Valuation of SAS Going Concern and Liquidation Perspective Copenhagen Business School, 2015

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Copenhagen Business School, 2015

Master Thesis

MSc. (cand.merc) in Accounting, Strategy and Control (ASC)

Hand-in date: 19 June 2015

Supervisor:

Ole Vagn Sørensen

Authors:

Trym Krogstad

__________________________

Jardar Rike

__________________________

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Executive Summary

Purpose of the assignment:

SAS has on several occasions over the last decade been close to bankruptcy. Much due to the state owners, they have been able to survive through governmental support. Therefore, we will in this valuation

assignment include a liquidation perspective in order to find out whether SAS AB’s share price is fairly priced. Based upon this, the research question is: “Are SAS AB’s common shares fairly priced on 1 February 2015?”

Analytical framework:

We will conduct a strategic analysis in order to analyse the external and internal environment that SAS operates in and extract the key value drivers for change. Then we will perform a financial statement analysis, in which we will introduce a peer group. We will reformulate both SAS’ and the peer’s financial statements and make adjustments (for instance to operating leases) in order to make them truly comparable. Thereafter, we assess SAS’ profitability and liquidity against its peer group. The results from the strategic and financial analysis are summarized in a SWOT matrix. Based upon this, we conduct a sales-driven forecast and a valuation based on the implicit forecasting assumptions. The valuation methods will be a discounted cash flow, economic-value added, multiple valuation and a liquidation method.

Findings:

The airline industry is highly reactive to the macro forces, but the years ahead seems to hold good conditions for the airline industry. The supply and demand shows that the industry is characterised by intense

competition, much driven by unprofitable airlines continuing to fly (as investors will not realise their losses) and exogenous negative supply-and-demand shifts. Porter’s Five Forces shows that the airline industry is unattractive and does not offer a good profit potential. The internal analysis shows that SAS has two sustainable competitive advantages; SAS’ brand name and grandfather rights. The profitability analysis shows that SAS has underperformed since 2005. Yet, SAS has reduced its unit cost and switched to a more flexible cost base. Supplemented by a change in pension commitments, SAS shows indications of a positive trend for the future. SAS shows red flags on both short- and long-term liquidity risk. Our DCF valuation indicated a share price of SEK 19,60, while a relative valuation indicated a share price of SEK 12,41. The liquidation method indicated that there would be zero left for the owners after a liquidation.

Conclusion:

Our valuation conclusion is that SAS’ share price on 1 February 2015 was fairly priced. Even though our DCF valuation yielded a 20% higher share price, the fact that there would be nothing left for the shareholders in the case of a liquidation implies that the equity is even more risky than our DCF input was. Therefore, the observable share price of SEK 16,40 is fairly priced.

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1.0 Introduction

1.1 The Airline Industry and Competitors

The airline industry has traditionally been characterized as a tough industry to operate in. The industry is characterized by low profit margins, price-concerned customers, substantial safety measures and intense competition. The demand for airline travels have always been sensitive to economic trends (SAS Annual Report 2012/2013; 4).

The European airline industry has undergone two major changes in the last 30-40 years. Firstly, in the 1990s, a deregulation of the EU market led to a market liberalisation for the airline industry in Europe. This led to the rise of international airline alliances, but it also led to the introduction of a new business model,

challenging the original business model that was successful before the deregulation, adopted by full-service carriers (FSCs). Before the deregulation, the traditional business model was the hub-and-spoke network. In this model, the focus is not only on transporting passengers from point A to B, but also on connecting them to other flights to other destinations. The new business model, point-to-point network, focuses mainly on transporting passengers from point A to B, and not on connecting them with other flights. This business model is mainly used by low-cost carries (LCCs), which saw a boom in the 1990s (flightglobal.com). Secondly, terrorist attacks, epidemics, trade globalization and the rise of oil prices has put substantial pressure on the airline industry. From the mid 1990s to 2000 the airline industry faced some of its best years in history, giving the airline industry a growth of 4-6% per year (Cento, 2009; 3). However, the industry

faced severe trouble after the terrorist attack on the 11th_{of September 2001 and the SARS virus in 2003.}

Even so, LCCs were able to generate profits, leading the traditional airline companies into cost-reduction programmes and structural changes in order to compete with the LCCs (Cento, 2009; 4). In some cases, traditional airlines were forced to adopt many of the characteristics of the LCCs in order to survive in the deregulated market (Cento, 2009; 21).

The Scandinavian market differs in some aspects from the global airline market. In Scandinavia, short-haul routes are far more common than in other parts of Europe. This is mostly due to long distances between the (relatively small) cities, cumbersome topography and the fact that the countries are surrounded by seas, making substitutes like boats a far more time-consuming alternative. In fact, this is probably the reason why

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an average Scandinavian flies 4 times per year, while the average European flies 2 times a year (SAS Annual report 2012/2013; 20). The market-share distribution in Scandinavia is illustrated in the pie chart below.

1.2 Company Presentation

History:

Scandinavian Airlines was formed in 1946 through a consolidation of Svensk Intercontinental Lufttrafik AB, Det Danske Luftfatselskap A/S and Det Norske Luftfartselskap A/S. The group’s first global flight was between Stockholm and New York. In 1954 it established the world’s first Copenhagen to Los Angeles polar route in scheduled service. Moreover, it was the first company to give its customers “round the world service over the North Pole (1957) (sasgroup.net; 1). SAS AB (which will be referred to as “SAS” in the rest of the assignment) was one of the founding members of Star Alliance which was established in 1997 and became the world’s first truly intercontinental airline alliance. Today, it comprises 27 members and is the largest alliance in the industry (sasgroup.net; 3).

50% of SAS is state owned, and in the fiscal year of 2013/2014 SAS grossed over bSEK 38 in revenue. SAS currently owns 51 aircrafts and leases 99, ranging in seat size from 50-200 seats, which enables them to meet the customer demand all over Scandinavia (SAS Annual Report 2013/2014; 79). In 2013/2014, SAS

transported more than 29 million passengers (SAS Annual Report 2013/2014; 88). Since thetryingyears in

the aviation industry after 2001, SAS has also been struggling with negative results. On several occasions, the public owners paid billions in order to keep the company from a default. One of the fundamental strengths of SAS’ business model is that it offers more departures and traveling destination than any other Nordic airline.

In 2009, SAS was in a crisis. The management and the workforce union were negotiating wage cuts, longer work hours and a change in the pension plans. The negotiations came to an end, and SAS avoided

bankruptcy. Again in 2012, SAS was in a crisis, maybe closer than ever to a bankruptcy. SAS’ CEO Rickard Gustafson said himself that this time, SAS was only 30 minutes away from a bankruptcy

Figure 1: Market shares in Scandinavia. Own creation. Source: SAS Annual Report 2013/2014; 5.

33% 23% 6% 6% 6% 5% 3% 2% 1% 16% SAS Norwegian Ryanair Lufthansa Widerøe Air France-KLM IAG Wizz Air easyJet Other Market shares in Scandinavia, 2014

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(dagensperspektiv.no). After delivering positive net earnings in 2012/2013, SAS delivered a slightly negative financial result in 2013/2014. Even though the sky seems clear ahead, investor’s might not feel at ease yet, due to SAS’ troublesome past.

