Capital Structure Current Debt ratio 86.65% 23.87% 44.86% 0.00% Optimal Debt Ratio 20.00% 10.00% 45.00% 20.00% Change in WACC 7.06% 0.04% 0.00% 0.54%
Approach American Airlines Ryanair BAA Asur B B B B
Beta 6.26 1.24 1.42 0.82
EVA (1,129.50) 53.30 (191.00) (37.30)
Duration 0 5.3 3.3 0
Dividends 0 0 145 14.3
FCFE 765.3 23.5205 257.1 41.2
Value/share 10.06 6.76 3.22 31.69
Price/Share 10.20 5.55 5.80 30.45
EXECUTIVE SUMMARY................................................................................................... 3 INTRODUCTION AND THE COMPANIES........................................................................ 4
1. Introduction ......................................................................................................................................................................... 4 2. Brief description of the companies .................................................................................................................................. 6
CORPORATE GOVERNANCE ANALYSIS ...................................................................... 8
1. Balance of power between management and shareholders.......................................................................................... 8 2. Management compensation.............................................................................................................................................. 9 3. Market coverage................................................................................................................................................................ 11 4. Social responsibility.......................................................................................................................................................... 12
STOCKHOLDER ANALYSIS.......................................................................................... 14 RISK PROFILE ............................................................................................................... 16
1. Market risk and return...................................................................................................................................................... 16 2. Bottom up betas................................................................................................................................................................ 20 3. Cost of equity .................................................................................................................................................................... 22 4. Cost of debt........................................................................................................................................................................ 23 5. Cost of capital.................................................................................................................................................................... 25
CAPITAL STRUCTURE CHOICES................................................................................. 33
1. Current financing mix ...................................................................................................................................................... 33 2. Trade off on Debt and Equity......................................................................................................................................... 35
OPTIMAL CAPITAL STRUCTURE................................................................................. 37
1. Current Cost of Capital / Financing Mix ...................................................................................................................... 37 2. Cost of Capital at Different Financing Mixes............................................................................................................... 37 3. Firm Value at Optimal ..................................................................................................................................................... 38 4. Optimal capital structure – APV approcah ................................................................................................................... 40 5. Sector and market debt ratios ......................................................................................................................................... 42
MECHANICS OF MOVING TOWARDS THE OPTIMAL................................................. 43
1. A Path to the Optimal...................................................................................................................................................... 43 2. Quantitative Analysis and Overall Recommendation on Financing Mix................................................................. 43 3. Summary of desirable debt charachteristics ................................................................................................................. 47
DIVIDEND POLICY ......................................................................................................... 48
1. Current Dividend Policy .................................................................................................................................................. 48
DIVIDEND POLICY: A FRAMEWORK ........................................................................... 51
1. Affordable Dividends........................................................................................................................................................ 51 2. Management Trust and Changing Dividend Policy ................................................................................................... 51
Corporate Governance and Stockholder analysis We believe that the stockholders’ interests are generally well protected in the companies subject to our review with the exception of American Airlines, which has some controversial corporate governance practices in place. The marginal investor in all companies is well diversified, often internationally, investors. In three out the four companies there were significantly large institutional holdings. Risk Profile We used two measures of bete to estimate the exposure of each company to market risk. Not surprisingly, the results reflect the fundamental characteristics of each company and in particular variance of earnings and leverage. The riskiest company as measured by historical regression beta is American Airlines and the least risky – BAA. Because of the historical character of the regressions beta and high standard errors of the estimates we used bottom-up betas in our further analysis. In addition, we used two methods to compute returns of each company with relation to its risk – Jensen’s Alpha and Treynor ratio. Under both methods the top performing companies were Ryanair and Asur. Investment analysis In analyzing the returns of the investment projects at which companies we looked at a typical project in each line of business and computed accounting measures of returns, such as ROC and ROE. Ryanair proved to be the company with highest returns and it was the only company that generated positive EVA. In addition we assessed the future prospects of each company, analyzing the sustainability of its competitive advantages. This analysis was used as a basis for the valuation of the firms. Capital structure The four companies adopt very different policies with regards to their capital structure, ranging from the highly overlevered American Airlines (debt ratio of 87%) to the all equity financed Asur. Taking into account the potential benefits and disadvantages from the use of debt we computed optimal capital structures for each firm and assessed the impact on the share price from moving from the current capital structure to the optimal. The result was an average of 8.12% increase in the firm
value of the firms, although most of this increase comes from American Airlines. It was interesting to find that BAA’s current debt ratio is equal to its optimum – roughly 45%. Dividend policy Both Amrican Airlines and Ryanair are non-dividend paying companies, although for very different reason. While focus of AA’s policies is to return to profitability before being able to afford any dividends, Ryanair exhibits a great potential to invest in projects with positive excess returns (ROC exceeds Cost of capital). BAA and Asur are companies with more steady and predictable cash flows and reinvestment needs and this is reflected in their dividend policies. Our analysis is presented in Sections X and XI. Valuation The results from our valuations are presented in the table below:
Valuation summary Model Chosen Value per Share Current Stock Price Undervalued / (overvalued) Reccomendation Source: Analysis American Airlines FCFF 2 Stage 10.06 10.20 -1.3% HOLD Ryanair FCFF 3 Stage 6.76 5.55 21.8% BUY BAA FCFF 2 Stage 3.22 5.80 -44.4% SELL Asur FCFF 2 Stage 31.69 30.45 4.1% HOLD
The valuation models are based on the results from our analysis as presented in the following pages. II. Introduction and the companies
1. Introduction The current report examines major trends in the Air transportation sector focusing on four companies in particular – American Airlines (“AA”), Ryanair, BAA and Asur. The companies reviewed operate in two different businesses, airlines industry (AA, Ryanair) and airport operators (BAA, Asur), utilize different business models and are at different stage of their life cycle. The purpose of the report is to analyze different aspects of their corporate finance policies and to assess the effect of these policies on the value the managements of these firms create for their shareholders. Summary information for each company is presented in Figure 1.
Figure 1 Summary company information American Company information Airlines Country of incorporation United States Primary listing Year of establishment Year of stock exchange listing Reporting currency Revenues in 2004 (MM local currency) Revenues in 2004 ($ equivalent1) Book value of capital (MM 2004 local currency 2) Book value of capital (2004 $ equivalent) NYSE 1926 1939 US dollar 18,645 18,645 13,749 13,749
Ryanair Ireland ISE 1985 1997 Euro 1,074 1,336 2,939 2,158
BAA United Kingdom London Stock Exchange 1965 1987 British pound 1,970 3,546 8,960 16,128
Asur Mexico NYSE 1998 2000 US dollar 1,976 177 12,326 1,106
Throughout the report analysis has been presented based on information gathered from various sources, including statutory filings with regulatory authorities in the respective jurisdiction, company annual reports, management presentation and other publicly available information. We have tried to acknowledge each source of information where possible. Figures and data that is not referenced to any source has been result of our own analysis. A list of commonly used terms and abbreviations is presented below:
Term AA, AMR BAA BoD BVE BVD D E Load Factor MVE MVD n.a, N/A n.m. RAPM or Revenue Yield T Meaning American Airlines British Airport Authority Board of Directors Book value of equity Book value of debt Debt Equity Percentage of seats sold to total available seats Market value of Equity Market value of debt Information not available Information not meaningful Revenues per passenger per mile Tax rate
Translated using the average Local Currency/ Dollar rate for 2004 Translated using the closing local currency / Dollar rate as at 31 December 2004
For computational ease the analysis for each company has been undertaken in the reporting currency under which the company reports annual results – US dollars (for AA and Asur), Euro (Ryanair), British pounds (BAA). All figures are in million local currency unless otherwise indicated. 2. Brief description of the companies American Airlines AMR was established in 1926 and had Charles Lindberg as chief pilot of its fleet of 3 DH 4 biplanes. The company was listed in 1939 and throughout the years grew on acquisitions and survived several crisis (included World War II that forced them to turn half of the fleet to the military airline). The company grew internationally and domestically especially after the deregulation act of 1978. In 2001, before September 11 acquired all the assets of TWA, but then was hit by an economic recession, increased competition from low cost carriers and the terrorist attack. Nowadays AMR Corporation is a holding company that provides scheduled passenger and airfreight services to approximately 150 destinations in North America, the Caribbean, Latin America, Europe and the Pacific through its American Airlines subsidiary. The Company in 2004 employed roughly 92,000 people and its headquarter is at Dallas Forth Worth Airport, Texas. For the FY ended 12/31/04, revenues rose 7% to $18.65B. Net loss fell 38% to $761M. Results reflect higher affiliate passenger revenues a decline in wage costs but also an increase in fuel costs. Ryanair Ryanair was founded in 1985 by the Ryan family in Ireland. It started with one scheduled flight between south-eastern Ireland and London Gatwick. First crew members were required to be less than 5 foot 2 inches tall in order to fit in the tiny cabin of the only 15-seater aircraft. Soon after its launch, the company acquires permission to challenge British Airways and Aer Lingus on the Dublin – London route. The number of passengers grew from 5,000 to 82,000 in the first 2 year of operations. The next few years are marked by growth in the number of routes and passengers between Ireland and the United Kingdom. However, by 1990 the company had accumulated over 20 million in losses. The Ryan family invested additional 20 million in capital in the business which went through substantial financial and operational restructuring – copying the South West Airlines model, Ryanair was re-launched as Europe’s first low cost airline. This was a revolutionary new model for the European air transportation market and some publications note that “people queued up for three days 6
to get the Easter sale fares”. The new model incorporated move towards same aircraft fleet, direct sales, scrapping of drinks and food served on board and cutting turnaround time and costs. In 1995 the company launches the first low cost airfares on UK routes and in 1997 – in Europe. In the same year the company gets listed on the Irish Stock Exchange. Promotional fares of 1 on domestic and European routes attracted the attention of passengers. Today, Ryanair is the largest European low cost airline carrying over 7 million passengers annually on 220 routes across 19 countries. Operations are concentrated in 12 European bases and the company employees over 2,600 employees. BAA BAA is engaged in the management and operation of airport facilities in the UK and overseas. The company is headquartered in London, UK and has a workforce of about 12,500 employees. The company owns seven UK airports: Heathrow, Gatwick, Stansted, Glasgow, Edinburgh, Aberdeen and Southampton. BAA also has interests in 13 airports located in Italy, Australia, US and Oman. BAA’s airports in the UK and overseas serve 230 million passengers a year. The company’s operations are divided into the following segments: airports, retail, BAA Property, rail and other. The airport segment primarily oversees terminal and airfield management. In the terminal management area, the company looks after buildings, passenger services and cargo. In the airfield management division, the company maintains and operates runways and taxiways. BAA also develops, manages and markets commercial activities at its UK airports. BAA’s UK airport retail activity is made up of two complementary businesses: Retail management at UK airports and World Duty Free. Retail management at UK airports involves the development, management and marketing of commercial activities at BAA’s seven UK airports. These include shopping, catering, financial services, travel, services, parking, telecommunications and media management. The business specializes in luxury brands and operates 64 stores across the UK airports. Asur Grupo Aeroportuario del Sureste (“Asur”) holds a concession from the Mexican government to operate, maintain and develop nine airports in the, primarily touristic, Southeastern region of Mexico. The company’s main airport is the Cancun International Airport, which generates over 70% of Asur’s revenues and is the second busiest airport in Mexico. Cancun and the surrounding Mayan Riviera, are Mexico’s top tourist destination and among the fastest growing tourist developments in the country. Asur’s nine airports served more than 13.8 million passengers in 2004, of which around 7
60% were international passengers and 40% were domestic passengers. Approximately 70% of the international passengers traveled on flights originating from the United States. Asur’s airports. Asur was established in 1998 as part of the Mexican government’s airport privatization program, which included three regional airport groups and the Mexico City International Airport. A private consortium, ITA, led by Copenhagen Airports won the 50-year concession to operate the nine airports in the Southeastern group. The consortium acquired a 15% stake in Asur, while the remaining shares were floated in the NYSE and the Mexican Stock Exchange on October 3, 2000. The Mexican government, through one of its development banks, Nafin, retained an 11.1% stake in Asur to be floated on a future date. As the long-term operator of the airports, Asur generates revenues from two main sources: aeronautical services and non-aeronautical services. The former account for 75% of total revenues and are derived primarily from passenger and landing charges, aircraft parking charges, and general airport services. Non-aeronautical services are divided into retail operations and access fees charged to third-party providers of complementary services. While the aeronautical revenues are heavily regulated by the Mexican government, the retail operations and access fees provide an important growth opportunity for Asur. These have grown at a compounded annual growth rate of 22.9% since 1999, when they accounted for only 14% of total revenues. Summary financial data for each company is presented in Appendix I. III. Corporate Governance Analysis As of 2003, 17 Mexican and 45 international airlines operated directly or through code-sharing agreements from
1. Balance of power between management and shareholders We believe that the interests of shareholders are relatively well protected by the corporate governance policies of the four companies analyzed, with the possible exception of American Airlines. As an example at AA, directors are nominated for life and more than half are CEOs of other companies, two of them in related businesses. A shareholder is challenging the lifetime rule at the next general shareholders’ meeting in May. Recently, some board members and the CEO have raised their own salaries. Insiders are generally not overrepresented in the companies’ boards, while the CEOs tend to have a long history with their companies, once again with the notable exception of American Airlines. One interesting common feature is that all of the CEOs are relatively young with an average age of 8
only 48 years. These last two factors could suggest a dynamic leadership with intimate knowledge of the challenges and opportunities facing their businesses. Although the balance of power seems to tilt in favor of shareholders, it is interesting to note that 3 out of the 4 companies have board members who are CEOs of other companies. This could indicate a lesser oversight due to the lack of time and possible conflicts of interest, although it should be noted that only AA board members are CEOs of related companies. Nonetheless, the large percentage of institutional shareholders in most firms, as well as the relative absence of insiders in the boards of directors, leads us to believe that shareholders hold an adequate level of power and oversight in their companies. An exception in terms of number of insiders is BAA, where company executives represent a majority of the board. We believe that management discretion is counterbalanced in this case by the oversight of the regulatory authority, the Civil Aviation Authority (“CAA”).
