The airline industry is one of the more volatile industries. During lean years in the early 1990s, the industry wiped out the earnings it had reported during its entire history. Pan American Airlines and Eastern Airlines ceased operations, while Continental Airlines, TWA, and US Air filed for bankruptcy protection. The industry bounced back in the mid-1990s, riding on the wings of the US. economic prosperity and lower energy prices. The airlines have been especially profitable since 1996, with returns on equity often in excess of 25%. The stock market has rec- ognized the stellar growth in profitability as market capitalization of many airlines has tripled since then. Volatility in airlines' earnings arises from a combination of demand volatility, cost structure, and competitive pricing. Air travel demand is cyclical and sensitive to the economy's perfor mance. The cost structure of airlines is dominated by fixed costs, resulting in high operating leverage. While most airlines break even at 60% flight occupancy, deviations from this can send earnings soaring upward or downward. Also, the airline industry is price competitive. Because of their cost structure (low variable but high fixed costs), airlines tend to reduce fares to increase market share during a downturn in demand. These fare reductions often lead to price wars, which reduces average unit revenue. Hence, airfares are positively correlated with volume of demand, resulting in volatile revenues. When this revenue variability is combined with fixed costs, it yields volatile earnings. Airline companies lease all types of assets-aircraft, airport terminal, maintenance facilities, property, and operating and office equipment. Lease terms range from less than a year to as much as 25 years. While many companies report some capital leases on the balance sheet, most com- panies are increasingly structuring their leases, long-term and short-term, as operating leases. The condensed balance sheets and income statements along with excerpts of lease notes from the 1998 and 1997 annual reports for AMR (American Airlines), Delta Airlines, and UAL (United Airlines) follow. AMR DELTA VAL 1998 1997 1998 1997 1998 1997 Balance Sheets ($ millions) Assets Current assets.................. $ 4,875 $4,986 $ 3,362 $2,867 $ 2,908 $ 2,948 Freehold assets (net)......... 12,239 11,073 9,0227,695 10,9519,080 2.147 299 3472,103 1,694 Intangibles and other.......... 3,042 2,714 1,920 1,832 2,597 1,742 Total assets............. $20,859 $14,603 $12,741 $18,559 (continued) DELTA UAL AMR 1998 1997 1998 1997 1998 1997 $ $ 63 4,514 $ 62 4,021 $ 176 5,492 171 5,077 249 1,533 4,046 175 322 1,475 3,698 156 2,113 2,858 3,848 791 1,679 2,092 3,493 615 Liabilities and equity Current liabilities Current portion of capital lease... $ 154 $ 135 Other current liabilities ......... 5,485 5 ,437 Long-term liabilities Lease liability 1,764 1,629 Long-term debt 2,436 2,248 Other long-term liabilities. 5,766 5,194 Preferred stock. Shareholders' equity Contributed capital ......... 3,2573,286 Retained earnings.. 4,729 3,415 Treasury stock (1,288) (485) Total liabilities and equity......... $22,303 $20,859 Income Statement ($ millions) Operating revenue ......... $19,205 $18,184 Operating expenses.............. (16,867) (16,277) Operating income............. 2,338 1,907 Other income and adjustments .... 137 Interest expense*............ (372) (420) Income before tax.............. 2,164 1,624 Tax provision ............... (858) (651) Continuing income .............. $ 1,306 $ 973 3,299 1,776 (1,052) $14,603 2,896 812 (701) $12,741 3,518 1,024 (1,261) $18,559 2,877 300 (840) $15,464 $13,594 (12,063) 1,531 $17,378 (16,119) 198 91 $14,138 (12,445) 1,693 141 (197) 1,637 (647) $ 990 (216) 1,406 (561) $ 845 $17,561 (16,083) 1,478 133 (361) 1,250 (429) $ 821 1,259 551 (291) 1,519 (561) $ 958 *Includes preference dividends. AMR Operating DELTA Operating UAL Operating Capital Capital $100 $ 341 (5 millions) Capital Excerpts from Lease Notes (1998) MLP Due 1999............... $ 273 2000............... 2001............... 323 2002............... 274 2003.............. 2004............... 1,261 Total MLP due .......... 2,663 Less interest ........... (745) Present value of MLP..... $1,918 $ 317 308 399 $ 1,012 951 949 904 919 12,480 $17,215 950 950 940 960 341 $ 1,320 1,329 1,304 1,274 1,305 17,266 $23,798 191 10,360 $15,120 400 242 1,759 3,366 (1,077) $2,289 $312 (continued) (concluded) DELTA (5 millions) Capital Operating Capital Operating Capital Operating $ 288 $ 1,011 985 250 $101 100 68 315 935 840 Excerpts from Lease Notes (1997) MLP Due 1998 $ 255 1999 2000 2001 297 2002 ....... 247 2003 and after....... 