Business strategy:

SAS’ primary geographical segment is the Nordic region. 27% of SAS’ passenger revenues comes from domestic flights, 10% from intra-Scandinavia, 41% from Europe and 22% from intercontinental flights (Appendix 5 and SAS Annual Report 2013/2014; 61). SAS’ primary customer group are “people who travel often and who see a value in easier and more time-efficient travel”, also called frequent travellers (SAS Annual Report 2013/2014; 6). To accommodate this, there has been structural changes and continued improvements focusing on passengers with these travelling requirements (sasgroup.net; 2). This has been the primary customer group and strategy for at least the last decade (SAS Annual Report 2005; 10). In this regard, SAS has stayed true to its strategy for a long time.

In 2009 launched the Core SAS strategy, where companies in the SAS portfolio not part of the core

operations were sold off (SAS Annual Report 2009; 8). In 2011, SAS launched yet another strategy concept; 4Excellence (SAS Annual Report 2011; 1). The focus was again put on cost-reductions, but also on

improving the leisure-travel offering. This strategy was considered a success, but three challenges remained; Cost/flexibility (expensive and inflexible cost structure), liquidity (too dependent on external credit facilities to maintain financial preparedness) and equity (new accounting rules for pensions which will yield a

negative impact on the equity) (SAS Annual Report 2012; 5). In order to respond to these challenges, SAS extended the existing strategy by naming it 4Excellence Next Generation. In addition to the mentioned challenges, it also places more emphasis on the home market and punctuality, as well as simplifying the service offering and making the sales channels more effective. The programme is an attempt to align the situations at SAS with the rest of the market (SAS Annual Report 2012/2013; 38).

Today, SAS have set themselves three strategic priorities (SAS Annual Report 2013/2014; 7):

1) Establish an efficient production platform; Strengthening the cost-reduction programmes and increasing flexibility

2) Win the battle for Scandinavia’s frequent travellers; Clearly defining the target group and increasing customer offering

3) Invest in our future; Streamlining and renewing the aircraft fleet. Cost-reduction initiatives:

As mentioned above, SAS has been delivering varying financial results for the last decade and has implemented several cost-reduction initiatives in order to stay competitive. Seemingly, along with every strategy launch, there has been a corresponding cost-reduction initiative. In 2005, SAS launched Turnaround

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2005 as a response to a slow economic growth in Europe, greater competition and a change in the passenger mix (SAS Annual Report 2005; 20). In 2009, yet another cost-reduction initiative became known under the strategy Core SAS. Along with the 4Excellence strategy in 2011 another cost-reduction programme was initiated in order to reduce the unit costs by 3-5% per year (SAS Annual Report 2011; 1). Most recently, in 2012, SAS launched a cost-reduction initiative along with the 4Excellence Next Generation strategy. Today, SAS is still working on maximizing the potential of the cost-reduction initiative in 4Excellence Next Generation.

Ownership structure:

On 31 October 2014 SAS had 329 million common shares and 7 million preference shares outstanding, constituting a total market capitalization of mSEK 6 639. SAS is 50% governmentally owned divided between Norway, Denmark and Sweden. The remaining 50% is split between institutional and private ownership, where Knut and Alice Wallenberg’s Foundation, followed by Avanza Pension, is the largest stockholder (SAS Annual Report 2013/2014; 86). SAS’ current company structure is summarized in the figure below.

A full description of the ownership structure follows in the figure below.

Figure 2: SAS’s company structure in 2014. Own creation. Source: SAS Annual Report 2013/2014; 66

SAS Ground Handling Denmark A/S SAS Ground Handling Norway AS 90% SAS Ground Handling Sweden AB Blue1 Oy 100%

SAS Cargo Group A/S 100% SAS Danmark A/S SAS Sverige AB SAS Norge AS Consortium Scandinavian Airlines System

Denmark – Norway – Sweden

Widerøe’s Flyveselskap AS 20% AS Estonian Air 2,7%

Air Greenland 37,5% SAS AB

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1.3 Research Question and Motivation

Through this assignment we will assess SAS from an investor’s perspective. As mentioned in the

introduction section, SAS has been having financial difficulties for some time. Therefore, we are interested to see whether SAS’ going-concern value is higher than its liquidation value, which it normally should be when the board of directors and management team are working to improve the value of the company (Sørensen, 2012; 29). Our argumentation will be that the market share price should be the highest of the going-concern and liquidation value.

Based on SAS’ historical performance, especially with regards to the financial distress it has gone through, our research question is:

“Are SAS AB’s common shares fairly priced on 1 February 2015?” In order to answer this, we have conducted two approaches:

1) A fundamental analysis based on a going-concern assumption to see if the stock is over- or underpriced

2) A liquidation method to see what SAS AB is worth in the case of a liquidation.

Based on the insights from these two approaches, we will conclude whether SAS AB’s common shares are fairly priced.

Motivation for research question

After having a lot of different courses the first year on our master programme, we both developed a genuine interest for the Financial Statement Analysis course. Together, we decided to write our empirical business project in that field, where we evaluated a fish-farming company. The whole valuation process was a great experience for us, so we decided that our thesis would be within the valuation topic. After discussing various valuation approaches, we found out that it would be interesting to compare different present-value

approaches with relative valuation and liquidation valuation in order to see what the outcome would be when applying it on a real-life case. We spent some time coming up with a list of different companies that the

Institutional ownership 30 % Private ownership 20 % State ownership 50 %

SAS’ Ownership structure _{SAS' 10 largest stockholders} _{Ownership stake}

The Swedish Government Offices 21,4 %

Statens Administration (FSC), Denmark 14,3 %

Norwegian Ministry of Trade, Industry and Fisheries 14,3 %

Knut and Alice Wallenberg’s Foundation 7,5 %

Försäkringsbolaget, Avanza Pension 1,4 %

Unionen 1,3 %

JPM Chase NA 1,2 %

Robur Försäkring 0,9 %

Handelsbanken Fonder AB RE JPM 0,5 %

Svenska Handelsbanken for PB 0,4 %

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liquidation model would be applicable on, and we realised that the shipping and air travel industry were appropriate industries. The reason for this is that these are both industries with a lot of tangible assets (ships and airplanes). We decided to go for the airline industry, basically because we knew that it was easy to get a lot of good information as an external analyst. The reason why we decided to go with SAS, is that SAS has been a hot topic in the news several times over the last decade, due to the fact that it has been very close to bankruptcy. This suited our case very much.

1.4 Methodology

The methodology section should provide the reader with an overview of the methods applied and the sequence of the methods and models.

Research philosophy

The research philosophy we adapt contains important assumptions about the way in which we view the world (Saunders et al, 2009; 108). Our research philosophy is considered to be positivism. This means that in terms of ontology (what assumptions do we make about the way in which the world works) we take a stance as external, objective and independent of social actors. In terms of epistemology (the researcher’s view regarding what constitutes acceptable knowledge) only observable phenomena can provide credible data where the focus is on causality and law-like generalizations. When it comes to axiology (the researcher’s view of the role of values in research) we are independent of the data and maintains an objective stance. Lastly, in terms of data collection techniques, we try to make them highly structured, we try to use large samples, mostly quantitative, but we will also use qualitative data to some extent (Saunders et al, 2009; 119). Research approach

Our research approach is a deductive one, which basically means that we deduce a testable proposition from the theory, express this proposition in operational terms, test it and examine the outcome (Saunders et al, 2009; 124-125).

