Current Financial Position of JetBlue - Case Study Example

Introduction In February 1999, founder David Neeleman announced his plans to launch JetBlue Airlines and within a span of a year, JetBlue started operations with its inaugural flight between Fort Lauderdale and the John F Kennedy airport. (JetBlue, 2009) Within the span of three years, JetBlue expanded its fleet to 44 aircrafts and signed deals worth $6.8 billion in order to increase its aircraft strength by 207 planes. The financing arrangements for the 44 aircraft, currently operational were as follows: 22 aircrafts were secured on the basis of operating leases while 22 had been bought with secured debt financing and were owned by JetBlue. The current scenario differs from the previous situation where, additional capital was required not only to but aircrafts but also to finance its short term obligations, to add strength to its balance sheet in terms of increased number of assets when the airline would be spending heavily on interest payments. The interest payments would not show on the balance sheet while the increased assets would, making JetBlue look like a viable investment opportunity. Thus a decision needs to be made on the mode of financing that will lend strength to JetBlue's capital structure. However before analyzing the options of financing and recommending the most suitable alternative, it is imperative hat the current situation of the company be analyzed so that the structure can be evaluated for the option most suitable to it. Current Financial Position To evaluate the current financial position based on the published data, the company will be evalaluated based on its profitability, its financial strength, the adequacy of its cash flows and its leverage and relationship between the fixed and variable costs of operating the airline. On the basis of profitability, assuming that salaries and related costs along with fuel are variable costs, JetBlue's contribution margin ratio indicates that the contribution of revenue to variable costs was 52% in 2000, 61% in 2001, and 62% in 2002 and by 64% in the first half of 2003. However, a more detailed look at the profitability indicates that the operating margin, which considers the contribution of revenue to total operating costs, is much lower. In fact, operating costs were higher than revenue in 2000. But this is because the revenue earnings of the airline were much lower in 2000, than in consequent years. The shortfall in revenue and its failure to cover operating costs can be attributed to the fact that the airline had just started and customers, wary of trying out a new airline might have preferred travelling on the older airlines. Moreover the airline might not have had the proper connections and incentives in place for travel agents, which it covered for in later periods, leading to an increase in sales revenues. Comparing operating and contribution margin, an analysis of the two indicates that fixed costs account for a large portion of the airlines costs. The operating margins for the years 2000, 2001, 2002 and half year ended June 2003 were -20%, 8%, 17% and 18% respectively, indicating that fixed costs pulled down the profit amounts. The graph below illustrates the Net Profit Margin, before and after taxes and shows the impact that tax has on the net profit margin. As it can be observed, taxes pull down the net profit margin in periods where there is revenue growth but in periods where there is a loss the tax waivers do not further the losses. However the taxes when carried forward in the next year increase the difference in before and after tax margins, the consequent year remedies this. Upon further scrutiny we can observe that the return on assets (ROA) for JetBlue has been positive from 2001 onwards, with a -6% return in the starting year. For the rest of the periods return on assets was 6%, 7% and 3% (till June 2003). The returns on investment (ROI) were much higher than the returns on assets, being 24%, 23% and 10% in 2001, 2002 and half year ended June 2003 while negative returns were posted in the initial year of operations. Elaborating further, the return on assets analyses the efficacy with which the company has been able to invest the money in the company's assets and how efficient assets have been in generating profits. In this case the return on assets was adequate in 2001 and 2002 but it fell to 10% in the first half of 2003. This is because the returns did not rise in line with the increase in assets. From December 2002 to June 2003, income fell by 50% whereas assets rose by 14% which led to low returns on investment. In the upcoming years, assets will increase by a significant amount and profits will have to be in line with the increase in order to maintain profitability. With regards to competitor's returns for the same period, considering Southwest Airlines as JetBlue's main competitor, the ROA was 9.79%, 6.53%, 2.68 % and 4.69% for the years 2000 to 2003. (Morning Star Inc., 2009) this indicates that the return on assets for JetBlue were higher than competitor's average. Comparing the ROI for the two airlines Southwest had returns of 19.19% in 2000, 13.69% in 2001, 5.71% in 2002 and 9.33% 2003. This again indicates that JetBlue's ROI, other than in its initial year was more than its main competitors'. The times interest ration measures the extent to which income can pay interest payments. In the case of jet blue the ratio indicates that in 2000 the interest payments could not be covered at all. In fact they were much higher than