1,206 Total MLP due.......... 2,570 Less interest........... (806) Present value of MLP.... $1,764 931 57 241 314 277 1.321 $ 1,419 1,395 1,402 1,380 1,357 19,562 $26,515 887 850 9,780 13,366 $18,115 $14,020 2,703 501 (117) $384 $1,850 Both the capital and operating leases are noncancellable. Interest rates on the leases vary from 5% to 14%. (Assume a 35% marginal tax rate for all three companies.) CHECK (e) AMR restated Year 8 continuing income, $1,210 Required: a. Compute key liquidity, solvency, and return on investment ratios for 1998 (current ratio, total debt to equity. long-term debt to equity, times interest earned, return on assets, return on equity). Comment on the financial performance, financial position, and risk of these three companies both as a group and individually. b. To understand the effect of high operating leverage on the volatility of airlines' earnings, prepare the following sensitivity analysis: Assume that 25% of airline costs are variable that is, for a 1% increase (decrease) in operating revenues operating costs increase (decrease) by only 0.25%. Recast the income statement assuming operating revenues decrease by two alternative amounts: 5% and 10%. What happens to earnings at these reduced revenue levels? Also, compute key ratios at these hypothetical revenue levels. Comment on the risk of these companies' operations. c. Why do you think the airline industry relies so heavily on leasing as a form of financing? What other financing options could airlines consider? Discuss their advantages and disadvantages versus leasing d. Examine the lease notes. Do you think the lease classification adopted by the companies is reasonable? Explain. e. Reclassify all operating leases as capital leases and make necessary adjustments to both the balance sheet and income statement for 1998. (Hint: (1) Use the procedures described in the chapter. (2) Assume identical interest rates for operating and capital leases. (3) Do not attempt to articulate the income statement with the balance sheet, i.e, make balance sheet and income statement adjustments separately without "tallying" the effects on the two statements. (4) Make adjustments to the tax provision using a 35% marginal tax rate. Since all leases are accounted for as operating leases for tax purposes, converting operating leases to capital leases will create deferred tax liabilities. However, since we are not articulating the income statement with the balance sheet, the deferred tax effects on the balance sheet can be ignored.] 1. What assumptions did you make when reclassifying leases in (e)? Evaluate the reasonableness of these assumptions and suggest alternative methods you could use to improve the reliability of your analysis. & Repeat the ratio analysis in (a) using the restated financial statements from (e). Comment on the effect of the lease classification for the ratios and your interpretation of the companies' profitability and risk (both collec- tively and individually). h. Using the results of your analysis in (g), explain the reliance of airline companies on lease financing and their lease classifications. What conclusions can you draw about the importance of accounting analysis for financial analysis in this case? It is recommended that this case is solved using Excel. Case data in Excel format is available on the book's website. The airline industry is one of the more volatile industries. During lean years in the early 1990s, the industry wiped out the earnings it had reported during its entire history. Pan American Airlines and Eastern Airlines ceased operations, while Continental Airlines, TWA, and US Air filed for bankruptcy protection. The industry bounced back in the mid-1990s, riding on the wings of the US. economic prosperity and lower energy prices. The airlines have been especially profitable since 1996, with returns on equity often in excess of 25%. The stock market has rec- ognized the stellar growth in profitability as market capitalization of many airlines has tripled since then. Volatility in airlines' earnings arises from a combination of demand volatility, cost structure, and competitive pricing. Air travel demand is cyclical and sensitive to the economy's perfor mance. The cost structure of airlines is dominated by fixed costs, resulting in high operating leverage. While most airlines break even at 60% flight occupancy, deviations from this can send earnings soaring upward or downward. Also, the airline industry is price competitive. Because of their cost structure (low variable but high fixed costs), airlines tend to reduce fares to increase market share during a downturn in demand. These fare reductions often lead to price wars, which reduces average unit revenue. Hence, airfares are positively correlated with volume of demand, resulting in volatile revenues. When this revenue variability is combined with fixed costs, it yields volatile earnings. Airline companies lease all types of assets-aircraft, airport terminal, maintenance facilities, property, and operating and office equipment. Lease terms range from less than a year to as much as 25 years. While many companies report some capital leases on the balance sheet, most com- panies are increasingly structuring their leases, long-term and short-term, as operating leases. The condensed balance sheets and income statements along with excerpts of lease notes from the 1998 and 1997 annual reports for AMR (American Airlines), Delta Airlines, and UAL (United Airlines) follow. AMR DELTA VAL 1998 1997 1998 1997 1998 1997 Balance Sheets ($ millions) Assets Current assets.................. $ 4,875 $4,986 $ 3,362 $2,867 $ 2,908 $ 2,948 Freehold assets (net)......... 12,239 11,073 9,0227,695 10,9519,080 2.147 299 3472,103 1,694 Intangibles and other.......... 3,042 2,714 1,920 1,832 2,597 1,742 Total assets............. $20,859 $14,603 $12,741 $18,559 (continued) DELTA UAL AMR 1998 1997 1998 1997 1998 1997 $ $ 63 4,514 $ 62 4,021 $ 176 5,492 171 5,077 249 1,533 4,046 175 322 1,475 3,698 156 2,113 2,858 3,848 791 1,679 2,092 3,493 615 Liabilities and equity Current liabilities Current portion of capital lease... $ 154 $ 135 Other current liabilities ......... 