We Don’t Believe in LUV at First Sight: Southwest Airlines Analysis

1
The University ofTexas at Dallas
James,Tyler,Trevor
We Don’t Believe in LUV at First Sight

$0
$10
$20
$30
$40
$50
$60
Feb-15
Mar-15
Apr-15
May-15
Jun-15
Jul-15
Aug-15
Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Close Price Current Price Target Price
Executive Summary
2
Market Profile (as of 02/04/2016)
Closing Price: $37.54
52-Week High-Low: $31.36 / $51.34
Diluted Shares Out. : 679.55 M
Average Volume (6M): 8.44 M
Market Cap: $ 22.78 B
LTMDividend Yield: 0.76%
Short Interest (%) Float: 3.77%
Beta: 1.11
EV/EBITDAR*: 5.0 x
P/E*: 12.7 x
Institutional Holders: 82.94%
Insider Holdings: 0.28%
NYSE: LUV Recommendation: HOLD
Industry: Airlines Current Price: $37.54
Sector: Transportation Target Price: $34.53 (8% Downside)
LUV $34.53
LUV $37.54
Investment Themes:
 Low Cost, No Frill Approach
 Conservative Operating Philosophy
 Declining Competitive Advantage
 Strained Employee Relations
*Multiples adjusted for Operating Leases
Investment Highlights Company Overview Industry Analysis Financial Analysis Valuation Risk Analysis Conclusion

3
Employee Relations
Cost Structure
A B
C D
E F FC
E
D
B G
A
Low Cost
Structure
Point to
Point
Each route serves
a single city-pair
Higher aircraft
utilization and
turnaround times
Hub and
Spoke
Hub connections
significantly
increase CASM
Routes are
interdependent
for connecting
passengers
Vs.
Historical Competitive Advantage
The Southwest Effect
Traffic Demand In New Markets
Average Fares in New Markets
Low Fares Brand Image

4
Executive Council * denotes company tenure
Gary C. Kelly
Chairman of the
Board, CEO
Tammy Romo
EVP/Chief
Financial Officer
Robert E. Jordan
EVP/Chief
Commercial
Officer
Michael G. Van deVen
EVP/Chief
Operating Officer
Jeff Lamb
EVP of Corporate
Services
Mark R. Shaw
SVP Gen. Counsel,
Corporate Secretary
Thomas M. Nealon
EVP Strategy &
Innovation
29
12
0
24
28
11
15
*
“Your people come first, and if you treat them right, they’ll treat the customers right.”
- Herb Kelleher, Founder of Southwest Airlines

Major Markets, Pre-AirTran Acquisition (2011)
5

Major Markets,After AirTran Acquisition (2014)
6
ATLANTA
PARADISE ISLAND
BERMUDA
CHARLOTTE
MEMPHIS
BRANSON
WICHITA
GRAND
RAPIDS
FLINT
RICHMOND
ROCHESTER
PENSACOLA
PORTLAND
CABO SAN LUCAS
MEXICO CITY
CANCÚN
MONTEGO BAY
ARUBA
PUNTA CANA
SAN JUAN

Major Markets,After Wright Amendment Repeal (2014)
7

8
Industry
Rivalry
Threat of
Substitutes
Threat of
New
Entrants
Power of
Buyers
Power of
Suppliers
Porter’s Five Forces

Changing Dynamics
9
$200
$250
$300
$350
$400
$450
$500
1979 1986 1993 2000 2007 2014
Average Fares
Deregulation
Weakened
Barriers
Laissez-faire
Pricing
Bankruptcy
Converging Interests
LCC’s ULCC’s
Legacy
Legacy
Before 1978 2016

IndustryTimeline
10
AAL/TWA
Merger
MetroJet
Liquidation
9/11Terror
Attacks
AmericanWest/US
Airways Merger
DAL/Northwest
Merger
Financial
Crisis
UAL/Continental
Merger
LUV/AirTran
Merger
2001 2005 2008 2010 2011
AAL/US Airways
Merger
2013
-2
-1
0
1
2
3
4
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Strengthening Z scores
AAL DAL UAL LUV
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
$0 B
$50 B
$100 B
$150 B
$200 B
2007 2008 2009 2010 2011 2012 2013 2014 2015
Improving Operating Margin
Revenue Operating Margin

