AirlinesAirlines

David ChanDavid ChanMaggie HanMaggie HanFranky YuenFranky YuenSean LiSean Li

Categories of AirlinesCategories of Airlines

• International

• National

• Regional

• Cargo

Large issues about airlines

• Weather

• Fuel Cost - typically, 14-16% of total cost is from fuel cost.

• Labor - Estimated to be 40% of the total airline expenses

Regulatory Government AgencyRegulatory Government Agency

• The Department of Transportation (DOT)

• The Federal Aviation Administration (“FAA”)

• President of the United States

• The Transportation Security Administration

• The Department of Justice (“DOJ”)• The United States Environmental

Protection Agency (“EPA”)

RegulationsRegulations

International Air Transportation Competition Act U.S. Transportation Code Federal Air Regulations Occupational Safety and Health Administration (OSHA)

regulations Food and Drug Administration (FDA)regulations Aviation and Transportation Security Act

The Airport Noise and Capacity Act of 1990

Influence of Regulatory ChangesInfluence of Regulatory Changes

• Enaction of Aviation and Transportation Security Act

• TSA assumed the aviation security functions and assumed passenger screening contracts at U.S.

• Cost on reducing the number of waiting lines

Special Regulatory risk for DeltaSpecial Regulatory risk for Delta

• Periodic renewal of certain route authority is required

• Success in renewal is not guaranteed

Risk Factors of Airlines

Pressures to airline companiesPressures to airline companies

• Threat of New Entrants

• Power of Suppliers

• Power of Buyers

• Competitive Rivalry

Risk Participating Stock DropsRisk Participating Stock Drops

Strategy RiskStrategy Risk

• Strategic risks are defined by business design choices and how these interact with various external factors

-Challenge from a new form of competition,

-Shifts in customer preference

-Industry consolidation

Strategic Risk MitigationStrategic Risk Mitigation

• Conserve cash during the boom times and invest in the tough

• Selection of an appropriate business design itself

• Traditional responses– Creating a culture focused on the customer– Developing a rigorous strategic planning process– Maintaining an independent board of directors

Strategy Risk Mitigation by SouthwestStrategy Risk Mitigation by Southwest

• Selection of the business design

-Attract customers in good times and in bad

- Use of secondary airports

- Low debt levels reduce the exposure to interest rate fluctuations.

-Profit sharing and a fun culture reduce the chance of labor difficulties

Financial RiskFinancial Risk

• Financial risks involve the management of capital and cash, including exogenous

• factors that affect the variability and predictability of revenue and cash flow

• (e.g., general economic conditions or foreign exchange rates).

Hedging Financial RiskHedging Financial Risk

• Design and placement of financial transactions

-Structured finance

-Derivatives

-Insurance

-Contingent financing

-Debt/equity offerings

Operating Income of Fuel HedgingOperating Income of Fuel Hedging

New Financial Risk ManagementNew Financial Risk Management

• Guarantees for credit card transactions.

Operational RiskOperational Risk

• Operational risks arise from the more tactical aspects of running the business day-to-day, such as crew scheduling, accounting and information systems, and e-commerce activities.

Operational Risk MitigationOperational Risk Mitigation

• Organizational solutions - Process redesign - Organization structural changes - Improved communication - Contingency planning - Performance measurement - Reward systems - Capital allocation and pricing

Operational Risk MitigationOperational Risk Mitigation

• Working with the government to shape industry regulation

Delta AirlineDelta Airline

BusinessBusiness

• “We are a major air carrier that provides scheduled air transportation for passengers and cargo throughout the United States and around the world”

Corporate InformationCorporate Information

• Headquarters: Atlanta, Georgia • Subsidiaries: Atlantic Southeast Airlines,

Comair• Destinations: 497 cities in 88 countries• SkyTeam Alliance• Daily flights+partners: 7,697

Stock PriceStock Price• NYSE Symbol: DAL

Route MapRoute Map

• Cost Reduction [Bankruptcy or

restructure]

GoalsGoals

RisksRisks• Fuel Price

• Currency

• Interest Rate

• Others

Fuel PriceFuel Price

• Fuel price structure

• Average fuel price up by 20% from 2000-2003

Percentage of TotalGallons Consumed Cost (1) Average Price Operating

Year (Millions) (Millions) Per Gallon (1) Expenses2001 2649 1817 68.60 ¢ 12%2002 2514 1683 66.94 12%2003 2370 1938 81.78 14%

