Final CFA Challenge Trinity University Team Submission

CFA Institute Research Challenge

Hosted by:

CFA Societies Texas, Louisiana, New Mexico and Oklahoma

Local Challenge- Southwest US

Trinity University

CFA Institute Research Challenge February 5, 2016

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Sector: Transportation Industry: Airline

Ticker: LUV (NYSE) 52 Week Range: $31.36 – $51.34 Current Price: $35.69 Recommendation: BUY

Investment Thesis We issue a BUY recommendation at $35.00 (69% upside.) Based off our multiple valuation, Southwest (LUV) has an intrinsic value of $59.21, yielding downside risk of -20%.

Low-cost advantage The foundation of LUV success has been its ability to keep its costs low. The basis of this low-cost structure is their focus on operating only one type of plane, as well as operating as a point-to-point carrier. Although the industry as a whole is very capital intensive, LUV stands out as the most efficient capital allocator within its peer group. Currently, LUV is undergoing fleet modernization, where they are retiring some of their older planes and introducing newer planes that have higher capacity and are thus more fuel efficient.

Industry Consolidation During the recovery from the last recession, the airline industry as a whole transformed to become much more cost efficient through consolidation. As Southwest was created with the purpose of being a low-cost carrier, they were untouched by the large scale industry consolidation and left the other carriers chasing their low cost structure. LUV has grown into the largest carrier of passengers in the US while continuing to demonstrate maintenance of their low costs. Although their low-cost advantage against the industry is decreasing, they have been the only airliner to post 43 consecutive years of profitability, a trend that is not expected to change.

Market Growth Potential Initially, LUV was limited to where they could operate, capping their market exposure to mainly Texas because the Wright Amendment. In late 2004, the restrictions from the Wright Amendment began to be lifted from LUV and they were able to expand to neighboring states, and in 2014 all restrictions were lifted. During the time of the restrictions, LUV was able to capture an immense amount of market share because they were able to offer much lower fares due to their low-cost structure. With all restrictions lifted, LUV can service all 50 states, as well as expand internationally. The recent acquisition of AirTran also expands their scope of operations, and will continue to enable them to capture more market share.

Figure 1 Source: Estimates

Figure 2 Source: Southwest 10k

Figure 3 Source: FactSet


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Business Description Southwest (LUV) began operations in 1971 flying three Boeing 737 Aircrafts in between Dallas, Houston, and San Antonio. Now LUV services 97 destinations through 40 states and is considered the largest low-cost carrier in the United States. LUV operates under the Southwest Airlines and AirTran Airways brands and is the largest domestic US airline by number of passengers enplaned and scheduled domestic departures, according to the Bureau of Transportation Statistics. Since 1971, LUV has expanded their fleet to 704 Boeing 737s and no other models. This single aircraft type strategy contributes to the company's low-cost business structure, allowing it to simplify scheduling routes, plane maintenance and the training required to maintain the fleet. LUV also strays from the traditional hub-and-spoke model of air travel, and focuses primarily on point-to-point travel. This allows the company to keep the size of the fleet down as well as reduce time spent on the ground. LUV also utilizes secondary airports in cities in an effort to reduce travel delays and increase their presence in cities without directly competing with legacy airlines, such as Delta and American Airlines. In 2001, the company became the first airline to develop its own reservation system and now sells a significant proportion of its seats through its own website. Through all of these cost cutting innovations, LUV has had 43 consecutive years of profitability. Recently, LUV purchased fellow low-cost airline AirTran Airlines for $1.4 billion in 2011. The purchase has expanded Southwest's international reach as AirTran provides service to nine destinations in six near-international countries including Mexico, Jamaica, The Bahamas, Aruba, Dominican Republic and Bermuda. Despite this expansion, revenue relevant to Southwest's international operations accounts for less than 1.0% of the company's total revenue.

Macroeconomic Outlook Given recent data, we are more pessimistic on GDP growth than other analysts. Thus, we believe in Real Business Cycle Theory, where prolonged periods of growth are followed by decline due to real shocks in the economy. If the economy were to begin a decline, the airline industry would be adversely affected, driving sales down. In the long-term, we expect business travel to stay constant relative to economic activity. Leisure travel, on the other hand, correlates directly with GDP growth. If the economy begins to decline, consumers will save more of their discretionary income, leading to lower sales for airlines. Southwest, in particular, has little exposure to international economic activity due to their focus on the domestic market.

Industry overview Competition is high, and increasing Four of the major players in the Domestic Airline Industry make up 68.8% of the total market share as is seen in Figure 5 while the three legacy airlines stated here make up 64% of the market share of the international airline industry in the United States. This high degree of market concentration is due to the acquisitions of AirTran by Southwest and the merger of Continental and United. This high level of competition also has caused smaller airlines to make an extended effort to differentiate their product. Because of this, the industry has low cost carriers such as Spirit Airlines and JetBlue, and then Legacy airliners such as Delta and American. The combination of the legacy airlines merging, and the low cost carriers finding ways to increase market share have cause the prices of airline tickets to remain stagnant over the past five years when factoring in inflation which is visible in Figure 6.

Figure 5 Source: IBIS World

Figure 4 Source: IBIS World


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GDP and Retail Sales are main drivers for the industry Passengers make up over 70% of the total revenue in the domestic airline industry which is estimated to total at $157.1 billion dollars in 2014. As of now, discretionary income is on the rise which can be see with the stable growth of GDP around 2% a year for the past five years. On top of this, if airfare increases at a slower rate than income growth, people will be more inclined to spend their discretionary income on airfare. The high correlation between GDP, Retail Sales, and Industry revenue can be seen in Appendix B.

OPEC drives the price of Oil to 15 year low As OPEC continues to increase the supply of Oil in the market, prices have dropped to a 15 year low. In the airline industry, purchases account for between 20 and 40% of all operating expense for the firms in the industry, but have declined recently due to the bottoming out of the oil prices which can be seen at the bottom of Figure 7. Being the most significant variable cost, this drop of oil to 30 dollars a barrel means that Jet Fuel prices are the lowest they have been in almost 10 years. While this drop in price is a positive for the airline industry short term, but these companies could experience future losses due to an adverse locked in oil prices due to hedging. Also, if oil prices rise again in 2016 those who are unhedged will be at risk for a cost hike. For example, JetBlue had 17% of its 2015 fuel usage costs hedged, while southwest had removed its hedging position in 2015, and has recently done the same in 2016. For further reference, see Appendix N.

Industry wages continue to rise at a slower rate than revenue Because the industry is subject to a large degree of unionized labor, there is no expected large-scale employee cutbacks expected in the future. Wages paid out to employees in the industry is expected to increase at an annualized rate of 1.6% until 2020. If the unions fight for a greater increase in wages, the costs will go up significantly more than expected, potentially stunting operating income growth.

Cyclical airline industry has stayed positive in recent years Despite the airline industry's history of following a cyclical pattern, the airline industry has maintained positive net income for five years in a row. This could be due to a variety of factors, including decreasing oil prices, acquisitions to increase size of the profitable airlines, and the lack of increase in employee wages over the past five years. Although the industry returns have remained positive, they have been in a trough of sales growth with the industry growing at around 4% over the past three years as shown in Figure 8.

Technological advances in recent years help differentiate carriers Smaller airliners now have the capability to differentiate from the giants of the industry with technology such as on board Wi-Fi, Online third party booking, personal entertainment devices, among others. The increase in technology in regards to aircraft development allows an airline to differentiate their fleet. There are companies like Delta who have 10 different aircrafts and 18 total models, while LUV has just the B-737 in their fleet to simplify and streamline efficiency of the travel.

Competitive Positioning When analyzing the industry, we selected JBLU, ALK, DAL, and SAVE as our comparable companies to reflect a balanced mix of legacy and low cost carriers and market share holders to compare to LUV.

Southwest has seen greater stability than industry comparables When looking at the past 20 years of sales of Southwest and the comparables, LUV has the 2nd lowest standard deviation of the companies compared. This low standard deviation combined with the 20 year sales average of 10.65% in comparison with the 8.3% growth of the industry highlights the stability of

Figure 6 Source: Dept. of Transportation




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Southwest as a company. This 20 year sales average was taken for the four comparable companies as well and it was seen that Southwest has the highest of all the companies that have data that can be found from at least the past 20 years which can be seen in figure 8. Other Sales metrics can be seen in appendix B

Use of smaller airports decreases Southwest market competition Although Southwest has about 16% of the U.S. airline market share, they excel in regards to competing in areas that are not as concentrated with the legacy airliners. When looking at data for the U.S Bureau of Transportation, you see that while Southwest has only 14.09% market share of the 10 largest airports in the U.S. This compared with the 52.97% market share that the Legacy airliners have shown that although Southwest is competitive in these regions, they are not the market leaders. On the other hand, if you look at the top 10 grossing airports for Southwest in this last year, you see that LUV has a market share of 55.19% which easily outweighs the 28.51% market share of all the legacy airliners combined. This gives SW greater control of pricing in their highest grossing areas because of their monopoly position on airports such as HOU (92.18%), DAL (90.77%), and MDW (94.76%).