Figure 2 Balance of power between stockholders and current managers
AA AA AA
2. Management compensation Management compensation does not appear to be an issue at any of the companies analyzed. Only the CEO of Ryanair earns more than US$1 million in total compensation (half of which is in All firms, with the exception of Asur, use stock options as a mean to align management’s interest with those of shareholders, but with the exception of Ryanair, none of the CEOs own a significant stake in their companies. Details about the CEOs, their compensations and the composition of the Board are presented in Figure 3 and Figure 4.
Asur Asur Asur
er Balance of pow
Figure 3 Brief presentation of management Chief Executive Officers Name Age Years at the Company Years as CEO Education American Airlines Ryanair Gerard Arpey Michael O'Leary 46 43 23 3 MBA 17 9 n.a. BAA Mike Clasper 52 4 3 MA, Engeneering, St John's College Cambridge Asur Kjeld Binger 50 6 (Asur), 11 (CPH) 1 BSc in Structural and Civil Engineering (Denmark) N/A N/A N/A 0 1,317.0* 0% 0.0
CEO Compensation Salary ('000) Bonus ('000) Other (‘000) Stock Options (‘000.) Total Compensation (‘000).) Stock Ownership (% of Total) Market Value of Stock Held (mm)
518.8 0.2 172.0 691.0 0.1% 1.14
505.0 127.0 49.0 502.0 1,183.0 5.44% 237
553.0 167.0 21.0 525.0 741.0 0.001% 0.1
* Compensation to all 5 executive officers including the CEO Source: Annual reports, Statutory filings Figure 4 Board of Directors Board of Directors Number of members Insiders CEO of other Companies? Related Companies? American Airlines 13 1 7 2 Ryanair 9 1 no no BAA 9 5 yes No Asur 7 3 3 Yes
Source: Annual reports, Bloomberg, various public sources
3. Market coverage
Figure 5 Firms and markets – sources of information
Source of information
All firms, with the exception of American Airlines, have shares listed in more than one stock exchange and thus garner significant investor’s interest outside of their home markets. In the case of Asur, its shares are more heavily traded in the NYSE than in its home market of Mexico. The two airlines in our sample are leaders in their sectors, while BAA is the largest airport group in the world and Asur is the only public airport company in the Americas. As such and despite the travails of the air transportation sector, all companies are relatively widely followed by the financial community and command significant trading volumes. Nevertheless, with the exception of American Airlines, most of the information on the companies is provided by the firms themselves, since some of the sub-sectors in which they operate, discount airlines and airport operations, are relatively new and with few comparable companies. With respect to the view of research analysts, this seems to be about evenly split between buy and hold recommendations, despite their out-performance of the market, once again with the notable exception of American Airlines.
Figure 6 Listings American Airlines 1939 NYSE no 161.2 157.98 Ordinary Ryanair 1997 ISE NASDAQ, LSE 754.3 660.32 Common BAA 1987 London ADRs 1,060.9 1,060.9 Common Asur 2000 New York Stock Exchange Mexican Stock Exchange 30.0 0.6941 Series B (85%) and Series BB (15%)
Year of Listing Main Listing Other listings Shares (million) Free Float Type of Stock Source: Bloomberg
Figure 7 Market coverage Analyst coverage Number of Analysts Analysts Recommendations (%) Buy Hold Sell Daily Average Trading Volume (mm) 2002 2003 2004 2005YTD
American Airlines 10 50% 40% 10% 2.14 8.06 5.13 4.06
Source: Annual reports, Statutory filings, Bloomberg, Zacks, Yahoo Finance and various public sources
4. Social responsibility Due to the wide variability of business environments under which the four firms operate, we have chosen to do a firm specific analysis of social issues.
Figure 8 Social consciousness and responsibility
American Airlines Given the poor operating performance of the past few years, driven by (i) a steep fall-off in the demand for air travel, particularly business travel, (ii) reduced pricing power due to increasing competition from low-cost carriers and (iii) the aftermath of the terrorist attacks of September 11, 2001, American Airlines did not consider corporate responsibility a top priority and stopped publishing the “Annual report for the Coalition for Environmentally Responsible Economies” in 2001. AMR is therefore focusing on the mere respect of the many local and federal environmental laws and regulations (air and water pollution, noise).
The company has been named as a potentially responsible party for land or water contaminations in California, Oklahoma and Florida. AMR has already accrued $ 6 millionn for settlement expected, but the actual amount that AMR will have to pay is still unknown. Ryanair The perceived image of Ryanair as a low cost air carrier and provider of value of its passengers is extremely important for the company. This image is aligned with the operational model of the company, using modern fleet of aircrafts with lower fuel consumption reducing the emissions and environmental damage. In addition, its policy to operate from remote airports resulted in numerous benefits for the communities in these regions, increasing economic activity. However, major focus of the company is to be perceived as a value provider for its passengers. BAA Given its handling of all the major airports in the UK BAA as well undergoes substantial public scrutiny. Recently the debate over the environmental impact of the new Terminal at Heathrow and the new runaway at Stansted has further heightened attention. BAA has always been receptive to issues coming from airport communities and currently pledges 0.15% of its pre-tax profits (equiv. to slightly under £1 mm in 2004). to 21st Century Communities Trust, a charity it created. Asur As the monopoly provider of the main airport facilities in nine southeastern Mexican cities, Asur faces significant public oversight and societal constraints. The Mexican Airport Law of 1995 established the general framework regulating the construction, operation, maintenance and development of Mexican airport facilities in the benefit of the public good. Moreover, Asur is also subject to Mexican federal and state laws and regulations relating to the protection of the environment. The level of environmental regulation in Mexico has increased in recent years, and the enforcement of the law is becoming more stringent. Asur generally has a positive image with the Mexican public and a strong reputation as a good corporate citizen, since it has greatly improved the quality and scope of the facilities and services offered by its nine airports. However, in the near future the company could face criticism by local
government officials that want to build new airport facilities in their regions, such as in Veracruz and Quintana Roo (Cancun and Cozumel airports). IV. Stockholder Analysis
All firms in our sample, with the exception of BAA which has a more widespread investor base made up of small private investors, have a strong institutional shareholder base which commands over 2/3 of the total outstanding shares of their companies. This contrasts sharply with an industry average of only 33%, and gives credibility to our argument that corporate governance is relatively strong and minority shareholder rights are well protected. Moreover, the top 5 institutional shareholders in all companies are among the largest and most diversified asset management companies in the world. On the other hand and with the exception of Asur, insider holdings are relatively small and in line with the industry average of 6%. All these facts suggest that the marginal investor for all firms is a well diversified global institutional investor and we can thus proceed to carry out CAPM based risk and return analyses for the companies. In the case of BAA, even though the majority of the shares are held by private individuals, these tend to be buy-and-hold investors with the majority of the trading is done by institutional funds, which are therefore the marginal investor. Most firms in our sample have only one type of share, common or ordinary. We take a look at the exceptions below: American Airlines AMR Corporation has only common stock outstanding, but the board of directors has already authorized the CEO to issue 20million shares of preferred stock, probably to ease the deep financial stress of the company. Book value of equity has been negative for the last 3 quarters and debt ratio is around 90%. Asur Asur has two types of shares: B shares and BB shares. Series B shares currently represent 85% of the company’s capital, while series BB shares represent the remaining 15%. Each series B share and series BB share entitles the holder to one vote at the general shareholders’ meeting. However, holders of series BB shares are entitled to elect only two members of the board of directors, while holders of series B shares are entitled to name the remaining directors. Under the company’s bylaws, each shareholder or group of shareholders owning at least 10% of Asur’s capital stock in the form of
series B shares is entitled to elect one member to the board of directors for each 10% interest that it owns. Directors and senior management do not own any shares of Asur. Pursuant to the company’s bylaws, the holders of series BB shares are entitled to appoint and remove Asur’s CEO and one half of the executive officers reporting directly to the CEO. Currently, four executive officers report directly to the CEO, one of whom was appointed by ITA as holder of the BB shares. The shareholders distribution as well as details about institutional and insiders holdings in the companies are presented in Figure 9, Figure 10 and Figure 11.