5,485 5 ,437 Long-term liabilities Lease liability 1,764 1,629 Long-term debt 2,436 2,248 Other long-term liabilities. 5,766 5,194 Preferred stock. Shareholders' equity Contributed capital ......... 3,2573,286 Retained earnings.. 4,729 3,415 Treasury stock (1,288) (485) Total liabilities and equity......... $22,303 $20,859 Income Statement ($ millions) Operating revenue ......... $19,205 $18,184 Operating expenses.............. (16,867) (16,277) Operating income............. 2,338 1,907 Other income and adjustments .... 137 Interest expense*............ (372) (420) Income before tax.............. 2,164 1,624 Tax provision ............... (858) (651) Continuing income .............. $ 1,306 $ 973 3,299 1,776 (1,052) $14,603 2,896 812 (701) $12,741 3,518 1,024 (1,261) $18,559 2,877 300 (840) $15,464 $13,594 (12,063) 1,531 $17,378 (16,119) 198 91 $14,138 (12,445) 1,693 141 (197) 1,637 (647) $ 990 (216) 1,406 (561) $ 845 $17,561 (16,083) 1,478 133 (361) 1,250 (429) $ 821 1,259 551 (291) 1,519 (561) $ 958 *Includes preference dividends. AMR Operating DELTA Operating UAL Operating Capital Capital $100 $ 341 (5 millions) Capital Excerpts from Lease Notes (1998) MLP Due 1999............... $ 273 2000............... 2001............... 323 2002............... 274 2003.............. 2004............... 1,261 Total MLP due .......... 2,663 Less interest ........... (745) Present value of MLP..... $1,918 $ 317 308 399 $ 1,012 951 949 904 919 12,480 $17,215 950 950 940 960 341 $ 1,320 1,329 1,304 1,274 1,305 17,266 $23,798 191 10,360 $15,120 400 242 1,759 3,366 (1,077) $2,289 $312 (continued) (concluded) DELTA (5 millions) Capital Operating Capital Operating Capital Operating $ 288 $ 1,011 985 250 $101 100 68 315 935 840 Excerpts from Lease Notes (1997) MLP Due 1998 $ 255 1999 2000 2001 297 2002 ....... 247 2003 and after....... 1,206 Total MLP due.......... 2,570 Less interest........... (806) Present value of MLP.... $1,764 931 57 241 314 277 1.321 $ 1,419 1,395 1,402 1,380 1,357 19,562 $26,515 887 850 9,780 13,366 $18,115 $14,020 2,703 501 (117) $384 $1,850 Both the capital and operating leases are noncancellable. Interest rates on the leases vary from 5% to 14%. (Assume a 35% marginal tax rate for all three companies.) CHECK (e) AMR restated Year 8 continuing income, $1,210 Required: a. Compute key liquidity, solvency, and return on investment ratios for 1998 (current ratio, total debt to equity. long-term debt to equity, times interest earned, return on assets, return on equity). Comment on the financial performance, financial position, and risk of these three companies both as a group and individually. b. To understand the effect of high operating leverage on the volatility of airlines' earnings, prepare the following sensitivity analysis: Assume that 25% of airline costs are variable that is, for a 1% increase (decrease) in operating revenues operating costs increase (decrease) by only 0.25%. Recast the income statement assuming operating revenues decrease by two alternative amounts: 5% and 10%. What happens to earnings at these reduced revenue levels? Also, compute key ratios at these hypothetical revenue levels. Comment on the risk of these companies' operations. c. Why do you think the airline industry relies so heavily on leasing as a form of financing? What other financing options could airlines consider? Discuss their advantages and disadvantages versus leasing d. Examine the lease notes. Do you think the lease classification adopted by the companies is reasonable? Explain. e. Reclassify all operating leases as capital leases and make necessary adjustments to both the balance sheet and income statement for 1998. (Hint: (1) Use the procedures described in the chapter. (2) Assume identical interest rates for operating and capital leases. (3) Do not attempt to articulate the income statement with the balance sheet, i.e, make balance sheet and income statement adjustments separately without "tallying" the effects on the two statements. (4) Make adjustments to the tax provision using a 35% marginal tax rate. Since all leases are accounted for as operating leases for tax purposes, converting operating leases to capital leases will create deferred tax liabilities. However, since we are not articulating the income statement with the balance sheet, the deferred tax effects on the balance sheet can be ignored.] 1. What assumptions did you make when reclassifying leases in (e)? Evaluate the reasonableness of these assumptions and suggest alternative methods you could use to improve the reliability of your analysis. & Repeat the ratio analysis in (a) using the restated financial statements from (e). Comment on the effect of the lease classification for the ratios and your interpretation of the companies' profitability and risk (both collec- tively and individually). h. Using the results of your analysis in (g), explain the reliance of airline companies on lease financing and their lease classifications. What conclusions can you draw about the importance of accounting analysis for financial analysis in this case? It is recommended that this case is solved using Excel. Case data in Excel format is available on the book's website