Problem

Long-Term Solvency Risk: Southwest and Lufthansa Airlines

The first decade of the 21st century witnessed a flurry of losses, bankruptcies, acquisitions, and strategic partnerships in the airline industry. The heavily levered firms in the industry are particularly susceptible to increases in fuel prices, economic changes that affect travel, and safety concerns. These conditions require you to have a strong understanding of the long-term solvency risk of firms in the airline industry.

Two of the larger liabilities of airlines relate to promises to provide free flights to customers (frequent-flyer programs) and promises to make cash payments under flight equipment and ground facilities agreements. The former liability is captured in the total liabilities to assets ratio. The latter promise is captured in the total liabilities to assets ratio and in the long-term debt to shareholders' equity ratio, but only if the promises are treated as long-term debt.

Exhibits 7.23 to 7.28 present the income statements, balance sheets, and other key information for U.S. airline Southwest, which prepares financial statements under U.S. GAAP, and German airline Lufthansa, which prepares financial statements under IFRS.

REQUIRED

a. Using the information in the exhibits, provide a comprehensive and detailed comparison of the long-term solvency risk of Southwest to Lufthansa as of December 31, 2008, and as of December 31, 2007. (Ignore tax effects. Deferred taxes are covered in Chapter 8 on operating activities.)

(1) Consider the following ratios in your analysis:

Operating Cash Flow to Average Total Liabilities Ratio = Operating Cash Flow/ AverageTotal Liabilities

Interest Coverage Ratio (cash basis) = (Operating Cash Flow + Interest Paid + Taxes Paid)/Interest Paid

(2) Compute the ratios using financial information (a) as reported and (b) after capitalization of operating leases. (Hint: Adjusting operating cash flow for assumed lease capitalization requires the removal of rent paid from operating cash flows and the inclusion of interest paid in operating cash flows. Use rent expense and interest expense to approximate rent paid and interest paid, respectively.

b. An analyst who compares the debt ratios of firms under U.S. GAAP and IFRS must consider key differences in the two sets of standards related to convertible debt and troubled debt restructurings. In general, which system would most likely yield lower debt and higher equity? Explain.

Exhibit 7.23

Southwest Airlines Co.

Consolidated Balance Sheet (in millions, except share data)

Exhibit 7.24

Southwest Airlines Co.

Consolidated Statement of Income (in millions, except per-share amounts)

Exhibit 7.25

Southwest Airlines Co.

Additional Data from December 31, 2008, 10-K Filing

From 2008 Note 8 (Leases)

... Total rental expense for operating leases, both aircraft and other, charged to operations in 2008, 2007, and 2006 was $527 million, $469 million, and $433 million, respectively. The majority of the Companys terminal operations space as well as 82 aircraft were under operating leases at December 31, 2008. Future minimum lease payments under capital leases and noncancelable operating leases with initial or remaining terms in excess of one year at December 31, 2008, are provided in the following table.

From 2007 Note 8 (Leases)

Total rental expense for operating leases, both aircraft and other, charged to operations in 2007, 2006, and 2005 was $469 million, $433 million, and $409 million, respectively. The majority of the Companys terminal operations space as well as 86 aircraft were under operating leases at December 31, 2007. Future minimum lease payments under capital leases and noncancelable operating leases with initial or remaining terms in excess of one year at December 31, 2007, are provided in the following table.

Exhibit 7.26

Lufthansa Consolidated Balance Sheet as of 31 December 2008

Exhibit 7.27

Lufthansa Consolidated Income Statement for the 2008 Financial Year

Exhibit 7.28

Lufthansa

Additional Data December 31, 2008, from Annual Report

Operating leases

In addition to the finance leases, a large number of leases have been signed which, on the basis of their economic parameters, are qualified as operating leases, i.e., the leased asset is deemed to belong to the lessor. As well as 106 additional aircraft on operating leases, these are mainly aircraft leased as part of the Lufthansa Regional concept and leases for buildings.

The operating leases for aircraft have a term of between one and nine years. These agreements generally end automatically after the term has expired, but there is sometimes an option for extending the agreement.

The leases for buildings generally run for up to 25 years. The fixtures at the airports in Frankfurt and Munich are leased for 30 years.

The following payments are due in the years ahead (amounts in millions; p.a. denotes per annum):

In the previous year the following figures were given for operating leases:

Liabilities to Assets Ratio = Total Liabilities/Total Assets Long-Term Debt to Shareholders' Equity Ratio = Long-Term Debt/ Total Shareholders' Equity ASSETS Current assets: Cash and cash equivalents Short-term investments Accounts and other receivables Inventories of parts and supplies, at cost Fuel derivative contracts Deferred income taxes Prepaid expenses and other current assets Total current assets Property and equipment, at cost: Flight equipment Ground property and equipment Deposits on flight equipment purchase contracts Less allowance for depreciation and amortization Other assets \begin{tabular}{rr} $1,368 & $2,213 \\ 435 & 566 \\ 209 & 279 \\ 203 & 259 \\ - & 1,069 \\ 365 & - \\ 313 & 57 \\ \hline 2,893 & 4,443 \\ 13,722 & 13,019 \\ 1,769 & 1,515 \\ 380 & 626 \\ \hline 15,871 & 15,160 \\ 4,831 & 4,286 \\ \hline 11,040 & 10,874 \\ 375 & 1,455 \\ \hline$14,308 & $16,772 \\ \hline \end{tabular} LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued liabilities Air traffic liability Current maturities of long-term debt Total current liabilities Long-term debt less current maturities Deferred income taxes Deferred gains from sale and leaseback of aircraft Other deferred liabilities \begin{tabular}{rr} $668 & $59 \\ 1,012 & 3,107 \\ 963 & 931 \\ 163 & 41 \\ \hline 2,806 & 4,838 \\ 3,498 & 2,050 \\ 1,904 & 2,535 \\ 105 & 106 \\ 1,042 & 302 \end{tabular} Commitments and contingencies Stockholders' equity: Common stock, $1.00 par value: 2,000,000,000 shares authorized; 807,611,634 shares issued in 2008 and 2007 Capital in excess of par value Retained earnings Accumulated other comprehensive income (loss) Treasury stock, at cost 67,619,062 and 72,814,104 shares in 2008 and 2007, respectively Totol sts-bhalidere' enping See accompanying notes. Souroe Southwest Airlines Co, form 10-K for the Fiscal Year Ended December 31, 2008. Years Ended December 31, OPERATING REVENUES; Soarce: Southwest Aulines Co. Fann 10-K far the Fiscal Year Lnded December 31, 2000. From Consolidated Statement of Cash Flows (in millions): Net cash provided by (used in) operating activities Interest paid Income taxes 2008${1,521)$100$712007$2,845$63$94 in millions 2009 2010 2011 2012 2013 After 2013 Total minimum lease payments Less amount representing interest Present value of minimum lease payments Less current portion Long-term portion \begin{tabular}{lcc} in millions & Capital Leases & Operating Leases \\ 2008 & $16 & $400 \\ 2009 & 17 & 335 \\ 2010 & 15 & 298 \\ 2011 & 12 & 235 \\ 2012 & - & 195 \\ After 2012 & - & 876 \\ Total minimum lease payments & 60 & $2,339 \\ \hline \end{tabular} Less amount representing interest Present value of minimum lease payments Less current portion Long-term portion Source: Southwest Airlines Co., Form 10-K for the Fiscal Year Ended December 31, 2008. *incl. goodwill. Source: Lufthansa Group, Annual Repont for the Fiscal Year Ended December 31, 2008 . Traffic revenue Other revenue Total revenue \begin{tabular}{lrr} Notes & 2008 & 2007 \\ 3) & 19,998 & 17,568 \\ 4) & 4,872 & 4,852 \\ \hline & 24,870 & 22,420 \end{tabular} Changes in inventories and work performed by the enterprise and capitalised Other operating income Cost of materials and services Staff costs Depreciation, amortisation and impairment Other operating expenses Profit from operating activities \begin{tabular}{rrr} 5) & 178 & 119 \\ 6) & 1,969 & 1,571 \\ 7) & (13,707) & (11,553) \\ 8) & (5,692) & (5,498) \\ 9) & (1,289) & (1,204) \\ 10) & (4,946) & (4,269) \\ \hline \end{tabular} Result of equity investments accounted for using the equity method 11) Result from other equity investments Interest income 11)12)42202131177 Interest expense 12) Other financial items 13) Financial result Profit before income taxes Income taxes 14) Profit from continuing operations \begin{tabular}{cr} (22) & 223 \\ 42 & 131 \\ 202 & 177 \\ (374) & (371) \\ (427) & (133) \\ \hline(579) & 27 \\ 804 & 1,613 \\ (195) & (356) \\ 609 & 1,257 \end{tabular} Profit from the discontinued Leisure Travel segment 15) Profit after income taxes Minority interests Net profit attributable to shareholders of Lufthansa AG Basic earnings per share in E 16) Diluted earnings per share in 16) Source: Lufthansa Group, Annual Report for the Fiscal Year Ended December 31, 2008. From Consolidated Statement of Cash Flows (In m ): Net cash provided by (used in) operating activities Net interest paid Income taxes 12) Net interest Net Interest \begin{tabular}{lrr} In em & 2008 \\ & 11 & 2007 \\ Income from other securities and financial loans & 113 \\ Other interest and similar income & 191 \\ \hline Interest income & 202 & 177 \\ Interest expenses on pensions obligations & (119) \\ Interest expense on other provisions & (16) \\ Interest and other similar expenses & (239) \\ \hline Interest expenses & (208) \\ \hline \end{tabular} Liabilities