Fuel Price RisksFuel Price Risks• Solution: Hedging

• Problem: No jet fuel market

• Hedge contracts – up to 36 months, hedge up to 80% of expected fuel requirement on a 12 month rolling basis

• Dec 31, 2003, hedged 32% of aircraft fuel requirement for 2004 at an average 76.46¢

Fuel Price Risks ContinueFuel Price Risks Continue• In February 2004, all of our fuel hedge contracts

are settled prior to their scheduled settlement dates; received $83 million in cash

• SFAS 133, gains of $82 million will be recorded in accumulated other comprehensive loss until the related fuel purchase, which were being hedged, are consumed and recognized in expense during 2004

Fuel Price Risks ContinueFuel Price Risks ContinueFuelDerivative

(in millions) InstrumentsBalance at December 31, 2000 268

-Unrealized gain (loss) -100Realized loss -299Tax effect 156

-Net of tax -243

-Balance at December 31, 2001 25

2002liability adjustment 0Unrealized gain (loss) 143Realized (gain) loss -136Tax effect -3Net of tax 4

-Balance at December 31, 2002 29

2003liability adjustments 0Unrealized gain 159Realized (gain) -152Impairment 0Tax effect -2Net of tax 5

-Balance at December 31, 2003 34

Fuel Price Risks ContinueFuel Price Risks Continue

ASSETS(in millions) 2003 2002

CURRENT ASSETS:Prepaid expenses and other 476 356

NONCURRENT ASSETS:Other noncurrent assets 2,143 1,509

Consolidated Balance SheetsDecember 31, 2003 and 2002

Fuel Price Risks ContinueFuel Price Risks Continue(in millions) 2003 2002 2001

Net loss (773)$ (1,272)$ (1,216)$ Other comprehensive loss (776) (1,587) (335)

Comprehensive loss (1,549)$ (2,859)$ (1,551)$

Other comprehensive loss• Additional pension liability

2) Effective unrealized gain/loss of fuel hedging contracts

3) Effective unrealized gain/loss of market securities

Interest Rate RisksInterest Rate Risks• Solution: Interest Rate Swap• (1) $300 million principal amount of

unsecured Series C Medium-Term Notes due March 15, 2004, which pay interest at a fixed rate of 6.65% per year and

• (2) $500 million principal amount of unsecured Notes due December 15, 2005, which pay interest at a fixed rate of 7.70% per year.

Interest Rate ContinueInterest Rate Continue• May 9, 2003, settled these interest rate swap

agreements prior to their expiration. As a result, we received $27 million, including $7 million previously recognized as adjustments to interest expense under the terms of the swap agreements. The fair value adjustments to the previously underlying debt related to the interest rate swaps totaled $20 million.

Exchange Rate RiskExchange Rate Risk• Solution: may enter into foreign

currency options and forward contracts with maturities of up to 12 months. We did not have any foreign currency hedge contracts at December 31, 2003 or 2002.

Fair value of derivativesFair value of derivatives

December 31,(in millions) 2003 2002 2001Change in time value of fuel hedge contracts -75 -23 -1Ineffective portion of fuel hedge contracts 58 13 -3Fair value adjustment of equity rights 8 -29 72

- - 0

Fair value adjustments of SFAS 133 derivatives, pretax -9 -39 68- - 0

Total, net of tax -6 -25 41

Income (Expense)-For the Years Ended

Fair value of derivativesFair value of derivatives

(in millions, except share data) 2003 2002 2001Other Income (expense)Operating income (loss) (786) (1,309) (1,602)Interest income (expense), net(6) (696) (610) (410)Miscellaneous income (expense), net(7) 302 (2) 80Gain loss on extinguishment of debt, net - (42) - Fair value adjustments of SFAS 133 derivatives (9) (39) 68Miscellaneous income (expense), net(7) (19) 1 (47)Tota other income (expense) (403) (693) (262)

Consolidated Statements of Operations For the years ended December 31, 2003, 2002 and 2001

Stock OptionsStock Options• All stock options granted had an exercise

price equal to the fair value of the underlying common stock on the grant date.

