing 737, surface, the result could be major downtime or a damaged image.


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Appendices Appendix A:

Appendix B:

Income Statement (GAAP) Historical Forecast

(in millions) 2012 2013 2014 2015 2016 2017 2018 2019 Operating Revenues 17,088 17,699 18,605 19,820 20,971 21,715 22,950 23,864 % growth (yoy) 15.97% 3.58% 5.12% 6.53% 5.81% 3.55% 5.69% 3.98%

Operating Expenses 16,465 16,421 16,380 15,704 15,796 17,148 18,491 19,905 % growth (yoy) 10.02% -0.27% -0.25% -4.13% 0.59% 8.56% 7.83% 7.65%

Operating Income 623 1,278 2,225 4,116 5,175 4,567 4,459 3,959 % growth (yoy) -10.10% 105.14% 74.10% 84.99% 25.73% -11.74% -2.37% -11.23%

Net Income 421 754 1,136 2,181 3,105 2,740 2,676 2,375

% growth (yoy) 136.52% 79.10% 50.66% 91.99% 42.36% -11.74% -2.37% -11.23%

Operating margin 3.65% 7.22% 11.96% 20.77% 24.68% 21.03% 19.43% 16.59% Net margin 2.46% 4.26% 6.11% 11.00% 14.81% 12.62% 11.66% 9.95%

Source: Southwest.com


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Appendix C:

International Model (Base Case) Seats per 737-‐800 175 Load Factor 83.60% Average Passenger Fare $154.85 737-‐800 Potential Revenue/Flight $22,654.56 2 Departure Flights $45,309.11 2 Return Flights $45,309.11 Potential Daily Revenue/Destination $90,618.22 Potential Yearly Revenue/Destination $33,075,650.30 Potential Int'l Total Revenue $363,832,153.30 Potential EPS for Current Int'l Expansion $0.062 Potential Stock Impact (P/E) $0.580 Potential Stock Impact (P/B) $0.153 Potential Stock Impact (P/S) $0.055 Potential Stock Impact (P/FCF) $0.238 Proprietary Weighted Average ex DDM $0.487




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Appendix D:

Sensitivity Analysis Price Per Barrel Millions of Gallons Used

FUEL COST 1800 1900 2000 2100

$15.00 2340 2470 2600 2730 $25.00 2700 2850 3000 3150 $30.00 3060 3230 3400 3570 $45.00 3600 3800 4000 4200 $55.00 3960 4180 4400 4620 $60.00 4500 4750 5000 5250

NET INCOME 1800 1900 2000 2100

$15.00 3522 4392 5262 6132 $25.00 3162 4012 4862 5712 $30.00 2802 3632 4462 5292 $45.00 2262 3062 3862 4662 $55.00 1902 2682 3462 4242 $60.00 1362 2112 2862 3612

EPS 1800 1900 2000 2100

$15.00 5.42 6.75 8.09 9.43 $25.00 4.86 6.17 7.48 8.78 $30.00 4.31 5.58 6.86 8.14 $45.00 3.48 4.71 5.94 7.17 $55.00 2.92 4.12 5.32 6.52 $60.00 2.09 3.25 4.40 5.55

STOCK PRICE (P/E) 1800 1900 2000 2100

$15.00 51.07 63.68 76.30 88.91 $25.00 45.85 58.17 70.50 82.82 $30.00 40.63 52.66 64.70 76.73 $45.00 32.80 44.40 56.00 67.60 $55.00 27.58 38.89 50.20 61.51 $60.00 19.75 30.62 41.50 52.37



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Appendix E:

1% Increase in Load Factor Model (Base Case) Seats per 737-‐800 175 Load Factor 1.00% Average Passenger Fare $154.85 737-‐800 Potential Added Revenue/Flight $270.99 Potential Added Yearly Revenue $343,438,176.03 Potential EPS for 1% increase in Load Factor $0.058 Potential Stock Impact (P/E) $0.55 Potential Stock Impact (P/B) $0.14 Potential Stock Impact (P/S) $0.05 Potential Stock Impact (P/FCF) $0.22 Proprietary Weighted Average ex DDM $0.459

Appendix F: Awards

• Named to FORTUNE Magazine's World's Most Admired Companies list for 21 consecutive years. Southwest was ranked as the No. 7 Most Admired Company, and is the only commercial airline to make the Top Ten.

