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Copenhagen Business School

Master Thesis

Spring Term 2017

(A Case Study) Name: Said Guraieb Izaguirre (Finance and Investments) Name: Johannes Rossmann (Applied Economics and Finance)

Supervised by: Edward Vali

Submission Date: May 15, 2017

Pages: 120

Characters: 266,422 (incl. spaces)

1

This analysis describes, analyzes, and assesses easyJet and the market it operates in. It proves a statistically

relevant and strong relationship between the highly regulated and capital-intensive top-line (i.e. revenues) growth and the condition of the overall economy (i.e. the GDP

growth rate). It also shows how in an extremely competitive market, that nevertheless has a tendency for

oligopolies on a specific route, abottom-line (i.e. the profit margin) is largely a function

of (i) finding the right place in the value chain, (ii) differentiating services, and (iii) building comparative (cost)

advantages. The analysis of ts business has relative

to peers to cope with (i) weak non-seat revenues and (ii) higher costs, meaning easyJet is facing issues with

respect to both top- and bottom-line. The assessment of easyJets theoretical value follows a present value

approach, based on models looking at discounted cash flows and the economic value added. The results being

challenged by multiple sensitivity analyses. As per reference date (November 15, 2016) and based on the

analyses and assessment of strategy and options, the theoretical value of easyJet comes in at 1,766.44 pence

per share, indicating a premium of 62.5% relative to the corresponding London Stock Exchange closing price

(1,087 pence), however, -BREXIT level, and 6.6% below the -time high (April 13, 2015). Consequently, the analysis and assessment of easyJet

options c.p. indicate: easyJet is better suited relative to its peers than market price suggests and/or that investors

on average assume higher uncertainty and/or make more conservative assumptions regarding its prospective

top- and bottom-line development.

Note: The image on the cover represents one of easyJet's Airbus Sharklet-equipped A320 (Airbus, Photo Gallery, 2017).

2

Acknowledgements

Firstly, we, Said Guraieb Izaguirre and Johannes Rossmann are grateful for the guidance and advice received

from our thesis advisor Edward Vali of Copenhagen Business School. Thank you very much, Edward, for your

support and encouragement, for the time dedicated to our work and, last not least, for your most valued advice

and your comments. Secondly, we would like to thank the second reader for reviewing our thesis. Thirdly, we

extend our gratitude to our families and friends, and we also thank each other for always cooperating smoothly

and with a positive spirit throughout the entire process and for being a friend. Conayct and FUNED, handing

in this thesis I, Said Guraieb Izaguirre, acknowledge your generous offer and prove your incredible gratitude

is rewarded. I sincerely thank you from the bottom of my heart for providing me the opportunity to prove

myself. Furthermore, I would like to thank Edgar and Patricia for their kind support.

Copenhagen, May 15, 2017

Said Guraieb Izaguirre Johannes Rossmann 3

Table of Content

1 INTRODUCTION: FORMING AN OPINION RE EASYǯPTIONS 5

1.1 BACKGROUND 5

1.2 RESEARCH QUESTION 5

1.3 METHODOLOGY 9

1.4 STRUCTURE 9

1.5 DELIMITATIONS 10

2 OUTLINE: EASYJET AND THE AIRLINE INDUSTRY 11

2.1 BUSINESS LAYOUT 11

2.2 SHAREHOLDER ISSUES 12

2.3 CORPORATE GOVERNANCE 13

2.4 BUSINESS SPECIFICS 15

2.5 MARKETING APPROACH 19

2.6 VALUE CHAIN ANALYSIS 21

2.7 OPERATED MARKETS 23

2.8 MARKET SHARE 26

2.9 COMPETITORS 28

2.10 PEER GROUP 29

3 FINANCIAL ANALYSIS: OPERATIONAL PERFORMANCE OF EASYJET AND ITS PEERS 31

3.1 BACKGROUND 31

3.2 INCOME STATEMENT 34

3.3 BALANCE SHEET 36

3.4 OPERATIONAL DRIVERS 37

3.5 TREND AND COMMON SIZE ANALYSIS 42

3.6 PROFITABILITY ANALYSES 45

3.7 ASSET AND LIABILITY RATIOS 52

3.8 LIQUIDITY AND SOLVENCY RATIOS 56

3.9 RED FLAGS AND GOLDEN NUGGETS 59

3.10 PEER GROUP ANALYSIS 60

4 STRATEGIC ANALYSIS: NON-FINANCIAL DRIVERS FOR THE AIRLINE INDUSTRY 61

4.1 BACKGROUND 61

4.2 PESTEL: POLITICAL, ECONOMIC, SOCIAL, TECHNOLOGICAL, ENVIRONMENT, LEGAL ISSUES 61

4.3 PORTERSǯ FIVE: COMPETITION, SUPPLIERS, CUSTOMERS, SUBSTITUTES, RIVALRY 73

4.4 VRIO: VALUE, RARITY, IMITABILITY, ORGANIZATION 77

4.5 SWOT: STRENGTHS, WEAKNESSES, OPPORTUNITIES, THREATS 83

5 ǯǣǯTIVE FINANCIAL STATEMENTS 84

5.1 BACKGROUND 84

5.2 INCOME STATEMENT 84

5.3 BALANCE SHEET 93

5.4 FINANCIAL ANALYSIS 96

5.5 LONG-TERM GROWTH RATE 98

4

Table of Content (cont'd)

