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JetBlue Airways IPO Valuation

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IPO Valuation

By: Ryan DeCoudres & Jose Alessandro de Vasconcelos
March 24, 2009

TABLE OF CONTENTS

JetBlue IPO Valuation

March 24, 2009

INTRODUCTION...............................................................................................................2

INTRODUCTION
Following the terrorist attacks of 9/11, the airline industry was in the doldrums. Many of the largest carriers in the nation had filed for bankruptcy protection and were asking the federal government for help so they could survive. Certainly few people at this time considered the airline industry to be an extremely profitable venture, but where others saw despair, David Neeleman, CEO and founder of JetBlue Airways, saw opportunity. In 2002, after 2 years of profitable operations and less than a year after the attacks that shook the industry to its core, JetBlue Airways had its Initial Public Offering (IPO) and went public. This case study outlines the IPO underwriting process and uses JetBlue as an example to describe the steps throughout the way. It also asks the analyst to come up with a valuation for this IPO, based on the financial and non-financial data presented. In the following pages, we will discuss the pros and cons of going public, the IPO process itself, and walk through the calculations that led us to our recommended offering price. In

DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

addition, we will also give some insight into the process from a first-hand perspective afforded by a member of the team.

COMPANY AND INDUSTRY BACKGROUND
Started in 1999 with the promise to “bring humanity to air travel”1, JetBlue entered the “Discount Fare Airlines” to join the likes of Southwest, ATA, Frontier and others. With a strong and experienced management team, having Continental Airlines’ former vicepresident as president and COO, and Southwest Airlines’ former executive vice-president and treasurer as CFO, David Neeleman believed that his new airline would thrive. Neeleman built JetBlue’s business model around the customer, and his primary goal was to fix everything that “sucked” about airline travel. JetBlue’s airplanes were new, and the airfares were low and simple. They offered free LiveTV at every seat, there was preassigned seating (which is different from most discount airliners), reliable performance, and high-quality customer service.2 Southwest Airlines pioneered the low-fare airline market, and soon many other newcomers copied it, including JetBlue. This model centers on providing the customer with higher quality service, while taking measurers to minimize the costs where possible. The norm is to have one or few different types of airplanes, to minimize complexity and reduce maintenance and training costs. This model also counts on point-to-point service to secondary airports in major metropolitan areas. Other U.S. players in this industry were AirTran, America West, ATA, and Frontier. JetBlue was able to deliver on the cost savings better than others in the industry as evidenced by its cost per available seat mile, which was 6.98 cents, while the industry averaged 10.08 cents. By early 2002, JetBlue operated 24 airplanes, flying 108 flights per day to 17 destinations3. The company also believed in using advanced technology to help with its operations and was the first U.S. airline to secure cockpits with bulletproof Kevlar doors after the September 11th hijackings4.
The most recent IPOs in this industry were from non-US companies. Ryanair, WestJet, and easyJet had gone public with trailing EBIT multiples of 8.5 times, 11.6 times and 13.4 times, respectively, and first day returns of 62 percent, 25 percent and 11 percent, respectively.5

While these IPO’s would help give management an idea of where to price the offering, they were in a different market and in other countries. In addition to those differences, the overall stock market was in the dumps and had been declining for the better part of 2 years. Investors were skittish in general and knowing exactly how they would react to a company that looked promising but was in an underperforming industry would be impossible. 1 Bruner 2 Bruner 3 Bruner 4 Bruner 5 Bruner DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

GOING PUBLIC
The decision to go public for JetBlue was one born out of necessity, as it is with most companies in their position. The firm itself had been profitable on an annual basis, but in order to grow at the rate that management had envisioned, JetBlue needed to raise capital in amounts that were greater than management could risk or provide on their own. For companies in this position, setting up an IPO is the only reasonable option; however, there are Pros and Cons about doing this. Management was going to have to give up some of the control that they had worked with in the previous years. However, money is typically the ultimate determining factor and there can be substantial amounts made for the current working members of the company. Here are some of the advantages and disadvantages of going public. PROS • Increases liquidity and allows founders to harvest their wealth • Permits founders to diversify • Facilitates raising of new corporate cash • Establishes a value for the firm • Increases potential markets6 CONS • Cost of reporting • Disclosure • Self-dealings • Control • Investor Relations7 Once the decision is made to go public the IPO process is both exhilarating and arduous at the same time. “As the following sections show, the process of going public is a lot more complicated, expensive, and time-consuming than simply making the decision to go public.8”