Research strategy

As a research strategy, we have chosen the case study strategy. This strategy is defined as “a strategy for doing research which involves an empirical investigation of a particular contemporary phenomenon within its real life context using multiple sources of evidence” (Saunders et al, 2009; 145-146). A case study strategy is only natural in the case of doing a valuation.

Research choices

As a research choice, we will be using the multiple methods. This basically means that we use more than one data collection technique and analysis procedures to answer our research question (Saunders et al, 2009; 151). Moreover, we choose the multi-method quantitative study, where we choose to collect both

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quantitative data as well as qualitative data (for instance through a conversation with a SEB manager on 13.05.2015).

Research time horizons

In terms of research time horizons, our approach will be a cross-sectional one. This means that we take a “snapshot” of SAS at a particular point in time, namely on 1 February 2015 (Saunders et al, 2009; 155). We will be using multiple snapshots of SAS, at the fiscal year-end every year back to 2004.

The credibility of research findings

When it comes to reliability, this is often assessed through 3 criteria (Saunders et al, 2009; 156); 1) Will the measures yield the same results on other occasions?

2) Will similar observations be reached by other observers? 3) Is there transparency in how sense was made from the raw data?

In terms of 1) we argue that the measures will yield the same results on other occasions under the same assumptions and circumstances that we apply (and disclose). When it comes to 2), this is highly doubtful. No valuation assignment is the same, and the valuation is only as good as the assumptions it builds upon. Also, a perfectly reasonable valuation assignment might or might not yield the market share price, simply due to the fact that most valuation assignments assume that people and investors are rational, which might or might not be the case in real-life situations. In terms of 3), this is where the quality and credibility of our assignment is determined. Our approach is to give the reader as much transparency in terms of raw data, calculations and assumptions as we possibly can. This is why we have disclosed nearly 100 pages of appendixes, where the reader can see the raw data that our calculations rely upon.

Research techniques and procedures

Our approach to the valuation is based on a fundamental analysis. This basically means that a strategic analysis, in addition to a financial analysis, is conducted in order to find the non-financial and financial value drivers (Sørensen, 2012; 17).

Data use and references:

Our assignment is in large thoroughly data driven, meaning that our analyses, conclusions and forecasts are based on quantifiable data, at least as much as possible. Our data comes from different sources, depending on the availability of data. However, the sources used is in every case stated clearly to the reader. On several occasions we will be using abbreviations of words commonly used in the airline industry. These

abbreviations will be explained “as we go”, but in addition, the reader can always look up Appendix 42 in order to read more about the different abbreviations. An important note to make is that in some cases we have accessed a Bloomberg terminal in order to attain data. In these cases, we have decided not to refer to every keystroke pressed in order to find the data. We have used a desk-research approach, and we will in

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every case try and make it as easy for the reader to understand which report in Bloomberg the data comes from. This is also the case for Datastream and Euromonitor International. All three of them are accessible through CBS. In addition, we have in several cases added a screenshot of the terminals in 9.0 Appendix. These will be clearly referred to for the reader. We have also used qualitative data in a few cases. Most significantly in 6.0 Liquidation Method. Here, we have contacted Henrik Blymke, Head of Credit Research in SEB in Oslo, Norway. After initiating contact through an e-mail, we were able to conduct a 20-minute telephone interview with him. He had then read a one-pager of our most critical assumptions, and the telephone conversation was centred around these. This telephone conversation took place on 13.05.2015 at 14.00. He is aware that we are referring to him on some occasions in this assignment, but we will not be quoting him on any occasions. The interview was conducted so that we could verify or discard our assumptions. His help was of significant importance to us, and we thank him for his help.

Strategic analysis:

A strategic analysis will be conducted in order to identify the key strategic value drivers for SAS. This is important in order to understand the airline industry, how these strategic value drivers have affected the historical growth and risk. The strategic analysis is mostly based on Johnson et al’s “Exploring Strategy” book. The strategic analysis will start off with a PESTEL analysis. Here, we will look at political, economical, socio-cultural, technological, environmental and legal factors, and it will be concluded on whether they are key value drivers for change in the airline industry or not.

After the PESTEL analysis, we will try to understand the industry. As a starting point, we look at the supply and demand situation in the airline industry in order to understand what the current situation is. Further, an industry analysis will be conducted through a Porter’s Five Forces analysis in order to grasp a broader picture. The five forces will be assessed and a conclusion will be made on whether the industry is an attractive (offers a good profit potential) or unattractive industry to operate in. After that, we look at the strategic groups that takes place in the European airline industry. This is important in order to understand how the different airlines position themselves in the industry, and an important insight in terms of industry characteristic. A VRIO analysis will be conducted in order to make an assessment of SAS’ internal

sustainable competitive advantages. We will assess SAS’ resources based on whether they are valuable, rare, imitable and if the organization is structured in a way that the capabilities are able to utilize the structure of the organization.

Financial statement analysis:

In order to make a valuation, a financial statement analysis is necessary. We start off with an assessment of SAS’ accounting quality. Thereafter we need to reformulate the reported financial statements and balance sheet into operating and financial activities. We will do this for both SAS and the peer group. An important point to notice is that we have decided to capitalize the operating leases for both SAS and every actor in the

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peer group in order to make a comparison as good as possible. The peer group will then be introduce properly. Then a profitability analysis is conducted, where comparisons to peers are essential. We will along the way be calculating a number of ratios relevant in the airline industry. The profitability analysis will be structured after the DuPont model, where the return on invested capital (ROIC) is split up into profit margin and turnover rate of invested capital. Based on this we will conclude on SAS’ historical performance. After the profitability analysis we will conduct a liquidity analysis in order to understand SAS’ liquidity situation. The liquidity analysis will be structured after a short- and long-term horizon. In terms of the short-term liquidity risk, we will use the current ratio, quick ratio and the CFO to short-term debt.

The strengths, weaknesses, opportunities and threats derived from the strategic and financial statement analysis will be summarized in a SWOT figure.

Forecasting and budgeting:

Our forecast is a sales-driven forecast. This approach reflects that different accounting items are driven by the expected level of activity (Plenborg et al, 2009; 175). We will to some extent aggregate some of the accounting items into “buckets”. This means that certain accounting items will receive a more thorough consideration than others according to their significance and relevance.

Weighted-average cost of capital (WACC):

The weighted-average cost of capital is critical in any valuation assignment. In our case, the WACC

calculations are quite thorough. We have decided to apply two approaches; 1) a regression on the observable share price and the OMXS30GI and 2) by using an unlevered beta approach. Thereafter we use the average of these two valuations. In 2) we have been consistent in taking the Capitalized operating leases into

consideration with regards to the capital structure. The Capital Asset Pricing Model (CAPM) is used in order to estimate the owner’s required rate of return.

