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JetBlue Airways Initial Public Offering (IPO) Valuation

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JetBlue Airways Initial Public Offering (IPO) Valuation

Introduction

This paper seeks to help the management of JetBlue Airways to decide whether the original offer price for its initial public offering (IPO) should be increased or decreased and whether there is basis to increase the number of new shares offered. As basis for recommendation, this paper will look into the past performance of the company to determine its strengths using financial ratio analysis. In addition, this paper will also conduct SWOT analysis based on relevant management issues and the financial ratios as would be calculated. A scenario analysis on what will happen if prices will be increased or decreased will also form part of the discussion.

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Critical Historical Points

JetBlue Airways wants to raise additional capital through a public equity offering to support is planned growth and offset portfolio losses from venture capital ventures in 2002. As JetBlue management prepared for a meeting with IPO co-lead manager Morgan Stanley, it wants to decide whether there is a need to change the initial price range that had originally been targeted between $22 to $24 per share. Given also sizeable excess demand as reported for the 5.5 million shares planned IPO, the company management team was considering whether to support an increase in the offering of the new shares.

It was in July 1999 when JetBlue founder David Neeleman announced his plan to launch a new airline that would bring more travel to travel because of low and affordable fare. Despite the numerous airline failures in U.S. airline industry for the past twenty years, Neeleman was convinced that his commitment to innovation in people, policies and technology could make a difference thus sustain his airline business. His vision was shared by an impressive new management team such as David Barger and John Owen from Southwest Airlines from Continental Airlines. With him are a growing group of investors from the venture capital community from which he had been able to raise quickly $130 million in funding from such high profile firms as Weston Presidio Capital, Chase venture fund and private equity firm Quantim Industrial of George Soros.

Within seven months, the company had had secured a small flee of Airbus A320 aircraft and started service from several parts of the US including JFK to Fort Lauderdale, Florida cities (Orlando and Tampa), two other upstate cities (Rochester and Burlington, Vermont) and two California cities (Oakland and Ontario). The company rapidly grew through early 2002 and operated 24 aircraft flying 108 flights per day to 17 destinations as of 2002.

JetBlue’ early achievement was often credited to Neeleman’s wide-ranging experience in starting an airline business. Even from his early 20s as a University of Utah, Neeleman had managed low-fare flights between Salt-City and Hawaii under Morris Air, which led the way in ticketless travel. With the said airline later acquired by low-fare leader Southwest Airlines, Neeleman had spent brief time with Southwest. He left Southwest after assisting in the putting up of Canadian low-fare carrier West Jet. At about the same time, Neeleman was success turning the e-ticketing system into success under Open Skies which may have caused its acquisition by Hewlett-Packard in 1999.

JetBlue had acquired a fleet of new Airbus A320 aircraft which are reliable, fuel efficient and capable of affording greater economies of scale due to only one model of aircraft.

Financial Ratio Analysis

Table A below summarizes the important ratios of profitability, efficiency, liquidity and solvency of JetBlue Airways for the past two years.

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Summary of Ratios
Table A- Summary of Ratios; Source: Case Study- JetBlue Airways; See Appendix A.

Profitability and Efficiency

Profitability is normally influenced by revenue growth and Jet Blue was good enough to more than double in 2001 its 2000 revenue figure. Such could only be an indication of a phenomenal growth which a turnaround in its profitability and efficiency.

Return on equity (ROE) of JetBlue Airways indicates the past performance of the company in the past two years. From negative 19% in 2000, the company has had made a sudden turnaround of 22%.

A level of 20% or more return on equity encourages investors as it would mean that for every $100 investment, the investors expect returns of about 20 dollars. These rates could be viewed as something unprecedented for a company like JetBlue Airways if compared with an average rate of 5% long-term US Treasury bill rate as per case facts if money was invested in a risk free investment. The 2001 ROE makes finding a company that would more offer four times on that risk free rate. It must be something very attractive to investors.