6 ǯAIR VALUE: ANSWERING THE RESEARCH QUESTION 99

6.1 BACKGROUND 99

6.2 TRADING AND TRANSACTION MULTIPLES 99

6.3 EVALUATING STRATEGY AND OPTIONS BY DCF 102

6.4 ECONOMIC VALUE ADDED ANALYSIS 108

6.5 TOWS: THREATS, OPPORTUNITIES, WEAKNESSES, STRENGTH ANALYSIS 110

7 ǯ FURTHER ENHANCE VALUE: SCENARIO ANALYSIS 111

7.1 BACKGROUND 111

7.2 SCENARIO 1 : BOOSTING ENTERTAINMENT & RECREATION SALES 111

7.3 SCENARIO 2 : CUTTING BACK COSTS 112

7.4 SCENARIO 3 : PROACTIVELY DEALING WITH BREXIT 113

7.5 RESULTS 116

8 CONCLUSION: MARKETS UNDERESTIMATE EASYJEǯIONS 116

8.1 SUMMARY 117

8.2 MAIN FINDINGS 117

8.3 KEY CHARACTERISTICS 118

8.4 IMPLICIT SHARE PRICE 118

8.5 VALUATION CONSIDERATIONS 119

9 THESIS IN PERSPECTIVE: THEORY HAS LIMITS, BUT HELPS TO FACE THE TRUTH 120

LIST OF REFERENCES 121

TABLE OF TABLES 138

TABLE OF EQUATIONS 140

TABLE OF FIGURES 142

ABBREVIATIONS 144

APPENDIX 148

5

1.1 Background

The airline industry was chosen for this analysis because of its complexity, its strong growth over the recent

decades and its tendency to constantly change. Singling out easyJet was based on its business model, its

innovation focus, and also in light of the increased uncertainties a UK-based airline faces from BREXIT1. GDP

cyclicity and development have a huge impact on the top-line growth of the industry and the individual carriers.

easyJet focuses on enhancing its market share in Europe and especially in countries with the propensity of a

substantial future growth in GDP (in absolute and/or relative numbers), and as fuel accounts for the highest

proportion of the (variable) costs, and oil price fluctuations, therefore, directly impact a carriers bottom-line

(i.e. its profitability) it operates a rather challenging business model. To shelter from its atrocities, all major

airlines tend to hedge their short-term exposure to oil prices and foreign exchange rates. However, protection

against long(er) term changes is not for sale at derivative exchanges and carriers, therefore, they also try to

reduce overall fuel consumption. As the airline industry is very competitive the immediate question arises:

How can an individual carrier differentiate to generate a sustained competitive In its early days the airline industry was dominated by what are today called full-service carriers (FSC), however, low-cost carriers (LCC) emerged and soon cut themselves substantial slices from the

market. Therefore, an analysis of the business models and strategies is imperative to understand and to assess

easyJetcompany specific approach, its performance and competitive edge. To counter competition and

pressure on ticket prices, all airlines try to reduce costs. easyJet, however, has a second angle: it focuses on

innovation to broaden and sustain revenue streams. In this context, it is worth noting that easyJet today is one

of the largest European airlines, and even though it is most commonly placed within the low-cost carrier

segment, it, due to its business model, competes directly with LCC and FSC. easyJet is headquartered in the

Greater London area, therefore, BREXIT will directly affect the company, to which extent and how is not yet

clear. However, the uncertainties triggered, could already be observed in easyJet when it plummeted by 30% following the pro-BREXIT vote.

1.2 Research Question

The analysis aims to look into and assess easyJet options by applying various fundamental

financial and strategic analyses, also regarding markets, competition and peer group, to find out, whether

business model, its hopes, ambitions, options, and market achievements, and, too, whether its

refe 2 share price properly and fairly reflects these findings and to determine whether the

1 The from the European Union (EU) following the referendum on June

23, 2016 with a 53.4% vote for leaving the EU (Hunt & Brian, 2017). The UK government started the process officially on March 29,

2017.

2 All valuations are calculated as per November 15, 2016 (reference date or reference day), the release date of easyJetmost recent

annual report. 6 value of its shares is in line with the market participants views or whether

it could suggest or provide a recommendation to buy or sell the under- or overvalued shares in easyJet.

1.2.1 Problem Statement

Based on the above, the research question or problem statement unfolds as follows: Do easyJetbusiness model and strategy create shareholder value and do its reference date market capitalization and share price fully and fairly reflect its strategic and financial

Before answering the research question, in-depth analyses of the relevant sub-topics are carried out, based on sub-

questions for each of the sections. The findings of the different sections will then lead to the final

conclusion. The following provides an overview of all sections and their respective sub-questions.

