DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION ™ Client-Driven Solutions, Insights and Access U.S. Airline Industry Coverage Initiation Network Carriers Flying on Course for Continued Outperformance We initiate coverage of the U.S. Airline sector at Overweight. Based on structural changes to the industry, a strong demand & pricing environment, and ongoing margin enhancing initiatives, we have a favorable bias toward the three U.S. network carriers. Our out- of-consensus top pick is UAL, as we expect self-help initiatives to propel momentum over the next 6-18 months, and see a string of catalysts and tailwinds in 2015 that should drive upside to both earnings & valuation. We rate JBLU Underperform based on the view that incremental strategy/management change in 2015 will disappoint relative to elevated expectations. Cyclical juice remains on structural industry shifts. We are in the fifth year of industry profitability and while operating margins have approached historical peak levels of ~9%, we expect a healthier, more rational airline industry will reach midteens EBIT margins by 2016. Unit revenue (PRASM) growth and margin expansion is moderating mid-cycle, but we see further upside potential from continued pricing gains, evolution of revenue and cost initiatives, and as merger synergies are fully realized. However, yields bear watching after four years of growth. While upward pricing trends appear intact domestically, pockets of competitive tension are building in certain markets and the battle for high-yielding corporate travel is intensifying following industry consolidation. In this report, we take a close look at capacity and pricing trends in certain regional markets. Comps are getting tougher and international trends are mixed, but network carriers have been quick to adjust capacity and restructure where needed to protect yields. Going forward, we see the most opportunity for UAL to catch-up. Stock calls. We initiate coverage with Outperform ratings on UAL, DAL, and AAL, a Neutral rating on LUV, and an Underperform rating on JBLU. September 8, 2014 RESEARCH TEAM Julie Yates Research Analyst 212-325-3706 [email protected]Krishna Vege Research Analyst 212-325-6949 [email protected]
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DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS
OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors
should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION™
Client-Driven Solutions, Insights and Access
U.S. Airline Industry Coverage Initiation Network Carriers Flying on Course for Continued Outperformance
We initiate coverage of the U.S. Airline sector at Overweight. Based on structural changes to the industry, a strong demand & pricing environment, and ongoing margin enhancing initiatives, we have a favorable bias toward the three U.S. network carriers. Our out-of-consensus top pick is UAL, as we expect self-help initiatives to propel momentum over the next 6-18 months, and see a string of catalysts and tailwinds in 2015 that should drive upside to both earnings & valuation. We rate JBLU Underperform based on the view that incremental strategy/management change in 2015 will disappoint relative to elevated expectations.
Cyclical juice remains on structural industry shifts. We are in the fifth year of industry profitability and while operating margins have approached historical peak levels of ~9%, we expect a healthier, more rational airline industry will reach midteens EBIT margins by 2016. Unit revenue (PRASM) growth and margin expansion is moderating mid-cycle, but we see further upside potential from continued pricing gains, evolution of revenue and cost initiatives, and as merger synergies are fully realized.
However, yields bear watching after four years of growth. While upward pricing trends appear intact domestically, pockets of competitive tension are building in certain markets and the battle for high-yielding corporate travel is intensifying following industry consolidation. In this report, we take a close look at capacity and pricing trends in certain regional markets. Comps are getting tougher and international trends are mixed, but network carriers have been quick to adjust capacity and restructure where needed to protect yields. Going forward, we see the most opportunity for UAL to catch-up.
Stock calls. We initiate coverage with Outperform ratings on UAL, DAL, and AAL, a Neutral rating on LUV, and an Underperform rating on JBLU.
Best self-help story. Margin recovery efforts shld drive ~400-500 bps of margin improvement by 2016. UAL has yet to fully realize benefits from structural industry changes and its merger with CAL, but the
carrier is on track for a turnaround and we expect it to transition unit revenue outperformance in 2015. We see a string of catalysts and tailwinds in 2015 that should drive earnings and valuation upside. We see no
structural impediments to UAL achieving a low double-digit EBIT margin, which is not priced into the stock. O/P $68.00 34% 6.0x 14.0x
Delta (DAL)
O/P $56.00 43% 6.6x 14.4x Best-in-class. A key holding for airline investors given index presence, lower debt levels, a fully integrated
merger, an established shareholder return program, top-level management, the best FCF generation in the group, and a leading position in the corporate market share that yields a 13% domestic unit revenue
premium to the industry. The December 11th investor day gives management another opportunity to remind investors why they should own DAL in 2015.
American (AAL)
O/P $52.00 37% 7.2x 10.6x Merger integration upside outweighs risk. Relative underperformance since Q2 report offers longer-term investors an attractive entry point with shares off 17% from the 52-week high. A conservative $1.4B synergy target, structural improvements to legacy American post-integration, and upside to capital deployment drive our above consensus 2015 estimates. Long-term, we think AAL can exceed DAL margin levels. Expect re-rating
as integration progresses in 2015.
Southwest (LUV)
N $32.00 (3%) 6.1x 15.7x Fewer levers for margin expansion. Despite a strong brand and leading domestic footprint, rising unit cost pressures and labor tensions, decelerating yield growth, premium valuation and leading YTD performance
temper our enthusiasm on shares. Limited ancillary opportunity given customer friendly policies and low-fare
brand bound yield potential, in our view.
JetBlue (JBLU)
U/P $11.00 (12%) 6.1x 12.9x Unlikely to see major strategy shift investors are waiting for. Share outperformance (+66%) and multiple analyst upgrades since late April have centered primarily on optimism for a CEO / strategy change and earnings upside from fare unbundling, but we see little change to JBLU’s hybrid growth strategy. We
are less bullish on the level of incremental earnings from fare family/ancillary revenue. We think
disappointment on the latter two, combined with lagging returns and more limited margin upside will make
JBLU a relative underperformer.
Company Rating Target Price
Upside/
(Downside) vs. Current Share Price
TargetPrice
Multiple on 2015
EBITDAR
TargetPrice
Multiple on 2015 EPS
(Fully Taxed)
UAL O/P $67.00 39% 4.89x 13.78x
DAL O/P $57.00 41% 6.34x 14.20x
AAL O/P $53.00 34% 6.38x 10.97x
LUV N $32.00 (0%) 5.47x 15.70x
JBLU U/P $10.89 (13%) 5.34x 12.80x
TOP PICK
4
Executive Summary & Conclusion
Structural industry changes make industry investable
Key Investable Theme. U.S. airlines represent a key investable theme within
industrials as structural industry changes are driving unprecedented profitability
& S/H returns in what historically has been a capital-destructive industry.
Earning Cost of Capital, Returning Cash to S/H & Avoiding Prior
Cycle Sins. Management teams are avoiding prior cycle sins, with an intense
focus on improving financial metrics, not just land grabbing for market share.
Balance sheets are cleaner, debt loads are reduced, and U.S. airlines are
finally generating returns above capital cost. Managements are leveling new
aircraft spend, taking a more balanced approach to capital deployment. Five of
the six largest U.S. airlines are returning cash to shareholders as of July.
Oligopolistic Structure has Lead to Pricing Power: Five major mergers
since 2005 have consolidated the domestic airline industry to 4 carriers that
control more than 80% of capacity. This oligopolistic structure and consistent
capacity discipline is driving sustainable pricing power. Domestic capacity
remains 6% below 2007 levels. International trends remain mixed, but we
think recent Transatlantic excess capacity fears are overdone and note that
84% of trunk routes between the U.S. and Europe are a duopoly, greatly
reducing the risk of irrational capacity or pricing decisions.