Figure 9 Distribution of stockholders
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% AA Ryan Institutional 98% Insider 0.03% Institutional 12% BAA Asur Institutional 87% Other 88% Institutional 69% Other 1% Insider 2% Insider 12% Insider 31%
Figure 10 Institutional Holdings Institutional holdings American Airlines
Number of shares held (million) % of Shares Outstanding Top 5 Holders 158.0 98.0% Fidelity Management Primecap Management Wellington Management Allianz Global Hall Phoenix Number of shares held by Top 5 (million) % of Shares Outstanding 69.5 43.1%
n/a 70% + Fidelity Investment Capital Group Company Guilder Gagnon Holding Wellington Management Janus 392.2 52.0%
124.2 11.6% Legal & General Scottish Widows Newton Inv. Mgmt Threadneedle Inv. Causeway Capital 93.1 8.7%
20.8 69.41% First State Investment Management UK Columbia Wagner Asset Management Oakmark International Small Cap Fund Schroder Investment Management Group American Express Financial Corp 6.5 21.57%
Source: Bloomberg, Statutory filings
Figure 11 Insiders holdings Insiders ownership Number of shares held (million) % of Shares Outstanding Major Holders American Airlines 3.22 2% Daniel Garton (CEO) Jeffrey Campbell Charles Marlett (Executive VP) Gary Kennedy Ryanair 88.3 12.47% Michael O'Leary Anthony Ryan Ryan Family members BAA 0.3 0.03% Sir Mike Hodgkinson (Exec. Director) Joel Hoerner (Non-exec. Dir) Tony Ward (Exec. Director) JanisKong (Exec. Dir.) Source: Bloomberg, Statutory filings, various public sources Asur 9.2 30.59% ITA (15.01%) Nafin (11.10%) Copenhagen Airports (2.50%) Fernando Chico Pardo (1.98%)
1. Market risk and return
In analyzing the risk characteristics of the four companies we first looked at their returns over a five year period compared them to the returns of a broad based market index such as the S&P 500. Figure 12 below presents the rebased share prices of all four companies and the level of the S&P 500 (Jan 2000 = 100).
In general, three out of the four firms (Ryanair, BAA and Asur) did better than the market. These results were expected for Ryanair and Asur since the two companies are at the growth stage of their evolutionary cycle. BAA on the other hand, is more mature less volatile company characterized by steady income stream and cash flows. AA suffered serious problems after swift change in its operating environment – dramatic drop in air transport passengers, higher security related costs and economic slowdown impacted negatively the company, especially after September 11 terrorist attacks in the US. To analyze the market risk of the four firms we regressed their returns against broad based market index and used the coefficient of the regression as a measure of market risk. We used 5 year monthly returns for the regression, with the exception of Asur, which was listed in late 2000. The choice of index reflected the marginal investor in each company, assuming that each investor is exposed to the same market risks in their respective market. Although based in Europe, Ryanair and BAA attracted a number of large institutional investors with operations around the world and with the ability to diversify their holdings more broadly. Therefore, the reference index used in the regression for these companies was the Morgan Stanley Global Index. The reference index used for Asur was the S&P 500, since it is traded mostly in the US and its marginal investor is based in the US. Our analysis
focuses on the regression coefficient (beta), the regression constant (used for computation of Jensen’s alpha) and the regression R-squared. The results from the regressions are summarized in Figure 13.
Figure 13 Risk return characteristics Risk profile American Airlines Regression Beta 4.67 Reference index S&P 500 Industry average beta 1.34 Average Risk free rate Jensen's Alpha -5.92% R2 of Regression Standard Error of Beta Jansen's Alpha industry average 35.0% 0.56 -4.27% Ryanair 1.21 MS Global Index 1.80 4.59% 27.35% 27.0% 0.48 -4.27% BAA 0.35 MS Global Index 0.95 4.58% 4.43% 7.0% 0.17 n/a Asur 0.99 S&P 500 0.95 4.24% 28.42% 15.0% 0.32 n/a
Source: Bloomberg, analysis, www.damodaran.com
Slope of the regression - Beta The coefficients of the individual regressions are the companies’ betas and are used as a measure of the company exposure to market risk. The analysis indicates that American Airlines is the company with highest exposure to market risk (regression beta of 4.67), which is also more than 3 times the industry average. This is a reflection of high indebtedness and negative and volatile earnings. Ryanair and BAA on the other hand have regression betas much lower than the industry averages, while Asur is close to its peers. The reasons behind the different risk profiles of each firm will be examined in greater details further in the report. We also examined the excess returns of each firm as measured by its Treynor ratio. The Treynor ratio measures the excess return of a stock given its level of risk (non-diversifiable) and is computed with the formula below:
Rstock " Rf !
Figure 14 below presents the Treynor ratios and the spread between stock Treynor ratio and the market Treynor ratio over different investment horizons. The results suggest that over the last 5 years Ryanair had highest excess return compared to the market taking into consideration its risk. None of the stocks outperformed the market over a 10 year period. Over the last couple of years the best performing stock was Asur. These two stock were excluded from the 10 year horizon analysis, as data for them was not available.
Figure 14 Treynor ratios
70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 1 year 2 year 5 year 10 year -10.00% -20.00%
70.0% 60.0% 50.0%
40.0% 30.0% 20.0% 10.0% 0.0%
Treynor ratio AA Excess return AA Treynor ratio Ryanair Excess return Ryanair Treynor ratio BAA Excess return BAA Treynor ratio Asur Excess return Asur
The calculations of the Treynor ratios are presented in Appendix II. Intercept of the regression and Jensen’s alpha We further used the intercept of the regression to compare the actual stock performance of each company to the market expectation. For each stock we computed Jensen’s alpha equal to Intercept – Risk Free rate x (1 – Beta), using the average monthly risk free over the period. The results were annualized using the formula: (1+Monthly excess return) 12 – 1 The annualized returns indicated that on average all companies except for American generated returns that exceeded the markets expectations. In addition, comparing Ryanair’s high excess return to the negative industry Jensen’s alpha suggests that the company performed better than expected at a time when the sector as whole did not meet the market’s expectations.
R-squared R-squared of the regression provides information as to what proportion of the variability in returns could be explained by the regression, or in other words what part of the variability in the returns (total risk) can be attributed to beta (market risk). The market non-diversifiable risk represents 35%, 27%, 7% and 15% for AA, Ryanair, BAA and Asur respectively. The remainder is company specific, non-diversifiable risk. While the relatively low R-squared for Ryanair and Asur could be explained by the fact that they were small, fast growing companies during the observed period and were facing numerous company specific challenges in establishing their business models, we were surprised to estimate that BAA was characterized by a large proportion of (93%) of company specific, diversifiable risk. One possible explanation could be the fact that airport operators’ revenues are generally much more stable stream and have a fixed nature – they are based on long term contracts under which airport slots are sold to airline companies. Even in the event of drop in passenger numbers the charge payable to airports is generally steady. Standard errors The standard errors of the regression betas appear to be significant, suggesting a wide interval for the possible values of the beta. This is one of the reasons why we considered an alternative approach to measuring the companies exposure to market risk, which is described bellow. 2. Bottom up betas As an alternative approach to regressions betas we considered using bottom-up betas for our analysis. This is mainly due to the following factors: As growing companies Ryanair and Asur are likely to change over time, hence alter their risk profile. In addition, their capital structure is likely to change; BAA is mature, steady company which risk profile is likely to remain similar. However, the standard error of the regression beta indicates that it might nor be a reliable measure of risk; American Airline as a company facing financial difficulties is likely to change in the long term if it is to return to profitability. Making a going concern assumption about the business requires change in the company and hence, its risk profile. Therefore we believed that historical indicators might not be a reliable measure for the future. 20
Estimates of unlevered beta We used market information about firms in the sector to estimate the risk profile of each of the companies. While the main stream of cash flows for BAA and Asur come from their core business (Airport Development and Maintenance), a significant part is generated from general retail services, electronics and luxury goods retail and restaurants. Each of the businesses is exposed to a different extend to market risks. In order to capture these differences in the risk profile of each business we estimated the value of each business and used these values as a weight to come up with an overall beta of the firms. The value of each business unit was estimated by applying a market Enterprise Value / Sales ratio to the respective revenue streams from each business. The average unlevered beta for each respective sector was then used to compute the firm beta. Calculation of the unlevered beta of BAA and Asur is presented in Figure 15 and Figure 16.
Figure 15 Unlevered Bottom up Beta for BAA Estimated Business line Value Airport 4,125 Retail Firm total 4,770 8,895
Since Ryanair and American Airlines operate in a single business we used the respective unlevered sector average betas (for European and US firms) to compute bottom-up betas.
Bottom-up betas After estimating unlevered beta for each firm we levered back the beta to estimate a firm beta that reflects the additional risk associated with financial leverage. The sector betas were unlevered and re-levered using the formulae bellow:
" unlevered =
Where: T D/E
" market (1 + (1 ! T )( D / E )
applicable tax rate;
" levered = " unlevered x(1 + (1 ! T ) x( D / E ))
market value of debt / market value of equity
The market value of equity has been computed as current share price multiplied by the number of shares outstanding. Details of the computation of the market value of debt are presented in Figure 21.
Figure 17 Beta estimation - summary Beta measure Top down Beta Bottom up Beta (levered) Industry avg. Beta (levered) American Airlines 4.67 6.26 1.34 Ryanair 1.21 1.24 1.80 BAA 0.35 1.42 0.95 Asur 0.99 0.82 0.88
3. Cost of equity The computed bottom up beta has been use to compute the cost of equity for the firms. This is the return expected return by equity investors in the observed companies and an important input for the calculation of the overall cost of capital. The cost of equity has been calculate using the Capital Asset Pricing Model and includes the following inputs: Risk free rate of return (Rf) – in estimating the cost of equity we have used long term government bond denominated in the respective currency to come up with the risk free. The current 10 year US, German and UK bond yields were used in the analysis for AA, Ryanair and BAA respectively. The 10 year maturity of the bond used reflects the long term investment horizon of the likely projects. Other periods should be considered for shorter term projects. The analysis for Asur is done in US dollars and the relevant risk free rate used in the analysis is the 10 years US treasure bond. Market risk premium (Rp)– this measure reflects the excess return to which an investor is entitled as a compensation for the higher risk he/she undertakes by investing in risky security rather than a
riskless one. We have used the geometric average of excess returns from the US market over long term Treasury bonds for the period between 1929 and 2004. We assumed that the US market, being the largest and most mature capital market in the world is a good proxy for the market risk premium required by the investors. In the case of Asur, we added an additional country risk premium of 1.8%, to account for the increased risk to equity investors of investing in a Mexicanbased company. The country risk premium is based on the Mexican sovereign debt rating of Baa (spread of 1.2%) and relative volatility of equity compared to bonds (assumed to be 1.5 times). The country risk premium applied to Asur was 1.8% Beta – as computed above. The cost of equity, for all companies except Asur, is defined as: Ke = Rf + β x Rp The cost of equity for Asur, is defined as: Ke = Rf + β x (Rp+Country Risk) We did not add any country risk premium for AMR, Ryanair or BAA, since the US, Republic of Ireland and the UK are all AAA rated countries. The cost of equity computation is summarized in Figure 18.
Figure 18 Calculation of cost of equity Cost of Equity American Airlines Risk Free Rate 4.27% Beta 6.26 Risk Premium 4.82% Country Risk Cost of Equity 34.54% Ryanair 3.47% 1.24 4.82% 9.45% BAA 4.5% 1.42 4.82% 11.30% Asur 4.24% 0.82 4.82% 1.80% 9.65%
4. Cost of debt The other important component of the cost of capital is the cost of debt. It reflects the perceived risk of the companies by lenders and debt investors, or its credit risk. The two components of credit risk are default risk (or the probability that a company will cease making payments as agreed in the credit agreement) and non-recovery risk (or the probability of recovery of the capital provided, once the company goes in default). More detailed analysis of the borrowing policies of all firms is presented in Section VII Capital Structure.