THE IPO PROCESS
Once the decision to go public is made the real work begins. Typically the process from start to finish normally lasts about 3 months which can feel like an eternity in the business world. There can be a huge amount of excitement and buildup to the final offering day for management and investors alike if the process goes well. On the other hand, if the issuance is not well received, it can be scrapped altogether. The following depicts an outline of the IPO process and gives the idea of the time that management and underwriters are working on the issuance. Life Cycle of Typical U.S. IPO Transaction 6 Brigham & Ehrhardt 7 Bruner 8 Brigham & Ehrhardt DeCoudres & de Vasconcelos

JetBlue IPO Valuation
(# of Days) <0 0 15 – 44 45 45 – 75 50 60 – 75 75 – 99 99 100 108 After Market

March 24, 2009

Event Underwriter selection meeting. Organization “all hands” meeting. “Quiet Period” begins. Due diligence. Underwriter interviews management, suppliers, and customers; reviews financial statements; drafts preliminary registration statement. Senior management of underwriter gives OK on issue. Registration (announcement) date. Firm files registration statement with SEC; registration statement is immediately available to the public. SEC review period. SEC auditor reviews for compliance with SEC regulations. Underwriter assembles syndicate and prepares road show. Distribute preliminary prospectus (“red herring”). Road show. Underwriters and issuing firm management present offering to interested institutional investors and build book of purchase orders. Letters of comment received from SEC; amendments filed with SEC. Effective date. Underwriter and firm price offering. SEC gives final approval of registration statement. Public offering date. Stock issued and begins trading. Settlement date. Underwriter distributes proceeds to issuing firm. Underwriter may support new equity by acting as market maker and distributing research literature on issuing firm9.

The most important aspects or timeframes regarding the IPO process mentioned above are the selection of the underwriter, the road show, and the 1st day of trading. Each one of these has a substantial impact on the pricing of the stock and the success of its issuance. Because Capital Market activities via Investment Banks are mainly a relationship affair, the choice of the Underwriter for an issue is very critical. Throughout this paper we will refer to the underwriter by different names: Underwriter, Lead Underwriter, Lead Manager, and Book Runner. These terms refer to different roles that are played in an issuance, and sometimes different firms perform these roles. However, many times the Lead Underwriter will play all of these roles, so the terms are used interchangeably. Throughout the process, the Underwriter is responsible for performing many functions to make the issuance a success. First the Investment Bank or Underwriter helps management to determine the preliminary offering price for the stock and the number of shares to be sold. Second, the underwriter is responsible for coordinating the activities and responsibilities of the other members of the syndicate group, if any, as well as allocating them a number of shares to be sold. In addition, “the investment bank actually sells the shares to its existing clients, which include a mix of institutional investors and retail customers10.” Because of this last function, the Underwriters with the best relationships within the investment community has the best chance of getting the issue launched with the highest price and in less time for the company going public. Finally, the investment bank assists by having an analyst cover the stock and provide guidance, reports, and recommendations regarding future prospects of the company. 9 Bruner 10 Brigham & Ehrhardt DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

To help with the choice of the Underwriter, different companies, specialized in providing market data, publish what are known as a League Tables. This is a ranking of the Investment Banks in the industry based on the number of successful deals, the dollar amount of proceeds from these deals and similar data. These tables cover both equity and debt markets and the equity ones are not limited to IPOs, but also include follow-on equity offerings, and convertible transactions. Firms considering raising capital on the market usually take data from these League tables into consideration when choosing the Underwriter, or Lead Underwriter. The following picture shows a League Table from Thomson Reuters11.