Margin Expansion Moderating, but Still Room to Go. The pace of margin
expansion is moderating mid-cycle, but we see further upside at network
carriers as revenue & cost initiatives bear fruit, and merger synergies are fully
realized. Airline profitability is extremely dynamic, driven by (1) pricing, (2) load
factors, and (3) unit costs. Since 2010, yields have risen 20% representing
real pricing gains above inflation for the first time since the late 1990s.
System load factors of 80%+ are at all time highs. Carriers are steadily
refleeting & eliminating structural costs to keep unit cost growth sub-inflation.
Re-rating Upside: Network carriers trade at a significant discount to leisure
carriers, industrial transports, and the S&P 500. We expect an upward re-
rating as structural industry shifts, sustained pricing and cost control drive mid-
teens operating margins & capital is returned to S/H, similar to the “Rail
Renaissance”.
Where are We Different?
Favorable bias to network carriers, less positive on leisure carriers
Out of Consensus Top Pick is UAL; Underperform on JBLU.
Our Neutral rating on top YTD performer Southwest (LUV) is also less-
consensus. We initiate at Outperform on Delta (DAL) and American (AAL) given
our favorable bias to network carriers on structural industry changes post
consolidation, as well as stock specific reasons. DAL and AAL are more
consensus longs, but we think valuation remains attractive for both.
UAL Turning it Around. Self-help initiatives should propel momentum over the
next 6-18 months, and we see a string of catalysts and tailwinds in 2015 that
should drive upside to both earnings and valuation. Sentiment on UAL has
improved since the Q2 report, but Delta’s performance since early 2013 has
doubled that of that of United. We expect near-term outperformance as sidelined
investors gain confidence in an inflection.
JBLU Change Optimism Overdone: We rate JBLU Underperform based on a
view that incremental upside from management / strategy change and ancillary
revenue in 2015 will disappoint relative to elevated expectations, following
multiple analyst upgrades and rising 2015 consensus (+10% in last 3 months).
DAL Remains Key Holding: We see DAL as a key holding for airline investors
given its S&P presence, lower debt levels, fully integrated merger, established
shareholder return program, and leading margin and return profile. DAL is
successfully executing a lower risk, differentiated strategy with its approach to
fleet, fuel, and maintenance.
AAL May Take Longer to Play Out: Our Outperform call on AAL has a longer-
term horizon and we think strong YTD stock performance, Venezuela PRASM
headwinds in H2 and merger risk has sidelined some. Despite these challenges,
we see significant upside potential in margins as management executes on the
merger, and optimizes legacy AMR over the next 18-36 months.
LUV Fully Valued on Our Estimates: LUV has a strong brand and leading
domestic footprint, but we see fewer levers for margin expansion & relative share
outperformance given it is the best YTD performer (+73%) and is now the only
airline in our converge that trades at a premium to the S&P 500 on FY2 P/E.
Flying High on Structural Shifts
5
Following significant outperformance since early 2013, we think the market will be more
discriminating in H2 of 2014 and 2015
Innovative revenue management, heightened cost control, greater focus on ROIC, and shareholder friendly capital deployment are key themes that have
primarily been shaped by industry consolidation
Following a decade wrought with the worst industry downturn since deregulation, fuel volatility, bankruptcies, and five major mergers, the U.S. airline
industry has emerged stronger than ever as reflected by sector's appreciation since early 2013
We subscribe to the bullish view that the industry is now investable, and think the next leg of the story will be driven by further margin expansion, improving ROIC
and consistency in capital allocation.
U.S. airlines are in the 5th year of current upcycle, but cyclical juice remains on structural industry shifts
We are in the 5th year of industry profitability and while operating margins are approaching (and some have exceeded) historical peak levels of ~9%, we expect a
healthier, more rational airline industry can exceed prior peaks and reach midteens. If current macro trends hold (or improve) and fuel is stable (or declines), we think
this cycle's peak may not be until 2016 / 2017, suggesting two to three more years of improving profits, cash and shareholder returns.
The industry remains beholden to fuel, but Brent crude prices are stable despite pockets of geopolitical instability, and we think the price trend is gradually down given
supply growth in the U.S. and steady demand.
Multiple re-rating on improved industry performance
Post-consolidation, the U.S. network carriers are now a functioning, disciplined oligopoly earning returns above capital costs. We believe the airlines can re-rate
similar to the rails, on the back of a pricing renaissance that drove improved returns and shareholder-friendly capital allocation. While the evolution of the shareholder
base is well underway, we think the group is still under owned with network carriers trading at 9.5x fully taxed P/E versus the S&P at 15.7x and transports at 17x.
Sector 2015 EV/EBITDAR of 5.7x is below where we think airlines should trade mid-cycle (between 6-7x EV/EBITDAR).
More Runway to Go, but Selectivity Key
Source: Company data, CS estimates, Bloomberg
We still see upside in airline stocks given the following factors:
2. Durable pricing gains with room to go - Yields should continue to grow ahead of inflation on better revenue management & strong domestic demand
3. Increasingly attractive shareholder returns, improving ROIC and inexpensive valuations - The paradigm shift to shareholder-friendly capital allocation and
improving ROIC should drive a sector re-rating
Sector valuations reasonable versus prior peak (late 90s) and relative to other industrials.
6
82.9%
83.6%83.9% 84.0%
85.1%
14.57¢
15.85¢
16.41¢
16.80¢17.09¢
12.50
13.50
14.50
15.50
16.50
17.50
81.0%
82.0%
83.0%
84.0%
85.0%
86.0%
2010 2011 2012 2013 H1 2014
Domestic Load Factor Domestic Yield
$12.00
$13.00
$14.00
$15.00
$16.00
$17.00
$18.00
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
Domestic YieldJet Fuel
Jet Fuel 6 Mth MA A4A Avg. Domestic Yield 6 mth MA
0.87 correlation & 0.75 R squared between Jet Fuel & Airline Pricing
from 2010-2013...