The cost of debt for each company has two components – a risk free rate of return and compensation for the credit risk associated with the company. In estimating the credit risk for each company we took 2 approaches: For American Airlines and BAA we looked at the current credit rating of the company. The companies had recently issued traded bonds which represent a good indicator of the risk of their debt and hence we used the implied default read on long term publicly traded debt. Since Ryanair has not issued any publicly traded debt, we computed synthetic credit rating for the firm based on its interest rate cover ratio. Asur currently has no debt. After obtaining the respective credit ratings we looked at the credit default spreads corresponding to each rating, which is a measure of the risk premium required. For AA and BAA we used the credit default spread embedded in current yields of publicly traded debt. We computed the cost of debt for each by adding the default spread to the risk free rate for the respective company. The results are presented in Figure 19.
Figure 19 Calculation of cost of debt Cost of debt Credit Rating Spread vs. Treasury (a) Risk Free Rate (b) Pre-tax Cost of Debt (c) = (a) + (b) Marginal Tax Rate After Tax Cost of Debt (c) * (1-tax rate) American Airlines CCC 9.66% 4.27% 13.93% 35.00% 13.93% Ryanair A1.00% 3.47% 4.47% 12.50% 3.91% BAA A+ 0.70% 4.47% 5.17% 30.00% 3.62% Asur n.a. 0.00% 0.00% 0.00% 33.00% 0.00%
After computing the cost of debt for each firm we computed the after tax cost of debt. The after tax cost of debt reflects the fact that interest payable on debt is deductible from the operating income for tax purposes and results in tax savings for the firms. In the case of American Airlines, the company cannot benefit from lower tax bill by financing its operations with debt. The company has net operating loss before interest and hence pays no taxes. In addition American Airlines has a huge accumulated tax loss, which could be carried forward and used to offset future taxable income. Therefore the company does not enjoy tax benefits from the use of debt and we excluded this component from the cost of capital calculation.
5. Cost of capital Market value of equity The market value of equity for each firm has been estimated by multiplying the number of shares outstanding for each company by the current share price. The market values of equity are presented in Figure 20.
Figure 20 Market values of equity Market Value of Equity (million) Market Value of Equity (million) Source: Bloomberg American Airlines 1,862.2 Ryanair 4,352.4 BAA 6,153.3 Asur 912.7
Market value of debt In estimating the market value of debt we again took two approaches: Use the current value for debt that is publicly traded and information is obtainable; Project interest and principal payments and discount them back at the current cost of debt as estimated above. In projecting the interest payments we have used the current interest payments to book value of debt ratio as a proxy for the average interest rate payable on the debt; and the average maturity of the outstanding debt. In addition, AA, Ryanair and BAA have significant operating lease commitments, which are not recorded in their books. Such commitments require that the firms make regular payments to the lessors in exchange for the use of assets (aircrafts, real estate). Such transactions are treated as rent for accounting purposes and lease payments are recorded as operating expense. The essence of the transaction, however, is financing the use of the assets and lease payments could be viewed as interest and principal repayment of a loan provided for the acquisition of the assets. Moreover, the companies are committed to making these payments for a long period of time. We treated lease commitment as another form of debt and discounted the future lease payments at the current cost of debt to estimate their current market value. The present value of all future lease payments have been included in the market value of the companies’ debt and the operating income has been adjusted by adding back the operating lease payment and subtracting the estimated depreciation charge associated with recording the leased assets in the companies’ books. Summary of the market value of debt calculation is presented in Figure 21.
Figure 21 Estimation of market value of debt Market value of debt (million) American Airlines Book Value of Debt 14,254.0 Current cost of debt 13.93% Average maturity 7.3 Interest Expense 894.0 Market Value of Debt (a) 6,261.3 PV of Operating Leases (b) 5,822.57 Total Market Value of Debt (a) + (b) 12,083.9
Debt and Equity ratios The market values of debt and equity have been used as weights in calculating the weighted average cost of capital.
Figure 22 Capital weights American Airlines 1,862.2 12,083.8 13,946.0 86.65% 13.4% Ryanair 4,352.4 1,361.3 5,713.7 23.82% 76.2% Industry Avg.* BAA 6,153.3 5,007.1 11,160.4 44.86% 55.1% Asur 912.7 912.7 0% 100% Industry Avg.**
Market Value of Equity (a) Market Value of Debt (b) Firm Value (a) + (b) D/(D+E) E/(D+E)
33% - 49% 67% - 51%
9% - 35% 91% - 65%
Source: Bloomberg, own analysis, www.damodaran.com *Airline Transportation industry, **Airport maintenance and operation industry
Comparing the debt ratios for the analyzed companies to the industry average we observe that AA’s financial leverage is significantly higher than that of the average for the sector (between 39% for European companies and 49% for US airlines.). On the other hand, Asur is rather unusual in its industry since it does not have any debt. These inputs are used in computing the cost of capital for each firm. The weighted average cost of capital is computed as follows: WACC = Ke x E/(D+E) +Kd x D/(E+D) The inputs and results are summarized in Figure 23.
Figure 23 Calculation of cost of capital Cost of capital American Airlines Beta 6.26 Cost of Equity 34.54% E/(D+E) 13.35% After-tax Cost of Debt 13.93% D/(D+E) 86.65% WACC 16.69%
Ryanair 1.24 9.45% 76.18% 3.91% 23.82% 8.13%
BAA 1.42 11.30% 55.14% 3.62% 44.86% 7.85%
Asur 0.82 9.65% 100.00% 0.00% 0.00% 9.65%
Not surprisingly the company with highest cost of capital is American Airlines, reflecting its high risk. The high cost of capital is driven by two factors – high beta (volatile earnings and high debt to equity ratio) and high cost of debt (low credit rating because of high debt and huge interest payments). The lowest cost of capital, that of BAA, reflects the fact that the company is relatively mature and stable, with predictable earnings and cash flows and is less subjective to market fluctuations. The estimated cost of capital of and cost equity are the hurdle rates that should be used in capital allocation decisions in each company. These are the minimum acceptable rates against performance of each new project considered should be measured – return on equity against the cost of equity and return on capital against cost of capital. In addition, the cost of equity and cost of capital rates are the rates at which projects’ cash flows should be discounted to estimate their net present value. VI. Investment Return Analysis
The ability of each firm to grow and create value for its stockholders ultimately depends on its management capability to identify and undertake projects that generate returns exceeding the cost of capital employed. In this section we will analyze the quality of the projects that the four companies undertake ad review the past performance of the companies as measured by indicators such as Return on Capital (ROC) and Return on Equity (ROE). 1. Typical project The companies, subject to our analysis are involved primarily in 3 types of businesses – air transportation, aeronautical services and retail services. Aeronautical services include operation and maintenance of airport and all related facilities that are used by passengers and airlines. Some of the characteristics of a typical project for each business are presented in Figure 24.
Figure 24 Typical projects Business Typical Project / Flow Characteristics Airlines Fleet Acquisition: Long term payment, Long life of the asset New Route Opening: local offices and labor force. Long term and different currencies Set up of new bases – long term, may have option value to expand in new routes at a later stage. New Terminal buildings and maintenance. Long term, single currency Cash flows are volatile and sensitive to macroeconomic risk factors. Medium to long term Cash outflows that are primarily in local currency, but there could be a significant dollar component Cash inflows that are almost exclusively in local currency Part of cash flows related to passengers can be volatile and sensitive to global risk factors. Another significant part of cash flows is less volatile as it consists of fixed payments made by airlines for use of facilities and servicing. Medium term Cash outflows that are almost exclusively in local currency Cash inflows that are primarily in local currency, but there could be a significant dollar component Can be very volatile, specially sensitive to global risk factors
In general, the time horizon of the core businesses of companies is long term with the exception of the retail business which has shorter duration of its projects. Airline and retail businesses cash flows are sensitive to macro risk factors and certain cyclicality (following the economic cycles) might exist. Aeronautical services business, however, is less exposed to such cyclicality as the bulk of its revenues are generated from long term contracts with airlines for the use of their facilities. Even in the case of an airline to meet its payments, big international hubs such as Heathrow and Gatwick operated by BAA have a solid backlog of airlines, which are ready to purchase potentially available landing slots. 2. Measuring Returns ROE and ROC For each of the company we computed the Return on Equity (ROE) and Return on Capital (ROC) as follows:
Economic Value Added We further compared the obtained returns to the cost of equity and cost of capital. The results are presented in Figure 27 and Figure 28.
The ROE calculation is not meaningful as it has negative net earnings and negative book value of equity
Figure 27 Equity Economic Value Added ROE (a) 4 Cost of Equity (b) Equity Return Spread (a)-(b) Average book value of equity Equity EVA American Airlines nm 34.54% nm (268.0) n.a Ryanair 14.69% 9.45% 5.24% 1,574.7 82.5 BAA 8.50% 11.30% -2.80% 4,797.0 (134.5) Asur 5.15% 9.65% -3.23% 1,057.7 (47.6)
From the companies included in the analysis only Ryanair created excess returns on equity (Return in Equity – Cost of Equity). It created a positive equity economic value added (EVA) of € 82.5 million based on the last 12 months results. At the same time the airline industry destroyed on average value of $ 4,95765.7 in 20045. Both BAA and Asur had return on equity lower than their cost of equity. Comparing these results with the positive Jensen’s alpha values calculated in Section IV, we can conclude that although both firms performed better that the market expected, they still have not generated equity returns in excess of their equity costs. Multiplying the spread between the return on capital and cost of capital for each company by the average book value of total capital (equity + debt) we estimated the economic value added for each firm.
Figure 28 Economic Value Added American Airlines 8.54% 16.69% -8.15% 13,862.5 (1,129.5) Ryanair 10.14% 8.13% 2.01% 2,652.8 53.3 BAA 5.59% 7.85% -2.27% 8,427.0 (191.0) Asur 4.76% 9.65% -4.89% 1,057.7 (51.7)
ROC Cost of Capital (b) Capital Return Spread (a)-(b) Average book value of capital EVA (million)
Again the only company that created value during the observed period was Ryanair. The average EVA for the sector in 2004 was $9,551.76 3. Future outlook The ability of any of the companies to generate positive excess returns depends on its competitive advantages and their sustainability in the medium and long term. In this section we look at some key
The ROE calculation is not meaningful as it has negative net earnings and negative book value of equity Equity EVA for US market used as a comparison. Source: www.damodaran.com 6 EVA for US air transportation sector used as comparable. Source: www.damodaran.com
indicators for the air transportation sector, which could help us to understand how the companies are positioned for the future.