• Named one of the Top 20 America's Best Employers of 2015 by Forbes. • Named 2015 Airline of the Year by Air Transport World. • Rapid Rewards Program recognized for Best Redemption Ability, Best Airline Customer Service, and Best Loyalty

Credit Card by InsideFlyer. • Among the Environmental Protection Agency's List of Fortune 500 Partners • Recognized as one of the Top 100 Military-Friendly Employers by Victory Media, publisher of G.I. Jobs and

Military Spouse. • Recognized as one of the Best Places to Work in the Glassdoor Employees' Choice Awards 2015. • Named one of the National Conference on Citizenship's The Civic 50. • Recognized in the top 10 Best Companies for Leaders by Chief Executive Group. • Named Domestic Airline of the Year by Express Delivery and Logistics Association for the 15th year in a row. • Named Domestic Carrier of the year for Cargo by the Airforwarders Association. • Recognized by Newsweek as one of America's Greenest Companies 2015. • Selected as the Travelers' Choice “Favorite Airline” by TripAdvisor. • Best Low Cost Carrier in North America award from Premier Traveler's Best of 2014. • Recommended.com 2014 Readers' Choice Award for Best Airline – Domestic. • Air Cargo Excellence “ACE” Diamond Award winner in the “up to 399,999 tonnes” category by Air Cargo

World Magazine. • Received Logistics Management Magazine's 2015 Quest for Quality Award. • Received CIO 100 Award from CIO Magazine. • Ranked #9 on the Dallas Business Journal's Top Public Companies List. • Designated a 2015 Most Valuable Employer (MVE) for military by CivilianJobs.com. • Named one of the Best Corporate Citizens 2015 by Corporate Responsibility Magazine • Named a 2015 STEM Jobs Approved Employer.



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• Named the #2 Low Cost Carrier in the J.D. Power 2015 Airline Loyalty/Rewards Program Satisfaction Report. • Ranked as a Top 100 Company by BetterInvesting. • Received a 2015 Texas Excellence Award from the U.S. Commerce & Trade Research Institute. • Ranked among the Top Companies for HR on the Workforce 100. • Recognized among the Top Domestic Airlines on Travel + Leisure's World's Best List. • Ranked #27 of Top 50 Employers by Workforce Diversity for Engineering & IT Professionals Magazine. • Named one of Best Companies for Work-Life Balance by Forbes. • Ranked among Best Airline Rewards Programs by U.S. News & World.

• Outsmart Magazine's Best Airline.

Appendix G:

"Bags Fly Free" Opportunity Cost number revenue revenue

customers flown

118,171,211.00 B1=$15, B2=$25 B1=$20, B2=$30 potential single bags (80% customers flown) 94,536,968.80 $1,418,054,532.00 $1,890,739,376.00 potential double bags (50% single bag cust.) 47,268,484.40 $1,181,712,110.00 $1,418,054,532.00 potential total bags 141,805,453.20 $2,599,766,642.00 $3,308,793,908.00 potential eps $0.44 $0.56 potential stock impact P/E $4.15 $5.28 potential stock impact P/B $1.09 $1.39 potential stock impact P/S $0.39 $0.50 potential stock impact P/FCF $1.70 $2.16 proprietary weighted average ex DDM $3.48 $4.42



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Appendix H:

Proprietary Weighted Valuation Models

P/E

Major Airlines Regional Airlines

AAR Corp. [AIR] 16.6 Alaska Air Group, Inc. Common S [ALK] 11.4

American Airlines Group, Inc. [AAL] 5.7 Allegiant Travel Company [ALGT] 16.1 Avaianca Holdings S.A. [AVH] 1.4 Copa Holdings, S.A. Copa Holdin [CPA] 7.3

Baktic International USA Inc [BISA] 0.2 Gol Linhas Areas Inteligentes [GOL]

China Eastern Airlines Corporat [CEA] 6.5 Great Lakes Aviation, LTD [GLUX] China Southern Airlines Company [ZNH] 7.3 Hawaiian Holdings, Inc. [HA] 14.7

Delta Air Lines, Inc. Common St [DAL] 12.9 JetBlue Airways Corporation [JBLU] 12.8

KLM N.V. [KLMR] Latam Airlines Group S.A. [LFL] Mesa Air Group, Inc. [MSRPW] Republic Airways Holdings Inc. [RJET] 4