Enterprise discounted cash flow:

Our valuation will be based on a two-stage enterprise discounted cash flow model. When using the

discounted cash flow approach in estimating the value of a company, the value is determined by the present value of the expected future cash flows. The expected future cash flows are divided into two; cash flows from the explicit forecasting period and the cash flows from the terminal period (Plenborg et al, 2012; 216). In order to end up with the equity value, we deduct Net interest-bearing debt in 2013/2014 and the value of minority interests. Thereafter, the equity value is divided by the number of common shares outstanding in order to reach the common share price. We have calculated a share price at 31.10.2014 and 01.02.2015. The reasoning behind this is that one can assume that the cash flows occur frequently throughout the year. Therefore, we want to discount the share price back to 01.02.2015, and not to 31.10.2014 (see 1.3 Research Question). Due to the fact that the airline industry is highly cyclical on a 12-month perspective (i.e. more air travels during holidays), this adjustment may or may not approximate the cash flows generated in January

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very precisely, but it is a better approximation than not “forward discounting” them. The discounted cash flow valuation will be backed up by a two-stage enterprise economic value added model in Appendix 35. This is done mainly as a sanity check for ourselves, as under the same assumptions, these two valuation models should yield the same enterprise value.

Sensitivity analysis:

A quick sensitivity analysis will be conducted. We will see how the common share price reacts to changes in important variables such as the WACC and the terminal growth rate. Also, we will see how sensitive the base case is to changes in terms of Jet fuel expenses and Payroll expenses, which are the two most significant cost items.

Multiple valuation:

As a relative valuation approach, we have decided to use two multiple valuations. The first multiple we use is a slightly modified EV / EBITDA multiple. More specifically, we use EV / EBITDAR. The reason for this is that we want to adjust for operating leases. As a second multiple valuation approach we have decided to look at EV / Invested capital. In terms of making averages out of the multiples, we have decided to calculate both normal averages and harmonic mean averages of the peers. By using the harmonic mean, we avoid the impact of extreme multiples (for instance Air Berlin’s multiple). Arguably, using a harmonic mean gives the most accurate value estimate in comparison to mean, median and a value-weighted mean (Plenborg et al, 2012; 234).

Liquidation method:

Our assignment will lastly be looking at the value of SAS through a potential liquidation. Every balance sheet item (and off-balance sheet item) will be discussed thoroughly, but this section will build substantially on the assumptions we make. In order to build credibility to our assumptions, we have specifically contacted Henrik Blymke, Head of Credit Research in SEB in Oslo. He has substantial experience and knowledge of valuating SAS, and has, through a 20-minute telephone conversation with us, been able to answer some questions and come up with his thoughts on the most critical assumptions we have made (which we had sent him in advance). On the matters where his opinion has been used to back up our assumptions, we will make a note of it. It should also be noted that we did clarify some matters with regards to the forecasting with him as well, though the main focus of the telephone conversation was the assumptions in relation to the

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Thesis structure

Our thesis structure is summarized in the figure below.

1.5 Demarcation

1.3 Research Question

Our research question states that the valuation will take place on 1 February 2015. This means that we will not incorporate important company events, for instance like strikes or volcanic eruptions, if they were to happen after this date. Also, we have not used quarterly reports after SAS’ annual report of the fiscal year 2013/2014. This is also the case for peers.

On the other hand, there are cases were we have used web pages and reports that have been released after this date. An example would be the peers’ annual reports. They were released in April 2015, but the information regarded the fiscal year of 2014. Another example is when we estimate the value of slot pairs (6.0 Liquidation Method). SAS sold off two slot pairs in February 2015, and we have used the values and information in order to come up with an estimate of the remaining slot-pair values. Still, these types of information does not affect our forecast or our prediction of SAS’ future discounted cash flows in any ways, and we have been consistent in that regard. Therefore, we are keenly aware that we have references that are newer than 1 February 2015.

3.0 Financial Statement Analysis

3.2 The Analytical Balance Sheet and 3.3 The Analytical Income Statement:

In terms of reformulating the financial statements, we are restricted with regards to information. We have no further information than what SAS state in their notes. On some occasions, this means that we have to make assumptions.

3.5 Profitability Analysis:

Firstly, we have decided to analyse SAS’ historical performance from the year 2005. The reason for this is

Figure 4: Thesis structure. Own creation.

1.0 Introduction

1.1 The Airline Industry and

…..Competitors

1.2 Company Presentation 1.3 Research Question and

…..Motivation

1.4 Methodology 1.5 Demarcation

2.0 Strategic Analysis

2.1 PESTEL Analysis 2.2 Supply and Demand 2.3 Porter’s Five Forces Analysis 2.4 Strategic Groups

2.5 Internal Analysis

3.0 Financial Statement Analysis

3.1 Accounting Quality 3.2 The Analytical Balance Sheet 3.3 The Analytical Income Statement 3.4 Introduction of Peer Group 3.5 Profitability Analysis 3.6 Liquidity Analysis 3.7 SWOT 4.0 Forecasting 4.1 Forecasting Period 4.2 Revenue Growth 4.3 Cost Growth

4.4 - 4.11 Misc. Forecasting Items

5.0 Valuation

5.1 Weighted-Average Cost of Capital 5.2 Enterprise Discounted Cash Flow 5.3 Sensitivity Analysis 5.4 Multiple Valuation 6.0 Liquidation Method 6.1 Introduction 6.2 Theoretical Framework 6.3 Assumptions 6.4 Liquidation Analysis

6.5 Conclusion of Liquidation Method

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that we have collected financial data for the last 10 years. The airline industry is driven by long-term

investments in assets like airplanes, which means that we find it necessary to analyse performance over such a substantial amount of years. Secondly, when looking at SAS’ ROIC after tax and comparing it with the historical WACC (Figure 18), we have decided to apply the WACC for the whole airline industry over the past years, as we have not calculated SAS’ WACC for more than at the date of 1 February 2015. Thirdly, as 75% of the total revenue in 2014 stem from Passenger revenues, the emphasis of the revenue drivers in 3.5 Profitability Analysis will be on the passenger operations. The remaining 25% revenues stems from a number of different sources (in fact from 9 different sources). The level and development of these 9

remaining revenue sources will be given more emphasis in 4.0 Forecasting than in 3.5 Profitability Analysis. This will also be the case with certain cost items, which will be “bucketed” together.

3.6 Liquidity Analysis:

When calculating the financial leverage ratio, we decided to leave out Air Berlin in the fiscal years of 2012-2014, due to the fact that they significantly diluted the averages. In fact, in 2013 and 2014 Air Berlin have reported negative equity.

4.0 Forecasting 4.2 Revenue Growth:

Firstly, as with 3.5 Profitability Analysis, we will focus on passenger revenues when it comes to drivers. Secondly, when forecasting the price development, we have decided to estimate them to grow at the inflation rate. The reason for this is that airline companies use advanced algorithms in calculating ticket prices, and it is difficult for us to get more information on their expected pricing policy based on publicly available data (flightfox.com).Therefore, we have assumed that the ticket prices will grow at the inflation rate.

4.3 Cost Growth:

When forecasting the Payroll expenses (which is done in large on expected productivity level and historical level and development of Payroll expenses) it is done on a “as quantitative as we can” approach. It is difficult to know how much a productivity increase will mean in Swedish kroner. Still, we know, based on a peer comparison in 3.5 Profitability Analysis, what monetary level we can expect it to approach. The same is the case with Jet fuel expenses, which is forecasted on the basis of the historical level and development, expected jet kerosene price and technological improvements in the aircraft fleet.