Figure 29 Comparison of key figures – airline transportation US Industry EU Industry Traditional and low cost air carriers at a glance AMR RyanAir Average Average Revenue Yield per Passenger Mile (RAPM) ($ cents) 11.5 n.a. 12.3 15.8 Load Factor 72.8% 84.0% 73.4% 64.8% Number of Planes 1,013 79 213 80.9 Revenue per Employee ('000 $ or EURO) 202.4 489.3 174.6 n.a. Average Age of planes 12.5 n.a. 11.2 n.a. Source: AMR annual Report, Ryan Air Annual Report, ATA (Air Transport Association), AEA (association of European Airlines) and Elfaa (association of low fares airlines) Economic reports
The analysis suggests that while Ryanair is relatively small airline in terms of number of aircrafts it has more efficient operations which is evident from higher load factor (seats capacity utilization) and higher revenues per employee ($635K7 compared to $202K for American Airlines). Further analysis supports the fact that Ryanair relies on operational efficiencies to maintain its cost advantages:
Figure 30 KPI Key Performance Indicators Ryanair 10,050 40.0 0.5 35 93.0% Low cost carriers 6,000 86.3 n.a. n.a. 85.0% Industry Average 1,069 206.6 11.3 n.a. 81.2%
Passenger per employee Average fare (Euros) Lost bags per 1000 passengers Employees per aircraft Schedule on time
Source:Ryanair, Association of European Low Cost Airlines (www.elfaa.com)
On average Ryanair benefits from much higher passenger to employee ratio and much lower employees to aircraft ratio, which helps the company to maintain cost efficiency. Indicators such as lost bags per 1,000 and schedule on time suggest operational efficiencies and customer satisfaction. One of the reasons for this is the structure of the aircraft fleet that Ryanair uses as compared to its peers – Ryanair currently employes predominantly two types of aircrafts – Boeing 737-200 and Boeing 737-800 and a program whereby all aircrafts will be replaced with 737-800 machines is in place. American Airlines, on the other hand, has a large fleet comprising of 11 different types of aircrafts, which have different technical and maintenance requirements, adding to the costs of the company. Composition of the fleet is presented in Figure 31.
At approximate exchange rate of $1.3 per Euro 1
Figure 31 Composition of the aircraft fleet – American Airlines Number of Age and Costs planes Long Haul 727 Short Haul 286 Total 1,013 Source AMR and ATA Economic Report
Number of different models 7 4 11
Average Age (years) 12.5 4.8 10.3
Conclusions In conclusion, we believe that in the medium term Ryanair can sustain competitive advantages which will allow the company to earn return on capital in excess of its cost of capital. The company has an investment program aimed at increasing its capacity from the current 15 million passenger per year to 50 million by 2010. This would enhance Ryanair’s growth, however at the expense of huge capital spending. American Airlines, on the other hand is facing fierce competition in a market where it clearly lacks significant competitive advantages. Excess domestic capacity, fragmented market and increasing competition from low cost carriers such as JetBlue and SouthWest Airlines are all factors that have negative impact on the company. We believe that the renewal of the fleet is crucial for AMR: the current aged and too diverse fleet generates, by itself, an inefficient cost structure (more maintenance costs, different training for pilots and mechanics, different scheduling of engines check up). Moreover the average age of AMR fleet is over 10 years and this represent a huge cost in term fuel (old airplanes are less efficient) landing fees at the airports (old airplanes are heavier) and customer satisfaction (old airplane are less comfortable and therefore less attractive). Finally the company is targeting expansion in international markets, where it believes it can enjoy higher growth an margins, but new long haul planes are needed to successfully compete in that arena. AMR average age of long haul planes is close to 13 years. Overall we believe that AMR as a traditional flag carrier should focus on the international long haul segment (not threatened by low cost carriers, as passenger need to be comfortable in a long trip) by renewing its fleet on offering a vast network of routes thanks to international alliances. Returns on capital and operating margin long term are going to be positive again, but below the peaks of the mid nineties. In the case of BAA what project it takes and the associated returns depend on negotiations with the CAA, the regulatory authority. Negotiations take place every place 5-years with the next one scheduled to be in March 2008. Tariffs are currently set below their market prices and the consequence of this is that BAA shareholders are subsidizing the airlines landing at its airports. We
think that this situation is very unlikely to change in the short term, at least until the new review in March 2008. Similarly for Asur, the company faces mandatory capital investments which are negotiated with the Mexican Ministry of Communications and Transportation every five years. In the coming years, Asur’s main investment project will be the construction of a second runway at the Cancun airport, to handle the higher than expected growth in passenger volumes. This project has already been moved forward five years from its original start date, signaling the company’s strong confidence in its growth prospects for the coming years. VII. Capital Structure Choices
1. Current financing mix Figure 32 below summarizes the current debt structure of American Airlines, BAA and Ryanir (Asur has no debt). As can be observed, the three companies employ very different kinds of debt: American Airlines AA has outstanding a wide variety of notes, from bank debt, plain vanilla bonds to more structured debt instruments. On one hand this is driven by the necessity to tailor the debt to match the company’s cash flow profile and risk, which is very specific. On the other hand this is a symptom of the financial difficulties the company has been going through and the need to raise capital in any form it was available. With this respect, it is worth noticing that the BoD has even authorized (but not yet issued) the emission of 20million preferred shares. Ryanair Ryanair has only bank debt outstanding and this is a reflection of both the early stage of the life cycle is in and its ability to generate cash flows, thus funding growth largely with internal funds. We expect the financing mix to change as the company continues to expand and it will need to access the public bond markets to fund its future projects.
BAA BAA’s debt is almost all made up by straight bonds (82% of the total), with the rest coming from bank debt and two outstanding convertible bonds issues. This is due to the high stability and predictability of its cash flows, which has given BAA easy access to the public the bond markets. The company has issued substantial debt over the last years (Gross Debt went from approx. £1.0 bn in 1995 to over £4 bn today with D/E climbing from 20% to 81%) as a result of the expected capex expenditures connected with the fifth terminal at Heathrow and other projects. Asur Asur has no debt outstanding as it has been able to fund all its capex requirements through internal cash-flows.
Figure 32 Current debt characteristics Company Type of Financing Secured Variable and Fixed rate indebtness Enhanced Equipment trust certificates Special facility revenue bond Credit Facility Agreement Senior Convertibles Notes Debentures Notes Other Straight Bond Straight Bond Straight Bond Straight Bond Straight Bond Straight Bond Straight Bond Convertible Bond Convertible Bond Secured bank debt Secured bank debt Secured bank debt Secured bank debt Secured bank debt Amount (mm) 6,340.0 3,707.0 946.0 850.0 619.0 330.0 303.0 1,159.0 200.0 400.0 300.0 250.0 200.0 900.0 750.0 424.0 425.0 80.3 84.2 88.1 92.1 608.2 Interest Rate on Books 2.03% - 9.16% 2.14% - 9.09% 6.00% - 8.50% 9.150% 4.25% - 4.50% 9.00% - 10.20% 7.88% - 10.55% 7.875% 5.750% 11.750% 8.500% 6.375% 5.750% 4.500% 2.940% 2.625% n.a. n.a. n.a. n.a. n.a. Maturity 2021 2011 2036 2010 2023-2024 2021 2039 2007 2013 2016 2021 2028 2031 2014 2008 2009 2005 2006 2007 2008 2009 - 2016
In addition to the balance sheet debt 3 of the 4 companies analyzed have relevant off-balance sheet items related to operating leases that we summarize below.
Figure 33 Debt embedded in operating lease commitments Off Balance Sheet Debt PV of Operating Leases As a % of total market value of debt American Airlines 5,822.57 48% Ryanair 181.64 13% BAA 388.82 8% Asur -
2. Trade off on Debt and Equity Each company advantages and disadvantages of debt are analyzed in the table on the next page.
Figure 34 Assessment of Debt / Equity Trade off
Factor Added discipline American Airlines
AMR debt is so overwhelming that an increase in debt would not be a benefit for the company. The management is struggling to bring the p&l back to black in order to be able to meet the payments for the debt
Ryanair's stockholder base is quite concentrated and major shareholders are represented in the management. The added discipline from increased debt would not be major benefit for the company
BAA would not benefit from an increase in debt as it is already very close to its optimal debt ratio and an increase would therefore push up its cost of capital. Furthermore there is very little to gain from a discipline perspective given the highly regulated environment in which it operates, which already restricts management discretion BAA effective tax rate is 30% with nearly no variation over the years and it is equal to the marginal tax rate
The additional debt is likely to provide little in added management discipline, since Asur is a highly regulated company with strong shareholder representation in management and a primarily institutional shareholder base Asur could derive a significant tax benefit if it carried some debt in its balance sheet, since it faces a 33% marginal tax rate
Since the company has been losing money in the past 5 years, there are no tax advantages related to the use of debt. Moreover due to high tax losses carried forward it is quite likely that the company is not going to pay taxes in the next few years. This is also reflected in our Cost of capital calculations With a negative book value in the past 3 quarters, a negative operating income in the past 4 years and a 88% debt ratio the company is clearly risking bankruptcy. The company has no sustainable advantage in the competitive arena and in the 2004 annual report the management stated that "the reduced pricing power, resulting mainly from greater cost sensitivity on the part of travelers (especially business travelers), increasing competition from low-cost carriers and the continuing increase in pricing transparency resulting from the use of the Internet, will persist indefinitely and possibly permanently". Typical projects for the company are expansion of aircraft fleet and set of of new hubs. Funds are easy to track and agency costs are not expected to be high
The marginal tax rate of the company is 12.5% while the effective tax rate is only 9.6% (9.5% average over the last 3 years)
The earnings of the company have been growing steadily, although in the long term this might be more difficult to sustain. In general, the company is less volatile to the economic cycle relative to its peers because of more efficient cost structure. In addition, it provides low price services which might be preferred in times of recession, i.e. some counter-cyclicality may exist.
Bankruptcy risk is very remote thanks not only to the very stable nature of its cash flows, but most importantly to the regulatory environment and the resulting indirect oversight on its activities exercised by the British government through the Civil Aviation Authority
Given that Asur's cashflows are highly sensitive to external shocks, it would face considerable bankruptcy costs if it were to carry significant amounts of debt
Typical projects for the company are expansion of aircraft fleet and set of of new hubs. Funds are easy to track and agency costs are not expected to be high
The company has at the moment no financial flexibility: covenants on debt are stringent and the price war on the market can be met only renewing the fleet. The company also intend to expand in the international markets in search for higher growht and markets, but do not have the financial resources to fully support such initiatives.
As the company is in its growth phase, the need for financial flexibility is high. Ryanair has a big number of projects launching new routes and setting up new bases every year and the ability to take such projects in the future depends on its financial flexibility.
Agency costs are minimized by the restrictions imposed on the projects BAA can take and the return on capital is allowed to earn, which is negotiated with the CAA every 5 years. Given these factors, BAA's stock has very similar characteristics to a bond, minimizing therefore conflicts of interest between stockholders and lenders The company has in theory excess debt capacity, although using debt to fund new projects (assuming similar returns to the current ones) would be value destroying, given the current negative ROC-WACC spread. Notwithstanding this, BAA plans to use debt to fund the very large capital commitments it will face over the next 5 Year, which are almost totally due to the construction of a fifth terminal at Heathrow (2004-2009 total expected capex is over £6.0 bn. with average capex/sales climbing from 27% in 1993-2003 to 49% in 2004-2009)
Asur's well-regarded management team is largely drawn from the ITA consortium which is the largest shareholder in the company
Given Asur's considerable visibility on its investments requirements, additional debt is unlikely to take away much future financing flexibility
Based on the above analysis, we draw the following conclusions: BAA and Asur have the ability to carry higher debt ratios given the relative stability of their cash flow profile compared to Ryanair and American Airlines. Whereas BAA debt ratio is a at the correct level, Asur has substantial untapped debt capacity which it should use Given its profitability (and the resulting capacity to reap the tax advantages of debt) and relative lower sensitivity to economic cycles compared to other airlines, Ryanair should be able to have a higher debt ratio. American Airlines debt ratio is clearly too high, even though it must be noted that AA’s distress is more the result of its negative operating profitability than excessive debt in the first place. VIII. Optimal Capital Structure
1. Current Cost of Capital / Financing Mix In the table below we computed the current cost of capital for each of our companies, with the cost of equity based on a levered bottom-up beta and using market values to compute the debt/equity weights. As expected given their operating and financial profiles, American Airlines has the highest cost of capital and BAA the lowest. Asur’s cost of capital is equal to its cost of equity given that it is only equity financed.