to Assets Ratio = Total Liabilities/Total Assets Long-Term Debt to Shareholders' Equity Ratio = Long-Term Debt/ Total Shareholders' Equity ASSETS Current assets: Cash and cash equivalents Short-term investments Accounts and other receivables Inventories of parts and supplies, at cost Fuel derivative contracts Deferred income taxes Prepaid expenses and other current assets Total current assets Property and equipment, at cost: Flight equipment Ground property and equipment Deposits on flight equipment purchase contracts Less allowance for depreciation and amortization Other assets \begin{tabular}{rr} $1,368 & $2,213 \\ 435 & 566 \\ 209 & 279 \\ 203 & 259 \\ - & 1,069 \\ 365 & - \\ 313 & 57 \\ \hline 2,893 & 4,443 \\ 13,722 & 13,019 \\ 1,769 & 1,515 \\ 380 & 626 \\ \hline 15,871 & 15,160 \\ 4,831 & 4,286 \\ \hline 11,040 & 10,874 \\ 375 & 1,455 \\ \hline$14,308 & $16,772 \\ \hline \end{tabular} LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued liabilities Air traffic liability Current maturities of long-term debt Total current liabilities Long-term debt less current maturities Deferred income taxes Deferred gains from sale and leaseback of aircraft Other deferred liabilities \begin{tabular}{rr} $668 & $59 \\ 1,012 & 3,107 \\ 963 & 931 \\ 163 & 41 \\ \hline 2,806 & 4,838 \\ 3,498 & 2,050 \\ 1,904 & 2,535 \\ 105 & 106 \\ 1,042 & 302 \end{tabular} Commitments and contingencies Stockholders' equity: Common stock, $1.00 par value: 2,000,000,000 shares authorized; 807,611,634 shares issued in 2008 and 2007 Capital in excess of par value Retained earnings Accumulated other comprehensive income (loss) Treasury stock, at cost 67,619,062 and 72,814,104 shares in 2008 and 2007, respectively Totol sts-bhalidere' enping See accompanying notes. Souroe Southwest Airlines Co, form 10-K for the Fiscal Year Ended December 31, 2008. Years Ended December 31, OPERATING REVENUES; Soarce: Southwest Aulines Co. Fann 10-K far the Fiscal Year Lnded December 31, 2000. From Consolidated Statement of Cash Flows (in millions): Net cash provided by (used in) operating activities Interest paid Income taxes 2008${1,521)$100$712007$2,845$63$94 in millions 2009 2010 2011 2012 2013 After 2013 Total minimum lease payments Less amount representing interest Present value of minimum lease payments Less current portion Long-term portion \begin{tabular}{lcc} in millions & Capital Leases & Operating Leases \\ 2008 & $16 & $400 \\ 2009 & 17 & 335 \\ 2010 & 15 & 298 \\ 2011 & 12 & 235 \\ 2012 & - & 195 \\ After 2012 & - & 876 \\ Total minimum lease payments & 60 & $2,339 \\ \hline \end{tabular} Less amount representing interest Present value of minimum lease payments Less current portion Long-term portion Source: Southwest Airlines Co., Form 10-K for the Fiscal Year Ended December 31, 2008. *incl. goodwill. Source: Lufthansa Group, Annual Repont for the Fiscal Year Ended December 31, 2008 . Traffic revenue Other revenue Total revenue \begin{tabular}{lrr} Notes & 2008 & 2007 \\ 3) & 19,998 & 17,568 \\ 4) & 4,872 & 4,852 \\ \hline & 24,870 & 22,420 \end{tabular} Changes in inventories and work performed by the enterprise and capitalised Other operating income Cost of materials and services Staff costs Depreciation, amortisation and impairment Other operating expenses Profit from operating activities \begin{tabular}{rrr} 5) & 178 & 119 \\ 6) & 1,969 & 1,571 \\ 7) & (13,707) & (11,553) \\ 8) & (5,692) & (5,498) \\ 9) & (1,289) & (1,204) \\ 10) & (4,946) & (4,269) \\ \hline \end{tabular} Result of equity investments accounted for using the equity method 11) Result from other equity investments Interest income 11)12)42202131177 Interest expense 12) Other financial items 13) Financial result Profit before income taxes Income taxes 14) Profit from continuing operations \begin{tabular}{cr} (22) & 223 \\ 42 & 131 \\ 202 & 177 \\ (374) & (371) \\ (427) & (133) \\ \hline(579) & 27 \\ 804 & 1,613 \\ (195) & (356) \\ 609 & 1,257 \end{tabular} Profit from the discontinued Leisure Travel segment 15) Profit after income taxes Minority interests Net profit attributable to shareholders of Lufthansa AG Basic earnings per share in E 16) Diluted earnings per share in 16) Source: Lufthansa Group, Annual Report for the Fiscal Year Ended December 31, 2008. From Consolidated Statement of Cash Flows (In m ): Net cash provided by (used in) operating activities Net interest paid Income taxes 12) Net interest Net Interest \begin{tabular}{lrr} In em & 2008 \\ & 11 & 2007 \\ Income from other securities and financial loans & 113 \\ Other interest and similar income & 191 \\ \hline Interest income & 202 & 177 \\ Interest expenses on pensions obligations & (119) \\ Interest expense on other provisions & (16) \\ Interest and other similar expenses & (239) \\ \hline Interest expenses & (208) \\ \hline \end{tabular}