Integration of AirTran proven successful as of 2015 Southwest Airlines completed the integration of AirTran destinations and fleet at the beginning of 2015 and has since shown signs of operational improvement. EBITDA Margin, ROA, ROE, and the RASM/CASM spread have continued to improve since the acquisition as seen below. This integration has also opened up the international market to Southwest and give Southwest more opportunity for growth. During this time, Southwest has experienced a higher five year average sales growth than other competitors.

Using one type of plane allows for lower maintenance costs than competitors Southwest’s operates 704 Boeing 737 aircrafts and does not differentiate outside of this model. The single aircraft strategy allows for simplification of scheduling, maintenance, and training for operating the aircraft's. When looking at the comparable companies and their maintenance costs only Alaska Airlines who follows the same model just at a smaller scale, has a lower maintenance cost than LUV. These costs could decline further as they continue to retire the older fleet and bring in the 737-800 model. In Appendix B there is a Soft Factors analysis of LUV and competitors that looks further into the competitive positioning of Southwest vs. the competitors.

Financial Statement Analysis Pro Forma Financial Statements In order to gauge Southwest’s future performance on an individual account basis, we forecasted financial statements for FY 2016 through FY 2019. All financial statement item forecasts are subject to our own assumptions and actual future performance may differ. Even with the large amount of uncertainty regarding allocation of funds to certain line items, especially those that involve derivative hedging, we have obtained a target price based on corresponding Free Cash Flow



Column1 EBITDA Margin ROA ROE RASM/CASM spread

2011 11 1.1 2.7 -0.19

2012 9.7 2.3 6.1 -0.29

2013 12.3 4 10.6 0.23

2014 17.6 5.8 16.2 0.98

2015 28 10 30.9 1.84


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to the Firm that shows upside potential relative to the current trading price of $35.69. This price incorporates pessimistic sales growth as well as a conservative discount rate.

Sales Sales were increased on a weighted average estimate from various databases to an increase of 5%. This growth rate reflects our pessimistic perspective on revenues due to stagnant short-term demand, economic uncertainty in the short term, and conservative forward looking views. For every 1% increase or decrease in the sales growth rate, net income increases or decreases in the same direction. Share repurchases Allocated the 500 million share repurchase plan in 2016, as given by management. The assumption was made that the board would authorize management to buy back more shares in the future, and a constant 250 million shares was assumed for all three years. Guidance Accounts like current maturities of long-term debt, leases, and share repurchasing were all forecasted in line with the guidance provided either in the annual report or quarterly earnings calls.

Ratio Analysis We analyzed historical and forecasted performance for LUV based on industry and competitor ratios and statements to understand how well the company is managed relative to its peers. Debt management: Southwest had the highest TIE ratio in the industry in 2015. Furthermore, EBIT is projected to increase steadily and sufficiently cover projected interest payments that will come due as guided in the 2015 10-K. Such debt management capability is crucial given the leases and debt obligations the company has taken on to fund its fleet modernization and equipment purchases. Liquidity: LUV has had a very low current ratio in the past and in comparison to its competitors, indicating that it has an insufficient quantity of assets to cover its current liabilities. This trend is not projected to change through 2019 as the company maintains its asset management strategy. Profitability: As of 2015, LUV had the second highest ROE in the industry at 30.9%, a strong position that is expected to wane in future years to approximately the industry average of 27.5% due to economic stagnation. ROA is even with the industry average and significantly behind ROA top-performer SAVE, though SAVE is projected to lose this advantage as its cost structure matures. We projected LUV ROA to remain approximately the same, given their historically adequate asset management. Significant increases in EPS and slight increases in ROIC will demonstrate continued profitability and shareholder returns via stock buybacks, increasing revenues, and cost synergies from fleet modernization. Margins: LUV has a net margin that is approximately the same as the industry average. Net margin will stay the same in accordance with management guidance given the combination of dependable cost management and a lagging economy.

Cost Structure Analysis Profit Profit in the industry is measured as earnings before interest and taxes (EBIT). Profitability is highly volatile. Over the past five years, profit margins for this industry have increased considerably from 4.0% of revenue in 2010 to an estimated 10.7% in 2015. A 40.7% decrease in the price of crude oil in 2015 is largely responsible for the increase in earnings across the industry. Nevertheless, the drop in the price of fuel has impacted yield (which determines fare prices) reducing the average fares by approx. 6.8%. In this lower oil prices environment airlines are determined to reduce fare prices in order to gain market share.

Figure 11 Source: CFA Conference


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Operating costs The point-to-point strategy has allowed low cost carriers to maintain lower CASM (cost-per available seat mile, see Appendix N 1) than traditional Legacy Airlines. Operating under this strategy, Southwest has been able to gain cost advantage over some of its larger competitors. LUV is the most fuel efficient airline in the industry with fuel expense of 18.24% of sales while the industry average is 21.64%. Based on our estimated pro formas, each 1% change in fuel and oil expense changes net income in the opposite

direction. The company will keep benefiting from this cost advantage in 2016 because they are accelerating plans to retire older fleet (Classic 737). Simultaneously, the company will add newer and more fuel efficient planes therefore improving CASM because there are going to be more seats on more fuel efficient planes. The transition from the classic fleet to the Max fleet will increase fuel efficiency by approx. 18%. Accelerating plans for new fleet is going to be especially important if jet fuel prices were to increase significantly. It is important to mention that the company will continue to benefit from lower fuel prices, and currently estimates this year’s fuel costs to be more than $500 million lower than 2015, based on market prices and their current fuel hedge as of January 15, 2016. However, other ultra-low cost carriers such as JetBlue, Spirit Airlines and Alaska Airlines which also operate a point-to-point network have lower CASM than LUV. There are two important reasons why these smaller competitors operate with lower CASM. The first one is Southwest is the highest paying airline with approx. 37% of sales destined to employee compensation because of the seniority of their employees. The second reason is that smaller airlines have newer fleets and therefore incur in less charges in the maintenance of planes. The Trend graphs of RASM and CASM for the industry comparables can be seen in appendix

Valuation Discounted Cash Flow Analysis Discounted Cash Flow (DCF) analysis was applied to arrive at a present valuation for the future free cash flows of LUV. This method assumes that the company will have a high growth rate for a certain number of years, followed by a period of stable growth. This model yielded an intrinsic value of $43.31 relative to the 2/5/2016 closing price of $35.69, representing upside potential of 21.3% based on the base case (App E). The CAPM model was used to calculate a required rate of return, which was then used to discount the cash flows rendered from team pro forma statements for the years 2016 and 2017. As a component of CAPM, the 10-year USD treasury rate of 2.32% as of 2/7/2016 was used for the risk-free rate. The team estimated a beta of 1.25 based on the assumption that the stock is 25% more risky than the market. Scenario analysis with FactSet’s 52-week adjusted beta of 1 produced a higher implied stock price and upside (App E). The chosen base case calculates a cost of equity of 8.57%. Within the DCF model, a super growth rate of 7% is expected for 7 years as LUV is a mature company with fairly stable revenues but is also facing economic headwinds. This scenario yielded a Free Cash Flow to the Firm (FCFF) estimate of $1358M for 2016 and $1485M for 2017, leading to a final implied stock price of $41.43.

Dividend Discount Model We applied a Dividend Discount model to LUV to gauge its intrinsic value relative to its current market price and calculate a target value. However the assumed cost of equity is greater than the dividend growth rate, producing an impossible negative stock price and rendering the model invalid.