... Since then, that relationship has broken
down with R squared and correlation
falling to 0.05 and -0.23, respectively
Network Carrier Operating Margins & Expansion
(bp/%)
Key Charts Record Domestic Load Factors & Strong Yields
(%/¢)
Jet Fuel Pricing vs. Domestic Yield
Source: Company data, CS estimates
Trailing 12-month ROIC vs. WACC & Company Targets
Correlation between yield & fuel decoupling as fundamentals strengthen…
Sustainable pricing on tight supply / demand balance ROIC > WACC at 3 of 5 top U.S. airlines
ROIC a key driver of share prices
Pace of expansion slowing, but more upside on pricing, revenue initiatives and unit cost control
8.0%7.0%
9.0%7.5% 7.0%
15-18%
No target
10%
15%
7%
DAL
(pre-tax)
AAL
(pre-tax)
UAL
(pre-tax)
LUV
(pre-tax)
JBLU
(post-tax)
ROIC (Q2 2014) WACC Target (in bold)
4.8%
7.4%
10.1%
12.2%
13.6%
97 bp
254 bp270 bp
210 bp
141 bp
2%
4%
6%
8%
10%
12%
14%
0 bp
50 bp
100 bp
150 bp
200 bp
250 bp
300 bp
2012 2013 2014E 2015E 2016E
EBIT Margin
Y/Y Margin Expansion
Average Op Margin (Network Carriers)
Y/Y margin expansion
7
Number of Competitors on Top 25 Domestic Routes
Oligopolistic structure ensures more rational behavior
Capacity and Market Share Analysis
Transatlantic Trunk Route Market Share by Immunized JVs
(% Share)
Percentage of Top 25 U.S. Routes where Carrier is Dominant (>45% share)
Market Share of Domestic Seats
(% Share)
84% of transatlantic trunk routes are duopolies; 50% are monopolies
Today, 4 carriers control 83% of domestic seats vs. 8 in 2007
United has dominant share on ½ of the top 25 U.S. city pairs 3 or fewer players control 60% of the top 25 U.S. city pairs
Source: Company data, CS estimates
14% 13% 13% 13% 13% 13% 13%25%
14% 13%21% 22% 21% 21% 21%
21%17% 18%18% 18% 22% 22% 22%
21%11% 11%
11% 11%17% 17% 17%
16%44% 44%36% 36%
26% 27% 27%16%
2007 2008 2009 2010 2011 2012 2013 2014
American Airlines Delta Southwest United Other
26% 27% 26% 26% 26%19% 25%
26% 28% 26% 28%37%
36% 35%35%
100%
81% 75%
48% 45%
12% 11% 2%
2007 2008 2009 2010 2011 2012 2013 2014
STAR JV SkyTeam JV oneworld JBA Other
United53%American
35%
Delta12%Duopoly
24%
3 competitors36%
4 competitors24%
5 competitors16%
8
We equally weight EV/EBITDAR with P/E
Our Valuation Approach
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
12.0x
14.0x
Discount to S&P Bloomberg US Airline Index FY2 P/E
Source: Bloomberg, company data, CS estimates
EV/EBITDAR on 2015 Consensus
Price-to-Earnings on 2015 Consensus (fully-taxed earnings)
We Equally Blend EV/EBITDAR and P/E
We look at CFROI Using Credit Suisse HOLT® to Cross Check
5.0x
4.2x 4.3x
5.6x
4.6x
DAL AAL UAL LUV JBLU
10.0x
8.1x
10.5x
15.9x
13.8x
15.8x
DAL AAL UAL LUV JBLU S&P 500 0%
2%
4%
6%
8%
10%
AAL DAL LUV JBLU UAL
CFR
OI
CFROI 10-Yr Median CFROI LFY CFROI Forecast Market-Implied CFROI
EBITDAR = EBITDA + Aircraft Rents
Normalizing aircraft financing across carriers
Target
Price
Target EV/EBITDAR
multiple
Target P/E
multiple
Explanation
of multiples
Delta $56 7.0x 13.5x
implied price $59.94 $52.55
United $68 6.5x 12.5x
implied price $76.16 $60.78
American $52 6.0x 11.0x
implied price $53.75 $49.71
Southwest $32 7.0x 13.5x
implied price $36.82 $27.52
JetBlue $11 6.0x 13.0x
implied price $11.68 $11.09
Premium for higher quality,
lower debt
Discount for execution risk
Discount for merger
integration, higher leverage
Premium for Investment
Grade B/S, Consistency
Discount to LUV for lagging
returns and B/S
9
U.S. coverage rounds out existing Latin American, European & Asian airline coverage
Credit Suisse Global Airline Coverage
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
12.0x
14.0x
Discount to S&P Bloomberg US Airline Index FY2 P/E
Source: Bloomberg, company data, CS estimates
U.S. Carriers trade at a discount to Asian and Latin American Airl ines on EV/EBITDAR
Company Reuters Share price Rating Target Last Close Upside Mkt Cap
Name Ticker curncy Price Price /Downside (%) (US$ mn) EV / EBITDAR ROIC
U.S. Airlines - Analyst: Julie Yates 7.1x 15%
American Airlines AAL.OQ USD OP $52 37.85 37% 27,259 7.6x 14%
Delta Air Lines DAL.N USD OP $56 39.22 43% 33,063 6.1x 20%
United Continental UAL.N USD OP $68 50.73 34% 18,951 6.9x 13%
Asia Aviation AAV.BK THB UP 3 4.74 -30% 718 8.9x 14%
Garuda GIAA.JK IDR UP 430 437.00 -2% 964 9.8x 12%
AirAsia X AIRX.KL MYR UP 1 0.77 -9% 575 16.2x 13%
Industry Themes
11
Consolidation has led to a paradigm shift where airlines are focused on profits and returns
instead of market share
Capacity discipline and revenue management
3 network carriers have demonstrated commitment to sub-GDP capacity growth; 4 largest carriers control more than 80% of domestic capacity
Yield improvement prioritized over capacity growth drives real pricing gains. Growth decelerating following four years of strength
Robust corporate & leisure demand driving record load factors and enhancing pricing power
Fare unbundling & innovative ancillary merchandising initiatives driving high-margin revenue
Continuous network optimization and improving yield management practices
Cost control
Structural cost reductions keeping ex-fuel unit cost growth below inflation
Operational improvements include productivity, sourcing & distribution initiatives
Full realization of merger synergies should drive margin upside
Improved fuel efficiency driven by refleeting, up gauging, interior reconfiguration
Capital discipline and improving profits are driving returns above cost of capital
Carriers are smoothing capital expenditures through slower fleet replacement and used aircraft strategies to avoid prior cycle peaks and valleys
Healthier balance sheets post bankruptcies and significant debt reduction lowers interest burden and improves credit profile
Management teams are stepping up commitment to shareholder returns
– As of July, 5 of 6 largest U.S. airlines now returning cash to shareholders through share repurchase; 4 have dividends
Structural Industry Shifts Alter Competitive Dynamics…
Source: Company data, CS estimates
We subscribe to the bull ish view that the industry is now investable, and think the next leg of the story wil l be driven by further margin expansion, improving ROIC and consistency in capital allocation.
12
Still a highly cyclical industry sensitive to macro and fuel
Are pricing and loads peaking, limiting further margin expansion?
PRASM/Yield growth deceleration following 4 years of strength; pockets of international weakness (Asia (China), LatAm (Brazil, Venezuela), Transatlantic)
We believe any deterioration in the domestic pricing story is the biggest risk to the bull thesis
Domestic load factors of 85% peaking, International load factors at 80% under pressure due to competitive capacity additions from non-U.S. airlines
Renewed concern over fuel price volatility given geopolitical unrest
Fuel is the single largest cost for the industry averaging over 30% of operating expenses; level of hedging varies among airlines
Macro environment
Sustainability of GDP growth
Rising interest rates will drive up aircraft financing and leasing costs
Currency risk includes further devaluation of Yen, repatriation of Venezuelan Bolivar
Consolidation
Merger integration risk
– Still significant for American; lingers at United and Southwest to a lesser extent
Labor negotiations unresolved
Wages represent 25% of operating expenses on average and as industry profits improve, employee wage expectations elevate
Benefits from restructuring post-bankruptcy diminishing with open negotiations, expiring contracts, and pending unionization posing risk for some carriers
Disruptors remain key question for skeptics
Skeptics remain focused on the PRASM / yield deceleration, signs of international overcapacity, the durability of profits and cash during a recession, or fuel spike
and international capacity discipline and the yield environment.
