JetBlue IPO – Case Study

Concepts Content:

IPO Process

A company attempting to raise additional capital may decide to perform an IPO

(Initial Public Offering) in which they establish shares of stock which can be traded by

the public in the secondary market. The initial issuance is a way to inject potentially

needed capital and deleverage a business (highly leveraged firms carry higher risks).

Steps in performing and IPO include:

Selecting an investment bank

This is the process in which the firm will choose the investment firm who will

help the company with the issuance. The investment bank will then become referred to

as the underwriter or lead underwriter. They will set a preliminary price and help assign

a value to the company. Picking the right investment bank is important because often

times their reputation helps convince buyers to invest. They also have access to wealthy

investors and are able to sell issuances to existing clients. The investment bank will also

pick an analyst to cover the stock which is important because it increases the likelihood

of liquidity in the secondary market.

The Underwriting Syndicate

This is the process where the investment bank team lends its expertise in the

underwriting process. They will either guarantee with the stock issuance a “firm

commitment” underwriting or do a “best efforts” agreement. “Best efforts” agreements

are not guaranteed by the bank that the securities will sell. Most IPOs are handled

through “firm commitment” underwriting. This basically means that the underwriter
guarantees the issuance by first purchasing the shares then turning around and selling

them to investors. Because there is significant risk from the underwriter’s perspective,

syndicates are created in order to minimize risk for the lead underwriter. Other

investment banks make up the selling group and the collective group is referred to as the

underwriting syndicate. Typically the lead underwriter charges 7% of the gross proceeds

which is referred to as the spread. The spread is compensation which the lead

underwriter typically receives 20% for their fee while 60% is paid as selling commissions

to the lead underwriter and other syndicate members and the remaining 20% is typically

to pay for expenses such as legal and travel expenses, which is discussed later in more

detail (Ellis, Michaely, O’Hara 1999). During this stage the prospectus is created and

becomes part of their registration which a company files (on Form S-1) as its intent to go

public. A component of the Form S-1 is the “Red Herring” report (or preliminary

prospectus) and becomes the primary marketing tool once it is approved by the SEC .

The Roadshow and Book Building

Once the underwriter is selected the group will go on a week to three week tour

referred to as the roadshow. The roadshow is where the group travels to a new city every

day to meet with potential investors and attempt to impress them. During this process the

company is required by the SEC to enter a “quiet period” where the preliminary

prospectus (“Red Herring”) is the main selling tool. The issuing company and the

investment bank is permitted to answer questions but not allowed to put anything into

writing. This is also the part of the process where the investment bank begins “book-

building”. The term book building refers to the process where the investment bank

determines the number of shares that each investor is willing to buy. These trips are
typically geared to larger more institutional investors as well as retail salespeople and do

not typically include the “average Joe” investor. The issuing price is then set on the

evening before the offering date. Then comes the excitement of the first day of trading.

Advantages/Disadvantages

According to Brigham and Ehrhardt there are many advantages and disadvantages of

going public through an IPO.

Advantages include:

• Increases liquidity and allows founders to harvest their wealth

• Permits founders to diversify – allows initial investors to remove “all eggs” from
one basket.
• Facilitates raising new corporate cash – difficult to get outside investors to
provide capital because of voting control, therefore going public provides public
disclosure to investors.
• Establishes a value for the firm
• Facilitates merger negotiations
• Increases market potential – many companies feel it becomes easier to market
their products when they are public.

Disadvantages include:

• Cost of reporting – costs associated with reporting can be significant as well as

compliance costs.
• Disclosure – information may become available to competitors and/or individuals
who hold shares net worth becomes transparent.
• Self-dealings – becomes more difficult to justify “perks”.
• Inactive market/low price – creates illiquidity and therefore may not represent the
true value of the stock.
• Control – management can lose control of its decision making ability.
• Investor relations – keeping investors informed.

Underpricing Anomaly

Often times IPOs are underpriced. Underpricing reduces the risk to the

underwriter therefore they have strong incentive to do so. Also underpricing is a way for

the underwriter to reward institutional investors, who generate large commissions for the
investment bank, for past and future commissions. Issuing companies know this often

happens but often times it is acceptable to the issuing company because it creates a buzz

and excitement around the company during a run-up. They also often times have a large

portion of shares therefore personally benefit from a stock run-up so are less inclined to

oppose the underpricing. They also may view it as a way to ensure future success with

future offerings, which many companies intend on doing, by creating confidence in the

stock. The challenge for investment banks and issuing companies is to price the initial

offering low enough to generate excitement and interest but high enough to raise an

appropriate level of capital for the company.