Figure 35 Current cost of capital and inputs for calculation of optimal cost of capital Cost of capital - summary American Airlines Ryanair BAA Cost of Equity 34.54% 9.45% 11.30% After-tax Cost of Debt 14% 4% 4% D/(D+E) 87% 24% 45% E/(D+E) 13% 76% 55% Rating CCC AA+ Stock Price 10.2 5.77 5.8 Cost of Capital 16.69% 8.13% 7.85% Firm Value (million) 13,946.0 5,713.7 11,160.4
Asur 9.65% 0% 0% 100% Not Rated 30.45 9.65% 912.7
2. Cost of Capital at Different Financing Mixes As the next step in our analysis to estimate the optimal capital structure we used the cost of capital approach to compute a different WACC at each debt ratio for our companies. The table below summarizes our results
Cost of capital
Based on the objective of minimizing the cost of capital, the table above yields the following results: American Airlines: assuming a normalized EBIT of $ 2600million (which results in a ROC of 8.54%, American Airlines should reduce its debt/capital ratio from the current 87% to 20%. Ryanair: contrary to the result of our qualitative analysis, this analysis shows that Ryanair is currently over levered and should decrease its debt/capital ratio from its current 24% to 10%. BAA: BAA is currently at its optimal capital ratio (the actual optimum is at the current debt ratio of around 45%). The higher optimum can be explained by the low variability and uncertainty of its operating profitability due to the regulatory environment in which BAA operates. This enables the management to design the company’s debt profile with a low level of error. Asur: The company is clearly under levered and should move to a 20% debt/capital ratio in order to maximize firm value. 3. Firm Value at Optimal The following tables present the computed expected Firm Value and Stock Price (both assuming positive growth and no growth) if our companies were to move to their optimal capital ratios.
Cost of Equity After-tax Cost of Debt D/(D+E) E/(D+E) Rating Current stock price Cost of Capital Firm Value (1) (million) Firm Value
Stock Price at optimum (1) Stock Price at optimum(2)
(1) assuming no growth, (2) assuming 3% growth * BAA is currently at its optimum debt ratio
Figure 37 Firm value at the optimum capital structure Firm value at optimal capital American structure Airlines Debt Ratio Current 86.65% Optimal 20.00% Rating Current CCC Optimal Current Optimal Current Optimal BB+ 16.69% 9.63% 13,946.0 24,173.0 10,227.0
Cost of Capital Firm Value (1) Change in firm value (1) assuming no growth
Asur 0% 20% Not Rated A- (probably capped at BBB) 10.13% 9.59% 912.7 963.5 50.8
As the table shows American Airlines is the company that would benefit the most from the transition, whereas the effect on Ryanair and Asur’s value would be more limited. More in detail: American Airlines: a strong deleveraging (from 86.65% to 20% debt/capital) will be difficult to execute in the short term, barring a Chapter 11 situation which in any event would significantly impact the equity value as well. The crucial aspect is that we believe that AMR cannot but maintain current Capex. We therefore believe that even though necessary, moving to the Optimal capital structure is going to be a very long process. More specifically, the company needs to reinvest in the fleet (particularly the long haul fleet: the only one that cannot be
threatened by low cost carriers, and the one that is operating where the company believes the higher growth and margins are) in order to be able to compete in the market and get back to profitability. Ryanair: the company should focus on reducing its debt/capital ratio by raising more equity capital to fund its future projects, instead of using debt as it has done in the last years. Asur: raising its debt ratio by issuing debt would benefit the company not only from an increase in firm value, but also from opening a new capital source, therefore facilitating access to it in the future. We estimate, that although Asur’s interest coverage ratio at its optimum 20% debt ratio would warrant an A- rating, this would probably be capped at BBB, which is the sovereign debt ratio for Mexico. 4. Optimal capital structure – APV approcah We also applied the APV approach with American airlines in order to verify the optimal capital structure we have identified earlier. Given its state of financial distress we believed that this additional approach can give us more insight about their real debt capacity. Our basic assumptions in this process are: Cost of Bankruptcy: direct and indirect costs of bankruptcy are estimated very high given the high capital intensive business model and the complex regulations of the industry. Our guess estimate is 45% of firm value. Tax rate is assumed at 35% stable Unlevered firm value is calculated as Current Firm Value – tax benefits on debt + Expected Bankruptcy cost.
Figure 38 APV optimal capital structure - assumptions Basic American Airlines Assumptions Current Debt ratio 86.8% Unlevered Firm Value = $12,615.13 Current Firm Market Value $13,923.99 Tax rate 35% Debt Market value $12,083.85 Tax Benefits on Debt $4,229.35 Expected Bankruptcy costs 45% Bankruptcy probability 47% Cost of Bankruptcy $2,920.49
We have undergone an iterative process that yielded us the capital structure that maximize the firm value.
Figure 39 AA optimum debt level – APC approach Unlevered Debt Tax $ Debt Firm ratio Rate Value 0% 10% 20% 30% 40% 50% 60% 70% 80% 87% 90% $0.00 $1,307.21 $2,707.69 $4,198.77 $5,515.42 $6,687.62 $7,457.22 $9,010.81 $10,679.48 $11,072.48 $11,614.96 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% 35% $12,615.13 $12,615.13 $12,615.13 $12,615.13 $12,615.13 $12,615.13 $12,615.13 $12,615.13 $12,615.13 $12,615.13 $12,615.13
Value of Firm $12,614.57 $13,072.07 $13,538.46 $13,995.90 $13,788.54 $13,375.25 $12,428.70 $12,872.59 $13,349.35 $12,758.61 $12,905.51
Source Aswath Damodaran, AMR Annual Report, our estimates
The analysis yields us an optimal debt ratio of 30%, not far from the results obtained with the optimal capital structure model. However, given the high subjectivity of the bankruptcy cost, we have run a sensitivity analysis that, taking into account also the tax rate, provide a measure of the debt ratio that maximize the firm value.
Figure 40 Sensitivity analysis – tax rate (horizontal axis) and bankruptcy costs (vertical axis) $0.30 20% 25% 30% 35% 40% 45% 50% 20% 80% 80% 90% 90% 90% 90% 90% 25% 30% 80% 80% 80% 90% 90% 90% 30% 30% 30% 80% 80% 80% 90% 90% 35% 30% 30% 30% 80% 80% 80% 80% 40% 30% 30% 30% 30% 80% 80% 80% 45% 30% 30% 30% 30% 30% 80% 80% 50% 30% 30% 30% 30% 30% 30% 80% 55% 30% 30% 30% 30% 30% 30% 30% 60% 30% 30% 30% 30% 30% 30% 30% 65% 30% 30% 30% 30% 30% 30% 30% 70% 30% 30% 30% 30% 30% 30% 30% 55% 90% 90% 90% 90% 80% 80% 80% 80% 30% 30% 30% 60% 90% 90% 90% 90% 90% 80% 80% 80% 80% 30% 30%
5. Sector and market debt ratios Sector debt ratios In addition, we looked at the sector and the debt ratios at which other firms in the air transportation industry operate. We looked at a sample of 44 companies at analyzed their debt to capital ratios. In order to account for the difference in size, risk and tax rate we regressed the market debt ratio against ln(Revenues), beta and effective tax rate for each company. The resultant regression is as follows: Market Debt to Capital = 0.387 - 0.260 Eff Tax Rate - 0.0195 LnRev+ 0.137 3-yr Regression Beta The R-squared of the regression is 41.1%. The T-statistics reveal insignificance at 95% confidence interval. The results from the regression indicate the following debt ratios:
Figure 41 Debt ratios based on sector information. Variable Coefficient AA Ryanair Constant 0.387 Tax rate -0.26 0% 9.90% LnRev -0.0195 9.83 6.98 Beta 0.137 6.26 1.24 Predicted Debt ratio 105% 40% BAA 29% 7.59 1.42 36% Asur 33.5% 7.59 0.82 26%
We are quite reluctant to base our recommendations on this ratios for two reasons: Although the relatively high R-squared of the regression the coefficients are with large standard errors and statistically insignificant (as indicated by the low T-values) The sector as a whole is characterized by high degree of financial leverage, which might result in the regression overestimating the appropriate level of debt. Market debt ratios We additionally looked at a regression based on the overall market. The regression applied is: Market Debt to Capital = 4.881 + 0.81 Eff Tax Rate - 0.304 Insider holding + 0.841EBITDA/AV – Capex/ Total assets The results are summarized below:
Figure 42 Optimal capital structure – market regression Variable Coefficient Constant 4.881 Insider holdings -0.304 Effective tax rate 0.81 EBITDA/EV 0.841 Capex/Total assets -2.987 Predicted Debt ratio AA 2.00 7.92 2.85 2.44% Ryanair 12.47 9.9 9.03 10.44 -14.47% BAA 0.03 29.0 9.46 12.56 -1.20% Asur 30.59 33.5 13.75 3.25 24.61%
The market debt ratio regression clearly provided some controversial results for AA, Ryanair and BAA, suggesting a negative market debt ratio, which is contrary to our previous analysis based on cost of capital or APV (for American Airlines)
Mechanics of moving towards the optimal
1. A Path to the Optimal In the table below we have listed the main cash flow characteristics of the three businesses our companies are in: Airlines (American Airlines and Ryanair), Aeronautical service and Retail (BAA and Asur). We have then listed what would be the optimal features of the debt for each business.