It is also interesting to find whether the company may also be considered as efficient by looking at the net operating margin and net profit margin of the JetBlue. Both rates have total revenues as denominators but the numerator of the first is operating income while in the second, it is net income. They particularly measure efficiency, which answers the question: “How much the company does get for every product or service that its sells?” The results of the operating profit reflected f negative rate in 2000 but improved to 8% in 2001. Given a long time to be profitable and for the early year’s operation for this kind of business, it may be asserted that the company was indeed very uniquely profitable and efficient compared with other companies in the industry.

Operating margin represents the margin after deducting cost of sales or services and operating expenses. Things to be added or deducted still are other income(s). The ratios mean that the management of JetBlue Airways is doing well thanks to the participation of employees in delivering value to customers and this was made more manifest in terms of net margin of the company for the years 2001 and 2000 which are computed at 12% and -20% respectively. Comparing higher net profit margins as against the lower operating profit margin in 2001 indicate that JetBlue Airways is not deriving its earning purely from its operations. The increase was however found to be increase in income tax benefits.

Liquidity

Liquidity connotes a capacity to meet a company’s currently maturing obligations. It is measured using the current ratio and the quick asset ratio (Van Horne, 1992). Getting current ratio uses current assets to be divided to current liabilities while quick assets ratio is almost the same except that the inventory and prepaid expenses are being removed from the current assets to have a new numerator but the denominator is the same. Quick assets therefore normally include cash, marketable securities and accounts receivable and the use of quick asset ratio is very much relevant for one intending to have higher form of measuring liquidity. In such case, one would prefer quick asset ratio over that of the current ratio.

As applied now, the current ratios of JetBlue Airways are 0.74 and 0.66 for the years 2001 and 2000 respectively while the quick asset ratios for same years are 0.71 and 0.62 for the same years respectively. Both ratios have increase in 2001 which correspond to the increase in revenues and profitability of JetBlue as analyzed earlier. See Table A.

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Solvency

Solvency or financial leverage refers to the company’s long-term capacity to keep up it stability over the long term. Normally measured by the debt to equity ratio, with the formula of having the total debt of the company divided by its total equity; solvency informs investors that the company is not to just to exist in the short term but it must also have a long life to recover long term investments which will required more years to produce the needed returns and assure them of stability of the company (Brigham and Houston, 2002) The debt to equity ratios of JetBlue Airways are 2.78 and 2.15 for the years 2001 and 2000 respectively and would show a deterioration since the higher the ratio, the less favorable it is for the company because of higher risk. See Table A.

The 2001 ratios is indeed very high since the ratio of 2.78 already means that the value the company invests is matched by what it borrows by more than double or 200%. It is indeed a deterioration of its solvency since there is increase debt over equity. Raising capital by initial public offering could improve its solvency. It is desirable to have a good solvency which to tell investors that the company is stable and that it could manage its long-term risk. Solvency should be normally be built over the years from profitability as a proof of a growing company and that raising capital by public offering should only come when profitability or additional barrowing could not sustain the capital requirement of the business without putting the company in a very high risk.

Valuation

There is a need to estimate the intrinsic value of the company as basis of determine the correct level of offer price for the IPO.

Estimate of cost of capital

To make a valuation of the stocks of JetBlue Airways, the first thing to know is the company’s cost of capital of the capital. Cost of capital is the equivalent to the concept of opportunity cost in economics which serves as a guide as to whether the investor puts it with JetBlue Airways. As a rule, a company must earn above the cost of capital. The said cost of capital will be used as discount rate in discounting cash flows for the company and to discount dividends using the dividend discount model.

To approximate the same a capital asset pricing model (CAPM) could be used. The model could illustrate how risk and expected return are related and balance against each other and investor use it to price securities especially if these are risky ones. The model is very simple to use since the required information includes the expected return of a stock or a bond or a group of stocks, a treasury or government bill rate which approximates risk-free free rate plus a premium for the risk (Van Horne, 1992). The formula to describe the CAPM relationship is as follows: Required (or expected) Return = RF Rate + (Market Return – RF Rate)*Beta