Evolving Structures
11
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2001 2003 2005 2007 2009 2011 2013 2015
Operating Cost Structure
Wages Fuel Other Costs
The industry dynamics have changed substantially since the Deregulation Act
0%
5%
10%
15%
20%
25%
30%
35%
40%
1998 2000 2002 2004 2006 2008 2010 2012 2014
Streamlined Labor Costs % of Revenue
Labor Other Costs

Current Dynamics
12
$0
$20
$40
$60
$80
$100
$120
-1.0 M
-0.5 M
0.0 M
0.5 M
1.0 M
1.5 M
2.0 M
2.5 M
3.0 M
Supply-Demand Spread (mbpd) WTI Spot Price
Supply Imbalance vs Crude Oil
Fuel tailwinds have created ROIC levels above WACC
44% Jet fuel price per gallon
Oil Supply Surplus
Global energy demand
 Alleviate debt obligations
 Increase shareholder returns

Macroeconomic Drivers
13
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
1986 1991 1996 2001 2006 2011 2016
0
10
20
30
40
50
60
70
Contracting PMI levels
PMI Index Real GDP YoY
0 B
10,000 B
20,000 B
30,000 B
40,000 B
50,000 B
60,000 B
70,000 B
80,000 B
90,000 B
0 B 500 B 1,000 B 1,500 B 2,000 B 2,500 B
Corporate Earnings vs AirlineTraffic
Correlation = 84%
PMI Non-PMI Corp. Earnings Traffic
*78% *84%*80%
* Denotes correlation

Industry Drivers
14
-10%
-5%
0%
5%
10%
15%
20%
2010 2011 2012 2013 2014 2015
Yield
Legacy LCC's ULCC's
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
03/06 10/07 05/09 12/10 07/12 02/14 09/15
Passenger Revenue per Available Seat Mile
PRASM Fuel Cost pASM Labor Cost pASM
Short-term industry yields are expected to stabilize
Yield = Passenger Revenue/Revenue Passenger Mile

Revenue Analysis
15
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
2006 2008 2010 2012 2014 2016
Capacity Expansion vsTraffic
ASM YoY Growth RPM YoY Growth
-15%
-10%
-5%
0%
5%
10%
15%
20%
2002 2005 2008 2011 2014 2017
HistoricalYield

Growth Opportunity
16
4%
Domestic
2%
Inter-
national
6%
Capacity
Expansion

Cost – Efficiency Analysis
17
0%
5%
10%
15%
20%
25%
30%
35%
40%
20182015201220092006200320001997
Significantly Above-average Labor Costs
Industry Wages LUV Wages
∆ = 10%
-60% -40% -20% 0% 20% 40%
Legacy
LCC's
ULCC's
Industry
Industry's CASM Ex-fuel compared to LUV
09/2015 12/2009
∆ = -19%
∆ = -15%
∆ = -8%
∆ = -11%

Cost – Efficiency Analysis
18
0%
2%
4%
6%
8%
10%
12%
14%
2011 2012 2013 2014 2015
Late Arrival Ratio
Southwest* Industry*
∆ = 34%
-60% -40% -20% 0% 20% 40%
Legacy
LCC's
ULCC's
Industry
Industry's CASM Ex-fuel compared to LUV
09/2015 12/2009
∆ = -19%
∆ = -15%
∆ = -8%
∆ = -11%
“Not only has the world changed, but our relative position within the industry on costs has changed.”
- Gary Kelly, CEO of Southwest Airlines

19
5 Union Work Groups
Current Negotiations:
Employees
Representing
55.8%
43%
57%
Labor Costs % Operating Expenses
Labor Expenses Other Expenses
83%
17%
Percent of Workers Unionized
Unionized Non-Unionized
Labor Cost Uncertainty

Fading Competitive Advantage
20
LUV no longer remains a low cost leader
LUV
Other
LCC’s
Legacy
Cost
QualityofService
Other
LCC’s
LUV
Legacy
Cost
QualityofService
ULCC’s
ULCC’s
Cost
This graph is illustrative purposes