The industry has significantly de-levered and structurally reduced costs and capacity, putting it in a much stronger position to weather a recession,
or fuel spike.
… But Potential Disruptors Sideline Some Investors
Source: Company data, CS estimates
While the industry remains deeply cyclical, it is less so than pre-consolidation.
13
Pre-2005:
8 CARRIERS
Four carriers now control over 80% of capacity, down from 8 in 2005
We Prefer Network Carriers Given Structural Improvements
and Ongoing Margin Enhancing Initiatives
Source: US DOT Form 41 via BTS, schedule T2, CS estimates
3 NETWORK CARRIERS + Southwest
CONSOLIDATION
60%
65%
70%
75%
80%
85%
90%
Network
LCC
Other
2014: 3 NETWORK CARRIERS
+ Southwest
CONSOLIDATION Carrier Reduction
Total System Load Factor (% of Seats Filled)
Favorable industry environment
The four major U.S. carriers should
continue to benefit from a favorable
industry environment, where the
landscape has been significantly
improved by consolidation. Capacity
and capital discipline are now
paramount
Strong demand is producing record
load factors. Revenue optimization
initiatives combined with structural
cost reductions should drive industry
operating margins to the mid-teens,
above the prior peak of around 9%
despite much higher fuel costs
Three immunized JVs control 98% of
key routes on the Transatlantic,
promoting rational decision making;
50% of trunk routes are monopoly
markets while 84% of trunk routes
U.S.-Europe are duopolies
60% of top 25 domestic city pairs are
controlled by 3 airlines
Global Alliances
United Star Alliance
Delta Sky Team
American One World
Load factors are at record highs
14
Margin expansion slowing mid-cycle, but we still see >300 bps of upside
Airline Profitability is Extremely Dynamic with 3 Key Variables
Avg. Network Carrier Unit Cost Growth vs. Load Factor
Variable
Unit Costs
(CASM - Cost per Available Seat Mile)
Pricing
(Yield – revenue per passenger carried)
Capacity Utilization
(Load Factor)
Primary Lever Reduce non-fuel operating costs
Network optimization, distribution, sourcing
Reduce fuel expense
Re-fleeting with more efficient aircraft, hedging
Increase labor productivity
Better IT, part-time flexibility
Increase aircraft density
Add more seats to existing aircraft
Better yield management
IT, variable scheduling, re-banking
Avoidance of marginal cost pricing
Driving higher value mix
Corporate market share, upselling
Ancillary revenues
Fare unbundling, merchandising, monetization of extras
Code sharing / JV coordination
Accurate demand forecasting
Booking curve, inventory control
Revenue management
Balance load factor versus yield
Source: Company data, CS research and estimates, A4A
80%
81%
82%
83%
84%
85%
0%
2%
4%
6%
8%
10%
2011 2012 2013 2014E 2015E 2016E
LoadFactor
Growth, Yield& Inflation
Average Unit Cost Growth (Network Carriers)
A4A Yield
Inflation
Average Load Factor (Network Carriers)
Network Carrier Operating Margins and Expansion
4.8%
7.4%
10.1%
12.2%
13.6%
97 bp
254 bp270 bp
210 bp
141 bp
2%
4%
6%
8%
10%
12%
14%
0 bp
50 bp
100 bp
150 bp
200 bp
250 bp
300 bp
2012 2013 2014E 2015E 2016E
EBIT Margin
Y/Y Margin Expansion
Average Op Margin (Network Carriers)
Y/Y margin expansion
15
UPCYCLE DOWNCYCLE CONSOLIDATION UPCYCLE
EBIT margins should reach midteens by 2016
Network carrier average EBIT margin peaked at 9.3% in 1997 when fuel was only 11% of operating expenses
2014E network EBIT margin average is ~10.2%, with consensus forecasting another 100 bps of expansion in 2015 and 2016
Given our expectations for more muted yield growth and rising unit costs
We think margins at Southwest and JetBlue have less potential for the following reasons:
Cost advantage eroding with age, and as network airlines become more efficient and ultra-low cost carrier models evolve
Yield upside limited as customer base is more price elastic and competition from both network and ultra-low cost carriers increases; comps more challenging in
H2 2014 and 2015
Ancillary revenue potential capped as customer-friendly policies key to brand loyalty for LUV and JBLU
– Southwest’s “Bags Fly Free” marketing campaign and operational underperformance in our view make a bag fee unlikely; lack of upsell product limiting as well
– JetBlue is introducing “Fare Families” in 2015 including a bag fee for its no frills offering, but we think the incremental contribution will be lower than consensus
is forecasting as management implements the initiative a “JetBlue way” to minimize customer reproach
Limited Margin Expansion Potential for Leisure Carriers
Source: Company data, CS estimates
Operating Margin, Adj.
(%) Operating Margin, Adj.
(%)
Margin expansion at LUV and JBLU more moderate DAL already best-in-class, but most upside at UAL and AAL
4.9%
8.2%
10.7%
11.9% 11.8%
7.5% 7.9%
8.9%
10.1%10.8%
2012 2013 2014E 2015E 2016E
LUV JBLU
7.1%
9.3%
12.4%
14.0% 14.1%
3.7%
8.1%
11.3%
13.8%
15.0%
3.7%
4.6%
6.4%
8.7%
11.4%
2012 2013 2014E 2015E 2016E
DAL AAL UAL
17
Domestic capacity discipline keeping supply and demand balanced;
Capacity growth has been below GDP since 2010
Schedule data shows total seat growth growing less than 3% in 4Q,
even with several carriers up gauging; even LCC growth only 3%
Domestic Supply, Demand, and GDP Total Seats (from US to RoW, incl. Domestic)
Capacity Discipline Remains Crucial
U.S. carriers continues to demonstrate commitment to sub-GDP capacity growth
Source: A4A, Diio Mi,Company data, CS estimates
Management Strategy
AAL “The domestic market, in particular, is mature. And so you certainly shouldn’t have growth that exceeds GDP in the domestic market.”
DAL “The goal over the next 5 years is for capacity growth of roughly 2% per year, which is well within our expectations of what the general economic forecasts for the future are.”
UAL “Over the next 4 years, we expect our consolidated capacity to grow less than GDP, or 1-2%.”
Pockets of competitive tension are building, comps are getting tougher
Matching capacity with demand is helping to circumvent unsustainable price competition, but, is yield growth sustainable?
We think so, as long as capacity growth is sub-GDP. That said, while upward pricing trends appear intact, pockets of competitive tension are building in certain
markets and the battle for high-yielding corporate travel is intensifying as the differentiation between network carriers wanes. Yields are up 20% over the last four
years, well ahead of inflation, on real pricing gains and record load factors.
PRASM growth deceleration is inevitable…we think UAL will transition to PRASM outperformance on easier comps and self-help
Comps are getting tougher and international trends are mixed with over capacity risk in the Pacific, Atlantic and Latin America. PRASM growth has averaged 5% since
2010 and going forward, we think PRASM outperformance will be driven by revenue management at the company level which is where UAL is poised to catch-up.
AAL should eventually outperform from integration upside, but near-term Venezuela issues and tough comps may cloud merger benefits for 6-9 months. DAL is now
challenged with protecting its 13% domestic revenue premium following successful corporate market share gains, while UAL is playing catch-up.