6.0 Liquidation Method

The liquidation method will in large build on several assumptions. Our focus has been on building credibility to our assumptions. We have basically gone about three ways to ensure this. Firstly, we have tried to

establish contact with SAS in both Norway, Sweden and Denmark. We have not been successful in this. Secondly, we have conducted a telephone interview with Henrik Blymke (SEB Oslo). This made our

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assumptions a whole deal more credible. Thirdly, we have used a “puzzle” of different sources in order to back up our assumptions, both from the Bloomberg terminal, SAS’ annual reports and the World-Wide Web. Fourthly, we assume that the liquidation will take 1 of February 2015, even though we use the reported balance sheet numbers from 31 October 2014. This means that we assume that the snapshot of the balance sheet at 31 October remains the same over the time gap. Lastly, when it comes to estimating the off-balance sheet item airport slots, we are restricted in that we do not necessarily know what a reasonable level of these might be.

2.0 Strategic Analysis

A strategic analysis is conducted in line with the fundamental analysis approach in order to identify the non-financial value drivers of the company’s stock (Sørensen, 2012; 17). This strategic analysis is structured into five parts. Firstly, we start off by analysing the macro-environment in which SAS operates in. Secondly, we take a look at the supply and demand picture. Thirdly, we analyse the industry forces at hand. Fourthly, we will look at whether, and in case how, the companies in the industry position themselves into strategic groups. Lastly, we will make an internal analysis of SAS.

From this analysis, we will derive the opportunities and threats in the macro-environment and the strength and weaknesses of SAS as a company.

2.1 PESTEL Analysis

The PESTEL framework is used to analyse the broad macro-environment of organizations, and categorizes environmental influences into six main types; political, economic, socio-cultural, technological,

environmental and legal (Johnson, 2014; 34). The PESTEL framework helps us identify the key value drivers in the macro-environment, which in turn affects the airline industry. These key value drivers are environmental factors that are likely to have a significant impact on the success or failure of a strategy (Johnson, 2014; 36).

Political factors

Political factors highlights the role of government in the airline industry (Johnson, 2014; 34). Historically, political factors have been the most important drivers for change in the airline industry.

Throughout its history, the airline industry has been through many political changes affecting its supply side. In the beginning, the industry was characterised by being highly regulated. However, as stated in 1.1 The Airline Industry and Competitors, it has become more deregulated. Prior to the deregulation, there were around two national airlines operating in Europe territory controlled by state-bilateral arrangements. The introduction of privatization and deregulation in the airline industry have altered how the airline market is organised, leading to increased capacity due to the emergence of low-cost carriers (Cento, 2009; 13). During

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the deregulation, governments started to negotiate traveling agreements. The US-EU “Open Skies” was signed in April 2007 (state.gov). This is a bilateral agreement with the purpose of removing barriers to competition and to give the US and other countries access to forging markets. This establishment has improved conditions for airlines to create alliances, increased freedom from many traditional forms of economic regulations and has enabled airlines to have international routes from their home countries (econlib.org).

Tax regulations and government fees:

Looking forward, there are a few political factors deemed to impact the aviation industry, though not as significantly as the deregulations in the past. These include tax regulations and fees directed at the airline industry in the countries SAS operates in. Both in Sweden and in Portugal a “Green passenger air tax” has been proposed. IATA strongly opposes this, and has estimated that this tax would put as much as 10,000 jobs in Sweden at risk, as well as reducing the GDP contribution from the aviation industry by as much as SEK 6 billion (iata.org; 1). In addition, 12% of SAS’ operating costs consists of Government user fees related to take-off and landing (SAS Annual Report 2013/2014; 19). If the different governments would increase these fees, it would affect SAS’ operations. However, SAS is in active dialog and negotiations with the authorities. In fact, the Government user fees has declined 4,6%, so this particular political factor seems to be under control (SAS Annual Report 2013/2014; 83).

Conflicts/political unrest and terrorist attacks:

Conflicts, wars and terrorist attacks are events that heavily impacts the aviation industry. These events are in their nature hard to predict. At the time of writing, there are a few conflicts that affects SAS in one way or another. The conflict in Ukraine as well as the IS militant group in Iraq affects Europe as a whole, and the development here could be of importance (warsintheworld.com). Fortunately, SAS has been aware of this risk, and been proactive. They have been, and is striving to, transition from a fixed cost base to a variable cost base (SAS Annual Report 2013/2014; 83). This will help them better react and align to extraordinary events.

Due to tax regulations, fees and extraordinary events such as conflicts and terrorist attacks, political factors are considered key drivers for change. The outlook in terms of political forces is fairly good. There have been reductions in government user fees, though the threat of “green passenger air tax” and conflicts in Ukraine and the Middle East is looming ahead.

Economic factors

Economic factors refers to macro-economic trends like exchange rates, business cycles, economic growth rates, etc. (Johnson 2014; 37).

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Growth in air travels and GDP:

Historically, growth in air travels have correlated with trends for gross domestic product (GDP) (IATA’s Industry Outlook Presentation 2014). However, it has been more volatile than the trends in GDP, meaning that air travels grows at twice the pace of GDP, and correspondingly declines at a faster rate than GDP (SAS Annual Report 2012/2013; 21). This means that understanding the economic factors in Scandinavia and Europe is essential in our case.

Looking forward, we see that there is an estimated steady growth in passenger demand as well as in GDP in Europe. Boeing estimates that the real GDP growth in Europe from 2013-2033 will be 1,9%, whereas the growth in airline traffic will be 3,9% (BOEING’s Current Market Outlook 2014-2033). Naturally, these forecasts doesn’t necessarily reflect the future, but the key take away from this is that there is an expected increase in passenger demand, which is good for SAS. This can also be seen from the graph below, which shows that there has been a clear increase in travellers in Scandinavia.

Figure 5: Development and connection between oil price, total profitability in the airline industry, world-wide passenger growth and world-wide GDP. Own creation. Source: IATA; 8 and .imf.org; 1.

55 65 73 99 62 79 111 112 109 101 85 3,5 % 3,2 % -1,0 % 8,9 % _{7,0 %} 2,3 % 1,8 % -16% -11% -6% -1% 4% 9% 14% 0 100 200 300 400 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 E2015

Crude oil price, Brent $/b World economic growth, % Net profit, % margin

Passenger growth, rpk, % European Union economic growth, %

Brent, $/b Growth and

margins Development in important value drivers for the airline industry

Figure 6: Development in travelling passengers from the airports in Scandinavia. Own creation. Source: Euromonitor International database, Passport.

Development in total number of passengers carried by airports in Scandinavia

32 43 28 33 45 28 36 47 29 38 49 31 0 10 20 30 40 50 2011 2012 2013 2014

Sweden Norway Denmark

Number of passengers

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Oil prices:

Jet fuel expenses constitutes 26% of SAS’ operating expenses in 2013/2014. In order to minimize the risk of jet fuel prices rising, SAS hedges 40-80% of its jet fuel consumption for the next 12 months (SAS Annual Report 2013/2014; 52). This is now the company policy (sasgroup.net; 4). The jet fuel price depends in large on the oil price (IATA; 4). The oil price, in turn, is largely affected by the OPEC organization (opec.org). Still, the jet fuel consumption is fairly stable, meaning that changes in the long-term level of oil prices has an important impact for the airline companies. In the beginning of 2015, the oil price nearly halved. However, it is difficult to say whether this is a new sustainable situation for the oil price, but it does leave room for some optimism for 2015 and perhaps 2016. SAS does not intend to change the fuel surcharge on their tickets until they know for sure that the low oil price will be sustainable (Dagens Næringsliv, paper edition).