Methods of Analysis

Expected Dividend Model – Argues that a company is only worth the amount of current

and future dividends it plans to distribute to investors. We didn't use this methodology

because JetBlue is a growth company therefore does not plan to pay out any stock

dividends. The issue with this methodology is that it assumes dividend returns are steady

and grow at a constant rate, which is rarely the case.

P0 = D1 / (r-g)

Discounted Cash Flows – is a valuation method used to estimate the attractiveness of an

investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow

projections and discounts them (most often using the weighted average cost of capital) to

arrive at a present value, which is used to evaluate the potential for investment. If the

value arrived at through DCF analysis is higher than the current cost of the investment,

the opportunity may be a good one. (Investopedia.com)

Free Cash Flow is the measure of financial performance calculated as operating cash flow

minus capital expenditures. Free cash flow (FCF) represents the cash that is actually

available for distribution to investors. FCF can be used for a variety of items including

paying interest to debtholders, repaying debt, paying dividends, repurchase stock or

reinvest it in the company (Brigham, Ehrhardt). FCF is calculated as: NOPAT – Net

investment in operating capital. The discounted cash flow model is calculated as

follows: DCF = CF1 / (1+r)1 + CF2 / (1+r)2 … CFn / (1+r)n

Market Multiples Analysis – compare market multiples of similar type and similar size

companies in order to benchmark or value your stock. The most common market

multiple is the P/E ratio which compares a company’s EPS to another companies P/E

Multiple. This multiple is calculated by taking dividing the companies price per share by

its earnings per share.

JetBlue Airways Case History

JetBlue was launched in July 1999, when David Neeleman announced he was

gong to bring “humanity back to air travel”. Neeleman was a former Southwest Airlines

employee with extensive expertise in the airline industry and created an executive team to

further involve this expertise, including John Owen from Southwest as well as David

Barger from Continental Airlines. The company is headquartered in Queens, NY and its

home airport is John F. Kennedy is New York. It currently flies to 54 destinations in 6

countries.

The airline started off by following Southwest’s approach of offering low-cost air

travel. However, Neeleman wanted to take it a step further, making travel of JetBlue and
highly enjoyable experience. The environment of the plane was improved by using new

airplanes furnished with leather seats and pre-assigned seating on all flights. Through an

acquisition of LiveTV in 2002, the company is able to provide each seat with 36 channels

of DirectTV. In 2004, 100 channels of XM satellite radio were added to each seat as well.

JetBlue is part of the Regional subset of the airlines industry. Its competitors

include Southwest, AirTran, Alaska Air, Express Jet, Frontier Airlines, Mesa Air Group

and Ryanair. For the purposes of this analysis, we will be using Southwest and AirTran

as comparables.

The Issue

There is a debate among the management at JetBlue about the appropriate pricing

of the IPO. The analysts reported that demand exceeded supply of shares and that the

market was eagerly waiting these stocks. Given this high demand, some thought that the

price should be increased to avoid leaving too much money on the table. However, others

were against the higher price. They believed that a more conservative stock price would

ensure that the deal is a success and that management would receive the funds that they

need to expand the business.

The task assigned to this team is to analyze the financials of the firm and its peers

to arrive at a recommendation for the IPO stock price that will maximize returns.

Financial Analysis

In order to provide the most accurate recommendation for JetBlue’s IPO stock

price, our team completed two types of analysis, a Discounted Cash Flows model (DCF)

and a market multiples analysis.

Discounted Cash Flows Model

In order to discount the future cash flows, it was necessary to calculate a weighted

average cost of capital. Since required information was not available in the case for

JetBlue, we decided to use the information for a comparable company, Southwest

Airlines.

A required rate of return of 10.50% by using Southwest’s beta of 1.1 and

multiplying that by the market risk premium of 5% provided in the text. This added to the

5% yield on 10-year Treasury stocks, also provided in the text, and gives a required rate

of return of 10.5%.

The total market value of equity was found by taking the total common shares

outstanding and multiplying by the current stock price as provided in the case.

Common Shares Outstanding (in millions) 776.80

Current Share Price $ 20.69
Total Market Value of Equity 16,072

The total market value of debt was found using the information provided in

Exhibit 6 from the case. All of the debt was discounted to arrive at a present value of

each type of debt. The total market value is a sum of all of the present values.
 Am ount
O utstanding Cou
$475.00
This information was combined to arrive at a total market value for debt and

equity of $17,920.77M. From this information, the capital structure for Southwest was

$200.00
calculated.

Using the cost of debt and equity already provided, we calculated a weighted

average cost of capital for Southwest Airlines as 9.96%. Since JetBlue is a younger

$614.00
company with more risk in regards to revenues and stability, we choose to increase this

figure to 11% before using in our valuation analysis.