Ancillary revenues should continue to rise as airlines become more advanced at monetizing extras and enhancing distribution
We see further pricing upside & expect non-ticket revenues to drive continued yield improvement. New products, variable/dynamic pricing, distribution
enhancements, and different pricing methods are all contributing to higher ancillary revenues.
Non-ticket revenue as a percentage of total operating revenue for major U.S.-based airlines rose to nearly 10% in 2013 and are a significant driver of profit.
Ultra-low cost carriers have led the way with ancillary revenue as a percentage of total revenue averaging 30% of total revenues.
Upward Pricing Trends Appear Intact, but Bear Watching Closely
UAL 2015 – 2017 non-fuel unit cost growth below inflation
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
AAL
DAL
UAL
Stage Length Adjusted CASM ex Fuel (LTM 2Q 14)
9.82¢
11.06¢ 11.19¢
7.49¢ 7.21¢
0.00¢
2.00¢
4.00¢
6.00¢
8.00¢
10.00¢
12.00¢
AAL DAL UAL LUV JBLU
Non-Fuel Unit Cost Growth Ex-Items
AAL DAL UAL
2015 non-fuel unit cost growth -1% - +1%, below inflation.
Goal to keep non-fuel unit cost growth <0-2%.
2015 – 2017 non-fuel unit cost growth below inflation.
Management Stated Goals
20
U.S. airlines are now earning their cost of capital
U.S. carriers are approaching & exceeding stated ROIC targets as managements shift to return-driven strategies; Management’s must balance re-fleeting
needs while limiting growth in the invested capital base
Delta is leading network carriers. DAL raised its ROIC target range to 15-18% in May, and achieved 18.3% in Q2 on a trailing 12-month basis
United met its 10% target in Q2 and will likely exceed the target by year-end; expect management to push target higher over next 6-12 months
Southwest exceeded its 15% ROIC target in Q2, marking the first time LUV exceeded its 15% target since mid-2001; expect management to issue a higher target
at November investor day
JetBlue states it is on track to meet its 7% (post-tax) target by YE; expect management to issue a higher target at November investor day
Ultra-low-cost carriers (SAVE, ALGT) have industry-leading margins and generate much higher ROIC. SAVE pre-tax ROIC in 2013 was 32%
Consolidation has created economies of scale and is leading to higher investor returns
The airline industry has generated one of the lowest ROIC among all industries over the last 30-40 years, but consolidation and more return-driven management
teams are driving ROIC above WACC
Structural Industry Changes Leading to Improving Returns
8 CARRIERS
Source: Company data, IATA, McKinsey & Company for IATA
WACC
ROIC
19930%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
% o
f In
vest
ed C
apita
l
Q2 2014 ROIC vs. WACC & Target
U.S. Airlines finally generating ROIC greater than cost of capital
Historical Average Airline Industry ROIC and WACC
(% of Invested Capital)
8.0%7.0%
9.0%7.5% 7.0%
15-18%
No target
10%
15%
7%
DAL
(pre-tax)
AAL
(pre-tax)
UAL
(pre-tax)
LUV
(pre-tax)
JBLU
(post-tax)
ROIC (Q2 2014) WACC Target (in bold)
21
Managements smoothing capital expenditures and balancing capital deployment Managements stepping up commitment to shareholder returns with 5 of 6 largest U.S. airlines now returning cash to shareholders through share
repurchase; 4 have dividends
Healthier balance sheets post bankruptcies and significant debt reduction
Capital intensive industry finding discipline; shifting to a returns-driven approach to fleet planning
The airline industry is extremely capital intensive and capital expenditures to purchase new aircraft have historically been the primary use of funds. In the good times
(late 80s, mid-late 90s), airlines have historically ordered too many aircraft and added more capacity than needed, resulting in heavy debt burdens and limited flexibility
in capacity. Today, U.S. airline management teams are maintaining discipline, smoothing out new equipment buys and making ROIC-driven aircraft purchase
decisions.
So far in 2014 alone, five carriers have announced a combined $5.6B in buyback authorizations
Since February of this year, Delta, Southwest and Alaska have all boosted their dividends and authorized larger share repurchase programs and American and United
followed course in July, each unveiling $1B share buyback programs with an accompanying dividend at American. The timeframe is more aggressive at American
(targeted completion end of 2015) versus United (three year targeted completion suggesting mid-2017) which is not surprising given their respective cash positions
and relative size versus market cap. Both indicated the initial programs were just the start and we expect 2015 will bring more of the same.
Three airlines (DAL, LUV, ALK) have increased their dividends by 40% on average, and the largest airline (AAL) recently declared the first cash dividend at the
company since 1980. United's management will continue to evaluate a dividend as earnings improve and debt is reduced.
Returns must continue to improve to drive re-rating
EV / EBITDAR is the best valuation metric through the cycle
Removes distortions from taxes, capital structures and accounting polices
We apply a mid-cycle EV/EBITDAR multiple which we think is 6-7x
EV / Invested Capital is also a robust metric correlated with ROIC
Highest returns and cash flow generation warrant a premium
EV / EBITDAR and EV / Invested Capital Useful Metrics
Source: Bloomberg, company data, CS estimates
EV/EBITDAR (TTM)
Current EV/IC and ROIC
EV/EBITDAR (2015)
0.0x
1.0x
2.0x
3.0x
4.0x
5.0x
6.0x
7.0x
8.0x
LUV
DAL
JBLU
UAL
UAL
DAL
JBLU
LUV
(EV/IC) (ROIC)
1.5x
1.0x 1.0x
1.8x
0.9x
18%
14%
10%
18%
9%
0%
4%
8%
12%
16%
20%
0.0x
0.4x
0.8x
1.2x
1.6x
2.0x
DAL AAL UAL LUV JBLU
EV/IC ROIC
5.0x
4.1x4.4x
5.6x
4.6x
DAL AAL UAL LUV JBLU
42
We expect an upward re-rating
Multiples should re-rate as the structural industry shifts and cost control drive network carriers toward mid-teens operating margins
We expect a sector rerating similar to the “Rail Renaissance” as sector margins expand, ROIC improves, and capital is returned to shareholders
Airline valuation is challenging – P / E doesn’t capture Balance Sheet which can be misleading given higher leverage and pension deficits
Earnings volatility and leverage make it difficult to compare airline P/E to market or across industrials, so we incorporate EV/EBITDAR and cross check with balance
sheet value metrics including EV/Invested Capital and CFROI through the Credit Suisse HOLT® methodology.
Airline Sector Still at a Significant Discount to the Market and
Industrial Transports
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
12.0x
14.0x
Discount to S&P Bloomberg US Airline Index FY2 P/E
Source: Bloomberg, company data, CS estimates
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
0.0x
1.0x
2.0x
3.0x
4.0x
5.0x
6.0x
7.0x
8.0x
9.0x
10.0x
11.0x
12.0x
Discount to S&P
Index FY2 P/E
Discount to S&P Bloomberg US Airline Index FY2 P/E
Bloomberg US Airline Index vs. Discount to S&P
43
U.S. Airline Financials and Valuation
Overview
Price Upside/ 52 Week Range Market Cap EV Avg. 30D Vol Short Interest Beta Volatility Stock Performance (Total Return) Credit Rating
Company Ticker Rating 5-Sep Target Price (Downside) Low High (US$M) (US$M) # shares % of Float Cover Days 6-Month 6-Month 2013 YTD YTD Rel.* Past Week S&P Fitch
SMID cap average 85% 15% 11 yrs 80 78% 50 73.6 $3.21 32.5% 39.5% 22.0% 1.8x 10.4%
Industry Average 75% 25% 12 yrs 203 54.3% 73 68.7 $3.16 23.2% 35.6% 23.5% 1.9x 9.2%
*Mainline used for three major network carriers
**As of year end 2013
Source: Credit Suisse Estimates, Bloomberg, Company Data
45
Highly cyclical industry sensitive to fuel prices and the health of the economy
Because consumer demand for travel is fairly elastic, any economic uncertainty or downturn in the macro environment could jeopardize leisure traffic.