Figure 43 Typical projects and cash flow characteristics Business Typical Project Cash Flow Characteristics Airlines Fleet Acquisition: Long term payment, Long life of the asset New Route Opening: local offices and labor force. Long term and different currencies New Terminal buildings and maintenance Aeronautical Services Medium to long term Cash outflows that are primarily in local currency, (there could be a significant dollar component for Asur) Cash inflows that are almost exclusively in local currency BAA: very stable cash flows Asur: volatile due to exposure to tourism travel Medium term Cash outflows that are almost exclusively in local currency Cash inflows that are primarily in local currency although influenced by relative strength of pound/peso Can be very volatile, specially sensitive to global risk factors Medium/Long term Single currency (dollar portion for Asur) Asur: if possible tied to influx of tourism
Type of Financing Debt should be Long term Multiple currencies
Medium Term Mix of currencies Asur: if possible tied to influx of tourism
2. Quantitative Analysis and Overall Recommendation on Financing Mix To further evaluate the optimal debt characteristics for each company we regressed the firm value and the EBITDA of each of our companies against: Change in Long Term Rate, GDP growth, Change in local currency, Change in inflation and Change in the price of oil (only for American Airlines
and Ryanair). The Firm value regression results and the conclusion for each company are shown below. Regressions on EBITDA against macroeconomic variables are presented in Appendix IV. American Airlines The current crisis of the company makes firm variations very unpredictable and driven much more by company specific issues rather than macroeconomic variables. Not surprisingly results are disappointing in terms of signs of the coefficients and T statistic significance. Long Term Interest Rates: very weak R square and T statistic. The regression suggests that the duration of the operating assets of the company is very low. . GDP Growth: The company’s earnings are cyclical and shows a positive coefficient with EBITDA. R-squared is fairly significant: AMR is undoubtedly a cyclical company. The negative coefficient with firm value is likely to be related to the high leverage: high GDP growth rates are usually related to high interest rates that affects negatively the firm value. Dollar: A weaker dollar helps EBITDA, but at the same time has a slightly negative effect on firm value. Revenues in foreign currencies (about 35% of total sales) explain the relations with EBITDA, although the effect is small (probably offset by foreign currency costs and expenses). The company should use predominantly dollar denominated debt. Inflation: Does not impact significantly EBITDA, while is negatively correlated to the firm value, probably due to the high amount of debt, hence higher discount rate. Price of Oil: Oil seems to be completely non influent on company firm value or EBITDA. This can be due to two factors: 1) the company has pursued an efficient hedging strategy 2) company’s firm value is driven by company specific issues related to bankruptcy risk, rather than industry themes. Based on this analysis we would suggest the company to use mainly dollar denominated debt with fixed rates. The regression results for FV are presented below
Figure 44 Regression of Firm value against macroeconomic variables American Airlines Firm value (dependent variable) Change in Long Term rate GDP growth Change in Dollar Change in Inflation Change in price of oil Constant 8.205 20.3 8.2 7.29 7.34 Coefficient 1.81 -4.08 0.61 -3.3 0.047 T-statistic 0.55 -2.08 1.2 -1.13 0.24 R2 1.6% 19.3% 7.4% 6.6% 0.3%
Ryanair Long Term Interest Rates: - the regression on change of firm value on change in long term rates indicates that the average duration of the operating assets of the firm is approximately 5.3 year GDP Growth: - interestingly the firm value is positively related to the combined GDP growth of EU 15 countries (where the companies generates its revenues), while the operating income is negatively related. One possible interpretation of this is that higher GDP growth boasts company’s long term growth prospects. On the other hand, fundamentally the low cost airline model attracts more passengers during economic slowdown when travelers are generally more price sensitive, hence negative correlation with the operating earnings. Euro: - Alhough the value of the firm does not appear to be influenced by the Euro exchange rate, stronger currency has significant negative impact on operating income. Therefore we would recommend use of mix of currencies in the capital structure Inflation: - Ryanair’s firm value seems to be significantly related to the inflation rate and our recommendation would be to use floating rate financing. Price of Oil: - in addition, we looked at the price of oil as a facto that might impact the firm’s value and profitability. It appeared that changes in the oil prices have little impact on the firm, which is the result of the airline’s hedging strategy. In addition, during the analyzed period Ryanair was less exposed to the increasing oil prices compared to some its American counterparties as the price increases were partially offset by the loss of value of the US dollar, which is the referent currency for the price of oil. The results from the regressions are presented in the tables below.
Figure 45 Regression of Firm value against macroeconomic variables Ryanair Firm value (dependent variable) Change in Long Term rate GDP growth Change in EURO Change in Inflation Change in price of oil Constant 30.2 6.03 32.4 18.8 38.5 Coefficient -5.3 3.24 0.68 6.56 -0.532 T-statistic of coefficient -0.2 2.63 -0.27 1.56 -1.08 R2 0.70% 36.60% 1.20% 16.80% 16.3%
BAA Long Term Interest Rates: Both regressions have a negative coefficient which points to a longer duration of debt, approx. 2 years. It should be noted that the T-statistic and the R2 of both regressions are very weak. GDP Growth: BAA is positively correlated to GDP growth but shows a low degree of cyclicality as evidenced by the coefficients. GBP: BAA is not influenced by changes in the British Pound. Inflation: the FV regression shows a high positive sensitivity to changes in inflation, which therefore suggests the use of floating rate debt Based upon this analysis, we would recommend that BAA issues debt: With a high duration. Given the weakness of the regression we would not use the coefficient number as a proxy for the duration In British pounds Floating rate BAA’ current debt satisfies all these characteristics, except for the fact that most of the current debt is with fixed rate. The regressions results are presented in the tables below.
Figure 46 Regression of Firm value against macroeconomic variables BAA Firm value (dependent variable) Change in Long Term rate GDP growth Change in GBP Change in Inflation Constant 8.80 6.60 10.30 11.50 Coefficient -3.30 1.72 -0.72 15.9 T-statistic 0.21 0.20 -0.04 0.74 R2 0.6% 0.2% 0.0% 7.2%
Asur Long Term Interest Rates: the regressions on interest rates, suggest that Asur market value and EBITDA increase with higher Mexican interest rates, which is somewhat counterintuitive. A possible explanation might be that, often a rise in domestic rates is a response to higher inflation and/or a depreciation in the peso, both of which might entice more US tourists to visit Asur’s destinations. It is interesting to note the relatively high R2 of 54.4% in the EBITDA regression. GDP Growth: Once again we note the relatively high R2s, compared to the other three companies in our sample. Clearly, Asur’s prospects are highly correlated to economic activity as would be expected from a tourism-based company. The cyclicality of Asur’s business was quite evident after the terrorist attacks of 9/11, when its foreign passengers arrivals contracted dramatically. This leads to a recommendation for careful use of debt. Exchange Rate: Asur’s firm value and EBITDA seems to be affected little by changes in the value of the peso with respect to the dollar, which is, once again, a surprising result. Nevertheless, we would advise that if Asur issues debt in the future, it should do so for the most part in the domestic market and in peso denominations. Inflation: the link between firm value and domestic inflation suggests that Asur should issue any future debt with a variable, rather than a fixed, rate.
Figure 47 Regression of Firm value against macroeconomic variables ASUR Firm value (dependent variable) Interest Rate (Cetes) Mexican GDP Exchange Rate (Peso/Dollar) Mexican Inflation Constant 27.7 2.5 28.4 163 Coefficient 2.99 10.4 -0.98 29.7 T-statistic 1.12 2.52 -0.63 -1.68 R2 10.3% 36.6% 3.5% 20.3%
3. Summary of desirable debt charachteristics The profile of the ideal debt that the companies should use is presented in Figure 48 below:
Figure 48 Summary of desired debt features Company Maturity Currency
American Airlines Medium to long term, despite the regression US dollars
Analysis distorted by the distressed state of the firm Analysis is distorted by the growth stage of the firm n.a. n.a.
None, provided that the company is hedged against sharp movement in price of oil None, provided that the company is hedged against sharp movement in price of oil n.a. n.a.
medium term (5 years)
short term (2 years) short to medium term
British Pounds Peso
Fixed rate Floating rate
1. Current Dividend Policy Of the four companies that we are analyzing, only two of them pay dividends: BAA and Asur. This is consistent with their different characteristics in terms of cash flow profile, expected growth and profitability. The main factors behind American Airlines and Ryanair not issuing dividends are the following: American Airlines: The constraint is clearly the financial and operational distress the company is going through Ryanair: although the company is profitable it chooses not to pay dividend given the stage of the life cycle and the consequent growth it has to fund. Investors have been rewarded by the high stock price appreciation over the last years. In addition, the management of Ryanair stated on a number of occasion that it does not intend to pay out dividends in the foreseeable future as it intends to fund a large scale capacity expansion program. The management put up the issue for a large purchase of 50 new Boeing 737-800 aircrafts for vote at the forthcoming general annual meeting. BAA BAA has kept a stable dividend policy over the past 5 years, with an average dividend yield of 3.3%. The company’s policy of keeping a stable dividend yield was evidenced in 2002 when it paid a dividend although it recorded a much lower net income (this resulted in a dividend payout ratio of
114%). The only year in which BAA bought back stock has been in 2001 to return cash to its shareholders after it had sold some non-core assets.
Figure 49 Dividend policy - BAA Historical Dividends BAA Dividend Paid (mm) Stock Buyback Total Cash to shareholders Average Market Cap Dividend Yield (%) Dividend Payout (%) Source: BAA annual reports, Bloomberg
2000 150 0 150 4,071 3.7% 58%
2001 178 141 319 6,604 2.7% 46%
2002 188 0 188 6,787 2.8% 114%
2003 196 0 196 5,027 3.9% 52%
2004 205 0 205 6,106 3.4% 54%
Asur Asur has only recently started to pay dividends to its shareholders through a special cash dividend in 2002, in which it paid over 200% of its net income. The company generates enough cash to fully fund its increased capital expenditures and still have a significant dividend payout ratio. In the last general shareholder meeting, the company decided to begin a regular cash dividend of approximately US$0.50 per share and to set up a reserve account for stock buybacks. We welcome both moves, as the company‘s ROC is far lower than its cost of capital and it is rapidly accumulating excess cash. Figure 50 Dividend policy - Asur
Dividend policy – ASUR Dividend Paid ($ mm) Stock Buyback Total Cash to shareholders Dividend Yield (%) Dividend Payout (%) Source: Asur Annual reports 2000 0.00 0.00 0.00 0.0% 0.0% 2001 0.00 0.00 0.00 0.0% 0.0% 2002 43.42 0.00 43.42 12.0% 213.0% 2003 13.88 0.00 13.88 3.4% 56.5% 2004 n.a. n.a. n.a. n.a. n.a.
Figure 51 Trade Offs on Dividend Policy
Factor Stockholder Tax Preferences American Airlines
Most of the stockholder are American Institutional investors and should be therefore indifferent between the choice of dividends or buybacks. Given the financial situation of the company no investor is buying AMR shares expecting other than stock appreciation.
The marginal stockholder in Ryanair is large internationally diversified institutional investor, who probably has the flexibility to move any dividend and capital gains to locations with highest tax advantage. From this standpoint the stockholders might indifferent between capital or income gains. Given the good returns on capital and the largely announced capital investments plans a dividend announcement might signal that the company has run out of good projects and have a negative impact on the growth expectation hence on the stock value Dividend policy is constrained by the huge capital expenditure requirements related to the companies expansion program. Neither of these would be a constraint for Ryan air.
The Company has a consistent history of paying dividends. This is reflected in its stockholders base, which is made up mostly of small private shareholders
Asur Investor’s in Asur expect recurrent dividend payments
Information Effects and signaling Incentives
In the unlikely case of a change in dividend policy (the company paid no dividend in the past 5 years) the market would read that a strong signal of confidence.
Given the high number of analysts that follow the stock and the amount of disclosure given by the company, any signal imbedded in a change in dividend policy would have most probably already been captured by the market BAA’s dividend policy in the short medium term is constrained by the heavy capex spending related to the new terminal at Heathrow. Neither of these factors would be a restraint to BAA raising dividends
Minimal, as Asur has no history of sticky dividends and is more inclined to pay special dividends
Effects on flexibility
The good side of the crisis the company is suffering it is it could cancel dividends and now has free hands on this policy.
Asur has no debt
Bond Covenants and Rating Agency Constraints
Debt covenants are pretty high. The company must meet a detailed schedule of financing for the $ 850mn credit facility in terms of current assets (no less than 1.5bn every quarter) and Cash flow to fixed charges around 1x.
Investor’s in Asur expect recurrent dividend payments
Dividend Policy: a Framework
1. Affordable Dividends In order to determine the amount our companies could have paid out in dividends we have computed the average FCFE over the last 5-year and compared it to the dividends and buyback paid by the companies. As mentioned before American Airlines and Ryanair do not payout any dividends. Even though both companies could have potentially returned cash to their shareholders, none of them did, but for completely different reasons: American Airlines positive FCFE come exclusively from the borrowings necessary to pay previous debt and try to renew the old fleet; Ryan Air decided to retain its FCFE to fund future growth. BAA and Asur have as well paid out less than what they could have to their shareholders.