Figure 13 Source: Team Estimates


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Multiples Valuation We estimated bear and bull scenarios for valuation multiples based on LUV’s current trading position and our economic forecast. P/E NTM: We selected a bull case multiple of 14.5x versus a current multiple of 8.3x based on historical trends and multiplied it by FactSet’s estimated FY 2016 multiple of $4.29 for an intrinsic value of $62.21. This was discounted to the present value using the calculated cost of equity of 8.57% for a discounted intrinsic value of $57.29. P/S: We selected a bull case multiple of 1.69x versus a current multiple of 1.2x based on historical trends and multiplied it by the FY 2015 sales per share of $30.50 for an intrinsic value of $51.55. P/CF: We selected a bull case multiple of 10.5x versus a current multiple of 7.23x based on historical trends and multiplied it by the FY 2015 cash flow per share of $4.85 for an intrinsic value of $50.93. P/E LTM: We selected a bull case multiple of 23.67x versus a current multiple of 10.91x based on historical trends and multiplied it by the FY 2015 EPS of $3.27 for an intrinsic value of $77.40. We assigned weights to each calculated intrinsic value with particular emphasis on P/E NTM because its trend most closely represents our perception of the company’s position in the earnings cycle. We arrived at a weighted average price target of $59.21. We selected this as the final price target given the risks surrounding our pro forma financial statements and subsequent DCF analysis.

Risk Factors Highly Unionized workforce With nearly 80% of Southwest Airline’s labor force unionized, labor costs consume a large portion of their operational expenses. Dealing with labor unions can be extremely costly, as well as time consuming. The inability of reaching agreements with their employees can pose significant threats to the company’s operations such as strikes or demands for wage increases. Salaries, wages and benefits accounted for approx. 32% of operational expenses in 2015, and are expected to keep rising. With the ongoing labor disputes with the unions for LUV happening last year and this year, there could be pay raises of up to 20% in some workforces.

Fuel Costs One of the main drivers of profit in the industry is fuel costs. Although the industry is experiencing higher profit margins from the current low energy cost environment, the cost of fuel continues to be very volatile and subject to market conditions. Taking into account the unhedged position of Southwest for 2016, for every cent jet fuel rises, it could have an effect of upwards to 23 million dollars on costs. This puts Southwest and other airlines with the same unhedged position in an adverse position if OPEC decides to decrease the supply of crude oil they are pumping into the market. Fewer resources, higher prices.

Probability of Economic Recession Air travel demand is very unpredictable and particularly sensitive to negative economic conditions because it is a luxury good. Not everyone travels by air for long trips and flights for leisure are paid for with discretionary income. If GDP decreases, there is less discretionary income, therefore less leisure travel. Business travelers also have a cheaper substitute due to improved technology in regards to conference calls.

International Expansion By initiating international operations in 2014, the company is operating in a market where it lacks the expertise and may be deviating from its core operations. Operating in International markets require to compliance with regulation in these countries which in turn will rise operating costs. Also, the new added risk of exchange rates gets thrown into the equation with international expansion. Finally,

Figure 14 Source: Team Estimates


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the company lacks brand recognition in these markets so revenues abroad may take longer than expected to grow.

Security Concerns The industry as a whole has been subject to terrorist threats and attacks. Even though, the risk is remote, in the event of such event a revenue will drop sharply due to the decrease in demand for air travel. Additionally, costs will rise significantly due to increased security measures, higher costs of insurance and there will be less or no access to capital markets for debt financing.

Pending AirTran Litigation AirTran is currently subject to pending antitrust litigation, and if judgment were to be rendered against AirTran in the litigation, such judgment could adversely affect the Company’s operating results.

Financial Modeling Our financial models are based on assumptions from third party financial databases and team estimates of best practices and may be subject to human error, economic uncertainty, and other external factors that may cause them to differ from realized financial results.


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Table of Contents A) Company Statements (past 5 years)/pro formas (2015-2020)

a) Income Statement b) Balance Sheet c) Statement of Cash Flows d) Ratios

B) Sales/Industry Analysis C) Cost of Capital Calculation D) FCFF/FCFE Calculation E) DCF Model F) LUV and Industry Ratios G) Event History on Price History H) Unit Cost Comparison I) 50 vs 200-day MAV J) Multiples Valuation K) Multiples Price Impact Graphs

a) P/E NTM b) P/E LTM c) P/S d) P/CF e) P/B

L) Selected Competitors Price History M) Airline Glossary N) Competitor PRASM vs CASM graph comparison


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Appendix A: LUV Statements Appendix A.a Income Statement

Southwest Airlines Co.

Income Statement ($M)2010 2011 2012 2013 2014

Q1

2015

Q2

2015

Q3

2015

Q4

2015 2015

Q1

2016E

Q2

2016E

Q3

2016E

Q4

2016E 2016E

Q1

2017E

Q2

2017E

Q3

2017E

Q4

2017E 2017E 2018E 2019E

Total operating revenues 12104 15658 17088 17699 18605 4414 5111 5318 4977 19820 4635 5367 5584 5226 20811 4866 5635 5863 5487 21852 22944 24091

Passenger 11489 14754 16093 16721 17658 4178 4852 4716 4553 18299 4368 5070 5244 4913 19595 4587 5324 5506 5158 20575 21603 22684

Freight 125 139 160 164 175 44 46 44 45 179 45 48 48 49 190 47 50 50 52 199 209 220

Special revenue

adjustment -- -- -- -- -- -- -- 172 0 172 0 0 0 0 0 0 0 0 0 0 0 0

Other 490 765 835 814 772 192 213 386 379 1170 222 248 292 264 1026 233 261 307 277 1077 1131 1188

Total operating expenses -11116 -14965 -16465 -16421 -16380 -3634 -4026 -4093 -3951 -15704 -3792 -4224 -4291 -4142 -16542 -3981 -4435 -4506 -4349 -17272 -18237 -19042

Salaries, wages, and

benefits -3704 -4371 -4749 -5035 -5434 -1419 -1607 -1699 -1659 -6384 -1490 -1687 -1784 -1742 -6770 -1564 -1772 -1873 -1829 -7109 -7464 -7837

Fuel and oil -3620 -5644 -6120 -5763 -5293 -877 -1005 -936 -798 -3616 -921 -1055 -983 -838 -3797 -967 -1108 -1032 -880 -3987 -4186 -4395

Maintenance materials and

repairs -751 -955 -1132 -1080 -978 -229 -240 -259 -276 -1004 -240 -252 -272 -290 -1065 -252 -265 -286 -304 -1118 -1174 -1233

Aircraft rentals -180 -308 -355 -361 -295 -60 -59 -60 -59 -238 -63 -62 -63 -62 -252 -66 -65 -66 -65 -265 -278 -292

Landing fees and other

rentals -807 -959 -1043 -1103 -1111 -285 -299 -303 -279 -1166 -299 -314 -318 -293 -1237 -314 -330 -334 -308 -1298 -1363 -1431

Depreciation and

amortization -628 -715 -844 -867 -938 -244 -250 -258 -263 -1015 -256 -263 -271 -276 -1066 -269 -276 -284 -290 -1119 -1175 -1234

Other operating expenses -1426 -2013 -2222 -2212 -2331 -520 -566 -578 -617 -2281 -522 -591 -601 -642 -2355 -548 -621 -631 -674 -2473 -2597 -2726

Acquisition and

integration -8 -134 -183 -86 -126 -23 -3 -6 -6 -38 0 0 0 0 0 0 0 0 0 0 0 0

Other operating

expenses excluding

acquisition and integration -1418 -1879 -2039 -2126 -2205 -497 -563 -572 -611 -2243 -522 -591 -601 -642 -2379 -548 -621 -631 -674 -2498 -2623 -2623

Operating income / loss 988 693 623 1278 2225 780 1085 1225 1026 4116 843 1142 1293 1084 4269 885 1200 1357 1138 4580 4707 5049

Total other expenses /

income -243 -370 62 -69 -409 -57 -108 -292 -179 -636 -168 -208 -99 -114 -589 -175 -217 -102 -119 -613 -646 -672

Interest expense -167 -194 -147 -131 -130 -32 -29 -31 -28 -120 -32 -29 -31 -28 -120 -32 -29 -31 -28 -120 -120 -120

Capitalized interest 18 12 21 24 23 6 7 9 9 31 6 6 7 7 26 6 6 7 7 27 28 29

Interest income 12 10 7 6 7 1 2 2 4 9 1 2 2 4 9 1 2 2 4 9 9 9

Other gains / losses, net -106 -198 181 32 -309 -32 -88 -272 -164 -556 -143 -187 -77 -97 -504 -150 -196 -80 -102 -529 -562 -590

Income / loss before income

taxes 745 323 685 1209 1816 723 977 933 847 3480 675 935 1194 969 3680 710 983 1255 1019 3967 4061 4377

Provision / benefit for

income taxes -286 -145 -264 -455 -680 -270 -369 -349 -311 -1299 -252 -349 -446 -362 -1409 -265 -367 -469 -380 -1481 -1555 -1635

Net income / loss 459 178 421 754 1136 453 608 584 536 2181 423 586 748 607 2271 445 616 786 638 2485 2507 2742