income. In consequent years this ration increased to 11.7, 6.29 and 8.34 times respectively. The times interest earned ratio is a good measure of indicating whether or not the firm will be able to meet its long term liabilities. In the case of JetBlue, in years other than 2000, JetBlue can be seen to be able to pay of its interest payments obligations. This also means that the firm is less vulnerable to increases in interest rates in the future, and it bodes well for the company as the future indicates that it might need to take more loans to finance its obligations. In order to assess the company fully it is also important to consider the strength of the firm's cash flows and the financial strength of the company and compare it to the main contender in the market to evaluate how much better or worse Jetblue is. The company's quick ratio is 0.89, 1.02, 1.27 and 1.23 respectively which means that the current assets are barely sufficient to cover the current and short term obligations. In comparison the current ratios for Southwest are 0.51, 0.05, 1.39 and 1.16 for the years 2000-2003 inclusive. (Morning Star Inc., 2009). This means that Southwest is in a similar position and this could indicate an industry trend for airlines where their current assets are generally less. The inventories for airlines are generally minimal and that is the reason why the quick ratio has been considered rather than the current as the difference between the two is minimal. Considering the debt to total assets ratio for financial strength we can see that the ratio of long term debt to total assets is 1:2 where assets cover nearly double the amount of the long term debt in 2000 and this ratio has been more or less maintained being 0.53, 0.54 and 0.53 in consequent periods. However the debt to equity ratio is 1.54, 2.00, 1.80 and 1.73 which means that debt is at least 1.5-2 times more in value than equity. Thus the capital structure indicates more debt and less equity capital. Comparing to Southwest Airlines the debt to equity ratio for the years 2000-2003 is 0.22, 0.33, 0.35 and 0.26 respectively, implying that Southwest has more equity capital than debt. This means that the capital structure is such that it has more equity capital than debt in its structure. While this may mean less interest payments, but it also means diluted ownership of the company for shareholders. Further the risk of being unable to meet creditors demands increases and it can restrict the management by imposing restrictions on the actions a business takes as it affects the solvency of the firm. Taking into view the cash flow of the company, according to Dummies.com: Because cash is really the lifeblood of a business, financial strength assessments typically look at cash and cash flow ratios. But there's a hidden agenda behind these ratios: to assess earnings quality. (Dummies.com Website, 2009) There are two ratios that can serve the purpose of assessing the cash position of the company, the cash flow to earnings and the overall cash flow ratios. In case of JetBlue, the cash flow to earnings ratio was -0.13, 2.89, 3.94 and 4.7 from 2000-2002 and half year 2003 respectively. This indicates that income was greater than cash inflow in all the years except the first year and it kept on increasing. This indicates that the net income is not entirely converted to cash but is put to financing and investment use. While the cash flow to earnings ratio measures the net income as a ratio of cash flow, according to Dummies.com: The overall cash flow ratio tells whether a business is generating enough cash from its business to sustain itself, grow, and return capital to its owners. (Dummies.com Website, 2009). In case of JetBlue, the overall cash flow ratios indicate that the cash inflow from operating activities is being used to finance and invest in the business further. The figures for JetBlue indicate that in 2000 1% of the income from operations was being invested or used in financing the business further while, over the other years this percentage increased to 32%, 25% and 33% respectively. This means that the company is investing its money more rather than converting it into cash which does not yield any further returns. However it is also to be noted that if the entire amount is invested or used in financing activities, the company will not have enough cash at hand to meet day to day expenses which will create hurdles for business operations. Again, according to Dummies.com: If the overall cash flow ratio is greater than 1, the company is generating enough cash internally to cover business needs. If it's less than 1, the company is going to capital markets or is selling assets to keep afloat. It's best when cash flows march in step with or exceed earnings. If earnings increase without a corresponding increase in cash flow, earnings quality comes into question. (Dummies.com Website, 2009) Considering the firm's leverage, according to Bizwiz Consulting.com The operating leverage reflects the extent to which a change in sales affects earnings. A high operating leverage ratio, with a highly elastic product demand, will cause sharp earnings fluctuations. (Bizwiz Consulting Website, 2009). The operating leverage measures sensitivity of earnings to sales. Its is more or less similar to elasticity. If the operating leverage is high sales affects earnings to a greater degree while if operating leverage is low, the earning are impacted to a lesser degree with respect to any changes in sales. A high operating leverage bodes well when sales are increasing