The formula could actually be summarized as adding market risk premium to the risk free rate. (Van Horne, 1992) RF stands for risk free rate while the second part of the formula represents the market risk premium. For the purpose of this paper a long-term U.S. Treasury bill rate of 5% as per case facts. Risk free rate means that one there a sure chance the investor will get the money because the government is the guarantor. The beta stands for the measure of market risk, which is the extent to which the returns on a given stock move with the stock market (Brigham and Houston 2002). Since the risk premium is given at 5%, there is no need to compute to know market rate and reduce the same by risk-free rate and multiplying the difference with the beta. There is neither need to know the beta. Applying the formula would show that JetBlue Airways would have an estimated cost capital of 10% computed follows: Required (or expected) Return = 5% + 5%= 10%.

CAPM shows that JetBlue Airways has a required rate of return of 10%. One who plans to invest in the stock of the company should be getting at least 10% return on his investment. His failure to earn a minimum of this return indicates financial management error since such investor does not know how much he or she should be earning. Returns below the cost of capital should prompt a stockholder to think of disposing his or her stocks from the company in order not to further lose money. From the point of view of JetBlue it must earn from its investment above its cost of capital.

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Estimating the price per share

From the 10% estimated cost of capital, the market value can now be computed either using the dividend discount model or free cash flow model.

The market value using the constant growth model is not applicable because there are no historical dividends from which the growth rate of the dividend per share of and expected dividend next year would be used to use the model. Because the model is applicable only if there is constant growth of dividend and when the growth rate is lower that cost of capital then it would mean the need to have the free cash flows as basis of determining the share holder value by getting presented value of all the expected cash flows are projected and discounting the same using the estimated 10% cost of capital as estimated.

The application of the free cash flow model this paper assumes that the growth rate as per case facts and the resulting market value per share would be $2.39 per share. The amount was computed after getting the total present value of $97.47 million and divided by the estimated average outstanding shares of 40.76 million per case fact over the projected period. See Appendix B.

SWOT Analysis

This part in effect summarizes the discussions made in the external and internal analysis using Porter’s five forces to extract the industry opportunities and threats. This will also analyze the activities of the firm in terms of management issues and financial analysis as earlier done to extract the company strengths and weaknesses.

Strengths

These are conditions or characteristics of the company which could be tapped by the company in its design of its strategies. The following are the company’s strengths.

Being known as low-fare airliner — The Company may be considered to have the strength of competing in the industry for making itself appear as low fare company following the Southwest Airline model. This could be very relevant in times of recession like this time because customers would really have to find value for their money without sacrificing security and safety which are one of the most important value in the industry. Case facts say that low fare airlines survived in the aftermath of the 9/11 hijackings.

Strong and able CEO — The company appears to be led by its founder Neeleman who had good experience in the airline industry. This is a strength as this would assure the necessarily knowledge of company leadership to attain its defined objectives. This was actually proved that venture capitalists have trusted the man in setting up JetBlue for the initial capital to keep the airline running.

Strong Sales Growth and Strong Cash Flow Generation – The Company has experienced big annual growth in sales revenues in 2001 that resulted to profitable operation and good source of cash for its financing needs. The net increase in cash flow per Cash Flow Statement were indeed huge that could help the company to maintain its liquidity.

Good Level of Profitability — The company’s increased profitability in 2001 as with barely three years of operation is remarkable record among the airline considering the value high fixed cost that must be recovered in the earlier years. This could help the company to maintain good liquidity position and improve its solvency position as it continues to provide services to its customers competitively.

Weaknesses

The company has also to weak points which it should make stronger or avoid in its design of its strategies so that it could accomplish its objectives.

Highly leveraged Position – Its debt to equity ratio may have been low in prior years but in 2008 it has reached a level of above 2.0 which makes the company too risky to expand without infusing additional capital from stockholders. Thus the IPO would help improve this.

Low liquidity – This low liquidity as evidenced by below 1.0 current ratio could cause problems in its working capital needs that could put the company into bankruptcy.

Opportunities

Opportunities and threats derived basically from Porter’s five forces (Porter, 1980) and the greater macro-environment that may improve (in case of opportunity) or cause decline (in case of threat) in the profitability of the company.