Interest rate and currency risks:

SAS faces both interest rate and currency risks. SAS uses derivatives for both interest rates with regards to its interest-bearing assets and liabilities, as well as for its currency risk (SAS Annual Report 2013/2014; 52). However, any further analysis of these risks is not depicted out of two reasons. Firstly, we think these risks in large are affected by GDP and the oil price. Secondly, SAS is prominent in managing this risk in terms of hedging.

Due to the correlation between growth in air travels and GDP, intense competition and resulting low ticket prices, as well as the substantial effect of the jet fuel price on operating costs, economic factors are

considered key drivers for change. All in all, the economic conditions are positive for the future of the airline industry, based on positive outlooks for GDP and low oil prices, somewhat offset by intense competition and low ticket prices.

Socio-cultural factors

Socio-cultural factors includes changing cultures and demographics (Johnson 2014; 37).

Billion gallons Development in the oil price, jet fuel price and world-wide jet fuel consumption $/b

65 67 68 70 69 66 69 71 72 73 75 79 38 85 50 100 0 20 40 60 80 100 120 140 160 180 200 0 20 40 60 80 100 120 140 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 E2015

Fuel consumption, billion gallons Crude oil price, Brent $/b Jet kerosene price, $/b

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Among socio-cultural factors, we want to point out three trends that has affected the airline industry in the past, and probably will continue to do so in the future.

More air flights:

People are flying more than before. This is mostly due to the increase in seat capacity as an effect of the rise of LCCs (SAS Annual Report 2013/2014; 4). In addition, 80% of the market growth until 2020 will stem from leisure travels, clearly indicating a trend in the demography (SAS Annual Report 2013/2014; 5). Globalisation:

The world is becoming increasingly international. This means that using airplanes for traveling abroad is becoming more and more normal.

New substitutes:

The emergence of substitutes arising from technology is increasingly becoming a substitute for business travellers. It has become more common in business to use softwares like Skype and WebEx in business meetings and interviews. In spite of this, the number of aviation hours is forecasted to grow by an average of 2,5% per year through 2030 (e360.yale.edu).

Due to the trend in flight travels, especially for leisure travels, increased globalisation and the effect of technological substitutes like Skype and other video-conference softwares, socio-cultural factors are considered key drivers for change. The total trend of the socio-cultural factors outlined here is that there is an increased willingness for air travels.

Technological factors

Technological factors refers to innovations such as the Internet, nano technology, new materials or better aircraft engines (Johnsons, 2014; 37).

Though the technological factors have affected the airline industry significantly in the past, for instance with the auto-pilot function and online ticket sale, future technological trends does not seem to be quite as

substantial. However, more efficient engines as well as increased customer offerings, in terms of on-board Wi-Fi and TV screens, are all technological advancements affecting the aviation industry.

Computer technology:

As mentioned above, video-conference technologies like Skype and WebEx has become, to some extent, a substitute for air flights. However, as 80% of the market growth until 2020 will stem from the leisure segment, this is only a substitute to some extent (SAS Annual Report 2013/2014; 5).

Engine technology:

Aircraft manufacturers offers new aircrafts that require 20% less fuel and maintenance costs compared to SAS’ older aircrafts, while at the same time offering more seats (SAS Annual Report 2012/2013; 11). This

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allows new routes to become profitable, and hence affects the product range. In addition, testing on biofuels and batteries for aircrafts are being made (popularmechanics.com). Achieving such technology, once it is fully develop, can also help airlines answer some of the challenges arising from the environmental forces outlined below.

Due to the strategic implications of fuel efficiency and the historical impact technological factors have had, technological factors are considered key drivers for change. These technological factors seems to offer more possibilities than limitations, and hence the outlook of technological factors on the airline industry is a positive one.

Environmental factors

Environmental factors stands specifically for ‘green’ issues, such as pollution and waste (Johnson, 2014; 37). Emission requirements:

In 2014, all flights in, to and from the European Economic Area (EEA) countries were included in the EU

Emissions Trading System. This means that every flight has to pay a price for the emissions of CO2 it does to

the atmosphere. Aviation emissions is a growing concern. From the graph below it becomes apparent that CO2 emissions grows at the same rate as the fuel consumption. It is estimated that by 2020 global aviation emissions will be 70% higher than in 2005, despite the increase in fuel efficiency in this period

(ec.europa.eu; 1). In other words, keeping greenhouse gas emissions at a low will be of significant importance in the future. The aviation industry has agreed to commit to 1,5% annual fuel efficiency improvement to 2020 as well as a 50% cut in net emissions by 2050 compared to 2005 (IATA; 5). Fortunately, SAS is one step ahead here. SAS’ strategy is to replace older aircrafts with new ones. When SAS replaced the MD-80 aircrafts with the Airbus A320s, emissions per flight reduced by 20% in parallel with 18 additional seats per flight.

65 67 68 70 69 66 69 71 72 73 75 79 619 751 0 100 200 300 400 500 600 700 800 0 20 40 60 80 100 120 140 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 E2015

Fuel consumption, billion gallons CO2 emissions, million tonnes

Fuel consumption in billion gallons

CO2 emissions in million tonnes World-wide fuel consumption and C02 emissions

CAGR 1,8%

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Natural disasters and epidemics:

Due to the climate changes we are facing, we will be facing more extreme weather in the future, including natural disasters (nasa.gov). This impacts the aviation industry, due to disruptions and delays. Also, epidemics have had negative impacts on the demand of flights, as seen in 2003 with the emergence of the SARS epidemics (Cento, 2009; 52). Epidemics and pandemics are hard to predict, but likely to happen again (theguardian.com). Fortunately, as mentioned above, SAS is transitioning from a fixed cost base to a variable cost base, meaning that they can more easily adapt to extraordinary events like these (SAS Annual Report 2013/2014; 83). Still, this is a looming threat for the entire industry.

Due to the effect of emission requirements, natural disasters and epidemics, environmental factors are considered key drivers for change. The overall trend here is that the environmental factors poses quite a few significant challenges that the aviation industry has to consider at any time.

Legal factors

Legal factors concerns changes or constraints in terms of legislative factors (Johnson, 2014; 37). Staffing agencies:

LCCSs like Norwegian Air Shuttle and RyanAir are beginning to use hired labour for its long-haul operations, often stationed outside of their country of origin in order to reduce labour costs

(centreforaviation.com; 1). This also reduces the employees’ job security, giving the airlines increased flexibility. This trend puts even more pressure on network airlines (FSCs like SAS) to cut costs.

Due to the trend of using staffing agencies in low-cost countries, legal factors are considered key drivers for change. In the future, legal factors poses a threat for the airlines, especially network airlines like SAS. All in all, the PESTEL analysis tells us that the macro-environment poses both opportunities and threats. The overall outlook from the political picture, the economic conditions, the socio-cultural trends and the

technological developments is a good one. On the other hand, both environmental and legal factors are looming ahead, posing a few challenges. One of the interesting take-aways from this analysis is that all of the PESTEL factors are key drivers for change, which is quite rare. This means that the airline industry is reactive and sensitive to many factors, yielding a lot of uncertainty.