Basic earnings per share 3.27 3.63 4.02 4.10 4.54

Diluted earnings per share 3.26 3.59 3.97 4.05 4.48

Cash dividends declared per

common share 0.29 0.34 0.41 0.49 0.59

Line Item Assumption

Total operating revenues 5% RASM growth (guided), average of FactSet, ValueLine; components estimated as historical percentage of total revenues

Total operating expenses Components estimated as historical percentage of total operating expenses

Salaries, wages, and benefits Held constant due to uncertainty

Fuel and oil Held constant due to uncertainty

Acquisition and integration Company does not expect to incur any further acquisition and integration costs beyond 2015 (Guided in 2015 10-K)


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Appendix A.b Balance Sheet

Southwest Airlines Co. Balance

Sheet ($M) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E

Total assets 15463 18068 18596 19345 20200 21312 22366 23397 24419 25591

Total current assets 4279 4345 4227 4456 4404 4024 4262 4436 4639 4871

Cash and cash equivalents 1261 829 1113 1355 1282 1583 1699 1745 1825 1916

Short-term investments 2277 2315 1857 1797 1706 1468 1541 1618 1692 1777

Accounts and other receivables 195 299 332 419 365 474 498 523 546 574

Inventories of parts and

supplies, at cost 243 401 469 467 342 311 327 343 358 376

Fuel derivative contracts -- -- -- -- -- -- -- -- -- --

Prepaid expenses and other

current assets 89 238 210 250 232 188 197 207 217 228

Net property and equipment 10578 12127 12766 13389 14292 15601 16381 17200 17984 18883

Total property and equipment,

at cost 16343 18421 19497 20820 22513 24685 25919 27215 28455 29878

Flight equipment 13991 15542 16367 16937 18473 19462 20435 21457 22434 23556

Ground property and

equipment 2122 2423 2383 2666 2853 3219 3380 3549 3711 3896

Deposits on flight equipment

purchase contracts 230 456 416 764 566 1089 1143 1201 1255 1318

Assets constructed for others -- -- 331 453 621 915 961 1009 1055 1107

Allowance for depreciation and

amortization -5765 -6294 -6731 -7431 -8221 -9084 -9538 -10015 -10471 -10995

Goodwill 0 970 970 970 970 970 970 970 970 970

Other assets 606 626 633 530 534 717 753 790 827 868

Total liabilities and stockholders'

equity 15463 18068 18596 19345 20200 21312 22366 23397 24419 25591

Total current liabilities 3305 4533 4650 5676 5923 7406 7750 8165 7845 8684

Accounts payable 739 1057 1107 1247 1203 1188 1247 1310 1369 1438

Accrued liabilities 863 996 1102 1229 1565 2591 2721 2857 2987 3136

Air traffic liability 1198 1836 2170 2571 2897 2990 3140 3296 3447 3619

Current maturities of long-

term debt 505 644 271 629 258 637 643 321 42 491

Long-term debt less current

maturities 2875 3107 2883 2191 2434 2541 2459 2138 2096 1605

Deferred income taxes 2493 2566 2884 2934 2782 2490 2490 2490 2490 2490

Deferred gains from sale and

leaseback of aircraft 88 75 -- -- -- -- -- -- -- --

Construction obligation -- -- 331 437 554 757 795 795 873 1086

Other noncurrent liabilities 465 910 856 771 1255 760 798 798 876 920

0

Total stockholders' equity 6237 6877 6992 7336 6775 7358 8073 9011 10239 10806

Common stock 808 808 808 808 808 808 808 808 808 808

Capital in excess of par value 1183 1222 1210 1231 1315 1374 1374 1374 1374 1374

Retained earnings 5399 5395 5768 6431 7416 9409 10661 11849 13290 14107

Accumulated other

comprehensive income / loss -262 -224 -119 -3 -738 -1051 -1088 -1088 -1051 -1051

Treasury stock, at cost -891 -324 -675 -1131 -2026 -3182 -3682 -3932 -4182 -4432


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Line Item Assumption

Total assets

Based on historical 2015 allocation, in l ine with

increase in sales

Total current assets

We recognize that current assets and current

l iabilities accounts l ikely higher than will be

realized due to losses on derivatives l ikely to be

realized (affecting prepaid, other, and other non-

current l iabilities, accrued liabilities)

Cash and cash equivalents

Assumed percentage of assets based on 2015

quarterly allocation

Fuel derivative contracts Held constant due to uncertainty

Assets constructed for others

Balance plus 295M cost of Fort Lauderdale

expansion (Broken down evenly over 8 quarters-

construction started 2015, expected to end 2017.

Overestimating because some of the cost in 2015

(Q4) plus 526-148 already incurred (to 2018), held

constant in 2019 due to lack of guidance.

Allowance for depreciation and amortization

Goodwill Assumed constant based on historical stability

Current maturities of long-term debt Guided in 10-K

Long-term debt less current maturities Guided in 10-K

Deferred income taxes

Includes unpredictable items such as hedging

expenses. Plug from 2015 due to high historical

fluctuation (computed average of 4 quarters of

2015).

Deferred gains from sale and leaseback of

aircraft No leasebacks planned

Construction obligation

36.6% increase seen in 2015 (based on 10-K), at a

growing percentage. Conservatively high but not

accounting for future projects due to uncertainty

Accumulated other comprehensive income /

loss

Held constant due to uncertain outlook on hedging-

related gains and losses

Treasury stock, at cost

Repurchased $500M in 2016, $250M thereafter

assuming reauthorization from Board


13

Appendix A.c. Statement of Cash Flows

Southwest Airlines Co. Statement of Cash

Flows ($M) 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019ENet cash provided by / used in operating

activities 1561 1356 2064 2477 2902 3238 3128 3348 3474 3810

Net income / loss 459 178 421 754 1136 2181 2271 2485 2507 2742

Adjustments to reconcile net income / loss to

cash provided by / used in operating activities 886 928 906 912 1718 1019 1094 1147 1203 1262

Depreciation and amortization 628 715 844 867 938 1015 1066 1119 1175 1234 Unrealized / realized gain / loss on fuel

derivative instruments 139 90 -189 -5 279 113 28 28 28 28

Deferred income taxes 133 123 251 50 501 -109 -- -- -- -- Amortization of deferred gains on sale and

leaseback of aircraft -14 -- -- -- -- -- -- -- -- --

Share-based compensation expense -- -- -- -- -- -- -- -- -- -- Excess tax benefits / obligations from share-

based compensation arrangements -- -- -- -- -- -- -- -- -- --

Changes in certain assets and liabilities 216 250 737 811 48 38 -237 -285 -236 -195

Accounts and other receivables -26 -26 -33 -17 54 -88 -24 -25 -24 -27

Other assets -8 -196 -104 -46 142 103 -36 -38 -36 -41

Accounts payable and accrued liabilities 193 253 186 343 36 961 189 198 190 218

Air traffic liability 153 262 334 400 326 94 150 95 150 172 Cash collateral received from / provided to

derivative counterparties 265 -195 233 57 -233 -570 -285 -285 -285 -285

Other, net -361 152 121 74 -277 -462 -231 -231 -231 -231Net cash used in / provided by investing

activities -1265 -1022 -833 -1384 -1727 -1913 -20 -712 -515 -307 Payment to acquire AirTran, net of AirTran

cash on hand 0 -35 -- -- -- -- -- -- -- --

Capital expenditures -493 -968 -1348 -1447 -1828 -2143 -2306 -2308 -2241 -2198 Capital expenditures excluding assets

constructed for others -- -- -1348 -1433 -1748 -2041 -2000 -2000 -2000 -2000

Assets constructed for others -- -- 0 -14 -80 -102 -306 -308 -241 -198

Purchases of short-term investments -5624 -5362 -2481 -3135 -3080 -1986 -1589 -1366 -1175 -1011 Proceeds from sales of short-term and other

investments 4852 5343 2996 3198 3181 2216 3875 2962 2901 2901 Proceeds from sales of short-term and other

investments excluding other, net -- -- 2996 3198 3185 2223 3875 2962 2901 2901

Other, net -- -- -- -- -4 -7 -- -- -- --

Payment for assets of ATA Airlines, Inc. -- -- -- -- -- -- -- -- -- --

Debtor in possession loan to ATA Airlines, Inc. -- -- -- -- -- -- -- -- -- --Net cash used in / provided by financing