Profitability Analysis
21
 FASB Operating Leases Adjustment
 Add back Aircraft & Other Rentals
-5%
0%
5%
10%
15%
20%
25%
30%
ROIC
Reported ROIC Adjusted ROIC
0
1,000
2,000
3,000
4,000
5,000
6,000
Historical EBITDAR
Before Adjustment
 27.4% EBITDAR
 24.1% ROIC
After Adjustment
 28.9% EBITDAR
 20.3% ROIC
 +2.7B Debt

22
Capital Structure Analysis
NM
2.0 x
4.0 x
6.0 x
8.0 x
10.0 x
12.0 x
Total Debt/EBITDAR
Conservative Operating Philosophy
0 %
10 %
20 %
30 %
40 %
50 %
60 %
70 %
FY05A FY07A FY09A FY11A FY13A FY15A FY17E
Historical Debt to Capital
As reported Adjusted

23
Terminal EV/EBITDAR
Adj. for Operating Leases
DCF Analysis
Price: $38.81
RelativeValuation
Price: $30.24
LUV
$34.53
(50%) (50%)
EV/EBITDAR
Normalized P/E
8% Potential Downside
Valuation Overview

Assumption Breakdown FY16E FY17E FY18E
YoY Capacity Growth: 5.5% 4.0% 3.0%
Load Factor: 83.6% 83.6% 83.6%
Change in Yield: -1.5% 0.5% 1.0%
Passenger Revenue: 19,023 19,882 20,684
Freight: 180 184 180
Other Revenue: 1,257 943 971
Total Operating Revenue: 20,460 21,009 21,835
YoY Growth Rate: 4.1% 2.7% 3.9%
24
Revenue Assumptions
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
0 B
5 B
10 B
15 B
20 B
25 B
FY09A FY10A FY11A FY12A FY13A FY14A FY15A FY16E FY17E FY18E
Revenue Projection
-3 B
-2 B
-1 B
0 B
1 B
2 B
3 B
FY05A FY06A FY07A FY08A FY09A FY10A FY11A FY12A FY13A FY14A FY15A
Historical Earnings vs Reinvesment Need
Reinvestment Need After-tax Adjusted EBIT
~82%
Average Annual
Reinvestment Need

25
Cost of Equity 2016-2019 Terminal
Risk-free Rate*: 2.25% 3.00%
Risk Premium: 5.00% 5.00%
Adjusted Beta: 1.32 1.16
Cost of Equity: 8.84% 8.78%
Cost of Debt 2016-2019 Terminal
Risk-free Rate*: 2.25% 3.00%
BBB+ Default Spread: 2.00% 2.00%
Cost of Debt: 4.25% 5.00%
*Expected 10-Y U.S. Treasury
2016-2019 Terminal
WACC: 7.11% 7.60%
WACC Assumptions

DCF Outputs
26
SPE = Salaries per Employee
$55 - $65 - $75 Brent
+7.6% SPE
$55 - $65 - $75 Brent
+5.1% SPE
$45 - $55 - $65 Brent
+6.5% SPE
Base
$38.54
 $45 - $55 - $65 Brent
 + 650 bps SPE FY 2016
$45 - $55 - $65 Brent
+6.5% SPE
Bull
$54.70
 $35 - $45 - $55 Brent
 + 510 bps SPE FY 2016
$45 - $55 - $65 Brent
+6.5% SPE
Bear
$23.72
 $55 - $65 - $75 Brent
 + 760 bps SPE FY 2016
DCF
Target Price
$38.81