In conclusion, the years ahead seems to hold relatively good conditions for the airline industry.

2.2 Supply and Demand

In order to fully understand the value drivers in the airline industry it is important to understand the supply and demand picture. Historically, the supply and demand equilibrium has switched substantially, due to forces such as the market deregulation in the 1990s. We will start off by looking at the development in supply and demand from 2005-2014. Then we will outline two scenarios that we consider to be important in

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terms of why the prices are staying at the low level they are today. Lastly, we will elaborate on the price elasticity in the airline industry.

Supply

Supply is characterised by available-seat-kilometres (ASK), which means how many kilometres each available seats are carried. As mentioned in 1.1 The Airline Industry and Competitors, the market

deregulation in the 1990s, the Open Skies agreement between EU and the US, overall intense competition and the boom of the LCCs has significantly boosted the supply side. From the graph below we can see that the world-wide supply of air travels has grown steadily with an annual growth rate of 4,4%.

Demand

Demand is characterised by revenue-passenger-kilometres (RPK), which means how many kilometres each revenue-passengers (paying customers) are carried. From the graph below we can see that the world-wide demand for air travels has grown at a faster pace than the supply (5,1% compared to 4,4%).

Today’s supply-and-demand equilibrium

We see primarily two factors that keeps the air travel prices at a low today. Firstly, unprofitable airlines continue to fly despite years of significant losses, due to the fact that various stakeholders cannot afford to let the airlines close down the business (Investopedia; 2). This means that the airline industry offers a higher

Figure 10: Development in world-wide demand of air travels. Own creation. Source: ICAO’s Economic Development 2013. RPKs in

trillions

YoY growth Development in world-wide passenger demand for air travels

3,9 4,1 4,4 4,5 4,5 4,8 5,1 5,4 5,6 6,1 8% 6% -20% -15% -10% -5% 0% 5% 10% 0 2 4 6 8 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Revenue-Passenger-Kilometres (RPK) Year-on-Year growth

CAGR 5,1%

Figure 9: Development in world-wide supply of air travels. Own creation. Source: ICAO’s Economic Development 2013.

5,2 5,4 5,8 6,0 5,8 6,2 6,6 6,8 7,2 7,7 6% _6% -20% -15% -10% -5% 0% 5% 10% 0 2 4 6 8 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Available-Seat-Kilometres (ASK) Year-on-Year growth

ASK in trillions YoY growth CAGR 4,4%

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capacity than it can really afford, harming the profitable businesses. From a micro-economic perspective, this can be illustrated as in the graph below.

In Figure 11, today’s equilibrium between supply and demand is illustrated in point E1. However, if

unprofitable airlines did not fly and investors realised their losses, the equilibrium would have been in E2,

where prices are higher. Even though the volume of passengers would also be fewer in equilibrium E2, the

already fairly profitable airline companies would increase their load factor. This means that the remaining airlines in the industry as a whole would be more profitable.

Secondly, exogenous supply and demand shifts negatively affects the airline industry (Cento, 2012; 49). Examples of negative demand shifts are the SARS epidemic and terrorist attacks, while examples of negative supply shifts are volcanic eruptions and staff strikes. Such exogenous supply and demand shifts are

temporary in their nature, but their effect can be substantial enough to give airline companies negative annual results. Exogenous demand shifts can be illustrated as in the graph below.

The graph above illustrates how exogenous demand shifts temporarily affects the demand negatively (in the case of volcanic eruptions and staff strikes it would be the supply side that would shift). A new equilibrium

becomes established in E2, where both price and volume is lower. This harms the airline industry negatively

and substantially. Negative supply shifts are not illustrated, as the case is that the supply basically drops to zero, and the airlines that are affected has no operating income, but a lot of fixed costs to cover. An example of this is Air Berlin who delivered negative EBIT in 2010, mostly due to the volcanic eruptions on Iceland that year (Air Berlin Annual Report 2010; 3).

0 1 2 3 4 5 6 1 2 3 4 5 6 Price Volume Supply-and-demand equilibrium due to airlines continuing unprofitable operations

E2

E1

Figure 11: Supply-and-demand equilibrium due to overcapacity in the airline industry due to unprofitable competitors continuing operations. Own creation.

0 1 2 3 4 5 6 1 2 3 4 5 6 Price Volume Supply-and-demand equilibrium due to exogenous demand shift

E2

E1

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Price elasticity

Another important aspect to understand in order to fully grasp the supply and demand picture is price elasticity. The price elasticity expresses how much demand would change in response to an increase or decrease in price.

Passenger demand shows little variance in price elasticity in terms of short- and long-haul routes (IATA’s Economic Briefing 2008; 28). However, there is a substantial difference in price elasticity between business travellers and leisure travellers. In fact, studies have shown that business travellers are less price sensitive than leisure travellers, as business travellers generally has less flexibility to postpone or cancel their travel than leisure travellers (IATA’s Economic Briefing 2008; 6). One study conducted on short-haul routes shows that business travellers have a price elasticity of -0,7, whereas leisure travellers had a price elasticity of -1,5 (which indicates that an increase in price of 10% would result in a demand decrease of 15%).

All in all, the supply and demand picture is one that is characterised by intense competition and

overcapacity. This is much driven by the fact that unprofitable airlines continue to fly because the investors will not realise their losses, as well as occasional negative exogenous demand shifts. This yields a supply-and-demand equilibrium that is unfavourable for the airlines in the industry, but favourable for the end customers.

2.3 Porter’s Five Forces Analysis

Industries vary substantially in terms of their attractiveness. By industry, we mean a group of firms producing goods or services that essentially are the same (Johnson, 2014; 34). An attractive industry structure is one that offers a good profit potential. The Porter’s Five Forces framework helps us assess an industry’s attractiveness in terms of five competitive forces; the threat of entry, the threat of substitutes, the power of buyers, the power of suppliers and competitive rivalry (Johnson, 2014; 42). If the five forces are high, the industry is not attractive to operate in. The industry environment lies within the

macro-environment, and the macro-environment impacts the firm through its effect on the industry.

The Porter’s Five Forces framework has been under constant scrutiny ever since it introduced in 1979. One of the criticism concern the model being static, when in fact the forces might be dynamic. Another criticism relates to the buyer-supplier mentality in the model. Buyers and suppliers are seen as threats that needs to be tackled by the companies, and cooperation with suppliers, for instance, is excluded. In addition, the

framework has been criticised of ignoring the human resource aspect of strategy. Different cultures and management skills are not considered in this model (Lynch, 2009; 101). Ultimately, we think the Porter’s Five Forces framework gives us a good understanding of the forces at hand in the industry. For us, it gives sufficient insight into an industry, and we therefore choose to proceed with this framework.

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In this analysis, the emphasis will fall on the Scandinavian market, as this is SAS’ main focus. Still, today’s globalisation means that every markets are affected by each other and SAS does also have intercontinental operations, so this analysis will touch upon other areas of focus as well.

Competitive rivalry

Competitive rivals are organizations that offer the same products or service and are targeting the same customer group (Johnson, 2014; 41). The higher degree of competitive rivalry, the worse it is for the actors in the industry. Fundamentally, five factors make up the extent of rivalry in an industry, and we will discuss them in the following section.