Corporate spending on business travelers would also decline in a recession, which would further compress margins as business travelers pay higher
fares. The carrier is running at record load factors relative to history and any economic weakness would likely negatively impact loads and pricing.
Any terrorist attack or threat, epidemic, or natural disaster (real or perceived) would significantly reduce demand for air travel
Any terrorist attack or threat, epidemic, or natural disaster, real or perceived would significantly reduce demand for air travel and would significantly impact
airline operations. Similarly, an accident or crash, on any flight, irrespective of its operator, would create the perception that aircraft travel is dangerous
and would also negatively impact passenger traffic. The majority of many carriers’ labor forces are highly unionized and if an airline is unable to reach an
agreement with its unionized labor force regarding collective bargaining agreements or if additional employees were to become unionized, the company
may face flight cancellations and interruptions, which would adversely affect its operations and may increase labor costs.
Airlines are capital intensive, high fixed cost businesses with fuel and labor comprising 60% of operating expenses
Aircraft fuel prices fluctuate on a number of factors including supply/demand balance, inventory levels, geopolitical events, economic outlooks and
fiscal/monetary policies. Given the competitive nature of the industry, airlines may not be able to pass future fuel price costs to customers. Furthermore,
passengers frequently book flights in advance, thus fuel price increases occurring after the ticket purchase date must be incurred by the airline.
Airlines are highly competitive and if other major carriers lose capacity discipline, yields may come under pressure
With consolidation in the U.S. among network carriers, the differentiation between routes/networks has lessened. Network carriers are aggressively
pursuing corporate travel share and control of certain markets which could lead to price competition. Also, as ultra-low cost and low cost carriers pursue
aggressive growth plans, established carriers are at risk of market share erosion to low cost carriers, particularly in leisure markets. Furthermore, well-
funded, Middle Eastern airlines are competing with network carriers internationally and are also beginning to enter the U.S. market.
Government regulation and fees
The airline industry is heavily regulated and new or unexpected regulations may increase the company's operating costs. Future legislation mandating fuel
and noise efficient planes would also cause United to incur additional operating expenses. Additionally, taxes and fees are high and elevate the total ticket
price customers pay. Most recently, the Transportation Security Administration hiked fees, which could negatively impact leisure travel demand.
Key Industry Risks
Regional Detail Domestic Transatlantic Pacific Latin America
47
Record domestic load factors and strong yields
(%/¢) Southwest is the purest-play domestics; American has the most domestic
exposure among the network carriers
(% of Domestic — Revenues)
Domestic
Yield improvement prioritized over capacity growth Domestic capacity is still 6% below 2007 levels and 15% below 2001 levels. Since 2010, capacity has risen just 2% on 4% greater demand.
Domestic yields are up 17% over the same period (on a rolling 12 month basis)
Capacity data shows seat growth is greater in Q4, but still below GDP
(Domestic US Seat Growth YoY)
Domestic Market Structure
Domestic
A4A Pax Yield Report file_2014-
06_141 “LF tab”, and
Capacity charts from Diio Mi “Seats
from US” tab for pie chart
82.9%
83.6%83.9% 84.0%
85.1%
14.57¢
15.85¢
16.41¢
16.80¢17.09¢
12.50
13.50
14.50
15.50
16.50
17.50
81.0%
82.0%
83.0%
84.0%
85.0%
86.0%
2010 2011 2012 2013 H1 2014
Domestic Load Factor Domestic Yield
46.2%
57.7%64.1%
71.4%
98.8%
DAL UAL AAL JBLU LUV
American25%
United19%
Delta20%
Southwest18%
JetBlue5%
Other13%2.50%
1.60%
2.30% 2.20%
0.95%
2010 2011 2012 2013 H1 2014
Domestic ASMs YY Domestic RPMs YY Domestic GDP
-1.0%
0.7% 0.5%
1.1%0.9%
-0.2%
0.5%
2.3%
1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14E4Q14E
Domestic US seat growth Y/Y
Source: Diio Mi, A4A, company data, CS estimates
48
Transatlantic capacity creeping but yields holding in
(%/¢) Three JVs control 98% of US-LHR capacity
(% Market Share by Seats US-LHR)
Transatlantic
Structural positives but capacity decisions bear watching The Transatlantic is concentrated to three JVs, but AF and LHA profit warnings and signs of overcapacity worrisome. Based on our trunk route analysis,
we note that 50% of trunk routes are monopolies, while 85% of trunk routes are controlled by two JVs as duopolies.
Carriers are ratcheting back Q4 capacity to protect pricing
(US to Europe Transatlantic Seat Growth YoY) Transatlantic market
structure
Transatlantic
82.5%
80.5%
81.9%
83.2%
79.9%
12.83¢
13.73¢14.03¢
14.65¢14.89¢
8.50
9.50
10.50
11.50
12.50
13.50
14.50
15.50
76.0%
78.0%
80.0%
82.0%
84.0%
86.0%
2010 2011 2012 2013 H1 2014
Atlantic Load Factor Atlantic Yield
-3.7%
1.7% 2.0%
4.1%5.1%
6.1%
7.8%
5.5%
1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14
US to Europe seat growth Y/Y
Three JVs control 98% of US-LHR capacity
(% Market Share on Transatlantic Trunk Routes)
Source: Diio Mi, A4A, company data, CS estimates
26% 27% 26% 26% 26%19% 25%
26% 28% 26% 28%37%
36% 35%35%
100%
81% 75%
48% 45%
12% 11% 2%
2007 2008 2009 2010 2011 2012 2013 2014
STAR JV SkyTeam JV oneworld JBA Other
16% 17% 16% 17% 14%
7% 10% 10% 10%26%
56% 55%
58%77% 73%
18% 18%2%
2010 2011 2012 2013 2014
STAR JV SkyTeam JV oneworld JBA Non-alliance
STAR JV31%
SkyTeam JV
30%
oneworld JBA
23%
Other16%
49
Asian network restructurings addressing weak yields
(%/¢) United leads in the Pacific
(% of Asia — ASMs)
Asia
U.S. carriers restructuring Pacific networks to address weak yields and currency Accelerating industry capacity growth in China will pressure yields after the seasonal peak
Capacity additions to Asia are continuing, particularly to China
(US to Asia Seat Growth YoY) Asia Market Structure
Pacific
84.5%
81.1%
82.8% 82.5%81.8%
12.97¢
14.31¢
14.94¢
14.29¢ 14.11¢
8.50
9.50
10.50
11.50
12.50
13.50
14.50
15.50
76.0%
78.0%
80.0%
82.0%
84.0%
86.0%
2010 2011 2012 2013 H1 2014
Pacific Load Factor Pacific Yield
3.5% 3.9%
6.9%
4.9%
3.7%
8.3%
6.2%
9.2%
1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14
US to Asia seat growth Y/Y
United Airlines
17%
Delta Air Lines
16%
Korean Air
Lines
10%
Japan Airlines
6%
Cathay Pacific
Airways
6%
American
Airlines
6%
4%
13%
16%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
AAL DAL UAL
Source: Diio Mi, A4A, company data, CS estimates
-4.8%
-0.3%
5.6%8.7% 9.4%
18.4%
28.6% 29.9%
1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14
US to China seat growth Y/Y
50
World Cup-driven weakness pressured H1, Venezuela to weigh on H2
(%/¢) American has the most extensive Latin America network
(% of LatAm — ASMs)