and earnings register a greater increase; however, when sales are decreasing the earnings decline by a greater percentage making the firm a riskier investment. If on the other hand the operating leverage is low, an increase in sales increases earnings by a small amount and while sales are decreasing, earnings fall less, hence the firm is a les risky investment. In case of JetBlue, the operating leverage is -1.53 for 2000-2001, 1.34 for 2001-2002 and 0.93 from December 2002 till June 2003. For perspective the operating leverage for Southwest is 2.24, 2.02 and 1.96. hence JetBlue's leverage is lower than that of Southwest making JetBlue a less risky investment. To study the leverage further, the degree of operating leverage (DOL) is also taken into account where the contribution margin is seen as a percentage of net operating income. This also measures the relationship between fixed and variable costs where the contribution margin is revenue net of variable costs and net operating profit is net of all fixed and variable costs. In case of JetBlue, the DOL is -2.55, 7.24, 3.78 and 3.55 for 2000-2003. This means that the company in the initial year revenue was not able to cover variable costs however; in 2001 the contribution margin was 7.24 times more than operating income this means that fixed costs were more than variable costs but the immensity of the increase went down in 2002 and till June 2003. To further enlighten the relationship between variable and fixed costs, the ratio of variable to fixed costs over the years has been 67%, 76%, 82% and 78%. Moreover, as a percentage of total operating cost, historically variable costs have formed an average of 43% of total operating costs. The reasons as to why the company has been able to maintain its low operating costs are first, that it has served at airports which did not have high aircraft traffic and hence the charges there are lower. Secondly, it has used smaller fuel efficient aircraft and has managed to save on fuel costs. Third, it has been able to save on aircraft rent as it owns half the fleet of the planes it operates. Finally, it has been able to save on maintenance and repair costs as it uses new jets as a policy. Hedging Against Rising Fuel Costs The company is faced with the situation where fuel costs are raising everyday and the volatile situation in harming the operating costs of the company. There are several methods in which an airline can hedge against fuel costs. According to the Associated Press: Airlines can hedge in several ways, making financial transactions with banks, energy companies or other trading partners. They can buy contracts for crude oil or unleaded gasoline, and reap a gain if prices rise, offsetting the higher cost of jet fuel. They can buy a "call option" that gives them the right to buy fuel at a certain price. They can also use collar hedges, a combination of rights to buy and sell at set prices ("call" and "put" options). Collars provide protection from a decline in prices but less upside if prices rise. (Airlines Hedge Against Soaring Fuel Costs, 2008) Fuel hedging has long been carried out in the airline industry where operating costs are highly dependent on energy costs and any variation in the market pricing can lead to a massive decline in profits. Considering the option presented above, financial transactions with lending institutions entails detailed legal contracts where the company gets the trading partner or the bank to procure fuel and the amount which is fixed at the date of agreement is then paid by the airline. In case of contracts with energy companies, the airline makes a contract with the energy company to buy fuel at an agreed price at a previously agreed upon date, regardless of what the market price is at the time of purchase. A contract made by another company with the energy companies can be bought and then if market prices rise, the contract can be sold to another party at a profit. Even if it is not sold he fuel can be bought at a cheaper price via the contract. Swap options are also used by airlines to protect against speculated oil increases. The airline and the trader agree upon a date and price for fuel when they will buy and sell the fuel. Both sides speculate a worthy rate and agree. It is risky and has been likened to gambling where the future rate might exceed or be below the value agreed upon in the swap at the date the agreement is fixed for. If the price on the date is lower, the Airline looses as it would have been able to buy fuel at a lower price if it was not bound by the agreement. In case the rate is higher, the Airline profits from being able to buy fuel at lower rates due to the contract. This option should be exercised with caution and a portion of fuel needs can be secured through such an agreement, whereas other methods as discussed above can also be used in conjunction with the swap contract. Consideration of the Two Financing Options Given the above discussion on the firm's profitability, the options of raising additional finance should be viewed in consideration of various factors including: the impact of rising fuel prices, the dilution effects, the cost of capital, flotation costs and the ability of the firm to secure more debt. The impact of rising fuel costs will increase the variable costs significantly given that the firm is looking to expand its fleet significantly. The fuel costs can be hedged against, but keeping in view the market conditions one can assume that the costs will be facing a rising trend and the entire aviation