Competitor balance:

When competitors are much of the same size, there will be more rivalry amongst the competitors (Johnson, 2014; 42). The Scandinavian market is characterised by having two large actors, SAS and Norwegian, sharing more than 50% of the market (see 1.1 The Airline Industry and Competitors). The rest of the actors are small in comparison, but they are numerous. This means that the total capacity of seats in the industry is big. In Europe, the five largest carriers hold 52% of capacity on flights within EU. In comparison, the three largest carriers in North-America hold 82%, indicating a clearly more fragmented market situation in Europe. This has often been called upon to be the reason why the North-American market is a more

profitable one than Europe. The reasons why there has not been more consolidation in Europe is in large that it is easier to do mergers in a single country, European governments prize having an independent flag carrier and U.S.’ bankruptcy regime (ft.com; 1).

Both the European and Scandinavian market is a fragmented one relative to high-profit margin markets like North-America. This indicates a highly rivalrous competition.

Industry growth rate:

In industries with high growth rates (young industries) companies can usually grow with the market, but industries with low growth rates (mature industries) are often characterised by price competition and low profitability (Johnson, 2014; 44). In the next 20 years, the European airline industry is forecasted to have the second lowest compounded annual growth rate in the world of 3,9% (BOEING’s Current Market Outlook 2014-2033). The low growth rate in the European market indicates a rivalrous industry.

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High fixed costs:

Industries with high fixed costs are often more rivalrous, as the actors often seek to reduce their unit costs by increasing the volume, typically by cutting the prices. This leads to a price competition in the industry (Johnson, 2014; 44). The airline industry is characterised as having a high portion of fixed costs. Airlines are expensive assets, and regardless of the operating conditions, the airlines have to make large loan payments or lease payments every month. This means that they often seek to spread their costs by increasing volume. In addition, extra capacity in the airline industry can only be added in fairly large increments, typically creating short-term over-capacity (Johnson 2014; 44). This means that due to the high fixed costs in the industry, this indicates high rivalry in the industry.

High exit barriers:

High barriers to exit typically increases rivalry (Johnson, 2014; 44). As the airline industry is characterised by high fixed costs, there is also naturally high exit barriers. An example of this is how airlines running on a deficit continues to offer cheap flights for several years before going bankrupt, as the stakeholders cannot afford to close the business (Investopedia; 2). Therefore, the barriers to exit are high in the airline industry, indicating a rivalrous industry.

Low differentiation:

Where products are poorly differentiated, rivalry is higher, as the only way to compete is on price (Johnson, 2014; 44). Airlines are increasingly trying to differentiate themselves. They do this by, for instance, offering better customer service, seats that are more comfortable, etc. An example of this is SAS’ cabin upgrades taking place on all long-haul aircrafts (SAS Annual Report 2013/2014; 13). High-definition screens, Wi-Fi and seats that can be reclined are all investments made to differentiate SAS from its competitors. What mostly separates the LCCs from SAS and other flag-ship carriers is customer service and comfort. This

Figure 13: Development in different markets in the next 20 years. Own creation. Source: BOEING’s Current Market Outlook 2014-2033. 1,5 5,2 1,2 2,1 0,9 1,9 0,2 0,6 0,3 1,0 0,1 0,3 6,3 % 2,9 % 3,9 % 6,4 % 6,2 % 5,9 % 5,5 % 3,4 % 3,5 % 5,9 % 5,3 % 6,1 % 0% 1% 2% 3% 4% 5% 6% 7% 0 1 2 3 4 5 6

Asia-Pacific North-America Europe Latin-America Middle-East Africa

RPKs in billions

RPKs and RTKs growth rates in percentages Regional market development, 2013-2033

2013 2033 2013 2033 2013 2033 2013 2033 2013 2033 2013 2033

Revenue passenger-kilometres (RPK) growth rate

Revenue tonne-kilometres (RTK) growth rate

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makes the product offering somewhat heterogeneous, but to a small extent. Overall, the products offered by the different airlines are moderately homogeneous, indicating a moderately rivalrous industry.

After an assessment of the competitor balance, the industry growth rates, the high fixed costs necessary for operating the industry, and the moderately homogeneous products offered, the overall picture of the competitive rivalry in the airline industry is that it is a highly rivalrous industry to operate in, indicating brutal conditions for the actors operating in it.

Threat of entry

The easier it is for new competitor’s to enter the industry, the higher the threat of entry. The higher the threat of entry, the less attractive an industry is (Johnson, 2014; 45). There are five important considerations to make.

Scale and experience:

Once actors in the industry have gained economies of scale and the experience curve in their favour, it is going to be hard to set up a new shop to compete against them (Johnshon, 2014; 44). The airline industry is known to be a capital-intensive industry. Buying an aircraft fleet requires a substantial amount of money, and this creates a high entry barrier. On the other hand, setting up a shop and leasing the aircrafts does take away a lot of that barrier, but it still requires much cash. In addition, the airline industry is highly labour intensive, and the labour is highly unionized, making it difficult to negotiate payroll expenses (avjobs.com). The scale and experience needed in the airline industry indicates a moderate threat of entry.

Access to supply or distribution channels:

The ease at which new players can establish supply or distribution channels is an important determinant when it comes to the threat of entry (Johnson, 2014; 44). In terms of access to supply, access to airplanes would come from one of the two aircraft producers, Airbus or Boeing, or leasing companies. In addition comes acquiring staff and maintenance. In terms of access to distribution, this would be obtaining the right airport slots. Today’s regulations of airport slots promotes access to new entrants (ec.europa.eu; 2). Still, as will be seen in 6.0 Liquidation Method, airport slots costs a significant amount of money. The access to supply or distribution channels moderately increases threat of entry to the industry.

Expected retaliation:

If new actors expect significant retaliation from incumbents, this could be enough to discourage entry (Johnson, 2014; 44). Though the airline industry is known for offering tickets at low prices, this seems to be more due to existing compet

Valuation of SAS Going Concern and Liquidation Perspective Copenhagen Business School, 2015

Copenhagen Business School, 2015

Table of Contents

1.0 Introduction

1.2 Company Presentation

33% 23% 6% 6% 6% 5% 3% 2% 1% 16% SAS Norwegian Ryanair Lufthansa Widerøe Air France-KLM IAG Wizz Air easyJet Other Market shares in Scandinavia, 2014

1.3 Research Question and Motivation

Institutional ownership 30 % Private ownership 20 % State ownership 50 %

1.4 Methodology

1.5 Demarcation

1.0 Introduction

5.0 Valuation

2.0 Strategic Analysis

Crude oil price, Brent $/b World economic growth, % Net profit, % margin

Development in total number of passengers carried by airports in Scandinavia

Billion gallons Development in the oil price, jet fuel price and world-wide jet fuel consumption $/b

Fuel consumption, billion gallons CO2 emissions, million tonnes

2.2 Supply and Demand

trillions

ASK in trillions YoY growth CAGR 4,4%

0 1 2 3 4 5 6 1 2 3 4 5 6 Price Volume Supply-and-demand equilibrium due to airlines continuing unprofitable operations

2.3 Porter’s Five Forces Analysis

Asia-Pacific North-America Europe Latin-America Middle-East Africa