Figure 52 Dividend policy – sector analysis Dividend policy analysis Average FCFE in million (last 5 years) Average Dividends & Stock Buybacks Difference % Dividends / Stock Buybacks Figure 53 Dividend policy – sector analysis Dividend policy - Sector analysis Dividend Yield Dividend Yield (sector) Difference Payout Ratio Payout Ratio (sector) Difference American Airlines 0.0% 0.06% -0.06% 0.0% 2.6% -2.6% Ryanair 0.0% 0.05% -0.05% 0.0% 79.4% -79.4% BAA 3.4% 3.36% 54.4% 54.4% Asur 3.9% 3.90% 67.4% 67.4% American Airlines 765.3 0 765.3 0.0% Ryanair 23.5 0 23.5 0.0% BAA 248 183 -65 74% Asur 41.2 14.3 26.9 34.7%
2. Management Trust and Changing Dividend Policy As a second step in our analysis we analyzed past ROE and ROC to judge if firms that paid out less than they could afford created value for their shareholders. In the case of Ryanair the company has been justified in its policy of not paying out dividends by the largely positive spread, both in terms of ROE-Cost of Equity and ROC-WACC. On the other hand BAA and Asur both have recorded negative ROE-Cost of Equity / ROC-WACC spreads. This suggests that they should increase their dividend payout ratios.
Figure 54 Analysis of past returns and dividend policy
Analysis of dividend policy ROE Cost of Equity Difference ROC WACC Difference
American Airlines n.m. 34.54% Na 8.54% 16.69% -8.15%
Ryanair 14.69% 9.45% 5.24% 16.94% 8.13% 8.81%
Industry Average 2.76% 10.69% -7.93% 14.22% 8.65% 5.57%
BAA 8.23% 11.30% -3.07% 5.59% 7.85% -2.27%
Asur 5.15% 9.65% -4.50% 4.76% 9.65% -4.89%
Industry average 10.20% n.a. n.a. 5.71% n.a. n.a.
Figure 55 Analysis of past returns AA Historical returns AA ROE Cost of Equity Difference ROC WACC Difference
Recommendations American Airlines – AA has the priority to return back to profitability before being able to give any cash back to its stockholders. It seems that to a significant extend the problems of AA stem from its high leverage and any dividend payment would reduce the value of the equity, resulting in even worse debt ratio Ryanair – the company has not paid any dividends, but it appears that it has a good portfolio of investment projects that can and do generate positive value for its stockholders. In addition, good corporate governance practices ensure that investors money is in good hands with Ryanair’s management and we support the current non-divident policy of the company BAA – with its low risk profile and in its steady and reliable cash flows, BAA has definitely attracted “dividend addict” shareholders, evident by the distribution of ownership. It is the company with a large number of smaller investors who probably rely more on income than on capital gain from this company. Appropriately it payout out large portion of its available free cash flow to equity (74%) back to its shareholders. Taken into account the regulated nature of the business and the fact that BAA cannot upgrade the prices it currently charges from Airline until 2008, we suggest it accumulate a certain cash cushion to meet unexpected turns in the economic trends. Current retention ration of about 25% seems appropriate.
Asur – Asur has been retaining a significant portion of their available free cash flow to equity and on the other hand has not been able to deliver excess returns over it s cost of capital. We believe that it should return more cash to its stockholders in the form of dividends. In addition, it is not constrained by high debt ratio as its debt capacity is still unused. XII. Valuation
1. Valuation models Based on the analysis presented above we proceeded to perform valuation of the market value of the equity of all four companies. Table Figure 60 below summarizes the choice of our valuation model and the results.
Figure 60 Summary of valuation results American Valuation summary Airlines Model Chosen FCFF 2 Stage Value per Share 10.06 Current Stock Price 10.20 Undervalued / (overvalued) -1.3% Reccomendation HOLD Source: Analysis
Ryanair FCFF 3 Stage 6.76 5.55 21.8% BUY
BAA FCFF 2 Stage 3.22 5.80 -44.4% SELL
Asur FCFF 2 Stage 31.69 30.45 4.1% HOLD
The choice of growth period reflects the sustainability of competitive advantages of each firm as outlined in Part 3 Section IV – Investment Returns and Future prospects. 2. Valuation assumptions and inputs. The valuation assumptions are presented in Figure 61 to Figure 64 below.
Figure 61 American Airlines – DCF valuation assumptions American Airlines Length of Period Revenues Pre-tax Operating Margin Tax Rate Return on Capital Non-Cash Working Capital Reinvestment Rate (Net Cap Ex + Working Capital Investments/EBIT Expected growth Rate in EBIT Debt Capital Ratio Beta Cost of Equity Cost of Debt Source: Company reports, analysis
Figure 62 Ryanair – DCF valuation assumptions Ryanair High Growth Phase Length of Period 4 years and 4 years transitional period Operating income growth 22.53% Tax Rate Return on Capital Cost of capital Non-Cash Working Capital Reinvestment Rate (Net Cap Ex + Working Capital Investments/EBIT Debt Capital Ratio Beta Cost of Equity Cost of Debt Source: Company reports, analysis Figure 63 BAA – DCF valuation assumptions BAA Length of Period Revenues Tax Rate Return on Capital Reinvestment Rate (Net Cap Ex + Working Capital Investments/EBIT Expected growth Rate in EBIT Debt Capital Ratio Beta Cost of Equity Cost of Debt Source: Company reports, analysis 12.50% 15.48% 8.13% starting at 8.45% and declining to 2% 146% 23.87% 1.24 9.5% 4.5%
Figure 64 Asur – DCF valuation assumptions Asur Length of Period Revenues Pre-tax Operating Margin Tax Rate Return on Capital Non-Cash Working Capital Reinvestment Rate (Net Cap Ex + Working Capital Investments/EBIT Expected growth Rate in EBIT Debt Capital Ratio Beta Cost of Equity Cost of Debt Source: Company reports, analysis
In building our assumptions into the valuation model we had the following approach: We have used the bottom-up beta estimates we calculated earlier in the cost of equity computation. The risk characteristics in perpetuity are likely to change as follows: o American Airline – changing debt ratio (going concern assumption) should reduce risk and hence beta. The beta used in perpetuity is the unlevered average industry beta relevered to a more sustainable debt ratio o Ryanair – as the company grows and becomes more mature, the risk is expected to converge with the market o BAA and Asur – risk is assumed to converge with market risk, although at the low end reflecting stability in cash flows Growth rate are derived from fundamentals and based on ROC and Reinvestment rates. In perpetuity the growth rate is set at levels below or close to long term sustainable economic growth as we don’t expect these sectors to be the major drivers of economic growth. Growth phase Capex and Working capital changes have been projected on the basis of historical data. I perpetuity the implied reinvestment rates were used (derived as a function of growth and ROC). Leverage – we projected that in the long term the companies gradually move to their optimal capital structure, except for BAA,which is already at its optimum. In addition, Asur is assumed to generate a ROC slightly higher than its cost of capital in the future. The rationale behind this is that as the company becomes more mature and moves towards its optimum capital structure the cost of capital is likely to fall. This fall is likely to be supplemented by reduced risk 56
premium for Mexico, as the country becomes less risky place for investors. We believe that Asur could sustain the higher ROC partly because of its most valuable asset – the concession to use the airports. This asset gradually depreciates reducing the book value of the equity of the firm, and on the other hand does not require capital expenditures to replace it. It is also a natural barrier to entry to competitors in the sector and it give Asur the exclusive right of being airport operator. We assumed that in perpetuity the ROC of Asur will move towards the industry average of around 11.0% 3. Valuation results The valuation results are presented in
Figure 65 Valuation results American Airlines 13,776.0 148.0 13,924.0 12,083.8 1,840.1 217.9 1,622.3 161.2 10.06 Ryanair 5,272.9 1,447.9 6,720.7 1,549.1 5,171.7 71.7 5,099.9 754.3 6.76 BAA 7,452.1 973.9 8,426.0 5,007.1 3,417.9. 2.45 3,415.4 1,060.9 3.22 Asur 848.0 102.8 950.8 950.8 950.8 30.0 31.69
Value of Operating Assets Cash & Marketable Securities Firm Value Market Value of Debt Equity Value Value of Equity in Options Value of Equity in Common Stock Number of Shares Value per Share Source: Analysis
We performed the DCF valuation on the basis of the inputs presented above. The equity values of AA, Ryanair and BAA includes also the equity options outstanding written by the companies. In computing the options values we have used the annualized standard deviation in the log-normal returns
&P on a monthly basis for 5 years ( Ln$ 1 $P % 0
Valuation summary Value per Share Current Stock Price Undervalued / (overvalued) Recommendation Source: Analysis
# ! ), the average strike price and maturity of the options. ! "
Ryanair 6.76 5.55 21.8% BUY BAA 3.22 5.80 -44.4% SELL Asur 31.69 30.45 4.1% HOLD
On the basis of the valuations results we reached the following conclusions
American Airlines 10.06 10.20 -1.3% HOLD
AA –Balance Sheet Current Assets Currrent Liabilities Inventory Net Working Capital Tangible Assets Intangible Assets Financial Assets (cash) Total Assets Termination Indemnity reserves Net Capital Employed Total Debt Total Equity Net Capital Employed
Operating revenues Operating expenses Depreciation and amortization Lease payments Staff, fuel, route charges and others Total operating expenses Operating profit before exceptional costs Reorganization costs Other exceptional costs Amortization of goodwill Total exceptional costs EBIT Financial charges Interest expenses Other financial income/(charge) Total Profit before tax Taxes Net income
Fixed assets Intangible Tangible Total fixed assets Current asets Cash and liquid resources Receivables Prepayments and other receivables Inventories Total current assets Total assets Current liabilities Payables Accrued expenses and others Current portion of long term debt Short term borrowings Total current liabilities Long term liabilities Provisions Other creditors Long term debt Total long term liabilities Shareholders equity Share capital Share premium Profit and loss Total equity funds Total liabilities and equity
BAA - Income Statement Retail (incl. World Duty Free) Airport/traffic charges Property/op. facilities Other Total Airports Rail Other Total Revenues Labour Costs Retail Expenditure Operating Leases Expenses Other Operating Costs Total Costs Share of operating profit in Joint Venture Ebitda Depreciation and Amortization Ebit Interest Income Interest Charges Net Interest Other Financial Income Financial Income / (Charges) EBT Taxes Minority Interests Income (Loss)
BAA - Balance Shteet Trade Receivables Trade Payables Inventory Net Working Capital Other Current Assets / (Liabilities) Total Net Current Assets Tangible Assets Intangible Assets Share of Gross Assets Share of Gross Liabilities Loans Investments in JVs Investments in associates Othe investments Total Fixed Assets Other Liabilities Net Capital Employed Gross Financial Debt of which Convertible Debt of which Bonds of which Bank Loans other financial debt Cash & Marketable Securities Net Debt Minority Interest Total Equity Net Capital Employed
ASUR Income Statement Revenues: Aeronautical revenues Non-aeronautical revenues Total revenues Operating expenses: Cost of services Technical assistance fee Concession fee General and administrative Depreciation and amortization Total operating expenses Operating income Interest income Interest expense Exchange gain/(losses), net Chages in monetary position Comprehensive financing cost EBT Provision for asset tax Income tax and profit sharing Income before extraordinary items Contract termination fee Other special items Net income EBITDA
ASUR Balance Sheet Cash and marketable securities Trade receivables Recovarable taxes and other current assets Total current assets Property, plant and equipment Airport concessions, net of amortization Right to use airport facilities, net Total assets Trade accounts payable Accrued expenses and other payables Total current liabilities Long term debt Other Deferred income tax and profit sharing Total liabilities Capital stock Legal reserve Retained earnings Total stockholders' equity Total liabilities and stockholders' equity