$52.00
Southw est W AC C
$100.00
$100.00
T otal M arket Value
$100.00
T otal M arket Value
 The basis for finding the cash flows began with NOPAT, which was provided in

Exhibit 13 of the case. The NOPAT was adjusted by the change in net operating capital

from the previous to current year to obtain the free cash flow for the year. The present

value of each cash flow was received by discounting the value using the weighted

average cost of capital of 11%. The total of all of the cash flows is then divided by the

total number of shares to be outstanding after the issue to arrive at the recommended

offering price of $36.51. A chart illustrating the calculation is provided below.

2002 2003 2004 2005 2006 2007 2008 2009 2010

NO P AT 53 89 120 149 181 215 247 270 292
Net O perating Capital 63 94 126 157 191 227 261 285 308
LES S : Cha ng e in NO Ca p ita l 29 31 32 31 34 36 34 24 23
LES S : Ca p Ex 290 328 345 310 326 342 299 157 132

W ACC (e stim a te ) 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00%

Free Cas h Flow (266) (270) (257) (192) (179) (163) (86) 89 137
tim e period 1 2 3 4 5 6 7 8 9
P res ent V alue $ (239.64) $ (219.14) $ (187.92) $ (126.48) $ (106.23) $ (87.15) $ (41.42) $ 38.62 $ 53.56

Te rm in a l V a lue 2,035

Fu ture Co n sta n t G row th Ra te 4%

Total Present Value of CF $1,481.71

Value of debt
Shares (in millions) 40.58

DCF Model - Initial Price $ 36.51

Market Multiple Analysis

The first multiple we analyzed was the P/E multiple. This figure represents how

many times the current EPS are investors willing to pay for the stock. As mentioned

earlier, Southwest, Ryanair, WestJet and AirTran were used as industry comparables for

this analysis. For each firm, the current EPS for JetBlue provided in the case was

multiplied by the P/E ratio to arrive at an estimated stock price for JetBlue.
 EPS P/E JBLU $ Price

Jet Blue 1.14

Southwest 27.6 $ 31.46
Ryanair 44.00 $ 50.16
WestJet (in $US) 19.60 $ 22.34
Airtran 25.3 $ 28.84

Average for P/E Multiples $ 33.20

The second multiple that we analyzed was the EBIT multiple. This figure

represents how many times higher than the firm’s EBIT that investors are willing to pay

for the stock. For each firm, the current EBIT per share was multiplied by the EBIT

multiple to arrive at an estimated stock price for JetBlue.

EBIT/share EBIT JBLU $ Price

Multiple
Jet Blue 1.12
Southwest 18.60 $ 20.86
Ryanair 38.50 $ 43.18
WestJet (in $US) 12.70 $ 14.24
Airtran 13.00 $ 14.58

Average for EBIT Multiples $ 23.22

Recommendation

Upon completion of our analysis, we are recommending a stock price of $28 per

share. This is an average of the three stock prices found during our quantitative analysis.

Given this analysis, we believe that this price reflects the value of the firm at the time of

the offering and will give JetBlue the successful offering that it is looking for and raise

the funds needed to finance the further expansion of the company.

Future View: What Happened Next?

 The underwriters at Morgan Stanley set the final IPO stock price at $27 per share.

On April 12, 2002, the offering was issued to the market. It was considered the hottest

IPO to hit the market in two years and was considered a huge success. On the first day,

the stock rose as high as $48 dollars a share and settled for the day at $45 a share. This

resulted in a 67% increase in stock price. The company was able to raise $158.4M in

capital.

Many analysts believed that the firm couldn’t sustain the growth rate that they

were projecting. Some issues began to hit JetBlue. In October 2005, JetBlue announced

that quarterly profits had plunged from $8.1 million to $2.7 million due to rising fuel

costs and issues concerning their new fleet of Embraer 190 aircraft. In February 2006, the

company announced its first quarterly loss of $42.4 million. At this time, the executive

management team released a plan to turn the company around, entitled “Return to

Profitability”. By taking actions to lower costs and improve revenues, JetBlue was able to

announce a profit in the 4th quarter of 2006. They were one of only a few major airlines to

report a profit during that time. The stock is currently trading at $4.69 per share. The

chart below provides a comparison of the performance in JetBlue’s stock price with that

of its main competitor, Southwest Airlines.

Recommended Readings

For further reading in the area of Initial Public Offerings and their valuation, we

would like to suggest some articles that provide valuable information on these topics.

Sources:

Brighman, Ehrhardt 2007. Financial Management

Loughran, T. and Ritter, J.R. 2002. Why Don't Issuers Get Upset About Leaving Money
on the Table in IPOs? Review of Financial Studies, 15(2): 413-443.

Ellis, Michaely, O’Hara 1999. A Guide to the IPO, Cornell University

Investopedia.com