Stock OptionsStock Options

Assumption 2003 2002 2001Risk-free interest rate 0.022 0.044 0.058Average expected life of stock options (in years) 2.9 6.7 7.5Expected volatility of common stock 0.664 0.389 0.269Expected annual dividends on common stock 0 0.1 0.1Weighted average fair value of a stock option granted $5 $9 20

Stock Options Granted-

Stock OptionsStock Options

Four Stock Option Plans:

- Broad-based Employee Stock Option Plan

- Delta 2000 Performance Compensation Plan

- Non-Employee Directors’ Stock Option Plan(1998)

- Non-Employee Directors’ Stock Option Plan(1995)

Stock OptionsStock OptionsBroad-based Employee Stock Option Plan

-Broad-based pilot and non-pilot plans

-Granted eligible employees non-qualified stock options to purchase a total of 49.4 million shares of common stock in three approximately equal installments on October 30, 1996, 1997 and 1998.

Stock OptionsStock OptionsDelta 2000 Performance Compensation Plan

-Authorizes the grant of stock options and a limited number of other stock awards.

- Restates the prior plan

- No awards will be granted under the prior plan on or after this date

Stock OptionsStock Options

Non-Employee Directors’ Stock Option Plan(1998)

- Each non-employee director may receive an annual grant of non-qualified stock option

Stock OptionsStock Options

Non-Employee Directors’ Stock Option Plan(1995)

- A portion of each non-employee director’s compensation will be paid in shares of common stock

Stock OptionsStock Options

(In Millions) SharesTotal Shares Non-Qualified Reserved

Authorized for Stock Options for FuturePlan Issuance Granted GrantBroad-based employee stock option plans (1) 49.40 49.40 - Delta 2000 Performance Compensation Plan (2) 16.00 4.95 12.22 Non-Employee Directors' Stock Option Plan (3) 0.25 0.12 0.13 Non-Employee Directors' Stock Plan (4) 0.50 - 0.44

Stock OptionsStock Options

Stock Option Exchange Program

- Commenced on May 28, 2003

- Eligible employees

- Broad-based Stock Option Plans

- Delta 2000 Performance Compensation Plan.

- Board of Directors(CEO) not eligible

Stock OptionsStock Options-canceled approximately 32 million outstanding stock options on June 25, 2003 -issued approximately 12 million replacement options on December 26, 2003. The exercise price of the replacement options is $11.60, the closing price of our common stock on the grant date.

Stock OptionsStock Options-canceled approximately 32 million outstanding stock options on June 25, 2003 -issued approximately 12 million replacement options on December 26, 2003. The exercise price of the replacement options is $11.60, the closing price of our common stock on the grant date.

Stock OptionsStock Options

Weighted Weighted WeightedAverage Average AverageExercise Exercise Exercise

(shares in thousands) Shares Price Shares Price Shares Price- - - - - - -Outstanding at the beginning of the year 58806 44 51537 48 50365 48Granted 14235 11 8478 21 2358 46Exercised -38 11 -9 27 -76 34Forfeited -32769 47 -1200 48 -1110 53

- - - - - -Outstanding at the end of the year 40234 31 58806 44 51537 48Exercisable at the end of the year 22846 44 45996 48 44751 48

2003 2002 2001- - -

Stock OptionsStock Options

Weighted Weighted WeightedNumber Average Average Number AverageOutstanding Remaining Exercise Exercisable Exercise

Stock Options -0 Life (years) Price -0 Price- - - - - -

$9-$20 18231 7 11 2055 11$21-$35 4243 4 34 3800 34$36-$50 15915 4 49 15244 49$51-$64 1845 6 56 1747 56

Stock Options Outstanding Stock Options Exercisable- -

Stock OptionsStock Options-Earnings Per Share (EPS)

Years Ended December 31,(in millions, except per share data) 2003 2002 2001Basic and diluted:Net loss -773 -1272 -1216Dividends on allocated Series B ESOP ConvertiblePreferred Stock -17 -15 -14Net loss available to common shareowners -790 -1287 -1230Weighted average shares outstanding 123.4 123.3 123.1Basic and diluted loss per share -6.4 -10.44 -9.99

Southwest Airline

Company BackgroundCompany Background

• Southwest Airline is incorporated in Texas in 1971

- only 3 Boeing 737 aircraft - serving three Texas cities (Dallas, Houston, and San Antonio)

• In 2003, Number ONE carrier in terms of carrier in terms of domestic domestic boarding in the U.S. boarding in the U.S.