activities -149 -766 -947 -851 -1248 -1024 -1409 -890 -1134 -1586

Proceeds from issuance of long-term debt -- -- 0 0 300 500 -82 321 -42 -491

Proceeds from credit line borrowing -- -- -- -- -- -- -- -- -- --

Proceeds from revolving credit facility -- -- -- -- -- -- -- -- -- --

Proceeds from sale leaseback transactions -- -- -- -- -- -- -- -- -- --

Proceeds from employee stock plans 55 20 27 96 110 46 13 13 13 13 Proceeds from termination of interest rate

derivative instruments -- 76 38 -- -- 24 -- -- -- --

Reimbursement for assets constructed for

others -- -- -- -- 27 12 3 3 3 3 Payments of long-term debt and capital lease

obligations -155 -540 -578 -313 -561 -213 -603 -591 -519 -452

Payments of convertible debt 0 -81 -- -- -- -- -- -100 -- --

Payment of revolving credit facility obligations -- -- -- -- -- -- -- -- -- --

Payment of credit line borrowing obligations -44 -- -- -- -- -- -- -- -- --

Payments of cash dividends -13 -14 -22 -71 -139 -180 -217 -263 -315 -386

Repurchase of common stock 0 -225 -400 -540 -955 -1180 -500 -250 -250 -250

Other, net 8 -2 -12 -23 -30 -33 -23 -23 -23 -23 Excess tax benefits / obligation from share-

based compensation arrangements -- -- -- -- -- -- -- -- -- --

Repayment of construction obligation -- -- -- -5 -11 -10 -- -- -- --

Other, net excluding excess tax benefits /

obligation from share-based compensation

arrangements and repayment of construction

obligation -- -2 -12 -18 -19 -23 -23 -23 -23 -23

Net change in cash and cash equivalents 147 -432 284 242 -73 301 116 46 80 91Cash and cash equivalents at beginning of

period 1114 1261 829 1113 1355 1282 1583 1699 1745 1825

Cash and cash equivalents at end of period 1261 829 1113 1355 1282 1583 1699 1745 1825 1916

Cash payments for -- -- -- -- -- -- -- -- -- --

Interest, net of amount capitalized -135 -185 153 -133 -128 -- -94 -26 -23 -24

Income taxes -274 -13 100 -346 -155 -- -1409 -265 -367 -469

Noncash transactions -- -- -- -- -- -- -961 -1010 -1036 -1046 Noncash rights to airport gates acquired

through reduction in debtor in possession loan

to ATA Airlines, Inc. -- -- -- -- -- -- -- -- -- --

Flight equipment under capital leases -- -- -- -- -- -- -- -- -- --

Assets constructed for others -- 116 129 105 88 -- -961 -1010 -1036 -1046 Fair value of equity consideration given to

acquire AirTran -- 523 -- -- -- -- -- -- -- --

Fair value of common stock issued for

conversion of debt -- 78 -- -- -- -- -- -- -- --

Dividend Scenarios

Year 2015 2016 2017 2018 2019

Growth rate 0.2 0.2 0.2 0.2

Dividend 0.285 0.342 0.4104 0.49248 0.590976

Shares outstanding (non-diluted) 647.600 647.600 647.600 647.600 647.600

Total CF 184.566 -221.4792 -265.77504 -318.930048 -382.7160576


14

Appendix A.d LUV Ratios

Line Item Assumption Unrealized / realized gain / loss on fuel derivative

instruments Held constant due to uncertainty Capital expenditures excluding assets constructed

for others $2B utilized in 2015, assumed same over near future

Purchases of short-term investments 5 year average decrease by 14% Yoy, divided among quarters Proceeds from sales of short-term and other

investments excluding other, net Applied 4 year historical average

Proceeds from issuance of long-term debt Guided in 10-K

Proceeds from sale leaseback transactions Assumed none since no leasebacks planned

Proceeds from employee stock plans 5 year historical average in $

Reimbursement for assets constructed for others We acknowledge an undetermined schedule of reimbursement for various projects underway. No guidance given for forecasting purposes. Payments of long-term debt and capital lease

obligations See lease schedule appendix

Payments of cash dividends Increased by 20% for all forecasted years based on projected decrease from 25% change from 2014-2015 that has been decreasing over time Excess tax benefits / obligation from share-based

compensation arrangements Assumed none based on historical trend

Ratio 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E Trend 5 Yr AVG

Operating Margin 3.30 1.06 -5.92 0.77 8.24 6.41 4.72 7.36 12.57 22.87 20.52 20.96 20.52 20.96 10.78

Net Margin 5.49 6.54 1.61 0.96 3.79 1.14 2.46 4.28 6.13 11.02 10.91 11.37 10.93 11.38 5.01

Return on Assets 3.61 4.27 1.15 0.69 3.09 1.06 2.30 3.99 5.77 10.53 10.16 10.62 10.27 10.72 4.73

Return on Equity 7.60 9.63 2.99 1.90 7.84 2.71 6.07 10.57 16.16 30.92 28.14 27.58 24.48 25.38 13.29

Return on Invested Capital 6.20 7.59 2.04 1.15 5.13 1.86 4.24 7.80 12.17 22.87 11.12 11.75 11.60 12.22 9.79

Dividend Yield (%) 0.12 0.15 0.21 0.16 0.14 0.21 0.34 0.69 0.52 0.66 0.29 0.30 0.32 0.36 0.48

EPS (recurring) 0.20 0.07 -0.75 0.17 0.72 0.50 0.48 1.20 2.28 4.26 3.47 3.83 3.95 4.32 1.74

Current Ratio 0.90 0.92 1.03 1.25 1.29 0.96 0.91 0.79 0.74 0.54 0.55 0.54 0.59 0.56 0.79

EBIT/Interest Expense (Int.

Coverage) 2.34 0.88 -5.02 0.43 5.97 5.17 5.48 8.19 16.83 44.88 35.58 38.16 39.22 42.08 16.11

Projected ASM Growth (LUV): 5.00%

Year ASM

2016 147526

2017 154902

2018 162647

2019 170780

Year Shares Outstanding

2016 655

2017 649.4

2018 635.4

2019 635.4


15

Appendix B: Sales/Industry Analysis

YEAR OIL ($Barrel) UNEMP(%) GDP (%) CPI (Level) Retail sales

1994 15.66 6.1 4.0 148.20 2330235

1995 16.75 5.6 2.7 152.40 2450628

1996 20.46 5.4 3.8 156.90 2603794 SUMMARY OUTPUT

1997 18.64 4.9 4.5 160.50 2726131

1998 11.91 4.5 4.4 163.00 2852956 Regression Statistics

1999 16.56 4.2 4.8 166.60 3086990 Multiple R 0.996454199

2000 27.39 4.0 4.1 172.20 3287537 R Square 0.99292097

2001 23.00 4.7 1.1 177.10 3378906 Adjusted R Square 0.991151213

2002 22.81 5.8 1.8 179.88 3459077 Standard Error 81671.18856

2003 27.69 6.0 2.5 183.96 3612457 Observations 21

2004 37.66 5.5 3.5 188.90 3846605

2005 50.04 5.1 3.1 195.30 4085746 ANOVA

2006 58.30 4.6 2.7 201.60 4294359 df SS MS F Significance F

2007 64.20 4.6 1.9 207.34 4439733 Regression 4 1.49692E+13 3.7423E+12 561.049201 5.64015E-17

2008 91.48 5.8 -0.3 215.30 4392750 Residual 16 1.06723E+11 6670183041

2009 53.48 9.3 -3.1 214.54 4066822 Total 20 1.50759E+13

2010 71.21 9.6 2.4 218.06 4288339

2011 87.04 8.9 1.8 224.94 4601788 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

2012 86.46 8.1 2.8 229.59 4831131 Intercept -2402564.049 268297.095 -8.954864193 1.24692E-07 -2971328.482 -1833799.616 -2971328.482 -1833799.616

2013 87.13 6.7 1.9 232.96 5011740 OIL ($Barrel) -1404.878994 1620.822028 -0.866769436 0.39888084 -4840.868201 2031.110212 -4840.868201 2031.110212

2014 53.27 5.6 2.4 234.81 5208443 UNEMP(%) -94170.10769 14312.89817 -6.579387807 6.33955E-06 -124512.0964 -63828.11902 -124512.0964 -63828.11902

GDP (%) 21242.82431 12845.88715 1.653667362 0.117677773 -5989.239922 48474.88855 -5989.239922 48474.88855

CPI (Level) 35109.12119 1610.165199 21.80467024 2.51563E-13 31695.72345 38522.51893 31695.72345 38522.51893


16

Map of the Impact of Industry Soft Factors to Sales via Demand (Volume) and Price

Sector = Transportation

Industry = Airlines

Life Cyle = Mature

Highly Correlated Economic Variables (list relevant) Pos/Neg Significance Outlook Reasoning

Retail Sales + medium neutral/positive

Discretionary income is where the majority of revenue earned comes from.