1.2.2 Outline: easyJet and the Airline Industry

To provide a base for the financial and strategic analyses, to contribute to a better understanding of easyJet

and the industry, this section positions the company in the airline industry, by providing (i) a brief overview

(history, shareholder and governance issues) and insight in

approach, also analyzing (iv) its value chain proposition, (v) the markets the company operates in, (vi) market

) its peers. Based on this outline, business model,

competitors and peers materialize, and in order to prepare for answering the research question, especially the

following sub-questions are answered in this section: What is easyJet doing and how? How did the company develop? How is it organized and structured?

Which services and products are offered?

doing? and where are they to be found? How do the

1.2.3 Financial Analysis: Operational Performance of easyJet and its Peers

Following the outline, the financial analysis provides detailed insights into the operational performance of

easyJet regarding: (i) income statement, (ii) balance sheet, (iii) value, (iv) revenue, and (v) cost drivers, (vi)

profitability, (vii) assets and liabilities, (viii) liquidity and solvency ratios3, as well as (ix) red flags and golden

nuggets, also in (x) comparison with its peers4. The analysis covers one business cycle of the airline industry,

which according to academic literature and findings comprises a minimum of seven years (Liehr, Groesler,

Klein, & Milling, 2001), in order to avoid overlooking issues, that only occur in certain phases of the cycle,

3 Financial ratios, such as profitability ratios, are fundamental when it comes to evaluating a business and its performance. As these

ratios are industry specific, the analysis responds to economic characteristics of the airline industry (Petersen & Plenborg, 2012).

However, more important than the analysis of numbers, is the interpretation and evaluation of the results (Stepanyan, 2014).

4 s too (Soliman, 2008). 7

e.g. when the number of aircraft operated is increased extraordinarily strong to answer perceived market

potential5. Consequently, the review period, i.e. the seven years the financial analysis refers to, comprises the

years from 2010 to 2016 (both years included). The financial analysis, the trends identified here and in the

strategic analysis will shape the model forecast and thus lay the foundation for answering the research question.

Based on this and in order to prepare for answering the research question, especially the following sub-

questions are answered in this section: did the financial performance of easyJet and its peers develop over the review period6? Have the companies been profitable over the entire review period/in each and every review year? How did easyJet perform relative to its peers? Is it financially healthy enough for investments improving profitability further? How do profit and loss accounts react when varying industry specific drivers?

1.2.4 Strategic Analysis: Non-financial Drivers for the Airline Industry

The strategic analysis leads to non-financial aspects that impact

performance. They are drilled down by (i) a PESTEL approach (referring to external political, economic,

uch as

competition, suppliers, customers, substitutes, and rivalry), (iii) a VRIO analysis (related to internal

considerations regarding value, rarity, imitability, and organizational topics), and (vi) concluding a SWOT

gths, weaknesses, opportunities, and threats). The issues identified in the

strategic analysis and in financial analysis will later shape the model forecast and thus lay the foundation for

answering the research question. Based on this and in order to prepare for answering the research question,

especially the following sub-questions are answered in this section: s

relative to its peers? What are the most important external and internal factors affecting the industry?

How are the global and the regional airline markets structured (e.g. in terms of players and customers)?

What is the potential impact of BREXIT and how can easyJet pro-actively react? What trends can historically be observed in the industry? What is the foundation laid for the future?

5 easyJet for instance, once took 16 new aircraft on in one year, compared to the long-term average of 10 p.a. (calculated over the entire

extraordinary

high training and/or integration costs), that may force misleading conclusions, if only this specific year is looked at.

6 The review period, i.e. the seven years (i.e. review years) the historic review refers to, comprises the years 2010 to 2016 (both years

included). 8 The findings from the financial and the strategic analyses, from the assessment of easy options are used to s years7, namely: (i) income

statements (including a Monte Carlo simulation regarding fuel costs/oil prices) and (ii) balance sheets, (iii)

preparing for a financial analysi -term growth rate. The projections are 8. Based on this, and in order to prepare for

answering the research question, especially the following sub-questions are answered in this section:

How can easyJet perform in the future, based on its business model and the industry and the European

market? What happens if the model input (i.e. the forecasts) turns out to not be met later? What is a

reasonable long- to be applied for easyJet, based on what can be observed today in the debt and equity markets?

Building

is reviewed based on: (i) trading and transaction multiples, (ii) a discounted cash flow (DCF) model, (iii) a

model referring to the economic value added (EVA), and (iv) a threat, opportunities, weaknesses, and strength

analysis. All four assessing

sensitivity analyses where appropriate9. Based on this, and in order to prepare for answering the research

question, especially the following sub-questions are answered in this section:

true and fair price of a share equal to as per reference date and according to the valuation model and

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