• “ LUV “ --- Stock Exchange Symbol

•Southwest operated 388 Boeing 737 aircraft

•Provided service to 59 airports in 58 cities in 30 states throughout the United States

•The “largest carrier” in the United States(based on originating domestic passengers boarded and scheduled domestic departures)

Southwest AirlineSouthwest Airline

Market Share of SouthwestMarket Share of Southwest

Southwest Airline CharacteristicsSouthwest Airline Characteristics

• Short-haul

• High-frequency

• Point-to-point

• Low-fare

Competitive Strengths:Competitive Strengths:

• low operating costs

• the lowest costs among the major airlines

• focus principally on point-to-point service, rather than hub-and-spoke

Major CompetitorsMajor Competitors

• American Airline• Jet Blue Airway• Delta Airline

AMR = AMR Corp

DAL = Delta Air Lines Inc

JBLU = JetBlue Airways Corp

Industry = Airline

LUV AMR DAL JBLU Industry

Market Cap: 11.13B 1.40B 625.05M 1.97B 684.11M

Employ ees: 31,011 92,100 70,600 5,956 5.96K

Rev. Growth (ttm): 10.00% 0.80% 0.00% 26.80% 13.50%

Revenue (ttm): 6.53B 18.65B 14.97B 1.27B 1.46B

Gross Margin (ttm): 29.83% 18.91% 4.61% 34.57% 19.69%

EBITDA (ttm): 986.00M 1.15B -208.00M 189.48M 119.37M

Oper. Margins (ttm): 8.50% -0.77% -9.71% 8.92% 3.65%

Net Income (ttm): 314.00M -760.00M -3.34B 47.47M 12.00M

EPS (ttm): 0.386 -4.731 -26.757 0.429 0.35

PE (ttm): 36.79 N/A N/A 43.92 12.77

PEG (ttm): 1.81 N/A N/A 3.19 1.52

PS (ttm): 1.66 0.07 0.04 1.48 0.38

Major competitors Major competitors comparison:comparison:

Above average industry performance Above average industry performance

"Southwest is the only airline that has

made money since 1973 with stock value

up more than 500% since 1990"

General Airline Cost StructureGeneral Airline Cost Structure

Southwest Airline Cost StructureSouthwest Airline Cost Structure

OPERATING EXPENSES: 2003 2002 200141% 39% 38%15% 15% 16%8% 8% 8%7% 7% 6%7% 7% 6%3% 4% 4%

0.9% 1% 2%Other operating expenses 18% 20% 20%

Aircraft rentals Agency commissions

Fuel and oilMaintenance materials & repairs Depreciation Landing fees and other rentals

Salaries, wages, and benefits

Southwest 5 Years PerformanceSouthwest 5 Years Performance

Southwest Vs. Airline IndustrySouthwest Vs. Airline Industry

Industry

Potential RisksPotential Risks

• Political risk

• Economic risk

• Competition risk

• Fuel risk

• Weather risk

• Air Traffic Constraint

Political Risk Political Risk

• War risk

• Military Actions

• Terrorist attack risk (eg. 911 event)

• Regulation changes

InsuranceInsurance

Purpose of Insurance:• protect the Company and its property • comply both with federal regulations and certain of the Company’s credit and lease agreements.