Therefore the hike in Retail Sales shows an increase in Airline Revenue

CPI + low neutral/positive

As inflation has increased in recent years, so have sales in the airline industry.

This is also affected by the hike in Retail Sales

Oil + medium neutral/positive

Oil price have fallen over the past three years. And since Oil is the main cost of

the Airline, this is allowing for better deals and increased flights

GDP + High Positive Cyclical indsutry forces it do depend on domesitc growth

Correlation with employment - driscretionary imployment check new regression pg

Pos/Neg Degree +/- Probable Impacts

Positive = + Low = 1 or 2 Low = 1 or 2 Demand

Negative = - Average = 3 Avg = 3 Costs

High = 4 or 5 High = 4 or 5 Price

External Factors Pos/Neg Degree+/- Probable Impacts Notes

Technology

Aircraft fuel efficiency changes + 4 3

Costs/Price - The fuel efficiency per available ton-mile has improved over time

because of increased aircraft size, while also making aircrafts more aerodynamik

and lighter

IBIS World Domestic Airlines

Aircraft capacity + 5 2

Cost/Price/Demand - The new A380 by Airbus can fly 853 passengers and is

allowed to fly over 10000 nonstop. This allows for the capability for direct

flights to almost anywhere in the world, which allows for convenience increases

for passengers while making the route more efficient for the airline


WiFi - 2 3

Cost - WiFi service is a positive for passengers, but it is a negative cost for the

airline IBIS World Domestic Airlines

Online booking/payment/checkin + 4 5

Cost/Demand - An increase of simplicity and accessibility allows for the

increase of tickets sold while also eliminating paper costs and administration

labor costs. This is even more apparent with the increase in smart phones and

the ability to download tickets to your phone


Government

U.S. Environmental Protection Agnecy = 3 5 Costs, Make sure that airlines are up to date with emission requirements IBIS World Domestic Airlines

Aviation and Transportation Security Act = 3 5 Costs. Responsible for TSA, IBIS World Domestic Airlines

Federal Aviation Administration + 1 1

Costs. Assist airlines in solving congestion problems caused by air traffic control

systems. Paid companies affected adversely by 9/11 disruption of markets. Also

enforces noise standards for aircrafts set from the Airport Noise and Capacity

Act of 1990


Social



Demographic

Business Travel + 3 3

Price - Much less responsive to price change. Demand for business travel only

increases or decreases when the economy is doing well, so business is doing

well.


Leisure Travel - 2 2

Demand/Price - When Factors such as disposable income grow, more

consumers will spend more money on interstate travel. Cheaper prices tend to

attract more passengers.


Foreign

Highly globalized IBIS World Domestic Airlines

Oil Markets

Because of volatility of the market for oil globally, the domestic airline market is

affected IBIS World Domestic Airlines

Pricing Factors

Product Segmentation (Generic v. Brand Industry)

All offer the same service

Degree of Industry Concentration (Monopolistic)

Highly concentrated

Ease of Entry (Monopolistic)

Huge barriers

Limited Input Suppliers/Materials

Very limited

Industry Sales Forecasts

Source 2016 2017 2018 2019

IBISWorld Forecast

% growth 4.20% 4.80% 4.40% 4.80%

FactSet Forecast

% growth 0.79% 4.30% 5.35% 5.42%

First Research Forecast

% growth 5% 4% 4% 5%

Based on Correlations and Soft Factors - Industry Sales Forecast 2016 2017 2018 2019

Amount

% growth 4.20% 4.37% 4.58% 5.07%

Legend

Legend


17

Map of Economic/Industry to Firm-Level Sales - Hard Factors - Growth Forecast

Levels

Industry LUV JBLU ALK DAL SAVE

Year Sales ($M) Sales Sales Sales Sales Sales

1994 16,267 2,592 1,316 12,359

1995 16,259 2,973 1,418 11,868

1996 17,135 3,406 1,592 12,137

1997 18,615 3,817 1,739 13,059

1998 20,200 4,164 1,898 14,138

1999 21,529 4,736 0 2,082 14,711

2000 24,673 5,650 105 2,177 16,741

2001 21,895 5,555 320 2,141 13,879

2002 21,686 5,522 635 2,224 13,305

2003 22,683 5,937 998 2,445 13,303

2004 25,522 6,530 1,266 2,724 15,002

2005 28,451 7,584 1,701 2,975 16,191

2006 32,143 9,086 2,363 3,334 17,360

2007 36,126 9,861 2,842 3,506 19,154 763

2008 41,558 11,023 3,388 3,663 22,697 787

2009 45,799 10,350 3,286 3,400 28,063 700

2010 52,251 12,104 3,779 3,832 31,755 781

2011 60,727 15,658 4,504 4,318 35,176 1,071

2012 64,690 17,088 4,982 4,657 36,670 1,293

2013 67,396 17,699 5,441 4,964 37,638 1,654

2014 71,926 18,605 5,817 5,368 40,204 1,932

2015 74,634 19,820 6,416 5,598 40,704 2,096

Company vs. Company vs.

Year GDP Industry LUV JBLU ALK DAL SAVE GDP Industry

1995 2.70% -0.05% 14.70% 7.75% -3.97% 14.75%

1996 3.80% 5.39% 14.56% 12.27% 2.27% 11.86% 9.18%

1997 4.50% 8.64% 12.07% 9.23% 7.60% 8.27% 3.43%

1998 4.50% 8.51% 9.09% 9.14% 8.26% 4.59% 0.58%

1999 4.70% 6.58% 13.74% 9.69% 4.05% 9.24% 7.16%

2000 4.10% 14.60% 19.30% 4.56% 13.80% 14.60% 4.70%

2001 1.00% -11.26% -1.68% 204.76% -1.65% -17.10% -5.78% 9.58%

2002 1.80% -0.95% -0.59% 98.44% 3.88% -4.14% -1.59% 0.36%

2003 2.80% 4.60% 7.52% 57.17% 9.94% -0.02% 5.72% 2.92%

2004 3.80% 12.52% 9.99% 26.85% 11.41% 12.77% 7.19% -2.53%

2005 3.30% 11.48% 16.14% 34.36% 9.21% 7.93% 12.34% 4.66%

2006 2.70% 12.98% 19.80% 38.92% 12.07% 7.22% 16.50% 6.83%

2007 1.80% 12.39% 8.53% 20.27% 5.16% 10.33% 5.83% -3.86%

2008 -0.30% 15.04% 11.78% 19.21% 4.48% 18.50% 3.15% 9.98% -3.25%

2009 -2.80% 10.21% -6.11% -3.01% -7.18% 23.64% -11.05% -5.81% -16.31%

2010 2.50% 14.09% 16.95% 15.00% 12.71% 13.16% 11.57% 19.75% 2.86%

2011 1.60% 16.22% 29.36% 19.18% 12.68% 10.77% 37.13% 26.86% 13.14%

2012 2.20% 6.53% 9.13% 10.61% 7.85% 4.25% 20.73% 7.53% 2.61%

2013 1.50% 4.18% 3.58% 9.21% 6.59% 2.64% 27.92% 1.38% -0.61%

2014 2.40% 6.72% 5.12% 6.91% 8.14% 6.82% 16.81% 3.62% -1.60%

2015 0.76% 3.76% 6.53% 10.30% 4.28% 1.24% 8.49% 4.13% 2.77%

Mean (all years) 2.35% 7.72% 10.45% 37.88% 7.25% 6.19% 14.34% 7.81% 2.73%

Mean (5 years) 1.69% 7.48% 10.74% 11.24% 7.91% 5.14% 22.22% 8.70% 3.26%

Mean (3 years) 1.55% 4.89% 5.08% 8.81% 6.34% 3.57% 17.74% 3.04% 0.19%

GDP Industry

Year Forecast* Forecast All Year 5 year 3 year All Years 5 years 3 Years

2016 4.14% 4.20% 11.95% 12.85% 7.18% 6.93% 7.46% 4.39%

2017 4.24% 4.37% 12.05% 12.95% 7.29% 7.10% 7.63% 4.55%

2018 4.60% 4.58% 12.42% 13.31% 7.65% 7.31% 7.84% 4.77%

2019 4.76% 5.07% 12.57% 13.46% 7.80% 7.80% 8.33% 5.26%

Year Min Max Mean Median Value Line FactSet

2016 4.39% 12.85% 8.46% 7.32% 11.82% 4.99%

2017 4.55% 12.95% 8.59% 7.46% 5.28%

2018 4.77% 13.31% 8.88% 7.75% 13.23%

2019 5.26% 13.46% 9.20% 8.07%

Year Real GDP CPI *Nominal GDP

2016 1.90% 2.20% 4.14%

2017 2.00% 2.20% 4.24%

2018 2.35% 2.20% 4.60%

2019 2.50% 2.20% 4.76%

Percentage Growth

GDP Forecast + Company Difference Industry + Company Difference

Range Published Forecasts


18

Soft Factors Affecting the Company's Position within the Industry (Ultimately Sales Growth)