Low availability of product substitutes – This is an opportunity as it could lessen the chance of other products to compete since airline travel could not be easily matched in the speed of travel for passengers.

Difficult entry by new entrants – The airline industry requires big capital before one can really operate. This is therefore a restraint to new comers as not every company could find sources of capital that would venture into this kind of business. This is therefore an opportunity

Threats

High Bargaining power of buyers – There are numerous passengers of all over the world and they are believe to exert a pressure on pricing as compared when there are only small in number. This could aggravate the company’s low profitability as customers would need to cut their expenditures due economic pressures caused by present recession in the US and other parts of the world. This is supported by the adoption of low fare strategy by players.

High bargaining power of sellers – There are only few suppliers of aircrafts for airline industry. Case facts say that the company only have airbus type plane. Hence the same is being made only by a single company that could dictate its price. This is therefore a threat since it could also reduce the profitability of the industry.

High rivalry of competitors – Case facts say that there are a number of airlines competing in the industry. The fact the company is competing on price indicates the existence of strong rivalry in the industry.

Scenario Analysis

If the price will be increased the consequences could include the following: First there could be a possible increased proceeds or decreased proceeds since prices could affect the demand for stocks depending on how the investors would perceive the value of the JetBlue stocks. From the initial valuation of $22 to $24 per share the same was found very high using the CAPM model to estimate the cost of capital after discounting free cash flows of the company. The estimated value per share as computed based from the forecasted cash flow per case was at $2.39 per share. To increase price appears not good as this could result to lower number of investors buying and lower funds to be raised by the company. This is in the light of the case facts that subscribers are given the law the chance to cancel purchase orders for share for a limited period of time.

To decrease the price, there is need also to assume that the investors would conduct the same estimate of the values and comes out with more or less with the similar result of $2. If the price will be decreased the consequences could include the following: First, the effect of price decrease would be the opposite of price increase. If again assuming the investors would have the same estimate of the stock value at $2.39 per share. See Appendix B. This would cause investors to think that such estimate is the most reasonable price and hence the offer price of $22 to $ 24 appears overvalued for them to invest at the company’s stocks. However, case facts provide there is already and excess demand at the original price. Since not all investors would compute the same way in getting the intrinsic value, JetBlue has all the reason to offer discounted prices of its IPO so that it could meet still its target. Lowering the price could result to higher number of investors buying and could mean higher funds raised by the company and possibly meeting the targeted number of shares.

Conclusion

It can be concluded that the price of its stock should be at $2.39 per share if intrinsic value is used as basis after the discounting the free cash flows at 10% cost of capital. However since there is excess demand at the price of $22 to 24 per share, there seems to be no justification to further increase the offer price. Increasing the price above what is true value could result to lower capital being raised and this could mean a failure of the IPO. Decreasing the price could possibly make the better choice since the prices of company appears overvalue in the light of the limited growth in the industry as forecasted per case facts and based on discounting the free cash flows at 10%.

Recommendations

Since the result of the valuation indicates that intrinsic value of the stock is lower than original price of $22 to 24, the same should not be increased despite the reported excess of demand over supply. On the other hand, if discounted price would be needed to reach the targeted amount, the same should be done. Issuing additional share which may not be needed by the company for the next few years hence the same should not be made despite excess demand since the company has a very high cost of capital of 10% and having an excess would be forfeiting the added 5% for market risk premium that would be lost if there is no investment that could produce 10% return to cover the cost of capital. At most the money would just be invested in a risk free rate of 2% in case of short term or 5% in case of long-term based on US Treasury bill.

Appendix A – Basis for Computation of Table A.

Basis for Computation of Table A

Appendix B – Computation of Share Price.

Computation of Share Price

References

Brigham, E. and Houston, J. (2002) Fundamentals of Financial Management, Thomson South-Western, US Case Study – JetBlue Airways IPO Valuation, University of Virginia, Darden Business Publishing.

Porter (1980) Competitive Strategy, Free Press, London, UK.

Van Horne, J. (1992) Financial Management and Policy, Prentice-Hall International, USA.

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