Ryanair Holdings RLC [RYAAY] 13.4 SkyWest, Inc. [SKYW] 15.1

Spirit Airlines, Inc. [SAVE] 10 Southwest Airlines Company Comm [LUV] 13.7 United Continental Holdings [UAL] 2.8

Virgin America Inc. [VA] 8.9

sector average 7.790909091 sector average 11.8875

60% weight 4.674545455 40% weight 4.755

industry average: Morningstar 8 P/E weighted average for LUV 9.429545455

P/S

Major Airlines Regional Airlines AAR Corp. [AIR] 0.5 Alaska Air Group, Inc. Common S [ALK] 1.7

American Airlines Group, Inc. [AAL] 0.7 Allegiant Travel Company [ALGT] 2.2

Avaianca Holdings S.A. [AVH] 0.1 Copa Holdings, S.A. Copa Holdin [CPA] 0.8 Baktic International USA Inc [BISA] Gol Linhas Areas Inteligentes [GOL] 1

China Eastern Airlines Corporat [CEA] 0.5 Great Lakes Aviation, LTD [GLUX]

China Southern Airlines Company [ZNH] 0.3 Hawaiian Holdings, Inc. [HA] 1 Delta Air Lines, Inc. Common St [DAL] 0.9 JetBlue Airways Corporation [JBLU] 1.2

KLM N.V. [KLMR] Latam Airlines Group S.A. [LFL] 0.2

Mesa Air Group, Inc. [MSRPW] Republic Airways Holdings Inc. [RJET] 0.1 Ryanair Holdings RLC [RYAAY] 3.2 SkyWest, Inc. [SKYW] 0.2

Spirit Airlines, Inc. [SAVE] 1.4 Southwest Airlines Company Comm [LUV] 1.3

United Continental Holdings [UAL] 0.5 Virgin America Inc. [VA] 0.2

sector average 0.83 sector average 0.97 60% weight 0.498 40% weight 0.388

industry average: Morningstar 0.5 P/S weighted average for LUV 0.886


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P/B


AAR Corp. [AIR] 0.8 Alaska Air Group, Inc. Common S [ALK] 3.7

American Airlines Group, Inc. [AAL] 6.7 Allegiant Travel Company [ALGT] 8 Avaianca Holdings S.A. [AVH] 0.3 Copa Holdings, S.A. Copa Holdin [CPA] 1

Baktic International USA Inc [BISA] Gol Linhas Areas Inteligentes [GOL]

China Eastern Airlines Corporat [CEA] 1.1 Great Lakes Aviation, LTD [GLUX] 0.1 China Southern Airlines Company [ZNH] 1.2 Hawaiian Holdings, Inc. [HA] 5.1

Delta Air Lines, Inc. Common St [DAL] 3.4 JetBlue Airways Corporation [JBLU] 2.2

KLM N.V. [KLMR] Latam Airlines Group S.A. [LFL] 0.9 Mesa Air Group, Inc. [MSRPW] Republic Airways Holdings Inc. [RJET] 0.2

Ryanair Holdings RLC [RYAAY] 4.3 SkyWest, Inc. [SKYW] 0.5

Spirit Airlines, Inc. [SAVE] 2.6 Southwest Airlines Company Comm [LUV] 3.5 United Continental Holdings [UAL] 2.1



60% weight 1.482 40% weight 1.008

industry average: Morningstar 2.1 P/B weighted average for LUV 2.49

. P/FCF


AAR Corp. [AIR] 10.3* Alaska Air Group, Inc. Common S [ALK] 6.7 American Airlines Group, Inc. [AAL] 4.1 Allegiant Travel Company [ALGT] 7.9

Avaianca Holdings S.A. [AVH] 2.7 Copa Holdings, S.A. Copa Holdin [CPA] 4.6

Baktic International USA Inc [BISA] 3 Gol Linhas Areas Inteligentes [GOL] 49.9* China Eastern Airlines Corporat [CEA] 2.1 Great Lakes Aviation, LTD [GLUX]

China Southern Airlines Company [ZNH] 1.7 Hawaiian Holdings, Inc. [HA] 5.2

Delta Air Lines, Inc. Common St [DAL] 5.2 JetBlue Airways Corporation [JBLU] 4.9 KLM N.V. [KLMR] Latam Airlines Group S.A. [LFL] 1.3