industry is bound to suffer from the after effects. In considering the dilution effects, in case of issuing convertible debentures, the firm will have more dilution effects where the option of converting debt into stock will be available to all debt certificate holders. However one should also consider that the company does not plan to issue dividends and this could encourage the debt holders to hold on to the convertible debentures to get fixed income rather than relying on future dividends. Although the convertible stock will be convertible to shares at $63.75 per share which is higher than the current market rate of $41.98 per share, the lack of dividends could be a put off for many long term investors. Considering the issue of equity capital first, as no cash dividend has been paid and will be paid, we can assume that the cost of the issue will be its flotation costs at $3591250. The number of shares outstanding will go up to 66,953,818 via the issue but the shares will be issued at $0.52 per share higher than market value. This issue will raise $110.5 million. Therefore the cost of capital will be 3% which is the flotation cost. Considering the case of issuing convertible debentures, with a par value of $1000 and 3.5% paid over 30 years, a debenture holder will save $2806.79 which means that the company will be spending $421,019,055 in terms of interest payments. The issue will raise an additional capital of $150 million. The cost of debt in this case is 3.5% paid annually for 30 years. With regards to the current financing arrangements, going by the financial forecast prepared by Morgan Stanley, which takes the current mode of conducting business as the assumption behind its forecasts, the aircraft fuel and rent expenses will be increasing. As a portion of available seat miles, salaries and wages will increase from 1.96% to 2.1% from 2003 to 2005, whereas aircraft fuel, though rising in absolute terms will fall from 1.04% to 0.91 %. Similarly aircraft rent will fall from 0.46 to 0.43%. Overall the operating expenses as a percentage of ASM will increase minutely from 6.06% to 6.13%. In 2002 the earnings per share were $1.63 for a total of 64353818.outstanding shares whereas in accordance with the projections. In considering the earnings per shares based on the projections, if the additional shares are issued the earnings per share will fall in 2003 from $2.76 to $2.65, from $3.91 to $3.77 in 2004 and $5.18 to $4.98 in 2005. This is assuming that no further capital will be issued in the upcoming years and provided that all the shares are taken up by the market upon issue. On the other hand, based on the same revenue and expense projections the interest payments will be $5250000, $5433750 and $5623931 from 2003-2005. Conclusion Taking both the scenarios into view, I would recommend that option 1 of issuing equity be preferred. This is because, not only are the costs of issuance less than that of debt being 3%, the fact the company will be safe from making fixed interest payments when in fact it will be needing the cash to pay off its aircraft suppliers. The company could continue in its current financing capacity of operating lease and outright purchase of planes in a 1:1 ratio as it is currently doing, but given that the fleet will be tripled in a span of 7 years, gives little hope that revenues will be able to generate enough money to finance ownership of these planes. Considering also that banks and lending institutions could be approached, the loans will be more expensive than issuing debentures. Moreover banks will regulate the company's affairs as a single creditor lending all the money will have more power than many debenture holders who usually do not have a right to interfere in company affairs unless the situation is dire. Therefore an equity issue seems like the best choice at this time as the earnings per share are expected to increase and an issue of 2600,000 more shares will not affect the earnings per share as indicated by the above figure. Moreover, the equity issue, with no dividends paid at the current moment seems to be a deterrent in the absorption of shares by the investors, JetBlue sound profitability and low operating costs indicate that the company will be able to pay dividends in the future. Also the fact that JetBlue has been able to have lower costs where its peers have not, will make the company appear more viable as an investment in the industry. References JetBlue Website. Our History. [Online](updated 2009) Available at: http://www.jetblue.com/about/ourcompany/history/about_ourhistory.html [Accessed 24 February 2009]. Bizwiz Consulting Website. Profitability raio calculation. [online] (updated 2009) Available at: http://www.bizwiz.ca/profitability_ratio_calculation_formulas/times_interest_earned_ratio.html [Accessed 24 February 2009] Dummies website. Financial strength ratios for investment analysis. [Online](updated 2009) Available at: http://www.dummies.com/how-to/content/financial-strength-ratios-for-investment-analysis.html [Accessed 24 February 2009] Business Dictionary Website. Earnings per Share. [Online] (updated 2008) Available at: http://www.businessdictionary.com/definition/earnings-per-share-EPS.html [Accessed 24 February 2009] Morning Star Website. LUV: Southwest Airlines [Online] (updated 2009) Available at: http://quicktake.morningstar.com/StockNet/FinancialHealth10.aspxCountry=USA&Symbol=LUV [Accessed 24 February 2009] Tsao, Amy 2003, 'Too High at JetBlue and Southwest', BusinessWeek, 14 October, viewed 24 February 2009. Read More