It is common to have an Underwriter ranking differently in each catagory, based on the League table used, but overall the positioning tends to be consistent. The next significant event in the timeline above is the Road Show. This is a period of time when the Lead Underwriter and members from the company’s management team go on the road to pitch their deal to different investors. The road show normally lasts a couple of weeks and makes use of the “Red Herring”, the “selling ability” of the participants from the IPO team, as well as the relationships between the Underwriter and the investors being visited. In parallel to the Road Show, the Underwriter starts to take indications of interest (IOI) on the deal from different investors. These IOIs are submitted back to the underwriter deal team, and input into the issuance system for later data analysis. This is the book building process, and even though the indications of interest are non-biding at this point, the data gathered during this time is used to get a better handle on the pricing range and 11 http://www.thomsonreuters.com/content/PDF/financial/league_tables/de/2008/4Q08_e quity_capital.pdf DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

number of shares for the Issue. The following images show a typical book building application used in the industry and a sample Red Herring.

DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

Finally and perhaps most importantly, the first day of trading puts all of the guesswork to rest and determines the value of the issuance to the marketplace. If priced appropriately, the stock should see some premium for the first day of trading. If the stock is overpriced or there is little fan fare with regards to the new issuance, the price will fall from its initial offering. Here again the experience and market relationship of the chosen Lead Underwriter comes into play. Because pricing an IPO is much more art than science, the Lead Underwriter needs to bring all the parties involved to an agreement on the best price for the deal out of the differing prices being considered. Also, the underwriter has to play a very delicate balancing act when establishing the offering price. This is because there are opposing forces in play. On one side there is the company issuing the stock, whose goal is to raise as much capital as possible with the least amount of shares, which implies the highest offering price possible. On the other side there is the investment community, whose goal is profit maximization, which implies getting the highest amount of shares at the lowest possible price. The responsibility of the Lead Manager is to make sure it can balance these two goals effectively. If it prices the deal too low and the price sky rockets afterward, the market will take notice of this and companies planning issuances in the future are less likely to use this underwriter, lest they will “leave money on the table”. If the price is set too high, investors who buy into the deal will lose money when the price drops, and this too will be noticed and remembered the next time this underwriter comes to the market with another deal to sell. Assuming the deal is properly priced, the Lead Manager has two final functions: allocating the number of shares to the different investors who portrayed interest in the deal, and making sure it provides some level of price stabilization in the short-term after the IPO. To perform the first, the relationship between the underwriter and the investment community comes again into play, and the investors who have come through in the past and bought into “tough deals” are sure to be awarded with being allocated most, if not all, of their interest. The following picture shows an Allocation Report for a fictitious IPO, to illustrate how different investors will be allocated a number of shares that is not always the same as what was indicated earlier on during book building. Here, as in real world issuances, the largest investors tend to be allocated all they want, as a way of making sure the “big boys” are taken care of and who have the ability to “make or break” a future offering for a given Underwriter. Also, the total interest in the deal versus the amount allocated shows an example of an oversubscribed issue, which is the norm.

DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

JETBLUE VALUATION
Stock valuation can be accomplished in a few different ways: namely using the Dividend Discount Model, Gordon Growth Model (constant growth model), or by using market multiples. The Dividend Growth Model is described by the following equation.

12

Gordon Growth Model described as follows:

12 http://www.investopedia.com/terms/d/ddm.asp DeCoudres & de Vasconcelos

JetBlue IPO Valuation
Where: D = Expected dividend per share one year from now k = Required rate of return for equity investor G = Growth rate in dividends (in perpetuity)13