Mesa Air Group, Inc. [MSRPW] Republic Airways Holdings Inc. [RJET] 0.5

Ryanair Holdings RLC [RYAAY] 10.5* SkyWest, Inc. [SKYW] 1.8 Spirit Airlines, Inc. [SAVE] 7.1 Southwest Airlines Company Comm [LUV] 8.1

United Continental Holdings [UAL] 3.8



60% weight 2.04 40% weight 1.822222222 industry average: Morningstar 3.8 P/CF weighted average for LUV 3.862222222

Source: Morningstar and Group Estimates


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Appendix I:

Period

Average percent of estimated fuel consumption covered by fuel derivative contracts at varying WTI/Brent Crude Oil, Heating Oil, and Gulf Coast Jet

Fuel-equivalent price levels Q1 2016 — Full year 2016 Approx. 20%

2017 Approx. 65% 2018 Approx. 35%

January 3,2006-January 24,2016

September 1, 2015- January 24,2016

0

20

40

60

80

100

120

140

160

WTI $

LUV $

-‐‑50.00%

-‐‑40.00%

-‐‑30.00%

-‐‑20.00%

-‐‑10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

WTI

LUV

Source: Company Financials and EIA


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Appendix J:

Expense Breakdown Historical Forecast (in millions) 2012 2013 2014 2015 2016 2017 2018 2019 Operating Expenses

Salaries, wages, and benefits $4,749 $5,035 $5,434 $6,383 $6,767 $7,401 $8,093 $8,851

% change (yoy) 6.02% 7.92% 17.46% 6.02% 9.36% 9.36% 9.36% % of total expenses 28.84% 30.66% 33.17% 38.97% 41.32% 45.18% 49.41% 54.03%

Fuel and oil $6,120 $5,763 $5,293 $3,616 $3,116 $4,000 $4,500 $5,000 % change (yoy) -‐5.83% -‐8.16% -‐31.68% -‐13.83% 28.37% 12.50% 11.11% % of total expenses 37.17% 35.10% 32.31% 22.08% 19.02% 24.42% 27.47% 30.53% Maintenance (m&r) 1,132 1,080 978 1,005 967 903 844 788 % change (yoy) -‐4.59% -‐9.44% 3% -‐4% -‐7% -‐7% -‐7% % of total expenses 6.88% 6.58% 5.97% 6.14% 5.90% 5.52% 5.15% 4.81%

Aircraft rentals $355 $361 $295 $238 $242 $198 $198 $198 % change (yoy) 1.69% -‐18.28% -‐19% 2% -‐18% 0% 0% % of total expenses 2.16% 2.20% 1.80% 1.45% 1.48% 1.21% 1.21% 1.21% Landing fees/other $1,043 $1,103 $1,111 $1,166 $1,210 $1,238 $1,266 $1,295 % change (yoy) 5.75% 0.73% 5% 4% 2% 2% 2% % of total expenses 6.33% 6.72% 6.78% 7.12% 7.39% 7.56% 7.73% 7.90% Depreciation and

amortization $844 $867 $938 $1,015 $1,080 $1,158 $1,243 $1,333 % change (yoy) 2.73% 8.19% 8% 6% 7% 7% 7% % of total expenses 5.13% 5.28% 5.73% 6.20% 6.59% 7.07% 7.59% 8.14%

Acquisition and integration $183 $86 $126 $39 $57 $53 $68 $75

% change (yoy) -‐53.01% 46.51% -‐69% 47% -‐7% 29% 11% % of total expenses 1.11% 0.52% 0.77% 0.24% 0.35% 0.32% 0.42% 0.46%

Other expenses $2,039 $2,126 $2,205 $2,242 $2,314 $2,394 $2,477 $2,563 % change (yoy) 4.27% 3.72% 2% 3% 3% 3% 3% % of total expenses 12.38% 12.95% 13.46% 13.69% 14.13% 14.62% 15.13% 15.65% Total operating

expenses $16,465

$16,421

$16,380

$15,704

$15,512

$17,148

$18,491

$19,905 % change (yoy) -‐0.27% -‐0.25% -‐4.13% -‐1.22% 10.54% 7.84% 7.65%



17

Disclosures:

Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation:Compensation of the author(s) of this report is not based on investment banking revenue. Position as an officer or director:The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making:The author(s) does not act as a market maker in the subject company’s securities. Disclaimer:The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with CFA Societies of Texas, Louisiana, and Oklahoma CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

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