Latin America
Competitive capacity additions and Venezuela headwinds Ex-Venezuela, pricing is flat to down as competitive capacity additions continue
Capacity coming down as Venezuela flying pulled, but still seeing high-single
digit capacity additions to the Caribbean and Central America
(US to Latin America Seat Growth YoY) Latin America Market Share
Lat Am
79.6%
80.2%
81.2%81.8%
80.0%14.04¢
15.70¢ 15.80¢15.93¢ 15.81¢
12.50
13.50
14.50
15.50
16.50
76.0%
78.0%
80.0%
82.0%
84.0%
86.0%
2010 2011 2012 2013 H1 2014
Latin Load Factor Latin Yield
3.2%
1.6%
2.7% 2.5%
4.1%
8.8%
6.0%
4.1%
1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14
US to Caribbean, Central & South America seat growth Y/Y
American
Airlines
21%
United Airlines
14%Delta Air Lines
12%
JetBlue Airways
11%
US Airways
7%
Southwest
Airlines
4%
Aeromexico
4%
15%
8% 8%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
AAL DAL UAL
Source: Diio Mi, A4A, company data, CS estimates
3.2%
1.6%
2.7% 2.5%
4.1%
8.8%
6.0%
4.1%
1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14
US to Caribbean, Central & South America seat growth Y/Y
Yield management can help maximize passenger revenue per flight
Fare increases are not the only way to drive unit revenue improvement
Implementing scheduling improvements such as rebanking of hubs and variable scheduling to efficiently capture demand
Expanding ancillary offerings and merchandising capabilities to drive incremental, high margin revenue and increase first-class paid load factors.
Restructuring network to optimize fleet allocation and eliminate unprofitable routes/hubs
Improving mix (split between high-fare and low-fare passengers) incredibly important to driving unit revenue
– Business travel is price inelastic and accounts for the bulk of revenues
– Leisure travel is price elastic and makes up the majority of traffic volume
Source: Company data, A4A, MIT Airline Data Project CS estimates
(20.0%)
(15.0%)
(10.0%)
(5.0%)
0.0%
5.0%
10.0%
15.0%
Network Carriers LCCs
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
10.00¢
11.00¢
12.00¢
13.00¢
14.00¢
15.00¢
16.00¢
17.00¢
A4A Pax Yield Y/Y % change
A4A Industry Average Passenger Yield Y/Y% Change in Passenger Yield Network and LCC Average
58
Renewed concern over fuel price volatility given geopolitical unrest
Fuel Is Single Largest Cost at 30% of Operating Expenses
Source: Company data, CS estimates, Bloomberg
CS HOUSE VIEW
2014: $111/bbl 2015: $102.5/bbl 2016: $95/bbl We expect Brent crude to be range bound and for refining margins to continue to compress Long-term, expect Brent crude to gradually trend down given increasing supply in U.S. and stable demand
Source: Boeing, company data, CS estimates Source: Boeing
Capital Providers 2007 2008 2009 2010 2011 2012 2013 2014F
Leasing Companies
Commercial Banks
Capital Markets
Export Credit Agencies
Private Equity & Hedge Funds
Tax Equity
New Sources of Funding
Airframe & Engine Manufacturers
61
Interest Rates
Source: Company data, CS estimates
THE CS HOUSE VIEW
The Fed could become more hawkish on rates once the following conditions are met:
1. US core inflation rising towards 2%
2. US employment on track to <6%
3. Global growth momentum increasing
4. Robust credit market conditions
With inflation recently rising significantly, all 4 conditions could be in place relatively soon.
CS Expects 1st Fed Funds Rate increase in 3Q15, with market likely to increase yields prior to that.
$698
$1,184
$762
$125 $162
26%
61%
70%
16%
96%
0%
20%
40%
60%
80%
100%
$0
$250
$500
$750
$1,000
$1,250
DAL AAL UAL LUV JBLU
FY 13 Net Int. Exp ($M) FY 13 Net Int. Exp as a % of Adj. Net Income
FY 13 Net Int. Exp as a % of Adj. Net Income ($M)
Rising interest rates will drive up aircraft financing and leasing costs
62
Porter’s Five Forces
Hyper-Competitive Industry
Source: Michael Porter, IATA
Subsidies and export-
financing for aircraft manufacturers pushes capacity growth and entry
Labor market regulations
give power to unions and crate advantages for new entrants
Privatization of airports
and ground handling services has raised costs
Government-mandated fees
(over flight rights, air control, security fees) raise costs
Competition rules limit consolidation
Restrictions to FDI/M&A limit consolidation
Government ownership leads to uneconomic decisions, through privatization is increasing
Public service requirements require serving
unprofitable markets
Bankruptcy laws and bail-outs allow uneconomic carriers to persist
Environmental standards and taxes raise costs
Safety and air traffic control procedures reduce service quality and create costs
Safety guidelines and technical standards limit potential for differentiation
Consumer protection
laws on pricing transparency and delays raise airline costs
“Fly national” rules for
government employees and government contractors distort market choices
Some legal entry barriers remain (domestic,
international) which limit consolidation
Policies influence allocation of slots/gates
Safety standards create limited barriers
Government financing for substitutes (e.g., high-speed trains)
Inconvenience and delays for airline travel created by security
procedures and air traffic control
Threat of New Entrants
Threat of Substitute
Products or Services
Bargaining
Power of
Suppliers
Bargaining
Power of
Channels
Bargaining
Power of
Buyers
Rivalry Among
Existing Competitors
Disclosures
Companies Mentioned (Price as of 05-Sep-2014)
ANA Holdings (9202.T, ¥258) AirAsia (AIRA.KL, RM2.47) AirAsia X (AIRX.KL, RM0.755) Alaska Air Group (ALK.N, $47.14) Allegiant Tr (ALGT.OQ, $126.04) American Airlines Group Inc. (AAL.OQ, $37.85, OUTPERFORM[V], TP $52.0) Asia Aviation (AAV.BK, Bt4.82) Asiana Airlines (020560.KS, W4,780)
Cathay Pacific (0293.HK, HK$14.36) Cebu Pacific (CEB.PS, P66.85) China Airlines (2610.TW, NT$10.05) Copa Holdings (CPA.N, $124.75) Delta Air Lines, Inc. (DAL.N, $39.22, OUTPERFORM, TP $56.0) Deutsche Lufthansa (LHAG.DE, €13.66) EVA Air (2618.TW, NT$15.2) EasyJet (EZJ.L, 1366.0p) Gol Linhas Aerea (GOLL4.SA, R$15.1) International Airlines Group (ICAG.L, 368.7p) Japan Airlines (9201.T, ¥5,930) JetBlue Airways Corporation (JBLU.OQ, $12.54, UNDERPERFORM, TP $11.0) Korean Air (003490.KS, W37,900) LATAM Airlines (LFL.N, $13.03) Malaysia Airlines (MASM.KL, RM0.255) PT Garuda Indonesia Tbk (GIAA.JK, Rp432) Ryanair (RYA.I, €7.547) Singapore Airlines (SIAL.SI, S$10.1) Southwest Airlines Co. (LUV.N, $32.83, NEUTRAL, TP $32.0) Spirit Airlines (SAVE.OQ, $73.2) Thai Airways International (THAI.BK, Bt15.3) Tiger Airways (TAHL.SI, S$0.42) United Continental Holdings, Inc. (UAL.N, $50.73, OUTPERFORM, TP $68.0)
Disclosure Appendix
Important Global Disclosures
I, Julie Yates, certify that (1) the views expressed in this report accurately reflect my personal views about all of the subject companies and securities and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities
As of December 10, 2012 Analysts’ stock rating are defined as follows:
Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark*over the next 12 months.