March 24, 2009

Unfortunately in this particular case, neither of the above mentioned formulas for calculating at stock price works because according to JetBlue management, “We have not declared or paid any dividends on our common stock. We currently intend to retain our future earnings, if any, to finance the further expansion and continued growth of our business.14” Also, because before the IPO companies are not required to file formal annual financial documents with the SEC, even though they tend to do that a couple of years leading to the IPO, numbers coming out of these documents is not deemed as reliable as those for public companies. Thus, to get a proper range for JetBlue’s offering price we will look at market multiples for the Low-Cost Airline Industry and come up with a number that makes sense, once we compare those other financials to JetBlue’s. Below is a chart describing some of JetBlue’s competitors and the multiples that they carried at the end of 2001. We’ve calculated what their price should be based upon these multiples and can now apply the same technique for JetBlue.
Pri ce/ Sh are $6. 60 $17 .00 $32 .10 $18 .50 $15 .90 Ear ning s/Sh are PE M ult ipl e EBI T Mu ltip le

EBIT/S hare

AirTran Frontier

0.3 2

Ryanair Southwe st

0.7

0.7

WestJet

0.8

Avg PE = JetBlue Dilluted EPS Proforma EPS Stock Price (Dilluted

22 .0 0 8. 50 45 .8 6 26 .4 3 19 .8 8 $2 4. 53

0.8 3

8.2 5 5.6 7 35. 67 16. 82 12. 23 $1 5.7 3

0.9

1.1

1.3

Avg EBIT Mult.

1.14 1.3 $27. 97

13 http://www.investopedia.com/terms/g/gordongrowthmodel.asp 14 Bruner DeCoudres & de Vasconcelos

JetBlue IPO Valuation
EPS) Stock Price (Proforma EPS) EBIT/share (2001) Stock Price (EBIT)

March 24, 2009

$31. 89 0.72 057 279 $11. 33

Based upon the information above we can figure out what the average PE Multiple is for the five companies similar to JetBlue, which comes out to be 24.53. According to Exhibit 3 in the case write-up, JetBlue has a Diluted EPS of $1.14. Multiplying those two together would give us a Price/Share of $27.97. If we were to go off of the Pro Forma EPS ($1.30/share) the equity price would be even higher at $31.89. This is obviously a very large range, but sometimes it is best not to use static prices based upon just the current year. The case also gives forward looking ratios for these companies as well. As shown below we have gone ahead and calculated what they look like moving forward.
EBIT/Shar e 0.8 0.6 1.2 1.4 1.6 Earnings/Sh are 0.3 0.4 0.9 0.7 0.6 Price/Shar e $6.60 $17.00 $32.10 $18.50 $15.90 Book Debt/Shar e $4.00 $0.00 $3.30 $1.80 $1.00 EBIT Multiple PE Multiple

13.25 28.33 29.50 14.50 10.56 19.23

22.00 42.50 35.67 26.43 26.50 30.62

Averages =

Thus, much like before using the average EBIT multiple and PE multiple for these five companies, we can extrapolate figures for JetBlue as well and come up with an equity price of $37.71 and $13.67 respectively. Taking all five of these figures into consideration and averaging them out gives us a price of $27.81.

RECOMMENDATION
Given the figures that we calculated and the current economic state of the market, we would recommend the IPO price to be set between $23 and $25. Those average figures are based off of numbers coming out of just about the worst year for airlines in history. In addition, the IPO is oversubscribed which tells us that the demand out there is heavy for the JetBlue shares. “Many IPOs are oversubscribed, with investors wishing to purchase more shares than are available. In such a case the investment bank will allocate shares to the investors. If demand is high enough, then sometimes they will increase the offering price.15” 15 Brigham & Ehrhardt DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

The market seems very receptive to the thought of purchasing shares of JetBlue because of the troubles with the larger airline carriers and the success of Southwest, which had posted a profit for 27 straight years. Low cost airline carriers seemed to be the way of the future and institutional investors were ready to jump on board. However, because of the overall market going through difficult times, we don’t want to put an IPO out there that is overvalued, which is another reason that we recommend the $23-$25 range.

