Southwest Airline - Essay Example

?Southwest Airline The industry chosen is airline industry and the point of reference is Southwest Airline. Airline industry is one of the most lucrative yet challenging industries to operate in. It is among the most regulated industries in the world. This is because the risks facing the industry are real and enormous. The regulatory body of the industry is the Federal Aviation Administration (FAA), which provide operating standards and guidelines as well as enforcing the regulations and punish the offenders. Air is the fastest mode of transport, which connect both short and far geographies. Southwest Airlines was first incorporated as Air Southwest Company on 15, March 1967. Its mission is to provide air transport to passengers within Texas State. However, Southwest Airline is currently operating in six states. It is serving over seventy cities, which enables the airline to make about three thousand three hundred flights daily. The porter’s five forces of the Airline industry with reference to Southwest Airline The first factor is the new entrant’s factor. Air industry is critical to economic growth and development. It is critical in any economy. Therefore, it is an industry perceived by many as highly lucrative. However, huge amount of capital is required to start air transport business and industry is riddled with high level risks. The industry also experiences complicated licensing, certification and regulations procedures, which makes it hard to penetrate. Furthermore, increasing cost of fuel makes it difficult for many people to venture it. The second factor is threats of substitutes. The substitutes to air transport are road, rail and water. Southwest Airline faces competition from road because most (80%) of its customers are domestic customers. If road transport improves, the airline may lose bulk of its domestic customers. Southwest Airline has been lobbying against the introduction of high speed rail transport services in the State of Texas. This is to prevent competition from substitutive high speed train services. Third factor to consider is the bargaining power of customers. Customers do not have a strong bargaining power in the air industry. As a result, they do not have a collective bargaining power to influence air prices. The fourth factor is the bargaining power of suppliers. Suppliers of aircrafts and spares are influential to prices making it difficult for operators to bargain. This is due to the standards on aircrafts and its spares that FAA imposes on operators. The operators must purchase genuine parts that are mostly expensive. The suppliers of fuel are few; therefore, they largely influence the prices of fuel. Airline operators do not have powers over the fuel suppliers and are left to develop ways of improving fuel efficiency. For example, Southwest Airlines introduced use of high pressure water to clean the engine, an exercise that improves fuel efficiency by 1.9 percent. The company has also managed to contain its employees through strong team coordination, open communication and promotion of work-life balance. Furthermore, the employees are also supported by top management. This has made employees proud of the company. Fifth factor to consider is the level of rivalry within the industry. This is among the real threats that can bring the industry down. Southwest Airline faces direct competition from JetBlue and AirTran Holdings, which are also low cost carriers. To minimize competition and increase its revenue base, the company acquired Muse Air in 1985, Morris Air in 1993, ATA Airlines in 2008 and Air Tran Airways in 2011. Acquisitions enabled Southwest Airline to absorb key routes in the Pacific Norwest and acquire operating certificate as well as landing slots in LaGuardia Airport. However, the company failed to acquire Frontier Airlines thus lost Denver market. Strategic valuation method The strategic valuation method that is useful in valuing the company is the shareholder Value Analysis. Shareholder value analysis refers to financial analysis, which estimates the total net value of a company for a specific period of time by discounting future cash flows. Net present value of the company is then divided with total amount of the shares of the company to arrive at shareholder value. The key principle of shareholder value analysis is that a company adds value to its shareholders only when the cost