Neutral (N) : The stock’s total return is expected to be in line with the relevant benchmark* over the next 12 months.
Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months.
*Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ra tings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. Fo r Latin American and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potentia l within an analyst’s coverage universe. For Australian and New Zealand stocks, 12-month rolling yield is incorporated in the absolute total return calculation and a 15% and a 7.5% threshold replace the 10-15% level in the Outperform and Underperform stock rating definitions, respectively. The 15% and 7.5% thresholds replace the +10-15% and -10-15% levels in the Neutral stock rating definition, respectively. Prior to 10th December 2012, Japanese ratings were based on a stock’s total return relative to the average total return of the relevant country or regional benchmark.
Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances.
Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.
Analysts’ sector weightings are distinct from analysts’ stock ratings and are based on the analyst’s expectations for the fundamentals and/or valuation of the sector* relative to the group’s historic fundamentals and/or valuation:
Overweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is favorable over the next 12 months.
Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months.
Underweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is cautious over the next 12 months.
*An analyst’s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors.
Credit Suisse's distribution of stock ratings (and banking clients) is:
Global Ratings Distribution
Rating Versus universe (%) Of which banking clients (%)
Outperform/Buy* 44% (54% banking clients)
Neutral/Hold* 40% (51% banking clients)
Underperform/Sell* 13% (44% banking clients)
Restricted 3%
*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, an d Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other indivi dual factors.
Credit Suisse’s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein.
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Price Target: (12 months) for American Airlines Group Inc. (AAL.OQ)
Method: Our $52 TP for AAL is the equally weighted average of (1) a 11x mid-cycle P/E multiple on our 2015E fully-taxed EPS, (2) a 6x mid-cycle EV/EBITDAR multiple on our 2015E EBITDAR.
Risk: Primary risks to our $52 target price for AAL include the health of the economy, fuel price volatility, event risk (terrorism, weather) and labor disruptions. Furthermore, AAL has significant merger integration risk as it completed its merger with US Airways in December of 2013 while peers such as DAL and UAL consolidated much earlier. Failure to complete certain steps necessary to begin realizing synergies, such as the issuance of single operating certificate and integration of reservation systems, could negatively impact investor sentiment on AAL.
Price Target: (12 months) for Delta Air Lines, Inc. (DAL.N)
Method: Our $56 TP for DAL is the equally weighted average of (1) a 13.5x mid-cycle P/E multiple on our 2015E EPS and (2) a 7x mid-cycle EV/EBITDAR multiple on our 2015E EBITDAR forecast.
Risk: Primary risks to our $56 target price include the health of the economy, fuel price volatility, event risk (terrorism, weather) and labor disruptions. While DAL's labor force is the least unionized out of network carrier, its pilots have a contract renegotiation in 2016, which, if unfavorable, could increase wage expenses. Furthermore, investor expectations on the company's performance are high, given that DAL has been the best performing network carrier for the longest period of time. Any failure to consistently execute could impact shares given elevated expectations.
Price Target: (12 months) for JetBlue Airways Corporation (JBLU.OQ)
Method: Our $11 target price for JBLU is the equally weighted average of (1) a 13x mid-cycle P/E multiple on our 2015E EPS; and (2) a 6x mid-cycle EV/EBITDAR multiple on our 2015E EBITDAR
Risk: Primary risks to our $11 target price for JBLU include the health of the economy especially given the carrier's focus on leisure travelers which makes its demand more price elastic. Other primary risks include fuel price volatility, event risk (terrorism, weather) and labor disruptions. Also, the carrier's growth strategy could lead to overcapacity and falling yields if competitors also add supply into those markets. Competitive capacity into JBLU's key growth markets (Fort Lauderdale, the Caribbean, and Latin America) has been increasing.
Price Target: (12 months) for Southwest Airlines Co. (LUV.N)
Method: Our $32 target price for LUV is the equally weighted average of (1) a 13.5x mid-cycle P/E multiple on our 2015E EPS; (2) a 7x mid-cycle EV/EBITDAR multiple on our 2015E EBITDAR.
Risk: Primary risks to our $32 target price for LUV include the health of the domestic economy, given that LUV almost exclusively serves the United States and is more focused towards leisure travelers, making its demand more price elastic. Other primary risks include fuel price volatility, event risk (weather, terrorism) and labor disruptions. Also the carrier is planning to expand internationally and while that will be a small proportion of the company's overall network, this will still pose some risk as LUV is relatively new to operating in geographies outside of the U.S.
Price Target: (12 months) for United Continental Holdings, Inc. (UAL.N)
Method: Our $68 target price for UAL is the equally weighted average of (1) a 12.5x mid-cycle P/E multiple on our 2015E EPS (fully taxed), and (2) a 6.5x mid-cycle EV/EBITDAR multiple on our 2015E EBITDAR.
Risk: Primary risks to our $68 target price for UAL include the health of the economy, fuel price volatility, event risk (terrorism, weather), execution and labor disruptions. UAL also has the most exposure amongst any of the domestic network carriers to Asia where overcapacity has resulted in weakening yields and loads. If these trends continue or if the Asian economy weakens, UAL could be adversely affected.
Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures for the definitions of abbreviations typically used in the target price method and risk sections.
See the Companies Mentioned section for full company names
The subject company (AAL.OQ, JBLU.OQ, UAL.N) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse.
Credit Suisse provided investment banking services to the subject company (AAL.OQ, UAL.N) within the past 12 months.
Credit Suisse has managed or co-managed a public offering of securities for the subject company (AAL.OQ, UAL.N) within the past 12 months.
Credit Suisse has received investment banking related compensation from the subject company (AAL.OQ, UAL.N) within the past 12 months
Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (AAL.OQ, JBLU.OQ, LUV.N, UAL.N) within the next 3 months.
As of the date of this report, Credit Suisse makes a market in the following subject companies (AAL.OQ, DAL.N, JBLU.OQ, LUV.N, UAL.N).
As of the end of the preceding month, Credit Suisse beneficially own 1% or more of a class of common equity securities of (UAL.N).
Important Regional Disclosures
Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report.
The analyst(s) involved in the preparation of this report have not visited the material operations of the subject company (AAL.OQ, DAL.N, JBLU.OQ, LUV.N, UAL.N) within the past 12 months
Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares.
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