Company = Southwest Airlines Co. (LUV)

Competitor 1 = JetBlue Airways Corporation (JBLU)

Competitor 2 = Alaska Air Group, Inc. (ALK)

Competitor 3 = Delta Air Lines, Inc. (DAL)

Competitor 4 = Spirit AeroSystems Holdings Inc. (SPR)

Pos/Neg = current attribute + -

Degree = intensity of attribute Low= 1-2 Avg=3 High=4-5

Total = Pos/Neg * Degree

Trend in the Future + = -

Pos/Neg Degree Total Trend Pos/Neg Degree Total Trend Pos/Neg Degree Total Trend Pos/Neg Degree Total Trend Pos/Neg Degree Total Trend

Factor

Previous Industry Factors that Vary by Company

Degree of Industry Concentration (Monopolistic) - 5 -5 = - 5 -5 = - 5 -5 = - 5 -5 = - 5 -5 =

Sales Patterns (see previous tab)

Sales Stability - Low Standard Deviation + 4 4 = = 0 0 = + 5 5 = + 4 4 = = 0 0 0

Negative Sales Growth + 2 2 = + 5 5 - + 1 1 = = 1 1 = = 3 3 -

Products, Innovation, and Technology

Product Mix N/A 0 N/A 0 N/A 0 N/A 0 N/A 0

Product Quality + 2 2 = + 4 4 = + 4 4 = + 4 4 + = 0 0 =

Reputation for Producing Safe Products + 4 4 = + 4 4 + + 5 5 = + 5 5 = = 3 3 +

New product Introductions N/A 0 N/A 0 N/A 0 N/A 0 N/A 0

R&D Plans N/A 0 N/A 0 N/A 0 N/A 0 N/A 0

Management Quality + 4 4 = + 5 5 + 4 4 = + 5 5 = + 1 1 =

Customer Satisfaction + 5 5 = + 2 2 = + 5 5 = + 3 3 + + 2 2 =

Marketing/Advertising + 4 4 = + 4 4 = + 2 2 = + 1 1 = = 0 0 0

Customer Base

Loyalty + 4 4 + 5 5 + 5 5 + 2 2 0

Sum of Totals, % Positive Trend 24 24 26 20 4

Legend

LUV JBLU ALK DAL SAVE


19

Appendix C: Cost of Capital

Cost of Debt Capital

Cost of Debt (Rd) = 4.33%

Cost of Equity Sensitivity Bear Base Bull

Beta Assumption 0.8 1 1.25

Cost of Equity Capital Re 6.32% 7.32% 8.57%

Risk Premium Approach Source: FactSet and Team Estimates

Risk Premium = 5.00% 3-5%

Cost of Equity (Re) = 9.33%

Base Bull Bear

CAPM Approach CAPM Approach CAPM Approach

Risk-free Rate = 2.32% Risk-free Rate = 2.32% Risk-free Rate = 2.32%

Beta = 1 Beta = 1.25 Beta = 0.8

Market Risk Premium = 5.00% Market Risk Premium = 5.00% Market Risk Premium = 5.00%

Cost of Equity (Re) = 7.32% Cost of Equity (Re) = 8.57% Cost of Equity (Re) = 6.32%

WACC WACC WACC

Weight of Debt = 30.16% Weight of Debt = 30.16% Weight of Debt = 30.16%

Weight of Equity = 69.84% Weight of Equity = 69.84% Weight of Equity = 69.84%

Cost of Debt = 4.33% Cost of Debt = 4.33% Cost of Debt = 4.33%

Cost of Equity = 7.32% Cost of Equity = 8.57% Cost of Equity = 6.32%

Tax Rate = 37% Tax Rate = 37% Tax Rate = 37%

WACC = 5.93% WACC = 6.80% WACC = 5.23%


20

Appendix D: Free Cash Flow Calculation

Southwest Airlines Co.

Free Cash Flow Calculation

All figures in millions of U.S. Dollar, except per share items.

2016 Free Cash Flow 2016 Inputs

Net Income CF from OperationsEBIT(1-t) EBITNCC(1-t) Item Location Input

Beginning Number 2271 3128 2308 2994 Net Income IS 2271

Non-cash charges 1094 1094 408 CF from Operations CF 3128

Interest Expense (1-t) 75 75 Non-Cash Charges CF 1094

-Investment in NWC 237 237 237 Interest Expense IS 120

-Investment in FC 1846 1846 1846 1846 Investment in NWC CF 237

FCFF 1358 1358 1319 1319 Investment in FC CF 1846

-Interest Expense (1-t) 75 75 75 75 Tax Rate IS 37.3%

+Net Borrowing -972 -972 -972 -972 EBIT IS 3680

FCFE 311 311 271 271 EBITNCC IS/CF 4774

Net Borrowing CF -972

2017 Free Cash Flow

Net Income CF from OperationsEBIT(1-t) EBITNCC(1-t) 2017 Inputs

Beginning Number 2485 3348 2487 3206 Item Location Input

Non-cash charges* 1147 1147 428 Net Income IS 2485

Interest Expense (1-t) 75 75 CF from Operations CF 3348

-Investment in NWC 285 285 285 Non-Cash Charges CF 1147

-Investment in FC 1938 1938 1938 1938 Interest Expense IS 120

FCFF 1485 1485 1411 1411 Investment in NWC CF 285

-Interest Expense (1-t) 75 75 75 75 Investment in FC CF 1938

+Net Borrowing 415 415 415 415 Tax Rate IS 37.3%

FCFE 1825 1825 1751 1751 EBIT IS 3967

EBITNCC IS/CF 5114

Net Borrowing CF 415


21

Appendix E: DCF Model


22


23

Appendix F: LUV vs Industry Ratios

Company Ticker LUV DAL JBLU ALK SAVECompetitors

Average

Current Ratio 0.54 0.68 0.73 0.93 1.97 1.08

Gross Margin 34.2% 28.1% 22.4% 33.2% 27.4% 27.8%

Net margin 11.0% 7.0% 9.2% 14.6% 14.3% 11.2%

Net margin NTM 13.3% 12.9% 13.0% 16.2% 12.7% 13.7%

ROA 10.5% 5.4% 7.0% 12.6% 16.2% 10.3%

ROA NTM 12.4% 9.0% 10.1% 12.3% 10.0% 10.3%

ROE 30.9% 25.0% 21.3% 35.0% 28.5% 27.5%

ROE NTM 28.0% 34.0% 21.1% 30.5% 20.0% 26.4%

ROIC 22.9% 14.6% 11.3% 27.3% 23.0% 19.1%

Net Income (M) 2,185 2,834 575 805 299 1,128

Net Income NTM (M) 2,780 5,249 913 953 304 1,855


24

Appendix G: Event History on Price History

Note: Late 2009 was failed acquisition of Frontier Airlines Note: late 2010 was acquisition of AirTran Airlines