of equity is less than revenue generated. There are seven factors that are considered when arriving at shareholder’s value. The factors are sales growth, tax rate, operating profit margins, period with competitive advantage and cost of capital as well as working capital and fixed capital growth. South West Airlines seven factors Table1: Various Capital and WACC Source of capital Amount in million $ Weighted capital Cost of capital Weighted Cost of Capital Equity 6237.0000 0.7489 0.0733 0.0549 Bonds 117.0000 0.0140 0.0738 0.0010 Bank loans 1974.0668 0.0592 0.0672 0.0040  WACC   0.0599 Source: Southwest Airline 2011. Where Cost of equity (Re) = Rf +b(Rm-Rf)= 4.17% +1.24*(6.72% -4.17%)=7.33 % Market free rate (Rf) is 4.17% (CIA 2011). Market rate of interest (Rm) is 6.72% (Southwest Airline 2011) Bond interest rate (Rb) is 7.38% (Southwest Airline 2011) Tax rate is 2.3% (Leonhardt, 2011) Beta (b) is 1.24 (Southwest Airline 2011) WACC = (E?Re) + ( B?Rb) +( L?Rm) = 5.99% (table E= equity and Re is cost of equity L=loan and B=Bonds and Rb is cost of bonds Table 2: the seven factors of computing Southwest Shareholder value   2010 2009 2008 2007 2006 2005 Average Sales $2,104.00 $10,350.00 $11,023.00 $9,861.00 $9,086.00 $7,584.00 Sales growth rates 0.17 -0.06 0.12 0.09 0.20   0.10 Operating profit margins $988.00 $262.00 $449.00 $791.00 $934.00 $820.00 570.67  Operating profit margins growth rates 0.08 0.03 0.04 0.08 0.10 0.11 0.06 Tax rate             0.063 Working capital $4,279.00 $3,358.00 $2,653.00 $4,443.00 $2,601.00   $4333.50  Working capital growth rate 0.27 0.27 -0.40 0.71     0.21 Fixed capital $1,184.00 $10,911.00 $11,415.00 $12,329.00 $10,859.00   14174.50  Fixed capital growth rate 0.03 -0.04 -0.07 0.14 0.00   0.01 Cost of capital             0.0733 Period of competitive advantage           5 years Table 3: Shareholder value calculation Given: ('000) Base sales: $12,104.00 Base year: 2010 Growth rate of sales 1.1 Profit margins 0.06 Fixed investment rate 0.01 Working investment rate 0.21 Tax rate 0.063 Cost of capital 0.054 Market securities $ 2,277.00 Debt $ 2,875.00 shares outstanding 807,611,634 Period 5 years (all Dollars in thousands) 2011 2012 2013 2014 2015 Sales $ 13,314.40 $ 14,645.84 $ 16,110.42 $ 17,721.47 $ 19,493.61 Operating Profit $ 798.86 $ 878.75 $ 966.63 $ 1,063.29 $ 1,169.62 NOPAT $ 748.54 $ 823.39 $ 905.73 $ 996.30 $ 1,095.93 New Investment $ 12.10 $ 13.31 $ 14.65 $ 16.11 $ 17.72 Add Working capital $ 254.18 $ 279.60 $ 307.56 $ 338.32 $ 372.15 Free cash flow $ 482.25 $ 530.47 $ 583.52 $ 641.87 $ 706.06 PV to year 5 $ 2,495.09 1. Value years 1-5 $ 2,495.09 Market securities $ 2,277.00 Total Value $ 4,772.09 Less debt $ 2,875.00 SVA $ 1,897.09 Shareholders value 0.002 When computing the shareholder’s value, revenue from operations and expenditure incurred in increasing fixed and working capital are considered as expenses together with taxes paid. Therefore, to compute net present value in each year, the following formula has been factored into the above table. For example, net value of 2011 was obtained as below. Annual sales ((12,104?0.1(growth rate)) + 12,104) 13,314.40 Less Investment on fixed assets 12.10 Investment on current assets 254.18 Expenses 12,249.26 Taxes 50.32 Net income which is discounted 748.54 The shareholder value in the fifth year (2015) beginning 2011 will be $0.002 per share issued. This is obtained by dividing the net present value at the fifth year with the number of shares of the company that has been issued. Southwest Airline strategy to improve shareholder value To maximize shareholder value, the company should seek for ways to increase its revenue base and minimize cost of operations. Use of technologies that increase fuel efficiency is welcomed. The company should continue washing its engines using high pressure water. This activity is likely to reduce the fuel expenses by about 1.5%. The company should also ensure that all its aircrafts are airworthy to prevent heavy penalties that will reduce company’s profitability. Sources Central Intelligence Agency. North America: United States. (14 June 2011). 20 June 2011. . Leonhardt, David. ‘The Paradox of Corporate Taxes’. New York Times. (1Febr. 2011). 20 June 2011. . Southwest Airline. 2010 Annual Report to Shareholders. Dallas, Texas: 2011. Southwest Airline. Southwest Airlines Co. (LUV). (2011). 20 June 2011. < http://finance.yahoo.com/q/ks?s=LUV>. Read More