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

InsuranceInsurance

Following the terrorist attacks

• Insurance premiums increase significantly– Increase operating expenses

• Reduced war-risk coverage for commercial carriers

Competition RiskCompetition Risk

• Fare sales

• Decisions by competitors

• Changes in competitors' flight schedules

• Mergers and acquisitions

• Codesharing programs

Economic RiskEconomic Risk

• General economic conditions

• Demand for travel

• Consumer ticket purchasing habit

Fuel Risk Fuel Risk

• Jet fuel – 2nd largest expenditure

• Jet fuel Consumption •2003 15.2% of operating expense•2002 14.9% of operating expense •2001 15.6% of operating expense

•Large fluctuation in fuel price

• Hedging fuel prices is required

Average cost of jet fuel, net of hedging Average cost of jet fuel, net of hedging gains, over the past five years gains, over the past five years

Income StatementIncome Statement

Fuel HedgingFuel Hedging

• Risk of increasing jet fuel prices

• Derivative instruments not for trading purposes

• No reliable forward market for jet fuel

• Company must estimate the future prices of jet fuel

• Observe similar commodities (such as crude oil and heating oil)

Fuel HedgingFuel Hedging December 31, 2003Use call options, collar structures, and fixed price swap agreements hedge the jet fuel 82% of its 2004 total anticipated jet fuel requirements 60% of 2005 total anticipated jet fuel requirements

• First quarter 2004 hedges are effectively heating oil-based positions in the form of option contracts • Remaining hedge positions are crude oil-based positions.

Fuel RiskFuel Risk

Fuel Hedging Fuel Hedging

• consume 1.2 billion gallons of jet fuel in 2005

• A change in jet fuel prices of one cent per gallon would impact the Company’s “Fuel and oil expense” by approximately $12 million per year.

Stock-based Employee CompensationStock-based Employee Compensation

Stock-based compensation plans covers:

• Company's Board of Directors

• Employment contracts with CEOs

• Majority of employee

Employee Stock PlanEmployee Stock Plan

• Two classes of employee stock plans:1) Collective bargaining plans

• Subjective to collective bargaining agreements• Granted at or above pair value• Normally have terms ranging from 6 to 12 years• No executive nor member of the Board of Directors are

eligible to participate in this plan• Not required to be approved by Shareholders

Stock-based Employee CompensationStock-based Employee Compensation

2) Other employee plans

• Not subjective to collective bargaining agreements

• Granted at fair market value• Have 10-year terms and become fully

exercisable after three, five or ten years• Need to be approved by shareholders

Stock-based Employee CompensationStock-based Employee Compensation

Stock-based employee compensationStock-based employee compensation

Financial Risk Financial Risk

• SW capitalize conservatively and grow capacity steadily and profitably.

• financial leverage

• An "A" credit rating on its senior unsecured fixed-rate debt with Standard & Poor’s and Fitch ratings agencies

• A "Baa1" credit rating with Moody's rating agency.

Credit Risk Credit Risk

• Default of counterparties to the financial derivative instruments agreements

• Solution :• Review credit rating statuses of counterparties• Spread exposure among several counterparties• Monitor market position of the program and

relative market position with each counterparty.Result: No default of counterparties

Interest Rate RiskInterest Rate Risk

Type of debt

Amount ( in million dollars)

average interest rate%

weighted average maturity

Percentage of non-current asset

floating rate 1222 4.42 7.1 13.6fixed rate 474 6.97 5.8 5.2

Debt structure at Dec 31,2004

Floating Rate Debt ObligationFloating Rate Debt Obligation

• Floating-rate financing arrangements

• Interest rate swaps

Objective of interest rate swapsObjective of interest rate swaps

– Reduce the volatility of net interest income

– Take advantage of market conditions

Interest Rate SwapInterest Rate Swap

TypeInterest rate%

Time of maturity Type

rates% during 2004

385senior unsecured note 6.5 2012

LIBOR+Margin every six month 4.49

375

class A-w pass-through certificates 5.5 2006

LIBOR+Margin every six month 4.695

2004 350senior unsecured note 5.25 2014

LIBOR+Margin every six month 2.814

Pay

Time(Year)

2003

Notional Amount

Receive

Fixed Rate DebtFixed Rate Debt

– Pass-through certificates

– Senior unsecured notes

Hedge of Interest Rate RiskHedge of Interest Rate Risk

• Use Short-term investment cover part of floating interest rate debt– Certificates of deposit– Highly rated money markets– Investment grade commercial paper– Other highly rated financial instruments.

Influence of Change in Interest RateInfluence of Change in Interest Rate

• a hypothetical ten percent change in interest rate results in:

• --No material effect on fair value of fixed rate debt

• --Less than $2million change in net earnings and cash flows