WHAT HAPPENED
According to JetBlue’s website in press releases prior to the public date, “The offering is being lead-managed by Morgan Stanley, the sole book runner. Merrill Lynch & Co. is the co-lead manager, and Raymond James and UBS Warburg are co-managers of this offering.16” These investment banks certainly did their job and were paid handsomely for it based on the results they obtained. “Helped by Lead Underwriter Morgan Stanley, the company saw its stock price jump up 67% on the first day of trading, making it the highest first-day gainer out of the IPOs in 2002, as shares of JetBlue (JBLU: up $18.00 to $45.00, Research, Estimates) closed at $45 on the Nasdaq, up $18 from their $27 offer price.17” “JetBlue raised $158 million late Thursday when it sold 5.87 million shares at $27 each, above its expected price range, via lead underwriters Morgan Stanley and Merrill Lynch. JetBlue had expected to sell 5.5 million shares at $25 to $26 each, up from its previous $22 to $24 range.18” Certainly there was money left on the table from a management teams’ standpoint, but the IPO was an unequivocal success. The amount of buzz and excitement created by the surge of the stock price on the opening day was huge, and “JetBlue's gains hark back to the IPO gold rush of 1999, when deals often would open with a big pop.19” However, perhaps it was a bit too early to celebrate the victory and celebrate the IPO. Long-term growth is something that needs to be sustained over periods of time and not just a single day. JetBlue’s closest competitor and biggest comparison is Southwest, “but shares of Southwest (LUV: up $0.92 to $19.26, Research, Estimates) are trading much lower than JetBlue's $40 range. ‘Southwest is such an established business and such a close comparison,’ Holmes said. ‘But it would be surprising if JetBlue held onto its premium.’20” As a matter of fact, by the end of 2002 JetBlue’s stock price had fallen below its IPO price, and other IPOs that happened that year were providing a better return to investors, as shown in the next two images below.

16http://investor.jetblue.com/phoenix.zhtml? c=131045&p=irolnewsArticle&ID=278612&highlight 17 http://money.cnn.com/2002/04/12/markets/ipo/jetblue/ 18 http://money.cnn.com/2002/04/12/markets/ipo/jetblue/ 19 http://money.cnn.com/2002/04/12/markets/ipo/jetblue/ 20 http://money.cnn.com/2002/04/12/markets/ipo/jetblue/ DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

Indeed shares did fall back to Earth in a quick manner, as shown in this chart below.

DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

21

Shares have fallen 87% since the IPO almost exactly 7 years ago, and they’ve fallen 92% since the closing of the 1st day of trading. “Although IPOs on average provide large firstday returns, their long-term returns over the following 3 years are below average. Thus, the offering price often appears to be too low, but the first-day run-up is generally too high.22” As of December 31, 2008, JetBlue operates approximately 600 daily flights serving 52 destinations in 19 states, and a fleet of 107 Airbus A320 aircraft and 35 EMBRAER 190 aircraft. The IPO brought them to the forefront of the investing world, but just like everyone else in the industry, once the euphoria wears off from the IPO, the company starts to trade with the overall market and airline industry which is struggling as a whole.

21 http://finance.yahoo.com/q?s=jblu 22 Brigham & Ehrhardt DeCoudres & de Vasconcelos

JetBlue IPO Valuation

March 24, 2009

REFERENCES
Bruner: Case Studies in Finance 5th Edition. Brigham & Ehrhardt: Financial Management 12th Edition; Theory & Practice. http://www.investopedia.com/terms/d/ddm.asp http://www.investopedia.com/terms/g/gordongrowthmodel.asp http://investor.jetblue.com/phoenix.zhtml? c=131045&p=irolnewsArticle&ID=278612&highlight http://money.cnn.com/2002/04/12/markets/ipo/jetblue/ http://finance.yahoo.com/q?s=jblu http://www.thomsonreuters.com/content/PDF/financial/league_tables/de/2008/4Q08_equi ty_capital.pdf http://www.ipreo.com/pdf/datasheets/capital_markets/Equity_Institutional_Bookbuild.pd f http://www.ipomonitor.com/reviews/2002/pages/comprehensivepchange.shtml

DeCoudres & de Vasconcelos

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