25

Appendix H: Unit Cost Comparison

Southwest

Airlines Average Median JetBlue

Alaska Air

Group

Spirit

Airlines

Delta Air

Lines

Fiscal Period 12/31/2015 09/30/2015 09/30/2015 09/30/2015 09/30/2015

ASM LTM 141,207.0 89,529.6 44,922.0 49,695.9 40,148.0 21,649.2 246,625.0

LTM Growth 7.2% 13.0% 10.2% 9.6% 10.8% 28.9% 2.6%

ASM NTM 148,698.0 92,123.9 48,511.8 54,362.9 42,660.7 25,919.4 245,553.0

CASM LTM 11.16 10.53 10.61 10.52 10.70 7.68 13.23

LTM Growth -9.9% -14.2% -13.7% -10.0% -11.4% -19.4% -16.0%

CASM NTM 11.02 9.97 10.10 10.11 10.09 7.44 12.24

Fees 1 Yr Growth 4.9% 11.7% 7.9% 4.7% 10.3% 26.4% 5.4%

Landing Fees 1,166.0 567.3 313.0 337.0 289.0 126.0 1,517.0

Factor LTM 83.61 84.60 84.71 84.67 84.10 84.75 84.89

Factor NTM 83.68 84.53 84.59 84.44 84.11 84.73 84.83

PRASM LTM 13.01 10.85 11.95 11.93 11.97 5.40 14.08

LTM Growth -3.5% -7.6% -4.4% 0.5% -5.3% -22.3% -3.5%

PRASM NTM 12.89 10.49 11.63 11.71 11.55 4.82 13.88

RASM LTM 13.96 13.33 13.46 12.99 13.94 9.99 16.42

LTM Growth -1.6% -5.8% -4.2% 0.6% -5.9% -15.3% -2.5%

RASM NTM 13.77 12.67 12.83 12.65 13.02 9.36 15.64

RPM LTM 118,111.0 75,925.0 37,924.1 42,074.8 33,773.4 18,345.7 209,506.0

LTM Growth 8.7% 12.3% 10.0% 10.4% 9.5% 26.2% 3.0%

RPM NTM 124,562.0 78,097.7 40,920.6 45,969.4 35,871.7 21,934.5 208,615.0

Wages/Sales 36.97% 23.88% 24.96% 27.84% 25.38% 17.75% 24.53%

1 Yr Growth 20.6% 20.1% 16.9% 33.3% 13.8% 20.1% 13.1%

Wages 7,328.0 3,372.8 1,574.0 1,745.0 1,403.0 372.1 9,971.0

Yield LTM 15.56 12.81 14.15 14.11 14.20 6.39 16.54

LTM Growth -4.8% -7.2% -4.1% -0.2% -4.3% -20.6% -3.9%

Yield NTM 15.43 12.29 13.71 13.88 13.54 5.64 16.10

ASM

CASM

Landing

PRASM

RASM

RPM

Yield

Wages


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Appendix I: LUV Weekly 200-day MAV vs 50-Day MAV

This demonstrates a hold signal as the current price has been intertwining with the moving averages and is indicating resistance in not breaking above the 52-week high of $49.41 in 2015. This is likely to change in the near term given fleet modernization benefits and growth into untapped domestic and international markets.


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Appendix J: Relative Multiples Valuation

Cost of Equity 8.57% Cost of Equity 8.57%

EPS '16 4.29 Upside/Downside CF/share '15 4.85 Upside/Downside

P/E NTM 8.05 34.5345 31.81 -3.1% P/CF LTM 3.75 18.1875 18.19 -92.8%

8.3 35.607 32.80 7.23 35.0655 35.07

14.5 62.205 57.29 74.7% 10.5 50.925 50.93 45.2%

Cost of Equity 8.57%

EPS '15 3.27 Upside/Downside Cost of Equity 8.57%

P/E LTM 9 29.43 29.43 -21.2% EBITDA/share '15 5548 Upside/Downside

10.91 35.6757 35.68 EV/EBITDA LTM 3.58 19861.84 19861.84 -15.4%

23.67 77.4009 77.40 117.0% 4.13 22913.24 22913.24

7.13 39557.24 39557.24 72.6%

Cost of Equity 8.57%

Sales/share '15 30.5 Upside/Downside

P/S LTM 0.94 28.67 28.67 -27.7%

1.2 36.6 36.60

1.69 51.545 51.55 40.8%


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WAV Target Price (Bull)

Multiple Target Price Weight

Calculated

WAV Intrinsic

ValueP/E NTM 57.29 45% 25.8

P/S 51.55 20% 10.3

P/CF 50.93 15% 7.6

P/E LTM 77.40 20% 15.5

Final Price 59.21

WAV Target Price (Base)


Calculated

WAV Intrinsic

Value

P/E NTM 35.07 45% 15.8

P/S 36.60 20% 7.3

P/CF 35.07 15% 5.3

P/E LTM 35.68 20% 7.1

Final Price 35.49

WAV Target Price (Bear)


Calculated

WAV Intrinsic

Value

P/E NTM 31.81 45% 14.3

P/S 28.67 20% 5.7

P/CF 18.19 15% 2.7

P/E LTM 29.43 20% 5.9

Final Price 28.66

Base Current 35.69 -

Bull Upside 59.21 66%

Bear Downside 28.66 -20%


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Appendix K: Multiples Price Impact Graphs Appendix K. a P/E NTM

Appendix K. b P/E LTM


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Appendix K. c P/S


31

Appendix K. d P/CF


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Appendix K. e P/B


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Appendix L: Competitor Price History


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Appendix M: Airline Glossary Aircraft Utilization – The hours and minutes in a day an aircraft is used. ASM (Available Seat Mile) – One seat (empty or full) flown one mile. Often referred to as the airlines industry’s measures of capacity. Average Length of Haul – The average distance in miles a paying passenger is flown. Average Passenger Fare – The average amount of passenger revenue per Revenue Passenger Carried. Average Stage Length – The average distance in miles the aircraft is flown. CASM (Operating Expenses (Cost) per Available Seat Mile) – The average cost of flying an aircraft seat (empty or full) one mile. Often referred to as a “unit cost” measurement. Calculated as Total Operating Expenses/Total Available Seat Miles. DOT (Department of Transportation) – Established by an act of Congress on October 15, 1966, the DOT consists of the Office of the Secretary and eleven individual operating administrations. Leadership of the DOT is provided by the Secretary of Transportation, who is the principal adviser to the President in all matters relating to federal transportation programs. Enplaned Passenger – One passenger, originating or connecting, boarded on an aircraft. Load Factor – The percentage of a plane filled with paying passengers. Calculated as Revenue Passenger Miles/Available Seat Miles. Passenger Yield (Passenger Revenue Yield per Revenue Passenger Mile) – The average amount of revenue received per paying passenger flown one mile. Calculated as Passenger Revenues/Revenue Passenger Miles. PRASM (Passenger Revenue per Available Seat Mile) – Passenger Revenue per seat (empty or full) flown one mile. Often referred to as a “passenger unit revenue” measurement. Calculated as Passenger Revenues/Available Seat Miles. RASM (Revenue per Available Seat Mile) – Total Operating Revenue per seat (empty or full) flown one mile. Often referred to as a “unit revenue” measurement. Calculated as Total Operating Revenues/Available Seat Miles. Revenue Passengers Carried – The number of Origination and Destination (O&D) paying passengers. (O&D – a measure of the point of origination of a passenger to the final destination). RPM (Revenue Passenger Mile) – One paying passenger flown one mile. Often referred to as the airline industry’s measure of “traffic”. Trips Flown – Number of one-way nonstop flights by all aircraft.


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Appendix N: Competitor PRASM vs. CASM Graph Comparison


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References https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CDIQFjAA&url=http%3A%2F%2Fwww.bea.gov%2Fnational%2Fxls%2Fgdpchg.xls&ei=fWEUUeCiDcSvyQGXyYCYCQ&usg=AFQjCNFe70KjeZ-G8b1adaOvkdSHj0KkHw&bvm=bv.42080656,d.aWc http://www.bls.gov/cps/cpsaat01.htm http://www.federalreserve.gov/releases/h15/data.htm http://inflationdata.com/Inflation/Consumer_Price_Index/HistoricalCPI.aspx?reloaded=true http://inflationdata.com/Inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp http://www.census.gov/construction/nrc/historical_data/ http://clients1.ibisworld.com/reports/us/industry/industryoutlook.aspx?entid=1125 http://www.theacsi.org/index.php?option=com_content&view=article&id=147&catid=&Itemid=212&i=Airlines http://investor.jetblue.com/~/media/Files/J/Jetblue-IR/Annual%20Reports/2014-ar-10-k.pdf http://ir.delta.com/stock-and-financial/sec-filings/ file:///C:/Users/athiesse/Downloads/FINAL%202015%20PROXY%20AND%202014%20ANNUAL%20REPORT.PDF http://files.shareholder.com/downloads/ABEA-5PAQQ9/1446530844x0x818446/85F2240B-211D-46BD-B789-37B88FB5935E/Spirit_10K.pdf http://commons.erau.edu/aqrr/25/ http://www.jdpower.com/press-releases/2015-airline-loyaltyrewards-program-satisfaction-report http://www.atlanta-airport.com/fifth/atl/operation_statistics.aspx http://www.lawa.org/LAXMarketShare.aspx https://skyharbor.com/About/Information/AirportStatistics http://www.flydenver.com/about/financials/passenger_traffic http://fly2houston.com/about-traffic-updates FactSet LUV, JBLU, ALK, SAVE, DAL Company, Economic, and Airline Industry Reports and Charting Southwest Airlines - Investor Relations, Earnings Calls 2015 Q1, Q2, Q3, Q4


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Disclosures:

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

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