Jet Fuel Expense
25.00$ 30.00$ 35.00$ 40.00$ 45.00$ 50.00$ 55.00$ 60.00$ 65.00$
$120,862 1.21$ 1.30$ 1.39$ 1.48$ 1.57$ 1.66$ 1.75$ 1.84$ 1.93$
$123,884 2.5% 48.75$ 47.71$ 46.68$ 45.64$ 44.60$ 43.56$ 42.53$ 41.49$ 40.45$
$125,092 3.5% 47.25 46.21 45.18 44.14 43.10 42.06 41.03 39.99 38.95
$126,301 4.5% 45.72 44.68 43.65 42.61 41.57 40.54 39.50 38.46 37.42
$127,510 5.5% 44.17 43.13 42.09 41.05 40.02 38.98 37.94 36.90 35.87
$128,718 6.5% 42.58 41.54 40.51 39.47 38.43 37.39 36.36 35.32 34.28
$129,927 7.5% 40.97 39.93 38.89 37.85 36.82 35.78 34.74 33.71 32.67
$131,136 8.5% 39.32 38.29 37.25 36.21 35.17 34.14 33.10 32.06 31.03
$132,344 9.5% 37.65 36.61 35.58 34.54 33.50 32.47 31.43 30.39 29.35
$133,553 10.5% 35.95 34.91 33.88 32.84 31.80 30.76 29.73 28.69 27.65
AveragePer-employee
Expense
Sensitivity Analysis
27

28
RelativeValuation
North American
Airlines
Market Cap >1.5B
Revenue >1.5B
Screening
Criteria
Comparable Valuation
Multiple Turn Price
2016E EBITDAR: 4.4 x $30.47
2017E EBITDAR: 4.5 x $26.64
Normalized P/E Valuation
Comparable P/E: 24.7 x
Normalized EPS (LUV): 1.37$
Implied Price (LUV): 33.84$
0.0 x
5.0 x
10.0 x
15.0 x
20.0 x
25.0 x
Historical LUV EV/EBITDAR

Valuation Summary
29
 $45 - $55 - $65 Brent
 +6.5% SPE
 $55 - $65 - $75 Brent
 +7.6% SPE
Consensus Team Analysis
 Adjust for Operating Leases (BOTH
LUV and Peers)
 Add back full Operating Lease
Expenses (Aircraft + Facility + Others)
 Integrate the impacts of labor contracts
 Cycle-average EV/EBITDAR, normalized
P/E
 (Some) Adjust for Operating Leases
 Add back only Aircraft Rentals
 Wait for new contract releases and
then revise investment thesis
DCF Analysis
$38.81
(50%)
RelativeValuation
$30.24
(50%)
Target Price
$34.53
(8% Downside)

30
High
OR1
OR2 MR2
MR3 MR1
OR3 UCLow
Low Medium High
Impact
Medium
Probability
Legend
OR1: Operational Risk – MR1: Market Risk – Economic Uncertainty
Balancing Employee Compensation MR2: Market Risk – Commodity PriceVolatility
UC: Uncertain Catastrophes
Risk Analysis

31
Market Risk
30
35
40
45
50
55
60
65
Manufacturing PMI vs Non-Manufacturing PMI
NAPMPMI Index NAPMNMI Index
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
$3.5
2000 2003 2006 2009 2012 2015
Economic Fuel Price vs Market Price
Carrier 2015 2016 Comments
Southwest 40% 20% Most heavily hedged (65% through 2017)
Delta 40% 5% Owns refinary to offset flucuations
American 0% 0% Does not hedge
United 22% 35% Opportunity to gain philosophy
Alaskan 42% 33% Uses call options as insurance
JetBlue 17% 0% Opportunity to gain philosophy
Virgin 27% 0% Hedged 31% H1' 16
Spirit 35% 0% No hedging target
Allegiant Air 0% 0% Does not hedge

Zika
Hezbollah
Tornado
32
Hurri-
cane
MERS
-CoV
TB
Impact
Frequency
Ebola
H7N9
H1N1
Vol-
canoes
Thunder-
storm
ISIS
Al-Qaeda
Cybersecurity
War
Geopolitical
Tension
Regulation
Uncertain Catastrophes

Investment Summary
33
Tenuous Pricing Power
Strained Labor Relations
Air travel
Commoditization
Cyclicality
Customer Service
Low-cost Structure
HOLD
Conservative Operating
Philosophy Target Price
$34.53
(8% Downside)

We Don’t Believe in LUV at First Sight: Southwest Airlines Analysis

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